With government support for suffering households and struggling businesses needed for months to come, better taxation and government spending policies must accompany any access to emergency EU funding
By Les Manison
The basic economic problem is to allocate limited resources efficiently among competing ends. The coronavirus pandemic with its adverse impact on public health and real economic activity and resultant tax collections has made this problem more acute for government policymakers. Governments throughout the world now have less resources particularly in the form of falling tax receipts to deal with more problems stemming from the economic shock of the coronavirus. Governments not only have to fund their normal operations in providing education, health and social welfare services, and maintenance of physical infrastructure and of law and order, but have to provide economic assistance for new health problems and for households and businesses negatively affected by the economic crisis. Furthermore, policymakers are needing to look ahead and raise sufficient funds to finance the expenditures required to support the robust and sustained recovery of their economies.
But coronavirus-induced problems are not the only challenges facing economic policymakers. In fact, many economies including Cyprus entered the current crisis period with serious problems such as excessively high debt, very low investment outlays and productivity, and widening income and wealth inequalities. While these pre-crisis problems will need to be dealt with economic reforms and adjustments to produce a more efficient allocation of resources, much of what follows is confined to an analysis of taxation and budgetary policies required to bring about a more effective collection and allocation of budgetary resources.
More specifically, the economic problems facing government policymakers can be presented in the case of Cyprus. The economy of Cyprus has been particularly hard-hit by the economic shock stemming from the spread of the coronavirus with value added of the important tourist industry estimated to fall by more than 75 per cent in 2020. Furthermore, with domestic demand subdued, real GDP could decline by at least 14 per cent in 2020. And depressed economic activity together with suspensions of certain tax payments (for example, personal income tax returns for 2019 deferred until November 2020) are likely to contribute to a large decline in actual tax receipts in 2020.
Against this background the Cyprus government has needed to deal with the concurrent health and economic crises by providing economic support to the health sector and to households and businesses adversely affected by the harmful economic repercussions of the crises. To date the government has allocated over €1.2 billion or more than 5 per cent of 2019 GDP in fiscal expenditures for such assistance. In order to finance these measures and not deplete government reserves in the face of serious declines in tax revenues the government during the first part of 2020 borrowed large amounts of euro in international markets. This brought the government debt to GDP ratio to around 120 per cent by mid-July. And with government reserves, that mainly comprise deposits at the Central Bank of Cyprus, around €5 billion, the net debt to GDP ratio of the government was approximately 97 per cent.
However, with private sector business continuing to be depressed by feeble demand, especially for exports of tourist services, and recent monthly tax receipts declining by well over 30 per cent on a yearly basis, large deficits are being recorded in government accounts. It is expected that the government will register a substantial overall deficit in 2020, somewhat beyond the official estimate of 4 to 5 per cent of GDP. Yet in the coming months despite the grim state of the public finances it is likely that the Cyprus authorities will need to support the economy through among other things extending more fiscal assistance to suffering households and struggling businesses. In addition, the government has debt maturities of some €770 million during the remainder of 2020. And with these more immediate financing requirements the government most probably will have to deplete use its reserves and be forced to reduce and/or delay certain public expenditures.
When the current socio/economic problems associated with the coronavirus are mitigated, hopefully with the early production and distribution of an effective vaccine, the government would be able to focus more on policies and reforms required for bringing about a sustained and equitable recovery of the economy.
In this respect, the formulation of fiscal and taxation policies underlying the Cyprus Medium-Term Budgetary Framework for 2021-2023 and the new “temporary” fiscal rules and facilities of the EU, including the proposed Recovery Fund, provide Cyprus with some scope and opportunity for undertaking the policies and reforms required to support the healthy recovery and transformation of the economy.
The government cannot continue to borrow large amounts so as to fund its mounting expenditure demands as its debt would reach unsustainable levels even if borrowing costs remain historically low. This means that the government will have to substantially raise tax revenue as well as secure increased grants from the European Union in order to fill the fiscal hole. In this connection it is noted that the latest Eurostat figures for 2018 show that the ratio of revenue from taxes and social contributions to GDP for Cyprus was 33.8 per cent compared with EU and euro area averages of 40.3 per cent and 41.7 per cent, respectively. With such a revenue shortfall a substantial reform of the Cyprus tax system is called for so as to render it higher-yielding and fairer. Progressive taxes on immovable property and inheritances should be introduced and personal income tax rates should be made more progressive as well. In addition, the tax administration should be overhauled to combat the very large extent of tax evasion in Cyprus. Indeed, tax arrears to the Tax Department, the tip of the iceberg, amounted to €2.2 billion at end-2019.
To add to tax resources to fund its expenditures the government needs to access grant money available under new EU Medium Term Financial Framework for 2021 to 2027, that could be up to €1.45 billion for Cyprus, and under the proposed Recovery Fund, provide around €1.25 billion in total funds including possibly up to €650 million in grants.
However, even if the government is successful in raising substantially its revenue envelope it will still have insufficient resources to finance its large and various expenditure demands. And with such resources limited the composition of expenditures will need to be adjusted in line with socio/economic and environmental priorities, especially to be in accord with the conditions required for use of resources from the EU budget and the Recovery Fund. More resources will have to be devoted to investments advancing “green” technologies and initiatives to prevent environmental degradation and in the greater digitisation of the economy, while budgetary constraints are likely to require cutbacks in certain current expenditures.
Even if better taxation and government spending policies are instituted there are underlying problematic factors that are likely to hinder a sustained and equitable recovery through seriously impeding the efficient raising of tax revenue and the productive allocation and effective implementation of government expenditures. In Cyprus these factors derive in part from the failure to strictly and even-handedly enforce laws and regulations such as on tax payments and returns. This latter shortcoming in turn has led to prolific tax evasion, especially by self-employed professionals, resulting in the government losing large amounts of potential revenue.
Furthermore, institutional incompetence reflecting politically influenced appointments and promotions and inefficient procedures has contributed to the unsatisfactory preparation and implementation of growth-enhancing projects and programmes. Most notably, Cyprus has failed to absorb and use productively a considerable proportion of the funds available from EU institutions under the current financial framework for 2014 to 2020 owing to the incompetence and inefficiencies of government institutions in preparing and implementing projects eligible for using EU funds. In this respect, the inefficient procedures and unsavory decisions of the Tender Review Authority represent a prime example.
Finally, it can be concluded that in spite of what may be the best efforts of economic policy-makers to produce an efficient allocation of resources these endeavours tend often to be undermined, among other things, by the lack of the strict and even-handed enforcement of laws and regulations as well as by politically influenced institutional incompetence. Indeed, it is hoped that the productive use of the imminently available EU funds will not be derailed by these negative factors!
Leslie G Manison is an economist and financial analyst. He is a former senior economist at the International Monetary Fund, an ex-advisor in the Cyprus finance ministry and a former senior advisor at the Central Bank of Cyprus