ECONOMYNEXT – Sri Lanka is planning to finance a 9.8 percent of gross domestic product budget deficit or 1,807 billion rupees domestically and has continued a policy of deadly retrospective windfall taxes started by the failed 2015 administration in a budget for 2022.

The budget also returned to a cascading 2.5 percent turnover tax, whimsically calling it a ‘social security contribution’, in trying to reverse a policy error involving a steep valued added cut in 2019 to create what policy makers call a ‘production economy’ which is said to exist elsewhere.

The VAT cut devastated state finances and led to severe monetary instability, and an external crisis involving possible sovereign default as the central bank tried to keep rates down in the face of the deficit by printing money.

The tax cuts as well as the attempt to keep rates down despite the deficit has led to cascading policy errors involving import controls, exchange controls and forex surrender requirements as well as the seeking of credit lines for consumption imports which tend to push up external debt.

In 2021 revenues is estimated to have recovered 13.3 percent to 1,556 billion rupees from 1,373 billion rupees. However revenues are were still down from 1,890 billion in 2019 when the VAT framework was intact.

The overall deficit for 2021 had been revised up to 1,826 billion rupees or 11.1 percent of GDP in the budget.

Going by past experience the final deficit tends to go up from what is presented in the budget.

Current spending at 2,817 billion rupees in 2021 is estimated to have come down to 17.1 percent of GDP from 17.8 percent in 2020.

Current Expenditure

Sri Lanka’s current spending had ratcheted up to over 17 percent of GDP from 12.2 percent in 2014 when the disastrous ‘revenue based fiscal consolidation’ debacle started in 2015 throwing spending based consolidation out of the window hiking subsidies and salaries.

Politicians were led to believe by the International Monetary Fund among others, that there were large volumes of untaxed money just waiting to be plucked via ‘revenue based fiscal consolidation’.

Classical economist B R Shenoy has said ‘revenue based fiscal consolidation’ is a ‘statistical’ method of balancing budgets which is not founded on the political realities of democracies, and will devastate the private savings available for investment and future growth.

The budget for 2021 at least has made token gestures towards cutting spending, including a freeze on salaries except teachers who have agitated and won a 30 billion rupees pay rise.

Finance Minister Basil Rajapaksa also promised to enact legislation to stop supplementary estimates, or midway increases in spending which may legally block further salary hikes.

Rajapaksa, who of late has displayed a tendency to speak plainly of late said the public sector was an unbearable (uhu-lun-ner barry) burden on other sectors.

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The public sector has been bloated by unemployed graduates in a policy driven by the Janatha Vimukthi Peramuna in 2004, and was latched on to the Sri Lanka Freedom Party led coalition and has been continued ever since.

Tax Policy Reversal

After severely undermining the Value Added Tax regime with the 2019 cuts, the current budget is trying to shore up revenues by resorting to a new cascading Social Security Contribution.

Sri Lanka tried to end cascading turnover taxes with the introduction of GST/Value added taxes in the mid 1990s, but bureaucrats keep bringing them back.

Cascading taxes tend to give high tax yields while adding to end prices and undermining export competitiveness.

The budget has also continued a policy started in 2015 of charging retrospective windfall taxes from large companies, calling it a ’25 percent surcharge’.

The 2015 budget as part of efforts to bridge the 100 day program heedless spending, brought it a windfall tax labeling it a ‘super gains tax’ starting a new deadly trend in regime uncertainty.

Several rent-seeking import substitution business had made actual windfalls in 2021, exploiting consumers under cover of import controls, analysts say.

Windfall taxes are now being shown to be a habit.

Other than the windfall tax, which is expected to destroy 100 billion rupees of investible capital in 2021, no other investment destroying income taxes have been increased.

However both taxes will go some way to bridge the deficit, which is required to help bring some stability to state finances and the external sector by reducing the corrective interest rates that is required in 2022 to prevent a monetary meltdown and default.

Domestically Financed

The 2022 budget is planning a 8.8 percent budget deficit or 1,658 billion rupees, down from an 1,826 billion rupee or 11.1 percent deficit in 2021 which is still not final.

The 2021 deficit was financed with 962 billion rupees in printed money of which 331 billion rupees was absorbed in a reserve money expansion and inflation and the rest went out in a balance of payments deficit.

According to revised estimated a deficit of 1,874 billion rupees or 11.4 percent of GDP was financed domestically with 48 billion rupees being repaid on a net basis on foreign borrowings.

In 2022, the finance ministry is expecting to repay 179 billion rupees in foreign borrowings pushing up the domestic borrowings 1,807 billion rupees, which is one percent of GDP higher than the 8.8 percent deficit.

The 9.8 percent number is under 10 percent, but Sri Lanka has a history of exceeding projected deficits.

The interest bill for 2022 is projected at 1,115 billion rupees up from 1,055 billion in 2021. Analysts expects 2022 to require higher interest rates to fix the external crisis and end money printing.

However there may be room to cut capital spending. It is also not clear whether the planned land sales are including in non-tax revenues and how it may help the budget.