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Thoughts on the Budget and what comes next

Friday, 15 December 2017

The recent Budget definitely improves on previous budgets. It is a promising


debut for Mangala Samaraweera, the new Finance Minister. He sees it as the
beginning of long-delayed market reforms.

In his opening remarks to the Budget statement, he promised to reform factor


markets to free the economy, and to liberalise and globalise to improve
competitiveness. He also promised fiscal consolidation to boost revenues as a
proportion of GDP, reduce budget deficits, and deliver a primary budget surplus.
His goal is an Enterprise Sri Lanka that will unleash the entrepreneurial energies
of small and large businesses.

Here I offer my thoughts on the Budget, positive and negative, and on what
comes next.
Finance Minister Mangala Samaraweera presenting the 2018 Budget in
Parliament

The political context


What has clearly made a critical difference is the mid-year cabinet mini-reshuffle,
when Samaraweera replaced a finance minister who delivered disastrous
budgets, held up market reforms for two-and-a-half years, and was a national and
international embarrassment.

The minister of finance sits in the cockpit of economic policy-making; his ministry
has the power of the purse, and is the only one with a birds-eye view of the
economy. The international record shows that no substantial market reforms are
possible without a credible finance minister.

Samaraweera came to this position with a clean reputation he is clearly not in


politics to make money for himself, his friends and relatives and a record of
delivering in his previous portfolios. He is serious about market reforms, as his
public pronouncements attest. He is willing to stick his neck out for them. He is a
good listener who does not pretend to know what he does not know. He solicits
good advice and draws talent to him. He has a gentlemanly manner, putting
people at ease rather than talking down to them. His State Minister, Eran
Wickramaratne, is equally committed to market reforms and brings to his job
level-headedness, analytical nous and technocratic skills. The two ministers are
very different personalities, but they complement each other well.

The Ministers advisory team Mano Tittawella, Thilan Wijesinghe and Deshal de
Mel is the best, a combination of political-savvy, analytical competence and
managerial experience. The Treasury also has competent senior officials, starting
with its secretary and deputy secretary. Before, Treasury officials were side-lined.
Now ministers draw them into policy-making. Morale in the Treasury is definitely
up.

A credible finance minister and a credible Treasury team make a big difference, as
it did in the making and delivery of this Budget. But this is only a start. So much
continues to go wrong in Sri Lanka, and so much depends on effective budget
implementation and further reforms.

Debits

I will divide the Budget into debits and credits. And start with debits.

Great finance ministers are on my mind right now. I am re-reading Ron Chernows
enthralling blockbuster biography of Alexander Hamilton, the USs first Treasury
Secretary, a founding father of the US Constitution, the chief author of The
Federalist Papers, and all-round human dynamo. Hamilton, more than any other
founding father, laid the foundations for modern American capitalism. As
Treasury Secretary, he established solid public finances and a new financial
system.

But more than Hamilton my fiscal hero is William Ewart Gladstone, many times
Liberal Prime Minister in Victorian Britain, and before that a reforming, highly-
successful Chancellor of the Exchequer. In three landmark budgets in the 1850s,
Gladstone gave life to what came to be called Gladstonian finance. To quote
from Joseph Schumpeters History of Economic Analysis:

(Gladstonian finance) translated a social, political and economic vision, which was
comprehensive as well as historically correct, into the clauses of a set of
coordinated fiscal measures. Gladstonian finance was the finance of the system
of natural liberty, laissez-faire and free trade. the most important thing was to
remove fiscal obstructions to private activity. (Revenue) would still have to be
raised in such a way as to deflect economic behaviour as little as possible from
what it would have been in the absence of all taxation (taxation for revenue
only). taxation should as little as possible interfere with the net earnings of
business. Last, but not least, we have the principle of the balanced budget or
rather, since debt was to be reduced, the principle that Robert Lowe, one of the
chancellors of the exchequer of the Gladstonian era, embodied in his definition of
a minister of finance: an animal that ought to have a surplus.

My key takeaway from this passage is that taxation should be for revenue only; it
should not be used, nanny-state-like, to intervene in this-or-that sector of the
economy to micro-engineer this-or-that outcome. That distorts business
incentives, creates red tape and corruption, and results in myriad negative
unintended consequences.

In this light, this Budget, and all previous budgets, look pretty shady. Sri Lankan
budgets are choc-a-bloc with micro measures. Gladstonian finance is all about
simplicity; Sri Lankan budgets are mind-bogglingly complicated. The budget
process is upside down: instead of starting with general principles and objectives,
and then accommodating exceptions, it starts with tax and spending measures on
individual items, from toddy to three-wheelers to electric cars, hotels, plastic
bags, start-ups, SMEs, and much else besides. Pet spending measures cascade
from line ministries, and then swell and metastasise the budget. It is worse in Sri
Lanka with its profusion of needless ministries and ministers. Only then does the
Treasury try to impose some order on an out-of-control process.

The minister ends up reading out a dreary list in Parliament: a special tax on super
luxury vehicles with an engine capacity exceeding 2,500cc; an excise duty of Rs.
10 per kg on plastic resins; eight credit schemes with low interest rates to support
SMEs and micro enterprises; an excise duty of 50 cents per gram of sugar in
beverages; and so on ad nauseam. The result is a dogs breakfast, a horrible mess
that breeds bureaucracy, wastes money and suffocates the economy.

This Budget is better than its predecessors in one respect: the Treasury takes
spending limits and revenue-raising more seriously, given commitments to the
IMF and the recently-enacted Inland Revenue Bill. But still. To pick out a few
highlights of what is wrong with Sri Lankan budget-making: I dont see any sense
to discriminate in favour of electric vehicles, with implausible targets to phase out
vehicles that run on fossil fuels. That is a costly diversion. There are incentives
galore for SMEs. The graveyards of the world are littered with failed SME
incentives. What SMEs need is less obstructive government regulations, not a
Niagara Falls of low-interest loans and other incentives. Another national
development bank is a silly, costly idea, as is a government agency to act as an
angel investor for start-ups. Some sectoral export-promotion schemes seem
designed to keep the EDB on life support. (One has visions of investment and
exports shooting up the day the EDB, not to mention other government business-
promotion agencies, are shut down.) Does Sri Lanka really need a sugar tax when
there are so many more pressing problems to tackle?

And finally, the tax on telecom towers and the transaction tax on banks. Both are
short-term revenue-raising measures. The telecom sector argues the tax on
towers will hurt profitability and investment, and could cause two foreign players
to leave the market. The banking sector argues the transaction tax will deter
savings and lending, not least to SMEs. Both sectors have a point. The best way to
raise revenue is through general taxes on corporations and individuals, not
through bitty sectoral measures with inevitable unintended consequences. The
former signals simplicity, consistency and predictability, the latter complexity,
inconsistency and uncertainty.

My main point is that Sri Lanka needs a radically different budget-making process,
one that emphasises taxation for revenue only and overall simplicity. Only then
will Sri Lankan budgets pass a high credibility test.

Credits
Now to the Budgets credits. I highlight four: modernising antique legislation;
trade-and-investment reforms; doing-business reforms; and PPPs and
privatisation.
Revising antique legislation
The Minister mentioned, among other items, the Customs Ordinance, the Excise
Ordinance, the Rent Act, the Paddy Lands Act, the Land Act, the Shop and Office
Employees Act, and bankruptcy laws. He also announced the repeal of the
Underperforming Enterprises and the Underutilised Assets Act. If implemented,
this would be a major accomplishment.

These gobs of legislation, some over a century old, gum up Sri Lankas factor
markets its markets for land, labour and capital. Repeal and modernisation, with
effective implementation, would make these markets freer and more flexible,
with a growth and jobs dividend.
Trade-and-investment reforms
The Minister announced that about 1,200 para-tariffs (CESS and PAL duties)
would be removed. The Rajapaksa Government built saw-toothed alpine ranges
of para-tariffs on imports, on top of existing MFN import tariffs. Para-tariffs piled
up to protect politically-connected domestic producers (in steel, cement, tiles,
ceramics, footwear and furniture, to name just a few sectors), and to plug short-
term revenue shortfalls. Sri Lankas protectionist fortress soared to the heavens:
para-tariffs account for about two-thirds of import-duty protection.

This Budget announcement is a very belated and modest start to trade


liberalisation. Revenue considerations drove its extreme caution: the revenue loss
is only Rs. 5 billion. Almost 5,000 para-tariffs remain untouched. Hence this must
be just the start of much bigger tariff liberalisation. The minister has announced
that para-tariffs will be phased out completely in three years.

The next budget should cut remaining para-tariff protection by more than half,
with remaining para-tariffs abolished in the 2019 Budget. Fears of revenue loss
are greatly exaggerated. Studies done by the World Bank and a Harvard team of
economists show that higher domestic tax revenues (from higher import volumes)
will more than compensate for revenue losses from repealed import duties.

But this should not be the end of tariff reform. All export duties should be
abolished as soon as possible. Once para-tariffs disappear in three years, there
should be an extra three-year timetable to simplify and reduce MFN import
tariffs. My preference is for most goods to enter duty-free, and for other goods,
or at least non-agricultural goods, to face a uniform tariff of 5%. So, six years from
now, Sri Lanka should have by far the simplest and lowest level of import
protection in South Asia, and a level of protection similar to the East-Asian
average.

The Government will also enact new legislation on trade remedies (antidumping
and safeguard duties) to deal with import surges and unfair trade. And it will set
up a trade-adjustment-assistance programme to cushion the pain from more
import competition. Both are unavoidable political expedients. But any sensible
trade economist would counsel caution. Trade remedies, especially antidumping
duties, could become open-ended protection for inefficient domestic producers.
The bias should be for safeguards, which have tighter WTO disciplines, and
against antidumping duties, which are a favourite tool in the protectionists box of
tricks. Similarly, trade-adjustment assistance could land up in the pockets of rich
but inefficient employers and labour unions. It should rather be targeted to
retrain and reskill affected workers.

A good way to achieve these goals is to depoliticise the process as much as


possible. That could be done with an independent trade commission, at one
remove from politicians and officials, to conduct import-injury and trade-
assistance investigations, and then publicly announce its recommendations.

The Budgets biggest and most controversial liberalisation measure is removing


foreign-equity limits on shipping agencies and freight forwarders. It is a bold
decision, and the right one.

Predictably, the affected local cartels, especially the shipping agents, have risen
up, lined up their political backers, and raised a ruckus. Their representations, in
the media and to ministers, are spurious and easily refutable. The shipping
agencies claim they bring in about $ 800 million of revenue a year and account for
about 100,000 jobs, and that shipping is mostly open to foreign players anyway.
This is nonsense. The former sum is the total freight bill; all the agents do is
pocket tidy fixed commissions from incoming freight (around 3-5%, creating a
revenue pool of $ 25-40 million). Directly, they have little more than 10,000
employees.

These cartels are typical Sri Lankan rackets that benefit a handful of insiders with
excellent political connections, keep out competition, and deliver a mediocre
service. There are five main players in the shipping agents cartel, and casting a
pall over the whole industry is Dhammika Pereras Hayleys, which is busy gobbling
up smaller players.

Perera makes much of his fortune in businesses protected from competition; this
is one link in the chain. Controlled local markets condemn Sri Lanka to crumbs
from the table of global shipping and logistics. It makes Colombo Port heavily
reliant on the low-margin transhipment business with India. But much of this will
probably vanish within a decade, given Indias massive port-building programme
and the likelihood that some Indian ports will get their act together.

Post-Budget squealing from local shipping agents and their proxies could leap
straight out of the pages of Adam Smiths Wealth of Nations, which was
published 241 years ago. Smith was intensely suspicious of the clamorous
importunity of partial interests and the sneaking arts of underling tradesmen,
who, like an overgrown standing army, become formidable to the government,
and upon many occasions intimidate the legislature. Here is a much-quoted
passage:

People of the same trade seldom meet together, even for merriment and
diversion, but the conversation ends in a conspiracy against the public, or in some
contrivance to raise prices. To widen the market and narrow the competition is
always in the interest of the dealers. To widen the market may frequently be
agreeable enough to the interests of the public; but to narrow the competition
must always be against it, and can only serve to enable the dealers, by raising
their profits above what they naturally would be, to levy, for their own benefit, an
absurd tax upon the rest of their fellow citizens.

What is the alternative? The prize on the horizon is to make Sri Lanka South Asias
maritime-cum-logistics hub, halfway between Dubai and Singapore, and bang in
the centre of a vast emerging Indian Ocean market. Sri Lanka should attract
anchor investments like Maersk (in shipping), DHL (in logistics), and even Amazon
(in warehousing for e-commerce) for higher-value regional hub operations, and
not only to serve low-value Indian transhipment and a tiny local market. If they
come, other MNCs will come too, and they will create a growing ecosystem of
ancillary service providers, and a platform for local companies to plug into,
upgrade their skills and technology, raise capital, boost productivity, and even go
global. This is a vision of a much bigger shipping and logistics market in Sri Lanka,
with more jobs, and better paid and more rewarding jobs.

But to do that Sri Lanka needs to break decisively with the status quo. MNCs will
only consider regional hub operations if they have full freedom of decision-
making, and costs and services that are competitive with rival ports. That
demands two basic reforms at the outset: removing foreign-equity limits; and
abolishing price controls. The government needs to hold the line on the former.
On the latter, it should repeal regulated freight agency charges (the CASA tariff,
set by the shipping agents association and enforced hitherto by the central bank)
so that full market pricing applies. Other reforms need to follow on terminal
handling charges, warehousing and other restrictive port practices. But this must
be the start.

Liberalising shipping and freight-forwarding is important in another respect. If it


happens, it should catalyse opening up of other local services markets to
competition. This is vital to improve productivity in local services, plug them into
global value chains, and generate growth in trade and investment that will feed
into higher growth, better employment and higher living standards at home.
Services are the future. For Sri Lanka, the future should start with liberalising
shipping and freight-forwarding.
Doing-business reforms
Sri Lanka languishes in 111th place in the World Banks Doing Business index
while other countries including India in the last two years climb up the
rankings. Everyday stories abound of how awful it is to do business in Sri Lanka
getting licenses and permits, starting a business, paying taxes, registering
property, enforcing contracts and so on. All relate to the frustrations of dealing
with Government departments. Many quick-win solutions to improve the
business climate involve digitisation simplifying paperwork, putting it online,
making procedures automatic, and eliminating bureaucratic discretion and
procrastination.

In this vein, the Budget proposes a single identification number for businesses
lodged with the Registrar of Companies; online applications for Local Government
approvals, construction permits and land registration; a national single window to
link trade-related agencies with the Customs Department; and a new trade portal
with accessible and reliable trade information (such as trade statistics, regulatory
requirements, and export and import procedures). The latter two trade-
facilitation measures, long discussed but so far not implemented, dovetail with
the trade-and-investment reforms I covered earlier.

These are small-sounding announcements with potentially big, beneficial,


economy-wide effects. Implementation, of course, is key. And sooner rather than
later.
PPPs and privatisation
The Minister announced a Public-Private Partnership model for infrastructure
projects, to be led and coordinated by a new unit in the Ministry of Finance. That
is welcome, and it should be centralised in the MOF rather than left to line
ministries. He also announced the Government would divest its stakes in non-
strategic enterprises. And he made a more important announcement: that the
Bank of Ceylon and the Peoples Bank would be allowed to raise debt and equity
capital, thereby creating minority stakes for private investors. That is a potentially
major boost to local capital markets.
Conclusion
This, then, is a mixed budget, but significantly more positive compared with
budgets in recent Sri Lankan history. It signals the beginning of market reforms
that should have started almost three years ago.

We know the sorry record of budget implementation: Verit Research has


estimated what a large chunk of budget measures never get implemented. This
time must be different. So all eyes will be on the new Budget Implementation
Unit in the Ministry of Finance. That is the first task. The second is to use reform
momentum from this Budget to roll out more reforms in the coming year, and
build up to a more ambitious reform budget in November next year. The clock is
ticking fast: this Government has probably two years at most to make a positive
difference to the lives of ordinary, less privileged Sri Lankans.
(The author is Chairman of the Institute of Policy Studies and Senior Adviser to
the Ministry of Finance.)
Posted by Thavam