Second post of three catching up with some of my recent articles.
This is an unedited version of Sunday Times article from April 7, 2013.
Just when the EU leaders were ready to relax after the tough couple of weeks spent dismantling the economy of Cyprus, the news flow has turned once again and, predictably, not in their favour.
Over the last week, euro area Purchasing Managers Indices for manufacturing have showed that the economic activity in the sector has fallen for 19th consecutive month. The downturn in the eurozone manufacturing has accelerated, slipping to 46.8 in March, down from 47.9 in February. In Ireland, manufacturing PMI reading fell to a 14-months low at 48.6.
Meanwhile, Eurostat data showed that seasonally adjusted unemployment in the common currency area reached 19.1 million in February, up on 17.3 million a year ago. In Ireland, seasonally adjusted unemployment rate is stuck at 14.2% since December 2012, while youth unemployment rate rose to 30.8% in February.
Adding insult to an injury, CEPR and Bank of Italy leading growth indicator for the euro area, eurocoin, posted another negative reading in March. This means that the euro area economy has been contracting now for 18 months in a row. The previous crisis of 2008-2009 counted only 13 months of continued sub-zero readings.
In short, over the last 10 days we had a plethora of reminders that the current growth crisis sweeping across the euro area is both deep and structural in nature. Which puts into the context last week’s warning from the IMF to Ireland that the headwinds to our economic growth prospects in the medium term are posing some serious risks to the prospects of our recovery and debt sustainability.
The underlying causes of the crisis we are experiencing since 2008 relate to the structural weakness in our economic system when it comes to identifying, pursuing and delivering organic growth opportunities.
Since around 1997-1998, Irish economy has been growing by one asset bubble displacing another. We started with a sizeable bubble in the ICT sector that inflated out of any proportion with the real economy from 1997 and finally met its end with the dot.com crash of 2000-2001. Alongside this bubble, around 1998, we began to inflate a public spending and investment bubble. Between 1999 and 2005 Irish Government voted spending rose from EUR22.8bn to EUR45.1bn, with 2001-2002 period increases accounting for 43% of the total rise over 1999-2005. Rampant over-spending in the public sector was coincident with (and co-dependent on) a massive bubble in the property market.
In short, Irish economy has been running on steroids of spending or credit bubbles for some eleven years prior to the crisis of 2008. An entire generation of Irish policymakers, analysts, bankers, investors and businessmen has matured with not a slightest idea as to where the real sustainable economic value added comes from other than the over-inflated egos, valuations and leverage.
As the result, today, we need serious reforms to reduce our reliance for growth on the structurally sick euro area, and to shift our own economy's development engine away from unsustainable reliance on bubbles-inflating activities and re-focus it on growth reliant on high value added activities, entrepreneurship and human capital.
On human capital, OECD's annual Going for Growth report from 2013 shows that Irish economy suffers from structural deficiencies in labour force participation by women. On average, women outside the workforce have higher skills and better work experience than men in similar demographics and work status. However, women participation rates in Ireland are below those in many other advanced economies due to a combination of factors, including high cost of early age education, childcare.
Improving affordability and access to childcare is an imperative for Ireland, given our demographics, but we also require a wholesale re-balancing of our tax system to reduce Exchequer reliance on income tax-related revenues. Current tax system in Ireland penalises skills and higher investment in human capital through excessive taxation at the upper marginal tax rate and exceptionally low threshold for the upper tax band applicability.
Other labour market measures needed include: increasing resources for job-search assistance and workplace training within the existent education systems, and better aligning training programmes with skills needs of the economy. Both of these objectives formed cornerstone of the Fas reforms. However, these reforms were only partial, especially considering that the very same people who were responsible for the past training and up-skilling systems failures are now manning in the reformed entities.
Irish economy must become more knowledge and skills-intensive - a process that requires simultaneous development and rapid expansion of our R&D capacity and output, as well as our human capital base.
On R&D front, the Government pursued policy of retaining and even enhancing R&D tax credits. Alas, recent research shows that lower tax rate on patent income is more effective in improving R&D climate in the economy than R&D tax credits and allowance.
Supporting human capital investment in the economy means strengthening value-for-money delivery in public services, providing higher quality services to skilled workers (an area where Irish system fails completely), reducing tax disincentives relating to human capital and enhancing our education, training and immigration systems to improve inflow of human capital.
Education acts as major driver of human capital formation and innovation in the economy, as well as a viable exporting sector. In a small economy like Ireland we have to think outside the box to deliver greater efficiencies in the higher education sector.
We need to decentralise pricing and decision-making in universities and IT sector by introducing variable, flexible fees reflective of differences in degrees and awarding institutions. To continue increasing access to education a system of merit and need-based grants should be used to offset the cost of tuition. Ireland has three or four internationally competitive universities with potential to compete globally for quality students and staff, including TCD, UCD and UCC. These universities should move toward a model of accepting 2nd and 3rd year undergraduates to deliver full and internationally-competitive 4 year degrees. This can free more resources to focus on post-graduate education. Other Universities can continue with the current model of 3 year degrees and focus on undergraduate education with post-graduate training geared toward more applied fields. IT schools should become feeder-schools for universities, supplying early-stage undergraduate training equivalent to years 1 and 2 of the 4-year degrees, and on professional and applied training.
Both OECD and the IMF focus a lot of attention on increasing competition and efficiencies in our non-manufacturing domestic sectors, including energy, utilities, health insurance, legal and professional services. The recent strengthening of the Competition Authority is helpful, but hardly sufficient, especially in the environment where regulators of the domestic services are captives of the semi-state companies operating in these sectors. The way to break this industry stronghold on the state is to break up and privatise commercial semi-state entities. The Government has committed to such actions, but no privatizations took place to-date and the break ups under the planned privatizations remain inadequate in scope.
The same principles of increasing completion and choice of service providers should apply to the all client-facing public services. Alas, the Government is incapable of even starting a debate about such a change in the status quo.
Another major reform of domestic economy we need to undertake that is not covered by the Government strategies is the change in the way we fund our business creation and growth. Globally, as the fall-out from the financial crisis settles, advanced economies are shifting more and more corporate and SMEs funding away from debt, toward business equity. In Ireland, such a change is being held back by a number of small policy bottlenecks.
One is the unequal treatment of debt and equity in taxation. Last month, IMF published a research paper looking at the effects of preferential treatment that debt financing receives over equity in the majority of the advanced economies. The paper concluded that such asymmetry in taxation increases likelihood and severity of the financial crises. IMF study shows that providing for a tax on business equity returns, in line with the treatment of bonds returns, is the most effective measure to improve systemic stability of the economy.
The second, and somewhat related bottleneck is the punitive treatment of employee share ownership in Ireland. Issuance of business equity to key and long-term employees is both an efficient means for raising capital for the firms and for incentivising key employees. However, in Ireland, such a move triggers income tax liability on equity granted for the employees, which is completely divorced from any actual returns accruing to the employee. The solution to this problem is simple enough: the state should apply capital gains tax to employees shares, with an added incentive for shares issued to long-term key employees.
Another major problem with out tax regime is the application of taxes to proceeds from the sale of business. Many new ventures are launched by entrepreneurs on the basis of funding obtained from the sale of pervious business. Allowing a 2-3 year tax-deferral for any reinvestment of such proceeds can stimulate flow of funding into the Irish economy, reduce incentives for entrepreneurs to domicile outside Ireland prior to the sale of business and net exchequer more tax revenues over the medium term than the current regime allows.
Reaching well beyond the confines of the existent Troika and Government-own programmes for reforms, the above measures can help shift Ireland’s growth model away from unsustainable reliance on tax arbitrage activities of the MNCs and bubbles-prone domestic investment.
Recent data from CSO’s Residential Property Price Index and the GeoView/DKM survey of commercial property vacancy rates shows that contrary to the Government claims of turnaround in the Irish property markets, our real estate sector continues to suffer from the ongoing crisis. Per GeoView/DKM survey, 23,432 commercial premises remained vacant in Ireland in January 2013, up 6.7 percent on previous survey results from August 2012. In Dublin, some 13% of all commercial premises are empty, up on 12% in August 2012. Meanwhile, prices of residential properties have fallen 1.53% in February 2012, compared to January, marking the steepest decline in 12 months and the decline is accelerating over the last 3 months period compared to previous 3 months through November 2012. In other words, the green shoots in our domestic investment, claimed by the Government and property sector analysts over 2012 so far appear to be an illusion. Irish property market remains stagnant, with occasional volatility pushing prices up a few percentage points only to see subsequent reversion to the zero growth trend established since January 2012.