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2019 tax cuts led to rating downgrades, made borrowing harder

08 Dec 2021

  • Prof. Ricardo Hausmann says tax cuts weakened fiscal position
  • Says ‘countries similar to SL’s earlier rating borrowed easily, but SL struggles’
  • Notes impossible to attract FDI with the current economic state 
   BY Shenal Fernando The tax reforms in late 2019, which reduced the tax base and the value added tax (VAT) before the Covid-19 pandemic, significantly weakened the fiscal position of the country which has in turn exacerbated the economic fallout due to the disruptions caused by the pandemic. This was noted were made by Harvard University Centre for International Development Growth Lab Director and Harvard Kennedy School Rafik Hariri Professor of the Practice of International Political Economy Prof. Ricardo Hausmann yesterday (7) at the Sri Lanka Economic Summit 2021 organised by the Ceylon Chamber of Commerce (CCC). According to him, due to the tax reforms in end 2019 the country had to face a collapse in tax revenue during Covid-19 and the Government was in a very weak position to support the economy during the crisis. “I was working in countries that originally had a credit rating very similar to Sri Lanka such as Albania, Honduras, and Guatemala. These countries were able to borrow more at record-low interest rates during the crisis. Unfortunately, Sri Lanka, given the weakening of its tax base, lost access to voluntary financial markets and was downgraded lately, as I understand, to ‘CCC’ because of the way it decided to run its fiscal policy,” he said. Explaining further, Prof. Hausmann claimed that when comparing the World Economic Outlook projections for the gross domestic product (GDP) of Sri Lanka published in October 2019 and October 2021, the Sri Lankan GDP in 2024 is expected to be 12% below pre-Covid-19 projections. Therefore, Sri Lanka is expected to be significantly poorer and to grow at a slow rate when compared to pre-Covid-19 forecasts. According to him, this situation has been exacerbated by the misguided policies implemented in addressing the Covid-19 crisis, which includes the mandatory foreign currency surrender, and financial repression has resulted in a black market premium of around 20%. Furthermore, inflation is rising and the Government has failed to announce a credible fiscal plan and has also not announced a debt restructuring plan. “Under these conditions it’s impossible to attract the kind of foreign direct investment (FDI) that the country would need to tackle its long-term growth problems which will require attracting investors in new areas and new fields. The current management of the macro economy reminds me of Latin America in the 1980s, which, for us, ended up being a loss decade and it reminds me of the policies that led to the implosion of my own country, Venezuela, in the last few years,” stated Prof. Hausmann. Sri Lanka has traditionally run a high fiscal deficit, which reached around 14% of the GDP in 2020 and due to the effect of the recurring waves of Covid-19 fiscal deficit, is estimated to be around 11.1% in 2021. However, according to government forecasts, the fiscal deficit will fall to around 8.88% in 2022. Public debt is a concern for Sri Lanka, reaching 108% of the GDP in 2020. However, in recent years, the Government has reduced its reliance on foreign sources of funding and consequently, foreign debt accounted for only 40% of the public debt in 2020. Regardless of this development, Sri Lanka still owes over $ 4 billion in foreign debt per year over the next five years. So far, the Government has continued relying on ad hoc arrangements such as bilateral swaps and small ticket loans to service the said foreign debt. Prof. Hausmann opined: “In my mind the country needs to adopt a different direction; it has to implement a tax reform that will give the State the revenue base with which to finance its obligations to its people. I have looked at the tertiary enrolment rates; they are still very low in Sri Lanka. There are plenty of things that can be done with public resources and the country needs a stronger tax base.” He further claimed that Sri Lanka needed to engage in debt restructuring, pointing to the fact that the debt-to-GDP ratio is above 100% and 45% of that debt consists of coupons at high rates of 6-7.5%. “Avoiding debt restructuring isn’t responsible. When a country is insolvent it is best that it adopts debt restructuring sooner rather than later,” added Prof. Hausmann.  He further stated that when he first became involved with Sri Lanka in 2015, he had identified two key issues which the country needed to address. “First issue was macro stability, which in my mind had a fiscal origin and that fiscal origin was based on a low and rapidly declining tax revenue as a share of GDP. That fiscal weakness was causing recurrent balance of payment crises and the need for IMF (International Monetary Fund) programmes. The second was the slowdown in the long-term rate of growth of the country, which I associated with slow export growth and in turn connected to the fact that there had been a very slow upgrading of the country’s export basket. In 1990, the country had moved from agriculture to export of garments and it has been fairly successful in the export of garments. But what we saw in other parts of Asia is that after garments, countries added electronics, machinery, cars, chemicals, and pharmaceuticals, etc. These extra exports didn’t happen in Sri Lanka. Consequently, the exports of the country grew much slower than the growth capacity of the economy.” The incumbent Government has taken steps to reverse the 2019 tax reforms in the 2022 Budget and accordingly, a 25% tax surcharge was introduced on companies which earned more than Rs. 2 billion in taxable income during the 2020/21 tax year, which is expected to raise Rs. 100 billion. Similarly, a 2.5% social security contribution has also been introduced on all entities with a total turnover exceeding Rs. 150 million. Moreover, the VAT on financial services was increased from 15% to 18% and a goods and services tax (GST) was also introduced. However, critics have pointed out that such indirect taxes are disproportionately damaging to the general public that is suffering due to inflation and high unemployment, and claimed that the Government should have focused on direct taxes over indirect taxes in order to increase tax revenue.

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