ISM UNIVERSITY OF MANAGEMENT AND ECONOMICS

ISM UNIVERSITY OF MANAGEMENT AND ECONOMICS
ECONOMICS PROGRAMME BACHELOR STUDIES
IV year student
Aleksandr Kuznecov .........................
(signature)
2011 05 09
ASSESSMENT OF FISCAL POLICY IMPACT
ON BUDGET DEFICIT IN IRELAND
BACHELOR THESIS
Supervisor:
Aras Zirgulis
2011 05 09
VILNIUS, 2011
SANTRAUKA
Kuznecov, A., Fiskalinės politikos įtakos Airijos biudžeto deficitui vertinimas [Rankraštis]:
bakalauro baigiamasis darbas: ekonomika. Vilnius, ISM Vadybos ir ekonomikos universitetas,
2011.
Šio darbo tikslas yra nustatyti fiskalinės politikos įrankius, labiausiai tinkamus Airijai.
Galimi įrankiai yra tiek mokesčių patobulinimai, tiek ir išlaidų mažinimas įvairiose srityse. Tam,
kad būtų nustatytos prioriterinės fiskalinės politikos sritys, šiame darbe nagrinėjami Airijos
ekonomikos bruožai, pristatoma fiskalinės politikos įtakos ekonomikai teorija ir atliekama regresinė
analizė, skirta nustatyti ryšiui tarp biudžeto deficito ir tam tikrų ekonominių veiksnių.
2000-2010 metų duomenų empirinis tyrimas leido sudaryti lygtį, kuri patvirtina, kad BVP,
nedarbas ir importo kiekis daro statistiškai reikšmingą poveikį biudžeto deficitui. Šis rezultatas
toliau naudojamas pasiūlyti aktualius ir praktiškus fiskalinės politikos pakeitimus, kurie leistų
Airijai pažaboti biudžeto deficitą iki 3 procentų lygio, reikalaujamo Europos Augimo ir Stabilumo
pakto, padaryti viešojo sektoriaus skolą pakeliamą ir stimuliuoti Airijos ekonomiką. Tarp pasiūlytų
pakeitimų yra pajamų mokesčio bazės padidinimas, kuris padidintų vyriausybės pajamas nedidinant
mokesčio tarifo, PVM tarifo padidinimas ir naujų mokesčių, kaip kad taršos ir žemės, įvedimas.
Reikšminiai žodžiai: nacionalinis biudžetas, mokesčiai, valstybės išlaidos
2
SUMMARY
Kuznecov, A., Assessment of fiscal policy impact on budget deficit in Ireland [Manuscript]:
bachelor thesis: economics. Vilnius, ISM University of Management and Economics, 2011.
The aim of this paper is to determine the fiscal measures which would be the most effective
for Ireland. These measures include tax adjustments and expenditure cuts in several areas. In order
to find out which areas must be focused on in the first place this paper explores the economic
background of Ireland, presents theory of fiscal impact on the economy and performs a regression
analysis which establishes the relationship between some economic factors and the budget deficit.
The empirical research of the data for the years 2000-2010 produces the regression equation
which proves that GDP, unemployment and volumes of imports have statistically significant effect
on the budget deficit. This result is further used to propose up-to-date and realistic changes in fiscal
policy which would allow Ireland to bring budget deficit to the level of three percent which is
required by the European Growth and Stability Pact, make the public debt sustainable and stimulate
the Irish economy. The measures suggested include increase of the income tax base, which would
boost the government revenues without the increase of the tax rate, increase of the VAT rate and
introduction of new taxes such as carbon tax and tax on the land.
Keywords: national budget, taxation, government expenditures
.
3
TABLE OF CONTENTS
Introduction
7
1.
Public budget deficit in Ireland
8
1.1.
Main concepts
8
1.1.1.
Budget composition
8
1.1.2.
Budget expenditure items
9
1.1.3.
Budget receipts
10
1.2.
Current economic position
10
1.2.1
Gross domestic product
10
1.2.2.
Labour market
11
1.2.3.
Trade balance
13
1.2.4.
Consumption
15
1.3.
Problems of fiscal policy application
16
2.
Theoretical aspects and research methods of fiscal policy and budget deficit
19
2.1.
IS/LM model
19
2.2.
Automatic stabilizers
22
2.3.
Discretionary fiscal policy
23
2.4
Deficit and debt policy
24
2.5
Statistical research methods
26
3.
Research of the factors influencing budget deficit
29
3.1.
Data quality
30
3.2.
First model analysis
30
3.3.
Second model analysis
32
3.4.
Propositions
32
3.4.1.
Income tax
33
3.4.2.
Value added tax
34
3.4.3.
Corporation tax
34
3.4.4.
New taxes
35
3.4.5.
Expenditures
35
Conclusions
37
List of references
39
Appendices
41
List of appendices
42
4
LIST OF FIGURES
1.
Gross expenditure (current) by ministerial vote group in 2011 (estimate)
9
2.
Gross receipts (current) both tax and non-tax in 2010
10
3.
GDP Volumes, Ireland, quarterly data, in mio. of Euro, 2000-2010
11
4.
Unemployment, Ireland, quarterly data, percentage of the workforce, 2000-
12
2010
5.
Average weekly salary, Ireland, quarterly data, in units of Euro, 2000-2010
13
6.
Exports and imports, Ireland, annual data, index (base year 2000=100), 2000-
14
2009
7.
Imports composition by country of origin, 2009
15
8.
Final consumption aggregates, Ireland, quarterly data, in mio. of Euro, 2000-
15
2010
9.
10.
Final consumption aggregates, Ireland, quarterly data, percentage of GDP,
2000-2010
IS/LM framework
5
16
21
LIST OF TABLES
1.
The first linear regression coefficients
31
2.
The first linear regression summary
31
3.
The second linear regression coefficients
32
4.
The second linear regression summary
32
5.
Distribution of Income Earners 2004-2010
33
6
INTRODUCTION
The issue of the budget deficit is a very important one. The government is the representative
of the state, thus no wonder that the public budget designed by the government has the most direct
impact on each and every member of the society. When for some reason the budget is not designed
properly and the country runs into the deficit, the consequences of this fall on every participant of
the economy.
The logic presented above is very obvious to the people of the countries which were hit by
the recent world financial crisis. One of these countries is Ireland. The example of the western, rich
and fast-developing country falling into financial crisis, recession, debt crisis and political crisis
over the last few years is not only very illustrative, it is the example which has to be researched
thoroughly and from which useful lessons may be drawn.
Currently, Ireland is believed to have survived the harshest years. However, the question
how to bring a heavily distressed country’s public finance back on track is still open. Logically, one
of the tools which might be used is the fiscal policy. But what fiscal measures are the most
effective? As there are plenty of them available it might not be clear where the government should
start. Each one of these measures has an effect on particular economic indicator and every economic
indicator in its turn affects the budget deficit in some way. Consequently, knowing which of these
indicators has more impact on the budget will allow the government to adress it with adequate tax
and hence correct the deficit very fast. That is why the aim of this paper is to find out which fiscal
policies are the most effective for managing the budget deficit. In order to do that one will have to
complete several objectives:
-
Introduce the composition of Ireland’s budget, its main items and sources.
-
Describe the economic background of the country and its link to the budget change.
-
Discuss theoretical approach to the fiscal policy and budget deficit.
-
Perform a regression analysis of the factors influencing the budget deficit.
-
Suggest fiscal policies which would deal with the most important factors.
The data used in the paper comes from numerous economic sources such as the Irish
Department of Finance, Central Statistics Office of Ireland, Eurostat, Organization for Economic
Development, European Central Bank etc. This data will be analyzed empirically in order to
determine its possible connection to the budget deficit. Then in the third chapter the regression
analysis of the selected data will be introduced showing the actual numerical relationship. The
analysis will be performed with the SPSS analytical software. One supposedly will be able to get
some insights on the effect of certain economic factors on the change in the budget deficit and then
construct a line of reasoning leading to particular taxes or expenditure cuts which have proved to be
the most effective. The conclusions of the paper will be useful to the public authorities of Ireland as
well as any other country in the similar situation and to the companies running business or planning
investments in Ireland.
7
1. PUBLIC BUDGET DEFICIT IN IRELAND
The main goal of this chapter is to introduce the concept of the budget deficit, the items
included in the Irish budget and their links to the public expenditures and taxation measures. The
amount of taxes collected by the government and the amount of expenses which the government
faces produce, when combined, a net figure of the budget balance which is currently negative for
Ireland. It will then be explained why and in which way the existing situation in the public finance
presents a problem.
1.1. MAIN CONCEPTS
1.1.1. BUDGET COMPOSITION
According to the definition of the Irish Department of Finance the budget is setting the
government budgetary targets for the following three years. It is usually not a single document but a
package of the statements and reports, with each of them covering the specific area in the budget
development and implementation process. The list of these documents is shown below and the
objectives which they follow will now be briefly discussed.
-
Financial Statement;
Budget Measures;
Budget Statistics and Tables;
Financial Resolutions;
Stability Programme Update;
White Paper on Receipts & Expenditure;
Estimates for Public Services and Summary Public Capital Programme;
The Financial Statement is a Minister’s of finance speech to the Parliament. It is delivered
on a Budget Day, which last time was on December the 7th 2010. The Budget Measures introduce
the changes proposed by the new budget and the costs and yields it will create and more detailed
information comes in the Statistics and Tables appendix. Financial Resolutions deal with the
legislative backing for the suggested changes and Stability Programme Update focuses on the
strategic compliance of the budget with the European Union Growth and Stability Pact. Finally, the
so-called White Papers give the most up-to-date data on the present situation in government finance
and Estimates calculate the way this data will change with the new budget policies (Department of
Finance, 2011). All this documentation is published and is freely available, thus it will be actively
used in this paper and many further references to it will be made.
All entries in the budget are divided to Receipts and Expenditures, which represents their
positive or negative effect on the public budget. Each one of them is then further divided into the
current and capital categories, depending on whether the corresponding entry is serving the ongoing
needs and collects current incomes or is dealing with the capital transactions. All together, this
produces the Exchequer Balance or in other words balance of the Department of Finance activities.
However, it is worth mentioning that the Social Insurance Fund (SIF), National Pension Reserve
Fund (NPRF) and some other extra-budgetary funds and authorities are not appearing on the
Exchequer Balance but are considered the part of the General Government Balance. For this reason
8
transactions made, for example, between the SIF and the Exchequer will not show on the General
Government Balance but can have some effects on the public budget. It also should be said that data
used throughout this paper for the year 2010 represents projected outturns based on the information
known in the end of November 2010 as the fully audited annual reports will be published only in
September 2011. Consequently, the data for the year 2011 and further represents the estimates
which take into account measures introduced by the National Recovery Plan (The Stationery Office,
2010).
1.1.2. BUDGET EXPENDITURE ITEMS
The expenditures of the Irish Exchequer budget are divided into two major groups: voted or
non-voted. The difference between them is obvious as the amount of funds provided for the first
one is discussed and voted in the Parliament while the second one is paid directly from the Central
Fund. The reason for this is that the items included in the second group do not allow any broad
discussions. The major items in it are the service of the national debt (which accounts for 75% of all
non-voted current expenditures in 2010) and contribution to the EU budget (correspondingly 21%),
major non-voted capital expenditures are contributions to the European Agricultural Guidance &
Guarantee Fund (FEOGA, 47% of all non-voted capital expenditures in 2010), Euro Area Loan
Facility for Greece (21%) and National Asset Management Agency (NAMA, 18%) an agency
created in 2009 to act as a “bad bank” aquiring toxic assets from Irish banks. These nondiscretionary payments made up about 14% of total expenditures in 2010 and once again are not
voted on. The voted group, on the other hand, accounting for another 86% of the budget
expenditures is widely discussed as the funds should be distributed among 41 positions. The full list
of them can be found in appendices (see App. 1), while further in the paper they will mostly appear
combined in groups by their objective. For illustrative purposes the estimated spendings by group
for the year 2011 are shown in the Figure 1.
Figure 1. Gross expenditure (current) by ministerial vote group in 2011 (estimate)
13%
Social Protection
4%
38% Health
Education
Justice
Agriculture
16%
Enterprise
Other
27%
Source: Department of Finance
It should be said that these spendings represent not only the one made by the Exchequer but
also the transfers coming directly from the SIF and the National Training Fund (NTF). They are in
fact reflecting the actual payments in a more accurate manner, but some confusion may arise if the
origin of the funds is ignored.
9
1.1.3. BUDGET RECEIPTS
The major source of the government revenues are definitely the taxes, which accouted for
approx. 92% of all current receipts in 2010 in Ireland. Tax revenues are in turn divided in 8 main
groups being namely: customs, excise, capital gains tax, capital acquisitions tax, stamp duties,
income tax, corporate tax and value-added tax. The more detailed statistics for them is presented in
the appendices, although it should be said here that two of them generating highest yields are the
income tax and VAT making in 2010 correspondingly 32% and 30% of all current revenues (see
Figure 2). The other source of the current receipts is the non-tax revenue with the most important
part of it being guarantee schemes such as CIFS and ELG. These are the bodies covering banking
deposits amounting over 100.000 euro. The former expired in September 2010 and the latter is
currently expanded up to June 2011. Their income is coming from the banks participating in the
programme (which are all major Irish banks) and in a year 2010 they generated 49% of all current
non-tax revenues. Another item on this list is the income surplus of the Central Bank (26%), which
is transferred annualy to the Exchequer, and such exotic sources as National Lottery Surplus (9%).
Figure 2. Gross receipts (current) both tax and non-tax in 2010
13%
Income Tax
32%
3%
Value-Added Tax
Excise
11%
Corporation Tax
Stamp Duties
Customs
Capital Acquisition Tax
Capital Gains Tax
13%
Non-Tax Revenue
30%
Source: Department of Finance
As for the capital gains, they constitute a very small part of the government income (about
one twentieth of the current revenue in 2010) and the chief sources for them are transfers from the
FEOGA mentioned in the previous section (44% of capital receipts in 2010) and from the sinking
fund (34%).
1.2. CURRENT ECONOMIC POSITION
1.2.1. GROSS DOMESTIC PRODUCT
As a result of progressive reforms implemented in 1995 Ireland has been experiencing a
double digit GDP growth for the most of the 90‘s and an average 5,5% growth rate in the 00‘s (see
Figure 3). The reforms included the reduction of the corporate tax rate to 12,5% as compared to
23,5% average in the EU (Eurostat, 2011).
Consequently many multinational corporations were attracted to Ireland and established
their headquarters over there thus bringing a lot of investments and expertise in the Irish economy
and creating many workplaces. Combined with the English speaking and well-qualified workforce
10
it allowed Ireland to become open, modern and globalized economy focusing on R&D, hi-tech and
pharmaceuticals. However, it has all changed in the year 2007 when Ireland was hit by the burst of
the bubble in the construction industry. In 2008 driven by the world financial crisis country was
pressured even further down officially entering the recession in September 2008. After that January
2011 was actually the first month to demonstrate positive change in the GDP and prognoses now
are that Ireland wil be able to expand at an annual average level of 2,75% between 2011 and 2014
(The Stationery Office, 2010).
Figure 3. GDP Volumes, Ireland, quarterly data, mio. of Euro, 2000-2010
Source: Eurostat
All in all, currently the GDP has fallen some 11% below its respective level in 2007 in real
terms. This is mostly explained by the excessive credit expansion, disproportionate growth in
construction and rapid property prices growth through the 00’s. The factors that could account for
the future trend change and successive growth will be outlined in the sections to follow.
1.2.2. LABOUR MARKET
Labour market is interconnected with the budget balance in several ways. From the debit
part of the budget decrease in domestic employment washes out the amount of collected income tax.
As it was shown in the previous section this tax is the most important source of government
receipts, thus no wonder that even marginal change in it can present a threat for public finance
stability.
To make matter worth, unemployed population requires substantial social help in a form of
numerous transfers, payments and tax exemptions, hence creating additional pressure on the credit
side of the budget. Labour force size is also expected to have strong correlation with the
consumption, as people losing jobs will have to slash their consumption thus in some way
decreasing incoming VAT – the second most important source of income for the public budget. The
arising chain reaction can bring budget deficit to the new heights in a very short-term that is why
analyzing the employment is crucial for understanding alterations in budget deficit.
There are several features of the Irish workforce, which make it different from the
workforce in many other European countries. These features can partly explain the rapid
11
development of Ireland in the period of 1995-2007 as well as suggest some insight in the probable
ways of the recovery.
First, Ireland has the youngest population in Europe with over 35% of people being under
25. The benefits of having such proportion of the youngsters from the economic point of view are
obvious. Younger workers are not expected to get any high wages because they do not have any
work experience and are happy to get any pay at all. On the other hand they can work hard and long
hours. As a result, the firms hiring them can cut labour costs and boost profits driving up the whole
economy. Moreover, in the social security system young people act as the contributing party - they
pay all the costs probably without any possibility to get something back from the system in the next
forty to fifty years. This type of a “loan” for the government allows keeping the budget deficit under
control despite any disturbances.
Second, the population is quite well educated with 44% of the people aged 25-34 having the
third level education, which means college or university degree, as compared to the average of
28,6% across the European Union (International Institute for Management Development [IMD],
2010). The education level has the most direct link to the overal competitivness and effectivness of
the labour. As it was mentioned earlier, many of companies based in Ireland focus on research and
development in such areas as hi-tech, pharmaceuticals and computer software. All these areas have
two certain features: they require an educated workforce and they are very efficient in creating
value. Hence, having the former Ireland will most likely get a lot of the latter. Putting it in figures,
as the IMD has calculated the labour productivity per person per hour for Ireland is $49,26 which is
much higher than comparable number for Germany ($38,54) and on the same level with the USA
$53,25.
After the reforms of the 1995 the unemployment started to diminish falling below EU
average in 1997 and bottoming out in 2001. Then the long period of remarkably low level of about
4% occurred, which can be explained by normal frictional unemployment (see Figure 4). After that
the unemployment rate has tripled from the minimum level in the end of 2006 to more than 300.000
people out of work during the third quarter 2010. What is more, a large proportion of them,
something around 140.000, have been registered as a long-term unemployed, which is a disturbing
sign.
Figure 4. Unemployment, Ireland, quarterly data, percentage of the workforce, 2000-2010
Source: Eurostat
12
During the recession years there was a clear pattern of unemployment being fueled mostly
by the sectors which experienced employment boom in 2004, namely construction and wholesale &
retail. The desrepancies in the expansion rate of the construction sector have created structural flaws
in the specialization of the workforce. More than was needed Irishmen focused on the skills
required in constructing and foreigners with those skills were attracted into the country.
As a result it will take some time and public funds to reeducate this part of the labour force.
However, at the same time the percentage of the labour force employed part-time was increasing
even at the faster pace than before crisis. It means that as a part of their cost-cutting schemes
companies were using transition to the reduced hours instead of full layoff for some of their workers
hence expecting their skills to be needed shortly. This suggests that to some degree change in the
economic trend will be followed by the employment increase without a long lag. (EURES, 2011).
The average salary in Ireland has been increasing during the period of economic growth
through the most of the 00‘s. The fourth quarter of the year 2007 was the first to signal the stop of
the positive trend. After that average salary has been relatively stable, fluctuating around the level
of 700 euro per week. From the point of view of the public finance, increasing salary generates
more income tax – the main source of the government receipts. Therefore, it can be concluded that
stop of the positive trend and even some degression in the wages presented the public budget with
some difficulties in financing its increasing needs.
Figure 5. Average weekly salary, Ireland, quarterly data, in units of Euro, 2000-2010
Source: Central Statistics Office [CSO]
1.2.3. TRADE BALANCE
Less than 1% of government revenue in Ireland comes from customs on the imported goods.
This is a really low figure especially when compared to corresponding number of about 30% in
China (Xinhua, 2010). This seems to be counterintuitive to the fact that Ireland is an open country
focused on international trade. Hence, the reasons for that number to be that low as well as possible
consequences of its change need to be analyzed and understood. If the situation alters in the future
one might want to know what effects will it have on the budget deficit and consequently what fiscal
policies should be introduced to deal with it. An inderect effect of the trade is also the revenue of
13
corporations engaged in it. If they are based in Ireland, probably some amount of corporate tax is
further paid on this activity thus bringing extra public receipts when the trade is booming.
The importance of the trade for Irish economy cannot be undermined. For the last five years
exports from Ireland averaged on 50% of the GDP and imports on 30%. The corresponding figures
for the whole EU are 15% and 15% (Organization for Economic Cooperation and Development
[OECD], 2011). However, during the crisis years levels of trade have been falling far below the
average which can be seen from the Figure 5. Currently recovery is fueled particularly by booming
exports and Irish government puts a large bet on this strategy expecting about 150.000 work places
to be created in related to trade areas according to the new „Trading and Investing in a Smart
Economy“ development plan.
Figure 6. Exports and imports, Ireland, annual data, index (base year 2000=100), 2000-2009
Source: OECD
However, the reasons for such large activity area to bring practically no revenues to the
government budget lie in the Ireland’s EU membership. The customs union is the essential element
of the EU single market concept and one of its guaranteed freedoms is a free circulation of goods.
The ultimate goal of the custom union introduced back in 1960’s was to eliminate all customs duties
and restrictions among member countries and to develop common custom policy towards countries
outside EU. And it can be claimed that by now this goal has been fully achieved.
Combining presented historical insight with the current statistics for major Ireland’s trading
partners shown in the Figure 7 constitute a strong case for Ireland not to be able to draw any
substantial profits from border duties. It can be seen that 53% of imports in 2009 came from five
major European countries and besides that among partners shown as “Others” are a lot of EU
members as well.
What is more, the customs policy towards non-EU countries is developed conjointly for the
whole EU and practically cannot be influenced by such a small country as Ireland. Putting it another
way trade is related to the Irish budget mostly in an indirect way through general trade effect on the
economic growth and can be beneficial through general increase in corporate profits and sales.
14
Figure 7. Imports composition by country of origin, 2009
35%
UK
US
Germany
Netherlands
France
Other
5%
6%
17%
7%
Source: CSO
1.2.4. CONSUMPTION
Being the part of the GDP the level of aggregate consumption in the economy constitutes
the part of the income which is not saved. For the government and in the context of this paper,
consumption is appealing as an indicator of the collected value-added tax.
After the earnings have been paid out and taxed by the income tax they actually have two
possible routes. One is saving, which puts them most likely into the deposit and hence out of the
reach of the public budget. Other is consumption, which pours this income back into the economy
allowing the government to refill its receipts. Having in mind, that in Ireland VAT accounts for
30% of all government receipts, the extreme case of zero consumption would constitute a
significant problem for the budget balance. But even without extremes, any fluctuations in the
consumption patterns are one way or another reflected in the public budget deficit.
Figure 8. Final consumption aggregates, Ireland, quarterly data, in mio. of Euro, 2000-2010
Source: Eurostat
15
In Ireland consumption figure mostly repeats the one of the GDP. It has been growing from
the year 2000 up to the last quarters of 2008, when it slashed and took on a negative trend (see
Figure 8). However, in order to separate the effect of the general economic recession and
understand the changes in the patterns of consumption itself one would need to look at the
aggregate consumption expressed as the part of the GDP (see Figure 9).
Figure 9. Final consumption aggregates, Ireland, quarterly data, percentage of GDP, 20002010
Source: Eurostat
It can be seen that at the times when the consumption felt in absolute values, its role in the
GDP formation increased significantly. This demonstrates that the negative effect of the depressed
economy on the taxes collection, was partly offset by the lower part of the income put away as the
saving and bigger part being consumed and thus repaid to the government in the form of the valueadded tax.
1.3. PROBLEMS OF FISCAL POLICY APPLICATION
The budget deficit can be a signal of many problems in the economy and a problem itself
that is why efficient management of it is crucial for any country. Whether the government is
struggling to decrease budget deficit in order to stop accumulating public debt or it wants to help
the economic recovery by adjusting budget composition the tool it will use is the fiscal policy.
However, as attracting as this tool might seem it has its own problematic features that most
definitely must be taken into account before undertaking any action.
1. The time inconsistency problem in fiscal policy is described as that policy makers
deciding on measures today may find counter measures to be preffered tomorrow.
This is because of the complexity of the economic conditions and their continuous
change. For example, at some moment in time it might seem as an appropriate step
to increase government spendings in order to boost slowing economy, however in a
16
very short-time after that this very step might become the one overheating an
economy and draining the budget. To make matter worse, in democratic countries
public finance issues are most usually decided through developed net of voting
systems, which means that changes in prevailing political opinions can influence
decisions supposedly meant to be economic.
2. Closely related to the inconsistency is the time lag problem. Not only does it take
some time to push a tax initiave through the numerous committees and commissions
set to make the budget deliberation process transparent and democratic but also the
fiscal policy in its own nature does take some time to start operating in a way it was
designed. Most of the taxes cannot become effective immediately and need to be
announced at some advance in order to be introduced e.g. from the next year.
Government spendings for that matter can act faster but still need some time period
to pour through the economy and cause the needed effect. Such lagging once again
can create the situation when fiscal policies actually worsen the budget deficit or
slow down the economy.
3. The effeciency of fiscal policy is often unmeasurable. The data for major economic
indicators is available and is calculated with high accuracy by the statistics office.
However, it is practically impossible to distinguish what percentage of the indicator
change can be attributed to the newly introduced measure and not to the seasonality,
global trends, new technologies etc. This is especially true as the fiscal measures
tend to come grouped in the packages, which means that several fiscal measures start
to affect the economy at the same moment and failure of one can be perfectly
covered by the success of the other. Moreover, in current globalized economy fiscal
decisions made abroad can have substantial effect as well, confusing the issue even
further.
4. Taxes levied on some activities can instead of bringing additional income just scare
off participants of the field in question, thus not only decreasing government receipts
but ruining particular areas. The most relevant example for Ireland would be
corporate tax, which was a long known driver of the economic growth of the 90’s.
Being one of the lowest corporate taxes in Europe it was attracting huge investments
into the country and motivating international companies to establish in there.
However, even minor changes in tax rate will probably cause a great run-off and that
is why Irish government continuously reaffirms that no changes will be made to this
tax even in the worst case scenarios of budget deficit and piling on debt.
5. Fiscal policy can be hard in social context. Politician introducing any changes in
public finance will probably have to face a lot of resistance from people falling under
the suggested measures. If that politician will be an elected one, then enforcing such
measures can become challenging. This is very much confirmed by Ireland, where
the Parliament broke up and was dissolved during the voting session on the new
budget. For that matter, not doing anything and just leaving the debt for future
17
generations to worry about can be the most attractive option at the exact current
moment.
6. Fiscal measures ultimately need to be taken, especially in the absence of the
monetary policy at hand (as in case of the monetary union). Government debt can be
piled for a relatively long time, transferring debt burden to the future generations,
however, at some point in a time it will become unsustainable and will be corrected
by fiscal tightening.
Taken together all these points prove that fiscal policy is a complicated tool, which however
must be used in order to control the economy. That is why doing as much research as possible and
trying to tune the fiscal measures with the highest accuracy is very important. The ideas suggested
by this paper will not eliminate the problems presented above, but will allow to deal with them in a
more informed manner and thus might prevent many costly mistakes which otherwise would take
place. Putting it the other way round, random fiscal actions are very likely to destabilize economy.
Hence, one would need to determine the areas which have more impact on the budget deficit and
only then adress them with the fine-tuned fiscal measures.
18
2. THEORETICAL ASPECTS AND RESEARCH METHODS OF THE
FISCAL POLICY IMPACT ON BUDGET DEFICIT
The fiscal policy is a set of measures used by the governments in order to achieve certain
economic goals. Main goals usually are price stability, economic growth and employment as these
are natural needs and wishes of the country and its citizens. By adjusting public expenditures and
taxes government is able to influence aggregate demand in the economy which leads to further
changes in macroeconomic background. As the objective of this paper is to suggest fiscal policy for
Ireland and to assess the impact of this policy on the budget deficit it is very important to introduce
theoretical approach to the relation of fiscal policy and the economy.
According to Carlin and Soskice (2006) the macroeconomic role of the fiscal policy is as
follows:
 to create automatic stabilizers which would protect the economy against the sudden
shocks and economic cycles without the need for constant adjusting;
 to use discretionary changes when they are needed for stabilization of the level of
output and hence general economic well-being;
 to maintain a sustainable level of the public debt and prevent it from burdening the
economy;
Each of these roles will be examined further in the section as this will allow to set a
theoretical structure for the statistical research run in the third chapter and will create a hard base
for suggesting the fiscal measures in the summary of this paper. But before that a simple short- to
medium-term macroeconomic model need to be set. The model used in this work will be a standard
IS/LM model of the goods and money market equilibrium.
2.1. IS/LM MODEL
The aim of this model is to show how the level of output and employment is determined by
the level of aggregate demand in the short-run, when the prices and wages are assumed to be sticky.
(Carlin & Soskice, 2006). The reason why the prices are believed to be fixed in the short-run is
actually out of the scope of this paper and will be further on given as an assumption. Also other
short-term conditions will be used everywhere unless the contrary is articulated.
Starting from the IS (investment-savings) part of the model one must state that condition of
the goods market equilibrium is the equity of planned real expenditure and real output. This
condition can be written down as:
yD = y,
where yD is planned real expenditure and y is real output.
Breaking down the left part of this equation by the items composing it, one gets:
yD = c (y, t, wealth) + I (r, A) + g,
where c is consumption (depending on real output y, taxation t and wealth), I is investment
(depending on real interest rate r and other non-interest factors A) and government spendings g.
19
For the sake of simplicity all features of this model will be shown using linear functions,
because this will make a case for the paper without overloading it with the details. So, the
consumption function can be presented as:
c = c0 + cy (y − t),
where the consumption is shown as the sum of disposable (after-tax) income multiplied by the
marcinal propensity to consume cy and a constant factor called autonomous consumption c0.
Moreover, taxation t can be broken down to linear tax function of the tax rate and real
output:
t = tyy,
which in its turn can be substituted back into the consumption function producing:
c = c0 + cy (1 − ty)y.
Now going to the investments it can be assumed that decreasing interest rate lowers the cost
of capital for the firms allowing them to undertake projects which would not be profitable
beforehand. By the same line of reasoning expected future profitability – one of the factors proxied
by the term A in the initial equation is also increasing the amount of investments made today. All in
all, putting it in a linear function one gets:
I = A – ar,
where a is constant.
Pulling it all together back to the original planned expenditure equation and making some
rearrangements:
yD = c0 + cy (1 − ty)y + A – ar + g
yD − cy (1 − ty)y = c0 + A – ar + g
y = (c0 + A – ar + g) / [1 − cy (1 − ty)]
y = [1 / (sy + cyty)] (c0 + A – ar + g),
where 1 − c y is substituted by the new term sy or marginal propensity to save and the term in
the square brackets is from now on called the multiplier. This term is of particular interest for the
topic of this paper and will be discussed later in the section considering the role of the fiscal policy.
The LM (Liquidity-Money) part of the model on the other hand is representing the money
market and consequently the monetary policy is used to influence it. As the monetary policy tool is
mostly unavailable for the members of the monetary union such as Ireland there is no need to get
deep in this issue. However, for the model to be complete LM background will be briefly outlined
in the paragraph to follow.
A natural description of the equilibrium in the money market is the demand for money being
equal to the supply of money. Both of these terms need to be expressed in the real terms as the
nominal values have little relation to the economic decisions:
MD / P = MS / P,
20
Now the left part of the equation is driven by the interest rate and the level of output,
namely:
MD / P = L (y, i)
This is so because of the transaction and asset motive for holding money. The former argues
that most of the transactions need to be carried out in the form of most liquid assets i.e. money. So,
the increase in the level of income (output) requires more liquid money to be in the economy in
order to keep the mechanism going. The latter suggests that when the interest rate is high the costs
of holding non-interest bearing assets become too high and more participants of the money market
are inclined to get rid of any excessive liquidity transfering their wealth to let’s say bonds, hence
decreasing demand for money.
As the real money supply in the short-term is suggested to be fixed the real money demand
needs to be fixed too. The implication of it is that increasing interest rate and hence falling demand
for money as an asset is needed to be offset by the adequate rise in the transaction driven demand
for the money, which is once again possible when the output and income are rising. This puts the
interest rate and the output in the linear dependency producing the upward sloping LM curve.
The resulting model is shown in the Figure 10. To test its workability and relevance to the
topic in focus one can disturb the initial equilibrium by changing i.e. incorporated in the IS curve
level of the government spendings. This will shift the initial line to the right because the output in
the economy will increase for any given level of the interest rate. The equilibrium will move to the
point where both interest rate and real output will be higher.
Figure 10. IS/LM framework
Source: Mankiw
This process can be divided into smaller steps. First, government spendings will create
higher aggregate demand and higher income level. This will create a need for more money to be in
the economy for the transaction purposes. Then the bonds will be sold and turned into liquid funds,
thus driving interest rate up because of the inverse relation between bond market price and the
21
market interest rate. The aggregate demand is then diminished because less projects become
profitable and investments fall. However, the decrease in demand because of the falling investments
is less than increase due to increase in government spendings because of the multiplier effect
mentioned earlier. All together, the steps described are called the transmission mechanism and can
be formulated as:
↑g → ↑y → ↑(M/P)D → ↑r → ↓I
The logic demonstrated above shows a clear pattern of the budgetary decisions influencing
the economy and provides a hard basis for the research of the fiscal policy affecting economic
variables and these variables later on repercussioning in the budget balance.
2.2. AUTOMATIC STABILIZERS
As it was mentioned in the beginning of this chapter automatic stabilizers are one of the
roles which the fiscal policy is expected to play in the economy. The best way to understand them is
through the prism of the IS/LM model. With the zero tax rate multiplier in the IS function would
simply be reciprocal of the marginal propensity to save. However, adding the tax related to the level
of income to the denominator automatically decrease the size of the multiplier, as does the social
transfers which are also related to the income in the economy (less income leads to less employment
leads to more benefits). Thus with the system of taxation and spendings directly connected to the
level of income, the multiplier in the IS function becomes lower and as a result of that any changes
in the exogenous factors have less effect on the aggregate demand. Assuming that the demand was
in equilibrium in the first place this is clearly a good thing.
The further effect of the automatic stabilizers is their impact on the budget deficit. Setting a
simple model:
g (yt) – t(yt) = [g (ye) – t(ye)] + a (ye – yt),
where yt is the current output, ye is the equilibrium output and a is a term for automatic
stabilizers, one can see that with the current output being lower than the equilibrium, automatic
stabilizers are actually increasing the actual government debt by increasing spendings and cutting
tax revenues. This will help to stabilize the economy in the recession but will also accumulate some
debt. However, one must notice that the debt created by automatic stabilizers will effectively
disappear as the economy will get back on tracks and to the equilibrium level of the output.
Therefore, some part of the actual debt does not present a problem at all and is just the automatic
effect of the taxation systems. In order to evaluate the quantitive effect of automatic stabilizers the
research by Auerbach and Feenberg can be quoted. The research was exploring stabilization impact
of the taxes in the US and found that taxes and benefits together would offset about 10% of the
initial shock to the GDP (Carlin & Soskice, 2006).
Projecting the mentioned results on Ireland it can be claimed that some part of the budget
deficit does not need to be dealt with by the means of discretionary fiscal measures at all. The
recovering economy will automatically correct some percentage of the budget imbalance.
Moreover, because of the things said discretionary measures should be introduced with caution
22
leaving some place for the automatic stabilizers, because otherwise excessive measures can
depress the economy beyond the point.
2.3. DISCRETIONARY FISCAL POLICY
The discussion about theory of the discretionary fiscal policy should begin from setting the
government budget identity. This identity shows the sources and uses and funds of the government
budget and goes like:
G + iB = T + ∆B + ∆H,
where G is the government expenditures, i is the interest rate and B the amount of the bonds
outstanding. One the right side are the sources of financing such as tax revenue, newly issued bonds
and newly printed money. One can say that the third one is merely theoretical for Ireland and cannot
be used in practice because of the monetary union constraints.
The effect of the government expenditures on the economy has been modelled above in the
previous section. In the framework of the IS/LM model it results in the shift of the IS curve.
However, no attention has been paid to the source of financing for the increased expenditures. As it
will be shown further this factor also have impact on the way the fiscal policy measures will pour
through the economy. It is clear from from the budget identity that the sources are taxation, debt or
seigniorage.
First of all, one must say that increase in the government spending can be partially financed
through the increase in the tax revenues induced by it. However, most often that would be
insufficient to cover the gap between income and expenditure and would inevitably create budget
deficit. Using the same variables from the IS/LM model it can be written as:
∆g = (sy + cyty)∆y
∆g = sy∆y + cy∆t,
from where it is obvious that if there are any so-called leakages on savings, then the
spendings cannot be financed only by taxes. In other words, multiplier should be equal to 1/t y so
that all spendings would come back in a form of taxes, which is generally not the case. If however,
the condition of ∆g being equal to ∆t will be assumed to hold, the resulting multiplier (∆g / ∆y)
must be equal to one (also called balanced budget multiplier). It is that the government spendings
will have only initial impact on the economy and no further multiple effects.
As for the debt financing, the main question here is whether bonds are believed to be a form
of wealth by the people holding them. The part unfinanced through the taxes will come in a form of
bonds sold to the population, so if the population is considering them as a net wealth, then piling
bonds will influence both consumption and money demand. In IS/LM framework it will mean IS
line shifting to the right because there is more income at every interest rate level and then shifting
even more right, because of the rising consumption triggered by the rise in wealth. On the LM side
it will appear as increasing demand for money because money and bonds are held in a certain
proportion which reflects people belief intheir relative riskiness. That is why increase in the number
of bonds must be balanced by increasing amount of money. As the money supply is assumed not to
23
change in the short increasing money demand will shift the LM line to the left and to the new
equilibrium.
The alternative theory for the issue discussed in the previous paragraph was suggested by
Barro and based on the works of David Ricardo. This theory argues that the bonds are not
considered to be the wealth because the population knows that interest on these bonds as well as the
principal will be ultimately repaid by the taxes. Hence there is no increase in the consumption and
the effect of such bond financing is equal to that of a full tax financing with a balanced budget
multiplier. This theory generally does not find support in the empirical researches and is, quoting
“not a good representation of macroeconomic behaviour” (de Mello, Kongsrud & Price, 2004).
2.4. DEFICIT AND DEBT THEORY
The main tool used here is the debt to GDP ratio. By understanding the factors driving the
growth of that ratio such as primary deficit ratio, real interest rate, growth of real GDP and current
ratio of debt to GDP one will be able to set up a framework for evaluating the fiscal measures
introduced by the government. To begin with, the government budget identity, mentioned earlier,
needs to be rearranged. As it was said financing debt by printing money is not available for the
country in focus that is why the new form of the identity is going to be:
G + iB = T + ∆B
Besides that two terms actual and primary deficit need to be defined. The actual deficit is the
part of spendings and interest costs financed by the debt (∆B) and primary debt does not include
interest payments thus being equal to G – T. Now introducing the debt to GDP ratio b:
b = B / Py,
where y is the real income and P is the current price level. Their multiple is logically the
nominal national income. Turning all parts of the budget identity in the nominal figures:
(G + iB) / Py = (T + ∆B) / Py
and rearranging the terms:
∆B / Py = (G – T) / Py + iB / Py = d + ib,
where d is a new term for primary deficit ratio to the national income and b is the ratio of
existing debt to the GDP. In order to find ∆b – the change of the debt to GDP ratio, one can do
following arithmetical approximations:
∆B ≈ Py∆b + by∆P + bP∆y
∆B / Py = ∆b + b∆P / P + b∆y / y
∆B / Py = ∆b + bπ + bγγ,
where π is a growth rate of prices or inflation and γγ is the growth rate of income. All in all:
∆b = d + (i – π – γγ)b
∆b = d + (r – γγ)b,
24
because nominal interest rate i minus inflation is a real interest rate r.
The equation just set draws two possible scenarios. One is when real interest rate is higher
that the GDP growth rate. In this case the debt to GDP ratio will be growing (∆b will be positive)
unless the d term is negative and arithmetically bigger than the second term on the right side.
Recalling that d is a ratio of a primary deficit to GDP, negative d implies a budget surplus during
the period, which might be problematic. The second scenario is the case when real interest rate is
lower than the growth rate. In that case interest payments are covered by the new income from
growing economy and depending on the difference between r and γ even some amount of budget
deficit is allowed.
In the equation interest rate is presented as the exogenous variable. However, as the
empirical data suggest, at some point of the rising debt, the concerns about default may arise. If so,
the high debt to GDP growth rate will be pulling interest rate and vice versa creating a vicious cycle
and eventually ending up in the debt crisis or default. To escape that, another useful technique can
be employed. Each and every policy can be tested for its adequacy to the sustainable budget
constraint. Assuming that at time zero there is already some government debt outstanding, this is b
> 0, the conditions for ∆b ≤ 0 need to be found. Arithmetically the constraint looks like:
b ≤ –d / (r – γγ),
meaning that if the long-run real interest rate exceeds expected growth rate, the government
will need to run a constant primary surplus for that period.
Yet another consideration in maintaining sustainable debt is the speed of adjustments when
the government needs to decrease the debt which has become too high. This is called fiscal
consolidation and can be theoretically divided into two different approaches. The sharp tightening
method as it is clear from the name requires a rapid cut in the expenditures which would allow
achieve substantial primary surplus on a very short notice. Once the debt to GDP ratio reaches the
desired value fiscal stance is relaxed. The negative consequences of this approach are a high peak in
unemployment rate and painful social adaptations. On the other hand, the gradual tightening method
allows to keep unemployment stable, as the fiscal stance is adjusted constantly and only by
marginal figures. However, this approach may require longer time horizon which is not always
available for the highly indebted countries.
An alternative interpretation of the the fiscal consolidation would be an expansionary
approach developed by Alesina, Perotti and Tavares (1998). They argue that composition of fiscal
intervention is much more important that its size. Basing the research on hard empirical data from
European consolidations in the 90’s, they suggest that if the consolidation is made through cut in
government consumption instead of tax increase it will send a signal to the taxpayers that the
burden will not be passed on them. As a result their perception of own wealth improves driving the
consumption and aggregate demand up. Developing that “signalling” theory further Alesina et al.
suggested that hence the cut in expenditures is more demanding politically the government
undertaking it signals the seriousness of its commitments thus bringing confidence to the investors,
who would demand lower risk premiums and provide more funds for the economy.
25
2.5. STATISTICAL RESEARCH METHODS
In order to determine the impact of certain macroeconomic indicators on the change of the
budget deficit and hence suggest the fiscal policies which could adjust these indicators and
influence the deficit one needs to establish a strong mathematical link between these variables. As it
is clear from the setup one of the variables, namely the deficit of the public budget, is considered to
be random and dependent in a sense that it can aquire any value and is explicitly driven by some
other thus independent variables. The tool that is normally used for such researches is a regression
analysis. Further through this section the classical regression model and its features as well as some
limitations will be described and the prerequisites for the research introduced in the third chapter of
this paper will be made clear.
According to Brooks (2008) the objective of the regression is to establish and measure the
relationship between one variable and several other variables, specifically “...to explain the
movements in a variable by reference to movements in one or more other variables”. In its most
basic form the linear regression equation can be noted as:
yt = α + βxt + μt,
where y is a dependent variable, x is an independent variable (for the sake of simplicity
there is only one independent variable in this case which is usually not very realistic), α is a
constant which denotes the y value when x is equal to zero, β is a constant showing by how much
the dependent variable changes when the x changes by one unit or a figure determining the slope of
the line if the equation is shown graphically, μ is a random disturbance term and t (= 1, 2, 3 ...) is
the observation number.
Consequently finding the values for α and β allows building a linear equation where for any
given x an estimated value of y can be calculated. Naturally, the resulting line will not fit the actual
values perfectly and some residuals between estimated and actual value will arise. The key step here
is to find α and β which would minimize the sum of these residuals squared as such line will be the
most accurate representation of the actually observed phenomena.
Now certain assumptions must hold for the model to work properly. The four of them
concern the disturbance term μt. The reason for it is that, yt depend not only on the observable term
xt, but also on the unobservable error term ut, which is why “one should be specific about how the ut
is generated” (Brooks, 2008). Thus the classical linear regression model includes four assumptions,
namely:
E(ut) = 0 The errors must have zero mean;
var(u t) = σ2 < ∞ The variance of the errors is constant and finite over all values of xt;
cov (ui, uj) = 0 The errors are linearly independent of one another;
cov (ut, xt) = 0 There is no relationship between the error and corresponding x variate;
ut ~ N(0, σ2) ut is normally distributed;
26
There are many reasons for these assumptions to be necessary and several qualities of the
estimators which arise becuase of that assumptions, however it is not the objective of this paper to
get in the explanation of the regression analysis itself, so from now on it will be just stated that
these assumptions must hold and that neglecting them may lead to appearance of certain errors in
the resulting model.
On the other hand, what should be looked at with particular attention are the errors which
could arise when these assumptions are violated. There are several statistical tools which can be
used in order to detect some problems with the data:
-
Violation of the first assumption could not happen if the constant term is included in the
regression (Brooks, 2008).
-
The violation of the second assumption can be detected by simply plotting residuals
against one of the variables. Ideally residuals should be dispersed around x axis without
any system, if however the pattern can be observed it means that variance of residuals is
not constant and hence any inferences from the model can be misleading. The standard
test used in the statistical packages is the White’s test. This test explores the dependency
of the disturbance term on the original explanatory variablel. The null hypothesis is that
there is no relation between them and hence the error term is homoscedastic. If the null
hypothesis is rejected, then logically some part of the resiadual term is explained by the
explanatory variables and varinace is not constant.
-
The third assumption is violated when the error term is correlated with its own values
from other periods or autocorrelated. This problem can also be observed graphically
plotting u t against ut-1 - it is the same variable one period earlier. If the pattern is
observed then the error terms are correlated with one another. The formal test for
computer packages is a Durbin-Watson test. Once again the null hypothesis here would
be that there is no relationship between successive residuals.
-
The fourth assumption prevents having data where explanatory variables are correlated
with disturbance terms. If that were the case, the regression line would seem to explain
the data very well, which actually would not be the true. The logic behind that is as
following, if the regressor is high when the error term is high (there is a positive
correlation), then the resulting high value of the explained variable would be attributed
to that particular regressor, while in reality it is just a result of high disturbance term.
Hence the result of model with covariance between regressor and error would be biased.
-
The fifth assumption is saying that the disturbances must be normally distributed. One
would need to know the mean and the variance, and then look at possibly arising
skewness (symmetry around the mean) or kurtosis (fattness of the distribution tails). The
distribution must be unskewed and have a kurtosis coefficient of 3.This is usually
established through the so-called normality test.
Yet another assumption implicit in the linear regression model is the absence of the
correlation between explanatory variables. To some degree the correlation is presumed to be benign
27
(and it is usually present in the model) however, if the correlation coefficient is very high the
problem of multicolinearity will emerge. As such multicolinearity impedes the possibility to
observe the effect of each separate explanatory variable. In other words, the R 2 will be relatively
high implying that the whole model is of good quality, but individual variables will appear to be
insignificant.
Substantial attention must be paid to the functional form. It is obvious that the proper
functional form of the relation between x and y is linear, however, as it was mentioned before, the
model should be linear in the parameters; hence the actual variables can initially be in many other
forms and then linearised using logarithms. In order to establish whether the log of the variable
should be used instead of the variable itself, one could run a Ramsey’s RESET test, which would
show the linearity of the relationship between variables.
28
3. RESEARCH OF THE FACTORS INFLUENCING BUDGET DEFICIT
This chapter will present the results of the regression analysis and the conclusions drawn
from it. Supposedly, the regression analysis will let to establish the link between the budget deficit
and certain areas of economic activity. By knowing this relationship, one will be able to decide
which one of them should be taxed.
The logic underlying this research is straightforward. Empirical observations suggest that
each and every economic indicator is treated by one or several taxes. However, it can be argued that
taxing some areas is more effective than taxing some other areas. Independent of the current tax
rates it is just the implicit nature of these areas, which make taxation in them very effective or
ineffective at all. This is why putting these areas (or to be precise, the economic indicators
accounting for these areas) in the regression equation will determine their effect on the budget
deficit. As a result, the government or any other responsible authority could focus on the areas
which have proved to have the most direct impact on the budget deficit. It can be adressed through
introduction of new taxes, increase of the current taxes or any other measures which can get
additional profit from the area or stimulate it. By prioritizing fiscal measures the government will
avoid excessive taxation in the areas which actually do not help to correct the budget deficit and on
the other hand will create fiscal policy for the areas which are very profitable from the standpoint of
the public finances.
The choice of the independent variables used in the regression analysis is justified by the
composition of the budget receipts (see Figure 2.). As it was mentioned in the first chapter two main
sources of the government revenues are the income tax and the value-added tax. One could easily
establish the direct connection of the income tax to the number of people employed (or unemployed
putting it the other way round) and to the average wage in the economy. By the same token valueadded tax is effectively a tax on consumption and can be proxied by the final consumption
aggregates. Following that line of reasoning one would need to put the volumes of imports in the
regression to establish the effectivity of the customs and duties (yet another source of government
revenues). The industry production index can demonstrate the effect of the corporation tax. All
other government sources are considered to be too small to have any substantial effect, however, the
GDP variable included in the regression will demonstrate the effect of the whole economic activity
on the budget deficit. All in all, the resulting regression equation can be written as follows:
budget_deficit = β0 + β1 ∙ GDP + β2 ∙ Unemp + β3 ∙ Av_W + β4 ∙ Cons + β5 ∙ Prod + β6 ∙ Imp + μ,
where: GDP - is the gross domestic product;
Unemp – is the number of unemployed people;
Av_W – is the average of the weekly salary in all sectors;
Cons – is the final consumption expenditure of the households;
Prod – is an industrial productivity index;
Imp – is the volume of imports;
29
3.1. DATA QUALITY
The data used for the regression was collected from the Eurostat and Central Statistics
Office databases. According to Hair, Anderson, Tatham and Black (2010) the minimal requirement
for the number of observations in the sample should follow the rule of 5 to 1, meaning that there
should be at least five observations for every independent variable. That is why in this case, 44
observations have been used, which makes the results of the regression generalizable. These 44
observations were collected every quarter from the year 2000 to 2010. All the data has been
seasonally adjusted in the databases, therefore no additional correction is needed; it can be claimed
that significance of the coefficients does not arise because of the seasonal factors (Brooks, 2008).
The research is using time-series – the same variables are measured at successive time
periods. That is why the problem of non-stationary data may arise, if such parameters as mean or
variance change over time. For the data to be analyzed with the regression it should be distributed
stochastically around the mean. The non-stationary nature of such variables as GDP or consumption
is very obvious however, in order to confirm it formally, one might use the correlograms. The
correlogram is plotting the autocorrelation between time-lagged data, which is assumed to be
around zero in stationary data. As it can be seen from the Appendix 3 all independent variables
taken for the regression have some degree of the non-stationarity, which therefore should be
corrected by detrending with first-order differences. Appendix 4 demonstrates that moving averages
have become stationary and thus can be further processed in the regression analysis.
The correlation coefficients (see Appendix 5) between the independent variables have been
calculated in order to detect any multicolinearity signs. The correlation between consumption and
unemployment is negative and quite high. It does not compromise the logic of the research, as the
lower consumption during high unemployment can be explained by the economic theory, however
for the regression it can mean that one of these variables may need to be removed. It must be noted
that high correlation between two particular variables does not present any problem for other
variables in the regression. Their coefficient as well as signs are not altered and thus still stay
reliable.
3.2. FIRST MODEL ANALYSIS
The first regression coefficients table (see Table 1) demonstrates that two variables, namely,
GDP and unemployment are statistically significant (with a 10% and 5% significance level
accordingly). It should be noticed once again that the use of the stationarised by detrending data
changes the interpretation of the beta coefficients. They now represent not a nominal
increase/decrease of the independent variable but a percentage change. For example, the coefficient
for GDP is positive 1,535 meaning that increase of the growth rate of GDP by one percent decrease
budget deficit by about 1,535 million of Euro. This figure goes in line with the theory of automatic
stabilizers which argues that governments are experiencing larger deficits during the recession time
and generate surpluses during the booms. It also can be explained by the discretionary measures, as
naturally government would tend to increase spendings during the recession, while getting lower
income from the taxes.
30
As the unemployment is measured in thousands of people, the coefficient of −308,29
means that increase of the pool of the unemployed by 1 percent, drains 308,3 million of Euro from
the budget both in decreased income tax revenues and social policy expenditures. Other variables
have proved not to be statistically significant.
Table 1. The first linear regression coefficients.
The overal quality of the model (see Table 2) as evaluated by the R square is quite high,
meaning that about 45% of the variation in the budget deficit can be explained by the variation in
the independent variables included into the regression.
Table 2. The first linear regression summary.
The significance levels of the independent variables naturally prompt to remove some of
them from the regression as that would probably increase the accuracy of the research. The three
variables: average wage, consumption and production are going to be removed now and the new
regression equation will be computed.
As it was mentioned earlier the consumption is highly correlated with the unemployment
and there are certain economic reasons for that correlation. That is why removing it form the
regression might actually increase the quality of the research. By the same token, production index
(which measures the activity in manufacturing, mining, construction etc.) is arguably incorporated
in the GDP performance. Therefore, leaving one instead of two variables could actually serve a
good purpose. Average wage indicator seems to be the most insignificant. The economic
explanation behind that can be the increase of the minimal wage by about 34% since the year 2000
(Eurostat, 2011). As the average salary was growing, government was pulling the minimum and
hence the non-taxed part of the wage up too. As a result, increasing incomes of the citizens had
mostly no effect on the government receipts.
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3.3. SECOND MODEL ANALYSIS
The second regression analysis results are presented in the Table 3. One can see that all
coefficients are statistically significant at 10% significance level and Uneployment variable is
significant at 1% significance level. The signs of the coefficients go in line with the economic
theory, which argues that GDP growth as well as increasing imports are going to generate additional
revenues to the budget and hence decrease its deficit.Incresing unemployment on the other hand
would be affecting public finances negatively. The imports variable which was insignificant in the
previous regression was not removed from. That was done on purpose, as one can see now that after
removal of three other variables Imports are actually explaining some part of the deficit fluctuation.
Table 3. The second linear regression coefficients.
The fit of the whole model is measured by the R squared coefficient which practically has
not changed and is now equal to 44% (see Table 4). It means that removing additional variables was
the right decision, because even without them the independent variables included in the model
explain quite the same part of the dependent variable variation. The generally admitted level of the
R squared is 25%, which means that the model is specified correctly and its results are of good
quality.
Table 4. The second linear regression summary.
The resulting regression equation can be denoted as follows:
budget_deficit = 1441,48 + 1,213 ∙ GDP_St – 264,69 ∙ Unemp + 1,24 ∙ Imp + μ
3.4. PROPOSITIONS
The goal of this section is to introduce real world fiscal decisions which would allow Ireland
to correct its deficit, bringing it back to the threshold level of three percent required by the
European Union. Qualitative propositions must have several desirable features. First of all, they
have to be executable in a sense that their implemention could start this or at least next year.
Suggesting only theoretically possible decisions may look good on the paper, however, will not
bring any real use to the decision-makers. Second, they have to correct the problem. Ireland’s
deficit in 2010 was 32% of the GDP. Therefore, suggesting only marginal changes to the deficit rate
32
might help in the short-term, but will not resolve the issue and will leave the situation in
unsustainable state. Third, the propositions must have strictly determined time frames. Once again,
suggesting measures that would help in the distant future might be useful from the theoretical point
of view, however, will not correct the situation requiring imediate attention.
For the propositions to have all the features mentioned above, several methods will be
employed. First, they will be based on the situation analysis presented in the first chapter of this
paper. This will ensure their most close relationship with Ireland’s current economic position.
Keeping the propositions in line with the economic conditions is crucial for them to be up-to-date
and specific. Second, the theoretical background described in the second chapter will assure the
academic quality of the decisions. For example, one might keep in mind the effect of the automatic
stabilizers and thus try not to tighten fiscal stance excessively, which would actually worsen the
recovery prospects of Ireland. Third, the regression analysis introduced in the beginning of this
chapter provides some further insight in the relation of different economic areas to the budget
deficit. Prioritization of the suggested measures will be made according to the results of the
regression. All in all, proposal of the most effective fiscal measures should be well-weighted and
backed by strong arguments.
3.4.1. INCOME TAX
The income tax system in Ireland is progressive, meaning that at some level of income the
tax rate becomes higher. Moreover, some low incomes are subject to tax exempts. The base for the
former has been eroding during the “rich” years, when the borderline between standard and higher
taxed incomes was increased and more exempts were introduced. As a result, according to the latest
calculations more than 45% of all population is out of the income tax base (see Table 5).
Table 5. Distribution of Income Earners 2004-2010.
Source: The Stationery Office
This situation is clearly unsustainable and it is merely impossible to introduce any new or
higher taxes on the taxpayers when such a large part of the population is enjoying exempt havens.
Therefore, the first suggestion for the income tax would be the increase of the tax base and more
even distribution of the tax burden among population. This could be done through abolition of
reliefs and incentives. As the regression analysis suggests, the income (proxied by the employment
and wage) related tax is the one most affecting the change in the deficit. Thus, naturally, it should
33
be adressed with the fiscal measures first and foremost as it has a potential of generating the
highest returns for the budget.
3.4.2. VALUE ADDED TAX
The value added tax is an indirect tax which is incorporated in the price of the goods sold
instead of being paid directly as a separate item. That is why increase in it is believed to be less
damaging economically. Increasing the VAT even by marginal figures could generate substantial
returns because VAT is the second largest government reciept. At the same time because of its
broad range of application (being in principle a tax on all goods consumed), VAT would not create
excessive pressure on any particular area, thus distorting the economy. The only area where it could
actually have negative consequences is the labour intensive and low margin industries, such as
mining, as additional VAT could diminish the profitability of that industry and create
unemployment problem. However, in Ireland these sectors are already treated by lower rate of VAT
exactly because of the presented logic. Consequently, the proposition would be to left VAT
unchanged, where this could be justified by underlying economic logic and increase it everywhere
else.
This argument is further supported by the example of other members of the EU. According
to Eurostat data, VAT is 19% or higher in 23 countries (out of 27) and has been increased in many
of them during the crisis. Particularly, United Kingdom has introduced tax rate of 20% from
January 2011. In Ireland VAT is currently 21%, thence further increase to 22% or even 23% could
be implemented. In the regression analysis consumption did not show any statistically significant
effect on the budget deficit formation, however, this might be due to its correlation with other
variables and hence can be attributed to the research specification. As such consumption is
predicted to be economically linked to the VAT revenues and therefore increasing VAT is a right
thing to do for the budget deficit correction.
3.4.3. CORPORATION TAX
The corporation tax is believed by the Irish government to be the “international brand of the
country” (The Stationery Office, 2011). That is why no changes should be made to it. As the first
chapter of the paper has argued, corporation tax is very sensible to any changes and only its
extremely low rate allowed Ireland to attract so much foreign business into the country. Because of
the mobility of the capital and the globalized nature of many businesses even slight changes in this
tax rate may cause companies to leave Ireland, thus not helping to correct budget deficit but quite
the opposite – bringing the country even furhter down.
The only thing about taxation of the corporate sector that actually can be made without
painful consequences is the abolition of the reliefs for local manufacturing companies which was
introduced through the last three years. A special tax rate of 10% was created for this sector, and
one might argue that it has served well allowing Irish business to gain cost advantage and partly be
the reason of the export driven growth ongoing in Ireland this year. What is important, the
consolidation of this sector with other businesses will be most likely met with the approval by the
broad public and thus will not create any political disturbances.
34
What is more, Ireland has actually managed to redirect the revenues from the corporation
tax to the research, creation of intellectual property and start-ups even during the crisis years. The
proposition would be to keep this course further on, as it is exactly the technological and intellectual
advantage that can help to rebuild the country and be its distinctive and attractive feature creating
the further growth.
3.4.4. NEW TAXES
The introduction of the completely new taxes has some limitations due to possible costs. In
most cases a new tax would require formation of the base for this tax, development of the collection
mechanism and legislative incentives etc. All together it could actually overweight the possible
revenues from the tax. Despite that, two new taxes can be suggested for Ireland and one can claim
that their introduction will be economically viable.
One of these taxes could be the tax on land. It has several advantages, such as, the base for
the tax is well-known, as the cadastre includes all the information needed and can be easily adjusted
for the fiscal needs. Moreover, tax cannot be somehow evaded as the land cannot be transferred to
other country or manipulated by the means of accounting. From the social and political point of
view it would be a tax on excessive assets, as owning land is definitely not the first order need.
Thus, besides being easily implementable, this tax would generate substantial revenues for the
government. As the recent survey by the Irish government suggest, this tax would generate about
530 million euro in the first year of introduction (The Stationery Office, 2010). What is more, this
tax is believed to decrease instances of the housing bubbles, such as the one that hit Ireland in 2008,
by making investment in the real estate for speculative purposes less attractive (Wetzel, 2004).
The other possible revenue source is so-called green taxes. One of them is now widely
advocated carbon tax which taxes the amount of the carbon emission. The carbon is considered to
be negative externality, which cannot be controlled by the market (Harvey & Gayer, 2008). That is
why introducing an indirect tax on the carbon would not only improve government budget balance,
but also serve socially desirable goal of cleaner environment. The idea behind this tax would be to
fix pressured budget at the same time creating external benefits. The tax rate of 15 euro per tonne of
the CO2 was suggested by the 2010 budget. However, further increase by 50% to 100% can
actually be justified. Once again, the Stationery Office calculations assume about 330 million euro
of annual revenues from this tax.
3.4.5. EXPENDITURES
From the expenditure part of the budget the Irish government could introduce several
measures, which would correct the budget deficit. The main principle in cutting cost without
affecting pace of the economic recovery is to focus on increasing effectiveness. Such areas as public
services staff expenditures can be cut significantly without major impact on the growth levels. On
the other hand the level of investment in education, enterprise or innovation should be maintained at
the same level.
The reduced by 5% to 10% staffing levels are projected to generate around 1 billion euro in
expenditure reduction. The key issue here is to maintain the quality of the public services with
35
limited number of workers. A suggestion would be to move towards consolidating different
organisations in more generalized departments, which would provide a wide range of services but
save on the administrative costs. This policy was partly followed during 2009 and 2010 and should
be pursuited further on. The level of public staff education could be increased as well as their
mobility and cross sectoral awareness, which would allow to centralize many functions in hands of
fewer organizations and agencies.
The concept of the eGovernment could adhere in this process, as many functions could be
automated. The argument for this approach is that Ireland has already done some steps in that
direction before the crisis. That is why further broadening of this tool will not require high
additional costs.
36
CONCLUSIONS
The aim of this paper was to suggest fiscal policy options for Ireland, which would allow it
to correct budget deficit. In order to do that, several objectives have been stated and completed
throughout this work. The result of that will now be presented in the conclusions part.

Irish budget is a broad spectrum document package which is developed by the
Department of Finace and is covering many public finance topic for the period of
the next three years. It presents a number figures as well as comments and
suggestions from the government authorities. The expenditure items of the budget
are divided in 41 positions and banded in voting groups. This structure provides
better understanding of the government goals and routes of the financing. The
receipts of the budget mainly come from the taxes which give 92% of all revenues.
The division of the taxes by type allows to link every one of them with the particular
area of economic activity. This is further used in the paper, when the regression
analysis researches effect of the certain economic factors on the budget change.

The current economic situation in Ireland is described by several indicators. The
GDP figure demonstrates a significant growth in 1995-2007 and a following
recession caused by the world financial crisis and the burst of the housing bubble.
The debt crisis in 2010 added further diffuculties to the national development and
only the beginning of the 2011 suggests a possible change of the trend. The labour
market is described by period of low and stable unemployment prior to crisis and a
steep pick in 2008-2010; the strong relation of the employment to the public finance
and a general importance of the employment for the government authorities make
this indicator of particular interest for this paper. Several other areas are presented in
the sitaution analysis part introducing the general background of the country and
setting the fields of the research carried later on.

Theoretical model presented in the second chapter gives further insight in the nature
of the relation between budget deficit and fiscal policies. Analyzing fiscal measures
through the prism of IS/LM model provides the better understanding of the
automatic stabilizers, discretionary measures and budget deficit to debt relations.
The theory of the statistical research argues why the regression analysis is useful in
this particular case and also underlines several assumptions and limitations
important for the research.

The regression analysis tests the actual impact of the economic factors on the budget
deficit. The results of the research require to remove some variables, that is why the
second regression is tested. Three independent variables left are confirmed to be
important for the budget deficit change and further fiscal policy propositions focus
on the ways to tax these three areas. The overall model fit of 44% argues that the
regression is constructed correctly and that the results can be trusted.
37

The propositions in the end of the third chapter are actually answering the question
what shall the Irish government do. The measures suggested there cover all areas
admitted to be important in the regression and several others, which are believed to
be implementable and helpful. The plan if accepted would most likely give the
desired results in the period of three years, thus allowing the country to get back in
line with the EU Growth and Stability Pact.
38
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APPENDICES
41
LIST OF APPENDICES
1.
Voted current expenditures, 2010 and 2011 (forecast)
2.
Correlograms of GDP, Unemp, Av_W, Cons, Prod & Imp variables.
3.
Correlograms of GDP_St, Unemp_St, Av_W_St, Cons_St, Prod_St & Imp_St
stationarized variables
4.
Correlation matrix for independent variables
42
Appendix 1. Voted current expenditures, 2010 and 2011 (forecast)
Source: Stationery Office
43
Appendix 2. Correlograms of GDP, Unemp, Av_W, Cons, Prod & Imp variables.
44
Appendix 3. Correlograms of GDP_St, Unemp_St, Av_W_St, Cons_St, Prod_St & Imp_St
stationarized variables.
45
Appendix 4. Correlation matrix for independent variables.
46