Budget-making should be first order of business for new Parliament: Pathfinder Foundation

Following the successful containment of the pandemic and the fixing of the date for the Parliamentary Elections, it is now timely to focus on the next major milestone which will be the presentation of the new Government’s first full budget.

It will be presented shortly after the elections. Government budgets always involve a very complex process of balancing a multitude of needs, interests and obligations. The best budgets are framed based on a set of priorities which address short-term needs while creating a framework for inclusive (employment-generating) and sustainable growth while providing an effective safety net for the poor in the medium term.

Budget-making in Sri Lanka is constrained by some serious rigidities. Debt-servicing, amortisation and interest payments absorb almost all of revenue, which means much of the rest of the budget has to be financed out of borrowing. Yet, the debt to GDP ratio is over 90% of GDP while the median for comparator countries is 55%. This places a serious limitation on fiscal space. 

Furthermore, there is very little flexibility for adjusting recurrent expenditure as interest payments, public sector emoluments and social welfare entitlements account for all of it. Hence, any fiscal adjustment has to fall almost totally on Government revenue and capital expenditure.

Sri Lanka’s budgetary outcomes have a legacy of other structural weaknesses. Only three years since 1954 have had primary surpluses (i.e., when revenue covered all expenditure except interest payments). Progress cannot be made in addressing Sri Lanka’s onerous debt servicing without achieving a primary surplus. The fiscal consolidation needed to achieve this must be supplemented by structural reforms to ensure that growth is not stifled. 

Sri Lanka’s experience under the last two IMF programs implemented by the two previous governments shows this very clearly, as progress made in containing the budget deficit was accompanied by a decline in economic growth. In addition, receipts from indirect taxes account for over 80% of total tax revenue. 

This makes Sri Lanka’s tax system one of the most regressive in the world (in the case of indirect taxes the richest person in the country and the poorest person are subject to the same rate of tax). A fairer system would involve a 60/40 balance between indirect and direct taxes: a goal to be achieved over time.

The above are general observations about the overall context in which budgets in Sri Lanka are formulated. The challenges confronting the forthcoming budget-making process are being greatly compounded by the highly elevated uncertainties currently affecting both the national and international economies in the post-COVID world. 

Up to now, the Government’s capacity to respond has been constrained by the lack of fiscal space due to the long-standing legacy of adverse deficit/debt dynamics and the limitations imposed by the Vote on Account and the borrowing limit associated with it. 

For its part, the Central Bank of Sri Lanka (CBSL) has implemented a series of measures. These have included printing of over Rs. 200 billion to finance the Government; a 150 basis point reduction in its policy rates; a 300 basis point reduction in the statutory reserve ratio; a 500 basis point reduction in the Bank Rate; use of EPF funds to reduce benchmark Government securities rates, thereby reducing the cost of borrowing for the Government and easing market rates; regulatory forbearance through relaxation of global standards related to capital adequacy, capital buffers, liquidity and reporting requirements; a Rs. 20 billion liquidity facility for non-bank financial institutions; a Rs. 50 billion (now 150 billion) refinancing facility at 1% to enable banks to provide working capital loans to pandemic-affected businesses at 4% concessional interest. 

These measures are all intended to create financial conditions which facilitate the flow of credit to support firms and jobs. The efficacy of these measures would be improved by a partial guarantee scheme which would serve to share credit risk. 

The new Budget offers the Government more room to manoeuvre in targeting assistance to protect the vulnerable and support key sectors of the economy. However, it is important to dampen expectations by recognising that the scope to do this is constrained by a lack of fiscal space arising from many years of inadequate fiscal discipline. 

The Pathfinder Foundation recommends the following.

There would be merit in presenting the Budget within a medium-term framework in the present circumstances, when one has to balance the contradictory objectives of an immediate need for counter-cyclical fiscal policy with the compulsion to achieve fiscal consolidation over the medium term. 

A counter-cyclical stance which responds to the contractionary pressure from the effects of the pandemic can be presented for the remainder of 2020 and 2021. In doing so, one would, however, have to take account of fact that the budget deficit increased to 6.8% of GDP in 2019 and is projected to be 8.5% this year. 

These are clearly unsustainable. High priority would need to be attached therefore to backloading fiscal consolidation in the succeeding years to meet the government’s target of a fiscal deficit of 4% of GDP by 2023. 

In the immediate term, priority should be attached to using some of the fiscal space available to support the poorest groups whose livelihoods have been severely affected by the pandemic. In addition, evidence has emerged that fiscal stimulus targeted at specific competitive sectors contribute more to recovery than generalised support. 

The medium term budgetary framework should set out clearly a path for ensuring debt sustainability to reinforce the creditworthiness of the country. This is crucial given Sri Lanka’s extremely challenging debt dynamics, particularly external debt. 

Within the overall framework, priority should be attached to achieving a surplus in the primary balance as early as possible, and to making progress in redressing the regressive impact of the balance between receipts from direct and indirect taxes.