Promoting growth and job creation through investment

Cormac Staunton: Taxes have both positive and negative effects on the economy and job creation. However, discussions of ‘tax cuts’ often focus on the positive impact for business and consumption, while ignoring the other side of the coin; public investment and services are also good for business and jobs.

Public spending is part of our economic output (GDP) along with private consumption, investment, imports and exports. Hence, all things being equal, tax cuts will lower GDP because it will lead to lower public spending. This is what is meant when Budget’s ‘take money out of the economy’.

Classical economic theory assumes that lower taxes lead to cheaper labour costs and more money in people’s pockets, which would increase employment and consumption. Ultimately, the theory argues, this leads to growth in the private sector and more tax revenues that should off-set the losses from cuts to public spending. This theory has been repeatedly shown to fall short in the real world, especially when taxes are already extremely low.

This is the situation in which Ireland now finds itself, with the lowest tax ‘wedge’ on average wages in the EU and a total tax take that is three quarters of the European average. As a result, more direct interventions to boost the economy through increased public spending are needed. These are likely to have a more positive impact on increasing growth and employment than tax cuts.

One of the major challenges facing the Irish economy is weak investment. Our gross capital formation (public and private investment) is only 10.7% of GDP, which is the lowest in the EU. The low level of investment in Ireland can partially be explained by the slump in construction, as well as by lack of access to credit and high corporate indebtedness. There may also be a perception of low returns on investment given the low growth in the economy.

It is also caused by the fact that successive budgets have disproportionately targeted capital spending over current spending, radically reducing Ireland’s investment in infrastructure, which is the backbone for future economic activity, including in education (‘human capital’) and research (for innovation).

Tax cuts won’t increase investment
Cutting taxes relies on the private sector to make up the shortfall in investment and consumption. High levels of private debt, means that tax cuts are highly like to result in people paying down debt, rather than investing or increasing savings. While paying down debt will be beneficial in the long-term, there is no guarantee that these funds will be lent to Irish companies and entrepreneurs and used for investment in Ireland.

The dysfunction of Ireland’s banking system certainly means that most of these funds will not be lent to SMEs in the short-term. If tax cuts are only targeted at the small minority who currently pay the higher rate (estimated to be 17% of income earners), there will also be no corresponding boost to consumption from low and middle income households that would help struggling business.

Public Investment
Public spending not only provides essential services, like health and education, but it can also be a key investor in the economy. The private sector relies on the quality of public infrastructure such as roads and broadband, as well as education, training, public transport and other services, all of which create an environment in which private business can thrive.

Public bodies also purchase a huge volume of goods and services from the private sector in Ireland, everything from office equipment to bricks and mortar. In fact, with increased tendering and outsourcing in recent years, the public and private sectors have never been more interwoven.

Government spending directly results in increased business and employment in the private sector too. In 2011, a TASC report estimated that the government expenditure in the enterprise sector was between €4.7 and €6.2 billon.

As a result, public investment and Government consumption impact directly on aggregate demand. A recent IMF study found that the economic multipliers from government investment and consumption are larger than the multipliers from cuts to labour income taxes, consumption taxes or corporate taxes.

In other words, measures that directly impact on demand in the economy (such as government spending increases) have a greater impact on economic growth than those that rely on private sector spending to boost demand (such as tax cuts).

Of course, it is not possible to increase Government’s contribution to GDP unsustainably. Public spending is limited by available revenue and the size of the public debt, the sustainability of which are directly related to the strength of the economy. What is required is an intelligent balance between public spending and private sector activity, including measures to optimise the efficient co-operation of the public and private sectors.

Given that Ireland has low taxes and low public expenditure, and a low overall level of investment in the economy, there is an opportunity to maximise returns from public investment. If the Government has identified available funds, these should be used to complement the low level of private investment, and potentially ‘crowd in’ additional private finance by providing attractive investment opportunities in key infrastructural projects.

This would increase economic growth in the immediate term and put in place the necessary infrastructure to foster long-term growth, to the benefit of private sector activity and sustainable job creation.

Cormac Staunton     @cormac_staunton

Cormac Stauton is currently a policy advisor on EU and international policy in the Central Bank of Ireland. Prior to this, he was a policy analyst in TASC, and co-authored the first economic inequality report, Cherishing All Equally.