TURKISH CYPRIOT ECONOMY: NAVIGATING THROUGH CHALLENGING TIMES Macroeconomic Monitoring Report SPECIAL ISSUE: DO FISCAL POLICIES HELP REDUCE INCOME INEQUALITY IN THE TURKISH CYPRIOT ECONOMY? May 2023 NAVIGATING THROUGH CHALLENGING TIMES M croeconomics, Tr de & Investment TURKISH CYPRIOT ECONOMY: NAVIGATING THROUGH CHALLENGING TIMES Macroeconomic Monitoring Report SPECIAL ISSUE: DO FISCAL POLICIES HELP REDUCE INCOME INEQUALITY IN THE TURKISH CYPRIOT ECONOMY? May 2023 Document of the World Bank This report is part of the Supporting Economic Convergence and Integration in Cyprus Programme which is funded through through the European Union Aid Programme for the Turkish Cypriot community. The opinions expressed in this study do not reflect any official opinion by the European Commission and the World Bank’s Board of Executive Directors, nor do they in any way constitute recognition of boundaries or territories. l i NAVIGATING THROUGH CHALLENGING TIMES © 2023 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 +1 202-473-1000 www.worldbank.org Disclaimer The opinions expressed in this study are those of its authors and do not reflect any official opinion by the European Commission, the World Bank Group, its Board of Directors, or the governments they represent, nor do they in any way constitute recognition of boundaries or territories. The term ‘Turkish Cypriot community’ refers, solely for the purposes of this study, to the areas in which the government of the Republic of Cyprus does not exercise effective control. If reference is made in the report to any ‘ministries’, ‘departments’, ‘services’, ‘bodies’, ‘organizations’, ‘institutions’, and ‘authorities’ in the areas not under the effective control of the government of the Republic of Cyprus, or respective acronyms or abbreviations are used, it is to allow a clear factual understanding of the administrative structures in the Turkish Cypriot community and shall not imply recognition of any public authority in the areas other than the Government of the Republic of Cyprus. Similarly, comparisons between the areas where the government of Republic of Cyprus exercises effective control and those areas where it does not are factual only. ii l NAVIGATING THROUGH CHALLENGING TIMES TABLE OF CONTENTS Acknowledgements............................................................................................................................v Abbreviations and Acronyms............................................................................................................ vii Executive Summary........................................................................................................................... ix Chapter 1: Recent Economic Developments and the Short-term Outlook............................................1 1.1 Recovery has gained strength amid new challenges.............................................................. 1 1.2. Rising inflation and inflation persistence raise concerns....................................................... 6 1.3. Pressures on fiscal and external imbalances remain elevated in 2022................................13 1.4. As with other small economies, the Turkish Cypriot economy faces overlapping crises and multiple challenges............................................................................................. 15 1.5. The outlook for 2023 is subject to uncertainty and downside risks.....................................18 1.6. In the aftermath of multiple crises, key policy priorities emerge........................................ 21 Chapter 2: Special Issue: Do Fiscal Policies Help Reduce Income Inequality in the Turkish Cypriot Economy?................................................................................................27 2.1 An overview of taxes in the Turkish Cypriot economy.........................................................27 1. Direct Taxes......................................................................................................................27 ................................................................................................................... 28 2. Indirect Taxes. 2.2 The impact of fiscal policies on poverty and inequality in the TCc......................................29 References .....................................................................................................................................36 l iii NAVIGATING THROUGH CHALLENGING TIMES iv l NAVIGATING THROUGH CHALLENGING TIMES ACKNOWLEDGEMENTS T his report was prepared by Natasha Rovo (Senior Economist, World Bank) and Stefano Curto (Senior Economist, World Bank), with contributions from İzge Arısal (Local Technical Coordinator, World Bank), Lucia Luzi and Mertkan Hamit (Consultants, World Bank), and Metin Nebiler (Economist, World Bank). Box 2 on “The impact of the global food crisis in the Turkish Cypriot economy” was written by Xueling Li (Agriculture Economist, World Bank). Box 6 on a preliminary assessment of “The impact of COVID-19 on human capital in the Turkish Cypriot community” was written by Lucia Luzi (Consultant). The Special Issue builds on the Commitment- to-Equity (CEQ) model, developed by Maynor Cabrera and Beenish Amjad (Consultants, World Bank), under the guidance of Metin Nebiler (Economist, World Bank). The team is grateful to Jasmin Chakeri (Practice Manager, World Bank), Salman Zaidi (Practice Manager, World Bank) and Goran Tinjic (Program Manager for Southern Europe, World Bank) for their guidance in the preparation of this report. The team is also thankful to the peer reviewers Mikhail Matytsin (Data Scientist, EPVGE) and Claire Honore Hollweg (Senior Economist, EECM1) for helpful comments. The team is also grateful to Suay Anıl and İlke Erdal, who supported the team to gather necessary data and information, and to Peter Kjaer Milne for editorial support. The team would also like to thank Oya Koçak Barçın (Programme Manager, European Commission) for useful comments and feedback, and Betül Atasayan Gülseven and Tuğyan Atıfsoy from the European Union Coordination Centre for their support to the preparation of this report. The team is also grateful for the strong collaboration with the Turkish Cypriot community ‘administration’ and business chambers in the preparation of this report, including the Turkish Cypriot Chamber of Commerce, the Turkish Cypriot Chamber of Industry, and the Turkish Cypriot Chamber of Shopkeepers and Artisans. l v NAVIGATING THROUGH CHALLENGING TIMES vi l NAVIGATING THROUGH CHALLENGING TIMES ABBREVIATIONS and ACRONYMS AW Average Wage CEQ Commitment to Equity CIT Corporate Income Tax COVID-19 Coronavirus Disease 2019 DRM Disaster Risk Management EMDEs Emerging Markets and Developing Economies ERPT Exchange Rate Pass-Through EU European Union EUR Euro FCS Fragile and Conflict-Affected Situations FDI Foreign Direct Investment GC Greek Cypriot GDP Gross Domestic Product GL Green Line GRADE Global Rapid Post-Disaster Damage Estimation IMF International Monetary Fund kW Kilowatt MW Megawatt NPL Nonperforming Loan OECD Organisation for Economic Cooperation and Development PIT Personal Income Tax RE Renewable Energy RoC Republic of Cyprus SA Social Assistance SSC Social Security Contribution SDG Sustainable Development Goal US$ United States Dollar TC Turkish Cypriot TCc Turkish Cypriot Community TL Turkish Lira VAT Valued-Added Tax VET Vocational Education and Training Yoy Year-on-year l vii NAVIGATING THROUGH CHALLENGING TIMES viii l NAVIGATING THROUGH CHALLENGING TIMES EXECUTIVE SUMMARY O n February 6, 2023, two powerful earthquakes of 7.8 and 7.5 magnitude struck southeast Türkiye northwest Syria, with significant socio- and However, the economic recovery was also associated with record high inflation, which peaked at 120.7 percent year-on-year (yoy) in October 2022, with highest impact on economic implications for the Turkish the poorest households. Headline inflation Cypriot community (TCc), through trade surged in 2022—more sharply than in any and inflation. The earthquakes struck at a previous year—as rising commodity prices, time when the Turkish Cypriot (TC) economy particularly for energy and food, and currency was striving to recover from the impact of depreciation passed through to consumer COVID-19 pandemic, record high inflation and prices. Inflation has slightly decelerated since the challenges associated to Russia’s invasion its peak in October 2022, reaching 84.9 percent of Ukraine. Following a deep recession in in February 2023, but nonetheless remains 2020—the most severe in Europe —and a very elevated. Core inflation has also increased modest rebound in 2021, the TC economy significantly since end-2021, suggesting a recovered rather more strongly than expected persistent inflationary entrenchment and in 2022—albeit a year characterized by rising expectations. The TC economy has also multiple crises. While the TC economy was witnessed a large variation in price changes already dealing with high inflation—triggered across products, with food and energy prices by the post-COVID-19 recovery and the leading, especially in the first half of the depreciation of the Turkish lira (TL)—the war year. This means that, due not only to the in Ukraine in February 2022 added further composition of the consumption basket but pressure through supply chain disruptions, also to the differentiated price increases increasing prices still further and raising levels across groups, the poorest households have of uncertainty. Against this background, the been facing the highest inflation rates. economic implications of the earthquakes in Türkiye for the TC economy are also expected The twin fiscal and current account deficits to be significant, mostly through trade and aid also deteriorated because of mounting channels, and inflation. Increased spending, inflation. In 2022, ‘public’ spending surpassed both to provide immediate emergency support TL 20 billion, with more than 40 percent of total and to strengthen disaster risk management expenditures destined to transfers, followed (DRM), will also weigh on the already strained by wages and compensation at almost 40 ‘public’ finances. percent, and capital expenditures declining Before the earthquakes, the recovery of the to about 9 percent. The share of defense TC economy had been characterized by two spending dropped slightly from 7 percent of positive features, helping the TC economy total expenditures in 2021 to 5.8 percent in consolidate its recovery from the COVID-19 2022. Meanwhile, revenues excluding grants shock. The year 2022 was a record year for reached almost TL 18 billion, mostly driven Green Line (GL) crossings, and for GL trade. Like by indirect taxes, which make up about 37 other services-reliant economies in Europe, percent of revenues, due to rising prices. Aid the TC economy witnessed a convergence received from Türkiye in the form of grants to pre-pandemic levels. A strong rebound in constitutes the most important source of the ‘export’ of both goods and services, and funding in alleviating the large financing gap stronger-than-expected domestic demand led between revenues and budget expenditures. the recovery. From the supply side, the services The current account deficit, excluding grants sector contributed to the rebound, supported from Türkiye, is also estimated to remain by strong credit growth to the private sector. elevated. l ix NAVIGATING THROUGH CHALLENGING TIMES Against this background, the fragile manner. In this context, also risks stemming recovery of the TC economy is exposed to from the financial sector should be closely high downside risks. Due to the weakening monitored and acted upon. Only an adequate of growth prospects, both in the EU and in macroeconomic policy framework can help Türkiye, and due to further trade disruptions, the TC economy build resilience and should the key driving sectors for the TC economy, anchor any reform agenda. In the aftermath of such as ‘exports’ of goods and services, may multiple crises, five reform priorities emerge: witness a deceleration in 2023. Agriculture may be further negatively impacted by • Maintain the focus on providing emergency rising input costs and unfavorable weather support to the poor and most vulnerable, conditions. While inflation is expected to i.e., those most impacted by the cost-of- decline, it is nevertheless likely to remain living crisis. among the highest in Europe. This may • Strengthen energy security, by boosting have further negative consequences for the investment in renewable energy (RE) purchasing power of households, leading to sources, promoting energy efficiency, and a slowdown in poverty reduction, income reforming energy tariffs. convergence, and a reduction in consumption. Risks for the outlook of the TC economy remain • Strengthen resilience to natural disaster- skewed to the downside, mostly driven by and climate change-related risks. This can external factors, above all a more prolonged be achieved by strengthening financial or increasingly intense war in Ukraine. The protection, investing in risk reduction, and TC economy faces risks arising from its high improving preparedness. inflation, because of both domestic factors and currency depreciation, exacerbated by • Strengthen resilience in the broader loosening monetary and fiscal policies in sense, through competitiveness-enhancing Türkiye, in response to the earthquakes and reforms, thereby building a more ahead of the 2023 general and presidential competitive private sector elections. Substantial inflation and further • Enhance human capital and recover from currency depreciation may weaken both pandemic-induced losses. corporate and ‘public’ balance sheets. Already limited fiscal space may be further eroded and Policy inaction and delays in implementing debt vulnerabilities amplified. urgently needed structural reforms in the TC economy have also contributed to its The TCc ‘administration’ should maintain its vulnerability. focus on providing emergency support to those in need, while reducing vulnerability The Special Issue analyzes the impact of taxes to future crises and building macroeconomic and transfers on poverty and inequality in the stability. In the context of high inflation, the TCc. It shows that fiscal policy has overall only empirical association between fiscal policy a limited impact on reducing inequality, but and developments in inflation should be the system is unable to reduce poverty. The monitored and fiscal policy deployed to restore Special Issue provides an initial step towards price stability and lessen the impact of the understanding the distributional impact of cost-of-living crisis. To respond effectively to fiscal policy in the TCc. The Special Issue builds high inflation, the TCc ‘administration’ should on the first ever Commitment to Equity (CEQ) first have a full understanding of how fiscal model developed for the TCc, which analyzes policy impacts inflation and how households the impact of taxes and transfers on poverty are affected. The distributional impact of fiscal and inequality. Based on the latest announced policy should also be understood. In a context estimates from 2015 Household Budget Survey, of extremely high imbalances, prudent relative poverty is estimated at 22.2 percent. fiscal policies should be pursued aimed at Income inequality is also high based on 2015 ensuring medium-term debt sustainability, HBS, with the Gini coefficient estimated at 34 while raising potential growth in a sustainable percent, 3 percentage points above the EU x l NAVIGATING THROUGH CHALLENGING TIMES average. The TC fiscal practices contribute to a impact of fiscal policy in the bottom half of moderate reduction only in income inequality. the distribution. When in-kind transfers are Overall, inequality in the TCc drops from 0.445 excluded from the analysis, all households to 0.361 after fiscal interventions, a reduction beginning in the second decile are net payers to around 0.08 of a Gini point and among the the system, as the share of taxes paid exceeds lowest levels observed. When looking at the the cash benefits received for all but the poorest 10 percent of the population. When impact on poverty, while transfers and direct included, instead, all households in the 1st to taxes have a redistributive effect, indirect 5th decile result net beneficiaries, reporting a taxes have a significant negative impact on positive net fiscal position. Overall, the results household budgets and lead to an increase point to potential improvements that could be in poverty from 21.8 to 25.5 percent. In-kind achieved in the TCc through a more effective transfers, such as health and education, have system of taxes and transfers to reduce the important redistributive effects and lift the burden on the poor and address inequality. l xi NAVIGATING THROUGH CHALLENGING TIMES xii l NAVIGATING THROUGH CHALLENGING TIMES Chapter 1: Recent Economic Developments and the Short-term Outlook 1.1 Recovery has gained This reflected stronger-than-projected growth in the first half of the year, a quicker-than- strength amid new expected rebound in international travel as challenges economies reopened, and additional support measures that helped shield households and Notwithstanding the multiple shocks and firms from rising prices. In the RoC, despite persisting structural challenges, during 2022 rising inflation, private consumption remained the TC economy consolidated its recovery robust, supported by increased employment from the COVID-19 shock. Following a deep and wages, and underpinned by targeted recession in 2020 and a very modest rebound measures to compensate for high energy in 2021, the TC economy recovered more prices. In the RoC, tourism also played a role, strongly than expected in 2022—a year as arrivals reached 80 percent of the 2019 characterized by multiple crises. While the levels. In addition, exports of business services TC economy was already dealing with high increased significantly. In Türkiye, 2022 inflation, triggered by the post-COVID-19 growth exceeded expectations. A tripling of recovery and Turkish lira depreciation at the the minimum wage between December 2021 end of 2021, the war in Ukraine added further and January 2023, and a rebound in tourism pressure through supply chain disruption, helped support activity and offset drags increased prices, and higher uncertainty. from multidecade-high inflation, significant As in most economies across Europe, GDP currency depreciation, and swelling external growth in the TC economy in 2022 was stronger liabilities. In this context, the TC economy than expected, albeit not fully returning to also consolidated a robust recovery in 2022, its pre-pandemic level (Figures 1.1 and 1.2). with growth estimated at almost 10 percent. Growth was revised upward for most European However, GDP has not yet returned to its pre- economies in 2022, including the Euro zone, pandemic level. the Republic of Cyprus (RoC), and Türkiye. Figure 1.1 Real GDP annual growth Figure 1.2 Real GDP 17 12 11,4 9,6 6,6 7 5,5 5,6 5,3 4,7 3,9 3,2 3,3 1,6 1,9 1,6 2 1,3 Percent 0,8 0,5 0,2 -3 -4,4 -6,1 -8 2019 2020 2021 2022e 2023f -13 -16,2 -18 TCe RoC Türkiye Euro Area Source: TCc ‘statistics office’ (‘SO’); World Source: World Bank staff estimates; TCc ‘SO’. Development Indicators (WDI). Note: Light-blue line for pre-crisis GDP trend. l 1 NAVIGATING THROUGH CHALLENGING TIMES Two record highs characterized the TC percent). Processed foods, including olive economy’s recovery in 2022: oil, jams, and carob syrup, eventually allowed to cross the GL once again in 1. Green Line (GL) crossings.1 In summer 2022,3 amounted to almost 7 percent of 2022, the TC economy recorded the total GL trade. In addition to reported highest number of GL crossings ever. GL trade transactions, intra-island trade The number of GL crossings, after the also consists of consumer transactions, lifting of COVID-19 restrictions, jumped including fuel purchases, among others, and surpassed 700,000 in August 2022, a some of them tracked through credit card value exceeding pre-crisis levels (Figure payments, others in cash. Credit card 1.3). The same trend was seen among GL transactions by Greek Cypriots in the TC crossings that exclude Turkish Cypriots, economy more than doubled during the surpassing 500,000 in the same month. first eight months of 2022 compared with Overall, almost 6.6 million crossings were the same period in 2019.4 recorded in 2022. The lowest numbers of GL crossings were observed in May 2020, The labor market has also recovered to with only 1,056 crossings for the whole pre-pandemic levels, but not for women. population and 108 excluding Turkish Employment has returned to its 2019 level, Cypriots. while the unemployment rate has decreased, returning to its 2019 rate, at 6.3 percent. 2. Green Line transactions. In 2022, GL trade2 But the labor market recovery has not been hit an all-time high of EUR14.8 million equal across workers. In particular, women’s (US$15.6 million), breaking the record employment has remained low, at 34 percent, set in 2008, with the monthly average since the start of the pandemic, while female for that year surpassing EUR1.2 million unemployment has remained above the 2019 (US$1.3 million) (Figure 1.4). The top- level.5 five traded goods include: construction- related materials (61 percent), plastic In the first five months of 2022, TC ‘exports’ products (12 percent) and fresh fish (6 declined by 3 percent, with Türkiye remaining Figure 1.3 GL crossings, for the entire Figure 1.4 GL trade, annual value and population and excluding Turkish Cypriots, monthly average values in euros, 2019–2022 2004–2022 Source: TCc ‘ministry of tourism’. Source: TC Chamber of Commerce. 1 GL crossings refer to the movement of people across the Green Line. 2 GL trade measures the movement of goods from the TC economy to the RoC. In 2021, it amounted for 5 percent of overall ‘exports’ of the TC economy. 3 Source: https://cyprus-mail.com/2022/06/09/olives-carob-syrup-and-grapes-added-to-green-line-regulation/ 4 Source: Cyprus News Agency. 5 Source: Labor Force Survey, 2022 (TCc ‘SO’) 2 l NAVIGATING THROUGH CHALLENGING TIMES the main recipient of TC products. As a of specific products to cope with supply small, open economy, the TC economy has chain disruptions, rising prices, and to secure an unbalanced external trade structure, food security. Türkiye, for example, banned with a strong reliance on ‘imports’ for both exports of potatoes and fresh onions in intermediate goods and final consumption, 2022 to a specific set of partner economies, accounting for 43 percent of GDP over the nevertheless the TC economy was exempt from period 2010–2019. Conversely, the average the export ban.7 Even though this minimized share of ‘exports’ of goods in the same period the implications for the TC economy, the food was small, at just 3 percent of GDP, with Türkiye security crisis adds to the problem that the as the main destination market for TC products, agriculture sector was already facing due to hence further limiting the benefits for TC unfavorable weather conditions, particularly ‘exports’ arising from currency depreciation.6 the frosty weather in 2022.8 As a result, in The three most ‘exported’ goods by the TCc the first five months of the year, the ‘export’ in the first five months of 2022 were dairy of potatoes from the TC economy dropped products, citrus fruit, and scrap materials. to zero. Potatoes used to account for about 5 Overall goods ‘exported’ to Türkiye in early percent of total ‘export’ in 2014/15, but on a 2022 hit US$40.7 million, representing about declining trend since then. Instead, products 60 percent of total goods—an increase of just have been destined for local consumption 3 percent compared with the same period in and GL trade. This episode follows a series 2021. The value of ‘exports’ to third countries of difficulties facing the agriculture sector in early 2022 represents over 40 percent of for many years. Over several years, a lack the total, decreasing by 11 percent compared of rainfall, high temperatures, and diseases with the same period in 2021. have taken a toll on agricultural production in The severe compression in ‘exports’ of key Cyprus. The production of potatoes in the TC agricultural products, in particular potatoes, economy decreased by 60 percent in 2018 and reflects both the food security crisis and subsequent shortages in supply led to soaring the difficulties facing the agriculture sector prices of potatoes. Similarly, serious shortages in recent years. In 2022, many economies in the supply of locally produced potatoes around the world resorted to banning exports have also affected the RoC economy.9 Figure 1.5 Most purchased products from Figure 1.6 Fuel ‘imports’ (% merchandise Türkiye ‘import’) Percent of merchandise imports Small economies RoC 20 TCc Euro Area 18 16 14 12 10 8 6 4 2 0 Fuel imports Source: World Bank staff, Turkstat. Source: World Bank, 2023; WDI; TCc ‘trade department’. Note: Bubble size represents the share in total ‘imports’ Note: Small economies include a sample of 37 economies, from Türkiye in 2022. among which 28 are small islands. 6 Accounting for high inflation, the nominal depreciation of the Turkish lira resulted in an appreciation of the real effective exchange rate, hence making Turkish exports – and more so, TC ‘exports’ - less competitive.. 7 Source: https://www.tarimdunyasi.net/2022/11/24/patates-ve-kuru-sogan-ihracatina-kisitlama-getirildi/ 8 Source: https://cyprus-mail.com/2022/03/27/potatoes-fall-victim-to-war-and-weather/ 9 Source: https://cyprus-mail.com/2018/11/06/potato-crisis-also-seen-in-the-north/ l 3 NAVIGATING THROUGH CHALLENGING TIMES Stronger-than-expected domestic demand rose, particularly for ‘import’ and ‘export’- has driven ‘imports’ up, especially for related loans, but decreased across other intermediate goods. In the first five months categories. The business loans category of 2022, ‘imports’ increased by 39 percent. remains the predominant category, amounting This may reflect stronger than expected to almost three-quarters of total loans in 2022. demand, rising prices, as well as households Higher production costs for businesses since frontloading consumption in a high inflationary 2021 translated into stronger demand for environment. The three most purchased goods working capital, especially in 2021. Consumer by the TCc in the first five months of 2022 loans remain low at about 20 percent of total were fuel, vehicles, and construction iron.10 loans. Among them, credit card debt remained However, ‘import’ growth over the same stable at 3 percent of total loans. Consumer period of 2021–2022 was led primarily by glass confidence also regained strength, with the (processed glass), generators, and power plant deposits-to-loans ratio reaching an historical systems, almost all increasing by over 200 high at 2.05. The Central Bank of Türkiye percent. Most of the purchased construction lowered its policy rate further to 9 percent materials come from the RoC. However, in November 2022, driving the Turkish lira to Türkiye remains the main supplier for the TC new record lows. Although cuts to the policy economy, especially for intermediate goods interest rate have totaled 1,000 basis points (Figure 1.5). In fact, overall goods supplied since mid-2021, interest rates on bank loans from Türkiye in early 2022 hit US$493 million, have risen in the TCc, with interest rates on TL representing more than 68 percent of total loans about four times the policy rate (as of goods, and with an increase of 59 percent March 2023). compared with the same period in 2021. The value of ‘imports’ from third countries in early Since the end of 2021, there has been an 2022 represented over 32 percent of total inversion in the ratio between the Turkish ‘imports’—an increase of 9 percent compared lira and other currencies for both loans and with the same period in 2021. deposits (Figures 1.9 and 1.10). While the Turkish lira has predominated since 2009, The high dependence of the TC economy on with the share of Turkish lira loans amounting ‘imported’ fuels exacerbated the impact of to an average of 59 percent, after the latest the 2022 energy crisis (Figure 1.6). Mineral depreciation episode from the end of 2021, fuels, such as crude oil and natural gas, remain the share of Turkish lira loans has declined the main products supplied from abroad to the and stabilized below 40 percent. A similar TC economy. In a context of high energy prices phenomenon characterizes deposits. While and restricted supply since the beginning of the the increase in foreign currency credit— war in Ukraine, this has translated directly into namely, credit denominated in a currency higher energy bills and wider current account outside the currency area—is an indicator of deficits in energy-importing economies such liquidity in the financial markets, it also carries as the TC economy. Box 1 discusses the impact increased exchange rate risk. De facto, banks of the energy crisis on the TC economy. transfer currency risks to customers, when Domestic demand was also supported by customers commit to debt service payments credit growth to the private sector. As of the in foreign currency, regardless of the currency end of 2022, the total amount of bank loans denomination of their revenues. Table 1.1 Interest rates on deposits and loans by private banks, by currency (annual %) TL US$ EUR GBP Deposits 16.5 2.35 1.75 2.6 Loans 36.76 8.76 8.76 8.76 Source: TCc ‘central bank’ and sample of private banks; March 2023. 10 https://ticaret.gov.ct.tr/Portals/11/Raporlar/%C4%B0statistik/01%20DT-%C4%B0th-%C4%B0hr-Rapor/01-DT- %C4%B0thalat/%C4%B0thalat-2022/ITHALAT%20OCAK%20-%20MAYIS%202022.pdf?ver=2023-02-20-133544-897 4 l NAVIGATING THROUGH CHALLENGING TIMES Box 1: The impact of the 2022 energy crisis on the TC economy The impact of the energy crisis, further exacerbated by the war in Ukraine, has been particularly severe for the TC economy, given its high reliance on ‘imports’. About 60 percent of ‘imported’ fuel is used in electricity generation, while the rest is used in sectors such as transport, industry and agriculture. KIB-TEK, a ‘public’ company, deals with production, transmission, and distribution, while AKSA, a private company, is also involved in energy production. K-PET and ALPET instead deal with the sourcing of fossil fuels for the energy needs in the transport, industry, and agriculture sectors. Other domestic sources include renewable energy (RE),11 such as solar, which amounted to 5.6 percent of total electricity production in 2022. Almost 3 percent was instead transferred from the RoC through the interconnection of the electricity networks (Figure 1.7). Despite the frequency differences between the electricity networks, which generate power outages, the interconnection plays an extremely important role in the security of energy supply. The TCc ‘administration’ has adopted measures to counteract the energy crisis, including expanding the social assistance; going forward, structural reforms to improve energy security will be of vital importance. In 2022, a multiple tariffs system based on the amount of electricity consumption was introduced. In addition, the amount of electricity consumption to qualify for energy subsidies more than tripled (from 1,444 MW in 2018 to 4,657 MW in 2022). Those under the poor-in-need support receive a cheaper tariff for the first 500 Kw utilized, with a tariff of TL 0.3442. For comparison, ordinary households face a tariff of TL 1.6110 for the first 250 Kw, and TL 3.3237 between 250 Kw and 500 Kw. Tariffs increase to TL 3.5737 between 501 Kw and 750 Kw, TL 3,8737 between 751 Kw and 1,000 Kw, and TL  4.5237 above 1,000 Kw. This has allowed for an expansion over time of the coverage of the social assistance (SA) support (Figure 1.8). Going forward, measures to promote energy efficiency and increase RE investments are a top priority to increase energy savings and energy supply, respectively. In addition, strengthening the energy cooperation between the two communities can contribute to overcoming structural problems and boosting the potential for RE across the island. Figure 1.7 Electricity production in the TC Figure 1.8 Electricity consumption by economy (2022) consumer type, 2017–2022 Source: World Bank staff, KIB-TEK. Source: World Bank staff, KIB-TEK. 11 11 In 2011, the ‘Renewable Energy Law’ (No. 47/2011) introduced the Renewable Energy Board and defined the key principles for RE production. With amendments in 2016, 2017 and 2021, further regulation was introduced with respect to the permits and implementation of the ‘Renewable Energy Law’. l 5 NAVIGATING THROUGH CHALLENGING TIMES Figure 1.9 Loans, by currency Figure 1.10 Deposits, by currency 100% 100% 90% 90% 80% 80% 70% 70% 60% 60% 50% 50% 40% 40% 30% 30% 20% 20% 10% 10% 0% 0% 01/2009 12/2009 11/2010 10/2011 09/2012 08/2013 07/2014 06/2015 05/2016 04/2017 03/2018 02/2019 01/2020 12/2020 11/2021 10/2022 01/2009 01/2010 01/2011 01/2012 01/2013 01/2014 01/2015 01/2016 01/2017 01/2018 01/2019 01/2020 01/2021 01/2022 TL Foreign TL Foreign Source: World Bank staff, TCc ‘central bank’. Source: World Bank staff, TCc ‘central bank’. For example, firms that belong to industries lira, may expose the TC banking system to that generate more revenues abroad tend to indirect systemic risk. The recent initiatives borrow in foreign currency. If customers are promoted by the TCc ‘central bank’ are not perfectly hedged, a depreciation of the expected to help reduce NPLs. In this context of local currency increases the probability that a elevated price pressures, tightening financial firm will become past due on its loans.12 On conditions, and exchange rate volatility, the the other hand, growth of foreign currency banking system exposures to exchange rate deposits reflects higher ‘tourism’ receipts. risk and rollover risk need to be monitored However, an increased exposure to foreign carefully and contained through macro- and currency through deposits may also have micro-prudential policies. negative implications, by increasing the pass- through of exchange rate shocks to domestic 1.2 Rising inflation and inflation inflation. persistence raise concerns In this context, risks stemming from the A record of 120.7 percent inflation was financial sector should be closely monitored reached in October 2022 year-on-year (yoy), and acted upon. As of December 2022, amid a global surge in commodity prices and nonperforming loans (NPLs) amounted to driven by the Turkish lira depreciation, which almost 4 percent of total loans and reached continued throughout 2022 (Figures 1.11 and 8 percent of the total for loans in Turkish 1.12). Headline inflation surged in 2022— lira, decreasing from the peak reached in more sharply than in any previous year—as 2020. Similarly, provisions for NPLs (as a currency depreciation and rising commodity share of NPLs) partially recovered, increasing prices, particularly for energy and food, to 60 percent, but remained still below the passed through to consumers. Box 2 discusses pre-pandemic ratio of 68 percent in 2019. the impact of agri-food inflation in the TC The capital adequacy ratio of the sector economy. Inflation has slightly decelerated declined toward the end of the year. Currency since, reaching 84.9 percent in February 2023, mismatch, with almost 80 percent of deposits but remains elevated. Core inflation, however, denominated in foreign currency, while a large has also increased significantly since end- share of loans is still denominated in Turkish 2021. 12 Niepmann F. and T. Schmidt-Esinlohr (2022). Foreign currency loans and credit risk: Evidence from U.S. banks. Journal of International Economics. Vol. 135. 6 l NAVIGATING THROUGH CHALLENGING TIMES Figure 1.11 Turkish lira annual exchange rate Figure 1.12 Inflation components depreciation in the TC economy, percentage (2019.12–2023.02) change, 2006–2022 Food inflation Energy inflation 120 Core inflation Headline inflation 100 80 Percent 60 40 20 0 Ara.19 Ara.20 Ara.21 Ara.22 Haz.20 Haz.21 Haz.22 Mar.20 Mar.21 Mar.22 Eyl.20 Eyl.21 Eyl.22 Source: World Bank staff, Central Bank of Türkiye. Source: World Bank staff, TCc ‘statistics office’. A key transmission channel of the Turkish lira its partner economies, also including the TC depreciation on the TC economy is through economy. On November 4, 2022, based on its effect on domestic prices, namely the the amendment to the Article 9 of the Export exchange rate pass-through (ERPT). Consumer Circular of the Central Bank of Türkiye, the prices in the TC economy have historically use of the Turkish lira became mandatory for moved with the exchange rate and exchange export declarations issued as of December 5, rate shocks tend to be far stronger and have 2022, and collections made within this scope, a more prolonged impact on inflation in the vis-à-vis the TC economy.14 This policy may TC economy than in Türkiye.13 The Turkish further weaken the position of TC companies lira shock has also had a double-sided impact vis-à-vis their Turkish peers and render the TC on TC firms. From a cost/supply perspective, economy increasingly vulnerable to exchange the Turkish lira depreciation generates rate shocks. higher inflation for TC firms compared with The TC economy shows a large dispersion Turkish firms, putting TC firms at a greater in price changes across consumption goods, disadvantage. From the demand perspective, reaching above 80 percentage points in since the Turkish market is by far the most February 2023. The large dispersion in price important for TC products, TC companies changes in the TC economy is evident when cannot take advantage of the Turkish lira looking at the price change by consumption depreciation. Instead, Turkish companies are group in February 2023 (Figure 1.13). able to benefit from increased competitiveness While the 12-month price change was 84.9 of their own products and boost their exports percent, the prices of the entertainment and to foreign markets. restaurants groups increased both by almost To strengthen the international role of the 140 percent in the same period, and the price Turkish lira, Türkiye has promoted, and of the education and transportation groups in some cases mandated, the use of the increased by around 56 percent—a difference Turkish lira in commercial transactions with between them of up to 84 percentage points. 13 World Bank (2022a) Macroeconomic Monitoring Report. Testing the Resilience of the Turkish Cypriot Economy. 14 Source: https://www.kizilkaya.com.tr/media/8217/Ihracat%2BGenelgesi.pdf l 7 NAVIGATING THROUGH CHALLENGING TIMES Figure 1.13 Twelve-month price change across Figure 1.14 Inflation and expenditure share for items, February 2023 poor households, by item, February 2023 160 160 30 12-month price change in %, Fenruary 140 140 25 120 120 100 20 100 80 60 80 15 2023 40 60 10 20 40 0 20 5 Food CPI Tobacco Housing Enter tainment Goods Transportation Other Communication Health Clothing Education Restaurants 0 0 Expenditure share, poor households (%) Expenditure share, non-poor households (%) Rate of price change (yoy) - February 2023 Rate of price change (yoy) - February 2022 Source: World Bank staff, TCc ‘statistics office’. Source: World Bank staff, TCc ‘statistics office’. The high dispersion across price changes instead mostly driven by rapid increases in implies that the increase in inflation affects restaurant (121 percent) and entertainment households differently. Throughout Europe, (145 percent) prices (Figure 1.14). Accounting the cost-of-living crisis in the region is so acute for the variability of inflation rates across that 93 percent of Europeans identify inflation household types is crucial in designing effective as their most pressing concern and the high strategies to protect vulnerable households inflation of 2022 had a heterogeneous impact and promote economic growth. on the population.15 Especially in the first half As shown in Figure 1.12, core inflation has of 2022, price increases in the TCc were high also increased significantly. Since the 2021 in food, housing and transportation (Figure currency depreciation episode, inflation in 1.14), which constitute about two-thirds the TC economy has become more broad- of consumption expenditure among poor based, with core inflation significantly on the households. Therefore, due not only to the rise. Although inflation is likely to gradually composition of their consumption basket, but moderate in the short term, underlying also to the differentiated price increases across inflationary pressures have become more groups, in the TCc as well as in almost every persistent. Rising core inflation reflects in economy in Europe, the poorest households fact inertial inflation, the loosening fiscal and were the ones that faced the highest inflation monetary policies, and second-round effects rates. In the second half of 2022, inflation was driven by wage and pension indexation. 15 World Bank. 2023. Europe and Central Asia Economic Update Spring 2023. Weak Growth, High Inflation, and a Cost-of-Living Crisis. World Bank: Washington, DC. 8 l NAVIGATING THROUGH CHALLENGING TIMES Box 2: The impact of the global food crisis of the TC economy Global food prices, which reached a record high in 2022 caused by the COVID-19 outbreak and amplified by the war of Ukraine, have increased food insecurity and added to the cost-of-living crisis. Agricultural, cereal, and export prices remained relatively stable at the beginning of 2023, after food commodity prices declined in the third quarter of 2022 from their all-time highs in April 2022 (Figures 1.15 and 1.16). Despite a decline in the third quarter of 2022, food price indices remain almost 20 percent higher than one year ago and above historical standards. High food prices have also strained households’ budgets, which required policy interventions to fund extra social protection measures for the most vulnerable. Figure 1.15 Agricultural price trends Figure 1.16 Cereal price trends (nominal indices) (nominal indices) Source: Food Security Update #79. Agriculture Source: Food Security Update #79. Agriculture and Food Global Practice. World Bank. and Food Global Practice. World Bank. Domestic food price inflation16 remains high in almost all low- and middle-income economies, including in the GC and TC economies (Figures 1.17 and 1.18). In all, 83.3 percent of low-income economies, 90.2 percent of lower middle-income economies, and 91 percent of upper middle- income economies have seen inflation levels above 5 percent, with many experiencing double-digit inflation. The share of high-income economies with high inflation is also high, with about 85.5 percent experiencing high food price inflation. In the RoC economy, food price inflation reached 10.9 percent in January 2023 compared with the previous year (Figure 1.17), while the TC economy experienced the highest inflation since 1994, and some essential food product (Figure 1.18). Figure 1.17 Food inflation in the RoC and Figure 1.18 Food product inflation in the TCc TCc (% change, yoy) (% change, yoy) 30% 800% 700% Olive oil 25% 600% Veal 20% 500% 400% Lamb meat 15% TC 300% Rice 10% 200% Milk RoC Bread 100% 5% Poultry chicken 0% 0% Jan-22 Feb-22 Mar-22 Apr-22 May-22 Jun-22 Jul-22 Aug-22 Sep-22 Oct-22 Nov-22 Dec-22 Jan-23 Feb-23 16 Source: CYSTAT; TCc ‘SO’. Source: TCc ‘SO’. 16 Domestic food price inflation is measured as year-on-year change in the food component of a country’s Consumer Price Index (CPI). l 9 NAVIGATING THROUGH CHALLENGING TIMES (continued) A rise in food inflation is the result not only of the pass-through of high global prices to domestic prices, but also of local factors. In a year of average weather conditions, the RoC has a self- sufficiency rate above 75 percent in almost all fresh agricultural products, including citrus, fresh fruits, fresh vegetables and potatoes. The self-sufficiency rate is also above 75 percent in most meat types (except beef and veal), including sheep and goats, pork, and poultry, but is dependent on external factors to feed them. The same applies for eggs and milk, but not for milk products where, apart from halloumi, other types of cheese are mostly imported. A shortage is observed in legumes, where almost 86 percent of local consumption is imported. Feedstuff used in livestock production is mostly imported, reaching 90 percent of the total consumption for barley and wheat, while for soya/oilseeds and corn all the locally consumed quantities are exclusively imported. Rising prices reflect the slowdown in agricultural growth observed more recently, driven by the disruptions of the supply chains triggered by the COVID-19 outbreak and recent drought episodes, but also due to declining productivity and limited resilience to climate shocks. In the TC economy, the high food inflation reflects the exchange rate depreciation and high dependence on ‘imports’ for both agricultural inputs and food products. Finally, the oligopoly of some ‘importers’ and the presence of ‘import’ restrictions17 have contributed to maintaining prices elevated. Temporary measures have been introduced to offset rising prices of agricultural inputs and food items. More recently, in January 2023, the TCc ‘administration’ imposed a cap on the LPG price and appointed a working group for quality and price inspections. In the RoC, the first supplementary budget of 2022, passed by parliament in early June, included EUR18 million for the purchase and storage of strategic reserves of grains, plus EUR7.6 million in direct support to goat, cattle and pig farmers, but only to cover higher production costs, not to increase production. Global and local food prices are projected to stay elevated in 2023 and 2024. The continuation of the war in Ukraine could create an export gap of 35 million tons of grains and oilseeds in the 2022/23 marketing year. The weather phenomenon El Niño could cause droughts in south and southeast Asia and Australia, and floods in Latin America. The International Monetary Fund (IMF) estimates that globally a 1-percent increase in fertilizer and oil prices—which have climbed recently and remain high—boosts food prices by 0.45 and 0.2 percent, respectively. All these risks, coupled with other important factors for the GC and TC economies (see Section 1.6, which discusses the short-term outlook), are expected to put upward pressure on food inflation globally, and in both the GC and TC economies in the foreseeable future. To address high food price inflation and build food security, four key areas have been identified for further actions.18 First, it is necessary to continue to provide immediate support to the vulnerable. Second, trade facilitation should be strengthened by removing trade restrictions and adopting inspections and licensing processes that are more flexible to help minimize supply disruptions and lower prices to producers and consumers. Third, increasing transparency and improving the monitoring of trade measures will be critical. Fourth, further investments and targeted support are also needed to encourage farmers to boost sustainable food production and invest in climate- resilient agriculture. Increasing food prices have negative distributional impacts and should be monitored closely. Rising food prices have a higher burden on the budgets of low-income households and can push households into poverty if their incomes are not rising at the same rate (Laborde et al., 2020; Baez et Al., 2021). Rising food prices (and also prices in general) can deepen the extent of deprivation among poor and vulnerable households, and force them to use unsafe coping strategies (i.e., skipping meals, selling assets, etc.), which could have severe and long-lasting consequences. Transfer programs should support low-income families to offset the adverse impacts of rising prices. 17 18 17 World Bank (2021). Policy Note on the Impact of Import Restrictions on Goods Accessing the Turkish Cypriot Market. mimeo. 18 https://www.worldbank.org/en/news/statement/2022/07/15/joint-statement-by-the-heads-of-the-food-and-agriculture-organization-international- monetary-fund-world-bank-group-world 10 l NAVIGATING THROUGH CHALLENGING TIMES Box 3: Informality in the TC economy Informal—or shadow—economies consist of activities that have market value but are not formally registered in national accounts and fiscal balances. Informal economic activity is widespread in emerging markets and developing economies where, on average, it accounts for about one-third of output and more than two-thirds of employment. In general, the informal economy, as a percentage of national income, has been in decline in emerging markets for several decades, a trend attributed in large part to policy reforms. Indeed, between 1990 and 2018, the informal sector’s contributions to national economies, on average, fell by about 7 percentage points of GDP (Ohnsorge and Yu, 2022). Widespread informal sector activity hampers economic development in a variety of ways and is broadly associated with weaker economic outcomes. Economies with large informal sectors have lower per-capita incomes, greater poverty, more limited financial development, and weaker growth in output, investment, and productivity. Economies with above-average informal activity tend to have one-quarter to one-third the GDP per capita of economies with little informality. Moreover, informal activity strains fiscal revenues, hampering the abilities of governments to provide services, conduct countercyclical policies, service debt, and/or implement crisis-response measures (Ohnsorge and Yu, 2022). More effort is needed to assess the extent of informality in the TC economy, and to design effective policies to tackle it. Some initial estimates of the size of the informal economy exist (Kıbrıs Türk Ticaret Odası, 2015). More recently, the TCc ‘administration’ has announced renewed efforts with the aim of combating informality. In March 2023, inspections have been announced by the ‘department of labor and social security’ to provide an assessment of the informal economy and to develop measures to reduce it.19 Overcoming the challenges of informal economic activity requires a combination of policies tailored to economy-specific circumstances, informed by the drivers of—and challenges posed by—informality. Where informality is predominantly a reflection of poor governance, streamlining regulatory and tax frameworks while improving the efficiency of public revenue collection and regulatory enforcement as well as strengthening public service delivery can help bolster tax morale. Complementary measures should be also designed to expand access to finance, markets, and inputs to foster firm productivity and growth; to improve education system to facilitate formal sector employment; and to enhance safety nets to cushion household risks. The response of wages—both private and population groups, and the consequent ‘public’—and pensions to an increase in erosion of real incomes, is in fact the single inflation is one of the factors leading to second- biggest cost of inflation. At the same time, round effects, hence making the inflationary indexation may contribute to making the shock more persistent. Indexation—namely, inflationary shock more persistent, creating the practice of adjusting wages (both private a19spiral inflation-wage indexation-inflation. and public and including also minimum wages) When the indexation of wages and pensions to and pensions (including minimum pensions) based on the changes in another price or inflation is automatic, the transmission tends composite indicators of prices—broadly aims to be more likely, particularly in high inflation at preventing purchasing power losses for the contexts. While transmission from wages recipients. In an inflationary environment, a may likely affect both the demand and the reduction in purchasing power due to rising production sides, pensions are likely to impact prices, with heterogenous impacts across demand through disposable income.20 19 Source: https://csgb.gov.ct.tr/HABERLER/kay%c4%b1t-d%c4%b1%c5%9f%c4%b1l%c4%b1k-%c4%b0le-m252cadele-ele-al%c4%b1nd%c4%b1 20 Alvarez et al. (2022) shows that wage-price spiral risks still appear contained. Based on the historical evidence, only a small minority of such episodes were followed by sustained acceleration in wages and prices. Instead, inflation and nominal wage growth tended to stabilize, leaving real wage growth broadly unchanged. l 11 NAVIGATING THROUGH CHALLENGING TIMES Figure 1.19 ‘Public’ wages spending (% of Figure 1.20 ‘Public’ wages growth and inflation GDP) in the TC economy Source: Eurostat; TCc ‘ministry of finance’. Source: World Bank staff, TCc ‘statistics office’, TCc ‘ministry of finance’. Similar to other small economies, the TC once again (Figure 1.19). Personnel spending economy has a large ‘public’ sector, with has decreased significantly in the past decade, ‘public’ employment reaching 30 percent of following a reform of ‘public’ employment, total employment, which is double the EU introduced in 2010 (‘Law 47/2010’), which average. As a share of GDP, the size of ‘public’ introduced a new salary system for ‘public’ administration in small economies tends to employees.21 Earlier, in 2008, a performance- be larger than in other emerging economies. based assessment had been introduced for This partly reflects the fixed costs of ‘public’ promotion. Indexation of ‘public’ wages sectors, which are high relative to their small remains de facto fully automatic, with ‘public’ economies and their populations. In the case wages growth following closely lagged of the TCc, this is also a reflection of a large inflation and current inflation in 2022 (Figure informal sector (see Box 3) and a significant 1.20).22 Similarly, both pensions and minimum wage gap between private and ‘public’ sectors, pensions can also be considered to be fully despite the modest ‘public’ salaries compared indexed to inflation.23,24 with the EU average. Similar to other EU economies, recent events While compensation for employees still and policy measures have partially reversed accounts for significant budget resources, this trend. Since 2018, spending on ‘public’ it has decreased significantly over time, wages has picked up in both the TC and GC momentarily approaching alignment with economies. Moreover, minimal economic the EU average in 2018, before increasing growth in 2019, followed by the deep recession 21 Teachers, armed forces personnel, and contract-based ‘public’ servants are paid on a different salary scale. 22 In the EU, (full or partial) price indexation of public wages is relatively limited and applies to about one-fifth of the Euro zone public wage bill. In most economies, public wages are not automatically indexed to inflation, nor does inflation play a formal role in wage setting. Full and partial price indexation is reported in five countries, representing about 20 percent of the euro area public wage bill in 2021. In two of these (Belgium and Luxembourg), public wages are fully automatically indexed to prices (with a backward-looking index, linked to the cost of living); the RoC and Malta have a similar but more restricted indexation scheme categorized as partially automatic. In Italy, expected inflation excluding energy is taken into account during negotiations for contract renewals: if inflation turns out to be higher than the increase in public wages over the three-year contract period, the difference is made up in the following three-year period. Finally, public wages are currently frozen in Greece and France (in the latter, until end-2022; the freeze does not apply to education, health and low wages). 23 See ‘Law 7/79’; ‘Law 82/2009’; and ‘Law 47/2010’. 24 In the EU, public pensions are indexed automatically—fully or partially—to prices and wages, mostly in a backward-looking way, in almost all countries. Only Ireland does not apply automatic indexation. Full price indexation of public pensions is applied in six countries (Belgium, Greece, Spain, Italy, Luxembourg and Slovakia); indexation to economy-wide wages and the minimum wage is applied in Germany and the Netherlands; all the remaining countries apply partial automatic price indexation. 12 l NAVIGATING THROUGH CHALLENGING TIMES Figure 1.21 Number of SA beneficiaries and Figure 1.22 Minimum wage, 2005–2023 energy consumption subsidized, 2017–202125 Total No of Social Assistance beneficiaries Total no of Beneficiaries in Poor in Need Other SA Beneficiaries Total Electric Consumption of Social Assistance Beneficiaries (MW) 6218 5180 4625 4538 4586 4420 3726 3690 3773 3590 3246 3211 2376 1660 1444 1038 899 848 830 813 2017 2018 2019 2020 2021 Source: ‘TCc ‘department of social services’, KIB-TEK. Source: www.csgb.gov.ct.tr in 2020 and the subdued recovery thereafter, 1.3 Pressures on fiscal and have also contributed to a reversal in the external imbalances remain declining trend in the personnel spending-to- elevated in 2022 GDP ratio in the TC economy, well ahead of what has been observed in other economies.25 The strong recovery and higher revenue collection have led to a reduction in the deficit, The TCc ‘administration’ has stepped in despite mounting inflationary pressures to control the wage bill, strengthen social (Figure 1.23). In 2022, spending surpassed TL 20 billion, with more than 40 percent of total support and promote a fairer system, expenditures destined to transfers, followed especially toward low-income households. by wages and compensation at almost 40 The TCc ‘administration’ has introduced percent and capital expenditures declining measures to reduce the wage gap between to about 9 percent. The share of defense people employed in the ‘public’ sector before spending dropped slightly from 7 percent of and after the 2010 reform.26 In parallel, since total expenditures in 2021 to 5.8 percent in 2022. Meanwhile, revenues, excluding grants, 2018, the TCc ‘administration’ has increased reached almost TL 18 billion, mostly driven the coverage of social assistance (SA), mostly by indirect taxes, which make up about 37 driven by the expansion of the energy subsidy percent of local revenues, due to rising prices. program in which eligibility is limited only to Aid received from Türkiye in the form of the social assistance beneficiaries (Figure 1.21; grants constitutes the most important source see also Box 1). Finally, the TCc ‘administration’ of funding in alleviating the financing gap between revenues and budget expenditures, has also raised the minimum wage, but amounting to TL 2.6 billion, of which almost its increase since 2019 has been modest, half was in the form of defense grants (Figure especially if compared with the inflation rate 1.24). Loans from Türkiye amounted to TL increase (Figure 1.22). 1,191 million. Debt is expected to remain 25 The “Others” category includes: disabled veterans; martyrs’ families; parents of the martyrs; disabled; foster families; urgent allowances. 26 http://basbakanlik.gov.ct.tr/BASIN-VE-HALKLA-%C4%B0L%C4%B0%C5%9EK%C4%B0LER/BASIN-A%C3%87IKLAMALARI/472010-sayili- yasa-kapsamindak%C4%B0-kamu-199ali%C5%9Fanlarina-maa%C5%9F-arti%C5%9Fi-%C4%B0199%C4%B0n-protokol-%C4%B0mzalandi l 13 NAVIGATING THROUGH CHALLENGING TIMES Figure 1.23 Fiscal accounts: revenues, expenditures and balance (% of GDP) Source: World Bank staff, TCc ‘ministry of finance’. Figure 1.24 External financing from Türkiye Source: World Bank staff, TCc ‘ministry of finance’. high, but the debt-to-GDP ratio should remain elevated. Based on the available data until below the historical average due to high May 2022, merchandise ‘exports’ declined inflation (Table 1.2). However, while in the by 3 percent, while ‘imports’ increased by 39 short run this may benefit ‘public’ finances, in percent compared with the corresponding the context of high inflation, a negative impact period in 2021. Despite the expected increase on economic activity from an adverse supply in ‘exports’ over the course of the year, this shock may end up outweighing the positive may not have been enough to compensate for impact of higher inflation on debt ratios.27 rising ‘imports’, and the current account deficit The current account deficit, excluding is therefore expected to remain elevated at grants from Türkiye, is estimated to remain about 4 percent of GDP (Table 1.2). 27 Bankowski et al. (2023). 14 l NAVIGATING THROUGH CHALLENGING TIMES Box 4: Key features of small economies Small economies are a heterogeneous group with diverse economic features, but they share com- mon attributes that make them especially vulnerable to shocks. These include limited connectivity, dependence on imports of essential goods, highly concentrated economic structures, a large public sector, reliance on external financing, and susceptibility to natural disasters and climate change. The TC economy shares most of these characteristics with the other small economies. However, policy inaction and delayed urgently needed structural reforms add to its vulnerability. Key characteristics. Small economies are defined as economies with populations of 1.5 million or less. As of 2022, none of these economies is classified as low income. They have very high levels of trade openness, importing a large percentage of their food and/or fuel, and are three times more reliant on global shipping than the world average. Their exports are concentrated in tourism and the production of primary commodities, and in most cases not energy, metals, meat, or grain. As a group, small econ- omies tend to run fiscal deficits and depend on a mixture of aid and foreign direct investment (FDI) to finance large current account deficits. On average, small economies have higher public debt levels than other EMDEs. Nearly all small economies have fixed exchange rates. Due to their size and geo- graphic locations, they are also more vulnerable to the effects of climate change. These features, to- gether with other country-specific challenges, make small economies especially vulnerable to shocks. Categorization into subgroups. The sample of small economies is categorized according to the subgroups: tourism-reliant;28 commodity importers or commodity exporters29; with fixed exchange rates;30 islands or land-locked; remittance-reliant economies;31 fragile and conflict-affected situations. The TC economy shares similar economic characteristics with tourism-reliant and commodity-import- er island economies. 1.4 As with other small by more than 11 percent in small economies, economies, the Turkish seven times higher than other EMDEs. The recession was even deeper in tourism-reliant Cypriot economy faces small economies, including the TC economy, overlapping crises and with GDP contracting by nearly 13 percent and multiple challenges 28 29 30 31 more than 16 percent in the TC economy. In the RoC, a small, open and advanced economy Small economies suffered disproportionate adverse economic impacts from the that is also tourism-reliant, the output COVID-19 pandemic, largely due to prolonged contraction was also pronounced at 5 percent, disruptions to global tourism. As a group, they albeit much less than in other small economies, suffered a far more severe recession in 2020 but more than the EMDE average, once small and a much weaker initial rebound than other economies are excluded. Its openness renders emerging markets and developing economies the RoC especially vulnerable to both demand (EMDEs) (Figure 1.25).32 Output contracted and price shocks in the Euro zone. 28 Tourism-reliant economies report inbound tourism expenditures as a share of GDP during 2015–19 above the 3rd percentile of the share in all EMDEs, based on UN World Tourism Organization data. 29 Exports of these two types of commodities accounted for 20 percent or more of total exports, on average, in 2017–19. Economies that meet these thresholds as a result of re-exports are excluded. 30 Fixed exchange rates include managed arrangements, pegs within horizontal bands, crawl-like arrangements, crawling pegs, stabilized arrangements, conventional pegs, currency boards, and the absence of a country-issued legal tender. 31 Remittance inflows as a share of GDP between 2015–20 above the 75th percentile of all EMDEs (i.e., above 8 percent of GDP), based on World Bank data. 32 EMDEs include all those that are not classified as advanced economies and for which a forecast is published for the World Bank (2023) Global Eco- nomic Prospect report. Dependent territories are excluded. Advanced economies include the RoC, among others. l 15 NAVIGATING THROUGH CHALLENGING TIMES Figure 1.25 Real GDP annual growth, Figure 1.26 Real GDP annual variation (%) from 2019–2022 2019 baseline, 2020–2022 Source: World Bank staff estimates. Source: World Bank staff estimates. Note: EMDEs = emerging market and developing economies; Note: EMDEs = emerging market and developing economies; FCS = fragile and conflict-affected situation economies. FCS = fragile and conflict-affected situation economies. Country groups are GDP weighted at average 2010–19 prices Country groups are GDP weighted at average 2010–19 prices and market exchange rates. and market exchange rates. Sample includes 34 EMDE small economies (of which 11 are Sample includes 34 EMDE small economies (of which 11 are commodity-exporters, six are FCS, and 22 are tourism-reliant) commodity-exporters, six are FCS, and 22 are tourism-reliant) and 115 EMDEs excluding small economies and Guyana. and 115 EMDEs excluding small economies and Guyana. The typical features of small economies also the byproduct of ineffective policies to amplified the effects of the 2020 global build resilience and competitiveness. Small recession and have slowed their recoveries. economies, including the TC economy, are Recoveries remained weak in 2021 and for not expected to regain their pre-pandemic at least part of 2022, as new COVID- 19 levels of per capita output until after 2023, variants prolonged travel restrictions. In and only after other economies recover more parallel, soaring global prices and supply chain fully (Figure 1.26). Conditions in the RoC and disruptions resulting from the war in Ukraine other advanced economies have deteriorated and the global monetary tightening cycle, sharply since mid-2022 (amid high inflation, brought into focus the risks of depending on rapid monetary tightening, reduced fiscal imported essentials. From 2 percent in January support, and major energy supply disruptions 2020, inflation in the median small economy and price hikes in Europe). In all, growth increased to 7.5 percent in September 2022, in advanced economies slowed from 5.3 even as domestic demand remained weak. percent in 2021 to 2.5 percent in 2022 and it With debt levels well above the EMDE average, is projected to slow to 0.5 percent in 2023, as global monetary policy tightening raised debt central banks continue to tighten monetary servicing costs and threatens to further slow policy to contain inflationary pressures, labor small economies’ recoveries, with large and markets soften, and energy market disruptions possibly permanent losses to their levels of in Europe persist. output. Small economies are subject to a variety of The TC economy had a far more severe risks, including dependence on imports of recession in 2020, a weaker initial rebound, essential goods, highly concentrated economic and a slower recovery than other small structures, reliance on external financing, and economies. In addition to the indicated susceptibility to natural disasters and climate challenges, the TC economy suffered even change. Most small economies entered the more than other small economies (Figures global tightening cycle with adequate reserve 1.25). The deeper impact of the overlapping buffers, but an external financing shock could crises observed for the TC economy reflects nonetheless create significant financial stress, instead not only its economic structure, but particularly in small economies with highly 16 l NAVIGATING THROUGH CHALLENGING TIMES Figure 1.27 Average annual growth, Figure 1.28 Average annual natural hazard 2000–2010 vs 2011–2021 occurrence in Cyprus for 1980–2020 Source: World Bank staff estimates. Source: World Bank Climate Knowledge Portal Note: EMDEs = emerging market and developing economies; https://climateknowledgeportal.worldbank.org/country/ FCS = fragile and conflict-affected situation economies. cyprus/vulnerability Country groups are GDP weighted at average 2010–19 prices and market exchange rates. Sample includes 34 EMDE small economies (of which 11 are commodity-exporters, six are FCS, and 22 are tourism-reliant) and 115 EMDEs excluding small economies and Guyana. indebted private sectors. In the long term, increasing. Similar to other small economies, small economies, including the TC economy, and particularly island economies, the TC face adverse structural conditions that have economy is susceptible to natural disasters weakened their growth even before the and climate change. The island of Cyprus is recent succession of shocks (Figure 1.27), and vulnerable to earthquakes and floods, with further weaken their prospects. Remoteness, the former posing the greater risk of a high lack of scale, and limited connectivity raise impact and lower probability event. The costs and constrain diversification efforts for World Bank disaster risk profile for the island small economies such as the TC economy. of Cyprus34 shows that: (i) the annual average Trade costs are almost one-half higher in population affected by flooding in Cyprus EMDEs than in advanced economies. In the TC is about 400 and the annual average effect economy, the average price of goods accessing to GDP is about US$4 million; (ii) the annual the TC market is 20.1 percent higher than average population affected by earthquakes in similar goods accessing regional benchmark Cyprus is about 5,000 and the annual average economies, rising to 26.6 percent for varieties effect on GDP is about US$70 million; (iii) and protected by bans.33 The RoC has experienced the annual average fatalities and capital losses a reduction in its average annual growth from due to earthquakes are less than one, and 3.6 to 1.6 percent in the past two decades. the losses about US$10 million, respectively. However, access to the EU market has partially The fatalities and capital losses caused by eased the problems related to remoteness more intense, less frequent events can be and limited connectivity for the RoC. substantially larger than the annual averages. As global temperatures keep rising, extreme Damage from climate and natural disasters, temperature and storms—the most common estimated at nearly 5 percent of GDP shocks in Cyprus since 1980 (Figure 1.28)—are annually, on average, for small economies, is expected to become even more frequent. 33 World Bank (2021). Policy Note on the Impact of Import Restrictions on Goods Accessing the Turkish Cypriot Market. mimeo. 34 World Bank (2017). Disaster Risk Profile: Cyprus. https://www.gfdrr.org/en/publication/disaster-risk-profile-cyprus l 17 NAVIGATING THROUGH CHALLENGING TIMES 1.5 The outlook for 2023 is zone—with large multiplier effects—will boost growth in late-2023 and beyond. However, pre- subject to uncertainty and election spending and earthquake recovery downside risks are expected to further weaken fiscal balances On February 6, 2023, two powerful and long-term debt sustainability, as observed earthquakes of 7.8 and 7.5 magnitude after episodes of reconstruction following natural disasters.36 struck southeast Türkiye and northwest Syria. In Türkiye, the earthquakes resulted The policy response of the Turkish in widespread damage across 11 provinces, government to the earthquakes, including where around 14.01 million (16.5 percent) further monetary and fiscal expansion, of Türkiye’s population live, including Adana, may require budget reallocations and lead Adıyaman, Diyarbakır, Elazığ, Gaziantep, Hatay, to further depreciation, inflation and debt Kahramanmaraş, Kilis, Malatya, Osmaniye and pressures. The Central Bank of Türkiye is Şanlıurfa. More than 55,000 fatalities have expected to cut its policy rate further. It also been reported overall, of which over 50,000 used reserves to help steady the Turkish lira in Türkiye. Millions have been displaced. Two in the aftermath of the earthquakes, and weeks after the powerful earthquakes, a reserves could remain under pressure in third 6.3 magnitude earthquake hit southern the weeks ahead. The central bank is also Türkiye, causing additional deaths and reported to have asked banks to take actions injuries. The earthquakes have caused an to ease pressure on the lira. Lastly, the central estimated US$34.2 billion in direct physical bank announced government bonds purchase damage in Türkiye, equivalent to about 4 plans. The earthquakes added pressures to an percent of the country’s 2021 GDP. According increasingly fragile macro-financial situation to the Global Rapid Post-Disaster Damage amid a deteriorating external environment Estimation (GRADE) Report (World Bank, and particular domestic policy mix. Despite 2023),35 the recovery and reconstruction costs rapidly rising inflation, the Central Bank of are expected to be much larger, potentially Türkiye continued to cut interest rates by twice as large, and GDP losses associated to 550 bps from August 2022 to February 2023, economic disruption will also add to the cost of while relying on an increasingly complex mix the earthquakes. The affected region accounts of heterodox macro-prudential regulatory for more than 9 percent of the economy, measures to support the Turkish lira, reduce and 14.3 and 11 percent of agricultural and inflation, and control and direct credit growth. industrial production, respectively. The social implications of the Türkiye and Despite a drag on growth in 2023 due to Syria earthquakes for the TCc are significant. earthquake-related production, export, The TCc mourns the loss of 49 Turkish Cypriots and consumption disruptions, pre-election who died in Türkiye during the earthquakes on spending and earthquake recovery are February 6. The TCc ‘administration’ amended expected to support growth in Türkiye in the relevant legel text enabling relatives of the 2023. Economic activity is expected to remain earthquake victims to access financial support. solid in H1 2023, supported by a 55 percent Moreover, an estimated 1,000 people among net minimum wage increase in January 2023 the displaced from Türkiye have applied for and expansionary fiscal policies ahead of the humanitarian aid to the TCc ‘social services 2023 elections set for May 14, which will department’. They can apply for ‘humanitarian counteract weakening global demand. Massive residence permits’, which have a validity of six reconstruction efforts in the earthquake months. However, for them to work, relevant 35 Gunasekera, Rashmin; Ishizawa Escudero, Oscar Anil; Daniell, James Edward; Pomonis, Antonios; Macabuag, Joshua Lee David Clifton; Brand, Johannes; Schaefer, Andreas; Romero, Roberth; Esper, Sarah; Otálora, Samuel González; Khazai, Bijan; Cox, Kerri Dionne. Global Rapid Post-Disaster Damage Estimation (GRADE) Report: February 6, 2023 Kahramanmaraş Earthquakes - Türkiye Report (English).  Washington, DC: World Bank Group.  http://documents.worldbank.org/curated/en/099022723021250141/P1788430aeb62f08009b2302bd4074030fb 36 Fan, R.Y., Lederman, D., Nguyen, H. et al. Calamities, Debt, and Growth in Developing Countries. IMF Econ Rev (2023). https://doi.org/10.1057/ s41308-023-00200-3 18 l NAVIGATING THROUGH CHALLENGING TIMES restrictive permits would need to be lifted. and long-term growth, as more aid is received Access to health and education systems is when the economic activity is at full potential. free and granted, as no regulatory change was On the spending side, all components tend to needed. be highly procyclical, with the only exception being defense spending, which tends to be The economic implications are also expected countercyclical, decreasing in good times. The to be significant, mostly though trade and combination of these factors has resulted in aid channels, and increased risk of further more volatile economic cycles and less fiscal depreciation and inflation. Both ‘imports’ space to counteract them, and in a reduced and ‘exports’ to and from the affected areas effectiveness of fiscal policy as a lever to reduce are expected to be impacted, not only given macroeconomic volatility—an essential role in existing trade relations, but also due to the the context of the TC economy. disrupted functionality of the İskenderun port. Box 5 provides details on the trade relations The TCc ‘administration’ has reacted promptly between the TC economy and the affected to provide emergency support, but more cities, and a comparison with the 1999 action is needed going forward to strengthen earthquake. The TC economy is expected to preventive and preparedness mechanisms. experience additional supply chain disruptions Coordination groups, both at the central and and price increases. The TC economy faces local levels, have been established to deal risks arising from its high inflation, as a with emergency and disaster preparedness consequence of both domestic factors and in the case of a possible earthquake directly the currency depreciation, exacerbated by affecting the island. The ‘disaster and loosening monetary and fiscal policies in emergency management committee’ under Türkiye, in response to the earthquake and the ‘prime minister’ was established in ahead of the 2023 presidential elections. 2016. One of the first tasks undertaken in Moreover, aid from Türkiye, expected to be 2023 was a review of the safety of school around TL 5.5 billion in the 2023 budget of buildings. Consultations are ongoing for the the TCc ‘administration’, could be significantly establishment of an ‘earthquake legal process downsized due to the need of the Government follow-up committee’ to deal with the reform of Türkiye to repurpose spending toward of earthquake regulations. Efforts are needed emerging support and reconstruction. Aid to update the existing regulations and to align from Türkiye is a critical source of financing them with EU and international best practices. for the TCc ‘administration’. It has however On March 2, a ‘communication committee’ contributed to overall procyclicality of fiscal was established to prepare for, and ensure, policy. Since the early 2000s, aid from Türkiye uninterrupted communications in the case of a has turned from being countercyclical to possible earthquake. A bi-communal initiative procyclical—namely, increasing during good has also been initiated to deal with disaster times—hence contributing further to the risk management (DRM) from an island- economic volatility of the TC economy. Overall, wide perspective. Moreover, the ‘ministry of both revenues and spending have been finance’ has considered a set of measures to procyclical in the TC economy since 1977, and deal with increasing financing needs by either procyclicality has increased over time. Among cutting spending, including through (voluntary) revenues, while the procyclical nature of tax pay cut or paycheck deductions, a 1 percent revenues represent a good feature, as they act deduction on interest rates on TL deposits (2 as automatic stabilizers of the business cycle, percent if deposits in other currencies) above procyclicality of aid is detrimental to short- 100,000 TL, or by raising revenues. l 19 NAVIGATING THROUGH CHALLENGING TIMES Box 5: The economic impact of the İzmit earthquake in 1999 The economic impact on the TC economy from the 2023 earthquakes may be mostly felt through ‘exports’, as the affected Turkish provinces account for almost one-quarter of total ‘exports’ to Türkiye (Figure 1.29). The 11 provinces hit by the earthquakes, mostly from the East Anatolia region and two from the Mediterranean region, have become less important over time in terms of supply for the TC economy, but more important as destination markets for TC products. In the past, despite the strong trade linkages with affected areas by similar disasters, the TC economy proved resilient. The Izmit earthquake on August 17, 1999, with a magnitude of 7.4, struck the Anatolian fault system with the epicenter at about 7 miles southeast of Izmit. About 17,000 people lost their lives and some 250,000 people were left homeless. The Izmit earthquake happened in the industrialized and most densely populated urban areas, also including Istanbul. Overall, the nine provinces accounted for one-third of Türkiye’s GDP. The earthquake triggered a recession for the Turkish economy, with GDP dropping by 5.8 percent. Despite of significant trade links, the economic impact in the TC economy was not large, as opposed to the financial crisis that struck just a few years later (Figure 1.30). Figure 1.29 Trade by provinces of Türkiye, Figure 1.30 Real GDP growth pre- and post- 2002–2022 1999 Source: Turkstat. Source: WDI; TCc ‘SO’. Against this background, GDP growth for the reconstruction spending, but with implications TC economy is expected to subside in 2023 at for further depreciation and rising inflation. just above 1 percent. The forecast builds on The Euro zone, instead, is expected to grow the assumption that the war in Ukraine persists at 0.5 percent in 2023, and inflation to remain in the near term, with no further escalation in still above policy targets. In this context, the the intensity. The projections also assume that key driving sectors for the TC economy, such sanctions imposed on Belarus and the Russian as ‘tourism’ and ‘exports’, may witness a Federation remain in place. Energy prices are deceleration. However, the new supply chain assumed to moderate from 2022 averages. disruptions are expected to further increase the Türkiye’s growth is expected to remain robust price of intermediate goods. The agriculture at 3.2 percent, driven by pre-electoral and sector may also be negatively impacted by the 20 l NAVIGATING THROUGH CHALLENGING TIMES Turkish lira depreciation and a further increase stability. In a context of extremely high imbal- in input prices, combined with the adverse ances, prudent fiscal policies should be pur- impact of weather and the drought risks for sued, aimed at ensuring medium-term debt 2023. While inflation is expected to decline sustainability, while raising potential growth from the all-time peak reached in 2022, it is in a sustainable manner and addressing the nevertheless expected to remain high and resilience objective. Only an adequate mac- among the highest in the region, with negative roeconomic policy framework can help the consequences for the purchasing power of TC economy restore price stability, lessen the households, hence leading to a slowdown impact of the cost-of-living crisis and anchor in poverty reduction, income convergence, any reform agenda. In the aftermath of multi- and a reduction in consumption. While the ple crises, five reform priorities emerge. First latter, together with a deceleration of energy is to maintain the focus on providing emergen- and commodity prices, may contribute to a cy support to the poor and most vulnerable, reduced growth of ‘imports’, this may not be i.e., those most impacted by the cost-of-living enough to compensate for reduced ‘exports’, crisis. Second is to strengthen energy security, hence resulting in increased pressures on by boosting investment in renewable energy external accounts. (RE) sources, promoting energy efficiency, and Risks for the outlook of the TC economy reforming energy tariffs. Third is to strength- remain skewed to the downside, mostly en resilience to natural disaster- and climate driven by external factors. The earthquake change-related risks. This can be achieved by hit an already fragile recovery which, despite strengthening financial protection, investing in speeding up in 2022, was facing several risk reduction, and improving preparedness. uncertainties and downside risks. Above all, Fourth is to strengthen resilience in the broad- these uncertainties could manifest in a more er sense, through competitiveness-enhancing prolonged and increasingly intense war in reforms, thereby building a more competitive Ukraine. The TC economy faces risks arising private sector. Fifth is to enhance human cap- from its high inflation, as a consequence of both ital and to recover from pandemic-induced domestic factors and Turkish lira depreciation, losses. incremented by loosening monetary and fiscal policies in Türkiye, in response to Building an adequate macroeconomic the earthquake and ahead of the 2023 framework presidential election. Substantial inflation and An adequate macroeconomic policy frame- continuing depreciation may further weaken work should anchor any reform agenda. The both corporate and ‘public’ balance sheets. TC economy is confronted by the challenge of The already limited fiscal space may be further increasing social and fiscal pressures that are eroded and debt vulnerabilities amplified. The exacerbated by its acute vulnerability to ex- TC economy has long been afflicted by low ternal developments. Advancing reforms to productivity, per capita income growth, and create fiscal space, reduce fiscal risks, increase convergence. These trends are set to persist, counter-cyclicality, and reduce budgetary ri- with elevated prices for essential goods gidities will be key in building resilience and endangering poverty reduction. Economic enhancing macro-fiscal stability. Reorienting losses from climate-related and natural ‘public’ finance toward emerging needs and disasters add to these challenges. development priorities will be paramount in successfully steering the TC economy toward a 1.6 In the aftermath of new growth model, rather than allowing pre- multiple crises, key cious resources to be absorbed by inefficient policy priorities emerge ‘public’ spending in non-viable sectors. A grad- ual shift toward a simpler, more progressive, The TCc ‘administration’ should maintain its and more efficient tax system is also needed to focus on providing emergency support to increase revenues and reduce distortions. In those in need while reducing vulnerability addition, ensuring strengthened revenue col- to future crises and building macroeconomic lection for the Local Community Bodies (LCBs), l 21 NAVIGATING THROUGH CHALLENGING TIMES while enhancing their accountability, will also ing and monitoring mechanism to avoid their be key in ensuring the sustainability of local fi- future build-up. In the medium term, a broad- nances. Finally, a counter-cyclical stance, sup- er reform of both the revenue and spending ported by the implementation and monitoring frameworks, together with a broader strate- of simple fiscal rules, is crucial in protecting gy to support private sector development, is the economy from future shocks. needed to achieve a return to growth. In the context of high inflation, the Providing emergency support to the poor empirical association between fiscal policy and most vulnerable and developments in inflation should be monitored and fiscal policy deployed to Transfer programs, such as the “Poor in restore price stability and lessen the impact Need” program, and programs for disability, of the cost-of-living crisis. While fiscal education, and health care, should continue policy’s impact on inflation has changed to support low-income families to offset the over the decades, it remains significant; for adverse impacts of rising prices. In the short a sample of advanced economies since 1985, term, the system should aim to protect the it is estimated that reducing expenditure by real value of the SA transfers. Second, the 1 percentage point of GDP lowers inflation system should aim to provide SA transfers to by half a percentage point (IMF, 2023). To poor and vulnerable households, by improving respond effectively to high inflation, the its targeting mechanisms, especially given TCc ‘administration’ should first have a full limited resources. For example, the “Poor understanding of how fiscal policy impacts in Need” program has an age limit. De facto, inflation and how households are affected. The the TCc does not have a program to support distributional impact of fiscal policy should also poor people just because they are poor. be understood. The Special Issue provides an The eligibility criteria for the “Poor in Need” initial step in this direction. Furthermore, the program could be adjusted to improve the TCc ‘administration’ should carefully assess the coverage of the program. impact of ‘public’ wage setting during periods Strengthening energy security of high inflation, including through indexation, on the setting of private wages, the impact of To strengthen energy security, the TCc pension indexation, and the potential effects ‘administration’ could focus on: (i) boosting of inflation on the structure of the tax system. investment in RE sources, also in a joint effort with the RoC; (ii) promoting energy efficiency; Key short-term and medium-term actions and (iii) reforming the energy tariffs system. can help improve the macroeconomic policy While a multi-tariff rising block structure is framework. In the short term, actions include: often motivated by the need to subsidize basic (i) conducting a fully-fledged ‘public’ finance consumption for the poorest, it is important to review, including tax policy and tax expen- assess whether the tariff structure is calibrated diture, ‘public’ expenditure, fiscal incidence to ensure that the average tariff equates with analysis (with the Special Issue laying the basis cost recovery and that the benefits do not leak for it), and the incentive system; (ii) designing to higher income groups, which is especially and introducing a cyclical-adjusted fiscal rule important at a time of heightened fiscal and fiscal council to help monitor and guaran- pressures. Subsidies are also unsustainable tee fiscal sustainability and macroeconomic because the developments in the energy management; (iii) enhancing domestic mobi- markets, coupled with the need for significant lization, including through reforming income investment in the sector, suggest that energy tax and broadening the revenue base of the costs are going to continue increasing. To LCBs; (iv) improving ‘public’ debt, mitigating avoid passing such an increase through to exchange rate risks and monitoring financial households would require even greater sector risks; and (v) taking stock of arrears and subsidies. Continuing to shelter consumers contingent liabilities, and developing a report- through subsidies to the sector might therefore 22 l NAVIGATING THROUGH CHALLENGING TIMES prove to be unsustainable in the near future.37 the EU Acquis. Special attention should contin- Finally, fiscal measures that are not temporary, ue to be devoted to the regulation concerning targeted and tailored to preserving incentives ‘imports’ and GL trade. Pre-permits, licenses to consume less energy are likely to exacerbate imposed by the TCc ‘administration’, and bans inflationary pressures.38 as well as the lack of risk management prac- tices, on top of regulatory uncertainty and Strengthening resilience to natural other cumbersome procedures, contribute to disaster- and climate change-related increasing prices, penalizing consumers and risks eroding competitiveness of TC firms vis-à-vis their competitors. In addition, addressing risks As the TC economy recovers from the impacts of the pandemic and deals with the socio-eco- to the financial sector, stemming from further nomic consequences of the earthquakes, there currency depreciation but also sharp slow- is an opportunity to become more resilient to down in economic activity in reference to cap- natural disaster- and climate change-related ital adequacy and NPLs, can help strengthen shocks. This can be achieved by strengthening financial stability and access to finance. financial protection, investing in risk reduc- Enhancing human capital tion, and improving preparedness, also in co- ordination with the RoC. Key actions include: The COVID-19 pandemic caused large losses (i) enhancing technical and human capabilities in working hours, especially for female in civil defense and DRM to prioritize, design, workers, and extended school closures in the and implement interventions; (ii) improving TCc, as in other small economies, which may the availability of risk information on disaster have left permanent scars. Box 6 provides a and climate risks at different scales; and (iii) preliminary assessment of the impact of the learning from, and sharing, best practices and pandemic on health and education in the knowledge on prevention and preparedness TCc. Enacting policies that increase access to to raise awareness of the importance of invest- pre-primary education is crucial to sustaining ing in prevention and preparedness.39 and strengthening the current and future workforce. Greater access to high-quality Strengthening resilience in the broader childcare and early learning programs will sense, through competitiveness- support mothers so that they can work, and enhancing reforms this will benefit children, leaving them better The TCc ‘administration’ should continue to re- prepared for school and the job market duce the administrative burden on businesses later in life. Re-skilling policies should also and facilitate GL trade, which, despite having be introduced, as participating in the labor increased significantly, remains extremely low. market may have become more difficult A shift in paradigm is needed through over- for workers who lost their jobs and may hauling the current fiscal incentive framework have become low-skilled since. The quality toward a more effective use of resources, in- of Vocational Education and Training (VET) cluding investment in climate-resilient agricul- and Lifelong Learning programmes should ture, quality-enhancing processing technolo- also be improved, thereby enhancing the gies, and increased compliance to standards. employability of youth graduating from VET Building a competitive private sector would schools and ensuring skills and competences require reforming business regulations and are in line with the needs of the private sector. procedures that are under the mandate of Investing in human capital should be at the the TCc ‘administration’ and that should be center of any policies aimed at bolstering the aligned with international best practices and economy. 37 See, for example, World Bank (2013). 38 Bankowski et al. (2023). 39 World Bank (2021). Economics for Disaster Prevention and Preparedness Investment in Disaster Risk Management in Europe Makes Economic Sense. l 23 NAVIGATING THROUGH CHALLENGING TIMES Box 6: The impact of COVID-19 pandemic on human capital in the Turkish Cypriot community Despite unprecedented human development gains over the past 25 years, serious challenges remain, especially for developing economies. Human capital consists of the knowledge, skills, and health that people invest in and accumulate throughout their lives, enabling them to realize their potential as productive members of society. Investing in people through nutrition, health care, quality education, jobs, and skills improves human capital development—a critical component in ending extreme poverty and creating more inclusive societies. Despite development gains over the past 25 years, gaps in human capital are widening amid rapid global changes in technology, demography, fragility, and climate. Conflict events and pandemics can have a devastating effect on human capital through loss of life, livelihoods, nutrition, and the interruption of essential health and education services. Such impacts reverberate throughout many individuals’ lifespan, limiting their total productivity. Despite these known effects, investment in people are relegated to a lower economic priority.40 In the TCc, a dramatic reversal of the declining trend of the infant mortality rate points to the need to develop more data to understand the causes and inform needed measures to address them. The infant mortality rate is the number of infants dying before reaching 1 year of age per 1,000 live births in a given year. In addition to providing information regarding maternal and infant health, the rate is a primary indicator of a society’s overall health. Ending preventable deaths of newborns and children under 5 years of age is a major priority on the list of the SDGs (Target 3.2). Compared with 1961, the infant mortality rate in all EU member states, including the RoC, has fallen dramatically. Over the past decade alone, the infant mortality rate in the EU fell from 4.0 deaths per 1,000 live births in 2010 to 3.1 deaths per 1,000 live births in 2021 (Figure 1.31). Türkiye has a higher incidence of infant mortality. However, it too has made remarkable progress, halving infant deaths from 15.5 to 7.7 per 1,000 live births in the past decade. Meanwhile, the TCc, which had the lowest infant mortality rates in previous years, shows an alarming reversal in infant mortality reduction. While the infant mortality rate in the TCc remained between 2 and 3 deaths per 1,000 live births, it started increasing after 2016 and surpassed 7 deaths per 1,000 live births in 2021. Possible socio-economic factors driving the recent rise in the indicator could include the indirect effects of the COVID-19 pandemic. The direct impact of COVID-19 on child, adolescent and youth mortality seems to be limited, but there is concern that the indirect effects of the pandemic on mortality in these age groups due to strained health systems, household income loss, and disruptions to care-seeking and preventative interventions, such as vaccinations, may be more substantial.41 Additional factors contributing to a deterioration in infant health may be related to: (i) the decline in ‘public’ health expenditure, which declined from 3.6 percent of GNP in 2019 to 3.1 percent, and from 9.9 percent of total spending to 7.6 percent over the same period; (ii) aging health infrastructure and a reduced availability of ventilators during the pandemic, and numbers of physicians/health personnel; and (iii) reduced levels of education of expectant mothers, such as breast-feeding, and also family planning and birth control methods, among other. Other factors could include access to clean drinking water, hygienic conditions, and maternal health. The COVID-19 pandemic took its toll on education outcomes more severely in the TCc in 2020. The gross enrolment ratio—namely the ratio of total enrolment, regardless of age, to the population of the age group that officially corresponds to the level of education shown42—indicates the capacity of each level of the education system. A high ratio may, however, reflect a substantial number of overage children enrolled in each grade because of repetition or late entry rather than a successful education system.43 40 41 42 43 40 In 2018, the World Bank launched the Human Capital Index (HCI), which quantifies the contribution of health and education to the productivity of the next generation of workers. The index is a summary measure of the amount of human capital that a child born today can expect to acquire by age 18, given the risks of poor health and poor education that prevail in the country where she lives. The index was updated in 2020 and covers 98 percent of the world’s population. Read more at: https://www.worldbank.org/en/publication/human-capital#:~:text=The%20Human%20Capital%20 Index%20(HCI,the%20next%20generation%20of%20workers. 41 Source: https://data.unicef.org/topic/child-survival/covid-19/ 42 UNESCO Institute for Statistics (UIS). UIS.Stat Bulk Data Download Service. Accessed October 24, 2022. https://apiportal.uis.unesco.org/bdds. 43 Enrolment indicators are based on annual school surveys, but do not necessarily reflect actual attendance or dropout rates during the year. Also, the length of education differs across countries and can influence enrolment rates, although the International Standard Classification of Education (ISCED) tries to minimize the difference. 24 l NAVIGATING THROUGH CHALLENGING TIMES Ensuring, among other things, the completion of equitable and good-quality primary and secondary education to all school-age children is crucial for development and is a major priority on the list of the SDGs (Target 4.1), which call for all children to complete free, equitable and quality primary education, leading to relevant and effective learning outcomes, by 2030. From the late 1990s, the level of primary education in all EU member states has remained high. However, over the past decade, the gross enrolment ratio in primary education in the EU declined from 103.4 percent in 2013 to 100.5 percent in 2020 (Figure 1.32). Türkiye also has a high level of primary education. However, it too has had a reversal in the past decade, when its primary education gross enrolment ratio fell from 107.2 percent in 2013 to 93.2 percent in 2017, after which it started to rise once again and stabilized at 97 percent in 2019. While the RoC showed low levels of education in the 1970s and 1980s, the gross enrolment ratio in primary education jumped from 80.5 percent in 1992 to 101.1 percent in the following year, and since 2005 has maintained a stable rate above 90 percent. The TCc also experienced an increase in the primary enrolment rate44 over time. However, the ratio decreased more in 2020, by almost 3 percent, from 95.3 percent in 2019. A similar drop is observed in the pre-primary enrolment rate (Figure 1.32). Despite both ratios recovering in 2021 back to their pre-pandemic levels (not shown in the figures), the relatively sizable drop in 2020 compared with that observed in the EU or the RoC, suggests that long-lasting scars from the pandemic losses may be more severe. Figure 1.31 Mortality rate, infant (per 1,000 Figure 1.32 School enrolment, pre-primary live births) and primary (% gross)45 Source: WDI and TCc Statistical Yearbook 2021. Source: WDI and TCc Statistical Yearbook 2021. Note: For the TC economy, ‘primary school includes ‘primary and junior high school’ (5–14 age group). Finally, relatively low pre-primary enrolment rates, when compared with the EU average, also reflect low female participation in the labor force both in the TCc and the RoC. Childcare challenges can be a barrier to work, especially for mothers who disproportionately take on unpaid caregiving responsibilities when their family cannot find or afford childcare. Studies show that the universal free pre-primary policy has a positive impact on the labor force participation of mothers with pre-primary school age children.46 In some cases, the availability of private preschools instead do not increase work participation of women in the labor market, but instead increases the likelihood of holding a second job. The availability of preschools induces mothers to informal sector occupations that do not require full-time 44 45 commitments.47 The reopening of schools may not be enough to return mothers’ labor force 46 47 48 49 participation back to its pre-pandemic levels.48 This is particularly relevant for the TC economy, since women made up for 76 percent of job losses in 2020 and only partially returned to work in 2021.49 44 Education in TC is compulsory until the age of 15 and the literacy rate is almost 100 percent. Specifically, the education system consists of pre-school education (for children between the ages of four and six), primary education (7–12 age group, it lasts for five years and is free and compulsory), secondary education (13–15 age group, it lasts for three years and is free and compulsory) and higher education (16–18 age group, it lasts for three years). 45 The gross enrolment ratio is the ratio of total enrolment, regardless of age, to the population of the age group that officially corresponds to the level of education shown. 46 See for example, Li (2020) and Ilin et al. (2022). 47 See Halim et al. (2019). 48 https://www.brookings.edu/research/the-relationship-between-school-closures-and-female-labor-force-participation-during-the-pandemic/ 49 Source: LFS. l 25 NAVIGATING THROUGH CHALLENGING TIMES Table 1.2 Key economic indicators of the TC economy   2018 2019 2020 2021 2022e 2023f Real economy Real GDP, % change 1.3 0.2 -16.2 3.9 9.6 1.3 Agriculture, % volume change 2.6 2.7 1.8 -1.5 -6.1 -5.0 Industry, % volume change -12.4 -14.6 -15 16.8 3.0 -5.0 Services, % volume change 3.2 1.4 -18.4 7.9 12.1 5.1         CPI, period average, % change 23.1 19.5 11.7 21.4 94.5 70         Fiscal accounts       Revenues, % GDP 29.8 34.6 35.5 29.7 30.2 28.6 Expenditures, % GDP 29.8 35.9 40.6 34.5 32.7 33.8 Fiscal Balance, % GDP 0.1 -1.3 -5.2 -4.8 -2.5 -5.1 excluding aid from Türkiye, % GDP -2.4 -4 -10.1 -9.2 -6.6 -10.4         Local Balancea % GDP 0.9 -0.5 -3.5 -2.5 -1.9 -4.3         ‘Public’ Debt, % GDP 120.1 142.1 168.2 156.3 140.8 126.9 Internal, % GDP 30.0 37.9 44.4 40.5 38.5 33.5 External, % GDP 90.0 104.2 123.8 115.8 102.2 93.4       Balance of Payments       Current Account Balance, % GDP 5.7 11.8 -8.5 -1.4 -3.9 -6.8 Excl. foreign grants, % GDP 3.3 9.1 -13.5 -5.8 -8.0 -12.0               Source: ‘SPO’, ‘statistics office’ and World Bank staff. Note: e=estimate; f=forecast. Forecast may be subject to revision as data for 2022 become available. a Local Balance is computed as the difference between local revenues (total revenues, excluding grants from Türkiye) and local expenditures (total expenditures, excluding the ones financed by Türkiye). 26 l NAVIGATING THROUGH CHALLENGING TIMES Special Issue: Do Fiscal Policies Help Reduce Income Inequality in the Turkish Cypriot Economy? Income inequality in the TCc is considerably 2. how does TCe compare with other higher than in most European economies. economies in terms of the distributional Using data from the 2015 Household Budget impact of its fiscal policy? Survey, the Gini coefficient in the TCc is estimated to be 34.1 percent, 3 points above 3. how can the analysis be used to inform the EU average of 31 percent. This places policy reform? the TCc at the higher end of the range of economies for which similar estimates can be 2.1 An overview of taxes in the derived using Eurostat data, which show this Turkish Cypriot economy measure varying from 24 percent in Slovakia Revenue collection of the TCc ‘administration’ to 40 percent in Türkiye. Income inequality in is relatively low compared with EU economies. the TCc is also much higher than in other small While the EU average for tax-to-GDP50 ratio islands such as Malta (28.1 percent), Iceland is around 41.7 percent in 2021, it was only (24.7 percent), and the RoC (33.6 percent). 19.7 percent for the TCc ‘administration’. The relative poverty rate in the TCc - derived As the recovery gains speed, increasing tax following the Eurostat methodology of revenue mobilization is key to build fiscal proportion of households with an equivalized space to counteract future shocks. In the TCc, disposable income below 60 percent of the median equivalized disposable income revenue collection is largely implemented at - is estimated at 22.2 percent. This is high the central level. Total tax revenues constitute compared with the EU average (17 percent) 19.7 percent of GDP, according to the most and it is among the highest ones, after Serbia, recent information in 2021, of which indirect Romania, Türkiye and Latvia. taxes (value-added tax [VAT], and customs and excise tax) account for 35 percent of all the This Special Issue assesses the effectiveness of tax revenues or 7 percent of GDP, while direct fiscal policies in reducing poverty and income taxes (personal income tax [PIT] and corporate inequality in the TCc. These policies include income tax [CIT]) constitute 44 percent of all taxes, fees to collect revenue and transfers tax revenues or 8.6 percent of GDP in 2021. to support households, including subsidies, Overall, around 79 percent of the fiscal pensions, other direct transfers, as well as revenues in the TCc come from four primary education and health. Their distributional sources (PIT, VAT, CIT and customs and excise impact depends on which households bear duties), and the remaining 21 percent are the relative burden of taxes and which ones primarily from other tax revenues (property benefit from transfers and social spending. tax, 4%; duty fees, 7%; vehicle tax, 2%) or non- The identification of the distributional effects tax revenues (around 8 percent). of existing policies and new reforms can play a key role in redistributing the benefits 1. Direct Taxes of economic growth and in enhancing the incomes of poor households. This chapter Personal income tax is the primary presents the first attempt to quantify their source of direct tax collection in the TCc distributional impacts; in essence, the analysis ‘administration’. PIT applies progressive aims to answer the following three key taxation to labor income and other sources questions: of individual income. PIT is collected monthly through withholding on labor income and 1. what is the overall impact of fiscal policy on through annual declarations. Personal income inequality and poverty? tax brackets range from 10 to 37 percent. 50 Includes taxes and social contributions l 27 NAVIGATING THROUGH CHALLENGING TIMES Table 2.1 Key parameters for PIT and allowances (TL, per year) 2019 2020 2021 2022 2023 Annual personal discount 28,300 36,800 42,000 75,600 150,000 Top of 10% bracket 5,000 15,000 Top of 20% bracket 10,000 30,000 Top of 25% bracket 19,000 57,000 Top of 30% bracket 30,000 90,000 Top of 37% bracket 30,000+ 90,000+ Source: TCc ‘tax department’. Note: There is also a max SSC. In 2023, this amounts to 94,941 TL (per month). A set of several allowances is used to further the TC system also foresees a minimum and inject progressivity into the system. Beyond maximum contribution. the personal allowance reported in Table 2.1, there are six more categories of allowances: a Finally, among direct taxes, property-related special allowance on PIT due on net earnings taxes are paid according to the type of for employees; an allowance for the dependent property. Property owners pay property taxes spouse; an allowance for dependent children, to local administrative units, and it is based which varies with the number of children; a on the square meter size of the property. disability and old-age allowance; an allowance However, the central ‘administration’ collects for social security expenses; and an allowance VAT from the buyers and income tax from the for expenses for municipal occupation tax and sellers in case of an exchange of properties. life insurance premiums. Allowances apply to all individuals and reduces the effective tax 2. Indirect Taxes rate for personal income tax significantly. Among the indirect taxes facing households, Similar to other economies, there is only VAT in the TCc is the major indirect tax one Social Security Contribution (SSC) revenue55 and is characterized by numerous rate, independent of the income level. The rates and exemptions. In the TC economy, contribution rate to the Social Security Fund is five VAT rates are applied: 0, 5, 10, 16, and 20 applied on the gross wage and amounts to 11 percent. The standard VAT rate of 16 percent is percent for the employer and 9 percent for the below the EU average and applies only to a very employee.51 The employer’s rate is relatively limited set of products56 due to the long list of low compared with the OECD/EU economies. reduced rate goods. A few basic goods, such as The TCc ‘administration’ contributes 6 percent, agricultural raw materials, cereals, and milk, bringing the overall SSC rate close to the OECD/ have 0 percent VAT rate. Most intermediary raw EU average.52,53,54 Similar to other economies, products such as flour, honey, cheese, diapers, 51 From the gross taxable income, 13 percent of the mandatory SSC can be deducted. 52 Most OECD economies adopt instead a progressive schedule. Among them, five adopt a minimum threshold for employer SSC, while 13 countries adopt a maximum threshold (which does not necessarily correspond to maximum PIT income threshold), hence de facto setting the maximum SSC rate. Finally, nine countries instead do not apply any income thresholds to SSCs. 53 In the RoC, since January 1, 2019, the employees’ own contribution to the state-administered social insurance fund is 8.3 percent of their gross remuneration, with a maximum annual cap on insurable emoluments as of January 1, 2023, of EUR60,060. The rate of 8.3 percent applies for both employee and the employer up to December 31, 2023. Thereafter, the rate will increase every five years by 0.5 percent until it reaches 10.3 percent as of January 1, 2039. 54 A similar provision exists in the RoC. Source:https://ec.europa.eu/employment_social/empl_portal/SSRinEU/Your%20social%20security%20rights%20in%20Cyprus_en.pdf 55 Other major indirect taxes are customs taxes and taxes from the vehicles, and additional fees. 56 Most services and products not defined by law are subject to 16 percent VAT rate. For specific products, which fall under a reduced rate of 5 percent regime in the EU, namely feminine hygiene products, a high rate of 16 percent is applied. The VAT rate of 20 percent is applied the alcohol, tobacco and luxury items. 28 l NAVIGATING THROUGH CHALLENGING TIMES property, and related items with construction 2.2 The impact of fiscal policies have 5 percent VAT rate. Fossil fuels, fizzy on poverty and inequality in the drinks, all kinds of prefabricated products, TCc wooden or metal materials and similar items are subject to 10 percent VAT. Alcoholic drinks, The distributional impact of fiscal policy in all kinds of tobacco-related products and all the TCc is assessed through the Commitment luxury services and products are subject to to Equity (CEQ) methodology. The CEQ, based 20 percent VAT. In addition, tax on ‘customs’ on Lustig (2018), is a comprehensive incidence analysis that uses data from household constitute a large share of revenue collection surveys and administrative accounts to assess in the TCc (around 25 percent). Tax on motor the impact of taxes and social transfers vehicles, communication tax, electricity on household poverty and inequality. ‘municipal’ tax, water ‘municipal’ tax and road Box 1 provides a brief explanation of the tax are also paid by the consumers of these methodology and data used. The approach goods and services. has been applied in over 70 economies. Box 1: The Commitment to Equity (CEQ) model for the TCc: methodology and data The method is based on an accounting approach; it adds and subtracts taxes and transfers to household per capita income to measure income before and after each fiscal intervention. The per capita household income after transfers and taxes Yh for household h is given by (1) where Ih is the income before taxes and transfers, Ti are the taxes paid by households (i is the range of taxes analyzed), Bj are the transfers received by households (j is the range of transfers studied), and Sih and Sjh are the share of tax i and transfer j paid and received by households, respectively. The CEQ measures the distributional impact of fiscal policy sequentially by defining four income concepts (Figure 2.4). First, market income is the income received by each household before taxes and transfers. It includes wages and salaries, income from capital (e.g., rents, profits, and dividends), private transfers (e.g., remittances), and other income, all before administration taxes, social security contributions, and transfers. Second, disposable income includes the impact of direct cash transfers and subtracts PIT and employee contributions to social security from market income. Third, consumable income subtracts the impact of indirect taxes on consumption (e.g., VAT and excises) and adds indirect subsidies to the disposable income. Lastly, final income adds the social spending on education and health as in-kind public transfers to consumable income. The main source of information is the 2021 Household Budget Survey, a representative household survey that collects detailed information on consumption, labor income, social assistance, pensions, remittances, financial income, assets, housing characteristics, accessibility to labor and financial market, health services, education opportunities, and individual characteristics such as education, health, and labor market status and experience. The survey has been collected every 6–7 years. The survey interviewed 1,391 households in twelve months and is representative at the administration and urban/rural level. The survey collected data on the most important dimensions of welfare, which is expected to support evidence-based policy making in areas such as education, health, housing, employment, and poverty alleviation. The survey also gathered information on the consumption patterns, income, and expenditures of the households in the TCc, intended to update the Consumption Price Index basket and inform calculations of economic activity. l 29 NAVIGATING THROUGH CHALLENGING TIMES To measure progressivity, the CEQ follows the standard practice and use the Kakwani index (Kakwani, 1977). A tax (benefit) is progressive whenever its burden (entitlement) rises (decreases) with income. In the case of transfers, the index is defined as the difference between the Gini coefficient of market income plus pensions (when pensions are treated as deferred income) and the concentration coefficient of the transfers. For each tax, the Kakwani index is calculated as the difference between the concentration coefficient of the tax and the Gini coefficient of market income plus pensions. A Kakwani index for taxes will be positive (negative) if a tax is globally progressive (regressive), while a Kakwani index for transfers is positive if a transfer is progressive in relative terms. Figure 2.1 Income concepts under the CEQ analysis Source: Lustig (2018). The fiscal system in the TCc contributes to a deferred income or transfer.57 After direct moderate reduction in income inequality. taxes and transfers are included, the Gini Figure 2.2 shows how the measurement of further declines to 0.411 at disposable income. inequality changes before and after fiscal At consumable income, the Gini increases policy interventions are accounted for – slightly to 0.414 after including indirect taxes. namely, at market income, disposable income, Finally, in-kind education and health spending and consumable income. Before any fiscal has the largest equalizing effect, with the policy, described with market income in the Gini dropping to 0.361. Overall, inequality analysis, the Gini coefficient is 0.493 and it in TCc drops from 0.445 to 0.361 after fiscal drops to 0.445 when pensions are added. It interventions, a reduction of around 0.08 of a is critical whether pensions are treated as Gini point (Figures 2.2 and 2.3). 57 The CEQ uses two different options to treat pensions. Contributory pensions as pure deferred income refers to the scenario where the workers save a share of their earnings during employment to receive as a pensions when they are retired. Contributory pensions as administration transfer refers to the scenario where the retirement pensions are mainly sponsored by administration budget. When we treat the contributory pensions as deferred income, pensions are included in the market income and excluded the fiscal policy hence the poverty rate is lower compared to pensions as administration transfers scenario (where pensions are excluded from the market income and included in the fiscal policy). 30 l NAVIGATING THROUGH CHALLENGING TIMES Figure 2.2 Inequality before and after fiscal policy in TCc, 2021 Source: Own estimates based on TCc 2021 HBS. The TCc results are preliminary. Note: The figure shows the Gini coefficient for each income concept described in Box 1, Figure 2.1. Market Income refers to before and after fiscal interventions; Disposable Income refers to after direct taxes and transfers; Consumable Income refers to after indirect taxes and final income refers to after in-kind (education and health) transfers. Figure 2.3 Gini coefficient before and after fiscal policy in TCc, 2021 Source: Argentina (Ladronis et al., 2019); Poland (Goraus and Inchauste, 2016); Spain (Bengoechea et al., 2020). The TCc own estimates based on TCc 2021 HBS. The TCc results are preliminary. Note: Marginal contribution to equality is the difference between the Gini coefficient without the particular fiscal intervention and the Gini coefficient of all income components together. Fiscal policy in the TCc has significantly resources in the world (and for which a similar smaller contribution to reduction in income analysis is done). The objective of comparing inequality. Income inequality generally falls TCc with the best performers is to understand in all economies after taxes and transfers, the potential of fiscal policy to redistribute which implies that there is always some resources in an economy and promote inclusive fiscal redistribution. The differences are in growth. Reduction in income inequality can the magnitudes. Argentina, Poland and Spain reach up to 0.17 Gini points as in Spain and are used as comparator countries in this Argentina and 0.13 Gini points in Poland, while analysis. These countries are among the ones the reduction in income inequality after fiscal that achieved the highest redistribution of policy was only at 0.08 Gini points in the TCc. l 31 NAVIGATING THROUGH CHALLENGING TIMES TCc’s fiscal system is not effective in For a better understanding of the changes in reducing poverty. Figure 2.4 shows how the inequality and poverty brought by taxes and measurement of poverty changes before and transfers, Figure 2.5 looks at the incidence after fiscal policy interventions are accounted of fiscal interventions across households, for – namely, at market income, disposable as a share of market income plus pensions. income, and consumable income. If pensions When only cash transfers are considered (i.e.. are considered as deferred income, market excluding in kind benefits such as health and income (before taxes and transfers) increases, education), only households in the bottom thus poverty measured at market income 10 percent of the income distribution are net is lower at 20.9. If pensions are treated as beneficiaries of the system and their net cash transfers, hence as a fiscal policy item, market position is positive (Figure 2.5). In other words, income is instead lower, thus poverty higher these households receive higher transfers at 24.1. After taking into account all direct than the taxes they pay. For households in transfers and direct taxes, poverty is estimated the second decile and above, cash transfers at 21.8. However, since indirect taxes are received are not sufficient to offset the burden regressive and have a significant impact of taxes. These households are net payers into on household budgets, eventually poverty the system with a negative net cash position. increases from 21.8 to 25.5 percent. The effects of spending on education and health provide significant positive benefits to In-cash transfers only are not sufficient to all households. These in-kind transfers improve offset the burden of taxes across all deciles of the impact of fiscal policy in the bottom half the distribution but the bottom 10 percent; of the distribution, with all households in the in-kind transfers, such as education and 1st to 5th decile reporting a positive net fiscal health, have important redistributive effects. position. Figure 2.4 Poverty before and after fiscal policy in the TCc, 2021 Source: Own estimates based on TCc 2021 HBS. The TCc results are preliminary. Note: The figure shows the poverty rate for each income concept described in Box 1, Figure 2.1. Market Income refers to before and after fiscal interventions; Disposable income refers to after direct taxes and transfers; Consumable income refers to after indirect taxes and final income refers to after in-kind (education and health) transfers. 32 l NAVIGATING THROUGH CHALLENGING TIMES Figure 2.5 Net cash position and fiscal position, by decile Source: Own estimates based on TCc 2021 HBS. The TCc results are preliminary. Note: The net cash position includes the monetary fiscal policies, taxes, transfers and subsidies. The fiscal position includes the monetary value of education and health spending (computed as total spending on education and health divided by number of beneficiaries, students for education and total population for health spending). Even though education and health spending do not affect the budgets of the households directly, they benefit households. Direct taxes are progressive in the TCc, but a slight increase in inequality (Figure 2.8). they are relatively low (Figure 2.6). Having The regressivity of indirect taxes in the TCc a progressive personal income tax bracket is the lowest among all economies. Other and generous allowances for low-income economies have more regressive indirect tax households lead to progressivity of direct systems compared with the TCc, while the un- transfers. Direct taxes include PIT, interest from equalizing effect of indirect taxes on income bank deposits tax and occupational municipal distribution in TCc is higher than in Argentina tax. Those taxes also contribute to reducing and Spain. The un-equalizing effect was higher inequality in the TCc. The direct tax system has in Poland as indirect taxes are the main source relatively moderate equalizing effect—higher of revenue collection. reduction in Gini points (0.015 reduction in Gini), compared with Argentina (0.009) and Overall, the inability of the TC system to Poland (0.013), while it is significantly lower reduce poverty, and the limited impact on than Spain (0.05). inequality, call for a more effective system to address inequality and reduce poverty. Direct transfers are progressive and contribute The direct tax and transfer system of the to a reduction in inequality (Figure 2.7). Direct TCc is redistributive, with progressive and transfers are successful to deliver cash transfers redistributive direct taxes, in line with other to low-income households, as the progressivity economies. However, indirect taxes are of the system is relatively high. The equalizing regressive and un-equalizing. Although direct effect of the direct transfer system, however, transfers are progressive, their impact on is significantly low. While progressivity of the reducing inequality and boosting the incomes system is comparable to other countries, it of low-income households is very limited is significantly less equalizing than in other due to low adequacy. With regards to in-kind economies, Spain (0.089), Poland (0.081), and transfers, both education and health have Argentina (0.055). The TCc allocates a smaller important redistributive effects. These results budget to social transfers as a share of GDP point to potential improvements that could be and the adequacy levels of cash transfers are relatively low. achieved in the TCc through a more effective system of taxes and transfers to reduce the Indirect taxes are regressive and lead to burden on the poor and to reduce inequality. l 33 NAVIGATING THROUGH CHALLENGING TIMES First, reallocating resources from subsidies to should also be prioritized as means to spur well-targeted cash transfers can achieve higher long-term growth and contribute to poverty reductions in inequality and poverty. Evidence and inequality reduction. Finally, revenue shows that subsidies tend to be regressive mobilization should be improved, especially and inefficient, with a large share of subsidies given the low tax revenue collection in the going to better-off households (World Bank, TC economy, while minimizing economic 2022b). Well-targeted cash transfers are distortions and negative distributional instead more effective mechanisms to support impacts. This can be done by broadening the poor and vulnerable groups. Second, high- tax base, reducing regressive tax exemptions, return investments in education, research and strengthening tax administration. and development, and infrastructure projects Figure 2.6 Direct taxes Source: Argentina (Ladronis et al., 2019); Poland (Goraus and Inchauste, 2016); Spain (Bengoechea et al., 2020). The TCc own estimates based on TCc 2021 HBS. The TCc results are preliminary. Note: Marginal contribution to equality is the difference between the Gini coefficient without the particular fiscal intervention and the Gini coefficient of all income components together. 34 l NAVIGATING THROUGH CHALLENGING TIMES Figure 2.7 Direct transfers Source: Argentina (Ladronis et al., 2019); Poland (Goraus and Inchauste, 2016); Spain (Bengoechea et al., 2020). The TCc own estimates based on TCc 2021 HBS. The TCc results are preliminary. Note: Marginal contribution to equality is the difference between the Gini coefficient without the particular fiscal intervention and the Gini coefficient of all income components together. Figure 2.8 Indirect taxes Source: Argentina (Ladronis et al., 2019); Poland (Goraus and Inchauste, 2016); Spain (Bengoechea et al., 2020). The TCc own estimates based on TCc 2021 HBS. The TCc results are preliminary. Note: Marginal contribution to equality is the difference between the Gini coefficient without the particular fiscal intervention and the Gini coefficient of all income components together. l 35 NAVIGATING THROUGH CHALLENGING TIMES References Alvarez J., John Bluedorn, Niels-Jakob Hansen, Fan, R.Y., Lederman, D., Nguyen, H. et al. 2023. Youyou Huang, Evgenia Pugacheva, and Calamities, Debt, and Growth in Developing Alexandre Sollaci. 2022. Wage-Price Countries.  IMF Econ Rev  https://doi. 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Disaster Risk Profile: Cyprus. https://www.gfdrr.org/en/publication/ disaster-risk-profile-cyprus l 37 NAVIGATING THROUGH CHALLENGING TIMES Disclaimer The opinions expressed in this study are those of its authors and do not reflect any official opinion by the European Commission, the World Bank Group, its Board of Directors, or the governments they represent, nor do they in any way constitute recognition of boundaries or territories. The term ‘Turkish Cypriot community’ refers, solely for the purposes of this study, to the areas in which the government of the Republic of Cyprus does not exercise effective control. If reference is made in the report to any ‘ministries’, ‘departments’, ‘services’, ‘bodies’, ‘organizations’, ‘institutions’, and ‘authorities’ in the areas not under the effective control of the government of the Republic of Cyprus, or respective acronyms or abbreviations are used, it is to allow a clear factual understanding of the administrative structures in the Turkish Cypriot community and shall not imply recognition of any public authority in the areas other than the Government of the Republic of Cyprus. Similarly, comparisons between the areas where the government of Republic of Cyprus exercises effective control and those areas where it does not are factual only. 38 l NAVIGATING THROUGH CHALLENGING TIMES l 39 Contact Person: Goran Tinjic, Program Manager for Southern Europe, g�njic@worldbank.org