Is the Government’s budget policy pushing up prices? This is the argument put forward by the Irish Fiscal Advisory Council (Ifac), the budget watchdog, in its latest report. Quoting Central Bank research, it says that by adding to demand in the economy, Government policy has pushed up prices and is, in effect, costing the average household €1,000 a year. Government sources in recent months have dismissed the Ifac over-heating argument, pointing out that the rate of inflation here has fallen alongside those of other EU countries. So what is going on?
1. The evidence: The Ifac argument is that the economy is already at full capacity and has, in fact, been growing above its potential rate. By further adding to demand through tax cuts and rapid spending increases, the Government is pushing up prices faster than would otherwise be the case. While overall inflation has fallen, partly due to a big drop in energy prices, Ifac points to ongoing strong price increases in parts of the services sector, such as restaurants and hotels, rents and medical services such as doctors and dentists. Inflation in these sectors, it argues, is resulting from stronger domestic economic activity, and the Government’s budget policy is playing a part in this.
To underpin its argument, it looks at some Central Bank research published earlier this year. Like Ifac, Central Bank researchers, in a signed article with the latest quarterly commentary, estimate that the economy has been operating above full capacity as growth took off after Covid. It estimates that the Government decision to breach its own spending rule – which is to keep the annual rise in permanent spending at 5 per cent – is adding about 0.5 of a percentage point to annual inflation. So the cumulative impact in the four years from 2022 to 2025 would be to leave prices about 1.9 per cent higher than they would otherwise be by the end of the period. Ifac uses an annual household spending figure of €52,000 to arrive at its €1,000 figure.
Proving precise cause and effect here is difficult, of course and as Ifac and the Central Bank point out, strong growth has also increased wage growth. But like Ifac, the Central Bank does see ongoing inflationary pressures in the services economy, pointing out that inflation here is forecast to remain at 3 per cent plus out to 2026.
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And there is other evidence that the Irish disease of high prices is worsening compared to what is happening across Europe. The latest Eurostat figures showed that Ireland is the second most expensive country in the EU after Denmark, with prices 42 per cent above the average. Back in 2016 Ireland was also in second place, but prices here were 25 per cent above the average. By 2019, just before the pandemic, this had grown to 34 per cent. Ireland has steadily grown more expensive relative to other countries and, as well as for consumers, this has implications for competitiveness.
2. Goods versus services: Taking a view back to the middle of the last decade, the rise in the price of services has far exceeded the rise in the price of goods. As the graph – mapping an index for goods, services and total consumer prices – shows, goods have risen by just over 8 per cent since 2016 while service prices are up 34 per cent. The sharp rise in energy prices during the crisis, only partly reversed by recent declines, is a factor in the services index. But the latest figures show ongoing strong rises in areas of domestic services, like restaurants and hotels and transport costs.
This diverging trend is an international phenomenon, even if the Irish figures do appear particularly stark. ECB research has pointed out that this gap in relative prices, evident in the euro area since its creation, show that inflation is complex and does not purely relate to changes in consumer purchasing power.
It points out, in particular, that in an open economy – and Ireland is one of the most open – a higher level of demand typically leads to bigger increases in the prices of non-tradable services such as the domestic ones we avail of every day, compared to goods, many of which are traded on international markets. On this analysis, strong domestic demand in Ireland due to a high employment level and rising earnings can indeed be expected to be reflected more in the price of services, where supply is often slow to respond to more spending power, compared to goods, many of which are imported.
Domestic services also have a high wage cost base as a proportion of total costs, and so in a tight labour market where wages are bid up as companies compete for employees, they can be expected to pass on higher prices to consumers.
For all these reasons, higher services inflation can be expected to “linger” in the Irish economy for longer, particularly in areas where there are shortages of supply – areas including doctors, childcare and, of course, rental property.
3. Running to stand still: On the analysis from Ifac, the Government is running to stand still to some extent. Adding demand to the economy which pushes up inflation and wages in turn puts pressure on the Coalition to compensate households and adjust income taxes so inflation does not take a bigger slice. The Central Bank analysis points out that even with the adjustment to bands and credits, the income tax take from wages is on the rise, in part because higher wages are pushing more earners into the higher 40 per cent tax bracket and lowering the real value of tax credits.
The paper found that the effective income tax rate – found by dividing total income tax receipts by total remuneration of all employees – increased from 24 per cent in 2021 to 24.9 per cent in 2023. “Given actual tax rates did not change, this increase must reflect a greater proportion of compensation being taxed at the higher rate,” it says. This was effectively a “stealth tax” on those at work, amounting to €1.2 billion.
As the paper points out, a higher proportion of people working in better paid jobs could also have had an impact, but it is fair to conclude that the slightly higher tax take on many earners was the main contributor. If Minister for Finance Jack Chamber wants to avoid this happening again in 2025 it will cost some €1.1 billion to €1.2 billion to fully adjust tax credits and the standard band for expected wage inflation, using up the bulk of the €1.4 billion available for tax reductions (some extra tax revenues raised could increase this figure a bit).
So while we will hear much talk of budget “giveaways”, it is wise to be a bit sceptical about the real-inflation-adjusted-impact. A large sum will be needed to adjust the income tax system for inflation. And if Ifac and the Central Bank are correct that Government budget policy is pushing up inflation, then that is costing households too and eating into the real value of permanent and temporary measures that will be announced on budget day.
