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Thursday, 11 July 2013 01:42 - - {{hitsCtrl.values.hits}}
Pro to countercyclical policies
IMF Resident Representative for Sri Lanka and Maldives Dr. Koshy Mathai spoke on the absolute necessity for Sri Lanka to move from pro-cyclical policies to countercyclical policies and compared Sri Lanka’s performance to those by countries in emerging Asia and Latin America in order to see where the country stands from a global stance.
He explained that a country’s fiscal deficit is so important because it has been found that over the past 50 years, the root of macroeconomic problems in most countries is fiscal. Sri Lanka’s Government is currently running a deficit and there are only limited options available to each country to finance that deficit.
Options include printing money, which increases inflation, borrowing money which could slow investment in the private sector and the third option, which is one that many countries have looked at, is by borrowing internationally, yet this comes with great risk. Mathai stated that research has shown that countries with looser fiscal policies tend to have higher inflation and interest rates. Countries with higher debt 
positions, where Sri Lanka is at now in comparison to other countries, tend to have lower growth.
“Over the last seven to eight years, the debt to GDP ratio in Sri Lanka has gone down steadily. This is thanks to the efforts of the Government to reduce the deficits it has been running each year. However, the battle has not been won – there is room to improve. Sri Lanka is still running a primary deficit,” Mathai observed.
If the Government is running deficits but they are all going towards financing very productive investments it’s fine, he explained but pointed out that since 1993, the revenues of the country have not been enough to finance even the current expenditure, therefore borrowings are used to finance both capital and current expenditure.
“The good news is that the situation is improving. Sri Lanka is still in a relatively weak position now, which is reflected in the high deficit even with three to four years of reductions. While there are countries with larger deficits such as Pakistan and India, Sri Lanka is not alongside countries like Thailand, Malaysia and Turkey – there is room to improve as Sri Lanka has a larger deficit in comparison to most of emerging Asia and Latin America.”
Furthermore, he pointed out that the share of total banking sector credit absorbed by the Government is high and while it is common for most countries to rely on bank credit, Sri Lanka’s absorption is relatively high. The share of the banking system’s credit going to State enterprises has increased steadily which is why the Government has now focused on improving these enterprises so that the resources could be instead directed to other projects to boost growth and job creation in the country.
On a more positive note, he added that Sri Lanka faces a very good set of debt dynamics. With high growth rates, he explained that over time, the debt to GDP ratio will naturally fall. However, he cautioned that these debt dynamics will not last for long. Sri Lanka as a low income country attracted a lot of concessional debt in the past more commercial borrowings now coming in will change the dynamics.
“When you’ve got undeveloped capital markets, there aren’t very many places for savings to go. So far, the large pools of savings in the country have gone to Treasury bills and bonds. Now, as the equity market grows, those savings will no longer only go to Government institutions,” Mathai noted. “We are blessed with good circumstances right now but things may change. Therefore, now is the time to make fiscal adjustments and it is very reassuring to see that this is happening and that it is a major priority of the Government.”
Sri Lanka has to raise its revenues somehow, he stressed, not by raising tax rates but instead by broadening the base and improving compliance. Sri Lanka has reduced tariffs over time but there has been an increase in non-tariff barriers and Mathai recommended looking at how these could be reduced as well.
“Corporate income tax at 28% is moderately high and we are not calling for that to be increased. Personal tax rates on the other hand are relatively low so there could be discussions about increasing them,” he added. “There is also the issue of tax efficiency – the size of collection for any given rate is still very poor and Sri Lanka is not collecting the amount of revenues that other countries are able to collect with similar rates.” He further observed that over the past 30 years, hundreds of projects have come out of the tax free status which is a very good thing.
Mathai also noted that the administration, computerisation, broadening of the tax base and bringing more people into the individual tax net are areas that need to be looked at and improved upon.
“Excises are relatively high in terms of collection, VAT is close to the Asian average but there is definite room to increase personal and corporate income tax. There needs to be a shift to more direct taxation, not just indirect.”
He stated that there is also some scope for the rebalancing of expenditures with the current high defence expenditures and lack of spending on education and health. There is also a dire need to improve investment and Sri Lanka needs to improve its investment to GDP ratio.
“It’s very important to look at how Government spending is correlated to the business cycle; whether Government spending tended to go up or down when the economy was booming. Over the past 40 to 50 years, OECD economies have been able to run countercyclical policies while more emerging markets have not been able to do this. Pro-cyclical policies worsen the volatility in an economy when it is going up. Sri Lanka has leant towards a highly pro-cyclical policy over the past 10 years. Reversing this trend can bring about good macroeconomic outcomes,” he said.
Pix by Upul Abayasekara
Panel discussion
The panel discussion consisted of Dr. Koshy Mathai, Aitken Spence Managing Director Rajan Brito and Ernst & Young Partner – Head of Tax Services Duminda Hulangamuwa, and was moderated by Tokyo Cement Company (Lanka) Director and Former Director Commonwealth Secretariat – Economic Affairs Division Dr. Indrajit Coomaraswamy.
Q: How important is fiscal consolidation for the business environment?
Brito: If interest rates are high, no businessman will start thinking of investments. Having a big deficit pushes up interest rates which is very negative for businesses. Demand for credit drops in terms of banks. Moves to artificially manage exchange rates create booms and busts. However, the environment in Sri Lanka is very encouraging for business. There are acceptable tax rates, monetary policies have eased but productivity and HR skills have to be improved.
Q: It is clear that revenue is a challenge – what are your thoughts on how this crucial issue can be addressed?
Hulangamuwa: If you look at Government revenue collection in 2012/13, while domestic taxes and personal income tax have gone up in absolute numbers, compared with GDP, the percentages have actually dropped. Corporate income tax has dropped because of the restructuring that took place over the last couple of years.
With a range of reductions in income tax rates, increased revenue in correlation to GDP will only come in two to three years. The tax revenues will come. If you look at personal income tax rate, there has been a 45% increase in the last six months which is a significant improvement.
There has to be increased revenue collection. In terms of tax compliance, 95% of the revenue of the Inland Revenue comes from self assessment. Revenue collection by the department, given the limited resources, they have done a good job but can definitely improve. How many can afford to pay taxes – we must look at this.
It’s a tripartite issue which requires the efforts of the taxpayers, Government and Inland Revenue. Policies have been consistent over the past couple of years. Revenue collection will always be a challenge with business becoming more complicated.
Q: Is there an opportunity for Sri Lanka to rebalance its exposure to US debt and debt related instruments?
Mathai: I think when the Government manages its debt portfolio, it will have to look at doing this. Sri Lanka in the past has relied on external commercial borrowings and has had some difficult times due to the issues brought about by this – those risks have to be balanced against interest savings.
Coomaraswamy, in conclusion, stated: “The theme shows that we have a lot of work to do in terms of benchmarking our performance with successful countries especially on the macroeconomic side. You could say that high fiscal deficit, high inflation, high nominal interest rates leads to the correlation to low growth and high pressure on the exchange rate but given the high import component of basic consumption, it will be difficult to keep depreciating the interest rate. The other countries we compared Sri Lanka against have had robust fiscal outcomes which have given them low inflation, enabling low nominal interest rates and have been able to maintain undervalued exchange rates – the opposite of what we have done. So the importance of managing the fiscal deficit is clear to all of us.”
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