Monday, October 24, 2011

24/10/2011: Budget 2012 - doing the right thing right

This is the unedited version of my article in Sunday Times (October 23, 2011).

As the Troika gives another ‘thumbs up’ to our fiscal policies, the reality check on our medium term fiscal objectives suggests that the real cuts are yet to come.

Staring into the barrel of the next budget, the Irish nation is now slowly, but surely coming around to the realization that the medicines for our twin malaise of unsustainable debt and deficit to-date not only failed to cure the disease, but instead made it virtually incurable.

Now the fourth year into the austerity, per latest figures, Irish budget deficits for H1 2011 remain stuck above 13% of the country GDP. Taken against the more realistic metric, GNP, the shortfall between Exchequer spending and revenue is running at ca 17.6%. Even per Stability Programme Update, current expenditure – stripping out banks measures and capital investment, for 2011 is expected to run ahead of the 2010 levels.

Austerity, to-date, has been visible solely in capital investment cut backs and tax increases on personal incomes of the households. The rest of the ‘savings’ are really a game of shells – shifting expenditure from one side of the balance sheet to the other. In medical terminology, courtesy of the Irish Government choices of policy tools, our economy is now like a body consuming itself from the inside.

Quarterly National Accounts clearly show that Gross Fixed Capital formation in the economy is no longer sufficient to cover amortization and depreciation on private and public capital stocks accumulated between 2004 and 2008.

Meanwhile, in nine month through September this year, income tax alone accounted for 38.4% of the entire Government tax revenues, up from 28.4% for the same period of 2007.

Taking out tax increases, Irish Government austerity has delivered no real, long-term changes to-date. Neither public sector pensions, nor numbers employed, nor public wages paid relative to comparable grades in the private sector have seen much of a change worth talking about.

Adding more injury to the economy, tax increases have been concentrated at the top of earnings distribution, creating in effect the unsustainable environment where by our exports-oriented, higher value-added economy is being starved of the main input into its activity – human capital.

In 2009, Irish residents earning ca €58,000 and above, faced an average income and social security tax burden of 39.9% - ahead of the OECD average of 39.4%. The OECD average tax calculations do not adjust for the fact that whilst in Ireland income tax and social security levies and charges yield no tax-specific benefits, in other countries, social security charges include payments into private pensions and insurance funds. After Budgets 2010 and 2011, and adjusting for private pensions and health insurance contributions, this figure has most likely risen to above 45%.

Lacking competitively priced access to early education, childcare, healthcare and transport services taken for granted in other European member states, Ireland has now lost its competitive edge in attracting, retaining and developing skills needed for successful growth of our core modern sectors: research-intensive pharma, biotech and ICT, and skills-intensive international financial and legal services, business analytics and creative industries.

All of this means two things for the forthcoming Budget 2012 and for the medium term budgetary framework. Firstly, to restore Irish public finances back to health, the next four budgets will require dramatic cuts in the current public spending. Second, there is no room for new tax revenue measures.

Any further increases in taxation even at the lower end of the earnings spectrum will increase effective tax burden on highly skilled workers. This will act to further undermine our economy’s competitiveness in the core growth areas of the skills and knowledge-intensive sectors.

The problem is not a trivial one. Currently, there are between 3,500 and 5,000 vacancies in the ICT sector alone that cannot be filled by indigenous and multinational employers in Ireland. Despite the fact that ICT workers have the highest private sector average earnings of all sub-sectors in Ireland and enjoy average earnings almost 20% above their EU counterparts, companies cannot fill these vacancies. The reason is simple – we are not competitive, compared to our European counterparts, when it comes to the value for money that our after-tax earnings provide.

And this problem is not restricted to ICT sector. In the last two months at least seven internationally competitive researchers previously working in top Irish universities and institutes have packed their bags and moved overseas, leaving highly paid positions to seek better value for money and career opportunities abroad.

The next Budget must, therefore, address the problem of current spending overhang by cutting into the most painful areas of spending: social welfare, education, health and public sector employment bills.

Education-related spending has remained constant over the years of this crisis, accounting for ca 18% of the total budgetary allocations in the nine months through September 2008 and in the same period of 2011. Department of Health share of total expenditure has risen from 27.9% in 2008 to 30% in the nine months through September 2011. Social Protection share rose from 19% in 2008 to over 30% so far this year. Combined, three top spending heads accounted for almost 79% of the total voted expenditure by the State in 2011 to-date. Year on year, for the period of nine months through September 2011, there has been zero change in Education spending, a 10% increase in Health spending and a 4% increase in Social Protection.

Any serious effort at fiscal austerity requires much more dramatic cuts in these three departments.

Combined deficit reduction measures between 2012 and 2015, envisioned by the agreement with the Troika add up to €11.8 billion. Last week, the Fiscal Council has correctly proposed revising this figure up to €15.8 billion, to be delivered with €4.4 billion adjustment in 2012 and €3.7-3.9 billion every year thereafter. In my view, the measures are not front-loaded enough. In my view, Ireland’s economy will require €5.0-5.5 billion adjustment in deficits in 2012 and 2013, followed by €3.5 billion in cuts in 2014 and a €2 billion or less cut in 2015 to the total target for deficits reduction of €16-16.5 billion.

Such frontloading of cuts is required to control for the risk of further economic slowdown in 2012-2015, with 1% reduction in nominal growth rate potentially leading to a debt/GDP ratio deterioration to above 120% and even more dramatic decline in debt sustainability as measured against GNP. Frontloading is also need to provide a buffer against the expected increases in interest rates in post-2013 environment. Current inflation rates and growth dynamics within the euro area imply optimal ECB rates in excess of 2.5%. 2012-2015 period is likely to see significant increases in ECB rates, leading to an uplift in overall debt financing burden for companies and households in Ireland. With Ireland’s private sectors debt well in excess of the majority of our euro area counterparts, imposing more austerity in later period of fiscal adjustment can risk coinciding with the period of reduced private debt affordability and lead to a simultaneous adverse shocks to growth. Lastly, frontloaded cuts will act to rebalance future growth expectations for 2014-2015, helping to restore some investment activity in the economy.

Of the above measures, only about €3.5-3.7 billion can be expected to come from increased tax revenues driven by organic growth in economic activity not new taxes. No more than €1.2-1.5 billion more in savings can be generated by cutting deeper into capital expenditure. This means that the Government must find some €11-12 billion in current spending cuts over the next four years. Spread across current weights of specific top spending heads, this implies cuts of €2 billion in Education, and ca €3.3 billion in Health and Social Protection, each. Much of these cuts will have to come from involuntary redundancies and possibly cuts to indexation awarded previously for existent public sector pensions.

If management is doing things right, and leadership is doing the right things, as Peter Drucker remarked, Ireland’s Government has no choice but exercise both in the forthcoming Budget.

Box out:
The latest European Commission proposals for banning credit ratings changes for euro countries applying for EFSF or IMF rescue funds is the embodiment of the complete detachment of the European leadership from the realities of financial markets. Instead of dealing with the pressing issues of spreading contagion, the EU Commission has largely remained in its usual modus operandi since the beginning of the sovereign debt crisis, seeking new and ever-more elaborate means for raising new taxes, banning markets activities that actually act to increase markets transparency and efficiency, such as short-selling and independent ratings, while issuing vast encycliae on economic growth, invariably based on some new subsidies, state supports and other markets distortions. As with other ‘measures’, the latest proposal can backfire spectacularly. Rating agencies, only recently burned by their own failures to properly assess risks of complex securitized products relating to the US mortgage loans, have been rebuilding their reputations by re-asserting independence and pushing stronger ratings discipline through. In the presence of the ban, off-shored rating functions will be more likely to more severely downgrade euro area sovereigns seeking emergency funding, just to show the markets their own models robustness. Someone should tell the EU Commission that spitting into the hurricane wind might not be such a good idea.

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