Thursday, October 15, 2015

Why are we betwixt and between the fiscal rules?

Ireland is set to leave the Excessive Deficit Procedure next year.  This is the “corrective arm” of our fiscal rules and is based on bringing a deficit that is above three per cent of GDP back below it.  The mechanics of the EDP are fairly straightforward: each year a country is set a headline deficit target with these targets reducing systematically to the three per cent of GDP level.

Once a country gets below the three per cent of GDP threshold it moves to the “preventative arm” of the fiscal rules which are based on reducing any remaining structural deficit.  In theory the “preventative arm” is more flexible than the “corrective arm” where rigid targets to bring the overall deficit below three per cent of GDP must be adhered to.

Under the Excessive Deficit Procedure Ireland had to get the deficit below three per cent of GDP by 2015.  This is a target that was set in December 2010 which is almost five years ago and it was not adjusted in the interim. Is a deficit target that was set five years ago appropriate for fiscal policy now?

In rough terms we had to reduce a deficit that was around €20 billion in 2009 to €5 billion in 2015  – and we achieved that with room to spare.   Ireland over-performed the EDP deficit target each year and this over-performance increased as the economy improved in the past two years or so.

In 2015 all we had to do was return an overall deficit that was below 3 per cent of GDP.  If there had been no changes on top of last year’s budget it is likely this year’s deficit would have been somewhere around 1.5 per cent of GDP. 

Hence, under the apparently more rigid “corrective arm” there was allowable space to introduce supplementary spending for 2015 and this was flagged with around €1.5 billion of supplementary spending estimates included in the White Paper last Friday.  This brought the 2015 deficit back up to 2.1 per cent of GDP so still well below the three per cent of GDP target.

From 2016 Ireland will have left the EDP so the fiscal landscape will be about reducing the remaining structural deficit at a particular pace and, measurement issues aside, the rules have some in-built leeway.

If the economy is doing poorly (negative growth) and is below its potential no effort has to be made to reduce the structural deficit under the balanced budget rule. The fiscal effort can be delayed until the economy improves.  If the economy is showing some growth and is close to its potential then some effort to reduce the deficit is required. This is where the figures published by the Department of Finance back in April put us.

Of course, as 2015 has evolved the economy has continued to improve and all growth forecasts have increased and most of these are now above the potential growth rates of the economy. In rough terms the four per cent plus growth rates for 2016 that most forecasters, including the Department of Finance, are pencilling are above the long-run potential rate of the economy.

The fiscal rules are designed so that countries with a deficit have to make greater effort to reduce that deficit when their economies are growing strongly. And the revised figures published by the Department of Finance this week reflect the fact that the Irish economy is growing strongly.

The original figures published in April put Ireland in a place where the required reduction in the structural deficit must be greater than 0.5 per cent of GDP.

However, the updated figures published this week put us in a position where the required reduction in the structural deficit must be greater than 1.0 per cent of GDP. That is, now that the economy is growing faster we should be doing more to reduce the deficit.

By the letter of the fiscal rules it appears the deficit reduction required is that which corresponds to the April figures. But the Irish economy is a small, open economy that can turn around very quickly and it has.

Should we ignore the spirit of the fiscal rules which requires countries with deficits to reduce them faster in times of economic growth simply because an earlier set of figures allow for a more expansionary budget?

And this is the key point. The key point is not some esoteric discussion about which figures for the output gap and potential GDP growth should be plugged in to a fiscal adjustment matrix

The key point is that at a time when the economy is growing, when we can reduce the deficit without significantly harming the economy, we are choosing to introduce policies that will prolong our borrowing.

This does not mean there cannot be increased spending.  There can be lots of additional spending but it must be matched by equivalent revenue measures.

We were led to believe that the budget would be framed around a fiscal space of €1.5 billion. In practical terms over the past week we have had over €3 billion of expansionary budget measures introduced.

First there was the €1.7 billion of supplementary spending estimates for 2015 that were flagged in the White Paper published last Friday.  On their own supplementary estimates are not unusual and have been a regular feature of public finance in Ireland.  But the public finance practices of the past are part of the reason we got into our current predicament.

As we will still be below the three per cent of GDP target for 2015 these supplemental spending increases become “baked in” and give the starting point for 2016.  One danger is that these permanent increases in expenditure are based on temporary sources of revenue.  And then on Tuesday we had a further €1.5 billion of tax cuts and expenditure increases added on top of that. 

So all told over the past week we have had expansionary measures totalling over €3 billion introduced.  The fiscal rules do not prevent additional spending. They direct that discretionary expenditure increases (such as these supplementary estimates) should be matched by equivalent revenue measures or offsetting savings elsewhere.  Unexpected inflows of Corporation Tax would not count as a revenue measure under the rules. 

This will be the position from 2016.  At the moment we are crossing the threshold from the “corrective arm” to the “preventative arm” and there are gaps in the crossover, particularly for an economy that is growing strongly, that allow this increase in spending under the letter of the rules.  Using these gaps for large supplemental increases in expenditure undermines the budgetary process as expenditure ceilings become meaningless if they can be increased when windfall revenues are available.

Ireland would come well short of meeting the required reduction in the structural deficit if we applied the deficit rule to the 2015 outcomes.  The budget documents show an improvement in the structural deficit of just 0.2 per cent of GDP is expected in 2015.  This is not an issue under the letter of the rules as what is required is for the headline deficit to be below three per cent of GDP and this is easily achieved because of improvements in the economy and the surge in Corporation Tax receipts. 

But the spirit of the rules is that countries with deficits should do more to reduce them in times of economic growth.  And, to repeat, this do not mean there cannot be increased spending.  There can be lots of additional spending but it must be matched by equivalent revenue measures.  Surely our recent history is proof of the benefits of that.  And the rules have some additional flexibility if that spending is for capital rather than current purposes.

If the structural deficit rule and the expenditure benchmark are good rules for 2016, and the budget documents make various positive references to adhering by those rules in 2016, surely then they are also good rules for 2015?  Is it prudent to frame our fiscal policy based on a target set in December 2010 when the notion of six per cent growth in the Irish economy would have been derided?

Fiscal rules are useful but they are imperfect.  They are a guide not a crutch. We have rules of the road for driving but we don’t blindly ignore the conditions around us and drive at the speed limit at all times.  There are many times we hit the brake because of road conditions even though the rules don’t require us to slow down. 

Irish fiscal policy for 2015 was framed based on a target set in 2010.  The economic conditions are hugely different now.  Of course, there are factors other than the economic cycle that drive fiscal policy but that is not our concern here.  Our fiscal stance may adhere to the letter of the fiscal rules but if you think it is too expansionary for the unknown twists in the road that might lie ahead then you are probably right.

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