I have written an article for today’s Sunday Business Post on the economics of public sector pay cuts: you can read it here. Although Karl is correct in saying that public sector pay cannot be the sole factor in the fiscal adjustment, it is clearly the most contentious issue in terms of the range of views that are being expressed.
In my discussion at Monday’s conference (slides here), I raised the question of where Ireland’s tax burden was going to settle down once the public finances have been stabilized. The Addendum to the Stability Report published last week by the Department of Finance shows how the Gross Budget Balance can be brought back to a deficit of 2.5% by 2013 through an adjustment process in which the revenue share of GDP stays roughly stable so that almost all of the adjustment occurs on the Revenue side. The document itself does not comment on the composition of the adjustment described in this table, so perhaps this isn’t an actual plan but instead an illustrative example. Still, it’s worth starting with as a baseline for discussing where we are heading.
I noted on Monday that the plan projects a government revenue share of GDP of 34% in 2013 and that this is well below the equivalent share for EU15 countries, which has been stable at about 45% for a number of years. A number of observers at the conference questioned this calculation on the grounds that the calculation should be done relative to GNP. In particular, since GDP has been about 17% higher than GNP in recent years, one might want to adjust the tax share upwards by this amount. Doing so would give a figure for 2013 of about 41.5%. This is still a reasonable amount lower than the EU15 average but not nearly as much as the figures I quoted
However, I do not view this higher GNP-based figure as a useful one, for two reasons.
First, I believe that GDP rather than GNP should be viewed as the correct tax base when making calculations of this sort. GDP represents all the income generated in this country and, technically, all of it is available to be taxed by the Irish government at whatever rate it chooses. Of course, profit income generated by multinational corporations is likely to move elsewhere if we tax it at a sufficiently high rate but this is an issue faced by all governments, not just our own.
Second, if one is going to exclude the substantial factor income repatriated abroad (€28 billion in 2007) from the tax base it is not consistent to then include the taxes earned on this income in the measure of the tax burden. Assuming that the €28 billion figure represents corporate profits repatriated after paying the 12.5% corporate tax rate, one comes up with a figure of €4.1 billion in taxes paid by multinationals on repatriated profits. Excluding tax payments of this magnitude would give a 2013 (adjusted) tax share of GNP of 39%. So, even if one agreed with the idea of GNP as the tax base, an internally-consistent calculation of the Irish tax burden would still leave it well below the European average.
The broader and more important point here is that we need a wider debate about the shape of future fiscal adjustment than the one currently taking place, which focuses almost without exception on the need to reduce public sector pay.
We now have a full decade of evidence concerning the impact of European monetary union on Ireland and the other member countries. While my view is that the euro has been beneficial in many ways, the next year or two will be highly revealing about the capacity of member countries to undertake economic adjustment while operating within the constraints of a common currency area.
I gave my own view on the impact of the euro on Ireland in an article for the Sunday Business Post back in May: you can read it here.
I have also recently written a couple of academic survey papers on different dimensions of the euro:
“ EMU and Financial Integration,” IIIS Discussion Paper No. 272, December 2008. Prepared for the 5th Central Banking Conference of the European Central Bank.
“ The Macroeconomics of Financial Integration: A European Perspective,” IIIS Discussion Paper No. 265, October 2008. Prepared for the 5th Annual Research Conference of DG-ECFIN (European Commission).
The IMF has released a detailed study about the optimal design of fiscal policy to combat the crisis. A key feature of this report is that it accepts that the appropriate fiscal response varies across countries. In particular, this extract from an online interview with two of the report’s authors (Olivier Blanchard and Carlo Cottarelli) is relevant to the Irish situation:
Cottarelli: That said, it is critical that this fiscal stimulus isn’t seen by markets as undermining medium-term fiscal sustainability. That would be counterproductive, including in its effects on demand today. Indeed, we’ve said that not all countries can afford a fiscal expansion.
How the stimulus package is designed is also key: fiscal measures should be reversible, and governments may want to precommit to unwinding some of the policies. Also, any stimulus should be formulated within a robust medium-term fiscal framework, which could be made more credible by strengthening independent oversight of fiscal policy.
Is this analysis by Paul Krugman a sign of debates to come in Europe?
I don’t particularly like the political implications, but if states like Ireland can’t use fiscal policy at a time like this, then the case for fiscal centralisation for EMU members has just gotten a lot stronger, especially from a small country perspective.