NPP’s maiden Budget

By Dhananath Fernando

Originally appeared on the Morning

The National People’s Power’s (NPP) maiden Budget will be presented to Parliament tomorrow (17). Ideally, a budget should not contain surprises – neither on the income front nor on the expenditure front. Government expenditure is the real tax burden on people; they ultimately bear the cost through taxes, inflation, or both.

Generally, a budget consists of two key components. The first is revenue and expenditure, while the second is the policy direction of the Government. This time, the business community is particularly focused on the latter, as it is evident that income and expenditure must align with the International Monetary Fund (IMF) programme.

Adhering to IMF targets 

The 2025 Budget has no alternative but to adhere to the parameters set by the IMF. While micro-level details and specific projects may change, key indicators such as gross financing needs, Government revenue-to-GDP ratio, primary balance, and debt-to-GDP ratio must be maintained as agreed under the IMF programme.

Additionally, the previous Government introduced new legislation under the economic transformation framework, covering many of the IMF’s targets. Achieving a Government revenue target of 15.1% of GDP will be a major challenge. Value-Added Tax (VAT), corporate tax, and income tax have already reached their upper limits, leaving limited scope for further increases. The Government is likely to bridge part of the revenue gap through vehicle importation.

When governments face revenue shortfalls, ad hoc taxes or sudden tax increases are common, often targeting sin industries such as tobacco and alcohol. However, the Budget must adhere to sound tax principles, ensuring simplicity, transparency, neutrality, and stability. 

The focus should be on simplifying the tax system and improving the efficiency of tax administration, as poor administration is as harmful as a bad tax system. Any unexpected changes in revenue policies could harm businesses, erode investor confidence, and slow down the economy. The best way to achieve the 15.1% revenue target is through efficiency measures and broadening the tax base.

Over 50% of recurrent expenditure towards interest payments

Sri Lanka has little control over its expenditure, with over 50% of spending allocated to interest payments. In 2023, approximately 90% of tax revenue was spent on interest payments. 

Currently, Sri Lanka has one of the highest interest payment-to-revenue ratios in the world, raising concerns about the possibility of a second debt restructuring. Post-debt restructuring, the Government has minimal room for fiscal adjustments.

While Government employees and various sectors may expect relief packages, the reality is that there is no fiscal space to accommodate such demands. It is true that salary structures for senior Government positions need improvement to attract the right talent, but this can only be achieved by restructuring the lower levels of the public service, which absorb the bulk of the salary bill.

Another solution is to drive economic growth and increase labour force participation, reducing the proportion of Government employees relative to the total workforce. Blanket salary increments are difficult to implement without compromising capital expenditure, which is crucial for long-term development. 

Currently, 20% of recurrent expenditure is allocated to salaries and wages, while pensions account for approximately 8%. Given this context, expecting significant relief packages is unrealistic, and any attempt to provide them could lead to long-term economic instability.

Investment should prioritise healthcare, education, social protection

Government spending should prioritise critical sectors such as healthcare, education, and talent development. However, expenditure in these areas – including the ‘Aswesuma’ social safety net – was lower than expected last year. 

The IMF has pointed out that Sri Lanka did not fully allocate the funds intended for ‘Aswesuma,’ which serves as the primary social safety net for the country. Ensuring proper allocation to these essential sectors is crucial.

Focus should be on structural reforms

Rather than solely focusing on balancing income and expenditure, the Government should use the Budget as an opportunity to set a clear policy direction. 

Key areas requiring structural reforms include land policies, labour laws, the export sector, and energy markets. These reforms are fundamental to Sri Lanka’s economic growth, as the country’s challenges are largely structural rather than issue-specific.

We will have to wait until tomorrow to see the extent to which the Government seizes this opportunity. Instead of expecting widespread relief measures, the public should push for meaningful policy reforms – an essential step for securing Sri Lanka’s future

(Sources: CBSL, Advocata Research)

(Sources: CBSL, MOF Annual Report, Advocata Research)

Rethinking tax policy in Sri Lanka

By Dhananath Fernando

Originally appeared on the Morning

• The case for adhering to tax principles

Many Sri Lankan budget speeches are essentially discussions on Government expenditure. Revenue proposals are often introduced piecemeal before the budget and frequently fail to align with basic principles of taxation. 

Under the current International Monetary Fund (IMF) programme, Sri Lanka has committed to achieving a revenue target of 15% of Gross Domestic Product (GDP) by 2025, increasing to 15.5% by 2026. Additionally, a primary balance target of 2.3% in 2025 must be met and maintained. 

While we have already exceeded the primary balance target, this achievement has come at the cost of cutting capital expenditure, which will likely impede long-term growth.

Tax revenue has met targets, primarily through record-high import tariffs collected at the border by Sri Lanka Customs, amounting to Rs. 1,500 billion. However, relying on such high border tariffs impacts both the cost of living and the cost of raw materials, adversely affecting exports and local production.

The need for adhering to tax principles

It is crucial that the Government prioritises adherence to fundamental principles of taxation when implementing revenue measures. Over-reliance on border taxes is not a sustainable strategy for achieving a higher tax-to-GDP ratio.

Why border taxes are problematic

Generating revenue through border taxes disproportionately affects importers, as they incur significant costs upfront, even before generating profits. In contrast, profit-based taxes are levied only after profits are realised, making them less burdensome from a cash flow perspective. The time value of money amplifies the impact of upfront border tariffs on profitability.

Sri Lanka’s import basket comprises approximately 80% intermediate and capital goods, with only 20% being consumer goods. Tariffs on these critical imports drive up production costs, ultimately increasing the price of exports and even domestic goods. For example, the Rs. 65 tariff on rice accounts for about 50% of its production cost, leading to a nationwide increase in meal costs by approximately the same margin.

A tax base built on three pillars

Globally, taxes are traditionally levied on three bases:

What you earn (e.g. income tax, corporate tax)

What you buy (e.g. Value-Added Tax, or VAT)

What you own (e.g. property tax)

Principles for an effective tax system

Simplicity: Taxes must be simple for taxpayers to understand and for authorities to collect and enforce. Overly complex tax structures with numerous thresholds lead to lower compliance, reduced revenue, and enforcement challenges. A standard and straightforward tax system is key to maximising efficiency and minimising leakage.

Transparency: Transparency in taxation fosters trust and reduces opportunities for corruption. For instance, Sri Lanka’s import tariff system, based on Harmonised System (HS) codes, lacks transparency due to its cascading structure. Similarly, ambiguities in income tax policies create doubts and complications. Transparency is especially critical for tariffs, which, even when necessary, must be clear and predictable.

Neutrality: Taxes should not create winners and losers by favouring or penalising specific industries, products, or sectors. For example, in 2015, Sri Lanka imposed taxes on profits from the previous year, undermining the fairness of the system. The primary purpose of taxation is revenue generation, not market distortion. Lowering tax rates can expand the tax base, ultimately increasing revenue and minimising evasion.

Stability: Tax rates should remain consistent over time to provide predictability for taxpayers. Frequent changes to tax rates, such as the numerous adjustments to VAT in Sri Lanka, create uncertainty, open avenues for corruption, and undermine economic stability. Temporary taxes and tax holidays should also be avoided to maintain consistency and fairness.

Taxes on property: A case for caution

Among all forms of taxation, taxes on property ownership are particularly burdensome. This is because taxpayers often have to forgo another revenue source to meet their property tax obligations. 

If a property generates income, that income is already taxed under income tax laws. Imposing an additional property tax not only constitutes double taxation but also discourages wealth creation. Such policies can deter investment and economic growth, undermining broader development objectives

Balancing revenue generation and expenditure

Sri Lanka urgently needs to increase tax revenue due to its high expenditure, particularly on interest payments, which account for approximately 50% of total expenditure. This is not repayment of debt but merely the cost of servicing bad debt. While room for expenditure cuts is limited due to the predominance of recurrent spending, hard restructuring is necessary to reduce this burden.

Although the Government has achieved a primary surplus by reducing capital expenditure, this strategy will have adverse long-term effects on growth. Therefore, adhering to fundamental tax principles is critical to improving Government revenue sustainably without jeopardising the country’s economic prospects.

Source: CBSL, Advocata research 

Source: CBSL, Advocata research 

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.)

Is Wealth Tax the Solution to Sri Lanka’s Low Tax Revenue Collection

Originally appeared on Daily FT, Biz Adaderana , The Morning, Daily Mirror, The Island and Lanka Business Online

By Sathya Karunarathne

Successive governments have run fiscal deficits. Inadequate revenue collection and unrestrained government expenditure have worsened the country’s fiscal position.  

Tax revenue which averaged over 20% of GDP in 1990 has declined to under 10% of GDP in 2020. Ad hoc tax policy changes have significantly eroded the tax base. Weak tax administration has also contributed to the sharp decline in tax collection.

While tax revenue has contracted, government expenditure has ballooned over time. Today, government revenue is not sufficient even to meet its expenditure on salaries and wages and transfers and subsidies to households which include pension payments and social welfare payments such as Samurdhi.  

In this context, there are various proposals put forward to raise government revenue. One proposal is the reintroduction of the wealth tax.  

A wealth tax is expected to bridge the gap between the rich and the poor, achieving equality. This tax shifts the tax burden to affluent households, taxing an individual’s net wealth, which is the market value of total owned assets. Proponents of wealth taxation argue that this is a progressive system of taxation and is a more powerful tool in comparison to income, estate or corporate taxes as it addresses the issue of wealth concentration.  

Moreover, a tax should ideally satisfy basic characteristics of taxation: it should not be distortionary; it should be fair, and it should not be difficult to collect. 

The rationale for a wealth tax

One of the earliest proponents of the wealth tax for developing countries was Nicholas Kaldor.  Based on his recommendation, a wealth tax together with an income tax, expenditure tax and a gift tax were introduced in Sri Lanka in 1958. However, these new taxes yielded little revenue due to difficulties in determining the tax base and problems in administration.  Following the recommendation of the Tax Commission in 1990, the government abolished the wealth tax from the year of assessment 1992/1993.

Wealth taxes have mainly been implemented in European countries. In 1990, twelve countries in Europe had a wealth tax. Today, there are only three: Norway, Spain, and Switzerland.  Several non-European countries have also imposed wealth taxes from time to time including such as Argentina, Bangladesh, Colombia, India, Indonesia, Pakistan 

In recent times there has been renewed interest in wealth taxes. Presidential candidates in the US proposed various forms of a wealth tax. In the UK and France, there were proposals to impose “super taxes” on the rich. The primary justification was to address the increasing inequality in society.  

Issues with a wealth tax

Despite renewed interest in the wealth tax as a progressive tax based on equity, it scores poorly on the criteria of efficiency, and administrative feasibility.  

Many factors have justified the repeal of wealth taxes in OECD countries. The reasons cited are related to efficiency costs, risk of capital flight particularly in light of increased capital mobility and wealthy taxpayers' access to tax havens, failure to meet redistributive goals as a result of narrow tax bases, tax avoidance and evasion, high administrative and compliance costs compared to limited revenues (high cost yield ratio).  

To understand the efficiency costs of wealth taxes one can look at taxing a person’s wealth accumulated through savings. Despite the common consensus that taxing savings is an effective way to redistribute, a person’s saving decisions reveal little about their underlying lifetime resources and wellbeing. It only reveals their preference to consume tomorrow rather than today. Thereby a wealth tax imposes a tax on those who prefer to spend their money later as opposed to taxing the wealthy. Efficiency costs refer to the reduction of the welfare of the taxed individuals by more than $1 to generate $1 of revenue. Therefore, the efficiency cost of a wealth tax in terms of taxing savings is a reduction of  future consumption that can be bought with earnings, reducing incentive to work for those who prefer to consume the proceeds later and reducing incentive for young people to save for their retirement.

Capital flight is the possibility of holding assets outside of one's resident country without declaring them.As wealth taxes are imposed on residents it increases the risk of the wealthy

reallocating their assets to avoid taxation. Therefore a high tax burden encourages taxpayers to change their tax residence to a lower tax jurisdiction or tax havens.

Both income-generating and non-income generating assets are taxed under wealth taxation. They can include land, real estate, bank accounts, investment funds, intellectual or industrial property rights, bonds, shares, and even jewellery, vehicles, art and antiques. However, this tax base for wealth taxes has often been narrowed through exemptions. These exemptions have been justified most commonly on the grounds of social concerns such as the negative social implications of taxing  pension assets. Further liquidity issues (eg - farm assets), supporting entrepreneurship and investment (eg- business assets), avoiding valuation difficulties ( eg- artwork and jewellery) and preserving countries cultural heritage (eg - artwork and antiques) have also been cited as reasons for wealth tax reliefs. While some of these exemptions can be justified, they have led to the reduction of revenue raised from wealth taxes. They have also contributed to wealth taxes being less equitable as the wealthiest such as businesses benefit from these exemptions defeating the very purpose of imposing a wealth tax which is to meet its redistributive goals.

Narrow tax bases in wealth taxation often leads to tax avoidance and evasion opportunities. For example, Spain's 1994 wealth tax exemption for the shares of owner managers resulted in wealthy businesses reorganizing their activities to reap benefits of the exemption resulting in a significant erosion of the wealth tax base. 

Further, several other factors have also discouraged countries to sustain a wealth tax. They are namely, the difficulty in determining the tax base or what assets to be taxed, underreporting and undervaluation of assets, difficulty in measuring wealth taxes, distinguishing between individuals who are asset rich but cash poor, the constant need to value assets and audit returns increasing administrative and enforcement costs

Low revenue collection as well as the other reasons discussed have led to the abolishing of wealth taxes in most countries  (See Table 1 for details) . Tax revenue from individual net wealth taxes in 2016 ranged from only 0.2% of GDP in Spain to 1.0% of GDP in Switzerland. Sri Lanka’s experience with wealth taxation was no different with the tax yielding low revenue as reported by the 1990 Tax Commission.

Table 1: Implementation of Wealth Taxes in Selected Countries

Conclusion 

Taxing the wealth of the rich to generate income and to eliminate economic inequality sounds promising in terms of political debate. However, wealth taxes have failed to generate adequate revenue, failed to meet redistributive goals as a result of narrow tax bases, proven to have high administrative and enforcement costs, resulted in tax evasion and avoidance due to underreporting and undervaluation of assets, increased the risk of capital flight and access to tax havens and may have contributed to the reduction of investment and employment. 

Therefore, imposing a wealth tax may not be the ideal policy response to Sri Lanka’s low tax revenue, especially given the country’s previous experience with the tax yielding low revenue.

Sathya Karunarathne is the Research Analyst at the Advocata Institute and can be contacted at sathya@advocata.org. Learn more about Advocata’s work at www.advocata.org. 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.