The task ahead for the Government

Originally appeared on Echelon

The Yahapalanaya Government is unpopular, as borne out by the results of recent local government elections. They were elected amid great expectations of change: people wanted better governance, lower corruption, more freedom; in sum, a better life. They have failed, dismally. It is uncertain which party will eventually form a government, but whatever party needs to pay heed to the concerns of the people.

What is the problem?

Sri Lanka’s macroeconomic fundamentals are improving, but to ordinary people, this is meaningless; what matters is how it benefits them: better jobs, higher salaries, lower cost of living. To comprehend the problems of the common man, we must view them from that perspective. Between 2015 and mid-2017, the government imposed a huge burden on the public; the combined impact of tax increases (VAT, PAL) and the currency depreciation added almost  25% to the cost of imported items. This is excluding increases in duty or the impact of extending VAT to previously untaxed items such as healthcare, alcohol and telecommunication; factoring these in would increase the impact even further.

How many average citizens were fortunate enough to receive a 25% increase in income during this period? Anyone who did not would probably face lower living standards.

To add to these self-inflicted woes is the impact of the drought and floods in both 2016 and 2017. Affected people, particularly in rural areas, lost livelihoods and income. With crops wiped out, urban people experienced soaring prices of coconuts and vegetables. When the cost of living rises, the government gets the blame, even when, in this instance, it’s not at fault. The impact is evident in consumer spending; one only needs to glance at the published accounts of companies such as Nestlé and Elephant House. Nestlé reported a 5.3% decline in turnover in the half year ended June 2017, while Elephant House reported a 5% decline in the quarter to June 2017. These are both food companies; noodles, malted milk, ice cream and sausages are hardly luxuries. Yet, overall sales revenues have declined; the fact that people have cut back on simple things like this illustrates the depth of the problem.

When people cutting back on basics are confronted by the spectacle of egregious corruption of ministers living in ostentatious luxury and driving around in convoys of vehicles each of which costs more than the house of a common man, the frustration boils over. The government cannot expect to tax punitively, spend lavishly on themselves, and expect the public to grin and bear. How should the government react? In the short term, some relief that does not upset fiscal stability, and reforms to promote growth in the longer term.


The First Step: A clear message of austerity starting from the top

The government must show, publicly, that they are concerned about waste, corruption and inefficiency. Mere words will no longer suffice, deeds must follow. A visible cutback in luxury and waste must be led from the top: this means no new vehicles, no fancy offices, fewer overseas jaunts, no large entourage of security/staff. It must be visible. Even if the impact on cutting back on ministers’ privileges yields comparatively small savings, they need to be seen to be tightening their belts to win public support.

They should launch an economy drive eschewing extravagance, and eliminating corruption and waste through increased transparency and open processes. Sri Lanka’s leaders frequently cite the example of Singapore. Fiscal prudence has been a hallmark of Singapore’s governing philosophy and successful management of the economy: an ethos that must become a watchword for Sri Lanka’s rulers. When faced with a crisis, Singapore set up a “Cut Waste Panel”, headed by members from the public and private sectors, to receive suggestions from the public on where the government can cut waste, remove frills and make savings in the delivery of public services. The minister could set up a similar panel and, in addition to suggestions from the public, actively seek other opportunities to reduce costs.Properly executed, with real results, this will help restore credibility.


The Second Step: For quick relief, cut protective tariffs

Sri Lanka has a high cost of living, partly due to taxes. The taxes are of two types – protective taxes to benefit local industries and revenue-generating taxes. Protective taxes bring minimal revenue to the government and can be cut immediately, with little impact on the budget deficit.

Local industries have lobbied for protective tariffs on imports, which benefit them by raising the price of imports. These earn little revenue for the state, but increase consumer prices. For example, the import of wheat flour is taxed, ostensibly to support paddy farmers but in reality to protect local wheat millers. Wheat flour is effectively taxed at around 85%, while wheat grain is taxed at around 23%. Local wheat millers pocket the difference.

The net result is high prices of bread. Wheat flour retails in Malaysia for half the price it does in Sri Lanka. Cutting the tax on wheat flour could reduce bread prices significantly, and thereby the cost of living.

This is not an isolated example, it is prevalent across many food items and sectors from building materials (construction costs in Sri Lanka are estimated to be 40-60% higher than in the region) to toiletries (shampoo is taxed at rates between 100% and 200%), to shoes. Local industries create a few thousand jobs to protect these, and millions of consumers pay higher prices. A much larger population loses, while a small group gains, which means negative results on overall welfare. If these taxes are cut, they will bring immediate and significant relief to people, with little pressure on public finances.


The Third Step: Resist giveaways, maintain macro stability, facilitate investment

As a result of increased taxes, the primary balance of the budget (all expenses before interest) showed a surplus as at November, the first in 63 years. This means that government revenue meets current expenditure without the need to borrow. This must be maintained to prevent debt from growing, so there is no room for panicked giveaways.

The temptation for salary increases or subsidies must be resisted at all cost: it will buy short-term popularity, but destabilise the budget in the long term. Indeed, it was the public sector salary increase in 2015 that ultimately forced the government to increase taxes. The government initially financed the increased salary bill in 2015 by printing money, the impact of which came later in the form of currency depreciation. Forced to contemplate either further currency depreciation or tax increases to pay for salary hikes, they chose the latter and the currency stabilised. The cost of increased salaries for 1.3 million public servants was ultimately borne by 20 million people. A minority experienced an increase in welfare, but ultimately the vast majority suffered.

Politicians and the public must understand that a government has no resources of its own to distribute, and what it can distribute is ultimately only what it can collect in taxes. Short-term giveaways will simply repeat this destructive cycle.

The solution to jobs is not to grant public sector salary increases or recruit more into service, but to enable new investment that will create new jobs and increase demand for workers, which will lead to higher salaries. A simple illustration of this is the sudden increase in demand for workers in Colombo hotels following the opening of Shangri-La Colombo – city hotels are competing actively, and overall salaries in the sector have risen. To do this, they need to facilitate investment by simplifying regulations and removing tariff barriers, while maintaining policy stability. A limited domestic market means the path to growth is through exports, not protected, import-substituting local businesses.


The Fourth Step: Pruning of debt, reducing expenditure

Around 50% of government revenue is spent on salaries and pensions, and a further 36% on interest. With 86% of revenue eaten up with these two items, the country is effectively borrowing to consume, and debt keeps growing. A primary surplus on the budget means that fresh debt is not needed for current expenditure (although it may be needed for capital expenditure). If expenditure is cut, then the surplus will grow and more debt repaid, leading to long-term reductions in interest. Fortunately, there is plenty of scope for this: simply, cut waste and reduce corruption. A key area is State-Owned Enterprises (SOEs), which have become little more than vehicles for corruption.

Corruption is endemic and deep-rooted, and can only be controlled at the source – government procurement. Politicians love to spend other people’s money, whether on capital expenditure or in procurement of ministries and state enterprises. The Auditor General (AG) has revealed a Rs15 billion scam in rice imports by Lak Sathosa – purportedly imported to reduce the cost of living, but in reality, for the purpose of making money. The AG also revealed a Rs4 billion scam in coal imports.

Spending presents opportunities for theft; the less the government spends, the less politicians can steal. Scaling back state involvement in economic activity will automatically lead to a reduction in corruption in absolute terms, even if the proportion stolen never changes.

Recall that the high taxes are what angered people, the taxes that fund government spending. Control spending to keep taxes low. There needs to be a comprehensive review of spending, reviewing, not only the scale of spending, but also the scope of government. The government should not expend any further funds expanding SOEs; these should be restructured to cut waste and losses. As many as possible should be sold or closed down. Privatisation can have a fourfold benefit:
a) raise revenue that may be used to repay debt,
b) obviate the need to fund losses (in the case of loss-making entities),
c) reduce opportunities for corruption, and
d) open new opportunities for private sector participation in the economy.

For whatever procurement that does take place, open and transparent processes must become the norm. Infrastructure can either be developed privately or in partnership with the government to minimise additional borrowing. Where corruption is detected, action must be taken, starting from within the government’s own ranks.

There are no quick and easy solutions, but measures described above will bring some immediate relief, while setting the foundation for sustainable growth. Enough benefits will flow to ensure re-election of whichever party implements this in full by 2020. There will be stiff opposition by politicians and businesses who benefit, but they are a minority. The vast majority, particularly the poor, will benefit.