The current economic and financial crisis has come about owing to the cumulative impact of successive fiscal deficits over many years. Containing the fiscal deficit to 5 per cent of GDP in 2016 and continuing to reduce it further in the next four years is vital for stabilization of the economy and economic growth. Fiscal [...]


Two-pronged strategy to resolve the foremost economic challenge of the fiscal imbalance


The current economic and financial crisis has come about owing to the cumulative impact of successive fiscal deficits over many years. Containing the fiscal deficit to 5 per cent of GDP in 2016 and continuing to reduce it further in the next four years is vital for stabilization of the economy and economic growth.

Fiscal consolidation is difficult as the policies needed to increase revenue and reduce expenditure are politically unpopular. They evoke political dissent, protests and opposition. Unless the government recognises the severity of the fiscal imbalance, its adverse repercussions and the urgency of containing it, it would not have a strong political resolve to take firm measures to bridge the fiscal gap.

Fiscal consolidation imperative
The reduction of the fiscal deficit is vital as it would otherwise increase the public debt further. The large debt servicing cost absorbs the entirety of government revenue, leads to further borrowing, inadequate resources for expenditure in vital areas for development, distorts priorities in expenditure and endangers economic stability and growth. In as much as large fiscal deficits have been the underlying reasons for the large public debt and unbearable debt servicing costs, the expenditure on servicing the debt is itself an important cause for increasing debt. This cyclic nature of the problem makes it imperative to put in place immediate measures for decreasing the fiscal deficit.

Fiscal targets
Therefore the fiscal deficit should be reduced to 5 per cent of GDP this year and reduced to 4.5 per cent in 2017 and 4 per cent in 2018. Once the measures for fiscal consolidation are in place the target of 3.5 per cent could be achieved in 2019 if the economy grows at about 6 to 6.5 per cent in 2018-2019.

Fiscal consolidation is however difficult owing to the limited revenue base of only about 13 per cent of GDP; large debt servicing costs that absorbs the entirety of revenue; huge expenditure on public service salaries and pensions that is the second largest government expenditure; big losses in public enterprises that are difficult to contain; a large defence expenditure; and expenditure on subsidies and welfare. Many of these expenditures have rigidity and are difficult to reduce.

Two pronged strategy
The reduction of the large fiscal deficit requires a two pronged strategy of increasing revenue much above its low 13 per cent of GDP on the one hand, and deceasing government expenditure, on the other. Although both these are undoubtedly difficult to achieve in the current fiscal and political context, they are essential for reducing the fiscal deficit. Much of the fiscal consolidation must be achieved by increased taxation.

Government revenue must be increased from its current low level of 13 per cent of GDP to about 15 per cent in 2016-17 and increased to 20 per cent by 2020 to further consolidate the fiscal balance. Although government revenue has increased in value, it has fallen as a proportion of GDP in recent years. Revenue decreased from 20 per cent of GDP in 2005 to 12 per cent of GDP in 2012 and about 13 per cent of GDP in 2014. This revenue to GDP ratio is below levels of countries with Sri Lanka’s per capita income. Tax exemptions, tax avoidance and tax evasion are important reasons for this shortfall in revenue.

Tax reforms
Comprehensive tax reforms are needed to increase revenue to 18-20 per cent of GDP in five years. Despite the recognition of this in the Prime Minister’s Economic Policy Statement of November last year that announced the government’s intention to bring down the fiscal deficit progressively to 3.5 per cent of GDP by 2020, the 2016 Budget hardly attempted to contain the deficit. Even its fiscal deficit target of the 5.9 per cent of GDP was itself woefully inadequate. The revisions of the budget since then are likely to increase the deficit rather than reduce it.

The 2016 Budget did not address fiscal consolidation in a systematic manner. Its tax reforms are likely to reduce revenue rather than increase it. The Finance Ministry needs to examine the Presidential Taxation Commission Report as well as obtain expert advice to restructure the tax system to yield higher revenue. A more progressive and higher direct income taxes are warranted than the 15 per cent income tax rate that is one of the lowest in the world. The government tax system should tax luxury consumption of the affluent who avoid direct income taxation in diverse ways. Instead, the taxation system has tended to be regressive by higher dependence on indirect taxes that fall heavily on low income earners and affect the livelihoods of the poor. Increasing revenue depends very much on the realistic nature of the tax reforms and the administrative capacity of the Department of Inland Revenue.

Curtailing expenditure to achieve a lower fiscal deficit is a more difficult task than increasing revenue. However the serious situation in public finances requires a fine combing of government expenditure to reduce whatever expenditure could be curtailed. Each ministry, department and institution should be given a target of achieving an under expenditure from its budgetary allocation.

The increase in defence expenditure since the end of the war must be critically examined to reduce non essential expenditure. Expenditure on military hardware should be brought down and fresh recruitment of personnel should be minimal.

Public enterprises
Losses incurred by public enterprises are a huge fiscal burden. Reform of state owned enterprises to reduce losses is an avowed intent of the government exemplified by the setting up of a separate Ministry of Public Enterprise Reform. Reforms of these public enterprises are an important means of decreasing expenditure. The privatisation of some enterprises that would not attract public protests, such as the sale of shares of Lanka Hospitals, is a means of increasing revenue.

Salaries of public servants and pensions, subsidies such as for fertilizer and Samurdhi payments are not likely to be reduced. In fact the salaries bill may once again increase due to both salary increases and further recruitment. The government should resist these due to fiscal stringency and the need to keep government expenditure down. However political compulsions are stronger than economic imperatives.

The containment of the fiscal deficit to a reasonable level is the most challenging and important task. It is imperative for the government to be resolved to achieve a large measure of fiscal consolidation despite the political difficulties it would face. The government must be resolved to adopt measures to increase revenue and decrease expenditure to achieve a fiscal deficit of 3.5 per cent of GDP in 2020.

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