Cyprus Urged To Cut Deficit

by Lorys Charalambous, Tax-News.com, Cyprus

09 July 2010

The foremost policy challenge for Cyprus is to reverse the large structural fiscal deficit that has emerged in recent years, according to the International Monetary Fund.

The IMF said in its Article IV consultation that Cyprus must act to cut the size of the public sector so that tax rates can remain low enough to attract foreign investment. The deficit was driven by rapid growth in public sector wages and employment as well as the expansion of social spending, much of which was not well targeted to help the poorest portions of the population, said the IMF. Meanwhile, the end of the real estate boom has caused an enduring loss of associated revenues, which, the IMF thinks, will not return to previous levels even as the economy resumes growth.

The IMF considers that levels of public debt are moderate relative to many other Euro area countries as a result of past policies, but it wants Cyprus to act forcefully to preserve this favorable legacy and protect debt sustainability. This is now more urgent in the face of growing pressures in Euro area sovereign debt markets and the increasing focus of investors on fiscal imbalances, says the IMF.

The IMF approves of government’s targets for reducing the deficit to below 3% of GDP by 2012, which would put the public debt ratio on a declining path, but wants to see bold measures taken to achieve these goals, while noting that Cyprus has started to reduce public sector employment and stop general increases in public sector wages.

While this may help to stabilize the deficit near last year’s levels of 6% of GDP, the IMF wants to see further actions to ensure official targets are met, in particular reducing the public wage bill and better targeting of social transfers. In the IMF's view, the public sector is large (close to half of GDP) and tax rates need to stay low to preserve the attractiveness of the Cypriot economy to investors.

The IMF offered the following options for consideration:

• Include adjustments to the incremental salary step increases;
• Introduce contributions by government employees toward their unfunded government pensions, and
• Reform the cost of living adjustment to increase wage flexibility while protecting lower paid workers.

The IMF expected to recommend further reforms of the pension system in coming years. Last year's reforms helped to prolong the system’s solvency, but the IMF expected pension outlays to rise steadily and outstrip contributions, putting pressure on the general budget.

In the long-term, the IMF thought pension outlays should be brought more in line with contributions, through a combination of lower replacement rates and higher retirement age.

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