Crude, across-the-board solutions should be avoided in favour of a clear ranking of projects

AS MINISTER for Finance Brian Lenihan made clear during a radio interview last Sunday, the focus in the December budget will be on achieving substantial reductions in public spending.

This represents a formidable political challenge for the Government, in view of the resistance of beneficiaries of individual public spending programmes to threatened cuts in expenditure.

The typical plea against a spending cut in a given area includes the following elements.

First, the economic and/or social value of the programme in question is extolled and the potential costs of a contraction in resources are highlighted.

Second, it is pointed out that spending cuts during a recession are generally a bad idea in view of the weak state of private demand and high level of unemployment.

For these reasons, it is argued that the programme in question needs to be insulated against expenditure cuts.

It is certainly true that it would have been better if sufficiently large surpluses had been accumulated during the boom period such that procyclical expenditure cuts could have been avoided during the current downturn. However, by the same token, a “leaning against the wind” fiscal policy during the boom would have required a much slower rate of growth in public spending and/or an expansion in the “structural” component of the tax base.

The budget adjustments over the past year have done much to address the latter component and some correction of the overshooting in public spending during the boom period has also been achieved.

However, the scale of the structural fiscal deficit is such that much more needs to be done in terms of rolling back the unsustainable expansion in public spending during the boom years.

Moreover, the fact that public spending surged during the bubble period should make it more viable to achieve expenditure reductions.

The impact of nominal spending cuts on the real level of public consumption and investment will be mitigated by lower procurement prices, relative to the high charges incurred during the boom.

This should extend to publicly provided services: it would be much better to protect public services through a reduction in public-sector pay levels than to require the full impact of cuts to the public-sector payroll to take the form of reductions in employment levels.

Since public-sector pay levels grew rapidly during the boom, the economic case for further pay reductions is strong.

The expansion in many public spending programmes during the boom was not the result of rigorously performed cost-benefit analyses. A more plausible explanation is that the windfall in construction-related tax revenues allowed the Government to expand many programmes, where the rate of expansion was guided by the rate of revenue growth rather than determined by an optimal allocation system.

For this reason, it seems clear that the pre-crisis levels of public spending in many areas were not set at the socially optimal level.

Accordingly, budget cuts in these areas would be justified on pure efficiency grounds, even if the state of the public finances were in perfect health.

The demand for many types of public services and the optimal level of the public capital stock can be typically modelled as increasing in the level of a country’s trend income per capita and decreasing in the level of the tax burden. A richer population will typically desire better-quality public services and the return on public investment is higher in a more productive economy.

Since it is now clear that the trend growth path for Ireland is worse than that envisaged during the boom period, the economic forces driving demand for higher public spending in many areas will be quelled.

In the same direction, the increase in the tax burden limits demands for public spending, in view of the distortions induced by higher levels of taxation.

For these reasons, it is desirable that the Irish political system delivers support for a substantial reduction in public spending.

Within the envelope of an overall target reduction in public spending, there remains plenty of room for public debate about the nature of the spending cuts.

In particular, more aggressive steps in some areas may enable a smaller set of cuts in other expenditure lines: a smart approach to expenditure cuts would avoid crude, across-the- board solutions in favour of a clear ranking of projects and programmes, by which those expenditure lines that offer the highest economic and social benefits suffer the least.

Once the crisis phase is over, a new fiscal debate will be required concerning the optimal level of long-term public spending in the economy.

The long-term level of public spending must be closely matched by the sustainable level of government revenues, since the delinking of structural spending plans and structural tax plans during the boom period has been a key aggravating factor during the current crisis.

Philip R Lane is professor of international macroeconomics at Trinity College Dublin and founder of the Irish Economy blog, www.irisheconomy.ie