The Ministry of Finance, under the direction of Prime Minister and Finance Minister Ranil Wickremesinghe, known as RW, has hiked main taxes in the country moving halfway back to the tax regime that prevailed prior to 2020. Before this action, the Inland Revenue Services Union, made up of Assistant and Deputy Commissioners, had addressed a memo to RW suggesting measures to be taken to deliver an improved annual tax harvest of Rs. 1,200 billion. The tax measures introduced by the Finance Ministry are short of these proposals. Perhaps in the next round of tax reforms, the Ministry might reckon those proposals and if it does not do, its budgetary position will remain perilous.
Rationale of tax cut by Gotabaya administration
The tax cuts offered by the Gotabaya Rajapaksa administration in January 2020 has been a contentious issue. The rationale presented by his policy advisors for these unsolicited tax concessions goes as follows. The previous tax regime introduced by Finance Minister Mangala Samaraweera had planned to attain fiscal consolidation – action taken to reduce the budget deficit to an affordable level and thereby check on debt accumulation – by increasing tax revenue. This is because the administration at that time had felt that attaining that objective by curtailing Government expenditure was considered an impractical strategy. But the administration had paid attention to rationalising Government expenditure as a means of improving the productivity of the sector. Accordingly, in the medium term, tax revenue was to be raised from 11.8% of GDP in 2018 to 15% by 2023.
However, such a high tax level was viewed as an unnecessary burden imposed on real economic activities by Gota’s policy advisors. Hence, instead of seeking to attain fiscal consolidation by increasing revenue, a strategy aiming at curtailing Government expenditure was planned. On the revenue side, it was planned to concentrate on a small number of large taxpayers and recover the tax loss by collecting the maximum from them. The rationale behind this strategy was that when tax rates are reduced, people would pay more taxes leading to an increase in the total tax revenue, a concept proposed by economist Arthur Laffer and now known as Laffer curve strategy.
Warning by independent economists
When this policy was announced Gota’s election manifesto, it appeared to independent economic analysts that it was a recipe for disaster. I took up the issue in December 2019 when the new government was making plans for its introduction and warned in an article in this series that the Government should control the damage before the unconventional stimulus would backfire (available at: https://www.ft.lk/columns/Tax-cuts-Control-the-damage-before-the-unconventional-stimulus-backfires/4-691207). The following is a reproduction of some of the arguments made in this article.
Bandula hails tax cuts as giving more money to people
The Cabinet spokesman Dr. Bandula Gunawardena had hailed the proposed tax cut that it will leave more cash in the hands of individuals and businesses enabling them to overcome the economic hardships they had been undergoing for some time. The public at large also welcomed it because they had more cash on hand to spend.
But others did not share this view
But the Moody’s Rating Services branded the stimulus as ‘credit negative’ implying that it would lead to a downgrading of the country’s present rating of B1/Stable unless it is managed properly. The Fitch rating had warned that the stimulus package which is hailed by Bandula Gunawardena will derail the budget disciplining exercise started by the previous government. A similar view was expressed by IMF’s Sri Lanka country head too. Dr. Indrajit Coomaraswamy who was about to leave the Central Bank at that time had warned that the stimulus package in question should not undermine the debt sustainability exercise introduced by the previous government.
The World Bank’s Chief Economist for South Asia, Hans Timmer, delivering a public lecture at the Central Bank’s Centre for Banking Studies was more polite in expressing his concerns. He said that though there may be reason for fiscal stimulus, there is no space for it in Sri Lanka and the policymakers should strike a proper balance between fiscal stimulus and the need for preventing the overheating of the economy – a situation where the aggregate demand was rising faster than the aggregate supply.
What it means is that if Sri Lanka’s potential growth is low, stimulating the economy either through fiscal policy or through monetary policy would simply increase the demand causing the prices to increase and the exchange rate to fall. Both these outcomes are what the Government wants to prevent from happening at any cost. Immediately, the reaction of the international community was visible in the form of a decline in the market prices of the international sovereign bonds issued by the Government.
Laffer curve strategy was irrelevant to Sri Lanka
I argued that the expectation of increasing revenue by cutting tax rates following the Laffer curve strategy was not relevant to Sri Lanka. Though the Laffer curve was a general law in economics, empirical studies have shown that it would be mostly effective when the tax rates are 70% or above. But Sri Lanka’s marginal tax rate was just 24% at that time and, hence, it had not reached the level at which the taxpayers would be incentivised to pay more taxes when the rates were cut.
Loss of tax revenue through tax cuts
Hence, it is not the Laffer curve which may have prompted Sri Lankan authorities to cut tax rates but some other consideration. That is to provide an additional income to the hands of the taxpayers, catch more liable people into the tax net and increase the tax revenue by getting more people to pay taxes. This last goal had been expressly mentioned in the election manifesto. According to press reports, the tax cut is intended to address both the individual taxpayers and the corporate taxpayers. The Government was therefore to lose a significant amount of tax revenue due to the tax cuts. That was estimated in December 2019 at about Rs. 650-680 billion. That was a revenue loss that could not be afforded by the cash-strapped Government. This advice as well as the warnings of others was not heeded to by Gota’s policy advisors. They went ahead with their program and implemented it.
Pandemic made the situ worse
When Sri Lanka was hit by the outbreak of the COVID-19 pandemic in the early part of 2020, due to the loss in revenue, the country had already lost the necessary fiscal space to address it. Expenditure had ballooned increasing the fiscal deficit to unaffordable levels thereby derailing the fiscal consolidation program initiated by the previous government. Given this predicament, in another article published in May 2020, I suggested to the Gotabaya administration that it should consider postponing the costly tax reforms (available at: https://www.ft.lk/columns/Constrained-fiscal-space-for-post-COVID-19-reconstruction-Consider-postponing-costly-tax-reforms/4-700327).
Consequences of bank funding of the budget: Inflationary depression
The Government was to use the Central Bank’s unelected money printing power to fill the budgetary gap and it entailed more problems than solutions. That was because when money was issued excessively, it would cause to establish inflationary pressures in the economy. Since the economy was also spiralling downward, it was obvious that it would also be hit by an economic depression. Hence, Gota’s liberal approach of using Central Bank’s money printing power was infecting Sri Lanka’s economy with a new ailment. That was inflationary depression. That ailment characterised by massive unemployment and low incomes amidst rising prices was to sow the seeds of an uncontrollable social and political disorder. Gota’s policy advisors who led the country to this disaster are no more with him. But the prediction made in May 2020 has now come true causing innumerable hardships to Sri Lankan people.
Suggestion to postpone the tax cuts
Hence, my suggestion to Gota was as follows: ‘These types of tax reforms should be tried under normal situations. The present COVID-19 environment is not the ideal situation to do so. It has handicapped the government by restricting its freedom to respond to the rising demands made of it by affected individuals and businesses. If the revenue does not flow into the Consolidated Fund, there is no way for the Minister of Finance to withdraw funds from it by issuing a warrant under the Constitution. Even after the expected approval of a formal budget by the new Parliament, the government will continue to suffer from this handicap due to its low revenue base. It will not be able to meet its financial obligations unless it borrows heavily from the local and foreign markets. Both would worsen the country’s debt situation pushing it further down to an inescapable debt trap. This has to be avoided at all costs. Given these circumstances, it will be prudent for the government to postpone its generous tax reforms until the country returns to normalcy’.
Tax Cut: Mother of the economic crisis
The loss in government revenue due to the tax cut has been the Mother of the Present Economic Crisis. Following an ideology presented by a breakaway group from mainstream economists who called themselves Modern Monetary Theorists, Gota’s policy advisors had liberally used the created moneys in the banking sector to finance the budget deficit.
Shenoy’s objection to money printing
The danger of following this approach has been presented by Indian economist B.R. Shenoy who taught economics in 1940s at the University of Ceylon. In a book published in 2004 under the title ‘Theoretical Vision’, he has made a distinction between voluntary savings and involuntary savings Voluntary savings are real sacrifices made by people by curtailing real consumption and made available for investors for use in real investments. For instance, if a man produces 100 kg of rice and consumes only 80 kg, he makes a voluntary saving of 20 kg of rice in real terms. This is made available to investors to produce, according to Shenoy, higher order goods which economists call investment goods.
These investment goods will produce more consumption goods in the future, increasing the real income of people thus facilitating them to consume more consumption goods. It therefore leads to a change in the economic structure and thereby generation of long-term economic prosperity. Involuntary savings are those savings created out of the artificial credit and deposit creation by banks with the support of money printed by the central bank. These savings are imaginary savings arising from imaginary assets of financial institutions as against the real savings made by people by curtailing real consumption. Shenoy says that at first such imaginary involuntary savings can increase output but cannot sustain it since they are not backed by real production of investment goods. Hence, it leads to disaster. Sri Lanka is presently experiencing that disaster.
Depletion of foreign reserves
With money printing, aggregate demand for consumption goods will increase. Since most of these goods are obtained from abroad, it will increase the import bill eating into the country’s meagre foreign exchange reserves. Sri Lanka had a foreign exchange balance of $ 7.6 billion in December 2019. This has fallen to a negligible level by May 2022. The worst situation has been that Central Bank’s net foreign assets have become negative and they amount to a negative balance of $ 4.4 billion by March 2022. With no foreign exchange available, exchange rate has been in a freefall and Central Bank’s attempt at fixing it at Rs 360 per dollar has created an acute shortage of foreign currencies in formal banking institutions. The corollary has been the development of a lucrative black market for dollars outside the formal banking institutions.
Economic depression at its worst
Without foreign exchange, Sri Lanka cannot make any payments. Payment to commercial and bilateral lenders has already been suspended. There is no foreign currency available in the banking system to pay for essential imports. That includes consumption goods like fuel, cooking gas, medicines, foods, and investment goods like raw materials. These shortages have created queues on one side. They have also deprived the industrial sector of necessary raw materials. As a result, As a result, economic activities have been hampered leading to unemployment, income losses, and prolonged depression. Hence, the loss of revenue due to unplanned tax cuts has been the main contributory agent for these economy-wide ailments.
Choosing the lesser of the evil
In this background, RW’s tax hike is welcome. It will certainly pass a tax burden on to people. However, the alternative of printing more money to finance the Government expenditure will be more painful due to inflationary pressures that it will bring about. Already, the official inflation rate is running at 39% with a food inflation of 57%. This will further rise, if the Government resorts to money printing to finance the budget. Hence, RW has chosen the lesser evil.
Need for implementing strategies for real sector development
However, his responsibility should not stop there. He should come up with a road map to improve the real sector in the economy. That road map should necessarily contain strategies to introduce new technology and align Sri Lanka’s economy to the global economy within the shortest time possible. Without this, a mere tax hike to rescue the budget will be fruitless.