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UNCLAS SECTION 01 OF 05 COLOMBO 002063 
 
SIPDIS 
 
MCC FOR D NASSIRY AND E BURKE 
 
SENSITIVE, SIPDIS 
 
E.O 12958: N/A 
TAGS: ECON EFIN CE
SUBJECT: Sri Lanka FY 2007 Budget 
 
¶1.  (SBU) Summary:  President Mahinda Rajapakse, who is also the 
Finance Minister, presented the Government of Sri Lanka's (GSL's) FY 
07 budget to Parliament on November 16.  The budget envisages large 
increases in both expenditure and revenue.  Military expenditure 
will increase by 28 percent to a record Rs 139 billion (USD 1.3 
billion or 4.2 percent of GDP) in 2007.  Due to past fiscal 
largesse, two-thirds of government expenditure still goes to cover 
recurrent expenditures.  Despite a whopping USD 1 billion projected 
increase in revenue estimates, there were no significant tax hikes, 
although some sectors will see their tax liability increased.  The 
largest benefit to the private sector will come from reduced 
electricity prices.  The budget also granted specific assistance to 
a few selected industries and agriculture.   The GSL hopes to post a 
small recurrent account surplus, although the government is highly 
unlikely to meet that target.  The budget includes substantial 
infrastructure spending.  It was presented within the context of a 
three year framework, enabling the President to speak of plans 
without actually budgeting for them.  Despite criticism that the 
budget failed to lower cost of living, all political parties in 
Parliament except for one voted in favor of the budget in a rare 
show of unity.  End Summary. 
 
¶2.  (SBU) President Mahinda Rajapakse, who is also the Finance 
Minister, presented Sri Lanka's FY 07 budget, his second, to 
Parliament on November 16.  Unlike his first, made shortly after 
being elected, the 2007 budget did not offer significant increases 
in subsidies and handouts and contained some initial efforts to 
reform expenditure.  Opening the budget speech, Rajapakse said he 
was presenting the budget based on "Mahinda Chintana" (or "Mahinda's 
Thoughts"), an election document filled with subsidies and 
envisioning development of the rural poorer regions of the country. 
(Comment:  Mahinda Chintana is cited to justify most GSL actions, 
especially those involving economic development.  End Comment.) 
However, the budget was remarkably short on Mahinda Chintana-like 
policies that would have stretched the budget even further.  Mahinda 
appealed to the LTTE to enter peace talks and lay down arms, while 
listing difficulties faced due to increased violence.  He used the 
increased violence to highlight the GSL's focus on security and his 
inability to bring down the cost of living, stressing that people 
need to make sacrifices. 
 
¶3.  (SBU) FISCAL DATA, 2006-2007:  The following statistics provide 
a comparison between the projected (original) budget for 2006, the 
revised 2006 budget and the 2007 projected budget.  The figures in 
parentheses represent the percentage of GDP. 
 
 
Year              2006      2006       2007 
                  Proj.     Rev.       Proj. 
 
In billions of rupees 
 
Total Expenditure 732 (27)  722  (26)  898 (28) 
-current          509 (19)  547  (20)  596 (18) 
-capital          226 ( 8)  184   (7)  303  (9) 
---Of which are 
fully funded projs. 21( 1)   21   (1)   63  (2) 
 
Total Revenue     484 (18)  482  (17)  600 (19) 
 
Budget Deficit(a) 225(8.3)  218 (7.9)  235 (7.2) 
Budget Deficit(b) 247(9.1)  239 (8.6)  297 (9.2) 
 
Financing  (net) 
Foreign           124        84        142 
Domestic          123       156        156 
 
Notes: 
 
Exchange rate: USD1 = approximately Rs 104 in 2006 and Rs 110 in 
¶2007. 
Figures within parenthesis represent percentage of GDP. 
 
(a) Sri Lanka's Official Budget Deficit reported by the Finance 
Ministry:  There are two deficit numbers.  The Finance Ministry 
understates the budget deficit by excluding foreign funded tsunami 
and development projects implemented through the government in 
expenditure.  Accounting for these foreign funded projects in 
government expenditure will result in a higher deficit. 
(b) Embassy-Estimated Actual Budget Deficit:  We have included 
foreign-funded projects in expenditure, and therefore have used the 
higher deficit in our analysis. 
 
COLOMBO 00002063  002 OF 005 
 
 
 
BUDGET PROJECTIONS 
 
¶4.  (SBU) The budget has been structured with the expectation that 
both government spending and revenue are estimated to grow 
significantly, by 24 percent, resulting in a deficit of about 9.2 
percent of GDP in 2007.  The government is set to borrow about Rs 
230 billion (USD 2.1 billion) in 2007, over and above the Rs 63 
billion (USD 570 million) project lending that has already been 
secured in order to bridge the budget deficit.  In 2006, despite 
substantial overruns in recurrent expenditure, the fiscal deficit 
was held at 8.6 percent of GDP through cuts in capital spending. 
The government has not been able to meet targets set by the Fiscal 
Management Responsibility Act (FMRA) which sets a deficit target of 
5 percent for 2006 and beyond. 
 
¶5.  (SBU) The 2007 budget foresees a large increase in capital 
expenditure compared to 2006.  However, almost two-thirds of 
government expenditure (equivalent to about 18 percent of GDP) has 
been allocated for recurrent expenditure.  Although committed 
expenditure on wages, interest and subsidies leaves little room for 
allocating funds to vital sectors, the budget makes some effort to 
rationalize expenditure.  As an example, the government plans to 
spend less on subsidies and more on education and health in 2007. 
However, defense expenditure is set to increase substantially in 
2007 (see para 9). 
 
¶6.  (SBU) Revenue estimates seem precariously optimistic.  Total 
revenue is estimated to increase by 24 percent (Rs 112 billion or 
USD 1 billion) to over 18 percent of GDP.  The increase is not in 
line with inflation and growth.  In 2006, revenue increased by 29 
percent following substantial increases in taxation.  Therefore, in 
the absence of a similar tax hike, it is unlikely the government 
will meet this target in 2007.  The fiscal direction of the budget, 
however, was laudable as the government has budgeted for a marginal 
surplus in the current account (revenue-current expenditure), which 
indicates that revenue would be sufficient to cover current 
expenditure. 
 
MACROECONOMIC MANAGEMENT 
 
¶7.  (SBU) According to the President, the government is designing a 
10 year strategy which aims at an annual GDP growth of over 8 
percent and raises the per capita income from the current USD 1,200 
to USD 3,000.  In 2007, economic growth is expected at 7.5 percent, 
up from 7 percent in 2006.  Inflation and monetary expansion were 
high in 2006 due to high oil prices and increased borrowing by both 
government and private sector.  Dr P B Jayasundera, Treasury 
Secretary, speaking at a post-budget seminar said he expects 
 
SIPDIS 
inflation to moderate to around 9 percent in 2007 with measures 
taken to tighten monetary policy.  However, revealing the government 
stance on inflation, he said the government would not sacrifice 
economic growth for lower inflation. 
 
INFRASTRUCTURE FOCUS, IN PART 
 
¶8.  (SBU) The government expects capital spending to increase 
dramatically from Rs 184 billion (USD 1.7 billion) in 2006 to Rs 303 
billion (USD 2.8 billion) in 2007.  While this increase is touted as 
investment in further economic development, it should be noted that 
all of this will not be for key economic infrastructure. Some of the 
funding will be for defense, office buildings and vehicles.  Key 
infrastructure projects which are already funded and included in the 
budget are the Norochcholai coal power plant (funded by China), the 
Southern expressway (ADB/Japan), the Colombo south harbor breakwater 
(ADB), the outer Colombo circular road (Japan), and the Kotmale 
hydro power project (Japan).   There are other key projects, which 
still need to be funded.  This latter investment, however, will 
depend on foreign inflows and domestic investors.  There are 
concerns that with the increased violence and the breakdown of the 
peace process it will be difficult to attract foreign investors in 
the scale envisaged by the government.  The IMF has also warned the 
country against borrowing on commercial terms.  The budget proposed 
a new tax of 2.5 percent on motor vehicle imports to fund 
infrastructure. 
 
INCREASE IN DEFENSE SPENDING 
 
¶9.  (SBU) Defense spending will increase by 28 percent to a record 
Rs 139 billion (USD 1.3 billion) in 2007 (4.2 percent of GDP), and 
could increase further if the conflict escalates.  Defense spending 
was Rs 108 billion (3.9 percent of GDP) in 2006 and Rs 83 billion 
 
COLOMBO 00002063  003 OF 005 
 
 
(3.5 percent of GDP) in 2005.  Various groups have criticized higher 
defense spending, leading to the impression that the government is 
preparing for a war.  But a large portion of the increase is due to 
inflation, currently at 18 percent.  Further, in these more tense 
times, the government will increase the GDP percentage for defense 
by 0.7 percent compared to 2005.  In support of the increased 
defense spending, Jayasundera said that national security "cannot be 
compromised."  Further, not only the war, but the need to maintain 
law and order and reduce crime compelled the government to increase 
defense spending.  In addition, salary increases (due to increases 
granted to public service including military) also contributed to 
the rise in expenditure. 
 
CONTROVERSIAL PROPOSALS LEADING TO A MORE BLOATED GOVERNMENT 
 
¶10.  (SBU) In keeping with Mahinda Chintana, big government was seen 
prominently in the budget.  For instance, the government proposed to 
control dividend distribution of private companies.  Accordingly, 
companies that pay less than 25 percent of their distributable 
profits as dividends are required to pay a penalty tax of 15 
percent, on top of normal tax on profits.  This proposal has been 
widely discussed.  Companies say they need to save to fund future 
investment.  Capital market analysts argue that boards of directors 
should be allowed to decide how much they would distribute and how 
much they would keep for future needs.  In addition, the government 
made it mandatory for insurance companies to cede 50 percent of the 
re-insurance business with the new state-owned National Insurance 
Trust Fund, which has raised concerns regarding quality of insurance 
products in the future.  The government also proposed to create a 
National Wealth Corporation to own and manage government lands and 
other assets.  A new bank named Lanka Putra Bank, will take over 
functions of regional development banks (RDB) and the newly created 
SME Bank.  There are concerns that the new bank will centralize 
functions of the regional development banks, leading to inefficiency 
and corruption.  Already, Fitch Ratings has put the regional 
development banks on its rating watch.  In another move, the budget 
declared that Sri Lankans working overseas should get a minimum wage 
of USD 250 per month from 2007.  The government argues this move 
will ensure that Sri Lanka will provide a pool of skilled labor for 
overseas market.  Currently, the majority of Sri Lankans working 
overseas are female housemaids. Foreign remittances of over USD 2 
billion are the second largest source of foreign exchange to Sri 
Lanka after garment exports.  Although not mentioned in the budget, 
the disruption of families due to migration of women has become a 
social issue. 
 
A PASSING MENTION OF MUCH NEEDED REFORMS 
 
¶11.  (SBU) The budget speech briefly mentioned the need for crucial 
reforms.  Among them was a government commitment to monthly 
adjustments to petroleum prices in line with world prices.  On labor 
and education, the President said that educated youth are not 
capable of securing gainful employment and stressed the need to 
re-orient education and improve the studies programs in universities 
and vocational institutes.  There was no mention of new programs to 
address this issue to expand English education, nor the status of 
the current efforts.  The budget speech also mentioned the need for 
judicial reforms, and the need for management and unions to work 
together to strengthen performance in key public services such as 
electricity, ports and petroleum. 
 
¶12.  (SBU) The budget was silent on much needed welfare reforms, 
public sector reforms and public enterprise reforms.  However, on 
the positive front, total expenditure on subsidies and welfare 
programs have been reduced from 4.9 percent of GDP in 2006 to 3.9 
percent of GDP.  The allocation for Samurdhi, the main income 
transfer (welfare) program has declined from 0.7 percent of GDP in 
2006 to 0.5 percent of GDP in 2007.  According to a recent report by 
the Colombo-based Institute of Policy Studies (IPS), efforts to 
improve targeting are underway.  As a first step, over 40,000 
recipients have voluntarily exited the program by mid 2006. 
Currently, there are over 1.9 million Samurdhi recipients. 
 
ENORMOUS CIVIL SERVICE A DRAIN ON THE BUDGET 
 
¶13.  (SBU) The public sector wage and pension spending of Rs 265 
billion in 2007 has become a drag on the budget.  These expenses 
will use 45 percent of government revenue.  The public sector is to 
be given a part of a salary increase announced in the 2006 budget. 
In addition, the government has proposed to add another 8,000 
graduates to the approximately 1 million-strong public sector 
workforce in keeping with a 2006 budget proposal.  The government 
 
COLOMBO 00002063  004 OF 005 
 
 
has absorbed 45,000 graduates in 2005-2006, fulfilling the prior 
administration's promises, and partially fulfilling the President's 
election promise.  On the positive side, the budget proposes to 
rationalize the salary structure and improve the recruitment policy. 
 
 
TAXATION 
 
¶14.  (SBU) Both direct and indirect taxation have risen sharply in 
recent years.  Private companies in various sectors have complained 
of the high tax obligations and reporting complexities in Sri Lanka. 
 According to the World Bank's Doing Business 2007 report, Sri Lanka 
ranked 157 out of 175 countries in terms of tax liability/ease of 
paying taxes.  However, in the absence of significant government 
efforts to control recurrent spending, taxation is expected to 
continue expanding. 
 
¶15.  (SBU) The FY 2007 budget heaps additional taxes on businesses 
while curtailing leakages from the system. 
 
Some of the increases are: 
 
--a 0.5 percent increase in the ports and airports levy to 3 
percent 
--limiting input tax credit under the VAT and extending its 
coverage 
--lowering income threshold for economic service charge 
--changes to tax treatment of loan loss provisioning in banks 
--insurance companies will not be able to offset losses from life 
policies against profits in general business 
--increase in imputed profit margins for the calculation of VAT and 
Export Development Board levy. 
--Export Development Board levy on selected items was increased. 
 
INDUSTRY ASSISTANCE 
 
¶16.  (SBU) Noting that industries were fast losing their 
competitiveness due to the high prices of electricity and industrial 
fuel (used to generate electricity in some plants), the budget 
proposed to lower the electricity tariff.  This will be done by 
exempting electricity from VAT.  In addition, agriculture, 
livestock, prawn farming and construction will benefit from 
industry-specific assistance which ranged from VAT exemptions and 
concessionary duty for imported machinery to a Rs 3 billion credit 
line for farmers.  The following industries benefited from 
protection through increases in import tariffs and other import 
charges, as well as VAT exemption on local manufacture: handloom 
textiles, bus transport, panels, footwear, jewelry, and personal 
care products.  The local film industry was also given various 
generous concessions. 
 
MIXED REACTIONS 
 
¶17.  (SBU) The budget received mixed reactions.  Sectors projected 
to obtain government assistance have been quick to praise the 
budget.  For example, the Gem and Jewelry Association termed the 
budget "a glittering budget" as a result of concessions granted to 
the industry.  Overall, the private sector chambers have praised the 
infrastructure program of the budget while asserting the need for 
the implementation of the proposals.  They have also praised the VAT 
exemption on electricity as it will enhance the competitiveness of 
industries.  The dividend tax, however, received heavy criticism. 
Trade unions representing the private sector have condemned the 
budget as it did not grant them any concessions. 
 
¶18.  (SBU) Following the joint government-United National Party 
(UNP) Memorandum of Understanding to work together on the security 
situation in the country, the UNP has agreed to support the budget 
in principle.  Nevertheless, during parliamentary discussions of the 
budget, the UNP blamed the government for not addressing the rising 
cost of living and for pushing the country into war.  The UNP urged 
the government to pursue the peace process.  The Janatha Vimukthi 
Peramuna (JVP) and the Jathika Hela Urumaya (JHU) have complained 
that the budget did not contain their proposals and that it is not a 
people friendly budget.  Tamil National Alliance (TNA) members 
allege that defense expenditure is increasing to buy warplanes and 
ships in preparation for war. 
 
¶19.  (SBU) The budget was passed by an overwhelming majority of 130 
votes, with 142 voting for and 12 against.  The UNP, JVP, JHU, CWC 
and SLMC voted with the government, with only the TNA opposing. 
This was the first time in recent history that a budget received 
 
COLOMBO 00002063  005 OF 005 
 
 
such broad support amongst the political parties. 
 
¶20.  (SBU) Comment:  The government's FY 07 fiscal targets, for both 
revenue and expenditure, seem overly ambitious and unrealistic.  In 
particular, revenue is expected to increase by 24 percent (Rs 112 
billion or USD 1 billion).  As such, as seen in recent years, a fall 
in revenue and recurrent expenditure overruns are likely to be met 
by cuts in capital spending.  Government borrowing in 2007 is likely 
to rise further than anticipated and contribute to further 
depreciation of the rupee and fuel inflation which could stifle 
growth.  However, the budget was able to underline some economic 
realities.  The government should be commended for not granting new 
subsidies, and for attempting to end the oil subsidy despite the 
rising cost of living.  Further, while the budget did not contain a 
clear path for economic development, it signaled the government's 
stand on infrastructure.  Stronger fiscal adjustments and reforms 
will be needed to attain macro economic stability which will create 
room for private sector development and economic growth in the 8 
percent range in the medium term. 
BLAKE