Category: Fiscal Policy

A sane fiscal adjustment

Under the  Addendum to the Irish Stability Programme Update (January 2009), the deficit target for 2009 is 9.5 percent of GDP.    As a result of the February exchequer returns, it looks as if the actual deficit will be about 2.5 percent of GDP higher.   The government must now decide how to respond.

One approach would be to adjust taxes and spending to hit the original 2009 target.   As Jim O’Leary has pointed out, achieving a 2.5 percent reduction for 2009 based on changes that will be in effect for only a portion of the year would require an adjustment closer to 3.5 percent of GDP if in place over a full year (see here).   Since making permanent changes to taxes and spending part way through a year to hit a single year deficit target would be nothing short of ludicrous, I take it that the gap in question is indeed the 2.5 percent of a full year’s GDP.

In a comment on a previous post of mine, Patrick Honohan made the sensible suggestion that the government should target the structural (or cyclically adjusted) deficit.    It worthwhile to return to the Addendum and consider what level of adjustment would be consistent with the framework being applied in that document.  

Table 8 of the Addendum contains projections for the deficit, the cyclically adjusted deficit, real GDP growth, and the output gap (i.e. the gap between actual output and potential output as a percentage of potential output).    Assuming that the actual deficit as a percentage of GDP (Def) can be written as:  Def = Cyclically Adjusted Def + k(Output Gap), we can back out the value of k – -0.4 – being used in the projections.  The original deficit target for 2009 comprised of a cyclically adjusted deficit of 6.7 percent of GDP and a cyclical component equal to 2.8 percent of GDP (-0.4 times a negative potential output gap of 7.1 percent of potential GDP).  

A key issue is the appropriate adjustment for the recent cyclical deterioration of the economy.   In the Addendum, the projected growth rate for 2009 is -4.0 percent.    Recent official projections for the contraction of the economy this year have ranged from 6.0 to 6.5 percent.   Taking the lower bound, this requires an additional cyclical adjustment to the deficit target of 0.8 percent of GDP (approximately -0.4 times -2 percent of GDP).    (I assume here that the potential growth rate of the economy is unchanged and that the deterioration in the cyclically adjusted deficit is due to a larger than anticipated response of taxes to the bursting of the property bubble.)  This would lead to a modified target of 10.3 percent of GDP and require a full-year  adjustment of 1.7 percent of GDP (i.e.  2.5 – 0.8).   

While still very large (I’m inclined to think too large given the fragile state of demand), this is roughly half of the 3.5 percent of GDP adjustment apparently being contemplated. 

Fiscal Advice for the Irish Government

In today’s Irish Times, Patrick Honohan advises that the government focus on establishing a path towards a sustainable level of public spending and taxation, rather than chasing a particular overall deficit target for 2009: the article is here.

A European Rescue Plan: But Not for ‘Low Tax’ Economies

This report from Reuters reveals the thinking of some German lawmakers.

The Economist on Ireland

This week’s edition carries an analysis of the Irish economy: you can read it here.

“High fliers”

No doubt we all noticed this article in today’s Irish Independent. Aside from the issue of whether great universities require great academics or great beurocrats (and the intriguing question of how come, in this trawl for world class talent, the people chosen are so often Irish), one needs to ask what price Irish universities need to pay to get great academics, assuming that they want them.

Presumably that price is falling rapidly, for several reasons. First, a little bit of googling suffices to make it clear that the academic job market is collapsing in the United States. The contributors to this blog will all be familiar with this AEA site listing cancelled or suspended job searches, and there are many more indicators available out there. Second, the high Irish property prices which were used as an excuse for high salaries are also collapsing.

And then there is the bigger picture. The state just can’t afford to pay enormous salaries any more. Moreover, there are obvious political considerations that can’t be ignored. Given that people at the bottom are going to see their net income fall, the case for a cap on all wages paid for in whole or in part by the taxpayer is becoming increasingly compelling. Many posts ago, I suggested a cap of 200K, but that now seems much too generous. 150K should be enough for anyone, and if people want to chance their luck on the national or international market places, good luck to them.