ECONOMYNEXT – When the government changes ground rules and conditions or the operating regime suddenly, like in Sri Lanka, it is very difficult for ordinary people or businesses to operate and survive.

Countries that suddenly up-ends policies cannot grow fast and their people would be poor.

Sri Lanka can change taxes suddenly without going to parliament and debating about it. While cutting taxes may increase the freedom of citizens, certainly raising taxes doesn’t.

Uncertainty is not just in taxes. Virtually no certainty can be given about any policy, tax or any other rule, or its continuity, in countries like Sri Lanka.

Fluid Regime

Sri Lanka has a habit of suddenly raising import duties by midnight gazette.

Markets have all kinds of uncertainties.

But when governments add to this uncertainty, individuals and businesses in that country have to bear higher risks than a person or enterprise in countries with stable policies.

Such countries will lag behind, relative to others were individuals and businesses face no such risks.

In 2015 there was an outcry by people who had ordered cars after taxes were suddenly raised when the car had already arrived in the country. In Sri Lanka cars are expensive. If a person is suddenly asked to fork out a million rupees extra, they will fall in to extreme difficulty.

Then a policy was evolved that cars already ordered would be allowed to be imported at the old tax rate if the letter of credit was opened before the tax was announced.

Pettah traders face this problem often. When they go the port to clear a consignment in the morning, they suddenly find, that taxes have been raised or cut.

While a duty cut can be said to be beneficial, it can also cause losses because the value of all existing stocks fall. The man who cleared a stock the day before will face a substantial loss.

Executive Power, Royal Prerogative

It was sudden tax hikes that led to the Magna Carta being drawn by English Barons that eventually paved the way to moderating executive power and the creation of a parliament. In Sri Lanka laws were announced by Ana Bera before being implemented under ancient Kings.

But since independence, laws are implemented before the Government Gazette, started by the British, is even seen by the people. No time is given before a new law is implemented.

President Gotabaya Rajapaksa suddenly ordered by decree that plantations sector wages would be raised to 1,000 rupees, while a collective agreement was in force. An unexpected wage hike suddenly hit plantations companies which were already facing low global tea prices.

Any enforced wage hikes ends up expropriating the cashflows of a company, like a new tax imposed to finance a subsidy.

Before 2015, personal income taxes were brought down to 16 percent rate by a previous regime as part of efforts to create a competitive playing field for a highly skilled services-based economy.

It was suddenly changed to a progressive tax rate with the highest rate at 24 percent by the last administration under an International Monetary Fund program.

Personal income tax has now been brought back down to 18 percent – without going to parliament. The PAYE tax threshold has also been raised – without going to parliament. Value-added taxes have been cut from 15 to 8 percent – without going to parliament.

This may increase the freedom of citizens, but with budget deficit expected to grow, it has generated more uncertainty over interest rates, exchange rates and economic stability itself.

European-style governments – which Sri Lanka became under British rule – publish budgets to give certainty, recognising that government taxes and spending are a source of instability as the single largest player in an economy with coercive power.

More than the income tax, the VAT cut has fundamentally altered the 2020 mini-budget up to April, which has already been presented and ratified in parliament.

Monetary Instability

The taxes were cut as a ‘stimulus’ after economic growth slowed in the wake of a currency collapse in 2018.

What happens to car taxes from time to time is symptomatic of the overall problems facing Sri Lanka.

Sri Lanka’s car taxes are suddenly jacked up usually ‘to reduce imports’ after the central bank generates pressure on the currency by printing money to reduce short term interest rates.

In countries with monetary stability, such changes do not occur.

Government policies, involving ‘stimulus’ and other interventions that change the operating regime, also rapidly increase after a currency, credit and economic collapses, delaying a eventual recoveries by heaping more uncertainty and risks.

This shows that monetary instability and overall policy instability is closely connected. In 2018 rates cuts and injections from April, plunged the country into a new currency crisis, as it was recovering from an earlier one, triggering two busts in a row.

That is the cost of sacrificing stability for monetary stimulus.

Now banks are being asked to give debt moratoriums, reduce credit standards by ignoring credit information bureau data.

The list of interventions can go on.

The entire misguided approach dates back to the Great Depression in particular and Keynesianism in general.

During the Great Depression, the US rapidly expanded both the sizes and scope of government, by creating new agencies at a rate never before seen, which increased the burden of the state on the public on top of the economic downturn.

New Dealers in the US, in particular, created many new interventions after the Great Depression, in two episodes (the first and second New Deals) generating uncertainty for businesses to invest, and busting the first recovery.

Regime Uncertainty

Economists called this fluid and operating environment, Regime Uncertainty.

In Sri Lanka regime uncertainty is ever-present, with or without an economic collapse.

But most ‘developed countries’ have lower levels of regime uncertainty and more certain policy for several years. A key reason for their prosperity is the lack of regime uncertainty.

When developed countries change policies suddenly or adopt policies like those in Sri Lanka, their effects have also been devastating.

Britain became a shadow of its former self after World War II, pursuing Keynesian interventionist policies and socialist expropriation.

But Germany and Japan, which were occupied by the US, and the American military allowed German-like policies to be followed, zoomed head.

Hong Kong, which also eschewed stimulus through its ‘positive non-interventionism’, placed stability before interventions and stimulus, allowing it to power ahead. (Lessons for Sri Lanka from Hong Kong’s positive non-intervention: Bellwether)

America’s economy is now being buffeted by President Trump’s antics, though his party is for low direct taxes and de-regulation. But his capricious policies will reduce the benefits of the better ones.

The US was also severely hit by policy instability during the Great Depression.

The term ‘Regime Uncertainty’ was used by Robert Higgs, an economist who tried to find out why the US, which was recovering from the Great Depression, suddenly slumped with private investment again collapsing under Roosevelt’s New Deal.

Policy uncertainty is linked to business confidence, and property rights.

“To narrow the concept of business confidence, I adopt the interpretation that business people may be more or less “uncertain about the regime,” by which I mean, distressed that investors’ private property rights in their capital and the income it yields will be attenuated further by government action,” explains Higgs.

“Such attenuations can arise from many sources, ranging from simple tax-rate increases to the imposition of new kinds of taxes to outright confiscation of private property.

“Many intermediate threats can arise from various sorts of regulation, for instance, of securities markets, labour markets, and product markets.

“In any event, the security of private property rights rests not so much on the letter of the law as on the character of the government that enforces, or threatens presumptive rights.”

Expropriation

In Sri Lanka, the threat of expropriation is ever-present.

Expropriation can be outright – like the nationalisation of businesses, land reform or the Rajapaksa expropriation act.

Indirectly private property can be expropriated through high taxes, price controls or mandated wage hikes.

Under the last UNP administration, with an International Monetary Fund program, all sorts of new taxes were slapped by politicians who originally said they were coming to reduce the total number of taxes.

There were also retrospective taxes.

Higgs pointed out that economist like Joseph Schumpeter and many others had also pointed to the problem created by new laws and controls by New Dealer Keynesians.

“The subnormal recovery to 1935, the subnormal prosperity to 1937 and the slump after that are easily accounted for by the difficulties incident to the adaptation to a new fiscal policy, new labour legislation and a general change in the attitude of the government to private enterprise…” Schumpeter had said of the Great Depression.

“I for one do not see how it would otherwise be possible to account for the fact that this country which had the best chance of recovering quickly was precisely the one to experience the most unsatisfactory recovery.”

New Dealers also busted the US dollar from 22 to 35 dollars an ounce and prohibited US citizens from holding gold, much like present day central banks prohibit citizens from holding foreign exchange in the un-backed paper money era through exchange control laws.

After accepting his party’s nomination for the presidency in 1936, Roosevelt had blasted “economic royalists” allegedly seeking a “new industrial dictatorship”.

Former Prime Minister Ranil Wickremesinghe also blasted big businessmen, who had previously backed the Rajapaksa regime.

Under Wickremesinghe price controls were imposed money was effectively expropriated from diary and gas companies. An entirely new price control agency was established for pharmaceuticals.

Higgs says Roosevelt later changed new Dealer interventionists in government as the US entered the war, replacing them with private sector people to get the production machinery geared to arms and other military needs.

During the war, private investment was not very high. The real prosperity (called the Great Escape) happened after the War, Higgs says.

“…[G]iven the unparalleled outpouring of business-threatening laws, regulations, and court decisions, the oft-stated hostility of President Roosevelt and his lieutenants toward investors as a class, and the character of the anti-business zealots who composed the strategists and administrators of the New Deal from 1935 to 1941, the political climate could hardly have failed to discourage some investors from making fresh long-term commitments.”

After the war, the economy took off, in the ‘Great Escape’ despite many Keynesians forecasting that the depression would return.

Same Old, Same Old

The current administration is perceived as being more business-friendly. But midnight gazettes, sudden import bans, price controls are continuing unabated.

The last administration also expropriated depositors, first by depreciating the currency and then by slapping price controls on deposits.

Economist Steve Hanke calls the tendency to intervene and expand the government in the wake of a downturn the Law of the Ratchet.

Interventions and new government programs are ratcheted up after a downturn, and new agencies are created.

The public service is going to be expanded by 10 percent, with 100,000 ill-educated persons who had passed 8th grade and 50,000 graduates who are ill-suited for productive work and cannot get jobs being absorbed and to be paid by taxpayers to ‘reduce poverty’.

The interventions that were created during the Depression (like farm subsidies) could never be could not be reversed fully. In fact they were adopted by other countries, creating problems and distortions in those countries. The agencies that are created will find reasons to exist.

The uncertainty from budgets is also very present. As the Great Depression showed, monetary instability is a great driver of state interventions and stimulus.

There is also no real prospect of monetary instability ending either.

Under ‘flexible’ inflation targeting, there is a high degree of bureaucratic discretion. In January the central bank cut rates as inflation was spiking up and the threat of a higher deficit.

Executive Power

Most of Sri Lanka’s nationalism and state interventionism is copied from Europe.

Sri Lanka’s ancient rulers never engaged in such tactics. They also did not have the tool – the police, the jails, customs department or inland revenue – income tax itself is a new phenomenon – to effectively enforce controls on economic players like modern governments do.

Under Roosevelt Presidential power was increased, to a level not seen before and allowing him to generate uncertainty, though he was partly thwarted.

In 1937 and 1938 Roosevelt tried to pass a new law to give more powers to the executive branch in what critics described as an attempt by a would-be dictator “to subvert democratic institutions” by “importing European totalitarianism into the United States”, Higgs says, including the creation of a National Planning Board.

In India the National Planning Commission, which created much of the havoc in the Nehru Era 5-year plans, was finally abolished by Modi, after sitting around doing nothing much since the 1990s reforms that reduced the role of the state, allowing India to take off.

After Roosevelt’s bill was defeated, a watered-down replacement was passed in 1939, which gave more power to the President.

He used it to create the Executive Office of the President and the Office of Emergency Management. He was also accused of undermining the judiciary by so-called ‘court packing’.

It is through the Executive Office that President Trump now issues many controversial Executive Orders. Obama also issued several, many of which were uncontroversial.

Through his executive orders, Trump, a loose cannon and a nationalist, is creating Regime Uncertainty around the world, destabilizing the global economy.

In Sri Lanka, Regime Uncertainty is ever-present though a cyclical recovery is underway from the last balance of payments crisis.

On top of that, many policies are New Dealer-like in Sri Lanka, and have been for decades, which undermines both economic freedom and the rule of law. The threat of expropriation is ever present.

Monetary instability is always over the horizon with a soft-peg, threatening both the currency, which is the economic foundation of the poor, and debt repayment, regardless of the party or the leader in power.

This column is based on ‘The Price Signal by Bellwether‘ published in the February 2019 issue of the Echelon Magazine. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here.