The Politics of Economic Reform – Groundviews

Photo courtesy of Souara

The recent tax proposals have created quite a ruckus in all parts of Sri Lanka. While popular opinion was that the poor and trade unionists would oppose economic reforms, those who understand the political economy of Sri Lanka knew that opposition would come from the strangest places.

Several groups of people and businesses have opposed the new taxes: the SJB, the clothing industry, corporations, SMEs, professionals, IT associations, consumers and, strangest of all, the JVP. Sri Lanka has promised the IMF that it will achieve a rather ambitious primary surplus of 2.3% in its government budget by 2024. A primary surplus means achieving a positive difference between government revenue and government expenditure, at the exclusion of interest payments on debt. In the 72 years since 1950, Sri Lanka has only recorded a primary surplus in 5 years (1954, 1955, 1992, 2017 and 2018).

“The current tax system has contributed to the collapse of the national economy by totally discouraging national entrepreneurs. Instead, we would introduce a tax system that would favor production in the country,” reads Chapter 5 of the Vistas of Prosperity and Splendor manifesto authored by Viyathmaga. In addition, he clarifies that “the rapid implementation of our economic policies and the immediate impacts of the proposed tax cuts will help reduce the cost of living”.

I am sure we are all aware, against our will, of the seriousness of this new tax regime and its impact on the cost of living. Instead of getting richer and happier with the tax cuts, we all got poorer and angrier.

What many do not understand is that the crisis is a macroeconomic crisis and we all form the macroeconomics. Tailoring fiscal or monetary policy to the narrow needs of a narrow group of people will only deepen macroeconomic vulnerabilities, making us all worse off as a collective. It is primarily this policy development that brings us here. We are in a deep, deep crisis, of course, we cannot expect to be comfortable going through it; everyone has to carry the burden.

The already heavily burdened poor carry an even heavier burden; they eat less, smaller and less nutritious meals, their babies drink regular tea instead of milk, their children do not go to school because they cannot afford school supplies or sanitary napkins. Middle- and upper-income people also have to adapt, which means taking a hit to their standard of living. It’s painful and frustrating.

Business collectives complain that high interest rates prevent them from borrowing to meet their expenses, but high interest rates are needed right now to try to dampen inflation, which is approaching the 100%. High interest rates encourage savings and discourage consumption. Yes, it will reduce aggregate demand, but a contraction in the economy is what is needed. Under Cabraalesque monetary policy, which increased the money supply by 40%, kept interest rates low and the exchange rate fixed, it was cheap to borrow and spend.

So let’s borrow and spend what we did, putting pressure on the rupee to depreciate further as import demand grew (it’s cheap to borrow at 7% and buy an imported iPhone at Rs. 180 per dollar than borrowing at 30% and buying an imported iPhone at Rs. 360 per dollar). Overall demand was increasing, despite severe Covid-related supply shocks. With a fixed exchange rate in place, the Central Bank increasingly used its scarce foreign exchange reserves to defend the rupee, reducing foreign exchange reserves to almost nothing at the start of this year.

Eventually, when this impossible trinity of controlled interest rates, controlled exchange rates, and money supply expansion could no longer be maintained, all hell broke loose. Inflation rose rapidly, fuel prices doubled, interest rates were raised, fuel queues grew longer, power cuts reached 1 p.m., the rupee depreciated overnight, Sri Lanka defaulted and the IMF was called upon to resuscitate the country. If interest rates are kept low, this will further stimulate aggregate demand as it discourages saving and encourages consumption. This will cause inflation to rise and the rupee to fall, eroding purchasing power and making the situation worse for all of us.

What seems unappreciated is that citizens had no problem consuming subsidized fuel and electricity, or buying imported things at overvalued exchange rates, or attending free public schools, or driving private vehicles on public roads, or even supporting corrupt politicians – all paid. because, in the absence of adequate tax revenue, with borrowed money. For the most part, we paid for this with debt, and debt is tax deferred.

Debt was invisible and people were none the wiser. We enjoyed the comfort of knowing that in the event of an accident one could simply call a free ambulance from Suwa Seriya and be rushed to the free accident service in Kalubowila on free public roads and be treated by doctors and free, highly trained nurses, but we did not stop to wonder how the country paid for it.

The question should not be how much extra tax we should pay, but what we actually do with those taxes and whether everyone pays their fair share. It’s fair to ask if your tax dollars are doing what they should be doing, which is redistributing wealth and improving public services. In some cases, this is not the case. in the context of Sri Lanka’s political economy, some goes to fund corrupt politicians and their cronies, fund inefficient civil servants, fund an overstaffed army, for example. But in other cases, it is.

Despite chronic underspending on health spending, for example, Sri Lanka has achieved low infant and maternal mortality and life expectancy comparable to OECD countries, and despite very low spending on education, Sri Lanka has a fairly well-educated general population compared to its income levels and regional counterparts and even offers free higher education. The social benefits of a healthy and educated population are significant.

Admittedly, the quality of public services leaves much to be desired. Sri Lanka is far from being an advanced economy – there is low participation of women in the labor market, high youth unemployment, multiple labor market problems, quality issues in education and health , catastrophic public transport, appalling social protection and roads with potholes.

The quality, coverage, overstaffing and inefficiency of public services, corruption and the misallocation of public finances all need to be overcome, but none of these are more or less important than also increasing tax revenue ; they are all urgent and of equal and utmost importance.

Sri Lanka also has strong regional disparities and strong income inequalities. Public school children in wealthier districts have better opportunities than public school children in poorer districts, although they all benefit from the same free education system. On the same road where a red Porsche drives, a malnourished old man walks barefoot begging for a few rupees. To achieve sustainable, inclusive and equitable economic growth, which Sri Lanka has never done before, taxes are an important catalyst.

Of course, Sri Lanka’s tax system is fraught with pitfalls. There are problems in the administration and collection of taxes, tax evasion and evasion are high. It is easy to tax captive labor in the formal private sector, but more difficult to do so with the informal private sector. There are more than eight million people in the country’s labor force, but only 650,000 registered personal income payers. There are tens of thousands of businesses operating in Sri Lanka, but only some 8,000 corporate tax payers.

Income is under-declared, companies redirect their profits to shell companies to reduce their taxable income. Cash payments are sought by private medical consultants to avoid paper trails when filing taxes. Tuition teachers run television commercials during prime time, but pay little income tax. The problems go beyond the tax system and affect the psyche of Sri Lankans. Everyone wants free education, free health care, clean cities and a developed country, but no one wants to pay for it.

Ultimately, the government must bring its deficit under control and achieve an ambitious primary surplus of 2.3% of GDP by 2024. Without this, it cannot receive assistance from the IMF or anyone else. Our creditors would also consider how we plan to get out of this mess. How will the government raise funds to sustainably repay its debt? If not, how can the debt be credibly restructured? Low tax revenues are simply impossible at this stage. There is no way out of this mess without taxes.

The onus is on the government to regain what little faith the people had in it before the crisis, but recent events have done little to dampen public anger and resistance. Parents and children are attacked during demonstrations, activists are arrested, high profile criminals are released without prosecution. Cabinet Ministers laughingly admit that they are economically illiterate and unaware of the impending economic crisis before the total collapse.

There is no accountability for presidents, prime ministers, ministers, MPs and government officials. Politics remains intact, but the economy is set to experience a massive wake-up call. It’s no surprise that the public doesn’t feel they have a say in how the country is handling the crisis, it’s frustrating. The government is not trying to show that it too is sacrificing something. The public is not informed of the reasons why certain decisions are made, they are made to feel like pawns and it is not surprising that people misunderstand and even oppose reforms that are absolutely necessary.

It is easier to bring about economic reform than to change political culture and people’s mindsets, but without simultaneous change in all three, Sri Lanka will only ever achieve half-baked economic change and be left without no doubt in the same situation again.

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