Nathan Kowalski, Financial Ramblings from the Rock

On August 7, 1974 French high-wire artist Philippe Pettit took a walk between the Twin Towers of the World Trade Centre. The young French acrobat had to contend with winds, the natural sway of the tower and the logistics of setting up a solid line to balance on. A difficult feat to say the least.

Bermuda is doing its own tightrope walk. It has myriad items to balance as it makes its way across the void to the other side of fiscal solvency. Philippe began his walk, explaining that everything around him faded once he started, except the wire and himself, and that for the first time in his life he felt truly thankful and at peace.

I’m pretty sure this is not the Zen feeling the Minister of Finance currently has. This walk will be an incredibly delicate and tricky one. Here is the good and bad about the recent budget as we walk forward.

First let’s take the positive.

1. Acknowledgement of the importance to balance. They say the first step in solving a problem is admitting you have one. This budget lays this out very clearly. Anyone who cannot see at this point the negative effect that the cost of the debt and its effect has on almost all aspects of the economy and the future prosperity of the nation needs to read and re-read the statement. The threat of escalating debt and the associated negative credit rating impact is a very real threat. The Government appears to be taking this seriously and has noted that a negative rating action can have a detrimental effect on the entire economy and especially entities sensitive to credit ratings like our international business sector. The market is already suggesting that Bermuda’s credit rating is in the BBB range. At the end of the day, the value of government debt must be equal to a reasonable future stream of discounted government surpluses. If, at some point, the market feels the future stream of revenues and surpluses is insufficient to service these growing liabilities, it will revolt and force up interest rates at which the country can borrow.

2. Addressing imbalance in equality. The economic benefits of recent technological changes have not been shared widely. Productivity has increased globally but real median wages in various regions of the world, including certain segments in Bermuda, have stagnated, leading to a reduction in labour’s contribution to GDP. The resulting consequence has been the widening gap between the rich and the poor, or inequality. It should be noted that inequality itself is not a bad thing. The real evil arises in large gaps of inequality and more importantly inequality of opportunity. The commentary on the need for a more progressive tax system is critical in addressing this aspect. Furthermore, the suggestion to enforce a more realistic notional salary regime that prevents inequitable abuses is also positive. If a professional pays herself a junior staff salary but simultaneously earns hundreds of thousands of dollars in dividends, tax free, then you can see how “paying a fair share” is circumvented. And finally making so much money that you no longer pay tax on some of it (ie the payroll tax limit of $750,000) seems comical if you are serious about inequality and a more progressive tax system.

3. Acknowledging the denominator problem. The serious denominator problem which Bermuda faces has been extensively written about. To put it simply, the nation has an exponentially growing numerator of obligations (healthcare, debt and pensions) which is being serviced by a shrinking denominator (population and workforce). This numerator, if one includes unfunded healthcare schemes, pensions and guarantees, is now as much as $7 billion or approximately 120 per cent of GDP. This enormous obligation is being serviced by a population of about 61,000 or a workforce of only about 33,000 — or $115,000 per resident or $212,000 per worker. It is very true that growing the level of aggregate demand within our economy is severely frustrated when the population and workforce continue to shrink. Bermuda’s workforce, based simply on demographic attrition, is falling approximately 1 per cent per year while its productivity growth is running at about 1 per cent per year. This suggests a longer-term real GDP growth potential of essentially zero. Clearly, much is needed to break the island from this secular stagnation, lest we become another Japan. This can be ameliorated, as suggested, by a more updated immigration policy that encourages not only contributors to come and live but also contributors from not leaving.

Now a few more concerning items.

1 Little acknowledgement of Bermuda’s concentration risk and lack of diversification. Broadening the tax base is undeniably a decent approach to help tackle the escalating debt. But diversifying or broadening the economy or the push to do so would also help immensely as well. A great deal of the budget statement revolved around Bermuda’s current sectors. Understandably so as they are the current constituents of the economy. The Bermuda Business Development Agency, the Tourism Authority and various other groups are doing the best they can to move their current strategic imperatives forward. Regardless of how you feel about their accomplishments, I believe they are making progress. But meanwhile the world evolves around us. I don’t have time to go into great lengths on the future of work in Bermuda and the rapid evolution the world is facing. I’ve done that in prior articles and writings. What I will say, however, is that Bermuda seems to be lacking any exposure to this future. A future that involves sectors nowhere near like those of which dominate our current economic landscape. Think of the BRAIN industries — biotech, robotics, artificial intelligence, and nanotech. Although it is not up to the government to create these industries it can help create policies that encourage their formation on the island. If we do not at some stage tap into these sources of powerful growth and secular change we will ultimately become the source of their disruption.

2. Increasing the cost of business and the burden on the private sector. As noted previously, Bermuda’s private population and private sector are smaller and are now being asked to bear an ever-increasing burden to service the debt. The increase in payroll tax at a time when job growth is elusive strikes me as potentially damaging. For an island which is considered to already have a relatively high cost of labour, making it more expensive pushes us further into the category of uncompetitive. Also, if you want people to use more of something you don’t typically make that something more expensive. Rising the cost of labour simply makes labour less attractive as a productive input. The tax rate paid by employers will go from 9 per cent to 9.5 per cent, an increase of 5.5 per cent. Furthermore, the payroll tax paid by employees will go up from 5.5 per cent to 6 per cent, an increase of 9.1 per cent. The total tax paid by labour goes from 14.5 per cent to 15.5 per cent an increase of 6.9 per cent. Although the 1 per cent number seems small it is notable when considered in aggregate for the economy or many companies. On the margin it may defer additional hiring or workers and/or regrettably lead to some job loses for those barely hanging on. Also, the expiration of the legislation that grants concessions for new Bermudian hires should not have been expired. Again if you want more of something it helps to make it less expensive. The GST (general service tax) introduction of 5 per cent obviously increases the cost of business as well. Typically the end consumer suffers most as these additional costs get passed on down the line. The whole process will eventually be inflationary which is not what Bermuda needs in a macroeconomic environment of competitive devaluation and deflationary hyper-competitive markets.

Chart 8 from the budget statement goes so far in suggesting revenues are inadequate based on the size of the economy effectively suggesting the private sector is not doing enough. This is but one data point however. I would suggest that on other metrics the private sector does much already. As a short example, if you build a simple table of those countries found in Chart 8 with data from the CIA Factbook, and include those more similar to Bermuda such as Cayman, Jersey, Guernsey, BVI, and the Isle of Man you will find that Bermuda has the highest government revenue number in absolute terms. In fact, on a per person basis Bermudians pay over $16,000 in government taxes and fees versus around $8,500 for those in Jersey or Guernsey. Guernsey’s population at roughly 66,000 is also very close to ours.

What is maybe more telling is that Bermuda’s government expenditure, excluding public debt charges of $980 million, is higher than any of the previously listed countries. In fact, it’s higher than Jersey which sports a population of over 97,000. More analysis is needed to determine how much certain aspects of the private sector can actually bear as we balance revenue with expenses.

3 Limited focus on expenses and the size of Government. It is painful to me to witness increasing burden being placed on the private sector when one notes the almost static size of the government’s cost structure. The Fiscal Responsibility Panel suggests that savings from the rationalisation of public services will require difficult policy decisions. It will. But just because something is difficult doesn’t mean it shouldn’t be done. The FRP also stated in their report: “It will be important to demonstrate with visible actions that alongside increases in taxes the Government is serious in its endeavour to improve efficiency and reduce waste.” While I would admit the balancing act does need to consider progressive taxation and some form of broadening, more needs to be done to “demonstrate with visible actions” that the expense side is being tackled. Firstly, if near term economic growth prospects provide a window of opportunity to reduce the debt through tax raises it also provides an opportunity for cuts in civil service expenses. If the rationale is the economy can handle tax increases, surely it can handle more extensive expense reductions. Secondly, I still feel the Government and the Civil Service needs to be run more like the private sector with much greater accountability and discipline. Private companies that run into problems don’t have the luxury of legislating revenue growth. They must cope, to large degree, by managing their expenses. I really don’t think the Government should be any different. It may not need to be held to exactly the same standard or market discipline that is enforced upon private-sector companies, but it should at the very least demonstrate to the private sector from which it takes that it too is sacrificing for the country. Balance must be maintained. There are numerous excellent civil servants who do a tremendous job for this country. There are, however, undoubtedly a number of workers who are actually detracting from progress and may even be discouraging those high-flyers in Government. I believe the private sector would be more accepting in regards to future tax hikes if they simultaneously saw the Government’s more extensive attempts to reduce expenses. Again, if the reason for a three-year plan of tax hikes is because we think the economy can now handle it, part of that plan should include more focus on the expense side as well. To use a recent phrase, today’s Civil Service, is like the iOS on your iPhone, it has to be updated or else it will no longer serve the purpose of today’s users. Time to download the Sage Report.

Phillpe walked back and forth six times in his tightrope stunt. Bermuda will get one chance. We can maybe afford a few minor stumbles but a major error will send us tumbling into the void. This is a delicate task that requires sacrifice across all swathes of the economy. The way in which we negotiate this balance will determine if the island makes it across.

Nathan Kowalski CPA, CA, CFA, CIM is the Chief Financial Officer of Anchor Investment Management Ltd. and can be reached at nkowalski@anchor.bm

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