Sri Lanka has been on a drive to expand government by abandoning cost-cutting, based on a cookie-cutter model peddled by the International Monetary Fund to many other countries for several years.
High taxation is not a substitute for monetary stability. Flexible inflation targeting and its cousins have devastating effects on the fiscal framework which no amount of taxation can fix, as clearly shown in Latin America.
BIG GOVERNMENT
The revenue-based fiscal consolidation ideology, which rejects spending-based consolidation, puts the entire burden of fiscal adjustment on the private sector, with no responsibility for the rulers or bureaucrats to cut spending.
In Sri Lanka, people know that there is plenty of excess spending. There are also serious doubts about the gross domestic product calculations, which will tend to reduce the tax-to-GDP ratio. When work in progress was added to GDP for example there were no taxes.
In the case of Sri Lanka, the magic number was decided as 15% of the econometrically expanded GDP at a time when it was around 12. In Ghana, which defaulted and now has about 15% of GDP revenues, the magic number is 18. In Latin America, revenues are in excess of 20 to 23% but the pegged currencies still collapse with flexible or contradictory policies. triggering default.
The second part of the big government ideology is to hike income tax rates. Making the ‘rich pay their fair share’, a key Western leftist or ‘progressive’ slogan. A key problem with income tax, where money is transferred directly to the hands of politicians and bureaucrats, is it kills that economic activity and individual choice. Maldives, and Dubai, grew and created jobs and imported labour without an income tax. They also had superior monetary stability, which is also strongly connected.
LIBERAL OR LEFTIST?
People are taught the IMF’s reform based programmes which started in 1980 to fix defaulting Latin American soft-pegs which collapsed repeatedly – sometimes called the Washington Consensus – were based on Reagan and Thatcher-style reforms. However, the IMF programmes which were originally peddled to Latin America and by extension to Sri Lanka lacked the basic ingredient of sound money.
The IMF effectively or unintendedly eggs on currency collapses by empowering reserve-collecting central banks to do aggressive floating rate style monetary policy through ‘central bank independence’ and then claiming their currencies are ‘overvalued’. One reason for debasing money is the vain hope that some magic export competitiveness will come from debased unsound money.
This was the standard mercantilist dogma that drove social unrest in the third world and also disrupted developed nations in the 1930s but was rejected by Germany, Japan and the most successful East Asian export powerhouses.
The IMF programmes are far from the Margaret Thatcher/Geoffrey Howe/ Alan Walters-style policy. The basis of Thatcher’s reforms was sound money. Howes budget came after two back-to-back IMF programmes in the ‘Great Inflation’ period, failed to stabilize or put the UK on a growth path. The UK had 11 IMF programmes when it ran Sri Lanka style contradictory monetary policy, Keynesianism, and output gap targeting, though not all were drawn down.
SOUND MONEY
This is what Geoffrey Howe said: “It is crucially important to re-establish sound money. We intend to achieve this through firm monetary discipline and fiscal policies consistent with that, including strict control over public expenditure.
Present-day economists and the IMF have little, or no idea of what sound money is. Pushing aggressive monetary policy based on the in-vogue anchor conflicting monetary regime – money supply targeting conflicting with reserve collections then and domestic inflation targeting conflicting with the balance of payments now does not solve anything. It failed in Latin America and it failed in Sri Lanka from 2012 to 2019 and then up to 2022 taxes were also cut.
The fiscal probity of the Thatcher/Howe programme was to reduce the deficit and reduce the size of the government not to expand the state as a share of GDP through taxation, allow spending to catch up and leave the deficit unchanged, as happened from 2015 by abandoning spending-based consolidation.
Spending went up from 17-20% of GDP under revenue-based fiscal consolidation as spending-based consolidation was abandoned and monetary instability from flexible inflation targeting triggered currency crises and reduced growth.
In Sri Lanka, IMF’s driven income tax rates also led to a backlash from some professionals, who helped bring Gotabaya Rajapaksa to power along with tax cuts. The regime used an output gap (taught by the IMF to calculate) to also cut taxes and print money to bridge the gap.
It was unintelligent in the extreme to teach a central bank which had gone to the IMF 16 times and triggered a currency crisis in 2012 within a programme, to calculate an output gap. That was an invitation to disaster, as Singaporean economic bureaucrats would say.
Monetary stimulus and output gap targeting (which is to be legalized in the new monetary law) is a sure-fire formula to debase money and is aeons away from the sound money ideology of the Thatcher administration.
There is nothing new or otherwise liberal about printing money and output gap targeting. There is nothing liberal about expanding the size of the government. There is nothing liberal about raising income tax either. These are not liberal or neo-liberal ideologies but pink or left-leaning ‘American’ progressive ideas that brought down the UK and are also creating problems in the US itself now.
THATCHER AND INDIRECT TAXES
The major drawback of indirect taxes, like value-added tax is that people do not ‘feel’ the hit, since they pay in small bites. Because they do not hurt, the burden of government is not felt by the public. High import duties, particularly on foods, hurt the poor.
Value-added taxes and other indirect taxes in small percentages conform to the Kautilya principle of taxation that taxes should be charged to a bee taking honey without hurting the flower.
Income taxes on the other hand come in big chunks and are designed to hurt and people ‘feel’ it when they pay. Income taxes and wealth taxes – sometimes imposed without any incoming cashflows – destroy savings and investible capital. Progressive taxes are also illiberal in that they deny equal treatment under the law. They become expropriation at high rates.
In true socialist style, income taxes also take away individual choice and transfers the power of spending decisions to the politicians and economic bureaucrats, while killing economic transaction that solves people’s problems. The consumption hit that some Sri Lanka companies are complaining of in the first quarter of 2023 is a result of taking away that choice.
This is how Geoffrey Howe boldly gave choice to the people on the street and a boost to the economic decisions of the community vs the bureaucrats. “We made it clear in our manifesto that we intended to switch some of the tax burden from taxes on earnings to taxes on spending,” Howe said in his budget speech in 1979, where clarity of thought, reason and interconnected logic was worthy of any 19th-century classical liberal,” he said.
“This is the only way that we can restore incentives and make it more worthwhile to work and, at the same time, increase the freedom of choice of the individual. We must make a start now. The upper rates no longer affect only those on very high incomes. They apply – and Labour Members may find this surprising – not only to senior executives and middle managers in the industry but increasingly to skilled workers, as well as to professional people and the proprietors of small businesses. These are the people upon whom so many of our hopes for initiative, greater enterprise and national prosperity must depend.
“This year I propose taking a first and significant step to deal with these complaints by reducing the rate from 33% to 30%. Our long-term aim should surely be to reduce the basic rate of income tax to no more than 25%.”
He followed the same strategy that the Ordoliberals of West Germany had done in cutting Hitler’s progressive tax rates. UK’s basic rate is now 20%. Progressive tax rates of 60% failed to fix the UK in the 1970s, driving it to the arms of the IMF.
Howe also broadened thresholds. “These reductions in the burden of income tax, which are as substantial as they are unprecedented, mean those wage and salary earners will have more money in their pockets to buy the goods and services they help to produce,” he argued. “True, the prices of a good many of these goods and services will be increased by my tax proposals. But we have done everything we can to ensure that every family in the land will have more money coming in to pay the increased bills. What is more, the choice of the way they spend their income will rest increasingly with people, and not with the Government.”
In subsequent budgets, thresholds were increased at rates higher than inflation, reversing bracket creep. Then spending was cut, bringing deficits in line and reducing the burden of the state on the people and businesses.
THE LESSON FROM TAX RATES
The top income tax rates were very high in the UK. So was the basic rate. The important lesson is this. It is not only that income tax reduces choice and kills economic activity and misdirects economic activity away from serving the community’s needs to that of the priorities of the economic bureaucrats including the IMF and politicians but that high tax rates fail if money is unsound.
When there is monetary instability with a forex collecting-central bank triggers shortages the government borrows, and debt goes up. High tax rates and high corporate taxes failed to fix the UK. Due to operating contradictory exchange and monetary policy, UK foreign reserves plunged.
In 1976, the UK went to the IMF for the largest loan at the time, $3.9 billion.
Foreign debt goes up when there are forex shortages as happened in Sri Lanka during flexible inflation targeting/flexible exchange rates. Despite high rates under IMF programmes, the UK suffered, and its foreign debt went up.
“In our external policy we have also to take account of our official external debts,” Howe said. “These at present amount to $22 billion – a massive increase on the $8 billion which the previous Government inherited in 1974. It is our intention to reduce that burden of external debt substantially during the life of this Parliament.”
CENTRAL BANK INDEPENDENCE VS SOUND MONEY
In that budget, Howe raised policy rates by 2% to 14%. The problem is not central bank independence but whether the central bank or politicians or anyone else believes in sound money or flexible exchange rates.
He said fiscal measures alone cannot sort out the monetary morass. “Particularly given the continuing surge in bank lending, I have concluded that there is no option but to act directly to reduce that growth. It is not enough to speak of the importance of monetary policy unless one is prepared to carry one’s words into practice”
The Bank of England is accordingly rolling forward the supplementary special deposit scheme, or “corset”, by three months on the existing basis. In addition, the bank is announcing, this afternoon, an increase in its minimum lending rate from 2% to 4%.
Taxing everything in sight with more wealth taxes planned in 2025, cannot fix a country with monetary instability. The IMF can fix a country in crisis with very high rates and an economic contraction with a sudden hike in rates. But it has no consistent stable monetary framework to offer pegged central banks which collect reserves.
The hit from monetary instability (flexible inflation targeting/flexible exchange rates) on the fiscal framework is massive. Peaceful countries in Latin America, Africa and Asia are driven to default by such policies. In Sri Lanka, the value-added tax cut for output gap targeting was dumb, but the country tipped over the edge as the debt had rocketed in the previous years and growth had declined with instability. Several East countries cut taxes during the coronavirus pandemic – but did not print money – and saw their debt go up some, without a currency collapse.
Flexible inflation targeting and their cousins practised by Latin America – and the UK during its period of exchange controls in particular – kill growth. Each currency crisis kills consumption, reduces taxes, and expands deficit and debt-to-GDP ratios while also driving borrowings to fill payment gaps from forex shortages. IMFstyle ‘competitive exchange rate’ monetary instability also drives up interest rates and makes the interest bill a large part of public spending.
Countries with monetary stability tend to have low income and VAT rates. The lowest corporate tax and VAT rates and debt-to-GDP ratios are found in East Asian nations with the hardest money. Thailand has a 20% corporate income tax rate (VAT 7%), Singapore 17% (VAT 8%) and Cambodia (dollarized) also 20% (VAT 10%).
A good tax framework is indispensable, but it is not a substitute for monetary stability. To borrow a word from the West Germans, without stability everything is nothing.