The Fatal Flaw in Cape Verde's 2013 Budget

Cape Verde's incumbent government is about to make a fatal mistake in its budget for 2013. At a time when the second round of the global economic crisis is having a serious impact on the local economy, the government has proposed a sharp rise in the VAT (value added tax) on certain basic consumer staples and on certain business sectors. While the VAT on fuel prices will decrease, causing a welcome 20% drop in the price of fuel, taxes on other important drivers of economic growth could result in a major economic calamity in 2013.

Here is the backdrop of the current economic situation:

• Driven by strong growth in the tourism sector, Cape Verde's economy had been growing at a fairly robust pace of over 7% per year until the global economic recession of late 2008 / early 2009. The pace of growth then slowed to around 5% per year. (UPDATE: Six months after I wrote this article, Fitch rating agency published revised guidance on Cape Verde and said that "Revised GDP data show Cape's Verde's real GDP growth is significantly weaker than previously thought. Under the revised methodology, Fitch's estimate of five-year average real GDP growth up to 2012 is now 2.6%, compared with Fitch's previous calculation of 5.1%.").
• Cape Verde's finance minister, Cristina Duarte, famously claimed at the time that Cape Verde's economy was somehow immune to the global crisis even though there is a very strong and well known economic correlation between what happens in Europe and what happens in Cape Verde - economically speaking. It was not clear if these statements were politically motivated as the 2010 general election was just around the corner at the time the statements were made. It is difficult to imagine that the minister herself actually believes this.
• Meanwhile, the 5% growth rate in the overall economy in the face of an even higher pace of growth in the relatively significant tourism sector (which was largely confined to two of Cape Verde's nine islands) suggests that the rest of the economy is experiencing a slowdown (negative growth).
• In the 2012 State of the Union address, Cape Verde's prime minister, Jose Maria Neves, said that "Cape Verde is on the right track" even as the economic situation in Europe continued to dramatically deteriorate with riots in the streets of Greece and Portugal.
• In an interview published on 17 October 2012 in the journal A Nação, 267th edition, the prime minister appeared at a complete loss to explain how it was possible that an economy that he claimed to be growing robustly was shedding massive numbers of jobs left and right (the "official" unemployment rate is 12%, but the real rate is substantially higher, and in some islands - like São Vicente - is reputed to exceed 50%).
• The increase in traffic through Cape Verde's airports - most of which consists of tourists entering and leaving the country - slowed from a double-digit annual pace to a pedestrian 4% in the third quarter of 2012. This big drop is the result of a decline of 6% in domestic traffic along with a reduced pace of growth in international traffic. The decline in domestic traffic is a clear indication that business travel is declining which in turn obviously means that companies and entrepreneurs are doing less domestic business. It is also an obvious indicator that private households with the means to travel inter-island now have less disposable income to continue such travel. These trends clearly indicate an economic decline in the sectors outside of tourism and portend an eventual downturn in the tourism sector if global economic pressures continue unabated, especially in Europe.

It is quite clear from all indicators that Cape Verde's economy is quite fragile at this moment. Yet, the government budget which seeks to raise revenue primarily by increasing taxes, represents a fundamental misunderstanding of economics. The dramatic increase in taxes at a time when the economy is being buffeted by external global economic forces that are not likely to assist with domestic growth will only have one undeniable effect and that is to deliver a death-blow to the economy.

In other words, this economic action will have exactly the opposite effect to that which is desired by the government. It will lead to a reduction in revenues and a major increase in the country's deficit.

The government had already made a serious blunder and subsequently reversed itself when they attempted to increase the cost of entry visas that tourists and non-nationals must pay to enter the country. The outcry from foreign tour operators since this dramatic tax increase - that was levied without warning - was so loud and so severe that the reversal came within a couple days of the announced increase.

But that was only child's play compared to what was then announced in the 2013 Budget. The rate of VAT itself was not increased and remains at 15%. However, there are a number of products and services which were either exempt from VAT or were taxed at lower rates than 15%. These products and services will all see a massive increase in VAT. But what is most alarming is found in the details. Here are a sampling of the products and services which will see a massive increase in the effective consumption tax along with a discussion of the economic impact:

• Basic Essentials: water and energy are currently taxed at rates of 3% and 4.5% respectively and the increase to 15% will wallop all consumers. Consumers might react by saving energy and water which is not necessarily a bad thing. But I would bet that consumers will initially be very surprised by the higher costs because the bills now indicate an IVA of 15%, but do not make it perfectly clear that a "base" of 20% or 30% is first applied to the raw prices before the 15% tax is applied.
• Maritime Transport: currently, domestic maritime passenger tickets and maritime fuel are exempt from taxes, and will remain exempt. But IVA on maritime cargo will climb from 2.25% to 15%. What the government continues to misunderstand is that because Cape Verde's islands are separated by water, the movement of goods by sea - or maritime transport - is one of the keys to economic growth. This tax will cause a decline in the circulation of goods in Cape Verde.
• Hotels and Restaurants in the tourism sector: these services currently are taxed at 6% but the tax will more than double to 15%. This could have a major negative impact on the tourism sector. At least one politician is alarmed and believes that this will kill tourism in his neck of the woods - Jorge Figueiredo, the mayor of the island of Sal, one of the two islands which draw the bulk of tourists, has been very vocal in his opposition. His concerns may be well founded because most of the tourism business in Cape Verde is based on pre-paid packages promoted by tour operators. An increase in VAT will simply have to be absorbed by the operators who have received payments sometimes a year in advance of the tourist's arrival. These companies run on thin margins and the prospect of losses will simply drive these operators to send their clients to other destinations with friendlier tax regimes.

Naturally, the debate in the assembly (parliament) was very heated and quite correctly, the parties focused on tourism, the biggest driver of the economy. But what was most surprising to me was that the prime minister, José Maria Neves, argued that he believes that the budget which assesses a massive tax increase on tourism will keep foreign investments flowing in and will keep tourism growing. He charges that the tourism operators were complaining because they look out only for their own interest and not for the interest of the country. But that is exactly the point! That is what businesses do, and looking out for their own interest means that if the tour operators will lose money in Cape Verde, they will send their clients elsewhere...to destinations which are more tax friendly and where they can maximize profits in their own interest! This suggests either a lack of understanding of how a free market economy works, or more likely, that the government did not take the time to engage in dialogue to make their arguments and listen to the feedback well in advance of springing this budget surprise on the private sector.

In fact, the 2013 budget is already seeing some fallout in real terms. One of the largest investors in the tourism sector is the Meliá Group which owns the Tortuga Beach Hotel, a 5-star resort, on the Island of Sal. The group has called the proposal to increase the IVA on hotels,"an explosive surprise", has expressed a loss of confidence in the country, and has threatened to leave - in other words, they would make no further investments in tourism in Cape Verde. Perhaps these are idle threats, but the group points out that at 15%, the tax on hotels would be among the highest in the world (look at the document in the consultant's hands in the last 5 seconds of the video clip). Cape Verde should learn from the experiences in other countries where VAT was increased on tourism services. Here is what happened in Iceland which will treble VAT on hotels from 7% to 25.5% starting in May 2013, and in France which raised VAT on hotels from 5.6% to 7% in early 2012. The potential impact on the tourism industry is not for the faint of heart!

The sole exception to these tax hikes is an important one - fuel - and seems to be forgotten in the debate. The base applied to gasoline is 300% of the price, so the effective consumption tax rate cleverly hidden in gasoline prices is currently about 45%. The base will be reduced to 100%, so the effective tax rate will come down to 15%. Thus, if a liter of gasoline currently costs 180$30 including IVA, it will now cost about 143$00 or a price decline of almost 20%. However, the price decline on diesel will be much less because the taxable base on diesel was much lower than on gasoline. This is an important offset to the other tax hikes.

The question is to what extent the reduction in taxes on fuel will fully offset the tax hikes on the basics. Now, obviously, the cost of fuel drives many other prices in the economy because fuel is used to transports goods along the roadways and is also used to power certain machines and other equipment that produce goods and services. But does this mean that buses, taxis and Hiaces will lower their fares, or that Electra would lower its prices for energy and water, or that product distributors will lower their wholesale prices? The answer is that it depends on the price regulator, A.R.E. A.R.E may require that certain prices be lowered in response to the reduction in fuel prices. But I don't see that happening either.

Frankly, I believe that A.R.E should not exist - price controls in a free market economy only result in economic inefficiency. I also believe that many of the businesses which supply products and services regulated by A.R.E have been suffering major losses in their operations so they will only pressure A.R.E to leave prices unchanged or will suffer even more losses and potentially become insolvent. Furthermore, A.R.E fortunately does not control all prices.

So in the end, left to their own devices, I cannot see any Cape Verdean businesses offering to lower their prices under the current economic scenario. They will keep any savings on fuel costs in the bank. It is important to know that most of the fuel used in Cape Verde is diesel, not gasoline. So the savings will not be very much. The result is that prices without IVA will not change, but with a higher IVA, the final price to consumers will be higher for everything except fuel. But since we are talking about basic necessities, it is the poor who will be disproportionately impacted by the new budget.

Many business people have been vocal and unanimous in their indictment of the VAT changes. The minister of finance got an earful from the business community at a recent presentation of the 2013 budget changes. Click this link for the media coverage.

In my opinion, the government is making an economic mistake of significant proportions and is in danger of "killing the goose that laid the golden egg," or as they say in Cape Verde, they will "matar a vaca leiteira." The economic impact may be felt for years to come. Here are my recommendations for what should be done in times of economic malaise in the context of Cape Verde:

1. Acknowledge that the economy and the consumers and businesses within it are under severe economic and financial pressure - and this includes the government. Anyone who believes that Cape Verde is magically immune to the external global economy is living in a fool's paradise.
2. Simplify the VAT structure by setting the "tax base" to 100% on all products as they are attempting to do but instead of leaving the VAT at 15%, it should temporarily REDUCE the VAT (cut it in half!) in order to stimulate economic activity, which creates jobs and causes more money to circulate within the economy, which in turn adds to the governments coffers through more income tax revenues and more VAT collections via increased consumption. Later, when the economy recovers and is experiencing robust growth, the VAT rate can be gradually and eventually returned to the earlier levels.
3. Increase the incentives to stimulate maritime traffic and the physical circulation of goods, labor and money - the lifeblood of the economy - which has a direct relationship with economic growth.
4. Make it a lot easier for foreign investors AND LOCAL COMPANIES to do business in Cape Verde and create huge tax incentives for businesses to invest in infrastructure projects, build factories and industries that create export-oriented products and services, attract real tourists who spend money inside of Cape Verde, and thereby increase jobs. It is the act of bringing in large foreign direct investments, creating jobs and increasing exports that will drive up GDP and in turn government revenues.
5. Eliminate A.R.E. Price controls are the economic ropes that have always eventually lead to the strangulation of free enterprise in every economy where such controls have historically been implemented.
6. Cut down on wasteful government spending such as the huge number of boondoggle trips taken by the government ministers. What possible reason could the government officials of a relatively poor and tiny country have to be globe trotting as if they are members of the G7? I cannot think of a single reason. Obviously, judging by the results, this spending is a waste of time and money.
7. Cut out the government owned businesses that suck billions upon billions of escudos of real value from the economy...money which could otherwise be spent in much more effective ways. Here, I'm referring primarily referring to TACV and Electra, Cape Verde's equivalent of galactic "black holes." There is no reason these companies should continue to exist - the airline, energy and fresh-water industries should be turned over to private enterprise as quickly as possible.

Reading an economic situation and making the right projections can often be like reading tea-leaves. Two economists might look at the same situation and come to opposite conclusions. However, one thing is absolutely clear - if there are tea-leaves present in the economic cup, no one was drinking coffee from it! Likewise, the time for a massive hike in VAT is certainly not when the economy is in a state of decline and most definitely not advisable for the tourism sector which is the engine of the country's economic growth!