The Sunday Times Economic Analysis

Last week we dealt with one of the two fundamental economic problems that vex the Sri Lankan economy-the underlying and inherent balance of payment difficulties that have been masked by the aid inflows, the debt repayment moratoria and the deferred payment arrangements on oil.

The balance of payments was also aided substantially by the increased remittances of Sri Lankans from abroad that wiped about 75 percent of the trade deficit. These factors, some of which were of fortuitous circumstances may lull the country into a complacency that could aggravate the external balance in the long run.

Today we turn to the other fundamental economic problem, which is the continued high budget deficits that have led to a large public debt, starving the country of much needed development expenditure while generating inflationary pressures.

This problem has been recognised by successive governments. Budget speeches and other statements have indicated a desire to rein in the deficits, but the fact is that budget deficits have exceeded the desired levels. The 2005 Budget announced a projected deficit of 8.2 percent of a Gross Domestic Product (GDP) and many statements indicated that the deficit would be at that level. Yet the final figures showed a deficit of 8.7 percent. The budget deficit of 8.7 percent of GDP was financed through domestic resources to the extent of 5.2 percent of GDP and through foreign resources to the extent of 3.5 percent of GDP.

The Central Bank Annual Report and statements of the ministry of Finance have pointed out that the deficit, excluding tsunami expenditure in 2005, was 7.3 percent of GDP. While this is an explanation of the part of the deficit, it makes no difference in its impact whether it is due to this additional expenditure or not.

The actual out turn of the deficit being higher than indicated in the Budget has been the story over the years. In 2004 it was not different. The deficit exceeded the approved budget deficit by 7.5 percent to reach 8.2 percent.

This is not a recent phenomenon. Governments have been unable to keep current expenditure within the amount of government revenue for the year for quite some time. For some time the deficit was enhanced by an increased defence expenditure, while in other years additional expenditures especially on welfare measures and subsidies have resulted in the over run in public expenditure. Frequent elections in recent years have not helped public expenditure control. Making matters worse, the oil price hike has led to subsidies for both the Ceylon Electricity Board and the Petroleum Corporation. The additional expenditure on the employment of graduates and the public service salary increases have been additional unbudgeted expenditures.

Electoral politics is such that governments have tended to incur expenditures in addition to what they have budgeted and there have been inadequate commensurate revenue increases.

The deficit is budgeted to rise to 9.1 percent of GDP this year. If it turns out to be higher we could be reaching unhealthy double-digit proportions.

The problem arises due to inadequate revenue collection as well as excessive expenditure. Revenue collection has been quite inadequate over the years.

It has been less than 15 per cent of the GDP and was on a downward trend for sometime till the last few years. Last year saw a ray of hope in revenue collection. Revenue increased to 16.4 per cent of GDP in 2005, which was higher than even the expected 15.4 percent in the revised Budget 2005. In 2004, the tax revenue increased to 14.3 percent of GDP from 13.9 percent in the previous year.

It would be necessary to keep this increasing trend to raise revenue to around 20 per cent of GDP. In fact the level required, in line with current expenditure would be 21 percent of GDP that may be a difficult to achieve immediately but must remain a goal of fiscal policy.

This is so as total expenditure amounted to 25.1 percent of GDP in 2005, which was higher than the anticipated expenditure in the revised Budget for 2005. Current expenditure of 19.1 percent was higher than the budget target of 18.4 percent in 2005. Public investment too increased to 6.3 percent in 2005 from 4.8percent of the GDP in 2004.

While the overall magnitude of the Budget deficit is a problem, the more substantial issue is the reasons for such a high deficit.

On the expenditure side we are overburdened with a great deal of unproductive expenditure such as the high wage bill and pension payments, debt servicing costs, defence expenditure and wasted welfare expenditures. These costs and subsidies defray losses in public corporations that absorb about 80 percent of the government's current expenditure.

Consequently the capacity of the government to spend on capital expenditure is curtailed.

Successive governments have failed to address this problem seriously, postponing it to subsequent regimes. The problem becomes even more serious as the public debt rises and interest costs that now absorb 27 percent of government current expenditure keeps rising. Although the public debt as a proportion of GDP has declined somewhat owing to the revaluation of the external debt due to an appreciation of the rupee, the aggregate figure has increased and is likely to increase this year.

There may be an increase in defence expenditure and the rising costs of oil imports and the current practice of not passing the full increase to consumers could be a further burden on the public finances.

In these circumstances there is little likelihood for a fiscal consolidation that is imperative for growth.