Monday Nov 25, 2024
Monday Nov 25, 2024
Thursday, 12 September 2013 00:00 - - {{hitsCtrl.values.hits}}
Introduction
Chief Justice Mohan Pieris, Madam Pieris, family members of Lakmalee Nanayakkara, Chairman of the Faculty of Taxation of the Institute of Chartered Accountants, N.R. Gajendran, distinguished invitees, friends, ladies and gentlemen, I am thankful to the Chartered Institute of Taxation for giving me the honour to deliver the first Lakmalee Nanayakkara Memorial Oration.
I attach a lot of value for selecting me for this initiative to remember a remarkable person whom all of us knew well. I must extend my sincere thanks to Gajendran for speaking to me in this regard well in advance, which gave me sufficient time to prepare for the event. I am pleased to see that this event has been well organised with the participation of distinguished personalities in our society, which is a reflection of how well Lakmalee is admired and respected. I am honoured to deliver this memorial lecture in their presence.
Lakmalee was an extraordinary personality whom I met in my work as Secretary to the Treasury. She served as an active member of the Taxation Cluster of National Council of Economic Development (NCED), which I have the privilege to head, to promote a Private-Public Partnership in policy dialogue to ensure inclusivity in our work. She made an immense contribution in this task and won our confidence. She also served as a member of the Board of Directors of the Bank of Ceylon, while also being a member of its Audit and Management Committee, adding considerable value to the performance of country’s premier bank which has brought about pride to our nation.
She proved that the engagement of persons of her calibre in the management of enterprises can make a tremendous difference towards improving performance, regardless of whether the enterprise is State or private owned. She also pioneered the process of organising Post Budget Seminars, soon after every single Budget Speech that was presented in Parliament since 2004, mobilising corporate leaders and professionals in the country to disseminate detailed information on the Budget, while engaging all of us to deliberate issues at this nationally and internationally important annual event. Her presentations were well researched and were well received. I saw her presence at the 2012 November Budget 
Seminar organised by Ernst and Young, though she had by then relinquished her duties from her partnership with Ernst & Young.
I was entrusted to deliver the keynote speech and I distinctly remember acknowledging the valuable professional services rendered by Lakmalee in the opening remarks of my speech. My intention was to extend an appreciation and place on record how much we valued the efforts put in by her year after year, to make this annual event a success. Although it is a coincident, I am glad that it so happened, since I am a firm believer that those who well manage their responsibilities, deserves to be appreciated.
Lakmalee, I learnt, was the first woman in Sri Lanka to be appointed as a Partner in one of the reputed international accountancy firms – Ernst and Young. She started her career as an accounts trainee in the late 1970s when she was in her mid 20s. Her career spanned over 30 years, and she distinguished herself as a brilliant accountant, a perspective professional and an intellectual role model and left behind a professional legacy that would continue to influence our public lives in several ways.
I deliberated quite a bit to choose an appropriate topic for this lecture to honour the memory of this eminent professional and I thought of speaking on Taxation; the topic that was so close to Lakmalee’s heart, the subject that she was engrossed with throughout her entire professional carrier and earned a reputation as an expert. Taxation in relation to Government revenue, in particular the administration complexities of taxation and contemporary challenges are areas that Lakmalee was particularly interested in.
Our country has witnessed Government revenue declining from 20.2% of GDP in 1980 to 17.2% of GDP in 2010, where tax to GDP has declined from 19.1% to 14.5% in 1998 and moderately varied in a range of 13-15% thereafter during 2011-’13, underpinning a low level of tax revenue for some time. In this background, concerns have been raised regarding fiscal sustainability in the country in terms of Fiscal Management (Responsibility) Act which provides a sound legal framework to phase out fiscal deficits and associated debt accumulation. More explicitly, the hypothesis that deserves to be examined is, whether Government revenue in Sri Lanka is too low and whether the Government is concerned over the state of fiscal responsibility.
Regrettably, those who speak on the subject do not make reference to the declining Government current expenditure from 24% of GDP in 1980 to 16% by 2010, which has stabilised around 15% of GDP during the period 2011-13, underscoring the fact that the Government has now managed a lower revenue deficit than before. Similarly, the country has seen a stable 6% of GDP ratio in annual public investments, during the last seven years in comparison to less than 4% of GDP, along with an overall fiscal deficit below 6% of GDP as against a 12% deficit in 1980. The country’s debt level, which increased from 77.2% of GDP in 1980 to 105.6% of GDP by 2002, is now almost close to the 1980 level.
An analysis as taxation would not have much meaning and will be incomplete on its own unless it is taken up with other related components in Government finance. Therefore, by combining taxation and related policies and operational components, I will speak on the title ‘The Contemporary Policy Thrust of Taxation and Fiscal Policy in Sri Lanka,’ recalling Lakmalee’s own contribution to the subject matter.. So I 
consider that dealing with some policy concerns relating to these aspects at her first memorial lecture is more appropriate, in a gesture to appreciate the multifaceted contributions she had made while she was among us.
Historical perspectives
Sri Lanka had a strong revenue base from colonial days of administration, revolving around a primary commodity export economy nurtured through plantation agriculture. The successive post independent governments after a short period of time, having exhausted the windfall benefits and international reserves that accumulated from the Korean boom, adopted restrictive inward looking policies during the time of the Korean War that lasted till 1977 when the economy was reopened after having experienced many years of economic stagnation. The country also enjoyed a comfortable level of tax collection at the point of Customs as taxing imports and exports provided a good tax handle as opposed to having to tax agricultural income which accounted for nearly 30% of GDP at that time.
The gradual deepening of the liberalisation of the economy along with global developments, required successive governments to phase out export and import taxes and non tariff barriers except having to maintain them on grounds of national security, health, environment, quarantine and quality assurance considerations to consolidate the economy in the backdrop of the global economy. This transformation also shifted the economy from a primary commodity export structure which accounted for 80% of exports to a more value added export structure with industrial exports accounting for 83% of total exports now.
The result is that revenue from exports declined from 5% of GDP in 1978 to 0.3% of GDP in 2012 as exports are free of export taxes at the exporting country and were liable for tax only at the consuming country in term of that country’s tax system. The revenue from import tariffs also declined from 4.5% to 1.1% as tariff and non-tariff barriers are to be kept at minimum levels except in view of exceptional Balance of Payments challenges. Due to this, the trade tax to GDP ratio has taken a downward direction from nearly 10% in 1980 to 2.5% by 2000 and has remained around 1% thereafter with several measures having been put in place such as Free Trade Agreements to further deepen global and regional trade.
Successive governments till recently made several attempts to reform taxation but they were ad hoc. There was a Taxation Commission appointed in 1992 but we did not see its recommendations getting translated in to action in a systematic manner. Several complex and distortionary surcharges and indirect taxes crept into the system undermining a systemic expansion in the economy and thereby the tax base. The Board of Investment expanded its tax holidays and concessions to investments and project related imports, creating a dual tax regime as well as a dual customs regime, thus weakening the overall tax administration.
As of mid 2000, the country’s tax system was characterised with tax rates as high as 35% for income tax, with a social responsibility tax over and above income tax, financial sector taxation subject to a further 20% VAT, debit tax and, several indirect taxes operating at national and provincial levels in addition to a wide range of exceptions and concessions under virtually all tax laws. All these made the tax administration complex, with the enforcement of multiplicity of taxes and cascading elements working at Customs, with banking and domestic transaction based multiple taxes.
The corporate sector, which was operating with high profit taxes and surcharges, turned increasingly to the BOI regime to capitalise on the concessionary tax regime. As a result, the required backward integration of export and domestic investments within the local economy, particular in Small and Medium Scale Enterprises, did not materialise as BOI concessions granted duty free facility to import all investment goods and materials of which some could have sourced domestically. The implementation of many meaningful economic reforms in the 1980s 
and 1990s following the 1977 initial liberalisation and deregulation, had also to be carried out in a sub optimal environment and against uncertainties associated with LTTE terrorism as well as rising transaction costs, making ‘doing business’ more difficult.
The country’s fiscal policy was characterised with high deficits as well. In 1980, the debt finance budget deficit had reached 19.2% of GDP despite revenue to GDP being 23.5% due to loss of control in public expenditure which reached 42.7% during the aftermath of 1977 economic liberalisation. The relatively low level of debt in relation to GDP which was slightly below 70% accommodating high fiscal deficits in a relatively modest economic growth scenario, placed the country on a debt level of 100% of GDP within 10 years of economic liberalisation. The deficits were gradually moderated and averaged around 13% in the first half of 1980s, to around 11% in the next 10 year period till 1994 and to 8.5% in the next 10-year period till 2004.
However, this moderation in the fiscal deficit was brought about not by maintaining fiscal savings in the revenue account but by compressing social spending, the use privatisation proceeds and a sharp reduction in public investments to 3% of GDP in 2004 when the country witnessed a debt to GDP ratio of 105%. This high debt to GDP ratio was a combined result of a sharp depreciation of the exchange rate, domestic debt refinancing at high interest rates, large annual fiscal deficits and a slow economic growth.
Two other important and widely spoken fiscal indicators, namely the revenue deficit and bank financing of the budget deficit also reflected fiscal stress during the entire post 1977 market economy reforms. The recurrent expenditure exceeded revenue and the revenue deficit remained at an average rate of 3% of GDP. The deficit financing of the Budget was 10% of GDP in 1980 and remained high during most period of time reducing the freedom of the Central Bank of Sri Lanka, to conduct monetary policy and system stability in the banking system.
The privatisation of State enterprises although helped to relieve fiscal operations and contributed to raise one-off revenue, the remaining enterprises suffered and deteriorated due to lack of capital infusion, rigid administered pricing policies, poor quality management and continued failures in business focusing. State banks suffered with high non-performing loans and capital deficiencies making the then Government to announce insolvency of People’s Bank in 1992. The country was confronted with an excessively high interest rate that made access to finance difficult. The State bank restructuring initiatives that commenced in mid 1990s with capital infusions and new management inputs, managed to revive state banks. The privatisation of State enterprises in other sectors, paved way for further openings for private investments in the economy and helped to expand the role of the private sector in the economy, although privatisation per se produced mixed results.
A paradigm shift
By 2005, the country had been trapped in an intensified terrorist conflict, a failed peace process co-chaired by four foreign countries, the 2004 post-tsunami recovery challenges, lack of critical infrastructure facilities reflected by prolonged power cuts, capacity limits in ports and highways, sub optimal performance of tourism, urban property and weakened agriculture. The choices were very limited to economic planners and the Government elected in 2005. The Government of President Mahinda Rajapaksa prudently adopted a long term vision having respected the hitherto realised gains from market economy reforms, while recognising the need for public investments in infrastructure, agriculture, SMEs, rural development, public service delivery mechanism, human resource development and national security, as priorities in his policy strategy.
Public finance was in the centre of balancing macro economic considerations and hence deficit management was given priority through careful management of the revenue deficit to prevent public investments of around 6% of GDP from becoming causality as in the past. The development policies through public investments were much higher probably around 7-8%, and were considered favourably, while other factors were conducive and the fiscal space including the level of debt was comfortable.
The economy and the Government also had a heavy share of external challenges to mange. The high oil prices crossing US$ 125 per barrel, withdrawal of GSP concessions, the collapse of Lehman Brothers and investment banks in the US, contagious effects on the financial systems in advanced economies and the associated global economic downturn in 2008-09 particularly in markets that matter to Sri Lanka, uncertainties associated with the hedging disputes, high expenditure associated with the humanitarian operations during 2006-09 and post conflict demining and resettlement and reconstruction work, imposed constraints on macroeconomic management.
The Government, I must say, was bold and never lost its sight over the long term vision. It responded with a series of economic and financial market reforms including adjustments to realign domestic prices, the exchange rates and interest rates in line with global developments to ensure that country’s long-term growth with stability will not be compromised for short-term politics.
The country also went through successfully for the first time a three-year Stand-By arrangement with the IMF to rebuild external reserves and restore confidence in balance of payments and the external trade and payments regime. The Government worked with multi faceted development partners comprising of multilateral agencies as well as bilateral Government financial institutions, convincing the global community and the financial world that the country is on a sound development strategy backed by higher long term foreign financing for public investments.
This was the environment in which the Government projected its development strategy in the global financial capitals seeking a sovereign rating and entered the sovereign bond market in 2007, against many adversities. These indicate the risks that the Government and the country faced in recent times and had to successfully manage. As of today, Sri Lanka among other emerging market economies shows its presence in the international bond market with a 10-year trading stock of US$ 3,500 million, which is a fine demonstration of country’s relative economic strength.
It is in this background, that the 2006-10 first five-year plan under Mahinda Chinthana, within the 2006-16 10-year development policy framework was translated into action or conducted. Year 2010 marked a new beginning of the next five-year phase of development as by then Sri Lanka had become a post-conflict and a middle income economy. The Government announced its second five-year development framework 2010-15, ‘Sri Lanka, the Emerging Wonder of Asia,’ outlining key pillars of development based on a five hubs strategy concept with emphasis on shipping and aviation, energy and commercial aspects and the expansion of the real economy in to the globally competitive economy, together with other building blocks having been put in place to progress towards the upper middle income economy threshold by 2016. The policy strategy is not confined only to the export of traditional manufacturing centric goods but extended to a range of exportable services to ensure that the country could secure advantages from its vibrant service economy alone with manufacturing activities.
Beginning of a new taxation regime
Ladies and gentlemen, let me at this stage share with you some theoretical and practical considerations that have brought about yield in good tax and tariff systems prevalent in certain successful developing economies, in order to make a self-assessment as to whether we have got our strategies right. Best taxation systems are those that cause minimum distortions in the allocation of resources, are equitable and are relatively easy to administer. In practice, comprehensive tax and tariff reforms typically include the strengthening of a broad based value added tax with a single rate and minimum exemptions, and a threshold to exclude smaller enterprises, restricting traditional excise taxation to a limited list of products principally petroleum, liquor, tobacco products and selected luxury items.
It further includes maintaining a low average rate and a limited dispersion of rates to reduce excessive protection, avoiding export duties except on hard-to-tax sectors and non renewable resources, maintaining a few brackets and a moderate top marginal rate for personal income tax, while limiting personal exemptions and deductions to exclude persons with low income and applying one moderate rate for corporate income tax with a uniform depreciation allowance.
Successful country experiences suggest that tax and customs administration reforms demand the modernisation of systems and procedures. Typical reforms stress on the need to reorganise tax and customs administrations along functional lines, adopt a national system of unique taxpayer identification numbers, strengthen audits and improve tax payer services. Computerisation of the processes is a central component of reforms, while enabling automated services for filing of returns, payment of taxes etc. along with upgrading the skills of related staff while providing them with administrative freedom and incentives.
Let us look at the 2010 tax reforms in this context. As noted in the recommendations of Presidential Commission on Taxation, what is apparent is that limitations have stemmed due to ad hoc changes made, resulting reforms to move back and forth creating uncertainties and demanding the need to address structural weaknesses in Sri Lanka’s tax system. The President himself is engaged in a wider consultation process from the 2010 Budget, along with other reforms towards a prudent fiscal policy regime to secure development with stability. The Government has introduced far reaching changes to the tax system. The thrust of reforms was to create a simple and broad based tax regime to generate a buoyant growth in Government revenue and create an enabling environment for private investment and growth in the economy.
On taxation reforms, four tax legislations, namely, bank debit tax, infrastructure development levy, environmental levy and provincial turnover tax were repealed. A single rate VAT and Nation Building Tax were rationalised and extended to retail trade having a quarterly turnover in excess of Rs. 500 million. Excise Taxes were confined to cigarettes, liquor, petroleum, motor vehicles and a few selected consumer durables. Recognising the activities undertaken largely by the small and medium scale trading community and the seasonal nature of local production, a 
Special Commodity Levy was consolidated at the point of import in lieu of all taxes otherwise applicable to make it simple and facilitate trade and home based seasonal production. Customs duties were further simplified in a framework of a four bands tariff structure consisting of 0, 5, 15 and 30% with about 3,100 out of 6,800 total custom line items kept below 0% rate band and 30% of line items being kept within a 5-15% rate bands to maintain a low average rate. It is only 25% of international customs line items that are kept at the higher rate band of 30% which are essentially maintained on revenue considerations and not for trade protection, anymore. If figures are adjusted for Free Trade Agreements with India and Pakistan and trade arrangement with the EU, the rate structure argues further favourably for a low tariff regime. The maximum marginal rate for personal income tax was reduced to 24% with few tax brackets and a high threshold to exclude low income people. In respect of emerging sectors such as IT, construction, agriculture, SMEs, exports and knowledge base activities, a single corporate income tax rate of 12% was introduced and for the rest of business activities a single rate of 28% was introduced with provisions for expenditure on depreciation and research and development. Many exemptions were rationalised. Investment incentives were brought under Strategic Investment Law and Income Tax Law to rationalise tax holidays and the concession regime. The policy regime has been further strengthened by increasing the tax free threshold for VAT and NBT so as to exclude small businesses enabling the department to concentrate on the large tax payer base, effective auditing and better tax payer services. Multiple rates of taxation on telecommunication services were replaced by a single levy to simplify tax administration. Setting up a senior level official committee on administrative basis to give interpretations and setting up of a separate Tax Appeals Commission by an Act of Parliament has helped to maintain consistency and improved the dispute settlement arrangements relating to taxation.
One of the critical components which required to be next introduced is an IT based system to manage the tax administration and to proceed with human resource development of tax administrators. A Revenue Administration Management Information System is being introduced with technical assistance of the Singapore Government. Human resource development on subject specific knowledge and change management is being done through distinguished institutions including the National University of Singapore and other training programs supported by the Asian Development Bank. The government has made a remarkable progress in unifying diverse trade unions and interest groups by bringing them on to a common reform platform, by recruiting professionals who are in the younger age category and by introducing a new administrative Service Minute with the approval of the Public Service Commission to establish a governance structure in the Inland Revenue Department on a professional footing. Though it has taken almost eight years of our collective time and effort, with many gives and takes, I am proud of the progress we have made so far and we are certainly witnessing benefits of this consensus building process made through collective efforts of all stakeholders, although a very few may not be still fully satisfied.
At this point, I must pay a tribute to Lakmalee who always commended the officials of the Inland Revenue Department for their vast knowledge and hard work, despite having to serve under trying conditions and were appreciative of reforms we have implemented in the department. I also wish to note that I am also encouraged with the commitment of the present Commissioner General, the senior management team and staff unions, who are striving hard to regain the pride the department once enjoyed. I am positive that they will succeed.
The success of reforms depends not only on the policy, its implementation, the required institutional and human resource transformation and the transition to a revenue administration management information system driven administration. It also depends on the role played by private sector stakeholders – in particular the accountants and tax consultants who are engaged in the process.
Here too, the role that Lakmalee played was exemplary. She gave best advice to tax payers and tax administrators. Policy makers also sought her views. She advised her clients to pay taxes and not to evade taxes. Her advice on tax planning was to get corporates and individuals to understand taxation better and to make proper provisioning in business modelling and management. She never persuaded her clients to dispute taxes or guided them to engage in delaying tactics. In the case of a doubt, she sought clarifications to comply or worked with policy makers to improve the law and regulation to bring about greater clarity. She believed in taxation and respected it. The best respect that can be given by tax consultant colleagues to Lakmalee is to benchmark her professional standards and ethics. Through correct advice respecting such standards, a fair share of revenue that is evaded due to so called tax consultancy services can be recouped and a considerable improvement in tax revenue can be brought about even during this transitional period of tax reforms. It is the responsibility of tax consultants to make department passive and taxation simple. The Government does not want to over-regulate tax enforcement. The Government wishes to see there being self-compliance and not manipulated – compliance.
The successful operations of an efficient tax system require a tax payer friendly tax administration, tax audits, tax consultants with respect for ethics and an effective tax dispute settlement mechanism. All these components must operate based on mutual respect and trust, distant from suspicion and comply with the tax obligations to the Government. Sri Lanka’s current tax regime has removed differential treatment between political, public and private sector employees and requires everyone who earns beyond the threshold levels of income specified in the law, to pay tax appropriately. Everybody who becomes liable must pay tax with dignity and become a proud citizen and partner in progress regardless of whether the services have been rendered to the public sector or the private sector.
The expectation of the introduction of 2010 tax reforms was revenue neutrality in the immediate run and a buoyant growth thereafter with the expansion of the economy and thereby the tax base. A nominal growth of 16.7% in tax revenue in 2011 and a 7.5% nominal growth in 2012 were recorded in comparison to an average nominal growth of around 12% during the preceding three years. During the first half of 2013, nominal growth in tax revenue has been negligible.
However, disaggregated data indicates that the nominal growth in income taxes has been 14% and the nominal growth in domestic base VAT/NBT has been 16%, despite the slowdown in the credit growth, leasing activities and income losses from drought affected agriculture. The revenue from customs based taxes have shown only a marginal growth of 3% owing to import compression following the measures adopted to manage Balance of Payments difficulties of 2011/12. This in my view indicates that the new tax regime will have better performance with the economic recovery anticipated with the gradual easing of credit restrictions, prices stability and institutional improvement with the introduction of an IT System, associated efficient procedures and professional improvements in the human resource capacity, that will create an enabling environment to manage a sophisticated tax system.
We are now in the successive third year of our reform journey. In every Budget, the Government maintained the ‘3 Cs’ – namely, continuity, consistency and clarity, which were missing in all tax reform initiatives of the past. Despite revenue concerns, no ad hoc measures or reversals in the policy direction were made. Consecutive actions by the Government were consistent with the policy thrust towards creating a broad based, simple tax regime. Every Budget was made through a wider consultation process, expanding inclusivity in policy making. Detailed technical notes with regard to each proposal were included in the Budget document to provide clarity. Lakmalee and several other professional tax consultants, contributed through their analytical minds by participating in now so popular Budget Seminars pioneered by Lakmalee’s team.
All enabling tax legislations were made reflecting the ideas that evolved through this discussion process and we were also able to pass tax laws well on time, moving away from the past practice of passing tax laws after long delays. These are no doubt salutary features of Government policy strategies on taxation.
Towards a new fiscal policy regime
Let me now turn to the underlying fiscal policy reforms. The thrust of this process is to protect public investments at around 6% of GDP, implying that fiscal policy is expected to turn around Government dis-savings to a positive savings balance to be able to finance part of public investments, reduce the fiscal deficit and borrowing requirements. As such, current expenditure levels are as important as revenue levels in the initial phase of this transformation.
It is important to highlight that despite wage adjustments and strengthening of the public service delivery mechanism which involved the recruitment of required public servants into various services, non-interest recurrent expenditure has grown only by a modest 8% in nominal terms enabling the recurrent expenditure/GDP ratio to moderate from 20.2% in 2002 to 14.9% in 2012.
The reduction would have been more visible if not for the high interest cost which accounted for 5.4% of GDP in 2012 due to the monetary policy tightening that was required to manage the external reserve stability in the economy. Despite this pressure, the recurrent expenditure in relation to GDP in 2012 took a value of 14.9% as against a government revenue/GDP ratio of 13.9%, resulting in a dis-saving of 1% of GDP in comparison to 4.2% of GDP in 2002. The decline in government revenue in relation to GDP between 2002 and 2012 by 2.7% of GDP needs to be compared against the decline in recurrent expenditure in proposition to GDP by 5.3%, underscoring an overall improvement in the management of the revenue account of the budget in recent times.
Generally, non tax revenue as a source of revenue is not expected to be buoyant in an economy in which State enterprises do not occupy an important share of business activities. However, the present policy strategy recognises an important share of business for State enterprises as well. At present, there are 55 State business enterprises of which 10 large enterprises are engaged in activities in the field of port operations, aviation, water supply, electricity, petroleum, banking and insurance and account for 95% of the asset base of State enterprises. These enterprises could be strong revenue sources once the current capital infusion process and adjustments in prices are completed.
With the strong external reserve position of the Central Bank and the expansion of Government fee levying services, a further revenue growth could be expected, while State banks would have increased space to channel their resources to other needy sectors in the economy at lower interest rates.
The present level of Government revenue however, needs to be improved for a variety of reasons. First, the present level is below the lower middle income country average rate ranging between 16-18% of GDP. Hence, it is necessary to create a taxation policy and an administrative environment which will generate revenue that will commensurate with the nominal growth in GDP. In other words, the tax system needs to be revenue elastic. Second, it will provide adequate liquidity in relation to Treasury operations to facilitate budget execution and iron-out payment delays. Last but not least, it will enable the Government to finance a share of Government investments from the Government’s own savings through a revenue surplus. Such a surplus creation will reduce both domestic and foreign borrowing needs and thereby lower interest rates as well as interest costs of the budget, helping to consolidate a low interest policy regime with greater freedom to the monetary authority to conduct monetary policy as well as to promote system stability in the banking system as the regulator of banking and financial institutions.
The task ahead of us therefore is to eliminate the remaining dis-savings in the revenue account and to keep the deficit in the budget at below 5% of GDP, in order to protect public investments at 6% of GDP. This would require further consolidation of the prevailing low tax regime with a widening of the tax base through economic expansions and by narrowing tax exemptions to minimise distortions. Along with an improved tax administration with the assistance of those who are involved from the department and as tax consultants, a turnaround of the country’s State enterprises is equally important to get quick and best results from reforms. With taxes that generate 14-15% of GDP and non-tax revenue that generates 2-3% of GDP, government revenue of 16-18% of GDP remains a feasible and conducive target to create durable fiscal space that will support the macro-economic strength and policy instruments to fine-tune the economic behaviour when needed.
Another critical component in the conduct of fiscal policy management is the need to strengthen the monetary-fiscal coordination, which the Governor of the Central Bank so well-articulated in his speech delivered at the 18th Tax Oration of the Charted Institution of Taxation. The Monetary Law Act, which governs monetary policy and the Banking Regulations which are the core of Central Bank responsibilities, has recognised the Secretary, Ministry of Finance as an ex-officio member of the Monetary Board of the Central Bank, to represent the views of the Government in the conduct of monetary policy in the country. The underlying justification has been well articulated by John Exter, the eminent banker from the Federal Reserve Bank of US, who studied and submitted a report for the establishment of an independent Central Bank in Sri Lanka, who also became the first Governor of the Central Bank.
Further, the Monetary Law Act requires the Central Bank to write to the Minister of Finance when monetary growth exceeds 15% and or inflation exceeds 10%, drawing attention of the Government to the implications of the behaviour of such variables on the economy, with policy recommendations for consideration. Further, the Central Bank is also required to submit a report to Government before 15 September each year, for consideration in the preparation of the Annual Budget. So it is clear that we have a legal framework that compels a close working relationship when it comes to important policy coordination, which has worked so well particularly in recent times through grater consultations and dialogue between the two institutions.
However, one should not oversimplify this relationship. The monetary policy or fiscal policy cannot work in isolation as one affects the other due to obvious macroeconomic dynamics and the socio-political settings of any society. The budget balance, whether it is a deficit or a surplus, affects the money supply, external reserves, the foreign exchange regime, interest rates, inflation, etc., which are matters coming under the purview of the Central Bank. Similarly, the external balance whether it is a surplus or a deficit and variations in domestic financial assets of the Central Bank determines reserve money and influence the money supply, inflation, exchange rate, aggregate demand, etc., that affects fiscal policy through taxation, the expenditure and financing of the National Budget though these are matters coming under the preview of the Government but originates from the Central Bank.
Therefore, in an open economy macro framework, no Central Bank can perform its responsibilities if fiscal balances are exceptionally large and similarly, no fiscal policy can work if external reserves or domestic assets of the Central Bank are unstable. So it is a complex relationship. Therefore, these two powerful macro-economic policy agencies need to ensure a fine balance and coordination involving theoretical and practical judgments, particularly in an open market economy framework. In volatile situations or when having to operate under vulnerable conditions as is the case quite often due to external shocks, the judgment call that the Central Bank and the Ministry of Finance have to make is to ensure that benefits are balanced in order to prevent any crisis against a variety of potential costs, including inflation, high interest rates and external fiscal costs. It is necessary to appreciate that both institutions in these circumstances have to act in real time, while critics do so in post event – when results are known.
In this context, I am sure that respected Central Bankers, experienced policy makers, the business community, civil society, professionals and responsible politicians would agree that both institutions have made a credible progress. The Central Bank has recognised the implications of Government policy, the strategic role of State enterprises, adjustment challenges in a conflict and post conflict environment, short-term shocks from natural disasters, etc., with regard to fiscal policy, in conducting monetary policy in a globally volatile economic environment. The Government on the other hand has recognised the need for a market based monetary policy and the required policy space from fiscal policy for the conduct of monetary policy to achieve economic progress within a low inflation regime.
Let me go on to explain how the Government approached this balancing task. The present Government, while departing from previous policy strategies of privatisation of successive governments, recognised specific roles for the private sector and the public sector and their complementary contributions towards economic development in the country. It recognised the important role of agriculture, rural development and SMEs in improving livelihood and poverty reduction. It recognised the important role that the market can play and committed to improve ‘doing business’. It recognised both foreign direct investments as well as domestic investments.
In such a strategy, fiscal policy had to commit for public investments and required policy reforms in taxation and spending policies to create an enabling environment to translate such strategies in to a budget framework which was already saddled with a large fiscal deficit of around 10% of GDP and a high debt in excess of 100% of GDP. This fiscal framework had already weakened the freedom of conducting monetary policy freely. It had relied on an ad hoc and distortionary tax system that limited private investments. It had pre-empted available resources to the private sector by reducing access to finance. The budget itself had to manage high interest costs of an already large debt stock and the high depreciation of the exchange rate on already weak international reserves. The initial phase also demanded large financial resources accounting for about 5% of GDP per annum for the liberation of the country from the grips of terror.
However, the Government committed to a long-term growth strategy with stability through fiscal reforms towards a lower deficit in the national budget. The options were not easy. If privatisation was an option, assets sales would have been used. If low public investments was recognised a spending freeze would have followed. Subsidies would have been taken away and the budget would have been small. The monetary policy would have also been different if it was conducted entirely on market based policy instruments in which outcome of interest rates and exchange rates would not be affordable. This was not the path chosen. Instead the policy burden was shared between the monetary policy and fiscal policy to finance the required expenditure to counter terrorism, promote development, to invest in public investments and to proceed with tax, tariff and pricing policy reforms while gradually phasing out the fiscal deficit as adjustments through fiscal policy alone or monetary policy alone were not affordable. I consider that the chosen policy mix was pragmatic and effective in managing many difficult challenges the country had gone through in recent times.
The ending of the conflict, the prevalence of a sustained public investment strategy, the gradual pricing adjustments made in line with global developments and tax and tariff reforms have consolidated the country with peace, post conflict rehabilitation and reconstruction of affected districts and enabled broad based infrastructure development in power generation, transportation network, port and airport facilities, irrigation and water supply to make increased public access to such facilities. These in turn have created a gateway for both domestic and foreign investments in ports, tourism, basic industries and exports and import substitution and urban development. The budget deficit has been reduced to 6.4% of GDP and debt to GDP to below 80% by 2012. The Government has made a commitment to reduce these ratios further with a commitment to keep the deficit at 5.8% of GDP in 2013 and to move further down to below 5% by 2015 when the debt to GDP is also expected to be below 75%.
This policy direction has made the Central Bank more independent than ever in the recent history by facilitating to reach international capital markets with sovereign bond issues, enabling the Governor Central Bank to announce a mid single digit inflation target and conduct monetary policy using market based interest and exchange rate instruments with minimum intervention. This Government policy has enabled Sri Lanka to secure an investment grade international rating that has facilitated much deeper trade and financial integration with the global economy. The economy acquired this strength with the required political stability, backed by the policy reforms that were out in place with a least adjustment cost. It is in this period, that Sri Lanka was able to restore international confidence by completing a three year Stand-By Arrangement with the IMF. It is only now that the country’s private banks are also obtaining international ratings in a bid to leverage their balance sheet to raise foreign capital.
The successful conduct of fiscal policy also requires compliance of best practices, transparency and accountability. In this regard, the annual Appropriation Act that governs public spending and borrowing, was further strengthened with the amendments suggested in the Judgments of the Supreme Court being suitably incorporated in to the Appropriation Act. Total compliance with amended provisions has been made in the execution of the Budget. The administration of tax, disbursement of funds of both domestic as well as foreign financing and public debt management have been carried in terms of applicable laws pertaining to such operations.
The annual budget has been presented to Parliament for approval, with supporting documents specified in the Fiscal Management (Responsibility) Act of 2003. The Finance Ministry has regularly made operational disclosures through its Annual Reports and Mid-Year Reports required be preparing and placing in the public domain in terms of Fiscal Management (Responsibility) Act. These are also salutary developments achieved in the conduct of fiscal policy in recent times that ensures compliance with best practices and improved accountability.
Middle income country prospects
Post 2010 has placed the economy on a high growth path, managing to raise economic growth to around 8% and while getting public investments for a range of infrastructure, rural development and agriculture that commenced in 2006 and moved ahead. People benefited from having wider access to electricity, drinking water, transportation, etc. The economy is backed by increased investments of around 30% of GDP, improved business sentiments, expansions in integrated tourism, construction, urban township development, IT and knowledge based services, renewable energy, food and agriculture.
The outcome has been the declining of unemployment to 5%, poverty levels to below 6% and improved distribution of income. The economy as at present is crossing US$ 3,000 per capita income and is in a transition to an upper middle income threshold, despite a globally uncertain environment including the situation that prevails in our neighbourhood – India. It is challenging, and continued concentration is vital to be able to manage such challenges.
Sri Lanka’s graduation from a conflict and low income trapped economy to a post conflict middle income economy provides valuable lessons and experiences. The country has gone through difficulties due to a large fiscal deficit, high debt, high inflation, poverty, unemployment, excessive taxation and concessions and these characteristics should be scenarios of the past. Preventing them in the future demands reforms now, and widespread reforms covering diverse facets in the governance structure, State enterprise management, education and health services, legal and regulatory arrangements, the rural centric delivery mechanism and so on, to realise optimum outcomes from ongoing public investments in infrastructure, the peace dividend and from macroeconomic and taxation policy reforms. The promotion of international trade both ways, through imports and exports, needs new laws to address valuation challenges pertaining to imports and to encourage standardised products at correct prices to be traded, instead of having to use high tariff and non-tariff barriers for such purposes. Management centric reforms should be carried out to ensure ownership neutrality that would produce better results in State enterprises.
Stable progress in the middle income development stage demands right knowledge and skills at work places, whether in the private sector or the public sector as it is productivity and technology that creates competitiveness in businesses and employment creation in a country. As such, yesterday’s skills would not be the required skills for today and today’s skills would not be the required skills for tomorrow. Reform resistant groups need to appreciate the reality, that it is this transformation that will bring about sustainable growth that can expand government revenue. Hence, every effort should be made to carry out reforms with a sense of realisation on the need for such reforms, particularly to avoid the risk of getting into the so-called ‘middle income trap’ syndrome that brings about unwarranted stagnation.
What we need realise therefore is that the middle income stage of development and associated management responsibilities cannot be made within the existing governance framework, the institutional setup, certain constitutional provisions, etc., that have been then designed to manage a less developed economy. A modern Judiciary, a modern Government and a contemporary constitutional framework are necessary elements to achieve and consolidate an efficient service delivery mechanism that is capable of catering to the needs in an advanced stage of development.
Those who are seeking a political solution through fiscal devolution and decentralised spending should realise that it should not be at a cost of fiscal profligacy, be based on charity sources – both foreign and domestic – or at the cost of bringing about macroeconomic instability. Devolution, particularly in a small country, should be made used to improve the service delivery and should not create multiple layers in government that will eventually be a disincentive to create a strong fiscal and investment policies conducive for sustainable development. Further, ‘too much Government presence’ or ‘a too devolved Government’ will both be counterproductive, unaffordable and would inevitably lead to an inconsistent governance framework, in the same way that ‘too little Government presence’ or ‘a too centralised a Government’ would be counterproductive and unaffordable in the context of modern societies.
Hence, harmonious and complementary working arrangements between the Government and markets would bring about efficient strategies conducive to for the management fiscal policy. Public convenience and public satisfaction should be the ultimate objective when it comes to outcomes stemming from fiscal policies. This is since, what is important from the perspective of a Government is to meet the expectations of the people to the maximum extent possible. Taxation and fiscal policy directions in a contemporary society should therefore be guided, in my view, along these thoughts.
Concluding thoughts
Finally let me thank all of you for your attentive listening. You did that in appreciation of Lakmalee. I also did my preparation in her honour. However, I may also note that Lakmalee’s life has not been confined to that of a dedicated professional accountant and partner.
She has also been a socially responsible person and a caring mother to her young daughter Keshini. Lakmalee had also been a pioneer trustee of the Unity Mission Trust, which is committed to fostering unity, reconciliation and healing amongst teenagers and young adults across Sri Lanka, showing her involvement in contemporary social issues. This shows that while nurturing her loving daughter, she has also promoted values to bring about a caring society. I understand that Lakmalee has got her daughter also involved in social work through this Unity Mission Trust as she believed in purposeful living. This is what matters to all of us as well – to aim at not mere living but at purposeful living.
Therefore, let me conclude my speech by quoting the well-known American writer Richard Bach. This quote reflects my thoughts on Lakmalee. I quote: “Don’t be dismayed at goodbyes; a farewell is necessary before you can meet again and meeting again, after moments or lifetimes, is certain for those who are friends.”
Thank you.
