From fairy world to the ground…
View(s):“Sri Lanka’s hidden poor” has generated lots of responses. It was about how the fixed income-earning middle class employees in the formal sector have fallen down to poverty – not officially, but effectively.
After hearing the story of Chris in the column, some have raised their eyebrows, posed questions and made comments, as if it was unbelievable. Not surprisingly, some others have appreciated the story of Chris saying that “it was their own story” which has never been told so far.
During my conversation with Chris, I was struck by one of the statements he made: “So far we were living in a ‘fairy world’ and, we were made to live there by the leaders we elected to power. And that fairy world has collapsed now; isn’t it?”
By the term ‘so far’ he referred to the time prior to the economic crisis. What Chris said is absolutely true, and today I want to elaborate this point – how we fell from a fairy world to a ground reality!
Middle-income consumers have had to tighten their belts under current economic policies.
Permanent income
Before we turn to this issue, let me touch upon an economic concept known as the “permanent income hypothesis”. It was presented by the American economist, Milton Friedman in his 1957 book titled “A Theory of the Consumption Function”.
Friedman’s idea can also be considered as a critique of the Keynesian consumption function. It had been presented by John Maynard Keynes in his 1936 book titled “General Theory of Employment, Interest and Money”.
According to Keynes, it is the “current income” that determines consuption. Although we are not interested now in this economic debate, it is worthwhile knowing that, according to Friedman, consumption depends on the long-run average income. Accordingly, people decide their current living standards not by the current income, but by the long-term average income.
Simply, this means that expenditure patterns and lifestyles of a person belonging to a “middle-income” family is shaped by his or her long-term average income levels. It is difficult for them to shape their current consumption even if current income goes up or comes down.
Expenditure patterns
Therefore, people from different income groups, apparently, maintain different expenditure patterns. A high-income household has a particular expenditure pattern, which is different to that of a lower-income household which has a lower long-term average income.
The point that I want to get across is hopefully clear now: The employees at executive categories who have been drawing a higher salary have also shaped their lifestyles and expenditure patterns as these suit their average incomes.
They live in a good house located in a better environment, drive a motor car, wear better clothing, and eat better food. In many cases, they may have obtained a housing loan to build a house as such, vehicle loans to buy a motor car as such, and even personal loans for various such purposes. They intuitively know that they can afford to pay-off such loans comfortably within the next 10-20 years out of their long-term average incomes.
Fairy world
As Chris said, it was a ‘fairy world’ portrayed by our governments which continued to lead the country to live beyond its means. We could not agree more with him about the point that it was a ‘fairy world’ built upon non-available resources and opportunities.
The prices were lower and distorted, because they were determined not by the “market” but by the “politicians”. Fuel and electricity prices were lower than the cost, while such businesses were in the hands of the government. We don’t need to know economics to understand that businesses cannot survive by selling at a “price that is lower than the cost”.
But the state-owned enterprises (SOEs) survived because the government pumped money from the taxpayers or provided bank guarantees to borrow from banks. Of course, they were also state-owned banks which lent from depositors’ money.
We all know that their loans were hardly settled by themselves, but the losses were passed onto either taxpayers or the bank depositors. We have been maintaining 400 plus SOEs, without being reformed.
Jobs provision
The government should create jobs, and in order to create jobs investment should be promoted. In the absence of adequate private investment, there was little job creation in the economy.
Instead, the politicians carried out job provision in the public sector including the SOEs. The key positions were for their own family members, relatives and friends. Thus the government swelled in terms of public sector employment, institutions and expenditures. One of the key election promises was not job-creation, but job-provision.
The problem doesn’t end here. Swelling public sector should be maintained by spending from either the taxpayers’ money, borrowed money or printed money. The public sector that should perform a major role in contributing to growth and stability became a key sector that affected growth and stability.
Sri Lanka’s unemployment rate is low not necessarily because people find productive jobs. Out of about 8.5 million working-age people,
1.5 million is in the public sector. Another 2.2 million has slipped into rather unproductive and unrewarding agriculture sector because they didn’t have a choice. Another 2 million without a choice in the home country belongs to the migrant worker community abroad. Accordingly, Sri Lanka could boast a lower unemployment rate.
Internal and external finance
The country had not developed and established an efficient tax system to collect direct tax revenue which distorted in turn the indirect tax system. The government did not establish an information system to identify direct taxpayers while income taxes and corporate taxes remain rather low.
As a result, the government has to depend more on numerous indirect taxes which distort the commodity markets. Sri Lanka is one of the few countries in the region which has a high tax collection from international trade, deviating the economy from its liberalisation process. Accordingly, it became no more an “open economy” in the region.
As the tax exemption, avoidance and evasion are rather high the inadequate tax revenue has to be covered with borrowings. In the absence of growing investment flows and export growth, the external finance gap must be financed through borrowings. On top of all that came credit-financed mega infrastructure projects with rather inflated cost estimates – as per the IMF governance reports, three-times higher inflated costs than the world average.
The collapse
The fairy world burst and the economy collapsed. The bitter consequences of the crisis on people’s consumption patterns and life styles were two-fold:
- The crisis itself wiped out part of the incomes through economic contraction, high inflation and currency depreciation on the one hand. The immediate policy responses to the crisis affected the people’s lives mainly through tax reforms and price adjustments on the other hand. And the ‘reality’ got exposed and adjustments were made in the worst time of the country with an unprecedented crisis.
- All income categories, including the fixed salary earning middle employees, had shaped their expenditure patterns and consumption patterns prior to the crisis in line with their average long-term incomes. They didn’t have to pay a big amount of taxes, while market prices were unusually favourable. They had long-term borrowings for housing, vehicles, and other personal expenses.
Road ahead
It was at this point that the crisis implications eroded their take-home salary incomes, first through crisis impact and secondly through policy responses. Economic contraction, higher inflation, higher interest rates, and currency depreciation eroded incomes. At the same time, higher taxes – both direct and indirect taxes and cost-reflective price adjustments eroded the incomes further. And they were affected more on their “take-home portion of the incomes” which was needed for the basic needs of the families – food, healthcare, transport, clothing, education etc.
However, the economy is still only at the first step of its recovery from the crisis. What is needed to be done in the coming years is much more than what has been done.
(The writer is Emeritus Professor of Economics at the University of Colombo and can be reached at sirimal@econ.cmb.ac.lk and follow on Twitter @SirimalAshoka).
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