Fiscal Assessment Report, November 2022

This is the Council’s main biannual report, the Fiscal Assessment Report.

The report assesses the Government’s Budget 2023 in terms of: the broad fiscal stance, the economic and budgetary forecasts, and Ireland’s compliance with fiscal rules.

Boxes

Supporting Information sections

Supporting information sections

You can read the Minister for Finance’s response to the report here

Response of the Minister for Finance to the Fiscal Assessment Report, November 2022

Summary Assessment

Macroeconomic assessment

Ireland’s economic growth has slowed considerably during 2022. The rapid economic recovery from the pandemic has been stunted by a surge in prices. Energy and food pressures have driven inflation, although higher costs have become more widespread. In cash terms, Irish activity continues to expand, but the rising cost of living has weakened real incomes.

The near-term outlook for the Irish economy has weakened, and Budget 2023 forecasts real GNI* growth of 0.4% in 2023. While the possibility of gas shortages this winter have abated, Ireland’s main trading partners could be on the verge of a recession. The labour market is exceptionally tight at present, but some recent high-frequency indicators show signs of softening. As digital sectors have been a key driver of growth in national income, job losses including those recently announced weaken prospects for the Irish economy going forward.

The medium-term macroeconomic outlook in Budget 2023 is difficult to assess, given the forecasts are only to three years ahead. This is contrary to previous commitments made by the Department of Finance to produce five-year-ahead forecasts. Shortening the forecasting horizon does not allow for a comprehensive analysis of the medium-term trajectory of the economy, economic imbalances, or the Government’s medium-term plans. This comes at a time when many medium-term pressures, such as those related to ageing and climate change, are deepening. The Government should return to medium-term forecasting on at least a five-year-ahead basis.

Downside risks to the outlook are mainly related to global factors, especially Russia’s war in Ukraine and its implications for energy and food prices. The Department of Finance forecasts real GNI* growth of about 3% in 2024 and 2025. The extent of the pass-through of higher prices to wages will play a key role in determining the persistence of high inflation, and the future path of monetary policy. Pressures around the supply of housing are an important domestic challenge. Nonetheless, imbalances within the economy are relatively minor, and balance sheets are strong overall for households and firms, meaning a less significant effect of higher interest rates on economic activity.

Budgetary assessment

Budget 2023 included estimates of excess corporation tax receipts — receipts in excess of what can be explained by the domestic economy — and presented the government balance adjusted for these excess receipts. The Council welcomes this development, which follows a suggestion made in the Council’s May 2022 Fiscal Assessment Report.

Excluding excess corporation tax receipts, the Government forecasts a deficit of 3.1% of GNI* for this year. The substantial narrowing of the deficit (from 5.1% in 2021) — even with cost-of-living measures, the defective concrete blocks scheme, and increases in public sector pay — reflects strong revenue growth (even when excluding excess corporation tax) and lower pandemic-related spending. The balance could ultimately be more favourable than forecast in Budget 2023, with revenue likely to outperform.

Budget 2023 introduced a package of around €11 billion of measures in nominal terms. This included €6.9 billion in permanent measures (€5.8 billion in spending, €1.1 billion in tax reductions). A further €3.9 billion in temporary measures were introduced aimed at helping households and businesses adjust to the rise in the cost of living.

For next year, Budget 2023 forecasts a corporation tax adjusted deficit of 1.4% of GNI*. This relies on further falls in temporary spending, as well as growth in revenue which is in part due to the current inflationary environment.

Budget 2023 projections show a budget surplus (excluding excess corporation tax) in later years of 1 2% of GNI* in 2025 based on continued compliance with the Government’s 5% spending rule. However, this spending would be insufficient to maintain the real value of existing services and benefits as ageing costs rise. ‘Stand-still’ estimates from the Council — which assume that spending grows in line with demographic and inflationary pressures — suggest that current spending in 2024 and 2025 would be insufficient to fully accommodate demographic and price pressures, by an average of €0.8 billion per year. This would imply that, to meet the Government’s Spending Rule, spending would need to be adjusted in real terms or relative to wages and there would be no space for additional spending measures without finding offsetting resources elsewhere.

The net debt ratio is forecast to be 73% of GNI* at the end of this year. This ratio is expected to fall to 58% of GNI* by 2025, on the back of large primary surpluses, relatively high inflation, and moderate growth. Despite rising interest rates, Ireland’s interest expenditure is expected to remain largely flat until at least 2025.

Fiscal Stance

Current economic conditions suggest a broadly neutral fiscal stance is appropriate, but this assessment could change and the Government should stand ready to act. The Irish economy is currently operating at a very high level of activity, but the outlook for growth has weakened. Presently, there is evidence of labour shortages and slight overheating in the Irish economy. However, a contraction in activity this winter seems likely as cost-of-living pressures weigh on the international and domestic outlook.

Ireland’s debt ratio remains high by international standards. At the end of 2021, the Government’s net debt ratio was 82% of GNI*. This put it as the tenth highest in the OECD. When compared to other small open economies, only three other OECD countries have larger debt burdens: Greece, Portugal and Belgium. A higher starting debt ratio tends to amplify the sustainability risks that can arise from recessions, slower growth or increases in borrowing costs. It can also reduce the scope to respond to future downturns with sizeable budgetary supports.

Budget 2023 struck an appropriate balance between supporting vulnerable households and avoiding adding to inflationary pressures. The Government has used a mix of permanent budgetary measures and a large package of temporary supports to help address the rise in the cost of living.

The Budget package focuses on social welfare and pay together with a large package of temporary supports. The temporary deviation from the 5% Spending Rule is relatively limited, with core spending rising by 6.8% instead for 2023. The Council assesses that the permanent spending increases in both years are likely to be sustainable. These increases do not compensate for inflation in full, but the gap for lower income households is more than made up for by substantial temporary supports. These measures help limit the impact of the sudden rise in the cost of living on businesses and households. While there is still scope for these measures to be better targeted, the impacts on inflation are limited by virtue of them being temporary in nature. This approach is welcome. It should also allow the Government to better target supports in subsequent years as the uncertainty around the path for inflation gradually lifts.

In 2024 and 2025, the Government is planning to return to core spending increases of 5% each year, in line with the Spending Rule. This approach implies a broadly sustainable pace of expenditure growth. It will lead to a structural surplus — even with excess corporation tax receipts adjusted for — and a steady pace of reduction in the debt ratio.

The Government needs to start planning further ahead. The Government’s forecasting horizon continues to be only three-years ahead, despite its commitment to a five-year-ahead horizon. By not lengthening its forecast horizon, sizeable medium-term challenges are not being recognised sufficiently in planning. The expected costs of ageing, climate change and other policy initiatives need to be costed and factored in properly. There is now a good window for Ireland to reduce its debt burden to safer levels, while the exposure to changes in interest rates or growth is relatively manageable. However, this window is likely to be short-lived.

The climate transition is likely to have a significant budgetary cost, while the Government’s decision to maintain the pension age at 66 will lead to materially higher taxes unless spending is cut elsewhere. The public finances are also relying on unpredictable excess corporation tax receipts from the multinational sector estimated at €9 billion this year. Proper medium-term planning is essential if the Government is to address these issues.

To support medium-term planning, the Government should reinforce its 5% Spending Rule and extend its use of the budget balance adjusted for excess corporation tax. The Government’s 5% Spending Rule, first developed in summer 2021, has proven to be a simple and reasonably effective anchor. It has helped to ensure more sustainable fiscal policy, while appropriately reframing fiscal policy in terms of the trade-offs involved. The Department of Finance has also opted to emphasise the budget balance excluding excess corporation tax receipts in Budget 2023, in line with the Council’s past recommendations. These initiatives help contribute to a more sustainable budgetary framework for Ireland, yet they still need development. The Spending Rule should be put on a legislative basis, net out tax changes, have a link to debt targets, and be broadened to capture general government spending. The adjusted budget balance should be used more prominently, including in monthly Exchequer releases.

The Government should also give more thought to how it plans to use the National Reserve Fund. The Fund was initially devised as a countercyclical tool — supporting the economy in recessions and taking heat out of booms — and then later as an emergency fund. It is now being used to ensure that permanent spending increases are not unsustainably funded by excess corporation tax receipts. The Government’s decision to allocate a cumulative €6 billion to it over 2022 and 2023 means that it could swiftly hit its €8 billion cap. Moreover, the motivation for the Fund is less clear-cut now that the Spending Rule and the excess corporation tax-adjusted budget balance are in place and working reasonably well. The Government should consider increasing the cap and potentially changing the purpose of the Fund, including the option of making it a new National Pension Reserve Fund. This could help to take the pressure off tax increases in future years as a means of bridging the funding shortfall for Ireland’s pension system that will develop.

Fiscal Rules

The fiscal rules remain effectively suspended. The “exceptional circumstances” and general escape clauses of the domestic and EU fiscal rules were activated at the start of the pandemic in 2020 and have remained in place into 2022. This allows countries to temporarily deviate from the requirements under both the domestic and EU fiscal rules in these years.

The rules are expected to be reactivated in 2024. The European Commission has announced that present conditions warrant the extension of the general escape clause through 2023. The Commission cited high uncertainty and downside risks in the context of the war in Ukraine, along with energy price increases and supply-chain disturbances, as contributing to this decision. It expects to deactivate the general escape clause in 2024.

Major revisions to how the EU fiscal rules work are being planned. The European Commission has put forward proposed changes to the EU fiscal rules. The changes would see the fiscal rules shift to a net spending rule with a debt anchor and away from a reliance on the structural balance. In addition, a more country-specific approach would be adopted. Countries with high debt ratios would have to act sooner to adjust down their debt paths, while countries with lower debt ratios would be granted more time. These changes would likely require Ireland to update domestic legislation governing how the fiscal rules operate at a national level.

The Government should publish on time its three-year ceilings for how much each department will spend. Ireland’s Medium-term Expenditure Framework is intended to help Ireland budget over a longer time period than governments have tended to in the past — promoting more forward-looking budgets rather than focusing solely on one year ahead. However, for the third year in a row, the Government has not published these ceilings as part of Budget-Day documentation. Instead, the ceilings have been relegated in terms of their importance and are being published very late in the year (usually late December) — well beyond the October requirement. The Government’s failure to publish these ceilings on Budget Day, and their lack of integration into the budgetary framework more generally, represents a backwards step in transparency and a weakness in the overall fiscal framework. The Government should publish realistic spending ceilings on Budget Day from here on out.

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