Key Messages
The global economic recovery has been hindered by sharp increases in the cost of living amid the war in Ukraine and ongoing impacts of the pandemic. The war in Ukraine has led to sharp increases in global commodity prices, leading to a sharp pick-up in inflation. New outbreaks of the pandemic and subsequent lockdowns in China have exacerbated supply disruptions. These factors have led to a stalling of growth in 2022. At the same time, central banks have responded to rising inflation by tightening policy and raising interest rates, leading to a further downgrading of forecasts for economic growth in Ireland’s trading partners.
While still strong, Ireland’s recovery has lost some momentum in recent months. Ireland’s recovery from the pandemic was rapid. Domestic activity bounced back sharply as the pandemic’s effects unwound and modified domestic demand closed in on its pre-pandemic trend by the end of 2021. There are mixed signs for Ireland’s domestic growth in the first half of this year. Official data for the first quarter suggest consumer spending slowed, pulling down domestic demand over the quarter. This comes as prices have risen, reducing households’ spending power. However, other indicators suggest that consumer spending may have been more resilient in cash terms.
Contrary to initial expectations, a lasting upward shift in consumer prices now seems likely. The current outlook for oil and gas suggests that prices, while expected to fall eventually, will stay higher for longer than previously thought. In addition, the pass through to prices elsewhere in the economy could be greater than expected. This raises the risk that Ireland will face higher prices and slower growth over the coming years.
Downside risks have intensified. Long-standing international risks remain, including Covid-19 and Brexit-related uncertainties. Geopolitical tensions also remain, including the risk of a sharp reduction in European gas supplies this winter. Uncertainty around the future path of inflation is high, and financial conditions could tighten significantly. There are also domestic risks that could derail growth, including competitiveness issues and capacity constraints arising from labour shortages, rising wages, and housing costs.
This year, strong tax receipts are likely to push the Government’s budget into surplus, supported by high corporation tax receipts. Wage increases and strong cash spending have led to higher tax revenues, notably in the form of income tax and VAT. Corporation tax receipts have continued to surge, with the portion unexplained by domestic activity having risen to high levels. The Council estimates that the Government’s revenue in 2022 could be almost €3.5 billion higher than forecast in July’s Summer Economic Statement. Corporation tax receipts this year are likely to overtake VAT as the second largest tax heading. Assuming spending is in line with what is projected for the rest of the year, a surplus of about €4½ billion for 2022 is achievable. This compares to the Summer Economic Statement’s projection of a surplus of about €1.2 billion.
In the short term, the Government’s budgetary stance must strike an appropriate balance between creating space to protect those most vulnerable to the rising cost of living and avoiding stoking inflation further. The Government faces a delicate balancing act in avoiding adding to rising price and wage pressures, while also alleviating their impacts on those most vulnerable. The Summer Economic Statement plans entail a 6.5% pace of core spending growth for 2023, with core spending €4.9 billion higher than earlier plans, and a larger-than-planned tax package. This pushes the budgetary expansion beyond the Government’s 5% Spending Rule introduced last year — the pace that, in normal circumstances, would be considered sustainable. However, the Government’s temporary deviation from the rule is sensible given the exceptional rate of inflation. The pace of expansion is less than what would be implied by tracking both real growth and general price rises in full. The impacts on fiscal sustainability are mitigated by the likelihood that revenues could be higher on a sustained basis, given the higher path for wages. It is now important that the Government sticks to its announced budgetary plans. This would support economic stability and would imply saving any additional excess corporation tax receipts.
To strike the right balance, the Government faces difficult choices and needs to prioritise what it wants to achieve. The Council estimates that to fully track the wage and price increases this year and next and to implement existing plans, including planned capital increases, core spending would have to increase by almost €7½ billion in 2023. However, this would exceed the available space under the Government’s spending ceiling for 2023. Choices will need to be made between how far to uprate public sector wages, pensions, and social welfare payments and to what extent existing spending plans and any new permanent spending initiatives are pursued unless taxes are increased.
Improved targeting of supports can help strike the right balance. While policy support so far has largely come through temporary measures, the Budget will need both to address on-going short-term needs and how far to make permanent increases in public sector wages, pensions and welfare payments. The lack of targeting in earlier supports — Council (2022) estimates suggest about 90% were not targeted — leaves fewer resources to address other policy challenges. The Government can strike a better balance by ensuring that supports are targeted at those most in need. Ireland’s welfare and income tax system offer useful avenues through which to better target supports.
The Government needs to set out how it will address major medium-term challenges. First, the Government must halve Ireland’s greenhouse-gas emissions by 2030, but it has not factored in the full costs of achieving this. Estimates put the cost at an additional 1.7 to 2.3 per cent of GNI* on average over the years 2026 to 2030 (FitzGerald, 2021). Second, the costing for the Government’s “Sláintecare” reforms for healthcare is outdated and no spending plans are available beyond this year. Third, the Government has not responded to the Pensions Commission recommendations on how to address pension funding shortfalls but has indicated that it does not intend to raise the retirement age. Annual spending on pensions is set to rise by about 1½ to 2 per cent of GNI* (about €4 to 5 billion in today’s prices) by 2030. The Government needs to make choices about how to address these challenges, including how it intends to reallocate spending from other areas and/or raise taxes.
Against this background, the Government should strengthen its approach to budgeting to improve fiscal sustainability, ensure more effective planning, and achieve better value for money. Three things would help in terms of how Ireland approaches its budgeting. First, the 5% Spending Rule should be reinforced to recognise the impact of tax measures, give it legislative status, capture the full range of general government spending, and link it to debt targets. Multiyear baseline expenditure plans should be published with the headline ceiling. Second, the Rainy Day Fund or a new National Pension Reserve Fund should be used to save excess corporation tax receipts, gradually reducing the State’s over-reliance on these risky revenues. Related to this, the Government should routinely identify the level of excess corporation tax receipts and publish the general government balance with and without these receipts. Third, the Government needs to cost its major medium-term commitments properly and identify potential alternative revenue streams should these be needed. This includes the costs of achieving climate objectives, implementing Sláintecare, and addressing rising age-related spending.