The ESRI predicts that public finances will be €900 million in the red by year-end - poles apart from the Department of Finance's forecast of a surplus, writes John McManus.

Sometimes it is hard to believe that the Economic and Social Research Institute (ESRI) and the Department of Finance are located on the same planet, never mind within a mile of each other in Dublin. This week the State's most influential economic think-tank has predicted that the public finances will be some €900 million in the red by the end of the year, while the Department is blithely sticking to its end-year forecast of an unspecified surplus.

What makes the two positions so hard to reconcile is that the ESRI has arrived at its verdict after factoring in most of the things that the Department of Finance predicts will ride to the rescue of the public finances this year.

These include spending restraint and a late surge in tax receipts. The ESRI is assuming - optimistically some would argue - that there will be sharp cuts in both capital and current expenditure in the remaining five months of the year, which will bring the full-year spending numbers in close to target.

It is predicting that the full-year figures will be a 13.8 per cent increase in current expenditure and 12.9 per cent for capital expenditure.

This would be a significant achievement, given that current spending is running around 21 per cent ahead of last year and capital expenditure is up 27.8 per cent.

The ESRI has also assumed that tax receipts will be up 6.1 per cent as the income tax take picks up towards the end of the year. There is also €800 million added into the pot for the rescheduling of corporation tax payments.

The ESRI has also factored in the €1.4 billion that the Minister for Finance, Mr McCreevy, plans to raise from a number of once-off sources. These include a €635 million transfer from the Social Insurance Fund and a €610 million contribution from the Central Bank. There is also €153 million from the sale of ACCBank.

Even when all this is taken into account, the Government's outgoings will exceed its income by over €900 million, according to the ESRI.

It is hard to see where the Department of Finance can be hiding another €900 million that it will need to turn its dream of a surplus into a reality. Particularly when you consider that the cuts in spending used by the ESRI in its calculations could be characterised as over-optimistic.

If the Department knows something that the ESRI doesn't, it should become apparent when the July Exchequer returns are published early next month. Until then, the Department's position that the public finances are on track to record a modest surplus this year seems the stuff of fantasy.

The Department reiterated its position as recently as this week, when controversy broke out over the Budget arithmetic. Eurostat ruled that the €610 million that Mr McCreevy was planning to liberate from the Central Bank could not be used to calculate the General Government Balance (see panel).

It also emerged that the Department of Finance had known this was likely to be the case since the start of the year, but the lid had been kept on the issue.

The ESRI clearly had reached much the same conclusion as Eurostat because it does not include the Central Bank money in its forecast for the General Government Balance.

As a consequence, it is predicting that the General Government Balance will also be in deficit this year, in the region of €947 million.

The Department of Finance, on the other hand, is predicting a surplus on the General Government Balance of more than €600 million.

The diversity between the ESRI's forecasts regarding the General Government Balance and the Government's is a much more serious issue than the incompatibility of their respective takes on Exchequer finances.

It is the difference between coming close to breaching the terms of the Growth and Stability Pact and comfortably avoiding it. The deficit forecast by the ESRI represents something close to 0.7 per cent of the gross domestic product (GDP), which is the value in euros of everything produced by the economy.

Although 0.7 per cent is well short of the 3 per cent deficit limit set out in the Growth and Stability Pact, it is not far off the 1.2 per cent level at which the European Commission will start to get anxious.

The Commission has made it clear that small economies like the Republic will not be allowed approach the 3 per cent limit because of the ease with which they would then overshoot.

There is an argument that the Growth and Stability Pact is flawed and unfair on small countries such as the Republic, which have a huge infrastructural deficit and relatively small debts. But most observers and, crucially, the Government, agree that adhering to its disciplines is a political and economic imperative.

More to the point, failure to comply with the pact leaves the Republic open to both censure and fines.

The only good news - if that is the correct term - for the Government in the ESRI Quarterly Economic Commentary is that the General Government Balance deficit should fall to €588 million in 2003. However, the institute adds the caveat that: "This will entail a modest improvement in the public finance position. However, this forecast is based on a recovery in tax revenue growth accompanied by further cuts in the growth of current and capital expenditure."

It also assumes a reasonably benign economic environment. The ESRI is forecasting that GDP will grow by 3.4 per cent this year and will be "close to or above trend at 4.7 per cent" in 2003. Gross national product, which is GDP adjusted for multinational profits and other factors, will grow by 2.9 per cent this year and 4.5 per cent next year.

The institute's latest inflation forecast is 4.5 per cent in 2002 and 3.7 per cent in 2003. However, the ESRI warns that the appreciation of the euro "will inhibit the competitiveness of an export-orientated economy like Ireland that has significant non-euro-area trade. An appreciating currency, however, may also encourage a less- aggressive interest-rate response by the authorities."

The institute also points out that "the necessary deflation in public expenditure growth required to bring the public finances back to alignment may turn out to be greater than anticipated. This fiscal tightening, which may also require higher taxation, would dampen economic activity by curtailing domestic demand."

There is at least some common ground between the Department of Finance and the ESRI on the prospects for the economy. But this commonality makes their wildly divergent views on the public finances hard to understand.

It is tempting to dismiss the discrepancy as an academic argument between economists, but that would lose sight of the fact that they are among the most credible Irish economic forecasters and the difference between them is the difference between skirting disaster and comfortably avoiding it.

Hopefully, we will have some better insight into the Department's thinking next month when the Exchequer returns are published.

Let's hope the Department is right and the ESRI is wrong.