Economics

Advocata's submission for the Budget 2017

Echelon Magazine, Sri Lanka's premier business magazine published excerpts of Advocata Institute's Budget submission for 2017

THINK TANK ADVOCATA IS PROPOSING LOWER TRADE TAXES AND TRIMMING PUBLIC SECTOR EXPENDITURE IN ITS RECOMMENDATIONS FOR BUDGET 2017 PRESENTED TO THE MINISTRY OF FINANCE AND PLANNING

 

Summary recommendations
1. The immediate policy priority should be to restore emphasis on exports: Liberalise the trade and investment framework to attract FDI.

2. Public sector reforms to cut costs are vital. While tax increases may be unavoidable, the additional burden on the public must be minimised: Reforms for the public sector to reduce its size, cut corruption and improve efficiency are essential.

3. The current tax structure is incoherent and chaotic. It must be reviewed and policy grounded on sound fiscal and tax principles including fiscal adequacy, administrative feasibility, simplicity, transparency and stability.

Despite a significant improvement in the first half of the year, meeting Sri Lanka’s budget deficit for 2016 will be challenging. A significant amount of fiscal consolidation will still be needed over the next few years if the government is to achieve its stated goal of reducing the budget deficit to 3.5% of GDP by 2020 or indeed meet its commitments to the International Monetary Fund (IMF), which is likely to create considerable uncertainty over the likelihood of further tax increases.

Given the difficult environment and ambitious targets, the government may be tempted to resort to ad hoc, short-term measures to deal with fiscal crises as they arise, creating a volatile business environment, eroding confidence and leading to a lack of predictability in revenue targets. This, in turn, results in further ‘quick fixes’.

This is a vicious cycle that must be broken if consistency and predictability is to be restored to the tax system. This is possible if the government adopts a framework of evidence-based policymaking, and we urge that this be done as a matter of priority.

Making policy that is based on evidence is not easy, but it is possible to draw on the experience of countries such as the UK, which have adopted such an approach. Frameworks that governments can follow to build and support a system of evidence-based policymaking are available, and the government should seek specialised assistance to implement a structured approach. This will help ensure consistency and predictability in policy, improving business confidence.

Policy making must be an ongoing process, and consultation and assessment should not be limited to a period a few weeks before the budget. Poorly researched policy may cause unintended consequences and result in policy reversals. While all suggestions must be considered, many are likely to come from sectors seeking privileges. These must be carefully researched, subjected to wider consultation and adopted only if overall benefits to society outweigh costs. Some of the complexity and anomalies in the tax code may be traced to the accommodation of various special interest groups.

In achieving its fiscal targets, the government cannot limit its focus to raising taxes. Breaking from the pattern of the past, equal or even greater emphasis must be placed on the reduction of expenditure, reviewing not only the scale of spending but also the scope of the government.

An economy drive eschewing extravagance, the elimination of corruption and waste through increased transparency, and open processes must necessarily form a part of this exercise. 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. The Singapore Civil Service’s “Cut Waste Panel” and “Economy Drive” offer useful practical lessons in managing costs and could be adapted for Sri Lanka.

The tax system must be simplified, widening the base and increasing compliance. The finance minister’s commitment to this is laudable. The remainder of this submission seeks to outline a few key issues and offer avenues for the administration to explore. We believe these ideas are worthy of careful study and could yield outcomes that will assist in stimulating growth, reducing the budget deficit, and simplifying and rationalising the tax system.

RETHINK THE DEVELOPMENT STRATEGY
Restore policy emphasis on exports

Lacking a large domestic market and possessing few natural resources, exports offer the best opportunity for rapid development.

Successful integration of the manufacturing sector into global production networks has played a key role in employment generation and poverty reduction in China and other high-performing East Asian countries.

The market-oriented policy reforms of 1977/8 were based on this rationale and served the country well, resulting in a notable diversification of the commodity composition of Sri Lanka’s exports and a consistent improvement in share of world manufacturing exports until the late 1990’s.

However, protectionist pressures began to build in 2001, and from 2004, the relatively open trade policies of the past were explicitly and systematically reversed. A policy paper by the World Bank titled “Increase in Protectionism and Its Impact on Sri Lanka’s Performance in Global Markets” shows that, today, through the proliferation of a variety of para-tariffs, Sri Lanka’s tariff policies are just as protective as they had been more than 20 years earlier.

The present protectionist import tax structure has serious costs for Sri Lanka’s economic welfare and growth; Sri Lanka’s exports relative to GDP have declined, as has its share of world exports. Sri Lanka has fallen significantly behind its competitors. Vietnam, which was on par with Sri Lankan exports in 1990 with $2 billion per annum, today exports $162 billion versus Sri Lanka’s $10.5 billion.

A bulk of Vietnam’s exports is driven by foreign investment and a globally competitive agriculture sector that emerged in the wake of a liberalisation drive that moved away from ‘self-sufficiency’. FDI firms account for 71% of Vietnam’s and 44% of China’s exports. The lesson is clear: To boost growth and create productive employment, Sri Lanka should cut barriers to trade and investment, and focus on attracting export-oriented FDI.

The most important reforms needed are listed as follows:

1.Trade policy reforms: Move from the present chaotic tariff structure towards a transparent, uniform tariff structure
• Unify the existing Customs duty and the plethora of para-tariffs (PAL, VAT, CESS, Customs Surcharge) into a single Customs duty at the individual Customs code level, and then reduce Customs duties across the board to a uniform nominal rate of 15%. Moving towards a low, uniform tariff structure has the potential to increase tariff revenues. This would speed up Customs clearance and reduce the potential for corruption as it reduces the discretion of Customs officials and makes the trade regime predictable.
• On the export side, remove all cess as it reduces the effective price received by exporters, and thereby discourages exports. There is no evidence to suggest that these cesses promote local downstream processing of primary products that are now exported in ‘raw’ (unprocessed) form.
• Join the Information Technology Agreement of the WTO to create free trade in electronics, which will attract FDI to this sector.

2. Foreign direct investment reforms
• Restore the role of the Board of Investment as the ‘one-stop shop’ for investment approval/promotion (as envisaged in the BOI charter). This requires repealing the Revival of Underperforming Enterprises and Underutilized Assets Act (2011) and the Strategic Development Projects Act (2011), or passing new legislation to supersede these two acts.
• It is, of course, necessary to rationalise the fiscal incentives offered to investors, but there is a strong case for providing export-oriented foreign investors with time-bound tax holidays and investment tax allowances beyond the tax holiday period. There is evidence that tax incentives play an important role in influencing location decisions of export-oriented (efficiency-seeking) FDI, especially where competing countries still offer them, provided of course that the other preconditions are ‘reasonably’ met. (The evidence used in recent policy reports by the World Bank to argue against tax incentives comes from studies that have not made a distinction between ‘market seeking’ and ‘export-oriented’ FDI). Removing all tax incentives, while other negatives continue to weigh on the overall competitiveness in investment and trade, may be counterproductive.
• Sri Lanka has to improve property rights to draw investment. The guarantee against nationalisation of foreign assets without compensation provided under the Article 157 of the present Constitution needs to be maintained under the ongoing constitutional reforms.
• Avoid the current practice of ‘domestic value added’ [which is defined as per unit of domestic retained value (wages + profit + domestically procured intermediate inputs) as a percentage of growth output] as an evaluation criteria in approving investment projects.

The very nature of the ongoing process of global production sharing (production fragmentation) is that per unit value added of production plants located in a given country within vertically integrated global industries (such as electronics and electrical goods) is usually very thin. The contribution of such production to domestic output (GDP) depends on the volume factor and the ability to produce for the vast global market, not on per unit value added.

In some traditional industries that use diffused technology (such as garments, footwear, travel goods), there is opportunity to increase per unit value added by forging backward linkages, but this is a time-dependent process and depends on export volume expansion. In the garment industry, per unit value added was around 20% at the beginning, but is now over 60%. Backward-linked knitted textile production and other ancillary input industries (hangers, buttons, labels, packaging material) have emerged as the volume of export expanded, creating sizeable demand for such inputs.

3. Macroeconomic policy
Trade, investment and labour market reforms need to be accompanied/complemented by macroeconomic policies to regain international competitiveness of the economy. Relying solely on nominal exchange rate depreciation for this purpose is not advisable, given the massive build-up of foreign-currency denominated government debt. Also, given the increased exposure of the economy to global capital markets, large abrupt changes in the exchange rate could shatter investor confidence, triggering capital outflows.

What is required is a comprehensive policy package encompassing some exchange rate flexibility and fiscal consolidation, which requires both rationalisation of expenditure and widening of the revenue base.

The current import-substitution policy retards growth and hurts consumers.

The present policy stance and import tax structure have drawn capital, labour and land to high cost, and highly protected import substitution farming and agricultural processing activities with low or negative economic rates of return. Sri Lanka’s food prices are higher than in the region due to high tariffs imposed to achieve self-sufficiency, hurting the poor and possibly contributing to malnutrition particularly of poor children. At a time when the government is burdening people with higher taxes, it is imperative that attempts be made to reduce food costs; revising this policy could contribute significantly to lowering the cost of living.

An example of this policy is rapid growth of maize and soybean cultivation over the last 10 years. These are not traditional crops and were not cultivated on any scale prior to 1998. These are used primarily as raw materials for the production of animal feed. Subjected to heavy protective tariffs, the cost of these locally produced crops are far in excess of world prices and directly related to the high cost of local poultry products. Instead of reviewing a flawed agricultural policy, the government has reacted to high retail prices of poultry by introducing price controls.

The policy of protecting the local sugar industry has had a similar impact and should also be subjected to review. The protective policy toward wheat imports has resulted in increased retail prices of bread, despite a collapse of world wheat prices by 50% since 2013.

The above highlights just a few key issues; there are many others. The government needs to study the impact of its trade and agricultural policies on consumer prices, and review its policies to maximise benefits to society as a whole. The ill effects of poor agricultural policy are not limited to higher prices, and their unintended consequences may extend to the human-elephant conflict and the recent spread of chronic kidney disease. The review of policy needs to be holistic.

PUBLIC SECTOR REFORM

Cumulative public debt and the high budget deficit have been key drivers of macroeconomic instability in Sri Lanka. Higher government borrowing not only wreaks havoc in the government’s finances, but also crowds-out private investment by pushing up interest rates. Sri Lanka also operates a “Mega State” apparatus, with a massive public sector, unproductive/loss-making state enterprises and an oversized peacetime military that further diminishes the fiscal position.

The massive increase in public sector employees starting from about 850,000 in 2005 to around 1.27 million by 2016 also has knock-on effects on the political economy, with both major parties now having to pay homage to this large voting bloc by promising unfunded and unsustainable goodies such as salary increases and other benefits – what analysts term ‘an auction of non-existent resources’ – at each election.

While most commentators emphasize enlarging the tax net to address fiscal imbalances, Advocata believes that reducing the size and scope of the state is more pressing. While political space for reforms may be limited, public opinion is increasingly skeptical of loss-making state enterprises, which is an argument reformists in government could use.

Advocata urges policymakers to look into following avenues of reform:

Addressing the debt burden

The government’s debt/GDP ratio is 75%. Debt service costs (interest and capital) accounted for 90% of government revenue in 2014. The previous year’s debt service cost actually exceeded revenue; the ratio in 2013 was a whopping 102%. Interest cost alone amounted to 37% of government revenue in 2014.

Sri Lanka regularly runs a primary (before interest payments) budget deficit, which means recurring expenditure is being funded by debt, a situation that is clearly unsustainable. Sri Lanka’s debt ratios bear some uncomfortable parallels with those of Greece, just before the outbreak of the debt crisis.

Restructuring the debt to extend its maturity and reduce interest rates could provide some relief, but disposing of unproductive state assets and using the proceeds to reduce debt is a more permanent solution and we offer a few ideas below.

Reforming SOEs

Disposing of loss-making and unproductive state-owned enterprises (SOEs) is a way of easing the debt burden and preventing further deterioration of the fiscal position. The outstanding SOE debt to banks is at Rs757 billion, more than four times what the government spent on health services in 2015. Some SOEs have accumulated so much debt that even privatisation may not be possible. These could simply be shut down with generous severance payments to employees, which will be cheaper in the long run.

Reform of SOEs need not be limited to loss-making enterprises. SOE’s often employ significant resources in terms of labour, land and other factors of production, which could be better utilised. Conducting a comprehensive productivity study would allow the government to determine which ones to shut down, which ones to privatise and which ones could be held under ownership at a government holding company in the model of Singapore’s Temasek Holdings.

 

Reactivating “Dead Capital”: State-held land

The Land Reform Commission was vested with about 987,000 acres, some of which could be used for more productive purposes. Additionally, government ministries, schools and other facilities occupy prime real estate blocks in major cities like Colombo, which greatly outweighs their economic value.

As an initial step, accounting of property rents at market values would allow the government to get an accurate sense of the value of the dead capital that the government is occupying, which could be put to more productive use. The Colombo Dutch Hospital project and the clearing of the Army headquarters for commercial activity are examples of how dead capital in government-held land could be activated for more productive use. The government should draw up a Land Asset Sales Programme, an orderly and coordinated programme to dispose of surplus or underutilised land. The proceeds from these sales should be used to reduce national debt. The sales programme must be run in an open and transparent manner by an independent body free of political influence to minimise corruption.

Public-private partnerships for infrastructure

Converting existing infrastructure such as highways into Public-Private Partnerships could raise funds to pay down the loans that were used to finance them. Operational rights could be auctioned in a transparent manner to private investors. New infrastructure projects should be on the basis of a Build Own and Operate (BOO) model or Build Operate and Transfer (BOT) model, which has been used successfully all over the world to finance infrastructure projects.

Restoration of the National Procurement Agency (NPA)

The NPA was established in 2004 to streamline procurement, reduce waste and corruption, and ensure better transparency and governance by centralising procurement under an independent body. The agency was believed to have been effective, which lead to it being shut down, allegedly for political reasons, in 2007. Its operation should be revived and its independence guaranteed.

The defence budget

Spending on defence has grown from around Rs144 billion in 2009 to an estimated Rs306 billion in 2016, a massive increase in a time of peace. Due to the politically charged nature of the expenditure, this has been the ‘elephant in the room’. While acknowledging that immediate demobilisation or salary cuts are not feasible, continuous growth in defence expenditure seven years after the end of the war is something that requires questioning.

It is one of the largest items of expenditure, and discussion of this subject must no longer be avoided. Cutbacks in capital expenditure and hardware are necessary. More generally, a national plan to downsize the military should serve the long-term interest of all communities in Sri Lanka.

Voluntary retirement schemes

The state currently employs over a million people and an additional estimated 220,000 workers employed in SOEs. Some analysts put the figures much higher. In total, the public sector accounts for about 15% of the total labour force.

The public sector pensions and salaries bill for 2015 was Rs717 billion, representing 49% of government revenue. The weight of the wage and pension bill has crowded out priority expenditure in education, health and essential infrastructure, and even operational expenditure necessary to enable employees’ effective functioning. Not only do the salaries and entitlements of these workers burden the fiscal position of the government, it also mops up scarce labour from the private sector. By this account, Sri Lanka probably has the largest state sector in the world.

The dependence on excess labour also means that state agencies become reluctant to invest in new technologies or procedures in fear of backlash or simply not knowing where to allocate the labour.

Reforms in this area are not going to be easy, as the 2002 UNP government discovered to its peril. However, the current levels of state sector cadre places a massive strain on the fiscal position.

The government should commission a report on the labour requirement for the state sector. While attrition and a hiring freeze are preferred methods of cadre management, for some sectors and institutions, Voluntary Retirement Schemes (VRS) may be possible. To manage pension liabilities, a new contributory pension scheme should replace the current defined benefit scheme for any new recruits to the public service.

Reform of energy utilities

Sri Lanka’s energy utilities are a source of macroeconomic instability, and reforms to the sector are long overdue. While detailed studies for longer-term reforms must be undertaken as an interim measure, re-introducing the pricing formula for fuel and extending the formula to electricity will prevent large imbalances from building up. For the electricity sector, an immediate move to daylight saving time could reduce night peak load demand by as much as a third, with consequent reduction in thermal energy generation. In Sri Lanka, the discussion is private participation in electricity centres around fixed contract IPPs. In many other countries, however, this model is now considered outdated, the world has moved on to integrated energy markets. A study by the Pathfinder Foundation carried out in 2007 provides a useful starting point for ideas on moving to energy markets.

 

THE TAX SYSTEM

Recent budget statements by successive governments, including the present one, have not been in keeping with sound principles of taxation. While recognising the unique political moment in which the new administration operates and the politically expedient measures that were taken to create that political moment, continuing to ignore principles of fiscal discipline can only lead to further imbalances.

The following principles serve a guide to sound tax and fiscal policy:

Fiscal adequacy
The overarching objective should be that sources of revenue, taken as a whole, should be sufficient to meet the demands of public expenditure. Revenue should be elastic or capable of expanding or contracting annually in response to variations in public expenditure. Most crucially, any new benefit or relief measures offered must be fully funded. Government finances are in a dire state, they should not be made worse; ill-conceived proposals in the past have contributed to the structural weakness of the fiscal position.

The adoption of a medium-term budget framework to prioritise, present and manage both revenue and expenditure over a multiyear framework is desirable. It can help demonstrate the impact of current and proposed policies over the course of several years, and ultimately achieve better control over public expenditure.

Rules in the Fiscal Management (Responsibility) Act may be tightened to reinstate budget discipline, and ensure fiscal responsibility and debt sustainability.

Simplicity, administrative feasibility and transparency
Tax laws should be capable of convenient, just and effective administration. Tax codes should be easy for taxpayers to comply with and for governments to administer and enforce. It is far simpler to adjust rates to existing taxes than bring in new types of taxes.

Any changes needed to the tax code should be made with careful consideration of established practices and open hearings. Each tax in the system should be clear and plain to the taxpayer. Disguising tax burdens in complex structures to deceive the public, the preferred approach by politicians in the past, should be avoided. Simplicity will close loopholes for tax evasion, reduce the scope for corruption and minimise administrative costs.

Neutrality
By and large, taxes should neither encourage nor discourage personal or business decisions. The purpose of taxes is to raise needed revenue, not to favour or punish specific industries, activities and products. Minimising tax preferences broadens the tax base, so the government can raise sufficient revenue with lower rates.

Stability
Taxpayers deserve consistency and predictability in the tax code. Governments should avoid enacting temporary tax laws, including tax holidays, amnesties and retrospective changes. The periodic revision of taxes via gazette notifications should be avoided. Put simply, a good tax policy promotes economic growth by focusing on raising revenue in the least distortive manner possible.

Sin taxes need re-thinking

While our proposals are mostly concerned with broad issues of policy, we have made an exception for ‘sin taxes’ because of their importance to the exchequer.

‘Sinful’ items such as alcohol and tobacco have traditionally been taxed heavily and are the second-largest source of tax revenue for the state. A review of these policies could develop their effectiveness and improve collection. The present government, continuing the practices of the past, has now raised taxation to prohibitive levels. This may be counterproductive because, while high taxes do deter consumption, excess taxation may drive consumers to dangerous illicit substances, and support a thriving illegal alcohol and cigarette industry.

The link between higher taxes and substance abuse is that the use of highly hazardous home brews concocted from medicinal drugs, cosmetics and pharmaceuticals also need to be examined.

Both in Sri Lanka and even in developed countries, it is a tendency for lower income groups to consume cigarettes. In Sri Lanka, there is an additional tendency for lower income groups to consume cottage industry products and items like beedies. Further research needs to be done on the link between education and awareness as opposed to the assumption that cigarette and alcohol consumption is merely a function of affordability or a broader lifestyle/environment and an awareness issue.

High taxes on cigarettes have lead to a massive increase in the lightly taxed Beedi industry, as well as expansion in illegal cigarettes. Customs statistics indicate that beedi volumes have risen from 1.1 billion sticks in 2007 to 3.2 billion sticks in 2013, while cigarette volumes declined from 4.6 billion sticks in 2007 to 4.0 billion during the same period.

Studies carried out by the Institute of Policy Studies make a case for rethinking alcohol taxes, principally to move to a structure of taxation by volume, which will increase state revenues while modifying consumption habits.

The government needs to reconsider its policies for the taxation of both alcohol and tobacco in light of all available evidence. Recent experiences in India and Pakistan highlight the problems with outright prohibition.