Fiscal Assessment Report, June 2018

Summary Assessment

A rapid cyclical recovery has taken place since at least 2014 and this is continuing at a strong pace. Looking across a number of indicators, the Irish economy still appears to be growing very fast. Forecasts assume that the recent momentum in the domestic economy will only gradually moderate and they incorporate a reasonably strong outlook for Ireland’s main trading partners.

There is much uncertainty, yet most coherent estimates suggest that the domestic economy has been growing faster than its potential growth rate since 2014. Estimates suggest that the economy is producing close to its medium-term potential in 2018 and will move beyond it next year and after. There are also burgeoning pressures in the housing sector where persistent undersupply has been evident. There are substantial risks that a faster-than-assumed – and much-needed – pick-up in housing output could arise. Unless offsetting measures are taken elsewhere, including through fiscal policy, this could prompt overheating in the economy.

Ireland’s debt burden is still among the highest in the OECD. Ireland’s net government debt burden is understated by using standard GDP comparisons. When set against a comparable measure of national income like GNI*, the net debt burden is equivalent to 87 per cent, the sixth highest in the OECD behind only Italy, Portugal, Belgium, France and Japan.

Negative shocks will inevitably occur in future years. There are clear downside risks over the medium term, namely those associated with Brexit, US trade policy and the international tax environment. This report gives a stylised example of the direct impacts of a large, foreign-owned multinational firm ceasing its Irish operations. Corporation tax receipts would be particularly vulnerable to such an exit, given the high concentration of payments among the top ten contributing firms. The risk of a “hard Brexit” after March 2019 remains significant if the EU and the UK were not to reach agreement regarding a transition arrangement. It is also possible that the expected impacts of Brexit may be underestimated. Standard models may not fully capture the extent of the two countries’ closely integrated supply-chain networks, amongst other features.

Improvements on the budgetary front have stalled since 2015 despite the strong cyclical recovery taking place – one that is reinforced by a number of favourable tailwinds. While the economy has experienced a strong recovery, this has not translated into any notable improvement in the underlying budget balance, taking into account improvements driven by the cycle. Non-interest spending has risen at essentially the same pace as buoyant cyclical tax revenue since 2015. Allowing for the estimated effects of the cycle, the structural position would appear to have deteriorated since 2015.

The Government should at least stick to existing budget plans for 2019. The Council assesses that there is no case for additional fiscal stimulus in 2019 beyond existing plans as set out in SPU 2018. An appropriate policy for next year would be to increase government expenditure in line with the sustainable long-term growth rate of the economy. Central estimates of the economy’s medium-term potential output growth rate from the Council, the Department of Finance, and the ESRI would suggest that the economy’s potential growth rate is 3¼ per cent per annum. This would imply an approximate limit for spending increases or tax cuts of up to €3½ billion (i.e., the “gross fiscal space”) as the starting point for any budgetary plans for 2019. Anything more expansionary than this suggested maximum limit is not likely to be appropriate. Yet improving the budget balance more than currently planned would be desirable, especially given the risks of overheating and the opportunity provided by favourable times. The cost of previously announced measures, including sharp increases in public investment spending, means that the scope for new initiatives in Budget 2019 will be limited. If additional priorities are to be addressed, these should be funded by additional tax increases or through re-allocations of existing spending.

Any unexpected increases in tax revenues or lower interest costs should not be used to fund budgetary measures. Any further loosening of current plans would not be appropriate and the window of opportunity should be used to return debt to safer levels and to make the economy more resilient to shocks. Revenues arising from a faster-than-expected recovery in housing construction should be used to build buffers either through additional contributions to the Rainy Day Fund or through faster debt reduction. Moreover, spending should not be allowed to continue to drift up as unexpected – and likely cyclical or transitory – revenues arise.

The Government needs a credible plan for the medium term. Focusing on the right budgetary stance and being prepared to be more cautious than the fiscal rules allow is the correct approach for the Government to follow. Yet there are a number of challenges to following such a policy as Ireland exits its latest crisis and there is no scope for complacency. In particular, there is a danger that the current policy framework is insufficiently equipped to prevent a return to procyclical fiscal policy. Sensible policy tools such as the Rainy Day Fund and a medium-term debt target, which were set up to help with medium-term budgeting, are only half-formed and need more development if they are to be effective. The shortening of the horizon in the Government’s most recent projections from five to three years ahead is not compatible with the aim of achieving medium-term fiscal stability.

The Council welcomes the Department’s publication of alternative estimates of the output gap. Well-founded forecasts for the medium term are necessary to provide a sound basis for setting the economy and the public finances on a sustainable path. The publication of alternative estimates by the Department represents significant progress and is welcome. The estimates have not been assessed within the scope of the Council’s formal endorsement for SPU 2018. However, regular updates to these measures should feature as headline indicators of economic performance in future Department publications and be included for assessment under future endorsements.

The Medium Term Objective (MTO) of a structural deficit of no less than 0.5 per cent of GDP was reached in 2017. From an economic perspective – and in terms of the technical application of the fiscal rules – it would seem that the Government’s budgetary position is currently close to balance. As the MTO was met last year, requirements to adjust the structural deficit are not expected to bind for 2018. Over the medium term (2019–2021), plans currently show compliance with the rules based on the EU Commonly Agreed Methodology. The structural balance is expected to deteriorate below the MTO in 2018, leading to an adjustment requirement in 2019. However, this deterioration is followed by an offsetting improvement in 2019, which is forecast to be sustained over the medium term.

The Council sees the fiscal rules as a minimum standard for sustainability and continues to recommend that the Government commit to adhering to the Expenditure Benchmark even after the MTO is exceeded. If the achievement of the MTO is sustained, as in current plans for 2019, the Expenditure Benchmark will play a less binding role and would not on its own trigger non-compliance. One way to mitigate measurement problems affecting the MTO would be to use the Expenditure Benchmark as a guide together with estimates of the economy’s sustainable medium-term growth rate and the natural rate of unemployment (the Department’s alternative estimates of potential output growth for the medium term could help to inform this). This would also help to ensure that spending growth is more sustainable, notwithstanding some degree of procyclical bias affecting the spending rule.