Strategic Slips

25^th January 2008

The Malta Independent - Friday Wisdom

As the current administration enters the final lap to the finish, it is appropriate to reflect on two measures taken by this government which in my opinion, in the fullness of time, will become a millstone round the economy’s neck. They will be a very heavy price to pay for the short-term palliative that these measures could have created at their inception.

The first such measure is the change in taxation system involving the facility to pay final withholding tax at source at 12 per cent on the sales value of property within the first five years from acquisition, which facility becomes obligatory after the fifth year.

This measure could have had a short-term palliative in making it fiscally efficient to sell long held property which realises huge capital gains that otherwise would have been taxed at 35 per cent. However beyond its short-term palliative that essentially rewards the lazy hoarders, it will start to punish the enterprising risk takers as once the property market slows down and property sales easily slip beyond the five years facility period, developers would have to pay withholding tax which will be higher than the 35 per cent tax on realised profits. If the property market slows down beyond a short-term breather it could also become a direct tax without direct profits.

Such mechanism could easily render a normal slowdown in the property market into a full blown crisis as developers would be forced to cut losses by offloading their stock at a discount before the five year time limit elapses. Temporary breather is a healthy economic check but a full-blown crisis is in nobody’s interest in a society of wide home ownership.

There is another very valid reason why this measure would need to be re-visited in the not too distant future. The payment of a final withholding tax is practically a licence to shred the VAT audit trail in the construction sector where VAT compliance was being gradually achieved with great difficulty through the widening of the audit trail net. What the government may be gaining through the withholding tax mechanism at point of sale it could well be losing a good part thereof in dilution of VAT collection on construction expenditure as compliance in the construction sector now has lost a crucial tool of the compliance mechanism.

VAT compliance is a very laborious process where data is built and refined year after year until the tax authorities are in a position to fine-tune a system which flags gross cases of laxity or evasion. The moment where an important economic activity like construction and property sales falls out of the system by the implementation of a withholding tax on sales rather tax on profits where costs have to be properly documented and justified, it is equivalent to drilling a hole in the tax net through which the big fish could easily slip through. We should be moving in the direction of tightening the net to enforce compliance rather than punching holes through the system.

Another measure which goes diametrically against the direction we should be aiming for is the extension of new measures of social security which are applicable universally without any means testing. Take the extension of children allowance to universal application irrespective of means. It is yet another case of transfer payment where the government pays the taxpayer part of what the taxpayer has already paid the government.

We should be moving to a system which cuts through these useless unproductive transfer payments and aims to have the citizen interacting with government at only one point i.e. at the direct tax system which in cases of merit proved by reliable means testing it could even become a positive tax system where government pays the citizen. But this will happen at one point avoiding the present system of spaghetti payments between the citizen and the government.

The issue of reliable means testing is a crucial point critical to our rate of economic development. It is an inescapable truism that future governments, left, right or centre does not really matter, will not find it possible to sustain the universal application of social services, health and education services and pension obligations, and still stay within the budgetary constraints of the Euro monetary system.

As sure as night follows day there will come a point in the not too distant future where government will be constrained to curtail the universal application and introduce means tested application aiming to keep such services free only to those who really cannot afford to pay for them. If means testing is to perform the intended role it has to be reliable, which presently it is not.

To achieve reliability we firstly have to streamline, simplify and render sensible the current maze of means testing regulations for different types of entitlements. And more importantly it has to accurately measure whatever criterion is used for means testing, whether income, capital or a mix of both. No reliable means testing is possible unless we achieve high tax compliance and high tax compliance is not possible without an effective policing system and without a reduction in the highest marginal direct tax rate to a level which makes it more economic to comply than to evade.

The vision to achieve these goals, even if on a long-term range, is noticeable by its absence.