HOW WE SPENT THE BOOM/1: In the first part of a series looking at the how the fruits of the Tiger economy were spent, Brendan Walsh examines the public finances, as an extraordinary period of lower tax and rising Exchequer spending comes to an end
The end-of-millennium year 2000 was the most buoyant in modern Irish history. The economy expanded by over 10 per cent, the number of people at work increased by 5 per cent and the unemployment rate dropped below 4 per cent for the first time. The public finances were in robust good health.
Tax revenue grew by an amazing 17 per cent. Current spending increased in real terms but declined as a percentage of GNP to the lowest level recorded since the early 1960s. The Government surplus reached 4.7 per cent of GNP, compared with a target of only 1.5 per cent. The debt/GNP ratio continued to plummet.
During this annus mirabilis, the Department of Finance was anxious to defer tax receipts and play down the seemingly unending flow of good financial news. Such caution was warranted because of the euphoria generated by the protracted boom.
For example, some believed that building a billion-pound sports complex in west Dublin would not compete with eliminating infrastructure deficits in road and the health system. Inevitably Budget 2001, unveiled in December 2000, contained a utopian combination of major tax cuts and spending increases. The economic problem of scarcity seemed to have been banished from Ireland.
A sea change occurred in the course of 2001. The public finances began to deteriorate rapidly. The most important reason for this was the sharp fall in the economy's growth rate, which may have reached zero towards the end of the year.
Whereas Budget 2001 had projected a 12 per cent rise in tax revenue, the outcome was an increase of only 2 per cent. The ratio of tax to GNP fell by two percentage points in the course of the year (Figure 1). The way tax buoyancy evaporated during 2001 suggested that something more than the direct effects of the economic slowdown was at work.
The responsiveness of economic activity to tax cuts appeared to have run its course. Mr McCreevy's oft-proclaimed belief that conventional economics is irrelevant in the Irish situation seemed to be based largely on this phenomenon. In 2001 his luck ran out.
While spending on debt service continues to decline relative to GNP, spending under the other main headings is now rising more rapidly than national production. Between 1994 and 1999, day-to-day spending as a percentage of GNP was on a gentle downward slope, but it levelled off in 2000 and this year is likely to be back to its 1994 level.
This reversal is the most troublesome factor behind the recent deterioration in the public finances after 2000. The biggest cause for concern is the rapid growth in public-sector pay due to the increasing numbers employed and rising pay scales.
Not surprisingly, when Mr McCreevy delivered his Budget 2002 speech in December 2001 his mood was markedly less ebullient than it had been a year earlier.
"There is no point in wishful dreaming," he warned. He revised the projected Government surpluses for both 2001 and 2002 downwards by 3 per cent GNP. Only by appropriating revenue equal to over 1 per cent of GNP from the Central Bank, the National Treasury Management Agency and the Social Insurance Fund was he able to avoid projecting a deficit for 2002.
While the pattern of spending and tax receipts is unusually difficult to interpret this year, there are no signs of an improvement in the underlying situation from the returns for the first quarter. Most commentators now doubt that the small projected surplus cobbled together by the Minister last December will be achieved.
The full extent of the recent change in the prospects for the public finances is revealed in the projections for 2003. In Budget 2001 a surplus of 4.6 per cent was projected for 2003, but in Budget 2002 this was replaced by a projected deficit of 0.5 per cent. Even allowing for the uncertain nature of these projections, a downward revision amounting to over 5 per cent of GNP in the course of a year is remarkable.
Inevitably the fall in tax receipts and continued momentum of current and capital spending have led to a large drop in the Government's surplus. It is now likely that the overall balance will move into deficit this year after six successive surpluses from 1996 to 2001.
On current projections, by 2003 the deficit will have risen to the level last seen in 1996. However, the scale of the projected borrowing is modest by comparison with the unsustainable levels reached in the 1980s. The golden rule of not borrowing for current spending is unlikely to be breached, and the fiscal balance excluding interest payments should remain in surplus.
These features of the situation reassure us that the debt/GNP ratio will continue to decline, although not at the dizzying rate of the late 1990s. Moreover, by comparison with the larger economies of the euro zone - Germany, in particular - Ireland's public finances remain in good shape despite the recent deterioration.
But even if the macroeconomic ratios are not yet sending out any alarm signals, there is no room for complacency. The public mood belatedly caught up with the boom of the late 1990s and the healthy state of the public finances it produced. The perceived strength of the public finances is now incessantly invoked to support calls for higher public spending and spending ministers are less inclined to argue the case for restraint.
Many influential commentators have persuaded themselves that Ireland is now an exceptionally lightly taxed nation. Based on comparisons with the northern European club of the most highly taxed nations in the world, the idea has been sold that we could easily solve a range of problems simply by raising the ratio of public spending relative to GNP.
Never mind that the tax burden is still higher than it was in the 1960s or that single people on average pay face a combined PAYE and PRSI tax of 48 per cent on additional income, the political message is "tax and spend more" or just "spend more". Little credence is given to the likelihood that higher spending will be dissipated in a larger pay bill rather than providing better services.
To his credit Mr McCreevy has tried to resist these pressures and to link increased spending to greater efficiency. But despite his misgivings about the "tax and spend" philosophy he has not been able to avert a rise in current spending relative to GNP.
The philosophy that served the economy well during the second half of the 1990s has become a causality of the psychology of the boom years and electoral politics. We need a rapid return to tighter fiscal policies as soon as the election is out of the way.
Brendan Walsh is Professor of National Economics at University College Dublin and co-author of the recently published book After the Celtic Tiger: Challenges Ahead, published by the O'Brien Press.