Sunday, 15 November 2009

Unintended Consequences

Unintended Consequences

15th November 2009

The Malta Independent on Sunday

Alfred Mifsud

Minister Tonio Fenech’s second budget marks a stark contrast with his first, which was rendered irrelevant before he even read it in parliament this time last year. Never can I recall a budget that goes way off the mark as much as the budget for 2009.

It was framed on the false hypothesis for economic growth slightly below the normal trend line, when in fact all indications were that 2009 would be a year of negative growth caused by the recession resulting from the international financial crisis. Once this main hypothesis proved false, all else went way off the mark with a resulting deficit two-and-a-half times that projected, even though the government did not have to intervene to recapitalise our banking system and even though no specific stimulus measures were provided.

Perhaps I should say that the large deficit resulted because no stimulus measures were provided for in the 2009 budget, against the general advice of the economic corps and of the EU itself. As the economy floundered, the government tax take was hit at a time when it was forced into higher recurrent expenditure, as social triggers were released by rising unemployment, forced subsidies and rescue funding to imperilled industries.

The budget for 2010 seems thankfully different. It is framed in full recognition of the unfavourable economic scenario surrounding us and assumes that for next year we will only start recovering in the second half, leading to an overall growth of one per cent, which merely claws back half the negative growth (how oddly American this term “negative growth” is – would not the pure English term “contraction” fit better? The Americans have a knack for such funny terms – like “reverse split” when they mean “consolidation”) being registered in 2009.

Next year’s budget has clearly been a bottom-up exercise, adopting a wide array of suggestions made by the social partners represented at the MCESD table. These partners have generally expressed positive sentiments about the general orientation of the budget, as they felt an element of ownership in its structuring. Such positive sentiments are surprising, given that the pack is still missing the joker. When the utility rates for 2010 are announced, we will have to see how many of these positive sentiments will survive, but so far Minister Fenech has learnt from past mistakes and taken the social partners on board by playing the card of shared ownership of ideas.

Yet for all this positivism, there are two measures about which I express reservations, as they are likely to have unintended harmful consequences.

The first is the opportunity missed to reform the COLA mechanism, which is seriously prejudicing our international competitiveness – producing a combined legally enforced wage increase of e12.33 per week during the two recessionary years 2009/2010, when international industry is merely in survival mode through savage cost-cutting.

I can understand, though not necessarily agree with, the argument that COLA has worked well in the past, as it brought industrial relations harmony and has been a useful tool for creative destruction. Creative destruction is the term used to explain how certain outdated industries that cannot afford higher wages are forced to close so that new more value-adding competitive industries that can afford higher wages take their place. I don’t agree with it because creative destruction also occurs in countries – far outnumbering those that have COLA type mechanisms – that do not enforce cost-of-living adjustment wage increases across the board, except through minimum wage provisions.

However, keeping this tool of creative destruction working, at higher speed as it so happens, even during recessionary years, is playing with fire. In recessionary times, investments are scaled back and it is hard to attract new value-adding enterprises to replace those that wither away. So in recessionary years, safeguarding existing jobs has priority over creating new ones that are nowhere in sight.

This was the right economic environment to force the social partners to restructure the COLA mechanism. At the very least, the government should have offered to carry part of the COLA burden as a one-off measure, on condition that the social partners agree that, in future, the COLA increases will only apply to the minimum wage and to workers who are not covered by collective agreements. Transient provisions for existing collective agreements could have been negotiated up to their expiry.

This was a missed opportunity which could have unintended consequences in forcing the destruction of economic units before we can re-achieve an economic environment that permits the creation of new ones. Only an unlikely V-shaped recovery could now avoid a further spike in unemployment.

Another good measure that could have negative unintended consequences is the extension from five to seven years for the years 2010 and 2011 of the mechanism that removes the option to pay normal capital gains tax (CGT) on property sales and instead enforces a 12 per cent of sales value final withholding tax, irrespective of the actual profit element of the property sale in question.

The extension of the time limit from five to seven years meets the clamour of property developers who, in the face of a dead property market, are having to carry unsold inventory far longer than planned. Without such an extension, they would have been forced to dump property prices in order to avoid being caught by the 12 per cent withholding tax mechanism on sales that effectively leave them little or no profit, if not an outright loss, given the high acquisition prices of the peak years and the carrying costs of unsold inventory. A sharp fall in property prices could be very destabilising, even to our financial sector, given the banking sector’s exposure to the property market.

However, restricting this extension to the years 2010 and 2011 seems illogical and risks unintended consequences even greater than the ones the measure sought to prevent. The seven year extended period will mean that property sales for units acquired in 2004 will benefit from the CGT option till 2011. Come 2012, we flip back to the five-year rule, which means that, overnight, sales of property bought in 2005 and 2006 lose the CGT option. Now 2005 and 2006 was the peak of the property market, which began to crack late in 2007. Many of the properties bought at peak prices in 2005 and 2006 are unsold inventory today or, given the time lag of the building industry, are still in the development pipeline.

Given the size of the unsold inventory level, and the fact that recovery can only be very gradual, the government is being overly-optimistic in assuming that the property market could return to normality in the next two years. For the time being it would have been more prudent to allow the seven years option period for an indefinite time, to avoid unintended consequences. 

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