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Wednesday December 7th, 2022

Strong Medicine: Collective responsibility needed for economic reforms to work

L – R Duminda Hulangamuwa Senior Partner and Head of Tax, Sulaiman Nishtar Partner – Tax

EY Sri Lanka’s Duminda Hulangamuwa and Sulaiman Nishtar on what it will take to fix Sri Lanka’s economy.

EY Sri Lanka’s Duminda Hulangamuwa, Senior Partner and Head of Tax, and Sulaiman Nishtar, Partner – Tax, share insights into Sri Lanka’s worst economic crisis. They discuss the measures that have to be taken to get out of the crisis. With depleted foreign exchange reserves and defaulting on its external debt, Sri Lanka has limited options to stage a recovery. Its people must take collective responsibility and act decisively to turn around the economy and win back global credibility by biting the bullet to push through much-needed tax reforms, expenditure cuts, and SEO restructuring.

How do you define this economic crisis, and what are the underlying problems that deserve our unreserved attention?

We have two fundamental issues. One is external, which is the lack of foreign currency to meet our debt obligations and pay for essential and non-essential imports. The foreign currency crunch forced us to default on our external debt, disallowing us from borrowing from overseas until we reached an agreement with existing creditors to restructure the defaulted debt. The foreign currency problem has also compelled us to curtail imports and restrict the outward remittance of foreign payments.

Many businesses relying on imports got wiped out as they had no alternative. Then there are the costs embedded into essentials like food, fuel, and medicine by allowing the domestic currency to depreciate. So, we have had to identify non-essentials and temporarily stop those imports.

The second issue relates to the domestic front: state revenue and expenditure. The deep tax cuts of the last couple of years dried up the Treasury post-Covid. The substantial loss of government revenue adversely impacted the economy resulting in the inability of the state to meet its expenditure obligations.

In hindsight, the government introduced the tax cuts, as a stimulant to expand the struggling economy after the 2019 Easter bombings. The intention, it seems, was to attract foreign and local investments and increase disposable wealth and consumption.

Unfortunately, the unforeseen Covid19 pandemic shrivelled the economy and dried up the state’s revenue sources. At the same time, expenditure had to be maintained at the same levels because restructuring government services cannot happen overnight while citizens expect the various subsidies to continue, resulting in the budget deficit widening to precarious proportions. With the government unable to meet expenditures, they had to either print money or borrow. They resorted to printing money, but because it fuelled inflation – and on the recommendations of the IMF – they had to stop printing and instead borrowed more money at market rates, further contracting the economy and precipitating business closures and job losses. So, that is where we are today.

In our view, the government is trying to restructure the economy by putting the taxes back and improving the foreign currency situation, but it is a costly exercise. Higher taxes mean fewer investments, lower disposable incomes and eroding consumption, further contracting the economy, and compounding rising unemployment as more businesses fail.

In that situation, people will have to wait patiently for the economy to go through this process and come out of it. Everybody must understand that they have a responsibility in this because you cannot place the blame entirely on politicians. In our view, corruption, and mismanagement account for just 10% of the problem. 90% of our economic problems are due to what we have benefited from the subsidies. We consumed fuel at 180/- a litre, enjoyed electricity at below cost, paid fewer taxes, and for decades benefitted from free education and healthcare while expecting the government to create new public sector jobs with pensions every year. All of us must understand that we are all in this together. As a nation, we will have to resolve to face the challenges and work hard to turn around the economy over the next one to one and a half years. Our only option is to push through consistent reforms over the next two years. If the creditors agree to a debt restructuring framework and the IMF deal comes through, we can prove to the world that Sri Lanka is stable enough to attract investments.

What should an economic revival roadmap entail?

Any reforms roadmap must communicate what the requirements would cost and what the reforms will bring. The tax reforms, restructuring SOEs and dispensing with a lot of the subsidies except for the areas of health, education, and fertilizer, will have to be carefully considered and communicated to the citizenry. We ought to accept that there is pain that people will have to go through, and corporates paying high taxes will have to appreciate that there is a problem requiring expenditure cuts. There is no choice but to follow through with the reforms.

How have we done so far policy-wise? Have we made all the right moves at the right time?

We believe the government has taken the necessary steps to place the country on the right trajectory towards an economic revival. Sri Lanka could have defaulted earlier, and initiated IMF talks much sooner. However, we are finalizing an IMF deal which will restore some credibility while the debt restructuring process has also commenced. The recent tax adjustments will significantly restore government revenue and contain imports to preserve foreign exchange for more vital requirements. Those policy decisions have been taken and implemented, but there is more to be done, like restructuring state-owned enterprises to reduce the financial burden on the public. Cutting down government expenditure and restructuring the government sector cannot be done overnight. You have to keep public sector employees employed because you cannot have social unrest in the country.

Reforms need to be done gradually and will happen at some point in time. The government must communicate the reforms agenda to the masses in a language they understand. We must have a programme to change attitudes and mindsets and educate and make people understand their responsibilities and role in reviving the economy.

What is the fundamental problem with our tax system? How do we fix it?

Our income has always been less than our expenditure for several decades, but that has not been addressed. Instead, we go and reduce half the taxes that were anyway being recovered. To recover from that, you would have to look at various ways to bridge the gap by making taxes at least equal to or slightly higher than it is.

However, we cannot just be increasing rates and hammer the person who is always paying. We believe tax reforms should be three-pronged. First, restore the lost tax revenue from the various cuts and concessions, but avoid overburdening existing taxpayers. Second, we need to reform the tax administration to be efficient in identifying all those who are not paying their fair share. The third prong is that those enjoying exemptions by law are made to pay something because they also have to contribute. So, of the three-pronged approach, the immediate one, the first prong, like the PAYE tax proposals, can be implemented immediately, and then we can look at the other two to ensure that we have a balanced tax approach for the whole society.

What about expenditure?

That is something that cannot be rectified overnight, because of the recurrent expenditure on salaries. If we take the total salary bill of the government, a third goes for defence, another third for provincial councils and the rest finances central government expenditure. In our view, we have to cut the layers. There is talk about the defence budget, but we do not advocate cutting that, considering that we have had insurrections, disturbances, and wars from 1971 to 2010, and if not for the armed forces, we would not have got to live in this country. However, we do need to cut the other layers in overstaffed government offices, but we do not mean that we should close all government offices and buildings. The second biggest expenditure item is the provincial councils. There again, a critical analysis is necessary if we are to continue with it because it is in the Constitution.

How should the government approach SOE reforms?

It is a gradual process. In a country like Singapore, nothing is free, but Sri Lanka cannot do that yet. Education and health may have to be free, but for reforms, you have to identify two sectors. One is the business ventures like the Sri Lanka Insurance Corporation, Lanka Hospitals and Hotel Developers (Lanka) Plc. Those can be sold immediately because those are businesses where the government has a majority stake, and the government can get some cash, and also show the world that it is open for business.

The second one is the government banks – People’s Bank, Bank of Ceylon and NSB which are under pressure from political parties on the government side, their lending policies are dictated by the government because they have to finance other struggling SOEs like Sri Lankan Airlines, Ceylon Petroleum Corporation, and the Ceylon Electricity Board. Sri Lankan Airlines’ debt might be recoverable, but CEB and CPC can never pay back their debt to the banks. As a result, those banks are fully stretched and under-capitalized. State banks are also required to invest in treasury bonds whenever the government wants them to without regard to prudence, putting depositor funds at risk. We need to make these banks more transparent to the public, and as proposed in the budget by the President, a 20% equity stake can be allocated to employees and the private sector at a determined price to infuse better governance and management principles. That would make these banks truly commercial banks and not just government banks.

The rest of the SOEs like the CEB, CPC, CTB and the railways, are absorbing a lot of public funds to provide subsidized services to the public. The government will have to decide whether it will continue to make losses or be restructured, which is the only alternative.

They would have to gradually compel the CTB and the railways to introduce market rates. The government can provide well-targeted subsidies. For example, railway travel is cheap, and a lot of people use it, so a season ticket can be issued at a concessionary rate to those from economically vulnerable households. However, that will have to be taken away gradually because if you look at the railway coaches and the tracks, there has been no investment since the British left due to a lack of funds. The government has to look at ways of bringing in private funding, through privatizing coaches where the rentals can finance the maintenance of railway stations, tracks, and locomotives.

The same principle can be followed for the CTB, while the CEB has to be unbundled. We can privatize power generation with distribution remaining with the government because it is a difficult task. In the case of the CPC, it will have to market price its fuel, and if the government wants to subsidize vulnerable segments, then there should be a separate fund so that the CPC does not absorb heavy losses.