Fiscal Assessment Report, May 2022

This is the Council’s twenty second Fiscal Assessment Report. The report assesses the fiscal stance that the Government set out in SPU 2022. It assesses the Government’s overall fiscal stance, its macroeconomic and fiscal forecasts, and its compliance with fiscal rules.

  1. Macro Assessment
  2. Budgetary Assessment
  3. Fiscal Stance
  4. Fiscal Rules

Boxes

Supporting Information sections

Summary Assessment

Macroeconomic assessment

The Irish economy has continued to grow strongly despite global challenges, including the Covid-19 pandemic and the ongoing Russian invasion of Ukraine. But higher inflation, driven by energy prices, has reduced expectations for real economic growth. Uncertainty is very high and this has reduced consumer and business confidence. However, high-frequency data on consumer spending, labour demand, and tax receipts have nonetheless remained robust in recent months. The economic recovery from the pandemic, while uneven, has been faster than anticipated in official projections.

Downside risks to the economy over the medium-term have increased. Higher inflation due either to further rises in energy and food prices or second-round increases of domestic wages and prices could cause additional challenges for growth. Risks of a global downturn and tighter financial conditions have increased. Ireland has a high reliance on foreign multinationals as a driver of earnings growth. Brexit could cause further disruptions to trade if there is an unwinding of the current protocol between the UK and the EU related to Northern Ireland.

The Stability Programme Update (SPU) 2022 only projects three years ahead. This is contrary to previous recommendations by the Council, and intentions expressed by the Department of Finance that it would lengthen the forecasting period to five years ahead. The Council believes that the parliamentary term should not affect the horizon of official macroeconomic and fiscal forecasts. Medium-term forecasting should always be undertaken to five years ahead.

Budgetary assessment

Government forecasts a deficit of 0.8 per cent of GNI* in 2022. The substantial narrowing of the deficit reflects strong revenue growth and lower one-off pandemic-related spending. The balance could ultimately be even more favourable than forecast in SPU 2022, with possible current and capital underspends and higher–than–forecast revenue likely, although further spending measures would tend to offset this.

Higher inflation means significant spending pressures exist. Were the Government to fully offset price pressures by increasing wages and benefits, this would imply a higher level of spending than that currently forecast in SPU 2022 both over the coming 18 months and further ahead.

Over the medium-term, the budget balance is set to reach a surplus in 2023 and to improve thereafter to reach a surplus of 2.7 per cent of GNI* by 2025. This assumes that the economy continues to grow at a steady pace over the medium-term and that the Government follows its spending rule introduced in Budget 2022 based on growing core spending in line with the underlying growth of the economy. To understand the trends in the public finances, we can compare the 2025 fiscal forecasts to 2019 to “look through” the Covid crisis. The substantial increase in public investment planned over this period is achieved while improving the budget balance due to strong growth of the economy, large corporation tax receipts, low interest costs and moderate increases in current spending, following the newly adopted spending rule.

Given low interest costs, strong growth and the improving general government balance, the government debt ratio is projected to fall significantly in the coming years. By 2025, gross general government debt is forecast to be just under 80 per cent of GNI* (from 106 per cent in 2021).

Immediate risks to the public finances stem from costs associated with the war in Ukraine and spending pressures from a higher inflation environment. Higher inflation could impact the public finances together with a slowdown in global growth and further measures to manage the higher cost of living. Of the €7 billion in contingencies for spending set out in Budget 2022, €2.5 billion remains unallocated. These may be spent on humanitarian assistance for Ukrainian refugees or further cost of living measures.

There are significant medium-term challenges.The assumed path of government expenditure under the spending rule would allow very little room if at all for new policies. This assumes full indexation were implemented so that existing policies are maintained in real terms, though such an approach requires caution in the current high-inflation environment. Demographic change, Sláintecare reforms, costs in transitioning to a low carbon economy and defence spending are likely to be significant. Meanwhile the public finances are forecast to remain heavily reliant on Corporation tax receipts.

Fiscal Stance

The Government plans to stick to its 5% Spending Rule as set out in Budget 2022. Core spending — excluding temporary supports, such as for Covid-19 — is set to be the same in cash terms as projected at Budget time last October. In effect, the rule is being followed such that the original allocations act as ceilings on the level of core spending.

Sticking to the spending rule should see the debt ratio fall at a steady pace. Ireland entered the pandemic with a debt ratio that was already high by international and historical standards. With revenues recovering faster than expected, and the economy rebounding, sticking to the spending plans would see the Government’s net debt ratio fall by about 4½ percentage points per annum on average over 2022 to 2025. Ireland’s debt ratio still remains high by international standards — the ninth highest in the OECD. Reducing the debt ratio in line with these plans is appropriate to help to build a buffer so that future shocks could be cushioned by budgetary supports in a similar way to the response during the pandemic.

The risks around the path for the public finances are unusually wide. Growth is highly uncertain with several downside risks, including from the war in Ukraine, Brexit, and the impact of price inflation on the domestic and global economy. In addition, further pressures to provide additional temporary fiscal supports are likely, given the sectoral impacts of both the pandemic and Russia’s war on Ukraine. The space for funding new current spending initiatives on a sustainable basis without tax increases or spending reductions elsewhere is very limited.

The Government has some scope to introduce additional temporary measures this year. Some €2.5 billion of the contingencies set out for 2022 remains unallocated. These may be used for supports for Ukrainian refugees and measures on the cost-of-living targeted at those on lower incomes and most severely affected by higher prices.

This year, the Government has some space to introduce spending increases and adjustments to wages and welfare rates to reflect unexpected inflation, but it will have to make some choices. The unexpected inflation in 2022 is likely to mean cuts in real terms to the value of welfare payments, public sector pay, and to various public services. This is due to increases set out in last October’s Budget not having anticipated the scale of wage and price rises. Allowing for full indexation — tracking price and wage rises with welfare and public sector pay rates — could require another €2 billion in core spending increases. If introduced in October’s Budget, along with other planned increases, this would push spending increases beyond both the SPU 2022 plans and the Government’s current ceiling. Recent underspends could create some additional space if these continue. Taken together, the Government may face difficult choices between maintaining the real value of public services and supports, sticking to its capital plans, increasing spending elsewhere, or raising additional revenues.

Over 2023 to 2025, the Government faces challenges addressing substantial price and wage pressures and achieving its medium-term policy objectives. The Government’s spending plans would allow it raise investment to record levels, provide sizeable temporary supports, and reduce the debt burden. Many of these increases are already committed to. However, the planned increases in current spending under the spending rule would not be sufficient to fully maintain existing supports and services in real terms or to allow for new spending initiatives. For later years, the shortfall is relatively small at about €0.5 billion per annum over 2023 to 2025 on average. Revenue-raising measures could be used to offset these additional costs or fund new spending measures. Alternatively, only partially tracking price and wage increases would create space for new projects. This approach would see spending increase without providing excessive stimulus to an already fast outlook for growth; it would help avoid the risk of second-round increases in prices and wages, potentially destabilising the economy and the public finances; and it would ensure the steady pace of debt reduction set out in the SPU.

Council assesses that the overall fiscal stance in SPU 2022 is conducive to prudent economic and budgetary management. The stance set out in the SPU strikes an appropriate balance between managing the impact of higher inflation, avoiding cyclical imbalances, and supporting fiscal sustainability, although there remain significant gaps in the Government’s short- and medium-term budgetary plans. This assessments rests on four elements:

First, the Government faces a delicate balancing act in protecting the economy and poorer households from higher energy and food prices, while avoiding adding to inflation through second-round effects. A combination of carefully-calibrated temporary and targeted supports and permanent social welfare, wage and spending increases could help to achieve this.

Second, the Government should reinforce its 5% Spending Rule. The rule is a welcome innovation that can help to set the public finances on a sustainable path. It is currently providing a useful signal about the balancing act the Government needs to achieve. However, it should be broadened to capture general government spending, have a link to debt targets, and recognise the impact of tax measures.

Third, , the over-reliance on corporation tax should be gradually unwound. Corporation tax receipts represent nearly one-in-every four euro of tax raised by the Exchequer, and the top-ten paying companies account for more than half of those receipts: up from a quarter in 2008. The Government does not currently have a strategy to reduce this over-reliance. The Council’s assessment is that (1) the Government should clearly show the impact of excess corporation tax receipts on the budget balance, and (2) the Government should take measures to reduce its reliance on corporation tax. This includes capping the amounts of revenue from this source that are spent or gradually reducing spending that is reliant on this source. This could be achieved by making contributions to the Rainy Day Fund or running debt down more quickly. The Exchequer has benefited significantly from corporation tax receipts in recent years that could be considered “excess” — beyond what is explained by the performance of the domestic economy. By using these excess receipts to fund ongoing expenditure, the Government has potentially opted not to set aside some €22 billion in a Rainy Day Fund or to reduce net debt by a substantial amount.

Fourth, major policy commitments need to be properly costed and factored into the Government’s plans. There are major medium-term challenges for which the Government has not set out credible plans. These pressures on public spending raise significant questions about how they will be accommodated within the Government’s spending rule alongside existing policies. This would imply reductions in planned spending elsewhere or higher taxes. Providing an assessment of the costs of meeting these objectives needs to be addressed urgently. The Government is required to halve Ireland’s greenhouse-gas emissions by 2030, but it has not factored in the full costs to the state of achieving this. Estimates from FitzGerald (2021) put the cost at an additional 1.7 to 2.3 per cent of GNI* on average over the years 2026 to 2030. The Government has also not costed its planned major healthcare reforms under “Sláintecare” beyond this year and there is no clarity on how much progress has been made to date in terms of the overall cost of the reforms. The Government has not responded to the Pensions Commission recommendations on how to address funding shortfalls in the pension system. Annual spending on pensions is set to rise by about 1½ to 2 per cent of GNI* by 2030 amid a rapidly ageing population. Despite these and other spending pressures, the Government has limited plans for raising new revenues to deal with potential costs.

Fiscal Rules

The general escape clause has been active since the Covid-19 pandemic began. This flexibility in the fiscal rules has allowed for an appropriate fiscal response to the pandemic in 2020 and 2021. In 2022, it has facilitated a humanitarian response to the war in Ukrainian along with the introduction of a range of measures to mitigate the cost-of-living shock on households and firms. The European Commission has decided that current conditions warrant an extension of the clause for 2023.

In 2022 and throughout the forecast period, Government plans look set to comply with the fiscal rules. While the exceptional circumstances clause applies, both the headline and structural deficits are in any case forecast to be below their respective limits of 3 per cent and 0.5 per cent of GDP this year and beyond to 2025. The balance is projected to turn positive in 2023.

The Government’s medium-term Departmental expenditure ceilings are made on the basis of unrealistic technical assumptions. There is a legal requirement to produce medium-term expenditure ceilings by Department, which would help to underpin the Government’s overall spending 5% rule and the focus on medium-term planning. These ceilings were not published at Budget time and they are based on unrealistic technical assumptions.

The current unexpected inflation highlights some issues with the design of spending rules. For 2022 and throughout the forecast period, the Government plans to stick to its 5% Spending Rule in levels. With spending for 2021 revised down, this would allow for a faster pace of growth in 2022 as the rule is based on the original allocations rather than outturns. This may help to accommodate price and wage pressures in the near-term if underspends are not fully unwound. Over the medium-term, higher inflation means that prioritising between maintaining the real value of service provision and other competing demands could be a challenge for policymakers.

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