A child’s guide to fiscal literacy: Low literacy at all levels is the curse

People’s representatives lose their thinking power and conscience when they join a political party. They have to support the party line even when that party line is wrong. Hence, they are like programmed robots who will just say what the programmer has asked them to say. That is why there is no informed and intelligent debate of the budget by people’s representatives

Aseni, the Wiz Kid, has been puzzled by different ways in which different parties had commented on the Budget 2021 presented in Parliament two weeks ago. Some had hailed it as a development budget, some had scathed it for not giving relief to people, some had found fault with it for not addressing the problems they are facing, and so on. Aseni, as she had done on previous occasions, turned to her Grandpa, Sarath Mahattaya, an ex-employee of the Ministry of Finance, for guidance. The following is the conversation that took place between the two of them:

Aseni: Grandpa, I have watched the budget debate live in Parliament. What I noted was that those on the Government side did not see any fault in the budget, whereas to those in the opposition everything was wrong in the budget. Why should this happen? Has the budget polarised the people’s 

representatives into two groups?

Sarath: It is something that you have to expect in a party system. People’s representatives lose their thinking power and conscience when they join a political party. They have to support the party line even when that party line is wrong. Hence, they are like programmed robots who will just say what the programmer has asked them to say. That is why there is no informed and intelligent debate of the budget by people’s representatives. 

Aseni: Grandpa, was it the same always? Wasn’t there any occasion in the past where there was an informed debate of the budget?

Sarath: No, there had been occasions when some of the people’s representatives made good contributions to budget debates. They were all independent representatives not belonging to any political party. They could look at a budget with a critical approach because they were not subject to the deficiency which members of political parties were having. But, overall, all budget debates in the entirety of the post-independence era were partial, uninformed, and demonstrative of lack of knowledge known as budget literacy.

But there was an exception in Budget 2021. There was one member in the Government party who does not hold a portfolio making a sound representation. In the opposition, there were two such members who made a good contribution. Even then, they mostly found fault with budgetary numbers and did not go into an analysis of how the budgetary framework in Sri Lanka should be redesigned deliver sustained economic growth in the long-run.

Aseni: Grandpa, I can understand it. But private sector entities like Chambers too had only a good opinion about the Budget 2021 as if they too belong to the political party in power. All of them including the Ceylon Chamber of Commerce had praised the Budget 2021 as a development budget. Isn’t it odd?

Sarath: That can happen due to two reasons. One could be that their budget literacy may be very low. The other is the self-interest. They praise the budget to earn favours from the government in power. They had been playing this game throughout, whatever the government in power. When they claim that the budget is a development budget, they should come up with reasons for making that judgment. It is not proper for anyone to claim a particular budget a development budget without making an appropriate analysis.

Aseni: Is there any set of rules which we can use to classify a particular budget a development budget or not? 

Sarath: Yes, indeed. But they also change depending on the state of the economy and the aspirations which a nation has about its future considering the global developments and where its peers are now. What this means is that the criteria that we had used, say, 10 years ago, are not relevant and valid for deciding the state of the budget today. That is because the context that we use today is different from the context that had been there 10 years ago.

Aseni: Wow, what it means is that we have to keep us updated continuously if we are to be literate in fiscal terms. But how should we decide whether the Budget 2021 is a development budget or not?

Sarath: The way to do is to identify our immediate and medium to long-term development issues and examine how far Budget 2021 has addressed them. If it has done so, we can say that it is a development budget. If it has failed, then, to say that it is a development budget is simply making a superficial statement.

Aseni: So, it is a complicated matter. What are our immediate development issues, Grandpa?

Sarath: One is a recurring issue ever since we were independent from Britain. Economic development requires us to invest a large portion of our income in productive assets. What I mean by productive is that those investments should generate an output in a bigger volume, not for just one or two years but for a long period. To invest, we need resources and one way to find those resources is to save a sufficient amount out of our income by cutting down our consumption. It is a hard choice, but we have to make that choice. 

Sri Lankans are notorious savers because out of Rs. 100 they earn, on average, they save only about Rs. 25. The track record of the Sri Lankan Government in making savings is the worst. That is because it spends more than its income on consumption. This situation is called making dis-savings and historically, those dis-savings had been about 2% of our total income known as Gross Domestic Product or GDP. Therefore, the Government is an eater of private savings. That is because it reduces the 

national savings to that extent. To initiate development, the country has to reverse it. 

Therefore, to get the qualification that the budget is a development budget, the Government should have cut its consumption or increase income or both, generate savings and use those savings for investment in productive assets which have been very carefully selected based on the country’s priorities. This has not happened in Budget 2021. In 2020, the Government’s dis-savings have been as high as 8% of GDP. In 2021, since the revenue has been overestimated, the dis-savings will be in the same region. Hence, the Budget 2021 is not a development budget but a consumption budget. 

Aseni: But why haven’t people realised it?

Sarath: Mainly due to their own selfishness and myopic or short-sighted attitude. When the Government spends on consumption, a part of that money goes into their hands. They get into the false feeling of becoming richer than before. Hence, they expect the Government to spend more on consumption. That is myopic because they pay in the long run in several ways. One is that it impedes development and people have to settle themselves for a low improvement in welfare. Another is that they have to pay taxes at higher levels to finance the Government’s over-consumption. A third is some adversity which people do not understand immediately. That is, if the Government is planning to finance such high consumption by printing money, the consequential inflation – known as imposing an inflation tax – will reduce the quantity of real goods and services which they can consume. Therefore, they do not see the future but see only today.

Aseni: But Chambers also have not realised it. Surely, they have access to better economic knowledge than ordinary folk, haven’t they?

Sarath: Yes, they have. But they are extremely selfish. They do not want to run the wrath of the Government and disqualify themselves for various facilities the Government is offering. For example, the construction sector chamber will praise the budget because if it criticises it, its members may not get construction contracts. You would have noted that that chamber had branded the budget as construction sector friendly, though the budget had clearly pronounced that all contracts relating to the Government sector would be given to state construction sector entities. 

Aseni: Are there any other immediate developmental issues faced by Sri Lanka which have not been addressed in the budget?

Sarath: One prominent issue is country’s foreign debt problem. We do not have enough foreign exchange with us to repay the principal and pay interest on foreign debt. A classic case is that in the next 12-month period, we should have at least $ 6.7 billion to repay the principal and pay interest on foreign borrowings of both the Government and the private sector. But our liquid foreign exchange resources have declined to a level of just $ 5.4 billion meaning that we have to either default or borrow more to honour our debt obligations. This Government is not responsible for it because it is a legacy which it has inherited from previous governments. Yet, since it is in their court now, they have to come up with a solution. 

This budget has not given a satisfactory answer to it and our chambers have failed to notice it. Their members have to pay dearly if they have to default due to the lack of foreign exchange to meet their debt obligation. Individual country debt crises have been triggered in the past, such as those in Mexico, Chile, Argentina, Greece, and Portugal, by the default of the private loans. The risk which we face today is that the private sector has rupees, but the country does not have dollars to give them to pay their foreign debt. A debt crisis can occur not because of the Government debt per se. It can be triggered by the country’s private sector and then spread to the Government sector. 

Aseni: This is a critical issue. And an issue that should not be ignored. But what are the medium to

long-term issues that have to be used when assessing Budget 2021?

Sarath: Sri Lanka’s goal has been to become a rich country within a generation ever since it gained independence from Britain. The first Finance Minister of independent Ceylon, J.R. Jayewardene, named his budgets as ‘Budgets of Full Employment’ meaning gaining a high growth rate to elevate the country to that status. But that goal has been an elusive goal and even after 72 years of independence, we have not reached the full employment level. But we have a different problem now. That is, the country got itself elevated to the status of a lower middle-income country in 1997 and we have not been able to become even a higher middle-income country as yet. We are at the threshold and we do not know when we will be able to cross that threshold. 

But the problem is the crossing of the higher middle-income country upper limit and becoming a rich country. This problem is known as the ‘Middle-Income Trap’ and there should be a clearly laid road map to beat the trap. This is the most critical problem that we are facing today and there is no mention of this problem in the Budget 2021.

Aseni: Amazing that it has missed the eye of the policy makers. But what should Sri Lanka do to beat the middle-income trap? 

Sarath: To understand it, we must go a little back to history. It is relatively easy for a low income or a poor country to become a lower middle-income country. That is because those poor countries have abundant labour at low prices and therefore can increase its per capita income by producing mass consumption goods for rich countries by using that cheap labour. This is what Sri Lanka did in 1980s and 1990s by concentrating on developing its apparel sector. But after you reach the middle-income level, you start experiencing increases in wages making your production uncompetitive compared to the new entrants to your line of production. 

So, in the apparel sector, we cannot compete with Bangladesh, Myanmar and Cambodia which have entered the market recently. So, as a middle-income country, we lose that market. Then, we cannot become a rich country either because we cannot compete with rich countries due to a lack of advanced technologies. So, we are eternally caught in the middle-income level. If the Budget 2021 is to be categorised as a development budget as claimed by many, it has to lay foundation now to address this issue. That is not being done in the present budget.

Aseni: I understand it. But some have criticised the budget on the ground that it has not provided relief to common man by reducing prices. Even the people’s representatives in the opposition had raised this issue. How far is it justified? Can a government reduce prices?

Sarath: This is another myth that has been engrained in the mindset of people. Government can increase prices by printing money and causing inflation in the economy. But they cannot reduce prices. This is because prices are determined in the market in response to the interaction of two opposing forces. One is the demand force and the other is the supply force. The Government can influence neither one. Suppose to reduce prices, it cuts taxes on commodities. Suppliers are now in a position to supply the given commodity at a price lower than the prevailing market price. But whether the prices would come down in the market will depend on what has happened to the demand. But if the demand increases because the Government has printed money to finance the budget and release that money into the hands of people, the demand will increase, nullifying the attempt of suppliers in reducing prices. 

This was exactly what happened in the previous instances in which the Government had cut import duties to lower market prices. They did not generate the expected price reductions because people’s money incomes had been increased by financing the budgets by printing money. But this example tells us that the governments can increase prices by printing money and financing budget deficits. In that case, the demand will increase, and it will lead to an increase in the market prices too.

Aseni: But why do people expect the Government to reduce prices?

Sarath: That is because they do not have even the simplest literacy in economics. As I told you, prices are determined by the interaction of both the demand and supply forces. We cannot say which force would fix the prices. It is like a pair of scissors with two blades. We cannot say whether the cloth is cut by the upper blade or the lower blade. It is being done by both bladed together. Therefore, just by controlling only one of the blades, the Government cannot cut the cloth. If it is to reduce prices, it has to control both blades simultaneously. 

Aseni: Thanks Grandpa. I now know that people comment on the budget from their personal self-interest. A budget that promotes consumption cannot be branded a development budget. At the same time, a development budget should present a road map to take Sri Lanka to the future. Budgets submitted ever since the country gained independence have been suffering from these defects.

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)