Only growth can reduce the debt

Michael Burke: Over on Irish Ecoomy, Karl Whelan has initiated a useful discussion highlighting some of the differences between EU Commission and government forecasts. Very usefully, he has created an open spreadsheet which fleshes out the bones of the forecasts, which allows some of the underlying assumptions to be derived.

Only time will tell whether the EU Commission’s forecasts are more accurate. But they do at least have the merit of internal consistency, whereas DoF forecasts have none.

In relation to underlying (non-bank) deficit, the EU forecast a deficit of €16.4bn in 2011. Assuming an underlying deficit of €18.9bn in the current year, this implies that a €6bn ‘fiscal adjustment’ leads to actual deficit-reduction of €2.5bn. Likewise another package of cuts in 2012 amounting to €3.6bn leads to actual deficit-reduction of €1.5bn. In both cases the ratio is the same 1:2.4, €1bn in savings requires €2.4b in cuts/tax increases.

Contrast this with the DoF 1:1.6 in 2011, and an unfeasibly high 1:1.24 in 2012, that is cuts of €3.6bn could lead to a lower deficit of €2.9bn.
The facts are that cuts and tax increases in 2008/10 of €14.6bn led to a wider, not narrower deficit. So in both instances the Commission and the DoF are assuming a much less negative effect on government finances than has actually been the case.

But at least the Commission’s forecasts are at least within the spectrum of reasonable discussion and have the merit of consistency. Neither could be said for the DoF forecasts.

The (23yr old, single) laid off public sector worker previously on €35,000 pa was paying €6,500 a year in direct taxes and is now receiving €7,500 in JSA. At least another €2,000 is lost in VAT receipts on her lower consumption. So, without any account of the wider impact on the economy from this reduction in her output, or the incomes or consumption of others, or other welfare benefits to which she may be entitled, from just the direct effects alone, the gross saving for the government of €35,000 in spending cuts becomes a net saving of just €19,000. A ratio of 1:1.84.

Turning to the EU forecasts alone, it should be clear where the deficit-reduction is coming from. The forecasts are for nominal GDP to increase by €2bn in 2011 and by €4.3bn in 2012. At the same time, the deficit is expected to fall €2.5bn and €1.5bn in those years.

If the assumption is that the growth contribution to changes in government finances were simply the government’s share of total revenues (approx 35%), then growth would be responsible for €700mn of the deficit-reduction in 2011 and €1.5bn in 2012 (the entirety of the deficit-reduction in 2012).

However, this assumption reproduces a commonplace error. The sensitivity of the government finances to changes in GDP is a combination of the marginal tax take (not the average tax rate) plus the sensitivity of government outlays to changes in output (primarily changes in welfare payments). The DoF estimates these together total 0.6 (which seems to be an underestimate in current circumstances).

Using the DoF sensitivity estimate of 0.6, in 2011 growth would be responsible for €1.2bn or nearly half the total forecast deficit reduction, while in 2012 it would account for nearly €2.6bn in deficit-reduction, much greater than the anticipated level of €1.5bn. The measures themselves off-set this growth effect and are counter-productive.

If there is to be any deficit-reduction at all it can only come from growth. The EU forecasts demonstrate that deficit reduction over anything but the very short-term is entirely a function of growth. ‘Austerity’ measures run counter to promoting growth and are likely to lead to counter-productive increases in the deficit. Again.