Economics: A divergence between the original projection of tax receipts and the final outcome is by no means unusual, particularly against an uncertain economic background, writes Dan McLoughlin.

Budget 2003 will be delivered on December 4th against an economic background which is even more uncertain than usual.

This increases the risk of forecasting errors in terms of tax receipts, and the Department of Finance's recent record is not encouraging in this regard.

A tax shortfall of €1.3 billion is now expected in 2002, but this divergence between the original projection and the final outcome is by no means unusual or even large.

In 2001, for example, tax receipts ended the year a whopping €2.5 billion below the budget target, equivalent to an 8.3 per cent shortfall, against a 4.1 per cent error in 2002.

In 1999 and 2000, the forecasting errors were also large, albeit in the opposite direction, with tax revenue exceeding projections; the millennium year overshoot was €1.5 billion (a 5.8 per cent error), following a similar figure in 1999 (7.1 per cent error).

There is nothing new then in the 2002 Budget delivering revenue numbers that look very different from that set down by the Minister for Finance, with the error actually rather lower than of late.

One implication is that the Exchequer's fiscal position, as set out in the Budget, is only an approximation and one would be foolish to hang one's hat on a precise figure - a balanced budget forecast, for example, should carry warnings on the likely margin of error, with a surplus of €1 billion or an equivalent deficit just as likely.

Over time, tax receipts will normally rise in line with nominal GDP (real growth plus inflation) in the absence of substantial changes in tax rates.

The problem facing the Department of Finance right now is that next year's nominal GDP growth could be 10 per cent or so (6 per cent real, plus 4 per cent inflation) on the optimistic side, or 6 per cent or below taking a more pessimistic view (2.5 per cent real growth plus 3.5 per cent inflation).

The former implies a return to the economy's potential rate of growth, and is plausible if the US economy continues to recover from recession and the euro zone emerges from its current period of anaemic expansion.

The low growth variant is seen as more likely by others, partly on the view that the strong growth recorded in the third quarter in the US (which I estimate at 4-5 per cent) is an aberration, and that a return to a much weaker trend is probable, perhaps even a "double-dip" recession.

To cloud the issue further, domestic sentiment appears negative, although most of the recent data releases support the view that the economy is still picking up after last year's slowdown.

Employment grew by some 35,000 in the year to May and the behaviour of the unemployment rate since then (it is unchanged at 4.3 per cent) implies that this has not changed unduly. Retail spending has been soft but sales, excluding cars, rose sharply in August, to show a 4.8 per cent volume gain on the previous year.

Industrial production is growing at a double-digit pace, and Foreign Direct Investment reversed sharply in the second quarter of the year, with a €3 billion inflow following disinvestment of €1.7 billion in the first three months of the year.

Mortgage lending is still booming (up over 20 per cent in the year to September) and non-mortgage lending is finally showing signs of life, which suggests that business investment may well be recovering - a view supported by the sharp rise in industrial confidence recorded in September.

Tax receipts will end this year around €29 billion, so a few percentage points difference in the forecast matters a lot: a 10 per cent forecast rise in receipts yields €2.9 billion, against €1.7 billion if a 6 per cent gain is pencilled in.

No doubt the Department of Finance will err on the side of caution in its GDP forecast for 2003, and therefore its revenue projections, chastened by this year's undershoot, particularly the shortfall in income tax receipts, which is not fully explained by either a GDP slowdown or the unexpected take-up of SSIA accounts.

It suggests that the plethora of tax changes in recent years (individualisation, the change of tax year, the move to tax credits, the scale of tax cuts) has disturbed the relationship between tax revenue and economic growth in ways not yet fully understood. In other words, even if the Department is spot on in its GDP forecast, it may still be out in its revenue numbers.

Finally, a policy implication. It is obvious that fiscal policy in Ireland can appear very different ex post than it looked ex ante - what looks like an expansionary budget may not turn out that way at all.

Pointless, then, to advocate an activist fiscal policy in Ireland or indeed to request marginal changes in the fiscal stance, as did the European Commission in 2002, changes that are well within the margin of error of the forecast.

Dr Dan McLoughlin is chief economist with Bank of Ireland