HURRAH FOR TAX CUTS?
Applause greeted the recent tax cuts. While potentially costing the state Rs500 billion in revenue, the fiscal stimulus will boost aggregate demand and energize the sluggish economy. However, it has to be viewed as a short-term measure. According to rating agency ICRA Lanka however, in the long-run, the tax cuts will create instability. The tax cuts will result in a revenue loss estimated to be a fourth of the Rs1.9 trillion total revenue collected in 2018, and this is why the fiscal stimulus lays bare a structural fiscal management problem that’s challenging and could take years to fix. Sri Lanka’s new government which took office after the November 2019 Presidential elections announced a slew of tax cuts.
Corporate income tax was reduced from 28% to 18% and the Value Added Tax was reduced from 15% to 8%. A withholding tax, nation building tax and economic service charge were scrapped. The objective was to kickstart a floundering economy. In the second quarter that year, the economy fell to the lowest growth rate in a decade, 1.5%. The tax cuts serve to revive growth to 4-4.5% in 2020, up from 2.8% in 2019 and sustain the feel-good sentiment leading up to the parliamentary elections in April.
“Whilst acknowledging the potential boost to the aggregate demand and corporate profitability from the fiscal stimulus in the short-run, Sri Lanka should broaden the tax base and continue fiscal consolidation to avoid macroeconomic instability to benefit from the tax buoyancy effect,” ICRA Lanka, a unit of Moody’s, said in a statement.
For decades, government revenue has barely covered recurrent expenditure, leading to accelerated debt formation for capital expenditure. In the process, investments needed for long term economic growth have not grown substantially. With tax revenue reduced, the government must contain expenditure to avoid risks.
“Growth of recurrent expenditure should be curtailed to the maximum extent possible to avoid facing headwinds to economic growth,” ICRA Lanka suggests, but notes this will be challenging to do.
The government has very little manoeuvrability to cut expenditure. Recurrent expenditure is exploding and difficult to cut: interest payments and public sector salaries account for 71% of total recurrent expenditure.
In 2018, the government spent Rs500 billion as interest payments on treasury bonds alone: that’s equal to the revenue loss from the present tax cuts! Restructuring debt can bring down debt servicing costs but a widening fiscal deficit will make this challenging.
On the state salaries side, 30% of recurrent expenses are in the form of salaries and wages to a 1.4 million-strong public service. Letting go of public sector workers will be political suicide so the only option is to freeze recruitment. But this is unlikely to ease pressure on the deficit after the revenue cut. Reforming state-owned enterprises can result in non-tax revenue growth and reduce the cost of transfers to loss-making public entities.
However, state-sector reforms is a slow trudge through a political minefield. In this context, ICRA Lanka warned that the government’s commitment to fiscal consolidation “can be seriously undermined by a move such as removing the fuel price formula”.
“Given very little fiscal space the government is presented with, the prudent way forward is to expand the tax base to exploit the trickle-down effect of the stimulus and to continue fiscal consolidation to curb the expansion of the fiscal deficit,” ICRA Lanka suggests.
Expanding the tax base cannot be done fast enough. Fiscal stimulus may work in the short-term by boosting sentiment and business activity, but can have a negative impact beyond that.
“Strong consumer sentiment is vital for economic revival but sustaining it in the long-run requires structural reforms and fiscal discipline,” ICRA Lanka says. ICRA Lanka believes the government may need to consider raising some taxes to counterbalance the loss in revenue.
Prolonged fiscal stimulus doesn’t achieve the desired results, examples from other countries show. Vietnam created tax incentives that resulted in revenue losses worth 7% of its GDP in four years from 2012. The country’s low tax rates had not translated to increasing revenue compared to the size of its economy, ICRA Lanka noted. Vietnam’s corporate income tax collection fell to 4.3% of GDP in 2016 from 6.9% in 2010. “The impact of the fiscal stimulus on the economy cannot be looked at in isolation,” ICRA Lanka says. Sri Lanka has to service $3.7 billion worth of external debt in 2020 alone.
The rating agency believes a stronger rupee is required for reserve accumulation to meet external obligations. This leads to another concern: would the government resort to monetary stimulus too.
“More government revenue means a lesser requirement for monetary financing consequently preserving the value of the currency. Therefore, the importance of enhancing government revenue in the light of current stimulus cannot be left to its own devices,” the rating agency said.
While domestic investors and businesses are convinced the government will deliver results, external agencies like the IMF and ratings agencies may not be. After the tax cuts were announced, Fitch Ratings promptly downgraded Sri Lanka’s sovereign credit from ‘stable’ to ‘negative’ warning that the tax cuts were a departure from the previous revenue-based fiscal consolidation path.
This would create policy uncertainty and increased external financing risk, particularly given the large external debt repayments due in 2020 and beyond. While the government has maintained it would cut spending to contain the deficit and compel businesses to pass down the tax benefits to consumers, Fitch is not convinced.
“The announced tax measures create uncertainty about the feasibility of these plans,” Fitch said. It said the stimulus could undermine policy credibility, investor confidence and potentially complicate relations with the IMF. The Central Bank responded with a biting statement. It said the hypothesis presented by Fitch was grossly ill-informed and that the estimated fiscal impact of the recent tax changes was based on “erroneous and linear assumptions”.
The Central Bank has said there was a high likelihood that positive market sentiments could strengthen further in the period ahead, with the dissipation of political uncertainties.
“Initial measures introduced by the government thus far indicate the President’s resolve to maintain a professional and strong governance structure in the new administration,” it said.
The Central Bank’s statement was interesting for two reasons: First, it said the proposed tax cuts were offset or negated by increases elsewhere: reductions in VAT were offset by increased excise taxes; while a nation-building tax was removed, a port and aviation levy was increased.
Second, it noted that there will be no new capital expenditure, critical for long term growth, in 2020. It also said measures will be in place to cut unnecessary spending and improve efficiencies at state institutions. However, none of these is a quick fix. Even domestic businesses are well aware of the challenges ahead. Sri Lanka’s leading business chamber, the Ceylon Chamber of Commerce, acknowledges that much.
“The chamber hopes that the positive benefits accrued from the near-term fiscal stimulus will be sustained over the medium and long term,” it said in a statement. “This will require government’s focus on continuing progressive reforms on several key agendas including but not limited to those related to local and foreign investment, the expansion of exports and productivity enhancements in the public sector,” it said.
Fiscal stimulus is necessary, for now; but the government will have to pull out at the right time; before it’s too late