Tax package is not that bad, but just wait until next year

BUDGET 2012 will take a lot of money out of an economy still struggling to emerge from the deepest recession in its history.

Following Budget 2012, current expenditure will be cut by €1,395 million, capital spending will be cut by €755m, the tax changes are intended to raise €1,015m, and PRSI changes are intended to raise €57m. This gives a total of €3,222m, but this rises to €3,822m when the €600m expected to be raised in 2012 as a result of the full-year effect of the changes introduced in Budget 2011 are factored in. This is one hell of a fiscal adjustment.

The general economic background against which Budget 2012 was set is very difficult and challenging. The international economic backdrop is deteriorating at a significant pace, the eurozone crisis is far from being resolved and continues to threaten the future of the euro, and domestic demand remains very weak and will be weakened further by the overall fiscal stance in Budget 2012.

Economic activity in the developed world has slowed markedly over the past six months due to a combination of excessive government debt levels and the ongoing impact of the sub-prime implosion in 2007 on global credit conditions.

For a small open economy such as Ireland, this does not set a very constructive background and exacerbates the difficulty in framing this and future budgets.

The fiscal background to Budget 2012 is straight forward but is also very challenging. In the 11 months to the end of November 2011, the exchequer ran a deficit of €21.4bn — €10.65bn of this deficit is due to once-off payments relating to the banking system. When these payments are excluded the exchequer deficit was €2.6bn better than expected.

Notwithstanding this, the fiscal challenge remains very intense, with most tax headings remaining under pressure and the task of reducing spending is very difficult.

The Government has committed to adjusting the public finances by €12.4bn in the 2012 to 2015 period. This will be very challenging and will undoubtedly exact a heavy political price, but there are not too many alternative routes. The nature of the challenge has been reflected in the downward revision to the GDP growth rate in 2012 to 1.3%, compared to 1.6% at the time of the Department of Finance’s medium-term fiscal strategy a few weeks back. This is just recognition of reality. Unfortunately the risks in 2012 would still appear to be on the downside.

The tax and revenue package is certainly not as bad as might have been expected. The lack of change to income tax rates and bands will at least support employment; the increase in capital taxes will placate the left, but will not raise much in revenue as capital gains are currently elusive; the changes to mortgage interest relief will provide some help to those in difficulty; and the increase in the threshold for the USC will help the lower paid and offset some of the pain imposed by Minister Howlin.

The reduction in the stamp duty on commercial property transactions might just give some stimulus to a totally dead and dysfunctional commercial property market. But there is no basis to the claim that these property- related measures will re-create another property bubble. The market is still too dead for that. The increase in VAT rate to 23% was heralded in advance and will not be as negative as a 2% increase in income tax. Furthermore, some retailers will absorb the VAT increase and will not be inclined to pass it on to a very resistant consumer.

The tax and revenue part of the budget was never going to be easy, but at least some attempt at economic stimulation is being made. That is a relative term however, as the overall Budget 2012 package will act as a significant drag on the economy in 2012 and beyond.

Given the ongoing weakness in domestic demand, the contradictory nature of Budget 2012, the ongoing eurozone crisis and the deteriorating international economy, there would appear to be a high probability that the budgetary targets may not be met in 2012. It is inconceivable that if this turns out to be the case, the Government will be forced to target adjustments of more than the planned €3.6bn in 2013. This would prove extremely difficult. We just have to hope for a better international background in 2012 than currently appears likely.

Social welfare rates, state pensions, income tax rates and public sector pay were not touched directly in 2012. However, it will become much more challenging over the 2013 to 2015 period to identify and deliver the fiscal adjustment targeted over that period without re-visiting these areas. It is clear that Ireland has considerably more fiscal pain ahead, but there is little choice other than to re-create a sustainable public finance situation. A lot of pain has now been endured, but unfortunately there is a lot more to come.