AFTER THE TROIKA VERY TIGHT FISCAL DISCIPLINE WILL BE NECESSARY

AFTER THE TROIKA VERY TIGHT FISCAL DISCIPLINE WILL BE NECESSARY 

Anthony Foley, Dublin City University Business School

 

There is no “after the Troika” in the sense of a return to economic freedom, as seems to be generally understood by the phrase, even if, as is likely, we successfully exit our current financial support programme at the end 2013. There will be no “leap to freedom”.  The Troika is composed of the International Monetary Fund, the European Central Bank and the European Commission.  The Commission will exercise an enhanced supervisory and monitoring role on the Irish economy and economic policy as part of the EU response to the economic and public financial crisis and to implement the new fiscal rules. We will still be in an Excessive Deficit Procedure. The European Central Bank will have a substantially increased supervisory role on the Irish banking system as we move towards an integrated EU banking system, again as one of the EU responses to the financial crisis.  In addition, the IMF as a bank which is owed much money by Ireland will maintain a post-programme monitoring operation.  Our EU creditors will also keep a close eye on our ability to ultimately repay the bailout financial support.  While the type and intensity of the external oversight of our economic and banking affairs will be different, less detailed and less frequent, there will be tighter and tougher external supervision than operated before the economic crash.  We also have to comply with the Fiscal Responsibility Act which enshrines the public financial targets of the Fiscal Compact.  Also, if we expect to borrow from financial markets at low interest rates (which we will have to do to continually recycle the existing very large Government debt) we will have to meet financial market expectations. Overall, external monitoring, evaluation and supervision of our economy will continue after end 2013 when the bailout programme ends.

Economic Problems in the Past

It could reasonably be argued that continuing external monitoring is no bad thing, given our uninspiring record of economic management since our first leap to freedom in 1922.  Between 1926 and 1961 the population declined from 2.972 million to 2.818 million despite a very high birth rate.  Emigration cancelled the high natural increase.  Reflecting the weak demand for labour, emigration was high up to 1961.  Between 1951 and 1961 total net emigration was 400,000 persons. Emigration persisted at lower levels to 1986 (except for 1971-79) and took off again in 1986-91 when it was an average of 27,000 persons per year.  In recent years, emigration has resumed.

This is not our first public financial crisis. In 1981 and 1982 the annual exchequer deficit as a % of GNP was almost 16%, and that was without a banking crisis. Between 1983 and 1986 it was between 12% and 13%. In 1991 the general government debt was almost 96% of GDP.

We are not without our earlier financial crises, although nothing to match the scale of the current one.  There was PMPA, ICI and John Rusnak at Allfirst, and there was the DIRT issue.

Our long term performance in indigenous industrial development and innovation is also relatively weak.  Most of the good features of industrial performance are due to the inward multinational sector. This is the case even when the substantial improvement in indigenous performance over recent years is taken into account.  The number of indigenous high potential start-ups has increased. The export performance of indigenous firms improved greatly. But we are still very dependent on multinationals. For example, in 2011, multinationals provided 89% of Irish manufactured exports’ value, 99% of chemicals/pharmaceuticals exports, 96% of computer/electronics exports and 99% of medical devices exports.  If we look at indigenous manufactured exports we find food, drink and tobacco accounts for 60% of the total, and chemicals, computer/electronics and medical devices together account for 9.6%. The indigenous sector’s performance is better in international services and in other indicators such as foreign exchange earnings but the overall picture is one of a substantial dependence on inward FDI flows which are inward flows of industrial competences, entrepreneurial capability and technology and innovation.  So, let us not have too fond a retrospective view of our economic record and capability when we were “free”.

Where stands the Republic now?

 – we are very dependent on FDI and external industrial capabilities

 – we have unemployment of just under 14%

 – mortgage arrears amount to €142 million

 – salaries and wages have been cut

 – we have a high rate of emigration

 – public services have been reduced

 – we have huge public sector debt

Economic Strengths

That said, all is not pessimism.  The country does have substantial economic strengths and potential.  However, we have often, if not always, had potential.  The problem is turning it into “actual”.  Ireland is a world leader in attracting and retaining multinational enterprises.  We have 8 of the top 10 ICT corporations, 9 of the top 10 pharmaceutical companies, 3 of the top 5 games companies, 17 of the top 25 medical devices companies and more than 50% of the leading financial companies.  We are a world leader in the bloodstock industry and low cost airlines.  We have a good food processing industry.  We are ahead of most of our competitors in graduate output.  We have a young population. Our physical infrastructure is much improved.  We have a large influential diaspora.  We have free access to a 500 million consumer market.  We have lots of spare capacity. We have improved our cost competitiveness. We have, for now, a relatively stable political system.  As noted above, we have overcome large scale problems in the past.  And, despite the recent economic declines, we are reasonably rich by world standards.

Role of Public Finances

The public finances are an essential ingredient of building a prosperous economy in which all of the population can benefit from the prosperity.  Public expenditure provides the basic physical infrastructure without which growth will be curtailed. Public expenditure provides the education system which is essential for modern economic growth.  Public expenditure supports the research and innovation activity of the economy. Public expenditure supports industrial investment and enterprise performance. Public expenditure supports a wider concept of standard of living through the provision of health and other services.  Cohesion and equity is supported by transfer payments in the social security system.  Overall, most of us like the outputs that result from public expenditure.  Few would argue against smaller class sizes, better quipped schools, the latest IT  in the education system, very short or non-existent waiting times for health care, immediate access to medical consultants, better health promotion, cleaner streets, high quality parks, better social and health services for the aged and special needs groups and a more secure environment through increased numbers and better equipped Gardai.

The difficulty arises in that such services have to be paid for and payment is mainly through taxation.  Unfortunately, we are much less keen to pay the taxes than we are to receive the public services.  Doubly unfortunate is the fact that even if we are, in principle, willing to pay the required high taxes, such high tax rates will directly influence economic behaviour and economic growth.  For example, high VAT rates would encourage cross border shopping and the shadow economy.  High profits taxes would reduce the flow of inward FDI.  High income taxes would have a negative incentive effect.  High income taxes relative to other economies could encourage the exit of young, highly skilled mobile labour.

Fiscal Rules after the Bailout Programme

The Government will continue to be bound by fiscal rules of a budgetary and debt nature.  Part 2 of the Fiscal Responsibility Act identifies the following:

 – each year the budget is in balance or surplus, unless there are exceptional circumstances

 – the above condition is met if the annual structural balance is at the medium-term objective (agreed with the Commission and which is 0.5% of GDP)

  – or, if not currently met, is moving towards that level in accordance with agreed monitoring rules

 – if the debt to GDP ratio exceeds 60%, there should be a convergence towards the 60% target at the rate of one twentieth per year

 – where the debt/GDP ratio is well below 60%, a structural deficit of 1% will be acceptable.

Where these objectives are not being met and where the Commission issues a formal warning to the Government, the Government must lay before Dáil Éireann, a plan specifying what needs to be done to secure compliance with the budgetary rule.  This plan will specify the period of adjustment, annual targets, size and nature of revenue and expenditure measures and how these will relate to the different areas of Government. The plan has to be consistent with the rules of the Stability and Growth Pact. The rules are largely what were the original rules of the Stability and Growth pact (the general limit of borrowing of 3% of GDP is retained) but implementation of the rules is expected to be more active and more certain than under pre-fiscal treaty regime.

As can be seen, we will not operate a loose set of fiscal rules after the ending of the bailout programme.

The fiscal rules are concerned with borrowing and debt.  There is no constraint on increasing expenditure which is matched by sustainable increases in tax or other revenue.

Public Finances Facts and Figures

A brief overview of the public finances after 2013 is presented to see how we relate to the budgetary rules.

The 2014 budget will be agreed before the ending of the bailout programme.  It is a statement of where the public finances stand after the formal ending of the Troika deal. The future positions of the public finances depend on the rate of economic growth. A higher rate of growth increases tax revenues and reduces monetary amounts of borrowing and debt as a percentage of GDP.  Lower economic growth makes the attainment of targets more difficult. The government debt as a percentage of GDP will be 119.4% of GDP which is substantially in excess of 60%.  Regardless of the other fiscal rules, there will be a continuing need to reduce the debt to GDP ratio.  The general government deficit will be between 4.3% and 5.1%, depending on budget policy in October.  Both are above the target of below 3%.  The structural deficit in 2014 (allowing for measurement difficulties) will be 4.6% which is well above the fiscal rule level.

On current projections, 2015 will produce a deficit of below 3% which achieves one of the fiscal targets, the structural deficit will be reduced to 2.9% which is still above the medium term objective and the debt ratio will reduce to 115.5% which is consistent with the rate of reduction to get to 60%. 2015 will be the last budget requiring consolidation measures to achieve the target of less than 3% annual borrowing.  The main ongoing public financial target issues are reducing the structural deficit and reducing the debt ratio.  Growth in the economy will reduce the structural deficit and the debt ratio but if growth is much lower than expected additional specific consolidation measures will be needed.

In 2015 and 2016, there is no expectation of increased expenditure as the Government pursues the fiscal targets. Allowing for the full consolidation implementation in 2014 expenditure, including interest payments will be €69.1 billion. In 2016 this is expected to be €69.0 billion. This is made up of a substantial drop in the pay bill and an increase in interest payments with the other components largely unchanged. Allowing for price increases this will be a real drop in public expenditure.

The Government has produced long term fiscal and economic projections to 2019.  On the assumption of real annual GDP growth of between 2.3% and 3.5% and nominal annual growth of 3.8% to 4.8%, the debt/GDP ratio will drop below 100% in 2019 and the structural balance will be a surplus of 1.0% with an overall Government balance of a surplus of 0.8%.  The achievement of this is based on an (interest excluded) expenditure to GDP ratio decline from 31.7% to 28.4 % between 2016 and 2019.  This gives very little scope for increased levels of public services.  Between 2016 and 2019, nominal GDP is projected to increase by13.5%.  This implies an expenditure increase of only 1.6% before allowing for price increases.

While the infamous “consolidation” measures to achieve the below 3% borrowing requirement will end in 2015 on particular assumptions of economic growth, continued public expenditure restraint will be necessary to achieve the ongoing structural deficit and debt to GDP ratio targets. This is the case even with reasonably optimistic growth projections.

But, the above comments are based on a specific tax and other revenue yield.  Tax as a percentage of GDP is expected to be 31.5% in 2016 and this will drop to 30.9% in 2019.  Clearly, if the tax ratio was increased due to additional or higher existing taxes, a larger expenditure would be possible while still achieving the fiscal targets.

Tax as % of GDP

The normal international measure of tax burden in an economy is tax revenue as a percentage of GDP.  On this measure Ireland has by EU standards a relatively low tax burden which leads many to conclude that additional tax revenues are possible without stepping outside the fiscal management mainstream.  The debate about the accuracy of using GDP as a base in Ireland due to multinational outflows is well documented.  If we use GNP Ireland is slightly above the EU average and with an IFAC hybrid measure Ireland is just below the EU average. But even using GNP Ireland is well below Denmark, Sweden, Belgium, France, Finland Italy and Austria.

The above tax measure includes social security contributions which are relatively low in Ireland.  Excluding these, Ireland’s tax to GDP ratio is almost the same as the EU average.  Using GNP Ireland’s tax burden is the fourth highest in the EU.  Using the hybrid measure it is the 10th highest tax burden in the EU, ahead of countries such as France, Netherlands and Germany. (see O’Connor B., Department of Finance, The Structure of Ireland’s Tax System and Options for Growth Enhancing Reforms. 2013). The assertion, based on the Tax/GDP ratio, that Ireland is low tax economy is not as clear cut on more detailed analysis.

Conclusion

We are coming to the end of the severe fiscal consolidations needed to achieve the 3% borrowing target. Of course, this was made more difficult by the cost of the bank rescues. Some consolidation is required in 2014 and 2015. But even after 2013, external monitoring and direction of the economy will continue as we are expected to reach the other fiscal targets and as we follow the new fiscal rules. Even with optimistic economic growth there will be limited scope to increase public expenditure over the next several years unless it is financed by tax revenues in excess of that generated by current tax instruments and rates. Consideration of higher taxes should reflect the reality that the tax to GDP ratio which is internationally used is not an accurate benchmark of Ireland’s tax burden due to the GDP/GNP gap.  Overall, very tight fiscal discipline will be necessary.

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