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.

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Recent economic performance Growth is recovering from the Compact stepdown

GDP Growth and Inflation (in percent)

GDP growth

Inflation

-10

-5

0

5

10

FY1997 FY1998 FY1999 FY2000 FY2001 FY2002 FY2003 FY2004 FY2005

5

Recent economic performance

The Compact is the major influence on the economy:

Compact Grants in Percent of GDP

0

10

20

30

40

50

60

70

80

90

FY1987 FY1991 FY1995 FY1999 FY2003 FY2007 FY2011 FY2015 FY2019 FY2023

6

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

Overall fiscal balance

Current account balance

incl.official transfers

-15

-10

-5

0

5

10

FY1997 FY1998 FY1999 FY2000 FY2001 FY2002 FY2003 FY2004 FY2005

Current Account and Overall Fiscal Balance(Percent of GDP)

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:

1. Baseline: no fiscal or structural (growth-enhancing) reforms

2. Fiscal: tax reform and spending restraint

3. Fiscal-Private Sector Development: comprehensive reforms

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Economic challenges Only with comprehensive reforms is the fiscal situation

sustainable in the long run

10

20

30

40

FY2004 FY2008 FY2012 FY2016 FY2020 FY2024 FY2028 FY2032 FY2036 FY2040

BaselineFiscalFiscal-Private Sector Development

1 Compact grants for 2004-23; and Compact Trust Fund and other assets returns from 2024.

Compact Grant and Assets Returns1

(Percent of GDP)

Assets returnsCompact grants

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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

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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

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Options for budgetary savings Spending: public wage bill remains high, despite

reductions (and longstanding freeze)Public Sector Wages and Salaries/GDP (2004)

0

5

10

15

20

25

30

35

40

Kiribati FSM Palau MarshallIslands

Fiji SolomonIslands

PapuaNew

Guinea

Samoa

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Options for raising revenue

Tax revenues are low by regional standardsTax Revenue/GDP (2004)

0

5

10

15

20

25

30

Kiribati SolomonIslands

PapuaNew

Guinea

Palau Fiji Samoa MarshallIslands

FSM

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Revenues are uniformly low

Income taxes

Consumption tax and Excises

International trade taxes

Other taxes Total

Solomon Islands 7.7 8.5 7.8 2.8 24.0Fiji 6.2 6.2 4.5 0.0 21.0FSM 3.1 3.1 3.2 2.2 11.1PNG 14.6 5.8 2.5 0.0 22.3Palau 5.3 5.3 7.2 4.7 21.9RMI 8.9 8.9 5.8 0.9 23.3Samoa 4.4 14.0 3.6 0.6 18.7Vanuatu 0.0 0.0 7.9 0.3 22.6Sources: IMF staff reports

Tax Revenue Composition in Selected PICs (In percent of GDP )

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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

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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)

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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

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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

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Developing the private sector

GDP growth remains low by regional standards

Real GDP Growth (1992-2002 average)

-2

-1

0

1

2

3

4

5

Samoa Kiribati PapuaNew

Guinea

Fiji Palau FSM SolomonIslands

MarshallIslands

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Is the cost of doing business restraining growth?

TongaFiji

KiribatiMarshall Islands

Micronesia

Palau

Papua New Guinea

Samoa

Vanuatu

30

35

40

45

50

55

60

65

70

0 1 2 3 4 5 6Average Growth 2000-04

Cost of Doing Business

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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

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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

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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

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