In Irish Economy Note No. 11, Jim O’Leary writes on the external surveillance of Irish fiscal policy during the boom.
The Fine Gael “New Politics” document includes a number of proposals to re-shape the fiscal process.
In Government, Fine Gael will implement a Responsible Budgeting Initiative that will make the budgeting process much more transparent and give the Dáil a clear and meaningful role. In particular, it will allow both the Opposition and the wider public to examine in detail the key underlying financial assumptions on which Government is basing its actions before the budget is published.
Fine Gael will overhaul radically the entire budget process. We recognise that these new fiscal processes cannot by themselves buy international credibility or fiscal stability. However, we believe that a different budget process, such as we areproposing, might have limited the worst excesses of the last few years and will help avoid any recurrence.
• We will establish a Parliamentary Budget Office (PBO), supported by an Independent Advisory Council (IAC) to provide members generally, and the proposed Dáil Budget Committee in particular, with expert input and advice into:
o The underlying structural state of the public finances
o The desirable borrowing / savings target for Government in the Budget, taking into account the economic cycle and longer-term fiscal pressures;
o The long-term implications of specific spending and taxation policies, taking into account likely demographic and other social and economic changes;
o Opportunities for rationalisation and prioritisation of public spending; and
o Performance evaluation of spending programmes.
• We will overhaul the annual Government Budget Documentation to include:
o Presentation of high-level service delivery and outcome targets alongside proposed spending allocations for public services;
o Quantification of the cost of all major “tax expenditures” and “tax shelters”;
o Assessment of the Government’s financial and non-financial assets and its financial and contingent liabilities, including public sector pension liabilities, future liabilities under Public Private Partnerships and possible liabilities resulting from the National Asset Management Agency (NAMA).
• A new Parliamentary Budget Cycle will be established:
o September – Publication by the new Budget Office of its recommendation for the fiscal stance (borrowing target) in the Budget
o October – Government presentation to the Dáil of its Pre-Budget Outlook, including macro targets for spending, taxation and borrowing (saving) in the year ahead. The Government would have a “comply or explain” obligation with regard to the target set by the Budget Office.
o November – Government presentation to the Dáil of its draft Budget.
o March – Government presentation to the Dáil of a new Public Service Delivery Report, audited by the C&AG, showing compliance in the previous year with the levels of spending authorised by the Dáil, as well as a comparison of service delivery and outcome targets promised and actual
o March – Oireachtas Estimate Approval, following consideration of the Public Service Delivery Report.
o April, July, September, December – Government presentation to the Dáil of Quarterly Exchequer Reports (an expanded Exchequer Return), which would require the Minister to report on deviations from strategy and on the need for correction, at Departmental and macro-level
• Government will develop a new Medium Term Expenditure Framework which will
o Presentation of aggregate envelopes for expenditure and tax based on the appropriate fiscal stance, recognising the different constraints that should apply to:
Stable programme spending
o An explicit cabinet “rationalisation and prioritisation” mechanism to drive restructuring and to divide up the spending envelopes among broad departments and agencies. Cabinet would also retain a “strategic reserve” which could be applied to cross cutting activities and to Government priorities
o Within the broad allocations set by cabinet; units within Departments would be required to bid publicly for resources and offer a set of quantifiable service delivery and outcome commitments that they would deliver in return. New evaluation mechanisms within Departments would be established to judge whether commitments are being hit and to create an accountability framework.
On St Patrick’s Day, the European Commission issued its opinion on Ireland’s multi-year fiscal plan: you can download it here.
The Business&Finance website carries an interview with Brian Lenihan (conducted yesterday): you can read it here.
Around the world, there is renewed interest in estimating the macroeconomic impact of fiscal policy. This is notoriously difficult, in view of the myriad two-way interactions between fiscal policy decisions and the state of the economy. Economic research offers two general approaches: (a) simulations of macroeconomic models; and (b) estimating the impact of fiscal shocks on past data.
There are quite a number of factors to consider in such exercises:
- What is the exact nature of the fiscal policy? The macroeconomic impact will differ across different types of government spending and different types of tax policy – there is no unique fiscal multiplier.
- Is the fiscal stimulus temporary or permanent in nature? If it is the latter, the prospect of higher future taxes (in line with the permanent increase in spending) will act against the short-run stimulative effect of extra spending.
- Is the increase in spending to be financed by taxes (a balanced-budget fiscal expansion) or through an increase in debt?
- The interest rate channel. Under normal conditions, a fiscal expansion will induce a country with an independent monetary policy to raise the interest rate to offset inflationary pressures, limiting the impact on output. If the level of underemployed resources is high (as at present in many countries), the interest rate may not respond such that the power of fiscal policy is enhanced.
- Monetary union. Note that under normal conditions, this suggests that fiscal policy should be more powerful for a member of a monetary union, since the ECB interest rate will not be influenced by conditions in a small individual member country.
- Trade openness. The greater the share of imports in total demand, the smaller the boost to the domestic economy from a fiscal expansion. Moreover, a fiscal expansion will typically induce real appreciation (an increase in relative price of nontradables) that squeezes the tradables sector, such that the composition of activity changes. To the extent that a thriving tradables sector is fundamental for long-term productivity growth, this compositional effect is important.
- Sovereign risk. If a fiscal expansion raises investor concerns about debt sustainability, the increase in the sovereign risk premium may neuter the stimulative impact of a fiscal expansion. This is especially the case when the sovereign risk premium also raises borrowing costs for other entities, such as the domestic banks. In addition to higher borrowing costs, an increased risk profile also leaves an economy exposed to an inability to fund its debt and the consequences of such a ‘sudden stop’ in funding can be catastrophic, with the resolution typically involving a funding package by international institutions.
- Fiscal dynamics. The fiscal package in any one year has to be interpreted in the context of past fiscal positions and expected future fiscal positions. An economy with a structural deficit must cut spending and raise taxes at some point, such that the macroeconomic impact of fiscal tightening must be absorbed – the challenge is to time the fiscal adjustment to minimise the macroeconomic damage.
- Anticipation effects. The impact of fiscal policy on private-sector consumption and investment decisions does not wait until budget day – if a fiscal tightening is anticipated, many forward-looking decisions will already have taken into account the prospect of lower public spending and higher future taxes. Doubtless, the slowdown in consumption and investment in Ireland has in part been influenced by the prospect of major fiscal tightening over 2009-2014.
- Welfare analysis. Different types of fiscal policy will have a differential impact on the relative shares of private and public consumption and public and private investment. In addition, the levels of transfer payments and the structure of the tax system will also have significant effects on the distribution of incomes across the private sector. Such distributional concerns mean that there is no uniquely optimal fiscal policy, since individuals and interest groups will have different preferences across these dimensions.
As I have written about before, it is a matter of deep regret that Ireland should have to undertake fiscal tightening during a big recession. However, given the size of the structural deficit and the substantial funding risk, it is conditionally optimal to implement such an adjustment. The goal should be to design the fiscal adjustment such that there is a shift in the composition of spending and taxation in directions that will help the economy to recover as quickly as is feasible.
Finally, it would indeed be helpful if the Department of Finance produced a report that detailed its projections concerning the macroeconomic impact of the budget. The fiscal plan for 2010-2014 surely incorporates feedback effects between fiscal decisions and macroeconomic aggregates, but the estimates of these feedback effects have not been explicitly spelled out (as far as I know).
Extension: I forgot to make a few more points:
- One of the lessons from the bubble years, is that it is important to acknowledge uncertainty in making projections – the central forecast must be supplemented by analysis of downside and upside risks to any policy decision. To me, the main risk is the downside risk of Ireland facing a funding crisis.
- In assessing the impact of fiscal policy, it is important to work out the impact on future macroeconomic variables in addition to its short-run impact.
- Given the uncertainties, it is important that fiscal policy choices are robust to changes in specific modelling choices.