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UNCLASSIFIED COLOMBO 001661 
 
SIPDIS 
 
STATE FOR SCA/INS AND EEB/IFD/OMA 
STATE PASS USTR FOR ADINA ADLER 
COMMERCE FOR JONATHAN STONE 
DOL/ILAB FOR TINA MCCARTER 
TREASURY FOR LESLIE HULL 
 
SIPDIS 
SENSITIVE 
 
E.O. 12958: DECL: N/A 
TAGS: ECON EFIN KMCA PGOV CE
SUBJECT: SRI LANKA: 2008 BUDGET WOULD BOOST DEFENSE AND TRANSFERS TO RAJAPAKSA CONSTITUENTS 
 
REF: A. COLOMBO 1562 
     ¶B. COLOMBO 1464 
 
¶1. (SBU) Summary and comment: The Rajapaksa government could survive 
or fall depending on the outcome of a December 14 final vote on its 
2008 budget.  The proposed budget continues the president's emphasis 
on high taxes to fund big government and transfers to his primary 
constituents: civil servants, farmers, unemployed college graduates, 
and poor people.  The government claims that revenues will keep pace 
with expenditures, but this is no more likely for the 2008 budget 
than it was for the 2006 and 2007 budgets, whose deficit spending 
spurred inflation.  The budget significantly raises defense spending 
and substantially increases allocations to ministries that the 
president and his brothers control.  We share the view of many civil 
society critics that this budget illustrates the Rajapaksa 
government's short-sighted, politically driven, and often 
non-transparent management of the Sri Lankan economy.  From what 
this budget indicates, we doubt the government can contain inflation 
or realize the 7.5 percent growth it predicts for 2008.  End summary 
and comment. 
 
THIRD "MAHINDA CHINTANA" BUDGET PROMOTES BIG GOVERNMENT 
-------------------------- ---------------------------- 
 
¶2. (SBU) President Mahinda Rajapaksa presented to Parliament on 
November 7 his government's proposed budget for 2008.  Sri Lanka's 
fiscal year follows the calendar year; its budget process involves a 
series of three "readings" of the budget in parliament between 
October through December.  The budget narrowly passed on the 
November 19 second reading (ref A); the final reading is scheduled 
for December 14.  Defeat of the budget could result in the collapse 
of Rajapaksa' Sri Lanka Freedom Party-led coalition, so the vote 
will be purely a political contest, not a reflection of views on the 
budget. 
 
¶3. (SBU) Rajapaksa told Parliament that he had emphasized four 
priorities in formulating the 2008 budget: national security, 
infrastructure development, relief to low income groups, and 
"reawakening" local entrepreneurs and industry.   National security 
-- in the form of stepped up military efforts to eliminate or 
contain the LTTE -- has been the dominant theme of the Rajapaksa 
government.  The other three priorities are central to the 
Rajapaksa's "Mahinda Chintana" populist emphasis on big government 
and transfers to favored constituencies.  The government rightly 
believes that channeling investment into infrastructure will unlock 
growth potential.  Its poverty relief programs are both 
well-intentioned and politically motivated.  Many of its 
"reawakening" efforts involve subsidies and protection that are 
unlikely to stimulate productive enterprises, but again, are 
politically popular. 
 
THE BIG PICTURE: SEEKING TO CONTAIN DEFICIT 
------------------------------------------- 
 
¶4. (SBU) The 2008 budget forecasts large increases in both 
expenditure and revenue, but expenditure continues to far exceed 
revenue (see Fiscal Data table below).  In comparison with the 2007 
budget, total government spending will rise 21 percent to 1,044 
billion rupees (Rs), and revenue will rise 24 percent to Rs 751 
billion, resulting in a deficit of Rs 293 billion.  The government 
cites this projected deficit as equal to 7.0 percent of GDP, which 
would be an improvement compared with recent deficits of 8-9 percent 
of GDP, but this relies on the government's optimistic estimate of 
7.5 percent GDP growth in 2008.  Using the IMF's projected 2008 GDP 
growth of 6 percent, the projected deficit would amount to 7.7 
percent of GDP. 
 
¶5. (SBU) More than two-thirds of the budget goes to recurrent 
expenditure -- interest payments, salaries, pensions, subsidies, and 
welfare payments.  The remaining third would be for Rs 335 billion 
in capital investment, but inevitable revenue shortfalls will likely 
cause this amount to decrease.  (Note: About nine months into each 
budget year, when the government finds that it has not generated as 
much revenue as it projected, the Finance Ministry instructs 
 
COLOMBO 00001661  002 OF 007 
 
 
ministries to defer all remaining capital spending, in order to 
contain the deficit.  For example, late in 2007, the government said 
actual capital spending would be 23 percent below the budgeted 
amount.  The only exception to this restraint on capital spending 
was in the Ministry of Defense, whose capital spending actually 
increased by 11 percent.) 
 
¶6. (U) FISCAL DATA, 2007-2008:  Comparison between the proposed 2007 
budget, the revised 2007 budget released in September 2007, and the 
proposed 2008 budget.  Figures in parentheses represent the 
percentage of GDP.  Sources: Central Bank and the 2008 Budget 
speech. 
 
---- --------------------------------------------- ----- 
Year                 2007        2007        2008 
                      revised 
---- --------------------------------------------- ----- 
Billions of rupees 
 
Total Expenditure    898 (28)    862 (24)    1044 (24) 
-current             596         630          713 
-capital             303         233          335 
-other                 -          -2           -4 
 
Total Revenue        600 (19)    605 (17)     751 (18) 
 
Budget Deficit       297 (9.2)   257 (7.2)    293 (7.0) 
---- --------------------------------------------- ----- 
 
DEFENSE: INCREASES TO "SUPPORT INVESTMENT CLIMATE" 
--------------------------------------------- ----- 
 
¶7. (SBU) Finance Secretary P.B. Jayasundera told Colombo business 
people in November that high expenditure on national security is 
essential to create a stable investment climate, and therefore that 
the government "need not be shy about defense spending" as it had 
been in the past.  For this reason, he said, the government had not 
tried to hide defense spending within the budget as previous 
governments had. 
 
¶8. (SBU) Defense, budgeted at Rs 166 billion ($1.4 billion), is the 
second largest expenditure area after interest payments.  It would 
account for nearly 16 percent of total 2008 spending -- equivalent 
to about 4 percent of GDP (or 4.3 percent with more realistic GDP 
growth figures).  The planned increase in 2008 represents a jump of 
19 percent over the 2007 budgeted figure.  Actual 2007 defense 
expenditure swelled 49 percent to Rs 156 billion from Rs 105 billion 
in 2006 -- an increase in real terms of about 32 percent given 
inflation averaging about 17 percent.  The 2008 figure is also 
likely to come in higher than budgeted, though possibly not as 
drastically as the 2007 amount grew.  At the proposed 2008 level, 
the Rajapaksa government will have increased spending on defense 
from about $50 per capita to about $74 between 2006 and 2008. 
 
--------------------------------------------- -------- 
                         2006    2007    2007    2008 
                est.    rev.    est. 
--------------------------------------------- -------- 
Defense (Rs billion)    104.8   139.6   155.7   166.4 
        ($ billion)       1.0     1.3     1.4     1.4 
 
As percent 
 of GDP                   3.6%    4.3%    4.4%    4.0% 
 of govt expenditure     14.7%   15.5%   18.2%   15.9% 
--------------------------------------------- -------- 
Source: Budget estimates 2008 
 
EDUCATION AND HEALTH: UNIVERSAL BUT MEDIOCRE 
-------------------------------------------- 
 
¶9. (SBU) Sri Lanka continues to provide free universal education and 
health care.  In the budget address, the President said that in 
allocating funds for education, the government aimed to improve 
 
COLOMBO 00001661  003 OF 007 
 
 
teacher training and to upgrade university facilities to increase 
annual student intake to 20,000 from 16,635 now.  He reported that 
the government would increase funding for free text books, 
scholarships, school uniforms, midday meals, and school bus 
services.  The President likewise promised to increase health sector 
funding to improve hospitals, procure medicines, and provide living 
quarters for doctors. 
 
¶10. (SBU) The Rajapaksa government has increased per capita spending 
on education and health from $66 to $78 between 2006 and 2008.  (By 
comparison, it has taken defense spending from about $50 to about 
$70 per capita during the same period.)  Even at these levels, the 
systems are providing broad, but mediocre services.  For example, in 
education, only 49 percent of tenth grade students pass their final 
"O-level" exam.  And only 14 percent of twelfth grade students who 
pass the "A-level" exam can actually enter university, due to 
insufficient capacity in the public system.  To avoid such outcomes, 
a recent Asian Development Bank report found, many families are 
spending more on private tuition.  Similarly, to avoid delays and 
poor care, many Sri Lankans turn to private health providers if they 
can afford to do so. 
 
INFRASTRUCTURE AND EASTERN PROVINCE INVESTMENT INCENTIVES 
------------------------ -------------------------------- 
 
¶11. (SBU) The Rajapaksa government seeks to boost investment in 
infrastructure in order to "unlock" economic development potential, 
especially in the less developed parts of the country outside of the 
capital.  It has focused on particular on projects in the 
president's home district of Hambantota, where it seeks to create a 
bulk goods port, a small international airport, and a rail/road link 
to the capital.  The government also envisions continued investment 
in irrigation systems that would expand cultivable land in dry parts 
of the country -- mostly in the south, which is also the heart of 
Rajapaksa's voter base.  The government has sought to direct aid 
from bilateral and multilateral donors into these projects, and says 
that it will finance whatever donors will not.  In the budget 
speech, the president highlighted the Hambantota and irrigation 
projects.  However, as noted above, lower than predicted revenues 
are likely to force the government to curtail it planned capital 
spending, so these projects are likely to remain dependent on donor 
or investor interest. 
 
¶12. (SBU) The President also stated that the government would 
dedicate capital funds to develop the Eastern Province, over which 
it regained control from the ethnic separatist Liberation Tigers of 
Tamil Eelam in mid-2007.  Of the Rs 335 billion the government 
budgeted for capital investment, 8 billion are specifically 
designated for the east.  The budget also offered incentives for 
private development in the Eastern Province, including a five-year 
tax holiday for any investment over Rs 50 million which generates 50 
or more jobs. 
 
MORE SPENDING ON FAVORED CONSTITUENTS... 
---------------------------------------- 
 
¶13. (SBU) The 2008 budget includes heavy government spending to 
provide relief to low income groups, continue to expand the civil 
service as a source of employment, and support farmers and 
fishermen.  The budget also promises a range of subsidies, 
incentives, and protections to support certain domestic industry 
sectors. 
 
¶14. (SBU) The poor would receive significant new support in the 2008 
budget.  The 1.8 million recipients of the government's "Samurdhi" 
welfare program will get an additional kerosene subsidy of Rs 100 
per month in 2008 as part of a 10 percent increase in the overall 
Samurdhi budget in 2008.  The government also said it would continue 
welfare programs that would provide nutritional food to expectant 
mothers and free breakfasts to low income school children.  Finally, 
the government plans various programs to deliver essential 
foodstuffs to poor people: revival of a previously failed network of 
government-run "wholesale" food outlets; expansion of existing 
 
COLOMBO 00001661  004 OF 007 
 
 
wholesale food cooperatives; and creation of a state-owned trading 
company to import and distribute food to these wholesale and 
cooperative stores. 
 
¶15. (SBU) Public servants will consume 34 percent of expected 2008 
tax revenue.  (Including government pensioners, expenditure on 
public servants equals about 45 percent of revenue.)  Sri Lanka's 
civil service now numbers about 1.2 million after the Rajapaksa 
government recruited about 100,000 new employees in 2006-2007.  The 
President announced the government will hire a further 15,000 
university graduates into the public service in 2008.  Public 
servants, who received substantial salary increases in 2006-2007, 
will receive a cost of living increase averaging about four percent 
in their 2008 salaries.  They will continue to enjoy such costly 
benefits as the right to import cars at a 35 percent tax rate 
(compared to the standard 200-300 percent) and subsidies on their 
housing-related interest payments. 
 
¶16. (SBU) The budget contains a range of proposals to help farmers 
and fishermen.  These include increases in taxes on imported 
agricultural products in order to enable less efficient local 
farmers to compete; expanded subsidies on fertilizer, seeds, and 
other inputs; a partial debt write-off for rice millers; subsidized 
loans to farmers and millers; and a guaranteed price scheme for 
fish.  The government also plans a series of incentives to increase 
dairy production, including guaranteed minimum prices for milk 
producers; subsidized loans to develop 50,000 small livestock farms; 
and VAT exemption and Rs 100 million for cold storage facilities. 
(Comment: We regard the dairy incentives as well-conceived and 
likely to be productive, because the sector is underdeveloped; the 
rice incentives, by contrast, are pure handouts to an overcrowded, 
traditionally influential, but perennially inefficient sector.) 
 
¶17. (SBU) The budget also contains programs to help develop various 
industrial sectors.  It proposes tax exemptions to encourage import 
of cargo ships and their registration under the Sri Lanka flag.  The 
gem and jewelry sector would get tax breaks to encourage domestic 
cutting and polishing and subsidized credit to attract new 
investment.  Domestic textile production is to be encouraged through 
taxes on import of textiles for domestic garment production. 
(Textile imports for export production would remain tax free.) 
 
...AT THE COST OF FURTHER TAX INCREASES 
--------------------------------------- 
 
¶18. (SBU) The budget proposes higher taxes, both in the form of 
expanded collection and higher rates, to enable the government to 
provide the benefits described above and to continue similar 
existing programs.  The budget forecasts a 25 percent (Rs 136 
billion) increase in tax collections, of which Rs 24 billion would 
come from new tax measures imposed especially on companies and 
imports. 
 
¶19. (SBU) Sri Lanka's direct taxation involves personal income and 
corporate taxes.  The budget would keep personal income tax rates 
unchanged at 5-35 percent.  For corporations, all but the smallest 
have a 35 percent income tax rate and a 10 percent dividend tax. 
The budget would not change these rates, but it would increase the 
rate of a "Social Responsibility Levy" (first imposed in 2005 to 
fund child welfare programs) on profits from 1 percent to 1.5 
percent.  The budget proposed to remove this levy from personal 
income taxes. 
 
¶20. (SBU) The budget would hit harder on indirect taxes -- many 
imposed on imports on top of standard tariffs -- that generate much 
of Sri Lanka's tax revenue.  The 2008 budget, like its predecessors, 
would increase the rates of the following taxes: 
 
--Import duty surcharge (on all imports except certain "essential" 
items) 
 
--Export Development Board levy (on thousands of "non-essential 
imports") 
 
COLOMBO 00001661  005 OF 007 
 
 
 
--Excise Duty (on imported and local alcohol, cigarettes, motor 
vehicles, and other selected items) 
 
--Regional Infrastructure Levy (on motor vehicles) 
 
¶21. (SBU) The budget does not change the Value Added Tax (VAT) rate 
or that of the Ports and Airports Levy.  Aside from VAT, each of 
these taxes was originally created ostensibly to dedicate funds for 
provision of specific government services.  However, the government 
evidently uses the majority of the funds as general revenue.  For 
example, although there is no sign that the Regional Infrastructure 
Levy has been used as intended to improve roads, the total tax on 
cars with 1500 cc or smaller engines will rise from 173 percent to 
197 percent. 
 
ENVIRONMENT CONSERVATION LEVY 
----------------------------- 
 
¶22. (SBU) The budget introduced a new "Environment Conservation 
Levy" to counter damage caused to the environment through water and 
air pollution and soil erosion.  The government estimates the cost 
of these forms of environmental damage to be over 2 percent of GDP. 
The government intends to devote more funds to environmental 
protection by taxing individuals, businesses, and items considered 
to be harmful to the environment.  It will collect Rs 20 per month 
from every household that owns a vehicle, a telephone and an 
electricity connection.   (Comment: While the environment 
conservation goal is laudable, this is likely to be another of the 
many supposedly purpose-designated taxes that in practice mostly 
ends up going towards general revenue.) 
 
RAJAPKSE FAMILY CONTROLS 53% OF THE BUDGET 
------------------------------------------ 
 
¶23. (SBU) Another notable feature of the 2008 budget is its heavy 
total allocations to ministries controlled by President Rajapaksa or 
his brothers.  Between them, the four brothers effectively control 
53 percent of the 2008 government budget.  (Note: Some sources, such 
as a recent "Economist" article about the Rajapaksa family, cite a 
figure of 70 percent for their control of the budget, but this 
appears exaggerated.)  The President directly controls 51 percent of 
the budget: Ministry of Finance and Planning (29 percent), Ministry 
of Defense (16 percent, run by brother Gothabaya as Secretary), 
Ministry of Nation Building (5 percent for politically important 
poverty alleviation and village development programs, run by brother 
Basil as Advisor) and Office of the President (0.6 percent).  The 
President's elder brother, Chamal, heads the Ministry of Ports and 
Aviation (2 percent) and the Ministry of Irrigation and Water 
Management (0.06 percent).  One commentator on the budget noted that 
these ministries were the only ones whose budget allocations 
increased by more than the rate of inflation. 
 
¶24. (SBU) The President has used his control of the Ministry of 
Finance budget in a way that critics have charged is non-transparent 
and non-accountable.  Beginning in 2003 the government has allocated 
increasingly large sums to a Finance Ministry account called the 
"Development Activities Program."  The government has used this 
account to pay for expenses in various ministries as they arise 
throughout the year, by transferring funds on a case-by-case basis. 
This has given the president discretion over un-budgeted 
expenditures proposed by his 108 ministers, deputy ministers and 
non-cabinet ministers, as well as by his own office. 
 
¶25. (SBU) In a required "Fiscal Management Report," the government 
stated that its January through October 2007 expenditures in this 
account totaled 36 billion rupees.  Of this, however, the government 
only gave details on 11 billion in expenses -- for uses like 
"personal emoluments," "foreign travel," "purchase of vehicles," and 
"contractual services," plus capitalization of a new bank, and 
"expenses connected with failed state enterprises."  The 2008 budget 
allocates 50 billion rupees -- 5 percent of the total budget -- to 
this Finance Ministry account. 
 
COLOMBO 00001661  006 OF 007 
 
 
 
¶26. (SBU) Several parties challenged this practice in the Supreme 
Court, saying it unconstitutionally circumvents parliamentary 
control over public finance.  The Court quickly instructed the 
government to more fully report the use of these funds to Parliament 
as required by the Fiscal Management Responsibility Act; it did not, 
however, accept the claim that the government's actions were 
unconstitutional.  Nevertheless, the Chairman of the Committee on 
Public Enterprises (COPE, ref B) resigned from the government to 
protest the government's non-transparent use of these funds, failure 
to hold accountable ministers accused of corruption, and 
under-funding of poverty programs relative to the generous 
compensation provided to ministers. 
 
BUSINESS AND CIVIL SOCIETY NOT IMPRESSED 
------------------------------------- 
 
¶27. (SBU) The following is a selection of comments reported in press 
coverage of a variety of public programs convened in Colombo to 
discuss the budget: 
 
-- A Nestle rep urged the government to reduce waste and 
inefficiency in the state sector, in order to be more responsible 
towards the people whose welfare it is supposed to manage. 
 
-- The Business for Peace Alliance lauded the government's plans to 
improve regional and provincial infrastructure.  But it said the 
"colossal" increase in defense spending overshadows the proposed 
spending on productive sectors of the economy and "casts clouds on 
the hope for peace."  It added, "with the rate of inflation already 
at an unbearable level, such increased expenditure on 
non-constructive sectors will have a negative impact on the 
economy." 
 
-- Representatives of chambers of commerce representing small and 
medium enterprises were generally positive about the budget's 
support for local industry.  However, they criticized proposals for 
increased spending on government. 
 
-- The Sunday Times quoted an unnamed "top businessman" saying that 
"the budget is an eyewash, the country is on a major economic 
decline and the economy is mismanaged..." and another describing the 
budget as "disgraceful -- there is nothing conducive for the 
business sector and there are a lot of stealth taxes that are 
imposed on them." 
 
-- A professor of economics from the University of Colombo told the 
Sunday Times that incentives for investment in the Eastern Province 
would not work if the lack of human and physical capital in the 
region was not addressed first. 
 
-- Another leading economist criticized the government's public 
expenditure as "welfare oriented rather than workfare oriented" and 
tax policy as regressive due to its dependence on indirect taxes. 
He advocated decentralized tax collection and spending, so that 
development efforts would be more responsive to actual needs rather 
than central government political priorities.  He credited the 
government's Eastern Province development plans in principle but 
said they were unlikely to succeed without a return to democratic 
rule in the province. 
 
COMMENT: THE CRITICS ARE RIGHT 
------------------------------ 
 
¶28. (SBU) It would not be realistic to expect the Rajapaksa 
government -- which was elected on an economic platform that 
emphasized big government programs and transfers -- to propose a 
budget with the kind of reforms and priorities we think are 
necessary for Sri Lanka to realize its great economic potential. 
This budget will not change the fact that much of Sri Lanka's growth 
comes in spite of the government, not because of the programs it 
says will stimulate growth.  The government's attempt to contain its 
fiscal deficits is commendable, but comes from fear of inflation of 
 
COLOMBO 00001661  007 OF 007 
 
 
a political liability, not belief in sound fiscal management.  For 
this reason, the government continues to avoid the hard budgetary 
compromises needed to reduce inflation.  Thus Sri Lanka in 2008 is 
likely to continue to experience high inflation and high interest 
rates, and as a result is unlikely to see the 7.5 percent GDP growth 
that the government predicts. 
BLAKE