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Moving to create more fiscal space

The fiscal management challenges that Sri Lanka faces today are a legacy of some salient trends that manifested themselves over a few decades.

The early phase of liberalisation which was accompanied by a large public investment programme, resulted in a high budget deficit of 15 to 20 per cent of GDP for five to seven years, followed by another period of five to seven years with deficits in t he range of 10 to 15 per cent, but associated with declining public investments and rising government dis-savings. Although the deficit declined from around 20 per cent in the mid-1980s to less than 10 per cent in the 1990s and to around 7 per cent in recent times, it remains high in terms of fundamental macroeconomic norms. Moreover, overall national savings showed a modest growth from 12 per cent of GDP in 1980 to 16 per cent in 2004.

Second, although Sri Lanka eliminated export taxes in 1990, phased out prohibitive tariffs on imports over successive years and implemented free trade arrangements with India and Pakistan since 2000 with a consequent reduction in the quantum of such duties from about 10 per cent of GDP in 1977 to 2 to 3 per cent by 2004, it could not build alternative revenue sources although the reforms were conducive to promoting exports. Consequently, the revenue effort deteriorated: from a level in excess of 20 per cent of GDP prior to liberalisation, it fell below 15 per cent in 2004. Further, through the post-1977 liberalisation regime, the taxation strategy relied on a culture of tax concessions, tax holidays and relief for investment, while favouring consumer protection instead of promoting a broad-based taxation strategy.

Third, despite liberalisation, fiscal policy continued to support an extensive welfare state. Successive governments have been committed to universal free education and health services and somewhat untargeted relief-for-the-poor initiatives. Expenditure on welfare, which in 1970 was 6.6 per cent of GDP, reached 7.2 per cent in 2004. With the adoption of a devolved system of administration under the 13th Amendment to the Constitution, of 1988, government operations at the provincial level expanded. The Central government also was engaged in provincial and rural sector activities. Collection of devolved revenue remained below 0.5 per cent of GDP in 2004, while devolved expenditure accounted for 2.3 per cent. On top of these came the large payroll for the public service, which employs nearly a million people.

Fourth, the fiscal imbalances contributed to an increase in national debt, although Sri Lanka does not have large commercial debt in its total debt portfolio and the debt servicing cost is under 15 per cent of foreign earnings. The interest expenditure on public debt grew from 16.9 per cent of government revenue in 1980 to 38.5 per cent in 2004. This level of interest expenditure accounted for 5.7 per cent of GDP in 2004, compared to 3.3 per cent in 1980.

Fifth, the historical bias towards ‘welfarism’ in public policy, reflected in an administered price mechanism for services provided by the government, often resulted in losses in state enterprises or quasi-fiscal losses borne by the financial sector.

Sixth, over the last 30 years public policy in Sri Lanka has shown a delayed response to external shocks. Successive governments, with their bias towards short-term consumer welfare, have lagged behind in adjusting domestic prices to international trends. This deprived the country of many opportunities to exploit potential in agriculture and alternative energy sources. The cumulative cost of such losses for the past 20 years accounted for 20 per cent of GDP in 2004.

Finally, the engagement in countering terrorism led to the expenditure in relation to national security increasing from about 1.5 per cent of GDP in the early 1980s to nearly 6 per cent in the late 1990s. It has now moderated around 3.5 to 4 per cent. Studies by the Central Bank of Sri Lanka and the Institute of Policy Studies have estimated the cost of terrorism to be around 1 to 1.5 per cent denial of economic growth each year. The compound impact of this for a 25-year period reflects the fiscal and economic burden that policymakers today have to manage.

Even as the challenges mounted, successive governments were mindful of the imperative for reform. Having gone through the initial liberalisation phase from 1977, the reforms of the 1990s aimed to deepen the role of the private sector, create a more liberal trade and investment regime, have a free float exchange rate arrangement, and infuse foreign investment into previously state owned enterprises. This process was sought to be taken forward in the reform agenda, titled Regaining Sri Lanka, adopted by the government elected in December 2001. However, the public reaction to reforms became increasingly negative by 2003. As such, in the run-up to the 2004-05 parliamentary and presidential elections, political platforms were preoccupied with the adverse reactions to privatisation and public sector reforms.

Moreover, the overall development was characterised by imbalances. It took almost three decades for per capita income, which was around $300 in 1977, to reach $1,030 in 2004. Although human development has been favourable with the Human Resources Development Index reaching 86 per cent in 2004, its sustainability is undermined by the phenomenon of 50 per cent of GDP being concentrated in the Western Province, where Colombo is located.

President Mahinda Rajapaksa was elected in November 2005. The re-engineering of an alternative policy strategy is articulated in the document titled 10 Year Horizon: A Development Framework for 2006-2016 based on his manifesto for the 2005 presidential election, Mahinda Chinthana: Vision Towards a New Sri Lanka. It recognises market-oriented policy strategies and endorses the need to balance the roles of the private and public sectors.

While revitalising the national production base with emphasis on agriculture and infrastructure, it is committed to strengthening the public service delivery mechanism, particularly in health and education, and to correcting fiscal deficits and macroeconomic imbalances. Empowering the managements of state enterprises, as against their privatisation, is considered the way forward, given their strategic importance in the economy and the accompanying regulatory challenges.

The strategy was launched in a difficult environment marked by the post-tsunami recovery, the effort to counter terrorism, the rise in international oil prices and the lapse of the Multi-Fibre Agreement that had provided assured access for apparel exports to Western markets. The strategy has a four pronged approach.

1.The expansion of government revenue efforts through institutional capacity development and the introduction of technology to administer move effectively VAT and Income Tax, in Sri Lanka’s service sector led economy;

2.The elimination of unsustainable and economically costly fiscal losses, such as the dramatic reduction of the fuel subsidy which was SLRs. 26.4 billion in 2004 to SLRs. 0.6 billion in 2007;

3.Mobilisation of long term funding in support of large infrastructure projects, including hydro and coal power plants, highway networks, irrigation and water supply projects and the expansion of port facilities;

4.Restructuring of national debt to reduce associated fiscal costs, including through the recent entry of the Government into international capital markets and the opening of treasury bonds for foreign investors.

The four prongs are mutually re-enforcing, for each provides room to manoeuvre the national budget to accommodate new expenditure priorities, particularly in relation to public investment.

In the context of the medium term objective of reducing the fiscal deficit to 5 per cent of GDP, a level consistent with committed long term foreign funds and available contractual savings, the rise in public investment needs to be matched with fiscal savings in the revenue account. The challenge therefore, is essentially to bridge a saving-investment gap in fiscal management.

Nevertheless, the outcome of the fiscal policy reforms initiatives is encouraging. The reform process has raised revenue to 16 per cent of GDP and reduced recurrent expenditure to 17.4 per cent of GDP. Public investment has increased to 6.7 per cent of GDP and the overall deficit has declined to 7.7 per cent of GDP. The progress in reducing the public debt level is satisfactory and the 2007 level of public debt to GDP, is the lowest since 1997. With this fiscal transformation as the backdrop, the economy saw an average growth of 6.7 per cent during 2005-2006. Per capita income, which was $1,030 in 2004, reached $1,630 in 2007. Unemployment has declined to 6 per cent.

However, inflation remains high with core inflation itself reaching 9 per cent, demanding greater fiscal consolidation. In the context of global uncertainties and fears of an economic slow down, sustaining the growth process will require the continued attention of policymakers.

(Dr. P.B. Jayasundera is Secretary, Ministry of Finance and Planning, and Secretary to the Treasury, Government of Sri Lanka. These are edited excerpts from a presentation he made at the National Institute of Financial Management in Faridabad on March 30, on the theme “Contemporary Challenges in Fiscal Management: The Sri Lankan Experience”.)

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