Did austerity work?

Nevin Economic Research Institute Director Tom Healy reflects on the budgetary decisions taken since 2008 and considers how a different course could have been charted.

A year after the end of the bail-out, one of the paramount questions in the economic debate is whether austerity worked in Ireland’s context. A key consideration is not what might have happened if the fiscal consolidation had not been done but if it had been done differently with no cuts to public capital investment, minimal cuts to current spending and significant increases to revenue – especially those related to income from capital.

A carefully planned and strategic investment programme conducted ‘off-the-books’, availing of the limited resources available in the National Pension Reserve Fund, would have assisted economic recovery and government revenue buoyancy. Such measures would have been constrained by the need to maintain a large cash reserve as part of an adjustment to re-entry to the international capital markets. Moreover, borrowing costs for commercial enterprises were very high in the 2010-2011 period. However, there were choices available at different stages of the crisis, especially in regards to the balance of spending cuts and revenue increases as well as the discretionary use of pension funds.

Fiscal austerity describes policies to reduce a government deficit through planned cuts to spending or increases in government revenue with a view to aligning spending and revenue and avoiding increases in government debt. Typically, public spending rises automatically during periods of economic recession as unemployment rises and incomes fall, triggering greater demand for public services as well as social transfers. At the same time, revenue from income tax or consumption taxes falls as household spending is squeezed during an economic downturn. Leaving aside the above changes that occur due to the economic cycle, the focus of fiscal adjustments has been to narrow the gap between spending and revenue.

The aim of fiscal adjustment was to reduce the government deficit over a set period of time (2010-2015) to reach a maximum of 3 per cent of GDP. It was not possible to reduce the overall size of government debt relative to GDP before 2015 mainly due to the legacy of bank bail-outs as well as slow growth in the economy as deficits remained well above the absolute growth in GDP.

Table 1 shows the progress in relation to the primary government deficit – the difference between revenue and spending where the latter excludes the interest paid on public debt. Due to the huge impact of bank bail-outs in the period 2009-2012, the deficit includes a large component of one-off payments that were charged to the government deficit. Leaving aside these bank capital transfers, the primary deficit declined from 8.5 per cent of GDP in 2009 (peak) to an estimated 1.3 per cent in 2013. A small primary budget surplus is estimated for 2014 and is projected to rise to 4.0 per cent by 2018.

Between 2008 and 2014, a series of fiscal adjustments were carried out (see Table 1). In total, discretionary fiscal changes of around €29.8 billion were announced in various budgets between 2008 and 2014 i.e. from the budgetary measures announced in July 2008 to the Budget of December 2013 in respect of the fiscal year 2014.

Not all of these announcements were implemented subsequently. Caution is also noted in regards to announced revenue increases (as distinct from expenditure cuts) as some changes were reported twice (or double-counted) in some budgets and it is difficult to unpick these changes. The overall picture that emerges is that a total ‘effort’ of around 20 per cent of GDP (or €30 billion) was signalled over the seven-year period with a spill-over of measures already announced but not implemented until 2015 or later years. For example, changes to student charges in higher education were announced in 2012 but implemented on a phased basis up to and including 2015.

About two-thirds of the fiscal lifting was done in the four budgets between October 2008 and December 2010. The remaining €9.5 billion of adjustments was announced over three budgets in 2011, 2012 and 2013. The size of the Budget 2013 adjustment is disputed with a higher figure of €3.1 billion used in some communications and €2.5 billion in other communications. Table 1 shows a breakdown of the adjustments using the €2.5 billion estimate.

The total fiscal effort divides into a ratio of approximately 63:37 between expenditure cuts and revenue increases. This ratio was broadly similar over the period as a whole with a slightly lower proportion for expenditure cuts (at 62 per cent) during the period 2008-2010. The composition of adjustments was different between 2008-2010, on the one hand, and 2011-2014 on the other. Over the latter period, relatively greater reliance was placed on indirect taxes within the revenue adjustments. It should be noted that some of the fiscal measures have been reversed in Budget 2015 (announced in October 2014). Moreover, no new or additional fiscal consolidation is envisaged for 2015 at this point. Future growth trends and outcomes in regards to government deficits flows and debt levels may trigger additional fiscal adjustments under EU fiscal rules.

Economic impact

The initial estimate of savings or revenue raised may not correspond closely to the actual accrued saving or revenue raised. Finally, it must be emphasised that each and every fiscal adjustment – whether on the revenue side or the spending side – has a knock-on effect on the macro-economy through its impact on consumption and investment. These effects feed through to public finances in a feedback loop.

Estimating and modelling these impacts is difficult and subject to uncertainty as well as measurement error. However, work by the ESRI and by Dr Rory O’Farrell provides some indication of the indirect impacts through estimation of fiscal multipliers. Each cut in spending or increase in revenue has an impact on income and expenditure in the Irish macro-economy. In a NERI working paper, O’Farrell using the results of macro-economic modelling estimated the economic and fiscal impact of 11 different budgetary measures and applied these findings to the actual measures introduced by Irish governments in the years 2009 to 2012.

Table 2 shows the following shows the estimated reduction in the government deficit in the first and in the seventh year following a €1 billion reduction in various public expenditure categories.

The table also shows a wide variation in deficit reduction impacts. The estimates reported for adjustments in non-wage consumption are the largest. A €1 billion shock cuts the deficit by €732 million in the first year and an average of €674 million over the seven years.

Adjustments in public sector employment, on the other hand, had a relatively limited impact on the deficit in the first year and a negligible impact in the seventh year. While an adjustment in social transfers resulted in a 50 per cent deficit reduction, adjustments in public sector wages and public investment produce significantly lower deficit reductions of just under a third and just over one-fifth respectively.

With the exception of social transfers, all adjustment estimates show a declining impact over the seven-year period. This is particularly pronounced with public investment reductions. In the first year, a public investment adjustment resulted in a deficit reduction of €420 million reducing to an annual reduction of €222 million after seven years.

In summary, revenue and expenditure measures tend to have different impacts on GDP and the deficit. Expenditure cuts impact more negatively on GDP than revenue increases but expenditure cuts have less of an impact on the deficit (partly as a result of the negative drag on GDP).