Economic Challenges in the Federated States of Micronesia

1. Economic Challenges in the Federated States of Micronesia International Monetary Fund October 2005

2. Overview • What is the IMF and why are we here • FSM’s recent economic performance • FSM’s economic policy challenges • Fiscal policy—including tax policy • Developing the private sector

3. What is the IMF; why are we here? • “The IMF is an organization of 184 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty.” • Focus is on macroeconomic and financial stability • We’re in FSM at the request of the national government to give our view on economic policies.

4. Recent economic performance • Growth is recovering from the Compact stepdown

5. Recent economic performance • The Compact is the major influence on the economy:

6. Recent economic performance • Budget is improving too, but still deficit; BoP worsening

7. Economic challenges • Compact grants will decline, and disappear in 2024. Will the trust fund be enough? Depends on reforms. • In our 2004 reports, we examine three scenarios: • Baseline: no fiscal or structural (growth-enhancing) reforms • Fiscal: tax reform and spending restraint • Fiscal-Private Sector Development: comprehensive reforms

8. Economic challenges • Only with comprehensive reforms is the fiscal situation sustainable in the long run

9. Economic challenges • The risks of inaction include: • Weak growth & deteriorating living standards • A more painful adjustment down the road: adjustment cannot be avoided given declining Compact funds • Size and location are obstacles but: • Yap is fast-growing and relatively stable • Small remote states have prospered with good policies • Need to move soon to avoid a more disruptive future adjustment

10. Economic challenges • So, need to save for the future; and encourage private-sector-led growth • How much to save? • We estimate 3 percent of GDP • How to do this? • Options are: • Trim spending • Increase tax revenue

11. Options for budgetary savings • Spending: public wage bill remains high, despite reductions (and longstanding freeze)

12. Options for raising revenue • Tax revenues are low by regional standards

13. Revenues are uniformly low

14. How to Boost Tax Revenue? • Options: • Higher tax rates • Broader base (e.g. eliminate exemptions for noncash income and public enterprises) • A better tax system • Better administration (e.g. centralized) • Better enforcement and incentives to pay • But need to keep it simple (capacity is limited) • One option: a VAT with improved tax administration

15. How a VAT Works • Tax levied on value added: output minus inputs • To consumers: like GRT/import/sales taxes • Businesses: pay tax on sales, get refund on inputs • Example: buy $10 in rice, sell $15 in rice cakes •  tax is levied on $5 ($15-$10) • 10 percent tax = 50 cents (GRT: 6% of $15 = 90 cents)

16. Why a VAT? • Businesses have incentives to report •  helps with compliance • And gov’t can cross-check tax reports • No “taxes on taxes” (growth-friendly) • But there are challenges too: • Constitution: states levy consumption taxes •  would need to coordinate among states • Must design carefully, and improve administration

17. Frequently asked questions • Isn’t a VAT too complicated for FSM? • A VAT is in place and working well in a number of small economies (Cook Islands, Samoa) • Isn’t this just a tax increase? • No; burden won’t necessarily rise for everyone • What’s the alternative? • Could just raise rates or broaden base, but then need more spending cuts; and tax hikes could worsen compliance and “tax-on-tax” problems

18. Developing the private sector • GDP growth remains low by regional standards

19. Is the cost of doing business restraining growth?

20. Private Sector Development: Why & How • Why: • With Compact grants declining, a large public sector is not viable in the long run • Developing the private sector will help the fiscal problem: more growth more revenue • How: • Improve infrastructure to reduce cost of doing business • Ease land use for production & as collateral • Streamline foreign investment regime

21. Summary • Major challenges are ahead • Steps are being taken in the right direction • Tax reform tax force • Wage restraint • New bankruptcy law • Large contribution made to Trust Fund • But more remains to be done to avoid risks • And there is no other option • Comprehensive reform will not be easy • But countries that follow good policies do perform better in the long run

22. References • IMF Staff Report for FSM, 2004 • http://www.imf.org/external/pubs/ft/scr/2005/cr05104.pdf • IMF Selected Issues for FSM, 2004 • http://www.imf.org/external/pubs/ft/scr/2005/cr05103.pdf • IMF Regional Economic Outlook, 2005 • http://www.imf.org/external/np/pp/eng/2005/092705.pdf • Swimming Against the Tide? An Assessment of the Private Sector in the Pacific, Asian Development Bank • http://www.adb.org/Documents/Books/Swimming_Against_Tide/default.asp