Mahoshada

“Inflation is the one form of taxation which even the weakest government can enforce, when it can enforce nothing else.” League of Nations Report on European Inflations of the 1920s.

The Continuing Increase in the Cost of Living
It is unlikely to come as a surprise to anyone that consumer prices continued to increase rapidly last month. The government recently released data that show that in September prices were 15.4 percent higher than a year ago, based on the Colombo Consumer Price Index (CCPI). This was largely driven by increases in the prices for electricity, fuel and vegetables. This means that since May, prices have increased on average by more than 15 percent a month compared with the levels a year earlier – a rate of increase in the cost of living that the poor and middle class will find likely find increasingly difficult to bear.

The cost of living remains one of the most politically sensitive issues in the country and the continued surge in prices undoubtedly does much to explain the government’s recent decision to reduce gasoline and diesel fuel prices by Rs 2.00 and Rs 2.50. The government is also indicating that it intends to reduce fuel prices further in the coming weeks.

All governments have been elected with promises to reduce the cost of living; yet few governments have been able to deliver on such promises. The principal reason for this is that few governments have made much progress in substantially reducing their own budget deficits, which have been the driving force behind the persistent high inflation and the consequent increasing cost of living. The Treasury is hard pressed to make ends meet through borrowing alone, so the government resorts to printing money which quickly leads to higher prices. This has been one of the main sources of increasing inflation in recent years.

The Continuing Increase in Government Spending
This week the government provided an early indication of its intentions for the upcoming budget. The 2007 appropriations bill presented in the Parliament this week include a planned increase in total spending next year to Rs 804.6 billion. Compared to the Rs 568.3 billion budgeted for last year, this amounts to a 42 percent increase. Keep in mind that since prices have risen by 15 percent in the last 12 months, the government’s budget would have had to increase by that amount just to maintain real government spending at a constant level. In other words, what would cost the government Rs 804.6 billion today would have cost Rs 700 billion if prices had not increased. But even taking this into account, this would still mean that real government spending will increase by a substantial 23 percent next year.

It is also important to keep in mind that actual spending almost always exceeds budgeted spending by a significant amount. It is currently projected that actual spending this year will be on the order of Rs 609.3 billion, some 7 percent above the amount budgeted a year ago. And it is likely that by the end of the year, actual spending will be higher than the government now projects. So even this 23 percent budget estimate for next year’s spending is likely to be low, with actual spending even higher.

It is expected that spending on security (police and military) will account for an important part of the increase in spending. This is understandable given the current situation. More specifically, it has been reported that budgeted spending in this area will increase from Rs 96.2 billion for this year to Rs 139.6 in 2007. This would amount to an increase of 45 percent, which is roughly equal to the proportional increase for the entire budget. In other words, it is not the case that the sharp increase in total government spending is the primary result of a surge in military spending. Increased budget outlays in other areas would also go up substantially.

The largest claim on the government’s budget has been the interest on the public debt. In 2005 this required Rs 120 billion and accounted for 27 percent of total current expenditures. Because it is virtually impossible for the country to substantially reduce its total public debt in the short term, this will likely remain one of the budget’s largest claims on resources. To make matters more difficult, in recent years the government has increased its reliance on more expensive shorter term borrowing from national and international markets while reducing its use of less expensive and longer term concessionary debt available through international financial institutions such as the World Bank and IMF. As a result, it is to be expected that the budgetary allocation for interest will almost certainly increase proportionally more than for other types of expenditures.

The appropriation bill suggests that total government borrowing could reach as much as Rs 1,000 billion in the next year. Approximately Rs 700 billion of the increased borrowing would be in the form of increased foreign loans, local rupee loans and the issuance of government bonds at home and abroad. The remaining Rs 300 billion would be raised through increased borrowing through treasury bills.

Declining Fiscal Discipline?
An obvious concern raised by the proposed sharp increase in government spending is whether this will lead to an even further deterioration in fiscal discipline – an even larger budget deficit. In 2005 the budget deficit amounted to 8.7 percent of GDP. According to the Central Bank, for this year the projected deficit was 9.1 percent. It could well turn out to be even larger. Note that the deficits for both years were somewhat higher due to expenditures related to the tsunami, which may be less of a factor in the coming year. Nevertheless, it is still questionable whether continued budget deficits at these high levels would be sustainable for very long into the future without a substantial adjustment in revenues and/or expenditures.

We will have to wait until the budget is presented to see whether the government will also be proposing comparable large increases in taxes to boost revenues sufficiently to pay for its 42 percent increase in spending. It was reported that the Treasury has said that it is hoping that it will be able to contain the deficit to 8 percent of GDP. This will certainly be a difficult challenge to meet.

One of the reasons why some governments tend to be more relaxed about maintaining an inflationary environment is that price rises usually lead to corresponding increases in tax revenues. This is especially true when the government relies heavily on taxing goods and services through a VAT, import duties and excise taxes – as this government does. When prices go up by 15 percent, the revenues from these types of taxes also usually increase by a similar amount.

But according to the appropriation bill, the government will be proposing a substantial increase in spending, well above the level of inflation. As indicated above, removing the effects of inflation on the proposed spending levels would mean that real spending would increase by some 23 percent. Some of this additional spending could be paid for as a result of increased tax revenues that arise simply because the economy is growing. The total tax base – the incomes and profits generated by all economic activity – will be somewhat higher next year than in the current year. But even if one accepts the current high quarterly growth rates that have been reported, it is highly unlikely that this would generate sufficient additional revenue to even maintain the deficit at its current level without significant additional taxes. (The recent increase in excise taxes on alcohol and tobacco may be only an indication of larger changes to come.)

The “Growth Dividend”
There is, however, a larger issue that should be considered: How much of the “growth dividend”, the additional resources generated as a result of economic growth, should be channeled into additional government spending? There are other ways that these additional resources might be better utilized.

One option would be to utilize the additional tax revenues to reduce the government’s budget deficit and eventually the size of the public debt. Reducing the debt load would, for example, leave more room in the budget for the essential public services such as education and healthcare that are currently starved for funds. And because large scale of government borrowing currently absorbs such a large share of available financial resources, there is less money available for much needed investment to sustain higher growth rates.

Another option would be to reduce the tax burden on the poor and middle class. There is no doubt that the overall tax burden in Sri Lanka is quite regressive – the burden of total taxes falls most heavily on the poor. This is a consequence of the heavy reliance on taxing the purchase of goods and services or, to put it another way, the relatively small role played by the taxation of incomes. This would provide a major impetus towards reducing poverty and improve welfare throughout the country.

It is at least arguable that a substantial diversion of the country’s resources to increased government spending is not the most productive or generally beneficial path to follow. One would hope that the government would be obliged to present their arguments that they know best how to make use of the peoples’ hard earned money.