The state of the economy

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Instead of focusing on good governance and well-informed policies, the 2011 Budget revealed a disturbing reliance on the private sector. Malaysia can get out of the middle-income trap, but economic decentralisation is required for that to happen.

 

let’s get it right. The Budget is a fiscal plan informing the people how the government intends to raise and spend money in fulfilment of growth and development objectives that reflect the collective social choice of citizens. To say that the private sector will be the main engine of growth or “private push” as headlines in The Star put it might cause people to think that the government is no longer relevant, which is wrong. It is more correct to remind the citizenry during budget day about the importance of collective efforts as a people and as a nation. Beyond our individual identities and personal aspirations, beyond private risk-takings and anticipated returns, the whole is better than the sum of our individual parts. Instead of focusing on good governance and well-informed policies, the 2011 Budget revealed a disturbing reliance on the private sector. Malaysia can get out of the middle-income trap, but economic decentralisation is required for that to happen. Government Budget GDP

The message from the 2011 Budget should not be reduced to the issue of the private sector being in the driver’s seat. The private sector can drive, but it is the government that must pave the road ahead by doing things right so that the journey forward can be faster and safe. To do this, Malaysia’s current economic circumstances must be assessed correctly, shortcomings identified and then steps taken to overcome these.

There is a word often used to describe problems with the economy – distortions. These are circumstances that prevent prices from matching supply against demand. Over time, like on a chessboard, one’s pieces have all ended up in the wrong places, making it hard to launch an attack, or worse still, to defend. Those that manage the country’s economy are no doubt smart people and are well aware of the situation at hand. Doing what is necessary, however, is not a straightforward task. It takes political will but even though getting things right will benefit the nation as a whole, there is still the need to sort out the gainers and losers in society before policies can be put in place.

The government budget remains at a quarter of the GDP

In 1967, the government budget made up a quarter of the Gross Domestic Product; in 2011 it still accounts for a quarter. In advanced economies, government is big business making up as much as half of the GDP. The reason is, in high-income economies, once individual wants have been satisfied, there is greater longing for “club-goods” like safer and cleaner environments, better healthcare, better education, better infrastructure and amenities that cannot be individually owned. Bigger governments give greater scope in terms of the role of government.

Malaysia’s aspiration to be a developed high-income economy has not been accompanied by an expansion of government typical of other developed nations. Without a larger public delivery system, Malaysia’s progress towards developed nation status will fall short. On the other hand, it is a challenge for the government to find ways of raising public revenues to take its budget well beyond the GDP quarter mark.

 

Income tax makes up only 30% –40% of government revenue

Non-tax revenues make up a quarter of the public budget. This has largely been made possible because Malaysia has been an oil-rich nation. As a nation, we have been living off our assets but concerns of depleting oil reserves point to a need to look for alternative revenue sources. The value-added tax or VAT was to have been introduced in 2007 but was set aside because of the economic crisis. There had been talks of its implementation in the 2011 budget but ultimately nothing has come of this.

The numbers imply that the VAT may not be workable in Malaysia at all. Firstly, with 12 million or so working people (two-thirds of the total population falling in the working age and two-thirds of these economically active), there are only 4.5 million or so individual tax files and only one to two million people who pay substantial taxes. Unlike in many other countries, the VAT in Malaysia cannot become an alternative form of tax that reduces personal income taxes, since most people are not tax payers. Secondly, a VAT incidence in the three per cent range would only raise some RM2bil and this only represents 1.6% of the total public budget of RM212bil allocated for 2011 (compared to RM80bil currently raised from income taxes).

Malaysia’s tax base has to be carefully examined. Paying taxes cannot be seen as a burden. The poor are recipients of public social programmes funded through the public delivery system and thus a policy of higher taxes is actually good for them. The rich benefit from paying higher taxes, since higher public deliveries into housing, health, transport, education and so on overcome poverty and reduce crime rates. For the middle class, taxes are the means to pool funds for “club-goods” so that beyond individual consumption, there remains scope for joint consumption such as safer roads, cleaner environment, aesthetically pleasing living spaces, eff ective law enforcement and so on.

 

Most citizens would actually vote for higher taxes

It is actually a game-theoretic situation. One does not like to pay taxes yet one would like the government to provide better public services such as financial assistance for the poor and aged, better healthcare, better education, etc. Only higher taxes can help the government enhance its delivery. So should one vote for more or less taxes? Since the majority of people fall outside the income tax system (only 4.5 million tax fi les in a country of 27 million people), asking the government to raise taxes can actually benefit the majority of Malaysians.

5.4% deficit despite double digit current account surplus

Over the past decade, Malaysia’s current account has been in surplus by double digits, often as high as 15% of the GDP! Yet the country is running a budget deficit. This defies text book theories because collectively as a nation there is a surplus that must be in private sector hands if not in the government’s coffers. In theory, the government can tax the private sector in order to remove the deficit in a single instance. Unfortunately, the current account surplus (the excess of savings over domestic investments) is produced by forced savings in the employment provident fund (EPF) and therefore cannot be taxed.

To become a developed nation, the budget has to move towards the 50% of GDP mark in order to enhance the scope of the public delivery system. Despite decades of development, the budget has not only remained at the 25% mark but the source of public revenue is potentially shrinking as oil revenues cannot be sustained indefi nitely. Increasing the tax base is the only recourse. To do so will require a rise in public confidence in the government.

Domestic investments are curiously low

Domestic investments projected for 2011 only account for 21% of GDP despite national savings projected at 36% of GDP. The difference, amounting to 15% of GDP is known as the resource gap (by definition, equal to the current account surplus), which is negative since investments are less than savings. The curious thing is why does investment remain low even with adequate funds? Is it because the returns on domestic investments are not good? Is it policy to defend the Ringgit with adequate foreign reserves? Are funds needed for Malaysia’s outward direct investments? The belief that returns must be better for foreign investments is bewildering since Malaysia’s interest rates are relatively high.

 

Competition policy remains inadequate

Private investments are driven by competition policy. The efficient market hypothesis says that prices reflect information that helps create a so-called even playing field. This means greater transparency, especially in the public delivery system which tends to reduce freedom of entry and exit into all types of businesses. In Malaysia, mobile telephone networks have been a success story. Young people today do not realise that 30 years ago it was difficult to even install a phone line in the home because of inadequate land lines.

 

When the government opened up mobile networks to many service providers they began with a regulated price structure of RM60 a month. Later on it opened up competition by allowing a “free-forall”. Today, mobile telephone networks offer highly flexible pricing structures and also comprehensive services ranging from ordinary voice to data and multimedia packages including email and Internet coverage. Private investment opportunities widen when technology can be exploited and diffused into the marketplace in the form of greater demand that reduces unit price in the process.

Domestic consumption to create more jobs

The nominal (unadjusted for inflation) GDP projected for 2011 is RM811bil in which domestic consumption (RM503bil) will make up its traditional two-third share. Domestic investments (RM167bil) add another 21% share, leaving the remaining 20% or so of export surplus to make up the entire GDP. On the surface it is easy to infer that eight-tenths of the GDP is domestically driven, with export earnings filling in the rest. This is misreading the data, because the RM824bil export sales (leaving imports aside) projected for 2011 is actually a little bit more than the GDP and 1.6 times more than domestic consumption. In other words there are 1.6 times as

 

The looming currency “war”

For 20 years, a centre-peripheral model has emerged with the US in the centre buying manufactured outputs from production sweatshops mostly found in the developing East. This means that money has flown out of the US, strengthened Eastern currencies and made the people there rich, eventually turning them into net importers. Once this happens, the flow of funds reverses, naturally adjusting the world’s economy back to equilibrium.

What has happened instead is that East Asian nations have kept their exchange rates low and lent their trade surplus earnings to the US to allow the buying to continue. Unfortunately, US dependence on cheap Eastern imports has led to job losses at home (a process US workers call outsourcing), putting the US economy into crisis, while the depressed US economy also threatens jobs in the East.

 

The problem would have been less acute if not for the fact that China is a large economy that has been playing the selling game. The National Bureau of Economic Research (NBER) that established the centre-periphery model realises that the US cannot play as the centre indefi nitely, because it will eventually run out of money. There was anticipation that China with its huge population and years of export earnings would eventually take over the centre role, “saving” the world economy in the process. Economists have anxiously watched China’s numbers year after year, but no signs have yet emerged of China doing any serious buying from the world.

To the credit of Malaysia’s monetary policy (even though the Ringgit remains among the world’s most undervalued currencies), the Ringgit has actually been allowed to appreciate faster than many other currencies, strengthening by 10% against the dollar since the beginning of 2010. Fewer reserves have accumulated during the past five years.

 

A high-income society appears to be in sight

The much talked about middle-income trap characterised by early decades of astounding growth is something Malaysia has not been able to overcome. There are many solutions offered: creating a knowledge economy, increasing innovativeness, increasing productivity levels, boosting education, etc. For any of these solutions to work, Malaysia will need to manage its human resources better. With unemployment only around three per cent, Malaysia enjoys practically full employment and is even over-dependent on imported labour.

 

One way to overcome the problem is to sever the link between educational qualifications and wage remuneration that produces a hierarchical organisational structure with only a small handful of generals at the top, some captains in the middle and a whole army of lowly-paid soldiers at the bottom. In a high-income economy, the organisational structure is much flatter with fewer layers (and hence smaller wage differentials) between the top and bottom of the hierarchy.

At the bottom, numbers are substantially reduced, requiring one worker to do what used to take as many as five to seven people. Automation and specialised equipment provide the technological means to do this. But what is important is that this allows the lowest wage to rise by as many times. Sometimes, minimum wage policies are prescribed to force this change. To keep the wage bill unchanged, fewer workers are hired but mechanisation helps keep output levels up despite substantial decreases in the number of workers. The idea is that education and training will more or less determine one’s career but should not overly influence one’s earning potential.

Cities are engines of growth but government does not decentralise

A stark oversight of the 2011 Budget is that it seems to have forgott en that cities are engines of growth. The 10th Malaysia Plan (2011–2015) was just presented a few months ago and it explained how the efficient articulation of urban space could create economic density providing the basis for growth. Successful cities across the world were compared, revealing that while the nation’s capital Kuala Lumpur is eight times larger than the typical Malaysian town, Kuala Lumpur remains tiny by comparison with competing urban agglomerations worldwide, or for that matter, within Asia. If direct investments are to be entrusted to the private sector, then governance and policy-making should rightly focus on the development of Malaysia’s cities, with an emphasis on liveability and safety, overcoming the traditional urban plight of inadequate housing, failing public transport systems and insufficient public amenities. The 2011 Budget should be the first step (the first of five years) in the implementation of this new model of growth as outlined in the 10th Malaysia Plan.

Chan Huan Chiang is a senior research fellow at the Socio- Economic and Environmental Research Institute (seri).



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