Chapter 1: Overview and General Policy Strategy

Available evidence supports the conclusion that the Irish economy weathered the pandemic very well. The phasing-out of temporary budgetary supports during the spring of this year, for instance, did not result in any negative fall-out in the labour market – employment in the second quarter reached its highest level ever, while the unemployment rate fell to just over 4 per cent over the summer, an extraordinary rebound in such a short timeframe. Data also confirm no major uptick in the rate of corporate insolvency while, importantly, the domestic banking system emerged relatively unscathed from the pandemic. Overall, therefore, the macro-data suggest little evidence of any permanent (‘scarring’) damage to the productive capacity of the economy, with domestic economic activity in the second quarter of this year nearly 10 per cent higher than its level immediately before the pandemic.

Budget 2023 is framed against the backdrop of an economy that is currently operating at close to full employment, but where near-term prospects have deteriorated. Like elsewhere, stagflationary pressures – weaker growth alongside higher inflation – are building, with the Irish economy now subject to its third supply-side shock since the turn of the decade.

The weaponisation of Russian natural gas supplies has triggered an exceptionally large energy price shock and undermined global economic prospects. For Europe – the epicentre of the energy crisis – the eight-fold jump in gas prices relative to historical norms has resulted in the highest rate of inflation in nearly half a century, prompting an aggressive pace of monetary policy tightening in the euro area (as well as in other advanced economies).

Wholesale gas prices increased further over the summer, as countries attempted to replenish their stores – a ‘dash-for-gas’ – in advance of the European winter. Prices were also impacted by the reduction in supplies through the Nord Steam pipeline, with flows reduced to one-fifth of normal at end-July, and fully withdrawn from early-September.

While Ireland does not source natural gas directly from Russia, end-users nevertheless pay global prices. As a result, domestic inflationary pressures have intensified in recent months, further eroding the purchasing power of Irish household incomes.

At the same time, the rapid pace of monetary policy normalisation has resulted in higher borrowing costs for domestic households and firms, with market participants pricing in additional policy rate increases in the months ahead. This is an additional drag on the Irish economy.

Against this very difficult background, and alongside a deterioration in sentiment, the department’s projection for domestic economic activity in 2023 has been downgraded significantly. Modified domestic demand (MDD) is now expected to increase by just 1.2 per cent next year, a 2.7 percentage point reduction relative to the spring forecasts.

Downside risks dominate, with the potential to make a difficult situation even worse. For instance, the projections are calibrated on the assumption that the economic fall-out from the withdrawal of piped gas supplies to continental Europe is relatively contained inter alia via mandated reductions in demand and the shift to alternative energy sources. However, a particularly severe European winter could exacerbate the demand-supply imbalance, triggering more prolonged ‘outages’ across the continent and necessitating cuts to production. By further reducing activity in key external markets, this would be an additional headwind for the Irish economy.

In addition, discussions are resuming on arrangements for implementing the Protocol on Ireland and Northern Ireland within the EU-UK Withdrawal Agreement. It is also the case that the UK authorities have again postponed the date at which regulatory and other checks will be applied to imports. Notwithstanding current tensions, these forecasts assume no major disruption to bilateral trade with the UK.

In response to falling real disposable incomes, the government has mobilised substantial fiscal resources to support households. The key objective of Budget 2023 is to build on this approach.

An overall budgetary package of nearly €7 billion has been provided for next year, including adjustments to income tax bands and increases in transfer payments, such as social welfare and pension rates. Complementing this is a set of one-off measures amounting to just over €4 billion, which take effect from the final quarter of this year. This approach balances the need to provide necessary fiscal support to households and firms while, at the same time, avoiding a situation in which the government’s fiscal response becomes part of the inflation problem.

The National Development Plan 2021-2030 and Housing for All are also integral parts of the government’s overall fiscal strategy. The objective is to boost the economy’s stock of infrastructure and of housing, eliminating bottlenecks and laying the foundations for future improvements in living standards.

Government is also providing for €2 billion to be transferred to the National Reserve Fund this year, with €4 billion transferred next year. The purpose is to ensure that windfall corporate tax receipts are not used to finance permanent increases in public expenditure. This transfer is in line with the advice of almost all agencies – domestic and international – that provide economic advice to the government.

In designing its budgetary policy response, Government is conscious that there is a limit to what it can do to offset the impact of higher external energy prices; Ireland is a net energy importer and the upward shift in prices means that the country as a whole is worse-off than it would otherwise have been. The most important economic lesson from the energy price shocks of the 1970s / 1980s is that trying to use the public sector balance sheet to fully shield the household and corporate sectors from higher imported energy prices is doomed to failure.

Beyond the short-term, Government is conscious of possible longer-term structural shifts, ushered in by a combination of a global pandemic and war on European soil. For instance, higher inflation in Ireland and elsewhere may be symptomatic of a wider regime-shift, particularly if some of the factors that kept a lid on inflation in recent decades were to go into reverse. This would mean inter alia permanently higher borrowing costs.

In addition, the apparent structural change in energy markets has highlighted the risks associated with reliance on fossil fuel imports to meet Ireland’s energy needs. Higher prices for gas and oil will undoubtedly act as a catalyst to accelerate the transition to cleaner energy sources, but the transition will clearly be difficult in the short-term. The shift to greener technologies over the medium and longer-term will have implications for production and consumption and, hence, for the allocation of resources (workers and firms within the economy). It will also affect the State’s revenue stream, for instance through a reduction in excise duty receipts.

The near-term outlook for the economy has deteriorated relative to expectations in the spring. Inflationary pressures have intensified, squeezing household income, while heightened uncertainty has prompted higher savings from disposable income than was initially assumed. For firms, earnings in parts of the small- and medium-sized enterprise (SME) sector are coming under pressure, especially those operating in energy-intensive sectors. Perhaps most exposed are those SMEs operating in sectors relying on discretionary household spending, given the likely prioritisation of essential expenditure in the period ahead.

Incoming economic data suggest some loss of momentum over the summer, and most forward-looking indicators are pointing to a softening of economic activity in the second half of the year. Higher fuel bills over the winter, partly offset by government supports, will likely tip consumer spending into negative territory in the third and fourth quarters of the year (table 1) and in the early part of next year. Discretionary consumer spending appears most exposed, as households prioritise essential spending.

Table 1: Key macroeconomic variables – quarter-on-quarter, per cent change (unless stated)

Against this backdrop, the department’s projection for MDD growth next year incorporates a significant downward revision relative to its spring forecasts. For next year, MDD growth is projected at 1.2 per cent (2.7 pp lower than in the spring). This follows an assumed expansion of 7.7 per cent this year (table 2); this is an upward revision (3.4 percentage points (pp) higher than in the spring) and mainly reflects ‘carry-over’ effects. For exporting SMEs, weaker external conditions will likely weigh on demand; however, demand for higher-technology goods and services produced in Ireland by the multinational sector is assumed to remain strong, supporting GDP growth in both years.

The rapid rebound in the labour market is undoubtedly the most positive post-pandemic economic development. The level of employment reached 2.55 million in the second quarter, its highest ever, with unemployment falling to just 4.4 per cent in the same period. That said, higher frequency data suggest some moderation in labour demand in more recent months.

The baseline scenario set out in this document is one in which the labour market fall-out from a slower pace of output growth is relatively contained. This rests on the assumption that some of the labour market adjustment to more modest levels of economic activity takes place via a reduction in the number of hours worked. As a result, the projections assume the unemployment rate remains relatively low next year, albeit rising moderately relative to this year. A deeper, or more prolonged, downturn would clearly have serious additional consequences for the labour market.

Inflationary pressures have intensified in recent months, with energy prices the key driver. While other commodity prices also increased in the immediate aftermath of the Russian invasion of Ukraine, these have subsequently retreated somewhat. The acceleration in inflation, however, is far from being solely an energy price shock: the more generalised mismatch between demand and supply means that inflationary pressures have broadened. For instance, the latest data show that annual price increases for 80 per cent of the goods and services in the inflation basket are in excess of 5 per cent. On foot of this, consumer price inflation in Ireland, and elsewhere, has reached its highest level in almost half a century.

For this year, inflation is now projected to average 8.5 per cent. The department’s current assumption is that inflation will peak at 10.4 per cent in the final quarter of this year, but will ease only gradually over the course of next year. This projection is conditioned on the assumption of a modest easing in natural gas prices from the spring next year (as currently envisaged in futures markets) as well as a better balance between demand and supply in the wider economy. An average inflation rate of 7.1 per cent is anticipated for next year.

The key question is whether the economy is in line for a period of weaker growth or whether an outright recession is in prospect. While this is difficult to answer, it is important to recognise that the domestic economy is in reasonable shape, with few of the imbalances that characterised the situation in the mid-2000s. For instance, household and SME balance sheets are in a fairly solid position, at least in aggregate terms. If short-lived, therefore, the energy shock can probably be absorbed without excessive economic fall-out.

That said, the presumption of a short-lived economic shock is far from assured. For instance, the tightening of monetary policy could be more aggressive than assumed, reducing household and SME incomes by increasing debt-servicing costs. Moreover, there are reasonable grounds to believe that a structural change in energy markets is underway – the era of cheap fossil fuels may have ended. So, while the inflation rate is assumed to ease gradually over the course of next year, the price level will likely remain higher than households and firms have been accustomed to. Permanently higher fossil fuel prices could render the business model of some firms unviable, prompting higher rates of firm exit in the period ahead.

Turning to the public finances, tax revenue performance in the year to date has surprised on the upside. In the year to end-August, total tax receipts amounted to €49.8 billion, an increase of 26 per cent over the same period last year. Annual comparisons are, however, distorted by the timing of ‘lockdowns’ and the tax policy responses (such as tax warehousing) over the course of last year. Corporate tax receipts have been especially strong this year; that said, the maintenance of corporate tax revenue at current levels cannot be guaranteed into the future.

Table 2

For this year, tax revenue is now projected at €81.6 billion, with corporate tax receipts accounting for around a quarter of this, an exceptionally high level. For next year, taking into account the discretionary measures announced by the Minister for Finance as part of Budget 2023, as well as the baseline economic scenario set out in this document, tax receipts are projected at €87 billion.

Total (voted) spending is projected at €90.1 billion this year, composed of €80.8 billion of ‘core’ (or permanent) measures alongside €9.3 billion of temporary (COVID, Ukraine and cost of living) measures. For next year, the Government Expenditure Ceiling is set at €90.4 billion (€85.9 billion permanent, €4.5 billion temporary).

A general government surplus of €1 billion (0.4 per cent GNI*) is projected for this year. This headline surplus flatters the picture: excluding estimated windfall corporate tax receipts, the deficit would be €8 billion (3.1 per cent of GNI*). For next year, the general government surplus is projected at €6.2 billion next year (2.2 per cent of GNI*). Excluding estimated windfall corporate tax receipts, the deficit would be €3.8 billion (1.4 per cent of GNI*).

Public indebtedness next year is projected at €224 billion; pre-pandemic this figure was closer to €204 billion. Sovereign borrowing costs have risen as the cycle of monetary policy tightening has gained pace; while the cost of borrowing is still relatively low, it is also the case that the quantum of public debt has never been higher. While Government does not need to finance a deficit – at least under the baseline scenario – a large volume of existing debt falls due in the coming years and this will need to be re-financed.

Finally, Government is conscious that, beyond the short-term, the public sector balance sheet is vulnerable on a number of fronts.

Firstly, the aggressive pace of monetary tightening – involving higher policy rates and the exit from ‘quantitative easing’ – has raised sovereign borrowing costs. There are solid reasons to believe this is a structural, or permanent, shift, rather than a temporary, or cyclical one.

Secondly, exceptionally high corporate tax receipts flatter the headline fiscal balance and mean that the budgetary accounts are exposed to changes in firm-specific conditions. The continuation of corporate tax receipts at current levels is not a one-way bet, and recent history demonstrates how rapidly the public finances can change when confronted with the loss of a key revenue stream. This is why the government is transferring money to the National Reserve Fund.

Thirdly, an ageing population will involve significant fiscal costs simply to ‘stand-still’ – by the end of this decade, changes in the population structure will necessitate an additional €8 billion in public expenditure each year simply to maintain existing levels of service.

Finally, the need to finance the transition to carbon (net-) neutrality will involve significant public outlays as well as lower public receipts in the years ahead.