Pat McArdle, Chief Economist, Ulster Bank: Budget Commentary

 

Prudent is the word that best describes yesterday’s budget and it must be accorded a generally favourable welcome. There was a considerable focus on housing with both first-time buyers’ tax relief and stamp duty being overhauled. Current spending was boosted, mainly on social welfare, capital expenditure was maintained in line with the NDP provisions and the burden was kept unchanged.

 

A few months ago when it first became clear that the 2008 budget was going to be a difficult balancing act, the fear was that capital spending would be cut back. Early on, Minister Cowen let it be known that the National Development Plan was a priority. Then he promised to increase capital spending by 12.5%, in the event, it is up 11.2%. The Minister even promised to up the capital spend in coming years to 6% of GNP – the old target was 5% but was frequently missed.

 

Current spending, too, was broadly as signalled with public sector pay up 6.9% and net non-pay up by 11.5%. Whichever way you look at it, there is a lot more to do to get down to the 5 to 6% range that we need to be in to prevent the government expanding its share of national cake. The difficulty in making progress can be seen from the fact that a 5% increase was required just to maintain existing policies. Budget-day provisions added a further 4%, much of this going on social welfare where rates were increased by 6 to 7%.

 

The tax measures were as good as could be expected. The income tax system was indexed to wages, i.e. bands and allowances were increased by 4%. This means that the tax bill will remain constant as a percentage of income. Not surprisingly, more ambitious moves were postponed. Rates were left unchanged and the promised reform of PRSI deferred again. Business taxes were streamlined and taxes on plastic cards were belatedly lowered. Tobacco taxes were raised by 30c, adding 0.15% to the CPI.

 

The green agenda was obvious with the promised shift in motor tax to a carbon emissions basis coming in mid-2008. The promised increase in first-time buyer relief duly arrived. Surprisingly, it was accompanied by significant stamp duty reform. This is welcome as there is little doubt but that now the ideal time to tackle this thorny question.

 

The tax revenue estimates, on first sight, look conservative, up only 3.3% which is the smallest increase for more than a decade. However, it is difficult to be critical. The 2008 forecasts assume about 55,000 housing completions, down from a higher 62,000 estimate a month ago. In reality, there is a huge degree of uncertainty around this number and it could easily be lower. As every 10,000 houses costs the Government €1 billion in revenue, it is safer to be prudent.

 

The new stamp duty system applies to residential housing only and the commercial property regime was left unchanged. The new system is much simpler with only two rates and there is a saving of 3% for houses valued between €600,000 and €900,000. Above that, the saving in duty paid tapers off but is still more than 1% at the €2 million mark. It will certainly have a positive impact – at the very least the uncertainty that existed has been removed. At the same time, one cannot help feeling that it was a missed opportunity for a more dramatic reform with a greater likelihood of a positive market response. As it is, the Minister has costed the reduction at €190 million, or one fifth of the existing yield, which does not seem to envisage much of a rebound in transactions.

However, the combined impact of stamp duty relief and increased tax allowances could still be considerable. The additional repayments on a €300,000 35-year mortgage from the cumulative 2% point increase in interest rates is €365 a month. The doubling of the first – time buyer relief ceiling to €20,000 in the past two budgets, is worth an extra €200 a month. This offsets more than half the extra mortgage bill for those who qualify for the maximum. Affordability is set to improve anyway as incomes rise but interest rates remain unchanged. This will now be augmented by the tax measures in the budget and should in time lead to a turnaround in sentiment.

The 2008 Budget was expansionary – we have moved from a surplus of 0.5% in 2007 to a projected deficit of 0.9% in 2008, i.e. an injection of almost 1.5% into the economy. This is as it should be given that the housing adjustment should be a once-off event. The fiscal levers should be relaxed when times are tough and vice versa in times of plenty. We are fortunate that the experience of 2002 was not repeated.

 

Austin Hughes, Chief Economist IIB Bank:  Budget 2008: Cautious Steps in the Right Direction

• Modest tax and social welfare changes will offer some support to Irish economy but could have been larger.

• Cautious approach to public finances limits the boost to the economy.

• Stamp duty changes will help but a significant turnaround in Irish housing market will require a more favourable interest rate climate.

• Cowen’s approach is safe and/or dull and unlikely to boost or bury sentiment toward the Irish economy.

• Spending restraint to be a key issue for coming years.

Summary Assessment

Budget 2008 will do no harm to the Irish economy and is likely to offer a modest amount of support to activity in the coming year.  Importantly, increased spending on infrastructure is set to be maintained. The trend in Ireland’s public finances should remain fairly healthy and there appear to be no major ‘own goals’ on policy.  At the margin we think a little more could have been done to boost confidence in the economy.  Somewhat larger tax and social welfare concessions would have offered a slightly greater boost to household spending power without placing undue strain on the budget arithmetic. However, we can understand even if we don’t fully share Merrion Street’s caution in view of the weakening in tax revenues of late.

The Centrepiece of Budget 2008 is a modest boost to the Irish housing market in the shape of some reform to stamp duty.  Again, we think the Minister could have gone a little further.  That said, the removal of uncertainty regarding stamp duty, a worthwhile boost to the finances of prospective house buyers and the prospect of a less threatening interest rate climate in 2008 should help the Irish housing market stabilise.

A Poorer Global Backdrop Is A Significant Concern

First of all, it is important to note that the current slump in confidence is not unique to Ireland.  A sharp weakening in the US economy centred on a collapse in the housing market in the ‘States began the process.  That caused a major upheaval in financial markets worldwide because of the parcelling and re-parcelling of securities backed by now much depreciated sub-prime US housing assets.  This financial contagion threatens a sharp slowdown in the UK economy and notably weaker growth in the Euro area. 

The significant silver lining in what is a very cloudy economic sky worldwide is the prospect of offsetting action by Central Banks that means the interest rate outlook for 2008 looks altogether less threatening than it has been in the past two years.  The Federal Reserve has already cut rates by 75 basis points and a further reduction is likely next Tuesday.  UK interest rates could fall as soon as tomorrow and should be materially lower by next Spring.  In terms of the interest rates that matter directly to Irish borrowers, the European Central Bank opted not to implement a threatened rate increase in recent months.  While the situation remains finely balanced at present, we think Irish borrowers will see lower rates by next Spring. 

It should be emphasized that lower interest rates, while helpful to the Irish economic outlook, ultimately reflect a less favourable picture for global economic growth. It is certainly the case that a challenging external backdrop, which Mr. Cowen perhaps optimistically described as one of ‘significant uncertainty’, will play a key role in determining the futures of the Irish economy in the coming year.  That said, the sharp drop recorded in Irish consumer sentiment through 2007 also points towards a notable deterioration in the domestic forces shaping Irish economic performance.  It is these domestic influences that Mr. Cowen needed to address in budget 2008.  We think he has gone some way towards limiting the downside risk to the economy in the coming year but we think he could have gone a little further.

How Much Scope Had Mr. Cowen to Act?

It is worth putting the nature and extent of Wednesday’s budget changes in context.  Certainly, the view that Mr. Cowen had very little room for manoeuvre had become firmly established of late as a weakening trend in tax revenues became more evident.  While poorer tax receipts of late are disappointing, it must be remembered that surprising divergences in terms of budgetary outturns have been the norm in recent years.  Table 1 compares the outturn with the General Government Balance (the EU norm for measurement of budgetary positions) with budget day predictions of that outturn.  As the table indicates, there has usually been a wide gap between the two figures in recent years.  In part this reflects the fact that the General Government Balance (GGB) is the difference between very large spending and revenue aggregates that together sum to around €130 bio in 2008.  However, even if we allow for the fact that these spending and revenue numbers are enormous, the scale of the annual forecast ‘miss’ remains substantial.  For the years under review, we reckon this primarily reflects the particular sensitivity of tax revenues to strong economic growth.  Probably for this reason, the Department of Finance likely harbours some concern that more sluggish economic growth might mean tax revenues could disappoint in coming years.

Table 1

We draw attention to this aspect because we think one significant element in the framing of Wednesday’s budget was a desire to keep the GGB for next year just below 1 per cent of GDP.  There is an altogether misleading precision attached to the Minister’s forecast of a GGB deficit of 0.9% in 2008.  A slightly larger tax package might have given more significant support to the economy in the coming year with no material impact on the projected deficit beyond statistically spurious calculations.  Incidentally, on the Minister’s projection the deficit in 2008 will represent the poorest outturn since the early 1990’s.  However, in view of the fact that current revenues are projected to exceed current government spending by as much as 2.8 per cent of GDP, it does not seem at all unreasonable to run a deficit of just 1 per cent of GDP to fund infrastructure borrowing of around 4 per cent of GDP.  In brief, we don’t feel the public finances are on a threatening trend.

 How Big Or Small Were The Changes?

 The weaker than expected budgetary outturn now expected for 2007 understandably informed the scale of budget day tax and social welfare changes announced by Mr. Cowen.  Relative to nearly €2.8 bio worth of tax and social welfare changes a year ago, Wednesday’s announcements are notably more modest (see Table 2).  That said, nearly €1.8 bio worth of changes (if we include the cost of stamp duty changes) means budget 2008 can’t really be described as a non-event.

Table 2

The tax and social welfare measures will boost Irish household incomes by around 1½% relative to what would be a rather drastic assumption of no budget day changes.  This compares with the boost of around 3% delivered by last year’s budget.  In very broad terms the ‘real’ (ie inflation adjusted) position of most workers and social welfare recipients is largely maintained by Wednesday’s changes.  That said, the risk of slightly higher inflation means that many workers will see some real squeeze on spending power.  We felt that last year’s budget day measures were justified by the prospect of pressure on spending power in 2007.  At the margin, a little more could have been done to support purchasing power in what is likely to remain a fairly challenging climate in 2008.  In summary, the tax and social welfare changes are relatively modest although they might be seen as more notably generous than media reports had caused many to fear.  However, we don’t expect any lasting boost to consumer sentiment or spending from the measures.

 We think that the decision to make reasonably conservative concessions on more tax and social welfare spending reflects a number of influences.  First of all, it probably owes much to nervousness in Department of Finance that growth in tax revenues might now be set on a notably lower trajectory.  Second, as we discuss below, some leeway had to be created to finance stamp duty reforms.  Third, we think the pace of increase in day-to-day government spending (by virtue of the size of this aggregate) has limited scope for tax reductions.

 How Big A Problem Is The Pace Of Growth In Government Spending?

 It is generally agreed that continued substantial increases in government infrastructure spending are necessary and will benefit the economy.  Opinion is far more divided on day-to-day spending.  It is fairly obvious that increases in government current spending can’t permanently outpace growth in the Irish economy.  If the Minister can deliver a promised easing in the pace of growth in coming years, the trend of recent years should not cause lasting problems for the public finances. 

  Table 3

Although international comparisons are hampered by significant differences in national definitions, it is possible to get some impression of the scale of the increase in Irish public spending by looking at commonly used measures of Government spending in other countries.  Since 1995, Central Government spending in the UK and the US Federal Government’s gross spending have both averaged increases of around 5 per cent per year while central government outlays have averaged around 1 per cent in Germany and France over the same timeframe.  Judged from this perspective, a roughly 9 per cent average annual increase in Irish government spending since 1995 gives some flavour of the increased absorption of resources by the Irish public sector.  Of course, it must also be recognised that Irish economic growth has been more than twice as fast as that in the US and UK and nearly 4 times as fast as in the Euro area during this period.  So, notably greater resources were available. 

The real issue is not that Irish public spending has been dramatically out of step in the past.  Instead, two significant problems now suggest themselves.  First of all, as Mr. Cowen acknowledged, the pace of increase in public spending must be restrained in coming years.  In the light of somewhat softer economic growth, we reckon economic resources could permit annual increases in day-to-day government spending of 5-7 per cent in the next 2-3 years.  However, in a somewhat cooler economy, restraining the rate of public spending increase to around 9.5% in 2008 and even further in 2009 and beyond could prove difficult, particularly with a further benchmarking round looming.  A second and possibly more fundamental problem is the overriding sense among the population at large that quite dramatic increases in current public spending in the past decade have failed to deliver anything approaching either the quality or quantity of public services that might have been expected. 

Will budget 2008 support the Irish property market?

The major ‘news’ in Budget 2008 relates to Mr. Cowen’s decision to make some significant amendments to stamp duty on residential property.  While there is little doubt that higher interest rates were the main driver of the slowdown in the housing market in 2007, uncertainty about stamp duty and nervousness about the broader Irish economy also played significant roles in the scale of the downturn seen in the past twelve months.  Negative sentiment towards the Irish housing market is now firmly established and any significant recovery will require a range of positive influences. 

In this regard, the broad thrust of Budget 2008 will offer a welcome, if modest, degree of support to the property market and the broader Irish economy next year.  Although we don’t expect it to deliver a major boost to confidence we also think a notably less threatening interest rate outlook should provide a more supportive backdrop than has been the norm in the past two years.  In such circumstances, the stamp measures introduced by Mr. Cowen will offer a necessary, albeit modest, boost to housing market activity.  We think a marginally larger drop in the standard rates to 5% and 8% might have given a notably larger boost to the market and government revenues.

The cost of the measure as set out by Mr. Cowen at €190 mio is significant in terms of other budget changes announced and notably greater than the €70 mio cost of increased mortgage interest relief provided in Budget 2007.  However, judged in terms of net new mortgage borrowing of around €18 bio in the past twelve months the measure would be judged as fairly modest.  We think the impact should be notably greater than this sort of arithmetic might suggest for a couple of reasons.  First of all, for potential purchasers in the €750K range a prospective saving of around €24K in their immediate outlay is not insignificant.  More fundamentally, the change in stamp duty removes a major uncertainty that has been weighing on the housing market for the past fifteen months.  In tandem with a more favourable interest rate outlook, we think it will provide support that should stabilise the market in Spring 2008 and encourage a modest pick-up in activity and a flatter trend in prices.  If as we expect, the Irish economy remains reasonably resilient and lower borrowing costs materialise before mid year, a modest improvement in the housing market could become established in the course of 2008.

What impact will budget 2008 have on the Irish economy?

We don’t think Budget 2008 markedly alters the outlook for the Irish economy in the coming year.  We think Budget day tax and social welfare changes could have been a little larger and supported a stronger outlook for growth in spending power in 2008.  That said, we remain of the view that the Irish economy is reasonably resilient.  In particular, we think employment in services will remain reasonably healthy and layoffs in construction could be less threatening than some envisage.  As we also expect lower borrowing costs next Spring, we think consumer spending will be marginally stronger than the Department of Finance envisages.  However, we also worry that merchandise exports may not grow as much as the Budget forecast implies. 

Drawing together these slight differences, we arrive at a broadly similar outlook for GDP and GNP growth to that of the Minister.  At the margin, we think inflation might be a touch higher than the Department of Finance forecast suggests as strong upward pressure on global food prices appears threatening.  However, sluggish global economic activity could restrain this threat and also prompt some easing in oil prices.  As a result, we have no major quibble with the Department of Finance on this score.