Fiscal Assessment Report, November 2018

This is the fifteenth Fiscal Assessment Report of the Irish Fiscal Advisory Council. The report assesses the fiscal stance that the Government set out in Budget 2019. It also assesses the macroeconomic and fiscal forecasts, and monitors compliance with the fiscal rules.

Summary Assessment

The Council assesses that the pick-up in growth since about five years ago has been driven by a cyclical recovery in demand. The economy now looks to be operating close to potential in 2018, meaning that capacity and price pressures could begin to emerge.

While the short-term outlook for the Irish economy remains strong, a slowdown in coming years is inevitable. The Department of Finance’s preferred estimates of the output gap indicate that the economy will be just above its potential in 2019 and growth is expected to exceed its potential in the next few years. Significant overheating pressures could build up if a faster-than-expected pick-up in housing construction materialises. On the other hand, Brexit may prove to be more costly than assumed. Other risks are posed by the concentration of Ireland’s exporting sector in a handful of specialised areas, the global rise in protectionism, and possible future changes in the international tax environment.

The large government deficit that emerged in 2008 was brought close to balance in 2017. The turnaround was achieved through substantial efforts to reduce spending and raise revenues in the period 2009 to 2015, coupled with a number of favourable factors: a stronger-than-expected cyclical recovery, low interest rates, and surging corporation tax receipts. After a slowdown in improvements, the remaining deficit is expected to be closed in 2019.

Underlying improvements in the budget balance have stalled since 2015, despite the favourable environment. There has been no improvement in the budget balance excluding interest costs since 2015: non-interest spending has been increased at essentially the same pace as government revenues. As much of the improvement in revenues may be cyclical or temporary, this suggests that the structural position has deteriorated. This is a worrying pattern as it means opportunities to strengthen the budget balance during the upswing in the cycle are being missed.

A prudent fiscal policy would see net policy spending rise in line with sustainable revenues. The Irish debt burden is still among the highest in the OECD. Various stress scenarios considered in this report highlight how quickly the debt ratio could deteriorate under plausible scenarios. Given the fragility of the debt burden, strong cyclical growth, the risk of overheating in later years, and surging corporation tax receipts, there is no case for additional stimulus at this stage. The budget should be kept in balance in structural terms to ensure that debt ratios are on a steady downward path.

For 2018, the Government decided to increase spending by a further €1.1 billion beyond what was originally envisaged just four months earlier, largely due to health overruns. When compared to plans laid out in the Stability Programme Update 2018 and the Summer Economic Statement 2018, the Government increased spending by a further €1.1 billion in 2018, €0.7 billion of which was attributable to the Health area. These overruns are likely to be long-lasting spending items. This increase is not consistent with prudent budgetary management.

For 2019, the government has set out a level of government spending €2.3 billion above what was outlined in previous plans. The additional measures introduced on budget day imply a total package of tax and spending measures equivalent to €1.1 billion (€0.3 billion more than had been planned for the budget day package). When added to the within-year increases for 2018, this means a level of government spending €2.3 billion above what was set out in SPU 2018. While higher-than-planned tax increases will help to fund new spending, these cover only a part of the additional commitments. There are risks that further slippages will occur in 2019 should health spending overruns occur again, and provision should be made for the Christmas bonus.

Taken together, the Budget 2019 plans are not conducive to prudent economic and budgetary management. The plans imply a government spending increase (net of tax measures) of €4.5 billion in 2019 compared to what was planned for 2018. This is a substantial increase and it goes beyond the limit of €3½ billion for spending increases or tax cuts for 2019 that the Council had assessed as appropriate prior to the budget on the basis of sustainable growth rates. The larger increase mainly reflects the fact that the budget plans for 2019 are built on the imprudent increase in spending in 2018. The overall increases also go beyond the Government’s own plans set out prior to the budget. With the now-higher base for 2018, the underlying increase in total expenditure (net of tax measures) from 2018 to 2019 is currently €1.4 billion beyond plans set out in SPU 2018. The Council estimates that a general government surplus would have been achieved much earlier had the unplanned, within-year spending drift not occurred in each of the years 2015–2017.

Repeated failures to prevent unbudgeted spending increases have left the public finances more exposed to adverse shocks, with the budget balance in deficit rather than in surplus. Failures to prevent unplanned spending increases has meant long-lasting increases in spending that are difficult to reverse and that represent a repeat of the policy mistakes of the past. Instead, pressures in the health sector and elsewhere should be funded through sustainable tax revenues or decreases in spending categories elsewhere. Measures to increase taxes to support further spending are a welcome aspect of the budget as they allow for additional spending increases that are funded sustainably. However, the spending pressures that were accommodated in recent budgetary decisions are only partly offset by discretionary revenue measures being approximately €1 billion higher than originally set out.

The Department of Finance has made substantial progress on macroeconomic forecasting. The Department has developed and published its own estimates of the supply-side of the economy, which means that better measures of medium-term economic growth and of the underlying state of the domestic Irish economy are being used to inform policy.

However, the medium-term budgetary plans are not credible, and previous medium-term objectives have been effectively dropped. The current intention to run budget surpluses for the foreseeable future if conditions allow is vague. Previous commitments to outperform the requirements of the EU fiscal rules and to reduce debt to 55 per cent of GDP over the medium term—itself an insufficiently ambitious target and with no clear timing—are no longer referenced. The Government’s system of three-year budget ceilings is not working, with repeated, procyclical, upward revisions to ceilings taking place. Medium-term spending forecasts are based on technical assumptions that look unrealistic. The Council welcomes the introduction of the rainy day fund (the “National Surplus (Exceptional Contingencies) Reserve Fund”). Though it is potentially useful, the current design is insufficient to offset faster-than-prudent growth rates allowed under the spending rule as applied. Annual allocations to the Fund have been lowered from previously planned amounts, despite a surge in corporation tax receipts.

The Department of Finance’s own estimates suggest that Government plans will breach the fiscal rules for 2018 and 2019. The Medium-Term Objective (MTO) of a structural deficit of no more than 0.5 per cent of GDP is forecast to not be met in 2018 based on the Department’s own estimates. The estimated deterioration in the structural balance—based on the commonly agreed methodology—largely reflects changes to the estimated output gap that may be misleading. The MTO requirement is not forecast to be met in 2019 either, with an estimated structural deficit of 0.7 per cent of GDP. Net expenditure growth is expected to be within with the Expenditure Benchmark limits for 2018 and 2019. However, there are risks of slippage in 2019, which could worsen any breach of the MTO. For example, if Department of Health overruns or unbudgeted-for welfare increases were to be repeated.
The Council recommends at least meeting the Expenditure Benchmark based on the Department’s alternative estimates of potential output and the output gap. As a minimum standard, this would help to ensure that spending growth is in line with sustainable and prudent budget management. The Council also assesses that an appropriate debt commitment would be helpful, taking into account sustainability concerns. The commitment should be well specified. It should be time limited with a specific date by which the objective should be achieved and it should be clearly specified whether the commitment would be a target or a ceiling.

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