Why is domestic demand still strong?

The IMF says next year’s growth rate will only be 2 percent. Is it an overly pessimistic estimate? It could be. Although there has been a slight slowdown in growth, the third quarter’s figure this year was above expectations. In addition there was a sharp decrease in unemployment. Does it mean domestic demand is still strong? Is this the reason for the unexpected jump in industrial production? Everybody is aware that foreign demand for domestic goods is not so strong. There is only one reason left: In spite of some negative factors, strong domestic demand has been encouraging the increase in industrial production and growth.

But how? There might be many reasons. Everybody knows the present domestic and international economic conditions do not allow production to stockpile. Some economists say hot money inflow, which has been financing the current account deficit, increases money in circulation and as a result positively affects domestic demand. The problem is if that increase in domestic demand is quite homogeneous. It means that if rich and poor together spend more there is a serious domestic savings problem.

At the beginning of the 1960s a new concept was adopted in economic planning efforts: optimum savings ratio. It meant a savings ratio that would not discourage investments but at the same time would not encourage consumption expenditures. After a short time it was accepted that it was impossible to determine such a ratio even though the idea was quite logical. Nowadays it has been a hot debate that the main reason of the ever enlarging current account deficit, not only in Turkey but all over the world, is insufficient domestic savings. When expenditures exceed gross domestic product, the gap is financed mainly by hot money inflow. To stop this negative pattern, domestic savings must be increased. This is easy to say but difficult to implement. However, there is another important problem, especially in Turkey.

According to a report prepared by the Ministry of Finance accountants, 28 percent of the economy is informal in Turkey. It means total tax revenue loss was near $100 billion during the last decade. This report indicates that if a proper and efficient reform were adopted to fight tax evasion, the insufficient domestic savings problem could partly be solved. Again, it is easy to say but difficult to implement. Recently the Parliamentary Assembly of the Council of Europe presented a report explaining the informal economies in some countries including Turkey. According to this report the size of the informal economy in Turkey is around 33 percent of the gross domestic product. This huge unreported income might be an important reason for the recent surge in domestic demand.

Since 1950, “tax reform” has been in every government’s agenda. Personal and corporate income tax law was the first positive step. However, later on whenever a problem appeared related to financing the widening budget deficit, some changes were made in taxation, which was called “reform” but brought only deformation to the existing system.

Every textbook written on public finance begins to explain two very important taxation principles: “equality” and “justice.” This means equal tax burden on equal incomes and less tax burden for lesser incomes. In order to guarantee the implementation of these two principles during taxation process, a progressive tariff (which means higher tax rates for higher incomes) is used and special care is given to the fact that the share of the revenues from direct taxes (i.e., personal and corporate income tax) must be much higher than the revenues from indirect taxes (i.e., value added tax). The reason is obvious. Indirect taxes are proportional, levied at the same rate at all transactions whether the taxpayer is rich or poor. Unfortunately during recent years these two principles could not been taken into account, and shares of indirect tax revenues in total climbed almost over 70 percent.

It is not easy to estimate the real effects of this unjust tax structure on middle and low income families’ spending behavior. Do they cut their daily expenditures because of price increases caused by new taxes, or do they decide to use their already limited savings and later on quit to save totally? This also might be another reason for homogeneous increase in domestic demand. As a result, the steady increases in indirect taxes might destroy the savings tendency of the major part of the nation. That is worse than many other structural problems, and only after many decades successive governments using only rational and wise policies can repair the harm it created.