Challenges ahead for Ireland’s economy

Thanks to Maria at Crooked Timber, who hopefully will find time to take a detailed look at the report, I can note the Organisation for Economic Co-operation and Development Economic Survey of Ireland, released yesterday., which, among other points, makes recommendations on the fiscal framework, the housing market, removing obstacles to employment for women, closing the infrastructure gap, encouraging research and development, reforming all levels of education, increasing competition, and, most importantly, the key challenges for the economy in the near future – Executive Summary available hereOn the Fiscal frame-work the survey recommends –

Ireland has elements of a medium-term fiscal framework, especially with its rolling five-year capital expenditure envelope and its ten-year transport plan. Although the budget process has some top-down aspects, they need to be given more prominence relative to the bottom-up negotiation process. Ireland should take advantage of its current strong growth phase to strengthen the fiscal framework in order to prepare for negative fiscal shocks and to deal with them if they were to occur. Moving to a fully-fledged top-down budgeting process would help expenditure planning and control while a medium-term fiscal framework, as is in place for the multi-year capital envelopes, would give greater stability to policy and planning for other spending areas and would reduce the chances of repeating the sort of pro-cyclical spending that occurred earlier this decade.

The search for productivity improvements should also extend to the public sector. While Ireland is modernising its civil service, it needs to move faster to catch up with best practice. One requirement is to shift the focus of the budget and public management towards outputs instead of inputs and the government has announced that individual ministers will publish an annual statement on departmental outputs and objectives from 2007, while also reporting outturns from 2008. Hiring and promotion practices need to be modernised by moving to fully competitive and merit-based promotion and giving department managers greater freedom to recruit their own staff. Increasing demands on the public purse mean that the evaluation programme and value-for-money assessments will need to be improved. The expenditure review programme has had little success so far, with little impact on budget decisions. Recent changes to the process should improve things, however. The government has decided to phase out several property-related tax reliefs and to cap the overall amount of tax reliefs granted to an individual. Remaining tax reliefs should remain under scrutiny and be removed unless they can be shown to be worthwhile.

The Survey suggests two worrying scenarios for the Housing Market as possible alternatives to the most likely one –

Thus, the most likely scenario is that prices will level out or decline slightly, housing construction will fall back gradually, turnover will decline and the market will remain subdued for some time. But even in such a scenario, government receipts would weaken sharply, so that a substantial structural budget deterioration would come on top of any cyclical weakening.

While this is the most likely outcome, there are alternative scenarios on the upside and downside that could have significant macro-economic implications. The first is that the housing boom may not run out of steam of its own accord, leading to serious overvaluation and imbalances throughout the economy. The eventual fall-out in this scenario could be severe. With monetary policy now set by the European Central Bank, taxation is the main policy lever left to influence the housing market. Ireland’s tax system is significantly more favourable to housing than in most other OECD countries. To avoid the chances of this scenario unfolding, the government should avoid any tax changes that make housing more attractive; indeed, the tax bias should be phased out over time. Aside from not fuelling the housing market, there are efficiency and equity reasons for reducing the tax advantages. A property tax could be introduced to help fund local infrastructure. This would also redistribute some of the windfall gains that accrue to people living close to new roads and public transport links and shift the cost for local services such as water and sewerage facilities so that businesses and households each pay their fair share. While this makes economic sense, in an Irish context where over 80% of the population own their own homes, it is currently seen as a non-starter. The second scenario is that house prices fall sharply, either because they are more overvalued than they appear or because a negative shock hits the economy. The impact on activity and the budget could be large.

On improving competition there are a couple of important points made, notably –

The main problem in the telecoms sector is the slow take-up of broadband. This may be caused by insufficient competition. Eircom, the telephone incumbent, dominates the market and is dragging its feet in opening up the local loop. The regulator should fast-track this process.

THe OECD Survey identifies the following as key challenges ahead –

While incomes have caught up with the European average, there is still room for further progress. To maintain a dynamic economy, Ireland faces challenges that are common to many OECD countries:

– First, productivity growth will need to remain high since this is the primary determinant of living standards in the long term. The country’s remarkable productivity performance will become harder to sustain as activity shifts towards more labour-intensive services. Boosting competition will be important for meeting the productivity challenge, as will improving the education system and strengthening the research framework.

– Second, there is room to increase labour supply further. The main avenues here are to continue to attract immigrants – especially the highly skilled – and to facilitate the participation of women and older workers.

There are also some issues that are more specific to the Irish situation. The country’s infrastructure has come under severe pressure due to the extraordinary growth in population and economic activity. Bottlenecks have emerged that are imposing costs and may be acting as a brake on growth. The country is also going through a transition period during which it is upgrading many of its social services. The choices made here can affect other policy objectives in positive and negative ways. For example, better childcare and healthcare facilities would make Ireland more attractive for migrants with families. However, poorly designed and overly expensive welfare policies can reduce labour supply and drive up tax rates over time. Policymakers also face macroeconomic risks. As one of the OECD’s more open economies, Ireland is especially vulnerable to external shocks. But it also faces domestic risks. The most obvious of these concerns the housing market, but there is also a more general danger of the overall wage and price level overshooting its equilibrium level. Exports, foreign investment and immigration would all be harmed if Ireland priced itself out of the market. In this context, pursuing a prudent fiscal policy, strengthening the medium-term fiscal framework, enhancing competition and containing wage pressures via the centralised wage-bargaining framework will all be important.

In particular the Executive summary notes the following points –

Maintaining high rates of productivity growth. As Irish activity comes to rely less on foreign firms and more on home-grown services, productivity gains will become harder to achieve. The main areas where policy could make a difference in sustaining productivity growth are:

Boost competition. There are too many sectors where producers are shielded from competition, raising prices and stifling growth. Reforms are needed in the electricity and telecom sectors, and unnecessary restraints in services such as law, pharmacies and the pub trade should be removed. In the retail sector, the government’s decision to abolish the Groceries Order is welcome.

Improve education. Funding is still an issue in universities. One option is to re-introduce tuition fees, but backed by an income-contingent loan scheme. In secondary schools, the key challenge is to target resources on students who are struggling.

Encourage innovation. The science framework needs to improve before public spending is increased further. The many funding agencies could be amalgamated or better co-ordinated; public support could shift towards market-driven measures; and resources should not be spread too thinly.

Upgrade infrastructure. Rigorous cost-benefit analysis of infrastructure projects, including those in the ten-year transport plan, should play a greater role in decision-making than has been the case in the past. Moreover, an increasing number of projects should be financed by users.