The Central Bank of Ireland has warned the Government that big tax cuts in the budget or spending increases above the 5 per cent spending rule are likely to “add significantly” to inflation and run the risk of overheating the economy.
The intervention comes amid rising political tensions within the Coalition over possible tax cuts with Taoiseach Leo Varadkar having championed calls for a €1,000 tax break for middle-income earners.
In its latest quarterly bulletin, the Central Bank said the Irish economy had proved resilient in the face of the pandemic and war in Ukraine, and was now “operating at capacity” with unemployment at a multi-decade low of less than 4 per cent.
Most of the current growth in employment was being facilitated by immigration, it said.
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“Given the current cyclical position of the economy, discretionary Government spending increases or tax reductions outside the bounds of the Government’s net 5 per cent spending rule would add significantly to demand and inflation in the coming years,” the regulator warned.
The spending rule limits annual increases in Government spending to 5 per cent, viewed as a sustainable rate for the economy.
In a breakout article accompanying the bulletin, the Central Bank estimated that a 6.5 per cent increase in spending in the budget would add 0.3 per cent to inflation in 2024 and between 0.3-0.4 per cent to inflation in both 2025 and 2026, over and above where it would otherwise have been.
Tax cuts of the same magnitude would also be inflationary but not by as much, as some of the additional money placed in workers’ pockets would be saved.
The bank said both scenarios would lead to greater imbalances in the economy while placing more upward pressure on prices and wages.
“The economy is effectively at full employment, with the attendant risk that overheating dynamics could emerge. Charting a course for fiscal policy which does not exacerbate the imbalance between demand and supply conditions in the near-term will accordingly be important,” it said.
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Overheating occurs when demand exceeds the productive capacity of the economy, bidding up prices and wages.
Even if spending increases by an assumed 5 per cent, “there would still be a risk of overheating pressures emerging given current conditions in the labour market”, it said.
While wage growth has been relatively contained up to now, the tight labour market and “an anticipated degree of real wage catch-up” is expected to contribute to strong wage rate increases in 2023. It expects wage growth to rise above 6 per cent this year, up from 4.3 per cent in 2022.
The Central Bank also warned that inflation would be higher than expected this year, averaging 5.3 per cent, and would moderate more slowly than previously anticipated in the years after that.
“Inflation dynamics in 2023 are primarily being driven by the second round effects of the energy and other commodity price shocks seen throughout 2022 and early 2023,” it said, noting that as 2024 progresses the primary driver of price growth is expected to be “the strength of the domestic economy and associated capacity constraints”.
Overall, it said the growth outlook for the economy had improved and “real income growth is expected to turn positive in the second half of this year and to continue to grow thereafter, supporting consumption growth”.
