I welcome Dr. Tom McDonnell of the Nevin Economic Research Institute. I apologise to him for our over-run in time. Dr. McDonnell will outline to the committee his views and those of the institute on Ireland's economic and fiscal position in the run-up to budget 2017. Before we begin, I remind those present to turn off their mobile phones because interference from such devices can affect sound quality. I advise the witness that he is protected by absolute privilege in respect of the evidence he is to give to the committee. If he is directed by the Chair to cease giving evidence on a particular matter and he continues to do so, he is entitled thereafter only to a qualified privilege in respect of his evidence. He is directed that only evidence connected with the subject matter of these proceedings is to be given. He is asked to respect the parliamentary practice that, where possible, witnesses should not make charges against or criticise any Member of either House, a person outside the House or an official by name or in such a way as to make him or her identifiable. I ask Dr. McDonnell to make his opening comments.
Economic and Fiscal Position: Nevin Economic Research Institute
Dr. Tom McDonnell
I thank the Chairman for giving me this opportunity to appear before the committee. Following the recent upward revision in Ireland's GDP, the Nevin Economic Research Institute's next set of macroeconomic projections is likely to forecast a 2016 general government deficit of close to 0.8% of GDP and a gross debt ratio of close to 75%. Our autumn forecast has not yet been completed but our summer forecast was for real GDP growth of 4.6% this year and 3.7% next year.
Our summer forecast was for real GDP growth of 4.6% this year and 3.7% next year.
While it is true that the headline GDP figures give a misleading picture of economic activity in Ireland, there is much evidence that the real economy grew strongly in 2015 and continues to grow strongly, although growth may have been softening in recent months. Personal consumption increased 4.5% in volume terms in 2015 and 5% in the first quarter of 2016 compared to last year. The growth in spending is being driven by the strong growth in employment. Other factors boosting consumption include the reversal of fiscal austerity, the ongoing decline in household debt, pent-up demand, loose monetary policy, the fall in energy prices and Ireland’s position within the economic cycle.
Employment increased by 2.6% in 2015 and is up 2.7% in the first half of 2016 compared to the previous year. Total employment is now in excess of 2 million for the first time since the fourth quarter of 2008, although this is still more than 130,000 below peak employment levels. All regions remain below their pre-crisis employment totals, with recovery relatively strongest in Dublin, at 97% of second quarter 2008 employment, and relatively weakest in the west, namely, counties Galway, Mayo and Roscommon, at 89%.
The unemployment rate was 8.6% in the second quarter of 2016. Unemployment rates are lowest in the mid east - the area around Dublin - and highest in the south east. Long-term unemployment has fallen below 100,000 for the first time since the third quarter of 2009 and now stands at 4.4%. However, it is three times as large as it was in the first quarter of 2008.
Average weekly earnings were up 0.5% in the second quarter compared to the previous year while average hourly earnings increased by 0.2%. Average hourly earnings are essentially unchanged over the past five years.
Consumer prices in July were up 0.5% over the previous year and 1.3% when energy products are excluded. The consumer price index is now broadly at 2008 levels and is up almost 3% since 2011.
In considering the fiscal context, the parameters for budget 2017 are set by the requirements of the preventive arm of the Stability and Growth Pact. Adherence to the fiscal rules limits the net fiscal space, as we estimate it, for new commitments to between €900 million and €1 billion in 2017. The recent upward revision to GDP will have a minimal impact, if any, on the 2017 fiscal space. The Government estimates the net fiscal space available over the next five years at €11.3 billion. However, this estimate is based on an assumption that the economy is running a structural deficit of 2% of potential output in 2016 and that the economy is overheating. However, a strong case can be made that the economy is not overheating. This analysis is based on the economy’s still high unemployment rate; the evident lack of domestic price and wage pressure in the economy; the current account surplus even after correcting for multinational restructurings; the low underlying investment ratio, excluding intangibles and aircraft purchases; and lack of housing supply. If this analysis is correct, it implies scope for increasing the fiscal space in 2018 as structural deficit targets will have been achieved.
The fiscal space is sensitive to the potential growth rate of the economy. The Nevin Economic Research Institute's baseline estimate is for real GDP growth of close to 3% extending out to 2030. Potential GDP growth could well be higher than this in the short to medium term given the potential for above trend employment growth over the next five years. However, a structural shock to the economy, a secular productivity decline, sustained underinvestment or an underperformance of employment growth would damage the economy’s growth potential. An average reference rate of real potential growth of 3% over the next five years, as opposed to 3.5%, would reduce the cumulative net fiscal space by around €1.8 billion over the next five years.
Not all fiscal measures have the same impact on potential output. In the long run, sustainable growth can only come from productivity gains. Given Ireland’s relatively low levels of spending by advanced economy standards on education, research and development and capital expenditure, there appears to be scope to use fiscal policy to enhance future productivity by increasing per capita investment in education and skills; increasing per capita investment in research and development, the production, diffusion and use of new knowledge and ideas, and the development of a strong innovation system; and increasing investment in productive infrastructure. Long-run investments in these three areas could increase the fiscal space available to government in the long term because these types of investment increase the productive capacity of the economy.
The future of the universal social charge, USC, has come under question in recent years. The USC has a simple and highly progressive structure. Average rates of combined income tax and employee social security contributions in Ireland are significantly below OECD averages for both low and middle income earners. Dismantling of the USC would be regressive and extremely costly. While there would be a short-term boost to demand and, therefore, real GDP growth, there would be no increase in the economy's long-term productive capacity. Ireland is not a high tax or a high public spending economy. Given our ageing population, it is likely we will have to increase taxes in the future. Cutting taxes now is not a prudent long-term budgetary strategy. I will be pleased to answer Deputies' questions.
I thank Dr. McDonnell for his submission and taking time to appear before the committee. It is very much appreciated. I agree with his analysis in which he identified three areas of investment for growth, namely, education and skills, research and development and productive infrastructure.
The first question I have is where he thinks the money for that - the best place or the least bad place - will come from. Could we obtain it by increasing taxes, by not eroding the tax base any further, by reducing expenditure elsewhere, or by breaking the fiscal rules?
My second question relates to the expenditure benchmarks, which this committee will be poring over for years. It is my understanding that they are set at the starting point. The benchmarks provide that a country cannot raise its average spending more than X percent based on all of the factors we have spoken about today. However, they do not suggest that a reasonable amount of expenditure is X or Y or a percentage of X or Y. The indicators just say that wherever a country is at, it is coming from that point. Other countries spend more on education, be it per capita or as a percentage of GNP, than we do. This has been referenced in the witnesses' document. We invest considerably less in education than some other European countries. If we follow the benchmark and increase by a percentage per year, as other countries do, and because we are coming from a lower base of investment, unless we do something quite different, is it the case that we are perpetually locked into less investment than our competitors? If that is the case, does Dr. McDonnell think that is something we should change and, if so, how would he change it?
Dr. Tom McDonnell
The Deputy has asked two related questions which pertain to the three areas of productive investment and where and how they should be funded - by increasing taxes, by not cutting existing taxes, by cutting from other areas of spending, or indeed by breaking the fiscal rules. The Deputy's second question was whether we are locked into moving from where we already are and moving a certain percentage more than that each year, which is equivalent to the reference rate plus inflation once the structural target has been achieved. I will answer the two together. Essentially, the expenditure benchmark restricts growth in spending, while discretionary increases in revenue allow countries to expand the envelope for spending. Similarly, cuts in spending allow an expansion of the envelope for tax cuts. The expenditure benchmark and the structural balance rule, which will also affect us in 2017 and 2018 - that is the convergence margin, which I am also happy to talk about - affect the stance. They affect what the structural deficit will be over time if the rules are adhered to. We can talk about the appropriateness of those rules, but that is what they do - they affect the stance. They do not, however, affect the ability to invest in the economy, provided one is willing to pay for it. This means that cuts in taxes and radical investment cannot be achieved at the same time. It means that we have to choose. With €900 million to €1 billion of fiscal space - and the way capital spending is treated means that it is a little bit more than that, because capital spending is done over a multi-year envelope - a country can only increase that amount. It can only increase the space for education, infrastructure, innovation and so forth by increasing revenue or by cutting areas of public spending such as justice or defence - areas that are less associated with long-term inclusive growth. It does not preclude us from investing in the economy and it does not preclude us from investing any less than Denmark invests in its economy. It precludes us from adopting a fiscal stance that the European Commission does not particularly like. Obviously, with the fiscal stance and the convergence margin that is applied, particularly for 2018, the fact that we are allowed to spend only €1 billion instead of €3 billion is because the European Commission's methodology says that Ireland is overheating. We are not overheating at the moment.
I would argue that the fiscal space for 2018 should be closer to €3 billion. This is something that the committee could argue, perhaps, with the Commission and could challenge. I suspect the Department of Finance and the ESRI agree with me in that regard, which is that the methodology is flawed. There is scope for increasing the fiscal space in 2018 and potentially even in 2017. That is my point about the fact that Ireland's economy is not overheating. We will probably have a deficit in 2016 of approximately 0.8% of GDP. If we were overheating, our structural deficit would be worse than our actual deficit. If a country was underheating - that is, if it did not reach its long-term average - one would expect the country's actual deficit to be worse than its structural deficit. Our actual deficit will be approximately 0.8% of GDP. We are not overheating. It seems unlikely that our structural deficit is more than 0.8% of GDP. It certainly is unlikely that it is much more than 1%. That means that one more year of application of this convergence margin, which reduces the fiscal space from approximately €3 billion to €1 billion, improves our structural deficit sufficiently to get us down to approximately 0.5%, which is all we have to do. If all of that is true, it means we can increase our fiscal space in 2018, giving us more money for infrastructure, tax cuts or whatever it is we want. What the fiscal rules do is to modify a country's fiscal stance and constrain what it can do with that fiscal stance. We are not at all precluded from spending as much as we want on infrastructure, education or research and development. However, we have to pay for it through revenue or cut other areas of public spending. That really is what it is.
In terms of the options that were outlined, we are concerned that the overall level of spending relative to output in previous years has been moving along a very low trajectory compared to other European countries. It is true that GDP is a very bad metric to use in terms of the ratios for Ireland. The Irish Fiscal Advisory Council came up with a hybrid measure, which was reasonably applicable for previous years although it will not be applicable at all for future years because of what happened to GDP in 2015. However, even by that metric, we are still quite a low spender compared to our western European peers.
In our opinion, if we wish to have western European standards of public services, infrastructure, education spending or research and development, we will have to pay for it. The implication is that rather than cutting things like the universal social charge we should be looking at ways to expand the tax base, which is another question. One could look at tax expenditures or one could look at various types of property tax. There are different types. I was listening to the previous session. One of the comments was that 40% of tax revenues come from income tax. We are a little above the EU average in terms of income tax as a proportion of overall revenue, but the revenue base in Ireland is actually quite low. Let us consider implicit tax rates, which are shown in one of the tables I included in the presentation on labour. In terms of the implicit tax rate on labour - that is, the effective tax rate over the potential tax base - we are actually a little bit low, but not dramatically so. The point is that we are not over-emphasising income tax. In fact, we are a little bit over in terms of consumption taxes. That would be the long-winded answer. We are not precluded from investing in infrastructure, education and research and development. However, we have to pay for it, which means reducing other areas of public spending or increasing the revenue base. On balance, I would be inclined towards the second option but, again, it is more complicated than that because there are reforms on taxation and the public spending side that should be progressed at the same time. One could look at reforming the overall tax system to be more growth-friendly and equity-friendly at the same time. Tax expenditure is an area we could examine.
I have two questions. I will ask them separately because they are not related. I am not sure if Dr. McDonnell was here during the first set of exchanges. He may have been. I saw him at the back of the room for some of it. I will ask him for his view on a number of the issues that were raised. The first relates to the distorted GDP figures. In his statement, the chief economist from the Central Bank referred to the exclusion of aircraft and intangible assets when making calculations. He also argued that we should invent some sort of bespoke Irish methodology for calculating growth and GDP.
In Dr. McDonnell's view, how tenable is that? If we were to do that, would those figures be accepted internationally or by EUROSTAT? Would they fly or would they be seen as us trying to disguise a problem that might exist? Given the headlines that have gone around the world about leprechaun economics and so on, how tenable would it be to come up with a new formula or way of calculating growth? The chief economist made the point that we could then try to sell that as a new way of doing it.
There was a discussion on lowering borrowing in excess of the fiscal rules to below 60% of GDP. This was in response to a letter that was sent from the Governor of the Central Bank to the Minister for Finance. He seemed to be indicating that this would be a good thing. Again, the response from the chief economist was that this was long term. In his response long term is 2019, but the letter was sent in the context of this year's budget. That was the context in which the letter from the Governor went to the Minister for Finance. Even taking at face value that response, it would have an impact on the ability of the State to invest. Would Dr. McDonnell agree with that? Is that something he would support? Would he support the view that, whether it is short-term or long-term, we should look at reaching a debt target below the appropriate level? The Governor explained that the ceiling at the moment is 60% of GDP. That is the first part.
Dr. Tom McDonnell
The first question was on the distorted GDP figures. It is extremely frustrating having to forecast these things. Many of the tools available to us are not really useable now. I think it will be difficult for the Central Bank and the Central Statistics Office to come up with an alternative metric that will be accepted internationally. I think no such broadly based figure exists to capture perfectly the activity in the domestic economy, which is what people are really thinking about.
The corporate restructuring in 2015 polluted the data to such an extent that it is of arguable value anymore. I agree with the Central Bank in that it was a level effect. My baseline assumption is that we will go back to having reasonably normal growth levels from now on, albeit from that higher base, but I cannot guarantee that. There may be more corporate restructuring in 2016 and beyond related to tax planning.
I do not believe that Ireland trying to peddle an alternative metric internationally would fly particularly. If we were to use the figures based on domestic demand, it would be highly problematic because net exports are such a sizeable part of the Irish economy. I understand the motivation to remove intangibles, the intellectual property assets and aircraft. One reason I sympathise with this approach is that, historically, in an advanced economy we would consider an investment ratio of between 20% and 22% as being pretty standard. We have been well below that for a long time now. If we exclude intangibles, aircraft intangibles and so on, investment was approximately €31 billion in 2015, which is a small proportion of the economy. I would be keen to have some kind of metric which would allow us to have investment appropriately as a proportion of economic output. Clearly, we have an investment problem in the economy at the moment. It is probably one of the reasons we are not overheating, as it happens. Obviously, we have a major problem in terms of public capital investment, which is at extremely low levels. It is barely more than depreciation. We have low levels of private sector investment as well.
I do not believe the Central Bank and the CSO will succeed.
I do not believe they will come up with a better figure. I think in the end they will come up with a dashboard of measures which will include GDP, GNP, underlying investment and so on and employment, which will attempt to create a picture of how healthy the economy is and allow people like me and those in the Central Bank to try to determine the structural position of the economy. That is important for fiscal policy and so on and indeed for the Central Bank's macro-prudential rules.
In terms of the 60% target, those figures are not particularly scientific. They are ceilings but they are fairly arbitrary ceilings. Provided Ireland adheres to the structural balance rule, the expenditure benchmark rule and, in 2019, the debt brake rule, it will be doing more than enough in terms of how far it goes in adhering to fiscal rules. It is quite likely that the debt-to-GDP ratio will fall to around 60% by the end of the decade unless there is a negative shock to the economy. The cost of borrowing at the moment is quite low. There is still scope for the National Treasury Management Agency, NTMA, to re-profile the debt in order that it is all at a very low interest rate, which means the debt servicing costs will be very low. It is the debt servicing cost, rather than the debt, that really matters over the long term.
Going further than 60% reduces our ability to do everything in terms of fiscal policy. It means that the fiscal stance will be tighter over future years if we aim for lower targets. I do not think the debt rule will be particularly onerous for Ireland in the future but adherence to the expenditure benchmark rule shows Ireland’s commitment to fiscal prudence and I do not see the need to go any further than that. I think Ireland’s debt-to-GDP ratio will probably go below 60% anyway.
My second question was related to this year’s budget which we are focusing on as well. Dr. McDonnell dealt with some of the issues in his presentation.
He argues first that we should not phase out or abolish the universal social charge. Will Dr. McDonnell expand on the reasons for advocating that position? Leaving aside the debate on USC, would he favour discretionary measures, as in revenue raising or public spending measures to supplement the fiscal space that is there this year? If he were to, what type of measures would he advocate? How credible are the Government projections for capital spend this year - €60 million of fiscal space, €240 million in investment - given the very low levels of investment we have? Would Dr. McDonnell advocate greater levels of capital investment and, if so, in what areas? We know the obvious pressure points: housing, health and education. We have seen the Cassells report and know about the housing crisis. Aside from and with those, what other areas of investment would Dr. McDonnell advocate and what levels of increased capital investment would he advocate above the €240 million increased investment made available this year? Given that we can smooth as well, it seems a very small figure.
Dr. Tom McDonnell
It is a small figure. In response to the question why would we not phase out the USC, it is a great tax. It is extremely well designed and is well regarded internationally for that. It is very simple, extremely progressive, there are a minimum of reliefs and it brings in €4 billion per year. We are looking at an ageing population. At the beginning of the next decade there will be increasing calls on spending for pensions and health care. The €11.3 billion in fiscal space over the next five years looks like a lot of money but price and demographic pressures will eat into that. Given, as I have said, our already low levels of spending on infrastructure, research and development and other areas, such as child care, which is extremely important for labour force participation, particularly for women and lone parents, and all the other calls on spending and tax cuts, and given that maximum effective tax rates for low and middle earners are not particularly onerous by international standards, it is not clear to me what the economic rationale is for dismantling the USC.
As I pointed out in the presentation, there would be a stimulus to the economy from getting rid of it because it would increase disposable income. It would not do anything necessarily to increase the productive capacity of the economy, which is where long-term economic growth over decades comes from. It is the long-term picture at which one must look. It is a question of how does one inculcate growth in ten, 20, 30 or 40 years' time. Consequently, early learning education and so on are areas with much greater returns. In the case of research and development, for example, Ireland is very low. Countries such as the United States that are supposed to be market economies essentially have built their economies over the past 150 years by public capital investment and investing in those areas. These are much more important calls.
As to whether the levels of investment increase are credible, it obviously is positive that they are increasing but I believe the mid-term expenditure report that came out in the middle of the year envisages capital spending as being €7.1 billion in 2021. One is talking about GNP being approximately €260 billion by then and GDP will be more than €300 billion. While I acknowledge those figures are polluted, even so, one is looking at quite a small amount, even as a ratio of GNP. In our view, which is shared by a number of organisations including IBEC and even the European Commission - and which has been pointed out by the IMF and the London School of Economics - one thing that has been holding back growth and generating secular stagnation in the West is very low levels of public capital spending. Obviously, politically they are the easiest things to cut because one simply does not do the next project but the returns in respect of medium-term economic growth probably are higher for infrastructure spend than they are for anything else. Research and development, child care and education can be more long-term.
It is not necessarily a good idea to aim for a particular percentage of economic output because it depends on where one is in the economic cycle. One would do less when one's economy is overheating and more when it is under heated. The idea of a rainy-day fund was mentioned. That could be an alternative to cutting USC, for example, whereby the money allocated for that would go into a rainy-day fund which would be spent on infrastructure when the next recession came. However, I certainly would not be contemplating rainy-day funds or infrastructure spends as alternatives; infrastructure spend should happen. The correct number is not 3%, 4% or 5%, although 2% certainly is low. It will depend on the cyclical position of the economy. It should be above 3% when the economy is doing poorly and it could be as low as 3% or even 2.5% when the economy is doing very well. One uses it as a Keynesian demand management metric. A rainy-day fund potentially would allow one to get around the fiscal rules, were it set up properly and independently run. If, let us say, the Government had equity stakes in a special purpose vehicle, that perhaps would allow one to massage it long-term. However, I agree that infrastructure spending certainly has been disproportionately targeted in the austerity measures and must be disproportionately restored as the recovery takes hold. Even if we do start overheating to a certain degree, there still must be a certain minimum level of infrastructure spending on the public side. We must address the fact that we have a growing population, which means we must increase our infrastructure spend and not be in a position, as we are now, in which we are just maintaining what we have.
I thank Dr. McDonnell. On the argument that the economy is not overheating, is he in a position to provide the committee with a more detailed document on that argument and the analysis he has conducted to come to that conclusion?
I believe it would be helpful if we are to pursue that argument further. A little bit later in Dr. McDonnell's presentation he talked about increasing per capita investment in education and skills. There is a footnote referring to early years being the most important. Will he clarify what he means by early years? Is that preschool, national school or something else?
Dr. Tom McDonnell
We could certainly produce an in-brief document on the overheating to elaborate upon those points and to discuss the commission methodology and why we think it is flawed and so on. I would be very happy to do that, though it would take a period of time. Perhaps we would try to produce it before the budget.
In terms of education and skills, the growth literature talks extensively about education. There has been much work done in this area by people like James Heckman and others, as well as the OECD which has attempted to develop a theoretical framework connecting education spending with long-term economic growth. It relates to the concept of human capital development. The early years are particularly important because that is the point at which there is the greatest capacity for human capital development. Human capital is the ability to learn, question and think for oneself. That is much easier to do in the early years than it is in later years. Also, if one loses a child in the early years, it is extremely difficult to get that person back. Obviously, it is a tragedy for the child and the family, but it is also a loss to the economy in terms of the human capital base we have. The early years are particularly important to ensure no one falls behind because once one starts to fall behind, it is extremely difficult to catch up. When I refer to early years, I am talking in particular about pre-primary education as well as primary education. I am talking about bespoke solutions, which can, unfortunately, be expensive, being available to deprived communities or households that would be considered at risk of their children falling behind.
On a related matter, there is also literature that shows that things like family income support and measures that prevent child poverty are linked to long-run economic growth because they protect the child and they serve as a barrier, potentially protecting the ability to grow and develop that human capital. Often, teachers will talk about how once a child has fallen behind, it is very difficult, expensive and costly to bring the child up to speed or to re-engage him or her. Learning needs to be inculcated very early, both in the home and within the education system. The evidence and research I have seen, including that from the OECD, suggests that the returns are largest during the early years. They are also large in the fourth level sector for very different reasons due to high potential start-ups becoming businesses, inventions, innovations and so on, but that is a very different dynamic.
Again, the figures that I cite are percentages of GDP. We know that the GDP figures are polluted. The reason I present those figures is to show that education spending, despite a young population, is off base compared with the best performing countries, generally the Nordic countries, in terms of education spending and to advocate moving in that direction in terms of the overall education spend.
Regarding the suggestion that we need to increase investment in productive infrastructure, if the witness was to set out a list of priorities for budgets 2017 and 2018, what would the priorities for infrastructure be? I imagine broadband would probably fit in there.
Dr. Tom McDonnell
It would. Broadband is a topic I have spent a lot of time researching over many years.
Ireland has performed poorly in terms of broadband ever since the onset of the technology. Parts of Canada had broadband in the late 1990s but parts of Ireland still do not have broadband.
One of the areas on which we have not focused is the labour market, which includes the issue of regional employment trends. One of my findings was that, while it may be appropriate to let the market do its thing in areas with a high population density such as Dublin, Cork and Limerick, it is less likely that the market will provide it in rural areas. It is unlikely it will find there is a commercial return because of the very expensive network infrastructure associated with broadband. In this scenario, those rural areas fall even further behind. One of the policy measures that can be pursued to open up regional employment opportunities is high-speed broadband infrastructure everywhere in the country. That is expensive but it has its advantages. Some of my friends have been able to leave Dublin and go back to the mid-west because broadband has improved and they can do their IT jobs from home. They do not need to be living in Dublin for those jobs. Such examples, if a little bit unusual, show that opportunities can be created. Another obvious point is that local SMEs will find it very difficult to be part of the global market and to sell their goods and services online without broadband.
The Deputy's broader point was about productive infrastructure and much of the infrastructure in this case will be beneficial. There might not be a productivity-enhancing aspect to social housing but there is a competitiveness aspect because more housing means lower rental costs, which improves competitiveness in wage demands vis-à-vis other economies. There is an economic dimension to it and it is extremely important for inclusive growth.
The education sector is another area that needs to be looked at. We have regional hubs for many areas of the economy and we need to develop alternatives to Dublin on the west coast, though not to the exclusion of Dublin. We need to prioritise urban hubs on the west coast in Cork, Limerick and Galway and extending to Sligo and Donegal. There needs to be a regional dimension and we need to build up regional powerhouses so that they can become employment hubs which people can reach.
Other areas where productivity could be boosted include public transport, which can reduce the costs of getting to work. The road network reduces costs for business, and investment should increase at least in line with demographics. We are ranked very poorly by the World Economic Forum in terms of our infrastructure and bottlenecks have built up so competitiveness is relevant to this.
I was asked whether there were areas of infrastructure that were not productive. Arguably, there are. Some people would say there are white elephants in, for example, tourism but that does not mean we should not do certain things as they may have non-economic rationales.
Dr. McDonnell does not need to answer my final questions and may provide a document to the committee instead. What is his view on the tax base? Is it sustainable and broad enough? Can we put in place any reforms this year or in future years to make it more progressive and fairer? A concise document with Dr. McDonnell's thoughts on this matter would be very helpful.
Dr. Tom McDonnell
We will do that.
I was interested to hear Dr. McDonnell say that the economy is not overheating. While I agree that might be the case in terms of inflation, in other areas, such as housing, transport and so on we are, to use a different language, facing capacity constraints. Is there any economic analysis to which we could turn which shows how to ramp up capital spend in particular areas, as we need to do in the areas of housing and transport, without losing efficiencies? Are there any good examples of how to increase housing expenditure rapidly while at the same time ensuring no loss or reduced capacity constraint in the economy to provide housing?
I was also interested to hear Dr. McDonnell say that people in the middle income bracket pay a sufficient amount of tax and as such our profile of income tax is not that out of line. On the issue of our profile of income tax not being out of line, in regard to the arguments around abolition of the universal social charge, is our profile on the income tax side unusual in that regard? Is there any evidence or analysis in that regard?
In regard to the options set out by Deputy Stephen Donnelly and other possible revenue streams, including a possible revision to the property tax, has the institute undertaken any particular analysis or research of proposals on the property tax side?
Dr. Tom McDonnell
In regard to the Deputy's question on overheating, one of the reasons we have capacity constraints is because our infrastructure spending has been low for a long time. It is a type of chicken and egg situation. Given the investment rate in the economy is low now, excluding intangibles such as aircraft purchase and so on, which is essentially tax planning, I would not be concerned yet about getting to the point where we are bidding up costs, although one gets there eventually. The Deputy may recall that I said that for an advanced economy historically the investment rate would have to be 20% to 22% of GDP. Obviously, we cannot use GDP for Ireland any more but as a percentage of economic output we are still well below 20%. Even taking away the level effect from, say, 2015, we would still be well below in terms of the investment rate. I agree we need to be cautious. The point at which the economy starts to overheat is the point at which the ramping down of infrastructure spend as a percentage of economic output commences. When the economy is doing less well, spend can be ramped up. The purpose of rainy day funds and so on is to protect spend against the economic cycle and from short-term political considerations, which are the same everywhere in the world.
In regard to what all of this means at this point when the economy is probably close to capacity but still not quite overheating, given private investment is low and there is a lack of credit in the economy, there is certainly scope for increasing infrastructure. One area I did not mention is renewable energies in terms of potentially building up new industries never mind reducing imports or our carbon footprint. Bidding up costs over the economic cycle is a problem. The solution to that is, again, Keynesian management in terms of ramping up or down infrastructure spend to reflect the economy's position in the cycle. In other words, if the view is that infrastructure spend should be 3% to 3.5% on average over the economic cycle and if the economy is not underheating or overheating at a particular point in time, then the public spend on infrastructure should be 3% to 3.5%, with the percentage being adjusted depending on the level of overheating. In regard to long-term bidding up costs, I do not think it is an issue now.
In regard to construction employment, as I said earlier, employment in construction is 55% of what it was in the second quarter of 2008.
It is true that the figure for 2008 was not remotely sustainable. Even if one considers that only two or three out of five of those jobs might come back, one is still looking at scope for another 25,000 jobs on a two-out-of-five basis or 55,000 jobs on a three-out-of-five basis. Therefore, there is still scope for employment gains in that sector.
The income tax structure, including USC, is extremely progressive in Ireland. However, the pre-tax distribution of income in Ireland is very inequitable relative to many of our western European peers. Therefore, our income tax system is designed to do that much extra work to bring us back to the middle of the table in terms of Gini coefficients, the metric use for inequality of income. Ireland is in the middle of the pack in terms of inequality of income. If we reduce the progressivity of our taxation system, we will start to fall into the bottom half in terms of income distribution and that is obviously not an outcome that presumably anyone around the table wants. We must have a more progressive income tax system to compensate for the fact that the distribution of pre-tax income is so inequitable in Ireland.
May I ask the witness why that is? Why does he think our income taxation system is so inequitable and out of kilter with those relating to other economies?
Dr. Tom McDonnell
I do not have a full answer on that. We are above average in certain types of professional jobs associated with the IFSC, FDI, lawyers, accountants and so on. We have a larger percentage of those jobs and they tend to be highly paid. We also seem to have a large proportion of low-paid workers in Ireland. That seems to be the pattern in English-speaking economies compared to continental economies. It is not unique to us. There may be other aspects associated with the structure of the economy. For example, IT jobs are very highly paid and we tend to do reasonably well in that area. However, I do not have a full answer to that, although I would note that part of our research programme in 2017 and beyond will be looking at enterprise policy and the overall structure of the labour market. Hopefully, in future years I will be able to give a much more informed response.
There are issues of broadening the tax base, tax compliance and additional resources for the Revenue Commissioners. We are concerned about and wonder why, when there is a housing crisis, the Government would be looking at increasing thresholds for inheritance and gift tax, for example, which would be extremely regressive. In the hierarchy of taxes, other property taxes along with current property taxes and VAT tend to be the least damaging to growth. If we are looking for inclusive growth, there are no arguments that increasing thresholds from capital acquisitions tax will stand up from a growth or equity perspective. The business and agricultural reliefs, as they stand, also do not stand up from a growth perspective. We have written in our summer quarterly observer, will write further in the autumn observer and will be producing more working papers on the subject of the debilitating impact of tax expenditures from an equity perspective and an economic growth perspective. My colleague, Micheál Collins, who I do not wish to pre-empt, has a paper on pension tax reliefs coming out in late September that will look at the distribution of the benefits of those reliefs. The most recent work done on this showed that 80% of the benefits went to the top 20% of earners. Standard rating in respect of or reforming those types of reliefs would allow for a reform of the tax base. The latter would allow for a reform of marginal rates or provide an opening in respect of them on a tax-neutral basis. Potentially, it could also open up additional space for public spending.
We have identified other areas. We note it is not so much that Ireland is a low-tax economy, as it actually is not; Ireland is a low-revenue economy. As to what I mean by that, it means social security contributions are very low in Ireland. Again, labour taxation is not particularly low but if one looks at the implicit tax rate, which is the effective tax rate over the base in the economy, taxes on labour are low overall but not necessarily those paid by employees. The contribution paid by employers was 3.3% of GDP in 2014, that is, before the GDP numbers went haywire last year, compared with 7.7% for the EU. This is quite a difference and in the context of labour force participation, the type of additional welfare benefits could include things like child care subsidies, which would have advantages in preserving second earners and lone parents, for example, in the workforce. Obviously, it would be necessary to work out the details of policies like that and perhaps that is something at which the committee could look. If targeted at employments of more than €100,000 only, it would affect only 50,000 employments and yet could bring in well over €100 million. Consequently there is scope in this regard and it would not affect the marginal tax rate. Obviously, part of the incidence would fall on the employee, as well as the employer.
We are concerned about the non-indexation of property tax bands. The property tax as it currently is structured is not fully progressive and the Department of Finance's own research has pointed that out. It could be progressive, however, and one could deal with the situation whereby someone on a very low income must pay property tax - or indeed a wealth tax for that matter - by putting a lien on the property. Consequently, when it was transferred or inherited, Revenue would get first call whereby the property tax due would then be paid to Revenue with an interest carry on that. Therefore, over the long term, Revenue would be getting those receipts and would be able to pencil them in. I refer to situations of hardship, which would be quite rare, but obviously it would be possible to apply a more progressive structure in respect of the rates applied to different valuations. We know, from an economic growth perspective, that the recurrent property tax is one of the best taxes - land tax arguably is even better - and if one can construct a property tax which does not cause inequity and does not cause hardship, there then is a strong rationale for developing such a tax. Perhaps the committee could look at ways to reform the property tax and make it fairer and more growth-friendly. It certainly is not something that should fall behind a couch as a revenue-raising measure.
Another area that rarely gets touched upon is that of a wealth tax. It would not generate a huge amount of income but has advantages in terms of tax compliance. Were one to pursue it, I would set it with a minimum of reliefs and a very high threshold of possibly €1 million. That would only affect 1% to 2% of households and would be likely to be a highly popular tax. Obviously, as there would be much resistance to it, it should be set against the household in order that it then has no effect on foreign direct investment, FDI, those particular structures and so on. Basically, when I refer to sources of revenue, I am considering those within the literature that would minimise the hit to economic growth but which also would be consistent with social fairness. The Organisation for Economic Co-operation and Development, OECD, has identified these types of taxes and the Nevin Economic Research Institute, NERI, itself has done so in the past. These are the kinds of areas at which we would be looking and again, this is not about billions and billions but about reforms that still could open up additional space.
I have two short questions. I revert to some of Dr. McDonnell's earlier comments in respect of the letter from the Governor of the Central Bank to the Minister, Deputy Noonan, in which the Governor recommended that our debt ratio should fall from 60%. Is Dr. McDonnell basically stating he disagrees with that advice and that it would be better to use what leeway there is for investment?
Given that he has rightly suggested pension coverage for certain people is very inadequate, particularly lower paid workers, would Dr. McDonnell be in favour of part of the universal social charge being converted to a contribution to a supplementary pension? Also, in relation to a later comment, would Dr. McDonnell agree that the social welfare system is actually highly redistributive?
Dr. Tom McDonnell
I would agree that the overall tax and social welfare system is highly redistributive. As a result, we moved to the middle of the table in terms of overall Gini coefficients after tax and benefits. It is essentially the workhorse we use to reduce poverty and inequality within society and it is doing a good job. We would be concerned, if there was tax reform, that it would move away from that model and, by and large, it would be difficult to construct cuts to income taxes in such a way that they would not be regressive. As Deputy Burton has pointed out, the income tax ratio compared to GDP and the implicit tax rate on labour are not high in Ireland and we have to be cautious in terms of an ageing population not to undermine the tax base.
In terms of the Governor's letter, I think that it would be sufficient to adhere to the expenditure benchmark. The expenditure benchmark will be reasonably tough for this year and next year and even from 2019 onwards. We are really only talking about €3 billion per year in the context of an economy that is growing very fast and increasing by multiples of that year on year. The debt to GDP ratio will incline anyway and we will have to adhere to the debt-brake rule, which actually will not matter in the case of Ireland. I, therefore, think the Governor's concern will be assuaged anyway if Ireland adheres to the expenditure benchmark. One could argue that the forecast for potential GDP and the reference rate are too high. If that is true, and actual growth does not materialise as is hoped, then the dynamics could deteriorate. However, we update the fiscal space every year, so if there is such a deterioration, it should be caught reasonably quickly. Also, it is based on ten-year averages.
I will interrupt Dr. McDonnell briefly. The reason I asked the question was that the implication in the Governor's letter, which Dr. McDonnell referred to earlier, is that there is choice in the sense that one could simply raise more taxes. The critical issue, and I think everyone who spoke today seems to be agreed on this, is investment. In effect, the Governor's formula in terms of the medium term is essentially a kind of noose around the development of further investment. I think this will be a critical issue in terms of what the committee has been asked to do in terms of the budget strategy and am wondering if Dr. McDonnell agrees with that approach.
Dr. Tom McDonnell
Essentially what the Governor is proposing is the adoption of a lower number, possibly within legislation ultimately. That would impose an additional constraint, which obviously has the potential to reduce fiscal space in future years. It is my view that the approach currently being followed, which is to follow the expenditure benchmark, is sufficiently conservative and one need not go any further than that. Therefore, looking strategically at what he is doing, the Governor is taking a particularly austere approach to essentially act as a kind of tug-of-war push-back against rhetoric that might build up over the next five or six weeks that attempts to move it in a different direction. In a sense, it might be a degree of smoke and mirrors but that is not to say that the Governor does not believe what he is saying. I am quite sure that he does.
It is true that GDP is now a polluted metric, but I would say that the expenditure benchmark - difficult as it will be to deal with the 26% from 2016 in terms of the reference rate for future years - will potentially increase the fiscal space in future years. One option is to essentially set aside that year or to use a figure that would probably be more accurate, such as 5%, for that particular year to take forward. The latter might be a more suitable approach. Simply to decide that the rules are not tight enough and we must have even more rules - people acknowledge that the rules are already fairly tight in terms of Keynesian demand management - would be perhaps going too far. However, there is certainly a good case for adhering to the expenditure benchmark and the fiscal rules as they stand, notwithstanding my earlier comments about overheating and the potential for more space in 2018, which is a debate that perhaps the committee should have.
The Deputy's other question was about the USC and conversion to the supplementary pension. I have not done any research in that area and I do not have a particularly educated or profound view on that. I like the USC as it is because of its simple structure, minimal reliefs and so on. I would be more inclined to move parts of income tax towards a supplementary pension, although I realise low-paid workers would not necessarily benefit from that.
They are the ones who need it.
Dr. Tom McDonnell
Indeed. Perhaps what we are looking at is opening a debate about combining USC, PRSI and income tax and maybe simplifying them down to just two streams, where there would be modified PRSI and modified income tax-USC with a minimum of reliefs, retaining a progressive structure within which PRSI would be expanded to include new benefits such as supplementary pension, as is the case in other countries, and an employer contribution that goes towards child-care subsidies, which is important from the perspective of gender, lone parents, etc. I favour moving in that direction and using the social security system to encourage labour force participation, particularly by second earners. Ultimately, that too would boost potential GDP, and everyone would benefit from it. In budget 2017, assuming there will not be radical changes in terms of the reforms I have talked about, I would be reluctant to introduce measures of that type, but it would be a great idea for the committee to have that debate as 2016 and 2017 progress, and come up with recommendations on fundamental tax reform for budget 2018.
Whatever is contained in the budget, it will not be too radical.
Many of the issues have been covered. I welcome Dr. McDonnell to the committee and thank him for sharing his views and thoughts on these matters, and particularly for the excellent documents the Nevin Economic Research Institute has been producing, which are easy to comprehend and add to the understanding of complex matters by parliamentarians and the public.
Dr. McDonnell made clear his organisation's views on the USC. I may have heard him on a vox pop on RTE when I was driving home listening to people's views of what should replace the USC. To a person, every organisation answered that it should not be replaced but should be kept. Bearing in mind that view, which extended from ICTU to IBEC and everyone in between - around 12 organisations were asked in total - is Dr. McDonnell aware of any organisation that believes it is good policy and a fundamentally sound principle to abolish the USC? If so, we could invite its representatives before the committee to make an economic rather than an emotional argument.
Dr. Tom McDonnell
I am not aware of any mainstream organisation that is in favour of abolishing the USC. I am not sure of the position of the tax institute. It is generally against taxes and it might be willing to come in to lobby in that regard, but I do not know that such is its position.
It was clear from the national economic dialogue that no organisation is advocating the universal social charge, USC. Generally speaking, there is a recognition that the infrastructure, education and health care areas are not in an ideal state and, therefore, they should be priority areas. I do not know of any mainstream organisations advocating for the USC. There may be international organisations that would be willing to advocate for lower taxes in general, such as The Heritage Foundation that advises the US Republican Party. Lower taxes and flat taxes would be popular on the American right such that they may be able to produce some of the economic arguments. I am not sure of any mainstream organisation in Ireland that is pursuing that particular policy.
In regard to the universal social charge, USC, those in political circles who advocate such a position reference the high marginal tax rate as a tax on employment that is off-putting to investment and employers who want to create jobs. The Economic and Social Research Institute, ESRI, which will appear before the committee in the future and which has provided us with its view on this matter, has stated that this notion needs to be tested. In its view, employment is rising and the bigger challenge in terms of employment is child care. The ESRI believes that the impact on employment would be greater if rather than the USC being reduced, the €4 billion accruing from it were to be invested in the provision of affordable child care. Is research available that can hold up the argument that high marginal tax rates are a drag on investment?
Dr. Tom McDonnell
Much of the large scale foreign direct investment that is attracted to Ireland is related not so much to income tax but corporate tax and our highly educated workforce and so on. While it is true that the American Chamber of Commerce and other such organisations would lobby for lower marginal tax rates, evidence-wise the impact of marginal tax rates would not be in the same ball park as the issues I have just discussed.
The Deputy referred to child care costs. I agree with the ESRI position on child care. Child care costs in Ireland as a proportion of the disposable income of the average earner are the second highest in the OECD, which is a massive barrier to labour force participation by second earners and by lone parents. It is one of the reasons, historically, that Ireland, in comparison with other north-west European economies, has had a low employment rate. We are essentially deciding through policy that this cohort of the population is not going to be in employment and because to be in employment does not make sense for them we are losing extremely educated human capital and tax receipts and all of the economic benefits that come from that. I would certainly regard child care as one of the major potential policy reforms that could unlock economic growth and employment growth over the next five to ten years. Child care spend as a proportion of GDP is extremely low by OECD standards.
The Deputy is correct that marginal tax rates kick in at a high rate, which is a little above the average industrial wage. There is room for reform of the overall structure. I have spoken about moving to a two taxation system. For example, if various tax expenditures were abolished tax rates could be reduced. That would help. I imagine that most of the people in this room are on the marginal tax rate. I wonder if anyone here was disincentivised from working or whether-----
They are not rational.
Dr. Tom McDonnell
Politicians are not rational, indeed, but tax rates matter at the bottom because of the interaction in terms of take-home pay. One area where one could consider cutting taxes is by moving to the American model of refundable tax credits, for example. That is effectively an in-work benefit. By moving to that model, one essentially increases the incentive for low-paid workers to work additional hours. That is likely to increase employment rates and work intensity at the bottom in terms of the income scale. At that expensive margin, taxes and take-home pay matter but it is rare - certainly at the half of income rates we are talking about - that somebody on a marginal rate will work fewer hours because of that. Show me the evidence; it is just not there.
Tax rates used to be much higher throughout the OECD. The golden age of capitalism was 1945 to 1973 when marginal tax rates were never higher. Marginal tax rates were over 90% in the United States. I am not advocating that as a policy but I am pointing out that there is no - I will be happy to direct attention to the some of the research on this - empirical evidence in terms of meta-analysis, that is, studies of studies and bringing them all together, that marginal tax rates reduce long-run economic growth. That is not where the focus should be if one is interested in inculcating GDP growth over the long term but it is on infrastructure, child care, things like refundable tax credits and education spend, particularly for early years and fourth level. Building up our national innovation system means increasing the research and development budget, which means increasing linkages between universities and employer groups, are the areas that one needs to focus on, while tapering up welfare benefits, for example, and being an extremely open economy that encourages migrants in. The evidence, even in the UK, is that they tend to be net contributors to the budget, so their decision is something that we could perhaps benefit from.
Reducing income taxes when our revenue to GDP ratio is already low is unwise and not conducive to good policy in the long run.
I wish to ask Dr. McDonnell a couple of other brief questions. I introduced the issue of child care which the ESRI had flagged up in that context. Some of the policy options that are floating about on child care include, for example, tax breaks for parents as a way of supporting child care, as opposed to direct intervention and support for operators. What is Dr. McDonnell's view on that?
Can he also discuss another policy option which will take shape in this budget, that is, the help to buy scheme, which will assist people to purchase new houses and will be backdated to a point in June or July?
Dr. Tom McDonnell
The easier of those questions is the help to buy scheme. The problem in the property sector is clearly one of supply, not demand, so I would be extremely reluctant to support policies that would probably increase house prices and simply act as a subsidy to existing property owners.
The issues in the housing sector, particularly in Dublin, are fundamentally about supply. There is obviously a private sector dimension to that, whether it be access to credit or land, and regulation. However, there is also a public sector dimension to this. If one looks at the figures - I am sorry I did not include them in the submission - public provision of housing collapsed post 2010.
We need to start going back to those kinds of levels. Obviously, for approximately €1 billion per year, one gets approximately 5,000 units. Based on population, we are aiming for 25,000 or arguably 30,000 builds per year, because we have a housing waiting list and consequently must have more than 25,000 builds. There is a market failure in the private sector for various reasons and there is, therefore, a role for the Government to use its own capacities in a fiscal context to intervene directly and to start building houses. That would be where I would direct my energies and by increasing supply, we also will reduce rental costs, house prices and the cost of purchasing. This will help first-time buyers by reducing the debt they will take on in respect of mortgage costs and so on and that helps with macroprudential sustainability and so on. Consequently, in the housing sector, the policy response should be on the supply side, not the demand side.
As for tax breaks versus direct subsidies in child care, our view generally on tax expenditures is one should only go there when there is a proven case that subsidies or direct spending will not work and where there is clear evidence of a market failure. For example, one might give tax expenditures for research and development because there is a general market failure and there are knock-on benefits for the economy. In the case of child care, it probably is more complicated than simply talking about tax breaks versus direct subsidies. It ultimately is about bringing down child care costs for the parents and ensuring there is a quality of care. It is about educating and upskilling people to be able to fill those roles and making sure there are enough people. This is what I am talking about when I refer to child care, that is, they are in place, are providing good care and there are enough of them. In addition, it is about them being regulated by the State and that - possibly through the social security system - the State would be providing as a benefit a contribution as a direct subsidy to the pay and maintenance of those centres directly and that it would be a much more regulated sector. Unfortunately, there are too many stories about the child care sector. As this is not an issue or area on which I am particularly expert, my comments therefore are general from a macroeconomic point of view in respect of the cost of child care and from a macroeconomic perspective in terms of the deadweight losses that tend to be associated with tax expenditures. It is not a sector on which I would comment at a micro level.
Finally, I refer to the table provided on page 3 of the research in brief document by the Nevin Economic Research Institute, NERI, on the fiscal space. Has that table, with rows from A to N, been put together by NERI or has it been dragged from other sources? Is it the NERI's own-----
Dr. Tom McDonnell
The table is derived and updated from a combination of sources, including the fiscal council's most recent major publication and the summer economic statement. As for the changes we are likely to see in terms of this table, the table is constructed for purely explanatory reasons.
Yes, but the figures on the reference rate for potential growth are-----
Dr. Tom McDonnell
Yes, they are official figures.
They are official figures that draw upon the 3.5% average.
Dr. Tom McDonnell
Yes, it draws on the Department of Finance and the fiscal council. The same applies to the GDP deflator, which is the single missing piece of the puzzle that still is unknown and still has not been locked down in terms of budget 2017. Obviously, a higher GDP deflator will allow a little bit more of fiscal space, at least upon a ten-year average.
When will that be locked in?
Dr. Tom McDonnell
I imagine that may not be made public until the budget itself.
As the Deputy knows, the budget documentation is effectively almost a sister publication of the stability programme update. However, that GDP deflator, based on the most recent information we have, will probably be modified slightly but I cannot tell the Deputy exactly-----
That will be calculated by the Department of Finance itself.
Dr. Tom McDonnell
Yes. It will be ultimately reviewed by the fiscal council and European Commission. Ultimately, the figures get locked down around May by the European Commission, based on its calculations of the reference rate.
I must say that Dr. McDonnell's table is the best I have seen in terms of the walk through. He makes the point that if the reference rate had increased by 0.5%, there would have been a reduction of €1.8 billion. The opposite would also be true.
Dr. Tom McDonnell
That is right.
I am not sure if this was done before the CSO revision.
Dr. Tom McDonnell
It was. Yes.
Therefore, the CSO revision is likely to increase that figure because there will be a bigger output next year.
Dr. Tom McDonnell
That is right. It may well increase the fiscal space in future years.
It makes a nonsense of everything.
Dr. Tom McDonnell
Essentially, two or three companies engaging in corporate restructuring suddenly changes the fiscal space available to a country, possibly quite dramatically. The nine 3.5s get added to 26, divided by 10 and that is the reference rate. It is not as simple as that, of course. I would argue that while the reference rate should be increased marginally for future years, it shows what a nonsense it can be when a Government is basing economic policy on those kinds of things.
It is unlikely that these measurements are going to last the test of time. Indeed, I imagine that the rules we are governed by now will not be in existence in five years' time. I ask Dr. McDonnell to share his own opinion on that, taking into account the documentation, the overheating of the economy and the calculation of the structural deficit.
Dr. Tom McDonnell
The structural deficit is probably the hardest thing for macroeconomists to calculate. Essentially, to even begin to calculate it, one has to come to a judgment on the extent to which the economy is overheating. One also has to calculate what the output gap is and whether it is positive or negative. The Commission's methodology is pro-cyclical. The reason for that is because it overly emphasises recent unemployment rates. The Commission had an equilibrium unemployment rate of over 10% quite recently, which I would argue was a figure that even the Commission itself knew was wrong. What is the equilibrium unemployment rate? There is no answer to that because it is policy dependent. Since the Second World War, we have had unemployment rates as low as 3.5% or 4% in some advanced economies. In other countries, it has been much higher and in double figures. It is currently at about 5% in the US and the UK. If Ireland is able to get down to those levels, then we are clearly underheating at the moment. Again, that has implications for the available fiscal space. Our point is that we disagree that the economy is overheating and, therefore, the fiscal space figure for 2018 is overly conservative. I believe a nonsense will be made of all of the structural deficit calculations in five years' time. Looking back, one will be able to recalibrate what the fiscal space ought to have been and they will be very different numbers.
This is my final question. We have talked a lot about the expenditure benchmark but there is also another rule that governs us on the fiscal rules. That is the structural improvement rule that requires us to have a structural improvement rate of 0.6%. The latest projections by the Department that were published before the summer showed that we were not actually going to meet that target. The Government made the argument at the time because we were going to hit 0.4%, which would have meant that we would be okay. Given the revisions of the CSO, we are not going to meet that target at all. There may be no structural improvement. There is an argument put forward that there will be a blind eye turned to this by the Commission, despite the fact that we were told that this was actually the primary target as opposed to the expenditure benchmark. I would like to hear Dr. McDonnell's thoughts on some of that.
Dr. Tom McDonnell
I believe that in the future what we will find is that the expenditure benchmark will end up being the workhorse.
When we get into a discussion about structural balances and potential GDP, one quickly gets into an esoteric world of things that we cannot measure. That is problematic. It is extremely problematic for policy makers attempting to follow these fairly arcane debates. I would argue that the structural deficit is certainly not worse than the actual deficit. The actual deficit in 2016 is probably not likely to be worse than 0.8% of GDP. As it happens, the fiscal space of less than €1 billion will sufficiently improve our structural balance, I would argue, to get us to the 0.5% level that we need to be at, and, therefore, simply maintaining that and applying the expenditure benchmark in future years will be sufficient.
That does not mean I am correct. It is possible that the economy is overheating. It is possible that potential growth rates will not manifest. It is true that the potential growth rates being talked about by me, the Department of Finance and others are based upon assumptions for productivity in excess of 1% per year. It is true that productivity growth in the west has been less than 1% for over a decade, although there may be measurements associated with that, and it is possible that the reference rates are much lower, the structural dynamics of the economy are much worse than we think and, therefore, we need to be particularly prudent. That argument can be made, but in our view it is sufficient to apply the convergence margin, which is the structural deficit rule, for 2017 as a precautionary measure. We can then look at it again, not to pre-empt 2018, but to look at whether we are overheating, look at what the deficit is likely to be, attempt to come up with some methodology for determining the degree of overheating and the structural deficit, and to determine independently of the Commission where we are in terms of the fiscal position and, therefore, what fiscal space is available. We are arguing about the difference between approximately €1.2 billion and €2.6 billion here so it is quite significant.
I should point out that this is only relevant to that particular one year - there is no argument about future years, 2019, etc., - and this is a debate. This is not me coming in here and saying that people are wrong, rather I am saying that we need to have a debate about this and not simply accept that such is the appropriate fiscal space for 2018.
In terms of the structural balance rule, it is the structural rule and its application that is determining this debate but, for 2019 and onwards, it will be the expenditure benchmark that will really determine fiscal space in the future.
I have two brief supplementary points. Dr. McDonnell spoke about regional development. Being from the south east, this is a bugbear of mine. The south east continues to have the highest unemployment rates in the country and it annoys me. I am not laying a charge at Dr. McDonnell, but he mentioned developing regional hubs in the west. Is there any particular reason that at the height of the Celtic tiger when unemployment was so low, the south east lagged in terms of employment, household income and third level attendance? Basically, all the indicators were worse for the south-east region. Why is that the case?
How do we change the nature of the discussion? When we have debates in the Dáil and the Seanad, and at committees, even when I am talking to myself as I am now, people automatically think of the west. The south east does not get a mention even though, when one looks at the indicators, it has been the worst performing region for a considerable period.
Dr. Tom McDonnell
The south east lost almost one fifth of its jobs between 2008 and 2012. In the second quarter of 2016, it was back up to 94.2% of where it was, which, believe it or not, is slightly better than the State average.
The improvement has been better but the fall was deeper.
Dr. Tom McDonnell
The fall was deeper. It was the second deepest of all the regions.
The Chairman is right that something seems to be happening in the south east in terms of incomes. County Wexford in particular is one of the poorer counties. In a point that also is relevant to the Border counties, what the south east lacks is an economic motor. Obviously, nowhere has anything like Dublin but the south west has Cork, the mid-west has Limerick and the west has Galway. Prospects are fairly bright for each of those three cities and while one can talk about the west and about counties Mayo and Roscommon, at least there is a hub there. The south east does not have that to the same extent. Waterford obviously has been in secular decline for quite some time and certainly does not have the same population as Cork or Limerick. Moreover, it now is behind Galway too.
And yet the region has more than half a million people, all of whom basically live within an hour of one another.
Dr. Tom McDonnell
That is right.
It has a critical mass.
Dr. Tom McDonnell
Yes, that is right. It has a lot of small towns but no major urban area beyond Waterford.
This probably is not a discussion for this committee. It is more of a fireside chat.
Dr. Tom McDonnell
To answer the question, a region needs a strong economic motor and an urban space. Where there are high-potential spin-offs, there is innovation and-----
There is a university, perhaps.
Dr. Tom McDonnell
Indeed. As the Massachusetts Institute of Technology and Caltech are the best educational institutions in the world, one does not need to have the university moniker, although there certainly is no harm in it. However, what one needs is the funding going in there that produces the innovations and has the people working there with business to produce the high-potential start-ups for the south east, which are connected into the local innovation system. While NUI Galway, the University of Limerick and UCC can provide those roles in the other cities, that is not present to the same extent in the south east.
It has the lowest rate of participation at third level and those who do go tend to go to Dublin and Cork-----
Dr. Tom McDonnell
That is right.
-----and they just do not come home. Their higher incomes then are not reflected in the figures for the region. While that is what I found, I will have that discussion on another day.
Briefly and finally, Dr. McDonnell mentioned expanding the tax base and my ears pricked up at the term, "land tax". I presume he meant development land as opposed to farmland.
Dr. Tom McDonnell
It actually was a throwaway comment. I was just talking in general about economic theory where land taxes are considered to be pro-growth. Obviously, however, there are equity considerations associated with that. A lot of land is farmland and farmers often have fairly low incomes and, therefore, there are obvious equity issues associated with it. I perhaps can comment on-----
Dr. McDonnell was having a theoretical discussion.
Dr. Tom McDonnell
Yes, exactly. Just because something is pro-growth does not necessarily mean it automatically is a good policy.
On behalf of everybody, I thank Dr. McDonnell and apologise for the delay in starting. As this is our first day back at school, people have other business as well but I thank Dr. McDonnell for his attendance.
Dr. Tom McDonnell
I thank the Chairman and thank the committee for having me.