Populist tax cuts and pro-cyclical Budgets are no way to run the economy
The economy is in an unusual place. It’s been buffeted by Brexit, by the shock and disruption of the Covid crisis, and it is still coming through an energy price shock and cost-of-living crisis.
There is a sense of winners and losers — household wealth has reached record levels and corporate profits are healthy — while deprivation rates among Irish households are on the rise. Despite the sense of perma-crisis, the labour market has never been stronger.
Total employment, the employment rate, and hours worked are all at record highs while the unemployment rate is at a record low. There are clear capacity constraints across the economy.
Even so, real wages have fallen over the last year. Inflation remains high (though falling) across most of the euro area. Driven by their fear that high inflation will become ‘sticky’, European Central Bank policymakers are likely to increase interest rates twice more this year and then only start to gradually reduce rates sometime in 2024. Eventually this tightening of monetary policy will start to weaken demand and indeed the economy as a whole. However, so far, the economy is holding up.
Economies move in cycles, although each of these cycles has its own unique causes and characteristics. In general, we want to reduce the amplitude of the economic cycle and prevent boom-bust dynamics developing. Such dynamics can lead to permanent economic scarring and to a waste of human and physical capital. We can think back to the 2008 financial crash as a particularly bad example of this.
Macroeconomists are therefore always trying to understand where along in the cycle the economy is at any point in time. A correct understanding of whether the economy is ‘overheating’, ‘in recession’, or somewhere in between matters greatly for budgetary policy and for the appropriate fiscal stance taken by government.
If the economy is in a down-swing then it makes sense for the Government to stimulate the economy through higher levels of public spending or even, where appropriate, tax cuts. The opposite is true if the economy is overheating. In other words, fiscal policy should lean against the cycle or be- have ‘counter-cyclically’. My own view is that the economy is indeed overheating.
However, Irish governments have a long and unhappy history of pro-cyclical budgets and Budget 2024 seems likely to be the next chapter in this tradition. The Irish Fiscal Advisory Council has already attacked the Government for breaking its own spending rules and for risking further overheating while the ESRI and the Central Bank have both cautioned against tax cuts.
The Budget in its current form will add to overheating and to inflation, while the income tax cuts will disproportionately benefit the better off.
We also need to move beyond the fiscal stance and reflect on the com- position of the budget. For example, we need to protect low income households from cost-of-living pressures — not half-heartedly through targeted once-off measures as was done last year, but through structural uplifts in working age and old age payments that benchmark against wages and the cost of living.
In addition, we need to deal with the chronic issues in housing supply and affordability and we need to ensure that we consistently allocate adequate capital resources for the green transition.
This is essential to achieving a successful and ‘just’ net zero transition. These areas (setting up a housing company and a green transition fund) seem to me to be two strong candidates for how best to use the windfall and possibly unsustainable surge in corporation tax receipts.
On the other hand, paying for ongoing future ageing costs is best done through structural increases in self-employed and employer PRSI.
And of course there is a long list of other public funding issues that need addressing — from waiting lists and chronic underfunding of mental health services, to large classroom sizes, high childcare costs and lack of public transport services.
Crucially, the fiscal rules allow us to increase spending by as much as we want each year provided that there are offsetting measures that increase taxes.
The Commission on Taxation and Welfare correctly pointed out just last year that we will have to meaningfully increase government revenue as a proportion of national income over the medium-term. The Government seems set on ignoring this advice.
This article appeared in this month’s Liberty newspaper and is written by Dr Tom McDonnell, co-director of the Nevin Economic Research Institute
