Economic freedom for true independence

By Dhananath Fernando

Originally appeared on the Morning

For the last 76 years, we Sri Lankans have looked at different ways of making Sri Lanka a wealthier and developed country. A popular refrain during every Independence Day celebration week has been that “when we got independence, we were only second to Japan”. Another quote bragged about how good we were, as “Singapore was behind us and they took Sri Lanka as their model for development”. 

Unfortunately, much of Sri Lanka’s independence has only been ceremonial, not real. We have still failed to capture the science of equitable wealth creation, which only comes with economic freedom. Economic freedom leads to true and meaningful independence. All countries in the region, including Singapore and Japan, overtook us by establishing the elements of economic freedom at various degrees rather than simply taking Sri Lanka as an example.  

Science of wealth creation 

Wealth creation is science, not magic. It has always been a function of maximising the use of limited resources and increasing productivity. Both can be done when individuals have better incentives to create wealth. For individuals to create wealth, their rights over property have to be secure. The government should ensure that the property of people belongs to them. 

The government should allow individuals to do business and create wealth instead of trying to intervene in markets and pricing. Further, a government poking its fingers in and preferential treatments in a sector serve to discourage individuals from being in the same business. 

Wealth can also be created when raw materials are competitive in price and good in quality. Having a variety of choices in a competitive market system is paramount. The simplest way of creating a competitive environment is by opening up for international trade. 

Regulatory barriers have to be minimal. This does not mean the government plays no part in regulation. The government can adopt a regulatory function without intervening in the market to ensure that the competition and competitive nature of the industries are protected. 

Lastly, all transactions in the modern world take place in a fiat currency. Simply put, we store all our production as individuals in a form of a paper called money. The monopoly of money belongs to the government and when it does not protect the value of the money, it amounts to theft of the hard work and production of an individual. 

The science of wealth creation is simply establishing these five principles. This has been statistically proven by the Economic Freedom of the World Index by the Fraser Institute. 

Over the decades, it has monitored these five indicators and data have shown the relationship and causation between wealth creation. 

The per capita GDP of countries with the highest level of economic freedom is on average about $ 48,000 while for countries with the lowest level of economic freedom the per capita GDP averages at $ 6,300. 

Even if we consider the standard of living amongst the poorest 10% of the population in the countries with higher economic freedom, the income distribution among the poorest 10% is eight times higher than in countries with very low economic freedom. 

Sri Lanka falls under the third quartile, meaning that our performance in economic freedom is not that great. We have ranked 116 out of 165 countries. 

Science of economic freedom

In modern times, many people consider happiness as a function of wealth, freedom, and independence. When we look at the data on economic freedom, it is clear that countries with higher ratings indicate a higher score on the UN World Happiness Index as well. 

Even if we look at poverty numbers, the countries with higher economic freedom obviously have low poverty rates compared to countries with low economic freedom. 

Over the last 76 years, the science of economic freedom is something we have failed to utilise. One reason this column has always advocated for reforms of State-Owned Enterprises (SOEs) is because a limited government improves the economic freedom of people, which leads to creating wealth. People having ownership and rights over land is another reform we require to improve the property rights indicated in economic freedom, which will also lead the process of wealth creation.   

On this independence day, our prime focus has to be on creating wealth. We can create wealth by establishing economic freedom. When we have wealth and economic freedom, we become independent. That is when we leave the trap of poverty, our standards of living improve, and we provide value for the globe. 

Happy Independence Day, Sri Lanka.

The dangers of the Online Safety Bill

By Dhananath Fernando

Originally appeared on the Morning

The Online Safety Bill is scheduled to be taken up for debate at its second reading in Parliament on 23 and 24 January. Unfortunately, this bill is going to make our current economic situation a bit more difficult in the short run and as well as the long run.  

The Asia Internet Coalition (AIC), where tech platform giants such as Google, Meta, and Amazon are partners, twice brought up the danger this bill could pose to the digital economy.  

Economy is beyond just supply and demand of rupees and cents. Economies are mainly the ideas that solve a problem of fellow humans and an exchange of those products and services with scarcity of resources. 

Problem-solving for humans comes with the freedom to think and with freedom of speech and dissemination of information. All attempts to restrict our freedom of expression, speech, and dissemination of information will backfire on the country and the economy. 

Sadly, the Online Safety Bill seems to be doing just that.

Self-censorship kills ideas for prosperity 

The bill has left significant room for vagueness in many clauses and definitions. According to the proposed bill, the commission appointed by the Constitutional Council has the powers to determine whether some facts are true or false and take follow-up actions. 

One example to showcase the impractical nature of this approach is the case of the Government decision on cremation of Covid-infected bodies, claiming that viruses could leak into the waterbed and cause contamination. This decision was highly debated on social media platforms and even scientists were divided on the decision. 

So if someone complains based on the Online Safety Bill, how does the committee decide on what is true and what is untrue when even scientists are unsure? Later the Government withdrew its decision and changed its initial stance. What was perceived as truth at one point was proved to be wrong at another point. What could have been the outcome if the Online Safety Bill had been enacted by then and if legal proceedings had been taken forward for those who commented for and against cremation of Covid deaths?

Looking at lessons from history, Galileo was killed for bringing an alternative view of the perceived truth on the shelving of the solar system. This act in this form takes us back to the repression faced by Galileo. It is severely problematic when the arbiter of ‘truths’ of fringe politics can also hand out punishments.

Generally when there is uncertainty, for their own safety, people engage in self-censorship. Self-censorship restricts the flow of ideas and minimises the ability of the economy to solve the problem. 

Let’s imagine that the Online Safety Bill had been enacted before 2021. During that time many analysts and economists on all social media platforms warned the Central Bank that excessive money printing could lead to inflation. The Central Bank was of the view that there was no relationship between money printing and inflation. So if the Central Bank complained to the Online Safety Commision on the opinions on the matter, most of the economists would have been punished by the bill by the time inflation was hitting 72%.

If the Central Bank says inflation has no relationship to money supply, there would have been no other way the commission could establish what was true or what was false at that point of time. The other possibility is that most of the economists would have self-censored knowing the repercussions of the bill, which could have caused greater harm to society.

If this bill creates a culture of self-censorship, our ability to hold the State accountable, ability to innovate, and ability to create would be quenched, leading to a stagnant economy. 

Impact on SMEs

The business models of tech giants are very cost effective. They do not have offices in every country, nor staff to monitor all content. Most of that is done through algorithms. They regulate harmful content through technology (algorithms) and very strict community guidelines are adhered to.

Anyone can read how comprehensive the guidelines of these tech platforms are on safety and trust and how effective they are on responding to these platforms’ community guidelines. Tech firms have refined algorithms to an extent that not a single photo falling under nudity can be found as the algorithm restricts them automatically. In that sense the tech companies have done a fantastic job compared to what a government tries to do with a bill in a market-based system.

Platforms such as TikTok are not only concerned about human rights but also about human safety, where drone shots with a risk of accidents are eliminated due to very high community standards.

If the Online Safety Bill becomes too much of a burden for these tech companies, with a response time of 24 hours for inquiries by the commision as per the bill, they will tune their algorithms to be very strict, which will have an impact on SME businesses run on social media. Simply, the competitors can complain on certain pages featuring products with various claims and pose an unnecessary burden to SMEs. 

Our tourism industry, where we have a long-tail SME sector, especially uses these platforms for room reservations. The reviews coming in the form of discrimination will fall under this and the booking sites will also fall under that purview, so they are likely to react to the online safety regulation, which will have an impact on our dollar-earning tourism industry.

The AIC has already twice highlighted its displeasure in diplomatic language, claiming as follows in a statement: “The proposed legislation, in its present form, poses significant challenges that, if not addressed comprehensively, could undermine the potential growth of Sri Lanka’s digital economy.”

Wrong signals to markets 

The Online Safety Bill also provides wrong signals to the market, including the International Monetary Fund (IMF) and our creditors. The IMF has provided a governance diagnostic where many other pieces of legislation, including the SOE Holding Company Act and Procurement Law, are among the top 16 priorities. Sadly our Government has brought a bill on Online Safety Bill, for which no stakeholder group which assisted Sri Lanka during the economic crisis has shown any interest other than highlighting its problematic nature, which ultimately impacts economic growth. 

Since actions speak louder than words, this will provide the wrong messaging to our creditors, bilateral and multilateral partners, and investors that our Government’s priority is not the economic crisis.

From the point of view of the investor, this will also have a serious impact on attracting FDI and key players with the potential to transform our economy. For instance, one company which has shown interest in investing in Government shares of Sri Lanka Telecom is Jio, where a majority share is with Reliance Group in India. Meta, Google, Intel, and the Saudi Arabia Wealth Fund are a few other strategic partners and shareholders of Jio. Can we expect a tech company to provide a positive referral to its main shareholder in an investment decision when its own platforms are under risk through an Online Safety Bill in Sri Lanka?

This bill is beyond repair and just plastering over its shortcomings will not make it any better. If this goes through Parliament, the risks on freedom and signalling for investors will be quite negative. Importantly, in an environment where freedom does not prevail, economic growth and prosperity will fail drastically. The only solution left for this bill is to repeal it.

Non-negotiable reforms for election manifestos

By Dhananath Fernando

Originally appeared on the Morning

The year 2024 will be an election year. The general flow of events is that each political party and candidate will launch a manifesto of a grand-scale and present their plans for the people and the country. Most of these promises will not be implemented or will only be half implemented. In certain cases, the opposite of what was promised will be implemented. 

Most manifestos are presented in general terms with a target of 20 years ahead with little data. Many manifestos across all party lines are wish lists with no action plans.

In my view, this time there is a slight difference. 

Regardless of the party formation or whoever the presidential candidate will be, there are few reforms that are non-negotiable. Ideally, across all manifestos, there are five basic ideas which have to be the common denominator.

Strengthening social safety nets 

Following the worst economic crisis in Sri Lanka’s history and high inflation, about four million people have fallen below the poverty line. That puts seven million people under poverty. The recent Household Income and Expenditure Survey carried out by LIRNEasia and the World Bank indicates significant poverty levels and aftereffects of poverty due to the economic crisis. As a conscientious society, we need to take care of our poor people with the social safety net. 

The social safety net is not just an allowance. It is a system and a process of targeting the right people, providing an exit route, and with proper administration. The current Aswesuma programme is making some progress with World Bank assistance, but regardless of the political leader who comes to power, it is a non-negotiable condition that social safety nets have to be strengthened and improved. 

The current process has too many loopholes which have to be addressed and improved. Simplifying the process, providing the exit route, and monitoring and depoliticising has to be a continuous effort from the new leadership of the country.

SOE reforms 

Thus far, mandatory SOE reforms have been painfully slow. Many parties with vested interests are trying to delay it until the election. However, the continuation of SOE reforms is a must. 

Colossal losses, interference in the private sector, intervening in markets, creating an unfair playing field, and inefficiencies are a few reasons why SOEs played a pivotal role in Sri Lanka’s economic crisis. SOEs are vehicles of corruption and have diluted entrepreneurship and Foreign Direct Investments significantly. Without reforming SOEs, the future of Sri Lanka appears to be bleak. 

The principles announced by the SOE Restructuring Unit are in the right direction, but the SOE Act and reforms of the Ceylon Electricity Board, Ceylon Petroleum Corporation, and many other networking industries are a must. 

Anti-corruption and governance reforms

Execution of anti-corruption laws and governance reforms is another area which has no room for negotiation. The International Monetary Fund (IMF) Governance Diagnostic and many other locally-developed reports on governance provide direction on what needs to be done. 

Strengthening our Judiciary system, transparency and accountability in our tax system, removing tax exemptions, and repealing the Special Commodity Levy and the Strategic Development Act too falls under governance and anti-corruption reforms, as those acts provide the legal opportunity for corruption. 

There is a strong sentiment from people on the contribution of corruption to the crisis, so taking long-term measures regarding corruption is a must. Anti-corruption and governance reforms go beyond going after corrupt politicians. Rather, it is a system and framework for minimising government influence. Some reforms are complementary and reforming SOEs is also a key component of anti-corruption and governance reforms, as these SOEs play a vital role in corruption.

Following the IMF programme and debt restructuring 

Given the international financial architecture, we have no option other than sticking to the IMF programme. We can negotiate some of the actions that we have promised, but overall indicative targets and reforms have to be maintained. Otherwise, it will be yet another incomplete IMF programme and the debt restructuring process will be in jeopardy. 

Debt restructuring and the continuation of the IMF programme are very much interconnected. At the moment, external stakeholders are concerned about political instability and in fact, the IMF’s first review identifies the political risks for the continuation of the IMF programme. A commitment from any political leader on sticking to the programme will help Sri Lanka in rebuilding relationships with the world.  

Trade reforms and joining global supply chains 

We have to grow our economy to emerge from this crisis. Tax revisions make it likely that growth will slow down and the only solution to grow small island nations like Sri Lanka is through global trade. Our problems regarding global trade are mainly the problems in our own regulations and systems. 

We have to remove our para-tariffs and simplify the tariff structure for a few tariff lines. Not only will this help trade, but consumers will also have a greater choice of goods and services as well as competitive prices. 

On the other hand, the Government can improve the revenue from Customs since at the moment, the high tariffs are a main reason for revenue leakage in the form of corruption. Trade reforms are about growth, minimising corruption, encouraging exports, and assuring reasonable prices. Even at present, after very high taxes, there are levies such as the Special Commodity Levy, Ports and Airports Development Levy, and a huge array of taxes which hinder the competitive nature of our economy.

These five policies, in my view, are non-negotiable. If any administration deviates from them, it is very likely that we will fall back a few miles behind where we started. 

VAT: The good, the bad and the solutions

By Dhananath Fernando

Originally appeared on the Morning

The Value Added Tax (VAT) increase from 15% to 18% and the removal of about 95 items from the VAT exempted list to a VAT applicable list has raised concern among politicians and people alike. 

When taxes change too often, public confusion and erosion of tax revenue both have to be expected. VAT was once 8% in Sri Lanka and then revised to 12%. It was again increased to 15% and finally now to 18%. The VAT threshold was once at Rs. 12 million and later increased to Rs. 300 million. Currently it is at Rs. 80 million and expected to be reduced to Rs. 60 million. 

When the VAT threshold was increased to Rs. 300 million from Rs. 12 million, the number of individuals registered for VAT dropped to 8,000 from 28,000. Our policymakers are discussing expanding the tax base after diluting our tax base through our own inconsistent policies. 

One of the key principles of taxation is stability, according to the Tax Foundation. The other principles are simplicity, transparency, and neutrality. When tax rates and thresholds are changed often, thIMFe markets and individuals react and tax revenue will erode. 

A complicated context 

Sri Lanka’s context is sadly more complicated than many other cases. We have given a commitment to the International Monetary Fund (IMF) on increasing our tax revenue because our interest costs are extremely high. Most of the interest is inherited due to bad financial management over the years and there is very little meaning in blaming each other. 

On one hand, the Government has no other option but to increase revenue through taxation. However, on the other hand, when taxes are increased the economy will contract. Growth, which is also a key requirement for us to emerge from the crisis, will be affected due to the lowered purchasing power of the people. When the economy contracts, tax revenue will also start to decline.  

Given the perennial weaknesses in our tax administration, the Government has selected the most convenient option of VAT to be increased, since it can be collected easily compared to other taxes. VAT is considered to be better compared to other taxes such as the Nation Building TAX (NBT) or the Social Security Levy (SSL), which are considered to be cascading taxes, where throughout the economic process one tax is applied on top of the other. 

This leads to a situation where the effective tax rate becomes very high, but with VAT, tax will only be applicable for the value added throughout the supply chain. Also, high income earners generally contribute a higher VAT in total as VAT is a consumption tax. People with higher incomes tend to consume more, so the more they spend, the more taxes the Government can recoup. 

The negative impact of VAT can be witnessed when it is applied to food items. The poorest of society gets adversely impacted, since their percentage of expenditure on food is very high compared to people who fall into higher income brackets. 

There will be considerable impact on the overall prices for the common people with the new VAT revisions. The price of petrol and diesel is expected to increase by about Rs. 50-60 (provided the other taxes are not changed and global fuel prices remain the same). LP Gas (12.5 kg cylinder) will increase by about Rs. 500-600. 

Prices of solar panels, electronic items, laptops, and mobile phones are expected to rise. This will also have an impact on inflation as well, but we need to keep in mind that inflation is always a monetary phenomenon. With high prices, people may consider cheaper alternatives and supply and demand will readjust, provided we keep our monetary policy right. 

Solutions 

A key solution to bringing down prices of food items is to remove the Special Commodity Levy (SCL) applied to these items. The SCL not only increases prices, but the provisions provided to the minister to impose and remove the SCL overnight opens significant room for corruption. The recent increase of the SCL on sugar to Rs. 50 from 25 cents is a good example of how an overnight gazette creates room for corruption and passes the burden to the people. 

Other taxes on food items including CESS, Ports and Airport Development Levy (PAL), and many other para-tariffs should be removed. There is a myth that productivity can be improved by imposing tariffs on domestic food items. If that is the case, our industries for milk, yoghurt, cheese, and many other food items have to be extremely productive and efficient. Instead of domestic product growth, we see the same producers ask the Government for further protection. 

Tax competitiveness as a framework 

 Moving forward, Sri Lanka has to look at tax competitiveness as a framework for thinking about taxes. In the global context, everything is about competitiveness, including the tax system. As an example, if corporate tax is 25% in competing markets in the region, we cannot increase the corporate tax to 30%, only considering the revenue requirement of the Government. 

At the same time, we cannot compromise our healthcare and education systems, which help to develop better skills through taxpayer money, by bringing taxes unnecessarily down and compromising our tax revenue. In a market system, competition and prices play a key role, and the same is applicable for taxes, FDIs, and many other variables. 

We have to first take the basic steps of improving tax administration. We then have to rationalise our expenditure and spend where we need to spend, thereafter raising revenue by being competitive. A VAT increase to increase Government revenue alone will not solve our macro instability. We have to ensure macro stability by being competitive in all aspects of the economy.  

Looming political and economic challenges ahead of elections

By Dhananath Fernando

Originally appeared on the Morning

“We know what should be done to get the country on the right track, but we don’t know how to get power back after implementing the policies.” This is a popular statement I hear often when I meet quite a few politicians. The truth is that politicians do not know how to get back power because it’s not an attractive solution.

The popular policies that bring politicians into power are the very same that inspire their ousting at the very next election cycle. People hardly object to good policies unless the same politicians instigate false propaganda. The Right to Information (RTI) Act was just one such instance.

As an election is due next year, it is vital to understand and remember our priorities, otherwise our politicians are likely to take a wrong turn and pass the buck back to the people.

In an election year, the behaviour of any political party is to completely abandon rational economic reforms and play to populist narratives that result in outcomes that are the complete opposite, with the motive of coming to power.

Bringing down fuel prices and announcing other types of subsidies are common tactics. This is harmful, especially when those benefits cannot be financed sustainably, or in some situations, brought into life in the first place.

Even if it does not retain power, the newly-elected government will have a tough time preventing plans that have already been put in place and enacting better policies.

Political risk

In the current context, we run a very high risk of our politicians bringing us back to square one; i.e. another economic crisis. This, given the fact that 2024 is set to be an election year, is a recipe for disaster.

All political parties will shift their focus to slowly becoming more populist rather than being driven by objectivity. Therefore, the real risk is going back to another debt restructuring if we fail to grow the economy and our exports.

There are many politicians who do not understand the gravity of the need for reforms. Regardless of which party or coalition comes to power, there are fundamental issues that need to be addressed.

The process is more or less the same as handing over a house with structural issues from one tenant (government) to the other. The new tenant cannot function because neither the previous tenant nor the owner (people) is willing to fix the fundamental problems.

Risk of a second debt default

Given the unstable political environment coupled with a country already going through debt restructuring, the risks of a second debt default are astronomically high. As we are still struggling with finalising the first debt restructuring, adding a second one into the mix will leave us in dire straits.

The second one will undoubtedly be harder, especially given the significant increase in interest rates and being unable to print money with the new Central Bank Act. If we fail to raise money through markets in order to roll over debt and if we are not open to increasing interest rates, the only option we will be left with is to default again. At that point, most likely there will be pressure once again to amend the newly-enacted Central Bank Act to allow money printing.

Of course, that would be an inflationary measure and we will be back at square one with a balance of payments crisis, debt crisis, humanitarian crisis, and likely a banking crisis too.

Solutions: A common minimum programme for reforms

Reforms are easier in the first 100 days of any government. If we fail to enact reforms within the first 100 days, more often than not, no reforms will take place. Failing to undertake reforms in 100 days means a cost of a five-year delay plus many bad policy decisions in the middle, which are costly and difficult to reverse.

Ideally, if key political parties come to an agreement before an election on selected reforms and execute them regardless of who comes into power, it will at least ensure some stability for Sri Lanka. There are many ideas that all political parties have in common.

Regarding State-Owned Enterprise reforms, there is no political party that says the Government should run an airline. Even National People’s Power Economic Advisor Dr. Anil Jayantha, in an interview with Advocata, noted that they did not believe the Government should do any business with hotels.

Accordingly, there are many other similar areas where we can arrive at an agreement with little difficulty. Therefore, regardless of who wins elections, people can win and sustain some of the economic reforms.

The truth is that reforms are inevitable if Sri Lanka needs to move forward and for any political party to sustain its power. Implementing bad policies, especially considering the status of our country, will make it very difficult to sustain power, because then we will be setting the standard for a new normal in economics and politics.

Fiscal path amidst promises and uncertainties

By Dhananath Fernando

Originally appeared on the Morning

Starting from the second week of November, every minute in Parliament will be focused on the national Budget. Fortunately or unfortunately, many of the promises outlined in the Budget are unlikely to be implemented or fulfilled.

At the same time, items that are not in the Budget may be implemented midway through the year, based on the direction of the wind. Things are especially likely to take a completely different turn in an election year.

A key criticism against this Budget is that the revenue proposals to cover up the expenditure proposals are not adequately mentioned. A revenue of Rs. 4,100 billion is expected for an expenditure of Rs. 6,900 billion. It’s akin to wanting to spend Rs. 69 while only having Rs. 41 in hand. The challenge is that we are uncertain as to how we will earn even Rs. 41.

An earlier proposal to increase VAT by 3% and remove the exemptions on VAT can be seen as a measure to increase revenue. There are a few proposals to increase the tax base, which is a step in the right direction, such as the requirement of a Tax Identification Number (TIN) for opening a current account, obtaining a building licence, and for revenue licences for vehicles.

The question that arises is what would happen if we fail to generate even the expected revenue and I think there are three scenarios that can occur if we fail to achieve the revenue targets in the middle of the year.

Scenario 1: Cutting down on capital expenditure

Approximately Rs. 1,200 billion has been allocated for capital expenditure in the 2024 Budget. This includes some proposals such as a new airport and building a few universities. So we will likely have to rechannel some of the capital expenditure to recurrent expenditure if we fail to generate revenue.

What is important to note is that, compared to last year, capital expenditure makes up a lower percentage of total expenditure. So in a context of starting with an already lower capital expenditure base, cutting capital expenditure from key areas of growth such as health or education further will maim our growth in the long run.

Slower growth is also not favourable for Sri Lanka because the need of the moment is growth. Only growth will increase our tax revenue and create more employment opportunities and business opportunities.

Scenario 2: High inflation

The second scenario would be the Government exploring the opportunity to get finances from the Central Bank to bridge the deficit. With the new Central Bank Act, the space for doing this is very low, but if past experiences hold true, anything is possible. There is a transition period of about 18 months and we should not underestimate the crafty nature of our politicians to find legal loopholes.

If the Budget deficit is being financed through the Central Bank (money printing), further increases in cost of living and high inflation are unavoidable. It will also drain our forex reserves and build additional pressure on our currency and likely end up with a currency depreciation after a few months’ cycle: a cycle not so distant in memory.

The Central Bank financing this Budget deficit will also challenge the sustainability of the IMF programme. As the next year is an election year, politicians will mainly think about the elections before the economy, despite promises made. While the new Central Bank Act tries to stop this from taking place, the possibility cannot be ruled out fully.

Scenario 3: Hike in interest rates

The third scenario is where the Government borrows money from the market to bridge the gap and allow interest rates to move. This will not cause inflation as the Budget deficit is not being financed through the Central Bank, but the cost of money will go up (interest rates moving up).

When the cost of money goes up, growth will contract. When this happens, businesses start winding-up operations and expansions become difficult. Also, banks will lend more money to the Government at higher interest rates, slowing down credit for the private sector.

When the economy slows down there may be an impact on the tax revenue on one side. On the other side, with limited growth, achieving debt sustainability will be challenging.

Solution

In order to prevent these scenarios from taking place, it is imperative that we reduce wasteful expenditure. The key solution is to focus on reforming State-Owned Enterprises (SOE). SOE reforms can increase revenue, cut down expenditure, bring down our debt, and attract foreign investments.

The bank recapitalisation of Rs. 450 billion, mentioned in the Budget, is due to the debt owed by two SOEs that have losses which amount to Rs. 1,800 billion. The taxpayer is now expected to pay the bill. It amounts to about Rs. 20,000 per citizen from taxpayer money for bank recapitalisation. That is a staggering Rs. 80,000 per household of four members.

Boosting tourism is also another option. While there is a fund for tourism promotions which has to be utilised well for building our brand image, it will all be in vain if we do not do things as simple as removing regulatory barriers to tourism.

The final bird in our hand as a solution is the Colombo Port City. We have to accelerate the process and attract investments.

If we play our cards right, we can at least move a step ahead in 2024.

Navigating salary hikes amid the storm of inflation

By Dhananath Fernando

Originally appeared on the Morning

Sri Lanka is currently going through a difficult period and this extends to Government sector employees as well. In light of these difficulties, there have been recent discussions centred around the possibility of a salary hike of Rs. 20,000 for Government sector employees in the upcoming Budget. While a salary increment is desirable, a more effective policy-level alternative could be maintaining a low inflation rate, which is more than equivalent to a salary increment across the board. 

The call for salary increments in the Government sector intensified following last year’s inflation, which exceeded 70%. Private sector salaries are just now adjusting to the new economic landscape. Inflation is a significantly more severe and burdensome tax on people, and unfortunately, we have been experiencing its effects over the last year or so.

Government employees are undeniably facing a challenging period, but it’s crucial not to overlook the fundamental cause of the high cost of living. The current cost of living crisis is the direct result of carrying out excessive money printing, as endorsed by the Modern Monetary Theory (MMT).

If the salaries of Government sector workers are increased by Rs. 20,000, a simple back-of-the-envelope calculation suggests that it will cost the Government an additional Rs. 360 billion (1.5 million Government employees x Rs. 20,0000 (increment) x 12 (months) = Rs. 360 billion). 

For the year 2023, the expected Government revenue from PAYE Tax is approximately Rs. 100 billion following the tax revision. Notably, the salary increment alone requires more than three times the amount of tax collected through PAYE Tax.

In 2022, the collection of VAT amounted to Rs. 464 billion. This proposed Government sector pay increase would equal more than 75% of the total VAT collection. Even with a more modest increment of Rs. 10,000, it would still be 1.5 times the PAYE Tax collection and one-third of VAT collection. 

An alternative approach to financing this salary increase is to borrow from the Central Bank. Since the new Central Bank Act imposes significant restrictions on borrowing, it is not entirely impossible, especially during the transition period. 

If the Government opts to borrow from the Central Bank to cover additional expenditure while artificially keeping interest rates low, a second round of high inflation becomes almost inevitable. On the other hand, if the Government borrows at market rates, it would result in an increase in interest rates, potentially slowing down economic growth and creating challenges for businesses. 

If the Government intends to pursue this path, it is advisable to let interest rates fluctuate rather than resorting to money printing and keeping interest rates artificially low. This is because, in the aftermath of a high inflation cycle, there was an inevitable need to raise interest rates to curb inflation. 

On the other hand, we need to keep in mind that the last inflation cycle pushed four million Sri Lankans below the poverty line, bringing the total number of people in poverty to seven million. This has forced many to reduce the number of meals or the size of their meals. The latest reports indicate a rise in malnutrition levels, particularly among infants. 

Given the limited resources, the Government should prioritise assistance for the truly vulnerable and allocate the limited resources to social safety nets. For the last two months, the new Aswesuma programme has faced delays in cash distribution due to various political and logistical challenges. By continuing to not prioritise social safety nets, the Government is inviting instability at the grassroots level. 

International partners and donor agencies have generously supported the establishment of these social safety nets by providing foreign exchange. Delaying and complicating the process may result in the perception that addressing the issue is of lower priority, potentially reducing the willingness of stakeholders to contribute further.

According to the Appropriation Bill tabled in Parliament, total Government expenditure is expected to exceed Rs. 6 trillion for the first time in history. A substantial portion, over Rs. 2.5 trillion, accounts for interest expense on loans. There is limited room for new expenditure items as we are already on an IMF programme and any deviations could have a direct impact on debt restructuring. 

High inflation, though currently low, has lasting negative effects from the previous year. This cost of living crisis, affecting all citizens, particularly hits those below the poverty line. Some of the potential solutions may be challenging and carry potential risks, so the Government must exercise caution in implementation to avoid exacerbating problems.

Can Sri Lanka’s Economic Revival Weather the Storm of a 2024 Election?

By Rehana Thowfeek

Originally appeared on Groundviews

Photo courtesy of EFE

By all estimates, Sri Lanka’s economy is expected to grow around 1.5% in 2024, making inroads into reversing the economic contraction the country experienced since 2020. Sri Lankan authorities have reached a staff level agreement with the IMF earlier this month and, pending executive board approval, Sri Lanka will receive the second tranche of $330 million soon.

Sri Lanka’s reserve position has improved somewhat from the record low levels it was once at – there are $3.5 million currently in reserves, which is sufficient to cover 2.6 months worth of imports, albeit still a worrisome situation. Tourism earnings and worker remittances are picking up and the cumulative trade deficit has narrowed in comparison to last year. Inflation is tapering at 0.8% in September (the base year has been revised to 2021), the result of the tight monetary policy stance taken by the Central Bank since April 2022.

Import restrictions brought in response to the dwindling foreign reserves are now being phased out with all but a few items still restricted. Due to the rapid decline in purchasing power experienced by the people in the past year, demand for imports may remain subdued but maybe offset by more favorable credit conditions. Policy rates have been further reduced and due to more favorable economic conditions banks are now showing greater willingness to lend in comparison to 2022, which bodes well for business revival.

The ability of Sri Lanka’s economy to redeem itself and firmly place itself on a path of inclusive and sustainable growth lies in how successfully the country can execute the necessary economic and governance reforms. Debt restructuring will ease the burden of external debt repayments in the medium term but eventually Sri Lanka will have to start servicing its external debts once again.

If Sri Lanka does not manage to adequately grow its economy to accommodate these payments with sufficient tax revenues and export earnings, the country risks slipping back into a situation similar to that experienced in 2021 and early 2022. The global situation is not favorable for economic recovery with many large economies undergoing recession and multiple wars being fought on different fronts.

The tourism industry shows signs of recovery but can be impeded by the labor migration. The tourism industry already faced issues with attracting labor, as it is not seen as an attractive or well-paying industry to work in. With workers either having left the industry to join other industries in the wake of the Easter attacks and the Covid impact or migrating to other countries due to the crisis, the industry will struggle to cater to the demand that it once managed to.

This calls for exploring the possibility of opening up the borders for foreign labor to work in Sri Lanka, which is a controversial issue to say the least. With mass migration, the country’s health sector is also in a bad state but opening up this sector to foreign labor is even more controversial than it would be to the tourism sector.

The importance of governance reforms cannot be overstated; addressing the governance failures that precipitated Sri Lanka’s economic decline over the past few decades is the only way to prevent reneging back into bad policy making. Checks and balances are important for a well-functioning economy and society. Since pockets have grown fat and powerful with lax governance structures for many decades, dismantling these systems that work in favor of a few and shaping them to work in favor of many is a difficult endeavor in the best of time.

Reforms to state owned enterprises are in the works, albeit at a slow pace. There are plans to pass the necessary laws to divest State Owned Enterprises (SOEs) and to set up a holding company to manage whatever SOEs remain. Reforms to SOE behemoths like the Ceylon Electricity Board are being tackled separately. The country’s flagship poverty program, Samurdhi, is being rehauled into a consolidated welfare program called Aswesuma with better targeting mechanisms, better entry criteria and exit clauses to make the program more effective. The new program also attempts to depoliticize welfare which hindered the effective function of its predecessor.

The budget, which can effectively signal the incumbent government’s commitment to reforms, is already off to a bad start. The government announced that public sector salaries would be increased. With no access to printed money from the Central Bank since the enactment of the new Central Bank Act nor access to foreign loans, the government has decided to increase VAT, perhaps to fund these salary increments.

The incumbent government has made no attempt to cut public sector expenditure and has instead opted to further increase its salary bill, which already swallows up a massive share of the tax revenue – 65% in 2022. This number is even higher when you add in the pensions bill. The government has fallen short of IMF targets on tax revenues in the recent review, so increasing expenditure further, especially just to pacify public sector workers in the light of elections, is utterly imprudent in the context.

Continuing to burden the general public with taxes to fund frivolous, unbridled expenses with no meaningful reform of public expenditure would serve as a harsh reminder to the people of Sri Lanka that the system change once demanded by the sea at Galle Face is yet to be seen, precipitating another wave of civil unrest.

It is not an understatement to say that the precarious stability that has been achieved hangs in the balance, and now with a looming election, the precarity worsens. There is no political consensus on the way forward which can solidify the reforms that the country ought to take – every possible reform is contested which does not bode well for the economy. The jostle is between the NPP, SJB, SLPP+UNP and other possible wildcards such as Dilith Jayaweera and Dhammika Perera, all of whom propose varying economic policies.

The resolution lies in a concerted effort towards comprehensive economic and governance reforms, fiscal prudence and a unified political will that transcends party divisions. The critical choices ahead will determine whether Sri Lanka can chart a stable, inclusive and sustainable economic course or succumb to the persistent vulnerabilities that always threaten its progress.

Reforming the tax incentive structure in Sri Lanka

Originally appeared on Daily FT

By Roshan Perera, Thashikala Mendis, and Janani Wanigaratne

The second tranche of the International Monetary Fund’s (IMF) Extended Fund Facility (EFF) was delayed as the country failed to meet some of the program targets including the Government revenue target. This prompted the IMF in their latest review to reiterate the need to “strengthen tax administration, remove tax exemptions, and actively eliminate tax evasion” to ensure revenue is collected as per the program targets. This requires intense efforts by the Government if the country is to achieve sustainable macroeconomic stability.

Corporate Income Tax (CIT) in Sri Lanka has the potential to significantly contribute to Government revenue. However, CIT performance has been dismal with collection averaging around 1% of GDP over the last two decades although economic growth averaged around 4% during the corresponding period. It peaked at 1.9% in 2022 due to some one-off taxes.1 Compared to other countries in the region as well, CIT collection in Sri Lanka has been abysmally low (see Figure 1).

Further, CIT collection is concentrated in a few sectors in the economy. The 230 companies listed in the Colombo Stock Exchange (CSE) for financial year 2019/20 account for around 25% of total corporate income tax collection. However, financial services, food & beverages, and telecommunications account for a disproportionate share of taxes (see Figure 2). Sectors such as wholesale and retail trade, real estate and transportation which account for more than 25% of GDP, contribute less than 2% in CIT. Tax holidays and concessionary tax rates to selected sectors have eroded the CIT tax base, leading to lower CIT revenue collection. Ad hoc tax concessions complicate tax administration, distort resource allocation and provide opportunities for rent seeking and corruption.

Tax incentives

With the liberalisation of the economy in 1977 and the shift to a more export oriented development strategy, the Government sought to attract foreign direct investment (FDI) by offering attractive tax incentives, first under the GCEC Act No. 4 of 1978 and subsequently the Board of Investment (BOI) of Sri Lanka from 1992. Tax incentives were also offered under the Inland Revenue Act. The enactment of the Strategic Development Projects (SDP) Act, No. 14 of 2008 permitted the Minister in charge of investment the discretion to grant incentives to projects deemed of strategic importance with only subsequent ratification by Cabinet and Parliament.

The lack of clear criteria of what constitutes a “strategic development project” in the SDP Act and the discretion given to the Minister to decide on what constituted a “strategic” project led to generous tax holidays and incentives granted to projects that were not in any sense strategic (see Table 1 for a list of projects granted under the SDP Act). Furthermore, tax concessions under the Act have been awarded to projects that are not purely foreign funded, violating one of the core objectives of this Act, which is to attract foreign investment.

The operation of multiple tax jurisdictions has led to an overlap of tax incentives, obscuring the process of monitoring the overall benefits and costs of tax incentives provided. Lack of transparency and well-defined criteria as well as poor evaluation of projects has led to the granting of tax incentives without proper justification, leading to large revenue losses.

Transparency, availability and accessibility of information regarding companies that have received tax incentives, especially under the BOI Act, are limited3. In light of this, the IMF diagnostic report has highlighted the need for a more transparent data sharing protocol.

The case of Port City

More recently the Colombo Port City Economic Commission Act, No. 11 of 2021 was given the authority to grant tax incentives within the Port City.

The CPC Act grants incentives to businesses that are identified as strategically important. Extraordinary Gazette 2343/604 lists several industries as strategically important. Even though the Act provides a descriptive definition of a business of strategic importance, the rationalisation for these industries to be selected for special incentives is unclear. Especially as some of these industries already exist in Sri Lanka, which puts them at a disadvantage. Moreover, under section (4) subregulation (3) of the Extraordinary gazette 2343/60, one of the criteria for granting incentives is the ability of the business to demonstrate to the Port City Commission the potential contribution to Sri Lanka’s economy and social development by fostering innovation, knowledge transfer, technology transfer, research and development. This criteria is vague and subjective, thus allowing the Commission to grant incentives at its discretion.

Granting incentives often leads to differential tax treatment creating an unlevel playing field. While an entity in an already established industry within the country located within the CPC is provided generous tax incentives, the firm located outside is subject to the normal taxes operating in the rest of the country. Such differential treatment could create labour market distortions, as the employees in the Port City benefit from tax exemptions.

Sri Lanka has not been able to attract Foreign Direct Investments (FDIs) despite the plethora of incentives offered. It is questionable whether we can expect different results by applying the same failed strategy with the Colombo Port City. For instance, out of 74 land plots, only 6 were leased so far, and even those have not yet materialised.

To improve the performance of CIT, reforming the existing incentive structure is critical.

Improving investment environment

Evidence suggests that tax incentives are not the most important factor attracting FDI. Rather investors prioritise factors such as macroeconomic stability, access to skilled labour, and quality infrastructure facilities when making investment decisions. Therefore, shifting focus from relying on tax incentives to creating a favourable macroeconomic environment and policy consistency while providing the necessary resources and infrastructure will be more important to attracting investments. This will reduce distortions in the economy while ensuring the Government’s revenue base is protected.

Renegotiating tax incentives

Given the weak fiscal position of the country and the debt restructuring exercise being carried out at present, a similar exercise to renegotiate existing tax incentives may be warranted. Rationalising existing tax incentives would widen the tax base and enable lowering corporate tax rates.

Centralising tax incentives

If tax incentives are to be granted it should be done by a centralised authority. This authority should be able provide justification for granting special tax incentives by carrying out a cost benefit analysis. Clear objectives and proper criteria for granting incentives should be established and the authority held accountable for monitoring the progress of the investments to ensure the objectives of the investment are fulfilled. Failure to meet the objectives should lead to an immediate cancellation of the incentives granted. To ensure transparency, all incentives granted should require Cabinet and Parliamentary approval and information on incentives granted made publicly available through gazette notices. Sunset clauses will ensure that incentives have a limited timeframe and are periodically reviewed.

Conducting tax expenditure analysis

Tax expenditure refers to concessions such as tax exemptions, deductions, concessionary tax rates, etc. granted to specific industries or entities. While typically a government budget provides estimates of government revenue, tax expenditures are rarely reported. However, given the generous tax incentives offered it is vital to ensure the costs and benefits of tax expenditures are properly accounted for. Conducting regular tax expenditure analysis will enable comprehensive cost benefit analysis to evaluate the potential revenue loss and the expected economic benefits of tax incentives. Moreover, it is essential to carry out regular assessments to ascertain whether the revenue loss resulting from tax exemptions is justified by the employment, GDP contribution, and economic impact of these projects.

Global Minimum Tax 5

When tax incentives and holidays are granted, it should be ensured that their rates are not lower than the rate recommended by the Global Minimum Tax (GMT). This is an agreement introduced by the OECD/G20 in October 2021, with the purpose of establishing a minimum tax rate of 15% for large multinational companies. It allows countries with taxable parent companies of Multinational Enterprises (MNE) to impose a top-up tax on the profits of any foreign subsidiary that pays an effective rate less than 15%. It also allows the host country where the MNE subsidiary carries out its activities to charge a top-up tax rate on subsidiaries, if the home country of the parent company imposes a CIT rate less than 15%. So even if the countries are free to grant tax holidays and incentives with a CIT rate lower than 15%, the agreement grants the taxing rights to either the FDI exporting countries or the countries in which the MNE subsidiaries are operated. Therefore the MNEs would not be benefitted by lower rates as they will be taxed by either country.

The countries that do not adopt this GMT rule would lose out on tax income as the other countries will adjust their domestic tax rules to top up undertaxed profits. This proposal has already been strongly backed by 130 countries. Unfortunately, Sri Lanka was one of the nine countries that did not agree to this proposal.

The country is struggling to meet its revenue targets. The potential of CIT as a significant source of revenue has not been not fully exploited. A plethora of tax incentives granted under numerous agencies have seriously eroded the tax base. Reversing these trends are vital for restoring fiscal sustainability and enabling the Government to promote sustainable and inclusive growth.

Footnotes:

1This is due to the imposition of a retrospective one-time surcharge tax of 25% on individuals, companies, and partnerships with a taxable income exceeding 2 billion for the 2020/2021 tax assessment year.

2Based on the taxes paid by around 230 listed companies on the Colombo Stock Exchange in 2019/2020.

3Information on projects granted under the SDP Act are publicly available through gazette notices which are mandatory. This is unlike projects granted incentives under the BOI Act which are not publicly available. An RTI filed to extract this information was also not responded to by the relevant authority.

4http://documents.gov.lk/files/egz/2023/8/2343-60_E.pdf

5World Bank, 2023, “Can the global minimum tax agreement reduce tax breaks in East Asia?” https://blogs.worldbank.org/developmenttalk/can-global-minimum-tax-agreement-reduce-tax-breaks-east-asia#:~:text=In%20October%202021%2C%20the%20G20,to%20be%20implemented%20in%202024.

(Roshan Perera is a Senior Research Fellow at Advocata Institute. She can be contacted via roshananne@gmail.com. Thashikala Mendis is a Data Analyst at Advocata Institute. She can be contacted via thashikala@advocata.org. Janani Wanigaratne is a Research Consultant at Advocata Institute. She can be contacted via janani.advocata@gmail.com.

The opinions expressed are the writers’ own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.)

Port City more crucial by the day so don’t delay

Originally appeared on The Morning

By Dhananath Fernando

Debt repayments, human rights issues, credit rating downgrades and pandemic make Port City our big hope.

The company Google maintains the idea of “10X thinking”. What 10X thinking means is that if one is serious about innovation, one would ideally improve things by 10 times, rather than by 10%. While Google believes we have to move at 10 times the speed for real transformation, the Japanese believe in a business philosophy that goes by the name “Kaizen”. The Kaizen theory emphasises that small-scale productivity improvements, if done consistently, with the engagement of employees, will lead to effective transformational change over time.

In hindsight, looking at Sri Lanka’s development pipeline, our own 10X ideas or Kaizens are not something we can be too proud of. We’ve hardly had any 10X ideas, and have had little consistency in our policy. In fact, one could say that the only consistent aspect of our policy is that it is inconsistent.

One of the main 10X ideas for Sri Lanka that this column has extensively discussed is land reform, chiefly through building a digital land registry that could infuse capital into the economy and improve agricultural productivity. The other 10X idea we have on our table is the Colombo Port City, a project by China Harbour Company. 

The reclamation of 269 hectares of land was completed in January 2019. The construction of the water breaker was completed in June the same year. In this backdrop, it has been reported in the media that last week the Cabinet approved the Colombo Port City Economic Bill, which allows the establishment of a special economic zone within Port City.

What is so special about Port City? I am sure most Sri Lankans would say they know nothing much, other than the fact that it is a Chinese investment, and an ambitious project to build a city on the sea. Many view it as an infrastructure project to build a financial city with tall buildings, including hospitals, residential areas, hotels and schools, and many other ancillary services, to make Sri Lanka a financial hub. 

Then the main question we have to ask ourselves is: Why would investors want to come to Port City? The simple reason is that the Port City would act like a special economic zone with special laws and regulations. Therefore, it would be a more convenient place to operate. Secondly, reduced regulations would make it easy to connect with other centres, creating a conducive environment to make profits.

However, people are largely unaware that the new law in force in the Port City actually makes it a project with 10X additions, and gives it an opportunity to become a financial hub in the region. The significance is not in the skyscrapers or other physical infrastructure, but instead lies in its potential to create an easier operating environment with lower regulations.

The next question you may ask is: Why do we need a new law for the Port City? Why can’t it fall under existing Sri Lankan business law? The answer to that is simple: If businesses in Port City come under Sri Lankan law, and under the current jurisdiction and regulatory framework – starting from business registration to resolving a business conflict, or any transaction for that matter – then these businesses would experience the same inconvenient and cumbersome process of doing business that all investors in Sri Lanka presently have to endure.

To attract an investor to Port City, the laws and regulations it comes under should facilitate the creation of speedy business services, and have significant synergies in productivity, thereby significantly lowering business transaction costs. In addition, the laws incorporated will have to be competitive and on par with other competing financial hubs, such as Singapore.

The draft law will be a critical factor that determines the future of this multi-billion dollar project. It has to be competitive with other financial centres in the region if it is to succeed. If it fails to meet these standards, investors have no reason to bring their money, or to move their financial institutes and headquarters to Sri Lanka.

We cannot comment on this law until it is placed before Parliament, but we know for sure that this should have happened far earlier. The Port City project was launched in September 2014, but even after seven years, investors are yet to see this law. This is essential to their investment decisions.

Under the previous Government, it was reported that some attempts were made in drafting the law, but it was not presented to Parliament, and the project was on hold for renegotiation. While the Cabinet clearance of the Colombo Port City Economic Bill could renew hope for the project, we should not delay the process further. At the same time, we have to be absolutely confident that the law has been drafted with the right specifications to meet investor expectations. Because of the current delay in producing the legal draft to Parliament and getting it approved, a quick sale on land in Port City has been affected. Just by the sale of land, or 99-year lease agreements, the Government expects a minimum of $ 1.8 billion in revenue, and $ 3.4 billion for the China Harbour Company. However, in making an investment calculation, we look at not only the amount of money we invest, but also the time spent.

According to State Minister of Money, Capital Markets and State Enterprise Reforms Ajith Nivaard Cabraal, out of $ 32 billion expected in foriegn currency inflows to the country, $ 15 billion in exports and about $ 7-8 billion in remittances has been forecasted. More than $ 3 billion is expected in total only for this year in the form of Foreign Direct Investment, and the main investments are expected through the Port City project. Therefore, the development of the Port City is a significant source of income for the country.

With mounting debt repayments for the next three to four years, and now with the UN Human Rights Council’s human rights-related issues, we should understand the importance of the collective effort of maintaining Sri Lanka’s image as a credible global partner. In this backdrop, placing all our investment expectations into the sole basket of the Port City is going to prove risky.

Let’s think through this in the shoes of an investor. Imagine you have about $ 1 billion and you’re considering investing in the Port City project. But to date, you do not know the law that will be enforced, while concerns have been raised by the UNHRC. In addition, the country’s credit rating has been downgraded by rating agencies, particularly in the face of the pandemic. Would you, as an investor, confidently bring your $ 1 billion to Sri Lanka – or would you delay the investment and consider markets such as Singapore, Malaysia, and Vietnam?

On the other hand, the Government has to be very careful of the potential opposition from anti-competition lobby groups who will be affected by the Port City. A successful Port City project means the presence of international law firms, IT professionals, health care workers, and education experts; opening up competition with the best of talent and skill at the global level. Sri Lanka’s experience in the recent past has not been very positive when it comes to opening up to competition. Our strategy has always been to look inwards, rather than outwards.

Therefore, the Government has the twin challenge of first getting the legal draft right and getting it out fast; and providing investors with confidence and addressing investor expectations with a collective effort of easing businesses in Sri Lanka. Secondly, the Government will have to manage the resistance that is likely to pop up from lobby groups for changes in the legal draft, blocking international competition in certain sectors. 

If we are serious about a transformed Sri Lanka, we need a combination of Kaizens and 10X ideas; meaning we have to consistently implement 10X ideas for a significant period of time. But only time will tell what we will do.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.