1. Since the early 1980s Ireland has achieved an impressive fiscal consolidation, turning one of the largest deficits in the OECD area into a surplus and reversing a rapid rise in public debt. Besides policy measures to curb public spending and/or raise revenues, strong economic growth has been crucial to this success. Fiscal policy played a major role in the improvement during the 1980s, while high economic growth (associated in part with a reduction in structural unemployment and rapid increase in the labor force) has made the major contribution during the 1990s. For the future, particularly after the loss of the monetary instrument from January 1999, the Stability and Growth Pact (SGP) and demand management considerations will have to replace deficit and debt reduction objectives as the major guidelines for fiscal policy.

Abstract

1. Since the early 1980s Ireland has achieved an impressive fiscal consolidation, turning one of the largest deficits in the OECD area into a surplus and reversing a rapid rise in public debt. Besides policy measures to curb public spending and/or raise revenues, strong economic growth has been crucial to this success. Fiscal policy played a major role in the improvement during the 1980s, while high economic growth (associated in part with a reduction in structural unemployment and rapid increase in the labor force) has made the major contribution during the 1990s. For the future, particularly after the loss of the monetary instrument from January 1999, the Stability and Growth Pact (SGP) and demand management considerations will have to replace deficit and debt reduction objectives as the major guidelines for fiscal policy.

I. Fiscal Consolidation in Ireland and Challenges Ahead1

A. Introduction

1. Since the early 1980s Ireland has achieved an impressive fiscal consolidation, turning one of the largest deficits in the OECD area into a surplus and reversing a rapid rise in public debt. Besides policy measures to curb public spending and/or raise revenues, strong economic growth has been crucial to this success. Fiscal policy played a major role in the improvement during the 1980s, while high economic growth (associated in part with a reduction in structural unemployment and rapid increase in the labor force) has made the major contribution during the 1990s. For the future, particularly after the loss of the monetary instrument from January 1999, the Stability and Growth Pact (SGP) and demand management considerations will have to replace deficit and debt reduction objectives as the major guidelines for fiscal policy.

2. Part B of this chapter contains a description of fiscal developments since 1980 and an attempt to decompose the improvement in the fiscal accounts into contributions from pure fiscal policy measures and contributions from other factors. Fiscal policy in 1997 and the budget for 1998 are outlined in Part C, while Part D contains a discussion of the implications of the SGP for policy formulation in Ireland.

B. Fiscal Consolidation in the 1980s

3. Ireland entered the 1980s with its public finances in worse shape than those in any other OECD country: the general government deficit exceeded 12 percent of GDP, the gross debt had grown to more than 70 percent of GDP, and debt–servicing costs were increasing rapidly (Figure 1). The fiscal imbalances were accompanied by large external and internal imbalances; by 1980, the current account deficit was in excess of 10 percent of GDP, while the unemployment rate had grown to 7.3 percent. It was clear that a strong policy response was necessary, and the 1980s saw two major attempts at consolidating the public finances.

FIGURE 1
FIGURE 1

IRELAND: GENERAL GOVERNMENT FINANCES

Citation: IMF Staff Country Reports 1998, 126; 10.5089/9781451818703.002.A001

Sources: Department of Finance, Economic Statistics.1/ Budgeted.2/ Maastricht basis.

4. The first consolidation effort started in 1982, and after two years had succeeded in lowering the structural deficit by more than 6 percentage points of GDP (Table 1).2 Part of this improvement took place through higher taxes but the bulk of it was achieved through lower expenditure. The consolidation effort adversely affected domestic demand, which contracted by slightly more than 2 percent in both 1982 and 1983, in spite of lower nominal and real short–term interest rates resulting from the improved credibility of the exchange rate link to the deutsche mark through the participation in the ERM. Exports increased sharply in this period, but could not offset the drop in domestic demand; GDP fell in 1983 and the unemployment rate increased by 4 percentage points from 1982 to 1985. The public debt continued to grow unabated, reaching 116 percent of GDP by 1987.

Table 1.

General Government Structural Financial Balance, 1982–97

(In percent of potential GDP)

article image
Source: Staff estimates

The residual is used as a proxy for the effect of fiscal policy measures on the structural balance. Positive (negative) numbers imply a contractionary (expansionary) policy shift.

5. Notwithstanding the mixed results from the first consolidation effort, the new government that was elected in February 1987 embarked on another attempt at strengthening the fiscal position. The structural balance improved by almost 8 percent of potential GDP from 1987 to 1989 and a substantial primary surplus of close to 4 percent of potential GDP was reached in 1989. This time, however, a reduction in expenditure accounted for more than the total improvement in the structural balance. A “tax–based” incomes policy was a new and important element in the second consolidation effort. Marginal tax rates were lowered, contributing to a fall in the revenue–to–GDP ratio, in spite of a fiscal reform that widened the tax base. In sharp contrast to the previous attempt, this second round of consolidation sparked a strong economic resurgence. GDP growth accelerated from 3.7 percent in 1986 to 6.1 percent in 1989 and the unemployment rate came down to 15.6 percent in 1989 from a peak of 17.6 percent in 1987.

6. The successful fiscal consolidation in Ireland, together with a similar episode in Denmark earlier in the 1980s, gave rise to many articles in the economic literature about whether fiscal contractions could have an expansionary effect on the economy, and if so, under what conditions.3 The conclusions from the academic debate on this issue include the following:

  • The extent to which any expansionary effects can dominate the direct contractionary effects of fiscal tightening depends on the severity of the fiscal imbalance at the outset and on the composition of the fiscal tightening.

  • If the deficit and the debt levels are sufficiently large, the mere fact that the problems are being addressed might create expectations of lower taxes and higher private income in the future and thus spur private demand immediately.

  • Expenditure restraint is more likely to give rise to such expectations than tax increases, and the expansionary effects are thus most likely to occur if the consolidation takes place through lower expenditure.

7. During the 1990s, the structural balance has been relatively stable, but strong output growth—with the exception of the growth recession following the currency turmoil in Europe in 1992–93—has contributed to a continued improvement in the overall fiscal balance and a steep decline in the debt–to–GDP ratio. In 1997, the general government balance went into surplus for the first time in modern history. The assessment of the structural fiscal position and stance of fiscal policy during this period has been complicated by the increased elasticity of labor supply which has tended to raise potential output growth but to an extent that cannot be measured precisely. Nevertheless, it appears that while the continued reliance on tax cuts has helped keep wage growth down, it has also introduced a new element of procyclicality into fiscal policy. (Figure 2).4 At times, this procyclical bias in fiscal policy has been compounded by expenditure overruns. Overall, given the very strong output growth, especially since 1994, one might have expected an even larger improvement in public finances than has been the case.

FIGURE 2
FIGURE 2

IRELAND: OUTPUT GAP AND GENERAL GOVERNMENT BALANCE

Citation: IMF Staff Country Reports 1998, 126; 10.5089/9781451818703.002.A001

1/ Based on the production function.

Factors behind the improved structural balance

8. A decomposition of the improvement in the structural balance into factors stemming from fiscal policy, factors affecting the potential growth rate of the economy, and other factors can provide some insights into the nature of the fiscal consolidation in Ireland since 1980. While the change in the structural balance is often used as an indicator of fiscal policy changes, stronger potential output growth will improve the structural balance even in the absence of any policy measures. Of particular importance in that regard is the impact on potential output of labor market reforms and exogenous developments. A higher participation rate or a lower (structural) unemployment rate (NAIRU) and thus a lower dependency rate will not only permit the economy to grow faster on a sustainable basis, but also reduce current and future social expenditure and broaden the revenue base. In the following exercise, an attempt is made to estimate the effect on the structural balance of labor market variables as well as of changes in net European Union contributions and net interest payments.5 The residual from subtracting the impact of these factors from the total change in the structural balance is then used as a proxy for the contribution of fiscal policy measures to the change in the structural balance.6

9. The estimates in Table 1 suggest that fiscal policy measures played an important role in improving the structural balance in the 1980s, while supply–side factors related to labor inputs in the production process accounted for more than the total improvement during the 1990s, implying that fiscal policy may well have been expansionary in this latter period. The 1987–89 period is special in the sense that a lower expenditure ratio accounted for more than the total improvement in the structural balance.7 Structural revenues fell in 1987–89, whereas they rose in the periods before and after.8

10. The contributions to the strengthening of the fiscal position of net interest payments and European Union grants and transfers largely cancel each other out. Net interest payments worsened the structural balance up to the late 1980s, but lower interest rates and a declining public debt ratio have brought about a positive contribution since then. The contribution from European Union grants and transfers has followed the opposite path, as their increase since Ireland joined the EU in 1972 came to an end in the 1990s.

11. On the other hand, the contribution of labor supply factors to the improvement in the fiscal position has gradually strengthened throughout the whole period (Figure 3). In the first part of the 1980s it was negative, owing to a decline in the average working time and higher structural unemployment. In the latter half of the 1980s—when the improvement in the structural balance was strongest—the contribution of labor supply factors was in fact zero. Faster growth in the population of working age, a higher participation rate, and a lower NAIRU have all made a positive contribution to the strengthening of the public finances in the 1990s. In this period, improvements in the performance of the labor market tended to offset the apparent negative contribution of fiscal policy measures, thus ensuring a broadly stable structural budget balance.

FIGURE 3
FIGURE 3

IRELAND: LABOR INPUTS FOR POTENTIAL OUTPUT CALCULATION

Citation: IMF Staff Country Reports 1998, 126; 10.5089/9781451818703.002.A001

Source: Staff calculations.

C. Fiscal Policy in 1997 and 1998

12. Fiscal policy in 1997 and the budget for 1998 followed broadly the pattern of previous years; the continued strength of the economy, and the fact that the deficit had almost been eliminated and the debt halved since its peak made expenditure restraint increasingly difficult, while the procyclical impact of commitments made under the Partnership 2000 agreement became more evident. Measured by the change in the structural (or the primary structural) balance, fiscal policy appears to have been tightened by some ½ percent of GDP over the two years combined. However, as shown in Table 1, the improvement in the structural balance can be more than accounted for by continued favorable supply–side developments. Within this framework, fiscal policy can be viewed as expansionary in both years. Tax cuts beyond commitments made as part of Partnership 2000, significant slippages on current spending in 1997, which fed fully into the base for the 1998 budget, and strong growth in capital spending in 1998 contributed to this expansionary effect.

13. The fiscal outcome in 1997 was considerably better than budgeted because of buoyant tax revenues associated with the much stronger economic activity than projected. The general government balance showed a surplus of close to 1 percent of GDP, compared with a budgeted deficit of 1.5 percent of GDP. The increase in all categories of tax revenues exceeded projections, and overall tax revenues rose by 14 percent compared with a budgeted increase of 6 percent. Indeed, the strength of tax revenue, in spite of substantial tax cuts, might indicate that the nominal output growth in 1997 was even higher than suggested by the national accounts estimates.

14. There were slippages on the expenditure side in 1997, due in part to cash smoothing operations. Current expenditure was IR£625 million higher than budgeted, rising by 10.7 percent compared with a budgeted increase of 5.7 percent. In addition, government transfers to the social insurance fund were ERX150 million less than budgeted so that in gross terms actual expenditure exceeded the budget by about IR£775 million.9 The cash smoothing operations took the form of bringing forward some outlays for education that were due in 1998 (IR£100 million), the discharging of accumulated liabilities to the Post and Telecom pension fund (IR£305 million), and a transfer to the Small Savings Reserve Fund (IR£208 million).10 The genuine slippages, which can be estimated at about IR£250 million or about 2 percent of the original budget, were caused by extra costs for the nurses’ pay settlement, extra overtime pay for police and prison guards, higher than projected health spending, and higher spending on agriculture related to changes in the green pound. Both public employment and consumption turned out as planned.

Public Finances, Budget and Outturn

article image
Source: Data provided by the Irish authorities.

Revised, September 1998 estimates.

15. Even though the cash–smoothing operations in 1997 had raised the basis for expenditure growth in the 1998 budget, the budget reiterated the commitment to contain the growth in net current expenditure to 4 percent. The budget also provided for a 23 percent growth in public investment, which implied almost a 7 percent increase in total expenditure. Substantial tax cuts were also budgeted (see Box 1) and the general government surplus was targeted to fall to about ¼ percent of GDP, a lower surplus than the outcome in 1997.11 As tax revenues for the first several months of the year turned out to be much higher than anticipated, the government made it clear that any additional revenues would be used to retire debt rather than increase spending. Accordingly, the estimated surplus for 1998 has been revised up to 1.8 percent of GDP.

Recent Tax Measures

Personal Taxes: Under Partnership 2000 the government is committed to introducing personal tax reductions to the cumulative value of IR£900 million on a full year basis over the three years of the programme (1997–1999). The tax cuts in the 1997 budget amounted to IR£393 million, while the cuts in the 1998 budget amounted to IR£517 million, bringing the combined value up to IR£910 million, slightly above the three–year amount committed in Partnership 2000. The bulk of the tax cuts took the form of a reduction of 2 percentage points in the top and the standard income tax rates to 46 percent and 24 percent respectively, effective April 1998. It is the government’s intention to reduce the standard rate further to 20 percent over the next few budgets. In addition, the standard income tax band, the basic personal allowance and some other special allowances aimed at lowering unemployment and poverty traps and promote social inclusion, as well as the general income tax exemption limits were increased in the 1998 budget. To reduce the possibility for certain high–income earners to reduce their tax liability the government also introduced an annual cap of IR£25,000 on the amount of capital allowances on buildings that an individual taxpayer can claim against non–rental income.

The capital gains tax rate was lowered from 40 to 20 percent.

The 1998 budget reduced the standard corporate tax rate to 32 percent from 36 percent and the rate on the first IR£50,000 of profits to 25 percent from 28 percent. Furthermore, the government confirmed its intention to introduce a single corporate tax rate of 12½ percent for trading profits for all sectors to replace the current dual rate structure, which provides a 10 percent rate for manufacturing and certain internationally traded services.

D. Challenges Ahead

16. In An Action Programme for the Millennium, the government outlined the following medium–term fiscal objectives:

  • to run a current budget surplus

  • to eliminate the exchequer borrowing requirement over the next two to three years if present conditions continue

  • to limit net current expenditure growth to 4 percent and capital expenditure growth to an average of 5 percent and to reduce overall Government spending as a share of national output.

  • to fulfill the terms and commitments of the Partnership 2000.

17. Strong economic growth has already helped to achieve the first two objectives, the 1998 budget is fully in line with the third objective, and the government has delivered its tax cut promises in Partnership 2000 in two rather than in three years as originally promised (see Box 1). Limiting expenditure growth is arguably the most ambitious objective and one that the authorities have not been able to fully observe in the recent past. With output exceeding potential, rapid asset price inflation and signs of more widespread inflationary pressures, it would seem appropriate for demand management considerations to play a more prominent role in policy formulation. In addition, the commitments under the Stability and Growth Pact (SGP) will serve as important guidelines for fiscal policy in Ireland in the years ahead.

18. Historical experience might suggest that it will be challenging for Ireland to observe the 3 percent deficit ceiling envisaged in the SGP, as the general government deficits during most of the 1970s and 1980s were substantially larger than 3 percent of GDP. However, fiscal adjustment and the significant structural improvement in the overall economy have turned the deficits into a surplus and Ireland appears to have one of the strongest fiscal positions among the 11 countries that will enter EMU in January 1999. Whether that surplus is large enough to ensure that the balance would not exceed the 3 percent deficit ceiling stipulated in the SGP in a future recession is not clear: the answer would depend inter alia on an assessment of the current cyclical position of the Irish economy, the severity of shocks that might hit the Irish economy in the future and the economy’s ability to cope with those shocks; and the future evolution of the substantial budgetary transfers that Ireland receives from the EU’s structural funds.

19. Various methods of calculating potential output gaps give different results not only for the historical size of output gaps, but also for the current potential output growth rate, the current output gap, and the current structural balance (see Section II). The estimation of Ireland’s potential output is complicated by the highly elastic labor supply, arising primarily from the significance of inward and outward migration flows, and the increasing importance of the foreign–dominated modern manufacturing sector. The usual end–point problem one encounters in estimating potential growth is also more problematic in Ireland than in other cases because of the exceptionally high growth rates Ireland has experienced over the most recent years.

20. A safeguard against breaching the 3 percent deficit limit in the SGP might be to aim for a structural balance such that the deficit stays within the 3 percent limit even if the largest output gap experienced in the past should occur again. In Ireland, the largest output gaps occurred in 1986 and 1993. Based on a fiscal sensitivity of 0.5—implying that a 1 percentage point change in the output gap changes the budget balance by 0.5 percentage point of GDP—various methods of estimating the output gap indicate that the structural balance required to safely comply with the provisions of the SGP may be somewhere in the range of –1½ percent to ¼ percent of GDP. For comparison, the structural balance in 1997 is estimated at between –1 percent and –½ percent of GDP, suggesting that some additional fiscal adjustment may be desirable to facilitate compliance with the SGP in a future recession, while allowing the automatic stabilizers to operate fully. This could easily be achieved, for example, by allowing the lower debt–servicing costs stemming from favorable debt dynamics to feed into the overall balance.

21. It might be argued that in the future asymmetric shocks will likely be smaller than the one experienced, for example, in 1993 in the wake of sterling’s departure from the ERM. In the first place, the United Kingdom’s importance as a trading partner has fallen; its share in total exports has fallen to about 25 percent from 31 percent in 1992, while its share in total imports has declined to about 35 percent from 42 percent in 1992. Moreover, the new monetary policy framework in the United Kingdom could underpin a more stable exchange rate against core European currencies than experienced before.

22. On the other hand, one needs to keep in mind that discretionary fiscal and monetary policy measures helped to dampen the amplitude of cyclical fluctuations in the past. Moreover, there are factors that would underscore the desirability of setting more ambitious fiscal objectives. First is the prospective reduction in structural transfers from the EU. The authorities have built a contingency provision of 0.75 percent of GDP into the medium–term budget plan for 2000 to cover this possibility, but the size of the shortfall is still uncertain. Another consideration is related to the unusually high actual and potential growth rates of the Irish economy. In Ireland, where potential output growth might be as high as 5–6 percent, a slowdown in growth to the average European level would, if sustained for a few years, open up a considerable output gap with significant implications for the budget balance. In such a situation, Ireland would probably not benefit from the “exceptional circumstances” clause of the SGP which would allow a deficit in excess of 3 percent to be viewed as exceptional only if it coincides with a drop in output of at least ¾ of 1 percent.12 Also, the growth in the” modern’ industries has narrowed the export base, making Ireland potentially more vulnerable to industry specific shocks (e.g. computer industry). This consideration, combined with the loss of monetary policy independence implicit in membership of the EMU, makes it desirable to aim for a modest fiscal surplus over the cycle in order to provide room for discretionary fiscal policy in the future. The need for discretionary fiscal management is also supported by the expectation that the automatic stabilizers, which are weaker in Ireland than in some other EMU countries, would probably tend to weaken further in the future as progress is made toward a lower and less progressive tax burden and a leaner, better targeted, safety net. Finally, as discussed in Section IV, in deciding on an appropriate fiscal target for the period ahead, the authorities may also want to take into account the implications of the likely increase over the longer–term of social spending stemming from the aging of the population.

1

Prepared by Arild J. Lund

2

The structural deficit is calculated using estimates of the output gap derived by applying the production function approach, see Chapter II, and OECD Economic Studies 24, 1995, Potential Output, Output Gaps and Structural Budget Balances. See section D for the impact on the structural balance of employing alternative methods for calculating potential output.

3

This point was made in Giavazzi and Pagano: Can Severe Fiscal Contractions be Expansionary?, in O. Blanchard and S. Fisher (eds.), National Bureau of Economic Research, Macroeconomic Annual 1990, Cambridge, MA; MIT Press. A similar argument was also developed by McAleese in Ireland’s Economic Recovery, Irish Banking Review, Summer 1990.

4

Phillip R. Lane, On the Cyclicality of Irish Fiscal Policy, in the Economic and Social Review, Dublin, January 1998, provides new evidence of a procyclical fiscal policy in Ireland.

5

The elasticity of potential output with respect to changes in labor input has been estimated at 0.65, while the elasticity of structural revenues with respect to the output gap has been estimated at 1.08.

6

Arguably, changes in capital inputs and total factor productivity growth have a much smaller impact on the structural balance and therefore can be left out when calculating the contribution of supply–side factors to changes in the structural balance. Although a higher contribution of supply–side factors to changes in the structural balance. Although a higher level of capital would increase potential output, it would also be associated with a lower structural revenue ratio because of the lower taxation of capital income than of labor income and because of a reduction in revenues from VAT or sales taxes. As for the effect of higher productivity, it is reasonable to assume that higher productivity results in higher nominal wages in the business sector. If public wages and other public expenditure are indexed de facto to business sector wages, as they probably are in the longer term, higher total factor productivity would not affect the structural balance either.

7

Part of the fall in expenditure reflected accounting changes.

8

It should be noted that this method calculates the impact of fiscal policy as a residual and that other policy measures are not taken into account. Clearly, economic policy during the 1990s has contributed to the improvement in the fiscal position through other indirect channels, for instance through labor market reforms or income policies that helped reduce structural unemployment and raise economic growth.

9

Detailed information on expenditures in 1997 is available only on a cash basis (which is the basis employed in the Exchequer Accounts). The central government covers the difference between the social insurance contributions and the expenditure of the social insurance fund. Contributions soared in 1997 due to the strong economy and the government transfers needed to cover the deficit turned out to be IR£150 million less than budgeted.

10

The Small Savings schemes are tax exempt savings instruments aimed at financing public deficits. Interest payments are not due until the redemption of the saving certificate and as many investors have rolled over their investment the Schemes have built up considerable liabilities in the form of accrued interest payments. The Small Savings Reserve Fund is set up to fund those accrued interest liabilities.

11

Capital expenditure was budgeted to increase by as much as 23 percent from 1997 to 1998 because of extra allocations to education (the Scientific and Technological Education Fund) and environmentally based investment in infrastructure, and to a smaller extent extra allocations for the health sector and prison buildings.

12

A general government deficit in excess of 3 percent of GDP will be considered exceptional and temporary, and the country will not be subject to an excessive deficit finding and the sanctions associated with it, if the deficit results from an unusual event outside the control of the country in question or from a severe economic downturn, provided also that, should the unusual event or the severe downturn have passed, Commission projections for the following year envisage the deficit falling back to 3 percent or less. See IMF, World Economic Outlook, October 1997 for further details.

Ireland: Selected Issues
Author: International Monetary Fund