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Thoughts on the Budget and what comes next


Comments / {{hitsCtrl.values.hits}} Views / Friday, 15 December 2017 03:40


The recent Budget definitely improves on previous budgets. It is a promising debut for Mangala Samaraweera, the new Finance Minister. He sees it as the beginning of long-delayed market reforms.

In his opening remarks to the Budget statement, he promised to reform factor markets to “free the economy”, and to “liberalise and globalise” to improve competitiveness. He also promised fiscal consolidation – to boost revenues as a proportion of GDP, reduce budget deficits, and deliver a primary budget surplus. His goal is an ‘Enterprise Sri Lanka’ that will unleash the entrepreneurial energies of small and large businesses.

Here I offer my thoughts on the Budget, positive and negative, and on what comes next.

Finance Minister Mangala Samaraweera presenting the 2018 Budget in Parliament

 



The political context

What has clearly made a critical difference is the mid-year cabinet mini-reshuffle, when Samaraweera replaced a finance minister who delivered disastrous budgets, held up market reforms for two-and-a-half years, and was a national and international embarrassment.

The minister of finance sits in the cockpit of economic policy-making; his ministry has the power of the purse, and is the only one with a bird’s-eye view of the economy. The international record shows that no substantial market reforms are possible without a credible finance minister.

Samaraweera came to this position with a clean reputation – he is clearly not in politics to make money for himself, his friends and relatives – and a record of delivering in his previous portfolios. He is serious about market reforms, as his public pronouncements attest. He is willing to stick his neck out for them. He is a good listener who does not pretend to know what he does not know. He solicits good advice and draws talent to him. He has a gentlemanly manner, putting people at ease rather than talking down to them. His State Minister, Eran Wickramaratne, is equally committed to market reforms and brings to his job level-headedness, analytical nous and technocratic skills. The two ministers are very different personalities, but they complement each other well.

The Ministers’ advisory team – Mano Tittawella, Thilan Wijesinghe and Deshal de Mel – is the best, a combination of political-savvy, analytical competence and managerial experience. The Treasury also has competent senior officials, starting with its secretary and deputy secretary. Before, Treasury officials were side-lined. Now ministers draw them into policy-making. Morale in the Treasury is definitely up.

A credible finance minister and a credible Treasury team make a big difference, as it did in the making and delivery of this Budget. But this is only a start. So much continues to go wrong in Sri Lanka, and so much depends on effective budget implementation and further reforms.



Debits

I will divide the Budget into debits and credits. And start with debits.

Great finance ministers are on my mind right now. I am re-reading Ron Chernow’s enthralling blockbuster biography of Alexander Hamilton, the US’s first Treasury Secretary, a founding father of the US Constitution, the chief author of ‘The Federalist Papers,’ and all-round human dynamo. Hamilton, more than any other founding father, laid the foundations for modern American capitalism. As Treasury Secretary, he established solid public finances and a new financial system.

But more than Hamilton my fiscal hero is William Ewart Gladstone, many times Liberal Prime Minister in Victorian Britain, and before that a reforming, highly-successful Chancellor of the Exchequer. In three landmark budgets in the 1850s, Gladstone gave life to what came to be called “Gladstonian finance”. To quote from Joseph Schumpeter’s History of Economic Analysis:

(Gladstonian finance) translated a social, political and economic vision, which was comprehensive as well as historically correct, into the clauses of a set of coordinated fiscal measures. …Gladstonian finance was the finance of the system of ‘natural liberty’, laissez-faire and free trade. … the most important thing was to remove fiscal obstructions to private activity. …(Revenue) would still have to be raised in such a way as to deflect economic behaviour as little as possible from what it would have been in the absence of all taxation (‘taxation for revenue only’). …taxation should as little as possible interfere with the net earnings of business. … Last, but not least, we have the principle of the balanced budget or rather, since debt was to be reduced, the principle that Robert Lowe, one of the chancellors of the exchequer of the Gladstonian era, embodied in his definition of a minister of finance: ‘an animal that ought to have a surplus’.

 



My key takeaway from this passage is that taxation should be for revenue only; it should not be used, nanny-state-like, to intervene in this-or-that sector of the economy to micro-engineer this-or-that outcome. That distorts business incentives, creates red tape and corruption, and results in myriad negative unintended consequences.

In this light, this Budget, and all previous budgets, look pretty shady. Sri Lankan budgets are choc-a-bloc with micro measures. Gladstonian finance is all about simplicity; Sri Lankan budgets are mind-bogglingly complicated. The budget process is upside down: instead of starting with general principles and objectives, and then accommodating exceptions, it starts with tax and spending measures on individual items, from toddy to three-wheelers to electric cars, hotels, plastic bags, start-ups, SMEs, and much else besides. Pet spending measures cascade from line ministries, and then swell and metastasise the budget. It is worse in Sri Lanka with its profusion of needless ministries and ministers. Only then does the Treasury try to impose some order on an out-of-control process.

The minister ends up reading out a dreary list in Parliament: a special tax on super luxury vehicles with an engine capacity exceeding 2,500cc; an excise duty of Rs. 10 per kg on plastic resins; eight credit schemes with low interest rates to support SMEs and micro enterprises; an excise duty of 50 cents per gram of sugar in beverages; and so on ad nauseam. The result is a dog’s breakfast, a horrible mess that breeds bureaucracy, wastes money and suffocates the economy.

 



This Budget is better than its predecessors in one respect: the Treasury takes spending limits and revenue-raising more seriously, given commitments to the IMF and the recently-enacted Inland Revenue Bill. But still. To pick out a few highlights of what is wrong with Sri Lankan budget-making: I don’t see any sense to discriminate in favour of electric vehicles, with implausible targets to phase out vehicles that run on fossil fuels. That is a costly diversion. There are incentives galore for SMEs. The graveyards of the world are littered with failed SME incentives. What SMEs need is less obstructive government regulations, not a Niagara Falls of low-interest loans and other incentives. Another national development bank is a silly, costly idea, as is a government agency to act as an angel investor for start-ups. Some sectoral export-promotion schemes seem designed to keep the EDB on life support. (One has visions of investment and exports shooting up the day the EDB, not to mention other government business-promotion agencies, are shut down.) Does Sri Lanka really need a sugar tax when there are so many more pressing problems to tackle?

And finally, the tax on telecom towers and the transaction tax on banks. Both are short-term revenue-raising measures. The telecom sector argues the tax on towers will hurt profitability and investment, and could cause two foreign players to leave the market. The banking sector argues the transaction tax will deter savings and lending, not least to SMEs. Both sectors have a point. The best way to raise revenue is through general taxes on corporations and individuals, not through bitty sectoral measures with inevitable unintended consequences. The former signals simplicity, consistency and predictability, the latter complexity, inconsistency and uncertainty.

My main point is that Sri Lanka needs a radically different budget-making process, one that emphasises taxation for revenue only and overall simplicity. Only then will Sri Lankan budgets pass a high credibility test.



Credits

Now to the Budget’s credits. I highlight four: modernising antique legislation; trade-and-investment reforms; doing-business reforms; and PPPs and privatisation.

 

  • Revising antique legislation

The Minister mentioned, among other items, the Customs Ordinance, the Excise Ordinance, the Rent Act, the Paddy Lands Act, the Land Act, the Shop and Office Employees Act, and bankruptcy laws. He also announced the repeal of the Underperforming Enterprises and the Underutilised Assets Act. If implemented, this would be a major accomplishment.

These gobs of legislation, some over a century old, gum up Sri Lanka’s factor markets – its markets for land, labour and capital. Repeal and modernisation, with effective implementation, would make these markets freer and more flexible, with a growth and jobs dividend.

 

  • Trade-and-investment reforms

The Minister announced that about 1,200 para-tariffs (CESS and PAL duties) would be removed. The Rajapaksa Government built saw-toothed alpine ranges of para-tariffs on imports, on top of existing MFN import tariffs. Para-tariffs piled up to protect politically-connected domestic producers (in steel, cement, tiles, ceramics, footwear and furniture, to name just a few sectors), and to plug short-term revenue shortfalls. Sri Lanka’s protectionist fortress soared to the heavens: para-tariffs account for about two-thirds of import-duty protection.

This Budget announcement is a very belated and modest start to trade liberalisation. Revenue considerations drove its extreme caution: the revenue loss is only Rs. 5 billion.  Almost 5,000 para-tariffs remain untouched. Hence this must be just the start of much bigger tariff liberalisation. The minister has announced that para-tariffs will be phased out completely in three years.

The next budget should cut remaining para-tariff protection by more than half, with remaining para-tariffs abolished in the 2019 Budget. Fears of revenue loss are greatly exaggerated. Studies done by the World Bank and a Harvard team of economists show that higher domestic tax revenues (from higher import volumes) will more than compensate for revenue losses from repealed import duties.

But this should not be the end of tariff reform. All export duties should be abolished as soon as possible. Once para-tariffs disappear in three years, there should be an extra three-year timetable to simplify and reduce MFN import tariffs. My preference is for most goods to enter duty-free, and for other goods, or at least non-agricultural goods, to face a uniform tariff of 5%. So, six years from now, Sri Lanka should have by far the simplest and lowest level of import protection in South Asia, and a level of protection similar to the East-Asian average.

The Government will also enact new legislation on trade remedies (antidumping and safeguard duties) to deal with import surges and “unfair trade”. And it will set up a trade-adjustment-assistance programme to cushion the pain from more import competition. Both are unavoidable political expedients. But any sensible trade economist would counsel caution. Trade remedies, especially antidumping duties, could become open-ended protection for inefficient domestic producers. The bias should be for safeguards, which have tighter WTO disciplines, and against antidumping duties, which are a favourite tool in the protectionist’s box of tricks. Similarly, trade-adjustment assistance could land up in the pockets of rich but inefficient employers and labour unions. It should rather be targeted to retrain and reskill affected workers.

 



A good way to achieve these goals is to depoliticise the process as much as possible. That could be done with an independent trade commission, at one remove from politicians and officials, to conduct import-injury and trade-assistance investigations, and then publicly announce its recommendations.

The Budget’s biggest and most controversial liberalisation measure is removing foreign-equity limits on shipping agencies and freight forwarders. It is a bold decision, and the right one.

Predictably, the affected local cartels, especially the shipping agents, have risen up, lined up their political backers, and raised a ruckus. Their representations, in the media and to ministers, are spurious and easily refutable. The shipping agencies claim they bring in about $ 800 million of revenue a year and account for about 100,000 jobs, and that shipping is mostly open to foreign players anyway. This is nonsense. The former sum is the total freight bill; all the agents do is pocket tidy fixed commissions from incoming freight (around 3-5%, creating a revenue pool of $ 25-40 million). Directly, they have little more than 10,000 employees.

These cartels are typical Sri Lankan rackets that benefit a handful of insiders with excellent political connections, keep out competition, and deliver a mediocre service. There are five main players in the shipping agents’ cartel, and casting a pall over the whole industry is Dhammika Perera’s Hayleys, which is busy gobbling up smaller players.

Perera makes much of his fortune in businesses protected from competition; this is one link in the chain. Controlled local markets condemn Sri Lanka to crumbs from the table of global shipping and logistics. It makes Colombo Port heavily reliant on the low-margin transhipment business with India. But much of this will probably vanish within a decade, given India’s massive port-building programme and the likelihood that some Indian ports will get their act together.

Post-Budget squealing from local shipping agents and their proxies could leap straight out of the pages of Adam Smith’s ‘Wealth of Nations,’ which was published 241 years ago. Smith was intensely suspicious of the “clamorous importunity of partial interests” and the “sneaking arts of underling tradesmen”, who, “like an overgrown standing army, become formidable to the government, and upon many occasions intimidate the legislature”. Here is a much-quoted passage:

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. … To widen the market and narrow the competition is always in the interest of the dealers. To widen the market may frequently be agreeable enough to the interests of the public; but to narrow the competition must always be against it, and can only serve to enable the dealers, by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow citizens.

What is the alternative? The prize on the horizon is to make Sri Lanka South Asia’s maritime-cum-logistics hub, halfway between Dubai and Singapore, and bang in the centre of a vast emerging Indian Ocean market. Sri Lanka should attract anchor investments like Maersk (in shipping), DHL (in logistics), and even Amazon (in warehousing for e-commerce) for higher-value regional hub operations, and not only to serve low-value Indian transhipment and a tiny local market. If they come, other MNCs will come too, and they will create a growing ecosystem of ancillary service providers, and a platform for local companies to plug into, upgrade their skills and technology, raise capital, boost productivity, and even go global. This is a vision of a much bigger shipping and logistics market in Sri Lanka, with more jobs, and better paid and more rewarding jobs.

But to do that Sri Lanka needs to break decisively with the status quo. MNCs will only consider regional hub operations if they have full freedom of decision-making, and costs and services that are competitive with rival ports. That demands two basic reforms at the outset: removing foreign-equity limits; and abolishing price controls. The government needs to hold the line on the former. On the latter, it should repeal regulated freight agency charges (the “CASA tariff”, set by the shipping agents’ association and enforced hitherto by the central bank) so that full market pricing applies. Other reforms need to follow – on terminal handling charges, warehousing and other restrictive port practices. But this must be the start.

Liberalising shipping and freight-forwarding is important in another respect. If it happens, it should catalyse opening up of other local services markets to competition. This is vital to improve productivity in local services, plug them into global value chains, and generate growth in trade and investment that will feed into higher growth, better employment and higher living standards at home. Services are the future. For Sri Lanka, the future should start with liberalising shipping and freight-forwarding.

 

  • Doing-business reforms

Sri Lanka languishes in 111th place in the World Bank’s Doing Business index while other countries – including India in the last two years – climb up the rankings. Everyday stories abound of how awful it is to do business in Sri Lanka – getting licenses and permits, starting a business, paying taxes, registering property, enforcing contracts and so on. All relate to the frustrations of dealing with Government departments. Many quick-win solutions to improve the business climate involve digitisation – simplifying paperwork, putting it online, making procedures automatic, and eliminating bureaucratic discretion and procrastination.

In this vein, the Budget proposes a single identification number for businesses lodged with the Registrar of Companies; online applications for Local Government approvals, construction permits and land registration; a national single window to link trade-related agencies with the Customs Department; and a new trade portal with accessible and reliable trade information (such as trade statistics, regulatory requirements, and export and import procedures). The latter two trade-facilitation measures, long discussed but so far not implemented, dovetail with the trade-and-investment reforms I covered earlier.

These are small-sounding announcements with potentially big, beneficial, economy-wide effects. Implementation, of course, is key. And sooner rather than later.

 

  • PPPs and privatisation

The Minister announced a Public-Private Partnership model for infrastructure projects, to be led and coordinated by a new unit in the Ministry of Finance. That is welcome, and it should be centralised in the MOF rather than left to line ministries. He also announced the Government would divest its stakes in non-strategic enterprises. And he made a more important announcement: that the Bank of Ceylon and the People’s Bank would be allowed to raise debt and equity capital, thereby creating minority stakes for private investors. That is a potentially major boost to local capital markets.

Conclusion

This, then, is a mixed budget, but significantly more positive compared with budgets in recent Sri Lankan history. It signals the beginning of market reforms that should have started almost three years ago.

We know the sorry record of budget implementation: Verité Research has estimated what a large chunk of budget measures never get implemented. This time must be different. So all eyes will be on the new Budget Implementation Unit in the Ministry of Finance. That is the first task. The second is to use reform momentum from this Budget to roll out more reforms in the coming year, and build up to a more ambitious reform budget in November next year. The clock is ticking fast: this Government has probably two years at most to make a positive difference to the lives of ordinary, less privileged Sri Lankans.



(The author is Chairman of the Institute of Policy Studies and Senior Adviser to the Ministry of Finance.)


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