Courtesy Ceylon Today

As the Central Bank of Sri Lanka (CBSL) Law, gets established and the Bank’s practices evolve, a further strengthening of the legislation could be considered to safeguard the CBSL’s independence. In my view, three features of the law could be re-examined in that context, the last of which is the most important:

(i) First, we need to reconsider the description of the powers, duties, and functions of the Central Bank. Article 7 (j) states the CBSL will [quote] act as financial advisor and banker to the government” while Article 7 (k) states it will act as fiscal agent of the Government”.  Given the context in Sri Lanka where the government has relied on the Central Bank for expertise, the reference to financial adviser” is understandable, but not desirable. To safeguard more securely the CBSL’s independence, there needs to be a sharper line between its activities and the activities of the government. Also, given Sri Lanka’s history of money-financed deficits, it is best to avoid describing the CBSL as a Banker to the Government”. In common understanding, a banker” gives credit and liquidity to its clients. However, the main point of the CBSL Law is to ensure that the CBSL does neither! In my view therefore, Article 7 (j) should be eliminated altogether, and Article 7(k) amended to describe the CBSL as a fiscal agent and depository” of the government, so that it can carry out normal central banking functions, such as holding government deposits and effecting payments through government accounts held at the Bank. Eliminating this reference would also help people understand that the primary function of the Central Bank is to serve the public by protecting the value of the currency —that is the amount of goods and services they can buy with their money — which is what price stability achieves. Let me make clear that protecting the value of the currency shouldn’t be misunderstood to mean keeping the nominal exchange rate constant. A flexible exchange rate is essential to absorb shocks to the economy and facilitate adjustment of relative prices — the so-called real exchange rate. The focus of the Central Bank needs to be on the price level as a whole, not just the traded component of it.

(ii) A second strengthening given Sri Lanka’s history is to consider ring-fencing even more tightly the requirement imposed by the Supreme Court that the government should have access to direct Central Bank financing in emergency circumstances. The Central Bank’s job, including in emergency situations, is to provide liquidity to the market as a whole, not to the government in particular. For instance, the US Federal Reserve intervened in financial markets during the ‘September 11’ terrorist attacks in 2001, the Global Financial Crisis in 2008 and when the Covid-19 pandemic hit in early 2020. If the government has an emergency financing need it can and should issue short-term Treasury Bills in the market. If the market is short of liquidity, the Central Bank can provide liquidity to the market through various means such as Reverse Repo Operations with the banking system and/or the Liquidity Support Facility to stabilise financial conditions. This is different from providing direct financing to the government.

(iii) Third, and most importantly, the size of the Monetary Policy Board should be reduced, in my view, to five or seven members and not include members of the Governing Board. Let me hasten to add that this has nothing to do with the current members of these Boards, all of whom are enormously qualified and distinguished. My point is about the structure of the decision-making bodies from a good governance point of view.  Why do I say this? First, the conduct of monetary policy should be seen as a mainly technical function carried out by people with specific expertise in economics and finance. With the exception of the Governor, having the same membership across the two Boards mixes this very specific function with oversight functions, which belong to the Governing Board and require a broader range of expertise including banking, legal, accounting and audit, and risk management. Second, it is important to isolate the monetary policy decision, which affects the entire country, from the governance function which is specific to the Central Bank. To give an example, monetary policy decisions should not be influenced — or even appear to be influenced — by how they might impact the Balance Sheet or Profitability of the Central Bank, which comes under the purview of the Governing Board. Third, a large monetary policy-making body dilutes the transparency and accountability that is critical for an effective inflation-targeting regime. It is difficult, in my view, to
hold a group as large as eleven people accountable for a policy decision.
A five-member Board headed by the Governor and comprising two Deputy Governors and two independent experts from outside the Central Bank would be more nimble and cohesive. Finally, and most critically, it is highly unusual for the externally appointed members of a monetary policymaking body to outnumber members of the Central Bank staff. In fact, I couldn’t find a single example of such a structure in a major central bank. This feature potentially opens the CBSL to political interference. A more common structure where the number of Central Bank staff is matched by outside members allows the Governor to cast the deciding vote if there is an even split between insiders and outsiders on a monetary policy decision. It thus places a greater degree of accountability on the Governor when reporting to the Parliament and the Public. The current structure of the Monetary Policy Board where, other than the Governor, there are two Central Bank staff members and as many as eight outside members is in my view problematic given that policy decisions are taken by a majority vote. A future government could exert political influence over monetary policy decisions by swamping the Board with political appointees. This, in my view, seriously threatens the independence of the CBSL and needs to be rectified.

Let me now turn to Good Governance to meet the second policy objective that I said I would address — namely, achieving Fiscal Sustainability.

Prof. Lawrence Summers of Harvard University likes to say that IMF stands for It’s Mostly Fiscal.” That could certainly be said of Sri Lanka. The source of almost all of our economic problems is our collective inability to impose fiscal discipline and adequate standards of governance on both the central government and the larger public sector. Our successful Asian neighbours who have had IMF-supported programmes — India, Korea, Thailand, and Malaysia — have avoided resorting repeatedly to the IMF. We, on the other hand, have gone 17 times to the world’s lender of last resort. They say cats have nine lives, Sri Lanka seems to have at least 17!

The bottom line is that we need to stop relying on the lender of last resort. We are like a diabetic patient who refuses to give up their sugar-laden diet and repeatedly ends up in the emergency room. And then some people even blame the emergency room doctor, the IMF, for the severity of the treatment needed to save us. Having achieved some semblance of macro stability, the biggest danger now is that we will do what we have often done in the
past — that is, as soon as some stabilisation is achieved, abandon or drag our feet on the serious restructuring needed to address the underlying fiscal and governance problems. Many of the reforms promised under the current programme are similar to what we have promised before but never consistently implemented. We need to change our diet by strengthening governance to achieve fiscal sustainability — not because the IMF or external creditors require it, but because if we don’t, we will be in crisis again.

To achieve Fiscal Sustainability, we need Better Taxation

Adam Smith in his treatise on the Wealth of Nations wrote that tax policy should adhere to four principles: fairness, certainty, convenience, and efficiency
— principles that are consistent with the principles of good governance. The Organisation for Economic Co-operation and Development (OECD) has established similar criteria, with the added criterion of neutrality — meaning a tax system should raise revenue without distorting incentives vis-à-vis any particular economic activity or choice. Although Sri Lanka’s tax regime was improved by the 2022 tax reforms, it is fair to say that it still violates all five of these principles. Let me provide three examples to illustrate the point:

(i) First example, Sri Lanka relies excessively on indirect taxes rather than direct taxes and on taxing labour rather than capital. Both aspects violate the principle of fairness as indirect taxes shift the tax burden towards the poor who spend more of their income on goods and services, while capital income accrues mainly to the rich. In 2021, Sri Lanka collected 77 per cent of its taxes through indirect taxes such as VAT, excise, and trade taxes, which is notably more than the regional average of 66 per cent and the global average of 53 per cent. The recent increases in personal and corporate taxes, which are direct taxes, are a step in the right direction, but indirect taxes still account for 11 per cent of pre-tax income for households in the bottom income
decile — more than the 8 per cent share for households in the top decile. Personal tax collections rely on the PAYE system which ensures many professionals pay taxes, but most income from business profits remains outside the tax net because IRD has only a very small number of personal tax files. Capital income from capital gains, interest, and dividends is subject to lower flat tax rates, instead of progressive rates. And capital gains on property other than stocks are taxed at a very low rate of 10 per cent.

(ii) Second example, Corporations have for decades enjoyed extensive tax holidays, which violate all five principles of good taxation. Commendably, with the tax reform of October 2022, most companies are now subject to a standard 30 per cent corporate tax rate. However, projects continue to receive wide-ranging tax exemptions under the Strategic Development Projects Act. Under this Act, based on vague criteria, projects can negotiate exemptions from eight different tax laws, including corporate, personal, VAT, excise, and customs for as long as 25 years. The 17 beneficiary projects so far enjoy corporate income tax exemptions for 10 to 25 years, typically followed by time-bound reduced rates and exemptions from many other taxes and fees. Moreover, tax concessions can be granted to companies operating in three zones — Colombo Port City, a pharmaceutical manufacturing zone, and a textile manufacturing zone. The Port City Act allows exemptions from 13 different tax acts, covering casinos, the betting and gaming levy, and practically all other taxes, for up to 40 years without the approval of parliament, which raises the question of the constitutionality of these exemptions.

Such extensive tax holidays cannot be justified. Let’s be perfectly clear that tax exemptions are the equivalent of a cash payment from the government to special interests. It’s as if the corporation paid the standard tax and the government gave an equivalent amount to the corporation instead of spending it on social needs or repaying public debt. Tax exemptions mainly benefit the shareholders of corporations who I would guess are not merely rich, but super rich. So in Sri Lanka, we have welfare for the rich and the super-rich that far outweighs the small amounts the government transfers to the poor through programs like Aswesuma. Although tax concessions are often claimed to be necessary to encourage investment, particularly foreign direct investment, there is plenty of survey evidence to show that foreign companies do not choose their location based mainly on tax considerations. Factors that truly matter include a stable macroeconomic environment, reliable electricity and physical infrastructure, the rule of law, an efficient dispute resolution system, secure access to land, and a high-quality labour force. As the IMF’s GDA points out, tax exemptions also create opportunities for corruption — after all, someone has to grant them and the selection criteria, amounts, and beneficiaries are not transparent.

(iii) A third example of poor governance in taxation is the reliance on Gazette Notifications for implementing major policy changes. This makes the tax system uncertain and increases opportunities for corruption. In principle, the primary tax laws that Parliament enacts should contain all the necessary provisions to ensure taxes can be calculated and collected fairly and efficiently. All subsidiary instruments, such as Ordinances, Gazette Notifications and other regulations, should merely provide technical details to ensure the effective administration of the law. In Sri Lanka, however, tax rates, the scope of existing taxes, and the granting of tax concessions can be implemented through Gazette Notifications. Take, for instance, the Special Commodity Levy. A Minister can change this levy arbitrarily with immediate effect without parliamentary approval — which one would think is a violation of the Constitution which vests the power of taxation exclusively with the Parliament. Customs duties can also be changed without parliamentary approval. Such arbitrary changes in the Special Commodity Levy and import duties — not to mention quantitative restrictions on imports — not only create uncertainty but also opportunities for corruption, for instance through temporary reductions that create rents for connected individuals.

(To be continued)