Either/or: Exploring Sri Lanka’s budget deficit


Post-war Sri Lanka’s budget deficit fell substantially from 10% of GDP to 5.8%, the lowest in nearly three decades. Unfortunately, this significant decline was not steep enough for the government to meet its 2011 target of reducing the budget deficit to 5%. This Insight explores the government’s success and failure at tackling the deficit.

But first some definitional housekeeping. The budget deficit is calculated by subtracting government spending from government earnings in a given year. The government spends on providing public services. In return it taxes the population directly through income and corporation taxes, in addition to indirect taxes like VAT and customs duties. If government spending is greater than revenue, it needs to borrow the money either domestically or abroad.

Therefore the government can reduce the budget deficit in two ways: either through reducing expenditure or increasing revenue. Post-war, with hope of lower defence spending and higher growth, expenditure was expected to decline and revenue increase. As predicted expenditure declined, but contrary to projections revenue did not.

post-war fall

So first let’s see what happened to expenditure. Government spending is primarily allocated to public sector salaries and human/physical infrastructure; basically, recurrent expenditure and capital investment. Both declined considerably post-war. See Exhibits 1 and 2 for their decline between 2009 and today.

So what then explains declining expenditure? Other than defence, the answer is falling expenditure as a share of GDP on social services including education, health and welfare – important drivers of medium and long term growth. For example, education’s share of GDP experienced a year-on-year decline of 14% between 2009 and 2013. Currently it’s at 1.8% of GDP, the lowest share in the last 63 years.

Revenue and Revenue Expectations Down

Having examined declining expenditure, this section explores revenue’s status. Contrary to projections government revenue as a percentage of GDP did not increase, it declined. Exhibit 3 makes it clear that Sri Lanka’s declining deficit is not caused by increasing revenue. The exhibit also shows how over time expectations of government revenue also declined as revenues projected share of GDP declined.

Either Budget Deficit or Trade Deficit

Why is revenue as a share of GDP not increasing? One important obstacle for increasing revenue is that current policy for increasing revenue generates pressure on the trade deficit. Taxes on imports account for about half of all government revenue. Sri Lanka wants to reduce both the budget deficit and the trade deficit but it can’t do both simultaneously. It’s as if Sri Lanka needs a pair of shoes, but the shopkeeper only has one shoe. That is, if the government wants to increase revenue to reduce the budget deficit it needs to allow more imports. Increasing imports, however, exacerbates the trade deficit. So trying to improve the budget deficit has a negative effect on the trade deficit and vice versa.

The concern is particularly acute as the elasticity between imports and taxation can be high. Elasticity refers to how much a change in one variable affects another variable e.g. the length a piece of elastic will extend for a given level of force used to pull it. In the case of imports and taxation, elasticity refers to how much tax revenue changes as a result of changes in imports. See Imports declined by 0.9% between January and September this year. However, this small decline amounted to a 20% decline in expected international trade tax revenue.

Imports play an important role in promoting economic growth and thus in the medium run government revenue. Post-war Sri Lanka’s growth war initially led by import growth and then by construction. Imports played a critical role in both these stories. Import trade accounts for around 13% of services (which in turn account for over half the whole economy). But notably it seems to be the driving force behind service sector growth. With exceptional import growth in 2011, services also expanded rapidly; when the government curtailed imports in 2012 services growth in turn approximately halved. The same is the case the third quarter of 2013. In the case of construction, as the sector took off after 2011, imports of construction materials increased tripled in a year, showing how dependent the sector is on imports. As construction declines to pre-war levels ensuring raw material supply will be essential to sustaining growth.

The analysis above shows that in Sri Lanka fiscal deficit, trade deficit and economic growth are all closely linked and managing one without managing the other is not possible. Attempting to curtail imports and cut expenditure has its limits. Perhaps the time is now to focus on boosting exports and reforming domestic taxes. For more detailed analysis await our forthcoming report on the 2014 budget.

Verité Research provides strategic analysis and advice for governments and the private sector in Asia. Send us your comments on insights@veriteresearch.org

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