The sharp increases in revenue envisaged for 2016 seems to be a bit incredible but there is a very high capital spending component, which also seems to be a historical high given the lack of Chinese finance. The current administration has some ambitious revenue targets, with significant non-tax revenues also built in. If stock in several state-owned enterprises are sold, some revenue may come in.

The budget also sharply cut corporate income tax to 15 percent from 28 percent for mainly manufacturing companies, which is a big gamble to try and get more direct tax revenue. Whether it works and increases compliance, remains to be seen. If the proposals do not bring significant revenue, money printing and currency depreciation will continue and there may be labour unrest as hardships from the
currency depreciation kicks in. There may well be a political backlash.

In the 1980s, the benefits of economic liberalization failed to reach the masses, mainly because massive currency depreciation and inflation.

Proportionate Taxes
● The personal income tax threshold has also been lifted to Rs200,000 a month, with no exemptions. In following a proportionate tax of 15 percent, people with higher income will pay a higher volume of tax based on their income. There is an element of progressive taxation with the income of up to 200,000 exempted, but by and large, ordinary people are now treated the same as big companies with a single rate of tax. This is not a flat tax. A flat tax is a fee, such as those followed in the Middle East.

[pullquote]The proposal to put all new public servants in a contributory pension scheme will also reduce the burden on the people and end the current practice of members of the elected ruling class putting family members as personal staff to qualify for pensions[/pullquote]

Lower income taxes are critical to generating resources for investment. Unlike indirect taxes, which tax revenues, income tax takes saved investible capital, which are then busted for recurrent spending by the state. Income tax was only invented in the latter stages of the 19th century as better accounting records made it possible for firms to do it.

Having said that, however, the threshold of Rs200,000 for Sri Lanka takes many people out of pay as you earn tax. Even paying a small tax is good as responsible citizens learn about the weight of government and learn to pay.

Almost all state workers would now also be exempt from PAYE tax.

Equal Treatment
● The budget proposed to end tax-free cars to the ruling class and state workers. This is a significant move towards tax justice. The legislators who came to Parliament with people’s votes have shamelessly got themselves tax-free cars while state workers who collect the taxes have got themselves tax-slashed cars, while taxing the rest of the population mercilessly.

The proposal to put all new public servants in a contributory pension scheme will also reduce the burden on the people and end the current practice of members of the elected ruling class putting family members as personal staff to qualify for pensions.

There has also been some liberalization of building materials where monopolies have been built, which can help the homeless who are trying to build a house. With wholesale and retail trade out of VAT the unjust treatment of private firms and the Lak Sathosa chain and the VAT it was able to arbitrage has ended.

The government has taken significant political risk in proposing a contributed pension fund for state workers. That will also end the lifetime pensions for state workers and take out perhaps the equivalent of 25 percent of GDP contingent liability out of the shoulders of tax payers.

Banking Liabilities
● There are also a lot of interventions. In Sri Lanka it is not possible to do a budget without some interventions since everyone in Colombo seems to expect it. There seem to be a lot of interventions in the financial sector with the banning of leasing for banks and withdrawal taxes.The taxes may hurt the small and medium sector or make people withdraw less than a million rupees.

The credit guarantee for finance companies also came out of the blue. Credit guarantees create a ‘moral hazard’ promoting even more risk taking. This comes even as a deposit insurance fund is being created. The blanket guarantee for finance company deposits from the Central Bank seems to be a big contingent liability on the agency. It goes counter to reducing the burdens on the people, by reducing the pension liability.
It has been pointed out that the Central Bank has only 82 billion rupees in assets and it is not in a position to shoulder this burden. Finance Company liabilities are said to total over 400 billion rupees. The central bank is already on shaky grounds due to forex forward guarantees and a 1.1 billion US dollar swap it owes the Reserve Bank of India.

A credit guarantee to a deposit taking institution should be borne by the Treasury – not the Central Bank, even temporarily. In Western countries even governments are now unwilling to take on this risk and want to place a special tax on banks to recover this money.

Central bank Independence
● How the Central Bank came to shoulder this burden is a mystery. It also raises questions over the independence of the Central Bank. Was the Central Bank unable to say no? Or did it actually invite this? Either way it does not look very good. Already there are questions over the way an illegal finance company was bailed out by nonexistent profits of the Central Bank. It is one thing for the Central Bank to advise the Treasury to be fiscally prudent. It is also one thing for the Treasury or Finance Minister to advice the Central Bank to be prudent.

When people talk of fiscal dominance of monetary policy or losing central bank independence to the Treasury, the assumption is always made that the Central Bank wants to be prudent but the Treasury does not allow it. In Singapore the Monetary Authority has been under a Finance Minister who does not want to print money. Sri Lanka’s central bank is fundamentally flawed.

Financial Centre
● To talk of building a financial centre in Sri Lanka with a soft-pegged currency with a central bank that is prone to printing money is dangerous. “Encouraging the private sector to establish financial institutions that offer offshore services could generate skilled employment opportunities and support increased economic activity,” the budget speech said. “In parallel, a conducive legal infrastructure to facilitate operations of a global commercial centre should be developed in order to promote financial flows.”

[pullquote]Talk of he Exchange Management Law also shows that Sri Lanka lacks knowledge about monetary policy/ Is we have a reformed central bank in the lines of Hong Kong (best case) or Singapore (where more sophisticated discretion is needed(, or at leave Dubai with much less discretion, we can abolish all exchange controls[/pullquote]

While foreign money can come in if interest rates are high, a situation like in Iceland can develop where massive liabilities and bubbles develop. The major financial centres in the region, such as Singapore, Hong Kong, Dubai and Tokyo do not have a soft-pegged arrangement. Tokyo has a full or independently floating currency where the interest rate is controlled by the Bank of Japan and the currency floats. The Hong Kong Monetary Authority is an orthodox currency board, where the exchange rate is fixed to the US dollar permanently and the interest rate free floats. Singapore Monetary Authority is a modified currency board, which has a floating interest rate for all intents and purposes where the exchange rate is controlled. The Central Bank of the UAE acts almost like a currency board. It has a perfectly well functioning fixed exchange rate. It cuts and raises policy rate with the Fed. In effect it is a currency-board-like system.

Talk of the Exchange Management Law also shows that Sri Lanka lacks knowledge about monetary policy. If we have a reformed central bank in the lines of Honk Kong (best case), or Singapore (where more sophisticated discretion is needed) or at least Dubai with much less discretion we can abolish all exchange controls.

The constant uni-directional depreciation and high inflation, poverty and political instability we see will not be present if we reform the Central Bank. The bubbles fired by banks that have borrowed from abroad will be much worse as Iceland showed.