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Worsening management of Cyprus economy and delays in reforms

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Finance Minister Makis Kervanos

There are growing concerns about the recent weakening of economic activity, the persistence of inflation, and the deterioration in the government finances in Cyprus that come on top of underlying problems of corruption in the allocation of real and financial resources, the continuing relatively low incomes and heavy indebtedness of many households, and the deteriorating quality of the government finances.  What is equally worrying is the inadequate response of the Cyprus authorities to these issues that is reflected in the worsening management of the government finances and the long delays in carrying out required reforms as well as shortcomings in the handling of the cost-of-living crisis.

Misleading assessments

Apart from the period when economic activity was severely disrupted by the Covid crisis top officials from the Cyprus government and the Central Bank had been up to mid-2023 stating repeatedly that the economy was performing well by citing the relatively rapid growth of real GDP, the generation of fiscal surpluses, and the very large reduction in the NPLs of banks as supporting evidence.

But, has GDP growth since the beginning of economic recovery in 2015 improved the economic wellbeing of most citizens?

It is estimated that the more highly paid employees in the public sector increased their real incomes on average by around 9 per cent in the seven years to 2022 far exceeding their loss of incomes in the wake of the financial crisis of 2012/13. Suprisingly, on the basis of limited official statistics it is estimated that the real incomes of the majority of private sector employees comprising around 70 per cent of the total labor force increased at a slightly higher rate than 9 per cent over the years 2015 to 2022. But the average incomes of the bulk of employees in the private sector including those of many young couples hoping to raise families have remained at very low levels, being less than one-third of the average incomes of public sector employees. And with inflation persisting with food, energy and house prices at unprecedented high levels, a great many households dependent on private sector incomes and pensions must be suffering from soaring living costs. In addition, many households and businesses have remained heavily indebted despite the constant publicity by banks that they have largely removed NPLs from their balance sheets.

Obsession with fiscal surpluses

After regaining access to borrowing in international capital markets in 2014 following the pursuit of fiscal austerity policies, the Cyprus Ministry of Finance has remained obsessed with the achieving fiscal surpluses irrespective of the state of the macroeconomy. Indeed, the main criticism of former Minister of Finance Constantinos Petrides on the performance of the new government in managing the economy is that its excessive expenditures on personnel are endangering the prospect of the government continuing to produce surpluses. And the response of the current Minister of Finance Makis Keravnos has been to state in the submission of budgets for 2024 to 2026 that the main mission of fiscal policies is to generate government surpluses, seemingly giving no consideration as to whether the government might need at some time to inject money into the private sector to boost economic activity. Indeed, it is debatable whether the government should be currently running deficits with measures directed to boosting consumer and investment demand in the face of the present cost of living crisis. Even the European Commission has been advocating the adoption of targeted fiscal measures to raise the purchasing power of vulnerable households confronted by surging living costs.

Poor management

 

The deterioration in the management of the government finances by the new government is being reflected in the populist policy of extending deadlines for tax collections and instead is substantially running down its cash reserves (by over 900 million in July 2023) and by borrowing to fund its mounting and excessive expenditures on personnel and travel.

Moreover, as outlined in previous opinion pieces what is of key concern is how the government is diminishing the quality of its finances in order to produce fiscal surpluses per se. In preparing government budgets the Ministry of Finance keeps its much greater levels of current expenditure at minimum levels, while inflating allocations for the usually lower development or capital expenditures so as to show surpluses in its budget presentations. But as the fiscal years unfold Cyprus governments dispense much more funds than budgeted for current expenditures on the employment of consultants, advisors and casual workers, as well as recently for defense, mainly owing to ongoing political and populist demands. Indeed, under the government of Nikos Christodoulides such employment practices and nepotism have intensified, with the number of casual workers in the general government rising by 9.1 per cent to 20.435 over the last 12 months. Such workers now account for nearly 40 per cent of government employees compared with a much lower 20 per cent in 2015.

In response to overruns in current expenditures and its extreme reluctance to take measures to raise tax revenues the government repeatedly delays and even cancels the implementation of development projects in order to ensure a surplus in its accounts. In fact, the rate of implementation of the development budget has averaged under 65% over the last ten years, meaning that together with excessive current expenditures the quality of the government finances is being reduced..

Delayed reforms

The misleading official assessments that the Cyprus economy is performing satisfactorily and that prospects are favorable, as well as a reluctance to take unpopular measures, cause leading government officials and politicians to be extremely hesitant in carrying out promised reforms. This is particularly the case on the compelling need to reform the tax system and its dreadful administration.  Cyprus is in urgent need of a tax system that provides sufficient revenue to enable the provision of high-quality public services comprising education, healthcare and social protection as well as the construction and maintenance of infrastructure including the vital upgrading of the electricity grid. The system needs also to be fair in taxing persons and corporations according to their ability to pay, as well as being efficient and unbiased in its collection of taxes.

Unfortunately, the tax system of Cyprus is narrowly based, has become increasingly regressive and its administration grossly inefficient and inequitable with little effort to tackle prolific tax evasion. In this respect the main components for a tax reform are very obvious and definitely do not require a 24-month study by the University of Cyprus. Accordingly, there needs to be the re-introduction of a Central Government progressive tax on immovable property, increases in the tax-free threshold and tax rates to take account of inflation in the personal income tax system, and a raising of the corporate income tax rate from 12.5 per cent to 15 per cent.  Only the details of the specific tax rates to be applied and their potential revenue yields require study over the short-term. And most importantly tax system reforms should include an overhaul of tax administration to improve its efficiency and ability to combat tax evasion.

Repeated calls for public sector reform have been made including recommendations incorporated in the Recovery and Resilience plan. These recommendations are centered around modernizing public services through the digital transformation of public administration enabling the provision of public services to be more centralized, citizen-focused and better targeted. And a policy of enhanced mobility of public servants between government departments and agencies needs to be developed so as to respond to changing business needs, while reducing the scope for corruption. Furthermore, the appraisal system for the appointment and promotion of government employees needs to be redesigned and based on merit rather than on political connections and slavish loyalty.

But many of the stakeholders are dragging their feet in implementing necessary tax and public sector reforms. Politically-connected and often incompetent government employees gain unwarranted promotions under the current appraisal system, while others including managers remain in their positions for lengthy periods with many interested only in refining their skills for engaging in corruption. Furthermore, most political leaders and top officials do not want to reform the antiquated public service and taxation systems, let alone the judicial system, since they themselves are benefitting handsomely, and some corruptly, from enrichment and the exercise of power, while gaining and retaining political support from an expanding army of public sector employees and advisors.

 

Leslie Manison is a former senior economist at the IMF and an ex-advisor in the Cyprus finance ministry and at the Central Bank of Cyprus

 

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