High time to reduce demand, tackle inflation head-on

The government should target reducing demand through ensuring market-based interest and exchange rates as well as cutting allocation for infrastructure projects to rein in inflation and protect the foreign currency reserves, said economists yesterday.

Sadiq Ahmed, a former chief economist for South Asia at the World Bank, said blaming the sustained inflationary spike on global inflation and the Ukraine war is politically convenient but not entirely based on facts.

"While the origins of the domestic inflationary pressures lay in those external sources, they have been sustained for so long owing to the absence of adequate demand management policies."

"Evidence shows that countries that adopted demand reduction policies through hikes in interest rates have all succeeded in reducing inflation substantially."

Ahmed made the comments while making the keynote presentation at a seminar -- Four key challenges for the national budget 2023-24: some reflections -- organised by the Bangladesh Institute of Development Studies (BIDS).

The central bank has maintained a cap on lending rates since April 2020, a move that has prevented the country from using the potent monetary tool to tackle runaway consumer prices.

In September, Bangladesh moved to a multiple exchange rate regime with a less favourable rate for export proceeds than for remittances. The policy further discouraged exports and the repatriation of proceeds.

Because of the gap between the exchange rates for imports and remittances, importers have incentives to over-invoice imports to buy more US dollars from banks and send the profits back as remittances.

This rate arbitrage leads to a further decline in US dollar liquidity in banks and parallel exchange rates discouraged the inflow of foreign currencies, said the World Bank in a report recently.

In Bangladesh, inflation has been running high for the past one year, surging 9.94 per cent in May, the highest in at least one decade.

Ahmed said the proposed budget for FY2023-24 will face four key challenges when it comes to implementation.

The challenges are restoring macroeconomic stability, the challenge of revenue mobilisation, prudent financing of the budget deficit, and protecting social sector spending.

Ahmed, also the vice-chairman of the Policy Research Institute of Bangladesh, said the budget for the ongoing fiscal year has failed to anticipate the depth of the macroeconomic crisis and ended up without securing any sustained progress with macroeconomic stability.

The inability to introduce meaningful tax reforms over the past several years has constrained tax revenue mobilisation.

Bangladesh has one of the lowest tax-to-GDP ratios in the world and the National Board of Revenue (NBR) is set to fail to hit its tax generation target for the 11th consecutive year in the current financial year.

"Ad-hoc tax measures announced during the budget seasons have failed to make a dent in the resource mobilisation effort and this situation will likely repeat itself for the FY2024 budget," Ahmed said.

The proposed budget sets an overly ambitious target of increasing tax revenue to Tk 450,000 crore in FY24 as compared with estimated tax revenues of Tk 329,600 crore in FY23.

"The new tax measures proposed in the budget may provide scope for some modest additional increase but the projected 37 per cent increase is absurdly optimistic and the most likely outcome will be a huge shortfall in actual tax revenues," Ahmed said.

He said meaningful reforms require an overhaul of the tax system that involves major institutional changes in tax planning and tax administration.

Ahmed said the government faces an additional challenge of finding prudent ways of financing the budget deficit, which is targeted at 5 per cent of GDP.

"In the current environment of high inflation and pressure on the balance of payments, the government will need to cut the growth of domestic credit."

The former World Bank economist urged the government to make an effort to curb subsidies and phase the implementation of capital-intensive large infrastructure projects while increasing allocations for health, education, irrigation and flood control, water supply and social protection.

"Along with efforts to lower inflation, these expenses can also help the government politically by improving the income levels of the poor and vulnerable."

Binayak Sen, director-general of the BIDS, said: "We must bring in a market-determined single exchange rate. There is no point in getting scared of a uniform exchange rate because our foreign currency reserve is eroding."

The reserve has plummeted by about 29 per cent in the past one year, falling to $29.78 billion on June 7 from $41.75 billion on the same day last year, central bank data showed.

The import control measures, which were put in place to save the forex reserve, did not pay off, Sen said.

"Subsidies have to be cut. However, subsidies for the agriculture and food sectors could be continued."

He called the Tk 2,000 minimum income tax contradictory given the tax-free income limit has been raised to Tk 3.5 lakh from Tk 3 lakh.

There is a scope to expand the tax net since a strong base of the middle class has grown in the past few decades, according to Sen.

He argued that there are about 4.5 crore households in Bangladesh, with 50 per cent being non-poor. "But only around 22 lakh people pay income tax regularly."

Sen said the government should ensure that loan defaulters and tax evaders can't participate in the upcoming general elections.

"It should be done in a real sense. Loan defaulters should not be allowed to take part in the polls after giving 5 per cent to 10 per cent down payments on defaulted amounts."

He said the time has come for Bangladesh to move away from the policies that have been followed in the past one year.

Quazi Shahabuddin, a former director-general of the BIDS, suggested expanding the tax net instead of raising the rates.

He recommended slashing the allocation for infrastructure projects by 15 per cent.

MA Sattar Mandal, a former member of the planning commission, said ensuring food security should be the top priority and subsidies should be set aside only for emergency requirements.

Kazi Iqbal, a senior research fellow at the BIDS, said the government should overlook the implementation of less important projects owing to limited fiscal space.

He said other countries have been able to restore macroeconomic stability through effective policies.

"Effective policies are lacking in Bangladesh, so inflation is yet to come to under control."