Pat McArdle

Irish Economy: With the budget now little more than a week away, the fiscal situation is becoming clearer.

The economic assumption on which it is based will determine whether it is realistic or not. The Taoiseach recently forecast that the economy might contract by 6.5% this year. This is weaker than the 5% consensus forecast, but more optimistic than our own 8% estimate.

As we have said before, even our figure looks optimistic.

Last week’s national accounts data were much weaker than expected and revealed a rate of contraction in the final quarter of around 7%.

The negative carry forward into 2009 is, thus, even greater than expected and the January retail sales were exceptionally weak. The third item in this unholy trio will be the budget, which will add to the downturn. A double-digit contraction in economic activity could now be on the cards, though it is likely that budget will be based on a more conservative number.

In many ways, this is Garret FitzGerald’s budget. He recently campaigned for tax increases to replace the “lost” property taxes. His statistical analysis was correct and there was a need for some action. However, the focus on raising taxes rather than cutting spending was unfortunate and, indeed, reminiscent of the 1980s.

Happily, the extreme weakness of the economy has brought greater balance back into the debate and the Government increasingly acknowledge that an undue reliance on taxes could do permanent damage.

However, the corollary is that the arithmetic is well-nigh impossible. Last week, the Minister for Finance reaffirmed that taxes would undershoot by €3 billion and spending overshoot by €1.5bn. We thus know that he has a €4.5bn gap to plug to keep this year’s deficit to the €18bn, or 9.5% of GDP, notified to Brussels in January.

Remember, however, that he will only have eight months left in which to do so, i.e. the annual requirement is a much bigger €6.75bn. On top of that, we must add the reduction in taxes or negative buoyancy that goes with a restrictive budget, another €2bn, which brings the amount of medicine required to €8.75bn, about 5% of GDP. A restrictive budget of this magnitude would finish an economy which is already on its knees.

The Government should limit the package to €4.5bn with a first year, 2009, impact of €3bn and an associated knock-on tax loss of a billion. This would improve the 2009 deficit by a net €2bn instead of the €4.5bn sought by the minister. The consequent overshoot of the target is €2.5bn and the 2009 deficit would be 12% instead of the 9.5% notified to Brussels.

Even this would be difficult to achieve. How should the €4.5bn headline cuts be split between taxes and spending? I would go for €2bn in taxes and €2.5bn in spending. As pay is likely to be left alone for the time being, non-pay will have to bear the burden. If the Government does not grasp the social welfare nettle they will struggle to cut current spending. By default, capital will come under scrutiny. In the end, there is likely to be a mixture of both current and capital initiatives but, hopefully, the bulk will fall on the current side where the real problem is.

Property and carbon taxes are likely to be signalled but hopefully will not be rushed. Excises and the minor taxes will be raised but income tax will take the bulk of the hit. The administrative difficulties of changing bands and rates at this stage are considerable, but doubling the levy would yield a billion in a full year, leaving another billion to be found elsewhere.

Remember this is but the first of five tough budgets. It should also have a medium-term aspect which must focus on pay and numbers.