By Hema Senanayake –

Hema Senanayake

Rajan Philips observed that the regime is fast becoming a victim of its own. This is more so in the management of economy. Minister DEW Gunesekera openly acknowledged that this was the case at present.

“DEW has warned that “the SLFP-led alliance could become a victim of its own propaganda unless tough corrective measures were taken instead of boasting of unprecedented growth in the post-war era. The country is in peril due to economic mismanagement rather than international conspiracy.” (The Island, May 11, 2013).

It has been reported that the Treasury Secretary Dr. Jayasundera took the visiting IMF delegation to meet with Minister DEW Gunesekera who is the Chairman of COPE. The minister posed an interesting question to the IMF delegation.

He had asked IMF economists to explain “why the GDP and per capita income increases were not being reflected in state income”.

According to Central Bank figures, the GDP rose by Rs. 1 trillion in 2012 … while the per capita income rose from Rs. 313,000 to Rs. 373,000. At the same time the government’s revenue has fallen to 13% of GDP. In 1978 the state revenue was 24% of GDP. According to the Minister the current revenue is barely sufficient only to pay salaries of 1.4 million public sector workers and 510,000 pensioners, and pay interest on loans and pay subsidies.

In this context, it seems, the Minister’s question is very valid. I am not sure whether the IMF economists have answered the question duly because their answer/s had not been reported.

Therefore, I thought it will be appropriate if I can provide a credible answer to the Minister’s question. This essay is to serve for that purpose.

Some people might think that the correct answer is that the Central Bank had manipulated its statistics in order to show an economic progress that was non-existent. Rajan Philips writing an article to The Island had questioned the credibility of the Central Bank. Referring to the independence that the Central Bank enjoyed under Dr. N.M. Perera in early 1970s Rajan wrote “His period in office was also remarkable for the healthy distance between the government and the Central Bank. Quite frequently, NM would question the periodical assessments of the economy by the Central Bank. NM attributed the Bank’s negative assessments to its orthodox ideology but never tried to coerce or co-opt the Bank to fall in line with the government’s political direction. The Bank was left alone and, right or wrong, it was able to maintain its independence and credibility. How things have changed.” (The Island, May 11, 2013).

Yet my reply has a different dimension. There is no correlation between government tax revenue and GDP growth. This means tax revenue may go up or may go down but that has no bearing on GDP growth. Republicans in the United States are fighting a losing battle that tax cuts spur growth. But the statistics point out that there is no such correlation and sometimes GDP had grew considerably when high income earners pay more than 60% income tax. What affects to GDP growth is the positive change in the economic system’s healthy demand for consumption. (Some economists may rush to argue here that it is not the consumption but the investments that matters to GDP growth. I reject this notion because healthy demand for consumption creates the due demand for investments. I leave this subject for another day if any reader envisages so).

I said above that there is no correlation between tax revenue and GDP growth; and also said that from empirical data this lack of correlation has been proved. But this does not explain why there is no correlation between tax revenue and GDP growth. Let me explain this point as simple as possible.

An economic system allocates certain amount of funds (money) for the use of consumption from all entrepreneurial activities. This allocation is done by the revenue generating business entities. These entities may be private owned or government owned. Most of the households get their consumable income directly from businesses. And now some of these households pay income taxes to the government. In turn the government uses that money to pay the rest of the households as wages, salaries (of government employees) and subsidies.

The government employees produce products and services for the common interests of the society but these services are not sold. For an example the government produces judiciary service which cannot be sold. Therefore judicial service is, economically “consumption” and produced by tax money which is part of the already allocated consumption money in the economic system. Therefore if taxes are increased or reduced that won’t change the total money allocated for the consumption. If taxes are increased (and properly used) then the government would produce more things for the common interest and private consumers consume less. On the flip side, if taxes are reduced then the government produces lessor amount of things for the common interest and private consumption might go up.

However, if the GDP is increased as a result of the increase of revenue generating activities then the total allocation of tax revenue must go up. If we assume that tax structure did not change and the efficiency of tax collection did not change, then if the government’s tax revenue is not increased with increase of GDP we can conclude that increase of GDP has not been resulted from the revenue generating activities of the economy. This means there should be some other reason for the increase of GDP. That reason is the government’s deficit spending or in other words the government’s spending over the budget. I will try to explain this point as simple as possible.

Let us first see how GDP is calculated. GDP = C+I+G+NE. In this simple equation “C” is consumption, “I” is Investments, “G” is government expenditure and “NE” is for net exports (Exports-imports). Accordingly any expenditure of the government except the repayment of loans and interest will represent in GDP. Government expenditure consists of (1) tax revenue and (2) deficit spending (the amount borrowed and spent).

Let us now assume that the government’s revenue is Rs. 100. In the above we have already discussed that this amount of tax revenue is consumable income already allocated by the system, hence spending of this amount will not change GDP. But if the government borrows another Rs 100 and spends then that amount is extra and will represent in the variable of “G” in GDP equation. As a result of deficit spending, now the GDP will go up by Rs.100.  But as we noticed above the government’s spending in macroeconomic terms is consumption and hence will not contribute to increase the revenue generating activities; as a result the real consumable income does not increase. Without the increase of the total consumable income allocated from the revenue generating activities of the economy, the tax revenue can’t go up but the GDP has gone up due to deficit spending.

What does this mean? This means if the increase of GDP is equal or close to the deficit spending (budget deficit) then the government revenue will not go up even if GDP is increased. I think this is the answer to Minsiter DEW Gunasekera’s question.

This is theory. Now readers are invited to compare the percentage of the GDP increase and the percentage of deficit spending for the past few years. For example in 2011 GDP growth was around 8% and the deficit spending was almost 8%. I think in 2012 GDP growth is 6.5% and the deficit spending is 6.5% (I am not sure). If both figures are equal or close then you may realize the accuracy of my answer. This is the very reason that I am not against if the government spends to facilitate revenue generating businesses than spending by it; but IMF may disagree. Convincing the IMF is partly the job of the Treasury and the Central Bank in the today’s world.