The gradual reduction in income tax has boosted economic activity – as was hoped at the time – with the peak of the impact reaching 0.35 per cent of GDP next year, according to a report published by the Central Bank of Malta (CBM).
Aaron Grech, the head of the Modelling and Research Department of the bank, used macroeconometric models and found that the impact would stabilise at 0.28 per cent in the medium term, once the initial boost to consumption from more disposable income is eroded by a decline in exports as domestic prices raise.
Employment and investment are both expected to grow significantly but there is a downside: like in other small economies, in - creased do mes tic demand spurs more im ports, especially of consumer goods. Moreover, part of the increased investment also tends to seep out of the local economy, the report found.
The impact should decline gradually by 2020, but still remains significant at 0.28 per cent.
The main impact of a reduction in income tax is a boost in disposable income (see table). This, in turn, leads to higher private consumption and gradually to increased investment.
The impact on private consumption peaks in 2016, when its level is 1.84 percentage points higher. On the other hand, the effect on investment continues to accelerate till 2017, though the difference from the starting point is much less pronounced than in private consumption.
The improvements in domestic demand are partially offset by weakening net exports. Besides the rise in imports of consumer and capital goods, the tax reductions also lead to a gradual decline in exports. This occurs because higher demand for labour pushes wages upwards, leading to lower competitiveness.
This impact dampens over time, as the growth in employment moderates from its peak of 0.39 per cent in 2017. The unemployment rate declines initially as a result of a higher demand for labour, but this impact disappears when the labour supply starts responding to higher wages.
The report also calculated the impact of the reduction on the effective tax rates. Given the progressive nature of the income tax system, had the pre-2013 tax rates remained in place, the effective tax rate would have risen from 12.7 per cent to 13.5 per cent by 2015.
The 2013 tax reductions resul - t ed in a decrease in the effective tax rate to 12.3 per cent in that year, lowering it further to 12 per cent by 2015.
“Thus, in effect, the tax reductions reduced the average burden of personal income tax by 1.5 percentage points,” the report said. The reductions affected 42,500 taxpayers in 2013, giving them an average reduction in their tax bill of €380. The following year, 43,500 benefitted, this time seeing €819 shaved off their taxes, while in 2015, 44,000 were paying €1,440 less tax.