Prior to the pandemic Irish economic fundamentals were strong, with robust growth, a labour market close to full employment, and surpluses in the underlying current account and the public finances. The outbreak of the pandemic turned the economy on its head in the space of a few weeks however, with the introduction of Covid-19 restrictions resulting in a sharp contraction in economic activity last year. However, in keeping with the pattern seen in other countries, the economy rebounded as restrictions were eased.
As restrictions were lifted in the second quarter the domestic economy recovered strongly. Modified domestic demand, a proxy for the domestic economy, grew by almost 8½ per cent and surpassed the level immediately preceding the pandemic for the first time since the start of the crisis. This rebound in the economy was supported by consumer spending which increased by 12½ per cent in the second quarter, and the construction sector which grew by 23 per cent as restrictions were eased.
Although the fundamentals of the domestic economy remain strong there are challenges ahead involving possible international taxation changes and the risk of more persistent inflation. Government is currently planning for an expected impact on receipts from forthcoming changes to the international tax regime, with my Department estimating a loss of €2 billion in corporation tax revenue by 2025. As I have stated on many occasions, this underlines the importance of not building permanent expenditure commitments on volatile windfall revenue. Base broadening policy reforms have made Ireland’s tax system far more stable and resilient to external shocks – despite an unprecedented global pandemic, tax receipts only fell by 3.6 per cent last year.
Inflation is another potential concern with the annual rate of HICP inflation rate rising to 3 per cent in August – the highest rate since 2008. However, the recent rise in inflation is largely explained by one-off and temporary factors, which are expected to fade over time. Consistent with this view the ECB recently reiterated that the recent rise in euro area inflation has largely been driven by temporary factors and while inflation will likely remain elevated this year and next, it is expected to remain below 2 per cent over the medium term.
I am optimistic that the economic recovery will continue as our well educated work force and pro-enterprise culture mean that the long term fundamentals of our economy are strong and will facilitate continued growth. While the effects of Covid-19 have been severe, our resilience and strength comes from being an economy that remains open to investment and facilitates trade across our borders. This has proven to be the fundamental strength of the Irish economy over decades and is still the case today.