21 June 2006

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Business Today

Super tax on super profits

Veteran economist KARM FARRUGIA does not mince his words; the super profits made by banks and other entities operating in restricted markets should be taxed at a higher rate than the topmost income tax level.
Farrugia calls his proposal an oligopoly tax. He insists that certain sectors of the economy posit a high barrier for entry, effectively limiting real and full competition to the detriment of consumers.
Farrugia says that in these circumstances there is little government can do since the companies are not even breaking the law. But, he argues, the least government can do is take a bigger cut in the form of taxes, from the huge profits these companies are making by virtue of their dominance in the market.

You have often criticised the commercial banks for their dominant position in the market and have called for a special tax on their super profits. What is wrong in the banking sector to warrant such criticism?
The banking sector is one of those sectors of the economy in which there is a natural oligopoly because of the size of the local market. You can never tell whether the extra profits made by a company operating in an oligopoly are made through increased efficiency or because of the privileged status they enjoy in the market. Government can do nothing about the situation but the least it can do is identify those pockets of the economy where competition is restricted because of market size and the nature of the business, and raise the level of income tax on their super profits depending on the state of the oligopoly.
In the case of a duopoly the rate of income tax could go up to 50 per cent and drop to 45 per cent in the case of a restricted number of players. It all depends on how ambitious government is but in this way, at least, government would be taking something back from the advantageous situation enjoyed by the companies in question.

Which sectors of the economy would you identify as being an oligopoly?
Banks come out first. But there are also insurance companies, mobile telephony, port operations, the international airport and other small entities which government can focus on. Every market, in which competition is not allowed to run its course in the best interest of consumers, requires some innovative thinking by government. Normally, a sector that delivers a lot of profits attracts more players into that particular market ensuring ongoing competition that benefits consumers. With the level of profits being made by the banks it would seem natural for more players to enter the sector but this cannot happen because of the high capital cost required to break into the sector.
Real competition allows freedom of movement in and out of the sector but in the case of oligopolies new players can’t make it because there are limitations.
An oligopoly tax will hurt nobody except the super profits of the institutions in question. It is not a disincentive to investment because it is not a tax that will hit the exporter and there is no social impact on the general public.
The top tax rate for oligopolies can be set in every budget depending on whether the sector has opened up to more competition or not.

This is a different concept from the windfall tax on bank profits, mentioned quite often by various exponents and commentators. Why an oligopoly tax and not a windfall tax?
A windfall tax by definition is a once-only tax and I don’t want to see a once-only tax. I want a tax that becomes part of our financial set-up.
There is a case for a windfall tax on the increased building area recently announced by government. The authorities should be clever enough to say that from now on, permits for development in these areas where the value of property has shot up by 10 if not 20 times more, developers will pay a windfall tax.
There is no point in imposing a windfall tax on banks because it will only reap dividends for public coffers once. I want a more permanent feature.

Wouldn’t a new tax like you’re suggesting make Malta unattractive to investors?
The tax I’m talking about refers only to those industries that operate only in the local market and which by the very nature of the local market the entry barrier to a particular sector is very high. Our miniscule market does not allow enough competitors to compete freely in certain sectors. Our banking system is dominated almost entirely by two commercial banks. Each of these banks is so powerful that one has to question whether their super profits are reasonable and whether depositors and borrowers are being treated fairly.
There should be a super tax for super profits and this should only change if competition in the sector increases. I am not saying that the banks are abusing of their dominance, they are making the best out of it. I am not even suggesting there is any collusion between them, in reality they even compete between themselves. But the very nature of the market does not allow competition to take root as we would like it to. In an oligopoly the leader sets the pace and the others follow. There is no way of competing by trying to give the customer better terms.

Do you agree with the statement that huge bank profits are a good indication of how well the economy is performing?
Of course not. First of all, 60 per cent of banking ownership in Malta is foreign based. The profits of the banks and the contribution they make are part of our GDP (gross domestic product) but this does not necessarily mean that GDP reflects your income or my income, or anybody else’s income. Personal wealth is measured by GNI (gross national income) and very often in European Union parlance, it is the GNI that counts.
What is the point of Malta producing wealth only for it to go outside the country by way of dividends paid to foreigners? How can we say that the banks’ profits are in the interest of the Maltese citizen, because they are not?
Nearly two thirds of banking profits by way of dividends go abroad. How well the economy is performing should not be argued in terms of banking profits.

But we’ve had politicians arguing this way…
They don’t really see the implications. Most of the politicians are not economists so they don’t see it the way I am seeing it. You can argue that by the arrival of the foreigner, what was a pound made is now three or four and so the share of the Maltese product has also increased. Since we’ve had HSBC here the banks have been looking at other ways of making money but there is still the implication they operate in an oligopoly and therefore the amount of charges they levy are more than they would have done if there was effective competition.

The banks claim that their profits are not derived from raising charges but from increased efficiency and a diversified investment portfolio. What is your reaction?
They can say what they like. Just look at the charges they are levying and if they haven’t increased charges then they have been too high in the first place. Any industry that shows the profits the banks and others are making from the local market will need to be charging excessive charges. And the only proof that they are not making excessive charges can be obtained if there is free and full competition. How can that be achieved with two banks almost exclusively dominating the market?

With benefit of hindsight what is your assessment of the privatisation of Mid Med Bank to HSBC in 1999?
There are two aspects to it; de-nationalisation and selling off the bank to a foreign company.
I agreed with de-nationalisation of Mid Med Bank because nothing in the hands of government works efficiently but I did not agree with its sale to a foreigner. In the banking sector we had been well advanced to know what to do ourselves. We did not need to sell the bank to HSBC. We could have invited HSBC to come here just the same and compete with Mid Med Bank, Bank of Valletta or Barclays if they wanted to set up shop here. But not buying out our biggest bank. This gave them the chance to exploit our market. The bank could have easily been privatised by taking recourse to the domestic market.
People talk about bringing in a name by roping in HSBC. Alright, that is an argument but in the banking sector we’ve had a relatively long history and even though Mid Med Bank had been nationalised it was still a success story. Malta was always served well by the banks. It’s not as if we were completely raw in this sector.

Government’s hefty shareholding, almost 40 per cent including that of the Sicilians in Bank of Valletta is up for sale. Some have argued, including former finance minister George Bonello Du Puis that the shareholding should be sold to Maltese investors, retaining the Maltese character of the bank. Do you agree with this?
Of course! It should definitely not be sold to an outsider. If it wants to sell, Government should divide its shareholding and sell it off in pieces to Maltese shareholders. Bank of Valletta is well organised, it stands up to any competition, it is a good bank and it is Maltese owned.
Which foreigner would want to buy 40 per cent when HSBC owns 66 per cent in the rival bank? The foreign bank that would accept a 40 per cent shareholding will offer a low price for its slice of the cake. Government would be very unwise to sell BOV to a foreigner.
But I don’t think it should dispose of its shareholding in the first place. Government should not interfere in the running of the bank. It should allow it to be run in a purely commercial way and still reap the dividends. Even if an oligopoly tax is introduced like I’m suggesting, government would still receive more cash from the bank than it would be losing if it were to sell off its shareholding.
By disposing of its shareholding government would receive a cash bonus that would go to shave off some of our national debt but it would be forfeiting a yearly income from dividends. Is that wise? Of course not!
Only the theoreticians tell you that the national debt should go down. Let us first solve the deficit problem because by tackling the deficit we can ensure economic growth and the debt would automatically start to be reduced.

Banks have often been criticised for being quick on the ball to dish out house loans but very restrictive and difficult when it comes to venture capital funding for enterprise. Is this a defect in our financial set up?
It is unfortunate that banks would not even use part of their super profits to create a subsidiary venture capital company. If the country does not tax their super profits in a special way, it should at least insist with banks for them to create venture capital companies even if these are high risk ventures. The banks will not be impoverished.

The Central Bank has increased interest rates by 0.25 per cent, the second such hike in just over a year. Was it a wise decision?
In the circumstances I believe it was. There is a fear of inflation across Europe and the world with the security markets fluctuating up and down as never before. The Chancellor of the Exchequer in Britain has acknowledged this fear as has the chairman of the International Monetary Fund. In a situation like this which can get out of hand, it was obvious that interest rates were going to be raised. Luckily they have not been raised dramatically.
The Central Bank of Malta had to take its decision in the context of what is happening in the world but also in the context of its reserves. Until we join the Euro you need to have a certain amount of reserves so that people have trust in the Malta pound because we have nothing to back the Lira except the Central Bank’s reserves.
The Central Bank felt its reserves were depleting and needed to act to make the Malta pound more attractive.

But does a decision to raise interest rates in Malta to maintain the differential with interest rates in Euro land make sense when we should be converging towards the Euro?
It does make sense because we are not strong enough to be able to uphold the Euro rates of interest. That is why it is essential for us to work hard and pass the test to be able to join the Euro as quickly as possible not later than 1 January 2008. By reaching the criteria and eventually joining the Euro we will be giving a sign that the country can cope with the conditions imposed by Euro land, which are good.
Low rates of interest are an economy’s show of strength. High rates of interest are a sign of weakness.
This interest rate hike is a cost on businesses with loans and overdrafts. At a time when we need industry to continue investing and generating wealth they are being burdened with a bigger cost. Isn’t this a set back?
You’re right, it is a cost. Everything has a cost but the gains from this decision far out weigh the costs. If it wasn’t for this interest rate increase we would have a problem with the value of our money. We would be seriously jeopardising the fixed parity with the Euro and compromising eventual entry into Euro land. We need the reserves to back up our currency.
Admittedly it is a cost on industry but look at the bigger consequences of having depleted reserves and uncontrolled inflation.

All over Europe finance ministers have been critical of the European Central Bank’s decisions to raise interest rates because of the cost on industry. Are central banks in general out of touch with what society is feeling?
The commercial banks in Malta should not have raised their interest rates. Let the Central Bank increase the central intervention rate but the commercial banks should have said we are making so much oligopoly profits that we won’t pass this new increase on to the borrower.

But finance ministers are complaining about the behaviour of central banks…
If there are indications that inflation can get out of hand, what do the finance ministers expect? Haven’t we experienced inflationary problems in the seventies and the problems it creates in the economic build up of a nation?

Are you saying that the danger of having runaway inflation is bigger than the danger of increasing the burden on industry in the shorter term?
I’m not talking about a runaway inflation yet but there are indications that if action was not taken and will not be taken, inflation could start creeping back up again. Inflation, like a bad habit, if not stopped at its earliest stages can run away. And if that happens we will be in for some bad times.

Why is it important for Malta to adopt the Euro at the earliest possible stage?
It is absolutely important because the Euro made us do things which we have been dilly dallying about for ages. It gave us some more discipline in the way we are managing our economy and finances. There are still things that need changing but we have done improvements.

Is adopting the Euro the end of the story?
It’s not the end of the story but entering Euro land is almost more important than joining the European Union. In the history of the nation, joining Euro land is as important as achieving independence in 1964 because in our management of the economy, our politicians always take short-term measures expecting to face the consequences later. The rigours of joining Euro land, the long term interest rate and inflation trends, the controls on the annual budget deficit are all a help to us.
But we must not be content in reaching the three per cent deficit target. We need to go beyond that, if possible aiming for a zero deficit or even a surplus budget deficit. Only this will make sure that the one-off incomes government is making to try and reach the targets will be eliminated from the equation once and for all.

Karm Farrugia was interviewed by Kurt Sansone

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