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

UNCLAS SECTION 01 OF 05 COLOMBO 001905 
 
SIPDIS 
 
SENSITIVE 
 
DEPT FOR SA/INS:JBRENNIG; PLEASE PASS TO TREASURY:C.CARNES; 
COMMERCE:A.STERN; USTR:J.ROSENBAUM; MCC:S.GROFF 
 
E.O. 12958: N/A 
TAGS: ECON ETRD EFIN CE ECONOMICS
SUBJECT: GSL BUDGET "NOT AS BAD AS WE THOUGHT;" BUSINESSES 
EXPRESS RELIEF 
 
REF: A. A) COLOMBO 1858 
 
     ¶B. B) COLOMBO 1171 
     ¶C. C) COLOMBO 490 
 
¶1. (SBU) Summary: Finance Minister Amunugama presented the 
GSL's 2005 budget proposal to Parliament on November 18.  The 
budget included a number of provisions to expand revenue 
collection, widen the tax base and numerous new spending 
initiatives aimed primarily at the public sector, the rural 
sector and Small and Medium Enterprises (SME).  On the 
revenue front, VAT has been expanded to three tiers, 
corporate tax deductions were cut and fees and tax surcharges 
were increased.  Some reforms were offered for the Department 
of Inland Revenue, but fell short of the dramatic overhaul 
that had been pushed by the previous Government.  On the 
expenditure front, the budget includes funding for a new SME 
"bank," assistance to the apparel sector (anticipated in 
light of the pending removal of quotas in January), 
infrastructure projects and a significant salary increase for 
public sector employees (as well as funding to hire an 
additional 30,000 high school grads into public sector jobs). 
 The GSL proposes to increase revenue collection from 15% of 
GDP to 19% over four years.  It has also pledged to roughly 
halve the deficit by 2008.  While overall commentary on the 
budget has been largely positive, much of it falls into the 
category of "it's not as bad as we thought."  Opposition 
criticism has been muted.  The budget continues to send the 
signal that it is government, rather than the private sector, 
which should be the engine of economic growth.  At a time 
when the GSL needs to be focused on increased trade 
competitiveness and showing that it is "open for business," 
the budget does nothing to address either requirement. 
Perhaps having completed a "home grown" budget, something the 
GSL saw as a political necessity, it will now attempt to 
reach out more widely to donors, the IFIs and the 
international community as it moves into implementation.  End 
Summary. 
 
¶2. (U) During his November 18 presentation of the GSL's 2005 
proposed budget to parliament, Finance Minister Sarath 
Amunugama criticized the previous United National Party (UNP) 
Government's reforms as skewed against the rural poor and 
small and medium sized enterprises (SME's) and for having a 
heavy urban focus.  Amunugama claimed the United People's 
Freedom Alliance (UPFA) budget was a response to its election 
victory in April and had been widely consulted, taking input 
from over 1100 citizens. 
 
¶3. (U) Anxiety had run high prior to the budget submission, 
particularly in the business community.  Most observers 
believed heavy new taxes, despite recently imposed revenue 
measures (Ref A), would be accompanied by significant new 
spending priorities, including increases in social welfare 
payments and subsidies.  In the end, however, the budget was 
less troubling to business than predicted.  Though there is a 
clear move toward greater import substitution policies and 
enhanced revenue collection, the budget also had targeted 
spending increases and an emphasis on the need to cut the 
budget deficit (projected to be 8.6% of GDP in 2004). 
 
Macroeconomic Projections 
------------------------- 
 
¶4. (U) The UPFA's maiden budget aims to raise revenue from 
15.6% of GDP currently to 17.2% in 2005.  Its ultimate goal 
is revenues equivalent to approximately 19% of GDP. 
 
¶5. (U) The previous GSL had made cutting the deficit a high 
priority and lowered the deficit from over 10% of GDP in 
2001, to a projected 7.6% in 2004.  2004's actual budget 
deficit is likely to be around 8.6% of GDP.  The current 
budget proposal aims to lower the deficit to 7.6% of GDP in 
2005 and to 4.4% by 2008. 
 
¶6. (U) Current projections are that GDP will grow by 5 - 5.5% 
in 2004.  Inflation has been rising and the year-end rate is 
projected to exceed 7%, from around 6.3% in 2003. 
 
¶7. (U) The current account deficit continues to put pressure 
on the rupee, as does the absence of World Bank and IMF 
budgetary assistance in the overall balance of payments.  Now 
that it has produced a "home grown" budget, without foreign 
assistance, the GSL has indicated it will begin discussions 
with the World Bank and IMF (Note: the budget relies on 
almost USD one billion in unspecified donor money for public 
investment projects. End note.).  Some local bank contacts 
have projected a continuing depreciation of the rupee to 
around Rs 110/US$.  The current rate is approximately Rs 
104/US$. 
 
Revenue 
------- 
 
¶8. (U) The Value Added Tax (VAT) was widened to three tiers, 
from its current 15% rate.  The new rates are 5% for 
essential food items, e.g. sugar, lentils, potatos, onions, 
milk powder, vegetables; 15% for standard items and services, 
and 18% for luxury items, e.g. liquor, air conditioners, 
refrigerators, washing machines, televisions, cameras, 
jewelry and motor vehicles (other than three wheel "baby 
taxis" and passenger buses).  Certain imported inputs for the 
export sector, particularly the garment industry, will be 
exempt from VAT. 
 
¶9. (U) The income tax structure was left largely unchanged, 
though the tax bands were widened and public sector employees 
will now be liable for income tax on half their gross income 
(any public sector employee found liable to pay taxes, 
however, will be given an equivalent tax allowance).  The 
base income level for tax liability was also increased from 
Rs 240,000 (approximately US$2,400) to Rs 300,000 
(approximately US$3,000) per year. 
 
¶10. (U) The Economic Service Charge imposed by the previous 
government (a one percent tax on business turnover) was 
reduced to 0.5% for wholesale and retail trade, for both 
domestic and imported goods. 
 
¶11. (U) The recently re-introduced 100% tax on land purchased 
by foreigners was left intact, though land to be used in the 
development of affordable housing projects, hospitals or 
large-scale public infrastructure will be exempt. 
 
¶12. (U) Though corporate tax rates remain unchanged, 
corporate tax liability may rise, as numerous exemptions were 
removed or curtailed, including many standard deductions such 
as business expenses.  This provision has been the subject of 
the most criticism by the business community. 
 
¶13. (U) "Sin taxes" were increased, including additional 
excise taxes on liquor and an increased levy on betting and 
gaming. 
 
¶14. (U) A new tax on NGOs was established.  NGOs will be 
required to register with the Registrar of Companies and will 
be liable for a tax of 30% on 6% of funds received.  This tax 
will reportedly apply to all NGOs, except those working in 
the North and East, or on other projects approved by the 
Minister. 
 
¶15. (U) The VAT and income tax charges on profits from the 
sales of stocks will be replaced by a new 0.2% transaction 
tax on share trading.  The tax will be assessed at the 
purchase and sale of shares.  The Government has also pledged 
to repeal the retroactivity of a tax on gains from the sale 
of Government securities.  The recently imposed tax had been 
retroactive to 2002 (Ref A). 
 
16 (U) While no specific target date was set, Minister 
Amunugama pledged that fuel subsidies would be "phased out." 
 
 
¶17. (U) New fees were proposed on the export of cinnamon and 
ferrous or nonferrous metals in any form (including scrap), 
and on total turnover of small and medium-sized contractors 
(to help fund a construction guarantee fund to assist the 
construction industry). 
 
Tax Administration and Compliance Measures 
------------------------------------------ 
 
¶18. (U) In an effort to improve revenue collection, the 
Minister proposed several reforms to the Inland Revenue 
Department, though all fell far short of the IMF and 
ADB-sponsored plans for a complete Department overhaul and 
consolidation of revenue authorities.  The mostly 
administrative changes proposed in the UPFA budget include: 
establishment of an appeals unit; implementation of a tax 
charter outlining taxpayer rights; efforts to collect 
information on tax evaders; a requirement that all refunds 
made by the Inland Revenue Department be cleared by a newly 
appointed committee within one week; and, new dedicated tax 
courts.  A Tax Ombudsman was also proposed to facilitate fair 
and expeditious settlement of grievances. 
 
¶19. (U) With regard to tax compliance, the Minister noted 
that out of a working population of six million, only 200,000 
people pay taxes.  Several new measures to improve tax 
compliance will include withholding on certain large 
purchases, requirements that citizens who meet specified 
requirements with regard to credit card and utility bills 
open tax files, and a "gold card" for "honest taxpayers" 
which entitles bearers to special privileges (including a 
special lounge at the airport!).  Finally, a tax clearance 
certificate will be mandatory for bidding on government 
tenders. 
 
New Programs and Expenditures 
----------------------------- 
 
Public Sector: 
¶20. (U) The UPFA promised public sector workers a 70% pay 
hike during its campaign.  The current budget proposal grants 
a 40% increase on current basic salaries to a maximum of Rs 
9,000 (US$90) per month, for lower rank employees the actual 
raise is equivalent to the 70% promised.  The increase will 
come over two years.  Public servants will also get a 
comprehensive medical insurance program, access to 
Government-guaranteed housing loans up to US$ 10,000 and at 
least two weeks of training each year. 
 
¶21. (U) Surpassing its campaign pledge to hire 27,000 
unemployed graduates, the UPFA government actually hired 
42,000 graduates, who will now become "service oriented 
change agents."  The budget proposes an additional Rs 2.8 
billion (US$ 28 million) to place these 42,000 recent hires 
into permanent positions, and Rs 1.1 billion (US$ 11 million) 
to hire an additional 30,000 high school graduates into 
government positions. 
 
SME Bank: 
¶22. (U) A cornerstone of the new budget is assistance to 
SMEs, primarily in the form of a newly constituted SME 
"bank."  The "bank" will be established with a capital base 
of Rs. 5 billion (US$ 50 million) and will provide direct 
funds, credit guarantees, equity and debt capital and 
restructuring aid.  Whether this will be a new bank or GSL 
program run through existing banks is yet unknown.  Mano 
Tittawella, Senior Economic Advisor to the President, told 
Econchief that the funds would be used to provide guarantees, 
primarily through existing banks, to help diffuse the risk 
faced by banks when lending to SMEs with little collateral. 
 
Infrastructure Development: 
¶23. (U) New infrastructure programs proposed in the 2005 
budget include: a three-year accelerated infrastructure 
development program in the nation's two poorest districts; a 
village-level development program for two districts to 
provide minor irrigation schemes, feeder roads, basic health 
facilities and transportation services; low income housing 
units in the plantation and fishing areas; and a seven year 
tax exemption on income from rental houses of less than 1500 
square feet of floor area. 
 
Apparel Sector: 
¶24. (U) With the final phase out of the Multi-Fiber Agreement 
in January 2005, the apparel sector was a focus of the new 
UPFA budget.  Assistance includes: Rs 600 million (US$ 6 
million) for guarantees from the newly established SME bank 
to provide working capital and investment; exemption from VAT 
payments on the import of textiles and ancillary inputs; 
VAT-free services from the Garment Buying Office; a grant of 
Rs 200 million (US$ 2 million) for productivity improvement; 
Rs 100 million (US$ one million) to improve local designer 
training programs to expand domestic inputs to the overall 
value chain; and, establishment of an apparel-related 
industrial park in a free trade zone near Colombo.  The new 
SME bank will also provide working capital to the developing 
textile industry and all textile requirements for government 
uniforms are to be procured locally. 
 
Local Software Development: 
¶25. (U) The budget proposes 100% depreciation on locally 
developed software in the year of purchase.  The budget also 
stresses that the GSL will give priority to locally developed 
software in its software procurements (Note: several Sri 
Lankan software firms produce business application software. 
End Note.).  In cases where certain applications are not 
developed locally, additional benefits are available to firms 
who use local value addition for imported software. 
 
National Action Plan for Children: 
¶26. (U) A fee of 0.25% will be assessed on certain taxes to 
suplement funds required to implement the National Action 
Plan for Children.  The Plan is designed to ensure universal 
access for child-development services. 
 
¶27. (U) Other programs include: 
 
-- implementation of computer-linked resource centers in 320 
Divisional Secretariat areas, 
 
-- technical assistance for floricultural sector development, 
 
-- assistance to the dairy industry, with the goal of 
self-sufficiency in dairy production, 
 
-- assistance for organic product exports, 
 
-- development of the value-added cinnamon industry, 
 
-- incentives for the rubber industry, 
 
-- incentives for the foundry industry (fee on the export of 
ferrous metals outlined above), 
 
-- incentives for shrimp farming development, 
 
-- development of model farms for fruits and vegetables, 
 
-- employment creation and income generating projects for 
welfare recipients, 
 
-- an initiative for the revival of the construction industry 
(including a new Academy for Advanced Construction Training 
to meet the growing need for skilled labor), 
 
-- a housing loan scheme for returning overseas workers, 
 
-- new fuel subsidies for three-wheel "baby taxi" operators 
and assistance for converting existing three wheelers from 
gasoline to natural gas. 
 
Reactions to the Budget 
----------------------- 
 
¶28. (U) Local reaction to the budget has been generally 
positive, with many business groups lauding the government 
for not raising taxes further than they did and urging the 
Government to remain vigilant on cutting the budget deficit. 
All major Chambers of Commerce have hailed the budget, though 
Sri Lanka's premier business organization, the Ceylon Chamber 
of Commerce, has called for the removal of provisions that 
reduce business tax deductions (Note: several economists have 
commented to us that the larger chambers are happy because 
their proposals for protection for member industries were 
adopted.  End note). 
 
¶29. (SBU) Despite a budget that dramatically reverses many 
trends of the previous two years that were implemented by the 
UNP, reaction from the opposition has been largely muted. 
UNP complaints have largely been confined to a proposed 
requirement that an additional hour be added to the public 
sector work day in exchange for the pay raise (Note: news 
reports indicate that the GSL may make the extra hour 
"voluntary." End Note.).  The UNP may be feeling constrained 
in its ability to criticize given the populist nature of many 
of the budget provisions. 
 
Comment 
------- 
¶30. (SBU) The 2005 budget proposal is receiving widespread 
praise primarily because it is not as bad as most people 
thought it would be.  The Government's coalition partner, the 
Marxist Janatha Vimukthi Peramuna (JVP), got increased 
funding for its constituent areas, particularly with the 
rural and SME development provisions.  Belying the emphasis 
on an increased Governmental role in the economy, the 
Minister's speech did pay lip service at least to the need 
for private sector partcipation in the economy.  The 
Government's revenue projections are optimistic and the 
Finance Secretary has called budget implementation "a 
challenge." 
 
¶31. (SBU) Being less bad than expected is not what Sri Lanka 
needed in its budget.  The budget is an extension of the 
earlier Economic Policy Framework (EPF - Ref B) and continues 
to give the impression that the private sector is something 
akin to a necessary evil, while the Government must control 
the economy. 
 
¶32. (SBU) Also worrying is the increase in protectionist 
sentiment and new tariffs.  The Government wants to benefit 
from trade through exports but, rather than allowing imports 
to foster competition and push productivity and efficiency, 
the GSL sees only markets overseas and at home.  A nation the 
size of Sri Lanka must utilize its comparative advantages 
that have driven growth for the past three years, such as 
continued focus on high-end, "niche" apparel markets, 
continued movement into IT back office operations and 
software development, focused development of export-quality 
agricultural products. 
 
¶33. (SBU) During the recent TIFA talks in Washington, we 
understand the US side commented that Sri Lanka needs FDI 
(foreign direct investment) more than FTA (free trade 
agreement).  We concur, and are concerned that this budget 
does not provide sufficient incentive for foreign investors 
to take the risk of operating in Sri Lanka, and hobbles the 
local business community's ability to grow. 
 
¶34. (SBU) The peace process remains an unknown.  A continued 
ceasefire and progress in a return to the negotiating table 
could be a net benefit for Sri Lanka in any investment 
equation.  Nonetheless, the GSL needs to complement the 
"peace front" with policies that attract investment and 
promote enhanced competitiveness.  The current budget 
proposal does not fit the bill. 
 
¶35. (SBU) Nonetheless, the budget here, as everywhere, is a 
very political exercise, and tremendous emphasis was placed 
on producing a "home grown" budget, without foreign 
assistance.  There was also a need to produce something 
acceptable to the JVP faction in the coalition.  Now that 
that exercise is behind them, we hope the GSL will be willing 
to reach out more broadly, and seek input from donors and the 
international community.  Their approach to USG comments on 
their Millennium Challenge Account concept paper and possible 
upcoming meetings with the IMF and World Bank should help 
give an indication on this front.  End Comment. 
LUNSTEAD