Ireland: Trouble on the Horizon?

Transcription

1 Ireland: Trouble on the Horizon? Macroeconomics /5/05 Michael Delaney Jeffrey Lee Scott Schlimmer

2 1. Introduction and Assessment Ireland, the name invoked images of poverty and plague, of the potato famine and political fighting. In Angela s Ashes, Irish-American author Frank McCourt describes his childhood in Limerick. We have nothing but bread and tea Mam says, No, you ll stay here where there s no work and hardly a lump of coal to boil water for tea. You ll watch your sons going around with broken shoes and their arses hanging out of their trousers. Every house in the lane has electricity and we re lucky we have a candle. 1 For the better part of its history, these generalizations of Ireland did accurately represent the lives of most of her citizens. In the 1980 s, a shift in economic and fiscal policy laid the groundwork for an unprecedented economic boom in the 1990 s. 2 During that shift, foreign investment was courted; those investment dollars were funneled into education and improving the infrastructure; and both taxes and spending were cut. It translated into far and away the best economic growth in the European Union during the both 1990 s and this decade. While we can detect few weaknesses inside the Irish economy, both its membership in the EU and reliance on foreign investment do make it susceptible to outside shocks. We will address this issue more concretely and present several recommendations which would soften the impact of a shock. 1.1 Investment Foreign direct investment (FDI) into Ireland has been one of the largest catalysts for its economic growth. While the Irish government actively solicited foreign investors and corporations during the 70 s and 80 s, investment peaked when the standard corporate tax rate was lowered to 12.5% in the mid-1990 s. 3 The impact can be seen in Figure 1. Meanwhile, a parallel increase in domestic investment has accompanied that spike in FDI. While GDP has risen by an average of 6.6% between 1993 and 2004, total investment has increased by 11.6% (Figure 2). During the 1980 s, Ireland s investment in secondary and higher education produced a highly skilled work force, increasing the labor efficiency and spurring foreign investment by technology based firms. Figure 1: Foreign Direct Investment ( ) $35,000 $30,000 Millions of US Dollars $25,000 $20,000 $15,000 $10,000 $5,000 $

3 Figure 2: GDP Breakdown by percentage of GDP ( ) Millions of Euros 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Net Exports Investment Gov't Spending Consumption 1.2 Fiscal Policy In 1987, a new government in Ireland radically changed the country s fiscal policy. 4 Government spending was cut as was tax rates. In a bold move, an amnesty clause was included which greatly reduced the number of delinquents taxpayers, thereby broadening the tax base. To date, this lower level of spending and taxation has continued. As previously mentioned, the internationally favorable corporate tax rate has increased foreign investment. We think it is likely that this may have also played a role in increasing domestic investment. Regardless, the increase in investment has created the effect of an expansionary fiscal policy (Figure 3) which would correspond with the observed growth in real GPD. Figure 3: IS-LM Analysis Interest rate (r) r 0 =r 1 LM IS 0 IS 1 Y 0 Y 1 National Income (Y) The limited role of government has also had a positive impact on Ireland s debt. Since 1998, the country has maintained a budget surplus, using the additional money to pay down the debt.

4 Figure 4 illustrates both the change in deficit to GDP ratio and the drastic decline in debt to GDP ratio. During the four years of budget surplus, their debt has halved as a percentage of GDP (74.1%-36.6%) and decreased by 8.5 billion euros % Figure 4: Deficit and Debt as a Percent of GDP ( ) 100.0% 80.0% Percent of GDP 60.0% 40.0% 20.0% 0.0% -20.0% Deficit(-)/Surplus(+) Debt 1.3 Impact of the European Union In 1999, Ireland switched from the punt to the euro. The switch removes the option of monetary policy from the purview of the Irish government, limiting their options in the Mundell-Fleming model (Figure 3). Given the portability of money within the EU, the continent has, for all practical purposes, one interest rate. Therefore, the interest rate within Ireland is limited to that EU-wide rate and hypersensitive to any changes, manifesting in a horizontal LM curve. Its usage of the euro has two major economic implications for Ireland. First, because Ireland s economy is small relative to the remainder of the EU, the impact of any monetary change would be very limited. Given their recent economic performance, this could be a blessing, preventing policies which benefit the larger countries from having an overly large negative impact. However, it would also prevent Ireland from benefiting if their economy was lagging behind rest of the EU. Second, their membership requires Ireland to abide by EU regulations and directives. While these decisions may benefit the union as a whole, they may negatively impact on the Irish economy. We will address this in greater detail in section 2.3.

5 1.4 Overall Assessment The Irish economy has been a model of success over the past decade. Highlights of Ireland s economy include: High GDP Growth Rate (6.6% average between ) Low Inflation (4% average between ) Low Unemployment (4.5% in 2004) Positive Foreign Trade Balance Low Tax Rate High Foreign Direct Investment High Investment in Education and Infrastructure Figure 5: Real GDP Breakdown ( ) Billions of Euros Net Exports Investment Gov't Spending Consumption 2. Trouble on the Horizon? Ireland s economy has grown at exceptional rates, but its economic policies could lead to trouble in the near future. 2.1 Pro-cyclical Policies Ireland has pursued pro-cyclical policies, which could amplify the next recession. Keynes accepted that long-run output was relatively fixed. In the short term, however, Keynes noticed that economies deviate from the long-run output line. These fluctuations can deviate largely from the long-run, alternating chaotically between periods of major expansion and deep recession, or they can remain close to the fixed long-run level, alternating between mild expansion and mild recession. Keynes suggested promoting the latter of these possibilities. He suggested using counter-cyclical policies to minimize extreme expansion and extreme recession.

6 Figure 6: Cyclical Economic Growth Actual growth GDP Average growth time During recessions, governments can cut taxes, increase spending, and increase the money supply to catalyze recovery. During rapid expansion, governments can increase taxes, cut spending, and reduce the money supply to reduce inflation. These counter-cyclical policies minimize the deviations from long-run output levels. Ireland has been in an expansionary period for some time, keeping taxes low and investment high, while having no control over an ECB monetary policy aimed at fighting inflation in the struggling economies of the rest of Europe. This seems to have catalyzed GDP growth and helped make Ireland s economy especially strong. However, this defies Keynesian countercyclical policies. Ireland s pro-cyclical policies have resulted in a prolonged period of growth, but could make the next recession especially difficult. y y=y/l*e Figure 7: Solow Growth Model y=f(k) c i=sf(k) i k k=k/l

7 2.2 Overheated Housing Market Much of Ireland s investment has been in housing. In the short-term, the booming housing market had added to Ireland s economic success. However, this investment may be a detriment to Ireland s future prosperity because it should not lead to long-run growth. Long-run economic growth can be illustrated by the Solow growth model. Note that the model assumes a closed economy. While this is not a good assumption for Ireland because Ireland relies heavily on foreign trade, the basic principal still holds true. Given a level of saving in a country, steady state economic growth is determined by the rate of capital depreciation, the rate of population growth, and the rate of technological innovation. For simplicity, let s assume a constant population and an Irish economy based purely upon housing investment. Technological growth comes from advances in process and physical innovations, not from investments in housing. Technology growth would be almost non-existent. This would eventually lead to a steady state with the yearly amount of savings equaling the yearly amount of depreciation in housing capital. y = Y L * E Ultimately, the over-investment in the housing market will weaken economic growth. Money that was invested in housing should have been invested in sectors that would have led to technological innovations and improved labor efficiencies. These increases to E accelerate economic growth in the steady state of the Solow growth model. 2.3 Push for Standard EU Corporate Taxes Irish corporate tax rates are well below those of most other developed nations, bringing more businesses to Ireland and fueling the recent economic growth. However, some European Union countries, especially France and Germany, have been politically pressuring Ireland to increase corporate taxes to typical EU levels. An increase in corporate taxes would deter companies from locating in Ireland and reduce FDI and the amount of business done in Ireland, hurting future growth. If Ireland drastically changed its corporate taxes to typical EU levels, they would certainly experience an economic shock. Even if corporate taxes were increased incrementally in anticipation of a regulation by the EU, a severe shock would be less likely, but growth would be stunted.

8 Figure 8: Standard Corporate Tax Rate 5 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Japan India Italy Spain USA Brazil Belguim Germany Australia UK Sweden Finland Poland Latvia Ireland Cyprus 3. Recommendations 3.1 Institute a Property Tax We recommend that Ireland establish a property tax. This will provide two major macroeconomic benefits to the Irish economy. First, a property tax will help cool the Irish housing market. Housing will be more costly to own, hence demand will decrease. This will likely shift investment towards activities that will result in technology-induced growth. Second, a property tax reduces the risks associated with more pro-cyclical tax policies, such as consumption-based taxes. We recommend that the property tax be accompanied by tax cuts to make this policy shift revenue neutral. This should encourage the same level of investment that has currently made Ireland so economically successful, while directing those euros towards investments which will lead to greater long-run growth. 3.2 Maintain Low Government Spending Prior to the Celtic Tiger era of the 1990s, Ireland had a debt to GDP ratio of almost 100%. The situation was so bad that creditors were questioning the ability of Ireland to pay back their debts. 6 As a result of good fiscal policy and economic growth, Ireland has reduced their debt to approximately 36% of GDP. However, Ireland s overall fiscal policy is still vulnerable to economic shocks and downturns. Because of the pro-cyclical nature of their policies, an economic downturn would likely result in both an increase in government spending and a decrease in tax revenues. To guard against a return to heavy government debt, Ireland should maintain a low level of government spending in all but a severe economic recession. This fiscal

9 constraint will serve to further reduce government debt in the near term and allow the government greater flexibility in the event of a major economic shock or downturn. 3.3 Marginally Increase Corporate Taxes France and Germany are pressuring the European Union to adopt a standard corporate tax rate. This policy is meant to eliminate one of Ireland s comparative advantages over many EU countries. Many multinational corporations have located their EU headquarters in Ireland to take advantage of their favorable tax policies. First, Ireland needs to assess the probability that a standard corporate tax rate measure will become EU law. If a real threat exists, Ireland should marginally increase its corporate tax rate so as to minimize both the probability of passage of a standard EU corporate tax rate (which would reduce the pressure of a large gap) and the economic shock if an EU regulation were passed, while using political methods within the EU to defeat such a measure. 1 McCourt, Frank, Angela s Ashes, Chapter IX 2 Burnham, James B., Why Ireland Boomed. The Independent Review, vol. VIII(4), Spring 2003, pp Burnham 4 Burnham 5 Source Wikipedia.org 6 Burnham All Irish economic figured based on IMF data. International Financial Statistics Yearbook, 2005.