Why downsizing the public sector is economically daft

Whatever the reasons for cutting public sector employment and or pay, reducing the deficit is not one of them. By Michael Taft.

With negotiations over an extension of the Croke Park Agreement starting yesterday, it is helpful to remind ourselves how daft it is to downsize the public sector payroll in the hopes it will reduce the deficit.

There are two ways to downsize the public sector payroll: cut public sector employment and/or cut public sector pay. Since the crisis began, we have been doing both. Public sector pay has been cut twice through the pension levy and the wage cuts of Budget 2010. Public sector employment has been cut by approximately 29,700 since late 2008, or 9.3%.

Yet, the Government finds that it must cut more than it had already planned. It needs €1 billion more in austerity measures to achieve its targets. It’s like running in quicksand – cut, sink, cut some more.

Yet, downsizing the public sector produces little benefit in terms of stabilising public finances. Why? Because it is so darned deflationary – it bleeds the economy of employment, consumer spending and growth. When you factor in the economic consequences of the cuts, you find the Exchequer hasn’t saved as much as it hoped.

Let’s look at the estimates from the ESRI.

Public sector employment

Even using common sense, without the aid of calculators or models, cutting jobs in a jobs recession is not a very good idea. The ESRI’s model confirms this. They took the example of ‘saving’ €1 billion by cutting public sector employment. Because this is a model, they assumed the cut would happen in one year (but there would be little difference if this was spread out over years). So what would be the impact by 2015?

  • Impact on domestic growth: ‘Saving’ €1 billion would reduce GNP by €1.85 billion, or 1.3%. This is the most deflationary of the six budgetary cuts/taxes that the ESRI estimated.
  • Impact on employment: There would be 20,000 job losses. In the last budget the Government was estimating that employment would grow by 43,400 between 2012 and 2015. However, if it seeks ‘savings’ through public sector job losses, employment growth would be reduced to 23,400. Unemployment would rise from 13.1% to 13.8% in 2015 – and that’s only if there is increased emigration.

So growth and employment is cut, with a rise in unemployment. Consumer spending would fall by 1.2% (or approximately €1.13 billion) in 2015, putting more pressure on domestic businesses.  What would be the impact on the deficit?

A €1 billion ‘saving’ would reduce the budget by only €420 million – or 42% of the headline cut. This is extremely inefficient. In percentage terms, the deficit would fall by only 0.23%. That’s all.

Whatever the reasons for cutting public sector employment, reducing the deficit is not one of them.

Public Sector Pay

The ESRI did the same exercise with cutting public sector pay by €1 billion (or approximately 6%).  While the deflationary impact is not as high, it is also inefficient at cutting the deficit.

  • Impact on domestic growth: ‘Saving’ €1 billion would reduce GNP by €700 million, or 0.5% by 2015.
  • Impact on employment: there would be a loss of 3,700 jobs. These would be private sector jobs, lost through reduced domestic demand.

Naturally, consumer spending would also be hit – almost as severely as through cutting public sector jobs. Consumer spending would be cut by over €950 million.

After all this, the impact on the deficit would be minimal. By 2015, the deficit would be reduced by €479 million – or 0.26%. This is approximately the same impact as cutting public sector jobs.

What could happen

The Government has stated that they are looking for a mix of pay and job cuts in the public sector. So let’s use the ESRI numbers to estimate the impact of €1 billion ‘savings’ with half coming from both wage and jobs cuts.

savings from cuts in public sector pay or jobsOver €1 billion is lost in growth and consumer spending, nearly 12,000 jobs lost; and the deficit falls by only 0.2%.

Of course, models are not very nuanced. They just take numbers on the large stage and apply them through a number of indicators. For instance, what happens if you cut the pay of higher-income earners? The impact on demand would be less, so the damage to the domestic economy would be reduced. But the revenue gain could, ironically, be even less – in particular, given that the marginal tax rate of high-income public sector employees is 62.5% (tax plus pension levy). So a €1 billion cut would reduce direct tax/pension levy revenue by €625 million – and that’s not counting the loss from spending taxation. Given that there are only 6,800 public sector employees earning over €100,000, there’s not much change in that.

But a real problem with these estimations is that they were made in 2010. The baseline the ESRI used was one of modest growth (from the World Recovery Scenarios). What might such estimations look like against a baseline of lower growth and following on from substantial cuts in pay and jobs? It could be reasonable to assume that the risks to these estimations are on the downside – that is, if they change, they are likely to change for the worse.

This raises fundamental questions: is the large economic price worth the small fiscal gain? Is there a better way of reducing the deficit? And is this the best suggestion that the Government can come up with?

We elected a new government but all it did was to take over Fianna Fáil policy – a policy of downsizing. A new government could have taken a step back, tested these policies against the best available evidence, and engaged in some new thinking. They didn’t. It’s all rote and automatic pilot.

If we can’t elect another new government, can we at least elect some new ideas?


Image top: The Labour Party.