The Covid-19 pandemic and the Russia-Ukraine war have had major socio-economic repercussions reflected in slower eco-nomic growth and rampant inflation together with a related severe cost of living crisis in European economies and elsewhere. And the policy responses of European governments and Central Banks to these profound problems have threatened to cause a doom loop between expansionist government expenditure policies and restrictive monetary policies with rising fiscal deficits and interest rates contributing mutually to financial instability. Furthermore, deteriorating current account balances in most countries largely owing to extremely high energy prices are substantially increasing external financing needs and adding to upward pressures on interest rates.
This doom situation is the predicament that the United Kingdom economy finds itself in with the prospect of increased socio-economic instability, particularly if the cost-of-living crisis is not effectively dealt with. The United Kingdom authorities will need to maintain and even raise the government expenditures to mitigate cost of living pressures on households and businesses and continue to increase interest rates to combat inflation and deter destabilizing external capital outflows. But such policies would keep the United Kingdom in a doom loop with fiscal deficits and financing needs continuing to rise.
In order to fund higher government expenditures and contain the United Kingdom fiscal deficit a substantial boost in tax revenues is necessary. But given that lower and many middle-income households are being hurt disproportionately by soar-ing prices and costs any increase in tax rates should be levied to a large extent on richer individuals and highly profitable companies. While the redistribution of higher taxes on richer entities to help finance government assistance to vulnerable and poorer persons would constitute the main means for reducing the fiscal deficit it is unlikely to be enough to put the government finances on a sound footing. Indeed, in addition the United Kingdom Chancellor of the Exchequer, Jeremy Hunt, next month is expected to call for cuts in government expenditure to help safeguard fiscal stability.
As the recent United Kingdom experience demonstrates once a country gets into the doom loop of mutually reinforcing rising deficits, debt and interest rates, harsh action is required in the form of higher tax rates and even fiscal austerity measures to break this vicious spiral. In fact, policy mistakes including unfunded government expenditures by the Truss government have made the need for austere policies by the Sunak government much greater than otherwise required.
It is contended that if countries such as Cyprus want to achieve Northern European levels of social welfare to enable their populations to sustainably cope with financial difficulties such as cost of living crises, they will need strong redistribution policies entailing greater progressivity in tax rates, a broader tax base, and an overhaul of grossly inefficient tax administrations. As stated in previous opinion pieces the Cyprus government does not have the resources including the institutional capacity to finance the effective protection of the most vulnerable segments of society compatible with an advanced European country like Denmark.
The policies of the Cyprus government including those implicit in the budgets for 2023 to 2025 are not serious in facing up to reality, particularly of prolonged rapid inflation, and show little concern for the need to deal with the problems confronting ordinary citizens. Accordingly, the budgets should be substantially revised with funds allocated not only to enable the government to manage more effectively the current intensifying cost of living crisis, but also to safeguard adequate social protection in future years. Apart from allocating more funds to the Ministry of Labor and Social Insurance to finance the distribution of social protection benefits, additional funds are needed urgently to raise the Ministry’s competence to administer and dis-tribute efficiently social welfare. And, most importantly, to ensure that sustained higher government expenditures for social protection are adequately funded there is an overwhelming need to substantially raise government revenues through tax re-forms and revamping tax administration to combat massive tax evasion, thus, enabling the substantial redistribution of funds to social welfare recipients.
It can be concluded that strong redistribution of higher tax receipts through the government budget should contribute significantly to stability in the government finances and in turn provide the basis for supporting the sustained growth of a state with high-quality social welfare. Unlike in the United Kingdom currently, such policies would render the need for fiscal austerity-ty virtually non-existent.
Les Manison 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