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Cablegate: Sri Lanka: 2008 Budget Would Boost Defense and Transfers to Rajapaksa Constituents

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RR RUEHBI RUEHLMC
DE RUEHLM #1661/01 3471055
ZNR UUUUU ZZH
R 131055Z DEC 07
FM AMEMBASSY COLOMBO
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RUEHNE/AMEMBASSY NEW DELHI 1641
RUEHKA/AMEMBASSY DHAKA 0587
RUEHIL/AMEMBASSY ISLAMABAD 7574
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RUEHCG/AMCONSUL CHENNAI 8175
RUEHBI/AMCONSUL MUMBAI 5750
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E.O. 12958: DECL: N/A
TAGS: ECON EFIN KMCA PGOV CE
SUBJECT: SRI LANKA: 2008 BUDGET WOULD BOOST DEFENSE AND TRANSFERS TO RAJAPAKSA CONSTITUENTS

REF: A. COLOMBO 1562
B. COLOMBO 1464

1. (SBU) Summary and comment: The Rajapaksa government could survive
or fall depending on the outcome of a December 14 final vote on its
2008 budget. The proposed budget continues the president's emphasis
on high taxes to fund big government and transfers to his primary
constituents: civil servants, farmers, unemployed college graduates,
and poor people. The government claims that revenues will keep pace
with expenditures, but this is no more likely for the 2008 budget
than it was for the 2006 and 2007 budgets, whose deficit spending
spurred inflation. The budget significantly raises defense spending
and substantially increases allocations to ministries that the
president and his brothers control. We share the view of many civil
society critics that this budget illustrates the Rajapaksa
government's short-sighted, politically driven, and often
non-transparent management of the Sri Lankan economy. From what
this budget indicates, we doubt the government can contain inflation
or realize the 7.5 percent growth it predicts for 2008. End summary
and comment.

THIRD "MAHINDA CHINTANA" BUDGET PROMOTES BIG GOVERNMENT
-------------------------- ----------------------------

2. (SBU) President Mahinda Rajapaksa presented to Parliament on
November 7 his government's proposed budget for 2008. Sri Lanka's
fiscal year follows the calendar year; its budget process involves a
series of three "readings" of the budget in parliament between
October through December. The budget narrowly passed on the
November 19 second reading (ref A); the final reading is scheduled
for December 14. Defeat of the budget could result in the collapse
of Rajapaksa' Sri Lanka Freedom Party-led coalition, so the vote
will be purely a political contest, not a reflection of views on the
budget.

3. (SBU) Rajapaksa told Parliament that he had emphasized four
priorities in formulating the 2008 budget: national security,
infrastructure development, relief to low income groups, and
"reawakening" local entrepreneurs and industry. National security
-- in the form of stepped up military efforts to eliminate or
contain the LTTE -- has been the dominant theme of the Rajapaksa
government. The other three priorities are central to the
Rajapaksa's "Mahinda Chintana" populist emphasis on big government
and transfers to favored constituencies. The government rightly
believes that channeling investment into infrastructure will unlock
growth potential. Its poverty relief programs are both
well-intentioned and politically motivated. Many of its
"reawakening" efforts involve subsidies and protection that are
unlikely to stimulate productive enterprises, but again, are
politically popular.

THE BIG PICTURE: SEEKING TO CONTAIN DEFICIT
-------------------------------------------

4. (SBU) The 2008 budget forecasts large increases in both
expenditure and revenue, but expenditure continues to far exceed
revenue (see Fiscal Data table below). In comparison with the 2007
budget, total government spending will rise 21 percent to 1,044
billion rupees (Rs), and revenue will rise 24 percent to Rs 751
billion, resulting in a deficit of Rs 293 billion. The government
cites this projected deficit as equal to 7.0 percent of GDP, which
would be an improvement compared with recent deficits of 8-9 percent
of GDP, but this relies on the government's optimistic estimate of
7.5 percent GDP growth in 2008. Using the IMF's projected 2008 GDP
growth of 6 percent, the projected deficit would amount to 7.7
percent of GDP.

5. (SBU) More than two-thirds of the budget goes to recurrent
expenditure -- interest payments, salaries, pensions, subsidies, and
welfare payments. The remaining third would be for Rs 335 billion
in capital investment, but inevitable revenue shortfalls will likely
cause this amount to decrease. (Note: About nine months into each
budget year, when the government finds that it has not generated as
much revenue as it projected, the Finance Ministry instructs

COLOMBO 00001661 002 OF 007


ministries to defer all remaining capital spending, in order to
contain the deficit. For example, late in 2007, the government said
actual capital spending would be 23 percent below the budgeted
amount. The only exception to this restraint on capital spending
was in the Ministry of Defense, whose capital spending actually
increased by 11 percent.)

6. (U) FISCAL DATA, 2007-2008: Comparison between the proposed 2007
budget, the revised 2007 budget released in September 2007, and the
proposed 2008 budget. Figures in parentheses represent the
percentage of GDP. Sources: Central Bank and the 2008 Budget
speech.

---- --------------------------------------------- -----
Year 2007 2007 2008
revised
---- --------------------------------------------- -----
Billions of rupees

Total Expenditure 898 (28) 862 (24) 1044 (24)
-current 596 630 713
-capital 303 233 335
-other - -2 -4

Total Revenue 600 (19) 605 (17) 751 (18)

Budget Deficit 297 (9.2) 257 (7.2) 293 (7.0)
---- --------------------------------------------- -----

DEFENSE: INCREASES TO "SUPPORT INVESTMENT CLIMATE"
--------------------------------------------- -----

7. (SBU) Finance Secretary P.B. Jayasundera told Colombo business
people in November that high expenditure on national security is
essential to create a stable investment climate, and therefore that
the government "need not be shy about defense spending" as it had
been in the past. For this reason, he said, the government had not
tried to hide defense spending within the budget as previous
governments had.

8. (SBU) Defense, budgeted at Rs 166 billion ($1.4 billion), is the
second largest expenditure area after interest payments. It would
account for nearly 16 percent of total 2008 spending -- equivalent
to about 4 percent of GDP (or 4.3 percent with more realistic GDP
growth figures). The planned increase in 2008 represents a jump of
19 percent over the 2007 budgeted figure. Actual 2007 defense
expenditure swelled 49 percent to Rs 156 billion from Rs 105 billion
in 2006 -- an increase in real terms of about 32 percent given
inflation averaging about 17 percent. The 2008 figure is also
likely to come in higher than budgeted, though possibly not as
drastically as the 2007 amount grew. At the proposed 2008 level,
the Rajapaksa government will have increased spending on defense
from about $50 per capita to about $74 between 2006 and 2008.

--------------------------------------------- --------
2006 2007 2007 2008
est. rev. est.
--------------------------------------------- --------
Defense (Rs billion) 104.8 139.6 155.7 166.4
($ billion) 1.0 1.3 1.4 1.4

As percent
of GDP 3.6% 4.3% 4.4% 4.0%
of govt expenditure 14.7% 15.5% 18.2% 15.9%
--------------------------------------------- --------
Source: Budget estimates 2008

EDUCATION AND HEALTH: UNIVERSAL BUT MEDIOCRE
--------------------------------------------

9. (SBU) Sri Lanka continues to provide free universal education and
health care. In the budget address, the President said that in
allocating funds for education, the government aimed to improve

COLOMBO 00001661 003 OF 007


teacher training and to upgrade university facilities to increase
annual student intake to 20,000 from 16,635 now. He reported that
the government would increase funding for free text books,
scholarships, school uniforms, midday meals, and school bus
services. The President likewise promised to increase health sector
funding to improve hospitals, procure medicines, and provide living
quarters for doctors.

10. (SBU) The Rajapaksa government has increased per capita spending
on education and health from $66 to $78 between 2006 and 2008. (By
comparison, it has taken defense spending from about $50 to about
$70 per capita during the same period.) Even at these levels, the
systems are providing broad, but mediocre services. For example, in
education, only 49 percent of tenth grade students pass their final
"O-level" exam. And only 14 percent of twelfth grade students who
pass the "A-level" exam can actually enter university, due to
insufficient capacity in the public system. To avoid such outcomes,
a recent Asian Development Bank report found, many families are
spending more on private tuition. Similarly, to avoid delays and
poor care, many Sri Lankans turn to private health providers if they
can afford to do so.

INFRASTRUCTURE AND EASTERN PROVINCE INVESTMENT INCENTIVES
------------------------ --------------------------------

11. (SBU) The Rajapaksa government seeks to boost investment in
infrastructure in order to "unlock" economic development potential,
especially in the less developed parts of the country outside of the
capital. It has focused on particular on projects in the
president's home district of Hambantota, where it seeks to create a
bulk goods port, a small international airport, and a rail/road link
to the capital. The government also envisions continued investment
in irrigation systems that would expand cultivable land in dry parts
of the country -- mostly in the south, which is also the heart of
Rajapaksa's voter base. The government has sought to direct aid
from bilateral and multilateral donors into these projects, and says
that it will finance whatever donors will not. In the budget
speech, the president highlighted the Hambantota and irrigation
projects. However, as noted above, lower than predicted revenues
are likely to force the government to curtail it planned capital
spending, so these projects are likely to remain dependent on donor
or investor interest.

12. (SBU) The President also stated that the government would
dedicate capital funds to develop the Eastern Province, over which
it regained control from the ethnic separatist Liberation Tigers of
Tamil Eelam in mid-2007. Of the Rs 335 billion the government
budgeted for capital investment, 8 billion are specifically
designated for the east. The budget also offered incentives for
private development in the Eastern Province, including a five-year
tax holiday for any investment over Rs 50 million which generates 50
or more jobs.

MORE SPENDING ON FAVORED CONSTITUENTS...
----------------------------------------

13. (SBU) The 2008 budget includes heavy government spending to
provide relief to low income groups, continue to expand the civil
service as a source of employment, and support farmers and
fishermen. The budget also promises a range of subsidies,
incentives, and protections to support certain domestic industry
sectors.

14. (SBU) The poor would receive significant new support in the 2008
budget. The 1.8 million recipients of the government's "Samurdhi"
welfare program will get an additional kerosene subsidy of Rs 100
per month in 2008 as part of a 10 percent increase in the overall
Samurdhi budget in 2008. The government also said it would continue
welfare programs that would provide nutritional food to expectant
mothers and free breakfasts to low income school children. Finally,
the government plans various programs to deliver essential
foodstuffs to poor people: revival of a previously failed network of
government-run "wholesale" food outlets; expansion of existing

COLOMBO 00001661 004 OF 007


wholesale food cooperatives; and creation of a state-owned trading
company to import and distribute food to these wholesale and
cooperative stores.

15. (SBU) Public servants will consume 34 percent of expected 2008
tax revenue. (Including government pensioners, expenditure on
public servants equals about 45 percent of revenue.) Sri Lanka's
civil service now numbers about 1.2 million after the Rajapaksa
government recruited about 100,000 new employees in 2006-2007. The
President announced the government will hire a further 15,000
university graduates into the public service in 2008. Public
servants, who received substantial salary increases in 2006-2007,
will receive a cost of living increase averaging about four percent
in their 2008 salaries. They will continue to enjoy such costly
benefits as the right to import cars at a 35 percent tax rate
(compared to the standard 200-300 percent) and subsidies on their
housing-related interest payments.

16. (SBU) The budget contains a range of proposals to help farmers
and fishermen. These include increases in taxes on imported
agricultural products in order to enable less efficient local
farmers to compete; expanded subsidies on fertilizer, seeds, and
other inputs; a partial debt write-off for rice millers; subsidized
loans to farmers and millers; and a guaranteed price scheme for
fish. The government also plans a series of incentives to increase
dairy production, including guaranteed minimum prices for milk
producers; subsidized loans to develop 50,000 small livestock farms;
and VAT exemption and Rs 100 million for cold storage facilities.
(Comment: We regard the dairy incentives as well-conceived and
likely to be productive, because the sector is underdeveloped; the
rice incentives, by contrast, are pure handouts to an overcrowded,
traditionally influential, but perennially inefficient sector.)

17. (SBU) The budget also contains programs to help develop various
industrial sectors. It proposes tax exemptions to encourage import
of cargo ships and their registration under the Sri Lanka flag. The
gem and jewelry sector would get tax breaks to encourage domestic
cutting and polishing and subsidized credit to attract new
investment. Domestic textile production is to be encouraged through
taxes on import of textiles for domestic garment production.
(Textile imports for export production would remain tax free.)

...AT THE COST OF FURTHER TAX INCREASES
---------------------------------------

18. (SBU) The budget proposes higher taxes, both in the form of
expanded collection and higher rates, to enable the government to
provide the benefits described above and to continue similar
existing programs. The budget forecasts a 25 percent (Rs 136
billion) increase in tax collections, of which Rs 24 billion would
come from new tax measures imposed especially on companies and
imports.

19. (SBU) Sri Lanka's direct taxation involves personal income and
corporate taxes. The budget would keep personal income tax rates
unchanged at 5-35 percent. For corporations, all but the smallest
have a 35 percent income tax rate and a 10 percent dividend tax.
The budget would not change these rates, but it would increase the
rate of a "Social Responsibility Levy" (first imposed in 2005 to
fund child welfare programs) on profits from 1 percent to 1.5
percent. The budget proposed to remove this levy from personal
income taxes.

20. (SBU) The budget would hit harder on indirect taxes -- many
imposed on imports on top of standard tariffs -- that generate much
of Sri Lanka's tax revenue. The 2008 budget, like its predecessors,
would increase the rates of the following taxes:

--Import duty surcharge (on all imports except certain "essential"
items)

--Export Development Board levy (on thousands of "non-essential
imports")

COLOMBO 00001661 005 OF 007

--Excise Duty (on imported and local alcohol, cigarettes, motor
vehicles, and other selected items)

--Regional Infrastructure Levy (on motor vehicles)

21. (SBU) The budget does not change the Value Added Tax (VAT) rate
or that of the Ports and Airports Levy. Aside from VAT, each of
these taxes was originally created ostensibly to dedicate funds for
provision of specific government services. However, the government
evidently uses the majority of the funds as general revenue. For
example, although there is no sign that the Regional Infrastructure
Levy has been used as intended to improve roads, the total tax on
cars with 1500 cc or smaller engines will rise from 173 percent to
197 percent.

ENVIRONMENT CONSERVATION LEVY
-----------------------------

22. (SBU) The budget introduced a new "Environment Conservation
Levy" to counter damage caused to the environment through water and
air pollution and soil erosion. The government estimates the cost
of these forms of environmental damage to be over 2 percent of GDP.
The government intends to devote more funds to environmental
protection by taxing individuals, businesses, and items considered
to be harmful to the environment. It will collect Rs 20 per month
from every household that owns a vehicle, a telephone and an
electricity connection. (Comment: While the environment
conservation goal is laudable, this is likely to be another of the
many supposedly purpose-designated taxes that in practice mostly
ends up going towards general revenue.)

RAJAPKSE FAMILY CONTROLS 53% OF THE BUDGET
------------------------------------------

23. (SBU) Another notable feature of the 2008 budget is its heavy
total allocations to ministries controlled by President Rajapaksa or
his brothers. Between them, the four brothers effectively control
53 percent of the 2008 government budget. (Note: Some sources, such
as a recent "Economist" article about the Rajapaksa family, cite a
figure of 70 percent for their control of the budget, but this
appears exaggerated.) The President directly controls 51 percent of
the budget: Ministry of Finance and Planning (29 percent), Ministry
of Defense (16 percent, run by brother Gothabaya as Secretary),
Ministry of Nation Building (5 percent for politically important
poverty alleviation and village development programs, run by brother
Basil as Advisor) and Office of the President (0.6 percent). The
President's elder brother, Chamal, heads the Ministry of Ports and
Aviation (2 percent) and the Ministry of Irrigation and Water
Management (0.06 percent). One commentator on the budget noted that
these ministries were the only ones whose budget allocations
increased by more than the rate of inflation.

24. (SBU) The President has used his control of the Ministry of
Finance budget in a way that critics have charged is non-transparent
and non-accountable. Beginning in 2003 the government has allocated
increasingly large sums to a Finance Ministry account called the
"Development Activities Program." The government has used this
account to pay for expenses in various ministries as they arise
throughout the year, by transferring funds on a case-by-case basis.
This has given the president discretion over un-budgeted
expenditures proposed by his 108 ministers, deputy ministers and
non-cabinet ministers, as well as by his own office.

25. (SBU) In a required "Fiscal Management Report," the government
stated that its January through October 2007 expenditures in this
account totaled 36 billion rupees. Of this, however, the government
only gave details on 11 billion in expenses -- for uses like
"personal emoluments," "foreign travel," "purchase of vehicles," and
"contractual services," plus capitalization of a new bank, and
"expenses connected with failed state enterprises." The 2008 budget
allocates 50 billion rupees -- 5 percent of the total budget -- to
this Finance Ministry account.

COLOMBO 00001661 006 OF 007

26. (SBU) Several parties challenged this practice in the Supreme
Court, saying it unconstitutionally circumvents parliamentary
control over public finance. The Court quickly instructed the
government to more fully report the use of these funds to Parliament
as required by the Fiscal Management Responsibility Act; it did not,
however, accept the claim that the government's actions were
unconstitutional. Nevertheless, the Chairman of the Committee on
Public Enterprises (COPE, ref B) resigned from the government to
protest the government's non-transparent use of these funds, failure
to hold accountable ministers accused of corruption, and
under-funding of poverty programs relative to the generous
compensation provided to ministers.

BUSINESS AND CIVIL SOCIETY NOT IMPRESSED
-------------------------------------

27. (SBU) The following is a selection of comments reported in press
coverage of a variety of public programs convened in Colombo to
discuss the budget:

-- A Nestle rep urged the government to reduce waste and
inefficiency in the state sector, in order to be more responsible
towards the people whose welfare it is supposed to manage.

-- The Business for Peace Alliance lauded the government's plans to
improve regional and provincial infrastructure. But it said the
"colossal" increase in defense spending overshadows the proposed
spending on productive sectors of the economy and "casts clouds on
the hope for peace." It added, "with the rate of inflation already
at an unbearable level, such increased expenditure on
non-constructive sectors will have a negative impact on the
economy."

-- Representatives of chambers of commerce representing small and
medium enterprises were generally positive about the budget's
support for local industry. However, they criticized proposals for
increased spending on government.

-- The Sunday Times quoted an unnamed "top businessman" saying that
"the budget is an eyewash, the country is on a major economic
decline and the economy is mismanaged..." and another describing the
budget as "disgraceful -- there is nothing conducive for the
business sector and there are a lot of stealth taxes that are
imposed on them."

-- A professor of economics from the University of Colombo told the
Sunday Times that incentives for investment in the Eastern Province
would not work if the lack of human and physical capital in the
region was not addressed first.

-- Another leading economist criticized the government's public
expenditure as "welfare oriented rather than workfare oriented" and
tax policy as regressive due to its dependence on indirect taxes.
He advocated decentralized tax collection and spending, so that
development efforts would be more responsive to actual needs rather
than central government political priorities. He credited the
government's Eastern Province development plans in principle but
said they were unlikely to succeed without a return to democratic
rule in the province.

COMMENT: THE CRITICS ARE RIGHT
------------------------------

28. (SBU) It would not be realistic to expect the Rajapaksa
government -- which was elected on an economic platform that
emphasized big government programs and transfers -- to propose a
budget with the kind of reforms and priorities we think are
necessary for Sri Lanka to realize its great economic potential.
This budget will not change the fact that much of Sri Lanka's growth
comes in spite of the government, not because of the programs it
says will stimulate growth. The government's attempt to contain its
fiscal deficits is commendable, but comes from fear of inflation of

COLOMBO 00001661 007 OF 007


a political liability, not belief in sound fiscal management. For
this reason, the government continues to avoid the hard budgetary
compromises needed to reduce inflation. Thus Sri Lanka in 2008 is
likely to continue to experience high inflation and high interest
rates, and as a result is unlikely to see the 7.5 percent GDP growth
that the government predicts.
BLAKE

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