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Tithe an Oireachtais An Comhchoiste um Airgeadas & an tSeirbhis Phoibli An Ceathrú Tuarascáil Tuarascáil ar Bheartas Micreacnamaíoch agus Rialachas Éifeachtach Fioscach agus Eacnamaíoch Samhain 2010 _______________________________ Houses of the Oireachtas Joint Committee on Finance and the Public Service Fourth Report Report on Macroeconomic Policy and Effective Fiscal and Economic Governance November 2010 0 Tithe an Oireachtais An Comhchoiste um Airgeadas & an tSeirbhis Phoibli An Ceathrú Tuarascáil Tuarascáil ar Bheartas Micreacnamaíoch agus Rialachas Éifeachtach Fioscach agus Eacnamaíoch Samhain 2010 _______________________________ Houses of the Oireachtas Joint Committee on Finance and the Public Service Fourth Report Report on Macroeconomic Policy and Effective Fiscal and Economic Governance November 2010 0 Contents Page No 2. Chairman’s preface. 4. Acknowledgments. 6. Summary of Recommendations 13. Report of the Joint Committee. Appendices Page No. Appendix 1 Members of the Joint Committee. 40 Appendix 2 Terms of reference setting up the Joint Committee. 41 Appendix 3 Report of Professor Philip Lane. 45 1 Chairman’s Preface I welcome this report of the Joint Committee. Since the breaking of the economic and banking crisis certain structural issues regarding membership of the Euro have come to light. The most important matter is that Ireland no longer has sovereign access to two key monetary policy instruments; exchange rate instruments [the ability to devalue the sovereign currency] and fix interest rates In the past a Government was able to affect an across the board pay cut by devaluing the sovereign currency; the amount of money a worker took home in their pay-packet stayed the same after devaluation but what did change was the amount of goods and services that could be purchased. In the current economic climate the monetary policy instrument of currency devaluation is no longer an option. In considering this report it was a salutary exercise to understand that in bad times, when a country is in recession it is necessary to run fiscal policy in a particular way whereas the objective of this report is to chart a path so that in good times we run fiscal policy in a new way. This report makes a number of recommendations which it is considered should be adopted by Government as soon as possible; two particular areas spring to mind. Firstly, that the way Ireland operates its budgetary process is no longer optimal and secondly, that the macroeconomic data, models and analysis needs to be reviewed and changed. I would like to extend my appreciations to the members of the Joint Committee Deputies Noel Ahern, Chris Andrews, Joan Burton, Thomas Byrne, Damien English, Frank Fahey, Terence Flanagan, Brian Hayes, Michael McGrath (vice-Chairman) and Michael Noonan together with Senators Dan Boyle, Marc MacSharry, Feargal Quinn and Liam Twomey for their co-operation and work in dealing with this complex issue. 2 I would like on behalf of the Joint Committee to pay a special thanks to the staff of the Houses of the Oireachtas, the Head of the Oireachtas Library & Research Service, Ms. Madelaine Dennison, Dr. Gráinne Collins, Mr. Niall OCléirigh, Mr. Barry Comerford and the staff of the Economic and Environmental Science Team, The Committee Secretariat Director Mr. Art O’Leary, Deputy Director Mr. Ciaran Smith, the Clerk of the Joint Committee, Mr. Ronan Lenihan the staff, Mr. Eoin Hartnett and Mr. David Edwards, for all their hard work and assistance to the Members in bringing this report to finality. In conclusion, I wish to pay a special word of thanks to Professor Philip Lane, Head of the Economics Department of Trinity College Dublin (TCD) for his very comprehensive report and guidance to the Committee on the complex matter of macroeconomic policy. Michael Ahern T.D. Chairman of the Joint Committee on Finance and the Public Service 10 November 2010 3 Acknowledgments The Joint Committee wishes to expresses its gratitude for the work and effort by the staff in the Oireachtas Committee Secretariat, in particular Mr. Ronan Lenihan, Clerk to the Committee, the Library & Research Service in particular Dr. Grainne Collins and Professor Philip Lane for producing his comprehensive report within very tight time- lines. 4 5 Summary of Recommendations 1. DATA SETS, MODELS AND ANALYSIS 1.1 In the delivery of a new budgetary process, in terms of recommendation 4 below, a move to EU budget semester model; the Committee recommend the Government publish annually, by way of laying a report before the Houses of the Oireachtas, its macroeconomic data and both short-term and long-term projections. This report forms the basis of the recommended budgetary time- line as set out in Table 1 on page 29. 1.2 The Committee notes that there has not been enough investment in economic modelling and we have only one extensive model of the economy (the Economic & Social Research (ESRI) HERMES model) that is regularly used for macroeconomic policy analysis. There may be other models (for instance in the Department of Finance) but it is unclear how good these other models are, or how good their assumptions are because the Government and the Department of Finance do not explain or justify the data used, the conclusions drawn or the assumptions made. However, the Committee have two concerns; firstly in relation to the lack of information regarding the modelling used by the Department of Finance; and secondly, that Ireland does not have the range of models it needs to support policy making. The Committee notes that the HERMES model used by the ESRI is limited by its dependence on historically- estimated relations across key macroeconomic variables. Therefore, the Committee recommends that there should be a suite of models for the Irish economy maintained by the ESRI, the Department of Finance and the Central Bank. In the case of each model, the dataset, assumptions and analysis should be fully transparent with regular reporting by way of reports laid before the Houses of the Oireachtas and detailed briefing of the Joint Committee on Finance and the Public Service. Further, the Committee notes that while it is the norm for forecasting to put emphasis on the central scenarios; the Committee recommends that greater weight be placed on the distribution of risk with explicit discussion of the impact of negative scenarios. 6 1.3 The Committee recommends an independent group, including international specialists be established immediately to scope Ireland’s macro-modelling requirements and how these models should be developed and maintained by the relevant bodies: the ESRI, the Department of Finance and the Central Bank of Ireland. The results of the scoping exercise and its recommendations should be published and laid before the Houses of the Oireachtas. The Committee further recommends a Dáil debate of the exercise. The Committee recommends that this exercise should not delay other proposals. 2. FISCAL, BUDGETARY AND TAXATION POLICY 2.1 The Committee recommends that macroeconomic policy must plan for shocks by the creation of ‘fiscal space’. Fiscal Space relates to the Sovereign State’s ability to react to economic shocks in a sector, such as a spike in unemployment, and borrow at acceptable interest rates because government debt levels are low. If government debt levels are high and an economic shock occurs the sovereign state may be forced, by the bond markets, to borrow at rates that are punitive (as Ireland has experienced since the summer of 2010) or default on debt. 2.2 In terms of future macroeconomic policy the Committee recommends that if a government inherits a public spending level not on the trend level then it must be required to announce the time-scale it will take to get back onto the trend level. The Committee believes that an explicit transition plan builds confidence. 2.3 The Committee recommends, assuming that factors such as asset prices, inflation, the level of private spending and the sectoral composition of output are at their sustainable trend level, then, tax revenues should be set at a level that covers the desired level of public spending and the cost of servicing that level of public debt across the economic cycle. 2.4 The Committee recommends that if a Government inherits a tax level that is not at the sustainable level then it needs to announce a plan to achieve the sustainable level. This provides certainty about future taxes 2.5 The Committee recommends, in periods of deflation, that clauses on downward flexibility in wages may have to be introduced to national pay agreements. 7 3 THE FISCAL FRAMEWORK 3.1 The Committee notes international trends towards the establishment of formal fiscal frameworks. A fiscal framework is characterised by some combination of the following: 1) reform to the budget process; 2) a medium-term budgetary framework; 3) numerical fiscal rules; and 4) a formal policy role for independent fiscal institutions. The setting of formal fiscal frameworks forces Government policy to avoid short-termism or ‘capture by elites’. The Committee recommends the establishment of formal fiscal frameworks with binding fiscal rules to ensure that the long-term level of public spending is matched with the long-term level of revenues. 4. THE BUDGETARY PROCESS 4.1 The Committee considers that the traditional budgetary process of Votes, Sub- heads and Sub-subheads should be changed. Further, the Annual Output Statement (AOS) does not deliver. The Committee recommends that, with effect from budget 2011, a new budgetary process must be introduced. Further the method for presenting the Departmental Estimates must be changed and the new system must clearly link all expenditure, no matter how disparate, to all projects so that all activity including costs, current, capital, administrative etc. are fully captured and recorded against a project. This will be easier achieved in regard to certain capital expenditures; however, social spending can also be recorded against costs of providing such social spending even where the delivery costs of such social spending is across several programmes.