Budget of huge significance

Bangladesh is facing unprecedented macroeconomic pressures. Reserves are down, export growth has slowed, inflation is high and GDP growth is on a declining trend. The government took some bold reform measures on 8 May that essentially eliminated control over the interest rate to lower the demand pressures on the balance of payments and domestic inflation. To boost exports and reduce imports, the government also unified the exchange rate and adopted an interim crawling peg system with the intention to move to a market-based exchange system. The government understands that the adjustment agenda requires further policy actions involving fiscal policy, trade policy and banking reforms.

The fiscal policy agenda is particularly critical for macroeconomic stabilisation. Unless the fiscal policy is coordinated with monetary and exchange rate management to lower the aggregate demand pressures on the balance of payments and domestic inflation, macroeconomic stability will not likely happen.

Apart from the stabilisation agenda, the budget has major implications for economic growth and equity. Rapid sustained growth between FY09 and FY19 contributed handsomely to job creation and poverty reduction. The slowdown of average GDP growth since FY20 (5.8% over FY19-FY24 as compared with 6.8% between FY09-FY19) is raising concerns about the capacity of the economy to create good jobs.

Over the past several years, the equity agenda has also been on the backburner as growing fiscal constraints have limited the ability of the government to adequately fund public programs in health, education and social protection.

Against this backdrop, the FY25 Budget to be announced today is of huge significance. The macroeconomic challenge facing the Budget is to reduce the fiscal deficit significantly to lower aggregate demand. But this demand reduction should be achieved in a way that it does not compromise the future growth prospect or reduce equity.

The Stabilisation Agenda: As a result of eliminating interest rate controls, the deposit and lending rates have increased substantially. This has slowed the growth of private sector credit. The business sector is complaining about rising interest costs. So, from a policy perspective, the full load of demand adjustment cannot be placed on interest rate alone. Accordingly, monetary policy that determines permissible total credit growth needs to be coordinated with fiscal policy to ensure a proper distribution of credit between public and private sectors.

The largest public sector borrower is the National Budget based on fiscal deficit. In September 2023 the Bangladesh Bank took a wise decision to stop funding the budget deficit through money creation. The Treasury has since then resorted to sale of T-Bills to the banking sector. The growing sale of T-Bills to the banking sector has contributed to rising interest rates. Therefore, the only sustainable way to keep interest rates from rising is to limit the fiscal deficit.

Historically, the government has followed a golden rule of keeping the fiscal deficit at around 5% of GDP to preserve fiscal discipline This golden rule is based on debt-sustainability analysis, which suggests that this level of fiscal deficit is consistent with sustainable management of the public debt. But evidence suggests that in the current environment of high inflation and pressure on the balance of payments, the 5% of GDP deficit rule is inconsistent with macroeconomic stability.

The safest approach would be to keep the fiscal deficit at around 3% of GDP until such time that the inflation rate falls back to 5-6% level. The rationale for the 3% of GDP target is that this level of fiscal deficit can be safely financed through available external funding of around 2% of GDP and it reduces the budgetary domestic borrowing requirement to only 1% of GDP. This leaves enough space for the growth of private sector credit without undue pressure on the interest rate. If more resources can be mobilised through low-cost foreign borrowings from multilateral institutions, the fiscal deficit target can be adjusted upwards.

Growth and Equity Agenda: The budget's biggest contribution to the growth agenda has come from public spending on agriculture, water resources, energy, transport, health and education. The annual development program is the primary instrument for supporting these spending. Historically, the ADP as a share of GDP grew from a low of 2.7% of GDP in FY09 to 5.1% of GDP in FY19. Much of the increase in ADP was allocated to energy and transport, although small increases were also possible for agriculture and education. These investments were fruitful in supporting the growth agenda.

However, spending on water resources, health and social protection remained constrained despite the increase in ADP. The shortfall in spending on water resources has sharply slowed the implementation of the Bangladesh Delta Plan (BDP2100) with adverse consequences for reducing the water-related climate change vulnerabilities, especially flooding and riverbank erosion.

While the main focus of the past budgets was in supporting the growth agenda, some attention was given to human development. In particular, efforts were made to increase budget spending on education and training, reaching a peak of 2.5% of GDP in FY19.

The ADP spending is now on a downward trend, falling to 4.2% of GDP in FY24. The associated cutbacks in ADP spending, forced by domestic revenue constraint and the rising subsidy bill, are hurting Bangladesh growth prospects.

Nevertheless, the burden of expenditure cutbacks has fallen most heavily on social spending. Health spending in FY23 was a mere 0.7% of GDP. Spending on education declined to 1.8% of GDP. Excluding civil service pensions, which are not poverty focused and are obligatory in nature and therefore protected against cutbacks, social protection spending for the poor amounted to only 0.9% of GDP. This limited spending on social protection at a time of substantial inflationary pressure is deeply worrisome with likely adverse consequences for poverty reduction.

Reconciling fiscal policy with stabilisation, growth and equity objectives

The challenges for the FY25 Budget are deep. It not only must limit the fiscal deficit to around 3% of GDP but it must also increase public spending on agriculture, water resources, human development and social protection. Fortunately, the government has three major instruments to reconcile stabilisation with the growth and equity agenda. First and foremost, the government must take some meaningful measures to increase tax revenues. Second, the government should initiate a major reform program of the state-owned enterprises (SOEs) to sharply improve their financial performance. Finally, the government should reassess its subsidy strategy to only finance programs that contribute to poverty reduction.

Increasing tax revenues through focused tax reforms: Instead of ad-hoc tax measures with uncertain revenue prospects, the government should start implementing a focused medium-term tax reform programme. The main elements of the tax reform are well known and have been presented in public fora and shared with the government many times. These include (a) separating tax planning and tax policy from tax collection; (b) substantially strengthening both units with autonomy, professional management and quality staffing; (c) digitalising tax assessment and collection thereby eliminating the interface between taxpayer and tax collector; (d) simplifying tax filing by eliminating the income, expenditure and wealth reconciling; (e) selective and productive audits done by professional auditors; (f) implementing the 2012 VAT Law; (g) removing most tax exemptions unless justified by strong economic benefits; and (h) introducing a modern property tax system.

While the full implementation of the tax modernisation plan will take 2-3 years, an early start can be made in the FY25 National Budget with emphasis on items (c), (d), (e), (f) and (g). Items (c), (d) and (e) can have substantial positive revenue effects by eliminating leakages resulting from the present system of one-on-one dealings between the taxpayer and tax collector and the incidence of negotiated settlements. These reforms will also encourage greater tax compliance by eliminating the prospects of harassment resulting from the complexities of the income, expenditure and wealth reconciliation requirement, and the personalised tax collection and audit system.

Implementation of the 2012 VAT Law can also have substantial revenue boosting effects by improving the efficiency of the VAT system. Finally, the elimination of most tax concessions unless justified by demonstrated economic benefits can significantly raise tax revenues. The implementation of these reforms is conservatively estimated to yield additional tax revenue of 1% of GDP in FY25.

Generating higher revenues through SOE reforms: The government has invested heavily in SOEs. Most SOEs suffer from operating losses. Only a few enterprises make profits, mostly involving BPC, Telecoms Regulatory Authority, and the Chittagong Sea Port. As a result, as against a book value of total non-financial SOE assets of 17% of GDP in FY21, profits were a mere 0.6% of GDP. A 10-12% financial rate of return should yield profits equivalent to 1.8-2% of GDP. Research done by the Policy Research Institute (PRI) shows that a combination of corporate governance and pricing problems constrain the financial performance of SOEs.

The Research has also identified specific policy reforms to turnaround SOE performance. Corporate governance reforms essentially involve giving autonomy to SOEs in the selection of management, staffing, production and investment decisions, while keeping an arm's length relationship with the government as owners and also facing a hard budget constraint. This is the only way that SOE management can be held accountable for performance. Pricing reform entails setting market prices for SOEs operating in a competitive environment, while establishing autonomous regulatory bodies to set prices for public utilities.

While implementation of the corporate governance reform will take time, pricing reforms can be easily done and will immediately boost non-tax revenues by increasing the profitability of SOEs. It is conservatively assumed that the Treasury can raise an additional surplus of 0.3% of GDP from SOEs in FY25.

Reforming expenditures to minimise subsidies and increase higher priority spending: This is an easy win. Subsidy on fossil fuel is contradictory to the government's stated intention to reduce its carbon imprint. So, eliminating this subsidy will help reduce carbon emission. It will also save considerable budgetary resources. By freeing up the exchange rate the government can eliminate subsidies on exports and remittances. Some agriculture input subsidies on fertiliser, seeds and water may be necessary, but these can be contained to a modest level. Overall, it should be possible to reduce subsidy spending from a high of 1.9% of GDP in FY23 to 0.8% of GDP in FY25.

The savings of more than 1% of GDP from subsidy rationalisation can be redeployed to increase spending on health, education, social protection, agriculture and water resources. Additionally, the 1.3% of GDP mobilised through higher revenues can be used to reduce the budget deficit.

Dr Sadiq Ahmed is the vice chairman of Policy Research Institute of Bangladesh