The Budget for 2006-07

Never have economic ideas found such resonance in a Mauritian Budget as in the one presented on June 9 by Finance Minister, Mr Sithanen, for fiscal year 2006-2007. Good Economics offers the right incentives, recognises the importance and limits of the State, realises the constraints, threats and possibilities of modern times. Bad Economics yields the wrong incentives, delves into ideological debates, attempts to perpetuate the rents and privileges associated with bygone eras. Good Economics has finally arrived.

Getting Rid of Distortions

Complex tax regimes are notoriously distortionary. They distort the choice between labour and leisure (or working at home), between consumption and saving, between investment in machines and investment in skills, and even between honesty and dishonesty in reporting income and profits. They favour some industries over others, large firms over small ones, big investors over small ones. Over the years, more than a hundred items of personal income and more than 20 types of personal expenses have become deductible from income tax. Arguably, some needed a helping hand when they were first introduced (for example, private pensions), but for how long? And some were simply aimed at pleasing voters and lobby groups. Not surprisingly, revenue from income tax is meagre, at less than 10% of total tax revenue. The same applies to corporate tax: a dual-tax system together with countless tax breaks have distorted investment decisions, penalised some industries while delaying the modernisation of industries that enjoyed the breaks. The 2006-07 Budget unequivocally removes all exemptions, and sets the stage for a convergence of both income and corporate taxes to a flat rate of 15% within a few years. In the case of income tax, a personal deduction is retained to ensure an element of progressivity. This clearly goes in the direction of a flat tax proposed by economists Robert Hall and Alvin Rabushka, for which there is strong evidence of being conducive to effort, savings and investment.

Distortions are minimised when the behaviour of individuals and firms are not affected by taxes. For example, if time and effort spent at work, or the choice of occupation or of country of residence do not respond too much taxes, it will pay to tax income. If they do respond much, higher taxes can shrink the tax base up to the point, supply-siders believe, of being self-defeating. Thus, when choosing the mix of different taxes, activities that respond the most ought be taxed the least. Since capital can flow easily from one country to another (easier than workers), even tax-hungry countries like Denmark set low corporate tax rates. Now, consider the absurdity of a system which taxes income and profit, but not wealth in the form of immovable property (it is doubtful that individuals will resize their property as a result of higher taxes!). Worse of all, consider a system that charges a only few dollars per acre of State land on which sit some of the most valuable seaside villas on the island. By introducing a nationwide council tax and a market-oriented approach to the leasing of State lands, the new budget ensures higher tax revenues at minimum distortion. After all, it is only fair that property owners are called upon to contribute for the public infrastructure they enjoy.

Duties on imported cars represent a significant share of taxes from international trade, which are roughly three times revenue from income tax; a legacy from an under-developed economy that had no other means of collecting revenue. Rates start from 60% for small cars and go up to 200% the value of bigger ones. But a strange exemption applies: civil servants above a certain grade are eligible for duty remission (do they pollute less or create less congestion?). The unsurprising result is that nearly a third of new cars are bought under duty remission (a typical ‘crowding out’ effect).

New cars ought to be worth what they are worth. It is their use which creates congestion and pollution and should therefore be taxed (road tax, congestion charge, tax on petrol, which all are excellent Pigovian taxes). The new Budget lowers duties considerably and raises the possibility of duty remissions becoming insignificant in the near future or being phased out even. This shouldn’t alarm the civil servant, so long as this perk is met by an appropriate salary compensation in the next revision exercise (due 2008). In fact, standard Slutsky compensation predicts that they will be better off: those who do not need a new car can spend the extra income on other goods, those who do, can simply choose to spend it on a new car.

The Role of the State

A decade ago, government officials used to indulge in the right-wing mantra that the State was only to ‘act as a facilitator’ and ’set a level playing-field for the private sector’. The proposed tax cuts and simplifications of the tax structure does bring the country closer to being a level playing-field. The pledge to slash the waiting time to start a new business from the current minimum of 42 days to a maximum of 3 days and the easing of work permit regulation for high-skill migrants (processed again within 3 days) clearly makes it even easier to do business in the country (Mauritius is currently ranked 23th by the World Bank on the ‘ease of doing business‘). But the 2006-07 Budget goes beyond these by taking the lead and setting the tone. Market failures are addressed. Small enterprises with no access to credit and little means to acquire skills will be funded by an Empowerment Fund and offered training. Those operating in the export sector will benefit from Trading Houses set up in neighbouring countries. These ‘houses’ will bulk the warehousing, transportation and ordering of their products. Those operating in the tourism sector will gain from (1) the new open-sky policy (2) the creation of leisure centres devoted to the promotion of local arts and crafts.

The Budget sets the limit for the role of the State. Is it the role of the State to be repairing cars? As the answer is no, the Police Workshop has been rightly closed. Should the State continue to subsidise loss-making parastatal bodies that operate in sectors which the private sector find highly lucrative, such as construction? Again the answer is no, sealing the fate of the Development Works Corporation. There is a caveat however: outsourcing may prove costly and ineffective if improperly designed. For example, in the case of large projects, it is common for private contractors to bid low (to outdo competition), produce work of dubious quality and then ask for substantial cost overruns, not only because they fall victim to the winner’s curse, but also because their fees are a proportion of total costs. The 2006-07 Budget tackles the second issue by fixing fees to a nominal amount (why this wasn’t the case before is a puzzle!).

Rules vs Discretion

Rich countries distinguish themselves from poor countries in their reliance on the rule of law, from the enforcement of private contracts to the application of parking fines. Rules ensure fairness in treatment while discretion encourages corruption and nepotism. Why should a Finance Minister be able to waive duties and taxes for an individual or a company? Why should a Health and Safety inspector be able to decide arbitrarily whether a business complies to standards or not? Why should a District Council officer be able to decide on the length of time taken to process a development permit? Why should the government be able to borrow at will and not be subject to any ‘Golden Rule’? All of these are successfully addressed in the 2006-07 Budget.

Shortcomings

Nevertheless, the 2006-07 Budget has some serious shortcomings. Two key issues have not been satisfactorily dealt with. The first is the looming pension problem, as the population ages. By raising the retirement age and freezing pensions in real terms (i.e. pensions will only grow with inflation), the Government has chosen an easy escape route. Indeed, it seems that the consequences on the unemployment of the young have not been properly assessed.

The surprisingly low rate of female participation in the labour force is the other issue: more than 50% of women of working age are not in employment, even though their educational attainment is no different from men. An income tax system in which personal deduction depends on the number of dependents (eg. a married person whose spouse doesn’t work pays less taxes than a single person with same income) discourages married women from entering the labour force. This element is still present in the new Budget.

Finally the scope of annual budgets may need revision. For a start, the usual uncertainties surrounding the exercise do not do any good to the economy (every year, trading in the Stock Market slows down considerably during that period). Additionally, the annual budget has become an avenue to formulate short to medium term policies, rather than an accounting exercise in ‘book balance’. This begs the question of whether it would make more sense to scrap the annual budget and adopt a longer-term planning exercise (Martin Wolf makes a similar point on the UK Budget).