IMF report: A wet blanket for electoral tax cuts?

Veteran economist Karmenu Farrugia does not mince his words when interpreting the latest report by the International Monetary Fund as a clear message to both major parties to refrain from promising or enacting tax cuts before the next general election.  

“The need for fiscal consolidation demands that both political parties desist from even mentioning the possibility of lowering the standard rate of income tax (35%) for the foreseeable future, but especially before the next parliamentary elections expected in 2013,” Farrugia says.

The timing of the electoral promise to cut the top income tax rate from 35% to 25% featured highly in budget speeches of both political leaders, with Opposition leader Joseph Muscat calling for immediate tax cuts and the Prime Minister replying that the time is not yet right.

“Do you honestly expect me to be so irresponsible, in the midst of this international crisis, to keep a promise that cannot be implemented at this time?” Gonzi asked a few weeks ago amid interruptions in parliament by the Opposition. 

But the same Prime Minister hinted that he will honour his pledge in due time. “What I tell the leader of the Opposition and his colleagues is that this promise will be implemented at the appropriate time.”

Whether the appropriate time for the promised tax cuts will be before or after the next election remains unclear.

On his part, Finance Minister Tonio Fenech warns of uncertain times ahead.

When asked for his reaction on the IMF report, Fenech emphasised that “the situation around us is still very volatile and uncertain,” citing “experts around the globe warning that a second crisis is possible once the impact of austerity measures taken by various European Governments are felt”. 

Moreover, according to Fenech, the already fragile economic recovery is still not being reflected, on an EU-level, in the creation of new jobs, leaving millions on the job seekers list.

“This means less people purchasing goods and services, less people travelling... all factors which can have a negative impact on Malta’s economy and hence tax intake.”

But the crisis is not entirely imported, as Opposition spokesperson Charles Mangion is quick to point out, referring to the parts of the  IMF report which underline “certain structural weaknesses which in future are likely to hamper sustained economic growth.”

Specifically, the report refers to the increase in public debt, guarantees and implicit liabilities related to state-owned enterprises, which necessitate “ambitious fiscal consolidation.”

For Mangion, this implies that indebted state-owned enterprises covered by government guarantees, still constitute a contingent liability, which has to be taken into account when assessing the overall public debt exposure when compared to our GDP.

And while Malta’s banks weathered the international financial meltdown of 2008 successfully, the IMF analysts expressed  concern that some banks  have invested highly in foreign debt securities.

“Although the report does not state the extent of the exposure to these foreign securities, it nonetheless encourages more caution and less risky investment,” Mangion warns.

A weak underbelly?

While praising  Malta’s macro-economic management performance, the report seriously warns us about our micro-economic management weaknesses. If not rectified these weaknesses “are likely to impinge cruelly on the macro level, particularly on the government’s target of a sustained rate of economic growth,” Farrugia says.

One serious weakness identified in the report is the “seemingly healthy real estate market which might collapse and with it the very banking sector which it sustains.”

Another weakness is the overall poor rate of productivity improvement dragged down by a nonchalant public sector and over-dependency on the financial sector.

Farrugia concurs with the IMF on the “tardiness in reforming the pension regime, which will continue to absorb increasing resources from the country's future output.”

Economist Gordon Cordina considers the report as a balanced and fair view of our country’s economic prospects, by stating that the recovery we have experienced in the first half of 2010 is not likely to be protracted for the rest of 2010, and that there may be risks for 2011, also in view of uncertainties in the international economic situation.

“The statement is also right in highlighting the longer term issues with which our economy and fiscal finances will have to grapple in the future, including pensions and health care.”

Politicians face the crisis

For Malta Employers Association (MEA) Director General Joe Farrugia, the report is a clear warning to political parties not to resort “to making electoral promises which are not doable without incurring substantial deficits.”

The director general points out that the experience of other European economies is that “Harry Potter economics” only exist in fiction and “the price that society has to  pay is drastic austerity measures which are inevitable to bring state finances back on track.”

Joe Farrugia reminds political parties of their duty to make the population realise that one can only aspire for what one is prepared to pay for through taxation, and that no economy can live beyond its means indefinitely.

“The IMF’s statement should not fall on deaf ears, if we are to avoid the situation prevailing in many parts if Europe.”

But in their comments on the IMF report, both Fenech and Mangion refrain from making any reference to electoral tax cuts.

In light of the negative scenario, the government’s objective is to sustain and build on the achievements gained so far, Fenech insists.

“Despite the crisis, we supported those industries which required our push to achieve further growth, such as manufacturing and tourism. We backed small business through substantial tax credits which supported them in investing further to improve their quality.”

The government’s priority remains that of reducing the deficit and improving the sustainability of our finances, something which makes us more attractive to investors. “This is why Budget 2011 puts so much emphasis on the need to reduce our deficit levels and why we are taking active measures to reduce it.”

The minister also warns that Malta cannot continue to rely solely on the traditional sectors of the economy.

“We need to think further outside the box. A particular and specific way of doing so is by supporting local businesses which want to embark on the export route.”

Neither does he take the international climate for granted, warning that his government “will not fail to take pre-emptive or corrective action in order to address risks and thereby ensure the achievement of its economic and fiscal objectives.”

While insisting that a clear effort to reduce operational costs is being made, this is being done without reducing investment in “education and social care.”

But despite the rising investment in education, the IMF report highlights the skill mismatch in education which, according to Mangion, is condemning four out of 10 young people to the risk of becoming unemployable. “Despite the considerable spending in education, Malta is consistently ranked in the lowest places in the EU scales for educational achievement,” Mangion notes.

On his part, Mangion concurs with the IMF report recommendation that fiscal consolidation should be ‘expenditure based’.

“This emphasises the fact that the government needs to control its recurrent expenditure rather than cut its expenditure in investment.”

For Mangion, this implies more efficient public procurement practices, less bureaucracy, better quality and value for money service, and less costly public services.  But instead of cutting on recurrent expenditure between 2008 and 2010 “the government undershot its investment programme by over €220 million.” In contrast, the government overrun its wage expense estimate in 2010 by over €23 million.

Mangion concurs with the IMF that “tax amnesties may harm tax collection in the medium term” claiming that the government has  met its fiscal targets by a series of amnesties rather than through improved economic output and the higher revenue generated from it.

On his part, Green Party chairperson Michael Briguglio welcomes the government’s  aim to reduce its deficit for the coming years.

“One hopes that this trend is not reversed once the general election approaches, as was the case in the last general election.”

On the other hand he lambastes the Labour Party for promising the impossible “by trying to sell the illusion that you can reduce income tax whilst sustaining a comprehensive welfare state,” a case of  “populist rhetoric rather than of sustainable policies.”  

Unlike the other parties, AD addresses the deficit problem through revenue-generating measures such as a tax on properties kept vacant for speculation.

“This tax, which should apply from the third property onwards, would encourage the renting and selling of properties which are kept vacant for speculation purposes and the use of existing buildings, rather than building more areas.”

One concrete measure proposed in the IMF report and wholeheartedly endorsed by AD is the introduction of a second pillar in the pension system.

“In this way, the financial sustainability of the pensions system will not be jeopardised, as people will be saving an extra amount of money which will be used solely for pension purposes and will not be used by the government for other reasons.”

Meanwhile, Fenech insists that reforming the pension system remains a key objective of the present legislature, adding that “at present, a working group on pensions’ reform is preparing its proposals.”

Mangion also concurs on the need for a pension reform “with the main objective being to render present and future pensions sustainable and adequate.”

Textbook approach questioned

Still, the report itself does not offer much a practical blueprint for politicians to follow.

Cordina is sceptical on the report’s ‘textbook’ approach.

“The country does not have the luxury of wiping the slate clean and building an economy according to a textbook model.”

Cordina recognises that governments have to work within frameworks and setups developed over a number of years, “some justifiable, others perhaps less so.”

Farrugia is more positive on the IMF’s understanding of local conditions, noting  that  unlike the governor of the Central Bank Michael Bonello, the IMF resisted from identifying social services and student stipends as targets for the consolidation of the country’s finances, thus “recognising, as I certainly do, that probably this area of government expenditure, save abuses, of course, is a consolidating political factor much needed in Malta.”

But Cordina describes the report insistence on the need to link wages to productivity as an “often hear cliché.”

“While this is an obviously desirable situation, as indicated in any elementary economics textbook, I look forward to hear concrete, workable proposals regarding the way in which this may actually be done, and which produces an effective improvement over the situation as it currently stands”.