Reforming the Fiscal Process

The Fine Gael “New Politics” document includes a number of proposals to re-shape the fiscal process.

Some extracts:

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.

and

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
results achieved
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
include:
o Presentation of aggregate envelopes for expenditure and tax based on the appropriate fiscal stance, recognising the different constraints that should apply to:
Capital
Demand-led spending
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.

The Macroeconomic Impact of the Budget

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.

The Public Sector Pay Non-Deal

In the absence of reliable information on the details of the proposed deal, an overall evaluation is not feasible.  However, there are several key issues to consider in interpreting the deal that wasn’t.

At one level, it is remarkable that the broad parameters of the required fiscal adjustment seems to have been accepted on all sides,  such that there was a common overall objective. This should not be taken for granted and is a tribute to the social partnership process – it is possible to envisage ‘alternative universes’ in which the union movement adopted a more rigid attitude and failed to take into account the overall macroeconomic and budgetary situation. This also provides hope that a deal may be feasible in the future.

However, there are some fundamental problems with the union position.  The main point of resistance seems to be that the hourly rate of standard pay  (or pay per ‘unit of effort’) should not fall. Under this approach, beyond the savings from proposed changes to normal working hours that should lead to considerable savings in overtime payments, the balance of the required adjustment has to take the form of a reduction in aggregate work hours.  The decline in aggregate work hours can be achieved through some mix of unpaid leave (the focus of the plan for 2010), the continuation of the recruitment embargo and the various other schemes that have provided incentives for individual public sector workers to reduce the level of work hours.

On RTE radio today,  Mr Begg justified the use of ‘short time’ working by citing its prevalence in private sector adjustment in Ireland and elsewhere. However, there are some major differences. First, ‘short time’ working and partial capacity utilisation in the private sector is typically deployed in response to a decline in demand for the output of the industry or firm in question  – it makes no sense to continue a high level of production if there has been a substantial downward shift in demand, since over-supply will just drive down prices and/or reduce profitability.

In contrast, there is no such downward shift in demand for public services in Ireland (indeed, if anything, there is chronic under-supply of public services in many lines of activity). Accordingly, it is not appropriate to deploy ‘short time’ working as a general adjustment measure in the public sector.

Second, the level of public services can be better protected by achieving a decline in the hourly rate of pay – the more can be done in terms of a downwards shift in the pay rate, the more aggregate work hours can be delivered. In this way, in combination with extensive public sector reform, the prospects for transformation of the public sector would be enhanced by a decline in the pay level.

Another argument that has been applied in opposition to a pay cut in the public sector is that pay cuts are not so prevalent in the private sector.  However, many of the real and nominal rigidities that deter pay cuts in the private sector are the result of the highly-decentralised pay process in the private sector, leading to an inefficient response to macroeconomic shocks.  Indeed, that is a core rationale for activist monetary and fiscal policies – the decentralised market outcome leads to excessively high unemployment in response to adverse shocks.

These conditions do not hold in the public sector, especially under coordinated pay bargaining  – the union movement and the government should be able to internalise the overall macroeconomic environment and recognise that a pay cut can be the efficient response to negative macroeconomic developments and offer a superior outcome to the alternative of undesirable reductions in aggregate work hours.

Moreover, the distributional impact of pay cuts is more attractive than the alternative by allowing the maintenance of a higher level of public sector employment, rather than shifting the burden of adjustment onto those public sector workers whose contracts expire and those will be frustrated in their plans to pursue public sector careers by a recruitment embargo.

As I have repeatedly written about,  the necessity of downward wage flexiblity is essential for small member countries of a monetary union.  Negative macroeconomic shocks will often require a real devaluation in order to restore full employment:  inside a low-inflation monetary union, this can be achieved at lowest cost in terms of unemployment through a reduction in wage levels.  The idea that wages can only be adjusted upwards is not sustainable under EMU.

It is also important to appreciate that a resistance to wage cuts during the current crisis will also carry long-term costs for future pay settlements in the public sector.  In particular, a forward-looking government should be very reluctant to grant significant pay increases in the future if there is no ‘escape clause’ by which wage gains can be clawed back in the event of a large-scale negative shock.

Finally, the focus here on public sector pay should not deflect attention from wider policy issues.  In relation to attaining real devaluation,  a deal with the public sector unions that enables improved productivity in the public sector constitutes another source of a decline in the equilibrium real exchange rate.  In addition, the government can do much to foster wage reductions in industries in which it exerts considerable control. Similarly, it can go further in reducing fee levels in those professions that rely heavily on the public sector as a source of demand.  More broadly, tackling monopoly power across sheltered sectors of the economy will further help to engineer widespread reductions in prices and wages.

In relation to fiscal adjustment,  the public sector paybill represents only one dimension of the overall adjustment. Other spending categories face considerable cuts, while the tax/GNP ratio will have to rise considerably in the coming years.

The scale and multi-dimensional nature of the economic and fiscal crisis does call for a collective effort in its resolution.  As such, social partnership still has a lot to offer – however, an insistence on the ‘nominal fetish’ of no reductions in the rate of pay is not helpful.

Mis-Diagnosis

In my presentation to the DEW workshop yesterday and in several previous papers over the last two years  (my recent work on the Irish fiscal situation is gathered here, while you can look up my earlier list of papers here), I have tried to explain the reasons why the current Irish situation requires a fiscal response that is subtly different from the standard Keynesian prescription.  In general, my global view on fiscal policy would be very much in line with the IMF’s view during the current crisis (as explained here):  fiscal expansion should be pursued where it makes sense but “one size does not fit all” and some conditions call for a different fiscal approach.

Here are some of the key issues (but please read my actual papers if you want the more detailed versions of these arguments):

  • The current recession in Ireland is not just a demand slump.  The pre-crisis economy was highly distorted due to the construction boom and the debt-financed consumption boom.  The economy needs to be re-orientated towards the tradables sector and that requires real devaluation.
  • Outside the monetary union,  other countries are undertaking currency depreciation to achieve real devaluation.  The equivalent for Ireland is to reduce domestic wages and prices.  Since aggregate inflation is low in the euro area, a reduction in Ireland’s relative wage and price level requires nominal reductions.  While this is uncharted territory, real devaluation by this method should parallel the gains obtained by those countries that achieve the same outcome through nominal depreciation outside the currency union
  • Part of the distortion during the bubble was that pay rates in the public sector grew rapidly.  While this is understandable to some degree due to the very tight labour market at the time, the change in the labour market since then calls for a reduction in public sector pay rates. This is an important component of the overall real devaluation process.
  • If the government had run sufficiently large surpluses during the boom, the very large swing in the fiscal position in the last two years could have been tolerated without much corrective action.  I have repeatedly pointed to the example of countries such as Chile that successfully ran large enough surpluses during the boom.  I have been highlighting since my 1998 paper in the Economic and Social Review the dangers of such pro-cyclicality in fiscal policy.
  • A large proportion of the deficit is structural in nature:  the resumption of GDP growth in itself will not lead to a return to a sustainable fiscal position.  A combination of tax increases and spending cuts is needed to put the structural deficit on a course back towards balance.
  • Due to the ageing of the population,   public spending is set to increase sharply in the coming decades:  excessive accumulation of debt is not appropriate, given future spending needs.
  • Funding risk remains non-trivial for Ireland.  The sovereign debt spread remains substantial and it is an open question what would happen to the spread if the market’s re-assessed Ireland’s commitment to fiscal stabilisation.  The situation of the US and UK is quite different since the sovereigns in these countries ultimately control the currencies in which government debt is funded.

For such reasons,  I consider that those who advocate an ‘off the shelf’ Keynesian prescription (as advocated by Danny Blanchflower yesterday) do not have a correct diagnosis of Ireland’s current economic and fiscal situation.  The standard Keynesian prescription is appropriate if an economy on a sustainable growth path and with sustainable public finances has been temporarily knocked off course by a demand slump. For the reasons given above, this is not the situation in Ireland.

That said, I would not exaggerate the differences too much:  according to the ESRI’s latest projections,  Ireland is set for a general government deficit of 12.9 percent of GDP in 2009, which corresponds to 15.2 percent of GNP.  A fiscal package of €4 billion in 2010 would still leave the deficit at 12.8 percent of GDP in 2010  – it is not the case that the current strategy is seeking to ‘balance the books’ in the short term.

David Begg on Fiscal Policy and Deflation

In the Monday edition of the Irish Times, David Begg lays out his analysis: you can read it here. It is in line with the interpretation put forward by ICTU in its recent “There is Still a Better, Fairer Way” report.

Below I make some comments on specific points articulated in the article; I will return to the broader analysis in the near future.

Comment 1:  Mr Begg has persistently made the analogy to Japan, arguing that overly-aggressive fiscal retrenchment could “impart a severe deflationary shock to the economy which could precipitate a prolonged slump.”  As has been persistently pointed out,  this analagy is not appropriate:  Japanese-style deflation is not possible for an individual member of a monetary union, since declines in the price level are ultimately self-correcting through a competitiveness gain from cumulative real depreciation.

Comment 2:  Mr Begg suggests that a 50 percent tax rate on high earners (as has been announced in the UK) could be copied here.   Putting together the various levies on top of the statutory income tax rate means that a top rate of effective tax in excess of 50 percent already applies and kicks in at a relatively modest income level.  (See the graph in my note here.)

Comment 3:  Mr Begg notes that there may be €1.8 billion in outstanding uncollected taxes.  I am not familiar with the source of this number – I wonder how much of it may be explained by business enterprises that have failed (with little chance of recovery of the outstanding taxes), rather than by tax evaders.

An Bord Snip: Structural and Strategic Issues

In addition to the Department-by-Department blow-by-blow recommendations, An Bord Snip Nua has offered general comments and recommendations in Chapter 2 of its Volume 1. Among other things, it speaks about:

– Outsourcing and economies through shared ICT.
– Rationalization of Departmental structures and agencies including for the delivery of services at local level;
– Improvements in procedures for public procurement and property management.
– Value for money and performance appraisals.

I would welcome specific comments on these structural and strategic aspects in this thread.

An Bord Snip: Specific Savings

How about some specialized discussion on proposed cuts?

I haven’t yet counted the recommendations in Volume 2 of An Bord Snip’s report, but there is much detail on which specific expert comment would be valuable and could begin here.

Three-quarters of the potential savings identified by An Bord Snip nua are (unsurprisingly) in the three biggest spending areas: Health, Social Welfare and Education. I’m opening a separate thread for each of those three: keep this thread for the rest.

Please no general waffle on this thread please!

An Bord Snip: Education

I’m opening this strand to facilitate more specialized discussion on the cuts in Education proposed by An Bord Snip, which total €0.7 bn or 8% of the €9 billion currently spent in this area.

The proposed cuts include:

Structural efficiencies (e.g. amalgamation of some ITs and VECs).

Staffing reductions and productivity improvements
(e.g. in the area of sick leave arrangements, special needs assistants, pupil-teacher ratios, and more teaching hours)

Programme adjustments (mainstreaming of traveller education, costbrecovery of school transport, PRTLI)

An Bord Snip: Health

I’m opening this strand to facilitate more specialized discussion on the cuts in Health proposed by An Bord Snip, which total over €1.2 bn or 8% of the €15 billion currently spent through the HSE.

Cuts here include: staffing roll-back of over 6000; a tightening of the eligibility requirements for medical cards; increased co-payments for prescriptions and walk-ins to A&E; and some rationalization of agencies.

An Bord Snip: Social Welfare

I’m opening this strand to facilitate more specialized discussion on the cuts in Social Welfare proposed by An Bord Snip, which amount to €1.8 bn or 9% of the €18 billion currently spent in this area.

Among the proposed cuts are an overall roll-back in rates of 3% or 5% nominal; a 20% reduction in Child Benefit; and some changes in eligibility (double payments).

The Five Year Plan

Much of the post-budget analysis has focused on whether the correct balance between taxation and spending measures has been achieved. In fact, the 5 year plan leaves this quite open, at least in terms of the ultimate convergence towards the 3 percent budget target in 2013. This is because the plan leaves unallocated €4 billion in 2012 and €7 billion in 2013.

In the two charts below, I show the polar alternatives: in the first chart, all of the allocation is to higher taxes in 2012 and 2013; in the second chart, all the adjustment is to lower spending in 2012 and 2013. (Fiscal variables are expressed as ratios to GDP.)

The economic debate at the next general election may well focus on the relative merits of the two adjustment paths. [Of course, the likely outcome is an interior solution.]

Current Budget: Scenario A

Current Budget: Scenario B

Some Guiding Principles for the April 7th Fiscal Adjustment

Without attempting to be comprehensive, here are a few principles that are worth considering in designing the April 7th fiscal package:

1.  The size of the multiplier.   The current empirical literature on fiscal policy throws up a lot of estimates. Some considerations:

(a)  Anticipated fiscal policy versus unanticipated fiscal policy.  For a few months, Irish taxpayers have been living with a firm expectation that taxes are set to increase, albeit with considerable uncertainty about the allocation of the tax increases.  The sharp fall in consumption that has occurred has many sources but expectations of future tax increases is one reason. Accordingly, the extra impact on aggregate demand of raising taxes on April 7th will be less than in the case of an ‘unanticipated’ fiscal shock (the bad news has already been digested to some degree).

(b) The composition of spending cuts and tax increases.  The short-run and long-run impact on the economy varies across the different spending and tax components:  the aggregate multiplier effect depends closely on the precise details of the package.

(c) A positive slope for expenditure taxes.  While it is certainly important that extra taxes are collected in 2009, it is also important to be as specific as possible about the tax schedules that will be in place in 2010 (and beyond). In particular,  2009 expenditure tax rates that are credibly below 2010 expenditure tax rates will be supportive of aggregate demand in 2009 (forward shifting of expenditure plans to 2009).

2.  The fiscal target.

(a) In line with the suggestion of Patrick Honohan, the key fiscal objective should be to reduce the structural deficit within a reasonable time period. While there is uncertainty about the precise size of the structural deficit, it is sensible to take the 9.4 percent of GDP estimate that is adopted by the European Commission. Pushing the structural deficit towards zero over a 3-4 year period should be the guiding principle.

(b) If the correction of the structural deficit is accepted as credible, then some passive fluctuation in the overall general government balance can be tolerated, in line with cyclical developments in the economy. Otherwise, if the government simply targets the overall balance, it faces the problem that further unexpected cyclical bad news will either force it to pursue more within-the-year adjustment or miss its announced target.

(c) In communicating its strategy to fellow European governments and the European Commission, this technocratic distinction between structural and cyclical components must be ‘front and centre.’  The good news is that the  set up of the Stability and Growth Pact and the monitoring conducted by the European Commission takes such distinctions very seriously and the ‘framing’ of the analysis in this way would be a very natural communications strategy in this context.

3.  Front Loading.  In an ideal world, it is better to make structural reforms during good times. It would also be better if Ireland had entered the crisis with a sufficiently large budget surplus that a large budget swing could be happily tolerated, with fiscal correction deferred until the recovery takes.  However, there are domesic and international factors that support making substantial inroads in the structural deficit in 2009:

(a) Funding Risk.  While there are arguments that can be made that Irish bond spreads are an over-reaction to the fiscal/banking situation, we have to live with the judgement of the bond market. Moreover, the risk of ‘contagion’ from possible problems in Central and Eastern Europe should be acknowledged.  While such risks are hard to quantify, the high costs of funding crises justify prudential action to mitigate these risks.

(b) Signalling.  While the government has implemented some degree of fiscal tightening since Summer 2008, a central source of scepticism in the international markets is whether Ireland can make the switch from a long period of easy fiscal conditions to substantial fiscal retrenchment. The most credible way to demonstrate this capacity is to implement tough decisions.

(c) Domestic Political Economy.  By now, the level of awareness of the fiscal problem is much higher among the electorate than was the case in Summer 2008. It is timely to make a significant step forward in the process of restoring fiscal stability.

4.  Commitments about the Future.

(a) The tradition in Ireland has been to focus on an annual time frame for budgetary policy.  It would greatly help if the April 7th package could include credible commitments about taxes and spending plans in 2010 and beyond.  To be credible,  the announced tax increases and spending cuts for 2010 and beyond should be as detailed as possible, in order to minimise ambiguity. Moreover, the more credible is the ‘2010 and beyond’ element in the adjustment programme, the smaller needs be the initial fiscal adjustment in 2009.

(b) It is here that the opposition parties have an important role to play, since the period of fiscal retrenchment will likely extend beyond the next general election (whenever that is called).  It would greatly calm the markets if the opposition parties could be clear about which elements of the spending/tax package would not be overturned if the composition of the government changed.  The historical example is the promise by ‘New Labour’ before the 1997 election to maintain the fiscal parameters of the outgoing Conservative government for it first few years in office.

(c) Credibility about future fiscal plans could be boosted by institutional reforms that would make it more difficult for the government to deviate from its fiscal commitments.