Fiscal Policy for a Slowing Economy: the Irish Case

The Irish economy is clearly slowing down: the ESRI (the main local forecaster) now projects GNP growth of 2.9 percent for 2008. While this is quite respectable compared to most European countries, it represents a much more modest rate of expansion compared to the last decade. The primary source of the slowdown is the turnaround in the housing sector, with a significant decline in the number of houses under construction. An additional factor has been a decline in export performance, which is unsurprising in view of the rapid increase in Irish wage levels relative to labor costs in partner countries.

In relation to the fiscal implications of the slowdown, the Irish public finances are in generally good health: public debt (net of the assets held in the National Pensions Reserve Fund) is not much above 10 percent of GDP. However, the slowdown in the construction sector has a disproportionate impact on tax revenues. Taking the 2003-2006 period,  indirect taxes, income taxes and corporation taxes have all grown at rates that are roughly in line with nominal GDP growth. However, total tax revenue has grown 50 percent more quickly than GDP: this has been made possible by the extraordinary buoyancy in capital gains taxes and stamp duties: the former has grown by 344 percent since 2002, while the latter has grown by 219 percent.

The tax boom has enabled the government to undertake a major public investment programme without recourse to debt financing, while at the same time allowing very rapid growth in current spending items. A prolonged period of under-investment during the 1980s and early 1990s means that the level of public capital in Ireland is below its optimal level: accordingly, it is appropriate for public investment to grow more rapidly than overall output for a sustained period in order to close the gap between the existing and equilibrium levels of public capital. An efficient expansion in the public capital stock is also centrally important in restoring competitiveness in export markets.

With respect to current expenditure, the appropriate trend path is determined by socio-political priorities, one interpretation of the recent fiscal experience is that the high rate of expenditure growth in recent years reflects reversion to a long-term trend ratio of current spending to GDP. By this account, the extraordinary rate of output growth and the sharp reduction in debt interest payments in the late 1990s saw current expenditure plummet as a ratio to GDP and the subsequent acceleration in spending just reflects a catch-up phase. However, if the long-term ratio of current spending to GDP exceeds the current level, this requires that the tax burden also needs to increase as a share of GDP.

An alternative view is that the high rate of current spending growth in recent years reflects some combination of trend optimism (that high output growth rates might persist indefinitely), with pro-cyclical fiscal exuberance that was reinforced by the strong growth in tax revenues.

If tax rate increases are ruled out, growth in current spending has to be considerably restricted. Moreover, in tackling the competitiveness problem that is a contributor to the current slowdown, a reduction in the growth of the public sector payroll can relieve labour cost pressures in the private sector and facilitate a re-balancing of the economy towards the export sector.

For a more detailed exposition, see my paper “Fiscal Policy for a Slowing Economy” for the ESRI Budget Perspectives Conference.  The debate at this conference dwelled on the possibility of an increase in tax rates in order to allow a higher level of total public spending: such a move would reverse the prevailing political orthodoxy of the last twenty years.

3 Responses to "Fiscal Policy for a Slowing Economy: the Irish Case"

  1. BJ   November 2, 2007 at 12:20 pm

    The Irish case is indeed a remarkable one. Do you see a deep slump ahead following the construction boom or will past and present productivity increases provide a comfortable cushion?

  2. Guest   November 3, 2007 at 6:00 pm

    I expect a sharp growth slowdown once the real estate sector enters into a bust. Ditto for UK, Spain and a few other EU economies!

  3. Ulrich Fritsche
    Ulrich Fritsche   November 5, 2007 at 4:57 am

    This is indeed a very interesting case. I was in Irland for summer vacations and the signs for a necessary adjustment could not easily be overseen. And the argument is absolutely right — fiscal policy should be instrument to be considered since a labour cost adjustment has strong real side-effects in most economies (see also Carlin and Soskice). Maybe the case of Estonia could be of interest for Ireland as well: within the currency board, a stabilization fund was created (off budget), to sterilize the inflows (without breaking the currency board rules of no money-financed givernment debt).