Conclusion of IMF staff’s assessment

Overview: Although the immediate risk of a balance of payments crisis has receded and much progress has been made in rebuilding reserves and advancing financial sector reform, 2009 was a lost year in terms of deficit reduction and tax reform.

The war is over and elections are now past, and since then the government has given significant positive signals that it will exploit the window of opportunity offered by the current stable environment to launch reforms that improve private sector growth, attract investment, and address the fiscal vulnerabilities. The authorities have proposed a solid post-election policy agenda that would address past slippages and, if implemented, would result in significant progress toward meeting the programme’s original goals, including fundamental and sustainable budget deficit reduction.

Monetary policy and exchange rate policy - The Central Bank’s policy stance so far has been appropriate, although there may be a need to tighten its stance if credit picks up sharply in the coming months. The exchange rate will need to show more flexibility if rapid growth of imports begins putting pressure on the balance of payments.

Reforming the Board of Investment -  For 30 years, the investment promotion regime has relied primarily on wide-spread, often ad hoc tax concessions that have significantly eroded the tax base and distorted the playing field for domestic investors. Reforming this regime is fundamental to address these weaknesses. By undertaking these reforms, the government has demonstrated a recognition that in the post-war economy a stable and simple business environment is what is critical for attracting investment, and that large tax concessions are no longer necessary.

Fiscal policy - Although the budget outturn for 2009 and election-related delays in fiscal reforms call for some recalibration of the programme, the programme’s original goals of fundamental and sustainable deficit reduction remain unchanged. In line with this, the government’s proposed 2010 budget would be a first step toward meeting these goals by incorporating significant cuts in recurrent spending and allowing room for much needed public infrastructure investment. Beyond 2010, further deficit reduction will need to be driven primarily through increases in revenue to bring the ratio to GDP closer to key comparator countries. This adjustment will also need to preserve social spending and meet the need to resettle the remaining internally displaced persons and rehabilitate the war-torn north and east.

Tax reform - The government has already taken significant actions as part of their effort to simplify the complicated and inefficient tax system, address distortions, broaden the tax base, and ultimately bring about a sustainable increase in revenue. The reform of trade and excise taxes not only corrects a complicated and difficult to enforce regime which had been built up over the past decade, but will also add much-needed predictability to the tax system. By halting new tax concessions under the Board of Investment regime, the authorities have taken the first step in reversing the most significant source of tax base erosion. Further steps are needed however to put in place legislative changes to permanently reform tax concessions under the new regime, and to simplify and broaden the bases for the VAT and income taxes.

Financial sector reforms - The government’s actions so far have gone a long way towards addressing past weaknesses in the financial sector, and have demonstrated the authorities’ commitment take the necessary steps to strengthen regulation and its legal framework. This work will continue in important areas, including putting in place a deposit insurance system and establishing a regulatory framework for pensions.

Risks - The government has yet to carry out its commitment to deficit reduction, and actions on tax reforms have been delayed by one year. The fiscal performance so far this year and the recently-enacted tax reforms are first steps in helping to build the government’s credibility toward meeting its goals, but if this is to continue, it will be important that the government meets all of its deficit targets going forward, and carries out its commitment to enact the promised additional tax reform measures in the 2011 budget. The revenue yield from the tax reform measures is far from certain, and the government will need to be prepared to adjust tax rates if needed to meet its revenue targets.

Despite the poor 2009 fiscal performance, the government’s 2010 budget proposal, if carried out, would go a long way to address past fiscal slippages.

 The government’s significant up-front actions on tax reform are an important signal that the government has the will to bring its fiscal programme back on track. Financial sector reform has continued in line with the programme, and has gone far to address regulatory weaknesses. On this basis the staff recommends the approval of the Second and Third Reviews, and supports the authorities’ request for an extension and rephasing of the programme.