PRESIDENT PROMISES SIGNIFICANT WELFARE AND

UNCLAS SECTION 01 OF 06 COLOMBO 002116

SIPDIS

STATE FOR SA/INS M GOWER; MCC FOR D NASSIRY AND E
BURKE; Treasury for S.Chun

SENSITIVE

E.O 12958: N/A
TAGS: ECON EFIN CE ECONOMICS
SUBJECT: PRESIDENT PROMISES SIGNIFICANT WELFARE AND
TAX INCREASES IN 2006 BUDGET PROPOSAL

REF: (a) Colombo 1935 (b) Colombo 1853


1. (SBU) Summary: Sri Lanka?s newly elected
President presented the revised 2006 budget to
Parliament on November 8. In keeping with the
President?s election manifesto, the budget contained a
series of ?pro-poor? welfare measures and a
significant salary hike to government servants. The
budget also aims to increase public investment
spending. The budget is not private sector friendly
and increases the tax burden on corporations in
particular. The welfare focus of the budget and lack
of focus on economic growth oriented policies are key
worries. Increased welfare spending and the 9.1
percent deficit will likely fuel inflation next year.
End Summary


2. (U) On December 8, newly elected Sri Lankan
President Mahinda Rajapakse presented the revised 2006
Government of Sri Lanka budget in Parliament. The
budget aims to fund election promises and contains a
range of welfare measures and tax proposals. Soon
after coming into power in mid-November, Rajapakse,
who is also the Finance Minister, canceled the 2006
budget presented by former-Finance Minister Sarath
Amunugama under President Kumaranatunga?s
administration (Ref A).

Mahinda?s Thoughts
--------------


3. (SBU) In his budget speech, the President said
that his ?Mahinda Chintana? (Mahinda?s thoughts)
election manifesto (ref b) will form the basis for the
development programs for the next six years. He
expressed commitment to a ?sequenced? implementation
of programs which could indicate a lack of sufficient
funding or even plans to eventually abandon some of
them. His comments about needing to move from pure
economic theory and re-engineer the economy to create
opportunities for the poor highlight a continued focus
on government-driven, statist economic and social
policies. Statements such as ?we must accept that
many countries are reshaping their economic policies
to empower themselves through home grown policies?
call into question the GSL?s commitment to attracting
foreign investment and may be indicative of the
Marxist/Nationalist Janatha Vimukthi Peramuna (JVP)
party?s influence on policy making. In another JVP-
induced statement, the President also revealed plans
to present a new national development strategy in the
next six months, taking into account diverse views
expressed on the national economy. There was no
mention of the peace process in the budget speech
though the budget appears to be woven around an
assumption of the continuation of peace.


4. (U) Nivaad Cabral, the Economic Advisor to the
President, speaking recently at a post-budget American
Chamber of Commerce Sri Lanka (Amcham) event said that
given the disparities in income distribution, the
government is serious about social equity and the
budget is based on this premise. He said the
government was serious about attracting foreign
investment while simultaneously promoting Sri Lankan
business and entrepreneur-friendly policies.

Economic Growth
--------------


5. (U) The government expects a GDP growth rate of
6.9 percent in 2006. Inflation is projected to be
around 8 percent. Money supply growth is estimated at
16 percent (Note: the GSL told the IMF it would reduce
monetary supply growth to 15% (from 20%) in early 2005
- a rate it never achieved. The GSL has been relying
almost exclusively on open-market operation to absorb
excess liquidity. End note). The public investment
level is expected to rise to 30 percent of GDP from
23%. The Government expects to raise the overall
investment level to 35 percent of GDP to achieve an
economic growth rate of 8 percent over the medium
term. A statement issued along with budget to comply
with the Fiscal Management Responsibility Act states
the debt/GDP ratio of 85 percent required under the
act would be achieved by end of 2008 instead of 2006
as planned. Similarly a deficit of 5 percent of GDP
envisaged under the act in 2006 would be achieved in

2008.

Deficit Rises to 9.1 percent GDP
--------------


6. (U) The new budget targets a deficit of 9.1 percent
of GDP. Excluding tsunami reconstruction expenditure,
the deficit would be 7.3 percent of GDP (Note: The
government is using figures that do not include
tsunami reconstruction expenditures in its assumptions

SIPDIS
and economic estimates. The rest of the cable refers
to the expenditure and deficits inclusive of tsunami
reconstruction costs. End note). Despite initial
fears of a much larger deficit, these targets are only
slightly above those in Amunugama?s previously-
proposed budget, which was also ?pro poor?. The
deficit is, however, higher than the 2005 deficit
estimated at 8.5 percent of GDP. Both expenditure and
revenue are expected to be higher in 2006 than 2005.
Total expenditure is estimated at 27 percent of GDP
compared to 25 percent of GDP in 2005. Total revenue
is projected to be 18 percent of GDP compared to 16
percent of GDP in 2005. The expenditure side of the
new budget was largely a restatement of proposals in
the Amunugama budget except for additional expenditure
of about Rs 10 billion ($100 million) to augment funds
for key welfare programs promised in the election
manifesto.


7. (U) Government salaries, interest payments and
subsidies take up about 90 percent of current
expenditures. Defense expenditures, including police
and national security, are estimated at about Rs 91.6
billion (USD $916 million)(about 3.4 percent of GDP)
compared to Rs 76.5 billion (USD $765 million)in 2005
(3.3 percent of GDP). The budget deficit leaves a
funding gap of Rs 247 billion (USD 2.47 billion).
Total domestic financing is expected to be Rs 123
billion (USD $1.23 billion) (4.5 percent of GDP). The
balance will come from foreign grants and loans.
Tsunami-related expenditure projected at Rs 50 billion

SIPDIS
(USD $500 million)(1.8 percent of GDP) is to be funded
mostly with foreign grants and borrowing. It is not
clear if the 2006 budget targets can be met,
particularly given the extreme optimism suggested by a
26 percent rise in revenue expected in 2006. Revenue
rose 24 percent in 2005, due to one time effects of a
range of new tax and duty measures as well as
inflation.

Largest Gain To Public Sector Employees
--------------

8. (U) Public employees? salaries will be increased
substantially on a staggered basis in 2006 and 2007.
The lowest public sector salary will increase from Rs
9,350 (USD 92) per month to Rs 11,630 (USD 114) in

2007. The pay hike will cost an additional Rs 9.6
billion (USD 94 million) in 2006. Additional measures
include:

--Pension increases for public sector retirees

--Current workers and retirees to get a cost-of-living
allowance based on the consumer price index.

--10,000 new government jobs for university graduates
in 2006. In 2005, the government employed an
additional 42,000 graduates. (The President?s
election manifesto promised that 10,000 university
graduates will be hired into government service each
year.)

Welfare Programs
--------------

9. (U) In keeping with election promises to look
after the poor, a range of benefits were offered:

-- ?Samurdhi? welfare payments to increase by 50
percent.

-- community work programs and livelihood development
programs to create income earning opportunities for
welfare recipients (new benefits and programs will
increase the cost of Samurdhi to Rs 16 billion (USD
$160 million)from about Rs 10 billion (USD $100
million)in 2005)

-- Free meals and milk to poor expectant mothers,
children below 5-years and students in rural schools.

-- A skills development program to provide 50,000
jobs.

-- urban shanty dwellers and estate workers are to be
given housing facilities.

Agriculture
--------------

10. (U) There was a series of benefits for the
agriculture sector, the most well-publicized of which
was the fertilizer subsidy.

-- Fertilizer to be subsidized. Paddy and vegetable
farmers will get a 50 kg bag of fertilizer at Rs 350
(USD 3.50),at a total cost of Rs 8.5 billion (USD 85
million) per year.

-- producer prices of paddy and milk are to be
increased.

-- banks to be mandated to provide credit to the
agriculture sector.

-- the now defunct state-owned Paddy Marketing Board
to be restarted to purchase and store paddy.

-- dedicated agro zones for the cultivation of
tropical fruits.

-- tax benefits for agro processing and exporters.

-- import duty on milk to be gradually increased.

State-Owned Enterprises
--------------

11. (U) There will not be any privatization of
government bodies. Instead, they will be improved
through management reforms. All state-owned
enterprises (SOEs) are forecast to deliver dividend
income and not rely on treasury funding. (Note: In
2005 transfers from the Treasury to SOE's were Rs 20
billion (approximately USD 200 million) or 1.1 percent
of GDP. Profit-making SOE's, such as the port, banks
and lottery contributed approximately Rs. 6.3 billion
(USD 63 million) to state coffers in 2005. End note).


Business Promotion
--------------

12. (U) Other industries that received assistance are
fisheries, textiles, renewable energy, printing,
construction and the small and medium enterprises
(SME). For example:

-- construction machinery is duty free for 2 years.

-- a new bank to fund small and medium infrastructure.

-- two industrial zones for the textile industry.

-- a special IT zone in the Southern Province.

-- concessionary credit facilities for SME?s.

-- removal of VAT on computers

Fuel Subsidy Capped
--------------

13. (U) The budget did not contain any analysis of
the impact of high fuel prices on government finances
despite owing over USD $70 million (Rs 7 billion) in
unpaid subsidy obligations to the Indian Oil
Corporation, the private sector player in the fuel
retail business. However, the President said that the
fuel subsidy will be limited to Rs 3 billion (USD $30
million) in 2006 and given only to three wheelers
(scooter taxis),public transport and fisheries. He
said these measures would ensure that subsidies
provide relief to low income groups only.

Public Investment
--------------

14. (U) The public investment program shows a 51
percent increase to Rs 178 billion (USD 1.8 billion)
(6.6 percent of GDP) in 2006 from Rs 118 billion (USD
1.2 billion) (5.0 percent of GDP) spent in 2005. It
is unlikely that the government will be able to
sustain a large public investment program due to
various factors including the lack of funds and
tendering and implementation delays. The budget was
not explicit on public investment spending, but
referred to an ambitious list of infrastructure
projects including:

--power projects (hydro and coal power),

--a bunkering port in Hambantota,

--a new harbor in Colombo (Colombo South Harbor),

--a new runway at the main airport,

--a second international airport,

--tourism zones,

--several expressways, roads and railroads.


15. (U) Due to the aversion of the government?s
political allies to privatization, it is not clear if
these projects will be opened to private sector
funding although during his remarks to Amcham, Cabraal
said the GSL would welcome private sector
collaboration in implementing these projects.


16. (U) There was heavy emphasis on provincial
infrastructure with a pledge to develop 2000
irrigation tanks every year. In addition, 5000 kms of
rural roads are to be developed as well. Furthermore,
several multi-purpose irrigation projects are to be
developed in the next 2 years. (Note: It is not clear
whether some of the irrigation projects and roads are
the ones to be funded by Millennium Challenge
Corporation funds in line with the GSL?s compact
proposal or whether the GSL will finance these
particular projects in addition to the compact
proposal. End Note.)

Policy Bodies to Remain
--------------

17. (U) In terms of government economic policy and
management, the National Council for Economic
Development (NCED),a creation of the previous
government and headed by Treasury Secretary P.B.
Jayasundera, which brought private and public sector
experts together to plan and oversee policy
implementation in over 20 important economic sectors,
is to be continued. Other agencies such as the
National Procurement Agency and Strategic Enterprise
Management Agency, which oversee state-owned banks and
utilities, are to be parts of the newly created Plan
Implementation Ministry (PIM) headed by Cabral.

Tax increases
--------------

18. (U) On the revenue front, the budget contains
ambitious revenue targets. Revenue is projected to
increase 26 percent (Rs 100 billion or USD 1 billion)
in 2006 to Rs 484.4 billion (USD 4.8 billion) (17.5
percent of GDP). A range of tax increases are expected
to bring in Rs 25 billion (USD 250 million). While
previous governments had largely followed a policy of
increasing the tax base and lowering rates, both the
last United People?s Freedom Alliance (UPFA)
government and the new government have deviated from
this policy.

-- The corporate tax rate will rise from 32.5 percent
to 35 percent.

-- The highest personal tax rate will rise from 30
percent to 35 percent.
-- a stamp duty on transfer of property and assets
will be reimposed.

-- Several other taxes such as the social
responsibility levy, economic service charge, ports
and airports levy were all increased. Excise duties
on cigarettes and liquor were also increased. There
were also changes to Value Added Tax (VAT) rates. In
addition, upward revisions to import duty and the EDB
fees are also expected to increase revenue. Tax
administration is also to be improved and additional
revenue expected.

Tax breaks to some
--------------

19. (U) There were few measures to encourage private
investment. They included tax benefits to the
agriculture sector, exporters of non-plantation
agricultural products, domestic suppliers to the
export sector, and new industries outside the western
province. There were also measures to encourage the
use and import of high tech machines in certain
sectors. High tech machinery will also be free of
import duty. Tax concessions were also given to
professionals and companies providing professional
services for payment in foreign currency. Taxes on
foreign nationals working in Sri Lanka were also
increased. Imports and telecast of foreign films are
discouraged by a new Rs 75,000 (USD $750) tax per
movie or television episode, which could have a
significant impact on US films and television shows
aired in Sri Lanka.

Reactions of Opposition and Private Sector
--------------

20. (SBU) The budget received mixed reactions. The
main opposition UNP termed it an ?unrealistic? budget
with overestimated revenue projections and no
assurances of keeping expenditure at estimated levels.
The UNP criticized the budget for increasing the tax
burden and fueling inflation. For these reasons the
party will abstain during the vote but will not vote
against the budget as it provides relief for farmers.
Deva Rodrigo, head of the Ceylon Chamber of Commerce,
Sri Lanka?s largest trade chamber, and a member of Sri
Lanka?s monetary board, which sets interest rates and
monetary policy, told newspapers he was relieved to
see a ?manageable? deficit (excluding tsunami) around
7.3 percent of GDP. He said businesses were concerned
about the impact of the deficit on inflation and
interest rates. National Chamber of Commerce of Sri
Lanka (NCCSL),another large trade chamber, in a
statement praised the regional and Small and Medium-
sized Enterprises(SME) focus of the budget. The
Chamber said that while tax increases are negative
that they recognize the need for the increase. NCCSL
noted the budget is silent on many liberalization
issues key to private sector development.

Comment
--------------

21. (SBU) While the new budget kept largely to the
framework of the last Government?s submission, it was
presented in a manner more reflective of the new
President?s campaign platform. While its heavy
emphasis on Government welfare programs, non-
productivity enhancing agriculture policies (including
subsidies for fertilizer) and increased government
employment are worrying, its high tax rates (which
have been grudgingly accepted by the business
community in order to keep the deficit in check) and
cap on the run away fuel subsidy are important
counterweights. However, the increased corporate and
personal taxation and an increased VAT on banking may
discourage private sector activity.


22. (SBU) Comment cont.: In order to achieve an 8
percent growth rate in the medium term, the GSL will
need to adopt measures that spur investment and
increase productivity, but it is not clear that this
budget will give an impetus to private domestic
investment or attract more foreign direct investment.
While some of the major infrastructure projects called
for could have beneficial impacts on overall
productivity, the Government?s ability to finance and
implement such programs remains unproven. We will
monitor with interest the GSL?s performance this
budget year as well as the country?s macroeconomic
performance. One potentially related area of concern,
as we work with the MCC to conclude compact
negotiations, will be whether this budget reflects the
adoption of policies that might lead to deterioration
in Sri Lanka?s MCA eligibility score. End Comment.

ENTWISTLE