Sri Lanka’s Budget in Perilous Times

Sam Samarasinghe, in Sunday Times, 3 March 2019, where the title is “Budget 2019: Minister Samaraweera’s thankless task”

Finance Minister Mangala Samaraweera has the most thankless task in government just now. That is the management of public finances. Saying that Sri Lanka’s public finances are in a mess is a serious understatement. Many people think that the budget is a magic wand that can reduce prices, create jobs and perform other economic miracles. It plays an important role in the economy but is not a panacea for all ills.

File picture of Finance Minister Mangala Samaraweera presenting the 2018 budget in November 2017.

Budget deficit

Between 2010 and 2014 the Mahinda Rajapaksa administration spent Rs. 7,734 billion (18.2 per cent of GDP) but collected only 5,243 billion (12.4 per cent) in revenue and grants. The resulting deficit of Rs. 2,491 billion equal to 5.9 per cent of the GDP was met with Rs.1,086 billion (44.5 per cent) in foreign loans and Rs. 1.405 billion (56.5 per cent) in local loans.

Between 2015 and 2017 the Yahapalana government spent Rs. 7,197 billion (19.9 per cent of GDP) and raised Rs.4,994 billion (13.8 per cent) in revenue and grants. The resulting deficit was Rs.2,203 billion (6.1 per cent of GDP). It was covered with Rs. 1,038 billion (47.8 per cent) in foreign loans and Rs. 1,135 billion (52.2 per cent) in local loans.

At the end of 2009 central government debt as a ratio of GDP was 86.2 per cent and at the end of 2014 it was 71.3 per cent and at the end of 2017 77.6 per cent. But these figures are misleading because after 2009, under the Rajapaksa administration, a significant share of foreign loans that the government took at commercial interest rates were on the balance sheets of state banks and state-owned enterprises (SOE). For example, in 2012 the Bank of Ceylon raised US$500 million, and in 2013, Bank of Ceylon, National Savings Bank and Development Finance Corporation of Ceylon together raised $1.35 billion. The government is ultimately liable for such debt.

The Fiscal Management (Responsibility) Act (FMRA) was passed in 2003, mainly in response to IMF pressure. It stipulated that the public debt to GDP ratio should be reduced to 60 per cent by 2013. The actual ratio in 2003 was 102.3 per cent and in 2013 it was 70.8 per cent. In 2013 when the FMRA was amended and updated it was stipulated that the ratio must be reduced to 65 per cent by 2016 and further to 60 per cent by 2020. The actual ratio was 78.8 per cent in 2016, and 77.6 per cent in 2017.

It is clear that there is little to choose between the two parties in fiscal management, at least in terms of these numbers.

Bridging the deficit

Budget deficits can be met with local and foreign loans. There is no particular economic virtue to totally avoiding budget deficits and national debt. If the government uses long-term loans to fund education, health, highways, power plants and so forth that will benefit both current and future taxpayers it is reasonable to run a budget deficit to share the loan repayment burden across generations. But there are limits to deficits and debt. For Sri Lanka a budget deficit of around 3.5 per cent of GDP and a national debt between 50 per cent and 70 per cent are considered sustainable. The above figures show that Sri Lanka has exceeded these prudent boundaries that make deficits and the debt unsustainable and detrimental to economic progress.

Domestic borrowing

Increased government borrowing in the domestic credit market can increase interest rates for private business borrowers, house builders and others and crowd them out. In Sri Lanka successive governments have tried to mitigate this problem by providing subsidised credit to select groups such as farmers, small business and so on. Such schemes are expensive to run, often fail to meet targets, and a privilege for some borrowers but not others.

Government has the power to borrow as much money as it wants locally by issuing bonds to the Central Bank. In common parlance this would be “printing” money. It can lead to high inflation that is economically and socially harmful. In the worst-case scenario it can cause hyperinflation as happened in Zimbabwe about 10 years ago and is now happening in Venezuela.

Foreign borrowing

Borrowing from abroad without creating capacity to service such loans is a serious dereliction of fiscal duty. In 2019 Sri Lanka has to repay $5.9 billion to its foreign creditors. That sum equals 52 per cent of Sri Lanka’s total export earnings in 2017 and about 86 per cent of the country’s official foreign reserves at the end of 2018. This is a perilous situation.

Borrowing from the IMF

Successive Sri Lankan governments have sought assistance from the IMF. In recent years the IMF committed $2.6 billion to the Rajapaksa administration in 2009 and $1.6 billion to the Yaha Paalanaya admimstration in 2016. The amounts made available are relatively modest. The importance of an IMF facility is the signal it gives to other foreign lenders and investors that Sri Lanka’s finances are being placed on a sound footing.

Tax revenue

On the revenue side, Sri Lanka has had a very poor tax collection record in the past two decades. From the beginning of the Open Economy in 1978 until about 1996, tax revenue to GDP ratio was generally above 20 per cent. After 1995, the ratio has steadily declined to hit a record low of about 11.5 per cent in 2014. This is all the more troubling when GDP measured in US dollars increased by 514 per cent and the GDP per capita by 437 per cent during the same period.

There are three major tax problems that must be addressed.

Ad hoc taxes

The first is the proclivity to create a slew of ad hoc taxes that usually have a poor yield, are hard to collect, encourage tax avoidance and possibly corrupt practices, and definitely burden the limited capacity of the Inland Revenue Department (IRD). Many of these individual taxes also try to pick winners and losers by giving tax breaks to this or that industry. What is needed is a consistent general tax system with a level playing field that provides incentives to private investors, both local and foreign, to invest in whatever area that is most productive.

Reliance on indirect taxes

The second major tax problem is heavy reliance on indirect taxes such as value added tax and import duty which account for about 80 per cent of the tax revenue. These affect the poor much more than the rich because consumption is always a smaller proportion of income as one goes up the income range.

Weak direct tax base

The third problem is weakness in direct taxes, namely personal income tax, profit tax, capital gains tax, inheritance tax, and wealth tax. Direct taxes contribute only 20 per cent of total tax revenue. The richest 20 per cent of Sri Lankan households receive about 50 per cent of the total household income but they carry a relatively light tax burden. In effect we have a perverse tax system that taxes the poor proportionately more than the rich.

The limited number of active income tax files bear witness to the fact that the system is broken. IRD capacity must be built up. But political factors can stand in the way. For example it is an open secret that professionals resort to many ruses to avoid paying income tax. Mr. Rajapaksa’s group in parliament opposed the provision in the 2017 Inland Revenue Act that increased the tax on incomes that professionals earn in private practice to the same levels that other individuals have to pay.

Recurrent expenditure

This comprises expenditure on salaries, interest payment on debt and government transfers, for instance the Samurdhi scheme. The leeway in pruning such expenditure is very small. If at all the political pressure is in the opposite direction. For example, Yahapalana Government increased the monthly salary of government employees by Rs 10,000 in the interim budget it presented in January 2015 contributing to a sharp increase in the overall budget deficit from 5.7 per cent of GDP in 2014 to 7.4 per cent in 2015

Capital expenditure

This includes all government investment in such things as highways, power plants and ports. There is evidence that some of the projects that are grandly announced in budgets either do not get implemented or are badly behind schedule. Limited capacity in government to implement projects is one reason. A second is the lack of funds.

Emergency spending

There is one aspect of fiscal spending that is largely beyond the control of the government and can seriously upset even well designed fiscal plans. That is major emergencies such as a tsunami or a drought that requires the government to incur unplanned expenditure.

Conclusion

It should be clear from the above account that Sri Lanka has a problem with fiscal discipline both on the tax revenue side as well as the spending side. With elections due shortly, the temptation of any finance minister will be to extend the range of handouts for purposes of political expediency. It will make fiscal management even more difficult.

From a long-term perspective, efficient management of state-owned assets is key to economic success. In most countries, Sri Lanka included, the state is the single largest owner of productive assets when land, public buildings, railways, ports, airports, hospitals, schools and in Sri Lanka government owned enterprises such as the CEB, Petroleum Corporation and SriLankan Airlines, which the state owns, are included. Managing them efficiently to make them more productive is essential for economic success. Most economically successful countries manage to do so. Such success in turn makes fiscal management easier because productivity improves, waste is reduced, growth rate is boosted and tax revenues increased. Whether any government in Sri Lanka has the political will necessary to do so is another question entirely.

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