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Fiscal policy for a middle income Bangladesh


Published: Wednesday, May 25, 2016

Published : 25 May 2016, 00:28:36

Budget-making challenges

Fiscal policy for a middle income Bangladesh

Economic Analysis

Sadiq Ahmed

In 2015 Bangladesh secured a major economic milestone by moving up from a low income economy to a lower middle income economy.  It now aspires to climb further to an upper middle income economy by 2030. This aspiration is laudable. The platform built so far is a notable achievement and provides the basis for pushing towards the next development milestone of an upper middle income economy.

One of the anchors necessary for reaching the milestone is to secure an 8.0% plus average gross domestic product (GDP) growth rate over the next 15 years.  Another anchor is to reduce income inequality. There are many factors that will determine whether or not these are achievable. Among the factors that are necessary to lay the foundations for upper middle income Bangladesh include better institutions, better governance and better economic policies. Under economic policies, a major challenge is to institute a proper fiscal policy for middle income Bangladesh. Since this is budget season, this is an opportunity for the government to begin to develop the elements of this fiscal policy in the forthcoming national budget for the fiscal year (FY) 2016-17.

There are many details that have to be worked out and it is beyond the scope of this brief analysis.  Instead it will focus on the core principles of what will constitute a proper fiscal policy for a middle income Bangladesh.  If these principles are accepted, further details can be worked out through an informed consultative process.

FIRST CORE PRINCIPLE:  SUPPORT MACROECONOMIC STABILITY: The investment requirements for 8.0% GDP growth are substantial.  Based on international evidence and Bangladesh's own experience, the average incremental capital output ratio works out as 4.5, which yields an investment rate of about 36% of GDP by the end of FY20 and sustained thereafter.  This compares with an investment rate of about 28% of GDP in FY15 (22% for private sector and 6.0% for public sector). Indicative projections suggest that the private investment rate should grow from 22% to 27%.  This is a huge policy challenge, especially because private investment rate has grown by a mere 1.0% of GDP during the Sixth Five Year Plan period, covering the fiscal years between 2010-11 and 2014-15.

Many policies will be needed to achieve this massive expansion of private investment.  On the fiscal policy front a key requirement is to maintain fiscal stability by keeping public domestic borrowing under control.  Fiscal projections in the Seventh Five Year Plan (FY 2015-16 and FY 2019-20) suggest that this stability will be possible if the budget deficit is maintained on an average at or around 5.0% of GDP.  Monetary policy that is consistent with 5.0-6.0% long-term inflation target will then be able to adequately balance the private credit needs with public bank borrowing requirements.

Higher fiscal deficits financed by bank borrowing will either likely crowd out private credit or require higher liquidity growth that will be inconsistent with the long-term inflation target.  Higher inflation in turn can cause numerous problems for macroeconomic stability including exchange rate management, balance of payments (BoP) pressure, and pressure on domestic interest rates.  

Past record of Bangladesh is good in this regard.  Fiscal management in recent years has been generally prudent, although rising cost of public domestic borrowing needs careful watch and better management. The current excessive reliance on high-cost national savings certificates for Treasury deficit financing needs to be curbed in favour of lower cost T-bills.

SECOND CORE PRINCIPLE: MAKE BUDGET GROWTH-ORIENTED: There are many drivers of growth.  In addition to macroeconomic stability discussed above, fiscal policy affects growth in three other major ways: support public investment; provide incentives for private investment; and help stimulate the growth of a diversified export base.  The Seventh Plan projections suggest that public investment needs to expand by about 2.0 percentage points of GDP to facilitate the GDP growth target of 8.0% per year.  

Much of this additional investment will need to go for upgrading the physical infrastructure (power, energy, transport, flood control and irrigation). Better availability of infrastructure services will have a major positive effect on private investment.  

Additionally, the taxation policy and system of fiscal incentives need to be revisited and corrected through a careful review of their effects on the quantity and quality of private investments.  For example, the highly favourable tax treatment of capital gains from land and property transactions tends to divert resources from manufacturing and other private enterprises to land and property transactions, many of which are speculative in nature.  Another example is the heavy taxation of the information communications technology (ICT) sector that militates against new investment and growth of this high-development impact sector.  

Regarding exports, fiscal policy has been very supportive of the readymade garments (RMG) enterprises but has failed to correct the ant-export bias of the customs tariff and related supplementary duty (SD) regime for other manufacturing activities. A more rapid growth of exports requires a diversified exports base that will only be possible with a tariff regime that does not discriminate incentives against exports.  

Along with higher growth and poverty reduction, Bangladesh has experienced a serious long-term rise in income inequality. Development of a redistributive fiscal policy to income inequality should be considered third core principle to help constitute a proper fiscal policy for a middle income Bangladesh.

A middle income Bangladesh must tackle this forcefully to establish a more caring society and avoid fanning social instability down the line. Positive experience from Western Europe, Canada and Japan suggest that a redistributive fiscal policy can play a major role in tackling income inequality as income grows. This essentially involves a progressive income tax regime based on the principle of ability to pay combined with adequate spending on core social programmes including health, education and social protection.

The highest priority is to increase public spending on education and training. The skills base of a middle income Bangladesh will be vastly different from the present level where, as shown by the labour force survey of 2013, some 21% of the workforce did not have any education, only 29% had primary education and a mere 6.0% had tertiary education. A minimum of 12 years of compulsory education combined with adult literacy programmes and specialized skills training will be necessary.

An additional budget spending by at least 1.0% of gross domestic product (GDP) over the next five years is essential to develop the skills base for middle income Bangladesh.   This additional investment will also help reduce income inequality by reducing the skills gap between the rich and the poor.  Along with education, public spending also needs to grow in health, nutrition and social protection.

ESTABLISHMENT OF A PRODUCTIVE, EFFICIENT AND EQUITABLE TAX SYSTEM IS TO BE CONSIDERED THE FOURTH CORE PRINCIPLE FOR PUTTING IN LPACE A PROPER FISCAL POLICY FOR A MIDDLE INCOME BANGLADESH:  Notwithstanding recent reforms, the tax regime in Bangladesh is quite primitive and suffers from low productivity, low efficiency and is inequitable. The tax to GDP ratio has grown very slowly and is hovering around 10% of GDP. The tax structure is heavily reliant on trade and consumption taxes with low yield from income taxes. Personal income taxes yield a mere 1.0% of GDP despite a heavy concentration of income among the top 5.0-10% of the population. Corporate tax rates are highly discriminatory in nature with huge incentives for readymade garment (RMG), land and stock holdings but high penalty rates for others including banking and information communication technology (ICT).

A thorough overhaul of the tax system is needed to meet the development objectives of middle income Bangladesh.  The objectives of this reform should be: first, to increase the tax to GDP ratio by 4.0-5.0% of GDP in the next five years; secondly, to improve the efficiency of the tax regime by carefully reviewing and reforming the incentive effects of the tax regime and implications for private investment; and thirdly to improve the equity of the tax regime by instituting a progressive income tax system that is based on the ability to pay principle. The tax administration and planning needs to be modernized with particular objectives to strengthen tax planning, to simplify tax collection using electronic transactions and simple information, and to avoid the harassment of citizens. 

FIFTH CORE PRINCIPLE: REFORM PUBLIC ENTERPRISES TO MAINTAIN LONG-TERM FISCAL SOLVENCY AND AVOID MISUSE OF PUBLIC RESOURCES:  Historically, Bangladesh government has invested a huge amount of resources on a range of commercial activities including banks, electricity and gas supply, transport, manufacturing, hotels and tourism. Most of these state-owned enterprises (SOEs) are poorly managed, are riddled with corruption (especially public banks) and constitute a huge burden on the Treasury.

As result of the rapid accumulation of deficits and investment financing needs, outstanding debt liability of SOEs has climbed from Taka 727 billion (10.3% of GDP) in FY2009 to Taka 1920 billion (12.7% of GDP) in fiscal year (FY)2015. This is a huge contingent liability of the Treasury emerging from the inability of SOEs to cover operational deficits and finance own investments.  In recent years the sharp deterioration in the non-performing loans (NPLs) of state owned banks is another source of contingent liability of the Treasury. The NPLs soared to Taka 282 billion in FY2015 (2.0% of GDP).

Operational deficits of SOEs and NPLs are causing a serious drain on the limited Treasury resources.  Every year the budget is setting aside resources to finance the deficits of SOEs. As an example, energy subsidies alone climbed to Taka 204 billion in FY2013 (1.7% of GDP).  In the last few years, the Treasury has also been setting aside substantial resources to recapitalize public banks. Most SOEs are unable to finance their investment or service their debt from own resources. The adverse consequences for economic outcomes are obvious.  

In FY2013, total subsidy on energy was almost equal to the spending on education.  Should Bangladesh spend scarce public resources for financing oil subsidies that are regressive in nature (the richer population gets a larger share of the subsidy than the poorer population) or for educating the children?  Should Bangladesh divert tax payer money to fill the hole left by bad lending decisions, theft and other corrupt practices in public banks or use those resources for financing social protection programs for the poor? Should Bangladesh be financing the deficits and servicing the debts of SOEs from Treasury resources instead of requiring them to earn an adequate rate of return on invested assets that allows them to finance own investment and debt servicing obligations?  These are tough policy and ethical questions that need substantial debate in the National Parliament, the cabinet and in public domain for speedy resolution.     

Importantly, these issues will need to be swiftly addressed and resolved to maintain long-term fiscal stability and also to ensure the best use of limited public resources. Except in the case of pure public good, the case for public provision of commercial goods and services is weak.  Yet, if the government wants to continue with the SOEs, it must impose a hard budget constraint and require them to earn an adequate rate of return on invested assets. Subsidies must be limited to a few strategic services (e.g. mass transit, water supply, sewerage) and most enterprises, especially manufacturing enterprises, should be converted to profit-making ventures through proper restructuring.

Regarding public banks, international experience shows that in an environment of weak governance, state ownership of public banks will lead to serious misuse of these banks. In the absence of ownership, the bank management does not have any stake in its performance. Lack of accountability makes it even worse.  The transitory owner of these banks (the government of the day) often finds it convenient to use them for dispensation of political favours or for financing loss making enterprises and/or other politically motivated programs. There is no incentive to improve performance because the burden of NPLs can always be shifted to the tax payers or to the next transitory owner (the next government).

In this environment of perverse incentives, the best course of action would be to privatize all public banks except one bank (Sonali) that would primarily handle Treasury functions. If privatization is not a practical option, the next best option is to convert public banks into narrow banks that can mobilize deposits but cannot do any lending functions. They can use the deposits to invest only in safe assets, such as T-bills. The third best option is to keep them functioning as commercial banks but they should be required to perform on strict commercial principles and earn profit.  The bank management should be held accountable for performance. These banks must be fully supervised by the Bangladesh Bank and be required to comply 100% with all prudential regulations.

FIFTH CORE PRINCIPLE: PROMOTE FISCAL DECENTRALIZATION: Despite some progress with political and administrative decentralization, Bangladesh has not made any inroad on the issue of fiscal decentralization. Absence of fiscal decentralization has constrained the emergence of autonomous and accountable local governments. It has also reduced the quality and delivery of core basic services like health, education, nutrition, water supply, drainage and irrigation.

With a population size hovering around 160 million, it is absurd to imagine that basic services can be provided efficiently from the capital city of Dhaka by central ministries. It is equally unlikely that just by doing political and administrative decentralization, basic service responsibilities can be transferred effectively to local government institutions (LGIs).  

The central government's control over resources will reduce the ability of LGIs belonging to opposition political parties to provide service to their constituencies. More importantly, without local resource mobilization, the availability of budget transfers will always be a challenge. A system of well designed fiscal transfers along with built-in incentives for local resource mobilization will be necessary to support any effective devolution of service responsibilities to the LGIs.    

Sadiq Ahmed is Vice Chairman of the Policy Research Institute (PRI) of Bangladesh. He is a co-anchor of The Financial Express (FE) -PRI Economic Analysis Unit. He can be reached at sadiqahmed1952@gmail.com