Fiscal Assessment Report, November 2017

This is the thirteenth Fiscal Assessment Report of the Irish Fiscal Advisory Council. The report assesses the fiscal stance that the Government set out in Budget 2018. It also assesses the macroeconomic and fiscal forecasts, and monitors compliance with legislated fiscal rules.

Summary Assessment

The Council assesses the fiscal stance adopted by the Government in Budget 2018 for next year to be conducive to prudent economic and budgetary management. The Government increased expenditure at a faster pace than the initial limit permitted under the fiscal rules by introducing revenue-raising measures to fund these initiatives. This meant that the Government followed through on their plans to keep net spending and tax plans within the available gross fiscal space for 2018 of around €1.7 billion. The Department of Finance’s Summer Economic Statement 2017 set out that plan, while the Council’s Pre-Budget 2018 Statement recommended it be adhered to.

The Budget plans allow for a gradual pace of debt reduction; moderate increases in current expenditure; and a ramping up of public investment to rates that are among the highest in the EU, while also complying with the requirements of the fiscal rules. For the medium term (2019–2021), the general government balance is forecast to improve marginally in 2019, while projected over-compliance with the fiscal rules implies small budget surpluses in 2020 and 2021. With strong growth rates forecast and low effective interest rates on government debt, this should facilitate a steady pace of debt reduction from ratios that are still among the highest in the OECD (4th highest net-debt-to-GNI* and 5th highest net debt-to-revenue). The Council’s illustrative estimate of the cost of providing today’s level of public services over the forecast horizon to 2021 implies that the spending increases currently budgeted for in Budget 2018 over 2019–2021 would fully accommodate demographic pressures and the cost of maintaining real public services and benefits. By 2021, public investment is planned to rise to ratios that – across a number of measures – would be higher than that of EU peers.

Looking to the medium term, there is a risk that the economy may experience overheating should a rapid – albeit necessary – response from the construction sector to persistent supply shortfalls arise which is not offset by countercyclical measures elsewhere. While there is much uncertainty over the exact cyclical position of the Irish economy, it would appear that any remaining output gap is relatively small. There is a possibility that overheating would occur in the years ahead if growth were to continue at elevated levels, which could occur if there was a rapid response from the construction sector to persistent supply shortfalls. Improvements in the public finances in such circumstances might primarily reflect cyclical or transient developments. Temporary revenue inflows should be used to reduce debt at a faster pace or to build up buffers for future shocks.

There are also a number of downside risks visible over the medium-term horizon. Although a hard Brexit is the central scenario envisaged in Budget 2018, the impact of Brexit is highly uncertain, as is the timing of its economic effects. These effects could be more negative than currently forecast, particularly if the impact is front-loaded, which is not assumed in existing estimates. An additional risk is posed by potential future changes to tax arrangements among Ireland’s trading partners. There are also important domestic risks. The housing market and the highly concentrated production base are the most pertinent.

A further risk stems from the fact that measurements of the cycle underpinning the fiscal rules have a poor record of distinguishing between cyclical and sustainable developments. The methodology used to identify a “sustainable” pace of growth for spending in the fiscal rules (the EU Commonly Agreed Methodology) has a number of known shortcomings. Foremost among these is the issue of procyclicality. This shortcoming can mean that unsustainable improvements in the public finances that primarily reflect cyclical factors are inappropriately treated as permanent and structural changes.

The Government should set out a credible plan for the medium term. A lack of clarity means that the current medium-term budgetary plans could be undermined, particularly if a procyclical pattern of budgetary increases occurs as has often been the case. There are a number of solutions that could help to ensure the current plans are made credible:

  • make a firmer commitment to use the Expenditure Benchmark as an anchor for fiscal policy even when the Medium-Term Objective (MTO) is met;
  • strengthen the proposed design of the Rainy Day Fund. The Fund could serve as a useful countercyclical tool to ensure more sustainable growth and prudent management of the public finances. However, the current proposal is not adequate to achieve the necessary countercyclical effects and is small in size. Achieving these goals within the EU fiscal rules is a difficult challenge and remains to be fully addressed.
  • develop the Department’s toolkit for assessing the cyclical position of the economy beyond the EU’s Commonly Agreed Methodology; and
  • adhere to a target for public investment spending over the medium term. These measures should help to alleviate known measurement issues and prevent an excessively expansionary fiscal stance from being followed as in previous cyclical upswings. It would also allow the Government to reduce high debt levels at an appropriate pace and to build up buffers against future shocks.

It is unclear whether some of the revenue-raising measures included in Budget 2018 can be expected to have the same yield as is estimated for 2018 over the long run. For example, the expected yield from changes to stamp duty rates appears to be based on estimates made at a high point in the cycle of non-residential development and so the projected yield may prove to be relatively optimistic in terms of its long-run impact. In keeping with the spirit of the new budgetary framework, permanent expenditure increases should be funded by revenue-raising measures that can be considered sustainable over the long run.

The MTO for the public finances is expected to be achieved in 2018, based on forecasts contained in Budget 2018. The current MTO targets a structural deficit – that is, a budget deficit corrected for one-off items and the impact of the business cycle – of 0.5 per cent of GDP. While there have been breaches in required progress towards the MTO over 2016–2017, the expected change in the structural balance exactly meets this requirement for 2018. Budget 2018 forecasts suggest non-compliance with the spending rule (the Expenditure Benchmark) over a two-year assessment for 2017 and 2018, with forecast spending 0.1 per cent of GDP (€0.4 billion) in breach of the two-year average for these years. This second pillar of the fiscal rules is designed to ensure spending growth remains anchored to growth in medium-term potential output and revenue. Planned breaches of the Expenditure Benchmark should be avoided.

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