The path to fiscal instability paved with good intentions

By the Economist

It is difficult to fault the many good intentions of Budget 2007. Most intentions and objectives are in the correct direction, but their realisation is hardly likely. There are some bad plans as well that could be quite costly and do not reflect either the stringency of the fiscal situation or current national priorities. Some specific taxation measures are ill advised and unproductive.

Overall even if the revenue proposals were to materialise, the revenue collection is unlikely to meet the expenditure in 2007. As pointed out last week defence expenditure in particular is likely to exceed the budgeted figures for both 2006 and in 2007, if the level of conflict continues at current levels, in fact the 2006 budget deficit is unlikely to be contained at 7.9 per cent as stated in the Budget, except by creative accounting and postponed payments and credit lines especially from state banks. But sooner rather than later the liabilities would have to be settled through fiscal expenditure. Such postponement of settlement in 2006 means their accumulation into 2007. Therefore the estimates of the deficits for 2006 and 2007 are likely to be more in the region of 8 to 9 per cent of GDP than in the 7 to 8 per cent level stated in the Budget. The IMF estimates this year's deficit to be 9 per cent of GDP.

It is most likely however that the Budget did not disclose revenue measures to be introduced later this year and in later in the fiscal year. It has been a practice of governments not to disclose unpalatable and unpopular measures of taxation. It is most likely that taxes that fall on the general public would be introduced and could boost revenue. These may include increases in postal rates, further import duties on consumption items and taxes on liquor and tobacco. These are the hidden cards in the fiscal strategy that may bring the revenue figures into closer alignment with expenditure. Such taxation measures may be imperative in the current context of the fiscal imbalance, but their not being included in the Budget due to political expediency makes the budget proposals on taxation, as well as the predicted outcome, to be very different than proposed in the Budget. It appears that even the Fiscal Management Responsibility Act has not addressed this issue. In any event the Fiscal Management Responsibility Act's declared provision to reduce the deficit to 5 per cent is once again postponed.

The expectation of a substantial increase in income taxes is rather optimistic. The 2007 Budget expects revenue from income tax to rise to Rs.102 billion or 4 per cent of GDP. This is an increase of 36 per cent from the expected revenue that may itself see a short fall. In relation to the realised personal tax revenue of Rs.52.4 billion in 2005 it is a near doubling, an increase of 94 per cent in two years.

Some of the revenue measures are trivial and their objective and effect on revenue is unclear. The change in the fees for obtaining a passport is an example of this. If people opt for the normal process then revenue would fall, if they opt for the one-day option revenue would rise. This revenue angle is an incentive for inefficiency in the processing of passports. A better option that would have yielded higher revenue and not had this negative effect on efficiency would have been to have a higher fee that also limits the number of days in which the passport is issued to about a week and a second high cost option for a one-day processing of applications. Alternatively there could have been a single option with a high fee for issue of passports in a single day.

The change in the interest on deposits in banks is more meaningful and could achieve a good fiscal effect as well. The exemption of the withholding tax from those earning less than an annual income of Rs.300,000 and the WHT being limited to 5 per cent to those whose incomes are between 300,000 and 600,000 is an equitable change However this should not be allowed to be a loophole in taxation. Those who make such a declaration should also be asked to fill the basic form of income and assets declaration that is followed up.

In any event such issues are basically trivial in the context of the fiscal problem that is faced by the country. If the revenue proposals are unlikely to yield an adequate income for the government, the converse is likely on the expenditure side, as in the past. The overshooting of government current expenditure implies a cut in capital expenditure, again as in the past. What this implies is that the emphasis on infrastructure development in the budget would not be achieved.

On the expenditure side, the cost cutting exercises are limited and probably ineffective. There are no signs of improving the targeting of assistance on the Samurdhi Programme that has been characterised as a political one where the needy do not get relief while the unintended beneficiaries are probably a majority. The government takes a pride in expanding this programme and increasing its costs rather than reducing the cost and achieving the objective of targeting the real poor. Fifty per cent of households getting this benefit is a blatant example of financial abuse.

The lack of prioritisation in government expenditure is what gives the lie to the Budgets intentions of achieving financial consolidation. The glaring example is the expenditure of Rs.1.2 billion on the construction of a state of the art international airport in Weerawila. This project in the President's electoral constituency has become a sacred cow that all sorts of people have high praise for as an important development expenditure that would have huge ripple effects on the economy in general and on the southern region in particular. Two questions alone will call the bluff. First, has a serious cost: benefit analysis been done on this project, including an environmental impact studies that is a compulsory requirement for development projects? Second, is an international airport a priority in infrastructure development and in transport requirements? When the railways and public transport is in a chaotic condition, surely this sum of money spent in the improvement of these services, especially an efficient railway network, would have had a greater impact on the economy. In fairness to the government the construction of such an airport is a fulfilment of a promise in the Mahinda Chintanaya (MC) whose economic policies obviously have different priorities than cost effective expenditure and reducing the fiscal deficit. The economic policies obviously have different priorities. The expenditure estimate of this massive project is likely to have been grossly underestimated but it is also to be a priority in implementation. In the fullness of time, this sacred cow is likely to be a white elephant.

The 2006 budget deficit is likely to be around 9 per cent of GDP and not the much lower figure quoted in the Budget. The same is likely to be the scenario in 2007. Despite what was said in the Budget Speech as the year progresses it is most likely than inflation would rise to one of the highest in several decades, the currency would be further depreciated, interest rates would increase, capital expenditure would be cut, current expenditure would rise above the budget figures and the burdens on the common man would increase despite the rhetoric and intentions in the Budget.

The fiscal crisis is fast coming to an explosive head: too much government expenditure, not enough revenue to cover costs, not enough savings, too many people to be pleased with subsidies and handouts. Unless something severe is done, public debt will be out of control due to massive spending, particularly on the war, on debt servicing, public service salaries and subsidies. The fiscal problem is likely to escalate rather than be contained in the next few years at least.