Tuesday June 10 2014

Economic growth will reduce budget deficit

Finance Minister Maria Kiwanuka

Finance Minister Maria Kiwanuka displays the Budget brief case last year. File photo 

By FRANCIS KAMULEGEYA

According to the Budget Framework Paper 2014/15, the fiscal deficit for the current financial year 2013/14, excluding grants is projected at -9.1 per cent.

This is an increase of more than 60 per cent of the -5.6 per cent fiscal deficit for financial year 2012/13. A budget or fiscal deficit is the gap between what the government spends and what it gets in income, mainly from taxes.
When the government spends more than it collects from tax it has to borrow money to make up the difference.

This is the current situation the Uganda government currently faces. This deficit is funded by borrowing mainly from the domestic market.

This borrowing is necessary in order to provide fiscal support, following the aid suspension of 2012, as well as the lower than expected revenue collections for the current financial year.
The borrowing has enabled the government to continue front loading public expenditure in physical infrastructure development, a sector that is so important for the growth of the economy.

How is the deficit financed
Almost all governments in the world finance their budgets using a combination of both domestic revenue and national debt. It makes sense for the government to borrow money not only to finance budget deficits, but to pay for investment that will help make a country more productive.

Budget deficits are financed by a country’s bonds. In Uganda, it is financed by the Bank of Uganda Treasury Bills and Government Bonds. Whenever the government borrows to finance the budget deficit, this borrowing adds to the country’s national debt. As the debt grows, it increases the deficit in two ways.

First, the interest on the debt must be paid each year. This increases spending while not providing any benefits. Also, if the interest payments become too high, this creates a strain on the economy, as those funds could have been used to finance other sectors of the economy.

Secondly, national debt levels can make it more difficult for the government to raise funds.

Too much debt can cause a crisis
When the government’s debt to GDP ratio is very high, creditors become concerned about a country’s ability to repay its debt. When this happens, the creditors demand higher interest rates to provide a greater return on this higher risk.

This results in an increase in the deficit each year. This can eventually become a self-defeating loop, as the country goes deeper into debt to repay their debt.
At some point, the interest rates on new debt can become so high, for the country to afford, and a country may default on its debt. This is what caused the Greece debt crisis of 2009. Fortunately, we are nowhere near that point here in Uganda.

Prudent debt policy is
Uganda’s debt policy is guided by the government’s Public Debt Strategy. Most of the government’s foreign debt is on concessional terms, over medium and long term.

Due to this very prudent government external debt policy, total government debt is currently at about 29 per cent of GDP. This is equivalent to about Shs16 trillion. Of course it would be better if we did not have to borrow at all.

But for as long as elected officials are always promising the voters in their constituencies more public goods and services in form new roads, hospitals, electricity and even tax cuts, and at the same time tax collections remain as low as they currently are, the government will always have to borrow to finance the its budget.

No politician would want to tell voters that roads in their constituency will not be built, or that they will not get electricity because tax collections are low, and the government does not want to borrow to avoid increasing government debt. That would be political suicide.

Therefore, as long as the political leaders continue to make these electoral promises and citizens continue to demand that the promises be honoured, while at the same time tax collections remain at the current low levels compared to GDP, the government will always have to borrow to finance the budget deficit.

Is our debt bigger than other countries?
It is important to remember that the nominal value of the debt is not actually important. It is the level of debt relative to the earning capacity of the economy that is the important figure. This is known as the government’s debt to GDP ratio. Uganda’s government debt as a percentage to GDP is one of the lowest in Africa. The total government debt currently stands at about 29 per cent of the country’s GDP. This is the second lowest in East Africa, after Rwanda’s debt which is about 24 per cent to GDP.

Kenya’s national debt is the highest in East Africa at about 50 per cent of GDP, followed by Tanzania at 40 per cent.

These debt levels are still very low when compared the government debt levels in the developed economies. For example the debt to GDP ratios of both the USA and the Euro areas countries of the EU is over 100 per cent. Japan has the highest debt to GDP levels among the developed economies at 230 per cent debt to GDP.

How can we reduce the deficit?
Government debt is very different from domestic household debt. This is because financing the national budget is very different from financing our household budgets. For example, you and I can, as householders take decisions about how much to spend, how much debt to take on and how fast to pay it back without it having any effect on our incomes or wages. However, this is not the case for a nation.

Cut government spending
The obvious way to reduce a budget deficit is to cut government spending. However, as we have seen in the Euro zone area, this kind of fiscal tightening can cause lower economic growth, which in turn can cause a higher deficit as the government gets less tax revenue in a recession.

If a country spends less, this will have a negative effect on the country’s tax revenue, and an even more detrimental effect on the country’s economic growth and development. For example, if the Minister of Finance were cut spending on building new roads, schools, hospitals, this will have a knock on effect on the construction sector.

There would be reduced economic activity in the construction sector, and as a result construction companies will make less profit and pay less corporation tax.

They will buy fewer cement, steel bars, sand and bricks. This may result in the cement and steel companies reducing their staff numbers, and closing down factories.

These newly unemployed factory workers will stop paying income tax as they will no longer have income. They will also spend less in supermarkets, which in turn will reduce the profitability in the retail and trade sector, and therefore more job losses and fewer taxes, and so on.

Tax increases may not reduce the deficit
The other option is to increase taxation. Increasing taxes by such large amounts may lead to a recession and even a depression. This is because businesses will pass on the costs of higher taxes to their consumers. The increase in prices is likely to lower demand for goods and services.

The higher taxes will also result in lower levels of disposable income, and this will negatively affect demand.

Both factors will feed through to lower sales and therefore lower VAT and corporate taxes, forcing the government to further increase taxes to hit its debt reduction target.
Lower demand for goods and services will also lead to businesses cutting employment, lowering the government’s income from income taxes.

The best way to reduce the deficit as a percentage of GDP is to promote economic growth. If the economy grows, then the government will increase tax revenue, without raising taxes.
With economic growth, people pay more VAT, companies pay more corporation tax, and workers’ pay more income tax.

High economic growth is the least painful way to reduce the budget deficit because you do not need to raise tax rates or cut spending.

However, while aiming for positive economic growth may be the least painful way, the government must also evaluate its current borrowing levels, to ensure that it does not create too much strain on the future generations who will pay back this debt.
Government borrowing must also be directed towards financing capital goods as opposed to recurrent expenditure. Finally government must reduce its spending to levels that are sustainable.

Mr Francis Kamulegeya is the country senior partner for PriceWaterHouse Coopers Uganda.

editorial@ug.nationmedia.com

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