In its Article IV consultation, the IMF underscores that: "Decisive and credible measures to reverse the fiscal slippage and put the public debt ratio on a declining path are essential to restore access to capital markets, safeguard the confidence of investors that underpins Cyprus’ role as an international financial center, and protect the competitiveness of the economy".

Fiscal consolidation, while necessary to restore sound public finances and lay the foundations for durable growth, may dampen demand in the short-term, the IMF has warned. As a result, the economy is expected to show little, if any growth this year, and to register a small contraction in 2012.

“Bold corrective actions can set the stage for resumption of economic growth, based on the underlying strengths of the Cypriot economy," the IMF said. "These [strengths] include a successful international services sector built on the foundation of a highly-educated workforce and entrepreneurial spirit.”

Discussing future tax policy, the IMF welcomed recent policy decisions taken by the government in August, and agreed by parliament, which included the introduction of a new top personal income tax rate and increases to fees paid by companies.

“The government has set ambitious targets that would deliver a large reduction in the deficit in 2012 and a balanced budget within three years. This timeframe strikes an appropriate balance, providing for large up-front savings while avoiding an excessive contraction in demand in the near term,” the IMF noted.

“The measures passed in August were an encouraging first step towards achieving the government’s fiscal targets, in particular the introduction of contributions by public sector employees towards their pensions,” it added.

The IMF said that the reduction of the country's 7% of GDP deficit must be rapid in order to have the desired effect in restoring confidence.

In order to achieve the necessary adjustment, forthcoming] measures should comprise actions to contain public sector wages and benefits, such as a freeze of the cost of living allowance; targeting of social transfers, while protecting the social safety net for the most vulnerable; and an increase in the Value-Added Tax rate to 17%, which is still be well below the EU median level of 20%, the IMF recommended.

“The government should now move quickly to pass into legislation specific measures in the context of a credible multi-year consolidation plan for 2012-14. It should ensure that the magnitude of the measures is fully sufficient to achieve the target of fiscal balance by 2014, and stand ready to take additional measures if needed in the period ahead,” the Fund said.

“Cyprus has taken initial steps towards budgetary reform, but further actions are necessary to support the introduction of a multi-year budgetary framework. More accurate revenue and expenditure estimates and fewer budget rigidities will reduce the need for supplementary budgets,” the report stressed.

The IMF also recommended that reorganization of the revenue administration to combine separate departments that administer different taxes with limited exchange of information, will improve efficiency. Reforms in these areas will help the government succeed in its fiscal consolidation efforts, it said.