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Budgetary policy in an uncertain world: Opening remarks by Minister for Finance Paschal Donohoe
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Good morning.
I am delighted to have the opportunity to open this year’s Budget Perspectives conference. I think we can all agree that fora such as these are always better ‘in person’, and it is good to see so many of you face-to-face after a difficult few years.
This conference is now very much part of the budgetary process, and I know that some of the key fiscal issues facing governments down through the years have been discussed, debated and analysed in this forum. So let me thank Sean for the invitation to speak here this morning.
The context for this year’s conference is, in some ways, very different to that of a year ago. The pandemic, which has so dominated our lives for two years, has finally receded, although the economic effects linger, for instance through continued disruption to global supply-chains.
In other ways, however, the context is very familiar: the reasons may have changed but, once again, the forthcoming budget is being framed against the backdrop of heightened uncertainty. While there are multiple causes of this uncertainty, the main source is the economic fall-out from Russia’s illegal and immoral invasion of Ukraine.
The immediate impact of this war has been to raise the cost of living and we are now seeing increases in mortgage costs for homeowners as central banks around the world – including in the euro area – respond to higher inflation. This is creating significant hardship for many segments of our population, and Government is conscious of this.
I think it’s important to highlight that war on European soil is the third in a set of quick-fire shocks to hit our economy since the turn of the decade; it comes on foot of the UK’s exit from the European Union – which is reshaping our relationship with our closest trading partner – and the global pandemic.
While recognising each as unique and – we hope – once-in-a-generation events, the sequencing of these shocks does suggest that we are living in a more shock-prone and, hence, uncertain world.
In my remarks this morning, I want to tease out the implications of an environment in which risks that were previously in the tail of the probability distribution appear to be increasingly coming to pass. It will come as no surprise that my remarks will focus on the implications of this through a budgetary lens.
Before doing so, let me take a step back to briefly outline our assessment of the current economic situation.
For a brief moment earlier this year, just as the Omicron wave had passed, there was a great sense of optimism. Our economy had weathered the pandemic as well as could have been expected, with little evidence of ‘scarring’ effects, that is long-term damage to the economy.
This, in no small part, reflects the fiscal firepower deployed by the government during the pandemic – around €48 billion of support was made available, a scale of fiscal response that is unprecedented in the history of our State.
At the time, the one sting in the COVID tail was a pick-up in consumer price inflation, which triggered a lively debate, among economists and others, as to whether this was transitory or not.
On the 24th of February, however, the world became a darker place. I think it’s important to stress that the costs of the Russian invasion of Ukraine and subsequent war are, first and foremost, humanitarian, with major loss of life and millions being forced to flee their homes. We in Ireland are playing our part in providing refuge and support to those who have been driven from their country.
While of second-order importance, the economic headwinds caused by the war are significant nonetheless. From an economic perspective, we can think of this as a supply-side shock: the availability of key inputs, of raw materials and, most importantly, of food, has been curtailed. This has pushed up the price of energy and many other commodity prices.
Because of this, and other supply-side aftershocks from the pandemic, headline inflation is now at multi-decade highs in many advanced economies. In some poorer countries, the issue is even more severe: accessing food is becoming problematic.
From an Irish perspective, higher inflation is the main channel through which the war is being transmitted to our economy in the short-term. Inflation is currently running at 8¼ per cent, with nearly half of this due to higher energy prices.
This is eroding real incomes and weighing on economic activity. In common with elsewhere, household incomes in real terms will be impacted, and this is a major headwind for consumer spending. At the same time, businesses may decide to hold off on capital spending, given heightened levels of uncertainty.
Then there are the longer-term ramifications of war on European soil.
Only time will tell, but I suspect that the economic fall-out from the war will persist beyond the short-term, with several structural changes now on the horizon.
For instance, we are likely to see at least some reconfiguration of the global economy in the years ahead. Trade – and the associated improvements in living standards – has been a key factor in reducing geopolitical tensions in recent decades. This virtuous circle now looks likely to go into reverse: heightened geopolitical tensions reducing trade and giving rise to a bi-polar, or even multi-polar, world.
A related issue is that of global supply chains. Economists have documented the role of intra-firm trade in the expansion of global trade since the 1980s. In a nutshell, this revolves around ‘off-shoring’, and the locating of different stages of production in different geographical regions: for example, human capital-intensive production taking place where skills and knowledge are plentiful, with labour-intensive production taking place where unskilled labour is plentiful. This has allowed for greater specialisation and productivity, with these efficiency gains being passed on to consumers by way of lower prices.
The war in Ukraine, coming so soon after the pandemic, has exposed some of the vulnerabilities with this off-shoring model. To underpin greater resilience, one school of thought sees multinational companies re-shoring production to their home countries or, alternatively, ‘friend-shoring’ production to countries in the same geopolitical orbit.
From an economic perspective, any fragmentation of the global economy along geopolitical fault-lines would reverse many of the benefits of globalisation. Ireland, of course, has benefitted enormously from off-shoring: we have developed a comparative advantage in the production of knowledge-intensive goods and services that are subsequently exported around the world. So any move away from this type of production model is a potential risk for us.
A further structural change – and one that is almost certain – is a reduced reliance of European Union countries on Russian fossil fuels as an energy source. Indeed, the war is likely to accelerate the transition to renewable energy sources, including by making investment in alternative technologies more economic. While the benefits of this are clear, this accelerated transition is likely to involve short-term costs.
So what does all of this mean for near-term economic prospects?
In the spring, my department published its assessment as part of the usual European cycle. While an annual growth rate of 4.2 per cent was projected for this year, the risks to the outlook were, at the time, firmly tilted to the downside.
Our best assessment at this point is that many of these downside risks appear to have transpired:
The persistence of high inflation in many regions is a particular challenge. A well-known economist once remarked that the best definition of price stability is a situation in which nobody is talking about inflation. Clearly we are not in that position today!
Indeed, I think it is also worth noting that some have suggested that the ‘great moderation’ of inflation – and hence interest rates – is now a thing of the past. The argument here is that many of the structural factors that have kept a lid on inflation in the past three decades – such as globalisation and demographics – are now waning, and may even be moving into reverse.
Let me be clear that I am not talking here about inflation remaining at the rates we’ve seen this year; but rather at rates that are higher than we’ve become accustomed to in recent years. There are clear signals that an economic regime change is now happening.
So what does this mean for budgetary policy?
As I have said on several occasions, the government’s balance sheet can be used to absorb some of the price shock, but it cannot be used to absorb all of the price shock. Acting to protect households from the most severe impacts of the pandemic, and from rising inflation, has been both necessary and appropriate. But these interventions have come at a significant cost.
Immediately before the pandemic, our public finances were on a solid footing. Through careful budgetary management over many years, we had eliminated the deficit. Our economy was operating at near full-employment, suggesting an underlying, or structural, fiscal balance at the time. Our debt-income ratio was around 95 per cent and moving in the right direction.
This favourable starting point allowed the government to respond in a positive, counter-cyclical manner to limit the fall-out from the pandemic. And there is an important lesson in this: keeping your (fiscal) powder dry to address the outcome of ‘tail risks’ is an important way of addressing uncertainty.
With the passing of the pandemic, and the associated economic recovery, our debt-income ratio – at 96½ per cent of national income – is now back at close to its pre-pandemic level. While this is still too high, it is only slightly above the euro area average. Indeed, our current projections see the debt ratio declining to around 80 per cent of national income by the mid-part of this decade. I think it’s fair to say that this is testament to the resilience of our economy and public finances.
Of course Government came under pressure to do more during the pandemic; but I think we got the balance right. And there is a key lesson for the future in this: counter-cyclical, growth-friendly fiscal policy can generate favourable debt dynamics.
So this leads me to the government’s forthcoming budget and the strategy that underpins it. The first point to make is that, as quantitative easing gives way to quantitative tightening, sovereign borrowing costs are now on a rising trajectory. In these circumstances, it is imperative that we ensure our creditworthiness remains – at a minimum – in line with that of semi-core euro area economies.
In the Summer Economic Statement last year, I set out the government’s medium-term budgetary strategy. We committed to limiting core expenditure growth to the trend growth rate of the economy. Crucially, the strategy fixes expenditure ceilings regardless of movement in other variables.
This year’s Summer Economic Statement, which will be published over the coming weeks, will set out the framework for economic and fiscal discussion on Budget 2023. In particular, it will set out the budgetary stance for next year.
While it will be consistent with the strategy set out last year, we need to recognise two key factors. Firstly, the fiscal strategy was framed in an inflationary environment that was far more benign than today – this time last year, inflation was running at around 2 per cent, compared with just over 8 per cent today.
Secondly, there is the need to reduce our dependency on corporate tax receipts that now account for €1 in every €4 collected, a figure that is well in excess of both historical and international norms. These excess receipts present an artificially benign picture of the public finances.
Moreover, half of corporate tax receipts are sourced from just 10 large firms. So to put it another way: around €1 in every €8 in total tax collected by the State is sourced from a very small number of firms. This level of concentration is a key risk that we must be conscious of.
So to summarise: Budget 2023 is being prepared against the backdrop of:
So preparation of Budget 2023 will undoubtedly be complex and challenging. Having said that, some perspective is needed; budgets over the last couple of years were prepared against the backdrop of a once-in-a-century global public health pandemic and, thankfully, we are no longer in that situation today.
In framing the forthcoming budget, I’m setting out here a number of key principles that will guide our decisions and help us navigate this difficult period.
Firstly, to limit the exposure of the public finances to rising borrowing costs, I will be targeting the lowest level of borrowing.
Secondly, I will be aiming for a further reduction in the debt-income ratio, to continue rebuilding our fiscal buffers.
Thirdly, we will continue to help with the cost of living challenge but, overall, we will be aiming to design policy in a manner that does not add to inflationary pressures – in other words, budgetary policy itself must not become part of the problem.
Finally, we must continue to reduce reliance on exceptionally high levels of corporate tax receipts.
The National Economic Dialogue will take place later this month and will provide a forum for an open and inclusive discussion on competing priorities and economic perspectives in advance of Budget 2023.
The final piece of the fiscal jigsaw is the need to plan now for the risks that we know are ahead. There is no excuse for failing to acknowledge – and to plan for – the medium- to longer-term challenges that we know we will have to face.
In the near-term, changes to the international taxation regime are likely to have a negative impact on our corporation tax receipts in the years to come. This international corporate tax policy issue is, of course, different to the concentration risk I spoke about a minute ago.
We know that, on the basis of current demographic trends, Ireland will have one of the fastest ageing populations in the EU in the coming decades, placing enormous pressure on our public finances.
We also know that we must continue to reorient our economy towards low-carbon, renewable and sustainable sources of energy, and that funding this climate transition will be costly.
Finally, we know that the increasing pace of automation and the digital disruption will continue to change the nature of our labour market.
To inform the policy discussions around these issues, I established the Commission on Taxation and Welfare.
The Commission, which will publish its report in the autumn, is tasked with examining the underlying structural features of our tax and welfare system. Its report will contribute to the debate by making recommendations on how Government can best reform these systems to support economic activity, promote employment and ensure that we have the resources available to secure a stable and prosperous future over the medium-to-long term.
Let me now conclude.
The global economy is becoming more fragmented and in these unprecedented times, we cannot rely on old solutions for new problems.
We must be imaginative and resourceful in how we address the demands of today while preparing for the risks of the future.
This is an uncertain world which we can navigate.
That is why the topics that will be discussed at this conference are so important.
There are many challenges to meet, but there are also opportunities to seize, if we continue to make the right decisions.
Thank you.