Dr. Kieran McQuinn:

I thank the Chair for the invitation to the ESRI to appear before the committee. I am joined by my colleague Dr. Claire Keane. We are grateful for the opportunity to appear before the committee today to provide our views on the budgetary position.

In terms of Government budgetary policy, it is important to understand both the current and recent Irish macroeconomic context. The last number of years has seen the Irish economy perform particularly strongly, even after experiencing the impact of the Covid-19 pandemic. It is, of course, difficult to get an accurate understanding of the underlying pace of growth of the economy, especially as certain multinational-related transactions can cause significant distortions to headline economic indicators. In that context, it is worth reflecting on the recent contribution by our former colleague, Professor John FitzGerald, that seeks to estimate the underlying pace of growth in the Irish economy in the post-great financial crisis era. Professor FitzGerald indicates that the Irish economy has been increasing at somewhere between 4% and 4.5% over that period. This correlates with work carried out by the ESRI to address this issue. Presently, the Irish labour market is experiencing a degree of buoyancy unseen since the days of the Celtic tiger. The unemployment rate has been hovering around the 4% rate since May 2022 and employment creation has been significant over this period. The recovery in the labour market since the challenges posed by Covid-19, when unemployment was in excess of 30%, has been substantial.

Another indication of recent growth in the economy has been the strength of the public finances. After the Covid-19 shock, when the Government increased expenditure considerably to deal with the crisis, the general Government balance, GGB, experienced deficits of 5% and 1.6% in 2020 and 2021, respectively. However, since then the public finances have benefited from swift recoveries in income taxation, VAT and especially corporation tax receipts. In 2022, a surplus in the GGB of 1.6% of GDP, or €8 billion, was experienced, and this was after €2 billion was diverted to a special reserve fund, SPF, which we will discuss later. In the present year, the expectation is that a GGB of 1.8% of GDP, or €10 billion, will be achieved, and this is after €4 billion has been diverted to the SPF.

Notwithstanding the strength of the recent performance, it is now more than likely that the Irish economy will experience more moderate rates of growth. There are a number of reasons for this. Much of the post-Covid-19 growth performance had to do with the exceptional performance of the ICT and pharmaceutical sectors, sectors which have a significant presence in the domestic economy. While these sectors still perform well, it is highly unlikely that they will continue to sustain the rates of growth that characterised their recent performance. Therefore, as these sectors observe more modest rates of growth, this will be reflected in the domestic economy. Indeed, the current moderation in exports in pharmaceuticals and the global challenges in the ICT sector highlight the reliance of our overall growth on these key sectors.

In addition, recent ESRI research has shown that, after decades of falling income inequality, the latest data show a fall in income growth for the lowest 10% along with a stalling for others in the bottom half of the income distribution. This has been driven by a fall in work hours and months of full-time work per year, which suggests an unequal labour market recovery.

The immediate aftermath of Covid-19 gave rise to a significant degree of volatility in economic data because the periods of lockdown resulted in significant base effects whereby growth rates oscillated depending on the nature of Government restrictions up to a year previously. As we move beyond that period, the underlying pace of growth is more readily apparent.

Inflation is still exerting a negative impact on the Irish outlook. While the pace of price increases, which had peaked at over 9% in May 2022, has been declining on a persistent basis to its present rate of 6.3%, the decline has been somewhat more gradual than what many had originally envisaged. Energy prices are coming down. However, inflation is now being driven by other factors like food costs and housing costs. Higher rates of inflation act as a drag on domestic consumption levels, in particular as real household income levels are struggling to register positive growth.

Budget 2023 was unique in containing many one-off measures designed to provide relief to households experiencing strong cost-of-living challenges due to high inflation.

While budget 2023 met this challenge in a progressive manner, this was driven by one-off measures. Most permanent tax-benefit measures were either frozen or increased below the forecast inflation rate. This highlights the difficulties that will be faced in maintaining living standards when one-off measures expire.

Arguably a greater challenge at present is that posed by the response of monetary authorities to the inflationary period through increases in official interest rates. These have been substantial, with the official policy rate of the ECB increasing by more than 400 basis points in the past year. This constitutes a major degree of monetary tightening, which has also been observed in the United Kingdom and the United States. While it aims to curb inflation, it brings significant adverse side-effects as far as overall economic activity is concerned. These have been elucidated recently by contributions such as those of Ma and Zimmerman and Swanson, with investment in particular, and economic growth more generally, negatively affected. Rising interest rates across western economies inevitably have a contractionary impact on the global outlook through investment and consumption channels.

In a domestic context, higher interest rates will have negative implications for the housing market, where the cost of finance has increased significantly in the past year. There is a generally acknowledged deficit between actual housing supply levels and the structural demand for housing, the latter being determined by trends in demography and net migration. Increasing interest rates will have negative repercussions for the construction sector as the cost of finance is clearly an important consideration in housing supply. Increasing interest rates also pose affordability challenges for households looking to secure mortgage finance and this comes against the backdrop of continuously increasing house prices over the past ten years. The rising cost of finance will also pose challenges for other sectors of the domestic economy, including SMEs looking to access funding from debt financing. Recent research by Paul Egan, Conor O'Toole and Eoin Kenny has quantified these effects and notes the drag on activity caused by the higher rates.

The impact of rising mortgage interest rates will also differ across the income distribution. Work by the Central Bank may provide some reassurance as it shows that lower-income quintiles are much more likely to have a fixed-rate mortgage and are therefore less exposed to interest rate rises. Middle and higher-income groups, who may be more financially able to meet rising interest rates, are more likely to be exposed to interest rate increases due to a higher prevalence of tracker and variable mortgages among these income groups.

Another challenge on the horizon is the difficulties the Chinese economy is experiencing. While some believe that the present Chinese difficulties are somewhat transitory in nature, others such as Posen are less sanguine and suggest more structural issues are at play. In particular, the increasingly autocratic nature of the Chinese regime appears to be impacting consumer and producer confidence, with Chinese consumers and companies increasingly prioritising short-term liquidity over longer-term investments. This trend of saving rather than investing in the Chinese economy could result in less spending by Chinese households on technology goods and other durable goods which require imports, resulting in the Chinese trade surplus with the rest of the world continuing to grow. In that regard, it is worth recalling that Chinese growth was one of the main instruments of global recovery in the aftermath of the great financial crisis.

Finally, I will speak about the policy outlook. The present budget occurs at a time when the domestic economy is performing very close to capacity, but also at a time when it is likely to transition from a period of high growth to a more moderate pace of expansion. The substantial improvement in the public finances in recent years presents a certain opportunity for policymakers to address key infrastructural deficits in the domestic economy. In areas such as housing, healthcare and climate change, it is clear that significant investment by the State is required if infrastructural bottlenecks are to be addressed. Unfortunately, due to the higher interest rate regime we are now in, investment in these key areas by the private sector is set to be more expensive. This may entail the State having to incur greater levels of expenditure than had been previously anticipated. It is correct and prudent that a special reserve fund, SPF, has been established. This allows policymakers to differentiate the recent surge in revenues between those that are sustainable over the medium term and those that are more transitory or windfall in nature. This is particularly pertinent given that a large measure of the revenue surge is associated with increases in corporation tax receipts. Such transitory funds clearly should not be used to finance day-to-day current expenditure. At present, policymakers must be aware of stimulating the economy at a time of record low unemployment. Therefore, restraint is needed in other areas of fiscal policy in order to create the space for the investment that is necessary.

In particular, taxation policy must be particularly prudent if this risk is to be avoided. While our experience with managing and delivering large-scale investment projects has been problematic in the past, the present budgetary position is relatively unique in terms of the opportunities it presents. It will take a considerable degree of judgment and discipline in realising this opportunity while maintaining stable and persistent growth in the overall economy.