Moody’s Investors Service says that Sri Lanka’s (B1 negative) program with the International Monetary Fund (IMF) has helped stabilize the balance of payments and established an ambitious roadmap to fiscal consolidation and structural reform. However, sustained implementation of reforms will be challenging.
The 2017 budget confirms the government’s strong commitment to fiscal consolidation with a number of measures identified to improve tax revenues.
Given Sri Lanka’s weak fiscal position and need for growth-enhancing public expenditure on infrastructure and development programs, plans to increase government revenues will play an important role in bolstering debt sustainability and the overall sovereign credit profile. Revenue mobilization efforts will likewise be key to creating fiscal space for increased spending and deficit reduction, while tempering external vulnerabilities. After the VAT rate increase in 2016, the 2017 budget focuses in particular on raising corporate and individual income tax revenues through a simplification of the tax structure.
However, if effective, significant fiscal tightening and higher inflation in response to the VAT rate hike will dampen growth.
This will limit the revenue dividends of fiscal reforms for the government, at least in the short term.
The toll on households and corporates’ net incomes will make sustaining tight fiscal and monetary policy for several years increasingly challenging. The government’s projections for higher revenues rely on ambitious assumptions about real GDgrowth and about the effectiveness of the restructuring of income tax and new electronic tax collection system. If economic activity disappoints or tax-raising measures yield lower outcomes than currently budgeted, the fiscal targets may slip.
One option would be to cut back on public investment expenditure to meet its targets but such a scenario would weigh on GDP growth.
In turn, fiscal slippage and or weakening growth could undermine foreign investors’ confidence in the ability of the authorities to reduce Sri Lanka longstanding macroeconomic imbalances.
(See full report on page ii)
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