The Government faces a "delicate balancing act" in September’s Budget, according to the Irish Fiscal Advisory Council.
In its pre-Budget statement, the budgetary watchdog also says this year’s expected surplus in the public finances will be entirely based on corporation tax receipts.
The Council said the Irish economy recovered strongly from Covid-19, however, the recovery has lost momentum in recent months because of the surge in inflation which has reduced the spending power of consumers.
It is also presenting a dilemma for the Government in the upcoming Budget.
The Council estimates that even if the Government were to protect spending on existing levels of public services against current levels of inflation, it would cost an additional €6.7 billion, which is greater than the €4.9 billion allocated for new spending this year and next.
IFAC said it means the Government will have to "make difficult choices".
The Council forecasts a surplus in the public finances of €4.5 billion this year, but cautions that without revenue from unexpectedly buoyant but volatile corporate taxes, the Exchequer would actually be in deficit to the tune of close to €5 billion.
It repeats warnings about the imminent cost of pensions, climate change and Sláintecare reforms, which IFAC believes have not been realistically incorporated into government forecasts.
On inflation, the Council believes there is likely to be ‘a lasting shift in consumer prices’ and that higher prices will mean slower economic growth.
It also says the fact that inflation is now forecast to last longer, the pass-through to higher prices across the economy ‘could be greater than expected.’
Its forecasts for a surplus of €4.5 billion this year is based on its belief that tax revenue could be €3.5 billion higher than the Government’s forecast in the Summer Economic Statement.
It also believes that corporation tax will overtake VAT this year as the second biggest source of taxation.
Its forecast for a surplus also takes into account the planned €400 million of spending on new current expenditure measures for the remainder of this year.
IFAC says it will be important for the Government to stick to the expenditure plans it has already announced as this will 'support economic stability' and imply that any additional corporate tax receipts will be saved.
It says the planned 6.5% increase in core spending strikes a balance between ‘protecting the vulnerable and not adding to inflationary pressures.’
Speaking on RTÉ's Morning Ireland, the Chairperson of the Fiscal Advisory Council, Sebastian Barnes, said that the Government is facing a very difficult budget due to high inflation and cost pressures.
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Mr Barnes said the Government will have to strike a balance between cost measures and being able to help people who really do need the help while also not stoking inflation.
He said that the July Summer Economic Statement set out a plan based around the Government's 5% spending rule and the Government has given itself a little bit of extra leeway due to the higher inflation.
The Council believe this is a good plan and gives an appropriate balance, Mr Barnes said, adding that it was important they stick to that plan in the upcoming budget.
He said that there was space to help people, such as those on low incomes, older people or those living in rural areas.
On top of permanent measures, he said the Government also can undertake temporary measures if prices spike for a while.
But the reality is that the Government can not help everyone as much as it wants, he added.
He said that the Council was worried that 90% of measures so far had not been targeted and so wealthier houses are benefiting from that and given resources are limited, the Government should focus more on those who really need it and not the better off.
He said that a tax bracket would help compensate for higher inflation, as that would usually bring in more tax revenues but this was a choice for the Government.
Mr Barnes said that the overall budgetary envelope was very tight and this was not a time that the Government can launch huge new spending programmes on different things or make a radical cut decision on tax unless they are willing to face the consequences as a result.