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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The (slow) improvement in the Public Finances

Figures from the Exchequer Statements show that the Exchequer Balance has improved in each of the past four years.

However, for the years to 2013 this was because of improvements in “one-off” items in the capital account: large recapitalisation payments in 2011 moving to some (much smaller) asset sale receipts in 2013.

Last year, however, marked the first year where there was a clear improvement in the current account.  These are the regular and ongoing receipts and expenditures from the Exchequer Account.

We will have to move to a current account surplus but there was little or no progress on that until 2014.  And most of this was achieved through higher tax revenues.

Since 2011, tax revenues have increased by around €7 billion.  Over the same period the Exchequer Current Deficit has improved by €6 billion. There is still a bit to go (and early indications that the improvement has continued in 2015).

It should be noted that the Exchequer Account has become much more dependent on Non-Tax Revenue in the Current Account.

The composition of non-tax revenue is looked at here but it can be seen that it is now more than €2 billion greater than the pre-crisis levels seen in 2007.  A lot of this is down to banking support measures (central bank surplus, contingent notes interest, guarantee fees) and cannot be expected to last indefinitely.  These revenues will have to be replaced.

On the expenditure side, here’s a chart of net voted current expenditure.

On aggregate there doesn’t appear to be a lot happening there but voted current expenditure has been reduced from €41.4 billion in 2011 to €39.0 billion in 2014.

Offsetting this there have been increase in non-voted current expenditure – the main component of which is servicing the national debt. 

Debt interest expenditure rose rapidly in the years to 2013.  There was only a small rise in 2014 and the continuing low-interest environment allowing the refinancing of some debt at lower rates (such as the IMF loans) means that it is likely that debt interest expenditure will fall (but not by much) over the next few years.

By far the greatest change in the Exchequer Account during the crisis has been the huge scaling back of voted capital expenditure.  Since its peak in 2008 voted capital expenditure has been cut by more than 60 per cent.

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Some factors affecting the fiscal arithmetic

The debate around October’s budget has been heightened recently with the positive results in the half-year Exchequer Returns and the large upward update of nominal GDP by the CSO.  The impact of these was explored in this recent post.

There are other factors that will feed into the fiscals sums for 2015.  It is not clear what affect they will have but they may come to prominence over the coming months.  The first is recurring but small, the second is large but once-off and the third is large and recurring (for a while) but seems unlikely to happen.

1. Changes to the EU VAT Directive

From the first of January 2015 “VAT on telecommunications, broadcasting and electronic services supplied by a supplier established within the EU to non-taxable persons established within the EU will also be charged in the Member State where the customer belongs.”  See here.  It is not clear what impact this will have on VAT revenues but one would think it will be positive, though will probably be small. 

The most visible change will probably be in relation to subscriptions paid to BSkyB the VAT on which will now be payable in Ireland.

2. Return payment under the ELG from IBRC liquidation

When IBRC (formerly Anglo and INBS) was liquidated in February 2013 there was just over €1 billion of state-guaranteed liabilities remaining in the zombie bank.  These were covered under the Eligible Liabilities Guarantee that was introduced in early 2010.  When the liquidation was announced the guarantee was triggered and the guaranteed liabilities were immediately paid with €1 billion from the Exchequer.  After making the payment the ELG scheme took the place of the covered liabilities on the balance sheet of the IBRC but as an unsecured and unguaranteed creditor.  When the liquidation is concluded the proceeds of the sales (minus costs) will be divided between the remaining creditors at the time of the liquidation.  Creditors will be repaid based on their status but it does seem that there will be funds to make a payment to unsecured creditors.

It is not clear when this will be made or how much this will be.  If the proceeds are sufficient the amount returned could be close to the €1 billion paid out under the ELG. This is a once-0ff receipt relating to the public interventions in the banking sector.  Ireland has been in the Excessive Deficit Procedure since 2009 but the “once-off” payments to the banks were omitted to give the “underlying” deficit when examining whether Ireland had satisfied the limits set out under the EDP.

If there is a repayment from the IBRC under the ELG then it could be that the “underlying” deficit will be greater than the overall deficit.  Is it only payments to the banks that are excluded to get the “underlying” deficit?  If receipts from the banks are excluded maybe 2015 would be an opportune time to start measuring our performance to the EDP limits with the headline deficit?

3. Early repayment of IMF loans

The benefits of this were discussed here and here back at the start of the year.  The issue arose in a PQ to the Minister for Finance again last week.  He repeated the position that all the programme loans have to be repaid in equal proportion.  Repaying the IMF loans means repayments also need to be made to the EFSF, EFSM and bilateral loans.  But loan agreements can be renegotiated and the Minister outlined how much such a renegotiation would be worth:

It is the obligation to pay everybody if we pay one and makes it not worth pursuing. However, there may be ways around that and it is still worth pursuing that aspect. At present rates in the market and with the rate we are paying on the IMF loan, it is worth about €20 million for every €1 billion we financed. We have about €18 billion of that type of loan from the IMF.

€20 million times 18 equals €360 million – though it will be phased-in in a sense as the IMF loans are amortised (repaid in instalments) over the next few years.  But how long will the Ireland 10-year yield stay below 2.5 per cent?

So we have a small effect that definitely will happen (VAT), a large once-off effect that will happen but mightn’t be counted (ELG) and a large recurring effect that mightn’t happen at all (IMF).  In an imaginary world where they all fell right the 3 per cent of GDP deficit in 2015 should be easily achievable.

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Revised National Accounts and Fiscal Targets

The CSO have published the 2013 National Income and Expenditure Accounts along with this explanatory note highlighting the impact of some of the methodological changes.

Real GDP growth in 2013 was 0.2 per cent which is a revision of the previous estimate of –0.3 per cent. Nominal GDP has gone from a first estimate of €164 billion to a revised and updated estimate of €175 billion which is a very significant increase for the fiscal targets.

Here are the main fiscal aggregates as presented in April’s Stability Programme Update.

If we leave everything unchanged except the 2013 NGDP (i.e. use the same nominal growth rates and same fiscal projections) we get the following:

The changes are pretty clear.  The end-2013 debt ratio has changed from 123.7 per cent of GDP to 116.1 per cent of GDP even though the debt and the economy which has to service it is exactly the same – it is just measured differently.

The projections used in the SPU now result in a 2015 deficit of 2.8 per cent of GDP (and an ‘underlying’ deficit of 2.7 per cent of GDP which is the one that has been used up to now as the metric for the EDP targets).

The revisions and updates published today by the CSO mean that a larger deficit of around 0.2 per cent of GDP (c.€350 million) is allowable while still targeting the ceiling set for the deficit in the EDP – if that is what one wishes to do.

A second helping factor (and one that actually reflects economic performance rather than statistical revisions) is the revenue buoyancy that is evident in the Exchequer Returns for the first six months of 2014.  The budget day projection for general government revenue in 2014 was €60.9 billion.  This was unchanged in April’s SPU.

SEPA issues aside it seems that tax revenue is ahead of the DoF’s projections by around €500 million.  PRSI contributions are about €100 million ahead of the projection while the surplus from the Central Bank is around €200 million larger than expected.

There are some offsetting factors on the expenditure side – main health overrruns and a larger than expected contribution to the EU Budget.  Voted Capital Expenditure is “behind profile” but that could due to timing issues.

For recurring or standard items the fiscal position is probably around €500 million (c.0.3 per cent of GDP) better than was expected when the Budget and SPU projections were made.  This means the 2014 deficit outturn could be around 4.2 per cent of GDP if these improvements from H1 are just held and maybe even close to 4 per cent if the improvements continue to accumulate.

If the objective is to draft a budget targeting a 3 per cent deficit the fiscal effort required to so might be little more than the introduction of water charges.

PS Is there any indication somewhere of the budgetary impact in Ireland of the changes to the EU 6th VAT Directive that are due to come in force in January 2015?  That is the change that means the VAT payable on, for example, television subscriptions will be collected in the country of the customer rather than the country of the supplier.  

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The slow improvement in the Public Finances

The successful issue by the NTMA of another 10-year bond is a further small step to normality for our public finances.  They are a long way from being under control but the ability to raise €3.75 billion over 10 years at 3.5 percent indicated that decision makers in government bond markets think they are under control (or at least that they will be).

Getting a handle on Ireland’s public finances is not easy.  There are a plethora of sources and a variety of measures.  There are cash-based and accruals-based accounts.  There is the cross-over and subsidisation of central and local government.  There is the difference between voted and non-voted expenditure.  There is the difference between net and gross expenditure.  There are sinking fund contributions and appropriations in aid.  With all those in mind the following table may be comprehensible!  Click to enlarge.

A fuller spreadsheet with some constituent components of the revenue and expenditure items is available here.  Note though that composition changes have affected some of the items.  For example, on the revenue side, the Health Levy, a departmental receipt for Health, was replaced by the Universal Social Charge and now appears under Income Tax.  On the expenditure side, FÁS, or equivalent, was transferred from Enterprise to Education.  These changes don’t affect the overall totals shown above.

Some comments on the above table are provided above the fold but offers little that we do not already know.  It is little more than a thought-straightening exercise. 

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Getting to Three Point One

The level of the ‘adjustment package’ in last week’s budget has created some confusion.  The basic sum involves the €1.85 billion of new measures for 2014 announced last week, €0.65 billion of carryover effects (measures which were announced last year but kick-in this year) and €0.6 billion of “additional resources and savings”.  So we have

€1.85bn + €0.65bn + €0.6bn = €3.1bn

The €0.6 billion of “savings” was not set out in the Budget documents but the Minister for Finance has subsequently confirmed it to be €0.2bn from the activities of the NTMA, €0.1bn extra on the Central Bank surplus, €0.15bn due to Live Register “fluctuations” (!), and another €0.15bn arising mainly from state asset transactions.

It is not clear why these items should be counted as adjustments, measures or savings.  It is hard to see how policy changes have impacted them and most are things that would, or should, happen regardless of what was in the Budget.

The new measures in the budget were €0.35bn of net tax measures and €1.5bn of expenditure measures.  There was around €0.65bn of new taxes introduced but some of this was offset by the retention of the special 9% VAT for tourism etc. which cost around €0.3bn.  The tax measures are summarised in Table 7 of the Economic and Fiscal Outlook.

A summary of the €1.5bn of expenditure measures (€1.4bn current and €0.1bn capital) is not provided but it can be quickly extracted from the Expenditure Allocations report.  There are two current expenditure measures we can look at:

• Central Policy Developments: Pay policy measures
• Savings measures introduced in 2014 to adhere to the ceiling

The first are the savings that arise from the Haddington Road Agreement brokered between the government and the public sector unions earlier this year and the second are the measures announced in the Budget.  All comprise the adjustment made to current expenditure for 2014 and are summarised here (in €million).

The total of €1.9bn might suggest that there was over-achievement on the expenditure contributions but some of the savings here were used to loosen the pressure elsewhere.  In last year’s budget a ceiling of €49.2bn was set for gross voted current expenditure in 2014.  As a result of decisions taken the ceiling was increased to €49.6bn.  This means some of the savings above were used to fund expenditure elsewhere bringing the net expenditure adjustment to €1.5bn.

For example, Education shows €226 million of pay savings for 2014 but the Department’s pay bill in the Estimates shows a fall of €184 million. The difference is explained by additional staff (mainly teachers and teaching assistants). Staff numbers under the remit of the Department of Education will rise from 94,490 this year to 95,745 in 2014 – an increase of nearly 1,300.  Capital expenditure on education is also set to increase by around €135 million in 2014 – a rise €65 million greater than what was budgeted for last year.

So now it seems we are left with the following budgetary sum.

Whatever about their precise nature the €0.6bn of “additional resources and savings” are needed to bring the sum to three point one.

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Why is the projected budget deficit higher?

Back in April the Department of Finance published the 2013 Stability Programme Update.  In it the projected general government deficit for 2014 was 4.4% of GDP.  This assumed a package of adjustments of €3.1 billion in the Budget. 

Yesterday a package of €2.5 billion of expenditure cuts and tax increases was announced but because of measures put in place earlier in the year (mainly the Haddington Road Agreement) the amount of adjustment for 2014 remains at €3.1 billion.  The Economic and Fiscal Outlook (bottom of page 13) says:

Tax and expenditure consolidation measures of €2.5 billion are complemented with additional resources and savings of some €600 million, giving a total adjustment package of €3.1 billion.

So if the level of adjustment is the same why is it that the projections issued with yesterday’s budget are for a 2014 deficit of 4.8% of GDP.  A comparison of the April and October figures may provide some insight into where the deterioration comes from.

It is pretty clear why the projected deficit is higher: revenue for 2014 is now expected to be around 1% lower compared to what was set out in April.  Total expenditure is virtually unchanged.

Why is the revenue figure down?  It is mainly because of lower than expected receipts from Income Tax, VAT and Excise Duty.  As described in the notes to the table on page 33 of the Economic and Fiscal Outlook the 2013 outturn for these is set to be around €650 million than was projected even as recently as April.  These lower receipts in 2013 then have knock-on implications for the 2014 projections.

The composition of expenditure appears to have changed since the publication of the April figures but that is largely down to reclassification issues on about €1 billion of expenditure on third-level education.  Free fees (€250 million) and the block grant (€350 million) have been shifted from Other Expenditure to Social Payments and Subsidies respectively, while another €300 million to universities previously under Capital Transfers has also been reclassified to Subsidies.

A notable change in the expenditure list is the increase in Compensation of Employees of €665 million.  There doesn’t appear to be a reclassification item that is responsible for this.  There is also a €490 million fall in the figure for GFCF, though the Exchequer Account figures actually shows a slight rise in 2014 estimate for Gross Voted Capital Expenditure (€3,230 million in the SPU to €3,335 million in the Budget).  Again we may be looking at a reclassification issue but it does not appear to specified.

The Exchequer Account projections in April’s SPU and the Budget’s EFO also show that the deterioration is mainly due to a reduction in revenue forecasts.  In April, Exchequer Tax Revenue for 2014 was put at €40,975 million.  Yesterday a figure of €40,040 million was provided which represents a decrease of nearly €1 billion.

Why is revenue lower than expected? Mainly lower growth, and also lower inflation, than expected. A recent post covered this and the figures for nominal GDP at the bottom of the table above illustrate the problem.  Back in April, NGDP for 2014 was expected to be €174.3 billion.  Just six months later and the figure has been revised down to €170.6 billion.

Ireland collects the equivalent of 30% of GDP in tax revenue.  It’s a bit crude, but 30% of a €3.7 billion reduction in NGDP is roughly €1 billion.  And that is pretty much the reduction that has been applied to the forecast of tax revenue.

If it wasn’t for the accounting chicanery from the Promissory Note swap yesterday’s budget would have meant a 2014 deficit of around 5.4% of GDP.  As the previous post concluded, excluding the largely notional Promissory Note gains (see here) “the numbers [.] suggest that more should be done if the fiscal consolidation plan is to remain “on track” not less.”

Yesterday’s Budget had the full €3.1 billion of adjustments (as confirmed by the Economic and Fiscal Outlook) and the deficit is not falling as fast as planned.  Even if the 4.8% of GDP deficit targeted for 2014 is achieved there is still a significant step to be made to get it under the 3% of GDP limit in 2015 as required under the Excessive Deficit Procedure.  The gamble being taken (again!) is that nominal growth will have resumed by then and will carry most of the burden.  Who wants that bet?

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€12 billion in CT revenue?

The issue of Ireland’s corporation tax continues to generate lots of debate.  Whether this is a good thing or a bad thing is also open to debate.  At a recent Oireachtas Committee hearing a question on Ireland’s reputation was put to Prof. Frank Barry of Trinity:

Prof Frank Barry: That is a very interesting question. We speculated for some time about whether the US Senate hearings and reports would cause reputational damage for Ireland. The US newspaper, The Wall Street Journal, has had Ireland in its sights for a long time, complaining about Ireland’s tax regime. I spoke to one of its journalists from the US. It has a stringer in Ireland to whom I often talk, but I was called by a journalist in its US office and had a long chat on precisely this subject. They told me that the sense they were getting from Silicon Valley was that this was doing us no damage whatsoever. I talked with the IDA economists afterwards about this and they said that was exactly what they were hearing as well. That is interesting. I regard the The Wall Street Journal as a hostile source in that sense, so the fact it was saying that was interesting and certainly indicative. Yes, I think we might be over-paranoid here about the possible reputational consequences.

It is hard to know either way.  Moving on.  Yesterday’s Sunday Business Post had an article from David McWilliams on the topic.  It included this assertion:

If these companies were to pay tax at the very low – by international standards – of 12.5 per cent, the exchequer would net Euro 12 billion in corporation tax per year. Euro 12 billion!

[Gated with the SBP but available here.] That is €8 billion more than the c.€4 billion that is currently collected and “these companies” are just the US-owned ones.  The SBP piece is based on a recent article from the Finfacts.ie website.

US company profits per Irish employee at $970,000; Tax paid in Ireland at $25,000

Preliminary data [pdf] from the US Bureau of Economic Analysis (BEA) on majority-owned foreign affiliates of US firms show that in 2010 (latest available), Irish-based firms reported net income of $95.6bn and a payroll count of 98,500 [pdf], which gives profits per employee of $970,000.

And here is where we run into problems.  Depending on the exchange rate used that gives something around €75 billion of profits just from the US companies operating in Ireland.  If we add in Irish companies and non-US foreign companies we can see that the overall amount of profit reported in Ireland could be expected to be well in excess of the above €75 billion figure.  Is it?

We can use the Annual Statistical Report from the Revenue Commissioners to find the amount of business profit that is declared in Ireland for tax purposes.  In the 2010 report it was €70.8 billion.  And here is a table from this post that shows how the €70.8 billion of gross profit is translated into the €4.2 billion of corporation tax that was paid.

The table also shows that the effective tax rate on the €41.2 billion of “Taxable Income” in 2010 was 10.3%.  So what happened to all the profits that the US-owned “Irish-based firms” are making? 

It is not the case that US-owned firms are massively under-reporting their profits from their Irish subsidiaries to the Revenue Commissioners; it is more the case that the profits from these companies are not resident in Ireland for tax purposes.  The problem is down to the definition one uses for “Irish-based”.

For individuals, the US tax system recognises someone as being liable for US income taxes if they hold a US passport.  That is, it doesn’t matter where they live or where they work, as long as they have a US passport they are liable for US income tax, with offsetting credits received for the tax they pay where they live.  [For a discussion of this and recent changes brought in through the FATCA see this BBC article.]

For companies, US residency rules are also based on paperwork rather than activity.  Under US law, the tax-residence of a company is the country where it is incorporated (i.e. what country’s ‘passport’ does it carry).  All companies registered in Ireland are thus considered “Irish-based” under US law.

Ireland is similar in many respects but we have a slightly more intricate approach when it comes to determining corporate tax residency.  Historically, the rule was (from revenue.ie):

All companies whose central management and control is exercised in Ireland (whether it is incorporated in Ireland or not) is regarded as resident in Ireland for tax purposes.

This was revised in the Finance Act, 1999, and now:

in general, companies incorporated in the State are resident in the State.

One of the exceptions to this is:

a company that is ultimately controlled by persons resident in the EU or in a country with which Ireland has concluded a double taxation treaty or is is related to a company the principal class of the shares of which is substantially and regularly traded on one, or more than one, recognized stock exchange in an EU Member State or in a tax treaty country.

Thus, some foreign-owned, Irish-incorporated companies will not be viewed as tax resident in Ireland if they are not centrally managed and controlled here.  Prior to 1999 this was also possible for companies owned by Irish residents but the changes in the Finance Act 1999 tightened up the exceptions to the test of incorporation to foreign-owned companies only.

So what is at play here is that there are Irish-incorporated companies who, for want of a better word, “live” somewhere else.  Just like our income tax system does not levy income tax on Irish nationals who live and earn money abroad, our corporation tax system does not levy corporation tax on (some) Irish corporations who carry out their activities abroad.

There is little that is unique or unusual about this.  The issue is how our rules interact with rules of other jurisdictions, and the US in particular.

When the US Bureau of Economic Analysis says that US-owned, Irish-based companies had nearly $100 billion of profits in 2010 we actually have to go to Hamilton, Bermuda to find a good chunk of it (where Google Ireland Holdings is managed and controlled from) or Cupertino, California (where Apple Operations International is managed and controlled from).

Google Ireland Holdings is tax resident in Bermuda and pays corporation tax there on its massive global profits (the rate of CT in Bermuda is zero by the way).  Apple Operations International is tax resident nowhere and thus pays corporation tax nowhere.  Even though AOI carries out all its activity in the US, it is not resident in the US for tax purposes because it is incorporated in Ireland.  Could Irish emigrants in the US avoid US income taxes because they have an Irish passport not a US one?!? 

Both Google and Apple parent companies are liable for US corporation tax at 35% on their worldwide profits (with offsetting credits given for tax paid elsewhere).  Because of the structure of their businesses and the nature of their profits (passive income generated by intellectual property) they do not have to pay this tax liability until the profits are repatriated to the US.  In the case of Apple the profit is already in the US (and is managed in Reno, Nevada by Braeburn Capital) but because it is controlled by Irish-incorporated AOI it is still deemed “offshore”.

Google’s ability to shift profits to Bermuda where it has no activity or real presence is questionable and needs to be curbed; Apple’s ability to declare profits as tax resident nowhere is just wrong and needs to be stopped. Unilateral action by Ireland is unlikely to achieve either objective.

The OECD’s BEPS initiative may make some inroads in limiting the ability of companies to shift profits to no-tax, no-activity jurisdictions such as Bermuda.  This might impact the scheme used by Google.  The arrangement used by Apple is a bit more clear cut – companies should be tax resident somewhere.  Sinn Fein’s Pearse Doherty has made proposals in this vein over the past few months – that Irish-incorporated companies can only be non-resident here for tax purposes as long as they are tax resident somewhere else, even if that is no-tax Bermuda. 

We are probably not going to hear much at this level of detail in tomorrow’s budget but the Finance Act, 2014 may look to disassociate Ireland from the “ocean money” created by Apple.  How might Apple respond?  A likely response would be to move the management and control of AOI to Hamilton, Bermuda (which requires no more than a post-box) and do as Google does.  Of course, the US could move to treat AOI as US-resident for tax purposes (it does engage in all of its activities there) as suggested by Sen. Carl Levin back in June but the reaction by the company would probably be the same.

There will be no €12 billion of extra corporate tax revenue for Ireland but hopefully madcap notions that there could be will become a little less frequent.

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Deficit Effect of Recent Budgets

The White Paper with the Estimates of Receipts and Expenditure released at midnight last night shows that in a “do nothing” scenario the Department of Finance estimate that the 2014 general government deficit would be 5.8% of GDP (with the 2013 deficit now projected to be 7.3% of GDP)

In advance of Tuesday’s budget Minister for Finance, Michael Noonan has said that the projected deficit for 2014 will be 4.8% of GDP.  Therefore the projected effect of the measures to be announced on Tuesday is a 1 percentage point of GDP reduction in the deficit. 

How does this compare to recent budgets?

The “do nothing” scenario sees the deficit fall from 7.3% of GDP in 2013 to 5.8% of GDP in 2014.  Around three-quarters of the improvement can put down to three factors:

1. The February 2013 liquidation of the IBRC required a €1.1 billion (0.7% of GDP)  payout under the Eligible Liabilities Guarantee (ELG) which will not happen in 2014.
2. The 9% temporary VAT rate for the tourism sector introduced in July 2011 automatically expires on the 31st of December 2013.  This will increase VAT receipts by around €360 million (0.2% of GDP).
3. The full-year roll-out of the Local Property Tax is expected to generate an additional €250 million (0.2% of GDP) of revenue in 2014.

That only leaves 0.4 percentage points of the “do nothing” deficit improvement to possible growth effects (and there are other minor carry-forward effects that kick-in in 2014).

If the deficit outturn for 2014 is the 4.8% of GDP that means a 1.9 percentage point of GDP improvement in the deficit would be required in 2015 to keep in line with the limits set out under the Excessive Deficit Procedure (an EDP limit of 2.9% of GDP has been set for the deficit in 2015). 

Nominal GDP growth in 2015 may be a little faster than in 2014 but probably not by much. The current DoF forecasts is for nominal growth of around 3% in 2014.  If that was repeated in 2015, NGDP in 2015 would be around €175 billion.  The April 2013 SPU forecast was that it would be €182 billion. 

Those figures indicated that with slightly higher nominal GDP growth and a €2 billion package of adjustments in Budget 2015 that the deficit was expected to fall by 2.1 percentage points of GDP.  To get under the 2015 EDP limit that is pretty much what is required. 

However, with lower nominal growth and possibly smaller carryforward effects from next week’s Budget then the level of adjustments necessary to hit the 2015 deficit limit may have to rise above the €2 billion that has been pencilled in.  Reducing the cuts in next week’s budget may merely be delaying for 12 months the effort that has to be put in to bringing the deficit down.  Of course, the growth fairy may arrive over the next 18 months in time for 2015.  Hasn’t a return to growth always just been 18 months away?

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New emphasis on the primary balance

The repeated calls of what should be done with the Promissory Note “savings” is likely why we have seem the Minister for Finance try to put some emphasis on the primary budget balance in recent weeks.  The primary balance excludes interest costs so is the difference between government revenue and government expenditure on goods and services. The primary balance was unaffected by the Promissory Note restructuring discussed in the previous post.

At the time of Budget 2013 in December 2012, the projected primary balance for 2014 was for a surplus of €0.6 billion. April’s Stability Programme Update had an overall balance that showed a €1.2 billion improvement from the budget day figures (mainly because of the Promissory Notes restructuring) but the projection of the primary balance for 2014 was little changed with a primary surplus of €0.8 billion expected.

The SPU states that the improvement was “mainly driven by better than expected taxes in 2012 which have a carryover effect into later years”.

The target of fiscal consolidation is the primary balance. There are no budget measures that directly effect interest expenditure. The effect will be indirect through the interest rate charged by lenders and the size of the debt. This article written for Independent.ie back in April discusses the relationship between the primary deficit and austerity.

Excluding once-off measures such as the bank recapitalisation payments, the recent primary balances and near-term projections are:

• 2007: +€2 billion
• 2008: –€10 billion
• 2009: –€16 billion
• 2010: –€13 billion
• 2011: –€9 billion
• 2012: –€6 billion
• 2013*: –€3 billion
• 2014*: +€1 billion

The process of restoring a primary surplus after the collapse of the public finances in 2008 will have taken seven years and the accumulation of nearly €60 billion of primary deficits. Since peaking in 2009, the primary deficit has been steadily reduced. In most cases running primary deficits in response to an economic downturn is the appropriate policy but we ran up against the immutable element of all maximisation problems in economics – the constraint. In this case it is having someone lend the money to allow you run the deficits.

The reduction in the overall deficit has been slower because interest expenditure has risen from €2 billion in 2007 to €8 billion now – running €60 billion of primary deficits does not come cheap.  Based on figures from April’s Stability Programme Update, the 2014 deficit will be an €8 billion interest bill less a €1 billion primary surplus or €7 billion.

Although the deficit limits set out in the EDP are in terms of the overall general government balance it is the primary balance that matters in a debt sustainability analysis (i.e. the path of the debt/GDP ratio).

If a country runs a primary balance then the debt ratio will be constant if the average interest rate on its government debt is equal to the nominal growth rate of GDP.  This is because both the numerator and denominator in the ratio debt/GDP are growing at the same rate. For a country that wishes to reduce the debt ratio (as Ireland does) then one avenue for this is if the nominal growth rate exceeds the average interest rate.

The average interest rate on Ireland’s government debt is around 4.25%. As discussed in an earlier post on deficit targets this is greater than the current nominal growth rate and debt sustainability is further exacerbated by running a primary deficit. Unsurprisingly, Ireland’s debt ratio will rise this year, but most predictions are that 2013 will give the local peak of the debt ratio after which it will fall. Here is a chart from the IMF’s Tenth Review.

There are some stock/flow adjustments that mean the debt ratio is likely to fall next year almost regardless of economic conditions. This is mainly the €30 billion of pre-borrowing the NTMA has accumulated in advance of our expected exit from the EU/IMF programme this year. Of more importance, though, are the underlying debt dynamics: do the interest rate, nominal growth rate and primary balance satisfy the conditions of a declining debt ratio?

With a 4.25% average interest rate on government debt and current evidence suggesting that a 4.25% nominal growth rate for 2014 may not be achieved the underlying path for the debt ratio is up – unless a sufficiently large primary surplus can be run offset the difference between the interest rate and the growth rate.

While the interest rate on Ireland’s government debt is low by historic standards and a 4.25% nominal growth rate is below the long-run average, there is likely to be a gap between them and not one that favours debt sustainability. If the gap between them was 0.75 percentage points (4.25% interest rate versus 3.50% nominal growth rate) then given current Irish public debt levels at just north of 120% of GDP it would take a primary surplus of around 1% of GDP to stabilise the debt ratio.

With the €3.1 billion of adjustment in Budget 2014 the April SPU projected a 2014 primary surplus of 0.5% of GDP. This is not sufficient to stabilise the debt ratio in 2014 under the assumptions used here. Of course, it is almost guaranteed that the gross debt ratio will fall in 2014 as some of the cash resources built up will be used to finance the deficit as opposed to new borrowings.

It is the underlying debt dynamics that matter and these have yet to move in the right direction. Given the low interest rates, the size of the primary surplus necessary to stabilise the debt ratio is not large. With a further budgetary adjustment of €2 billion planned for 2015 the SPU projects a primary surplus of 2.7% of GDP in 2015.

That is well in excess of the level required to stabilise the debt ratio and, even with lower than projected nominal growth, by 2015 it is likely that the underlying debt dynamics will be for a declining debt ratio. This assumes that the improvement in the primary balance seen over the past few years is maintained.

The importance of primary surpluses for a high-debt country was emphasised in Moody’s statement last Friday on its revised outlook for Ireland:

Why did they improve their outlook on Ireland?

The rating agency expects the government to re-establish debt-stabilising primary surpluses in 2014 and for those surpluses to expand subsequently, resulting in declines in the government's headline debt-to-GDP ratios as well as improving the affordability of its debt.

How might their outlook further improve?

Upward pressure would develop on Ireland's government ratings and/or rating outlook if the government continued to comply with its fiscal consolidation targets, and growth were to resume at a pace that, together with consistent primary government budget surpluses, would be sufficient to firmly position the government debt metrics on a downward path and ensure debt sustainability over the medium to long term.

Conversely, downward pressure would develop on Ireland's government rating and/or rating outlook if the country's fiscal consolidation process were to falter to the extent that Moody's projected that government net debt metrics will increase significantly above their current level of roughly 100% of GDP.

It is all about the primary surplus.  Michael Noonan may be accused of “shifting the goal posts” by now talking about primary surpluses but the game is changing. Under the EU/IMF programme the targets were adopted from the Excess Deficit Procedure and were to reduce the underlying general government balance with little emphasis given to the debt levels that resulted.

Upon exit of the programme the objective will be to obtain funding from financial markets and one of the key parts of their approach is debt sustainability analysis. The change in emphasis to the primary surplus is merely a reflection of the changed position the country will be in but with little emphasis on the primary balance over the past few years it may be a necessary move that does not get much traction.  Especially when people are convinced they have €1 billion of savings to distribute!

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Deficit targets and nominal GDP

The upcoming budget is set to be framed around a general government deficit limit of 5.1% of GDP for 2014.  This was set as part of the EU’s Excessive Deficit Procedure (EDP) in an Council Recommendation to Ireland from December 2010.

There was much comment last week on the performance of real GDP in Ireland (up 0.4% in the quarter apparently) but debt contracts are written in nominal terms.  And last week’s National Accounts release from the CSO was not very positive on that front.

In this year’s budget from December 2012 the following GDP/GNP projections were used.

The current estimate is that nominal GDP in 2012 was €163.9 (thus exceeding the figure above) but the increases necessary to reach the subsequent levels seem unlikely.

In the Stability Programme Update published in April the projected general government deficit for 2013 was put at €12.575 billion.  If the actual outturn is close to this, nominal GDP will have to be around the €167.7 billion as projected in order for the deficit to satisfy the 7.5% limit set under the EDP.

The two quarters of 2013 data we have give the following estimates of nominal GDP:

• Q1 2013: €39,106 million
• Q2 2013: €41,679 million

These sum to give a half-year figure of €80.8 billion.  In 2012 (when nominal GDP was €163.9 billion) the figure for the first half of the year was €82.0 billion.

To meet the 2013 deficit target, nominal GDP needs to be nearly €4 billion higher than last year, but it is already running over €1 billion behind the 2012 level.  With revisions, nominal GDP of €87 billion is required in the latter half of the year for the €167.7 billion level to be reached.  The equivalent figure for H2 2012 was €81.9 billion, so year-on-year growth of just over 6% in H2 is required.

There are some indications that economic activity will pick up in the second half of the year.  Employment seems to be edging higher, retail sales were up in July and the change in car registrations all point to some improvement in Q3 and Q4.  Nominal figures are a combination of real changes and price changes and, on the consumption side at least, inflation is heading ever lower and is approaching zero.

Of course, Irish national accounts data is inherently difficult to predict.  A couple of intra-company changes in the MNC sector can have a huge impact on the figures (MNCs account for 90% of the export figure in the national accounts).  Nominal GDP of €167.7 billion could be reached but if it came up short at, say, €165 billion then a €12.6 billion general government deficit (as projected in the SPU) would give a deficit of 7.6% of GDP – in breach of the EDP limit set for Ireland, albeit by a very small amount (0.1 pp). This overshoot is actually the same as the 2013 deficit-increasing impact of the Promissory Note restructuring which took place in February.

It will be March of next year before a first estimate of the 2013 deficit/GDP ratio is known and no extra fiscal efforts will be introduced if it is felt the EDP limit will be breached this year.  It is also possible that developments since April will result in a smaller deficit than the €12.6 billion projected in April.  Whatever about 2013, it is definitely the case that the nominal GDP figures will have an impact on the fiscal effort required for 2014.

Last year’s budget included a NGDP projection of €174.1 billion for 2014.  The indications from the data released since then are that this projection will need to be revised down.  The 1.5% real GDP growth forecast for 2013 is unlikely to be met and the implicit GDP deflator resulting from the CSO’s chain-linking method may be less than 1.3%.  For 2014, real growth of 2.5% is projected with a GDP deflator of 1.3% again expected.

NGDP for 2013 is likely to be behind the budget projection and the 3.8% nominal growth rate for 2014 may also be underachieved.  A €165 billion outturn for 2013 and a 3% nominal growth rate for 2014 gives a 2014 figure of €170 billion.

If this is the case satisfying the EDP limit of 5.1% of GDP requires a general government deficit of no more than €8.7 billion.

Absent the Promissory Note arrangement, this lower nominal GDP would have meant achieving the 2014 EDP limit with a budgetary adjustment of €3.1 billion would have been difficult.  In last year’s budget projections an underlying deficit (i.e. excluding direct banking measures) of €8.9 billion for 2014 was projected.  This was sufficient to met the EDP limit when NGDP of €174 billion is used but would be in excess of the limit if NGDP was actually around €170 billion.  Using last December’s figures it is possible to see that an adjustment of more than €3.1 billion would be necessary to stay under the EDP limit.

There have been changes since then, of course, most notable the Promissory Note restructuring.  By April, the projection for the 2014 deficit (again with an assumed €3.1 billion adjustment) was down to €7.7 billion.  Even with lower NGDP this will be inside the EDP limit of 5.1% of GDP.  At €170 billion such a deficit in 2014 would be 4.5% of GDP.

It may be the case that next month’s budget will have a smaller package of tax increases and expenditure cuts then envisaged at the time of last year’s budget.  However, this not because of any unexpected improvement in underlying economic conditions.  In fact, the numbers last week suggest that more should be done if the fiscal consolidation plan is to remain “on track” not less.

The reason why less can be done is all down to the Promissory Note restructuring and some comments on these “savings” are presented in the next post.

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“Legacy of Debt”

Lots of talk about a “legacy of debt” in response to yesterday’s re-arranging of the Promissory Notes/ELA framework.  First up, governments don’t repay debt, they roll it over.  And, as well as the size of the debt, there are two things that matter for debt rollovers:

• average maturity
• average rate of interest

Today’s announcement does not change the size of the debt but the maturity and interest rate changes are very significant (and beneficial in case there is any confusion).

Yesterday, Ireland was faced with the prospect of carrying a debt of €25 billion on the Promissory Notes and needed to roll that over with payments of €3 billion every year at whatever the best available rate at the time was.

At the end of the Promissory Notes (which would probably have been around 2022) the debt would still exist and what would need to be rolled over would have been the borrowings undertaken in the interim to meet the €3 billion annual repayments.  This legacy of debt was always going to exist and would have needed to rolled over in 2025, 2035, 2045 or whenever.  Government debt is not extinguished, the burden of carrying it (the interest) is eroded through growth and inflation.

Yesterday’s announcement offers some significant benefits for Ireland on both fronts.  Firstly, the average maturity has been extended to an average of 34 years.  This means the debt has to be rolled over far less frequently and through that reduces risk.  Under the current arrangement there would be €25 billion of debt being paid off in chunks of €3 billion and these would quickly accumulate into a total of tens of billions that would need to be frequently rolled over depending on the nature of the borrowings used to fund the annual payments.

The new arrangement postpones this roll over to an average duration of 34 years.  Rolling over €25 billion of debt in 2020 could present significant difficulties.  Rolling over €25 billion of debt on a staggered basis between 2038 and 2053 will be far less onerous.

The new arrangement also offers the significant interest rate benefits.  Under the Promissory Note arrangement debt with a very low net external cost of 0.75% (the ECB MRO rate) was transformed into much more expensive debt (EU/IMF loans at 3.3%) at a rate of €3 billion per annum. 

The net external cost remains at 0.75% but the rate at which the debt is transformed into more expensive debt has been significantly reduced.  As a result of the Central Bank of Ireland selling the bonds it receives as part of the swap this will happen at a rate of €0.5 billion per year up to 2018, €1 billion a year from then until 2023 and €2 billion a year thereafter.

The €25 billion of Promissory Notes would have been turned into full interest-costing sovereign debt by around 2022.  Today’s announcement means that the full €25 billion will not become fully interest-costing until around 2032.  We have gained because the debt with a net external cost of the ECB MRO rate is now available for longer.

Future generations were always going to have a “legacy of debt” of €25 billion.  What yesterday’s announcements have ensured is that they will have access to lower interest rates for longer and will be faced with rolling over the debt less often.  In the arena of public debt both of these are a win.

Here are some figures since 2008:

• 2008: €10.9 billion
• 2009: €15.4 billion
• 2010: €11.8 billion
• 2011: €10.2 billion
• 2012*: €7.0 billion
• 2013*: €3.4 billion

This figures will give a “legacy of debt” of €58.7 billion.  This is more than €30 billion greater than the total in question in yesterday’s restructuring.  What are these figures?  They are the underlying primary deficits (the deficit net of interest costs and banking measures) that the state ran from 2008 to 2011 and the projections of what the primary deficit will be for 2012 and 2013.

This is the excess of government expenditure on public sector pay, intermediate consumption, social transfers, capital formation and subsidies for the current generation over the tax revenue the government is raising from the current generation.  Over a six- year period the government is spending nearly €60 billion more on us in services and transfers than it is collecting from us in taxes and charges.  Why is no one concerned about this “legacy of debt” for future generations?

If we could borrow this money with a zero-interest perpetual bond there would be no need to worry about future generations.  They would have to pay nothing for our borrowings.  This highlights that for governments it is not the amount of debt that matters.  With governments debt doesn’t matter, deficit spending does.

The debt only matters insofar as it generates an interest cost.  If this money has to be borrowed at 4% it will cost future generations over €2 billion a year in interest for the privilege of us spending more on ourselves than we are willing to pay in taxes.  Is this a legacy we are willing to impose on future generations?

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Deficit-, debt- and expenditure-impacting banking measures

A recent post over on Notesonthefront has attracted a lot of attention on “the cost of the banking crisis”.  The figures from Eurostat show that Ireland contributed 42% of the EU total and have been widely quoted including this prominent piece in The Irish Examiner

42% of Europe’s banking crisis paid by Ireland

Ireland has paid 42% of the total cost of the European banking crisis, at a cost of close to €9,000 per person, according to Eurostat.

This is not the correct interpretation of the Eurostat figures.  The Eurostat figures used to support the claim give one impact of the banking crisis on public finances, that is:

1. The impact on the flow of annual government deficits

It is not the case that this reflects the full cost of the banking crisis.  As will be discussed below not all of the measures introduced in response to the banking crisis are deficit impacting.  An additional impact that could be considered is:

2. The impact on the stock of the gross government debt

There is no reason to expect #1 to be the same as #2.  There may be transactions with the banking sector that are counted as deficit increasing but if they are funded from existing resources they will not add to the stock of debt. 

It will also be the case that there may be transactions which are not counted as deficit increasing but if funded with borrowed money they will add to the stock of debt.

Eurostat have produced figures on #1 as they can measure the revenue and expenditure flows on an annual basis.  However, they will not produce statistics on #2 for the simple reason that money is fungible.  Governments borrow money because their overall expenditure exceeds their revenue.  It is difficult to attribute changes in debt to a single expenditure item because reductions in any expenditure would reduce the need to borrow.  That doesn’t mean it isn’t attempted though!

The Eurostat figures show that between 2008 and 2011, measures related to the banking crisis contributed €41 billion to Ireland’s general government deficits.  By the end of 2011, the government had contributed around €63 billion to the banking sector and, of this we can guess that around €47 billion was with “borrowed” money (essentially it is non-NPRF money, but the assumption is that this expenditure increased borrowings).

The above paragraph shows a third, a more complete, measure of the impact of the banking crisis on the public finances:

3. Total expenditure incurred by general government as a result of the banking crisis.

Again Eurostat are not going to produce statistics on this as much of the expenditure will be by public investment funds (such as the NPRF) or by special purpose vehicles (such as NAMA).  A lot of these are “off-balance sheet” transactions.

So for Ireland, at the end of 2011, the figures were:

1. €41 billion
2. c. €47 billion
3. €63 billion

The first figure has received lots of attention but it is actually the smallest.  The second figure is a bit of a guess and although the largest the final figure could yet be under-stated. 

Number 3 will be clouded by the use of special purpose vehicles which initially keep the expenditure outside the government sector.  NAMA has spent €32 billion acquiring loans with a nominal value of €74 billion from our delinquent banks.  NAMA is not going to lose €32 billion but a shortfall of, say, €5 billion is possible on its operations which will have to be made good with expenditure by the government.

In Ireland in 2011 #1 makes up about two-thirds of #3.  In other countries the gap between #1 and #3 is likely to be even greater.  In part, this is down to the type of bailout adopted in Ireland, rather than the total cost.

For example, we know that the UK has contributed £66 billion to just two banks: Lloyds and RBS.  That is around €80 billion which would count in #3 (full expenditure) but the figure for the UK in the Eurostat deficit data is just €11 billion.  Where did the other €69 billion go?

To answer this question we must explore what Eurostat measured when they provided figures for the deficit-impacting measures introduced in response to the banking crisis.  This all comes back to a Eurostat decision published in July 2009.

The key is whether a measures is considered as a “financial transaction” or a “capital transfer”.  Financial transactions are not deficit impacting; capital transfers are deficit impacting.  The impact of both in the debt is not objective, while their impact on expenditure is unambiguous.  So what is a “financial transaction”?  Per the Eurostat decision:

The valuation of financial transactions: In principle the ESA 95 provides for financial transactions (which do not impact on the government deficit) to be recorded "at the transaction values, that is, the values in national currency at which the financial assets and/or liabilities involved are created, liquidated, exchanged or assumed between institutional units, or between them and the rest of the world, on the basis of commercial considerations only" (paragraph 5.134).

However it is acknowledged in paragraph 5.136 that "in cases where the counterpart transaction of a financial transaction is, for example, a transfer and therefore the financial transaction is undertaken other than for purely commercial considerations, the transaction value is identified with the current market value of the financial assets and/or liabilities involved".

It does, of course, leave something of a grey area but we can see that if a financial transaction is done at the “current market value” it does not impact on the government deficit, whereas if it happens above the “current market value” the transaction value is identified and the amount above that is considered a capital “transfer”. 

The Eurostat decision goes through different forms of banking support and shows whether they impact on the deficit or not.

1. Recapitalisation operations
2. Lending
3. Guarantees
4. Purchase of assets and defeasance
5. Exchange of assets
6. Classification of certain new bodies
7. Recording of certain transactions carried out by public corporations

Eurostat did not need to provide a separate decision for the general government gross debt measure it produces.  The debt is just the sum of all of the liabilities of the general government sector.  It does not matter what the money is used for.  All that matters is whether a liability exists or not.

For example, when the Promissory Notes were created in 2010 they were classed as a “loan to government” from Anglo/INBS and would immediately be added to the general government gross debt.  There was some issue of whether they would count in the 2010 deficit but the counter transaction to the loan was recorded as a “notional capital transfer” as the government promised to repay a €31 billion loan without first receiving the money from the bank as is the case with a typical loan.

Here is the full set of recapitalisation payments made to the banks since 2009, classified as “financial transactions” or “capital transfers”.

The payments under financial transactions were not deficit-increasing, whereas those recorded as capital transfers were deficit increasing.  It remains to be seen what value can be realised through the sale of the assets acquired through the financial transactions. 

There have been some sales already.  In 2011, €1.1 billion was realised from the sale of a 35% ordinary shareholding in BOI, while in January 2012 the €1 billion contingent capital note in BOI was sold at close to par.  There was also a transaction in 2010 that saw €1.7 billion of the preference shares in BOI converted into ordinary shares.

It can be seen that 75% of the capital transfers total arises from the Promissory Notes issued in 2010.  No other country has used such a scheme to prop up a bust bank and the loan loss figures mean that any mechanism devised would have been recorded as a capital transfer.

The transactions are split between those undertaken by the NPRF (directed by the Minister for Finance) and those undertaken by the Exchequer (directly by the Minister for Finance).

All of the financial transactions involving preference and ordinary shares in AIB and BOI were done through the NPRF.  It should be noted that the €3.5 billion of preference shares in both AIB and BOI bought in 2009 by NPRF was funded with €4 billion from the NPRF and a “front-contribution” of €3 billion from the Exchequer to the NPRF.  All the contingent capital notes transactions as well as the ordinary shares in PTSB and Irish Life were funded, and now held, by the Exchequer.

Most of the capital transfers were provided by the Exchequer but the €6 billion capital transfer provided to AIB in July 2011 was split with €2.3 billion coming from the Exchequer and €3.7 billion coming from the NPRF.  This €3.7 billion from the NPRF was a deficit-increasing expenditure (though didn’t impact on the debt as it came from pre-existing funds).

So has Ireland carried 42% of the total EU cost of the banking crisis?  Impossible to say.  We do know that Ireland has incurred 42% of the deficit-impacting measures introduced in response to the crisis.  But that is not the same thing as the total cost. 

In Ireland’s case, the Promissory Notes have pushed up the capital transfers to an extraordinarily high figure relative to other EU countries.  In fact the explanatory notes to the data say (on page 12) that:

The only case where government liabilities increased much more than government assets is Ireland. This can be explained by the fact that most interventions have been immediately recorded as deficit-increasing government expenditure and not as financial transactions.

Most EU countries have generally recapitalised their banks using financial transactions (purchase of shares and other instruments).   Ireland didn’t have any money to buy anything in Anglo and, as stated above, Anglo was nursing such loan losses that all efforts to keep it solvent were going to be recorded as capital transfers anyway.

Throughout the EU it remains to be seen what the assets acquired through these the financial transaction approach to recapitalising their banks will actually be worth.  If losses relative to the purchase price are crystallised on the sale of these assets then the difference will be recorded as a capital transfer and Ireland may not be such an outlier.

How much of the £66 billion pounds provided to Lloyds and RBS will be returned to the UK Exchequer? Will they get back much of the £14 billion (€17 billion) capital contributions that Lloyds through Bank of Scotland(Ireland) and RBS through Ulster Bank have made to their loss-making Irish subsidiaries?  In total, the UK has made a cash outlay of around €145 billion to rescue its banks.  See question on “current level of support” in this set of FAQs.

For the moment though, Ireland is extreme when it comes to the deficit-increasing impact of the banking crisis.  It makes a good headline and the extent and cost of the disaster in Ireland will always be high relative to other EU countries.  But it should not be thought that other countries have escaped lightly from the banking crisis.  They have simply gone about it in a different manner and haven’t used Promissory Notes.  The true cost of this period will only emerge over the next decade or longer when their investments and special purpose vehicles are unwound.

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Debt and Deficits Decomposed

A new dataset from Eurostat has received a lot of attention recently as it highlights the deficit costs of the bailout of our banking system that began with the blanket guarantee of September 2008.  On the other side of the same coin the data allows us to determine the non-banking crisis element of our recent deficits.

The following table shows the €105 billion of general government deficits that were accumulated between 2008 and 2011.  According to the Eurostat data €41 billion of these was due to measures introduced to deal with the banking collapse.  The final section of the table gives the ‘underlying’ deficit which is simply calculated as the difference between the total and banking-related figures in the sections above it.

Between 2008 and 2011 the ‘underlying’ deficits totalled €64 billion and this is a running total as the deficits continue to accumulate. 

At the end of 2007, the gross general government debt was just over €47 billion.  2007 was the last year when the general government accounts were close to balance and a small surplus of €143 million was recorded.

Since the end of 2007, the debt has ballooned and by the end of 2012 it is estimated to be around €190 billion.  The increase can be broken down as follows:

The figure for the 2012 general government deficit will be finalised later in the year and is likely to come around €13 billion.  With guarantee fees, interest on contingent capital notes, dividends on preference shares it is also likely that the revenues from the banking measures will exceed the expenditures. 

The surplus income paid to the Exchequer from the Central Bank has increased significantly in recent years (2008: €290 million; 2012: €958 million).  The increase is mainly as a result of profits made by the Central Bank on the Exceptional Liquidity Assistance it is provided to Anglo/INBS.  This is not included in the ‘banking’ revenues measured by Eurostat.

The stock/flow adjustment is mainly the increase in cash balances held by the NTMA from €4.4 billion at the end of 2007 to €24.0 billion at the end of 2012.

Just over one-fifth of the 2012 debt is due to the banks though the full cost of the bank bailout is larger when non-deficit increasing expenditures are included.  This includes the value of the some of the funds depleted from the National Pension Reserve Fund to buy ordinary and preference shares in AIB and BOI. It also includes the expenditure by the Exchequer on shares in PTSB and Irish Life and the contingent capital notes remaining in AIB and PTSB.  

Nearly two-thirds of the debt has been accumulated because of deficit spending by the government sector.

The 2007 debt accounts for 25% of the current total and that was the legacy of the last incident of national insolvency in the 1980s. The debt that resulted from the accumulated deficits of the time were simply rolled over and never repaid.  Growth and inflation meant the debt burden fell from 120% of GDP in the late 80s to 25% of GDP by 2007. 

The ongoing deficits since 2008 have contributed around 40% of the current debt mountain but the nature of them is changing as we move closer to a primary budget balance.

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