Which economic growth model?

Last Updated on Thursday, 27 July, 2023 at 12:18 pm by Andre Camilleri

Alexander Demarco is Deputy Governor, Central Bank of Malta

Debate on Malta’s economic growth model has recently gained traction again. This is a topic that from time to time has emerged for several decades. Pursuing higher value-added activity, preferably venturing in new sectors, as well as upskilling the workforce are the usual recommendations, with which one can hardly ever disagree.

However, over several decades the Maltese economy has indeed made significant progress in upskilling its indigenous workforce, as attested by the growing proportion of the Malta-born working age population with a tertiary level of education and decline in early school-leavers. Additionally, the Maltese economy has been lauded by international institutions for its resilience as it became increasingly diversified, embracing new sectors over time. Such trends remain ongoing.

Nevertheless, the current debate on Malta’s economic growth model fundamentally stems from constraints that appear to have become increasingly binding and require solutions that go beyond the usual recommendations.

Economic growth is basically a function of factors of production, traditionally grouped as land, labour, capital and total factor productivity. Land is usually fixed in terms of spatial area, although it could be used more intensively. Reclamation could be a way to expand spatial area, but for Malta such possibilities seem extremely limited. Therefore, growth essentially hinges on the quantity and quality of human resources, investment in equipment, technology and the physical infrastructure that supports human activity.

With respect to labour, the Malta-born working age population is on the decline as birth rates have been shrinking, now resulting in fewer entrants in the labour market relative to those retiring. Inward migration is therefore necessary to sustain the existing number of jobs as a minimum, let alone sustaining growth in employment and a pension system that entirely relies on intergenerational transfers. Upskilling Maltese workers would not make the need of inward migration go away. At best, it would shift demand for foreign workers to fill those jobs that require lower skill levels that the Maltese would have left to take up higher skilled work.     

The constraints that have become more binding essentially relate to the islands’ carrying capacity. Exploiting land more intensively through the construction of taller buildings could certainly host a much larger number of citizens, workers and tourists. However, people do not spend all their time boxed in their accommodation unit. Tourists visit the island to roam about, while indigenous and foreign-born citizens alike all need to spend leisure time outdoors, especially with homes shrinking in terms of spatial area.

However, the spatial area dedicated for leisure activities, be they beaches, countryside or open spaces in towns and villages all have expansion limitations and have been all constrained to host a growing number of persons, creating increased congestion in such spaces, including of course roads. High population density, even if all citizens were endowed with high skill levels and the three million or more tourists were to be all millionaires, inevitably creates greater stress on humans in coping with restricted personal space, time spent in traffic and finding a parking space, as well as pollution (light, noise, dust and other emissions).

This has an adverse impact on the lifestyle and its quality that escape the measurement of GDP but internalised by citizens in terms of well-being and happiness, and to an extent by tourists in terms of a satisfactory experience while visiting. There are signs that many citizens seem to have now reached the point of diminishing marginal utility, which could be reversed if Malta becomes more exclusive. There is no silver bullet. Trade-offs in the short- to medium-term need to be managed, making the transition challenging in juggling between the time horizon of policy-makers and potential conflicts with the free market philosophy.

For example, permit approvals for building more hotels and apartments are an invitation for tourists well beyond the three million mark. Moreover, it also creates a need for more migration to operate and service such accommodation establishments, more transport services and restaurants, which all add more to the existing population density. While setting quantity restrictions could address such matters, these may not be easily reconcilable with principles of competition and the free market.  

Policy-makers may wish to carefully reconsider the various incentive structures currently in place that could be encouraging investment that raises population density. For example, a 15% tax on rents, clearly provides an incentive to build and rent accommodation units to house more workers and tourists and divert bank lending to real estate activity that ultimately raises population density. Similarly, subsidies to low-cost airlines, water and energy subsidies on consumption of tourists in hotels and apartments and low VAT rates on tourist accommodation are incentives that lure further investment in tourism-related activity that require a growing number of tourists and workers to accommodate.

By contrast, workers that generate higher value added through activity that impacts less population density, such as export-oriented IT or other professional services, are taxed at 35% once their annual wage exceeds €60,000, in contrast to the 15% tax for landlords. Incentives that may attract investment without the need of onshoring all physical activity or that increasingly uses technology that substitutes labour or increases labour productivity, could shift investor preferences.

Existing distortions are sustaining demand for more property and activities that generate higher population density, at the cost of lifestyles and their quality. Not addressing such distortions risks heightening social tensions that would ultimately adversely impact economic growth.

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