The International Monetary Fund has backed the Government’s call for some flexibility in the implementation of EU rules governing spending increases.  

In its annual Article IV report on the state of the Irish economy - the first since the end of the bailout programme - the IMF says EU budget-making rules that will apply to Ireland from the next budget onwards present technical challenges in their calculation.

It welcomed moves by the Government and the European Commission to "refine" some aspects of the commission’s methodology. 

It also says the Government should continue to eliminate the budget deficit over a three-year period, and should be cautious in its tax and spending policies.  

But IMF mission chief Craig Beaumont said there is room for a flexible policy mix, which could allow the Government to make planned reductions in income tax levels and increase spending whilst still reducing the deficit.

He said the IMF believes a deficit should be reduced by around 0.5% of GDP per annum over the next three budgets.  

Continued strong economic growth would also play a part in reducing the deficit, and he said there is a case for reducing high marginal income tax levels to improve the labour market, increase the number of people in work and add to economic growth.

This would also reduce the amount spent on social welfare.

Mr Beaumont said that if spending grew by less than growth rates forecast, this too would contribute to closing the deficit.  

He also said there could be additional revenue-raising measures, including taking advantage of the recent oil price drops to increase carbon tax, and by a reform of Ireland complex VAT system of multiple rates and bases.  

He said a reduction of just one quarter of the so called "policy gap" in VAT could raise about one percentage point of GDP - around €1.8bn.

The IMF has also looked at the possible budget impact of Irish Water being deemed to be part of the general Government by Eurostat.  

This could add about 0.3% of GDP to the deficit for this year, possibly leading to the Government breaching the 3% deficit limit.

The projected deficit is 2.7%, assuming Irish Water is deemed to be "off balance sheet".  

If the Eurostat ruling goes against the Government, the IMF says it will need to bring in compensating measures, which it said should be of durable nature and not damaging to economic growth.

The IMF says the economic recovery in Ireland has made a good start, describing last year’s 5% GDP growth as "robust".  

It says the economy is starting to fire on all cylinders, with exports investment and consumer spending all playing a part in producing growth.

It says the revival of consumption is underpinned by improving labour market conditions and low inflation, with the numbers in work up just over 5% from its low-point in 2012.

It says high debt levels are still a drag on economic performance. Households have reduced their debt levels by 20% from the peak, but the household debt ratio is still high by international standards at 177% of disposable income.

This compares with 140% in Britain and 100% in the US.  

The IMF notes that household net worth in Ireland has increased 25% from its trough.

While property prices are growing, it says valuations "do not yet appear stretched".

The IMF also supports the Central Bank's recent introduction of loan-to-income and loan-to-value limits on mortgage lending by commercial banks, describing the move as "very welcome".  

It notes that house prices in Ireland grew by 16.3% last year - a rise in prices it says was as fast as in the boom years.  

However, it says house prices are still around 38% lower than at the peak.

It says commercial property rose 30% year-on-year in the final quarter of 2014 - the fastest growth since 1999 - though price levels are still 56% below the peak.  

It says rental growth in commercial property was up 19% last year, driven by a 31% rise in office rents.  

Rental yields have fallen to 6%, but the IMF says this still makes offices attractive to investors, especially when compared with the yield on Government bonds of less than 0.8%.  

However it warns the so called "search for yield" could lead to property values being pushed up, creating a new vulnerability for the economy.

Minister for Finance Michael Noonan and Minister for Public Expenditure and Reform Brendan Howlin both welcomed the report.

Mr Noonan noted the IMF's "recognition of the recovery which is taking hold" in the country, as well as its support for macro-prudential measures introduced recently.

Mr Howlin, meanwhile, said the Government would take note of the IMF's views on the country's short and medium-term prospects.

"These will be carefully considered in the context of our overall policy development in the medium term,” he said.