Tuesday, 10 March 2009

Borrow, Tax and Spend?

This notion that the economy is self-stabilising is usually right but it is wrong a few times a century. And this is one of those times...there’s a need for extraordinary public action at those times.” Thus Lawrence Summers is quoted in the Financial Times yesterday (Europe Rejects Extra Stimulus Appeal)

What of borrowing in Ireland?

Last December, in its publication 'Building Ireland's Smart Economy', the Government stated that 'It is likely that borrowing to pay for day-to-day services will be in the region of €9 billion next year. This is not sustainable or sensible' (page 44).

Alongside borrowing for 'day-to-day' spending a borrowing requirement of an additional €9 is required to cover what is termed capital spending. The total borrowing requirement is estimated at €18 billion against a backdrop of a projected figure of about €180 billion in Gross Domestic Product (all figures based on the Department of Finance Addendum to the Irish Stability Programme Update January 2009 - which is probably somewhat out of date two months later). This gives a figure of just under 10% of GDP. Set against the 'Growth and Stability' limit of 3%, the conclusion drawn by many conservative commentators is that we must retrench rapidly through a combination of tax hikes and spending cuts.

A number of points need to be made in this regard:

The application of an EU fixed limit of 3% in the current recessionary climate is clearly inappropriate, and this is conceded in practice by all concerned;

The borrowing requirement of very roughly 5% of GDP for 'capital' purposes is 'sustainable and sensible' on the grounds that such spending is a contribution to vital social and economic infrastructure which can yield long-term fruits (and a stream of repayments).

The borrowing requirement of another, additional, 5% of GDP for 'current' purposes is justifiable if it contributes to economic and social well-being at a time of crises. It could be viewed as a type of economic stimulus as well as a necessary measure to defend the quantity and quality of public services. An objection could be made to the way in which public (and national) accounting mis-specifiy spending on areas such as health and education as 'current consumption'. Spending on education and health represents investment in human and social capital, and this should be reflected in the way we look at public spending and measure the difference between 'day-to-day' spending and 'capital' (for the future) spending.

When commentators refer to a huge hole of €20 billion in our public finances they rarely mention that this includes 'capital' spending, for which borrowing is quite acceptable, as well as 'current spending' (for which borrowing is acceptable in a counter-cyclical strategy).

However, a prudent course is to constrain borrowing to around 10% and possibly reduce it to 8% - through a graduated series of tax-raising measures aimed at widening the tax base, increasing marginal taxes for higher-income earners and beginning the process of tax reform in regard to property, local and capital taxes of various kinds. Is some reduction in public expenditure required? Not if it means reductions in spending on:

  • Key social infrastructure such as health, education and affordable accommodation
  • Social transfers to those in need

If there are some areas of public spending that can be pruned and efficiencies made, then that needs to be done rapidly. On top of all this, there is scope to defer payments to the Pre-Funding for Future Pension Liabilities of about €1.5 billion per annum. Based on the Department of Finance's own estimates, Total Gross Government Debt will go to over 50% in 2009 compared to 25% in 2008 (and levelling off at around €65billion towards 2011/12). This is still manageable if fiscal policy is adjusted, wisely, to protect the incomes of those who are vulnerable to poverty, safeguard jobs in the public and private sectors, shift taxes towards those who do not pay their fair share currently and provide an economic stimulus to sectors and areas of investment that will bring Ireland forward in terms of jobs, environment and worthwhile social services.

The thinking that got us into this crisis is not the thinking that will get us out of it.


Gerard O'Neill said...

I think it's a fair point to split out capital spending from current spending, and to recognise that it is usually wise for any household/business/government to borrow long term to fund capital expenditures that can generate incomes to repay the borrowings.

The big problem as I see it right now for Ireland is that we are 'gambling' on a short lived recession. So borrowing 10% of GDP in one year is manageable if you quickly get that down to, say, 2-3% the following year - going into a negative budget situation when growth takes off.

But what if it more of an L-shaped than U or V-shaped recession? What if we need to borrow, say 15% of GDP next year, and the same again the following year as tax revenues collapse?

This is why I tend to side with those advocating a more radical approach to curbing public expenditure over tax increases because we will be digging ourselves into an even deeper hole by borrowing massively this year and next. Truth is, I think we're in for a deeper and longer recession than would be wise to broadcast too widely outside these shores.

Michael Taft said...

Gerard - I fear we can't keep the prospect of a deeper and longer recession secret too long. The Ulster Bank's recent quarterly report projects the economy will contract by 14% by the end of 2010. They further state that the fiscal corrections envisaged by the Government to bring the general government deficit below 3% by 2013 will be a 'major negative for growth in coming years'. They further go on to state that this fiscal contraction will push out 'the timing and extent of the eventual recovery'.

Clearly, embarking on deflationary policies at the very time the economy is contracting is to repeat the flip-side of the same mistake that Governments have made since the late 1990s - that is, pursuing pro-cyclical policies.

Of course, we can't stand idly by while the deficit balloons –(and balloon it will - with unemployment projected to rise to 16% by the end of next year and consumption to fall by 12% over this year and next). Doing nothing is not an option for so many reasons.

However, to turn to deflationary policies will only exacerbate the economic contraction. When commentators point to the collapse in tax revenue - and use this to argue for general tax increases - they fail to ask the question that is begging to be asked: why is tax revenue falling? Simple: depressed market activity and rising unemployment. The never ask this question because it would lead them to into the uncomfortable territory (for them, anyway) of major public spending and consumer boosts. That every other G-20 country is doing just that shows that not only do we have a national debate that fails to ask the right questions; it fails to lift its head and draw lessons from the rest of the world.