The Tribune

By NEIL HARTNELL

Tribune Business Editor

nhartnell@tribunemedia.net

The poorest Bahamians would face an 11.2 per cent spending/disposable income cut over 10 years as a result of Value-Added Tax (VAT) if no ‘social safety net’ is provided, with poverty levels increasing in line with the tax rate.

The Inter-American Development Bank’s (IDB) assessment of VAT’s likely impact on the Bahamian economy and society validates many concerns previously raised by the private sector, noting that poverty “would increase” in almost all the scenarios/models it ran unless the Government took action to counter the impact on the poor.

The study, long called for by the private sector, and finally released on Friday, apart from confirming VAT’s ‘regressive’ nature and the likely negative impact on poverty levels, also appeared to back up other private sector fears.

In sometimes wordy language that needs to be decoded, it said:

• The projected increase in government revenues resulting from VAT is a ‘wealth transfer’ from Bahamian consumers and the private sector that “is not fully compensated by the reduction of tariffs”.

In other words, the average 17 per cent reduction in Customs duties is not revenue neutral, and money will still end up being taken out of the economy, and from businesses and consumers, by the Government.

• While inflation is estimated to surge by 3.34 per cent above current levels, taking it to 5-6 per cent, the IDB study says price increases will start to drop from the second year post-VAT onwards.

One factor cited as being behind the drop in inflation rates is “lower levels of aggregate demand”. Translation: Bahamian consumers will be spending less as a result of reduce purchasing power/disposable income, with all that entails for businesses and the economy.

• The IDB study says each of the 16 economic scenarios that it ran assumed that “all additional revenue ($200 million)” raised from VAT would go towards reducing the Bahamas’ fiscal deficit, and paying down the national debt.

Given the Government’s history, and Prime Minister Perry Christie’s desire to embark on funding new projects, that is by no means certain. History has also shown that increased revenues inevitably leads to more government spending, becoming a self-fulfilling, never-ending cycle.

• The IDB analysis also appears to be based on a ‘developed country’ model where interest rates respond to market demand, and are used as a proactive tool of monetary policy.

That does not happen in the Bahamas, where interest rates are used to support this nation’s one:one peg with the US dollar. There have only been two changes to the Bahamian Prime rate this century.

Yet the IDB study suggests that reducing the Government’s borrowing requirements will lower ‘crowding out’ and free up credit for borrowing by the private sector, creating jobs and investments. This seems to presuppose the use of interest rates as a monetary tool.

The IDB study itself warns that it has to be used “with great care”, and: “There are no substitutes for good judgment.” It adds that its results need to be interpreted with “great care”.

It ran some 16 scenarios, using combinations of VAT rates of 15 per cent, 10 per cent and 7.5 per cent; hotel tax rates of 10 per cent and 7.5 per cent; Customs duty reductions of between 7.5 per cent and 17 per cent; and with or without social safety nets.

The IDB used financial and economic data for the 2000-2011 period as the baseline for its calculation, assessing the impact VAT would have on various indicators over that period.

The results emphasised the ‘regressive’ nature of VAT, namely that poorer and lower income Bahamians will spend a greater proportion of their earnings on consumption/taxes than those earning more.

In 10 of the 16 models run, low income Bahamians (the poorest 20 per cent) suffered a decline in disposable income/purchasing power.

And, for those Bahamians in the next quintile up (20-40 per cent, or the working and lower middle class, their disposable income/purchasing power fell in 15 out of the 16 scenarios.

“In the case of the scenario with VAT rate of 15 per cent, the fall in expenditure for the quintile one (poorer 20 per cent of the population) amounts to 11.2 per cent of the levels of the baseline scenario,” the IDB study said.

“The need to complement the introduction of the VAT with a social safety net program is a clear message that transpires from the simulation exercises.

“The introduction of safety net programmes reduces the level of poverty in all scenarios. In all scenarios, except for the scenarios with VAT standard rate of 10 per cent and with safety net programmes, the prevalence of poverty (poverty levels) would increase relative to the baseline,” it added.

“There is clearly a direct relationship between poverty levels and the level of the VAT standard rate.”

This was reiterated at various stages in the report, the IDB adding: “The Government’s intention to strengthen safety net programs would reduce significantly the negative effects of the VAT on poverty levels.

“Introduction of VAT translates into lower disposable income in most scenarios and as a result poverty levels tend to be higher in the absence of social safety net programmes.”

John Rolle, the Ministry of Finance’s financial secretary, told Tribune Business that the Government “would restore spending power” to lower income Bahamians via a “redistribution” of the increased revenues earned from VAT.

No new social security programmes will be initiated, he added, implying that the Government would seek to mitigate VAT’s impact on the poor and working class Bahamians via existing mechanisms.

“The study affirms the importance of redistribution programmes during any necessary fiscal adjustment of this nature,” Mr Rolle said in e-mailed responses to Tribune Business’s questions.

“Given that VAT is the superior instrument compared to income and other broad tax proposals, it is absolutely necessary that it be supported by redistributive policies.”

He added that “the most direct way to achieve a progressive outcome for the poor is to assist them directly” from revenues generated via VAT, rather than undermine the tax base by using a whole slew of revenues to protect them.

“Should the Government introduce the VAT and seek to use broad exemptions to protect the poor, it would undermine the revenue performance and broader long range economic goals,” Mr Rolle explained.

“The best practice is to do as the Government would, and redistribute revenue to restore spending power to those at the lowest end on the income spectrum.”

The Financial Secretary added that VAT-related social safety nets would be “a temporary intervention”.

He added: “The benefit of stronger jobs creation from a more vibrant economic base provides the foundation for more lasting private sector gains that would raise incomes and reduce poverty.”

Emphasising that the Government would introduce no new social security programmes specifically for VAT, he added: “There are no new social programmes recommended beyond those which exist.

“The Government has a range of programmes that can be augmented, and that either target the aged, or target poor households.

“These would encompass programmes administered through the education or public school system, the range of programmes administered by the Ministry of Social Services, and the reach of the public health system.”

Mr Rolle, meanwhile, also took on suggestions that the IDB study had got it wrong when it came to interest rates and reduced ‘crowding out’ of the private sector.

“It hard to argue against the logic that less borrowing on the part of the Government leaves more credit resources for the private sector to use,” the Financial Secretary said.

“It goes beyond the interest rate effect. The bottom line, though, is that less government demand for credit would drive down the rate of interest on government paper, which is a benchmark or guide for the cost of funds to the private sector.

“Less credit pressure from the Government, even in our system, gives the Central Bank, the guardian of monetary policy, more room to accommodate private credit expansion. So the link between fiscal consolidation and more relaxed credit polices for the private sector does exist in the Bahamas,” Mr Rolle added.

“Beyond this, the other very strong driver of investment would the reduced costs from lower Customs duties on capital goods, as in place of these, the VAT regime would introduce investment tax credits for businesses. The working capital demands for merchandising firms would decrease, which would be a reduction in business costs.”

The IDB study, which was completed last month, indicates that it only met with the Bahamian authorities - Ministry of Finance, Central Bank and Department of Statistics - on October 30-November 2.

This seems to suggest, at first glance, that the Government had decided VAT was the preferred tax reform option without any assessment of its impact on the Bahamian economy and consumers, but this was denied by Mr Rolle.

“This particular study commenced in June and took place over five months. There is no putting the cart before the horse,” he added.

“The two most important results we sought were validation of the importance of the social safety net response, and quantification of the inflation effects. There was no question that the employment and growth would be positive effects.”

VAT’s critics are likely to remain unconvinced. Rick Lowe, the Nassau Institute think-tank executive, told Tribune Business that the IDB study seemed to assume that companies would not increase their mark-ups (profit margins) to compensate for VAT.

“The IDB clearly state that this is a wealth transfer from the private sector that is not ‘fully’ compensated by the reduction in tariffs,” Mr Lowe said.

“In other words, for the models to be correct, businesses in the sale of goods, specifically, are not expected to raise their mark-ups to compensate for this loss.”

He added: “Also, taxpayers should expect to pay more for goods and services.

“Businesses, many of whom are struggling today, will have to adjust and increase prices where they can and remain competitive with direct imports.

“Consumers will also adjust, as their income will buy less, possibly slowing the economy further.”

Mr Lowe said inflation was also likely to be higher than the Government’s projected 5-6 per cent, given the likely impact on the economy’s services sector.