A GROWTH-FRIENDLY SPENDING MIX? BREAKING DOWN PUBLIC SPENDING IN IRELAND.

Author:McDonnell, Thomas A.
Position::Report - Statistical data
 
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  1. Introduction

    In this paper, we begin by discussing the role played by certain forms of public spending in maintaining and driving sustainable and inclusive long-run economic growth. In particular, we identify the role played by spending on education, public spending on Research and Development (R&D), and investment in public infrastructure. The importance of public spending that facilitates higher levels of labor force participation is also discussed. We next proceed to compare per capita public spending levels in Ireland with that of similar high-income European Union (EU) countries. Following on from this we consider the implication of Ireland's public spending profile for the Irish economy's long-run productive capacity.

    With a collapsing economy and a widening public deficit, Ireland began a program of fiscal austerity (tax increases and cuts to public spending) in 2008. The government finances have improved every year since 2010. Data from the CSO shows a 2016 general government deficit of 1.5 billion [euro] and 0.6% of GDP. The deficit was 5 billion [euro] and 2% of GDP in 2015 and 7.2 billion [euro] and 3.7% of GDP in 2014 (CSO, 2017). The gross level of public debt has declined from its peak of 119.5% of GDP in 2012 and 2013 and had fallen to 75.4% of GDP by the end of 2016. While the improvement in the debt-to-GDP ratio partially reflects the once-off surge in nominal GDP in 2015, the improvement also reflects a decline in the value of the debt from 215.3 billion [euro] at end-2013 to 200.6 billion [euro] at end-2016.

    One consequence of Ireland's years of fiscal austerity is that Ireland is now scheduled to have one of the lowest public spending-to-output ratios in the entire EU by 2021, and a historically low spending ratio by modern Irish standards. Such a low level of spending has significant negative implications for the future provision and quality of public services and infrastructure, and has implications for the future sufficiency of social transfers.

    In this paper we describe how the Irish state under-spends (1) on a per capita basis compared to similarly high income EU countries in a number of areas fundamental to long-run economic growth. Most significantly from the perspective of Ireland's long-run productive capacity are the under-spends in education, in infrastructure, and in Research and Development (R&D). In this context, we argue that Ireland's long-run economic growth; employment and equity goals can best be achieved by prioritizing use of the available fiscal space to increase public capital investment levels; to increase spending on education, along with family and child supports, and to increase direct spending and subsidies for R&D and innovation capacity building. Priority should also be given to measures to reduce barriers to employment such as more generous subsidies for childcare.

    Our conclusions, in terms of the necessary direction for aggregate public spending, have clear implications for the needed direction of future reforms to government revenue raising and taxation and have implications for the future composition of public spending. Prioritizing particular areas of spending must by definition mean de-prioritizing some other areas of spending.

    The paper proceeds as follows. Section 2 explains the relationships between certain types of public spending and long-run inclusive and sustainable economic growth. Section 3 then goes on to compare per capita spending in Ireland with per capita spending levels in similar high-income EU countries. We identify the functional areas in which Ireland is a particular outlier in terms of public spending. Section 4 focuses on the under-spends in the growth enhancing areas of public spending and the implications for future fiscal policy, including tax policy, in Ireland. Section 5 concludes.

  2. Long-run Economic Growth and Public Spending

    Long-run economic growth is a central concern for policymakers as the extent of quality of life improvements in future years depends on the ability of the economy to grow sustainably in the long-run. More precisely, quality of life improvements depend on the ability of the economy to produce and diffuse new innovations and to find ways to use capital and labor more efficiently. Knowledge is central to this process. Rosenberg (1972) and Romer (1990) go so far as to argue that the key to influencing long-run economic growth is to first influence the cost of obtaining knowledge and the cost of generating and spreading new ideas. We can represent economic output by the following production function:

    Y = AF (K, L) = A[K.sup.[alpha]][L.sup.1-[alpha]]

    where Y is output, K (capital) and L (labor) are the factor inputs and A is Total Factor Productivity (TFP), sometimes called the Solow (1957) residual.

    TFP represents the productivity of capital and labor and reflects things like the state of technology and its diffusion, the human capital of the workforce, the strength of economic and political institutions, the sectoral composition of output, and the efficiency of use of both capital and labor. [alpha] and 1 - [alpha] are the elasticities of output with respect to capital and labor respectively. The basic growth accounting formula for labor productivity is given by: [DELTA]ln(Y/L) = [alpha][DELTA]ln (K/L) + [DELTA]lnA

    Labour productivity can be decomposed into two parts:

    1) The contribution from the percentage rate of growth of the capital stock per unit of labor input (capital deepening), and

    2) The contribution from the percentage growth of TFP.

    By modifying the production function to explicitly account for the human capital (education and skills) of the labor force, we can decompose labor productivity growth into a third part:

    3) The contribution from the percentage rate of growth of the quality of the labor force.

    Further extensions to the production function can be made to incorporate the contributions to productivity growth from different types of capital (e.g. ICT and non-ICT), from Research and Development (R&D) inputs and, at least conceptually, from changes in the efficiency of factor use.

    As described in McDonnell (2015), per capita economic output is determined by: (A) the proportion of the working-age population as a percentage of the total population, (B) the percentage of the working age population working for pay or profit, (C) the average number of hours worked per person working and, crucially, (D) the average output per unit of hour worked (i.e. labor productivity). Policies that increase output are therefore those that either sustainably increase the amount of labor inputs employed or those that increase average labor productivity.

    The "new growth" models treat technological change as endogenous (Romer, 1986, 1987, 1990; Lucas, 1988). Their central proposition is that capital accumulation when taken in its broadest sense to include human capital does not exhibit the diminishing returns of the earlier Solow model (Mankiw, Romer, and Weil, 1992). The growth process is seen as driven by the purposive accumulation of human and physical capital together with the production of new knowledge, often created through R&D activities, and the subsequent diffusion of that knowledge (Snowdon and Vane, 2005). The neo Schumpeterian models (Grossman and Helpman, 1991; Aghion and Howitt, 1992) retain many elements of the new growth framework yet combines the evolutionary perspective of technological change as a path-dependent process with an understanding of the economy as a complex system. Competition between innovations, rather than competition between firms, is seen as the central force propelling economic growth. According to these various models, the public benefits to R&D activity will exceed the private benefits because knowledge is only partially excludable. Jones and Williams (1998) find that the social (i.e. economy wide) rate of return to R&D is between two and four times the private rate of return to R&D. However, the inability of knowledge producers to internalize all of the benefits of investing in R&D reduces their incentive to undertake such activity in the first place leading to underinvestment in R&D. The resulting market failure is the standard rationale advanced in favor of activist technology policy, whether in the form of R&D subsidies and tax incentives for the private sector or in the form of direct government investments in R&D and human capital.

    What are the implications for public spending decisions? Sustainable long-run growth in per capita output depends on innovation and knowledge driving improvements in labor productivity. As such, investing in education and skills (human capital), equipment and infrastructure (physical capital) and in the production, diffusion and use of new ideas, is the only way to sustain growth in productivity over the long-term. In other words, insufficient investment in skills, infrastructure and innovation will constrain future economic growth.

    2.1 The Fiscal Rules in Ireland

    In Ireland, the parameters for fiscal policy are set by the European Union's fiscal rules i.e. the requirements of the preventive arm of the Stability and Growth Pact (SGP). The preventive arm is assessed under two main pillars. These are the Structural Balance Rule and the Expenditure Benchmark Rule. An important implication is that the annual government finances must finish with a structural deficit of better than 0.5% of potential output or, alternatively, there must be an annual improvement in the structural deficit of more than 0.5% of potential output. As of 2018, Ireland has achieved its objective of a deficit in the structural balance of no worse than 0.5% of potential output as required under the preventive arm of the SGP.

    The Irish government retains almost complete flexibility over the composition and scale of its public spending and revenue raising. The only significant constraint on governments under the fiscal rules is over the fiscal stance or fiscal...

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