By W.A. Wijewardena  –

Dr. W.A. Wijewardena

The Tale of Two Countries

Two events hit the local and global media separately last week.

The local media event was the release of the Midyear Fiscal Position Report 2012 by the Ministry of Finance and Planning in terms of the requirements of the Fiscal Management (Responsibility) Act of 2003 (available here). The global event was the Keynote address delivered by the newly elected Prime Minister of France, Jean-Marc Ayrault, in French National Assembly outlining the policy framework and strategy of France’s new socialist government (available here).

Both events have been the response of the policy authorities to a brewing crisis in the budgetary outcomes of the two respective countries. Hence, they deserve public discussion, debate and deliberation.

Sri Lanka’s shaky budgetary outcome

Sri Lanka’s Midyear Fiscal Position Report has provided the latest data relating to the country’s government budget for the first four months of 2012. According to the data released, Sri Lanka’s budgetary performance is shaky, off-the track and demonstrative of a brewing crisis in the government’s finances.

The report has not compared the budget’s actual performance with its original budgetary targets and therefore does not provide the full picture relating to the true state of the government’s finances of the country. Instead, the report has provided a comparison with the previous year’s levels which always show an improvement in money terms, given the increase in the country’s total output measured in money terms due to inflation. This has, therefore, concealed the brewing crisis in the government’s budget from public eye.

The revenue of the government, according to the Midyear Report, has increased from Rs 285 billion in the first four months of 2011 to Rs 306 billion during the corresponding four months of 2012. This is an increase of 7 per cent and, hence, an achievement. However, when compared with a pro-rated budget of Rs 369 billion for the first four months, the revenue performance has fallen short by some 17 per cent in this period. Consequently, as a ratio of GDP, when pro-rated, it amounts to a mere 12.1 per cent in 2012. The comparative numbers in 2010 and 2011 were 14.6 per cent and 14.3 per cent respectively. This is clearly a sign of the erosion of the revenue base of the government.

Sri Lanka’s government a consumer beyond means

The government’s consumption expenditure, technically known as the recurrent expenditure, too has shown a similar pattern. Compared with the outcome in the first four months of 2011, it has increased dramatically by 24 per cent from Rs 360 billion to Rs 445 billion. But, compared with a pro-rated budget that had planned a consumption expenditure of just Rs 369 billion, there has been a marked overshooting of the government’s consumption expenditure by 21 per cent. Sri Lanka government is therefore a massive unrestrained consumer who cannot plan its consumption expenditure according to an announced expenditure plan. Economists call this ‘fiscal slippage’ and such a slippage is not a sign of good budgeting.

This has caused irreparable implications for government’s planned savings, known as the current or revenue account balance, during 2012. Sri Lanka government has been a spender on consumption more than its revenue in the last few decades and in the Budget of 2012, it had been announced that such overspending would be brought down to a minimum level of just little less than Rs 2 billion for the whole year. However, in the first four months, such overspending has been Rs 140 billion, much higher than the total overspending of Rs 75 billion made by the government in the whole of 2011. What this means is that the government has been borrowing money (or printing money or doing both) to meet its consumption expenditure and if it goes on without a restraint, the year might end up with a huge gap in its revenue account. When the government uses money in such huge volumes for consumption, it is left with no sufficient money to finance the much needed infrastructure projects unless it borrows from foreign commercial sources. But such borrowings will add to the already swelling foreign commercial borrowings by the government. In 2004, commercial and non-concessionary borrowings were just less than 5 per cent of total foreign borrowings of the country. In 2011, it had swelled to 43 per cent of the total foreign borrowings.

Arrest the brewing fiscal crisis

As it is, if the government continues to spend on consumption without restraint, the deficit in the revenue account is to shoot to well over 5 per cent of GDP in 2012. With a planned capital expenditure programme of 6.5 per cent in the year, the overall budget deficit is to shoot to above 11 per cent, again well above the planned deficit of 6.2 per cent in the Budget 2012. Or in the alternative, if Sri Lanka plans to remain within the original budget targets, it has to cut its capital expenditure drastically as it had done on previous occasions to give way for unrestrained consumption expenditure. This has adverse implications on Sri Lanka’s future economic growth prospects.

A fiscal crisis is, therefore, brewing in Sri Lanka requiring policy authorities to take adequate remedial measures without any delay. That requires the government of Sri Lanka to go for a massive ‘belt-tightening’ programme, known as ‘austerity measures’, to avoid the impending crisis.

France: The land of socialists

France had already got into a crisis situation before the new socialist government of Francois Hollande was elected to power a few weeks ago.

France’s budget deficit which stood at 7 per cent in 2010 was more than twice the EU’s 3 per cent benchmark of deficit financing set for its members. The country, by adopting an austerity programme, had managed to bring it down to 5.7 per cent in 2011. The plan of the French government, as communicated to the EU Headquarters, was to bring it down to the benchmark level by 2013. In the meantime, France’s public debt had shot up to 82 per cent of GDP in 2010 and was on its way to shoot to 90 per cent of GDP by 2013 if remedial action is not taken on a priority basis. The government had planned to bring it down to 85 per cent by 2014, again much higher than the EU benchmark of 60 per cent set for member countries. All of a sudden, the French voters rejected this austerity programme and elected a socialist government with a popular action programme to power a few weeks ago.

Jean-Marc Ayrault: ‘I reject austerity’

The new socialist Prime Minister, Jean-Marc Ayrault, admitted the brewing debt crisis but rejected austerity. Accordingly, he announced the government’s plan to expand the public sector by recruiting an additional 150000 workers mainly to police, nursing and teaching professions. Though it would be good news for French people who have among them some 10 per cent of people unemployed, it would worsen the shaky public finances of the country making it more difficult for France to meet EU benchmarks, because to meet those benchmarks, France has to cut its deficit, according to France’s Court of Auditors – a quasi-judicial body charged with conducting financial and legislative audit of public institutions – by about Euro 6-10 billion in 2012 and a further Euro 33 billion in 2013. Hence, the expansion of the government as proposed by Ayrault is not the surest way to achieve that target.

To meet the additional funding, Ayrault announced that the government would impose an income tax of 75 per cent on those who earn more than Euro 1 million per annum. It is reported that France has about 2.6 million people belonging to this category. These people will be forced to tighten their belts or embrace forced austerity. Hence, what Ayrault had meant when he said that his government would reject austerity, was the rejection of austerity by the country’s low and middle income earners. He has not rejected austerity wholly and simply shifted it from middle classes to rich people. This strategy, as presented by American economist Aaron Director, is called ‘fattening the middle class’. If France fails to attain economic prosperity by fattening the middle class at the expense of the rich people, eventually, the entire population will have to go for more stringent austerity measures.

Joseph Schumpeter: The tax state is in crisis

In this background, wisdom from a dead economist may come in handy for both Sri Lanka and France.

The Austrian economist Joseph Schumpeter, nearly a century ago, thought it necessary to give sound advice to governments that believe in their ability to deliver prosperity to citizens by expanding government services and financing the same through taxation or borrowing or by printing money. In an essay he published in 1919 under the title “The Fiscal Crisis of the State” and now republished as “The Crisis of the Tax State”, (available here) he argued against that popular belief.

Schumpeter: Demand for public services without tax obligations

Schumpeter said that tax payments made by people are like membership fees paid by members to a social club in anticipation of club services. When members desire to have more club services more membership fees have to be collected from them. But members have a natural limitation to pay more membership fees and as a result the club sooner or later comes to its own limit of supplying club services. Likewise, tax payers too demand more and more public services without accepting the obligation to pay more taxes. The state which expands its services to meet the demands of the tax payers will soon exhaust its capacity to produce more public services out of tax revenue and will have to resort to borrowing or printing of money or both. Thus, running budget deficits eternally by borrowing and inflating the economy through money printing would not augur well for the tax state. The reasons as one can see from the current experiences are obvious: The continuous borrowing will lead to an accumulation of public debt to an unaffordable level and it will drive the tax state to the mercy and tyranny of its creditors who would start demanding their “pounds of flesh” by way of calling for drastic and speedy expenditure cuts better known as “austerity measures”. Inflation will reduce the private wealth in real terms and shrink the tax base so that the tax state can no longer afford to provide those public services. So, according to Schumpeter, the powerful tax state which is engaged in meeting the ever increasing demands for public services without a corresponding undertaking by tax payers to pay higher taxes “can collapse”.

This is a powerful message which Schumpeter delivered to European nations when they were trying their best to come out of economic collapse caused by the World War I. It is specifically important because he did so as war ravaged Austria’s Finance Minister with responsibility to bring about the fastest recovery to that country.

Stimulate for long and get into trouble

Despite this sound advice by an economist of yesteryear, many nations have got into the habit of expanding their governments which Schumpeter called “tax states” by taxing people and when tax incomes were not sufficient, by borrowing and printing money. The theoretical justification for this practice was provided by the British economist John Maynard Keynes some 75 years ago when he published his main treatise on economics “The General Theory of Employment, Interest and Money”. He argued that when an economy is in deep recession due to people’s inability to buy all what it produces, the government can fill the gap by increasing government purchases by running budget deficits. Since deficit financing by governments conveyed a derisive connotation, they are now called ‘economic stimulus measures’ that aim at stimulating an otherwise stagnant economy and delivering prosperity to citizens. When governments got into trouble by over-embracing economic stimulus measures beyond their capacity, the solution suggested was to go for the opposite, namely, cutting the unnecessary government expenditure and allowing the economy to rebuild itself on a new foundation that is free from a wasteful government. They were called “austerity measures” and were supported specifically by international creditors.

The opponents to ‘belt-tightening’

An austerity measure means ‘tightening of belts’ voluntarily so that people would cut their welfare levels drastically for the sake of a nation’s future sustainability. However, like paying taxes, everybody wants his neighbour to tighten belts and not himself. Thus, austerity measures have been met with mass public protests which many national governments have not been able to successfully win over. Hence, nation states have chosen the easier path of continuing with stimulating their economies with ever-increasing government sectors. They have been morally encouraged by claims made by some leading economists – two Nobel laureates, namely, Joseph Stiglitz and Paul Krugman, and a third, a potential future Nobel laureate, Ha-Joon Chang of Cambridge University. These economists have been arguing throughout that austerity measures are inadvisable and do not work; on the contrary, it is the stimulus packages, they argue, that would take economies out of their current problems.

Thus, even the opinion of the economics profession is divided over which strategy would work and which strategy would not.

Stimulus packages need a supporting resource base

But, examples are a plenty about countries that have got into trouble because of the pursuance of stimulus packages for long without a supporting resource base developed in the private sector. There has been temporary economic growth in many countries as a result of governments’ stimulating the respective economies through expanded budgets immediately after the introduction of such packages. But, such growth could not have been sustained for long by them because the governments’ interventions have not been successful in getting the private sectors to produce wealth on a permanent basis. If the private sector does not produce wealth, the government does not have a wealth base to tap. Alternatively, one may argue that the government may have its own enterprises to create wealth in the society. But, experience in Sri Lanka and elsewhere has shown that governments are not good entrepreneurs and if they are to become such a lot, they have to emulate the private sector business enterprises.

Sri Lanka’s hard choice: ‘Tighten belts or perish’

Sri Lanka’s key public enterprises have become massive loss makers thereby bringing additional stress to the government’s budget. The Annual Report of the Ministry of Finance and Planning for 2011 had identified a set of prescriptions for making them efficient, effective and profitable, but all of them are short of the requirement because the reform programme is to be completed within the government’s ownership. Unnecessary political interference in the pricing of products in key enterprises like Ceylon electricity Board has made them eternal loss makers causing their invested capital to become negative. In the case of a private business, it is a state where the business would be closed because it is not considered a going concern in terms of the country’s Companies Act. But, in the case of a public enterprise, the government will have to make good their losses by transferring funds from the budget for their continued upkeep in the system. Thus, losses prosper, while the wealth of the nation shrinks.

The brewing crisis of Sri Lanka’s tax state indicates that it cannot go on offering stimulus packages to bring prosperity to the nation. The country has now been driven to a hard choice: austerity for future prosperity or stimulus for economic bankruptcy in the long run.

Sooner the country makes this choice, better for the future of the nation.

(Writer is a former Deputy Governor – Central Bank of Sri Lanka and teaches Development Economics at the University of Sri Jayewardenepura. This article first appeared in Daily FT  – W.A. Wijewardena can be reached at waw1949@gmail.com )