Fiscal Assessment Report, December 2021

This is the Council’s twenty first Fiscal Assessment Report. The report assesses the fiscal stance that the Government set out in Budget 2022. It assesses the Government’s macroeconomic and fiscal forecasts, and it monitors Ireland’s compliance with fiscal rules.

Boxes

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, December 2021

Summary Assessment

Macroeconomic assessment

The Irish economy has continued to recover strongly from lockdown measures to help contain the effects of the pandemic. Underlying domestic demand returned to the average levels observed in 2019 as of the second quarter of this year, with vaccinations progressing and restrictions eased. High-frequency data since July point to continued strong growth, a recovery in consumer services activities, and continued expansion elsewhere in the economy even as the number of Covid cases has again increased. However, the pandemic has been an uneven shock. New analysis in this report shows that overall earnings in sectors with below-average wages, such as tourism and hospitality, remain well below pre-pandemic trends whereas high-income sectors have seen little disruption to growth.

Risks to the economy over the medium term are broadly balanced. Growth could be higher if scarring from the pandemic proves less severe than assumed, if wages grow faster, or if an unwinding of savings boosts consumer spending more than assumed in 2022. However, the potential for virus mutations, further restrictions to manage the pandemic, risks to foreign direct investment from international tax developments, and continued uncertainties around Brexit could weigh on growth prospects.

Budgetary assessment

The government forecasts a deficit of 5.9 per cent of GNI* in 2021. The substantial narrowing of the deficit reflects strong revenue growth and lower pandemic-related spending. The balance could ultimately be more favourable than forecast in Budget 2022, with possible current and capital underspends and higher–than–forecast revenue likely.

For next year, Budget 2022 forecasts a deficit of 3.4 per cent of GNI*. This relies on a further expected recovery in revenues and lower allocations for Covid-related spending, together with a planned core Exchequer spending increase of €4.2 billion. There are significant upside risks to revenue from Income tax and VAT. Spending could be lower if contingency funding for Covid-related spending is not tapped.

Medium term spending projections in Budget 2022 make welcome improvements in the forecasting approach. The Budget 2022 forecasts are consistent with the Government’s announced fiscal plans and its newly introduced spending rule, while also making allowance for the cost of maintaining existing public services.

Accounting for maintaining existing levels of services provides a more realistic and informative picture of the public finances in line with the Council’s past recommendations. The Council had previously recommended that the Government fully account for ‘Stand-Still’ costs in its medium-term forecasts — the costs of maintaining public services and supports in real terms. By factoring in these costs and allowing sufficient budgetary resources to address them, the Government is now appropriately recognising demographic and price pressures that will arise in the coming years. However, additional detail on the assumptions and methodologies used would be informative in assessing the fiscal projections.

Over the medium term, the budget balance is set to reach close to balance by 2023 according to Budget 2022 projections and to improve modestly thereafter to reach a surplus of 0.3% of GNI* by 2025. This assumes that the economy continues to grow at a steady pace and that the Government follows its spending rule. Comparing 2025 fiscal forecasts to 2019 allows one to “look through” the Covid crisis. The substantial increase in public investment planned by the government over this period is assumed to be achieved without a deterioration in the budget balance due to strong growth of the economy, large corporation tax receipts, low interest rates and moderate increases in current spending, following the newly adopted spending rule.

Given low interest rates, strong growth and the improving general government balance, government debt is projected to fall at a steady pace but to remain high. By 2025, gross general government debt is forecast to be 89.5 per cent of GNI*. This high level of debt leaves the public finances exposed to increases in borrowing costs.

Fiscal Stance

For 2022, the Government stuck to its planned €4.7 billion budgetary package as set out in the Summer Economic Statement. The package included €1.6 billion to maintain the existing level of public services, an increase of €1.1 billion in government investment, and an additional €1.5 billion in new current spending measures. The remaining €0.5 billion is due to tax measures, including the Government’s decision to raise tax allowances in line with inflation.

The Budget for 2022 strikes an appropriate balance between continuing to support the economy and keeping the public finances on a sustainable path. As the Council noted in its Pre-Budget 2022 Statement, the Budget 2022 package looked to be at the limit of what is prudent and remains appropriate taking account of the improved growth outlook, the final tax package, and the pace of increase in broader general government spending. The overall pace of expansion is modestly above estimates of the underlying potential growth rate of the economy. This should help to support the recovery. In addition, a temporary spending amount of €4 billion of Covid contingency reserves has been budgeted, which is prudent and should not impact the underlying budgetary position.

For the medium term, Budget 2022 presents a clearer strategy than past budgets. As set out in the July Summer Economic Statement, there are three key changes to the Government’s medium-term budget plans. First, more sound spending forecasts are used that allow for the cost of maintaining existing levels of supports amid demographic and price pressures. Second, the Government has introduced a spending rule that seeks to limit permanent Exchequer primary spending increases to an average of 5 per cent annually, broadly in line with the economy’s trend growth rate. Third, the Government has set out public investment plans to 2030 in a new National Development Plan published in October. The Council welcomes these developments.

However, it is unclear how major commitments on health and climate change fit into the Government’s medium-term strategy and whether sufficient resources have been allocated. Despite the publication of the new Climate Action Plan in November, it remains unclear what the cost to the Government will be in halving Ireland’s greenhouse emissions by 2030. While a substantial part of the National Development Plan’s capital spending could contribute to these objectives, there may be significant additional costs to the State, particularly in encouraging the switch to electric vehicles and improving home energy efficiency. On health commitments, there is currently no clearly identified budget to continue implementing Sláintecare reforms in health beyond next year and there are no up-to-date estimates of the costs of implementing remaining reforms. In the areas of climate, housing and health, more detail is required on future plans and their expected impact and cost.

The lack of a plan to meet these commitments create risks to the implementation of the Government’s fiscal plans in the years ahead. Given the spending rule, the unallocated space for additional current spending is limited in the years ahead. The Budget suggests around €1.6 billion per year on average of new current spending remains to be allocated, while the Council’s estimates that around €0.5 billion would remain once Stand-Still costs are met. Any additional spending beyond this level would either require tax increases or spending reductions in other areas to be consistent with a total expansion of 5 per cent, including tax measures. Failure to fully plan for future spending pressures may make it more difficult for the Government to stick to its spending rule.

The Government needs to follow through on its strategy and reinforce its new 5% Spending Rule. The Government’s medium-term plans have the potential to set the public finances on a prudent path. With revenues expected to recover strongly, the plans could allow the Government to respond to pressures in housing, health and climate change areas, bring public investment to record levels, and maintain existing levels of services, while also allowing for a steady pace of debt reduction averaging close to 3 percentage points for the net debt-to-GNI* ratio annually over the forecast period. However, Ireland has a poor track record of sticking to budgetary plans. If the Government’s strategy is to be realised, the plans will need to be followed through on. To support this, the Government should set its new spending rule on a stronger footing. This includes backing it up through Departmental Expenditure ceilings, which have yet to be set out as is legally required, and linking it more closely to the domestic fiscal rules. Improvements to the framework could include giving it legislative backing and reinforcing the rule so that it captures non-Exchequer spending and the impact of tax changes.

Ireland faces several medium-term challenges, including an ageing population, alongside tackling climate change and improving public services. The Government will have to contend with an Irish population that is rapidly ageing. This will put pressure on pensions and healthcare costs. The Commission on Pensions set out a preferred package of reforms that would restore the fiscal sustainability of the pensions system. The Government now needs to set out its responses and future plans for pensions. Furthermore, the recommendations postpone increases in the pension age and imply a significant increase in PRSI contributions. While legitimate, this option raises questions about the willingness of governments to impose these measures. Setting out a plan to phase in any PRSI increases over the coming years could make these measure more credible.

The over-reliance on corporation tax receipts to fund public services that has built up in recent years should be reduced. One-in-five euros of tax receipts were from corporation tax in 2020, and more than a half of those receipts were from ten corporate groups. This concentration, coupled with the ongoing volatility of receipts and their vulnerability to international tax developments is a source of serious concern. The international agreement to new tax reforms, including a 15 per cent minimum tax rate, carries risks in both directions. Future corporation tax revenues and investment in Ireland might be reduced, but there is also a risk that the reliance on corporation tax receipts continues to build. It would be wise to treat any unexpected revenues in much the same way that Norway treats its proceeds from oil revenues — essentially as a finite and volatile resource. The Government should allocate any further excess corporation tax receipts, potentially including any increase due to the rise in the minimum corporation tax rate to 15 per cent, to the Rainy Day Fund. This would help to limit, and potentially reduce, the over-reliance on corporation tax receipts that has built up.

Fiscal Rules

The exceptional circumstances clause in the fiscal rules has been active since the Covid-19 pandemic began. This flexibility in the rules has allowed for an appropriate fiscal response to the pandemic in 2020 and 2021.

In 2022, Government plans look set to comply with the fiscal rules. The deficit is forecast to be 1.8 per cent of GDP. This is below the 3 per cent deficit limit in the SGP. In addition, the structural deficit is forecast to be 0.2 per cent of GDP, which is at the Medium-term Budgetary Objective (MTO) of a structural deficit of no more than 0.5 per cent of GDP over the medium-term, the fiscal rules look set to be complied with.

The Government has failed to publish three-year expenditure ceilings in the Expenditure Report, as was typically done in the past. The failure to publish these ceilings as part of the budget process represents a backwards step. This decreases transparency. It undermines the Government’s new spending rule as it means that Departmental expenditure ceilings, including in key areas such as health, are not fixed in line with the overall budgetary plan but instead as part of a technical exercise.

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