Quantum mechanics teaches that there is no such person as an independent observer. As we observe, analyse and evaluate, we change the environment being observed.

Individuals, acting as economic agents, develop an understanding of the economic environment using either anecdotal or theoretical models and so can, under certain conditions, pre-empt or render ineffective Government policy.

With this in mind, good budgets should communicate a clear and consistent message to decision makers in the private sector. For example, successive governments have adhered to a golden rule:

[rt] that current spending ($710m) should be less than tax revenue ($750m)

[rt] that debt ($260m) should be less than ten percent of GDP ($4,500m).

As a result, present and future generations will know that economic growth will not be adversely affected by public debt because significant resources, in the form of higher taxes, will not be needed to pay-off or service that debt.

Budget Statements outline the Government’s fiscal policy. They stipulate the source and rate of taxation, on the one hand, with the destination of spending on the other.

In Bermuda, the principal sources are customs duties and payroll tax, which make up over 60 percent of Government’s tax revenue, as well as relatively minor sources such as companies fees (seven percent), land tax (six percent), stamp duties (five percent), and passenger tax (four percent).

On the expenditure side, Health and Education are the largest recipients. The public sector spent over $800 million last year, which accounted for 20 percent of GDP and employed over 5,000 people (13 percent of the labour force), making Government, by far the largest employer.

Fiscal policy should be stated within a clear and consistent macroeconomic framework. I think we can all agree that a macroeconomic framework should have at its core price stability and Bermudian employment stability.

The Government can pursue price stability with appropriately designed monetary and fiscal policies. As a rule, domestic monetary policy has little impact in small open economies, due in part to the mobility of money and financial instruments in general.

Consequently, the monetary policy of Bermuda is the monetary policy of the US through the action or inaction of the Federal Reserve Bank.

This is why the Bermuda dollar base rate mirrors the US Federal funds rate. As a result the Bermuda Monetary Authority (BMA) will find it difficult to conduct an independent monetary policy.

Fiscal policy then is the primary instrument for price stability. Expansionary fiscal policy can enhance employment opportunities, but at the expense of more inflation.

The converse is also true and perhaps more relevant to our present situation. It has become painfully obvious that the economy is operating at a point of over-employment

[rt] there are 38,000 jobs

[rt] and the unemployment rate is 2.1 percent

according to labour market indicators published by the Department of Statistics.

A 2.1 percent unemployment rate suggests that not only is everyone who wants to work working; it also suggests that businesses are struggling to hold onto productive workers because there are more jobs than capable people.

This shortage is causing wages and salaries to rise above the sustainable level associated with the natural rate of unemployment.

The natural rate is determined by, among other things, the market power of oligopolies in financial services, energy, construction and wholesale sectors; the degree to which unions bargain for real wages and salaries; immigration policy; inflexible rents; and wage flexibility in non-unionised sectors. I think it fair to say that the natural rate is above 2.1 percent.

Given the institutional impediments listed above, we can, over the short run, utilise the well established Phillips relationship between unemployment and inflation to understand why over-employment is undesirable.

Unemployment below the natural rate causes wage inflation, which in turn causes price inflation, which sets in motion inflationary expectations of higher wages to compensate for declining real wages and salaries.

Fiscal policy should respond to the fact that labour markets are operating beyond capacity and that additional demand for labour and capital will be inflationary, even if an allowance is made for immigration and foreign investment.

The response to over employment is fiscal tightening, either as:

[rt] a decrease in Government spending or at the very least, no increase in spending or;

[rt] an increase in taxes or at the very least, no decrease in taxes

A decrease in Government spending would help slow domestic demand, that is, spending associated with the construction, retail and wholesale sectors, to the sustainable level.

An increase in taxes would help slow the flow of income associated with the demand for labour, housing and buildings to the natural level and so ease wage and real estate inflationary pressure.

Both responses result in a budget surplus. The economic environment in which we fortuitously find ourselves is well suited for the paying off of public debt. Additional Government spending is therefore not warranted nor is a tax reduction because these increase the flow of income and spending, thereby adding to inflation.

Fiscal tightening tends to adversely affect the least productive and able in our society. Provision would need to be made for these individuals and households.

A common shortcoming of previous budgets has been the unwillingness to deal with overspending and labour market shortages.

In the past, the adverse effects of overspending have been cushioned by rising overseas spending and tax windfalls.

The fiscal response set out here attempts to deal with the overheating phenomenon at its source and provide future governments with a war chest to fight a recession.Craig Simmons

Bermuda College

February 2006