A: It’s inevitable that when Budget proposals are announced, particular interest groups would object to certain proposals that aren’t favourable to them.
This Budget, in particular, has attempted to take on some challenging reform areas that hadn’t been touched for some time, as they are politically sensitive. But these are essential issues where change needs to happen. How the government resolves these will give us an indication of how serious it is about getting tricky but essential reforms done. Will there be policy paralysis and little reform getting passed? Or will there be policy bargaining where some reforms get through but the tricky ones are placed on hold?
Domestic and foreign investors are looking for clarity in policymaking and they will be closely watching the nature of policy cohesion among the key economic decision makers in the government – both in Budget 2016 and its aftermath.
Q: The government is in a desperate need of tax revenue. In that context they expect over a Rs 200 billion increase in non-tax revenue. How practical is this?
A: Sri Lanka has struggled with uplifting tax revenue for some time now. Our tax to GDP ratio is now below 11% and is well below our middle-income peers. So the need to raise revenue now is actually a culmination of years of putting off tax reforms. In Budget 2016 a substantial increase in government spending on several social sectors is envisaged, and that would necessarily mean an increase in revenue collection. Depending heavily for this revenue on non-tax sources is neither sustainable nor is it progressive. But it may be easier to collect and meet the revenue needs. We need to move towards a more robust tax system.
Q: How to sustain tax revenue increase which aims at reducing budget deficit?
A: The estimated increase in tax revenue for next year is 38%, while the average for the past few years have been only around 10%. This sums up the uphill task. There is a range of indirect taxes that have been raised or introduced. This will boost revenue. It’s not ideal, though, because indirect taxes are regressive in that it hurts less wealthy households more. Alongside this direct tax rates have been substantially cut. This is the challenge of Budget 2016 – maintaining high social sector spending, while cutting direct tax rates and raising thresholds. The way it can work is if it spurs a massive increase in private sector economic activity, new domestic and foreign investment and entrepreneurship. The government is also hoping that the new IRD IT system as well as the unique number identifier will help improve tax compliance and reduce evasion. But the deficit targets are certainly ambitious.
Q: Prime minister suggested to reduce indirect tax percentage from 80% to 60%. It had not been done from this budget. Instead indirect tax percentage has increased. How should the government approach this issue?
A: The focus needs to be on expanding the direct tax base and collecting direct taxes better. Improving compliance, audits, intelligence – all of this can help improve tax collection. I believe the new IT system can begin an important journey towards a better and smarter tax administration. The continued heavy reliance on indirect taxes is not ideal – but this problem cannot be fixed overnight. The PM’s statement is a five year vision and it cannot be achieved through one budget. But yes, the journey to tilt the balance must begin now.
Q: How is the Budget 2016 for the private sector?
A: The Budget hit many of the right notes in terms of private sector activity. It announced the opening up of new spaces for private investment – in railways, in public infrastructure projects, in education, industrial zones, in State land, etc. So that is certainly positive. But at the same time many proposals would need reworking to take cognizance of industry realities.
Particularly some of the proposals regarding the financial sector. But overall, the Budget moves in the right direction in terms of private sector development in general and foreign investment in particular.
Q: How do you see the vehicle tax increase?
A: It may not be the most ideal way to manage vehicle imports, but I can see where the government is coming from. There is a desperate need to reduce congestion on city roads and the substantial increase in new vehicles is not easy for existing infrastructure to cope with. But the problem is twofold.
Firstly, the continued under-investment in public transport; something we all agree and I will not dwell on.
Without this, there is nothing to shift behaviour away from private and towards public transport. Secondly, the problem of ‘sharp swings’ in tax policy regarding vehicles; ad hoc shifts from one year to another and even during the year that causes severe uncertainties for both motor industry actors as well as aspiring vehicle owners and businesses.
We need a more sustainable and well thought out strategy. What happens now is that in one year taxes are slashed on a certain category of vehicles to promote their use, consumers then respond to that incentive and purchase those vehicles, government then comes under pressure either on balance of payments reasons or for congestion reasons and decides to curb imports by increasing taxes on those vehicles. And this cycle repeats every few years. It especially hurts middle class families and small businesses, as they are unable to plan and adjust.
The Treasury and Customs needs technical capacity to analyse the optimal rates of vehicle import tax and estimate demand elasticities, so that policies are formulated in a way that balances competing considerations – vehicle numbers/congestion on the road, raising tax revenue and allowing consumer freedoms.
Q: There was a suggestion to set up an export import bank. How important is that?
A: I am not an expert on this – a banker may have more informed responses. But we need to evaluate whether existing banks are not able to provide these services, and whether our export sector is truly constrained by the lack of an EXIM Bank. Sri Lanka should go ahead once a gap analysis is done. And if one is set up, it should not be yet another State bank – it should truly be a private public partnership.
Q: Do you agree with fertilizer subsidies being replaced by cash transfers?
A: Any effort to cut down on inefficient subsidies is a good thing. I am yet to learn how the new cash grant scheme will work. But several studies indicate that the fertilizer subsidy in its current form wasn’t meeting the intended objectives. A cash grant to farmers can be good in improving agricultural productivity if farmers use the grant to purchase inputs that they feel are important for their fields – whether this is equipment, better seed varieties, irrigation or even fertilizer, they get to choose what to spend it on.
Rather than previous strategies of ad hoc handouts to boost the rural agricultural economy, which has had limited success, the focus of the Budget when it comes to agriculture seems to be to promote agri-entrepreneurship, value addition, technology adoption and reducing post-harvest losses by setting up cold-storage warehouses. The agriculture sector, while employing 30% of the workforce, produces less than 10% of GDP. These new measures can provide the opportunity to transform this.
Moreover, subsidies mask the true prices of things. So, hopefully this shift can also tackle the problem of heavy fertilizer overuse, which is having negative implications for water quality and health in farming communities. In the past few budgets, a lot of emphasis was placed on subsidies and welfare transfers that have the consequence of keeping people in low productivity and low income-generating economic activities.
Q: There are some changes on Research and Development (R&D) tax benefits – are these positive?
A: There is a new stipulation that the current R&D triple tax deduction will only be allowed if a technology advancement is achieved or there is a yield on the R&D. This proposal is problematic as it does not appreciate how innovation works. By its very nature, an R&D process is undertaken with little certainty that it will yield results or a commercial product at the end. Even if there is a commercial result, it may be several years after the original R&D spending was made. The idea behind an R&D tax credit is to incentivize companies to take risk and invest in R&D even with many unknowns.
There is also a proposal to extend the triple deduction to cover endowments to national universities. This must be extended beyond universities to cover research institutions like SLINTEC, ITI, etc.
They are already familiar with industry interaction, are more ready to absorb this money and can have faster impact. But tax breaks alone may not help boost industry-relevant research in universities. The example of Moratuwa University suggests that industry is closely interacting with them – through industry research cells and innovation centres– not because of tax breaks, but because of the talent and capability that companies see in that university.
Q: What are your views on the overall Budget 2016 and the deficit outlook for next year?
A: Ultimately, the credibility of a Budget lies in whether revenue targets are met, whether the spending plans go ahead on time, whether the proposals are implemented and whether the budget deficit is more or less on track.
The income tax cuts and other measures to encourage FDI can boost economic activity and have a positive knock on effect on tax revenue. But, more broadly, if the government fails to meet the ambitious revenue targets, it will impact on private sector credit availability as the government will need to borrow more from the domestic banking system. If the government decides to borrow abroad instead, this will also be tricky – as it will be in a higher global interest rate environment. The key issue that global ratings agencies keep highlighting for Sri Lanka is the budget – missing targets and not enough effort on fiscal consolidation. Even if Sri Lanka meets the budget’s ambitious 16.4% of GDP target next year, it will still be below the median for countries that have B-rated sovereign debt, which is 21.4%.
But maybe we have to see this year as an experiment. The Finance Ministry has gone out on a limb to initiate quite a few ambitious and innovative things. They are taking a chance on the private sector to deliver the goods. Many of these initiatives can herald in a new era of private sector and investment-led growth and make Sri Lanka truly outward oriented and globally competitive. The question is, which parts of the experiment will pay off? Which ones won’t? We will have to see the same time next year.