Friday, June 01, 2012

Is it all Greek to you? A simplified guide to the state of public finances

This is something that I wrote in May 2010 for an internal newsletter. There was an election coming around the corner and I felt that people should understand some of the fundamental problems that a Government should address. It is now more relevant than ever, especially since the problems are now apparent. I have been meaning to update the figures but have been too busy at work.

The Government continues to spend merrily, but the budget deficit is a lot better than it was in 2009, the reason being that taxation has increased, so that Government revenue has increased. Are citizens getting good value, in terms of services, for the vast sums expended? It is up to each individual to decide this question, but ask yourself if:

a) Would you send your children to free state schools and universities, if you had the means to send them to private universities here and abroad?
b)  When was the last time you used the free health services provided in state hospitals? How satisfied were you? 
c) Would you turn to the courts and law enforcement authorities, confident that you would receive justice if you had a dispute with the CEB, the CPC, a bank, your landlord or a debtor? Where do you turn to, if you have a dispute with a minister, over a simple matter of property?  

The press has highlighted a financial crisis that is taking place in Greece. In a nutshell, what happened was that the Greek government had borrowed too much money and seemed unable to repay. Investors who had lent money to Greece (by buying Greek treasury bills, bonds etc) panicked and it seemed that the Greek government would have difficulty in raising money. This would have meant that Greece, which needed to borrow money to pay expenses would not have been able to pay its workers or run its public services.

It has not yet come to this because the European Central Bank and other European Governments look likely to work out a package to save Greece.

The Government of Sri Lanka has published a pre-election budgetary position report on the 2nd of March 2010, which shows a weakening position.

The figures for Sri Lanka (in summary) are as follows

(The figures published are provisional. Chart from LBO).

Government revenue in 2009 is Rs.702bn (please refer column 4 headed “2009prov”) but expenditure is 884bn. The Government is spending Rs.182bn more than it earns – something that should be impossible, but happens anyway.

Anyone earning a fixed salary will wonder how it is possible to spend more than one earns. The answer is simple: by borrowing money. Of course, this means that while we can spend and enjoy today, we must repay tomorrow – with interest added to the bill.

As everyone knows, the Government’s revenue is made up mostly of taxes; VAT, income tax, Nation Building Tax, import duties etc but what does the Government do with all this money that we end up with a deficit?

The main items of expenditure in 2009 (in order of importance) are:

Interest                                     Rs.308bn
Salaries & pensions     Rs.268bn
Subsidies                                  Rs.194bn
Other goods/services            Rs.113bn.

Note that the single largest item of expense is interest. That is because the Government has for many years been running a deficit and borrowing to meet the difference so the interest cost has risen every year, until it is now the largest single item of expense. Given that the revenue deficit is RS.182bn and interest payments are Rs.308bn, the country is, in effect, taking new loans in order to pay the interest on the old loans.

Why is it that we have a deficit when taxes go up every year?  (Government tax revenue rose from Rs.509bn in 2007 to Rs.585bn in 2008 to Rs.619bn in 2009). The problem is the expenses have been rising faster than taxes. The increases in expenses between 2008 and 2009 are shown below:

Interest costs rose by                          Rs.95.8bn
Salaries/pensions rose by                 Rs.29bn
Subsidies rose by                                 Rs.24bn
Other goods/services declined by   (Rs.7bn)

The fastest increase in spending is on interest. There are two reasons for this. One is that the amount of debt has increased. The other is that the rate of interest paid on the loans has also gone up, partly because of tighter monetary control and partly because the country is now borrowing mostly in the open market rather than obtaining concessionary loans from donor agencies like the World Bank.

There is obviously a limit to which anyone can borrow and spend, so either income (in the form of taxes) needs to rise or expenditure needs to be cut for finances to reach a sustainable state.

Controlling the deficit early is essential: every time the government borrows to spend, the deficit has the potential to expand because of the added interest cost. If the cycle of ‘borrow and spend’ is continued things can go out of control very quickly.

This is why the deficit is important and why the IMF has set certain targets for the deficit. This is what got Greece into trouble.

Sri Lanka’s overall budget deficit is 10.3% of GDP. Last year Greece’s budget deficit reached 12.7% of GDP. Greece’s total debt as a % of GDP reached 94.6% of GDP. Sri Lanka’s total debt was around 82.9% of GDP. Things are a little too close for comfort when compared to Greece.

In the middle of last year the IMF warned that Sri Lanka’s debt, which has almost doubled from the year 2000, was in a very unhealthy state. Not only has the debt grown, its composition has changed. There has been a shift from lower cost external concessional borrowing to higher cost domestic and nonconcessional external borrowing. In addition to increasing the cost of the portfolio, the non-concessional borrowings have been of shorter maturities than concessional funds.

The country has been borrowing more, borrowing at higher interest rates and borrowing for shorter term periods, meaning that loans become repayable more quickly and can thus cause cashflow problems.

Clearly there is a serious problem. What can be done? It is not easy, but for the deficit to fall either Government revenue must increase (higher taxes) or expenditure must fall.

No one would like to pay higher import duties, VAT or other taxes but if waste were eliminated, expenditure would fall, even if nothing else changes. This alone may not be enough, but it would be a start and then other means for reducing expenses can be found.

It is better to face the problem early rather than let it go on until it blows out of control, like in Greece.

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