NPP’s economic policies - the good, the bad, the ugly

It would be a big mistake if any future government meddles with the foundational principles of the law and takes away the operational independence of the institution

The need of the hour is sound money – the Central Bank law attempts to provide it

All political parties are promising a brighter future. Let’s assume they are able to achieve it. One thing they should NOT do is to say they are going to revisit the debt sustainability analysis for higher GDP growth will indicate lower debt relief for Sri Lanka. This is the exact opposite of what we need. Let sleeping dogs lie

By Murtaza Jafferjee  

Following the release of the NPP manifesto, I find many of the items in their manifesto to be aspirational, they resonate with me, but I would like to have more details about the specifics when it comes to implementation.  
I would categorize my comments into the good, the bad and the ugly.  

The good
A vast majority of the items I would categorize in the good bucket. A few I would like to mention is that they are pro trade including new trade agreements, improving the doing business environment, improving tax administration, improving transparency, promoting PPPs, improving market efficiency, reengineering processes and digitization.  

Under the bad category, or issues I have concerns with are as follows:  

 Incorporating a new development bank – we are currently overbanked, we need a fewer number of financial institutions so that they can benefit from scale economies thereby reducing intermediation costs. Larger balance sheets permit absorbing risk. One way to incentivize riskier lending is for government to participate in risk sharing through a guarantee scheme.  

 Recapitalization of state banks presuming through the treasury. Capital enhancement is needed not only due to large impairments but also due to high leverage (BASEL III rules zero risk weight lending to government). It would be more prudent to access private capital markets to top up the capital base of these banks, which will also come with the added benefit of better governance.  

Under the ugly category I have very serious concerns about the following four areas about fiscal and monetary policy which they need to clarify   

 Stabilization of policy interest rates – I don’t know what they mean by this in relation to foreign exchange markets and stability of financial markets. For the first time in our post-independence history, we have a new Central Bank law that requires the CBSL to focus on price stability (flexible inflation targeting) and explicitly prohibits monetary financing (money printing). They are accountable to the public through parliament if they fail in their mandate.  
It would be a big mistake if any future government meddles with the foundational principles of the law and takes away the operational independence of the institution. The need of the hour is sound money – the Central Bank law attempts to provide it.  

 Amending the foreign exchange act with the aim of bringing back export proceeds into the country. Sometimes a lie told a 1,000 time becomes the truth – this is what has happened with the narrative that Sri Lanka’s forex crisis was due to exporters NOT bringing back their export proceeds. If this was so one would see a very large number in the errors and omissions line item in the balance of payment – this is NOT so. Undoubtedly, there is some leakage, but it is significantly smaller than what some politicians have been saying with the aim of getting airtime. Once again let me repeat it, Sri Lanka’s forex crisis was due to loose fiscal and monetary policies that led to excess consumption and investment, it was NOT due to poor export performance nor insufficient exports. In other words, we were living beyond our means and paying for it through foreign borrowings.  

 Meddling with the VAT. A middle-income country like Sri Lanka should be collecting around 6% of GDP through VAT (if you apply 18% on the entire economy including imports minus exports one should collect around 19% of GDP). Our VAT collection relative to GDP is a lot, less than 6%, we are still under taxing our economy. VAT is the least distortionary tax since it only taxes value added, a transaction tax cascades which creates friction. VAT is the best form of indirect taxation for both a developing and developed country. In a market economy like ours, allocation of resources is driven by prices of goods and services which signal their scarcity value. If you want less of something you tax it, if you subsidize something you will have more of it. When you exempt an item or reduce the rate of taxation you are making a conscious decision to favour some products over others through the tax system. For example, in the market for proteins fish is exempted from VAT but eggs, chicken, red meats, shellfish, etc. attract VAT – the implication is that through government policy fish is being promoted which advantages fisherman at the disadvantage of dairy and poultry farmers. If more items are exempted under the guise of giving relief to consumers, not only will it reduce government revenues but it will also significantly distort the allocation of resources by favouring some products over others. Further, so called essential items are probably consumed in more quantities by richer people than the poor people who the relief is targeted towards. For example in the market for fuel, 70% of consumption is done by 30% of the wealthiest households – for decades we were under taxing fuel.  
It would be far better to simply increase the cash transfer amount to vulnerable households to improve affordability without meddling with the tax system.  

 Increasing the tax free threshold from RS 100k a month to Rs 200k. My estimate is only the top 20% of households in Sri Lanka are within the minimum tax bracket – by doubling the tax free threshold you are giving relief to more affluent households. Our tax law does not consider family income thus a dual income household where each partner earns less than Rs 100k will be below the tax threshold – the combined income places these households amongst the top 10%. The need of the hour is to increase the tax contribution from direct taxation, by doubling the tax free threshold the contribution from direct taxation will come down. Further, it is important in a vibrant democracy to have more tax payers – it leads to better governance for they hold their rulers to account.  
One last point I would like to make – all political parties are promising a brighter future. Let’s assume they are able to achieve it. One thing they should NOT do is to say they are going to revisit the debt sustainability analysis for higher GDP growth will indicate lower debt relief for Sri Lanka. This is the exact opposite of what we need. Let sleeping dogs lie.  
Murtaza Jafferjee is a leading economist and the Chair of Advocata Institute