Fiscal Assessment Report, June 2019

Summary Assessment

As a result of continuing strong growth, the Irish economy has recovered from a deep crisis and is now operating near capacity. Yet the current outlook is unusually uncertain. Government forecasts assume that the UK makes an orderly and agreed exit from the EU at the end of 2020. However, this outlook is balanced between potential overheating on one side and an exceptional adverse shock in the form of a harder-than-assumed Brexit on the other. Further adverse risks are posed by the possibility of changes to the international tax environment; an escalation of protectionist measures; the onset of a cyclical downturn in major trading partners; and adverse financial developments (including those arising from Italy).

Efforts to turn around a large budget deficit were successful, but debt remains high. The Government’s debt burden is on a downward path as a share of national income, creditworthiness has improved, and the budget balance appears to be close to a balanced position when the effects of the cycle are accounted for. Notwithstanding the efforts by successive governments to improve the underlying balance up to 2015—with little progress since then—Ireland’s net debt ratio remains the fifth highest in the OECD, when measured appropriately. Reflecting this, creditworthiness is still vulnerable to rapid changes.

Corporation tax receipts in Ireland are now a long way from conventional levels and from what the underlying performance of the economy would imply. This report shows that some €3 billion to €6 billion of the €10.4 billion corporate tax receipts received in 2018 could be considered excess (in other words, beyond what would be projected based on the economy’s underlying performance and based on historical/international norms). Unlike typical revenue windfalls, these gains might persist for a number of years before reversals could be expected. They also represent a net injection to the Irish economy, given that foreign-owned multinational enterprises contribute four-fifths of receipts.

With the public finances still in a relatively vulnerable position, the Government has allowed a pattern of spending drift in recent years. When considering an appropriate measure of government policy spending (excluding one-off items and interest costs and recognising the impact of tax measures), the pace of annual spending growth has risen from 4.5 per cent in 2015 to 6.7 per cent in 2018. Spending increases within the year—over and above what was originally budgeted for—have contributed to a faster-than-planned pace of expansion.

The Council has adopted a new “principles-based approach” for assessing the fiscal rules. The European Commission assesses EU fiscal rules based on their own operational approach and based on estimates of the cycle that have tended to be implausible. The Council has therefore adopted a new principles-based approach that makes the assessment simpler and more robust, including using the Department of Finance’s alternative measures of the cycle. On this basis, the Medium-Term Objective (MTO) of a structural balance of no less than –0.5 per cent of GDP was achieved in 2018 as the structural balance was estimated to be +0.2 per cent of GDP. However, there was a significant deterioration in the structural balance in 2018 and government spending breached the Expenditure Benchmark limit in 2018. While net spending is forecast to grow below the limit for 2019, this would be at risk in the event of a large spending overrun occurring again.

Despite a favourable upswing in the cycle and the surge in corporation tax receipts, there has been no improvement in the budget balance excluding interest costs since 2015. The rapid pace of growth in non-interest spending has coincided with fast growth in revenues. These are boosted by recent surges in corporation tax receipts, the sustainability of which is unclear. As much of the recent improvement in revenues may be cyclical or temporary, this suggests that the structural position (looking through these effects) has deteriorated.

The Government needs to make a credible commitment to not use potentially short-lived corporation tax receipts for long-lasting spending increases. One way to credibly commit to saving unexpected—and potentially risky—corporation tax receipts might be to have a fixed rule under which the government sets aside excess receipts above a certain threshold. An option for saving unexpected corporation tax receipts would be to notionally set aside such receipts through in-year allocations to a “Prudence Account” (Box B). Allocations could be based on the excess between actual and forecast corporation tax receipts. At year end, these notional amounts could then be turned over to the rainy day fund (the “National Surplus (Exceptional Contingencies) Reserve Fund”) or set aside elsewhere.

In the near term, a Disorderly Brexit poses profound risks to the public finances. If it materialises, the shock to the economy, revenues, and cyclical spending from a disorderly Brexit could mean that debt ratios begin to rise again (Box C). A relatively more benign Brexit might suggest that policy should allow for a small rise in the debt ratio with limited need for more active policy measures to stabilise the debt path. However, a disorderly Brexit would have much more severe consequences for the public finances. Trade-offs here would be far worse and the Government might need to cut spending or raise taxes to prevent debt ratios from rising indefinitely. Should a more adverse shock materialise, the policy response would need to be carefully assessed. However, the Government should in principle act to support the economy in so far as possible during any period of unusually weak demand.

For 2019, the Government should stick to its existing plans as contained in SPU 2019. This means that no additional within-year increases should be introduced without offsetting measures. The fiscal stance initially planned for 2019 signalled an expansion in line with the economy’s potential and expected inflationary pressures. Yet the Government ramped up spending beyond its original plans. For 2018, it increased spending by €1.3 billion beyond the planned €3.2 billion increase, with much of the overrun arising in health areas. In addition to the higher base level of spending, the budget package of tax and spending measures for 2019 was €0.3 billion more than had been planned. Much of these unplanned increases were masked by the surge in corporation tax receipts, which could prove temporary.

These slippages imply a looser fiscal stance and contribute to further overheating pressures. There are risks that the pattern of upward revisions to spending estimates could be repeated yet again in 2019. The Government should offset any such unplanned spending increases through savings elsewhere. To stem the increasing reliance on corporation tax receipts, any additional unexpected receipts should be allocated to a Prudence Account during the year and then to the rainy day fund or elsewhere (Box B).

For 2020, the Government should be cautious with the budget. This reflects the risks associated with a hard Brexit, the reliance on corporation tax, possibilities of overheating, and the rapid rise in spending between 2017 and 2019. To limit the possibility of rising debt ratios, loss of creditworthiness, and a need for sizeable correction in the public finances, the Government should stick to its plans as set out in SPU 2019. This would allow room for further support to be provided in the event of an adverse shock materialising, and would allow fiscal policy to cushion some of its effects.

Sticking to the SPU 2019 plans, as the Council advises, would entail some €2.8 billion of budgetary measures for 2020. These amounts are already earmarked for increases in public investment, public sector pay, provision to cater for demographic changes, and for assumed tax cuts in 2020. Public investment alone is planned to more than double from its level six years ago (€8 billion in 2020 as compared to €3.5 billion in 2013). This approach would allow for minimal new tax and spending measures on budget day, taking into account previous announcements. If further discretionary measures are to be introduced beyond the SPU 2019 plans, then the Government should introduce additional revenue-raising measures to preserve overall sustainability or it should scale back planned spending increases and tax cuts elsewhere. A smaller expansion than the €2.8 billion currently implied by SPU 2019 plans would also be desirable, again, recognising the severe risks posed by Brexit, the reliance on corporation tax receipts, and the risks of further overheating. This could include not using the €0.6 billion that is currently set aside for assumed tax cuts and unallocated spending increases.

The Government’s medium-term plans are not credible. The projections laid out in SPU 2019 show a budget balance that is set to improve, with surpluses increasing in every year. However, the expenditure forecasts underpinning these projections are not credible. They imply an implausible slowdown in spending growth based on technical assumptions, which do not reflect either likely future policies or the future cost of meeting existing commitments. This also feeds through to the pace of growth shown in the Government’s official macroeconomic projections.

For 2021–2023, the Government needs to develop a credible medium-term strategy. The Government’s medium-term spending projections are based on technical assumptions that are unlikely to reflect actual policy decisions. A better approach to budgetary planning could be built around four elements. First, it should start with a clear statement of the sustainable growth rate that net policy spending can grow at. Second, multi-year departmental expenditure ceilings should be framed in the context of this upper limit and more realistic forecasts for spending should be developed. Third, the debt ratio target should be restated as a percentage of modified GNI* with a clear timeframe; it should be clarified whether it is a steady-state target or a ceiling; it should have clear staging posts; and it should be lower to reflect Ireland’s volatile growth rates. Fourth, the Government needs to gradually wean itself off the reliance on corporation tax receipts that has built up in recent years.