Wednesday, December 16, 2009

Economics 16/12/2009: Budget 2010 Analysis

As promised - here is my more in-depth view of the Budget 2010. This is an un-edited version of the Sunday Times (13/12/2009 issue) article.

After weeks of leaks, speculations and over-dramatized Partnership talks, this week Brian Lenihan has delivered the final move in the Government v Economy chess game. Lisbon, Nama and the Budget 2010, we were promised, were all that the Cabinet had to do in 2009 in order to manage the nation through the worst economic storm in its history.

In its last stance of 2009 the Government has reluctantly and belatedly recognised the reality of the crisis we face. Thus, the Budget has done just about enough to delay our descent into the nightmarish company of Greece. For this Brian Lenihan deserves praise.

A Chance at Reforms - Missed

But the net outcome of the Budget 2010 is that we are now entering the third year of recession with virtually no reforms that can support future growth.

There is no real stimulus to the rapidly contracting private sector. Cost efficient and much needed export credits are not in and neither are foreign exchange risk supports – the two cornerstone policies for sustaining exports, especially for indigenous companies.

Taxes remain regressively skewed toward ‘soaking the rich’, by which the Government means the middle class. As in 2009, the burden of taxation in 2010 will be borne squarely by those in the most productive employment with above average skills and aptitude. If a combination of consumption and income taxes accounted for under 68.9% of total tax revenues in 2009, by the end of the next year these taxes will account for 70.3% of total tax take.

Today, some 40% of Irish households deliver 90% of non-corporate dosh for the Exchequer. By the end of 2010, given current trends in unemployment and wages, this ‘honor’ will befall just 37% of households. This is hardly a sign of resilience in the economy.

In 2009, 4% of top earners – many of whom are wealth and jobs creating entrepreneurs and business owners – pay 50% of total income tax. Next year, we are risking to hike this share to 55%. This is hardly a sign of the economy promoting jobs growth.

Should Ireland-based multinationals reduce their transfer pricing activities in 2010 – a prospect consistent with a possibility of a restart of new investment cycle in Asia and the US – an even greater share of the burden of paying for public sector expenditure will be falling onto the shoulders of rapidly thinning minority who still have higher value-adding jobs.

Cuts to unemployment benefits in excess of reductions to social welfare imply that Budget 2010 only strengthened the incentives to transfer from unemployment benefits roster onto social welfare for anyone in long-term unemployment. This will lead a decline in labour force participation rates throughout 2010. Paradoxically this will result in lower official unemployment but a higher cost to the taxpayers.

Uncompetitive Costs Base - Remains Intact

The Budget has done nothing to address the issue of uncompetitive costs imposed onto businesses by our state-owned utilities and suppliers of services. It also did nothing to address excessively high local authorities’ charges and rates.

A net positive of the Budget was honorable mentioning of the internationally trading financial services. However, it remains to be seen what exactly will be done on this front.

Brian Lenihan missed another chance of reforming our business-crippling quangoes. In doing so, the Budget failed to recognize the real damages state and local authorities’ costs inflation poses to the survival of both domestic and exporting companies. If anything, the Budget further expanded the Fas empire – an unchecked state behemoth that yields dubious benefits and wastes hard cash in truckloads. The policy, it seems, is to shove more unemployed into perpetual training programmes with little hope of gainful employment in the foreseeable future.

A failure to introduce university fees means that our education system will spend another year mired in funding uncertainty. It will also mean that many graduating students will desperately cling to education for another 1-2 years. For some, this is a productive opportunity to invest further into their future skills. For many, however, it is an unnecessary extension of studies that will not lead to any meaningful skills augmentation but will consume precious resources. Classroom sizes will rise, international rankings will be threatened, but we will increase output of devalued in quality degrees, certificates and diplomas.

Retaining prohibitively high rates on PRSI, health and income will undoubtedly keep jobs growth on ice. Other, so-called soft labour costs, could have been tackled through simple measures, such as for example abolishing risk equalization scheme in health insurance to lower the costs of employees benefits. These opportunities were missed.

Banking Sector Costs - Unpriced

There are no provisions whatsoever for the banking sector in the Budget. Yet, two future developments with respect to the sector are now virtually assured for 2010.

First, we are likely to see significant demands from the banks for new capital. My estimates suggest that our six banking institutions will need €9.7-12.4 billion in capital post-Nama. If even a half of this falls in 2010, Budget deficit risks reaching 14.5% of GDP. The only way to avoid such a debacle will be to use Nama as a vehicle for issuing even more State-guaranteed bonds. This will make Ireland even more dependent on ECB’s good will.

Second, the Minister has introduced a set of new conceptual frameworks for using Nama to apply pressure on lenders to increase funding for SMEs and distressed households. All are ambivalent, although well-meaning, and all are regressive when it comes to securing stable future for our banking system. None will actually expand real lending.

Structural Deficit - Unaddressed

The Budget has failed to significantly tackle our structural deficit. The pre-Budget projections suggested that Brian Lenihan was facing €14-16 billion worth of structural deficit. The Budget promises to reduce this number to €10-12 billion. Even if this comes to pass the Government is now facing two stark choices. One – hope for a spectacular recovery from the crisis with an average rate of growth in the economy of over 5% per annum over the next 5 years. In this case, the Government will need to cut some €4-6 billion more in 2011 and 2012. Two – take the medicine and cut at least €8 billion in 2011. We have clearly opted for the first option to the detriment of the future growth.

Carbon Tax - More of the Same

Carbon tax introduction is a purely revenue raising and economically distortionary measure. In theory, carbon tax should alter environmentally harmful behavior of consumers and producers, pushing them to adopt cleaner technologies and habits, thus gradually reducing carbon tax revenue. Alas, in the case of Ireland, years of poor planning and zoning, successions of absurd spatial development plans and politically motivated capital investment programmes have resulted in a situation where many Irish consumers and producers have no room for altering their choices. Living and working in the Greater Dublin area often means no alternative but to use a car to commute to work, or even to visit grocery stores. The same can be said about all other parts of the country. Our family structures – with high fertility and dispersed households – mean that many of us have no choice but to do school runs in a car, to undertake international air travel and to deal with employment patterns that do not favor efficient time management that can be conducive to reducing emissions. Ireland’s shambolic (in quality and scope) public transport system simply compounds the lack of choices.

Hence, despite its ‘Green Policy’ label, carbon tax is nothing more than an extension of an income tax with all the associated disincentives when it comes to higher value-added jobs creation in Ireland. Irony has it, transforming this economy into more human capital intensive and thus environmentally cleaner ‘knowledge’-based one is an objective poorly served by the carbon tax introduction.

On the net, Budget 2010 turned out to be more a whimper than a bang. Whether or not it will pave the way for economically more constructive policies in 2010 remains to be seen. But the task left unfinished is daunting – Ireland will need to cut some €10-12 billion more off the Exchequer annual bill in 2011 through 2012. So far, we’ve only made a first step in a longer journey

Box out:

In light of this week’s events, it worth quickly revisiting one aspect of our budgetary trends – their frightening stickiness to historic targets that runs contrary to any change in the underlying economic realities. Looking at Budget 2007 estimates, one gets a sense of history playing a cruel trick on Department of Finance forecasting section. Back then, the Department projected a steady rise in spending from ca €45.5 billion to ca €58 billion in 2009. In line with this, the revenue was expected to rise from ca €47 billion in 2006 to roughly €58 billion in 2009. What actually happened between then and now is that the expenditure has shot up, settling at above €60 billion in 2009, while revenue has fallen to below €35 billion. Thus, Department for Finance forecasters were almost 97% right on the expenditure forecast side, but some 60% wrong on their revenue predictions. This implies an error swing of some160 points for the Department of Finance. A random error would be consistent with a 50-point range between two calls. In household economics such accuracy of forecasting could earn one a trip to a debt court. In public sector it guarantees the job for life and a nice tidy pension at the end of an errors-prone journey. Accountability is not really a strong point of Ireland Inc.

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