Category: Fiscal Policy

Both tax and spending need attention

Now that we all recognize the way in which the tax system has gone wrong and the need for adjustment so that it collects more revenue, it’s time to have a look at the balance between tax and spending adjustments needed to get back to the kind of reasonable budgetary structure that we had in the late 1990s.

To this end, I thought it would be useful to post charts showing total government expenditure and total government taxation as (i) % of GDP; (ii) Real terms.

I’ve used the latest NIE and the data in the October 2008 budget book, together with the ESRI’s latest GDP forecast. So this is all a little out of date.

Both charts reveal both the sudden collapse in taxation.

They also show the way in which real spending had a strong upward momentum which ran ahead of economic growth, especially as soon as this started to slow in 2007. (Some of this is the operation of automatic stabilizers, so important not to overcorrect.)

Pretty clear then that, if we’re to get back to the comfortable zone we were in in the late 1990s, it’s not just a tax adjustment that’s needed,  but also a reining in and rollback of spending.

Expansionary Fiscal Contraction

The February exchequer returns combined with ongoing default risk perceptions mean the government has little choice but to bring forward its fiscal adjustment.  I have doubts, however, about one argument for front-loading the adjustment that seems to be gaining currency – that it will be expansionary.  

The classic argument for an expansionary fiscal contraction focuses on cuts to government spending.  Permanent cuts in government spending lead to expectations of permanent cuts in taxes.   The expenditure effect of the latter can outweigh the former (especially if starting from a large and distorting tax burden).   In contrast, the current Irish debate is focused on adjustment through tax increases.   With apologies for oversimplifying, the argument seems to be that households and businesses already expect higher taxes, but uncertainty about the precise nature of those taxes is causing increased precautionary savings and investment delays.  Eliminating this uncertainty would lead to increased domestic demand.   

Two comments:  First, if the economy contains a significant share of myopic/liquidity-constrained individuals as well as forward-looking Ricardians, the reduced precautionary savings effect of the latter would have be very strong to offset the reduced spending of the former.  Second, and less speculatively, the empirical work of Alberto Alesina, Roberto Perotti and co-authors finds that fiscal adjustments based on tax increases tend to be less durable and more likely to be contractionary.

I draw two tentative lessons.   The first is that a cautious approach should be taken to front-loading until we understand better the role of discretionary fiscal contraction in the extremely sharp slowing of the economy.  The second is that a narrow intertemporal macro perspective suggests a significant part of any adjustment burden should fall on expenditure.   I would be very interested to hear views on the relevance of the expansionary fiscal contraction hypothesis to the current Irish situation.

No Room for Tax Increases?

During last night’s Prime Time, former Department of Finance official Cathal O’Loghlin made the following comments:

There’s a €16.5 billion gap to be filled by 2013 … If we go down the tax route to fill the whole of that, we’d be talking about a tax burden which is way above European levels … solving one-third of that problem by raising taxes would push our tax burden to the same levels as the Euro area average.

If true, these figures suggest that the room to use taxation to close our deficit is very limited and this should be a central issue in public debates about the fiscal crisis. However, I would not have characterised the tax burden in this way and thought I’d explain why. 

Continue reading “No Room for Tax Increases?”

Analysis of the Fiscal Problem

Read the article by Jim O’Leary in today’s Irish Times.

Fiscal Update

The February exchequer returns are available here; the statement also includes the announcement that further fiscal stabilisation measures will be announced later this month.

See also the Irish Times report.