After my article yesterday which analysed the speech given by a member of the UK Monetary Policy Committee Kate Barker and questioned her intellectual thoroughness and indeed her credibility my eyes alighted on a report from the International Monetary Fund (IMF). It was written by a Daniel Kanda and is titled Asset Booms and Structural Fiscal Positions. It relates to Ireland but the principles also apply to the UK particularly as Ireland until the credit crunch was affected by a large housing boom, sound familiar anyone?
Asset booms and sectoral changes can distort traditional estimates of structural fiscal revenue, and could lead to serious fiscal policy errors. This paper extends the estimation of structural revenues to take account of asset prices and sectoral changes, and applies this to the case of Ireland, where a property bust has revealed a large hole in the public finances. It is shown that excluding these factors led to a substantial bias in the estimation of structural revenues and the structural balance prior to the crisis was much larger than earlier estimated.
This paper extends the standard estimation of structural balances for Ireland in a number of important ways, explicitly accounting for asset price cycles, the housing bubble, and changes to the composition of national income. It is found that these factors have had a significant and ongoing impact on Irish fiscal revenues. The effect of the housing bubble is particularly pronounced in the case of indirect taxes like VAT, capital gains, and stamp duty. It also turns out that equity prices have a significant impact on personal income taxes. The analysis also highlights that there have been substantial changes in the sectoral composition of GDP, which have had an impact on the evolution of structural revenues.The paper also demonstrates that not accounting for asset price cycles, bubbles, or sectoral changes can generate a large bias in the calculation of the structural balance—one moreover that generally cannot be corrected for by changing the estimated output gap. In Ireland’s case, this bias, which made the revenue prospects seem much rosier than they actually were, helped stimulate an expenditure relaxation that created a large hole in the public finances that will take several painful years to close.
Thus, there is a strong case for expanding the standard OECD-based methodology to include the missing elements outlined above, as done in this paper. Indeed, the ECB is already moving in this direction to refine the treatment of asset-based taxes in its disaggregated approach revenues, and the structural balance prior to the crisis was much larger than earlier estimated.
What does this mean?
This report can be broken down into several factors
1. A policy error was made
2. This error related mostly to the booming housing sector which provided higher VAT, Capital Gains Tax and Stamp Duty Revenues. But the booming equity market also provided higher income taxes.
3. These larger tax receipts led the Irish government to think that a permanent and not a temporary change in her fiscal deficit had taken place and economic policy was predicated on this.
4. In other words public sector expenditure grew too large and when the housing boom ended then Ireland was left with an unsustainable fiscal deficit which will take years of pain to correct.
5. Pain, debate and hardship will follow.
6. Mr. Kanda like me but unlike Kate Barker feels that you should learn lessons from this situation and fundamentally change your methodology if necessary.
7. Regular readers will not be surprised by me pointing out that output gap theory yet again is of little use.
This analysis for Ireland plainly translates very well into the situation for the UK, and there are lessons for Spain and the impact of her housing boom too. We too felt that the taxation receipts from housing related activity such as Stamp Duty, Capital Gains Tax,Income Tax and so on were permanent changes and made the same policy errors. In both Ireland and the UK this error was added to by having relatively large banking sectors which have been affected by the credit crunch too leading to a fall in corporate taxes as well as personal ones. At its peak the UK financial sector was paying nearly 30% of UK Corporation Tax receipts. With the accumulated losses that this sector now has it will be quite some time before some of these banks have to pay any tax at all. Hence the enormous fiscal deficit that the UK has for this year which is similar to that of Greece.
An interesting side-effect of this analysis is the way that equity values are seen as significant. Often in the past this concept has been raised (usually in terms of a wealth effect) but studies have not identified it as well as this one and I will look into this as for an economist it has several implications.
In my view there is a lot to recommend this report as it identifies problems and looks at ways of solving them for the future. This is far better than the Kate Barker approach I identified yesterday and if you forgive the pun Mr. Kanda has shown some candour!
One rule that underlies this analysis is that human beings seem to always translate favourable changes as permanent even if it is temporary. This seems to particularly apply to politicians (and yes I can hear you saying it some economists too!).
The IMF and Poland
Whilst I am praising an individual at the IMF I am interested in the criticism of the organisation as a whole by Poland’s Finance Minister. He accuses the IMF of encouraging Poland to spend more in 2009 and then telling her to cut her budget deficit in 2010. As his criticism is well made I shall quote his interview with the Financial Times.
Spain is complaining that the same institution which was urging them to increase their budget deficit last year is now telling them what a dreadful mistake it was this year.We were on the end of that same advice but we took a contrarian view…
Well done to him both on his policy and for pointing out that the IMF is far from the omnipotent organisation that some present it as.