• Thursday, March 28, 2024
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Public finance in challenging times: A principled path to prosperity

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The ongoing pandemic foists difficult decisions on everyone. It has brought to the fore the inefficiency of several business models and the inadequacy of many plans and financial assumptions. This is unsurprising: both the existence and scale of disruption wrought by the pandemic were unforeseen. The good news is that this period also brings opportunities: the opportunity to rethink the business models and assumptions that have been exposed, and to create a crisis-proof path to prosperity.

This is as true for personal and corporate finance as it is for public finance. Through its impact on crude oil demand and the lockdowns which forced most businesses to temporarily shut down operations, the pandemic has had a tremendous effect on the finance of the Nigerian government, the full impact of which may not yet have been fully ascertained. Nigeria has now had a few years of fiscal deficits which have led the country to take on increasing amounts of debt on revenue assumptions that have now bottomed-up. The result has been painful to see: the revised 2020 budget of the federal government now has over 50 percent of planned spending unsupported by expected revenues.

The ensuing problem may be framed as follows: “How can the Nigerian state fund its present and future budgets and service its ongoing debts in the face of severely reduced revenues?” In very broad terms, three options are available.

The first is for Nigeria to default on (or seek forgiveness of) existing loans, and then continue on a path of fiscal prudence. The debt forgiveness path relies on circumstances outside government’s control and is therefore not unilaterally open to the government. Debt forgiveness can also impose stringent future obligations on the government and affect discussions for subsequent loans the government intends to take as lenders start to question the state’s ability to repay its debt. The default path is similarly problematic. Depending on loan conditions, a default on one loan could lead to lenders recalling other existing loans, thus crystallising repayment obligations early. This is, of course, apart from the legal, economic, diplomatic and geopolitical pressure Nigeria will face in a default scenario, which sum up to make this option unattractive.

The second option is to simply inflate away the problem. Given the state’s control over monetary policy and the power to print currency, government can devalue its existing currency so that the same amount of foreign reserves/exchange can now pay for more domestic goods or simply print additional currency which it uses to fund the budget and service debts. The problem here, of course, is inflation. Students of monetary economics will know all too well that an uncontrolled attempt to fund public expenditure in this way has led to hyperinflation, social unrest and ultimately revolutions. Wage freezes and price controls similarly do not work in this environment as they force firms out of business, lead to the creation of black markets and only exacerbate the inflation problem. Examples of this abound in history.

The third option is a principled path towards prosperity. It relies on a prudent management of revenue and expenditure and a disciplined approach to deficit spending. For clarity, I conceptualise the issues using a simple example from personal finance. I complicate the model gradually as we move from personal to public finance.

Consider a certain Mr. X. Mr. X has an annual income of N8,500,000. He reserves the sum of N2,500,000 to purchase new items such as a television or furniture. He pays the sum of N4,500,000 as annual rent and service charges for his flat in Ikoyi. He services a car loan he took some years ago with N2,500,000. He also supports his family, meets religious commitments and supports charity with N1,200,000 annually. It won’t take long to see that Mr. X is living above his means. Against an income of N8,500,000, he is spending 10,700,000. To fund this shortfall, he takes a loan of N2,200,000.

Assume further that Mr. X’s employer has informed him that because of reduced business activities arising from the pandemic, his remuneration will be reduced from N8,500,000 to N5,000,000. Mr. X creates a brilliant plan to react to this predicament. He will reduce spending on new items by N155,000. He will similarly agree a reduction in his rent by N25,000, and reduce his exposure to religion, charity and family by N153,000. In all, his expenses will reduce from N10,700,000 to about N10,300,000 against a revised income of N5,000,000. He will make up the shortfall by taking up N5,300,000 in loans.

This example explains how the budget works. Interestingly, this example is actually Nigeria’s 2020 budget divided by one million and rounded up as required. Mr. X’s remuneration represents Nigeria’s revenue; the planned spending on new items reflects capital expenditure; the spending on rent reflects recurrent (non-debt) expenditure; the car loan represents Nigeria’s debt service obligations; and the contributions to religion, family and charity represent contributions to the special intervention fund, sinking fund and other statutory transfers. When planned expenditure exceeds expected revenue, we have a fiscal deficit. Generally, the government funds these deficits primarily through loans and secondarily through its control of the monetary system.

As seen above, budgets are essentially made up of two components: expected revenues and planned expenditures. The key problem with Nigeria (typified by Mr. X) has been a suboptimal consideration of the expenditure portion of the budget. Hitherto, the government’s response to fiscal deficits has not been on cutting expenditure, but on increasing revenue. There are at least two problems with this. First, a substantial part of our public revenue is linked to oil prices which are entirely outside government’s control. A slump in oil prices therefore necessitates a slump in revenues accruing to the government.

Second, government’s approach to taxation (defined broadly to include charges and other levies) has long prioritised increasing revenues from tax-paying individuals and firms rather than widening the tax bracket to capture additional taxpayers. This has been done either through the increase in tax rates, or new impositions on existing taxpayers. In effect, existing taxpayers subsidise non-payment by those outside the tax bracket. These taxes increase the cost of doing business and leave businesses in the awkward position where they either take a hair-shave on their profits or pass on the increment to consumers. Ultimately, either consumers pay for these increased taxes, businesses cut down operating cost (often through laying off employees) to maintain profit margins, or businesses are forced to shut down altogether. None of these augurs well for the economy.

How then can Nigeria fund its budgets in the face of this revenue constriction? Unfortunately, not much can be done on the revenue side. Oil revenues have recently reached record lows as the industry continues to battle with global oversupply and reduced demand. Worse still, government cannot increase taxes now as several businesses are facing existential crises. To the contrary, this is the period when government needs to grant tax holidays to incentivise businesses to maintain production and retain employment and wage levels. What the FIRS loses in Companies Income Tax, the State Governments gain in Personal Income Tax. Since the states are closer to the people, they are better able to channel scarce resources to their most productive uses.

The answer to budget financing in this environment therefore lies in a principled approach to public spending. Returning to Mr. X’s example, Mr. X cannot respond to a pandemic that has caused a 40 percent reduction in his revenue, by proposing a 3 percent reduction in expenditure (which is what the revised 2020 budget is trying to achieve). Mr. X cannot aim to fund his expensive lifestyle by borrowing more than his expected income (maintaining a fiscal deficit of N5.18 trillion, with a revenue projection of N5.08 trillion).

The pandemic gives Mr. X an opportunity to rethink his spending: even a layman will tell that Mr. X cannot claim to be prudent whilst living in Ikoyi on his current income (i.e. recurrent non-debt expenditure of N4.46 trillion against a revenue projection of N5.08 trillion). A rent reduction of N25,000 (reduction in recurrent expenditure of N25 billion) does not nearly begin to scratch the surface. Mr. X must seriously consider moving out of Ikoyi to fully absorb the shock of the 40 percent slump in revenue. Similarly, the Nigerian state must seriously consider more intrusive means of reducing recurrent public expenditure on non-essential ministries, departments, agencies, and parastatals. The size of the public service and the budget of the National Assembly have always been singled out as immediate, low-hanging fruits in this regard. An ambitious borrowing plan (whether sourced from Central Bank overdrafts or domestic or foreign bond markets) to fund a steep fiscal deficit in these circumstances is, quite frankly, counterintuitive.

The Nigerian state has shown an inclination to avoid the public spending question in times past. We can only hope that it does not miss the opportunity the pandemic brings, to engage the question today.

Reginald is a Ph.D. Student of Law at the University of Oxford.