Central Bank warns spending hikes risk overheating economy

This comes ahead of the Government's last budget before an election

Head of Irish economic analysis at the Central Bank of Ireland Martin O'Brien with director of economics and statistics Robert Kelly. Picture: Sasko Lazarov/ RollingNews.ie

The Government is risking overheating the economy, which could lead to higher inflation and cause damage to Ireland's competitiveness, should it continue to increase core expenditure in the upcoming budget, the Central Bank of Ireland has warned.

This comes as the Government approaches its last budget before a general election. Next month, the Department of Finance will publish its summer economic statement, which sets the fiscal parameters for budget discussions over the coming months.

However, the Central Bank has warned there is not the capacity in the economy to deal with additional core spending, which could cause it to overheat, and instead the Government should focus on addressing housing as well as other infrastructure constraints such as water, energy and transport. It said this was necessary to maintain sustainable growth in living standards.

Director of economics and statistics at the Central Bank Robert Kelly said as economic activity was expected to be “broadly in-line with its medium-term potential”, policy attention needed to more firmly turn to bolstering that potential by “addressing capacity constraints and reducing structural vulnerabilities in the economy and public finances”.

The bank pointed out there were significant vulnerabilities at present to the public finances, particularly around corporation tax receipts, with 10 large multinational firms accounting for 52% of these receipts in 2023.

Mr Kelly also pointed out the majority of corporation tax being collected was now considered excess.

According to its latest economic bulletin, should the Government increase expenditure by more than 5% over the coming years, it would lead to an increase in domestic demand and inflation.

“If the recent pattern of net spending growth exceeding the 5% rule was to be repeated in future years, this would result in a stimulatory fiscal stance at a time when the economy is already growing at or above full capacity and would leave the public finances more exposed to adverse risks,” the bank said.

A continuation of Government expenditure net of discretionary changes in tax growing at a pace similar to recent years would significantly contribute to overheating risks. 

"Such a scenario would lead to higher inflation, damaging Ireland's competitiveness and long-term prospects for growth in living standards.” 

With the economy at full employment — which is projected to continue over the coming years — along with expenditures related to ageing and climate investment, the Central Bank said it would be “prudent” to introduce measures that would “contribute to increasing Government revenue as a share of national income and broadening the tax base”.

The bank is forecasting headline inflation to ease to about 2% this year, with core inflation — which cuts out the costs of volatile items such as energy and food — to fall to similar levels.

The bank said modified domestic demand — a measure of economic activity which excludes the impact of the numerous multinational companies that are based here — will grow by 2.1% this year and 2.5% next year.

Unemployment is expected to remain low, with wages to grow by an average of 4.9% a year out to 2026.