This record is a partial extract of the original cable. The full text of the original cable is not available.

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