Economic policy – Are we down the wrong lane?

The current Sri Lankan economic policy emphasises on two salient points:

1. Boosting government tax revenue by increasing taxes

2. Reducing government debt 

The esteemed economists and the International Monetary Fund (IMF) seem to be in agreement with this approach. I disagree with both and of the view that the strategies built on the above will lead us deeper into economic wilderness. 

Higher taxes affect economic growth

Starting from the super gains tax in 2015, the increase in value-added tax (VAT) from 11 percent to 15 percent to the latest proposition of ‘debt repayment levy’, the focus has been on introducing more taxes. The corporate tax rates have also been increased for a number of sectors.  
The simple logic is, higher taxes impede investment and curtail consumption. Therefore, the impact would be felt in terms of economic growth as investment and consumption are two key components of economic growth. The statistics clearly show the impact (refer Figure I). 

Gross domestic product (GDP) growth has been anaemic at less than 5 percent over the last two years. In fact, it could even be lower than 4 percent in 2017, which is the lowest growth since the ending of war in 2009. As a result, the per capita GDP has been trapped at just over US $ 3,800 since 2014 and it is unlikely to be significantly better in 2017 and 2018 either. While tax increases may not be the only reason for poor growth, it is one of the main reasons.     

Poor growth makes debt burden larger

Let’s turn to the government debt position. Despite the rhetoric of ‘reducing high debt burden’, it has actually increased over the last few years. In absolute terms, the total government debt has increased by 39 percent from Rs.7,391 billion at end-2014 to Rs.10,269 billion by 
September 2017.

According to the Central Bank data, the debt to GDP, which was 71 percent at end-2014, has increased to 79 percent by end-2016. It would have gone well past 80 percent in 2017. Rather than the increase in debt, the issue is the poor economic growth, which makes the debt burden more ominous (refer Figure II). 

In a nutshell, the current economic strategy does not seem to be working.

A better economic strategy

A better economic strategy would be to take immediate steps to revive the economy and make higher growth the number one priority. The objective would be to push economic growth towards 5 – 6 percent immediately and then to 7 – 8 percent in a few years. 

To achieve this objective, the tax rates need to be brought down for identified, priority sectors, which would drive growth. The government capital expenditure should be focused to provide the necessary environment for those identified sectors. Increase in current expenditure should be managed, keeping in mind the short election cycles. 

As for budget deficit and government debt, let it be where it is. If the budget deficit is 5.2 percent of GDP, neither let it increase nor try to reduce it. If the government debt to GDP is 82 percent, neither let it increase nor try to reduce it. Once the economic growth reaches 7 – 8 percent and the economy is running steadily, gradually decrease the budget deficit and the debt position in the long term. In other words, let it be a lower priority right now. 

This is contradictory to the current economic policy.

Two key factors for successful policymaking

I would argue that there are two key factors for strong economic policymaking:

1. Ensure the right team is setting policy

2. Prioritise

It is good to obtain the views of the IMF, US Treasury, etc. However, it is essential that local expertise provides the majority of the contents of economic policy. And in terms of local expertise, one shouldn’t rely too much on economists and theoreticians. Entrepreneurial thinking is essential to formulate a country strategy. We do have a handful of entrepreneurs, who have done exceedingly well in global markets – competing with global players.  The country strategy could be similar to the business strategy; it is how successfully your country competes against other countries in the global market place. Therefore, the entrepreneurial input would make the plan more practical (albeit slightly more risky) rather than a theoretical roadmap provided by foreign lending agencies or local theoreticians.

The budget proposals of successive governments and election manifestos of all main political parties, almost always tend to be a long wish list. These policy statements become irrelevant eventually as most of them don’t get implemented. They wouldn’t get implemented as resources are limited. Hence, the challenge for the next president and government (as the current leadership is well into the second half of its term), is to come up with a more rational plan. 

For example, identify the five key sectors they plan to develop. What tax concessions and capital expenditure would be provided to make it happen? Quantify the outcome expected in five years. Similarly, clearly indicate the priority is to get the GDP growth to 7 – 8 percent and not to reduce the fiscal deficit to 4 percent or government debt to 60 percent of GDP. Everything cannot be achieved immediately. Prioritise what should be achieved first and what should be achieved later.

Lower taxes recommended for identified stars

The key aspect of the proposed strategy is to provide tax reliefs with a view to promoting investments. This is not in reference to granting sweeping long-term concessions for foreign sovereign investors who are eyeing the strategic national assets but for local entrepreneurs – small and large and also foreign investors who could add long-term value to the country. The concessions should be directed at the sectors, which the country wants to grow rapidly over the next decade – e.g.: Logistics, tourism, IT, KPO/BPO, etc. 

The Sri Lankan economy is over dominated by consumption (close to 80 percent), which should actually shift towards export-oriented investments. Therefore, the increase in VAT itself is not undesirable. However, the rate of increase (from 11 percent to 15 percent) was probably too drastic. Instead a more market-based pricing mechanism for fuel and electricity could be implemented.

Prudency in government expenditure – not curtailing

Providing tax concessions and lower interest rates for identified sectors and weaker rupee are accommodative for export-related sectors, although the government capital expenditure also needs to be focused along these lines. For instance, the government could assist in terms of providing global markets for small and medium enterprises, aggressively invest in universities and training institutes to ensure the labour is amply supplied for the identified high-growth sectors, etc. It is with this level of focus that one could expect foreign direct investments (FDIs) to flow into these identified sectors. The absence of such measures could be the main cause for poor FDIs.   The sharp rise in the government sector salary bill by 27 percent in 2015 (in comparison to GDP growth of 4.8 percent and inflation of 3.8 percent in 2015) spiked the government’s current expenditure. The government sector salary bill has already increased by 27 percent in the preceding two years (from 2012 to 2014). With the short election cycles in Sri Lanka, these kinds of irrational measures are not surprising. 

However, attempts should be made to maintain the increases of the current expenditure in line with the GDP growth and inflation to ensure the budget deficit doesn’t expand significantly. It is not practical to slash the current expenditure sharply as proposed by certain economists.

Maintain budget deficit at current level

The tax concessions introduced to selected sectors to boost growth could affect the government tax revenue in the short term. However, as the economy picks up over time, despite the lower tax rates, due to higher volumes, the government could earn higher tax revenue. The public investments to boost the growth sectors would expand the capital expenditure, although through prioritising some savings could be expected. The current expenditure should be allowed to increase at modest speed. The above strategy may result in a marginal expansion in the budget deficit (towards 6 percent of GDP) in the near term although it could revert to the current level of 5.2 percent of GDP once the economic growth picks up towards 6 percent in a couple of years. The budget deficit could remain around 5.2 percent in the medium term (say five to 10 years). Attempts to reduce the budget deficit further could be undertaken once the economic growth is sustainable at 7 – 8 percent and the economy is capable of weathering a fiscal policy tightening.  

Debt problem and banking model

Consider the business model of banks. At any given time, there is a heavy debt burden on its head. Even if a minority of depositors attempt to withdraw their funds on a certain day (the money in savings and current accounts can be withdrawn on any day) even the biggest of banks could be insolvent – or wouldn’t be able to repay the depositors. 

Do the banks maintain their funds in a locker fearing that all depositors would turn up at their doorstep one day? The business model wouldn’t work that way as the funds in the locker wouldn’t grow. It needs to be invested to make it grow and ensure the viability of the banking sector business model.

 The main focus of the banks is to grow steadily while keeping the risks managed and not on how the depositors (or debt) will be repaid and reduced. If a bank is well managed, instead of withdrawing, depositors, lenders and investors would invest more in the bank. 

Inculcate confidence – key to sustain debt

The same would apply for a country managing its debt. If the country’s economy is growing steadily in a sustainable manner, if the policies are rational and the leaders are capable of implementation, the investors and lenders would flow in. The smart money/investors are often capable of picking sound investments. There would not be a need for the IMF bail outs, entailed with the check list-driven technical conditions. 

This is by no means to compare a country to a bank. Nor it is meant to recommend irresponsible borrowing. It is just to highlight the fact that borrowing is part of modern-day business strategy and country strategy.

Sustainable growth could reduce debt burden in long run

Strong sustainable economic growth would lead to less dependency on borrowings in the long run. The sectors on which tax concessions were granted and capital expenditure were incurred, should provide financial dividends over time. It should also be remembered that most large-scale infrastructure projects would have relatively long gestation periods and just because it is not self-sustained in a year or two, it doesn’t mean the investment was a waste. 

The key aspect is to monitor, whether interest payment as a percentage of tax revenue could be reduced to a manageable, sustainable level in the long run along with debt to GDP (refer Figure III). High tax revenue immediately subsequent to an increase in taxes may not be sustainable as the economic growth slows, tax revenue would also slow down.

Maintain debt at current level

Therefore, it would be sufficient to just maintain the current level of debt in the medium term (debt to GDP of around 82 percent). Steps to reduce it could be undertaken in the longer term when the economy is growing steadily around 7 – 8 percent. 

A final word

Currently we seem to be in a vicious cycle. The government is in a quest to boost revenue through higher taxes with a view to reducing budget deficit and thereby alleviate the increasing pressure on debt.

 However, the higher taxes have stifled growth. Poor growth has resulted in increasing debt to GDP. Poor growth would also affect tax revenues in due course, which may push the government to introduce more tax increases and the cycle could go on. What is proposed is to break this cycle by prudent fiscal loosening, which could revive growth. Despite a short-term expansionary impact on budget deficit, economic growth would pick up and alleviate pressure on debt to GDP. Once the economy picks up, tax revenue would also increase ensuring the debt is maintained at current levels. Once the economy is robust, steps could be taken to reduce budget deficit and debt. Hope sanity will prevail.

(Waruna Singappuli operates a boutique, independent macro/equity research house. He can be contacted at [email protected])