Fiscal Policy in Post-Independence Ireland

Richard Doyle - Junior Sophister

At the beginning of Ireland's independence fiscal policy was the means to a balanced budget. Over the years, the role of fiscal policy was broadened before diminishing in later decades. Richard Doyle traces the evolution of fiscal policy in post-independence Ireland and concludes that there is little opportunity for a return to an active fiscal policy.

Introduction

As a newly independent country, Ireland gained sovereignty over economic policy from 1922. One instrument of economic policy, over which it gained control, was fiscal policy. This can be defined as any change in the level, composition or timing of government expenditure or any change in the burden, structure of frequency of taxation. The topic of fiscal policy covers many important aspects of the Irish economy. This essay will trace the evolution of fiscal policy over the years 1922 to 1998. It will concentrate primarily upon government expenditure given its greater prominence within the realm of fiscal policy, but will also highlight aspects of taxation that warrant attention. The essay will not concern itself so much with the level of expenditure relative to GDP nor the absolute levels of taxation or expenditure. Rather, it will concern itself with the background to, expectations of and consequences of fiscal policy. The coverage of fiscal policy, government intervention, taxation and economic history is implicit throughout the essay, while the aspect of European integration will be dealt with in an analysis of the future of fiscal policy. Using the headings as a guideline, the essay will examine the thrust of fiscal policy in post-independence Ireland. In particular, it will show the rise and fall of fiscal policy as a policy instrument over this period.

The Balanced Budget

Cumann na nGaedhael provided the first Free State government. It came to power in 1922 and remained there until 1932. Given the political upheaval, which provided the background to its reign, the government's overriding objective was to ensure political stability for the fledgling state. Accordingly, economic policy did not change dramatically. In addition to this, Cumann na nGaedhael's support was from big farmers whose needs were low taxes and a corresponding low level of social services. This shaped the background to the party's fiscal policy.

Under Cummann na nGaedhael, public expenditure reached its peak at 39m in 1924 and declined thereafter to 25m in 1930. This mirrored the trend in taxation, which fell from 30m to 24m over the same period. This ensured a slight imbalance in the budget, though the commitment to the balanced budget was beyond doubt. In 1924, Industry and Commerce minister, McGilligan said that:

"It is no function of the government to provide work for anyone...people may have to die in this country and die through starvation."

This statement is indicative of the government's view that intervention in the economy to provide jobs or social services was well outside the remit of fiscal policy. The government's fiscal policy was aided by the prevalence of emigration at the time. As better welfare services were available elsewhere, the government was under less pressure to engage in welfare expenditure here.

Given the desire to restrain public expenditure, taxation was kept low. This was motivated to an extent by the State's determination to show her erstwhile mistress, Britain, that Ireland was capable of fiscal discipline. It was also motivated by a desire to minimise the costs to export industries by low taxation as well as the hope that Anglo-Irish capital would remain in the country. As an example of the commitment to low taxation, income tax was reduced from 5s to 3s in 1926. As this was 6d less than England, it must have created a good impression there. In those days, income tax accounted for only 20% of total tax with the remainder coming from customs, excise and indirect taxes. Farmers were favoured by the tax system: in 1926 agricultural land was derated, while farmers paid little or no tax.

The fiscal policy of the government between 1922-32 ensured a balanced budget. This helped stabilise the embryonic state. The taxation structure favoured the established, while the refusal of the government to spend significant amounts of social expenditure resulted in hardship for many, such as pensioners.

A Broadening of the Perspective

The next twenty years saw a widening of the parameters, within which fiscal policy operated. The new government of Fianna Fáil came to power in 1932. With it came a broadened fiscal policy. The government followed the world-wide trend and its own ideology by erecting tariffs. Aware that the outgoing government had lost popularity due to its austere limits on social expenditure, the new government aimed to increase those limits. However, this would not unbalance the budget as the state was prepared to raise tax levels too.

Illustrative of the government's fiscal intentions was the decision to exclude Sean MacEntee, Minister for Finance and self-proclaimed upholder of fiscal rectitude, from the Economic Committee. The thirties saw decisive increases in social expenditure. Between 1932 and 1942, 12,000 houses a year were built while both unemployment assistance and old age pensions were increased. Though Keynes's speech at U.C.D in 1933 may have tempted some, his alluring claim that government money spent "would make unnecessary any dole" was resisted. The harsh conditions caused by the economic war and the tightening of the immigration laws in America may also have influenced the government's fiscal policy, particularly its social expenditure. As a result of the taxation increases offsetting the rise in expenditure, the aggregate of current budget deficits was a mere 16m in 1946.

This low aggregate is also partly due to economising during the war. The Department of Finance saw the war as an opportunity to restrain expenditure, which only increased from 48m to 64m during it, while it decreased as a percentage of GDP. The main reason for this economising, however, was Ireland's low defence expenditure. Despite this, there were suggestions that fiscal policy could be raised to a new level. Professor Smiddy, de Valera's economic advisor made the bold suggestion of an unbalanced budget, while Lemass favoured an expansionist policy. Indeed, 1946 saw the establishment of the departments of health and social welfare, as well as the introduction of children's allowances. The adherents to fiscal virtue stood firm, with MacEntee opposing such social expenditure, as it would necessitate higher tax, which he claimed would lead to "mass poverty and mass unemployment".

In 1950, there was an important change in the framework of fiscal policy. Popular demand for consumer and capital goods, as a result of the rationing during the war was strong and in that year the government recognised its responsibility to:

"promote by an enlightened budget and investment policy, the continuous and efficient use of natural resources of men and material".

This was the year of the State's first formal capital budget. Representative of the change was finance minister, McGilligan (he of 'the people may starve' quote) who claimed that the value of expenditure should be measured not merely in terms of social stability but also expanding national income. Significantly, capital expenditure was now to be financed by borrowing rather than current revenue.

Thus, the period 1932-51 ended as it began: with a small measure of fiscal policy expansion. Furthermore, the period showed influential people being converted to the potential of fiscal policy.

A Missed Opportunity?

The fifties are often regarded as a lost decade because of the huge number of Irish people who emigrated. It can also be seen as a lost decade in that fiscal policy could possibly have been used to great effect. Domestically, unemployment was rising and industrial output falling while external developments such as the Korean war and Ireland's balance of payments deficit exacerbated this. Unlike the seventies, Ireland's economy was relatively closed and the rest of Europe was booming. This was the background to the challenge facing fiscal policy, which could have taken an expansionary path.

However, it did not. As mentioned, the economy was relatively closed. Tariffs reached their highest level in the history of the state in 1956-7, thus continuing to supply a large proportion of tax revenue. From 1952, fiscal policy was highly deflationary, caused by a worry about Ireland's unfavourable balance of payment's deficit. Despite the depressed conditions, fiscal policy remained deflationary with housing expenditure being cut back. In 1952, income tax rose by a shilling, while price increases were imposed upon drink, bread and petrol. The policy of austerity continued in 1956 under Finance Minister Sweetman, who implemented additional taxes.

This deflationary policy served to further accentuate the depressed conditions of the economy. Whitaker would later lament 1952 and 1956 as opportunities foregone in the context of demand management.

Innovation

The depression of the fifties meant that something had to change. Fiscal policy underwent a metamorphosis due to Whitaker's 'Economic Development', a landmark in Irish economic history. This document recommended tax relief to encourage foreign companies to Ireland, the abolition of tariffs and the embrace of free trade. Significantly, it recognised that fiscal rectitude alone wasn't adequate anymore and it recommended productive rather than social expenditure.

The next fifteen years proved to be ones of high growth, though what actually happened was that both productive and social expenditure rose, rather than just the former. Reflecting this, the early sixties saw both capital and current expenditure grow strongly. In the latter years of the period, Ireland's prosperity and growing population put pressure on public expenditure, yet the current balance remained intact. Tariffs fell due to Ireland's preparation for the EEC, "Economic Development" and the Anglo-Irish free trade agreement of 1965. The small tax base served to limit the scope of government expenditure, though this was addressed with the introduction of turnover taxes in 1960 and PAYE in 1963. Consequently, the period saw little borrowing.

The innovative nature of this period altered the perception of fiscal policy by widening its scope. However, as late as 1966, Lynch asserted that:

"No such justification for what is called 'deficit financing' exists in this country today".

Furthermore, Lee claims that Lemass's expansionism cannot be used to justify "later borrowing binges".

Activism

The Keynesian theory first expounded in Ireland in 1933 finally became endemic to Irish fiscal policy in the seventies. The consequences of this radical change in fiscal policy would be immense. The pressure of imminent EEC membership and a perception that the economy lacked buoyancy were prevalent at the time.

Thus, in 1972, despite the Central Bank's warning that a commitment by the trade unions to wage moderation was a prerequisite to expansionary fiscal policy, the government abandoned the convention of balancing current expenditure with current revenue. The planned current deficit of 1972 was 35m. The oil crisis of 1973 ensured the continuation of the expansionary fiscal policy and though taxation was increased it was insufficient to eliminate the deficit. This was because the Minister for Finance considered large tax increases to be inflationary, because of their impact on wage claims. At this stage, social insurance became compulsory for all employees, though farmers remained effectively outside the taxation system. The 1975 budget saw the introduction of a sum allocated for additional public service pay. This was the first occurrence of such an allowance. Tax reform was attempted with the overhaul of the income tax system in 1977, yet there remained a reluctance to raise taxes to the level necessary to eliminate the deficit. The realisation that fiscal policy was limited in the context of world developments became apparent in the mid- seventies, which was reflected in the tightening of fiscal policy in 1976 and 1977. If this tightening had continued, then the public finances would have been restored to health. Instead, an election and the consequent change of government in 1977 proved to be a watershed for fiscal policy.

The incoming government managed to outdo its election commitment to cut taxes and raise expenditure. Despite the prediction of rapid economic growth, a large fiscal stimulus took place. This was, in the words of Bradley et al:

"an unbridled pro-cyclical discretionary fiscal expansion".

The government was determined to compensate for the "massive underspending" of the previous government and did so by public service job creation and an increase in capital expenditure. Various indirect taxes were cut, while the lower interest rates reduced the cost of debt service, hence borrowing became more attractive. Despite the Central Bank's warning, no instrument to restrain pay was implemented, resulting in a doubling of public service pay between 1978 and 1981. By the time the second oil crisis occurred in 1979, fiscal policy had run out of steam, due to its pro-cyclical usage over the previous two years.

The seventies ensured the bankruptcy of fiscal policy as a policy instrument, because of its large deviation from a neutral stance. The shift of resources from the private sector to the public sector dented the economy's competitiveness. Whitaker recognised the problem by stating that, "only through a misunderstanding of Keynes" could the governments of the seventies have adopted the practice of financing current deficits as well as capital deficits by borrowing. In mitigation, one can say that even the best fiscal management during the turbulent seventies would not have prevented damage to the Irish economy.

Paralysis

The experience of the seventies effectively straitjacketed fiscal policy for the coming years, yet no measure in the eighties made any inroads into remedying this. In effect, fiscal policy had lost its discretion; it was now pre-determined by the fiscal imbalance.

Though the short-lived government of 1981 introduced a restrictive supplementary budget, the deficit remained stubbornly high at 7.5% GNP. The government's task was made more difficult by the climbing interest rates and debt service, which accounted for a large part of government revenue. This mini-budget was typical of governments of the early eighties in that taxation was increased but expenditure remained high. This fiscal policy failed because there simply was no revenue buoyancy. The reluctance to cut expenditure is understandable, yet would ultimately cost the economy; the finance minister's claim that such a policy of "harsh measures" could cause "severe hardship" ignored the reality of the time. The iron will to cut public expenditure was absent: in 1982, the political parties agreed that fiscal rectitude was essential, yet the date for the elimination of the budget deficit was postponed from 1986 to 1987. Furthermore, what cuts were made were in the area of investment rather than current expenditure.

Little progress was made on the fiscal deficit due mainly to the vicious circle of high taxation and depressed buoyancy. The years 1980 to 1987 merely saw a consolidation of the fiscal legacy of the seventies: paralysis.

Expansionary Fiscal Contraction and Stability

The last ten years have seen a restoration of the public finances. The background to this restoration was conducive to the task: the punt was devalued in 1986, oil prices collapsed and interest rates also fell. Thus, the government was able to cut its expenditure by 3%. A tax amnesty was granted in 1988, which resulted in a significant boost to the economy. This can be primarily attributed to the massive injection of confidence that the economy received from fiscal responsibility and also to the 'crowding in' effect. However, fiscal policy was relaxed with special pay awards to doctors and teachers, while increases in expenditure since 1991 have been hidden by revenue buoyancy. Nonetheless, current finance minister, McCreevy seems very aware of the dangers of repeating the mistakes of the seventies and eighties. This leaves fiscal policy with its integrity restored but in a limited state.

European Integration and the Future

Despite the slight relaxation of fiscal policy during the nineties, the future of Ireland as a European nation suggests that the days of fiscal policy as a policy instrument are gone.

Having ratified the Maastricht treaty in June 1992, the government is determined that Ireland will join Economic and Monetary Union (EMU) from the outset. Indeed, having comfortably satisfied the convergence criteria, Ireland is now, barring an unforseen disaster, a certain EMU founder member. One might argue that a government might exploit these criteria by maintaining a deficit close to the 3% limit. This is not viable as the cyclical nature of the economy ensures the necessity of running a low deficit or a surplus during a boom. Furthermore, if the government breaches the 3% limit, then it will be subject to the harsh fines of the Dublin summit stability pact. Hence, fiscal policy will be constrained to a large extent on the expenditure side.

Taxation may well follow. Neo-functional integration theory suggests that economic and monetary union will create an impetus for integration in related areas via the spillover effect. This would take the form of harmonisation of tax rates, bands and allowances. Indeed, it has already been proposed as a Franco-German initiative. It also seems likely, given the annoyance of other member states at discriminative measures, such as Ireland's 10% corporation tax rate for certain sectors of the economy.

Therefore, European integration suggests a bleak future for fiscal policy. The government will lose its ability to significantly alter taxation and public expenditure, thus ensuring the end of fiscal policy as an active policy instrument.

Conclusion

This essay has examined fiscal policy, in its guise of taxation and public expenditure, in Ireland over the post-independence years. In the beginning, the aim of fiscal policy was a balanced budget, regardless of the cost. Over the next forty years, the remit of fiscal policy was broadened gradually without ever embracing Keynesianism. When it did, its activism lasted for a relatively short period, the decade of the seventies. The misuse of Keynesian theory during this period effectively ensured fiscal policy's end as an active policy instrument. Fiscal rectitude returned after this abortive experiment, which ensured stability. A look to the future and in particular, European integration, suggests that no opportunity exists for a return to the use of an active fiscal policy.

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