NPP’s maiden Budget

By Dhananath Fernando

Originally appeared on the Morning

The National People’s Power’s (NPP) maiden Budget will be presented to Parliament tomorrow (17). Ideally, a budget should not contain surprises – neither on the income front nor on the expenditure front. Government expenditure is the real tax burden on people; they ultimately bear the cost through taxes, inflation, or both.

Generally, a budget consists of two key components. The first is revenue and expenditure, while the second is the policy direction of the Government. This time, the business community is particularly focused on the latter, as it is evident that income and expenditure must align with the International Monetary Fund (IMF) programme.

Adhering to IMF targets 

The 2025 Budget has no alternative but to adhere to the parameters set by the IMF. While micro-level details and specific projects may change, key indicators such as gross financing needs, Government revenue-to-GDP ratio, primary balance, and debt-to-GDP ratio must be maintained as agreed under the IMF programme.

Additionally, the previous Government introduced new legislation under the economic transformation framework, covering many of the IMF’s targets. Achieving a Government revenue target of 15.1% of GDP will be a major challenge. Value-Added Tax (VAT), corporate tax, and income tax have already reached their upper limits, leaving limited scope for further increases. The Government is likely to bridge part of the revenue gap through vehicle importation.

When governments face revenue shortfalls, ad hoc taxes or sudden tax increases are common, often targeting sin industries such as tobacco and alcohol. However, the Budget must adhere to sound tax principles, ensuring simplicity, transparency, neutrality, and stability. 

The focus should be on simplifying the tax system and improving the efficiency of tax administration, as poor administration is as harmful as a bad tax system. Any unexpected changes in revenue policies could harm businesses, erode investor confidence, and slow down the economy. The best way to achieve the 15.1% revenue target is through efficiency measures and broadening the tax base.

Over 50% of recurrent expenditure towards interest payments

Sri Lanka has little control over its expenditure, with over 50% of spending allocated to interest payments. In 2023, approximately 90% of tax revenue was spent on interest payments. 

Currently, Sri Lanka has one of the highest interest payment-to-revenue ratios in the world, raising concerns about the possibility of a second debt restructuring. Post-debt restructuring, the Government has minimal room for fiscal adjustments.

While Government employees and various sectors may expect relief packages, the reality is that there is no fiscal space to accommodate such demands. It is true that salary structures for senior Government positions need improvement to attract the right talent, but this can only be achieved by restructuring the lower levels of the public service, which absorb the bulk of the salary bill.

Another solution is to drive economic growth and increase labour force participation, reducing the proportion of Government employees relative to the total workforce. Blanket salary increments are difficult to implement without compromising capital expenditure, which is crucial for long-term development. 

Currently, 20% of recurrent expenditure is allocated to salaries and wages, while pensions account for approximately 8%. Given this context, expecting significant relief packages is unrealistic, and any attempt to provide them could lead to long-term economic instability.

Investment should prioritise healthcare, education, social protection

Government spending should prioritise critical sectors such as healthcare, education, and talent development. However, expenditure in these areas – including the ‘Aswesuma’ social safety net – was lower than expected last year. 

The IMF has pointed out that Sri Lanka did not fully allocate the funds intended for ‘Aswesuma,’ which serves as the primary social safety net for the country. Ensuring proper allocation to these essential sectors is crucial.

Focus should be on structural reforms

Rather than solely focusing on balancing income and expenditure, the Government should use the Budget as an opportunity to set a clear policy direction. 

Key areas requiring structural reforms include land policies, labour laws, the export sector, and energy markets. These reforms are fundamental to Sri Lanka’s economic growth, as the country’s challenges are largely structural rather than issue-specific.

We will have to wait until tomorrow to see the extent to which the Government seizes this opportunity. Instead of expecting widespread relief measures, the public should push for meaningful policy reforms – an essential step for securing Sri Lanka’s future

(Sources: CBSL, Advocata Research)

(Sources: CBSL, MOF Annual Report, Advocata Research)

The power of know-how over industry selection

By Dhananath Fernando

Originally appeared on the Morning

In most of our export strategies, the starting point has been the Government deciding which industries should drive exports – some of these decisions are data-driven. 

Accordingly, we examine current export figures and sometimes focus on expanding existing product segments. Secondly, we target additional industries with the expectation that exports can be boosted. While both approaches seem logical at first glance, we need to understand the broader framework of how to grow exports effectively.

Most of the time, we perceive exports as industry-specific, but in reality, exports are about know-how. Know-how becomes a product, and know-how makes a product competitive. However, know-how is not just knowledge – it is sometimes tangible, existing in tools, but more often, it is intangible. 

It is akin to Lasith Malinga’s bowling action and his ability to deliver pinpoint yorkers. We can analyse Malinga’s technique, attempt to replicate his action, and even learn from his strategies through interviews or YouTube videos. Yet, even with all this information, it is extremely difficult to replicate his unique skill set. 

Malinga possesses tangible components such as his slinging action, run-up, and release style, which can be considered tools. He also has knowledge that he shares through various platforms. However, his true know-how – what makes him exceptional – remains elusive, even to himself. 

This difficulty in transferring know-how is likely why the Mumbai Indians recruited Malinga both as a player and later as a coach in the Indian Premier League. If we consider Malinga as a product, he is export-competitive and his value lies in a combination of factors, primarily his unique know-how.

When a country seeks to expand exports, the know-how ecosystem is what determines success or failure. Our apparel manufacturers, for example, possess specialised knowledge that enables them to produce garments at the lowest cost while maintaining high quality. 

Initially, their products were relatively simple, but over time, they evolved in complexity. The industry experimented with various approaches – ethical garment production, lean manufacturing, and women’s empowerment – learning from both successes and failures to refine a sustainable model.

Today, Sri Lanka’s apparel exports are not merely about physical products but also the know-how that allows us to compete globally. Know-how thrives within an ecosystem that supports industries. 

For this to develop, the Government must provide entrepreneurs and businesses with the freedom to access and test resources – what economists refer to as factor markets. Land, labour, and capital must be available with minimal restrictions on a level playing field. 

This is why licensing requirements can be detrimental to exports; they obstruct access to essential resources, thereby stalling know-how development. For instance, if land acquisition is difficult, apparel firms may struggle to operate or innovate. Similarly, excessive labour regulations can increase operational costs, making products uncompetitive and disrupting the know-how ecosystem. Such obstacles discourage exports.

Another common discussion on boosting exports revolves around diversifying the export basket. To understand how diversification occurs, we can refer to Harvard’s Center for International Development, where Prof. Ricardo Hausmann uses the analogy of monkeys and trees in a forest.

In a forest, monkeys do not leap from one end to the other; they move from branch to branch. Similarly, export diversification does not occur in giant leaps but through adjacent product categories. Existing exporters and individuals within the know-how ecosystem expand into related fields. 

For instance, if we excel in gemstone exports, an adjacent category would be jewellery. This is why Government intervention in selecting export industries with large targets is often ineffective – diversification and expansion naturally occur within adjacent categories.

In making more complex products for export, Prof. Hausmann employs an economic theory likening diversification to a Scrabble board. If we have only three letters, our word combinations are limited. However, with four letters, the number of possible words increases exponentially. 

Therefore, minimising restrictions on factor markets – such as land and labour – enables more access to ‘letters,’ allowing for greater diversification.

Additionally, some ‘letters’ contribute significantly to forming words, like the letter ‘A,’ which is more versatile than a letter like ‘Z’. Similarly, removing barriers to factor markets increases the potential for new export combinations.

In Sri Lanka, our export strategy has traditionally relied on the Government selecting industries for growth. While this approach may work to some extent, if we seek rapid export expansion – like Vietnam – we must focus on the framework rather than forcefully pushing selected industries.

In today’s global economy, no country manufactures all its products on its own. Most nations produce parts, components, and assemblies, relying on international trade to complete final products. If we fail to open our economy to trade, our export ambitions will remain unfulfilled. Trade enhances competitiveness and provides access to multiple ‘letters’ at optimal costs.

Foreign Direct Investments (FDIs) are another crucial element in this equation. FDIs bring in individuals with specialised know-how, much like acquiring a player of Malinga’s calibre. They also introduce advanced technology, enabling the creation of more ‘letters’ and exponentially increasing the potential for new products over time.

If Sri Lanka is serious about exports, we need to focus on the process and the journey. We hope that the upcoming Budget will establish key milestones to guide us in the right direction.