Is Sri Lanka’s Fiscal House in Order?

Economic downturnBy Todd Schneider.                                               

Constructing a good budget is like building a good house. The foundation needs to be solid, high-quality materials make a big difference to durability, and careful craftsmanship will bring both stability and confidence to weather future storms. Similarly, budgets needed to be well grounded and credible, built with care to ensure both equity and support high levels of inclusive economic growth, and have enough room to adapt to shocks. Sri Lanka’s proposed budget brings many of these elements to the table, but the devil is in the details and some proposals raise questions.

The proposed budget is right to emphasize the secular decline in government revenue over the past two decades and to make reversing this trend a top priority. Sri Lanka’s tax-to-GDP ratio is one of the lowest in the world, and estimated tax efficiency is low compared with peer countries. However, the targeted rise in public revenue (tax and non-tax) of almost 40 percent seems ambitious—perhaps overly ambitious. This compares with the average rate of revenue growth over the past 20 years of 12 percent. Apart from being an unprecedented increase, the main underlying measures—for the most part—are likely to work toward lowering revenues. For example, the budget proposes to (i) reduce the rate of the value added tax (VAT); (ii) introduce multiple VAT rates (a practice that generally makes the tax more difficult to administer); (iii) reverse the extension of the VAT to the wholesale and retail sectors; (iv) raise significantly the threshold for the personal income tax; and (v) introduce new tax exemptions. Non-tax revenue is projected to rise by 300 percent, but the specific measures to achieve this increase are not clearly specified.

On the spending side, there are legitimate and long-standing public investment needs, and the projected increase in capital expenditures is welcome in that context. But the concern is whether the overall targets can indeed be met. Overall expenditures are expected to grow by a brisk 30 percent—with recurrent and capital spending increasing by 17 and 70 percent, respectively. After the sharp rise in wage and salary spending under the 2015 budget, the increase in spending in this area is expected to be contained to just 7 percent. However, spending for other goods and services almost doubles, and the reason for this has yet to be clarified. The increase in capital expenditures is ambitious, and from a macroeconomic perspective, a positive commitment given the need to bolster infrastructure in support of sustained economic development and growth. The risk is that capital spending could be slashed in the event of revenues falling short—which has been the case for the past several years. This underscores the need for realistic revenue estimates which would then provide greater certainty to the path of critical expenditures.

Even assuming the budget is executed as planned, there is still the question of how to finance a deficit close to 6 percent of GDP. The budget envisions a second year of heavy reliance on domestic debt—covering about three-quarters of the total deficit, with the remainder financed by issuance of new external debt. Here again, the numbers should raise questions. A large portion of new domestic financing is assumed to come from Sri Lanka’s nonbank financial sector, while bank financing (which rose precipitously in 2015) is projected to fall. It is not clear whether the nonbank sector has the liquidity to cover this financing gap.

Perhaps of greatest concern are not the absolute numbers, but the direction of policies and the lack of a medium-term context. The fundamental problem with Sri Lanka’s public finances—as amply highlighted in the budget speech itself—is low revenues. The fundamental solution to this problem involves restructuring the tax framework and tax administration to make the system simple, fair, and efficient. The proposed budget falls far short of steps needed to move the Sri Lankan tax system in this direction. Without such commitments, medium-term prospects may suffer from the same weaknesses seen in the past—continued deficits, tight limits on needed investment in infrastructure and human capital, and a persistent overhang of public debt that undermine Sri Lanka’s ability to cope with shocks.

What is needed? In the near term, spending has to be held in check. Careful scrutiny is needed to ensure that taxpayer funds are invested in such a way that maximizes public benefit and raises Sri Lanka’s capacity for sustained and inclusive growth. Revenues need to rise quickly enough to reduce the government fiscal deficit and allow public debt to fall. Several steps are needed. First, so called “tax expenditures” (exemptions, holidays, and special rates) need to be clearly outlined in the budget itself so that policy makers and the public can evaluate their cost in terms of foregone revenue. Second, most of these exemptions should be eliminated—which would significantly increase the tax base and spread the burden of public finance more broadly (and more fairly). Third, the structure of taxation (particularly the many rates which make the direct tax system almost indecipherable) needs to be simplified—the budget proposal to redraft Sri Lanka’s tax legislation is a good first step in this regard. Taken together, these steps would not only rebuild revenue, but also increase transparency, level the playing field, and help to ensure greater equity in taxation.

Prime Minister Wickremesinghe’s November 5 speech to parliament set out two major policy milestones: A budget deficit of 3.5 percent by 2020, and elimination of tax exemptions. It would be a welcome development to see the first steps toward these objectives captured in the 2016 budget—a new foundation for Sri Lanka’s fiscal house. (LBO)

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