Budget targets hard to achieve
WHILE I AM satisfied with the depth of the fiscal adjustment ($542 million), and I agree fully with the minister that the fiscal deficit should be eliminated, I have reservations about the feasibility of this plan, given the impact the adjustments could have on the wider economy.
I wish I had the data and the time to estimate the Laffer curve for, as this could have supported my response. The Laffer curve shows the relationship between the average tax rate and the level of fiscal revenue.
The relationship is non-linear, and beyond a certain tipping point, higher taxes actually do not lead to higher revenues, and the relationship becomes negative. We don’t know what that tipping point is for Barbados unfortunately.
But given the many tax increases we have seen over the past few years, which have not generated the expected rise in revenue, I suspect the relationship is not as positive as we would like, and therefore, it is unlikely that higher taxes will necessarily generate the revenue the minister expects this time around.
In addition, I am not convinced that the level of economic activity will only decline in real terms by 0.5 per cent as the Minister expects, and if the growth assumption is over-optimistic, the same will apply for the revenue assumption.
The Central Bank of Barbados recently announced that the level of reserves that commercial banks must hold in securities will be increased by 50 per cent, from ten per cent of total deposits, to 15 per cent of total deposits by June 15, 2017. Such monetary tightening usually dampens credit growth, credit-driven consumption, and overall economic activity.
Coupled with this monetary tightening, the Government has now announced significant fiscal tightening, based mainly on higher taxes. These measures combined are likely to put significant pressure on overall economic activity, which could then jeopardise the revised revenue and fiscal targets.
From July 1, there will be a two per cent tax on all foreign exchange transactions, including credit cards, wire transfers, and over the counter purchases of foreign exchange. This means that one US dollar will now cost BDS$2.04, and imported goods and services will now cost two per cent more.
This will likely reduce the demand for foreign exchange (which is the desired outcome) and cause inflation to rise, which in turn could lead to lower consumption and lower growth.
But there is a risk that this measure could also drive a greater proportion of foreign exchange transactions into the black market to avoid this two per cent tax. We don’t know whether the minister considered these possibilities in projecting revenue of $52 million from the introduction of this new tax.
The increase in the National Social Responsibility Levy from two per cent to ten per cent on all taxable imports and domestic production, is expected to raise $186 million in the current fiscal year. The VAT revenue from this is anticipated to be $32 million.
What is the likely impact that this tax, coupled with the foreign exchange tax mentioned above, will have on the cost of living, consumption, production, employment, investment, and growth? To what extent therefore, is the revenue target likely to be missed, as we have seen in previous fiscal years with VAT?
Further, I think this levy is a regressive tax, as it will be applied to all imports at ten per cent, barring specific exemptions. And since most of what is consumed by everyone is imported, this levy will affect consumers at lower income levels disproportionately.
The planned 34 per cent tax increase on gasoline and 120 per cent tax increase on diesel, will directly raise the price of transport, and the price of most other goods and services indirectly. Again, this increases the cost of living, putting pressure on consumption and overall economic activity, which could jeopardise the revenue target of this measure, as well as the other measures mentioned earlier.
By August 2017, the minister plans to implement the duty-free zones he initially outlined in last year’s budget. I am not convinced that this will generate meaningful additional foreign exchange inflows, since most of the goods sold on a duty-free basis to foreigners and locals would be imported anyway.
A second concern is that this measure, in effect, dollarises only certain areas of the country, and I am not clear how that is going to work in practice.
I am very concerned that the proposed debt re-profiling will mean lower returns on the NIS’ portfolio, potentially affecting their ability to meet their obligations and benefit payouts. This is a risk that the Government needs to carefully mitigate.
Overall, I think the debt re-profiling is a positive initial step in addressing the existing stock of debt, and should be followed by a wider and more in-depth liability management exercise.
The level of reserves is the most important number to watch, as this to me is the most critical vulnerability right now. Since April 2016, the level of reserves has been below the internationally accepted precautionary benchmark of three months. In February 2014, the International Monetary Fund defined the “comfortable” level of reserves for Barbados at US$800 million. Reserves are less than half that level now.
The fiscal deficit and the primary mechanism for financing it – CBB printing – are the major factors driving the net outflow of US dollars, and the level of CBB printing is reflected in the size of the monetary base. The monetary base has expanded by double digits, for every month since September 2014, averaging 26 per cent per month, year on year.
The level of foreign reserves would have to improve meaningfully, and the IMF suggested US$800 million is a comfortable level, to restore for confidence in the exchange rate. In addition, the expansion of the domestic monetary base through CBB financing of the fiscal deficit would have to cease.
I am in favour of eliminating the fiscal deficit, and spreading the burden of adjustment widely and equitably. However, given the proposed adjustment’s reliance mainly on higher tax revenues to balance the budget, the recent fiscal performance, and the likely impact on the economy, I am not convinced that the fiscal target will be achieved.
If the proposed fiscal measures are fully implemented, I expect growth to decline significantly, and the net outflow of US dollars (apart from debt servicing obligations) will slow, supporting a recovery in the level of reserves, and the import cover ratio.
Marla Dukharan is group economist, Caribbean Banking, Royal Bank of Canada. She shared this view in an interview published by Global News Matters.