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 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

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, IMF Selected Issues for FSM, IMF Regional Economic Outlook, Swimming Against the Tide? An Assessment of the Private Sector in the Pacific, Asian Development Bank

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