Category: Fiscal Policy

Stimulating Investment

A striking feature of the recent Quarterly National Accounts  was the dramatic fall in real investment: a 30.6 percent decline between 2007:Q4 and 2008:Q4.   The growth in real GDP over the same period was -7.5 percent.   Real investment contributed -7.3 percentage points (pp) to this change based on a standard decomposition with 2007:Q4 expenditure shares as weights.   [The contributions of the other components were: consumption (-2.0 pp); government spending (+0.1 pp); inventory investment (-1.8 pp); and net exports (+3.5 pp).]   It is worth noting that this dramatic fall in investment spending was not confined to building and construction.   In its recent Quarterly Bulletin, the Central Bank reports that overall real investment fell by 32.5 percent in 2008 (year-over-year), with building and construction investment down 35.3 percent, and machinery and equipment investment down 23.0 percent. 

Of course, investment is well known to be a volatile component of GDP.   Even so, the large decline raises concerns both because of its role in driving output below potential and also its influence on the medium-term growth path of that potential.  It is worthwhile to consider, then, what policies might be used to support private investment spending. 

One contributing factor to the decline is the contraction in the supply of credit.  Indeed, one of the central motivations for policy interventions to strengthen the balance sheets of the banks is to increase their willingness and capacity to lend.  The Central Bank’s recent Bulletin does report a modest tightening of reported credit standards between 2008:Q3 and 2008:Q4.  But the explanation for the tightening of standards is likely to lie at least as much in the problems with the balance sheets of the borrowers as with the banks.   Moreover, the deterioration in business net worth, profitability and cash flow are likely to have significantly curbed the demand for credit, explaining part of the decline in credit aggregates.

We thus need to look beyond banking policy to policy actions that might strengthen the financial condition of the non-financial business sector.   In considering possible policy actions, it is worth keeping in mind the well-supported finding from investment research that cash flow is strongly related to investment spending – particularly for smaller, less creditworthy businesses.   This is explained by various agency problems that make it hard to raise funds from financial intermediaries – problems that become more intense as the balance sheets of borrowers and the banks become weaker.    

These findings suggest the importance of examining policies that improve business cash flow.  Given the beating that business profitability has taken, cuts in corporate tax rates or investment-related tax breaks would be unlikely to have a strong stimulative effects.  However, one policy that would directly improve the cash flow (and after-tax profitability) of almost all businesses is a temporary cut in employer PRSI rates for all workers.   (Fine Gael has proposed a cut for new hires.  But this would have a very limited impact on the underlying cash flow position of businesses.)   It is hard to think of another single policy with more potential to ease the pressure on investment, production, and employment. 

Public Sector Pay Cuts

Speaking on today’s News at One, George Lee pointed to informal evidence from the Central Bank of average wage cuts in the private sector of 8%.  He then immediately noted that this raised the question of why there had been no wage cuts in the public sector.  (About 3.20 minutes in.)  George has a well-deserved reputation as an excellent economics reporter, perhaps the best of his kind on these islands, but this statement was unfair and unhelpful.   The pension levy is a wage cut.  It reduced the taxable income of public servants by an average of 7.5%, thus putting public sector workers exactly in line with the private sector figures that George is quoting.

As a public servant myself, I am conscious of the need to be careful when making statements about public sector pay.  However, the bottom line has to be this.  What is useful here is fair analysis of the full compensation package for public servants (including pension packages and the effect of levies) in comparison with the private sector—and the Irish economics profession has provided research of exactly this type.  What is not useful is analysis in which a pay cut is real if it happens in the private sector but not real if it happens in the public sector just because someone chooses to call it a levy.

I expect here that I will get a flood of comments linking the pension levy to the generosity of public sector pay packages.  But this would miss the point I’m making.  There is no link between this levy and public sector pensions.  The only real implication of the levy for public sector workers was to reduce their take-home pay.  Perhaps this step was needed (and perhaps more is needed) but let’s not pretend it didn’t happen.

The View from the Brokers

Davy, Goodbody and NCB have collaborated on this joint report on the Irish economy: you can download it here.

More on the Structural Deficit

It seems that the structural balance is going to be the primary target of fiscal consolidation in next week’s supplementary budget, thanks in part to the efforts of some of the contributors to this site, notably Philip Lane and Patrick Honohan. However, despite its obvious intellectual appeal, it is problamatical from an operational point of view: it is very difficult to estimate reliably. As a result, there is a fair amount of variation in current estimates of it for 2009, ranging from the lower bound of the ESRI’s 6-8% of GDP range to John McHale’s 9.6% in his post of March 30th.

Accordingly, all estimates of the structural deficit need to be treated with some caution. I think this is especially true of those that imply that a very small fraction of the prospective overall deficit for 2009 is cyclical in nature.

As any fiscal anorak will know, but perhaps not many normal readers, there are two main planks in the estimation of the cyclical (and hence the structural) element of the deficit: (i) the output gap and (ii) a measure of the sensitivity of the budget to the output gap. A word on each.

The output gap. The European Commission estimates that Ireland’s potential growth rate will be negative to the tune of 0.4% this year. This is surely a much lower figure than it is reasonable to use to represent the economy’s potential growth over the medium run. The ESRI’s latest estimate of the latter is 3%. Which one to use in calculating the output gap? If the former, it will mean a relatively small output gap and a correspondingly small estimate of the cyclical element of the deficit. Philip Lane has opted for this approach (see his post of March 26th). However, it can be argued that since the elimination of the structural deficit is properly regarded as a medium-term objective, it is the medium-term potential growth rate that should be used to estimate the output gap. The result is a bigger estimate of the output gap and a bigger cyclical component in the deficit.

The sensitivity measure. It has become commonplace to use 0.4 as the cyclical sensitivity co-efficient, implying that every 1% point change in the output gap changes the budget deficit by 0.4% of GDP through the operation of ‘automatic stabilisers’. The 0.4 is an OECD figure estimated on the basis of data for the 1980-2003 period. It is built up from a set of tax and spending elasticities with the overall tax elasticity computed as a weighted average of the elasticities of four different categories of tax, where the weights reflect the share of each in total tax receipts over the 1995-2004 period. An obvious point about this is that the composition of the 2008/09 tax take is different from that of this historical period.

A more important question is whether the elasticities so estimated accurately reflect the relationship between revenue and GDP in current circumstances. A case can be made for the proposition that the cyclical sensitivity of at least some categories of tax is higher than usual in the current recession. A very interesting comment from Niall on Patrick Honohan’s ‘Credit card sales’ post of March 31st sepaks to this point. He warns of a triple whammy undermining this year’s CT receipts, comprising (i) 2008 preliminary tax refunds; (ii) losses set back to 2007, and (iii) no preliminary receipts for 2009. In the OECD model, CT receipts are estimated to have an elasticity of 1.3. Does this chime with what’s happening out there?

To illustrate the difference that the above two points can make, consider the following arithmetic example. Assume a zero output gap in 2008, a volume decline of 8% in GDP and an overall budget deficit of 12 % of GDP in 2009. Now decompose that deficit into its cyclical and structural components using (i) a -0.4% potential growth rate and a sensitivity co-efficient of 0.4 and (ii) a 3% potential growth rate and sensitivity co-efficient of 0.5 (this being close to the OECD estimate of the EU average, by the way). In the first case, the cyclical/structural split is 3%/9%; in the second it is 5.5%/6.5%.

Taxpayer-Funded Car Scrappage

The retail motor trade is lobbying hard to get the government to introduce a car scrappage scheme, which would encourage people to scrap cars that are older than ten years and purchase new ones: See these pieces in yesterday’s Irish Times and the Morning Ireland interview with Alan Nolan, director of the Society of the Irish Motor Industry.

Willem Buiter discusses the plans of this sort that have been introduced in Germany, France, Italy and Spain.  He doesn’t like them—“This artificial shortening of the economic life of a car seems nuts.  It’s worse than getting paid to dig holes and fill them again.”  The case for these measures in Ireland is even weaker.  Unlike the countries listed above, we do not have car manufacturing, so this measure is largely aimed at helping a thin-margin wholesale and retail motor trade sector.

To be fair, Alan Nolan did put the case for the scrappage scheme articulately, arguing that the scheme would pay for itself by inducing new purchases and VAT revenue.  Economists, however, are always wary of claims about tax cuts and subsidies being self-financing.  In particular, schemes like this suffer from very serious “deadweight loss” problems: The government ends up subsidising lots of people who would be making the purchases anyway.

Mr. Nolan argued that since the scheme is limited to cars over 10 years old, the owners of these cars were unlikely to be in the market without this measure.  I think this could go either way.  Some people are happy to drive old cars but there is also the fact that old cars are far more likely to irretrievably break down, so their owners have no choice but to buy a new one (or take the bus …)

Beyond this small issue, there is an important general point that the government needs to be very wary of allocating increasingly scarce fiscal resources on this kind of special interest group subsidy.