WE thought that we were beyond the point when we could be shocked by dire tax return figures. We were wrong. When Taoiseach Brian Cowen, after sustained questioning by Labour leader Eamon Gilmore, told the Dáil on Tuesday that tax revenues would be "approximately €2 billion" less than projected, there was an audible intake of breath.

The November tax return figures were expected to be bad, but nobody was expecting them to be that bad.

Those figures mean that the deficit on the general government balance will be more than twice the supposedly sacrosanct 3% limit set by the European Commission.

The economy may be in much better shape than it was during the country's last recession in the 1980s, but the public finances are heading towards being every bit as bad. It's true that our overall debt is far lower than it was in the 1980s. However, the government is probably going to have to borrow close to €20 billion next year to balance the books. A few years of that level of borrowing and it won't take long for our debt-to-national-income ratio to deteriorate sharply.

In the space of a year, the public finances have gone from healthy surplus to a state of crisis. And what's really worrying is that the government's scope for tackling the soaring budget deficit is very limited.

It raised taxes in the recent budget, but economists – while divided on whether Ireland should follow the lead of the major global powers and attempt to stimulate the economy – are agreed on one thing: there is little scope for more tax increases. The Irish economy is simply too fragile at the moment. The negative impact of more tax increases on consumer spending and confidence could more than wipe out any planned gain from increased tax revenue.

Finance minister Brian Lenihan did not contradict this thinking in an interview on RTÉ's Morning Ireland when he ruled out further tax increases in 2009. But he very pointedly used the phrase that the country was living beyond its means, an exact echo of the words used by Charlie Haughey in his infamous state of the nation address over a quarter of a century ago. Back then Haughey talked the talk about fiscal rectitude but failed – at least until he was returned as taoiseach in 1987 – to walk the walk. Lenihan has a grim determination not to repeat Haughey's mistakes, regardless of the political consequences for him and the government.

With more tax rises out of the question, the emphasis inevitably shifts to public spending. There are those who argue that Ireland shouldn't cut spending at the moment. The government, they say, should follow the lead of the US, the UK and others and inject more money into the system to try and stimulate the economy.

However, seductive as this argument is, it ignores two realities. Firstly, unlike those other countries, Ireland has been spending hugely for the last decade – and continues to spend massively on capital projects now funded exclusively from borrowing – and our budget deficit is such that there really isn't any scope for fiscal injections.

Secondly, the Irish economy is so open – we export and import way more than the average country – that any big spending splurge by the government would likely go mainly on buying imported goods – giving, as NUI Galway economist Alan Ahearne puts it, very little bang for our buck. The type of package required to make a difference, given the openness of the economy, could be enough to set us on the road to bankruptcy.

The government therefore has to tread a fine line between not letting the budget deficit get out of control and yet not cutting spending too severely for fear of adding to the dramatic slowdown in the economic recovery.

In terms of spending cuts, the main responsibility is likely to fall on An Bord Snip Nua, the new body set up by the finance minister to look at expenditure and job numbers in the public sector. The group, chaired by economist Colm McCarthy, has already started work and may issue its first report to Lenihan before the end of January.

Understandable cynicism

There is understandable cynicism about yet more talk of public sector reform. But the brutal truth is that the state of the public finances is so serious that this exercise simply has to bring results in terms of reduced public sector numbers.

With a third of the government's budget going on public sector pay, that inevitably is also going to be a focus. Brian Cowen, for obvious tactical reasons, moved last week to dampen speculation that next year's 3.5% rise for 300,000-plus public servants may be deferred. Cowen won't do anything without extensive negotiation with the social partners, but it is simply impossible to see that pay award being granted.

And, smart people that they undoubtedly are, it's hard to believe that the union leaders don't know that.

Many of those union leaders are negotiating pay cuts in the private sector to ensure jobs are maintained. In that environment, and with double-digit percentage unemployment and budget deficits, it is unthinkable that the pay award can be granted, despite what union leaders say publicly.

Cowen's comment that he was talking to Ibec and the unions on a "plan for economic renewal" is significant. It has already been reported that such a plan will contain tax incentives and grants designed to make Ireland more attractive for companies engaging in R&D. But it needs to go a lot further than such touchy-feely measures.

In a speech on Friday night, Cowen said the plan would "set out a path for economic recovery." The hope is that it will set out realistic parameters – to use one of the taoiseach's favourite words – for budgetary policy for the next few years, showing how the government will seek to get the public finances under control.

Such a plan would be extremely welcome, if only to provide the kind of leadership that, rightly or wrongly, many people feel has been lacking. However, with the global environment so dire, the next couple of years will be simply about damage limitation – keeping a lid on the budgetary crisis until some form of growth returns to the international and domestic economies. It could be a long and painful wait – not least, one suspects, for the government.