Lower taxes and higher borrowing cannot eliminate our structural budget deficit, writes Jim O'Leary

EAMON GILMORE is right. The Government's fiscal problems are the result, not the cause, of our current economic woes. He is also right to follow this diagnosis with the question of whether some form of fiscal stimulus might have a part to play in getting the economy back on track. My heart is with him when he suggests the answer is yes, but not my head.

It is worth explaining the reason for this at some length because a great many people are puzzled on this score.

They wonder why it is that in so many other countries, governments have launched stimulatory fiscal policies in attempts to reflate flagging economies, while our government, confronted with an economy that is not just flagging but collapsing, seems to be embarked on a fiscal strategy that will make matters worse. So here goes.

Following last Tuesday's Exchequer Statement for November, it now looks like the Government's budget deficit will be as much as 6.5 per cent of GDP this year and, on the basis of existing policies in relation to taxation and public spending, could be 8.5 per cent of GDP or more in 2009. This is, of course, in the context of an economy where output and employment is set to shrink in both years.

If there was good reason to believe that the deficit, however large it may be, would automatically disappear when the economy eventually recovers and returns to its long-term trend level of output, there might be a case for the Government to assist the recovery process with some combination of cutting taxes and raising spending at this point.

But the budget deficit we are currently running is not that sort of deficit. Granted, it will be reduced when the economy gets back on track, as tax revenues grow again and spending on unemployment retracts, but there is a large component of it that will remain impervious to recovery. This component is what economists call the structural budget deficit and it is estimated by the Department of Finance that it will amount to 5 per cent of GDP, or about €9 billion, this year.

The main reason for this structural deficit is that the huge tax windfall harvested by the exchequer from the property and construction boom has disappeared, but the greatly elevated levels of public spending that were financed by that windfall have not.

Whatever its source, the structural deficit must at some stage be eliminated if Ireland is to honour its obligations under the euro zone's Stability and Growth Pact (SGP). Indeed, in a world without the SGP, prudence alone would ordain that the structural deficit be eliminated.

Its elimination can only be brought about by policy measures that reduce the ratio of government spending to GDP and/or raise the ratio of tax revenue to GDP.

There is plenty of room for debate about the pace at which to eliminate it, and there is a respectable, if not compelling, argument for not doing a lot in the short term. But there is little merit in adding to an already large structural deficit in an attempt to stimulate economic activity.

An obvious consequence of doing so would be to make an already daunting fiscal challenge even more difficult.

Gilmore has called for an accelerated programme of school-building, broadband roll-out and energy-proofing of houses as part of his proposed package and, it may well be that quickening the pace of development under each of these headings and increasing public expenditure allocations accordingly is the way to go. But, if it is, it should be financed, not from borrowing more than the very large amounts that are already planned (and likely to be well exceeded), but by reducing allocations to other, less meritorious programmes.

The case for borrowing more to fund an attempted stimulus package would be more difficult to rebut if there was a high probability of it being successful, but fiscal stimulus is notoriously difficult to effect in a very open economy like Ireland. The reason is that a high proportion of any increase in demand leaks out through imports.

From our point of view, the best sort of stimulus package are those put in place by our trading partners since these boost demand for our exports without costing us anything. And here, the good news is that most of our main trading partners have announced reflationary fiscal measures of one sort or another in recent weeks/months. What we need to do is ensure that we are well-positioned to avail of the opportunities that will flow from these and what that means, first and foremost, is reducing our production costs to competitive levels. More on this in a later column.

In the meantime, a parting remark on fiscal policy. Tuesday's exchequer figures prompted the Minister for Finance to commit to taking further steps to cut public spending. This is on top of the successive sets of measures put in train after the exchequer returns of June and September. The Government is now in danger of rewriting budgetary policy on a monthly basis. This is no way to proceed. Of course, there is a case for reviewing plans periodically, especially in the context of rapidly changing conditions, but such reviews should not be more frequent than half-yearly, and should be firmly anchored in a coherent medium-term fiscal framework that is based on realistic economic projections, aims for realistic targets, and sets out clearly how those targets will be achieved. The sooner such a framework is put together and published the better.

Jim O'Leary is a senior fellow of the department of economics, finance and accounting at NUI Maynooth. He can be contacted at jim.oleary@nuim.ie