IMF prescribes tax hikes, cuts in government spending

The International Monetary Fund’s latest report on Sri Lanka has painted a dismal economic outlook for the country and recommended drastic cuts to Government spending, the raising of corporate, personal income and value added taxes, the minimizing of tax exemptions and of ensuring greater contributions from high-income earners.

The IMF has also urged continued efforts to strengthen governance and reduce corruption. “With very limited fiscal space, the need for transparency and accountability in the use of public resources— including COVID- 19 spending— is more important than ever ,” it states. “Upgrading the anti- corruption legislation should be a priority, and the recent Cabinet decision to resume this reform process, after a significant delay in 2020- 21, is welcome,” it states.

“In staff ’s view, Sri Lanka’s debt is unsustainable,” the report says. “Based on staff analysis, fiscal consolidation necessary to bring debt down to safe levels would require excessive adjustment over the coming years, pointing to a clear solvency problem.” (This refers to an inability to repay debt).

Annual fiscal deficits--the shortfall in a Government's income compared with its spending--exceeded 10 percent of gross domestic product (GDP) in 2020 and 2021 due to pre-pandemic tax cuts, weak post-pandemic revenue performance and expenditure measures to combat the pandemic, the IMF says. (Economists have widely criticised these tax cuts which have led to significant drop in Government revenue).

Limited availability of external financing resulted in a large amount of Central Bank direct financing of the budget (referring to excessive money printing). Public debt is projected to have risen from 94 percent of GDP in 2019 to 119 percent of GDP in 2021.

Large foreign exchange (FX) debt service payments by the Government and a wider current account deficit have led to a significant FX shortage in the economy. (A current account deficit occurs when the total value of goods and services a country imports exceeds the total value of goods and services it exports). The official exchange rate has been effectively pegged to the U.S. dollar since April 2021.

“Rollover risk is very high,” The IMF says. “FX debt service needs of US$7 billion each year will require access to very large amounts of external financing at concessional rates and long maturities, sustained over many years.”

The IMF has welcomed the Government’s prompt policy response which cushioned the economic impact of COVID-19. But the pandemic took a heavy economic toll due to a sharp drop in inbound tourism and lockdown measures. And relief spending worsened a pre-existing debt overhang and inadequate external buffers.

“Should the external financing needs not be met, heavy reliance on domestic financing to cover fiscal deficits would eventually suffocate private credit growth or undermine monetary stability,” it warns, referring to borrowing from local banks.

The IMF calls for automatic fuel and electricity pricing mechanisms. “The authorities should develop a schedule for the import restrictions to be phased out,” it states. “A wide-reaching and coherent investment promotion strategy should help avoid excessive reliance on tax incentives. The Port City project should be managed prudently to maximise its growth benefits and minimise its fiscal and financial risks.”

Additional downside risks include COVID19 resurgence, rising commodity prices, worse-than-expected agricultural production, a potential deterioration in banks’ asset quality, and extreme weather events. Upside risks include a faster-than-expected tourism recovery and stronger-than-projected FDI inflows.