With the next budget imminent, the state of the government finances – it expects to spend €64bn this year, while core tax receipts are likely to come in at €32.5bn – is reasonably well known at this point. In reality, the maths aren't quite that bad, as non-tax revenues, such as health levies and PRSI should bring in additional monies, while capital spending of €7bn does not need to be covered by tax receipts, as this spending should be delivering projects that pay for themselves. Nonetheless, there's still a hole of almost €10bn a year in the government finances.

To put this hole into perspective, the government is proposing to pay €54bn for Nama's loan book, which some experts reckon may only be worth €30-€35bn, so the risk is that we overpay by €20bn. Left untouched, the exchequer is a Nama nightmare every two years. Our national debt, which was about €30bn two years ago, could easily climb to levels that increase our borrowing costs and irk our eurozone neighbours.

So, how should this gap be bridged? The two main tools are spending cuts or tax increases. Which should we use to adjust our government finances fastest? And which will ensure the foundations are there for future growth?

The economic literature has surprisingly little to say definitively on the topic. Various US economists have tried to estimate what sort of 'multiplier effect' government spending or tax increases might have but rarely compare one with the other. Paul Krugman makes the case that government spending will increase debt by a good deal less than the amount spent, because money will come back in to the government through taxation. In fact, a long string of economists have argued along similar lines, right back to William Petty, who believed it better to have useless pyramids on Salisbury Plain than wasted resources.

Columbia University's Joe Stiglitz goes further – in a recent article with Peter Orzsag of Brookings he argues that cutting government spending in a recession may actually prolong the recession, by removing some of the demand in an economy. However, he concludes by emphasising that "any spending reductions or tax increases are counterproductive at this time: they restrain the economy at a time when it is already slowing". Which brings us back to square one – because Ireland is not in a position to just leave things as they are.

Oddly enough, this is familiar territory for Ireland. In the late 1980s, Ireland had got its public finances into an awful mess, with public debt greater in size than the economy itself. The policy we adopted then became known as "expansionary fiscal contraction": expand the economy, by extracting the government out of it. The logic was that by reducing taxes, it would increase the incentives to firms to hire and for people to work, and tax revenues would increase again. The plan was a spectacular success, with the export-driven growth of the 1990s making Ireland the poster boy of economic growth.

Unfortunately, things are not quite as simple this time around. There is no scope to remove the government from the economy by reducing taxes. OECD figures show that all in, amazingly, a married worker with two children on the average industrial wage in Ireland not only pays no tax but is actually subsidised by the state. Contrast this with the typical OECD country, our economic peer group, where the average earner pays 20% of income in taxes. This undertaxing of workers is a phenomenon that has developed since 2000, mostly through changes in the tax credits – as opposed to the rates themselves.

At the same time, government spending is also high relative to our neighbours. Non-military spending as a proportion of the economy in the typical EU country is about 45%. In Ireland, it was almost 48% in 2008, looking at GNP. This year, government spending is set to grow 3%, while the economy will shrink by somewhere in the region of 9%. Thus, the government's proportion of the Irish economy in 2009 could be as high as 55%. This is a truly extraordinary level – higher than any other EU country, even economies such as France and Sweden, where the range of services provided by the government is far greater.

The public finances became dangerously unbalanced during the lifetime of the 2002-2007 government. On the back of one-off revenues from property, the government reduced taxes for all workers and rapidly increased spending, especially in education and health, while giving public servants wage increases that bucked all economic logic. Ireland's solution lies not in worrying about the choice of raising taxes or cutting spending – we will have to do both.

Ronan Lyons is an economist with experience in international competitiveness, globalisation and property markets. ronanlyons.com