Reforming the tax incentive structure in Sri Lanka

Originally appeared on Daily FT

By Roshan Perera, Thashikala Mendis, and Janani Wanigaratne

The second tranche of the International Monetary Fund’s (IMF) Extended Fund Facility (EFF) was delayed as the country failed to meet some of the program targets including the Government revenue target. This prompted the IMF in their latest review to reiterate the need to “strengthen tax administration, remove tax exemptions, and actively eliminate tax evasion” to ensure revenue is collected as per the program targets. This requires intense efforts by the Government if the country is to achieve sustainable macroeconomic stability.

Corporate Income Tax (CIT) in Sri Lanka has the potential to significantly contribute to Government revenue. However, CIT performance has been dismal with collection averaging around 1% of GDP over the last two decades although economic growth averaged around 4% during the corresponding period. It peaked at 1.9% in 2022 due to some one-off taxes.1 Compared to other countries in the region as well, CIT collection in Sri Lanka has been abysmally low (see Figure 1).

Further, CIT collection is concentrated in a few sectors in the economy. The 230 companies listed in the Colombo Stock Exchange (CSE) for financial year 2019/20 account for around 25% of total corporate income tax collection. However, financial services, food & beverages, and telecommunications account for a disproportionate share of taxes (see Figure 2). Sectors such as wholesale and retail trade, real estate and transportation which account for more than 25% of GDP, contribute less than 2% in CIT. Tax holidays and concessionary tax rates to selected sectors have eroded the CIT tax base, leading to lower CIT revenue collection. Ad hoc tax concessions complicate tax administration, distort resource allocation and provide opportunities for rent seeking and corruption.

Tax incentives

With the liberalisation of the economy in 1977 and the shift to a more export oriented development strategy, the Government sought to attract foreign direct investment (FDI) by offering attractive tax incentives, first under the GCEC Act No. 4 of 1978 and subsequently the Board of Investment (BOI) of Sri Lanka from 1992. Tax incentives were also offered under the Inland Revenue Act. The enactment of the Strategic Development Projects (SDP) Act, No. 14 of 2008 permitted the Minister in charge of investment the discretion to grant incentives to projects deemed of strategic importance with only subsequent ratification by Cabinet and Parliament.

The lack of clear criteria of what constitutes a “strategic development project” in the SDP Act and the discretion given to the Minister to decide on what constituted a “strategic” project led to generous tax holidays and incentives granted to projects that were not in any sense strategic (see Table 1 for a list of projects granted under the SDP Act). Furthermore, tax concessions under the Act have been awarded to projects that are not purely foreign funded, violating one of the core objectives of this Act, which is to attract foreign investment.

The operation of multiple tax jurisdictions has led to an overlap of tax incentives, obscuring the process of monitoring the overall benefits and costs of tax incentives provided. Lack of transparency and well-defined criteria as well as poor evaluation of projects has led to the granting of tax incentives without proper justification, leading to large revenue losses.

Transparency, availability and accessibility of information regarding companies that have received tax incentives, especially under the BOI Act, are limited3. In light of this, the IMF diagnostic report has highlighted the need for a more transparent data sharing protocol.

The case of Port City

More recently the Colombo Port City Economic Commission Act, No. 11 of 2021 was given the authority to grant tax incentives within the Port City.

The CPC Act grants incentives to businesses that are identified as strategically important. Extraordinary Gazette 2343/604 lists several industries as strategically important. Even though the Act provides a descriptive definition of a business of strategic importance, the rationalisation for these industries to be selected for special incentives is unclear. Especially as some of these industries already exist in Sri Lanka, which puts them at a disadvantage. Moreover, under section (4) subregulation (3) of the Extraordinary gazette 2343/60, one of the criteria for granting incentives is the ability of the business to demonstrate to the Port City Commission the potential contribution to Sri Lanka’s economy and social development by fostering innovation, knowledge transfer, technology transfer, research and development. This criteria is vague and subjective, thus allowing the Commission to grant incentives at its discretion.

Granting incentives often leads to differential tax treatment creating an unlevel playing field. While an entity in an already established industry within the country located within the CPC is provided generous tax incentives, the firm located outside is subject to the normal taxes operating in the rest of the country. Such differential treatment could create labour market distortions, as the employees in the Port City benefit from tax exemptions.

Sri Lanka has not been able to attract Foreign Direct Investments (FDIs) despite the plethora of incentives offered. It is questionable whether we can expect different results by applying the same failed strategy with the Colombo Port City. For instance, out of 74 land plots, only 6 were leased so far, and even those have not yet materialised.

To improve the performance of CIT, reforming the existing incentive structure is critical.

Improving investment environment

Evidence suggests that tax incentives are not the most important factor attracting FDI. Rather investors prioritise factors such as macroeconomic stability, access to skilled labour, and quality infrastructure facilities when making investment decisions. Therefore, shifting focus from relying on tax incentives to creating a favourable macroeconomic environment and policy consistency while providing the necessary resources and infrastructure will be more important to attracting investments. This will reduce distortions in the economy while ensuring the Government’s revenue base is protected.

Renegotiating tax incentives

Given the weak fiscal position of the country and the debt restructuring exercise being carried out at present, a similar exercise to renegotiate existing tax incentives may be warranted. Rationalising existing tax incentives would widen the tax base and enable lowering corporate tax rates.

Centralising tax incentives

If tax incentives are to be granted it should be done by a centralised authority. This authority should be able provide justification for granting special tax incentives by carrying out a cost benefit analysis. Clear objectives and proper criteria for granting incentives should be established and the authority held accountable for monitoring the progress of the investments to ensure the objectives of the investment are fulfilled. Failure to meet the objectives should lead to an immediate cancellation of the incentives granted. To ensure transparency, all incentives granted should require Cabinet and Parliamentary approval and information on incentives granted made publicly available through gazette notices. Sunset clauses will ensure that incentives have a limited timeframe and are periodically reviewed.

Conducting tax expenditure analysis

Tax expenditure refers to concessions such as tax exemptions, deductions, concessionary tax rates, etc. granted to specific industries or entities. While typically a government budget provides estimates of government revenue, tax expenditures are rarely reported. However, given the generous tax incentives offered it is vital to ensure the costs and benefits of tax expenditures are properly accounted for. Conducting regular tax expenditure analysis will enable comprehensive cost benefit analysis to evaluate the potential revenue loss and the expected economic benefits of tax incentives. Moreover, it is essential to carry out regular assessments to ascertain whether the revenue loss resulting from tax exemptions is justified by the employment, GDP contribution, and economic impact of these projects.

Global Minimum Tax 5

When tax incentives and holidays are granted, it should be ensured that their rates are not lower than the rate recommended by the Global Minimum Tax (GMT). This is an agreement introduced by the OECD/G20 in October 2021, with the purpose of establishing a minimum tax rate of 15% for large multinational companies. It allows countries with taxable parent companies of Multinational Enterprises (MNE) to impose a top-up tax on the profits of any foreign subsidiary that pays an effective rate less than 15%. It also allows the host country where the MNE subsidiary carries out its activities to charge a top-up tax rate on subsidiaries, if the home country of the parent company imposes a CIT rate less than 15%. So even if the countries are free to grant tax holidays and incentives with a CIT rate lower than 15%, the agreement grants the taxing rights to either the FDI exporting countries or the countries in which the MNE subsidiaries are operated. Therefore the MNEs would not be benefitted by lower rates as they will be taxed by either country.

The countries that do not adopt this GMT rule would lose out on tax income as the other countries will adjust their domestic tax rules to top up undertaxed profits. This proposal has already been strongly backed by 130 countries. Unfortunately, Sri Lanka was one of the nine countries that did not agree to this proposal.

The country is struggling to meet its revenue targets. The potential of CIT as a significant source of revenue has not been not fully exploited. A plethora of tax incentives granted under numerous agencies have seriously eroded the tax base. Reversing these trends are vital for restoring fiscal sustainability and enabling the Government to promote sustainable and inclusive growth.

Footnotes:

1This is due to the imposition of a retrospective one-time surcharge tax of 25% on individuals, companies, and partnerships with a taxable income exceeding 2 billion for the 2020/2021 tax assessment year.

2Based on the taxes paid by around 230 listed companies on the Colombo Stock Exchange in 2019/2020.

3Information on projects granted under the SDP Act are publicly available through gazette notices which are mandatory. This is unlike projects granted incentives under the BOI Act which are not publicly available. An RTI filed to extract this information was also not responded to by the relevant authority.

4http://documents.gov.lk/files/egz/2023/8/2343-60_E.pdf

5World Bank, 2023, “Can the global minimum tax agreement reduce tax breaks in East Asia?” https://blogs.worldbank.org/developmenttalk/can-global-minimum-tax-agreement-reduce-tax-breaks-east-asia#:~:text=In%20October%202021%2C%20the%20G20,to%20be%20implemented%20in%202024.

(Roshan Perera is a Senior Research Fellow at Advocata Institute. She can be contacted via roshananne@gmail.com. Thashikala Mendis is a Data Analyst at Advocata Institute. She can be contacted via thashikala@advocata.org. Janani Wanigaratne is a Research Consultant at Advocata Institute. She can be contacted via janani.advocata@gmail.com.

The opinions expressed are the writers’ own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.)

Are we getting the Port City Right?

Originally appeared on The Morning, Daily News, Lanka Business, Daily FT

By H. Dabarera and K.D. Vimanga

The Supreme Court determination on the Colombo Port City Economic Commission Bill will be announced by the Speaker to Parliament today (18) and the Bill will be debated in Parliament tomorrow (19) and Thursday (20).

Over the last few weeks, Sri Lankans have contemplated if the proposed Colombo Port City is the messiah that will rescue the country’s economy or whether it is another Trojan Horse that will throw firewood into the already smouldering regional geopolitical furnace. 

The Port City as a model has the potential to be a driver of growth. For that, it must be governed well within a globally accepted, transparent and accountable regulatory framework. The project can bring in much needed foreign investment and kickstart growth especially at a time when the state of public finance is weak with a looming risk of default of debt. 

The major part of the investment for the Colombo Port City is already made, hence there’s no option other than making use of it and making it work. However, it must be done in a manner that does not compromise the best interests of Sri Lanka and our regional partners. 

The proposed bill aspires to have a financial centre within the proposed “special economic zone” in the likes of financial centres such as Singapore, London and New York. Then it is crucial that such a centre maintains a separate legal and regulatory framework that is unhindered by the delays and loopholes in the local court system and is established in accordance with international norms and practices. If implemented correctly, a financial centre can open up opportunities in investment banking, insurance, off-shore financial services, hedge funds, institutional investors, clearing houses, etc. A financial centre combined with international living standards and financing options can also be attractive for tech startups especially those aspiring to operate in the South Asian region. This creates opportunities for ambitious Sri Lankans for jobs they have to now go overseas. 

However, this is a process that is protracted over a longer period of time and is dependent on the confidence and trust that the project invokes for investors. The key to building trust and confidence is dependent on two main factors. One, having a sound financial regulatory system. Two, having global recognition and acceptance for the governing law. As a matter of fact, most financial centres resort to a framework based on English Common Law. 

Challenges 

The comparative advantage Sri Lanka has compared to regional financial centre’s such as Dubai, Mauritius, Singapore, Hong Kong, etc. is limited in its strategic location, hence attracting investors to bypass established financial centres will take significant effort. The comparative advantage Sri Lanka offers must be unique to attract the global investor! 

The island’s geographic proximity to the sub-continent and the present geopolitical landscape of securing friends and off-shore assets by the regional super powers makes a compelling case for many to develop the Colombo Port City as a regional hub to manage money from the heavy rollers in the region. 

However, becoming such a magnet for investment can only be done by building bridges with our regional partners. But the question is, is that simply enough? One might argue yes, as Sri Lanka’s economy is only a shade above $ 80 billion. However, the question arises if the global financial elite such as HSBC, Deutsche Bank, Citibank, Bank of China, IOB, JP Morgan etc, will enter Colombo Port City to do business. 

Is providing tax concessions simply going to bring in these reputed banks? Observing the behaviour of these banks simply illustrate that a vast majority of these banks make big investment decisions such as opening onshore operations by assessing a whole range of factors including the regulatory environment, especially in the case of emerging markets. 

So, is the proposed financial regulatory arrangement sufficient? At present the act vests power onto the proposed commission to regulate and monitor and steer banking operations within the area of the Colombo Port City with the concurrence of the identified national bodies such as the Minister of Finance and the Monetary Board. Therefore, the bill lacks a regulatory framework conforms with international best practices set out by institutions such as the Basel Committee on Banking Supervision and the Financial Action Task Force (FATF). This is done in order to facilitate such capital flows due to the serious concerns on money laundering. So, it is vital that this issue of a lack of a supervised financial regulatory system is addressed, if the Port City is to be operated as a productive financial centre. 

A second serious drawback of the drafted bill is the lack of an accepted global recognised governing framework such as English Law. If we are going to benchmark ourselves with established financial centres such as Singapore and Dubai, the said financial centre must be framed around English Common Law. The rationale for this stems from the fact that, English Common Law underpins the legal systems of the world’s four top international financial centres – London, Hong Kong and Singapore. This is further exemplified by how the Dubai financial centre functions as an independent jurisdiction governed by an English Common Law framework which is distinct from the rest of the UAE. Such a framework will bring in operational and cross jurisdictional mobility. This is because the global financial sector already functions on an English Common Law dominated platform. Moving to complaint jurisdiction with the same legal norms is the standard best practice. 

In fact, Sri Lanka ranks poorly in the World Bank’s Doing Business Indicator (99 out of 190 countries), due to the country’s fledgling legal system related issues and has fallen behind regional peers such as Nepal and India. 

So to attract the global banking elite such a framework is preferable and will not only open the core financial sectors such as banking, securities and derivatives, but also related sectors such as insurance, shipping, international trade, commodities and logistics. 

The legal framework for settlement of disputes 

For resolution of disputes the Commission is expected to establish an “International Commercial Dispute Resolution Centre.” Any dispute that arises within the Port City between the Commission and other entities within Port City shall be resolved by way of arbitration. Further, all agreements made by every authorised person with the Commission should have a provision on mandatory reference to arbitration for any dispute that arises within Port City. The International Arbitration Centre shall be the sole authority to hear all such disputes within the Port City. 

However, with regards to disputes that authorised persons within Port City can face over business activities carried out with other entities from all over the world, they will have the discretion to resort to any form of conflict resolution; litigation or any form of Alternative Dispute Resolution (ADR) mechanism in any jurisdiction of the world. Hence, the reputation of our International Arbitration Centre will matter immensely. Especially if we are to ensure that these disputes can even be heard within the Port City in the form of ADR. This will bring in much needed business to the arbitration centre while reducing the cost to the investors within the Port City as other centres such as London, New York, Singapore, Hong Kong, Dubai, etc. will be a costlier option than Colombo. 

International Arbitration Centres in Singapore and Hong Kong have gained worldwide recognition as leading arbitration hubs. They have made a significant contribution to the economic growth of these countries and helped them attract international business, trade and FDI. Thus, if strategically utilised, an international arbitration centre can be complementary to the growth of international business within the country. However, in order to ensure such results, it is essential that the International Arbitration Centre has in place a proper set of rules and principles to ensure swift resolution of disputes and ease through predictability and consistency to the business community. 

The current International Arbitration Centre in Sri Lanka, despite being based upon the UNCITRAL model law of Arbitration, has ultimately failed in winning over the confidence of the public and investors due to the arbitration proceedings dragging too long (as long as three years in certain instances). In the world of finance, time is money as money never sleeps. So special emphasis must be placed on maximising efficiency within the arbitration centre. Additionally, constant political instability in the country and the failure of the judiciary to uphold rule of law has also acted as hindrances to propel Sri Lanka as a global hub for International Arbitration. 

Drawing from these failures, it is evident that if the Port City is to become like Singapore or Hong Kong as an International Arbitration Centre it needs to introduce sound principles that are able to win over the confidence of the business community. 

A case for legal neutrality and jurisdictional independence 

It is also important for the International Arbitration Centre at the Colombo Port City to establish legal neutrality in the eyes of international stakeholders. Legal neutrality is of utmost importance for a financial centre as impartiality is key to attract investors and reputed financial institutions. Hence, ‘trust’ in resolving disputes impartially and transparently will be a deal maker for the Colombo Port City to become a success. Especially as it will be competing with financial centres in the region, of the likes of Dubai and Singapore who enjoy reputational synergies due to the merits of maintaining neutrality and also efficiency. This further makes a serious case for the Colombo Port City to be an independent jurisdiction within an English Common Law framework. 

An International Arbitration Centre, manned by local expertise may not deliver the credibility investors seek from a virgin financial zone that has to compete with established facilities that operate with a proven track record on efficiency, transparency and infrastructure. Hence, the International Arbitration Centre can be opened to accommodate foreign professionals with a proven track in arbitration. The addition of such provisions to the existing Bill can make the International Arbitration Centre at the Colombo Port City attractive and marketable to become an alternative financial centre for the South Asian region. Further the inclusion of English Common Law which the international financial markets are very well versed in can bring in significant benefits when functioning as a financial centre. If this fundamental issue is not addressed the Colombo Port City will yet again be a case of missing the bus yet again. 

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Sri Lanka state fails in the core business: administration of justice

Originally appeared on the Economy Next

By Prof. Rohan Samarajiva

In a previous column I stated that “no political or economic theorist would argue that the state should not be engaged in the provision of law and order. . . even extreme libertarians would see a role for the state in law and order.”

Sri Lanka presents a façade of a functioning legal system. Justices and judges get appointed; ceremonial sittings are held. Funds from World Bank loans are expended; buildings are constructed. Lawyers walk around briskly in court premises; many of them live well.

But it is rare to see a modern state fail so badly in this core function.

Evidence of failure

The President’s Counsel currently serving as Minister of Justice presented the evidence in a speech to the 47th Annual Convocation of the Bar Association of Sri Lanka:

– the average time to enforce a contract in Sri Lanka is 1,318 days

– We have been ranked 161 out of 189 countries for the enforcement of contracts

– Our legal system is ranked 5th out of 8 in South Asia.

– Land, Partition and Testamentary cases on average take a generation to be settled.

– A criminal trial takes on average 9½ years to conclude in the High Court.

– A criminal matter on average will take a year to be fixed for appeal and 3-4 years for the said appeal to be completed.

But this is not all. From 1978, we have had justiciable fundamental rights. Fundamental is defined as “forming a necessary base or core; of central importance.” Therefore, one would expect fundamental rights cases to be given higher priority than the cases listed above.

But that is not the case. It took the Supreme Court until 2021 February to issue a decision on a fundamental rights case, Kurukulasuriya v Sri Lanka Rupavahini Corporation (SC FR Application No. 556/2008 & SC FR Application No. 557/2008), notwithstanding the unequivocal language of Article 126(5) of the Constitution: “The Supreme Court shall hear and finally dispose of any petition or reference under this Article within two months of the filing of such petition . . ..” Instead of two months, it took 145 months.

It is said that justice delayed is justice denied. Can it be said that justiciable fundamental rights exist in Sri Lanka?

Then let us look beyond law’s delays, at egregious injustice. At qualitatively bad decisions. We had a Chief Justice who publicly admitted that he absolved the current Prime Minister in the Helping Hambantota case on political grounds.

But this man’s unjust decisions were many, as I documented in an article published in the Financial Times of 27th November 2008. A bench headed by this Chief Justice decided on the 21st of July 2008 (CS/FR 209/2007) a matter that only came up for argument on the 27th of November 2008 before a different bench. That’s right. The case was to come up in November, but the decision was given four months earlier.

The bench headed by the Chief Justice ruled on the tax exemption in July: “The tax relief granted to JKH was not permissible under the existing Regulations and JKH got an amendment tailor made for its purpose and secured the tax exemption” (CS/FR 209/2007, pp. 60-61). Yet, the respondents in the case that came up for argument in November, including the then BOI Chairman Dhammika Perera, the BOI Chairman when the tax exemption was granted Arjuna Mahendran, and former Commissioner General of Inland Revenue A.A. Wijepala, all needed to determine the legality of the exemption, were not among those noticed in CS/FR 209/2007.

By initiating a separate case that was taken up for argument on 27th November and serving notice on the above individuals, the plaintiffs of CS/FR 209/2007 conceded that the tax matter was not part of that case. Yet, the Chief Justice issued a ruling, violating natural justice.

Was the former Chief Justice the only malefactor? What about the other justices on that bench? What about the counsel? I purposely published my indictment on 27th November 2008, the day the tax-exemption case was to be taken up.

It would have been difficult to miss because the editors had put a black border around it and stated that they were not responsible for the content.

Did anyone in the judiciary or the legal profession do anything about it? Was an inquiry initiated? No. Is it unreasonable to conclude that the rot in the legal system was not limited to one out-of-control Chief Justice?

Has the Attorney General’s Department, which wields enormous power, been insulated from the rot? Does it exercise prosecutorial discretion in a fair and reasonable manner? The large number of prosecutions dropped when governments change raise legitimate doubt.

Does the Legal Draftsman’s Department do its job in a professional manner? How could a Constitutional Amendment that sets a quorum of three for an Elections Commission with a membership of three have been cleared by that Department?

How could it have neglected to include the Consolidated Fund as a continuing source of revenue for the Fund of the Disaster Management Council in the Disaster Management Act, No. 13 of 2005?

What is being done?

The current Minister of Justice is striking the right notes:

“It is vital that we look at a complete structural change from end to end and roll it out in a targeted and efficient way. We have to stop looking at the legal profession as one which exists solely for the sustenance of its members, but as one which plays a much more important role as a public centric body which is driving the justice system forward – one which is ready to innovate, to evolve and to take the right decisions at the right time to create a paradigm shift in the administration of justice.”

Even if done in a way that was not quite proper, the Minister has increased the number of judges in the superior courts. Funds have been allocated for court automation. It is hoped that the foundation laid by the comprehensive study completed in 2017 and the extensive consultations the ICT Agency conducted with the judges of the superior courts in 2019 will be built upon.

The above actions will, if adapted from a working system in another country, carefully piloted and scaled up, and supported with the necessary technical personnel, fix the dysfunctions in the “registry” part of the court system, which involves, or should involve, low discretion. If the system is transparent to lawyers, litigants and the public and is hardened to resist malicious attacks and manipulation, a key piece of the solution will be in place. But this will not, by itself, yield the desired outcomes.

The procedures and rules must be redesigned placing the needs of the litigants at the center, and not those of the lawyers and the judges. Even if it is a monopoly buttressed by archaic and arbitrary contempt-of-court rules, what the courts do is supply a service.

The litigants want a service, and they pay for it, either directly or through their taxes. They should be treated with respect and provided the services they seek at high levels of quality.

Decisions, even against those charged for criminal offenses should be of high quality in that they have been reached based on the relevant procedure, and are based on the best possible evidence. High quality also means not having to live in limbo for years, while lawyers and judges take their own cool time.

Unless procedures are reformed to put the litigants at the center, law’s delays will continue. Judges must work reasonable hours and they must impose discipline on lawyers by refusing frivolous requests for postponements. Section 63(2) of the Colombo Port City Economic Commission bill illustrates the dysfunctions of the current system:

“In order to foster international investor confidence in the ease of doing business and in the enforcement of contracts, in the national interest and in the interest of the advancement of the national economy, the inability of a particular attorney-at-law to appear before the Court on a particular date for personal reasons (including engagement to appear on that date in any other court or tribunal) shall not be a ground for postponement of commencement or continuation of the trial or be regarded as an exceptional ground warranting such postponements.”

For cases involving companies registered with the Port City Commission, the conventional rules that privilege the convenience of the lawyers are not to apply. But the rest of us will not only have to continue to put our lives on hold for the convenience of the lawyers and judges; we will also have to suffer the indignity of the fast-track litigants from the Port City cutting in front of us in the queue.

Simply reforming the rules will not suffice. The overall quality of legal education must be improved with a greater openness to innovation. The lowering of the protectionist barriers erected to safeguard the earning potential of members of the legal profession is a necessary condition. In recent debates around bilateral agreements dealing with trade in services, activist engineers told me that they need the kinds of protections the lawyers had erected for themselves against foreign competition.

Innovation requires the transfer of tacit knowledge possible only by day-to-day interactions. It is energized by competition. It is only when the legal profession becomes open to innovation that the judges who are drawn from it can become innovative and responsive.

All professions are protective of the pecuniary interests of their members. They fight back when those interests are threatened in any way. Lawyers are fearsome adversaries. Even the most astute and committed politicians approach legal reform with trepidation. They understand that the reform will take the form of trench warfare unlikely to yield results within the political cycle. They devise workarounds.

Politicians can at least try. System-level workarounds are unavailable to ordinary citizens and businesses. Their workarounds are petty and, in some cases, illegal. They limit transactions to trusted parties, knowing unenforceable contracts are meaningless. They seek the services of thugs to enforce contracts. They keep buildings that can be rented for revenue empty.
Workarounds

The proposed Colombo Port City Commission is a workaround.

Legal-system-related factors are a main reason Sri Lanka is ranked 99th out of 190 countries in the Ease of Doing Business Indicator. Even Nepal is ahead of us; Pakistan is about to catch up. Poor performance in resolving insolvency and enforcing contracts are major contributors to Sri Lanka’s low rank. On enforcing contracts, the country is ranked 164th.

It is unlikely that high-profile financial and service businesses will want to locate offices in Sri Lanka in these circumstances. Despairing that the legal system can be improved, the drafters of the Port City Commission Bill propose to make arbitration by the International Commercial Dispute Resolution Center that is to be established within the Port City mandatory for disputes arising within its area of authority. They also propose a fast-track, exemplified by section 63(2) quoted above, for engagement with the Sri Lankan courts if required.

Despite all the talk of how bad bypassing the Sri Lankan legal system is, this has been going on for a long time.

The disputes between several international banks and the Ceylon Petroleum Corporation over hedging contracts entered in 2008 in the first Mahinda Rajapaksa government were not resolved by the Sri Lankan courts. Arbitrations on the contracts with Standard Chartered and Citibank commenced, respectively, before the English High Court and the London Court of International Arbitration.

Deutsche Bank’s arbitral proceedings against Sri Lanka for the actions of the CPC, Central Bank and the Supreme Court in relation to the failure to perform the hedging agreement were at the International Centre for Settlement of Investment Disputes (ICSID), an organization established by the 1965 Convention for Settlement of Investment Disputes between States and Nationals of other States (ICSID Convention).

The CPC lost the cases. They also bore the considerable costs of participation in expensive cities.

The legal agreements governing the Sri Lanka Telecom privatization by the first Kumaratunga government in 1998 did not give rise to a need for dispute resolution. But had such arisen, the arbitration would have been in Singapore under that country’s laws.

In this context, it is unlikely that commercial disputes where referral to the Dispute Settlement Center within the Port City is not mandatory will come to the Sri Lankan courts. They will go to Singapore, London, Geneva, or Washington DC. They will bypass the Sri Lankan legal system, understandably. At least the International Commercial Dispute Resolution Center will be on Sri Lankan soil and the lawyers need not be paid per diems.

Effects of workarounds

The petty workarounds of the citizen and the businessperson yield no good results. They simply overburden other parts of the system and let resources lie fallow.

We like to teach the Coase Theorem which describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem postulates that if trade in an externality is possible and there are sufficiently low transaction costs, bargaining will lead to a Pareto efficient outcome regardless of the initial allocation of property.

But with a dysfunctional legal system, the condition of properly defined property rights does not exist. Coasean bargaining is limited to the classroom. We are compelled to fall back on the command-and-control capabilities of the state, overburdening it further.

The system-level workaround of the Port City Commission Law could be a holding action until we improve our legal system and associated processes of relevance to investors and service industries that are to be attracted to the Port City.

In the same way that the Greater Colombo Economic Commission (GCEC) was to be a holding action until we improved the provision of planning, utility and related services throughout the country, there could be a plan to gradually bring the enclave within the general legal system which has been improved in the meanwhile. The doing business indicator measures good governance in the country as a whole (though for some components they focus on the capital), not in special enclaves.

It would be good if that were the case. But looking at the situation in the zones managed by the Board of Investment as the successor to the GCEC, we can see that the transition has not been completed even some 40 years later.

Even today, the services offered by the BOI in the zones are superior to those outside. We in Sri Lanka appear to be content with running superior systems and single windows for foreigners (and Sri Lankan who achieve such status) while letting the rest of the country suffer under second-rate systems and multiple windows.

The hope, always, is that the island of good governance will catalyze and drive reforms in the surrounding ocean of bad governance; that the land will take over the sea. We keep hoping.

Rohan Samarajiva is founding Chair of LIRNEasia, an ICT policy and regulation think tank active across emerging Asia and the Pacific. He was CEO from 2004 to 2012. He is also an advisor to the Advocata Institute.

The Port City We Need

Covered in the Daily Mirror, Daily FT, Daily News, The Morning, Lanka Business Online,

By Resident Fellows of the Advocata Institute

Better economic rules, not giveaways should be the focus of the new governance zone

Deng Xiaoping China’s great reform leader, faced a serious problem in the 1970s. Thousands of young Chinese were crossing to Hong Kong risking their lives. Rather than cracking down on the migrants, Deng sought to understand why they were migrating. Clearly the economic opportunities in Hong Kong were greater than in mainland China. Deng was also impressed by the rapid rise of the some asian economies, in particular the modernisation of Singapore.  Singaporeans, like the residents of Hongkong, were majority Chinese by descent and had even less natural resources. How did they achieve something that China couldn't?  

The answer was that these countries had better rules, better incentives, and a better economic governance system. Deng knew he needed to ‘reboot’ China with reforms that allowed markets to coordinate economic activity,  protect private property, and allow for Foreign Direct Investment: radical reforms in communist China at the time. He also knew that implementing these reforms in the entirety of the country would be a nonstarter. Entrenched interests who benefit from the status quo would fight to keep the existing order. To solve this, China demarcated the Shenzhen area as a special governance zone and implemented a new - more open - economic system. This was the start of the Special Economic Zones (SEZs) in China. It was promoted as a laboratory to experiment with market principles to serve “socialism”.  

The results are astounding. In the past forty years Shenzhen has been transformed from a fishing town of less than 30,000 to the third largest city in China with a population of more than 12 million. By 2018, the economy of Shenzhen was $366 billion, four times that of Sri Lanka. 

In some ways, Deng’s problem is now Sri Lanka’s problem. To be sure, emigration out of Sri Lanka is not as severe as it was in 1970s China. Sri Lanka’s business environment is also not as bad as the Chinese system at that time. Yet market based reforms started in 1977 have all but stalled.  

Like China, in “mainland Sri Lanka” too an entrenched elite who benefit from the existing rules lobby to maintain the status quo. The result is that very little progress has been made over the last 15 years on reforms necessary to boost economic growth. After a brief post-war spurt between 2010-2012, economic growth slumped and has remained stagnant.

This is visible in Sri Lanka’s low scores on various rankings that measure the efficiency of the business environment. In the World Bank’s influential Ease of Doing Business report, Sri Lanka is ranked 99 out of 190 jurisdictions. The country has fallen behind regional peers like India, Bhutan and Nepal, having once been an early economic reformer in the region.  

Take the legal system, where Sri Lanka is one of the worst performers in the world. In contract enforcement, the World Bank ranks Sri Lanka 164 out of 190, taking on average nearly four years to enforce a contract. In Singapore, it takes just over five months. It's no wonder that foreign investors prefer easier destinations to deploy their capital. 

This is the logic for the Colombo Port City. Poor governance is a barrier to growth in many developing countries but implementing broad reform for better governance is extremely difficult. The idea is that by building special governance zones, governments could adopt completely new systems that overcome the problems that exist in the rest of the country. These zones would operate like “one stop shops” with pre-approvals and fast-tracked court systems, making doing business easier and hopefully attract foreign investment.  

Special zones are not new in Sri Lanka. Much of Sri Lanka’s export industry resides in the country’s dozen or so Free Trade Zones. Colombo Port City is different by virtue of being the first special zone developed by an international operator.  Unlike the FTZs, the focus is on white collar jobs and financial services instead of manufacturing exports. It also has a broader remit: the proposed legal structure lists seven laws that don't apply to Port City, and a further 14 that could be exempted in the area by the proposed oversight body. The Port City masterplan promises world class living facilities, entertainment, financial services, and business.

Yet Port City’s success, and indeed its importance to the country at large, will only depend on its ability to provide a superior economic governance system. To be a success Port City will need to guarantee greater economic freedoms to its investors, have an efficient legal system with clear and predictable laws. It needs to minimise discretion of the commissioners and have a fair and transparent regulatory structure. These are the critical features that have made several small cities like Hong Kong and Singapore prosper. 

This is the Port City we need. A better governance zone that can attract FDI, skilled people, spread knowhow, and serve as a lab for policy experiments. Get this right, and Port City could create positive spillover effects and expand economic opportunities for Sri Lankans. By learning from it’s successes, we can hope to scale some of the policies in the enclave to the rest of the country.

What of the Port City we will get? In the coming weeks, the country will debate whether the specific provisions in the Port City bill are prudent.  The supreme court is already hearing 19 petitions that challenge its constitutionality.  Like any project of this nature, there are also political and economic risks that need to be considered.  

Managing the geopolitical risk is going to be an enduring challenge in Sri Lanka. Here there are no easy answers, except professional management of our foreign affairs and dealings. Big picture thinking is needed instead of the current win/lose mindset and transactional diplomacy.

Another risk is in the domain of economic distortions. Unlike in Shenzhen which was conveniently located far from the commercial centres at the time, Port City is on the doorstep of Sri Lanka’s capital. After the operation of the Port City, life as a businessperson could be very different depending on which side of the Chaithya Road your business is situated. You may be competing for the same resources but face very different rules and taxes. The latter is a deeper malaise.

Already stretched for revenue to cover even its debt obligations, the Port City may prove to be a leakage point of taxes for the State. Finally,  given its proximity to Colombo, there is a risk of capture of the regulatory framework of the same elite who have secured rents for themselves in the existing system. It’s no accident that successful SEZs tend to be away from the established power centres, such as Shenzhen was to Beijing. 

Only good rules, predictable policies, and oversight can overcome these challenges. A focus on better governance rather than tax breaks and giveaways would help keep the house in order.  

It would be better for the entire country to be governed by better rules and efficient systems that enhance ease of doing business. Given its size and scope, the Port City cannot perform miracles, but we can hope that Port City would be a catalyst in bringing about some of these changes to the country proper.

The project itself is an admission of failure in governance. Even when Sri Lankan leaders know what to do, a combination of backward ideology, political opportunism, vested interests, and lack of state capacity seem to hold back the vital growth oriented reforms. It is these reforms that are needed to expand economic opportunities for all Sri Lankans.  

The Port City can give the country a shortcut to attract foreign investments, provided it focuses on the right thing -- better economic governance.

The authors are resident fellows of the Advocata Institute, a free-market think tank based in Colombo. Learn more about Advocata’s work at www.advocata.org. The authors are grateful to the many useful conversations with the think tank’s advisors whose ideas helped this article.