by Kanes
A significant feature of the economy in both 2001 and 2002 is the low level of investment. Gross Domestic Capital Formation, which had increased year after year and reached Rs. 353 billion in 2000 declined by 12.2 per cent to Rs. 310 billion in 2001. Although it rose by 9.1 per cent in 2002 to Rs. 338 billion, it was still lower than that of 2000 by 4.2 per cent. As a proportion of GDP, total investment had risen from 25.7 per cent in 1995 to 28.0 per cent in 2000 and then declined to 22.0 per cent in 2001 and to 21.3 per cent in 2002. The average ratio in the six years 1995-2000 was 25.8 per cent of GDP but the average in the last two years was 21.6 per cent. The fall in investment from 28.0 per cent of GDP in 2001 to 22.0 per cent in 2001 may have contributed to the fall in GDP by 1.3 per cent in 2001. In 2002 however, GDP growth was 4.1 per cent despite the fall in investment ratio further from 22.0 per cent to 21.3 per cent.

Investment declined in both public and private sectors. In the public sector (government and public corporations) the ratio of investment to GDP fell from 6.6 per cent of GDP in 2000 to 5.8 per cent in 2001 and then to 4.6 per cent in 2002 - perhaps the lowest ratio in the last 50 years. This drop in public investment is understandable; it is the result of the declared government policy of downsizing the public sector, involving the cutting down and withdrawal of the government’s role in economic activity and handing over economic activity to the private sector in accordance with the free market policy. The privatization of public corporations and even some government departments, pruning the staff in government departments and emasculation of government’s involvement in all type of economic operations, including control and regulation bear testimony to this.

The cut in total government expenditure from 27.5 per cent of GDP in 2001 to 25.4 per cent in 2002 and the planned drop further to 24.6 per cent in 2003 - and the fall in current expenditure from 21.6 per cent of GDP in 2001 to 20.8 per cent in 2002 and capital expenditure from 5.9 per cent of GDP to 4.5 per cent in the same period - the reduction of public sector employment by 6.4 per cent from 1,164,990 in 2001 to 1,090,350 in 2002 and the privatization of public corporations and government linked companies such as Prima Ceylon Limited and National Insurance Corporation in 2001, Sevenagala Sugar Company and Lanka Marine Services in 2002 and Sri Lanka Insurance Corporation in 2003 illustrate the process of downsizing the state’s role in the economy.

The downsizing of the state’s role in economic activity is being done with the aim of making the private sector the engine of economic growth in the county by encouraging private investment to take the place of public investment. The government assumed that as public investment was reduced, private investment would rise to sustain rapid economic growth. What happened, however, was, quite different. Private investment which was 21.5 per cent of GDP in 2000, dropped to 16.2 per cent in 2001 and 16.7 per cent in 2002, the lowest level in recent years. The low level of investment in 2001 is understandable as the years witnessed negative growth with the insecurity and uncertainty created by the terrorist attack of the Katunayake Airport, September 11 attack on New York, the downturn in the US and poor demand for garments exports but the low level in 2002 when there was security and much less uncertainty, when the US had recovered to some extent and there was relative peace in the country, is difficult to understand, particularly when the new government offered several new tax incentives and other concessions to stimulate private investment such as reduction of corporate tax on small companies, abolition of capital gains tax, reduction of the 40 per cent surcharge on corporate taxation to 20 per cent, reduction of income tax, low bank interest rates and relaxed exchange controls and privatization of public corporations.

The low level of investment in 2002 also occurred when foreign direct investment (FDI) was increasing. FDI rose from $ 82 million (Rs.7,310 million) in 2001 to $ 230 million (Rs. 22,017 million) in 2002 or by 180 per cent. This was the highest inflow since 1997. Apparently, the high level of FDI had failed to stimulate private investment (which rose by only 16 per cent between the two years). The low level of private investment in 2001 and 2002 was mainly caused by the low level of investment in transport equipment and near stagnation in plant and machinery. Investment in transport equipment of Rs. 81.2 billion in 2002 dropped to Rs. 23.4 billion in 2001 or by 71 per cent and rose by 22 per cent in 2002 to Rs. 29 billion; plant and machinery fell by 9 per cent from Rs. 78.2 billion in 2000 to Rs. 71.4 billion in 2001 and rose by 13 per cent to Rs. 80.7 billion in 2002. Building and other construction, on the other hand rose by 15 per cent in 2001 and by 10 per cent in 2002.

The number of new registrations of buses for example declined by 43 per cent from 2,298 in 2000 to 1,310 in 2001; they rose by only 9 per cent to 1,429 in 2002. New registrations of private cars fell by 39 per cent from 13,848 in 2000 to 8,426 in 2001 and rose by 42 per cent to 12,003 in 2002 - but yet below the number in 2000. The low level of investment in transport equipment in 2001 and even in 2002 merits further study. The near stagnation in investment in plant and machinery is reflected in the private sector industrial production index, which fell by 3.7 per cent from 286 in 2000 to 276 in 2001 and rose slightly by 2.5 per cent to 282 in 2002.

What were the causes for the poor performance of private investment in 2002? We can only speculate on the possible causes. One is the lower external demand for our exports such as garments, footwear and travel goods as reflected in the fall in such exports. The lower investment in industries producing for domestic consumption however was not due to fall in consumer demand, which actually increased by 14 per cent in 2001 and 14 per cent again in 2002. Some industries were adversely affected by foreign competition from cheap imports, for example, shoes and steel which were forced to close down several factories; both have demanded higher import duties and this has been acceded to in the case of shoes. The third may be the high interest costs. The Chairman of the Ceylon Chamber of Commerce, Mr. Tilak de Soyza has stated recently that around 80 per cent of the loans disbursed by banks now are over 22 per cent interest rates and reduction is needed to stimulate small and medium size industries. The fourth may be labour problems such as lower productivity, wage disputes and strikes; in fact, some foreign factories closed down on account of labour problems. Fifth may be the poor infrastructure such as poor roads, railways and communications. On the other hand, some of those problems were there in previous years too but the investment levels were higher than in 2001 and 2002.

The authorities deliberately reduced public investment and consumption to stimulate private investment, but as the private sector’s response has been poor, there was a fall in total investment below those in previous years. If this is a temporary phenomenon and private investment would pick up this year it need not cause concern but if it continues this year too then it is an alarming matter that needs to be remedied without delay.

The simple fact is that both public and private investments are engines of growth. This is particularly so in a developing economy where the private sector is not yet fully developed as in Sri Lanka. There will be little private investment without public investment in infrastructural facilities. Expectation of private profits is as much related to infrastructural facilities as they are to tax and other incentives and infrastructure is most essential for private investment to take place. It is hardly necessary to point out that private investment will not be attracted by poor and inefficient infrastructure consisting of bad roads, railways, harbours and airports, frequent breakdowns in power and poor communications however attractive tax and other incentives are, for poor infrastructural facilities tend to raise the cost of production and to lower the profit margin. Public investment does not as some say, crowd out private investment. On the contrary pubic investment is a sine qua non for private investment. Further, public investment stimulates private investment by involving private firms through contracts in the creation and improvement of infrastructural assets.

In most countries, as in Sri Lanka, private firms are selected on a tender basis to build or improve roads, bridges, airports, seaports, irrigation and hydroelectricity dams and to construct buildings for schools, hospitals, administration and public housing. In addition, the equipment and materials needed by the government for these physical assets, machinery, spare parts, motor vehicles, ships, aeroplanes, railway engines, generators and others are purchased from private firms. So, expanding public investment results in expanding public investment in a symbiotic relationship. The experience during 1978-1982 is a good illustration of how public investment in the Mahaweli Development Scheme, Parliamentary complex and public housing led to a marked stimulus to private investment. The rise in public investment instead of crowding out the private sector, boosted it by about 50 per cent as shown below. The main reason for the decline in private investment in 2001 and 2002 therefore appears to be the reductions in public investment.

The developed countries have large public sectors although the developing countries are being advised to have smaller ones. Government spending as a percentage of GDP is 52 in Sweden, 50 in Denmark and France, between 40 and 50 per cent in Japan, Belgium, Italy, Germany, Netherlands and Canada between 30 and 40 per cent in the UK, Spain and Australia and 29 in the USA as compared to 27 in Sri Lanka in 2001 as shown in the table below. (See Table)

Funds for public investment

Public investment on such a large scale in developed countries is financed by high taxation. Total tax revenue exceeds 50 per cent of GDP in Sweden, varies between 40 and 50 per cent in Denmark, Finland, Belgium, France, Italy, Netherlands and Norway and between 30 and 40 per cent in Germany, UK, Canada and Switzerland and 20 to 30 per cent in US and Japan. In Sri Lanka, total tax revenue was only 14 per cent of GDP in 2002 - much lower than in developed countries. It is normally argued that public investment cannot be raised as there are no funds, but the fact is that the government has deliberately reduced taxes and tax revenue over the years — corporate income taxes and import duties in particular. Tax revenue as a percentage of GDP has been reduced from 19.0 per cent in 1990 to 14.0 per cent in 2002 - revenue from corporate income tax from 1.4 per cent to 0.9 per cent and revenue for import duties from 5.2 per cent to 1.9 per cent and revenue for tobacco excise duty from 1.7 per cent to 1.3 per cent. In addition to the reduction of taxes, state corporations which were "money spinners" — operated always at a profit — like the Distilleries Corporation and more recently the Insurance Corporation were privatized. No wonder there is no money for public expenditure!

The answer to lack of funds is thus higher taxation and profitable public corporations. Top income Tax rate is 60 per cent in Netherlands, 50-60 per cent in Denmark, Finland, Sweden, Belgium, France, and Germany and between 40 and 50 per cent in Italy and UK as compared to 35 per cent in Sri Lanka. Yet there are some who advocate a reduction or even abolition of income taxation to promote private investment when much higher corporate and individual income taxation has not discouraged private investment in developed countries. In any case, the reduction of income taxation does not seem to have promoted higher investment in Sri Lanka. Sri Lanka seems to have gone too far in liberalizing its economy, sacrificing the use of taxation as a tool to promote development. The reduction of import duties and restrictions for instance have undermined several domestic industrial and farming activities and created loss of employment and income apart from loss of much needed revenue. The weighted mean tariff of Sri Lanka in 2000 for example, was 7.4 per cent when it was 28.5 per cent in India which achieved an average 6.0 per cent growth in 1990-2000 as compared to 5.3 per cent in Sri Lanka. The need to review our pubic investment and tax policies in terms of economic development is a national priority.