Forum for a Better Economy publishes "Survey of the Malta Economy - Malta Budget '97" Report

The Forum for a Better Economy is releasing the attached reportentitled 'Survey of the Malta Economy - The Malta Budget of November 1997'which was drawn up by Prof. Maurice Mullard, consultant to the Forum.

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NOTE: This Paper is the personalopinion of Prof. M. Mullard and as such is not Government Policy. This wasstated by Finance Minister Leo Brincat in Parliament on the 14th January 1998.

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Survey of the Malta Economy

The Malta Budget of November 1997 - The NextThree Years
Prof. M. Mullard

The Economic Context in 1997

During 1997 the economy was growing at around 2.8 per cent perannum which represented a slowdown from the previous growth rates of 5.6 percent recorded in 1996. The tax reductions announced in 1995 together with thepublic expenditure increases planned for 1996 contributed to a major consumerboom in 1996. The attempt by the incoming government to bring the public sectordeficit under control after the government took office showed the success ofthe government policy since current expenditure during the survey period onlyincreased by 2.8 per cent. The further budget measures outlined in the November1997 Budget confirm the commitment to reduce the deficit from the estimatedforecast of 10 per cent of GDP in 1996 to around 6 per cent of GDP in 1998.

The Malta financial position in November 1996 was unsustainable inthe sense that the public sector deficit was planned to be expanding to 10 percent of GDP with debt servicing rising from Lm33m in 1995 to Lm56m in 1997. Thepolicy of reflation which combined reductions in taxation and increases inpublic expenditure provided a major boost to consumer demand which resulted inhigher levels of imports but which did not result in major declines in the rateof core long term unemployment. The danger for the government was that to leavesuch a policy stance unchanged would have resulted in a further deteriorationof the public sector deficit if the economy slowed down - there was an overalllack of synchronisation between the deficit and macro economic policy - withthe expansion in the economy the deficit should have been falling with theadditional tax revenues and falling unemployment yet by contrast while theeconomy was growing at over 5 per cent per annum the deficit was actuallyrising.

The impact of the November 1997 Budget on the macro economy shouldbe minimal since the budget has left personal taxation untouched although therehave been increases in indirect taxes - however the attempt to bring the publicsector deficit under control should eventually benefit monetary policy sinceboth the lower government borrowing and higher rates of savings should in turnreduce the competition for savings which should in turn result in lowerinterest rates which should be good news to business investment and also tomortgagors. The increases in indirect taxes and in charges for energy and waterwill be matched by lower interest rates. The combination of both monetary andfiscal policy should result in a budget which is neutral on the macro economy.

Departments as Policy Entrepreneurs

In future years the relationships between the Ministry of Financeand the Spending Ministries would change from the present position of highlycentralised control at the centre with department administering the budgets onbehalf of the Ministry of Finance to one of more financial autonomy withdepartments taking more responsibility for internal budgeting and auditing. Itis important that in their attempt to make effectiveness, efficiency and valuefor money the pillars of the policy on public finance that ministers createframeworks for civil servants to start becoming the policy entrepreneurs and tostart taking ownership of the policy priorities of their ministers.

The climate of expenditure constraint needs to be perceived to bea challenge and an opportunity for creativity and for new initiatives thatensure that policy is delivered in more effective ways. Policy implementationneeds to be evaluated and monitored if the government is to succeed in showingthe people that they are safeguarding the quality and improving publicservices. The study and evaluation of good practices become paramount.

Malta and the EU

The study of public finances in Malta would suggest that Malta isout of sync with other EU member economies. The Maastricht Treaty of 1992 whichestablished the threefold criteria for economic convergence including a limiton the public sector deficit of 3 per cent of GDP has to be compared to a Maltadeficit of 10 per cent of GDP. Even the efforts of the present government toreduce the deficit to 6 per cent of GDP is described as being austere - anyfurther attempts to reduce the deficit more drastically would certainly pushMalta into recession. Furthermore in the context of Europe's commitment tocompetition policy - the Malta government would have to remove all subsidies toindustries including energy, water and ship building. European Labour marketsexperienced major shake outs in manufacturing since the mid 1980's -manufacturing employment in Europe has declined from 30 per cent of the totalworkforce to 18 per cent - Europe at present has an unemployment rate of 12 percent which is equivalent to 18 million people seeking employment. Since 1992unemployment has only declined in the UK from 10 per cent to 5.7 per cent in1997. The UK left the ERM in 1994 and was able to reduce interest rates andalso for sterling to fall in value against the DM. The government labour supplypolicies of deregulation and flexibility attracted major inward investment fromboth Japan and the US.

There seems to be lacking in the debate on the EU the issue ofeconomic sovereignty and the position of micro states in the context of theglobalised economy. Within the context of the euro it will be the EuropeanCentral Bank which will make decisions on monetary and fiscal policy - Malta asa small country will have to live within the constraints set by the EuropeanBank - at present there is a debate as to the extent of political interferencewith the French Government favoring a more interventionist approach and theGerman Government preferring to run the central bank on the basis of the GermanBundesbank giving the Bank total independence in the management of monetarypolicy.

The euro enthusiasts in Malta seem to assume that by Maltabecoming a member the EU will resolve Malta's budget deficit - yet in lookingat the propositions for Europe 2000 which re-draws the map of areas in Europeexperiencing social deprivation - it will be difficult to take a case for Maltawhen per capita GDP for Malta is contrasted to the new emerging states such asthe Czech Republic, Hungary and Poland. There is an illusion that Europe will bailMalta out of the deficit - it is important that some figures are extracted forEurope. Malta could benefit from the Regional / Structural funds but again somefirm figures need to be derived.

Some Conclusions

During 1997 the government produced two budgets which in turn haveproduced a watershed in the financing of the public sector. The threat of acontinuing increased deficit which if policy had been left unchanged would haveincreased the deficit to around 12 per cent of GDP has now been brought under control.The forecast to reduce the deficit from a potential of 12 per cent of GDP to 5per cent of GDP would be a major achievement since the policy to reduce thedeficit would have left direct taxes untouched, protected social security andprovided additional funds for education and infrastructure projects.

The two budgets have however pulled at a number of levers in theeconomy - both fiscal and monetary - the advice is that from 1999 onwards thegovernment should proceed with prudence and caution and not pull at any moreeconomic levers - the aim should be to provide a stable economic framework ofpreferably untouched policies to see how the present budget measures impact onthe macro economy without producing yet more measures.

Fiscal Policy

The fiscal stance during the period 1994 to 1996 can be describedas being too lax in the sense that both the increases in public expenditure andthe reductions in taxation were contributing to a growth rate of 5.6 per centwhich was above the trend for the Malta economy and therefore not sustainablein the longer term. The economic buoyancy was dependent on a major boost toconsumer demand without a matching increase in productive capacity. Despite themajor boost to the economy there was no major decline in the rate ofunemployment.

The problem for fiscal policy was that the government was runninga deficit during a period of high growth which suggested that any blip in therate of growth was likely to result in a major deterioration in thegovernment's fiscal balance - any additional increases in unemployment or fallsin consumer demand were likely to result in a high public sector deficit.

Monetary Policy

It is difficult at this stage to point to any fiscal or financialcrowding out which can be attributed to the fiscal stance of 1994 and 1995.Interest rates did increase over the survey period although the inflation rateremained subdued. The reason for this must the managed currency which did notallow the Malta currency to reflect the fiscal stance. In an open economy aforecast 10 per cent deficit would have led to pressures on the currency to bedevalued for inflation to increase. The size of the Malta economy in a way hidthe real problems facing the Malta economy. It is because of the large savingsratio of the Malta people that the Malta deficit was financed - had thegovernment to resort to external sources than foreign investors would havedemanded a higher rate of interest to match the pressures of inflation.

The Malta rates of interests of 7.5 per cent are the highest inEurope where interest rates average between 3 and 4 per cent. In a way thisreflects the inflation pressures within the Malta economy and the problems of aloose monetary policy.

Macro Economic Policy since the 1997 Budgets

The two budgets of 1997 have sought to restore the fiscal balance- total tax revenues declined from 42 per cent of GDP in 1995 to 37 per cent ofGDP in 1996. Income tax revenue declined slightly from 33 per cent of GDP to 32per cent of GDP between 1995 and 1996. By contrast non tax revenues declinedsharply from 9 per cent of GDP to 6 per cent of GDP or from Lm102m to Lm66m.This reflected the impact of one off items including the sale of assets whichcame to a close in 1996. In 1995 the sale of assets brought revenues amountingto Lm29 million in contrast to Lm1m in 1996.

In the two budgets of 1997 the government sought to recover thefiscal balance - the increases in indirect taxation led to an increase intaxation from 32 per cent of GDP in 1996 to 34 per cent of GDP in 1997 and 33per cent of GDP in 1998. The total tax incidence which had declined sharplyfrom 42 per cent of GDP in 1995 to 37 per cent of GDP in 1996 increased to 39per cent of GDP in 1997 and to 42 per cent in 1998. The tax level in 1998 istherefore back to the same level it was in 1995.

The Malta tax incidence of 42 per cent of GDP would suggest thatMalta is close to the EU average of taxation - Malta is neither overtaxed norundertaxed. In 1995 tax revenue amounted to 33 per cent of GDP after the taxreduction of 1996 tax revenues fell to 32 per cent of GDP. With the two budgetsof 1997 tax revenues have returned to the 1995 level of 33 per cent of GDP. Itwould therefore seem that the increases in revenues will come from the sales ofassets and under one off items which will return the non tax revenues to 8.6per cent of GDP in 1998 similar to that of 1995 when non tax revenues yielded8.9 per cent of GDP.

Tax Revenues - The Next Three Years

The Government has aimed to increase revenue by over Lm60m in 1998which include increases in indirect taxes, taxes on services, charges in energyand water and the sale of assets. If none of the one tax revenues areimplemented during 1999 then tax revenues are likely to fall to Lm522m. Howeverif the government continues with asset sales of Lm25m then tax revenues wouldincrease to Lm547m. which would leave a shortfall compared with this year's taxyield of Lm4 million on the banks windfall tax and Lm9m. of reimbursement fromthe water industry. This means that the government will be getting some Lm13mless in 1999 when compared to 1998. However the GDP growth of 2.8 per cent peryear will lead to about an extra Lm11m. The increase in the price of energyshould improve the balances of Enemalta which should in turn improve therevenues to the government.

Overall the tax incidence returns to the 1992 level of 42 per centof GDP from 1998 onwards.

The recent Auditor General report on uncollected tax revenues ofLm247m would suggest that improvements can be made to improve on tax collectionbut furthermore that the government can attempt to close down tax loopholesthrough better regulation.

The government could visit the concept of recruiting financialadvisers who are at present advising their clients on tax avoidance and forthese advisers to become gamekeepers on behalf of the government rather thencontinue to be poachers. This would require a good payment by results system toensure payment according to performance.

Public Expenditure - The Next Three Years

During 1997 the government has achieved the major objective ofbringing current expenditure under control without undermining core servicesincluding health care, education provision or the payment of social securityand pensions. Indeed the government has continued to find additional resourcesfor health and education. The emphasis on value for money, removing waste andimproving effectiveness is already showing the potential of departments beingmore creative with less funding - the recent major projects in Bugibba andChadwick lakes, the decentralisation of some budgets to education all representgood practice in the provision of effective public services.

While the government is committed to put a lid on currentexpenditure - there are two major areas of expenditure where the government haslittle control; these include social security payments which are demand ledexpenditure sincg they depend on demographic pressures including the expansionin the number claiming pensions and secondly the levels of unemployment. It isestimated that the social security budget is likely to grow at around Lm17million per annum. Secondly there is the pressure on wage costs which arelikely to grow at Lm3 million per annum and the social security costs of Lm1million which together total Lm4m. The third element is the additional cost offinancing the deficit which is estimated at around Lm8 m. These three elementsare therefore likely to increase expenditure by Lm29m per year in the nextthree years. By contrast the attempt to control recruitment in the publicsector and the commitment by government to produce efficiency savings of 5 percent on operating expenditure could help Government meet some, if not all, ofthe increases in expenditure.

The attempt to improve efficiency could be linked with proposalsfor income generation and for departments to explore ways of generating moreincome. This is more likely to happen if departments are allowed to keep thisincome to improve services so that there will be advisable relationship betweencharging for services and the benefits to departments.

The above argument has also pointed out that with unchanged policythe levels of taxation in 1999 and 2000 should remain stable so that bothexpenditure and taxation on current policy should produce a PSBR of 6 per centof GDP. However improvements in tax collection, the growth in the levels oftaxation brought about by increases in GDP together with the effects of fiscaldrag should in turn reduce the deficit to around 5 per cent of GDP.

Reforming Public Expenditure Control

The Impact of Non Supplementary Estimates

The decision by the Malta government to phase out supplementaryestimates represents a major step in the reform of public finances. Since 1994supplementary estimates have accounted for a total increase in expenditure ofLm56m which explain the degree of policy drift between the Annual budgetestimates and the final outruns for public expenditure. The decision onsupplementary estimates means that in future years departments will have to takemore responsibility for internal reviews of their budgets.

On the effect of energy prices on consumption - there are majorlessons to be recalled from the oil prices shock of 1974 and 1981. During boththese major shocks consumers had to meet the higher costs of energy since thedemand for energy tends to be price inelastic - changes in the prices ofelectricity and water do not result in major changes in the pattern ofconsumption. With consumers paying more for essentials there is obviously lessdisposable income available to buy luxury products. If the demand for luxuryproducts falls then prices will also fall, that is, if the procurers of luxuryproducts do not want to be left with unsold goods. The total effect istherefore again neutral with consumers paying more for energy but paying lessfor luxury goods. In this the budget measures should be neutral on the standardof living since both the pressures on inflation and interest rates are likelyto recede.

In its measure of the cost of living the Government needs tobalance the likely effects of energy on household incomes but also take intoconsideration the decline in the inflation rate brought about by lowergovernment borrowing. The fall in the rate of interest and other consumerprices brought about in the shift from VAT to CET should also be considered.

Forecasts on the Economy Beyond 1998

Within the present economic framework I would like to venture theforecast that the Malta economy is likely to grow between 2.5 per cent and 3.0per cent in 1998. This could be taken to be prudent and a cautious forecast.

The budget neutral - the fiscal stance of the government to reducethe deficit relies on the sales of assets (Lm25m) the windfall tax on Banks(Lm4m), the repayment by the Water Industry (Lm9m). On public expenditure thegovernment has put a lid on the growth of current expenditure while capitalexpenditure has remained at the same level as in previous years. The policycommitment to reduce the deficit should now be accompanied by a relaxation ofmonetary policy since the PSBR should not be financially crowding out privateborrowing - it is therefore important that the Bank relaxes monetary policyotherwise there is the danger that over policy could be too restrictive.

Take the European context into consideration - it would seem againthat this forecast will again be seen as being prudent. With all Europeaneconomies heading towards EMU convergence this is likely to result in lowerinflation and lower interest rates which in turn are likely to produce theframework for stable growth and increased employment in Europe. Economicprosperity in Europe will benefit Malta in terms of tourism but also on thelevel purchasing power enjoyed by tourists visiting Malta. The expected growthrates in Europe should also benefit Malta's exports and also reduce the costsof imports.

Furthermore, the stable economic framework of low prices in Europeshould benefit the Malta consumer since there will be less imported inflationon the imports of goods to Malta which in turn should result in lower prices tothe Malta consumer for imported goods.

Taking both the European perspective and the Malta budget intoconsideration it can be safely assumed that the Malta economy will grow at thesame rate in 1998 as it did in 1997 despite the tight budget measures announcedin November, 1997.

The problem of the 1995 budget strategy is that this resulted in amajor consumer boom which was not sustainable in the long term. The taxreductions announced in 1995 meant that total revenue to government in 1996fell from 42 per cent of GDP in 1995 to 37 per cent of GDP in 1996 despite theattempt to switch from direct to indirect taxes. By contrast during the samesurvey period public expenditure continued to expand from 45.8 per cent of GDPin 1995 to 47.8 per cent of GDP in 1996 so that the gap between taxation andpublic expenditure widened with taxation falling and public expenditureincreasing in the absence of a policy to finance the reductions in personaltaxation.

The growth in the debt servicing programme confirms the state ofthe Malta public finances. In 1995 the cost of debt servicing was Lm25m, thisincreased to Lm30m in 1996 to Lm42m in 1997 and Lm55m in 1997.

On present policy the government would havesustained the levels of growth in the economy and also protected disposableincome while reducing the deficit. The policy of reducing the deficit withoutcausing a recession would be a major achievement. Furthermore the reduction ofthe deficit should start to benefit the economy through monetary policyincluding reductions in interest rates which should result in higher levels ofinvestment and lower costs of mortgages. Both policy consequences should leadto higher levels of employment and economic prosperity which is sustainable inthe longer term.