Article

Export Instability and Contracyclical Fiscal Policy in Underdeveloped Export Economies A Case Study of Ceylon Since 1948

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1959
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THE FACT THAT INSTABILITY in the export markets of under-developed countries poses grave economic and social problems for these countries is now widely recognized. Each primary producing country can do little, individually, to influence its export and import prices expressed in foreign currencies. However, it is generally maintained that each country can adopt domestic contracyclical monetary and fiscal policies to insulate, to a large extent, its economy from the adverse effects of such instability. In view of the importance of government transactions in the total economic activity of most underdeveloped countries, and because of the lack of well-organized and integrated monetary systems, the responsibility for formulating and implementing public contracyclical policies will rest primarily on the fiscal authorities. The problems and limitations of monetary policy in underdeveloped countries have been discussed widely, but little attention has been given to the difficulties which are likely to arise in the application of contracyclical fiscal policy. The objective of this paper is to analyze the role of such policy in underdeveloped export economies, and to use the budgetary experience of Ceylon in the period from 1948 to 1957 to illustrate some of the difficulties which may be encountered in its adoption and operation.

Economic Fluctuations in Underdeveloped Countries

Economic fluctuations in underdeveloped countries are mainly the result of business cycles originating in developed countries and are seldom due to any excess or deficiency of domestic effective demand. The price and income elasticities of world demand for and supply of primary products are such that fluctuations in economic activity in industrial countries cause greater fluctuations in the prices of such commodities and in the export receipts of the countries producing them. The prices of industrial manufactures, which constitute an important portion of the imports of underdeveloped countries, do not fluctuate as widely as those of primary commodities, although they tend to rise in a boom and to decline in a recession. The result is that the terms of trade of primary producing countries generally improve significantly in a boom and decline significantly in a recession.

The changes in the terms of trade of underdeveloped countries make it hypothetically possible for export income, and thus national income, in money as well as in real terms, to fluctuate widely through shifts in export and import prices, without any change in the levels of domestic employment and output for export and home consumption. In actual fact, however, price fluctuations are always accompanied by changes in output and employment. Such changes could be in response to the price fluctuations themselves, to noneconomic factors (e.g., weather conditions and political factors), or to noncyclical economic factors (e.g., the development of synthetic substitutes). The changes in output and employment caused by the last two factors can be quite large, and they may either aggravate or reduce the instability caused by price fluctuations (e.g., a good crop during a boom and a bad crop in a recession would increase the amplitude of income fluctuations); they are also more unpredictable than changes arising from business cycles in industrial countries and, therefore, are generally less amenable to any planned offsetting operation.

The changes in output and employment arising from price fluctuations, however, may not be large for most underdeveloped countries. The main factors which tend to limit them are (1) the relatively low elasticity of supply of export products as well as of goods produced for domestic consumption, especially if they are agricultural products1 (2) the relatively low multiplier effect—which is due to the high marginal propensity to import—of the initial rise in export income, and (3) the retarding effect on the propensity to save and to invest that could result from the uncertainty of price and income prospects.2 Furthermore, the possibilities of a change in export volume in response to price changes without a concurrent change in output may be small for most underdeveloped countries, since the domestic markets for their export commodities are generally too small to absorb or release large quantities of primary products for export markets.

The nature and origin of economic fluctuations in underdeveloped export economies are thus different from those in industrial economies, especially of the “closed” type. The two extreme types—an “exposed” underdeveloped economy specializing in the production of one or two primary products for export and a “closed” economy engaged primarily in manufacturing activity—may not be representative of the majority of countries, but a comparison between them helps to pinpoint the essential differences between economic fluctuations in developed and in underdeveloped economies. The difference will, of course, narrow considerably as the underdeveloped country acquires a substantial amount of manufacturing activity, and if the developed economy has a substantial export-import bias.

Role of Contracyclical Fiscal Policy

The difference in short-run instability between developed and underdeveloped countries naturally results in different approaches to contracyclical policy. The primary concern of contracyclical policy in industrial economies is to stimulate domestic monetary demand in order to eliminate unemployment of resources during a recession and to restrict demand when signs of inflation develop. In underdeveloped countries, where instability is due mainly to fluctuations in export income, contracyclical operations should be directed at offsetting the impact of export fluctuations on the domestic economy. The primary objective is to stabilize the flow of imports so that during a recession no hardship is caused to consumers of imported goods and no dislocation is caused to industries using imported raw materials and machinery.

The “external” aspect of such an import stabilization program is to conserve a part of the foreign exchange earnings in a boom for use during a recession. Such a program would have the additional advantage of preserving the confidence in the country’s currency, which is quite essential for attracting foreign investment. Furthermore, the real value of total imports obtained in return for a country’s exports over the cycle would be larger because import prices are usually lower during a recession. The “internal” aspect of the import stabilization program is to impound a part of the export income and the excessive liquidity of the public and of the banking system during a boom in order to prevent an expansion of imports, undue fluctuations in domestic wages and prices, and large changes in credit conditions in money and capital markets. While the “internal” aspect of the program thus parallels somewhat the contracyclical policy of industrial countries, it is fundamentally different in its purpose. It is not directed at the excess or deficiency of monetary demand relative to the flow of goods and services, since even in the most pronounced boom the rise in the level of money incomes and domestic liquidity in underdeveloped export economies is accompanied by a growth in real income through better terms of trade and an increase in the availability of imports. Internal liquidity is excessive in an underdeveloped country during a boom in a sense different from that which is applicable in an industrial economy. It is excessive in relation to the high marginal propensity to import, to the ensuing decline in export incomes and foreign exchange reserves, and to the ability of the economy to respond quickly to the increased monetary demand by increasing its output.

A significant corollary of such a program of import stabilization is that it must be initiated during an export boom, unless the country has accumulated foreign exchange in the past or can borrow from abroad to support its imports in a recession; such borrowings can be repaid during the next boom. In each case, the same domestic contracyclical policies will have to be pursued.

A contracyclical program of the kind outlined above is, by its very nature, not something to be adopted only by the government and the monetary authorities. The private sector, too, engages automatically in a measure of contracyclical financing by saving more in a boom and saving less, or actively dissaving, in a recession. Such automatic response on the part of the private sector, however, may not be adequate to prevent periodic foreign exchange crises or to achieve the magnitude and composition of capital formation considered appropriate for an underdeveloped country.

Broadly speaking, public contracyclical policy may be of two kinds. The first operates by encouraging or inducing the private sector to adopt consumption, saving, and investment patterns which accord with contracyclical requirements; in this sector, monetary policy would play the major role. The second operates through direct and compelling public intervention in the distribution of national income and its expenditure; in this sector, fiscal policy would play the major role. Domestic contracyclical commercial policy, which would consist mainly of price and production stabilization and marketing schemes for the export industries and some forms of foreign exchange budgeting, could belong to either category, depending on the nature of the scheme.

In recent years, the major responsibility in meeting short-run economic fluctuations in developed countries has been placed on monetary policy. However, it is also widely recognized that, whatever its other advantages, monetary policy as a contracyclical weapon is less important in underdeveloped countries and is to a large extent dependent on fiscal policy. The basic assumption in using monetary policy is that, by changing the supply and price of credit, the monetary authorities can influence private economic decisions relating to consumption, savings, and investment. This assumption may be largely valid in developed economies, where there are generally a number of creditworthy unsatisfied marginal borrowers who would be affected by the decisions of the monetary authorities to change the supply and price of money and credit, and where the financial system is likely to be fairly responsive to monetary policy because it is well organized and integrated. In many underdeveloped countries, however, either one or both of these conditions do not apply to any large extent.3 The two conditions are, in fact, very closely related, as both of them reflect the underdeveloped nature of the economy.4

In most underdeveloped economies, changes in money supply are not caused mainly by bank credit to the private sector but by fluctuations in export income and in bank credit to the government. Although new methods of monetary control—e.g., the issue and redemption of central bank securities and the use of advance deposits on imports—are being developed to meet the problems of export fluctuations, monetary policy is still not an adequately effective means of control. It is perhaps even less effective as an offset to deficit financing by the government. In fact, it has often been said that one of the chief results of establishing managed currency systems in some underdeveloped countries has been to enable governments to finance large budget deficits without difficulty.

As a general rule, therefore, the main responsibility for contracyclical finance in underdeveloped countries now rests with fiscal policy, supplemented to an increasing extent by monetary measures.5 There are also other reasons why monetary policy cannot prove an effective substitute for fiscal policy. A contracyclical policy of import stabilization has naturally to be integrated with other objectives of public economic policy, viz., the achievement of a high level of capital formation without inflation and the equitable distribution of income. Both are of particular significance for contracyclical fiscal policy in underdeveloped countries. In a number of underdeveloped countries the governments have planned programs of capital construction whose efficient implementation necessarily requires the adoption of contracyclical fiscal policies. Such programs require (1) an averaging of government expenditure over booms and recessions to achieve a steadily rising rate of capital formation without inflation, (2) an increase of revenue receipts and their sterilization in booms and a reduction of revenues in recessions, and (3) an increase in public debt during booms through loan issues, especially to the nonbank private sector, and the redemption of a part of the debt during recessions. All these factors are in accord with a contracyclical fiscal policy designed to offset export fluctuations. Government intervention through some form of contracyclical action will also be needed to offset the distorting effect of export booms on the distribution of income in favor of exporters, who often constitute the wealthier sections of the population.

As in developed countries, contracyclical fiscal policy in underdeveloped countries will essentially take the form of budgeting for over-all budget surpluses in a boom and for deficits in a recession, and the pursuit of appropriate public debt programs. How the deficits or surpluses are achieved, whether through changes in total expenditure or in total revenue; what effects these changes may have on the structure of revenue and expenditure; how the deficit is financed, whether through credit from the banking system or from nonbank sources; and how the changes in revenue and expenditure occur, whether automatically or through “discretionary” policy decisions of the government—these are all important aspects of a contracyclical fiscal policy, helping to determine its effectiveness both for the achievement of short-run economic stability and in relation to the other two major and often conflicting objectives of fiscal policy, viz., the achievement of a high rate of capital formation without inflation and of a less unequal income distribution. They will be discussed later when the budgetary experience of Ceylon is analyzed.

Contracyclical fiscal policy in underdeveloped countries does not require that budget surpluses and deficits must balance over the cycle. In a developing economy, there is need for an increasing money supply to keep pace with the growth in output and employment and the monetization of new areas of the economy, and for an expansion of financial assets (e.g., government securities, corporate shares, etc.) as financial media between savers and investors. A “net” budget deficit (i.e., an excess of budget deficits over surpluses over the whole cycle) could be an important means of meeting that need. Beyond these limits, a “net” deficit can be a means of mobilizing resources for the government to finance its expenditures. However, the extent of the “net” deficit will have to be considered in relation to bank credit created for the private sector, if inflationary pressures are not to develop, and to the need for increasing the country’s external assets to keep pace with any growth in its international transactions, if stability in the exchange rate is to be assured. The attempt to conform to these requirements may give rise to a number of problems, some of which are discussed below in relation to the budgetary experience of Ceylon.

Export Instability in Ceylon and Other Underdeveloped Countries

The degree of export instability may be regarded as an indicator of the relative urgency of the use of contracyclical fiscal policy. It depends upon the fluctuations in export prices and income, the importance of merchandise exports relative to national income, and the importance of other sources of foreign exchange relative to merchandise exports. A comparison from this point of view between Ceylon and other underdeveloped countries will help to clarify the significance of these influences.

Ceylon exports three primary commodities, tea, rubber, and coconut products. Of these, tea accounts for roughly 60 per cent and the other two for 17 per cent and 12 per cent, respectively, of total exports. Thus Ceylon more or less belongs to the group of single-commodity export economies. The price of tea, Ceylon’s most important export, has fluctuated somewhat more since World War II than during the period from 1901 to 1950. However, it is still less unstable than the prices of most primary export commodities.

Average year-to-year fluctuations in export prices (expressed in U.S. dollars) of 15 commodities important in world trade are shown in Table 1 for two periods, 1901-50 and 1948-57. With the exception of tea, cocoa, copper, and rubber, the fluctuations in the prices of these commodities were smaller during the latter period than during the former. The increase in the amplitude of price fluctuation for two of the commodities (tea and rubber) implies that Ceylon is in greater need of contracyclical fiscal policy than before. However, tea still has a relatively low degree of price instability compared with most other commodities.

Table 1.Average Year-to-Year Fluctuations1in Commodity Prices, 1901-50 AND 1948-57(In per cent)
1901-5021948-573
Cocoa±16.7±22.8
Coffee14.313.3
Copper12.515.6
Copra19.115.2
Cotton18.410.4
Hemp19.112.0
Jute16.114.3
Rice11.610.7
Rubber20.727.6
Sodium nitrate4.94.5
Sugar15.32.4
Tea8.811.8
Tin13.98.5
Tobacco10.18.3
Wool14.714.3
Unweighted arithmetic average±14.4±12.8
Sources: The figures for 1901-50 are from United Nations, Instability in Export Markets of Underdeveloped Countries (New York, 1952), and those for 1948-57 are based on data from International Financial Statistics.

A year-to-year fluctuation is defined as the change in the unit value (expressed in U.S. dollars) from one year to the next, expressed as a percentage of the higher of the two years’ unit values. In calculating averages, signs are neglected.

Based on U.S. import unit values.

Based on U.S. import unit values for commodities imported into the United States. For other commodities, the average U.K. import unit values expressed in U.S. dollars have been used where possible, viz., cotton and copper. For commodities not imported into the United Kingdom or the United States, the average export unit value in U.S. dollars of the principal exporting underdeveloped country has been used, viz., rice (Thailand) and tobacco (Turkey); the U.K. import price for tobacco is not available. For 1949, the average of the pre-devaluation period, January-August, has been used.

Sources: The figures for 1901-50 are from United Nations, Instability in Export Markets of Underdeveloped Countries (New York, 1952), and those for 1948-57 are based on data from International Financial Statistics.

A year-to-year fluctuation is defined as the change in the unit value (expressed in U.S. dollars) from one year to the next, expressed as a percentage of the higher of the two years’ unit values. In calculating averages, signs are neglected.

Based on U.S. import unit values.

Based on U.S. import unit values for commodities imported into the United States. For other commodities, the average U.K. import unit values expressed in U.S. dollars have been used where possible, viz., cotton and copper. For commodities not imported into the United Kingdom or the United States, the average export unit value in U.S. dollars of the principal exporting underdeveloped country has been used, viz., rice (Thailand) and tobacco (Turkey); the U.K. import price for tobacco is not available. For 1949, the average of the pre-devaluation period, January-August, has been used.

Average year-to-year fluctuations during 1948-57 in the export proceeds of a number of primary producing countries are given in Table 2; they are based on export proceeds both in U.S. dollars and in real terms. Real export income for each country was obtained by deflating its annual export proceeds in U.S. dollars by its index of import prices, also expressed in U.S. dollars. The figures show that Ceylon’s real export income had a relatively high degree of instability, whereas its export proceeds in U.S. dollars had a lower degree of instability than the average for the 17 countries listed. The greater instability in Ceylon’s real export income is due to the relatively wide fluctuations in Ceylon’s import price index, often in the direction opposite to the movement of the export proceeds in U.S. dollars. The year-to-year fluctuations in the import price index in Ceylon averaged 9.7 per cent, compared with 4.5 per cent for the whole of Latin America. Ceylon’s import price index varied widely because a considerable portion (40 per cent) of its imports consists of primary commodities—mostly rice, wheat flour, and sugar—whose average year-to-year price fluctuations were quite high (Table 1). Since the average figure for sugar in Table 1 is based on U.S. import unit values, it does not reveal the fluctuations in Ceylon’s import price for sugar. The average year-to-year fluctuation in the price of Cuban sugar exported to countries other than the United States, a more appropriate index for Ceylon, was 12.8 per cent.

The impact on an economy of fluctuations in export proceeds also depends on the importance of merchandise exports relative to total national income and to total foreign exchange receipts from all sources, including visible and invisible exports, grants, and long-term capital. Table 2 shows that Ceylon has one of the highest ratios of merchandise exports to national income. A related feature is the very low contribution-approximately 5 per cent-which industrial manufactures for domestic consumption make to national income. During the period under review, Ceylon’s foreign exchange receipts from sources other than merchandise exports have consistently been smaller than foreign exchange payments for nontrade items. The payments consist largely of remittances from Ceylon of donations by immigrant labor, of income from foreign capital invested in Ceylon, and of some liquidation of private foreign capital invested in Ceylon.6 Foreign aid and loans received by the Government were relatively small up to 1957, except in 1954 when a loan was floated in London. In 1957, for example, remittances of private donations and investment income amounted to approximately 10 per cent of the income from merchandise exports and net repatriation of private foreign capital amounted to another 3 per cent; receipts from official loans and grants were less than 2 per cent of merchandise exports.

Table 2.Relation of Principal Exports to Total Exports and of Total Exports to National Income, 1956, and Average Fluctuations1in Total Exports, 1948-57, Selected Underdeveloped Countries
Average Year-to-Year Fluctuations1 in Total Exports, 1948-57
Countries and Their Principal ExportsProceeds of Principal Exports as Per Cent Total Exports 1956Total Exports as Per Cent of National Income, 1956Based on proceeds in U.S. dollarsBased on proceeds in real terms2
Bolivia15.012.83
Tin56
Brazil911.013.3
Coffee69
Burma2813.5
Rice74
Ceylon429.414.9
Tea60
Rubber17
Chile9512.5
Copper644
Colombia15611.511.8
Coffee79
Cuba3412.97.37
Sugar76
Egypt17510.5
Cotton70
Ghana41612.715.1
Cocoa60
Indonesia13817.710.59
Rubber40
Petroleum26
Malaya281020.21119.211
Rubber58
Tin18
Pakistan815.11214.712
Jute46
Cotton23
Philippines1112.911.5
Coconut products40
Sugar23
Thailand17510.5
Rice41
Rubber22
Turkey411.215.17
Tobacco31
Uruguay17.720.43
Wool60
Venezuela4769.41310.213
Petroleum94
Sources: Based on data from International Financial Statistics and United Nations, Yearbook of National Accounts Statistics, 1957 (New York, 1958).

See Table 1, footnote 1.

Export proceeds in U.S. dollars deflated by each country’s index of import prices in U.S. dollars (1953 = 100).

Deflated by the import price index (1953 = 100) for Latin America.

Exports of large mining companies.

1954.

1955.

1948-55.

1952.

1950-57.

1953.

1948-56; includes Singapore.

1949-57.

Fluctuations for Venezuela were almost continuously upward.

Sources: Based on data from International Financial Statistics and United Nations, Yearbook of National Accounts Statistics, 1957 (New York, 1958).

See Table 1, footnote 1.

Export proceeds in U.S. dollars deflated by each country’s index of import prices in U.S. dollars (1953 = 100).

Deflated by the import price index (1953 = 100) for Latin America.

Exports of large mining companies.

1954.

1955.

1948-55.

1952.

1950-57.

1953.

1948-56; includes Singapore.

1949-57.

Fluctuations for Venezuela were almost continuously upward.

Foreign trade of ceylon since 1948

Data on Ceylon’s merchandise trade, import and export prices, and terms of trade are summarized in Table 3. Unlike Tables 1 and 2, where export prices, export proceeds, and import prices in U.S. dollars were used, the data in Table 3 are expressed in Ceylon rupees, since they reflect more adequately the impact of export fluctuations on the domestic economy and by and large provide a better basis on which to build a contracyclical fiscal policy than data expressed in dollar terms. The basic difference between the two sets of data for Ceylon arises from the devaluation of 1949.

Table 3.Foreign Trade and External Assets of Ceylon, 1938 and 1948-57
Export Price Index1
ExportsImportsTrade BalanceAll exportsTeaRubberCoconutImport Price Index1Terms of Trade 2Exports in Real Terms3External Assets
(million rupees)(million rupees)
1938285236493437561329117983
19481,011994171001001001001001001,011989
Cycle I
19491,0631,0293410611091107961111,107934
19501,5631,167396143127220133991441,5791,077
19511,9041,5593451731323641461191451,6001,185
19521,5021,702-200133116255911281041,173837
19531,5681,608-401361242221111181151,329607
Cycle II
19541,8091,3974121511561951031081401,675895
19551,9401,460480158166225831021541,9021,155
19561,7351,629106148151217851061401,6371,179
19571,6821,804-122142140207921121271,502943
Source: Central Bank of Ceylon, Annual Reports of the Monetary Board to the Minister of Finance (Colombo).

Based on data compiled in rupees.

ExportpriceindexImportpriceindexX100

Export proceeds deflated by the import price index.

Source: Central Bank of Ceylon, Annual Reports of the Monetary Board to the Minister of Finance (Colombo).

Based on data compiled in rupees.

ExportpriceindexImportpriceindexX100

Export proceeds deflated by the import price index.

Between 1948 and 1957, Ceylon experienced two complete cycles with different degrees of fluctuation in export income and terms of trade. The first cycle covered the Korean war boom of 1950 and 1951 and the subsequent decline in export prices during 1952 and 1953. The second cycle covered the boom in tea, which began in late 1954 and extended into early 1955, and a general decline that took place in 1956 and, more markedly, in 1957.

The fluctuations in export income in Ceylon have been due entirely to variations in export prices; export volume increased continuously up to 1956, and this partly mitigated the destabilizing effect of falling export prices during the recessions. There were also considerable fluctuations in import prices, mainly of foodstuffs, and the instability of export income in real terms was accentuated both by these fluctuations and by the tendency for export and import prices to move, as they often did, in opposite directions. The opposite movements of export and import prices were due partly to the fact that prices of industrial manufactures generally respond more slowly to cyclical influences than prices of primary products. A second reason was the existence of non-cyclical factors during this period, e.g., the scarcity of primary commodities immediately after the war, which tended to raise their prices, though this trend now appears to be more or less reversing itself, and the impact of uncertain weather conditions. Evidence of a reversal of the upward price trend is the decline in the prices of primary commodities in 1956 and early 1957 during a boom period-when prices of industrial manufactures were increasing.7 The impact of weather is well illustrated by the sharp increase in tea prices during 1954 and 1955, which resulted partly from the fall in Indian tea exports following floods in the tea producing areas.

Although the world price of rubber has fluctuated widely in recent years, Ceylon’s export prices for rubber have been relatively stable since 1952. This is due mainly to the fact that about 50 per cent of Ceylon’s rubber production has been exported annually to China under a long-term trade agreement, by which Ceylon’s export price for rubber has been fixed at a premium above the world price, with the premium rising when the world price of rubber declined and falling when the world price rose.

Government budget operations in Ceylon since 1948

As already noted, there were roughly two complete cycles in Ceylon’s export earnings and in the terms of trade during the period 1948 -49 to 1956-57. According to the theory underlying contracyclical fiscal policy, the Government should have had over-all budget surpluses accompanied by increases in external assets in the upward phases of the cycles and budget deficits accompanied by declines in external assets in the downward phases. In fact, the Government of Ceylon had no budget surplus (defined as the excess of revenues over all payments except borrowing and lending operations and use of cash)8 during the upward phase of the first cycle and a budget surplus in only one year of the upward phase of the second cycle (Table 4). Ceylon’s external assets, however, increased during both booms; in the first boom they increased despite the budget deficits, and in the second boom they were helped by the budget surplus. The increase in external assets was therefore larger in the second boom than in the first. This result was also due to the different ways in which the two booms affected the economy. In the second boom, the tea industry benefited the most, and as this industry is owned very largely by companies and individuals in the higher income brackets, there was a relatively high propensity to save out of the windfall increases in income. In the Korean war boom, however, the rubber industry, which is owned to a substantial extent by small-scale producers, gained the most and so savings were not as large.

Table 4.Government Revenue and Expenditure in Ceylon, 1948-49 to 1956-57(In millions of rupees)
ExpenditureFinancing of Deficit
Fiscal YearRevenue1Current2Capital3Other4Surplus on Current AccountOver-All Budget Surplus or Deficit (-)Net borrowingUse of cash5
1948-495766—4516—210—22125—1063670
Cycle I
1949-506236—4616—248—76162—1618675
1950-51910—691—248—18219—48114—66
1951-52954—866—350488—25718473
1952-53953—788—343—53165—23221715
1953-541,026—673—265—5435334—352
Cycle II
1954-551,159—726—32115433128—39—89
1955-561,257—863—366—29394—112—11
1956-571,261—977—347—133284—19617521
Source: Central Bank of Ceylon, Annual Reports of the Monetary Board to the Minister of Finance (Colombo).

Includes a negligible amount of capital transfers.

Current expenditure covers purchases of goods and services, other than the purchase or construction of capital assets, and transfer payments, excluding those earmarked for capital purposes. Of total current expenditure, food subsidies in the years 1948-49 to 1956-57 were Rs 55 million. Rs 36 million, Rs 132 million, Rs 248 million, Rs 127 million, Rs 12 million, nil, Rs 80 million, and Rs 105 million, respectively.

Capital expenditure covers purchases of goods and services which result in the construction or acquisition of assets with a life span of more than the financial year, loans and grants earmarked for such asset construction or acquisition, and large and identifiable items of expenditure on the maintenance of, and renewals and additions to, existing assets.

Miscellaneous accounts.

A decrease in the cash balance is indicated by a positive number and an increase by a minus sign.

Includes only the net profit or loss of the Railway and Electrical Departments. From 1950-51, their gross receipts and expenditures were included in the budget.

Source: Central Bank of Ceylon, Annual Reports of the Monetary Board to the Minister of Finance (Colombo).

Includes a negligible amount of capital transfers.

Current expenditure covers purchases of goods and services, other than the purchase or construction of capital assets, and transfer payments, excluding those earmarked for capital purposes. Of total current expenditure, food subsidies in the years 1948-49 to 1956-57 were Rs 55 million. Rs 36 million, Rs 132 million, Rs 248 million, Rs 127 million, Rs 12 million, nil, Rs 80 million, and Rs 105 million, respectively.

Capital expenditure covers purchases of goods and services which result in the construction or acquisition of assets with a life span of more than the financial year, loans and grants earmarked for such asset construction or acquisition, and large and identifiable items of expenditure on the maintenance of, and renewals and additions to, existing assets.

Miscellaneous accounts.

A decrease in the cash balance is indicated by a positive number and an increase by a minus sign.

Includes only the net profit or loss of the Railway and Electrical Departments. From 1950-51, their gross receipts and expenditures were included in the budget.

During the entire period, the budget speeches made by the Minister of Finance stressed the relationship between government budgetary policy and the level of external assets and the need for conserving foreign exchange in a boom for use in a recession. The phrase “economic development with stability” recurs continually in the speeches. However, the period might be considered in two parts: the earlier years up to 1953-54, when the “compensatory” objective of the budget was not clearly defined or asserted, and the years since 1953-54, when the budget speeches have featured an attempt, though by no means an elaborate one, to relate decisions in the budget to forecasts of export incomes and the terms of trade. An important factor which influenced budgetary decisions in the first subperiod was the large sterling balances accumulated during World War II. At the end of 1949 they were Rs 934 million, an amount roughly equal to that year’s imports. The existence of relatively high reserves undoubtedly encouraged the Government to expand its expenditure at a rapid rate, with the result that, even in 1950-51, when the Korean war boom was at its peak, the Government had an over-all budget deficit.

Expenditure

Government expenditure in Ceylon during the period as a whole increased rapidly both in absolute terms and in relation to national income. The increase was mostly in current expenditure, particularly on social services, including food subsidies and public assistance. Capital expenditure, on the other hand, increased slowly and not too steadily. The increase in government current expenditure was far more rapid during export booms than during recessions; capital expenditure, in fact, declined during the downward phases of the cycles.

The increase in expenditure during a boom is to some extent automatic. Expenditure increases with the rise in prices and wages, particularly prices of imported materials which the government either subsidizes or uses directly in its expenditure program. During a recession, lower factor prices automatically operate to decrease government expenditure. This automaticity played an important role in the expenditure structure of the Government of Ceylon, especially from 1951, through the food subsidies. The subsidies on rice and wheat flour, which are the basic food items, had been in existence for a number of years before the Korean war boom, having been introduced as an ameliorative measure against the steady but slow postwar rise in food prices. Under this subsidy scheme, rice and flour were sold on ration at prices below their cost to the Government. In late 1950, the Government reduced the sale prices of rice and flour as a further ameliorative measure against the rise in the prices of almost all other consumer articles caused by the Korean war boom. It did not, however, anticipate the spectacular rise in world food prices between 1951 and 1953, which progressively increased the food subsidy bill to Rs 132 million in 1950-51 and Rs 247 million in 1951-52. This, together with increased expenditure on other items, caused over-all budget deficits even in the two financial years which benefited from the Korean war boom.

When export prices declined in 1952 and food prices continued to rise, the Government took action in 1952 and 1953 to curtail the budget deficit by increasing taxes and reducing expenditure, including the amounts spent on food subsidies. The decision to cut the food subsidies by substantially raising the subsidized sale prices of rice and flour proved in fact unnecessary, since world food prices started to decline soon afterward, thus enabling the Government to reduce the subsidized sale prices again, practically without incurring any net expenditure on the subsidies in the following two years.

The automatic destabilizing impact of price and wage fluctuations on government expenditure was aggravated in Ceylon by the “discretionary” action of the Government to increase its expenditure sharply in a boom. “Discretionary” may not be an entirely suitable way of describing such actions, since in underdeveloped economies with relatively low standards of living the government is under continuous and strong pressure to increase its expenditure, particularly when its revenue increases in a boom.

Such “discretionary” increases in government expenditure in Ceylon were concentrated in current rather than in capital account. Current expenditure, excluding food subsidies, consistently increased, more rapidly in boom years than in others. Capital expenditure, on the other hand, fluctuated, rising in boom years and declining in years when revenue declined. This pattern of movement in government expenditure certainly did not help to offset export fluctuations. It also resulted in an unbalanced growth in government expenditure. Between 1949-50 and 1956-57 current expenditure, excluding food subsidies, increased by about 110 per cent, while capital expenditure increased by less than 50 per cent; the absolute increases in the two types of expenditure are far more striking—Rs 516 million9 and Rs 100 million, respectively.

The slow rate of growth of capital expenditure was also partly the result of physical and administrative bottlenecks, as shown by the fact that actual capital expenditure each year has been lower than the amount estimated in the budget. Current expenditure, on the other hand, annually exceeded original budget estimates and necessitated large supplementary appropriations. To some extent, each one of these two tendencies was partly responsible for the other: the inability of the Government to expand its capital expenditure quickly in a boom tended to strengthen public demands for increased current expenditure when the Government’s revenue increased, and the increase in current expenditure, which thereafter became more or less entrenched in the expenditure structure, reduced the amount of resources available for capital expenditure. For example, during the years 1949-50 to 1951-52, when government revenue benefited greatly from the Korean war boom, the Government had large budget deficits as a result of sharp increases in current expenditure; in 1952-53 and, particularly, in 1953-54, when revenue no longer rose, the Government was obliged to cut down its capital expenditure as part of a program to reduce the budget deficit.

Lessons from the experience of Ceylon

The uneven growth of government expenditure in Ceylon, with steep increases in booms and either smaller increases or declines (through the impact of food subsidies) in recessions, and the relative stagnation of government capital expenditure in recent years, are contrary to the contracyclical fiscal policy postulated earlier as appropriate for underdeveloped countries. The two features were, as pointed out, closely interrelated in Ceylon, and can therefore be regarded as part of a single problem, the achievement of a steady and controlled rate of increase in government expenditure without generating inflationary pressures. The tendency for expenditure to increase in a boom and to resist reduction thereafter, except automatically through price declines, as in the case of food subsidies, may also make for a faster rate of increase in expenditure than would occur if alternative conditions of export and income stability should prevail. As a result, the inflationary bias inherent in any underdeveloped country seeking rapid economic development could be increased.

The main difficulty of contracyclical fiscal policy in underdeveloped countries is, however, that any scheme for averaging the rate of increase in government expenditure will have to operate against a strong and perfectly natural tendency for expenditure to increase in booms. This is partly the result of the built-in destabilizers in the expenditure structure and partly the result of a lack of appreciation among the public of the advantages of contracyclical action. While the difficulties of contracyclical fiscal policy in underdeveloped countries, compared with developed countries, can easily be overdrawn, one cannot help feeling that, for the two reasons mentioned above, among others, the fiscal authorities in underdeveloped countries are somewhat more handicapped than their counterparts in developed countries.10

In underdeveloped countries, contracyclical fiscal policy requires that the government take firm action during booms to produce budget surpluses. To the public, this appears to be a negative approach. On the other hand, contracyclical fiscal policy in developed countries, at least as practiced in recent years, calls for firm action, particularly in a recession, by way of budget deficits, which broadly accords with public demands for positive action. The success of any contracyclical fiscal policy in any underdeveloped country would seem, therefore, to depend to a large extent on the government’s integrating it with a program for economic development, which could then appeal to the public as a positive approach to their economic problems.

Built-in destabilizers could have a substantial impact on government expenditure, as in Ceylon, particularly through the operation of consumer subsidies. Such built-in destabilizers are not absent in developed countries, but they are generally offset by the existence of built-in stabilizers in the expenditure structure itself, particularly through broadly based social insurance schemes, which are by and large absent in underdeveloped countries. Built-in destabilizers naturally cannot fit into any scheme of averaging expenditure but can in general be offset by built-in stabilizers in the revenue structure, which are quite strong in most underdeveloped export economies.

Revenue

If the expenditure structure of the Government in Ceylon has proved rather inflexible for the purpose of contracyclical fiscal policy, the revenue structure has shown a very high degree of responsiveness to changes in export prices and in income. This responsiveness, which has been largely automatic and partly induced through government “discretionary” action to raise and lower tax rates, particularly export duties, has been the mainstay of contracyclical fiscal policy.

Table 5 shows how government revenue responded to export fluctuations in Ceylon. The high degree of sensitiveness of tax revenue to income changes is to some extent misstated by these figures, since income taxes in a financial year are to a large extent paid on the income earned in the preceding year. On the other hand, tax receipts were also influenced greatly by changes in tax rates. From the point of view of their quantitative impact on tax revenue, the most important changes in tax rates have been those relating to income tax and duties on imports and exports. Income tax rates during the years since the war have been progressively increased; import duties on luxuries have been gradually raised and the duties on essentials likewise reduced. The year-to-year changes in income tax rates and import duties, however, have had no uniform relationship to income fluctuations; income tax rates have been raised in slump years (1952-53 and 1953-54) as well as in boom years (1950-51 and 1951-52). Only changes in export duties have had a consistent and positive relationship to export fluctuations, although they have shown an upward trend over the whole period.

Table 5.Major Components of Government Revenue in Ceylon, 1949-50 to 1956-57(In millions of rupees)
Tax Revenue
Fiscal YearTaxes on income and profitsExport dutiesImport dutiesOther taxes on goods and servicesOther taxes and leviesTotal tax revenueNontax RevenueTotal Revenue
Cycle I
1949-50117168188443154875623
1950-511352832454944756160910
1951-522052272605041783171954
1952-532321932516142779174953
1953-5421825924467478351911,026
Cycle II
1954-5520637125857519432161,159
1955-5630032228670561,0342231,257
1956-5727232430481621,0432171,260
Source: Central Bank of Ceylon, Annual Report of the Monetary Board to the Minister of Finance for the Year 1957 (Colombo, 1958), pp. 80-81.
Source: Central Bank of Ceylon, Annual Report of the Monetary Board to the Minister of Finance for the Year 1957 (Colombo, 1958), pp. 80-81.

The high degree of automatic responsiveness of tax revenue to export fluctuations results partly from export and import duties being linked directly or indirectly to export and import prices and partly from the highly progressive scale of income tax. In 1956-57, for example, tax receipts constituted 82 per cent of total revenue, and revenues from export duties, import duties, and income taxes were 26 per cent, 24 per cent, and 21 per cent, respectively. Export duties were, for a number of years, based on a sliding scale, whereby the duty was linked to the export price on the basis of an announced formula, so that the duty absorbed a progressively increasing proportion of the price as the price rose. The sliding-scale system as operated, however, created a number of administrative problems and also caused speculation in the local commodity markets.11 It was therefore replaced by a system of flexible export duties, by which the duties are changed with every significant change in export prices. The average incidence of revenue from export duties has varied between boom years and recession years from 16 per cent of export receipts in 1950-51 and 20 per cent in 1954-55 to 12 per cent in 1952-53 and 19 per cent in 1956-57; the figures have, of course, been influenced by the underlying trend of increase in the tax incidence.

Import duties in Ceylon are fixed either on an ad valorem basis, i.e., as a percentage of price, or at specific rates, i.e., a fixed rate for each unit of quantity. On imports with ad valorem duties, changes in import prices affect revenues immediately. The Taxation Commission (1955) estimated that in 1953 imports with ad valorem duties amounted to 34 per cent of total imports and imports with specific duties to 56 per cent. The remaining 10 per cent of imports were duty free. Revenue from ad valorem duties, however, amounted to 40 per cent of total revenue from import duties because the great majority of ad valorem duties were in the 10 per cent to 30 per cent range. The fairly high percentage of imports with ad valorem duties, the fairly high average level of ad valorem duties, and the tendency for revenue from imports with specific import duties also to move with incomes (though with a time lag) should have made import duties a built-in stabilizer of some significance. However, the quantitative impact of import duties as a built-in stabilizer was in fact negligible, except during the Korean war boom, as can be seen in Table 5. This was due to increases in import duties on luxuries during recessions, the time lag between the accrual of income and its expenditure on imports, and also the Government’s fiscal policy of stabilizing imports, to the extent it was successful.

Income taxes on individuals and companies constituted 21 per cent of total tax revenue in 1949-50 and 26 per cent in 1956-57. During the period 1949-50 to 1956-57, there was a continuous rise in the rates of income tax, the rates on individual taxpayers being increased in every year except 1949-50, 1954-55, and 1955-56, and the rates on companies in every year except 1954-55 and 1955-56. The income tax rates on personal income payable in the financial year 1957-58 in Ceylon were almost as steep as in India, the United Kingdom, and the United States. According to figures worked out by the Taxation Commission, a married man with two children and having an earned income of Rs 1 million in 1954 would have paid Rs 841,000 as income tax in Ceylon, Rs 850,000 in India, and Rs 903,000 in the United Kingdom; for the United States, the figure was Rs 700,000.

Corporate tax rates are also high: in 1957-58 they were 57.3 per cent (including profits tax) on resident companies, i.e., those controlled in Ceylon, and 61.5 per cent on nonresident companies, i.e., those controlled in foreign countries. The high rates of income tax, coupled with the fact that a large portion of the export sector is subject to income tax at corporate rates, makes the impact of fluctuations in export earnings on revenue very substantial.12 It is estimated that in 1956-57 the combined incidence of export duties and income taxes on the gross export proceeds of resident companies in the main export industry, tea, was about 33 per cent of gross export proceeds; for nonresident companies it was about 34 per cent.13 Rather similar ratios would apply for the rubber industry. The significance of these ratios is limited by two factors. First, only about half the area under tea and a some-what smaller portion of the area under rubber are owned by companies. Second, the final effective rates of income tax on the distributed profits of resident companies are the rates applicable to the shareholder who receives the dividend.14

Public debt management

Public debt operations, like monetary policy—but unlike government revenue and expenditure policies—cannot directly influence the impact of fluctuations in exports on domestic private disposable income. They can only seek to influence the liquidity of the banking system and of the private sector and thereby the supply and price of credit. Where, as in Ceylon, secondary credit creation by banks on the basis of a change in their liquid reserves is not an important economic variable, the effectiveness of public debt operations as a contracyclical measure will depend primarily on their direct impact on money supply, i.e., on their mopping up a part of the increase in money supply which results from the rise in exports, in order that it should not create a potential demand for imports when exports decline, and on helping to maintain short-term stability in interest rates in the money and capital markets. The sale of government securities to nonbank investors in a boom serves both objectives (except to the extent that securities are sold to banks when exports decline), whereas their issue to the banking system serves only the latter objective. Therefore, the issuance of government securities to the private sector, particularly of long-term maturities which cannot be easily monetized by sale to banks when exports decline, is to be greatly preferred.

Contracyclical public debt policies thus consist essentially of the issuance of public securities in a boom, particularly to the nonbank private sector, to siphon off a part of the savings held in the form of cash or bank deposits. The amounts so raised can either be used to redeem immediately government indebtedness to the central bank (which may have been incurred in the preceding recession) or conserved to finance a future budget deficit or even to redeem part of the debt held by the public in the following recession. Such policies will have a contracyclical effect on the liquidity position of both the private sector and the commercial banking system only if the government maintains its deposits with the central bank and not with the commercial banks. If government deposits are maintained with commercial banks, the proceeds of the budget surplus or security issues during a boom will not reduce, and might even add to, the cash resources of the commercial banks. This can be of particular importance in countries where changes in the commercial banks’ cash assets are likely to have a significant effect on their secondary credit creation.

The public debt operations of the Government of Ceylon from 1949 to 1953-54 reflect the need for cash to finance the budget deficits, except in 1950-51 when government borrowing exceeded the budget deficit. The very large budget deficits incurred in some of these years necessitated extensive short-term borrowing from the banking system, including the Central Bank of Ceylon. However, in 1953-54, and especially in 1954-55, which coincides with the upward phase of the second cycle, the Government redeemed a part of the large floating debt, including advances from the Central Bank accumulated in previous years, and converted another part of the floating debt into long-term securities. Both the redemption and the conversion of the domestic floating debt in 1953-54 and 1954-55 considerably decreased the amount of bank-held public debt. With the reduction of the high percentage of floating debt in the total public debt, the Government was better able to finance its budget deficits in the following export decline. In the following two years, 1955-56 and 1956-57, it again borrowed extensively from the banking system to finance its budget deficits.

Monetary measures, too, were used to some extent to achieve the same objectives as public debt management, and as such may be of interest. The main monetary measures adopted by the Central Bank of Ceylon were the raising of the minimum reserve requirements in the Korean war boom and their reduction in the ensuing export decline; the encouragement given to commercial banks to maintain their surplus funds in London during the Korean war boom and to repatriate these funds later; limited open market sales and purchases of government securities combined with a limited sale of securities issued by the Central Bank beginning in 1956; and the transfer of most of the government balances from commercial banks to the Central Bank so that fiscal operations would have the required contracyclical impact on commercial bank liquidity.

Technical Requirements of a Contracyclical Fiscal Policy15

The implementation of an appropriate contracyclical fiscal policy requires not only an understanding of its basic principles but also the ability to forecast fairly accurately movements in national income and expenditure (particularly of export receipts and import expenditures) and in savings and investment. The difficulties of making such economic projections in underdeveloped export economies arise from three factors: the cyclical instability in export receipts of underdeveloped economies and changes in terms of trade arising from non-domestic causes; the importance of noncyclical factors, particularly weather conditions and the vagaries of the “international situation,” especially for countries producing strategic raw materials; and the lack of sufficiently detailed and prompt statistical data on national income and its distribution and on the consumption, saving, and investment patterns and the propensity to import of various income groups. These factors may be somewhat less important for Ceylon than for some other underdeveloped countries, primarily because the market for tea is relatively stable and the basic economic statistics on national income and expenditure are available, although with a long time lag.

The presence of built-in stabilizers in the budgetary structure will reduce but not eliminate the need for accurate forecasting of short- run price and income movements. This is true even when the short- term contracyclical objective is integrated with a program of economic development extending over a number of years. In such a case, the primary need would be to forecast accurately the trend in prices and wages over the period covered by the development program. The development program would then provide the basic framework for the annual budget, leaving the built-in stabilizers in the revenue structure to take care automatically of short-run fluctuations. Forecasts of short-run fluctuations would then become less important in framing the annual budget decision—whether the budget should be in deficit or surplus. The importance of accurate forecasting is also reduced if adequate external reserves are available to take care of any errors in making estimates.

When there is a medium-term development program, forecasts of short-run fluctuations would still have a direct impact on the budget decision and on the revenue and expenditure estimates, depending on the extent of flexibility allowed in framing the annual budget. Such forecasts can also influence the budget decision indirectly. They provide an occasion to review the earlier forecasts of movements in prices and incomes on which the development program has been based. If these forecasts are revised in the process, the development program and consequently the shape of the budget will also be affected.

Accurate forecasts of price and income movements provide only part of the data needed for the operation of appropriate contracyclical and development programs. On these forecasts must be superimposed estimates of how the private sector would respond to such movements. However, the available statistical data on which such estimates have to be based are meager in most underdeveloped countries, with the result that forecasts have to be based largely on subjective impressions.

In Ceylon, the usual practice has been to frame the annual budget decision on the basis of forecasts of price and income for the ensuing budget year. The tendency has generally been to make cautious forecasts of export income and government revenue and thus to budget for an over-all deficit (which has been about Rs 150 million for the last three budgets of the period under review) considered to be “safe” in the light of all the economic factors, especially the level of external assets. If the forecasts proved wrong, the built-in stabilizers in the revenue structure were expected to provide a broadly offsetting result. However, a by-product of this system of budgeting in Ceylon has been an accelerated increase in government revenue and expenditure caused, as noted earlier, by the tendency for expenditure to increase when revenue increased in booms and to be matched by subsequent increases in tax rates in order to keep the budget deficits within the limits which could be borne by the amount of the country’s external reserves.

The budget systems of underdeveloped countries may quite often not be adequately geared for implementing a compensatory fiscal policy. In a number of underdeveloped countries, as in developed countries, important governmental functions are carried out by special funds and autonomous institutions, which sometimes arrange their finances independently of the central treasury or through earmarked revenues. Furthermore, revenue is raised and public expenditure incurred at various federal and local levels. The more complex the system of special funds and institutions, the greater are the practical problems of preparing over-all statements of public revenue and expenditure, especially in an ex ante form. The problems are considerably greater when there are public manufacturing and trading operations. Two other drawbacks in budgetary procedures, which have proved of particular importance in Ceylon, are (1) the timing of the budget decision and the absence of revised expenditure estimates and (2) the persistent overestimation of capital expenditure, referred to earlier. At present, work on the budget estimates is initiated nearly one year before the beginning of the financial year, and the estimates are presented to Parliament about three months before the beginning of the year and about six months before complete ex post data become available for the previous financial year. The revenue estimates for any year are revised once, at the time the following year’s estimates are presented, but the expenditure estimates are not revised even to include the large amounts of supplementary appropriations for current expenditure that are generally passed during each financial year.

Conclusion

Instability in the export markets of primary products has often had unsettling economic and social effects in the underdeveloped countries producing these commodities. The average year-to-year fluctuation in the export prices of 15 major primary commodities during the period 1948 to 1957 was 12.8 per cent; the average year-to-year fluctuations in the export incomes (in U.S. dollars and in real terms) of underdeveloped countries exporting these commodities were somewhat larger than the price fluctuations.

Remedies for these problems have to be sought at both the international and the national level. International action is possible through the prevention of pronounced economic fluctuations in the industrial countries, the “compensatory” flow of capital to underdeveloped countries from developed countries and from international financial institutions, and the operation of commodity stabilization schemes. However, as pointed out in the report of a UN group of experts, no international action “will relieve any country of the responsibility of limiting its demands for consumption and investment to the total resources available to it, if it is to avoid inflationary pressure. Each country, even on the most hopeful view, will still have to deal with the domestic impact of important fluctuations in international demand and prices, which it will have to offset if it wishes to maintain a reasonable degree of internal stability.”16

The primary objective of such domestic offsetting operations in underdeveloped countries is to stabilize the flow of imports in order to prevent periodic foreign exchange crises, the hardships which arise from the shortage of essential consumption goods, and the dislocation in investment and in the utilization of capacity in industries using imported materials and machinery. The “external” aspect of a program of import stabilization is to conserve a part of the high foreign exchange earnings during booms for use during recessions. The “internal” aspect is to impound during booms a part of the increase in money income and in the liquidity of the economy so that foreign exchange will be conserved and undue fluctuations in domestic prices and wages, and in interest rates in the money and capital markets, will be prevented.

It is not necessary that contracyclical finance be restricted to official policy. The private sector, when faced with instability in income, may automatically engage in an offsetting operation by saving more in booms and saving less or dissaving in recessions. While it is true that there is a tendency to underestimate the private sector’s offsetting action, particularly in countries where the corporate organization predominates in the export sector, the widespread concern about official contracyclical policy is evidence of the belief that the private sector by itself is inadequate to maintain stability in the domestic economy or in the external rate of exchange; there is also the feeling that it may not produce the level and composition of capital formation appropriate for countries seeking rapid economic growth.17

In recent years, there has been a revival of faith in monetary policy as a means of countering short-run economic fluctuations in developed countries. However, the use of monetary policy in underdeveloped countries for the same purpose is limited by the absence of a well-organized and integrated financial system and lack of a broadly based and active entrepreneurial class dependent on the money and capital market for finance. The progressive development of the financial system and of new methods of monetary policy suitable to under-developed countries can in time reduce these limitations. Nevertheless, in view of the importance of the financial operations of governments, monetary policy in most underdeveloped countries will continue to be largely dependent for its success on governments following appropriate fiscal policies.

Any short-run offsetting operation has also to be integrated with other major objectives of fiscal policy, i.e., the achievement of rapid economic development without inflation and the equitable distribution of national income. This is of particular significance in underdeveloped countries because, first, governments have undertaken medium-term or long-term programs of economic development for the public sector and, second, only governmental action can offset the distorting effect of export booms on the distribution of national income in favor of the higher income groups. Since in underdeveloped countries only fiscal policy encompasses all three objectives, neither monetary nor commercial policy can fully take its place.

The three objectives of fiscal policy will often be in conflict with one another. A proper balance between them can best be achieved by integrating the short-run offsetting operations with the long-term development program. Such an integrated fiscal program will require that the government draw up budgets providing for surpluses in booms and deficits in recessions, by having its expenditure increase at a steady rate while revenue rises in booms and declines in recessions. An active public debt policy of issuing loans during booms and redeeming them during recessions, especially with the private nonbank sector, would also form an essential part of the program.

The essential aspect of such an integrated program will be the averaging of the rate of increase in government expenditure at a level which will not cause inflation. In regard to this, the long-term development program plays a basic role. Once the rate of increase in expenditure is thus stabilized, the “net” built-in stabilizing effect (i.e., the built-in stabilizers in the revenue structure less the built-in de- stabilizers in the expenditure structure) on the budget structure will produce the necessary surpluses in booms and deficits in recessions. The possibility of achieving a planned rate of increase in revenue and in current and capital expenditure, and also the most suitable composition of capital formation, would then be greater.

An integrated program such as this will reduce, but not eliminate, the necessity of accurate annual forecasts of short-run fluctuations in prices and incomes in making the annual budget decision, i.e., whether the budget for the ensuing year should be in surplus or deficit. The primary need will be to forecast price and wage trends over the period covered by the development program. The development program will then provide the basic framework for the annual budget, leaving the built-in stabilizers in the revenue structure to take care of most of the impact of short-run fluctuations. Annual forecasts of short-run fluctuations will, however, still have an effect on the budget decision. Their effect will depend first on the extent of planning involved in the development program and second on its impact on the forecasts of price and wage trends on which the development program has been built.

The budgetary operations of the Government of Ceylon during the years 1949-50 to 1956-57 did not for the most part follow such an ideal fiscal pattern. During this period, although Ceylon experienced two complete export cycles, the budget was in surplus only during the two years which covered the upward phase of the second cycle. There was a pronounced tendency for government expenditure to increase sharply during booms and to increase less, or even to decrease, in recessions. The increase in government expenditure was concentrated on current account, while capital expenditure increased slowly and by no means steadily. Government expenditure has been notoriously sticky in the downward direction, except through the impact (as in the case of food subsidies) of a decline in import prices. The sharp increases in government expenditure during booms resulted in an unplanned and accelerated increase in government expenditure and revenue over the whole period. As expected, variations in revenue were the mainstay of contracyclical fiscal policy, but revenue showed a parallel trend of increase through increased tax rates and tax coverage to match the rise in expenditure.

The budgetary operations during the earlier years of the period were, to a large extent, influenced by the existence of large sterling balances, which encouraged the Government of Ceylon to increase its expenditures without too much regard for any contracyclical objective. But Ceylon’s experience during the whole period also reveals some of the difficulties which governments in underdeveloped countries may encounter in implementing a contracyclical fiscal policy, especially when it is not integrated with a fairly well-defined program of economic development. The difficulties arose mainly in regard to averaging the increase in government expenditure in the face of the destabilizing effect of fluctuations in prices and wages. Such fluctuations played an important role in Ceylon through food subsidies as well as through public pressures for increasing other expenditures when revenue increased during booms and against reducing expenditures in recessions. Other difficulties stemmed from the uncertainties of forecasting short- run fluctuations in prices and income (especially when noncyclical factors were present) and from inadequate data on the propensities of the private sector to consume, save, and invest, which are necessary in framing the annual budget. Public debt operations could play only a limited role which reflected largely the restricted role of monetary policy. And, finally, the “technical deficiencies” in budgetary procedures tended to aggravate the difficulties arising from other causes.

Mr. Kanesathasan, economist in the Statistics Division, is a graduate of the University of Ceylon. He was formerly economist with the Central Bank of Ceylon. This paper does not necessarily reflect the views of the Central Bank of Ceylon.

A UN study found, for example, that output of the nonexport sectors grew faster in boom years in countries where manufacturing industries were more developed and diversified. “The development of manufacturing industries further facilitated the maintenance of employment and production during periods of adverse movements in the terms of trade.” See United Nations, Economic Development of Underdeveloped Countries: Repercussions of Changes in Terms of Trade on the Economies of Countries in Process of Development (New York, Doc. E/2456, June 11, 1953), par. 15.

However, Sir Sydney Caine, in his paper, “Stabilizing Commodity Prices,” in Foreign Affairs, October 1958, p. 136, doubts the claim that export fluctuations reduce investment to a serious extent. He cites the experience of Malaya and West Africa, which have had considerable investment in unstable export industries. He concludes “that fluctuation is not of itself discouraging to investment but that false expectations based on failure to recognize the probability of fluctuation may lead to unproductive investment.” This assessment appears to need some qualification. The conditions which helped investment in export industries in the nineteenth and early twentieth centuries may not apply now. This is true of the investment not only of foreign capital but also of local capital. First, as H. Myint states in his article, “The ‘Classical Theory’ of International Trade and the Underdeveloped Countries,” in The Economic Journal, June 1958, p. 333, “the rapid expansion in the export production of the underdeveloped countries in the nineteenth century cannot be satisfactorily explained without postulating that these countries started off with a considerable amount of surplus productive capacity consisting of both unused natural resources and underemployed labor.” Caine gives Myint’s thesis of “surplus productive capacity” another interpretation, too: that the peasant who invested in the export industries in the nineteenth century not only used the surplus land and labor resources, but also did not change his basic consumption pattern, thus treating his new income as a sort of surplus. In neither sense is there now any “surplus productive capacity” in underdeveloped countries to any comparable extent. Second, there is now a tendency for the people and governments to expand their consumption expenditure patterns with each boom, to the permanent detriment of savings and investment. In this they are helped by what Caine admits to be a “natural tendency for producers to assume in times of high prices that the boom is going to last and to make their plans accordingly.” The windfall nature of export gains in booms perhaps contributes to such expectations.

Professor Sayers has offered an unorthodox remedy for the second problem by suggesting that the central bank should become a “bank for the general public.” “The central bank should strive … to encourage these independent banks But after making all allowances for the results of an encouraging atmosphere, their development of sound commercial banking may not be fast enough to make adequate provision for the country’s economic potentialities, and the central bank should be ready to step in to fill the gaps.” R. S. Sayers, Central Banking After Bagehot (Oxford, 1957), p. 118.

“The organization of a money market does not reach a high stage of development in a vacuum. Certain other conditioning factors must also be present. A bill market, for example, cannot be organized successfully unless the trading and banking practices are favorable to its growth … The security market cannot become broad and active unless the country has reached a certain stage of industrial development with the predominance of the corporate form of business organization. There is also a close connection between the money market and other related markets, such as the commodity markets, the foreign exchange market, etc. These markets provide opportunities for the investment of funds lent in the short–term money market. The high development reached by the London money market has been due to the fact that it was the center of the world’s trade in the staple commodities and also of a large part of the world’s shipping and insurance business.” S.N. Sen, Central Banking in Undeveloped Money Markets (Calcutta, 1952), p. 20.

Attention has been drawn to this tendency in Latin American countries by Bruno Brovedani, in “Latin American Medium–Term Import Stabilization Policies and the Adequacy of Reserves,” Staff Papers, Vol. IV (1954–55), pp. 258–87.

Long–term foreign capital was not an important factor in underdeveloped countries during the years 1948 to 1952. According to a UN report, although capital movements in the past have tended to aggravate the cyclical instability of the economies of underdeveloped countries, sometimes they are compensatory. In 1948–52 their role was not conspicuous, especially on private account, except for investments in petroleum. See United Nations, op. cit., par. 111.

“The fortunes of the raw material producing countries, on the other hand, have generally been less favorable, and most of them have experienced a worsening of their terms of trade. In the last two years, the average level of raw material prices has fallen by some 15 per cent. In part, this movement is clearly of a noncyclical nature, as is shown by the fact that more than half of it had already occurred during the boom, being attributable at least in part to the growing supplies of raw materials and of substitute commodities, such as artificial fibers, synthetic rubber, aluminum, etc. However, a further decline set in with the recession, which has led to a weakening in the demand for raw materials.” “Fund Report at. ECOSOC,” International Financial News Survey, April 18, 1958, p. 324.

Thus defined, the budget deficit is not very different from the excess of government purchases of goods and services over net transfers to government from current income (i.e., revenue less government transfer payments on current account). The difference between the two concepts arises only from capital transfers to and from government. Such capital transfers are small in Ceylon.

The absolute increase in current expenditure would be about Rs 450 million and the percentage increase about 100, if the figure for 1949–50 in Table 4 were adjusted to include the gross expenditure (and not the net loss) of the Railway and Electrical Departments.

“Discussion of monetary and fiscal policy of underdeveloped countries by American and European economists almost always takes on a patronizing air. Inflation would be cured if the country would cut back on expenditure or tax more heavily. Suggestions for new taxes occasionally involve elaborate new devices to eliminate tax inequities, like income averaging or expenditure taxation, which have not been tried in developed countries. But it is not so frequently recognized that the fiscal problem is more difficult in underdeveloped countries. The average rate of saving is small, the marginal rate low. Demonstration effect implies that consumption leads production or rapidly catches up with it. There is always need for further overhead capital investments to create opportunities for increasing productivity. Duesenberry asymmetry in the responses of consumers to increases and declines of income—the former being accepted, the latter resisted—and the political power of the masses, even under dictatorship, make the fiscal problem much more difficult. The differences in the intellectual and administrative capacities of the men operating the system are smaller, and certainly less important, than the differences in the difficulty of restraining inflation in a developed and an underdeveloped country.” Charles P. Kindleberger, Economic Development (New York, 1958), pp. 202–03.

A detailed analysis of the operation of the sliding scale of export duties in Ceylon is contained in Report of the Taxation Commission (Colombo, 1955), pp. 278–83.

Company profits are not taxed twice in Ceylon, as in the United States. The income tax paid by the resident company is offered as a tax credit to the share-holder when he pays his personal tax on his gross dividend receipts. The difference between the corporate tax rates for resident and nonresident companies is designed to make up the loss to the Government of estate duty on shares of nonresident companies held abroad. The margin was fixed by mutual agreement between the Governments of Ceylon and the United Kingdom.

The average incidence of the export duty and income tax on the export proceeds was estimated as follows: The average f.o.b. price per pound of tea was Rs 2.87 and the export duty was 65 cents per pound. The average Colombo market price per pound was Rs 2.01 and the estimated cost of production was Rs 1.50, leaving a gross profit margin of 51 cents on which a corporate income (and profits) tax of 57.3 per cent was imposed on resident companies and of 61.5 per cent on nonresident companies.

The system of tax rebates on distributed profits does not apply to nonresident companies. In 1956–57, corporate profits (distributed and undistributed) were divided almost equally between resident and nonresident companies. Distributed profits of resident companies accrued roughly in equal amounts to resident and nonresident individuals. The larger part of the dividends paid to resident individuals was in fact finally subject to the corporate income tax rate. On the other hand, about two thirds of the dividends paid to nonresident individuals were finally subject to a marginal rate of 20 per cent, the minimum rate applicable to nonresident individuals. See Commissioner of Income Tax, Estate Duty, and Stamps, Administration Report for 1957 (Colombo, 1958), Appendix I, Tables II, V, and VI.

The phrase “technical requirements” has been used by Gerhard Colm in a paper entitled “Technical Requirements for an Effective Fiscal Policy.” Colm observes that economic projections for fiscal policy require “(1) the most up–to– date actual data on national income and production and their component parts; (2) an appraisal of imminent trends, especially in government expenditures, business investments, and consumer attitudes; (3) a knowledge of the responses of business and consumers to changes in economic conditions on the basis of the record of the past; and (4) most of all, the exercise of good common sense in combining all the pieces of information and expert advice into a consistent pattern.” See G. Colm, Essays in Public Finance and Fiscal Policy (New York, 1955), pp. 184–85.

United Nations, Measures for International Economic Stability (New York, 1951), p. 13.

“In policy formulation, if the terms of trade through their effect on foreign exchange earnings have a direct relation to the possible rate of investment in an underdeveloped country, then stability of earnings becomes crucially important. Although a few have expressed views to the contrary, stable export earnings, even at a slightly lower average level, are vastly more effective in promoting development and enabling underdeveloped countries to form sensible investment patterns than fluctuating earnings are.” H. W. Singer, in his “Comment” on Kindleberger’s “The Terms of Trade and Economic Development,” The Review of Economics and Statistics: Supplement, February 1958, p. 86.

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