The train is on the move and the second fiscal stimulus package seems imminent even as the federal government scrambles with great difficulty to spend RM7 billion as promised in the first stimulus package announced back in November 2008. While that is so, press reports suggest that the general outline of the second stimulus has yet to be written. This is perhaps evident through the solicitation of the Finance Minister for stimulus idea from the public. If indeed that is so, then this is a good time to demonstrate why tax cut is a better solution than government spending within the context of the second stimulus.
If the purpose of an economic stimulus is to reduce the sufferings associated with economic downturn, then the stimulus package has to fulfill at least two criteria.
First, the lag between the administration, the execution and the effect of the stimulus has to be short. This is to ensure that the stimulus comes at the times when it is most needed. That period is when the economy is deep in crisis and not when it is already nearing reasonable level of recovery. Any later, a stimulus will become useless.
Secondly, it has to be widely distributed to among the participants of the local economy. A restricted distribution of stimulus will be meaningless in terms of alleviating the sufferings of individuals adversely affected by the downturn. While theoretically the economy could show sign of recovery even with a restricted distribution, it may do little in improving, for instance, the unemployment rate. The previous RM5 billion injection by the government through its various arms into ValueCap — a fund management company active in the equity market — is a case in point where a stimulus is extraordinarily focused. While the massive injection into ValueCap may save the company, the injection does nothing in improving the real economy.
Government spending is unlikely to achieve both criteria at the same time because there is a trade-off between the two factors as far as government spending is concerned.
For a government spending-based stimulus to act fast, it has to be administered on small items without complex distribution method. Any effort to distribute the spending widely will necessarily bog down the execution of the stimulus. Why?
Designers of the plan will have to know where and on what to spend. This information unfortunately does not come quickly. Any investigation into the subject requires time and an investigation of countrywide magnitude demands reasonable time to complete. It is possible that effort by the Finance Minister to harness the wisdom of the masses is partly to cut short the process of information gathering.
Independent to the quality of information is a question of execution. A widely distributed government spending-based stimulus by definition itself requires considerable number of transactions which transpires various levels in the government as well as the economy. Each transaction itself needless to say consumes time, especially so when transparent processes which include open tenders are applied.
While government spending suffers from the trade-off, tax cut simply does not. Tax cut can be done relatively quicker and more distributed than government spending.
Tax cut especially on transactional taxes on consumer goods like sales tax can be administered quickly because the information required is not a massive as the one required for government spending. The government could announce that tax cuts on sales tax in a matter of weeks if not days. In this age, simple information like that can travel fast and wide.
Secondly, a tax cut, especially on sales tax is more distributed in its effects than any practical government spending. Just imagine how many times a week does any one of us commit a transaction with sales tax appended to it? And then consider how many people do you know pay sales tax? Compare that to how many people do you know that may enjoy the direct effect of government spending on public works?
The reduction of sales tax in particular has the potential of increasing the quantity of goods demanded in the economy by making it prices faced by the buyers cheaper. More so if demand for those goods is elastic.
There are other taxes that could be reduced, like corporate and personal income taxes but that a cut on those will not come as quickly as a cut on sales tax. Regardless, it is possible to do tax rebates on taxes assessed and paid in the previous years in a quick matter. Proof: the government managed to return tax rebates quickly last year in less than a month or two.
Another method is through future tax cut. Future cut on taxes however is likely to be a game of expectation management.
In any case, tax cut on non-transactional taxes on consumer goods must be directed at the lower and middle classes. It has been demonstrated time and again that these groups are the ones most likely to spend instead of save the extra cash that they received. There are ample empirics to eliminate debate on positive economics on this specific issue.
A large tax cut will of course hurt government revenue in times when revenue from petroleum and its by-products may not be as large as projected last year. This therefore will increase the fiscal deficit. Concern for deficit however is immaterial if the alternative is greater government spending. Whether government revenue shrinks or its expenditure grows, the end result is likely the same in terms of direction if not in magnitude.
Besides, while RM7 billion is pale when compared to the size of drop in Malaysian exports seen lately — when exports consists of more than 100% of the Malaysian gross domestic product just months ago — and therefore unlikely to counter the full effect of weakened external demand, the path of government spending essentially has been explored. The first stimulus attacked the demand curve in its first wave. Perhaps it is wise to attack the supply side this time around. When the first and the second stimuli are combined, a more holistic view is taken.
Finally, for Barisan Nasional, tax cut has greater appeal over government spending.
The BN-led federal government has been accused to cronyism with government contracts circulating mostly among BN party members. Even in a system that favors the Malays, the general feeling is that only UMNO members are benefiting from it.
Consider government spending as fiscal stimulus: with its requirement to be executed fast, large spending is likely to bypass many transparent processes, if there is any at all. With an already bad reputation in place, the haste of commissioning various stimulus-conscious projects is likely to encourage the public and even more so for political rivals of BN to question the method of award of the contracts. Suspicion of corruption will be inevitable and that will only solidify the image that BN suffers.
With tax cut, especially on transactional taxes on elastic consumer goods, there is no room for the accusation of cronyism or corruption. A tax cut breaks away from that bad reputation and positions BN as an advocate of a more egalitarian stimulus.
A version of this article was first published in The Malaysian Insider on January 28 2009.
