Laffer Curve + Irish Implosion

To me an interesting article begins with an anecdote. So, Chris Farrell's piece on Arthur Laffer and his Curve, weaved with supply-side economic thinking as lead-ins to the current Irish economic crisis is, most certainly, an interesting article.

Basically, the point is that reduction of taxes a'la Ireland, is not a panacea to the challenges of managing an economy. But, then again, what policies are ever permanent? Of course, Farrell is dealing with the current set of economic challenges in the Western world - dealing with an era of tax cuts and deregulation - and witnessing the sheer and wanton abandon with which financial institutions failed to apply common sense and risk management principles.

Let me not get carried away.

I will just tease you with the opening lines of Farrell's piece. Then you can click on the "read more" to, well, read more:

It may be the most famous dinner in economic history. Arthur Laffer was a professor at the University of Chicago. In December 1974 he dined at the Two Continents Restaurant in Washington, D.C., with Donald Rumsfeld, chief of staff to President Ford; Dick Cheney, Rumsfeld's deputy; and Jude Wanniski, associate editor at The Wall Street Journal. According to Wanniski, Laffer grabbed a napkin and pen and sketched out the Laffer Curve, illustrating the trade-off between tax rates and tax revenues. In a few more years the tax-cut philosophy dubbed supply-side economics would dominate fiscal policy under President Ronald Reagan.

1MDB and IDR in the landscape of GTP, NKRA and ETP

I love History. I love it because there is much wisdom in having a context and perspective of how we arrived at where we are. Without knowing History, we will be forever groping in the dark. Not knowing which direction to take. Let's see how this post pans out.

Economics of development

In terms of the economics of development, the role of government is to decide how resources are to be allocated. There has to be a presumption that the resources must be allocated equally. There must also be a corollary rule that equal allocation be subject to merits.

"Merits" in the economic sense must mean the positive impact that such an allocation has on economic development and growth for the whole country.

This positive catalytic effect is termed the "multiplier effect".

Having put out the boring contextual matters let us dive into the issues at hand.

In the 1960s and 1970s, our economic planners were exemplary in identifying foreign investment to generate economic development. We had limited financial resources. We needed foreign money in the form of direct investment.

This meant getting foreign investors to set up shop here.

The name of the game at the time was industrialisation. We had a literate workforce. Wage levels were affordable to foreign investors.

Our economic planners made sure there was ample and reliable utilities in the form of roads, electricity and water supply.

Geography of development

But, beyond this generalisation, I wish to emphasise that our economic planners had to face up to the reality that the foreign direct investments (FDI) being manufacturing-based, needed access to a good supply of workers.

The logical location was Petaling Jaya first. PJ met the criteria. Next was Shah Alam, the logical extension since the direction of growth was towards Port Klang where the manufactured goods could be cost-effectively exported.

In the 1980s, Penang got into the game. The economics and locational principles remained the same.

From industrialisation to knowledge and services-based activities

Fast forwarding into the millennium, we witness the shift in emphasis from industrialisation to knowledge and services-based activities.

The reasons are obvious. Over time, the wages have risen. Industrial activity needs cost-effective wages since the skills of the work is limited and repetitive. Easy to train freshies. Experience is not a factor. That is why industrial FDIs have relocated elsewhere.

This situation is where our country is at. This is what people call the "middle income trap". We have become too expensive for industrial processing. But, we may not be skilled enough to get into creative work that pays well.

Finally, we get to 1MDB, IDR, GTP, NKRA and ETP

You may now ask what the relevance of such a long preamble on 1Malaysia Development Berhad (1MDB), Iskandar Development Region (IDR), Government Transformation Programme (GTP), National Key Results Area (NKRA) and Economic Transformation Programme (ETP) is?

Well, first, I need to say that this post is my way of expiating reasonably sceptical analyses done previously on these self-same matters.

I have felt strongly since Najib's tenure as Prime Minister began that the government has recognised the urgency of the "middle income trap" situation.

I have also felt very troubled that this urgent economic situation has been clouded by the ripple-effect of over-politicisation and power plays.

The message that the rakyat sent on March 8, 2008 was that change is needed. What the nature of the needed change was is something that we can debate until the cows come home.

Economics trumps politics

The takeaway from March 8, 2008 that I am recommending for your consideration is that the rakyat sensed the urgency of dwindling economic opportunities.

I am aware that many of you will not agree with this narrow interpretation. But, if you adopt the Abraham Maslow heirarchy of priorities, I will resoundingly say that economic welfare trumps any other issue in terms of priority. If you are not convinced, I suggest that you read about Mikhail Gorbachev and the perestroika saga.

So, what we have here today, is a set of nebulous principles in the form of GTP, NKRA and ETP.

If we were to take a helicopter to rise above the thicket of nebulous words in the GTP, NKRA and ETP, we may be able to get a better idea of the socio-economic landscape that confronts Malaysia.

Crossroads

We are at a crucial economic crossroad.

Yes, the GTP, NKRA and ETP are imperfect roadmaps. But, I don't have a better roadmap than this. So, yes, I have been prepared all along to buy-in. Of course, my buy-in is done with eyes wide open. That's the whole point of the exercise of buying-in, anyway. As citizens, taxpayers and stakeholders we must not be indolent. We have to be a part of the thought process.

And, what of IDR?

IDR makes geographic sense, I suppose. It's proximity to Singapore means that the chances of its key investment criteria succeeding is that much higher. The key areas of the IDR are:

6 categories of service-based sectors:

• Creative
• Education
• Financial advisory and consulting
• Healthcare
• Logistics
• Tourism

And, of course, the attractive features are:

• Exemption from the Foreign Investment Committee (FIC) rules
• Flexibilities under the foreign exchange administration rules as follows:
  • Make and receive payments in foreign currency with residents;
  • Borrow any amount of foreign currency from licensed onshore and non-residents;
  • Invest any amount in foreign currency assets onshore and offshore; and
  • Retain export proceeds offshore.
• Unrestricted employment of foreign knowledge workers
• Eligibility for tax incentives

The tax incentives are:

• Exemption from corporate income tax for a period of 10 years in respect of statutory income derived from qualifying activity carried out within the approved node for customers situated within the approved node and outside Malaysia or wholly for customers outside Malaysia. Such activities must commence on or before 31 December 2015; and
• Exemption from compliance with the withholding tax provisions on payment of royalty and services fee to non-residents for a period of 10 years from commencement of operations.

And, what of 1MDB?

Well, from my previous postings you will, no doubt, have gotten an idea of my concern about the debt edifice of 1MDB.

Be that as it may, I do wish for the Sungei Besi Airport redevelopment and KL Financial District projects to be successful.

Here comes the reason for my long preamble.

In a sense, the 1MDB projects can be seen as the present day equivalent of the industrial parks of past decades. Where industrial parks were meant to house and cluster manufacturing concerns, the 1MDB projects are intended to house services-based concerns. This is consistent with the ETP goals, I suppose.

And, I am making a strong assumption that to ensure the financial viability of the 1MDB projects, there will be IDR-like incentives in the pipeline. And, like IDR, the incentives will be legislated by Parliament and decreed by MIDA.

Calling the Klang Valley "Greater KL" is, I suppose, a branding exercise to the global customer base. I have no problems with that just as most of us have no problems with the KLIA being called KLIA even though it is in Sepang. It's about global branding.

Two key takeaways for you

All the foregoing is intended to lead to 2 points that I wish to make:

• First, how about extending the IDR-type incentives to the whole country?
• Second, how about (here I go again) reducing the corporate and personal income tax rate to 18%?

What a stimulus and seriously positive economic multiplier these will have on the whole country.

Pee Pee Pee Budget Issues

I found Budget 2011 to be a strange document. It is strange at many levels.

For one, there was really only one big expenditure item. That was the allocation for Operating Expenditure. No austerity measures there. There was, in fact, a marginal increase in allocation.

Another, is the great store put on the so-called Public-Private Partnership (PPP) formula. At a cursory level, PPP seems to mean that the private sector will foot most of the developmental bill. At another level, PPP seems to mean projects for private sector parties with access to the political masters.

The third feature is that this is a largely a budget for large scale (some say "mega", others say "grandiose") construction and property development.

The fourth matter that struck me, going back to the concept of PPP, is that the Government recognises that it is cash-strapped. The "innovative idea" is to take developmental matters to, what I will term, "off-balance sheet" transactions.

What do I mean by "off-balance sheet"? Well, I have deliberately put the expression in inverted commas (just like the way Dr. Evil did with his fingers in Austin Powers) because I don't mean it in the way that accounting standards mean it.

The "off-balance sheet" that I allude to is that PPP arrangements has less transparency than a basic, garden variety budgetary allocation that is open to Parliamentary and public scrutiny.

Take the case of the 100-storey Warisan Merdeka Tower. I was puzzled that the matter was even included in a Budget speech. Essentially, the RM5 billion outlay will be borne by Permodalan Nasional Berhad (PNB), not the Government. I imagine that the only involvement of the Government would be at the Economic Planning Unit level - to approve the project for its perceived salutary economic "high-impact".

In a sense, the Warisan Merdeka Tower project is more akin to the proposed Sungei Besi Airport project the land ownership of which is in the process of being transferred from the Government to 1MDB. That is "off-balance sheet". Not open to direct Parliamentary and public scrutiny.

In this sense also, there is a precedent in the KLCC Project. It was also "off-balance sheet". It was not open to Parliamentary and public scrutiny.

But, this is where the similarity starts and ends.

The KLCC Project was destined never to fail. It could never have failed because it had the financial clout of Petronas behind it. That the KLCC District has become the success that it has is due, in my humble opinion, to the benefit of a central location in the heart of Kuala Lumpur. It also had the benefit of Petronas, which is a Fortune International 500 company, occupying one whole tower block effortlessly. By the way, Petronas was also instrumental in keeping Dayabumi alive in terns of occupancy during Dayabumi's first decade of existence.

In contrast, new-fangled PPP projects such as Warisan Merdeka Tower will rely on PNB's finite resources. What is PNB? Unlike Petronas, which is a commercial going concern in the substantial oil and gas industry that generates significant revenue streams, PNB is at best a fund management entity and a passive asset owner.

How will PNB be able to acquire the skill sets and the commercial gravitas to fill up the floor spaces in the 100-storey Warisan Merdeka Tower? RM5 billion is a substantial outlay. And, lest we forget, PNB is the trustee of Malaysia's institutional wealth - especially for Bumiputras. Failure is not an option.

As for the Sungei Besi Airport project, I have touched on it previously. But, the analysis is substantially similar with one worse addendum - 1MDB is based on an RM5 billion bond issue. 1MDB is in the process of raising yet another RM5 billion bond issue.

A bond is a debenture instrument. It is a hypothecation. A debenture is a debt. A debt must be repaid.

Therefore, it is obvious even to the untrained mind that 1MDB's financial feasibility relies in large measure in its hoped-for ability to parlay the Sungei Besi Airport land into a valuable piece of real estate. This is something real estate developers do. Any member of REHDA could have done the job. Why is there a need for 1MDB? I'm just asking....

Finally, I just want to make an observation that, in recent decades, we have placed great store on Corporate Governance.

The International Financial Reporting Standards (IFRS) on mark-to-market valuations, property development sales revenue accounting treatment and, recently, leasing arrangements demonstrate a great concern for off-balance sheet transactions.

The IFRS Exposure Drafts on these and many other business practises are intended to ensure transparency so that investors and stakeholders that have dealings with corporations have a clear idea of the financial health of corporations as going concerns.

In this context, PPPs may not be a march forwards. History may see it as a troglodytic concept.

So, I leave you with this question: Should governments have a different accounting standard from corporations?

It's the tax incentives, stupid!

Malaysians have been witnessing rollout after rollout of programmes that are designed to catapult the nation into stratospheric heights of economic advancement and competitiveness. These programmes are strategic visions that signals another round of good intentions.

Some of the things that gnaw at me and, I believe, many other Malaysians are:

Where's the buy-in?

If you bother to review successful economic or social programmes that have high impact on nations you will find two versions.

One, is where there is a crisis, a serious crisis of such a large magnitude that fear and foreboding pervades the psyche of the general population. In such a backdrop, bold visions and action are widely received by the populace. The Roosevelt initiatives in the wake of the Great Depression comes to mind. The Marshall Plan to rebuild a devastated Europe in the aftermath of the Second World War is another example. Our own New Economic Policy is another. Yet another example is the more recent Obama Stimulus Plan.

Second, are initiatives that meander painfully through due process of consultation and exhortation to encourage the general population to understand, appreciate and accept the initiatives. The Reid Commission and Cobbold Commission hearings come to mind. The Malaysia Referendum in Singapore during 1962 (I think) is another example. The Japanese economic achievements of the 1980s was credited to bottom-up consultative processes.

The Pemandu-led initiatives to transform the Malaysian economy is said to be based on a template created by consultants. That template was then tested against a sampling of Malaysian stakeholders in various Labs. After that there was a write-up of the broad goals of the respective programmes. Only after that were the general Malaysian public invited to specific venues to listen. That listening process was largely passive. It was done in a compressed time-frame.

Is it any wonder that Malaysians are slow to "buy-in"? It feels like a fait accompli.

Big vision means big business only?

One of the most striking features of the Pemandu initiatives is that there is a pungent odour that deals have been done prior to the public airing of the programmes. These deals on infrastructure and grand property development are said to be based on proposals submitted by large Malaysian corporates.

Pemandu cannot absolve itself of the responsibility to implement the programmes. Will there be public tenders to invite all and sundry to bid for involvement in each of the matters?

One example of the fait accompli approach that springs to mind is the Sungei Besi Airport real estate. It is said to be a done deal between the Malaysian Government and 1Malaysia Development Berhad because 1MDB is wholly-owned by the Minister of Finance Inc. Two questions arise here.

First, by interposing a corporation, a corporate curtain has been drawn over how the Sungei Besi Airport land is going to be broken up. Second, when 1MDB starts divvying that piece of real estate, who gets the plum pieces and, on what basis will they get it?

It is not good enough to say that there is going to be "world class buildings" coming up in Sungei Besi, Sungai Buloh, Matrade or even, some say, certain Government-owned land in Bangsar.

It may all be innocuous, of course. But my message is on the need to be transparent and, to ventilate, so that that pungent odour is removed.

Talent Corp to leapfrog poor education?

The move to recall the Malaysian diaspora back to the Motherland is to be applauded. The move to reach out to foreign skilled workers is also worthy of many claps.

The absence of any clear moves to improve the quality of education is a concern.

In fact, this is one of the mysteries that is wrapped in an enigma that is the Pemandu programmes. There has hardly been any serious thought given to how to improve Malaysian education at all levels.

And here we thought that all the transformation is also to transform human capital, MALAYSIAN HUMAN CAPITAL. What gives, man?

From this standpoint Talent Corp's initiatives will be seen as another FDI-type initiative where human capital is imported to fill a void left by a paltry local human talent bank. Forget about creating skilled Malaysian human capital, just parachute the Malaysian diaspora and skilled foreign workers into Malaysia.

Tax incentives are the key

If you care to visit MIDA's website, you will find an environment that is reasonably exciting...if you are a foreign investor. If you are a Malaysian SME or SMI, then, you feel exasperated and marginalised.

In a previous blogpost I have mentioned a client's bad experience with trying to obtain a grant and soft loans during the Stimulus Package period in 2009. I know the news reports extol how great the SME programmes have been. Trust me, I know many SMEs who do not even have a whiff of any Government-initiated support programmes.

So, based on that bitter experience I wish to join some of the SME associations to make a call during this Budget season for a corporate tax reduction for SMEs to 18%.

From an economics standpoint such a tax break for SMEs is non-discriminatory in substance and effect. It rewards the outstanding SMEs. It creates a virtuous cycle where the good SMEs will thrive and the bad ones, well, the bad ones need to go into the financial and corporate rubbish heap. This is as things should be. Reward the good and leave the bad to rot and wither away.

I have been making tax reduction to 18% calls in this blog for two years now.

My reason is simple. Free up additional disposable incomes for SMEs to re-invest in business expansion and business development. Re-tooling is expensive. Expanding is expensive. It sounds like an oxymoron, I know. But, if you are involved in business you will understand.

When a business receives more orders than ever before, it is what I call a "happy problem" because more orders means that the business is creating products and services that the market wants. That is the "happy" part.

The "problem" part is where the business is operating at full capacity. But, usually, the business has insufficient ploughed-back capital to re-invest.

Then, we're back to the along loan-versus-bank borrowing-versus extended family and friends-versus government grant matrix of fundraising-borrowing decision-making dilemma.

This is why I am saying that the biggest policy initiative that the Malaysian Government can make - over and above all Pemandu transformations - is to reduce the corporate tax rate for SMEs to 18%.

That, in my humble opinion, will go a long way to initiate the process of transformation of the Malaysian economy at its most fundamental level.

Krugman and Ferguson: liberal and conservative

On the eve of a massive day of reckoning between the Orangemen and the Iberians with a Catalan spine; a mighty battle that may see the Dutch prevail...if von Bommel and de Jong can stymie Iniesta and Xavi...if Kuyt and Robben can interchangeably outflank the Spanish centre and confuse Xabi Alonso and Puyol...if Latin emotions lose out to Dutch cool...if...a bird's brain has better intuition than the psychic powers of a spineless octopus...

On this eve, I am taking some time out to make some observations on the ongoing pitched verbal battle between Paul Krugman and Niall Ferguson.

Paul Krugman.

Krugman has advocated strongly for further economic stimulus packages to be rolled out to ride over the spectre of a double-dip recession. That is his proposed remedy.

Ferguson believes that further deficit spending will leave governments and nations and economies in tatters and drown in a sea of debt.

Niall Ferguson.

Krugman has, in interviews, hearkened (with a straight face) the historical phenomenon where the Great Depression only truly ended when World War II happened, the War causing the U.S. Government to embark on a massive public spending programme. That was a tad too glib for my liking.

I tend to lean towards Ferguson in this debate.

Instead of further deficit spending I would urge governments to look into two key policy measures.

Krugman and Ferguson are in mutual agreement that the key issue is unemployment. But they differ on the economic policy prescriptions to reduce unemployment.

Being a liberal, Krugman is sceptical that the private sector can voluntarily unlock their savings and start re-investing (and, therefore, start employing).

Krugman, in the same interview that I saw, made another glib remark that the best and most immediate way to reduce unemployment was for governments to employ more people in the public services! As I said, a tad too glib for me. And, coming from a Nobel-winning economist at that! (Though the catty response would be that the Nobel Prize Krugman earned was for trade NOT fiscal policy).

The Krugman prescription leaves too many loose ends in economic policy not the least of which is a huge mountain of debt and, possible hyperinflation from overprinting of money.

First, tweak tax policy

The first policy imperatives that governments should look into to stimulate economic activity and stave off a double-dip is to tweak the tax rates.

Corporate and personal income tax rates should be reduced. This will stimulate private investment for sure. And, consumption spending will tend to increase since taxpayers will have greater disposable incomes unlocked by the reduction of income tax.

In the context of Malaysia, I say again, bring both corporate and personal income tax rates down to a top rate of 18%.

Second, reduce public spending and government size

Commensurate with the reduced tax revenue, governments should reduce public spending. This will be in tandem with the growth of private investment and consumption.

At the same time, the bloated civil service should be downsized to reduce operating expenditure.

__________

I realise that the difficult issue, one which liberals like Krugman are sceptical of, is whether the private sector will rise to the incentive offered by the reduction of income tax or, just sit on their fat tax savings.

It all boils down to confidence.

The capital markets throughout the world are highly concerned about greater deficit spending and more stimulus packages. This must surely be indicative of a fairly rational market environment that will respond positively to the effort by governments to pare down their bloated bureaucracies and profligate spending. The market will also respond positively to the likelihood that consumption will increase as disposable incomes increase.

This creates a virtuous cycle.

In contrast, increased deficit spending which increases public debt and increases the threat of hyperinflation creates a potential vicious cycle.

There, I said it.

GST and Budget deficit: Any robbery of Peter or Paul?

The goods and services tax (GST) proposal has been a non-starter in Malaysia for nearly a decade now. The Malaysian government's reticence on the matter may, in large part, be due to the burden that the GST, which is an indirect and consumption tax, will have on lower-income Malaysians. For, to raise the ire of the lower-income groups may be the straw that breaks the proverbial back of the camel from a socio-political standpoint.

This is something that hardcore economists and tax professionals often ignore in the continuing quest for fiscal purity and neatness of design. It is, however, a matter of political life-and-death for political leaders.

So, do we take the long-term view that tends to favour the GST? Or, shall we take the short-term view that avoids the possible alienation of lower-income groups caused by the temporary but, potentially disruptive effect, of a consumption tax? Let us not forget that over the past 2 decades Malaysians, especially lower-income groups, have enjoyed consumption subsidies (a policy that has made us lazy and inefficient). How will they react to a consumption tax?

The inconvenient matter of the budget deficit

As if to make algorithm of policy-making even more complicated there is that inconvenient matter of a ballooning budget deficit which, for 2009, is expected to be at 7.6% of the GDP of Malaysia. That's a lot of debt. At the height of the economic crisis in 1998-1999 the budget deficit was slightly above 5% of the GDP. This is a source of concern.

All the bond-raising exercises by the Malaysian government that has so excited the Malaysian person-on-the-street in recent months is obviously intended to deal with funding the budget deficit. But, at some point, these bonds will be redeemed and, at specific annualised intervals, yields will have to be serviced.

Which leads us to the curling observations made by Prof Emeritus Datuk Dr Mohammed Ariff Abdul Kareem, executive director of the Malaysian Institute of Economic Research (MIER). He believes that tax revenues for 2009 will fall below projections. Tax revenue, as we know, is the primary source of income for any government.

Dr Ariff also noted, as many of us has, that the government operating expenditure has been ballooning. Coupled with the stimulus packages, this can only mean that the funding mismatch between revenue and expenditure is likely to push the budget deficit to 8% of GDP or, higher.

So, the Malaysian government may have a fiscal problem although it will be interesting to consider the extent to which the borrowings from the public generated by the government bonds, such as the 1Malaysia Savings Bond, will be able to ameliorate the revenue shortfall.

A renewed call for GST

Anyway, Dr Ariff pointed to the need for the broad-based GST as an important fiscal policy option that the Malaysian government needs to seriously look into implementing. There have been many "dry runs" conducted over the past decade. The narrow-based income tax has become insufficiently efficient as a source of fiscal revenue.

The other rationale for GST that many taxpaying Malaysians may find appealing, is that implementation of the GST will support the argument that Malaysian income tax must be reduced.

Will GST have a salutary effect to reduce income tax?

I still maintain that a top corporate income tax rate of 18% would be an excellent strategy that will put Malaysia back on the map for foreign corporate HQ planners now based in Hong Kong and Singapore. Many foreign executives believe, correctly, in my biased opinion, that Kuala Lumpur is a much better place to live in than the other cities mentioned. KL is imperfect and, it is that imperfection that endears KL to visitors. Imperfection means character (let this also be understood by people who feel the desperate need for cosmetic surgery, especially those who believe that an impassive facial expression caused by Botox is more alluring than cute wrinkles, but, I digress).

A commensurate reduction in personal income tax would, then, also be order.

Planning for GST implementation needs a 2 to 3-year gestation because there will be a tsunami of paperwork. Rush the implementation and Malaysia will feel like a living hell for paper-pushing punishment.

So, it is true that I am going from cool to lukewarm with GST.

The context of policymaking

But, to put the whole matter into the proper context again, it will be necessary for our economic managers to consider the matter holistically. To a Malaysian breadwinner who earns a monthly salary of RM1,200-00, a 2% GST on basic necessities can be a big deal, especially if he or she needs to pay the rent, the hire-purchase on the motorcycle and, tuition for the children (yes, even poorer people want their kids to have tuition).

Don't just formulate policies by sitting in the ivory towers of Putrajaya. Serious and sincere efforts must be made to turun padang to study the impact of economic policies before implementation. But, judging by the decision to reverse PPSMI, many of us don't think that Cabinet members believed Najib when he said that the era of "Government knows best is over".
_______________________

Postscript: here's something relevant to the topic from Reuters which was carried in Malaysiakini:

M'sia relying too much on Petronas, new taxes needed

The International Monetary Fund has cautioned Malaysia not to delay plans to introduce a goods and services tax (GST) and to remove subsidies to ease pressure on its budget.

The taxes were proposed in 2005 but were shelved due to political and inflationary pressures and since then, Malaysia's budget deficit has surged and will hit 7.6 percent of gross domestic product this year.

"Legislation has been drafted and the necessary administrative infrastructure has been laid out. However, in the current uncertain environment, no timetable for a rollout has been set," Malaysian officials said in the IMF's annual report on the country, published on Friday

Malaysia's budget deficit has ballooned at a time of strong oil and commodity prices and state oil company Petronas provides half of government revenues. Excluding revenues from oil, the deficit was 11 percent of GDP in 2008, the IMF said.

The report comes as Malaysia is readying its 2010 budget and as the government tries to rally support after record losses in state and national elections in 2008.

Economy hit hard by global downturn

Malaysia's economy is set to contract by up to 5 percent this year and with exports equivalent to 110 percent of gross domestic product it has been hit hard by the global economic downturn.

"They will try as best as they can to delay the implementation of GST.

"How long they delay will depend on how whether they can find new sources of revenue to reduce the over dependence on oil and gas income," said Bank Islam senior economist Azrul Azwar Ahmad Tajudin.

Last month, the government deferred plans to hike gas and electricity prices, fearing a repeat of anti-government protests that saw its popularity slump in 2008.

Barking up the wrong Keynes

In almost all discussions on economics in the past year the name of John Maynard Keynes has been invoked. The shadow of Keynes writ large over the global economic landscape because his thesis, that the Great Depression could be arrested and, reversed by active fiscal policies by governments, was proven to be effective.

It was pointed out to me recently over a late night cuppa session by a highly knowledgeable economist (an authentic, practising economist, mind you) that many of us are unaware or, have forgotten the historical context of Keynes' General Theory which, in large part, was motivated by Keynes' desire to debunk the Marxist view that the Great Depression signalled the imminent death of Capitalism (with a big "C").

The context of the current economic turmoil is quite different from the Great Depression. But, I won't bore you with the details.

Suffice to say that policy makers and the worried public needs to be very, very clear that any economic stimulus will need to address short-term economic issues and long-term structural issues.

Short-term issues
It is always tempting and, inevitable, that economic stimulus packages will be directed at current ailments. These short-term policies will involve all sorts of spending. Roads, rails, bridges, schools and assorted infrastructure will be showered with funds. But, be warned, the tendering out of these jobs should at all times be open and transparent. Otherwise, there may be negative perceptions.

This form of spending stimulus may also be regarded as trickle-down policies since money goes to specific parties involved in that activity and their suppliers. Whether the broader economy benefits is moot.

That is why many people are, correctly, suggesting that spending be directed towards Malaysia's pathetic public transportation system. An inefficient public transportation is an economic cost because of time wasted in waiting for buses, trains and taxis. Or, time wasted in traffic jams.

And, then, there are tax cuts, fresh investment incentives, lower costs of borrowing and other revenue and monetary policies.

Bear in mind, though, that fiscal spending can only provide some cushion-effect. We will all be falling down and hurting ourselves. The challenge is to minimise the economic and financial injuries.

Long-term and structural issues
Less obvious but, more important, are components of the economic stimulus package that are directed to longer term and structural issues. What are these?

These are issues involving education, productivity, skills, values, creativity and innovativeness. I have written extensively on these points in earlier posts. These will be re-visited in due course.

Barking up the wrong Keynes
Stimulus spending are being characterised as Keynesian solutions. That may not be accurate. It may actually be a wrong characterisation.

To use a pyrotechnical metaphor, in a chemical fire, spraying water is not likely to douse the flame. Thus, economic stimulus packages provide a necessary cushion to attempt to soften the blow of the economic turmoil. However, it is never a complete panacea.

Why tax cuts are better than deferment of tax payments

There is a line of thought that tax cuts forming part of the Malaysian economic stimulus package may not be effective when compared to deferment of tax payments.

The thinking is that since Malaysia has a narrow base of taxpayers, any tax cut will not achieve distributive fairness.

The thinking is also that in the current economic climate, any tax savings arising from tax cuts would be saved by the Malaysian taxpayer and, thereby, negate the intended effect of tax cuts as part of an economic stimulus package.

The thinking is, further, that deferment of tax obligations spread, say, over three years, would have a better salutary effect. The thinking is that deferment of tax payments will leave much-needed funds with corporations and, that the effect would be similar to a form of financing to corporations. The additional effect is that the revenue authorities still get to collect tax revenue, only that it is spread over three years.

I respectfully disagree with the line of thought.

The valiant Malaysian taxpayer
It is a fact that Malaysia, being a developing country, has a smaller middle-class compared to developed countries. In fact, the size of the middle-class is probably the best yardstick for whether a country has achieved developed nation status or, not.

The correct perspective for policy-makers should be that this small middle-class taxpayer base in Malaysia has been valiantly supporting the revenue stream to the government coffers during the best of times and, during the worst of times, to borrow the Dickensian phrase.

Now that times are bad, the taxpayers should get their deserved relief.

Irrelevant consideration
The fact that most Malaysian workers do not pay tax and, therefore, would not enjoy any relief provided by the tax cuts is an irrelevant consideration in any decision relating to a policy to cut taxes.

The issue of fairness to all Malaysian workers is irrelevant in the context deliberating on tax cuts.

For Malaysian workers who earn such a meagre income that they are not eligible to pay taxes, their threats are in the form of unemployment and pay cuts. Such threats are also felt by the tax-paying middle-class, by the way.

Anyway, such threats can only be met with social safety net policies like unemployment insurance, re-training programmes and new job placements.

Predilection to save in bad times
Rationality plays a large part with taxpayers who receive tax cuts. The possibility that 40% to 50% of the tax cuts are saved by the taxpayers should not deter policy-makers. The taxpayers are just making sure that there is enough saved for an economic downturn that has an uncertain duration.

Being rational, they will start spending if economic policies are seen to be sound and sensible. By that I mean, that the rational taxpayer will NOT be optimistic and confident if they see that many stimulus packages are based on negotiated tenders instead of open tenders. Or, that stimulus packages are dressed up as rent-seeking arrangements.

Surely that is not emotive behaviour. That is rational behaviour.

Deferment of tax payments is only postponement of a debt
Deferment of tax payments only helps to ease the cashflow. But, it is still a debt liability for corporations and individuals. What if the economic downturn is longer than expected? A debt is a debt. It has to be paid sooner or later. How's that going to engender business confidence? How's that going to engender consumer confidence?

Tax cuts, confidence and optimism
A policy to cut taxes will be well-received. It will be perceived as an acknowledgement by the government for the taxpayers' contribution to the economic development of Malaysia in past years. It will be felt as a form of financial relief.

The tax savings will translate into additional disposable income. Certainly part of that will be saved. It's the Asian mindset. But, more that half of it will be spent.

More importantly, the Malaysian taxpayer will feel genuine relief. That relief will translate into optimism.

Optimism begets some measure of confidence.

And, as we have been told, confidence is what the moribund economy needs.

Spectre of GST

I had written about the portent of the Goods and Services Tax being introduced in Malaysia by a Federal Government that is increasingly desperate for more revenues to support the bloated Civil Service. To make matters worse, the Federal Government is finally beginning to worry about Malaysia' dwindling oil reserves.

Now the spectre of GST is getting more ominous. Read the Malaysian Insider report entitled, Rethinking GST option to maintain revenues. This is a trial balloon leaked out to test public reaction to GST. It is also a way to alert the Malaysian public to get used to the idea that GST is going to happen.

Better start preparing for the impact of GST. I suspect that the GST rate will 2% to 3% of the value-added on any goods and services consumed in Malaysia.

Reduce income tax (Part 2)

Here's an interesting albeit still pioneering finding by Andrew Mountford and Harald Uhlig (a prominent econometrician now at the University of Chicago) in an empirical study called "What are the Effects of Fiscal Policy Shocks?":

Our main results are that:

• a surprise deficit-financed tax cut is the best fiscal policy to stimulate the economy.
• a deficit[-financed government] spending shock weakly stimulates the economy.
• government spending shocks crowd out both residential and non-residential investment without causing interest rates to rise.

Greg Mankiw's observation is that these finding are not consistent with standard Keynesian theory, according to which government spending multipliers are larger than tax multipliers and crowding out occurs through increases in interest rates.

In these trying times, a gradual income tax reduction from the current 29% top rate to an 18% top rate might just be the good stimulus that the Malaysian government should seriously consider.

The lower income tax rates will be offset by increased economic activity and, therefore, greater income tax collections.

It will do the Malaysian government well to remember that necessity is the mother of invention and the mother that gave birth to the ultra-radical capital controls and de-pegging of the Ringgit  in 1997 (I'm certain that he has the sense of humour to forgive the maternalistic metaphor) was the redoubtable and unsinkable Dr M of Malaysia.  

Reduce income tax

One of the best stimulus that the Malaysian government can give the economy is to institute an income tax cut.

It's better than reducing EPF contributions.

It's better than having Valuecap borrow RM5 billion from EPF.

It's better than infrastructure spending.

An income tax cut is an enlightened fiscal policy.

The biggest single group of Malaysians that spends quite freely is the middle-class. This class of Malaysians has the greatest propensity to spend. Their consumption goes beyond basic necessities.
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They are the ones who fill up the shopping centres and buy anything and everything, especially for their children.

To the government, I say reduce income tax as soon as possible and stand back to witness the rise of aggregate demand at a rate that will bring a warm glow to the face of the ruddy, Panda-eyed Second Finance Minister.

It will make the First Finance Minister's cheeks rosy red.

It will light up the tired eyes of the Bank Negara governor.

Try it. You'll like it.