Budget 2015: Favourable features and fundamental flaws

Despite the fundamental weaknesses in fiscal policy discussed last week, there are favourable features in the 2015 Budget. The higher allocation for education and health, initiatives for the development of small and medium enterprises (SMEs) and assistance to smallholder agriculture are commendable. These favourable proposals, if implemented effectively, would benefit the economy. However, the actual disbursement of funds for these developmental needs may be stifled by revenue constraints.

The new proposals should be given priority so that the budget rhetoric is transformed into institutional reality. However, the overall budgetary weaknesses are likely to determine the final expenditures on education, health, agriculture and social welfare. Also increasing funding by itself does not get the best out of these sectors. It must be combined with some reforms.

SMEs

There are allocation of funds and policies to help small and medium enterprises (SMEs} that are important sources of production of goods and services. The policies include incentives for SMEs, such as creating different tariff bands for electricity charges for SMEs and credit schemes for small informal enterprises. The incentives for agriculture such as replanting subsidies to small tea holders, coconut cultivation and minor export crops and additional credit facilities at 6 per cent per annum for selected planting, replanting and social development of plantation workers could boost production.

Financial constraints are an obstacle to the expansion of small enterprises. In the past too there have been schemes to assist financing these that have been only partially successful as lending agencies have taken few risks in lending, have required security for loans and not met the full requirements of small enterprises then have to obtain high interest cost loans from informal money lenders. There have also been inadequate support services. Finance is not the only constraint on these enterprises. There must be a comprehensive policy package to assist small industry.

Some of the microfinance organisations such as Sarvodaya and Sanasa, among others, have been more effective by a finance plus approach, although the poorest segments of the population have not been reached adequately.

The mere announcement of assistance to these enterprises will not ensure successful implementation. Institutional arrangements have to be instituted to effectively service these enterprises as the benefits of these often go to persons who are not entitled to them. In addition good overall incentive policies would be also helpful to SMEs as research world- wide has shown.

It is noteworthy that the World Bank 2014 Doing Business survey has shown that Sri Lanka has slipped 14 places in the ranking to be 99th out of 189 countries. (Financial Times October 30, 2014).

Education

The Government's capital expenditure profile has been heavily weighted towards physical infrastructure expenditure, while expenditure on social infrastructure and human capital is low and inadequate. This has been a serious constraint to longer term economic development.

The 2015 Budget has addressed this issue to some extent by an increase in expenditure for improving both education and health infrastructure, the development of science and technical education. These are positive developments if these expenditures are effectively utilised.

However, they may not be incurred to the extent budgeted owing to emerging revenue constraints. If the fiscal situation deteriorates, the Treasury may be compelled to rein in expenditure by not releasing funds for these vital developmental needs. If fiscal stringency requires a curtailment of expenditure, then expenditure on large physical infrastructure should be phased over a longer period and wasteful expen- ditures of the Government should be reduced.

It is important for increased funding to be combined with education sector reforms such as results based evaluation of teachers, special allowances for hardship locations and penalties for absence of teachers from classes.

Private sector

Although diverse views have been expressed by the private sector, by and large these have been lukewarm and not unduly critical. The retention of the tax structure is confidence boosting, but government interventions such as determining salaries are not conducive to either domestic or foreign investment.

The tardy growth in investment, with the exception of the hospitality trade, is not likely to change as a consequence of this Budget. A more positive statement of encouraging private investment was needed to stimulate investment. This could not be expected from a government that has increased its interventions in economic activities and have increased its ownership and control in the banking sector.

The budget should have indicated signs of greater reliance on private investment. The Government does not show signs of slowing down the increasing size and power of the public sector since 2005. This is unfortunate as return to public investment is less than the return to private investment, even after taking into account the social benefits of public investments.

Fiscal flaws

As we pointed out last week the 2015 Budget had fundamental fiscal flaws. The unlikelihood of con- taining the fiscal deficit to desired level and targets is the most serious and far reaching deficiency. This overshadows the other features as it increases debt and debt servicing costs, has an inflationary impact and destabilises macroeconomic fundamentals.

The likely expenditure overruns and revenue shortfalls imply a further deterioration in fiscal discipline, increase in public debt and debt servicing costs and a continuing difficulty in achieving fiscal consolidation. The prioritisation of government expenditure leaves much to be desired owing to the disproportionate allocation of funds to ministries and over expenditure on large physical infrastructure projects that have left inadequate fiscal space for vital developmental expenditures such as on education, research, technical and tertiary education, health care, protection of vulnerable groups in the population. Furthermore, the financing of the fiscal deficit through foreign borrowing is raising foreign debt servicing costs that are a threat to the balance of payments. Increasing foreign debt could lead the country into a foreign debt trap.

The Government must focus on fiscal consolidation to ensure macroeconomic stability, sustain a high growth trajectory and ensure long term economic and social development. The Central Bank has underscored the need to be committed to fiscal consolidation and pointed out that this year's revenue collection has fallen. There is no reason to believe that the Budget proposals would bring about a significant increase in revenue to bridge the fiscal deficit adequately. This is the most serious concern.