Recent months have seen a major focus on inflation not just in Ireland but across the developed world. In the medium term the key instrument preventing inflation from becoming embedded in our economies is monetary policy.
However, fiscal policy also has a role, both in helping reduce inflationary pressures and in insulating those worst off from the consequences of higher prices.
Today is a bad time to pump money into an economy when demand is rising rapidly and where a significant factor in the rise in inflation is the disruption of supply. Under these circumstances adding to demand through reducing taxes or increasing government expenditure will add to demand pressures.
However, as some groups in society are particularly badly affected by the rise in energy prices it remains necessary for the Government to provide significant insulation for the most vulnerable over the coming year.
From an economic perspective the risk of trying to insulate most of us from the consequences of rising energy prices would be to add to demand when the economy is already close to capacity. And ironically that could add further inflationary pressure.
However, a much more important reason for not attempting to shield us all is that the rise in energy prices has made Ireland poorer. In the second half of 2021 the cost of fossil fuel imports rose by around €2 billion. Over a full year the increase in the cost of Irish imports of fossil fuel energy will amount to close to €4 billion, almost 2 per cent of national income.
Fossil fuels
All of the benefits of the price increase flow to countries such as Russia and Saudi Arabia. These countries are richer this year at the expense of countries that consume fossil fuels. The longer high fuel prices persist, the longer Ireland will experience this setback. A country that has become poorer can’t simply turn back the clock by compensating all its citizens for the change in prices.
In the 1970s Irish governments tried to insulate all households from an even bigger rise in oil prices through a range of measures such as food subsidies. These policies were badly targeted in terms of protecting those most at risk. Furthermore, the attempt to insulate everyone from the reality that Ireland had become poorer led to an increase in national debt.
The consequence was a decade of economic misery in the 1980s when living standards eventually had to adjust down to a sustainable level. This time around the Irish economy is in a much stronger position to absorb the hit in incomes.
Reducing everyone’s electricity bill by a subsidy of €100 or €200 makes no sense. It would be much better if this expenditure went solely on increasing the fuel allowance, targeting those most in need.
In the past the rate of inflation has been fairly similar no matter what your income level. However, the fact that the current surge in inflation is driven by energy prices means that the immediate impact will fall more heavily on those on low incomes because energy costs are a higher share of their budget. It’s helpful that the fuel allowance went up by €5 a week last October, and there was some relaxation of eligibility. Further raising this allowance is a way of targeting the most needy.
Savings
People with savings are also adversely affected by inflation. With zero interest rates and inflation of over 5 per cent the value of their savings is being continually eroded. However, those who have built up savings over their lifetimes are in a better position to weather the difficulties.
There are winners as well as losers from inflation, some of whom did not expect this bonus. Homeowners with mortgages will benefit from the inflation surge as their burden of debt will fall quite rapidly in real terms. By contrast, those in the rental sector will see their rents increase, following other prices upwards. This is an argument for higher property taxes to transfer some resources from winners to losers.
Government revenue will also rise, for example through higher VAT receipts. Although some of that will be paid out to compensate those on low incomes the effect of inflation is likely to further reduce the Government’s deficit this year.
While in the short run people are stuck with their current car or current heating systems, the rise in fuel prices will highlight for people the importance of more climate-friendly options. Government support to insulate our homes is a better long-term approach than Government measures to insulate us against fuel price rises.
