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The banning of several imports that are locally produced, incentives to the construction sector, reduction of corporate taxes, reduction in personal taxes and elimination of certain withholding taxes by the new government are expected to give a stimulus to the economy by increasing investment. Their impact on growth would take time, but the fiscal consequences would be immediate.

Most of these measures have been welcomed by the business community and the people. However, economists have pointed out that the shortfall in revenue and overruns in expenditure are likely to widen the fiscal deficit further and erode macroeconomic stability and economic growth unless countervailing measures are taken to increase revenue or reduce expenditure.

Politically mandatory

Changes in economic policy in the first month after President Gotabaya Rajapakse took office were politically necessary to strengthen the government’s legitimacy and credibility. In evaluating these measures due recognition must be given to the fact that the first month’s economic policy measures were politically mandatory and that similar measures are likely soon to consolidate the popularity of the new regime and placate  the electorate to enhance the government’s strength in the next parliament.

Beneficial

Some of the new measures are undoubtedly beneficial to the  economy and should have been taken earlier. The banning of pepper, cinnamon and tea imports would protect the country’s reputation of producing the best quality of these products. In recent years imports of lesser quality imports of these products mixed with the country’s products have harmed the reputation of the country’s quality exports of these commodities.

This policy measure should improve prices fetched by these crops and strengthen our capacity to increase exports. However, further support measures would be needed to increase the country’s exportable surplus of these spices. It is essential that higher value added products of these are vigorously marketed. It could reverse the recent decreasing trend in exports of spice crops.

Fiscal stimulus

The reduction in taxes is expected to give a fiscal stimulus to investment and enhance growth. This is however possible only if other conditions for investment too are propitious for the fiscal stimulus to enhance investment and propel economic growth.

The downside of this approach of a fiscal stimulus is that the fall in revenue that is estimated to be huge, together with the overruns in expenditure, could result in a fiscal deficit of much over 6 percent of GDP. This would undermine macroeconomic fundamentals and destabilise the economy.

Explanation

Dr Indrajit Coomaraswamy, in his last address as Governor of the Central Bank, explained the merits and weaknesses of the current fiscal stance: “The whole rationale behind the fiscal stimulus package is to put more aggregate demand in the system to revive the economy. We have had persistently slow growth for some time now, and there is space to do this. But it is extremely important that we are very vigilant and that this fiscal stimulus must be kept in a framework, which does not undermine fiscal sustainability, and even more importantly, it must not undermine debt sustainability.”

Further

Furthermore, he explained that “It is encouraging that the Government will be making a statement to show how this stimulus package will be accommodated without undermining stability, without it leading to a situation where there is overheating of the economy, and there is balance of payments pressure and inflationary pressure emerging. That broad framework within which fiscal consolidation has been taking place, within which we have been able to maintain both fiscal and debt sustainability, will be continued. That’s the framework.”  This is imperative.

World Bank

Similarly, the Chief Economist for South Asia of the World Bank, Hans Timmer, appreciated Sri Lanka’s fiscal policy stance to stimulate growth, but cautioned against the dangers of a fiscal stimulus if it is not carefully monitored. He pointed out that Sri Lanka’s government is in an incredibly “difficult balancing” act. “I find any attempt to stimulate a domestic economy and revive investment logical.”

However, he pointed out that “the government needs to be cautious in granting tax incentives without a fiscal guarantee as it could do more harm than good. It is incredibly clear that if tax incentives are granted without a fiscal guarantee it can do more harm than good.”

Way out

The way out of this fiscal dilemma is to find ways and means of increasing revenue from new measures and reducing as much as possible wasteful and unproductive expenditure. The government must recognise that Sri Lanka had one of the lowest tax to GDP ratios of 13 percent of GDP until the previous government‘s fiscal consolidation programme raised it to about 16 percent of GDP in 2018. However in 2019 a fiscal slippage occurred owing to increased government relief measures and increased public expenditure. This year’s fiscal deficit is likely to be about 6 percent of GDP. Also, the tax revenue to GDP ratio is likely to fall while government expenditure would rise.

Enhance revenue

Measures to enhance government revenues must be put in place. These must necessary come from mostly direct taxes and some progressive indirect taxes such as higher taxes on luxury vehicles, property taxes, stamp duties and wealth taxes are some suggestions.

Of utmost importance is an efficient and honest tax administration. Tax avoidance and tax evasion have to be drastically reduced to not only increase revenues, but make taxation more equitable, as the very rich are avoiding taxes. This is a most difficult task without a blood transfusion in the tax administration.

Concluding reflection

Hopefully the fiscal stimulus will spur investment. However for it to have a significant impact there are other preconditions in the business environment that have to be fulfilled. The adverse impact of the fiscal slippage has to be recognised and countervailing measures taken to ensure fiscal consolidation.

The government will do well to heed the words of Governor Indrajit Coomaraswamy: “We need to be very vigilant and make sure this(  fiscal stimulus) is accommodated without undermining stability within the system.”