Barking up the wrong tree: Economic bankruptcy due to tax cut policy

The country became insolvent after the government of President GR granted massive tax concessions, Leader of Opposition SP was quoted as saying in Parliament on July 6, when the Speaker announced that a select committee of Parliament has been appointed to investigate the causes of the financial bankruptcy.

Shed light on reasons for tax cuts and increases thereafter

The Covid-19 outbreak could be considered as the biggest health and economic challenge faced by mankind in the century. According to the health authorities and some independent analysts, Sri Lanka had successfully avoided the worst of the Covid pandemic at the outset in early 2020. 

However, the second wave of Covid in October 2020 and an even deadlier third burst of infections in April 2021, including the highly infectious Delta variant, forced the then government to restrict movements and day-to-today economic activities as demanded by many key opinion leaders (KOLs) and opposition political parties.

How did the central banks worldwide react to Covid-19? According to the IMF report 2022, the governments worldwide introduced both conventional and unconventional policy responses to address the challenges and these measures include monetary policy relaxation, government-led fiscal measures such as tax cuts, direct cash payments to affected people, moratorium, etc. 

The then government and CBSL also introduced a series of extraordinary policy measures to provide liquidity to the Sri Lankan economy and to businesses, especially for the MSME sector through the banking system. They had announced a package of relief measures such as interest-free loans, issue of food items free of charge, moratorium on leasing, loan repayments, etc. These relief measures and the concessions had been continued, in order to stimulate the economic activities, as in the case of other countries. 
This was considered a high priority, although it costs a lot of money and an additional burden on the General Treasury and Central Bank. Nobody had ever objected to these extraordinary measures taken by the government because it was essential to provide relief to the people affected by the economic downturn that resulted in the loss of livelihoods, loss of employment among a large section of the people and high cost of essential consumer goods due to
supply-side disruptions.

The income tax reduction announced in December 2019 by President GR was also continued for the next two and half years as well, in order to stimulate the economy. 
Prof. Gregory Mankiw at Harvard University, who wrote many textbooks on economics and continued with his research work, believes that tax cuts have a powerful influence on both aggregate demand and aggregate supply. This process increases household disposable income, as emphasised in Keynesian analysis. 
When a government reduces taxes, workers, including top professionals and academics, have a greater incentive to work longer hours, which means production and services in the economy expand without putting upward pressure on inflation. To be sure, reduction of interest rates through CBSL’s monetary policy is the first line of defence against economic downturn by increasing money supply. 

These measures of the government have in fact helped to achieve a positive economic growth rate of 3.5 percent in 2021. Since 2014, the economic growth has been declining and the GDP rates were negative during the last four years, starting 2019, 2020 and 2022,
except in 2021.

Both manifestos proposed tax reductions in 2019

Interestingly, both manifestos put up by the two main candidates during the 2019 Presidential Elections, namely GR under the SLPP and SP of the NDF, had clearly proposed tax reductions to be granted through necessary amendments to the Inland Revenue Act. The winning candidate is obliged to honour the promises given to the people at the elections. President GR received a massive mandate of 6.8 million votes, whereas both candidates have received a total sum of 94 percent of the overall votes cast. 

In fact, some had praised the tax reduction proposal as soon as GR came to power in November 2019. It is interesting to note that even the Ceylon Chamber of Commerce (CCC), through a media statement on December 5, 2019, stated that it is optimistic the revisions in taxes and levies announced as part of the stimulus package by the government will revive
the economy. 

During the ‘Aragalaya’ period, the opposition members, some professionals and academics, including private sector KOLs, had started campaigning against the government aggressively and some were highly critical saying that the economic crisis was caused by lower taxes imposed and other economic policies adopted by the then government. 
Two most important goals of taxation policy are equity and efficiency, which are often in conflict. One of the 10 principles of economics is that people respond to incentives and this includes incentives provided by the tax system. Because taxes distort incentives, they entail ‘deadweight losses’ to the economy. The dead weight loss to the economy arising from high taxation could reduce the net gain to the economy, even after taking into consideration the additional tax collected. Therefore, the tax experts alone cannot determine the best way to balance these two goals, as this involves political philosophy. The authorities would have to consider the prevailing economic situation of the country as well.

Adverse consequences of higher taxes; unwinding relief measures 

With the IMF policy package, the government of President RW has increased the income taxes, including one-off super gains tax on corporates, PAYE, VAT, etc. One could argue although it’s a step in the right direction, whether the quantum of increase and the timing of such rate increases are unreasonable. Unwinding the relief measures is always challenging for the countries. Experts warn that a premature withdrawal of support packages may be detrimental to post-pandemic economic revival. 

The Institute of Policy Studies, an independent think tank, in its annual report ‘Sri Lanka State of the Economy 2021’, published in October same year, stated, “Raising taxes to trim Sri Lanka’s large fiscal deficit when economic support measures to deal with the pandemic is most urgent is counterintuitive. In the economic recovery phase too, such measures will inevitably be a drag on growth just when a strong growth rebound is required.” 
In simple terms, it’s far from common sense to raise taxes when such relief measures are considered a high priority. However, continuation of low taxes leads to fiscal imbalances and thus resorting to borrowings.  

Although the tax revenue has increased from Rs.1,288 billion in 2021 to Rs.1,751 billion in 2022, the overall fiscal deficit has in fact increased to Rs.2,460 billion, from Rs.2,057 billion in 2022. The government budget deficit during the first four months in the current year has also increased despite high taxes imposed and collected. According to the Census and Statistics Department, the economy contracted by a staggering 11.5 percent during the quarter, January to March 2023. Accordingly, Sri Lanka’s last three quarters’ growth rates are all negative.
Compared to the negative economic indicators as explained above, some of the positive features during the year 2021 are as follows. The export income has increased to US $ 12.5 billion in 2021 – this was the highest in US $ terms during the last five to six decades. In fact, the annual export average during the last 10- year period from 2010 to 2019 was only US $ 10.6 billion. Sri Lanka’s ever-increasing external debt figure, which was US $ 54.5 billion in 2019, for the first time in the recent past has been reduced to US $ 50.7 billion by end-2021. The GDP growth rate during the year 2021 was positive 3.5 percent, despite the negative impact arising from Covid; also, the annual average inflation rate was 7 percent in 2021, although the inflation expectations were high during the first quarter of 2022. 

As for inflation figures during 2021, both the headline and core inflation rates – even year-on-year (YoY) inflation – were in single digits except in December 2021, where headline inflation has gone up to 12.1 percent, based on the Colombo Consumer Price Index (CCPI). 

Prof. Edward Prescott at Arizona University and Nobel Laureate in his research papers stated that higher income and consumer taxes have adverse consequences to entrepreneurship and risk taking. As we know entrepreneurship is much lower in Sri Lanka, the high interest rates and taxes in Sri Lanka discourage new business creation. He emphasised that economic growth needs new ideas and new businesses require a large group of talented young workers, who are willing to take risks of starting a business or putting longer hours of their professional and academic knowledge, skills and competencies. 
“This requires undoing the impediments and increasing the after-tax returns to succeeding,”
he argued.

Conclusion

Although the total exports have increased in 2021 as well as in 2022, it was not clear whether the proceeds have been repatriated within the stipulated time period in terms of the directives issued by the CBSL under the Monetary Law Act. During the height of the Covid outbreak, the then government had made arrangements for a vast number of expat workers living abroad to come back to Sri Lanka.

Further, in anticipation of exchange rate depreciation, they would have retained forex proceeds resorting to ‘Hawala and Undial’ money transfer channels. A low level of foreign remittances received during the ‘one-year’ period from September 2021 would have been due to these reasons. 
As for outgoings in the forex account, a total sum of US $ 2.5 billion ISBs was settled during the period commencing 2020 till January 2022, thus maintaining an unblemished record of meeting sovereign debt obligations, until the ‘pre-emptive debt default’ announcement in April 2022.
It seems neither the CBSL nor the Finance Ministry had ever advised the president and the Cabinet since 2019 to April 2022 to withhold repayment of debt. By that time, the CBSL forex reserves had come down to near zero. With the import restrictions, including fuel rationing and the suspension of some foreign debt servicing, the overall demand for the US dollar has reduced. 

Nevertheless, the rupee exchange rate movement is highly volatile and at present, it is around Rs.310 per US dollar. These aspects need to be further investigated, in order to shed light on the real reasons for the forex shortages during the first half of 2022 and trade -off between inflation and
economic growth.
The Central Bank annual report 2021, presented on April 16, 2022 by the current Governor Dr. NW, in its overview in page one itself stated, “The ultra easy macroeconomic policy package by the government and CBSL helped the economic recovery in 2021 while also helping cushion the impact of the pandemic on a broader segment of the stakeholders, which in turn ensured uninterrupted provision of public services.” 

It can be concluded that there is nothing wrong in providing stimulus packages when required,   based on the needs of society/economy. However, proper timing is also a crucial factor when unwinding the support package and introducing ‘austerity’ programmes. The problem in economic analysis and interpretation is that most people tend to interpret data and evidence to confirm beliefs they already hold. The stories stemming from recent economic activities and performance were sometimes blown out of proportion in the media, without finding the truth. From the above analysis, it can be seen that the main cause of the economic insolvency is not the tax cut and stimulus package implemented during
2020 and 2021.

(Jayampathy Molligoda is a company Director and a former Chairman of the Sri Lanka Tea Board)