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Economics whiz kid Aseni and her grandfather Sarath Mahatthaya of the Ministry of Finance fame are continuing their exchange of views of the economics of President Ranil Wickremesinghe, tagged as Ranilnomics. They had already discussed what Ranil should do to win the ideological battle with his Parliamentary supporters made up of the members of SLPP (available at: https://www.ft.lk/columns/Child-s-guide-to-how-Ranilnomics-should-be-designed-and-implemented-Part-I/4-739461), the weaknesses of temporary suspension of some selected items of imports (available at: https://www.ft.lk/columns/Child-s-guide-to-Ranilnomics-Part-II/4-739758), how he should put to practice what he preaches as Lichchavi principles of governance (available at: https://www.ft.lk/columns/Child-s-guide-to-Ranilnomics-III-Buddha-s-prescriptions-on-governance/4-740034), implications of the proposed debt restructuring program (available at: https://www.ft.lk/columns/Child-s-guide-to-Ranilnomics-IV-Proposed-debt-restructuring-will-pose-more-issues-than-answers/4-740260), and a mere IMF bailout will not be sufficient for him to rescue Sri Lanka from the current chronic and acute economic catastrophe (available at: https://www.ft.lk/columns/Child-s-guide-to-Ranilnomics-V-Need-is-going-for-IMF-Plus/4-740501).
Today, they look at his fiscal reform program.
Aseni: Grandpa, the Government has proposed a drastic tax hike to fill the empty coffers of the Treasury. But it has been criticised by many as a draconian measure, unsuitable for today’s economic conditions, and a deathblow to the country’s moribund economy. Are these criticisms fair?
Sarath: Sri Lanka’s budgets and budgetary policies have been in crisis ever since the country gained independence from the British in 1948. All successive governments had planned rising public expenditure programs year after year without looking at how those programs should be funded. When the situ deteriorated to an unmanageable level, the previous Ranil Wickremesinghe administration sought to resolve it, of course on advice by IMF, by increasing the government revenues. It is a strategy known as fiscal consolidation – a term used to describe measures taken to resolve issues of government budgeting – by increased revenue.
The Gotabaya Rajapaksa administration that came to power in 2019 reversed this strategy choosing fiscal consolidation by pruning expenditure. That is why it offered an unsolicited lucrative tax concession to income tax and value added tax payers creating a massive dent in the revenue base. It could not prune the expenditure and hence with reduced revenue drove the country to a bigger budget deficit from around 6% of GDP to well over 12%.
The new Ranil Wickremesinghe Government, seeking an IMF bailout, is planning to go back to the old era where it would once again seek to resolve it by increasing revenues. Its plan is to increase the revenue from the present 8-9% of GDP to about 12% in the medium term and finally to 15% by 2025 which is a plausible target for Sri Lanka.
The critics are aware of the need for increasing taxes and revenues of the Government. Their criticism is on the finer details of the proposal.
Aseni: Grandpa, Nobel laureate in economics Milton Friedman, in a public lecture delivered as far back as 1978, has presented a different view on fiscal consolidation. It has now been released to YouTube and you can have access to it at https://www.youtube.com/watch?v=8txLAkao6nI&t=2683
s. He has been a sharp critic of increasing taxes as well as government expenditure. How will it help Ranil Wickremesinghe administration frame its budgetary policy?
Sarath: In many ways. I think it should be made the learning exercise of all his Cabinet and State ministers and also his Parliamentary group. Because only when we listen to Friedman that we come to know that there are many subtle points about fiscal policy, fiscal governance, and the behaviour of both the Parliamentarians and voters. Both these groups work in self-interest. It is the duty of the ruler – in Sri Lanka’s case, the President – to use that self-interest for the benefit of the country.
Aseni: What are those subtle points, Grandpa?
Sarath: His main point and which we normally do not appreciate, is that tax burden falling on people is not what they pay as taxes to the Government out of their current incomes. It is the total expenditure of the Government. A part of that expenditure is financed out of the current tax revenue. We know higher these taxes, higher the tax burden falling on people. However, if the Government runs a deficit, that deficit is normally financed by borrowing. When the Government borrows from the domestic sources, money saved by people is transferred from the savers to the Government. Since it is those savers who make a sacrifice in the form of foregoing what they could do today, we believe that it is those savers who bear the burden of Government’s current borrowing. However, that borrowing should be repaid by the Government with interest by taxing us in the future.
You might say that the Government can avoid this future taxation by reissuing the debt. That is what many governments, including our own, have been doing. But one day when they cannot borrow anymore to play that game, they reach a position where they cannot raise any more loans, default the debt is the only option, and getting people to make a huge sacrifice. But when the Government raises taxes in the future to repay the debt, people are simply postponing current taxes to the future. Hence, debt financing of the government expenditure is same as tax financing. This was first presented by the classical British economist David Ricardo in early 1800s. Therefore, it is known as Ricardian Equivalence or in simple terms, both debt financing and tax financing have the same effect on the economy. In both cases, people have to pay higher taxes to keep the government expenditure going. What this means is that if you have a Treasury bill or Treasury bond, do not get elated that your net wealth has increased. That bond is simply a warrant for you to pay higher taxes in the future.
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Aseni: But what happens if the Government finances its expenditure by borrowing abroad? Is it also a future tax liability?
Sarath: Yes, indeed. But it is worse than borrowing from the domestic market. That is because when the Government borrows abroad, it mobilises the savings of those living abroad for domestic government expenditure. When the borrowing is made, there is an inflow of foreign exchange to the country enabling people to enjoy more imported goods. A good example is paying for petrol imports by borrowing abroad. You immediately enjoy the petrol which you can buy without standing in a queue. However, when the country will have to repay that debt, it has to make a bigger sacrifice because it has to repay the principal with interest. There is a resource outflow. That outflow is equal to a tax paid to the Government. Therefore, there is an equivalence between both the domestic borrowing and foreign borrowing.
Aseni: What happens if the Government finances its expenditure by borrowing from the banking system? Does it also cause people to pay a tax? Obviously, not. The printed money, when it comes to the hands of people, will increase their wealth, won’t it?
Sarath: That is the popular belief, especially those economists who subscribe to a new economic theory called the Modern Monetary Theory or MMT. According to them, there is no danger if the Government prints money and finances its expenditure. But that is true if and only if the new money created by the Government is just equal to the growth in the real goods and services in the economy, which economists call the real growth or the increase in the real GDP. In that case, any increase in money does not cause a corresponding increase in the prices. However, if money is printed over and above this real growth, it causes inflation and inflation is a tax on people who hold on to money balances.
Therefore, the safe way of printing money by a government without causing inflation is to set the money supply growth equal to the real economic growth.
Aseni: Can you give an example?
Sarath: Let’s assume an economy where there is only one real good, say coconut, and a facilitating agent called money. Suppose this economy has produced 10 coconuts and issued 100 units of money. Now, people will have to exchange money for coconuts and coconuts for money. The price of a coconut is simply the quantity of money divided by the quantity of real goods. In this case, it is 100 divided by 10 or simply 10 units of money. Now assume that the quantity of coconuts increases to 20 while the quantity of money goes up to 200. In this case, there is no inflation because the price remains at 10 units of money. Suppose further that when the coconut production increases to 20, the quantity of money increases to 400. Now the price goes up to 20 and it is due to the increase in the stock of money to 400. We can summarise this to a convenient formula. If the money supply is increased at the same rate as the real economic growth, then, there is no inflation. But if it is above the real economic growth, it leads to inflation. That is where the governments make mistakes.
Aseni: But how come inflation becomes a tax?
Sarath: Again let’s take an example. Suppose the Central Bank prints a 5,000 rupee note and gives to the Treasury to pay salaries to a teacher. The teacher sacrifices, say, 8 hours of her real labour services. But the Government’s real sacrifice is only the printing cost of that 5,000 rupee note, which, let’s assume, is only 10 rupees. In this case, the Government makes a huge profit of Rs. 4,990. This profit earned by the Government is known as seigniorage, a French word meaning the profits earned by a Lord by minting coins.
Now it is an unfair exchange. But why should the teacher agree to this unfair exchange? That is because at the time of her providing 8 hours of her real labour services, the teacher is told by the Government that if she takes that piece of paper to the market, she can get, say, 1 kg of milk food. Therefore, she has exchanged her 8 hours of real labour not for a 5,000 rupee note, but for another real good called 1 kg of milk food. But the Government plays this trick with all the people of the country. Therefore, it is not only this teacher who has a 5,000 rupee note in her possession. There are others.
When all of them go to the market to buy milk food, its price too increases. Let’s suppose that it has now gone up to Rs. 10,000 a kilo. Now she can buy only a half a kilo of milk foods. The decline in her real purchase from one kilo to a half a kilo is equal to a tax she has paid to the Government. In both cases, her disposable income falls. Since this has happened due to inflation, it is called the inflation tax.
The inflation tax is the easiest method of financing the government expenditure because it does not require the passage of a law, create a bureaucracy to collect taxes, and follow up on those who have not paid the taxes. Because of this convenience involved in the inflation tax, all governments resort to it as a safe form of financing the government expenditure.
Aseni: Is inflation tax an evil tax?
Sarath: Yes, it is far more deleterious than other forms of taxes. That is because it brings disastrous results to all economic activities. It forces people to shift from financial assets to unproductive real assets as a hedge against inflation. Once inflation hits a country, people are more concerned about today rather than tomorrow. As a result, future investments decline causing the economy to produce less than its capacity. If the Government fixes interest rates below the inflation rate, the resultant negative real interest rate will dry out savings, encourage borrowing, and cause savers to pay interest in real terms to borrowers.
If the exchange rate is not allowed to depreciate to maintain the purchasing power of the currency, it imposes a tax on exports discouraging them and pays out a subsidy to imports by making them profitable. The resultant deficit in the balance of payments will put further pressure on the exchange rate to depreciate. When people lose their real income, they are impoverished and there will be social and political chaos in the country threatening its stability. Hence, inflation is the public enemy number one and the inflation tax is the most evil of all taxes. w
Aseni: I now understand. People should be more worried about the total government expenditure and not merely about the taxes they pay. How is it relevant to the case in Sri Lanka today?
Sarath: Sri Lanka’s present inflation is about 70% if one goes by the Colombo Consumers’ Price Index. The food inflation is more alarming at 94%. What this means is that if a person had Rs. 100 12 months ago, its value today is simply Rs. 30. If he buys inly food items, its value is just Rs. 6. That is a drastic reduction in the purchasing power of people and the Government should not ignore it anymore.
As for the Government’s expenditure, its level will increase, according to the estimates presented in Parliament, to Rs. 7.92 trillion in 2023 from Rs. 4.67 trillion in 2022. What this means is that the total tax liability of Sri Lankans will increase by about 70% and it is much more than the increases in income tax rates proposed by the Government. Therefore, what the Government should do is to curtail its expenditure as well. Otherwise, the country will have to increase taxes every year to finance the rising expenditure programs. This is not feasible because one day when the country reaches its limit, there will be another economic bankruptcy at our doorsteps.
Aseni: Thanks, Grandpa, for your clarifications. I now understand the danger of increasing the government expenditure, which is simply a tax burden imposed on people, as direct payments to government as taxes, assuming a liability to pay more taxes in the future to repay government debt, and undergoing a reduction in the real value of money due to inflation which is also a tax. Therefore, the governments should cut their expenditure drastically, spend the available scarce resources after drawing a priority list, and relieve the people of the oncoming high tax burdens. If President Ranil Wickremesinghe ignores this, he does it to his own peril as well as the peril of the country.
(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)
Part I, II, III, IV and V of this series are available online at:
If the exchange rate is not allowed to depreciate to maintain the purchasing power of the currency, it imposes a tax on exports discouraging them and pays out a subsidy to imports by making them profitable. The resultant deficit in the balance of payments will put further pressure on the exchange rate to depreciate. When people lose their real income, they are impoverished and there will be social and political chaos in the country threatening its stability. Hence, inflation is the public enemy number one and the inflation tax is the most evil of all taxes