The public finances will move into the red next year, based on existing figures, writes Danny McCoy. It is against this yardstick that people should judge pre-election spending promises
With a general election looming, the perennial concern about the robustness of the public finances will come to the fore as the political parties roll out their tax and spending intentions.
The pronounced deterioration in the Exchequer finances, evident over the latter half of last year and continuing into the first quarter of 2002, prompts the question of what will be the state of the public finances for the incoming government? The answer, and its corollary of what are the budgetary options available, is intertwined in the prospects for growth in the economy, taxation and public expenditure.
After a tumultuous year for the world economy in 2001, the much-longed-for green shoots of recovery would appear to be taking hold internationally and optimism is rising that the sharp slowdown in economic growth rates experienced in Ireland may be about to be reversed. However, a realistic view is that Irish economic growth rates when adjusted for inflation will no longer reach the heady heights of recent years, with more modest rates in the order of 4 to 5 per cent likely for this year and next.
For budgetary arithmetic purposes, the appropriate measure of economic growth is inflation inclusive, which on current expectations would translate into nominal output growth in the order of 8 to 9 per cent per annum. Growth in government revenue and expenditure needs to be set beside this level of output growth for meaningful comparison both over time and with other countries.
Irish public expenditure as a share of national output, or gross domestic product (GDP), is at about 25 per cent among the lowest for any developed economy. Likewise, the share of government revenue, primarily made up of taxation, is of a similar magnitude, also among the lowest internationally. In addition, Ireland has a comparatively low government debt to GDP share at around 33 per cent.
This provides some, albeit limited, leeway for borrowing to finance expenditure growth, preferably for capital purposes, in excess of revenue growth in the short term. In the present context, the Exchequer returns for the first two months of the year show that current expenditure on the supply services grew by 22.4 per cent while tax revenue contracted by 0.5 per cent compared with the same period last year.
While these headline-grabbing figures exaggerate the underlying gap between expenditure and revenue growth, they nevertheless indicate that the public finance position will deteriorate further over the first half of 2002.
The most important budgetary indicator, given our commitments within the EU, is the general government balance as a proportion of GDP. This has fallen from a high of 4.5 per cent in 2000 to 1.4 per cent in 2001 and on current projections will be around 0.5 per cent in 2002.
The EU's Stability and Growth Pact for participants of monetary union requires that member-states should aim for public finances "close to balance" over an economic cycle with substantial fines applying if a deficit of 3 per cent of GDP or more arises.
Forecasts based on existing expenditure plans will have Ireland moving into deficit as early as next year. Indeed this was indicated by the Government in last December's budget in the Stability Programme Update required by the EU. This envisaged that even with the economy growing in excess of 5 per cent in real GDP terms, the general government deficit as a proportion of GDP would rise to around 0.5 per cent in both 2003 and 2004.
A new administration will quickly have to come to terms with the prospect of public finance deficits and that the Stability and Growth Pact conditions may well become a real constraint much sooner than is currently envisaged.
The European Commission has calculated that a "safe minimum" general government deficit of 1.2 per cent of GDP is needed to guard against a typical economic downturn pushing the Irish economy into a breach of the pact rules. As this safe braking distance is being approached, hard choices on tax and expenditure will have to be confronted sooner rather than later.
Handling a balloon may be a good analogy for the public finance decisions facing the next government. The decisions revolve around whether to keep pumping an expanding economy with increased public resources while not bursting a hole in the public finances.
SQUEEZING the budgetary balloon in one area with promises of increased expenditure growth will only shift the pressures on to other areas manifesting in the need for correspondingly higher revenue growth or accepting a deterioration in the overall public finance position.
The likelihood is that an incoming government in the middle of this year will be favoured by an economy growing at rates close to its trend rate over an economic cycle and a budgetary position that is broadly in balance. It will, however, inherit a situation where expenditure growth is outstripping revenue growth such that the public finance position is deteriorating from surplus towards deficit. In order to arrest that deterioration, the solution is easily stated - expenditure growth must be matched by revenue growth.
Either the expenditure growth has to be curtailed or the revenue growth increased - which inevitably means higher taxation - or some combination of both. As the public finance balloon gets squeezed in the coming weeks for the enchantment of the electorate, the hissing can only be expected to be heard later this year.
Danny McCoy is an economist with the Economic and Social Research Institute