Fiscal Consolidation: Cutting Waste as Key to Accelerating Growth

Overview
Prime Minister Datuk Seri Najib Tun Razak, who is also Finance Minister, has been mulling over plans to rein in the federal government’s debt-to-GDP ratio before it exceeds the statutory limit of 55%. After 15 unbroken years of budget deficit, starting from the 1997/98 Asian financial crisis, there is a new-found concern amongst the public over the sustainability of the fiscal balance sheet.

But, given the negative global outlook and narrowing trade surplus, would not any public spending cut or tax rise (or both) further dampens the economic growth? What should the plan for fiscal consolidation entail in order to avoid a self-inflicting wound on the Malaysian economy?

Spending-based adjustment is more likely to generate growth
The debate over Keynesian stimulus and Austrian austerity is still rife in the Western economy – at least among economists and policymakers – 5 years after the Great Recession of 2007/08. Deficit hawks argue that immediate deficit reduction is a necessary prerequisite of economic growth while the pro-stimulus camp defends government spending to end this depression now.

Empirical studies suggest that spending-based adjustment works better than revenue based.

In other words, when a government reduces deficits by raising taxes, the economy is more likely to experience prolonged contraction. But when the government arrests the growth of deficits by cutting spending, the outcome is more positive. The 2011 Italian experience of raising taxes had proven to be disastrous as the economy shrank further in the following year, forcing then Prime Minister Mario Monti to initiate a “spending review” as well as passing ancillary labor-market reforms. Of course, the Hoover’s administration serves as a classic case of tax folly where the top income tax rate was tripled to 63% during the height of Great Depression years.

Raising revenue from taxation without commensurate spending cut is akin to filling up a bucket of water with holes underneath. Such fiscal consolidation plan is not credible as it does not introduce the right incentives on the part of bureaucrats to spend resources prudently. On the other hand, if the government curbs spending today, it sends a signal to investors that tax rates will not be raised in future, therefore this certainty of tax policy creates a favorable outlook for investment. The risk of expropriation of wealth, either through direct taxation or inflationary means, is also lower as the government has larger room to introduce stimulus spending during an economic downturn.

But this does not mean that any form of spending cut will automatically generate growth. Spending-based adjustment must be supported by structural reforms such as greater liberalization of economic sectors and good public service delivery. So, well targeted spending cut complemented by structural reform can actually promote private investment growth.

Ending GLCs’ high barriers to entry
The Economic Transformation Programme (ETP) targets 6% annual GDP growth in order to increase Gross National Income (GNI) per capita from USD 8,000 to around USD 17,700 by 2020. The economy is expected to grow on the back of stronger domestic demand, especially private investment. But, the dominance of GovernmentLinked Companies (GLCs) in certain industries has been suggested to have crowded out the private sector.

The market share of GLCs is highest in utilities (93%), transportation and warehousing (72.3%), and information communications (43.7%). Many of these sectors could not be justified as natural monopolies, so there is no economic grounds for high share of public ownership while the close informal relationship that these corporations has with the bureaucracy continues to raise concern over the lack of transparency and leakages in the economy.

Under the Strategic Reform Initiatives (SRI), the government commits itself to a Government-Linked Investment Companies (GLICs) divestment plan which will see a reduction of public ownership in 33 companies by 2012. Winding down of public intervention in the market can theoretically spur competition and increase consumer welfare. Margaret Thatcher’s rigorous privatization of state enterprise had reinvigorated the British economy and hence marked the end of the road to serfdom.

Nevertheless, one has to reconsider the fundamental issue that is holding back private investment. The Malaysian case seems to be one of artificially high barriers to entry as much as inefficient public enterprise. Preferential treatment to GLCs and implicit guarantee to a bail-out discourage private investors from competing in the market. Moreover, some GLCs appear to diversify into other industries during the divestment period, thus accumulating huge bargaining power over both suppliers and consumers. As a result, private resources are not incurred adequately to promote innovation as firm managers are constantly focusing on cost-driven competitiveness.

The onus is on the government to institutionalize healthy market competition. Enforcement of competition laws by the Malaysia Competition Commission (MyCC) should be independent and credible in the eyes of business community. The parliament should also be empowered to hold regulatory authorities accountable as means to improve transparency and remove arbitrary jurisdiction practices.

Bloated public services
The latest Global Competitiveness Report cites “inefficient government bureaucracy” as the most problematic factor for doing business in Malaysia. The civil servant to population ratio, which currently stands at 4.68%, is the highest in the Asia-Pacific region. This casts some doubts over the efficiency of the public sector to provide services in a timely manner due to redundancies and overlapping of jurisdiction between different government agencies. Too much bureaucracy also raises the risks of corruption and therefore dampening investors’ confidence in the rule of law.

To successfully reform the public services, the government has to undertake a two-pronged strategy:
1) reducing the size of bureaucracy and 2) institutionalizing a meritorious reward system.

The Prime Minister himself has clearly identified the problem of bloated public services when he established the Performance Management & Delivery Unit (PEMANDU) as a unit under the Prime Minister’s Department. As a result, instead of going through many layers of authority, PEMANDU is able to liaise directly with key personnel and coordinate various government agencies in order to meet the Key Performance Indicators (KPI). The success of PEMANDU has probably inspired the creation of Education Performance and Delivery Unit (PADU) to develop and implement the Malaysian Education Blueprint.

It is evident that a leaner management can actually improve productivity even within the public sector. So, instead of a drastic retrenchment policy, the government should consider increasing the number of quasi-agencies like PEMANDU and PADU to exploit the twin advantages of a lower emolument spending as well as making public services more efficient.

Institutionalizing a meritorious reward system is as important to improving the efficiency of public services. The practice of offering bonuses in each year’s budget tabling does not link working performance to reward. Furthermore, the promotion strategy of civil servants must be based on merit to discourage rent-seeking behavior and political patronage.

Perception by the general public over the meritocracy of reward system matters because self-selection bias may arise where better quality workers systematically opt for employment in the corporate sector. Besides, the public workforce is predominantly Malay and this may adversely affect the job-seeking decisions of other ethnic groups. In short, the government has to put in place the right incentive structure to promote efficiency and attracting good talents to join the civil force.

Goods and Services Tax (GST): A stable source of federal revenue
The biggest difference between Malaysia and the Eurozone today is that the former is
not facing an economic crisis. This means that Malaysia is in a much better position to cushion on the immediate impact of lower government expenditure. But, the existing tax system needs to be reviewed as it is inefficient.

It is estimated that only 1.7 million individual taxpayers are contributing to the national coffer. This observation is further complicated by high level of tax evasion and generous tax exemptions given out without equal sum of resources to plug the gap. Also, the Malaysian government has to signal its determination to reduce dependence on natural resources for income. All these inadequacies matter to private investors because shortfall in fiscal revenue translates into slower future infrastructure development and also increasing the risk of expropriation of wealth.

The introduction of Goods and Services Tax (GST) aims to provide the federal government with a stable stream of revenue because the tax is anchored to the consumption behaviour which does not fluctuate like corporate profit or prices of commodity. Besides, the tax-net is spread out more widely as most consumers indirectly pay for GST at point of purchase, regardless of whether one is eligible for income tax. Cascading tax, or the tax-on-tax phenomenon, can be lowered with GST as the tax burden now shifts from producers to consumers, therefore the tax does not constitute as a cost to the firm managers. But if GST is indeed a better solution, then why has it not been introduced much earlier?

The short answer is that GST is not politically palatable. Despite commanding the majority of seats in the parliament, the Najib-led government faces a continuing erosion of support by the electorates, especially from the urban areas. With the opposition calling for more redistribution of wealth, the incumbent administration is compelled to match the electoral pledges set by the challenger, which in effect put on hold any plans for achieving fiscal sustainability. Drawing examples from other countries, incumbent parties suffered greatly from electoral losses in seeking for mandate to introduce the GST. Now that Najib’s administration receives fresh mandate to govern, it is about time to correct the flaws in the current tax system, and the GST appears to be a good candidate for its predictability as a source of federal income.

But cutting spending is not popular
Baby boomers will remember the post-World War II period as a golden age of welfare expansionism. High and sustained growth in the Western world had given politicians more leverage to extend welfare payments to the electorate. Successors of these generous welfare states have to now face the political challenge of rolling back the size of government in favour of fiscal sustainability. The age of austerity has proven to be ungovernable as current administration has to take the blame for correcting mistakes by the previous government. This serves to remind the Malaysian government of the problematic “subsidy mentality” that the country faces after years of generous subsidies on commodity prices and expansive tax exemptions.

Beneficiaries of welfare extension are usually comprised of well-targeted groups of people. The government raises tax revenue from a broader class of people and channel its spending to a narrower group of recipients, be it to the people or the industry. So, a person who pays the income tax usually do not find out how much fuel subsidy a local fisherman gets each month, if the taxpayer is aware at all about such scheme in the first place. But, recipients of fuel subsidy in this case feel the bulk of the pinch if the government decides to shed its subsidies payment as part of the fiscal consolidation plan. As a result, the fishermen, due to its size vis-à-vis average voters, could organize themselves to lobby for the continuity of such federal assistance.

The opposite idea of raising tax revenue is equally, if not even more, unpopular. Tax hike requires increase of tax payment across the board and a reduced net wealth will result in lower consumption, thereby reducing standard of living. Therefore, the success of government’s fiscal consolidation programme depends on the ability to juggle between revenue-based and spending-based adjustments, as well as promoting the growth of private investment in order to increase the country’s average income.

Conclusion
Malaysia does not suffer from political fragmentation – a key variable to explain why certain governments were more able to introduce fiscal reforms – which threatens the survival of the government when in power. The real challenge rather is for the government to demonstrate its political willingness to maintain fiscal sustainability. As the saying goes, the proof of the pudding is in the eating. Successful spending cuts which are well-targeted will shore up the government’s revenue base as well as investors’ confidence. The five-year term can be challenging to reverse the declining fiscal position and Prime Minister Najib has to make every hour count.

References
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Horwitz, S. (2008). Hoover’s Economic Policies. Available: http://www.econlib.org/library/Enc/HooversEconomicPolicies.html. Last accessed 30th Sep 2013.

Overview of ETP. Available: http://etp.pemandu.gov.my/About_ETP-@Overview_of_ETP.aspx. Last accessed 30th Sep 2013.

Menon, J. (2012). ‘Malaysia’s Investment Malaise: What Happened and Can It Be Fixed?’. ADB Economics working paper No. 312.

Prime Minister’s Office, ETP Annual Report 2011. Last accessed 30th Sep 2013.

World Economic Forum, 2013. The Global Competitiveness Report 2013-2014: Full Data Edition, Geneva.

Lim. (2013). Malaysian CEOs want civil service trimmed, survey reveals. Last accessed 25th Sep 2013.

Lee, W.L. (2012). Income tax cut expected to pave way for GST, say experts. Last accessed 30th Sep 2013.

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