Yet another Budget is being presented to Parliament on Thursday, November 21 by the Minister of Finance. Different sections of the public expect the Minister to deal with at least some of their problems, in the Budget. Those who are poor expect more and more free or subsidised goods and services, for their consumption. The rich and “super rich” expect more and more concessions in the name of economic development, to increase their wealth.

So-called middle class, knowing their fate, normally do not expect any miracles in the Budgets!

Whatever the purpose of the Budget presented to parliament annually, it is done in order to get parliamentary approval for various expenditure estimated by the Government in the coming year. This budget will also present such estimates for the year 2014. At the same time the Government will submit its estimated revenue for the year 2014 and the amount of borrowings required to bridge the gap between expenditure and revenue.

Budget deficit or fiscal deficit

In Sri Lanka, since independence in 1948, almost every year (except in 1954 and 1955) we have experienced such Budget deficits. In 1948, the deficit was only 1.7 per cent of GDP. By 1980; it went up to a massive 23.1 per cent of GDP. In the last decade, since 2003, the deficit was around 7.0 per cent (average)

Continuous budget deficits for the last so many decades have created a “debt trap” for Sri Lanka. As the above statistics show, the expenditure over revenue during the last seven years was a massive Rs. 2,788,817 million! It is not a secret that, the above deficits were mainly financed from borrowings within and outside Sri Lanka. The outstanding Government debt as at 31.12.2012 was a staggering Rs. 6,000,112 million which was only Rs. 2,585,648 million as at 31.12.2006. During this six year period, the Minister of Finance has made a record breaking achievement of borrowing Rs. 2,529,480 million net of repayments. This is almost 100 per cent of total debt outstanding as at 31.12.2006. If the gross borrowings were considered the increase was more than 230 per cent. In rupee terms the amount was Rs. 3,417,464. This can be compared with what Barack Obama has done in the US. When he came to power, the total debt of USA was US$10.6 trillion and currently has hit the ceiling of 16.7 trillion which is nearly 60 per cent increase! However that was only a 60 per cent increase.

Further, certain liabilities of the Government in relation to defense related activities in the previous years and liabilities created by SOEs (State owned Enterprises) may not have been considered in these statistics. For example borrowings by CPC and CEB were a massive Rs. 245 billion from state banks at the end of 2012. In addition CEB had short term liabilities of Rs. 137 billion and long term liabilities of Rs. 269 billion as at the end of 2012 from other sources.

The fiscal consolidation is amended at the reduction of the relevant budget deficit to accepted norms. For example the Fiscal Management (Responsibility) Act, No. 3 of 2003, required that the budget deficit at the end of the year 2006, not exceed 5.0 per cent of the estimated GDP and to maintain it at that level thereafter. However, the above statistics show that this requirement has never been satisfied.

It is an accepted norm that the countries should reduce debt levels around 50 per cent of GDP or lower to provide a safety margin against future adverse shocks.

However, having a very high rate of debt to GDP by itself may not be a problem for a country having a reputation for economies development and which has reached a satisfactory level of economic development. For example Japan, which is among the top economies in the world, is having the highest debt to GDP ratio, which is 230 per cent. The US has a ratio of 103 per cent whereas Singapore has a ratio of 101 per cent.

Anyway, having a fairly high debt to GDP ratio can be considered as a symptom of an economic illness. In the European Community when Greece faced severe economic problems suddenly, it was having a debt to GDP ratio of 153 per cent.
In Sri Lanka, we have experienced a debt to GDP ratios exceeding 100 per cent in the years – 1988 (101 per cent), 1989 (108.7 per cent), 2001 (103.3 per cent), 2002 (105.6 per cent), 2003 (102.3 per cent) and 2004 (102.3 per cent).

Revenue Performance -

(a) Direct Taxation -

Although, Sri Lanka has imposed income tax during the last 80 years, it is still searching for an ideal direct tax structure for Sri Lanka. Currently, we recover only less than 20 per cent of the total tax collection, as direct taxes. Since almost all capital related taxes have been abolished to accommodate investment for economic development, the only direct tax imposed now in Sri Lanka is income tax. However, in relation to GDP, income tax revenue has never reached even 3.0 per cent.

In relation to individual income tax, the main problem is inadequate coverage. As at 31.12.2011, less than 200,000 individuals have been registered with the IRD for income tax. The number of employees paying PAYE tax was around 530,000. In addition to a fairly high tax exemption limit which is Rs. 500,000 per year, a further exemption of Rs.100,000 has been given to employees and such employees enjoy a luxurious exemption of a travelling allowance also up to Rs. 600,000 per year. The revenue loss on this exemption is compounded due to the deductibility of such traveling expenses from the business income of the relevant employers.

The current tax rate schedule also creates problems in revenue generation. The lowest rate has been fixed @ 4 per cent and the next rate @ 8 per cent before reaching 12 per cent. The maximum rate is 24 per cent. A non employee having a taxable income (after Rs. 500.000 exemption) of Rs. 2 million will pay only Rs. 200,000 as income tax which averages to 10 per cent of taxable income. It may be appropriate to consider the lowest rate of 10 per cent thereby eliminating 4 per cent and 8 per cent.

Companies and corporations registered for income tax was around 33,000 as at 31.12.2011. Only about 56 per cent of them have filed income tax returns in time. Therefore, the full revenue potential of the corporate sector may not have been realized even though a low tax rate of 28 per cent has been given to them.

In addition to the required structural changes the tax administration can take appropriate action to strengthen the direct tax revenue collection in the short term.

Among them the following steps may be relevant -

- To sure that all employers who are liable to be registered under PAYE Scheme are registered.
- To make sure such registered employers are deducting correct PAYE tax which is now the final tax from the relevant employees.
- To strengthen the withholding tax (WHT) systems now in operation with the re-introduction of WHT on rent and other specified fees.
- To check the declarations furnished by the deposit holders to make sure that the correct WHT on interest has been deducted.
- To make sure that all banks and finance companies correctly comply with the WHT provisions in the Inland Revenue Act, in relation to interest income.
- To make sure that all registered companies are registered for income tax.

(b) Indirect taxation -

The main indirect tax ie- the VAT, administered by the CGIR (Tax chief), has lost its importance due to various reasons. In 2004 the VAT collection was around 71 per cent of total IRD collection but in 2011, it has dropped to 48.5 per cent of total IRD collection. The revenue potential of VAT has been lost due to various ad-hoc steps taken by authorities, without considering the consequences.

In 2012 Budget, VAT revenue was estimated at 3.5 per cent of GDP but actual collection was only 2.7 per cent of GDP.

The newly introduced NBT, which is also administered by the CGIR, after ceasing the recovery of Turnover Tax (TT) by the Provincial Councils’ has not been able to provide adequate revenue, even though the tax rate has been increased to 2 per cent from earlier T.T. rate of 1 per cent. Further, this revenue has to be shared with Provincial Councils in consideration of the loss of TT revenue by them.

The main problem in our indirect tax structure is the over dependence on importation of goods. Almost all indirect taxes have a component of import-related charges. When the import volumes are dropped, all related tax revenues will also be reduced.

When the import volumes were dropped in 2012, the revenue from VAT, Special Excise, PAL and NBT was also dropped in addition to Custom duties. The authorities should consider reviving of VAT on local consumption removing unnecessary exemptions granted and complimentary Excise duties on selected local productions as a formidable base of consumption taxes without depending on uncertain importation of goods. In such a situation the VAT should be a general consumption tax which covers about 70 per cent of local consumption of good and service

Can the Fiscal consolidation be achieved by increasing tax revenue?

If the budget deficit is to be reduced to 5 per cent of GDP, in-terms of 2012 statistics, the additional revenue requirement would be around Rs. 107,000 million. It is roughly a 10.8 per cent increase of revenue. Can our tax authorities increase their tax collection by 10.8 per cent from the current level in the short term? It is not a challenge but highly impossible task! Still we don’t have 2013 tax collection figures but the performances so far do not indicate any considerable increase in tax revenues. What we should achieve is not a 10.8 per cent increase in one tax. It is a 10.8 per cent increase in the total tax collection. Even in 2012, the total revenue increase was only around Rs. 53,000 million when compared with 2011.

The overall performance of tax revenue has declined from 12.4 per cent of GDP in 2011 to 11.1 per cent of GDP in 2012. The estimated revenue in the Budget-2012 was not achieved due to the reduction of VAT revenue specially on motor car importation, along with reduced import duties, and Special Excise Duties. This type of fragile indirect tax base coupled with inadequate direct tax base will not lead Sri Lanka to a satisfactory fiscal consolidation.

The Minister of Finance without providing for a strong revenue-based tax system depends on the existing inadequate and incompetent system to increase revenue. For example, in the 2012 Budget, he has proposed to collect additional revenue of Rs. 34,200 million but the achievements were hopeless!

The Governor of the Central Bank has become Santa Claus by giving Rs. 43,000 million to the Treasury when they asked for only Rs. 7,500 million. This shows the undependable and fragile nature of our revenue base in Sri Lanka.

Can we reduce expenditure?

It is true that certain expenses which have already been committed cannot be reduced. For example, interest payments on Government debt which absorb nearly 35 per cent of total Government revenue cannot be negotiated. However, more and more borrowings now at very high interest rates, specially dollar borrowings, may increase this expenditure in future. Since 2006 up to 2012 the total interest paid by the Government on borrowings was a massive Rs. 1,973,397 million.

Another big item of expenditure is salaries to public sector employees including defense related personnel. Since 2006 up to 2012 the total salaries paid by the Government were around Rs. 1,867,404 million. Currently, salaries absorb nearly another 35 per cent of total state revenue. No one will even suggest any reduction in salaries even as a temporary measure to overcome the fiscal problem. It will be a political Hara-kiri. In addition to salaries, the state foots the pension bill of retired public servants which was Rs. 111.7 billion in 2012, which increases annually.

Subsidies

Although on paper there are only a few subsidies, a lot of hidden subsidies are in operation. If there is a political will and commitment, some of these may be reduced.

For example, the Fertilizer subsidy has eaten up Rs. 36.5 billion in 2012. At least half of this may be reduced by proper targeting and using other regulatory measures.

Another subsidy, “Samurdhi” payments have become an organizational issue creating other problems due to political patronage. A lot of money is spent on the relevant organization established to deal with Samurdhi payments. In 2012 Samurdhi payments alone were Rs. 10.6 billion. This is another area where a substantial reduction can be effected.
Transfers to other organisations -

State Owned Enterprises (SOES) -

This is where the Governor of the Central Bank of Sri Lanka, anticipated reductions in order to achieve fiscal consolidation. However, this is a pet subject of political leadership in the Government and therefore, it is very unlikely that any reduction will take place. Estimated transfers in 2013 were Rs. 224,039 million. As long as such transfers are available the relevant organizations may not carry on their activities in a financially prudent manner.

Provincial Council (PCC) -

The PCC was established in order to provide more democracy at the doorstep of the people of Sri Lanka. Even after about 30 years, the relevant political authority has not cleared the air on the fate of Provincial Councils. In order to maintain these institutions and for other activities, the state spent nearly Rs. 685,808 million from 2006 to 2012.

The Government will have to get its fiscal priorities cleared and take some concrete steps to reduce its expenditure in a meaningful manner.

However it should not reduce its capital expenditure (which is negligible), in the name of fiscal consolidation, as happened in the past. The Minister of Finance may have to taste a small bitter pill, in consideration of a better fiscal system for Sri Lanka.

Conclusion -

A conscious policy effort is needed by the state to live within its means and thereby bring down the fiscal deficit and public debt. It includes among other things efforts to raise revenue and bring down wasteful expenditure such as subsidies, including hidden subsidies. The whole initiative should be planned as a long term exercise by the state and not think about it on a budget by budget basis.

Due to the scale of consolidation needs, most countries (including Sri Lanka) will need a sustained period of fiscal tightening acting on both the revenue and spending sides. The extent to which revenue or spending to be used as a ground of consolidation will depend on whether spending is already high.

The Minister of Finance in his “Budget-2013″ speech, says, “I will also assure the House that the fiscal strategy of 2013, will underscore the Government’s commitment to keep the deficit below 6 per cent of GDP and protect public investment at the present level, enabling development projects of the state to be continued. The underline fiscal, strategy will contribute to a Budget deficit of 5.8 per cent in 2013 and more towards a deficit of 4.5 per cent by 2015, with public debt below 75 per cent of GDP.”

Now let us see how our “big brother”, neighbouring India, looks at this problem in a more practical perspective. Pranab Mukherjee (Indian Minister of Finance) presenting his 2012-13 Budget has stated as follows -

“Fiscal consolidation calls for efforts both to raise tax – GDP ratio and to lower the expenditure. In this context we need to take a close look at the growth of our revenue, expenditure, particularly on subsidies. The major subsidies at the Centre are food, fertilizers and petroleum products. Some subsidies at this juncture in our development are inevitable. But they become undesirable, if they compromise macro economic fundamentals of the economy, more so, when they don’t reach the intended beneficiaries.”

In this speech he proposed to limit the central subsidies to under 2 per cent of GDP and in the next 3 years to further reduce to 1.75 per cent of GDP.

In the matters of public policy (fiscal or otherwise) the politicians should be honest. In Sri Lanka honesty is lacking not only among the politicians but among the general public as well. Honest, humble politicians have served their countries well, all over the world.

(The writer is a Tax and Investment Consultant in Sri Lanka)