Ireland's will be the smallest adjustment in 2012 among the five weak peripheral states, writes DAN O'BRIEN, Economics Editor
THE BALANCE of probability is that Budget 2012 will not meet its targets. Supplementary measures are likely to be needed next year. The extent of the additional adjustments will depend on the external environment.
The most important macro target for next year is to bring the general Government budget deficit down from this year’s estimated 10.1 per cent of gross domestic product (GDP) to 8.6 per cent next year – in both years these are the highest deficits among the 27 members of the EU.
Apart from being the most watched of the budgetary indicators by financial markets, the 8.6 per cent figure is an upper ceiling under the terms of the EU-IMF bailout. If it looks like being missed, the troika of institutions overseeing Ireland’s rescue can be expected to seek additional adjustments.
Hitting this budgetary target depends on three closely interlinked things:
implementing spending cuts successfully;
raising tax revenues as projected; and
meeting economic growth forecasts.
This last is the most difficult. Governments have limited influence over economic activity at the best of times, and much less when they are as fiscally hamstrung as the current administration.
Yesterday the Government changed its economic forecasts of just one month ago. The key figure is nominal GDP – ie GDP in cash terms, unadjusted for inflation – because this is the number used to arrive at the set-in-stone 8.6 per cent budget target.
Since early November, the Government’s forecast for nominal GDP in 2012 has been revised slightly upwards, from 2.3 per cent to 2.5 per cent.
The official explanation for this is higher inflation than expected just a month ago – both because of the increase in VAT confirmed yesterday and exchange rate movements over the month.
The first explanation is not plausible. Department of Finance forecasters were surely aware of the VAT hike last month.
The second seems more than a little curious. Tweaking forecasts on the basis of expected changes to exchange rates at a time of such chronic volatility is daft.
Far more important for the 2012 GDP outlook over the past month has been marked deterioration in the external environment. Almost every indicator of activity in real economy points to a stalling of growth in Europe. The financial crisis is now not only knocking confidence, but has begun to have a material impact on credit provision
While Michael Noonan’s forecasts yesterday did acknowledge this by revising down the real GDP forecast, it is the nominal figure that counts. And if the nominal figure had been cut, more cuts and/or tax measures would have been needed.
The Government may be living in hope – a meaningful pact to deal with the euro crisis among Europe’s leaders at the end of the week could boost consumer and investor confidence. But so serious is the crisis in the financial system that it will not be magicked away, even if political leaders get ahead of the curve on Friday.
Of the other two parts of the budgetary jigsaw, the expenditure component of Budget 2012 is most likely to be met, mostly because it is the variable over which the Government has most control. If an administration decides to cut €100 million, it simply does not spend the money.
One reason why spending cuts are generally more effective than tax increases in stabilising public budgets is that while government has full control over its outlays, it can never be sure how much revenue a tax hike will bring in. And there is considerable uncertainty over the third part of the budgetary jigsaw – revenues.
Even in times of economic stability, the relationship between tax rates and revenues is uncertain. A doubling of the rate of any given tax, for instance, will almost never lead to a doubling of revenue. Predicting revenues in times of uncertainty is even more difficult. Government receipts are extremely sensitive to economic activity. A renewed downturn would depress all sources of Government income.
Although the projections published yesterday make allowance for these factors, they may not make sufficient allowance.
This year general Government revenues – the widest measure – rose by just €200 million (to €54.2 billion). Yesterday’s projections foresee an increase of more than three times that – of €700 million – in 2012. Given the range of factors that influence growth in Government revenue, it would be wrong to say that this target is not achievable, but meeting it will be difficult.
The Coalition long ago decided on a split between spending cuts and revenue-raising measures in 2012 of 58:42, with cuts forming a bigger part of budget packages in subsequent years. Evidence from elsewhere points to a greater likelihood of successful consolidation if cuts are frontloaded and tax increases backloaded. With risks to revenue rising, the strategy looks more back-to-front than ever.
The budget also requires some comparative context. The 2012 adjustment of €3.8 billion amounts to a fiscal contraction of 1.2 per cent of GDP, according to straightforward estimates by economists at the investment bank Goldman Sachs (their measure is the difference between revenues and non-interest spending between one year and the next, expressed as a percentage of GDP).
As the table shows, in 2012, Ireland’s will be the smallest adjustment among the five weak peripheral countries – Greece, Ireland, Italy, Portugal and Spain. This is so despite the Government’s budget deficit target next year (that 8.6 per cent of GDP figure again) being far higher than those of any of its counterpart peripheral governments.
In this comparative light, the case for a bigger adjustment in 2012 – as advocated by the Independent Fiscal Advisory Council, among others – seems very strong.