The Fianna Fáil-led government in Ireland is unique among the industrialised countries. In 2009, while virtually the whole world was busy implementing a variety of packages to stimulate the economy, Ireland was alone in implementing a series of deep cuts in government spending programmes. This has drawn admiration from the leaders of the Conservative Party in Britain, who are hoping to emulate their fellow Thatcherites in Ireland.
According to the Organisation for Economic Co-operation and Development, Ireland has experienced a fiscal contraction amounting to 6.4 per cent of gross domestic product. Public sector pay has been cut twice, while investment programmes have been cut and welfare benefits have been slashed across the board. These include the jobseekers’ allowance for the young, in an effort to encourage the age-old blight of emigration, as well as a series of disability benefit cuts, including those to the blind.
By contrast, the G20 was attempting to revive the economy by increasing government spending, with the average stimulus package amounting to 2 per cent of GDP in 2009, with Britain’s more modest 1.6 per cent of GDP.
George Osborne recently urged us to “look and learn from the across the Irish Sea” – and so we should. What we find is that austerity policies deepen the recession and actually increase the deficit.
In the wake of the financial and economic crisis, the private sector has significantly increased its savings by paying off debt. For both individuals and companies, this makes sense, especially if they have falling incomes or their debts are high – or both. But the more they save, the less they are able to spend. For individuals, this means cutting back on consumption. For companies, this means cutting back on investment. Both these components of demand have declined, but the most severe decline has been the collapse in investment – as is the case in Britain.
Under these circumstances, it is economically disastrous for a government to join the savers. The net result is to depress activity even more, leading to further declines in incomes for companies and individuals, who respond by making further savings. And so the cycle continues. It is a death-spiral for the economy that is familiar from the Great Depression.
Instead, and just like the businesses which currently cannot or will not invest, government can invest to achieve a return that lifts both economic activity and the taxes emanating from it. In this way, not only does the economy grow, but also the deficit actually falls.
However, this process also works in reverse. In the latest Budget announced in the Dail, there were cuts of four billion euros, mainly in public sector pay and welfare. The Department of Finance accepted that pay cuts for public sector workers means lower taxes from public sector wages. However, there was no estimate of the impact on demand for goods and services. Nor had the ensuing effect on tax revenues from the private sector been taken into consideration. Further, there was no impact assessment made of the effects on other areas of government spending. This is to ignore a crucial aspect of austerity measures. Increasing numbers of low-paid workers or unemployed inevitably place greater pressure on government welfare spending, especially where benefits are means-tested.
Taxation revenues are dependent on activity. But just how dependent can sometimes be surprising. In real terms, adjusted for price changes, the Irish recession has been twice as severe as the British one. Most forecasters expected that Irish GDP would be little changed in the final quarter of 2007. In which case, through the course of the recession, the total contraction in GDP was 26 billion euros in actual cash terms.
The Irish exchequer’s tax receipts in 2007 totalled 48 billion euros. However, by the end of 2009, they had declined to 34 billion euros. So, a decline in the economy of 26 billion euros led to a fall in taxes of 14 billion euros – even though there were some tax increases over the period. Without those increases, the ratio of the fall in taxes to the fall in GDP would have been even greater than the actual level of 54 per cent (€14 billion euros divided by 26 billion euros).
One of the reasons that Ireland is so admired by George Osborne – and one of the reasons its government finances deteriorated so sharply – is that it is a low-tax economy. So, how can it be that falling activity led to such a high proportionate fall in taxation? The answer, in the jargon, is that taxation is elastic. If various economic activities are subject to thresholds or exemptions or are untaxed at all, the burden of taxation falls on a narrow part of overall activity. If that activity declines – and Irish investment has declined by 53 per cent – the taxes on it will fall disproportionately.
At the same time, government spending cuts can lead to increased pressures on expenditures in other areas. In fact, there were already cuts amounting to more than four billion euros, even before last December’s Budget. Yet, in 2007, government current expenditure was 41 billion euros. By the end of 2009, it had increased to more than 45 billion euros.
Here, if we exclude the direct effect of those cuts, the ratio of rising government spending to falling GDP is eight billion euros versus 26 billion euros – or 31 per cent. This is also because government spending is usually disproportionately required for the low-paid and the unemployed, who are the biggest victims of the economic slump.
However, the money wasted on the bailout of bank shareholders in both Britain and Ireland, not included in these data, dwarfs the economically useful spending on the poor and low-paid.
So, we have a situation in which a decline of 26 billion euros in GDP has led to both a fall in taxation revenue of 14 billion euros and an adjusted increase in spending of eight billion euros. This combined total deterioration in government finances of 22 billion euros is almost the same as the fall in GDP – a decline to which the austerity measures of the Irish government have directly contributed. But the culpability does not end there.
Austerity has also led to an increase in interest payments compared to those countries which have engaged in reflation. Yields on Ireland’s 10-year government debt have been more than 1 per cent higher than the eurozone countries which tried to stimulate their economies. Bond markets, for all the Thatcherite cheerleading of most of their participants, are above all focused on repayment of their loans to governments. Repayment requires tax revenues. But Ireland’s tax receipts have experienced the biggest falls in the euro area, aside from Greece, because of its austerity policies. As a result, it has been obliged to borrow 55 billion euros in the past two years. Because of both higher borrowing and higher interest rates on government debt, the additional cost to Irish taxpayers amounts to approximately one billion euros a year for the entire lifetime of that debt.
Taking these three factors together – falling taxes, higher automatic spending and higher borrowing costs – the “saving” arising from government spending cuts is virtually non-existent in the first year alone. And even if the economy makes a partial recovery in 2010, there will still be a tax shortfall and spending increase for years to come, rapidly turning the supposed saving into a huge cost burden. The lesson George Osborne has failed to learn is: You can’t cut your way out of recession.
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