Michael Burke: One of the key ways in which fiscal stimulus package have worked in the Euro Area- and the reason why the Irish government's policy has failed so disastrously- is the existence of fiscal multipliers. The measure of that success is that Spain has halved its budget deficit this year on foot of the largest investment package in the EU. By contrast, the deficit here has doubled following the 'austerity' measures.
For some reason the very existence of multipliers is contentious in Ireland, as if either of the economies operating here are subject to a separate set of economic laws. However, a glance at the Input-Output tables will show how all the outputs of the public sector draw on the inputs of the private sector. The detail for all the private and public sector multipliers are set out by the CSO here (see Table 5, the 'Leontief Inverse').
So, every €1bn spent on public administration, defence and social security, causes an additional €3mn of output in the agriculture sector, €1mn in mining, €4mn in food and beverages, and so on. The two biggest impacts are on business services and construction, where an additional €96mn, and a further €66mn is required. Altogether the multiplier for this category is 1:1.508. That is every €1bn of final output in this sector requires inputs of €508mn, overwhelmingly form the private sector. The multipliers for sewage, refuse and disposal activities is 2.172, and for health and social work 1.36 and education 1.302. On the face of it, these latter two seem to be severe underestimates, for a number of reasons. But they confirm the general principle, that the entire output of any economy requires the inputs of other sectors of the economy, and this is also true of the public sector.
It is therefore inevitable that cuts to public sector spending produce a depressing effect on private sector output. And the reverse would be true, increasing public sector output would require increase activity from the private sector too. This would create employment and generate increased taxes (as well as reducing welfare payments as employment rises).
But how to fund the increased government spending? This table below (click to enlarge) is reproduced from the European Commission's QUEST model of the European economies.
In the two columns shown there are revenue and expenditure multipliers for selected European countries. The first column shows what happens if a weighted average of tax cuts were made to labour, profits' and VAT taxes equivalent to 1% of GDP. The second column shows what happens when government spending is increased by 1% of GDP. It is important to stress that in both cases the measures are off-set by increases in taxes after 3 years so that the deficit an debt levels are otherwise unchanged.
I terms of the effects of these different measures, the assessment of the tax reductions is underwhelming. There is not much of a response. But the response from increased government spending is significant, an increase in Ireland's case of 0.4% of GDP.
This is despite the fact that the QUEST model includes 'crowdng out' effects, where increased government spending is supposed to push up borrowing costs and canny consumers, 'knowing' that the the boost to government spending will be followed by higher taxes will educe their own spending in advance of that. Frankly this nonsense should just be ignored. On the first, Irish real yields have soared as spending was cut, while those that stimulated their economies in 2009 have seen real yields fall dramatically. On the second issue of consumer behaviour, spending has had precisely the opposite pattern. When taxes were cut and spending increased during the boom, consumers increased their own spending and then cut it when their incomes and jobs were cut, oddly enough. Finally, the issue of corporate behaviour is not at all addressed by the model, but they entirely misdirected investment during the boom towards speculative activity and have been on an investment strike during the slump. Increased government spending would oblige that investment strike to be broken.
Even so, despite all these shortcomings which understate the real position, the model highlights an important fact. It is is possible to have a revenue-neutral increase in government spending, which will boost activity in other sectors, and create jobs, thereby raising tax revenues and lowering welfare outlays.