Key Messages
The economy is recovering swiftly as vaccinations progress and as individuals adapt to new circumstances. The likely unwinding of the huge savings accumulated by Irish households during the pandemic—a quarter of their disposable income in 2020—would represent a significant boost to economic activity in the coming months. Combined with a larger budgetary expansion now planned, this should mean a faster bounce back that could help to limit the long-term loss of output that will follow the pandemic. However, jobs are likely to recover more slowly than spending in the economy and the ultimate impacts of the pandemic are uncertain. While there are upside risks in the short to medium term, over the longer term it is likely, as was the case prior to the pandemic, that the ageing of the workforce and the convergence of Irish productivity to advanced economy norms would tend to slow growth.
The Government’s Summer Economic Statement (SES) published in July sets out a medium-term budgetary plan to 2025 as promised in the Programme for Government. The plan marks an important shift towards an expansionary fiscal policy. The SES includes a more realistic path for spending, but it also foresees higher capital investment and some tax cuts. The Council welcomes the move to more realistic forecasts, though key details of the fiscal plan are still lacking.
However, the SES’ macroeconomic projections for the Irish economy are not fully updated and are not consistent with the Government’s fiscal plans. The Government revised up its projections for GDP but left domestic economic activity unchanged. This partial update did not fully reflect the faster-than-expected recovery in recent months, nor the much larger budgetary expansion now planned for over the coming years. These factors reduce the risk of a more protracted recovery, yet the official projections still assume a high degree of “scarring” (permanent loss of output) compared to international forecasts for other countries. This raises significant issues about the consistency between the macro projections and fiscal plans. All government fiscal plans should be based on coherent projections for both the economy and public finances.
This report develops a “Recovery Scenario” for the economy so that an assessment can be made of the fiscal stance over the medium term. The Recovery Scenario takes on board the better starting point and also reflects a less pessimistic view of longer-term scarring. Overall, the scenario presents a more positive view of the most likely path for the economy in the coming years. The scenario shows domestic activity expected to recover to just 1.5 per cent below its pre-pandemic trend by 2025. By contrast, the latest official Government projections are consistent with scarring of about 5 per cent in 2025. Growth over the medium term in the Recovery Scenario is projected to be around 3½ per cent per annum on average, supported by the fiscal stimulus, but there is a wide range of uncertainty.
Ireland entered the Covid crisis with a government debt ratio that was already high, and the costs of responding to the pandemic have been large. Before the Covid-19 pandemic, Ireland’s budget deficit had narrowed over many years, finally reaching a small surplus in 2018 and 2019. This was helped by surges in corporation tax receipts, with overall receipts having risen to 21 per cent of Exchequer taxes in 2020 compared to a long-run average of about 13.5 per cent (1998–2015). In addition, interest costs have been repeatedly revised down as interest rates have fallen. This helped the public finances absorb the impact of the pandemic. However, at the end of 2020, the Government’s net debt ratio stood at 90 per cent of GNI*.
This year, the Government expects to run a large deficit again, amounting to about €20.3 billion (9.4 per cent of GNI*). This follows a deficit of €18.8 billion (9 per cent of GNI*) in 2020 — a marked deterioration in the fiscal balance compared to 2019 largely driven by €14 billion of policy measures and mainly for income and health supports. The pandemic’s prolonged impacts and the extension of supports introduced to cushion its effects will lead to a second year of an exceptionally large deficit.
With taxes outperforming expectations this year and the recovery gaining momentum, the deficit for 2021 is likely to be smaller than projected by the Government. Income taxes have recovered to above their pre-crisis trend levels, while VAT and corporation tax have also performed well thus far in 2021. The number of claimants of Pandemic Unemployment Payments also appears to be coming in lower than had been assumed. The Recovery Scenario would suggest that a deficit of closer to 7 per cent of GNI* might be possible this year (compared to 9.4 per cent of GNI* in SES).
The Government’s response to the crisis, in terms of providing sizeable temporary supports funded by large deficits and substantial increases in government debt, has been appropriate. Indeed, previous analysis by the Council suggests the supports may have halved the contraction in real GNI* in 2020. They also reflect an appropriate decision to support the economy through a downturn — a rare and welcome example of countercyclical fiscal policy that the State has been largely unable to follow in the past. The fiscal costs associated with Covid-19 could remain significant in the months ahead, but they are prudent and necessary to avoid lengthening and deepening the economic crisis.
However, the Government also introduced large unfunded permanent increases in spending in Budget 2021—outside of costs associated with the pandemic—that were not prudent. These increases amounted to at least €5.4 billion were reflected in large increases in public sector staff numbers and they were set out without long-term funding to offset them. The increases could be as high as €8 billion once non-Exchequer spending is considered. There continues to be little transparency around non-Exchequer areas of spending, which the SPU and the SES have not addressed. The Government should shift from its traditional focus on Exchequer data to a more harmonised general government presentation in line with Eurostat standards.
For 2022, the Council assesses that some of the temporary and targeted income and job supports may need to continue. These ongoing supports may be necessary for certain sectors to alleviate the impacts of the pandemic. If the economy continues to recover strongly, as the Council anticipates, a large-scale, untargeted stimulus would not be needed and support measures can gradually be withdrawn and made more targeted as conditions allow.
In terms of permanent measures, Budget 2022 plans look to be at the limit of what is prudent. The Government could better prioritise between all of the expansionary measures planned. In terms of “core” or permanent measures, the Government plans to increase the level of voted permanent spending by €4.2 billion in 2022 (+5.5 per cent), while cutting taxes by €0.5 billion. This is modestly above estimates of the underlying potential growth rate of the economy but would help to support the recovery. The spending increases reflect a €3.1 billion increase in current spending and a relatively-fast €1.1 billion increase in capital spending.
The Council welcomes the more realistic approach to medium-term budgetary projections in the SES. The forecasts allow for the costs of the “Existing Level of Services” — that is, the costs of maintaining existing public services and supports in real terms. While more details on the methodology should be provided, this addresses a long-standing weakness in budgetary forecasts. It provides a more realistic picture of the public finances and should avoid the need for expenditure ceilings to be revised every year. However, the more realistic forecasts crucially highlight how most of the space that a growing economy would sustainably generate is likely to be used up by the cost of standing still.
The SES plans for the medium-term set out a major shift in policy: the new spending rule and the objective to broadly stabilise the debt ratio in the medium-term imply a deficit by 2025 of close to 1½ per cent under the recovery scenario rather than a balanced budget. This would lead to a slower reduction in the debt ratio. The Government’s own projections in the SES suggest that the deficit would be around 3 per cent of GNI* and that the debt ratio would barely fall after 2022.
Running significant budget deficits for several years during a period of strong growth and with high public debt carries risks. Many factors would argue for a more cautious approach to budgetary measures in the coming years: the rapid budgetary expansions pursued in recent years; the likelihood of a strong recovery and risks of inflation and eventually overheating from persistent government borrowing; and the need to set high debt ratios on a steady downward path. Given these risks, the Government will need to stick to these plans at a minimum with any additional spending beyond the SES plans met through higher taxation.
Looking beyond 2022, the Government should prioritise between its plans for significant expansions in public investment, fast increases in current spending and a desire to simultaneously cut taxes. Many factors would argue for a more cautious approach to budgetary measures in the coming years: the rapid expansions pursued in recent years; the likelihood of a strong recovery; and the need to set high debt ratios on a steady downward path. The Council assesses that the Government could prioritise between tax cuts planned, the pace of investment expansion and the speed of increase in current spending. By expanding all areas at once, the Government is effectively evading difficult choices and slowing the return of debt ratios to safer levels. This reduces the scope to ensure that future downturns or crises could be cushioned by strong fiscal support in the same way as during the pandemic. A more prudent approach would be to limit current spending to a slower pace of increase or to avoid plans to reduce the tax base at the same time as a ramp-up in public investment spending is planned.
Even recognising that interest costs are likely to remain low, and that much of the State’s debt has been fixed at low rates and long maturities, there are risks to running persistent deficits. The deficits that the Government projects to run out to 2025 would be unprecedented in Irish experience: larger deficits have only previously been run on a sustained basis during the aftermath of the financial crisis. Even allowing for low interest rates into the future, the Council estimates a one-in-four risk that the Government’s debt ratio could end up on an unsustainable path. Ireland’s deficit and net debt ratio could also still be among the highest in the OECD by 2025, which increases the risks of higher borrowing costs if Ireland is viewed as an “outlier”, particularly as a relatively small economy. This leaves the public finances more exposed to shocks, particularly from unexpected shortfalls in growth. It also reduces the likelihood that the Government could respond to future crises by supporting the economy in the same way it did during the pandemic.
The increase in investment spending should help the Government to address pressures in areas such as housing and climate change. However, the speed and timing of the ramp-up carries risks and the Government should plan to eventually bring investment down to more normal levels. The Government plans to ramp up public investment spending to exceptionally high levels close to €13½ billion or 6 per cent of GNI*. These plans have been revised up very significantly over the past year from already ambitious levels with a new National Development Plan to be published shortly. The increase will take Ireland’s public investment spending to one of the highest rates in its history and to among the highest rates as a share of national income in the OECD. There is a good case for higher spending in areas such as health, climate change, and housing, given that there are clear needs to address various shortfalls. Interest rates are also low, such that a sustained period of exceptionally high investment has merits prior to returning to more normal steady state levels of investment. However, there are risks to this approach. First, the public debt ratio already is high, creating risks regardless of what the additional borrowing is used to finance. Second, with public investment management historically weak in Ireland, there is a need to ensure that future investments generate value for money. Third, many sectors in the economy are expected to recover rapidly in the coming years such that output may rebound to pre-crisis levels quickly and capacity constraints may begin to bite in the construction sector. This could mean higher costs to investment, weakening the Government’s ability to achieve value for money. To assess the risks, more information is needed on the Government’s investment plans and the underlying economic assumptions.
The Government has set out in the SES a new spending rule and debt objective. The use of these fiscal frameworks is welcome, but they should be better specified. The spending rule is intended to constrain permanent voted spending to grow at the same rate as potential output, assumed by the Government to be around 5 per cent. The Council has recommended a spending rule for several years to help safeguard the sustainability of the public finances by ensuring that spending grows in line with the Government’s ability to pay for it. However, applying the rule now at a time when sharp increases in permanent spending have taken place, means that the rule is likely to lock in a higher path for spending than would have been the case if the rule had applied before the pandemic. Aligning spending increases to sustainable revenue increases in this manner will likely maintain a budget deficit, but will not lead to improvements that put the debt ratio on a more prudent downward path. In addition, there are a number of design problems with the rule: (1) there are no legal underpinnings; (2) the assumed trend growth rate is high at 5 per cent and beyond what the Department’s own estimates of sustainable growth would suggest; (3) tax cuts are also planned for the coming years, but do not reduce the space allowed for by the rule (in other words, they are in addition to sustainable increases allowed by the rule); and (4) the expenditure rule should be on a whole of government or “general government” basis. As it is, by ignoring tax cuts, the Government has committed more budgetary resources than their own estimates would sustainably allow. The Government should refine the rule if it is to be an appropriate medium-term budgetary anchor that will help to ensure prudent management of the public finances.
The Government’s decision to adopt an objective for the debt ratio is also welcome. However, “to stabilise, and reduce slightly, the debt-income ratio in the coming years” is a riskier approach than the assumption previously set out that the budget could be “returned to broad balance by the mid-part of this decade”. A budget balance — while not necessarily an optimal goal in itself — would have been consistent with debt ratios falling at a steady pace of more than 3 percentage points per year over the medium term. By contrast, the new objective would see debt ratios remain at high levels well into the medium term. Moreover, the objective is vaguely defined. A better approach would be to develop clear medium-term targets for reducing debt as a share of GNI* and with specified timelines. It is also unclear what the relationship between the spending rule and the debt target is or whether both will apply with the most restrictive being the binding constraint.
The Government’s strategy still lacks key details. There are still potentially very large unknowns about expenditure for the coming years, such as whether additional spending might be needed to achieve the Government’s climate- and health-related objectives, including for Sláintecare. There is no indication of how taxes would be adjusted if risks arise with the new plans for the medium term. While the Government now plans to run much larger deficits in the coming years, there is no indication as to whether or not this will comply with the EU and domestic fiscal rules.
Ireland faces a number of major challenges over the coming years. It is possible that a large structural deficit will remain after the economy recovers from the pandemic. This would reflect the fast pace of permanent spending increases pursued and the pandemic’s impact on the economy and sustainable revenues. At the same time, the Government will face mounting pressures related to three key areas: ageing, climate change, and the continued over-reliance on corporation tax receipts. It remains unclear whether existing spending plans will be adequate to meet these challenges: additional information on Housing for All and the new National Development Plan should spell this out. The Government also needs to set out how its Programme for Government commitments, including the implementation of Sláintecare and commitments on other spending items and taxation, are to be funded within the SES package. The risks related to Ireland’s over reliance on corporation tax receipts remain high. Corporation tax receipts are typically more volatile than other taxes and are heavily concentrated in a handful of companies. In 2020, ten corporate groups accounted for 56 per cent of net receipts. This concentration exposes the Government to risks around firm-specific profitability and various other idiosyncratic risks. The Government should commit to saving future overperformances and to unwinding this over reliance.