Sri Lanka’s economic crisis has been precipitated by a drop in the country’s mainstay tourism earnings owing to the COVID-19 pandemic and economic dislocation caused by lockdowns to contain the viral infection, but the country’s political leaders are responsible for bringing the country to the point of vulnerability with debt-laden infrastructure-led growth and mindless tax cuts.
Though a combination of extraordinary adverse factors is necessary to bring a country to the situation that Sri Lanka is in, it is a cautionary tale for countries against following ideologically-driven policies that cause social strife, aggravate inequality, erode industrial and agricultural competitiveness and cause fiscal vulnerability.
Sri Lanka’s tourism earnings took a hit after the Easter Sunday bombings of April 21, 2019 when nine members of an Islamist group blew themselves up at three five-star hotels and three Catholic churches, taking lives of 350 people, including 36 foreigners. The bombings could have been averted because the country’s spy agency had warned of an imminent terrorist attack and even named the suspects, but the President did not share the information with the Prime Minster, as they were not on talking terms. So, the intelligence was not acted upon. The number of tourists in 2019 fell to 19 million from 23 million the year before and tourism earnings fell to $3.6 billion from $4.38 billion in 2018.
Sweeping tax cuts
Yet in November 2019, in the very first cabinet meeting after his election, President Gotabaya Rajapaksa announced sweeping tax cuts to honour his election promises and with an eye on the parliamentary elections in August 2020, when his brother Mahindra’s front won with just five seats short of two-thirds majority. Mahinda Rajapaksa was President from 2005 to 2015 and had given the Liberation Tigers of Tamil Eelam (LTTE) a crushing defeat in 2009. He is a Sinhala Buddhist hero.
The tax cuts were estimated to cost around two per cent of GDP. The tax-free allowance was raised six-fold to SLR 30 lakh. The peak personal income tax rate was cut from 24 per cent to 18 per cent. Corporate income tax rate was reduced from 28 per cent to 24 per cent. The standard rate of value added tax (VAT) was halved from 15 per cent to eight per cent. The threshold for VAT registration was raised from an annual turnover of SLR 12 million to SLR 300 million. Seven taxes including a 2 per cent nation building tax paid by businesses were abolished. Sri Lanka’s tax-to-GDP ratio fell from 11.6 per cent to 8.1 per cent, one of the lowest in the world. This was not entirely due to the cut in in rates. Economic disruption caused by pandemic-induced lockdowns and movement restrictions and suspension of inessential imports also impacted tax revenues.
There is a theory attributed to Arthur Laffer that says that if tax rates are too high, cutting them can increase tax revenue by increasing savings, fostering growth and inducing voluntary compliance. P Chidambaram as Finance Minister had tested the Laffer Curve in his 1997-98 Budget and reduced the top personal income tax rate from 40 per cent to 30 per cent, abolished corporate surcharge, cut the tax rate for domestic companies to 35 per cent and for foreign companies to 48 per cent. (Though the effect is seen with a lag, income tax collections did increase from ₹17,097 crore in 1996-97 to ₹21,430 crore in 1997-98 and ₹24, 910 crore in 1998-99).
But if tax rates are low, cutting them further might actually depress tax revenues. In Sri Lanka, income tax collections dropped 37 per cent to SLR 268 billion in 2020. VAT collections nearly halved. Excise revenue fell by a fifth. Overall tax revenues dropped 30 per cent to SLR 1,217 billion. According to the International Monetary Fund, the country’s fiscal deficit had exceeded 10 per cent of GDP in 2020 and 2021.
Yet in January 2022, the government gave wage and pension increases and made social transfers to defray the high cost of living. This is estimated to cost 1.2 per cent of GDP.
Chemical fertiliser import ban
The country scored another self-goal when it banned the import of chemical fertilisers in April last year. While making the announcement President Rajapaksa said chemical fertilisers had raised crop production, they had also contaminated lakes, canals and groundwater. Health specialists, he said, were of the opinion that this had led to an increase in non-communicable diseases like chronic kidney disease (CKD). The ban would not only save the country $400 million in annual import bills but also make the country the world’s first organic agriculture state.
A Reuters news agency report of March says the country’s agricultural production has been “decimated,” because of the fertiliser ban, which was reversed late last year after farmers protested. A farmer who got 60 bags of rice from two acres, told the news wire that he had got just 10. Agricultural production is likely to be affected also by shortages of fuel caused by a foreign exchange crisis. The fertiliser ban drove food prices up. It impacted the production and export of tea.
Though Sri Lanka’s economy is puny ($80.7 billion) compared to India’s $2.66 trillion, strong leaders with parliamentary majority can pursue bad policies. Giving a free hand to majoritarian religious extremists who dress themselves up as nationalists, can cause a pushback from radical elements among minority communities. In Sri Lanka, the Easter bombers wanted to provoke a backlash from majority Buddhists against the Muslim community so that more Muslims would be angered to join their ranks.
Ignoring science and trusting tradition for ideological reasons can affect crop production. In India the government has been harping on zero-budget, chemical-free farming despite the Indian Council of Agricultural Research proving on the basis of field experiments that it leads to a drop in productivity. There is a vocal and influential constituency among the middle classes, which includes officials in the civil services, who believe that India could have achieved self-sufficiency in food production without the Green Revolution.
Trying to promote exports by giving incentives to industrial sectors and protecting them with high tariffs can erode export competitiveness. Atmanirbharata should mean self-confidence to compete in world markets.
There is also a tendency among governments to win over voters with freebies. Giving free or subsidised rations is not such an issue. A country cannot let people go hungry or malnourished. Social safety nets are required. But providing water, electricity and fertilisers at highly subsidised rates, or buying grains indiscriminately at high floor rates is wasteful. Some state governments have started reverting to the old pension scheme, where government employees get half of the salary last drawn for the rest of their lives.
This is a ticking fiscal time bomb. India got close to a Sri Lanka type of situation in 1990. If imprudent, it can get there again.