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.
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.