Will Budget 2022 help reset Sri Lanka’s economy?

Originally appeared on Daily FT

By Dr. Roshan Perera

A budget sets out the government’s plan for the economy together with the financial resources required to achieve those plans. It also indicates the broad policy direction and priorities of the government. Any assessment of the Budget cannot be undertaken without an understanding of where the economy is right now. In other words, the Budget must be evaluated in the current economic context.

Looking at the key economic indicators, it is clear that the economy is at a critical juncture. The country suffered the sharpest decline in economic growth in 2020. Although growth is picking up, the economy is likely to remain below pre-pandemic levels. Inflation is rising due to external pressures from supply side disruptions and shortages in international markets. Domestically, financing of the Government’s budget through banking sources (Central Bank and commercial banks) is exerting upward pressure on prices. On the fiscal front, government revenue declined to historic lows due to the impact of sweeping tax policy changes as well as the slowdown in economic activity. Meanwhile, the Government has very little leeway on expenditure, as much of it goes to pay salaries of government servants and to make interest payments – all contractual obligations. The consequent widening fiscal deficit has been financed through increasing borrowings leading to higher debt levels and debt service payments. Downgrading of the sovereign by rating agencies has limited access to international capital markets, exacerbating issues in the macroeconomy. The current economic crisis is not due to the Covid-19 pandemic alone. Sri Lanka entered the pandemic with a slowing economy and a weak fiscal position; the result of years of poor economic policies undertaken by successive governments.

Budget 2022 was an opportunity for the country to reset and for the economy to move to a more sustainable growth path. With Sri Lanka losing access to capital markets and large debt service payments over the next few years, the urgent need was to restore fiscal credibility and strengthen market confidence. Because credibility of the fiscal strategy is vital for stabilising the macroeconomy and restoring the confidence of investors. Hence, the primary focus of the Budget 2022 should have been on correcting the twin deficits, i.e., the fiscal deficit and the external current account deficit, because of the spillover effects into the rest of the economy through interest rates and exchange rates.

According to the Medium-Term Fiscal Framework, the fiscal deficit is projected to decline to 8.8% in 2022 from 11.1% in 2021 (see Table 1 for details).

With minimal wiggle room on the expenditure front, the focus of fiscal consolidation is on revenue generation. Tax revenue is projected to increase by 50% in 2022 from the revised estimates for 2021. Given that actual revenue consistently falls short of estimates, how realistic these projections are is called into question. A major portion of the increase in tax collection in 2022 is expected from the introduction of several new taxes. In addition, the VAT rate on banks and financial service providers is proposed to be raised to 18% from 15% as a one-time increase. Collectively, these taxes are estimated to raise Rs. 304 billion, accounting for around 46% of the total projected increase in tax revenue in 2022 (See Table 2 for details).

As a comparison, the Interim Budget for 2015 introduced a super gains tax of 25% applicable on any company or individual with profits over Rs. 2 billion in the tax year 2013/14 as a one-off tax. The revenue collected from this tax was Rs. 50 billion. Furthermore, the social security contribution is similar to the Nation-Building Tax (NBT), which was a 2% tax on turnover imposed on entities with liable turnover in excess of Rs. 15 million per annum. In 2019, the NBT generated revenue of Rs. 70 billion before it was abolished in December 2019. With a higher turnover threshold and the current restrictions on imports, it will be challenging to raise the estimated revenue from the proposed social security contribution. In addition, the ability to raise the proposed revenue depends on how expeditiously required legislation can be presented to Parliament. Delays in passing legislation have hampered revenue collection in the past.

The question that needs to be asked is why introduce new taxes on a revenue administration that is already stretched when there is ample room to revise thresholds and rates on several existing taxes. This would have been much simpler to implement and would have required minimal amendments to existing legislation. In addition, taxes with retrospective effect, such as the surcharge tax, are not good signals for prospective investors.

The big question is whether the revenue estimates in Budget 2022 are based on reasonable projections. What if the proposed revenue collection does not materialise? Is there leeway to cut expenditure to match the revenue shortfall? If not, will this mean a widening budget deficit and additional borrowing? With minimal access to foreign financing sources, this will mean higher borrowing from domestic sources, particularly the banking sector. This will have economy-wide implications through higher domestic interest rates and crowding out resources from the private sector.

On the expenditure front, overall, there has not been a huge increase in total expenditure. However, the Ministry of Defence and Ministry of Public Security account for around 12% of total expenditure, while spending on health and education accounts for 6% and 4%, respectively, of the total. In terms of the composition of expenditure, salaries and wages comprise 34% of recurrent expenditure while interest payments account for 37%. While the Government has limited room to cut expenditure, making permanent another 53,000 graduate trainees may not provide the best signal in terms of the Government’s commitment to reversing the fiscal situation. Furthermore, the Budget for 2022 has reduced the allocation for subsidies and transfers. An important lesson from the pandemic was the need to build buffers during good times to be able to assist vulnerable households and micro and small and medium enterprises (MSMEs) who were disproportionately affected. Although the Budget proposes a one-off cash transfer to selected groups such as MSME entrepreneurs, school bus and van drivers, three-wheel drivers, and private bus drivers who were affected by the lockdowns, it does not address informal workers in other sectors of the economy who account for around 60% of the total workforce. Ad hoc cash transfers are not sufficient to address these issues. A more comprehensive social protection scheme is required to prevent vulnerable groups from falling into poverty due to unexpected events.

Macroeconomic stability also requires external sector stability. Large foreign debt service payments and dwindling foreign reserves have led to import controls and a tight rein on foreign exchange market. But a more sustainable solution to the external crisis is to encourage exports. The Budget refers to transforming the economy into an advanced manufacturing economy and encouraging exports to earn foreign exchange. This requires addressing the structural weaknesses in the economy hindering competitiveness and productivity. In this light, the question to ask is if spending priorities and policy measures announced in Budget 2022 address these bottlenecks. The Budget has allocated Rs. 5 billion for infrastructure for new product investment zones. In addition, the Budget refers to “…a special focus on expanding the IT sector and promoting BPOs and…a techno-entrepreneurship-driven economy”. However, the allocation for digitalisation is less than Rs. 5 billion. This is in comparison to the allocation for highways of around Rs. 270 billion and rural development programmes (Gama Samaga Pilisandara) of around Rs. 85 billion.

(The writer is a Senior Research Fellow at the Advocata Institute and a former Director of the Central Bank of Sri Lanka)

Can Sri Lanka afford to feed 225 mouths?

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

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By Dilshani N. Ranawaka

According to a recent news headline, the costs of parliamentary meals add up to Rs. 120 million annually. In addition, the total amount spent on electricity, telephone facilities, and drinking water is approximately Rs. 103 million per year. This brings the total to Rs. 220 million just to keep the Parliament functioning for a year, a place where poor policies and proper decorum are not taken seriously. However, there’s more to this story.

The story of meals

The parliament has 12 food and beverages outlets including five exclusive restaurants and VVIP dining suites. The resultant cost associated with this is Rs. 10 million per month. To put the cost in context, the aggregate amount is also equivalent to nearly one-fifth of the CESS revenue [1] (Rs. 542 million) collected through tea exports in 2018. Running a parliament is obviously vital, and given its size and functions, there are bound to be high costs associated with it. These costs however should be reasonable and justifiable.

The Parliament convenes only eight days a month

Parliament convenes on the first and the third week of the month on Tuesdays, Wednesdays, Thursdays, and Fridays. The only exception for this is when the Appropriation Bill is considered. However, even the process for the Appropriation Bill is restricted to a maximum of 26 days.

The official poverty line (OPL) is Rs. 4,856 [2]

The OPL calculated by the Department of Census and Statistics is the minimum amount a person requires for basic needs per month. Costs of Rs. 120 million annually just for food is comparatively a large amount. By looking at these numbers, it is evident that food expenditure can be reduced drastically. Has the present Government taken any measures to act on this?

Poor attendance

While expenditure on food is high, attendance in Parliament is low. The attendance at the last session held at the Parliament for this month was nearly 41%. There are numerous days where the Parliament does not convene because the quorum of 20 MPs is not met.

It is now evident that parliamentarians lead a highly luxurious life at the expense of the general public. Who is affected? Everyone except for these parliamentarians. Isn’t it obvious why people spend so much on election campaigns to secure their seat in the next election?

In their defence, the Finance Department of the Parliament claims 75% of this cost is incurred because of the parliament staff. However, the Budget allocates around Rs. 10,000 just for eight meals per parliamentarian. This fact is even more unacceptable because of the lack of commitment we see in them in solving issues of the country and standing for the people and for democracy.

The missing seats

It is known that MPs boycott the Parliament when there’s a crucial debate at hand. Statistics collated from Manthri.lk reveal that nearly 20% of the MPs were not seated for four out of eight sessions in the last three months (April, May, June). At the final session of this month, 92 MPs were absent. When representing their electorate, MPs are representing people. They are essentially the mouthpiece of their electorate in Parliament, and have committed to this role. It is important that the MPs know their significance in shaping governance and policies. Such absence in the Parliament is recorded even though they receive an allowance of Rs. 2,500 for each parliamentary sitting. If such positive incentives do not work, would a deduction for absence be a more useful nudge? In general, out of a 20-day monthly-cycle, an individual would try their best to report to work because of their responsibilities and piling-up of assigned workload. With all these facilities given to them to do a better job, are all these excessive expenses borne through tax money fairly treated by the MPs? The amount of wastage of resources created by Sri Lanka’s Parliament is unthinkable.

This further delves us to an important question that we further need to think on. The allocated amount for recurrent expenditure for the Parliament for 2019 is around Rs. 2.8 billion. Even though costs are indispensable in any process, it is evident that the Government spends an excessive amount of limited financial resources in this scenario. It is also evident that the Government does have the capacity to reduce such excessive costs which are indirectly borne by taxpayers. Even in spite of such privileges given to MPs, they have a low tendency to attend to the needs of people. The question to think about is are their services worth the money we spend on them? Don’t they have a responsibility to handle hard-earned public money responsibly? We are the financiers and they are our voice. The question is, do they do their job properly for us to bear all this cost? Is it worth it?

Edit: The previous version of this article stated that cost per parliamentarian on meals were Rs. 45000 per month. This number has now been corrected.

Should we abolish the budget?

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

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By Aneetha Warusavitarana

On the 5th of March 2019, the Ministry of Finance presented the much-delayed budget for 2019. The budget is a tool of extraordinary influence, which is used to affect government revenue, expenditures and national policy. That being said, our budgets don't appear to be exerting that influence, or creating the impact they could. According to Verité Research’s budget tracker only 8% of projects from the budget 2018 are progressing, with a staggering 59% lagging behind in implementation.

Everyone has come to expect the budget, but what purpose does it serve? Why does it exist? During the rest of the year the government continues to make decisions on policy, pass legislature and try to run the country. The allocations made during the budget to specific ministries are not set in stone. The reality is that these allocations are moved around government in a manner than bewilders all involved, and when a year passes and the next budget is announced, it is found that budget promises have not been met, and very little has actually been implemented.

Budgets by definition should focus on revenue and expenditure. In the case of Sri Lanka and the mountain of debt that we need to contend with, this is all the more important.

When looking at this year’s budget, a wide variety of topics have been touched on. The Ministry of Finance has revised taxes on multiple fronts, with a focus on reducing the indirect tax base and increasing direct taxes. However, the budget has not limited itself to detailing expenditure and revenues. There has been a substantial amount of general policy which has been included, bringing up the question of whether there is a point to their inclusion in the budget. Surely these general policies would be better suited in a national policy document or election manifesto?

The policy decisions in the budget 2019 have ranged from establishing a national pension plan, increasing government servants’ salaries, to amending labour laws, and this is where the problem lies. Increasing government servants’ salaries would technically be the duty of the Ministry of Public Administration and Disaster Management (an apt ministry to handle the government sector) and salary revisions should follow a system, and not be dependent on ad hoc decisions. A national pension plan, while much needed is not an endeavor that can be completed in a year. The same reasoning applies to amending labour laws. These two in particular will in all likelihood take at least a few years to be finalized and implemented.

The alternative?

The alternative to the current budgeting process is following a medium-term expenditure framework (MTEF). This framework integrates policy, planning and budgeting for the medium term, combining a top-down resource envelope with a bottom-up estimate of the current and medium-term cost of existing programmes. The result is the alignment of macroeconomic stability and broad policies with more specific programmes. It is essentially a three to five year rolling budget, which sets fiscal targets and allocates money for that time frame. This system addresses the reality that very few projects can be successfully implemented within one year and allows the government to acknowledge this and act accordingly.

What does a Medium-Term Expenditure Framework mean for policy?

Within this framework, policy proposals are considered in the medium to long term context. Spending agencies have a stronger voice, as they have significant input into the design of sector strategies and some flexibility in managing their resources to meet their objectives. New projects are undertaken dependent on whether they are affordable and implementable in the medium term, allowing the government to have a very clear and mostly accurate statement of fiscal policy objectives, fiscal deficit and debt management.

At a project level, this framework creates two main wins. First, both policy and funding are more reliable and predictable. Second, it allows for policy to drive funding, as opposed to the reverse. This in turn means that budgeting is linked more strongly to results, as focus shifts to specific outcomes and what resources are required to achieve them.

What happens to the annual budget?

The annual budget will be announced, but it will simply reflect what is achievable in the short-term, within the larger three to five-year framework. This is beneficial, as spending will be more specific, and tied to clear targets. Funding is not allocated for an entire project, but only for the section of the project that can be reasonably achieved during the next twelve months. The entire budget is more focused on results, and less on broad policy statements. Given the low levels of implementation mentioned earlier, it is evident that a greater degree of specificity, combined with a results-focused approach to the budget is required.

What needs to be done?

Interestingly, even now a substantial amount of planning follows the structure of a three-year rolling plan. The Public Investment Programme or the PIP, is a three-year rolling document which details government expenditure of projects and programmes. The Ministry of Finance also publishes an annual medium-term fiscal strategy which establishes the general direction or objectives of fiscal policy for the next three years. According to the Ministry of Finance website, budget estimates are prepared in the larger context of a medium-term budgetary framework.

It appears that the key components of an effective medium-term expenditure framework already exist. The next step would be to align the annual budget more clearly with these components. Allocations should be made more specific, with clear ties to the three-year plan. New projects and programmes should be introduced taking into account a three-year resource envelope and fiscal objectives. In other words, the budget in its current iteration should be completely overhauled and refined.

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Aneetha Warusavitarana is a research analyst at the Advocata Institute and her research focuses on public policy and governance. She could be contacted at aneetha@advocata.org or @AneethaW on Twitter. Advocata is an independent policy think tank based in Colombo, Sri Lanka which conducts research, provides commentary, and holds events to promote sound policy ideas compatible with a free society in Sri Lanka.

Bringing sanity to public finances

Originally appeared on Echelon

By Ravi Ratnasabapathy

Ad-Hoc policies have created unsustainable long-term spending commitments. A medium-term expenditure framework can discipline policymaking.

Sri Lanka has experienced a large and persistent budget deficit, averaging over 7.7% of GDP since 1990. The deficit has been met partly by borrowing, which is why the debt-to-GDP ratio has averaged 89.1% during the same period, almost double that of our peer group. The government has attempted to close the deficit through painful and unpopular tax increases; but amid the rising cost of living, public patience for this has already worn thin.

With elections looming and the popularity of the government sinking, there is a danger they will revert to giveaways without considering the impact this will have in the longer term. Giving jobs or salary increases to state workers is a popular short-term gimmick, but involves long-term commitments: salary payments over the life of the employee, often followed by a pension. With 1,358,589 people already on the State payroll and a further 600,000 drawing pensions, this is no longer sustainable. Salaries and pensions alone consume half of government revenue.

The accumulated ills of various shortsighted measures have taken the country to the brink of default. There is an unprecedented ballooning of foreign debt repayments over 2018-22 amounting to a massive $14.9 billion. To put this in context, the current IMF facility is only $1.5 billion.

The maturing debt is too large to be repaid, so must be rolled over, which means we need to borrow to repay. In order to do so, we must maintain investor confidence. Failure to do so will lead to higher borrowing costs – something we cannot afford. Moody’s ranks Sri Lanka among the countries most exposed to an interest rate shock. Interest payments already consume around 36% of government revenue, an increase in rates will put severe pressure on the budget.

“The accumulated ills of various shortsighted measures have taken the country to the brink of default. There is an unprecedented ballooning of foreign debt repayments over 2018-22 amounting to a massive $14.9 billion”

Moody’s warns, “Persistently high government liquidity and external vulnerability risks continue to pressure Sri Lanka’s credit profile, and specifically measures to build reserves and smooth the profile of external payments may be insufficient to stem imminent government liquidity and balance of payments pressures starting in 2019, when large international debt repayments come due and Sri Lanka’s three-year International Monetary Fund Extended Fund Facility programme concludes."

This is why the Finance Ministry has pushed through unpopular tax hikes and increased fuel prices. Foreign lenders will look at the country’s finances to assess its ability to repay; so in the short term, there is no sensible alternative but to collect more taxes. The real problem, however, is not tax but runaway spending; over 2000-16, total spending grew at a compounded annual rate of 12% (from Rs335,822 million to Rs2,333,883 million), with the deficit following suit (Rs119,396 million to Rs640,326 million). Foreign financing of the deficit grew from Rs495 million to Rs429,130 million in the same period. It is government spending not taxation that ultimately determines the total burden of government activity on the private sector. Although spending may be financed by borrowing or printing money (instead of taxes), all government spending is ultimately a call on resources that have alternative uses, or involves transfers from one group of society to another.

Debt is simply taxation postponed, with interest added. Money printing can tide over in the short term, but ultimately results in inflation and currency depreciation. The need, therefore, is to reign in expenditure, which must start with a proper plan.

Large businesses routinely plan for 3-5 years, but the government relies on an annual budget, which is produced by a bottom-up approach – i.e. the various departments submit their estimates of expected expenditure, which are then amended and collated centrally. Planning and policy is geared to the annual budget cycle, and little attempt is made to prioritize spending.

Planning must move away from annual budgets to a Medium-Term Expenditure Framework (MTEF), three-to-five year rolling plans, the important features of which are as follows:

• Extends the timeframe of budgeting from 1 year to 3-5 years.
• Projects the future cost of existing programmes and approved policy changes (baseline).
• Establishes hard spending limits – fiscal targets (i.e. deficit or total spending).
• Establishes a procedure for proposing any new policy initiatives.
• Rolls the MTEF forward each year, adding a year at the end.

The Treasury can work backwards from revenue, assuming no changes in the tax structure and the deficit target to arrive at the overall spending limit. Matching this with projected costs of current programmes will indicate if there is space available in the budget for new policy initiatives. Fiscal space is the difference between baseline projections and the government’s spending target; if there is no space, no new programmes can be accommodated, unless some existing programmes are cut.

The overall spending limit is a ‘hard’ limit, but within the overall limit, reallocation can take place. This forces the Cabinet to consider spending priorities – where should limited resources be allocated? The Cabinet can determine soft ceilings for ministries that need to ‘win’ competitively on the basis of plans submitted.

“Although spending may be financed by borrowing or printing money (instead of taxes), all government spending is ultimately a call on resources that have alternative uses, or involves transfers from one group of society to another”

The Treasury needs to reward credible plans, so those that provide performance measures, specify outcomes, outputs and costs should receive more funding. Performance measures help make the case for budget allocation and enable monitoring of programmes. Performance measures are based on the following parameters:

• Inputs: Measures the resources used to provide government services, such as personnel, operating expenses and capital.
• Activities or output: Measures what an agency does, the number of applications processed, the number of passengers carried and kilometers of roads paved.
• Efficiency: Measures the cost per unit of activity such as cost per patient, cost per student or cost per child vaccination.
• Outcome: Measures how well objectives are met. These are usually the ends of government such as safety, health or educational improvement.

Expenditures must be driven by policy priorities, but disciplined by budget realities, which means sudden and unplanned announcements cannot be made. The result is greater policy predictability, a focus on outcomes, priorities and expenditure management.

Conceptually, this is simple, but implementing it in practice is a daunting task involving a lot of political negotiation (to get ministers to agree to spending limits) and administrative work in estimating future costs, revenues and measuring performance.

The trickiest political negotiation involved is in allocating the spending limit according to priorities. This exercise is the most important – with an annual incremental budget, no one is forced to question the ‘base cost.’ With a hard spending limit to be allocated among departments, questions on priorities come to the fore. The other obstacle is weak capacity within the government, both the bureaucracy and among ministers, which means that external technical support is needed to implement this, which is fortunately available through donor programmes.

More than 16 African countries have adopted an MTEF, with Ghana and Malawi pioneering it in 1996. Since then, other countries in the region have followed. Implementing may be done in stages, starting with key spending units. In Malawi, the deficit contracted from 15% of GDP in 1994/5 to 5% by 1998/9, partly due to the MTEF. According to the World Bank (2013), by the end of 2008, more than two-thirds of all countries had adopted an MTEF. To work, the MTEF must become the government’s budget process and control the details of spending. Expenditure limits are agreed to by incoming governments giving intra-party policy consistency.

Properly planned expenditure means little need for periodic, ad hoc adjustments to taxes, which are witnessed at every budget, and even in between budgets through gazette notifications. Unexpected tax changes wreck havoc with the plans of businesses and households alike. Greater visibility will increase overall levels of confidence among lenders and investors.

When an MTEF is implemented well, public expenditure is limited by the availability of resources, budget allocations reflect spending priorities, and public goods and services are delivered cost-effectively. MTEFs, therefore, offer the prospect of achieving the three high-level objectives of public expenditure management: aggregate fiscal discipline, allocative efficiency and technical efficiency. Reaching this is an incremental process, but with good technical support, it is possible. The earlier this is adopted, the better.