02 August 2006

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Business Today

Gonzi’s Catch 22

Delivering a tax cut may not be consonant with the economic well-being of the country at this stage when government is gearing for possible entry into the Euro by 1 January 2008.
A tax cut may serve as a useful political tool to placate voter discontent on the eve of an election but Gonzi had better be warned that measures adopted to win an election may not necessarily be in synch with the economic requirements of a country wanting to adopt the single currency.
The key in the whole equation is economic growth. Despite the positive signals emanating throughout the last quarter of 2005 and the first six months of this year, Gonzi and his advisors know that growth is still very fragile and largely dependent on other factors then private enterprise. Besides, after years of stagnation, real growth of 2.5 per cent is still not enough to give this country the spurt it needs.
A broad tax cut at this stage will not help the productive sectors of this country rev up to fuel more growth. More money in the pockets of ordinary citizens is likely to be spent on imports with the additional risk of widening the trade balance further and forcing the Central Bank to raise interest rates once again to protect its reserves ahead of joining the Euro.
Exports are not yet the solid economic generator we would like them to be and any tax cut that would fuel the purchase of more imports would only help to exacerbate the trade deficit at a time when the price of oil is pointing towards the stars.
A two-step approach towards cutting general taxation would have been more desirable. In the first instance government should have reduced the tax burden for businesses and the commercial community through a mixture of income tax cuts and lowering of government-induced operating costs. After a two year period during which the productive sectors would have started to recoup their competitiveness hopefully fuelling economic growth, government should have proceeded to cut income tax levels in a meaningful way for private individuals.
It is obvious that Gonzi does not have the luxury of time on his side and a two-step approach is less likely to appease the Nationalist Party’s electoral strategists. In all probability the Prime Minister will adopt a short-term strategy and go for a general tax cut that would need to be generous to be meaningful but cautious not to disturb the road to the Euro.
In order to keep the deficit on track not to lose sight of the Euro, Gonzi has either of two options. The less likely is a window dressing tax cut that would have no appreciable impact on government’s overall tax take but which will also have no impact on people’s personal finances. The most likely option is a generous tax cut counter balanced with other measures to make up for the lost revenue.
If Gonzi adopts the latter option, electoral constraints will prevent him from announcing appreciable public expenditure cuts to make up for the lost revenue. He will not cut the extra fat around government’s gird in the form of additional public sector employees. He may trim the frivolous expenditure on cars, fuel, travelling and consultancies but this alone will not be enough.
In these circumstances the Prime Minister will be left, with what economists term as the unsustainable method of reducing taxes; generating one-off revenues.
Government can sell off more of its property, slap the banks with a windfall tax or declare an amnesty on those who have domestically held undeclared cash against a one-off 15 per cent withholding tax. These measures will give Gonzi the necessary leeway to deliver a meaningful tax cut and still keep the deficit on track.
The snag in this complex equation is that one year after joining the Euro, the exceptional one-off revenues will not repeat themselves but the tax cuts will still be in place. Less revenue would force government into facing the unpleasant situation of tackling its expenditure in a meaningful way or face a runaway deficit that would have the EU Commission breathing down the country’s neck.
The problem cannot be unravelled easily but Gonzi may very well find out that joining the Euro is not the best strategy to win an election. And if he decides to achieve both aims then he will have to be much bolder in tackling government expenditure unless the decision has already been taken to solve the fix in the short term, leaving the future to its own devices.
The pre-budget document will probably lay out all the options on the table but it is the budget in November that this leader will be taking a closer look at. Given last year’s experience when discussions on the pre-budget document were torpedoed by Austin Gatt’s massive surcharge proposal, anything can happen between the publication of the pre-budget document and what could possibly be Gonzi’s last budget presentation in November.
And it is not just the country that will be waiting to see how Gonzi will unravel this Catch 22 situation. The EU Commission will be scrutinising the details to make sure Malta remains on its chosen track to adopt the Euro and Gonzi’s much vaunted certificate from Europe, the argument he likes dishing out to rebut critics of his economic policy, may very well prove to be cautiously negative in 2007.

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