The government’s worrying policy route: Tax cuts!
With the rate of interest at the current levels, the fiscal easing will hardly pull the Turkish economy from a prolonged contraction phase. The anticipated one-off ease on the inflation front could hardly come by given the current ease on the fiscal policy front.
The modern day economic theory might be as puzzling as it can get. Like in the case when the Nobel Prize was divided equally between Nordhaus “for integrating climate change into long-run macroeconomic analysis” and Romer “for integrating technological innovations into long-run macroeconomic analysis.”
Yet, Macroeconomics 101 never changes and remains a reliable source to trace the roots of simple cause and effect type of macroeconomic fluctuations. Tax cuts on the fiscal side and monetary tightening on the monetary policy side combined is no recipe for a full-fledged fight against a high inflation. And that is the case in Turkey right now.
Turkey’s government today announced a tax cuts package including six topics be effective as of November 1st. Treasury and Finance Minister Albayrak informed that the mentioned tax reductions “aim full economic recovery following the currency turmoil in recent months”. The rational for taking such a curse of action on the fiscal policy front was “to reinvigorate the sectors that have contracted by currency impact.”
As per the new tax scheme:
- The value-added-tax (VAT) cuts in housing sales and the furniture sector from 18 percent to 8 percent has been extended until next year,
- The special consumption taxes on domestic appliances will be suspended until 2019.
- For motor vehicles with engines under 1600cc, special consumption tax rates will be lowered to 15 percent.
- All VAT rates for commercial vehicles will be lowered to 1 percent from 18 percent.
- The reduction of title deed fees rate from 4 percent to 3 percent will also continue.
The same minister, Treasury and Finance Minister Albayrak who is also the closest to President Erdogan trough kinship by marriage to Erdogan’s daughter, has just argued a day before that “the Aug. 10 economic attack against Turkey was planned in foreign capital” referring to Washington; based on Trump’s sanctions related tweet. On Aug. 10, the Turkish lira dropped as much as 18 percent against the U.S. dollar, reaching the height of its sell-off in 2018.
The government and the central bank had tried to reverse the trend since then with the central bank delivering 625 basis points rate hike in August and the government unveiling what it calls the “New Economy Program” promising fiscal rationality for the upcoming three years. What had stooped the free fall in lira reversing the trend was of course a political voice to free the US Pastor Branson earlier in October. What had given the US President Trump the ground to impose sanctions on Turkey was reversed by Turkey’s “courts” with an immediate positive impact on lira.
Albayrak carries on: according to him Turkey has entered a period of normalization since the beginning of October and that 2019 will be a year in which the markets’ confidence in Turkey will be restored. He adds that the inflation rate in September was the worst part left behind, despite “some circles doing crisis-mongering for Turkey”. He is sure that positive developments on the inflation front in October are in the pipeline.
So far, so good with the claims. Yet, while the Minister was giving all these positive messages to the market, the central bank of Turkey on Oct. 31, sharply raised its 2018 inflation forecast to 23.5 percent from its previous level of 13.4 percent. Turkey’s consumer price index currently stands at 24.5 percent as of September year-on-year -the 15-year peak- while the producers’ price inflation for the same term is dangerously high at 46 percent hinting further possible pass through.
So what was all the New Economy Program was about?
Let’s just for a minute recall that briefly: as per the 2019 program, monetary policy would be strengthened in coordination with fiscal policy by conducting it in line with inflation targeting in a way that also respects financial stability; so that with the measures to be taken, end of 2019 consumer inflation would ease to 15.9 percent from around 24 percent now expected by the central bank for the end of 2018.
The promise of fiscal austerity to lower Turkey’s very high 23.4 percent inflation and savings to a tune of TL70bn (USD 12.5bn) due 2019 as per the New Economy Program are not in harmony with the government’s brand new tax cut scheme announced on October 31st. Thus, it was no surprise the lira weakened more than one percent against the dollar to around 5.58-5.60 after Minister Albayrak announced tax cuts in automotives, white goods and furnitures.
As the graphs embedded above reveal, Turkey is now deep diving into economic contraction in the final quarter of 2018 to extend well into 2019. With local elections due on March 2019, the unexpected tax cuts no doubt targets smoothing the impact of economic contraction ahead of the 2019 polls.
With the lira’s strength to a tune of 18 percent since the start of September on hopes of ease of political tension in Turkey-US relations related to the Brunson case, the government must have seen an opportunity on the inflation front for the coming few months.
Yet, the move to cut taxes on various consumption goods have immediately weakened trust to fiscal policy promises for who have- once again- granted the AKP government the benefit of doubt with the New Economy Program.
Moreover, with the rate of interest at the current levels, the fiscal easing will hardly pull the Turkish economy from a prolonged contraction phase. The anticipated one-off ease on the inflation front could hardly come by given the current ease on the fiscal policy front. Moreover, Albayrak’s claims that the tax cuts “aimed at supporting economic rebalancing, employment and the fight against inflation” have no relation with economic truth.
Once again the Erdogan government has acted pragmatically, focusing on short-term economic problems and on only a part of them. The medium to long term economic maladies remain where they are; starting with the possible chain of events related with the private sector debt-banking sector.
With such focus, anchoring expectations on the inflation front will hardly be achieved, lira weakness could again set its foot in with an immediate negative effect on Turkey’s already very high inflation rate in 2019.