Non-negotiable reforms for election manifestos

By Dhananath Fernando

Originally appeared on the Morning

The year 2024 will be an election year. The general flow of events is that each political party and candidate will launch a manifesto of a grand-scale and present their plans for the people and the country. Most of these promises will not be implemented or will only be half implemented. In certain cases, the opposite of what was promised will be implemented. 

Most manifestos are presented in general terms with a target of 20 years ahead with little data. Many manifestos across all party lines are wish lists with no action plans.

In my view, this time there is a slight difference. 

Regardless of the party formation or whoever the presidential candidate will be, there are few reforms that are non-negotiable. Ideally, across all manifestos, there are five basic ideas which have to be the common denominator.

Strengthening social safety nets 

Following the worst economic crisis in Sri Lanka’s history and high inflation, about four million people have fallen below the poverty line. That puts seven million people under poverty. The recent Household Income and Expenditure Survey carried out by LIRNEasia and the World Bank indicates significant poverty levels and aftereffects of poverty due to the economic crisis. As a conscientious society, we need to take care of our poor people with the social safety net. 

The social safety net is not just an allowance. It is a system and a process of targeting the right people, providing an exit route, and with proper administration. The current Aswesuma programme is making some progress with World Bank assistance, but regardless of the political leader who comes to power, it is a non-negotiable condition that social safety nets have to be strengthened and improved. 

The current process has too many loopholes which have to be addressed and improved. Simplifying the process, providing the exit route, and monitoring and depoliticising has to be a continuous effort from the new leadership of the country.

SOE reforms 

Thus far, mandatory SOE reforms have been painfully slow. Many parties with vested interests are trying to delay it until the election. However, the continuation of SOE reforms is a must. 

Colossal losses, interference in the private sector, intervening in markets, creating an unfair playing field, and inefficiencies are a few reasons why SOEs played a pivotal role in Sri Lanka’s economic crisis. SOEs are vehicles of corruption and have diluted entrepreneurship and Foreign Direct Investments significantly. Without reforming SOEs, the future of Sri Lanka appears to be bleak. 

The principles announced by the SOE Restructuring Unit are in the right direction, but the SOE Act and reforms of the Ceylon Electricity Board, Ceylon Petroleum Corporation, and many other networking industries are a must. 

Anti-corruption and governance reforms

Execution of anti-corruption laws and governance reforms is another area which has no room for negotiation. The International Monetary Fund (IMF) Governance Diagnostic and many other locally-developed reports on governance provide direction on what needs to be done. 

Strengthening our Judiciary system, transparency and accountability in our tax system, removing tax exemptions, and repealing the Special Commodity Levy and the Strategic Development Act too falls under governance and anti-corruption reforms, as those acts provide the legal opportunity for corruption. 

There is a strong sentiment from people on the contribution of corruption to the crisis, so taking long-term measures regarding corruption is a must. Anti-corruption and governance reforms go beyond going after corrupt politicians. Rather, it is a system and framework for minimising government influence. Some reforms are complementary and reforming SOEs is also a key component of anti-corruption and governance reforms, as these SOEs play a vital role in corruption.

Following the IMF programme and debt restructuring 

Given the international financial architecture, we have no option other than sticking to the IMF programme. We can negotiate some of the actions that we have promised, but overall indicative targets and reforms have to be maintained. Otherwise, it will be yet another incomplete IMF programme and the debt restructuring process will be in jeopardy. 

Debt restructuring and the continuation of the IMF programme are very much interconnected. At the moment, external stakeholders are concerned about political instability and in fact, the IMF’s first review identifies the political risks for the continuation of the IMF programme. A commitment from any political leader on sticking to the programme will help Sri Lanka in rebuilding relationships with the world.  

Trade reforms and joining global supply chains 

We have to grow our economy to emerge from this crisis. Tax revisions make it likely that growth will slow down and the only solution to grow small island nations like Sri Lanka is through global trade. Our problems regarding global trade are mainly the problems in our own regulations and systems. 

We have to remove our para-tariffs and simplify the tariff structure for a few tariff lines. Not only will this help trade, but consumers will also have a greater choice of goods and services as well as competitive prices. 

On the other hand, the Government can improve the revenue from Customs since at the moment, the high tariffs are a main reason for revenue leakage in the form of corruption. Trade reforms are about growth, minimising corruption, encouraging exports, and assuring reasonable prices. Even at present, after very high taxes, there are levies such as the Special Commodity Levy, Ports and Airports Development Levy, and a huge array of taxes which hinder the competitive nature of our economy.

These five policies, in my view, are non-negotiable. If any administration deviates from them, it is very likely that we will fall back a few miles behind where we started. 

VAT: The good, the bad and the solutions

By Dhananath Fernando

Originally appeared on the Morning

The Value Added Tax (VAT) increase from 15% to 18% and the removal of about 95 items from the VAT exempted list to a VAT applicable list has raised concern among politicians and people alike. 

When taxes change too often, public confusion and erosion of tax revenue both have to be expected. VAT was once 8% in Sri Lanka and then revised to 12%. It was again increased to 15% and finally now to 18%. The VAT threshold was once at Rs. 12 million and later increased to Rs. 300 million. Currently it is at Rs. 80 million and expected to be reduced to Rs. 60 million. 

When the VAT threshold was increased to Rs. 300 million from Rs. 12 million, the number of individuals registered for VAT dropped to 8,000 from 28,000. Our policymakers are discussing expanding the tax base after diluting our tax base through our own inconsistent policies. 

One of the key principles of taxation is stability, according to the Tax Foundation. The other principles are simplicity, transparency, and neutrality. When tax rates and thresholds are changed often, thIMFe markets and individuals react and tax revenue will erode. 

A complicated context 

Sri Lanka’s context is sadly more complicated than many other cases. We have given a commitment to the International Monetary Fund (IMF) on increasing our tax revenue because our interest costs are extremely high. Most of the interest is inherited due to bad financial management over the years and there is very little meaning in blaming each other. 

On one hand, the Government has no other option but to increase revenue through taxation. However, on the other hand, when taxes are increased the economy will contract. Growth, which is also a key requirement for us to emerge from the crisis, will be affected due to the lowered purchasing power of the people. When the economy contracts, tax revenue will also start to decline.  

Given the perennial weaknesses in our tax administration, the Government has selected the most convenient option of VAT to be increased, since it can be collected easily compared to other taxes. VAT is considered to be better compared to other taxes such as the Nation Building TAX (NBT) or the Social Security Levy (SSL), which are considered to be cascading taxes, where throughout the economic process one tax is applied on top of the other. 

This leads to a situation where the effective tax rate becomes very high, but with VAT, tax will only be applicable for the value added throughout the supply chain. Also, high income earners generally contribute a higher VAT in total as VAT is a consumption tax. People with higher incomes tend to consume more, so the more they spend, the more taxes the Government can recoup. 

The negative impact of VAT can be witnessed when it is applied to food items. The poorest of society gets adversely impacted, since their percentage of expenditure on food is very high compared to people who fall into higher income brackets. 

There will be considerable impact on the overall prices for the common people with the new VAT revisions. The price of petrol and diesel is expected to increase by about Rs. 50-60 (provided the other taxes are not changed and global fuel prices remain the same). LP Gas (12.5 kg cylinder) will increase by about Rs. 500-600. 

Prices of solar panels, electronic items, laptops, and mobile phones are expected to rise. This will also have an impact on inflation as well, but we need to keep in mind that inflation is always a monetary phenomenon. With high prices, people may consider cheaper alternatives and supply and demand will readjust, provided we keep our monetary policy right. 

Solutions 

A key solution to bringing down prices of food items is to remove the Special Commodity Levy (SCL) applied to these items. The SCL not only increases prices, but the provisions provided to the minister to impose and remove the SCL overnight opens significant room for corruption. The recent increase of the SCL on sugar to Rs. 50 from 25 cents is a good example of how an overnight gazette creates room for corruption and passes the burden to the people. 

Other taxes on food items including CESS, Ports and Airport Development Levy (PAL), and many other para-tariffs should be removed. There is a myth that productivity can be improved by imposing tariffs on domestic food items. If that is the case, our industries for milk, yoghurt, cheese, and many other food items have to be extremely productive and efficient. Instead of domestic product growth, we see the same producers ask the Government for further protection. 

Tax competitiveness as a framework 

 Moving forward, Sri Lanka has to look at tax competitiveness as a framework for thinking about taxes. In the global context, everything is about competitiveness, including the tax system. As an example, if corporate tax is 25% in competing markets in the region, we cannot increase the corporate tax to 30%, only considering the revenue requirement of the Government. 

At the same time, we cannot compromise our healthcare and education systems, which help to develop better skills through taxpayer money, by bringing taxes unnecessarily down and compromising our tax revenue. In a market system, competition and prices play a key role, and the same is applicable for taxes, FDIs, and many other variables. 

We have to first take the basic steps of improving tax administration. We then have to rationalise our expenditure and spend where we need to spend, thereafter raising revenue by being competitive. A VAT increase to increase Government revenue alone will not solve our macro instability. We have to ensure macro stability by being competitive in all aspects of the economy.  

Looming political and economic challenges ahead of elections

By Dhananath Fernando

Originally appeared on the Morning

“We know what should be done to get the country on the right track, but we don’t know how to get power back after implementing the policies.” This is a popular statement I hear often when I meet quite a few politicians. The truth is that politicians do not know how to get back power because it’s not an attractive solution.

The popular policies that bring politicians into power are the very same that inspire their ousting at the very next election cycle. People hardly object to good policies unless the same politicians instigate false propaganda. The Right to Information (RTI) Act was just one such instance.

As an election is due next year, it is vital to understand and remember our priorities, otherwise our politicians are likely to take a wrong turn and pass the buck back to the people.

In an election year, the behaviour of any political party is to completely abandon rational economic reforms and play to populist narratives that result in outcomes that are the complete opposite, with the motive of coming to power.

Bringing down fuel prices and announcing other types of subsidies are common tactics. This is harmful, especially when those benefits cannot be financed sustainably, or in some situations, brought into life in the first place.

Even if it does not retain power, the newly-elected government will have a tough time preventing plans that have already been put in place and enacting better policies.

Political risk

In the current context, we run a very high risk of our politicians bringing us back to square one; i.e. another economic crisis. This, given the fact that 2024 is set to be an election year, is a recipe for disaster.

All political parties will shift their focus to slowly becoming more populist rather than being driven by objectivity. Therefore, the real risk is going back to another debt restructuring if we fail to grow the economy and our exports.

There are many politicians who do not understand the gravity of the need for reforms. Regardless of which party or coalition comes to power, there are fundamental issues that need to be addressed.

The process is more or less the same as handing over a house with structural issues from one tenant (government) to the other. The new tenant cannot function because neither the previous tenant nor the owner (people) is willing to fix the fundamental problems.

Risk of a second debt default

Given the unstable political environment coupled with a country already going through debt restructuring, the risks of a second debt default are astronomically high. As we are still struggling with finalising the first debt restructuring, adding a second one into the mix will leave us in dire straits.

The second one will undoubtedly be harder, especially given the significant increase in interest rates and being unable to print money with the new Central Bank Act. If we fail to raise money through markets in order to roll over debt and if we are not open to increasing interest rates, the only option we will be left with is to default again. At that point, most likely there will be pressure once again to amend the newly-enacted Central Bank Act to allow money printing.

Of course, that would be an inflationary measure and we will be back at square one with a balance of payments crisis, debt crisis, humanitarian crisis, and likely a banking crisis too.

Solutions: A common minimum programme for reforms

Reforms are easier in the first 100 days of any government. If we fail to enact reforms within the first 100 days, more often than not, no reforms will take place. Failing to undertake reforms in 100 days means a cost of a five-year delay plus many bad policy decisions in the middle, which are costly and difficult to reverse.

Ideally, if key political parties come to an agreement before an election on selected reforms and execute them regardless of who comes into power, it will at least ensure some stability for Sri Lanka. There are many ideas that all political parties have in common.

Regarding State-Owned Enterprise reforms, there is no political party that says the Government should run an airline. Even National People’s Power Economic Advisor Dr. Anil Jayantha, in an interview with Advocata, noted that they did not believe the Government should do any business with hotels.

Accordingly, there are many other similar areas where we can arrive at an agreement with little difficulty. Therefore, regardless of who wins elections, people can win and sustain some of the economic reforms.

The truth is that reforms are inevitable if Sri Lanka needs to move forward and for any political party to sustain its power. Implementing bad policies, especially considering the status of our country, will make it very difficult to sustain power, because then we will be setting the standard for a new normal in economics and politics.

Fiscal path amidst promises and uncertainties

By Dhananath Fernando

Originally appeared on the Morning

Starting from the second week of November, every minute in Parliament will be focused on the national Budget. Fortunately or unfortunately, many of the promises outlined in the Budget are unlikely to be implemented or fulfilled.

At the same time, items that are not in the Budget may be implemented midway through the year, based on the direction of the wind. Things are especially likely to take a completely different turn in an election year.

A key criticism against this Budget is that the revenue proposals to cover up the expenditure proposals are not adequately mentioned. A revenue of Rs. 4,100 billion is expected for an expenditure of Rs. 6,900 billion. It’s akin to wanting to spend Rs. 69 while only having Rs. 41 in hand. The challenge is that we are uncertain as to how we will earn even Rs. 41.

An earlier proposal to increase VAT by 3% and remove the exemptions on VAT can be seen as a measure to increase revenue. There are a few proposals to increase the tax base, which is a step in the right direction, such as the requirement of a Tax Identification Number (TIN) for opening a current account, obtaining a building licence, and for revenue licences for vehicles.

The question that arises is what would happen if we fail to generate even the expected revenue and I think there are three scenarios that can occur if we fail to achieve the revenue targets in the middle of the year.

Scenario 1: Cutting down on capital expenditure

Approximately Rs. 1,200 billion has been allocated for capital expenditure in the 2024 Budget. This includes some proposals such as a new airport and building a few universities. So we will likely have to rechannel some of the capital expenditure to recurrent expenditure if we fail to generate revenue.

What is important to note is that, compared to last year, capital expenditure makes up a lower percentage of total expenditure. So in a context of starting with an already lower capital expenditure base, cutting capital expenditure from key areas of growth such as health or education further will maim our growth in the long run.

Slower growth is also not favourable for Sri Lanka because the need of the moment is growth. Only growth will increase our tax revenue and create more employment opportunities and business opportunities.

Scenario 2: High inflation

The second scenario would be the Government exploring the opportunity to get finances from the Central Bank to bridge the deficit. With the new Central Bank Act, the space for doing this is very low, but if past experiences hold true, anything is possible. There is a transition period of about 18 months and we should not underestimate the crafty nature of our politicians to find legal loopholes.

If the Budget deficit is being financed through the Central Bank (money printing), further increases in cost of living and high inflation are unavoidable. It will also drain our forex reserves and build additional pressure on our currency and likely end up with a currency depreciation after a few months’ cycle: a cycle not so distant in memory.

The Central Bank financing this Budget deficit will also challenge the sustainability of the IMF programme. As the next year is an election year, politicians will mainly think about the elections before the economy, despite promises made. While the new Central Bank Act tries to stop this from taking place, the possibility cannot be ruled out fully.

Scenario 3: Hike in interest rates

The third scenario is where the Government borrows money from the market to bridge the gap and allow interest rates to move. This will not cause inflation as the Budget deficit is not being financed through the Central Bank, but the cost of money will go up (interest rates moving up).

When the cost of money goes up, growth will contract. When this happens, businesses start winding-up operations and expansions become difficult. Also, banks will lend more money to the Government at higher interest rates, slowing down credit for the private sector.

When the economy slows down there may be an impact on the tax revenue on one side. On the other side, with limited growth, achieving debt sustainability will be challenging.

Solution

In order to prevent these scenarios from taking place, it is imperative that we reduce wasteful expenditure. The key solution is to focus on reforming State-Owned Enterprises (SOE). SOE reforms can increase revenue, cut down expenditure, bring down our debt, and attract foreign investments.

The bank recapitalisation of Rs. 450 billion, mentioned in the Budget, is due to the debt owed by two SOEs that have losses which amount to Rs. 1,800 billion. The taxpayer is now expected to pay the bill. It amounts to about Rs. 20,000 per citizen from taxpayer money for bank recapitalisation. That is a staggering Rs. 80,000 per household of four members.

Boosting tourism is also another option. While there is a fund for tourism promotions which has to be utilised well for building our brand image, it will all be in vain if we do not do things as simple as removing regulatory barriers to tourism.

The final bird in our hand as a solution is the Colombo Port City. We have to accelerate the process and attract investments.

If we play our cards right, we can at least move a step ahead in 2024.

Reforming Sri Lanka's Tax System: A Path to Fiscal Stability and Economic Growth

Originally appeared on Daily FT

By Dr Roshan Perera, Thashikala Mendis, Janani Wanigaratne

This article provides an insight on the Personal Income Tax structure in Sri Lanka as the second part of a series discussing potential tax reforms

Raising government revenue is critical for Sri Lanka to recover from the current economic crisis and create a more sustainable economic environment. However, taxes should be paid by those who can bear the burden. 

Personal Income Taxes (PIT) is an effective instrument in generating revenue as well as in reducing inequality through revenue redistribution.  In Sri Lanka, there has been a steady decline in revenue from PIT from 0.9% of GDP in 2000 to 0.2% of GDP in 2022. Revenue collection is  lower than that of even other low income economies. Furthermore, PIT tax revenue as a percentage of direct tax revenue declined from 40% in 2000 to 9.3% in 2022, although GDP per capita increased from USD 869 in 2000 to USD 3,474 in 2022. 

Advanced economies raise approximately 9% of GDP from PIT, while emerging economies and low income economies raise only 3.1% and 2.1% of GDP, respectively. (1)  Sri Lanka reports the  lowest contribution of PIT as a percentage of GDP in 2021, both among  advanced economies in Asia such as South Korea, as well as developing economies such as Bangladesh, Malaysia and Vietnam (See Figure 1).

Figure 1: Performance of Personal Income Tax Collection among Selected Countries

Source : IMF Data Library, OECD

Narrow Tax Base

The narrow tax base is one of the main reasons for Sri Lanka’s low PIT revenue performance. A narrow base not only limits revenue generation but it also makes revenue collection reliant on a small segment of the population. 

The number of income tax payers under the  Pay As You Earn (PAYE)/Advanced Personal Income Tax (APIT) Scheme (2) as a percentage of the total employed population shows  a relatively small proportion of the workforce contributing to income taxes (see Table 1). In 2019,  the proportion of tax paying employees was 33%. This proportion declined to less than 1% in 2021 due to abolishing of PAYE taxes with effect from 1st January 2020.  A voluntary APIT System was introduced with effect from April 1, 2020, where employees can opt in. This shift not only led to a revenue decline but also created monitoring gaps. With effect from January 1, 2023, it was mandated for employers to deduct APIT from employees' income, reverting to the original PAYE scheme.

(2 ) Note: PAYE/APIT is where employers deduct income tax on employment income of employees at the time of payment of remuneration.  PAYE was replaced by APIT with effect from April 2020. This measure of replacing PAYE with APIT essentially made PAYE optional. However, with effect from January 2023, deduction of Withholding Tax (WHT), Advanced Income Tax (AIT)  and APIT has been made mandatory.

Table 1: Employee Contribution to PIT

Source: IRD Performance Reports, Labour Force Survey

The large informal sector also contributes to the narrow tax base and low PIT performance. According to the Labor Force Survey (3) 2022,  the informal sector accounts for around 58% of total employment (see Table 1).  A large portion of the economy operating  outside formal regulation enables tax evasion and avoidance. Transforming the current informal self-employment system to a modern formal employee-employment system would be one way to improve tax revenue collection. 

Two alternative recommendations are proposed to capture informal economic activities into the tax net.  Establishing a universal online payments system would reduce cash transactions in the economy enabling better monitoring; and secondly, by introducing a unique digital identification system that connects tax accounts with income sources, bank accounts, motor vehicle and land registration etc. Authorities could cross check information provided in income tax returns as well as identify individuals who do not file returns. 

Tax Free Threshold and Tax slabs/Brackets

In the recent amendment to the Inland Revenue Act (4),  the tax free threshold for income was reduced from Rs.3 million per annum to Rs.1.2 million per annum. Further, the tax brackets were reduced  from Rs.3 mn to Rs.0.5 million.  Accordingly, the incremental tax rate for each additional Rs. 0.5 million of income was set at 6% (see Table 2).

Table 2:  Tax Threshold and Tax Brackets

Source :Inland  Revenue (Amendment) Act, No. 4 of  2023

Applying the current tax free threshold, income taxes are applicable to  approximately the top 15% of households where around  36% of total  income is concentrated (see figure 2) (5).

(5) Note This is based on the Household Income and Expenditure Survey 2019

Figure 2: Share of Income by Population 2019

Source : HIES Survey Annual Report 2019

According to the national poverty line (6) for  July 2023, the minimum monthly expenditure per person required to meet basic needs is Rs. 15,978. Hence, the total cost for a family of four is approximately Rs. 65,000 per month. Assuming salaries and wages remain unchanged at 2019 levels,  more than two-thirds of income is spent by households up to the 9th decile, (see Table 3).  Any additional financial burden including income taxes could further reduce the disposable income of households up to the 9th income decile. Hence, information on household income and expenditure patterns must be considered when setting income tax thresholds.

Table 3 :  Mean Household Expenditure as a % of Mean Household Income

Source : HIES Survey Annual Report 2019 (7)

Although the current tax system applies differential tax rates based on income brackets, an analysis of the effective tax rates paid within these brackets indicates a less than progressive tax system.  An individual crossing the tax free threshold of Rs.1.2 million per annum (equivalent to a monthly income of Rs. 100,000) pays an effectives tax rate of 1%, which gradually increases to 12% until the highest income bracket is reached at over Rs. 3.7 million (which is equivalent to a monthly income of Rs. 308,333). All the income levels above this income would be taxed at the highest nominal marginal rate of 36%.  However, after a particular income level the effective tax rate flattens (see Table 4). This implies that individuals in the highest income categories effectively pay less taxes. Expanding the income tax brackets would introduce more fairness and progressivity into the tax system.

Table 4 :  Effective Rate of Tax

Source :  Author’s Calculation

Figure 3: Personal Income Tax as a percentage of Annual Income

Source : Authors’ Calculation

The fairness of the tax system is further exacerbated as those whose main income sources are subject to capital gains are taxed at only 10% versus those whose income are subject to PIT who are taxed at a higher rate of 36%. 

As wages and salaries rise to keep up with inflation, individuals may find themselves earning more in nominal terms, but their purchasing power remains relatively unchanged.  Adjusting thresholds for inflation ensures that employees are not disproportionately burdened by bracket creep where taxpayers are pushed into higher brackets due to inflation. A proper rationale and scientific basis for determining thresholds, tax slabs, and tax rates is needed to increase revenue collection and ensure fairness in the tax system.Also, the proposed tax system should generate the estimated tax revenue by the end of the year.

Frequent ad hoc policy changes

Tax policy is frequently subjected to change, without proper economic rationale. For instance, the tax slabs for PIT have been revised 9 times while the tax free threshold was revised 5 times since 2000. Frequent and ad hoc policy changes complicate tax administration and reduce tax compliance.

Conclusion

The country has failed to meet  the first quarter targets for revenue under the IMF’s Extended Fund Facility Program. Raising government revenue will be critical to remaining within the program. Improving revenue collection from income taxes will be critical to achieving the revenue targets, while broadening the tax base will ensure the burden of taxation falls on the broadest shoulders.

Part one of the OPED series on Reforming Sri Lanka's Tax System: A Path to Macroeconomic Stability and Sustainable Economic Growth can be found here

Sri Lanka needs a bottom-up approach

Originally appeared on The Morning

By Dhananath Fernando

Regrettably, over the years, Sri Lanka's approach to development has primarily relied on aid and subsidies for its impoverished population. Many politicians have spoken about poverty, but they have often neglected to address its root causes. If our policies were centered on eradicating poverty rather than simply targeting the poor, our development framework could have evolved significantly.

As the adage goes, "there are no poor people, only poor places or countries." A recent report by LirneAsia revealed a startling increase in poverty numbers, rising from 3 million to 7 million people, pushing over 4 million individuals below the poverty line. If our long-standing strategies, such as fertilizer subsidies, Samurdhi, and fuel subsidies were on the right track, how did an economic crisis suddenly plunge 4 million Sri Lankans into poverty?

The ability to maintain strong international relationships and secure more aid has been considered a crucial qualification for candidates, during election cycles. Within the voting community, politicians offering the most substantial subsidy handouts are often perceived as popular leaders. While it is true that we need comprehensive international relationships in modern politics and must take care of our citizens, we must do so while keeping a development-oriented mindset at the core. Regrettably, development cannot rely solely on foreign aid, nor can we lift people out of poverty by offering aid exclusively to the poor.

This situation is not unique to Sri Lanka; it's a global phenomenon. No country has achieved development solely through aid programs. Instead, countries that have reached the development stage share strong institutions and reasonably functioning market systems as common denominators.

The primary focus of any government or political leader should revolve around two key conceptual frameworks:

1. Are we establishing institutions that promote a level playing field?

2. Are we encouraging a functioning market system?

Development is generally a bottom-up approach. People often know what's best for themselves better than politicians or leaders do. We simply need to provide them with opportunities in a competitive environment. Recently, I had the privilege of meeting a few small and medium-sized exporters. The entire system and processes seemed designed to hinder their export activities. Many exporters emphasized the difficulties they face when exporting in Sri Lanka, including challenges and harassment from government regulatory authorities, such as Sri Lanka Customs.

A prime example of our low export numbers is not only market access problems but the barriers within our own system that obstruct exports. One exporter from Kandy, specializing in vanilla exports, highlighted how customs consistently questioned HS codes and demanded repetitive documentation, causing him to spend more time on export processes than on developing his product and capacity. These challenges are consistent across the board for exporters, explaining why Sri Lanka's exports remain stagnant despite numerous committees, task forces, and chairpersons at the Export Development Boards.

Real change should start from the bottom by removing barriers for businesses and offering people the freedom to pursue their desired endeavors. Such reforms may not bring personal glory, as they empower individuals to make their own choices. In contrast, an aid-driven approach often results in leaders or countries seeking personal recognition through associated aid packages.

In Sri Lanka's case, we must remind ourselves that only we can make a difference and pull ourselves out of this crisis. While we need the support of international institutions like the International Monetary Fund and bilateral and multilateral creditors, they alone cannot rescue us from our predicament. It is only through economic reforms and the development of inclusive institutions that we can compete on a level playing field and extricate ourselves from this mess. Both small and large reforms are essential, and we must implement them swiftly and effectively.

SL’s tariff regime

Originally appeared on The Morning

By Dhananath Fernando

The Minister of Finance mentioned that “many surprises” would be contained in the Annual Budget for 2024. In economics, surprises are something we would want to avoid; the more surprises we get, the lower stability is. Frequent surprises are a sure way to push away investors and the business community. One surprise measure mentioned recently in Parliament was a tax on primary dealers in the bond markets as they were left out in the Domestic Debt Restructuring (DDR) process.

Just a few weeks ago, this column speculated about the likelihood of selective taxes, such as super gains tax or wealth tax, in the Annual Budget for 2024. If the reason to impose a special tax on primary dealers is the high profits they made as a result of being left out of the restructuring process, does this mean the Government is admitting it made a mistake by leaving them out of the debt restructuring processes? If so, we cannot correct it by imposing a tax, since two wrongs do not make a right.

A special tax on selected groups or industries is the opposite of tax holidays. The way we select industries or business categories for special taxes is the same way we select industries for tax holidays. Both are two sides of the same coin.

It is true that Government revenue is low compared to the size of our economy, but it is definitely not the fault of the businesses which made profits, unless their profits are exempted from taxes.

Sri Lanka’s corporate tax of 30% is a reasonably high rate. Even the UK increased its corporate tax to 25% in 2023 from 19%. Tax competitiveness is already low due to unreasonably high taxes and an unstable economic and political environment. Therefore, what is the rationale for charging a higher tax on a selected industry or a group if they already pay a corporate tax of 30%?

The unfortunate reality is that we cannot increase tax revenue simply by imposing selected taxes or by spontaneously increasing rates. This would bring the same consequences as our tariff structure.

The issue with the tariff structure in Sri Lanka is that we have imposed different taxes for different HS codes, making it very complicated. Some HS codes are charged a CESS and others are charged para-tariffs, creating considerable doubt as to which taxes are applicable when importing anything. This complexity in the tariff structure has resulted in a high level of corruption.

It is argued that bringing the tariff rates down and making it simple will improve tariff revenue. The same logic is applied for income tax and corporate taxes. The more complicated and more targeted special segments are, the more likely tax evasion is, and will eventually lead to our overall tax revenue further deteriorating.

In 2015 and 2021, a similar attempt was made to impose a singular super gains tax on companies earning over Rs. 2 billion. There were many instances where special taxes were imposed on the financial sector without any detailed analysis or impact analysis on overall tax principles.

Has it made our tax revenue better? The answer is an obvious no. Therefore, special taxes which may come as surprises for selected industries may not lead to the expected outcome. Instead, they will create more confusion in the market.

It is likely that the Government is targeting primary dealers due to the controversy that arose during the bond scam in 2015 and similar incidents, with suspicions of insider trading taking place afterwards.

If the reason for super profits is insider trading, the answer is a forensic audit and bringing the related parties to justice. The Government can start the process by releasing the full forensic audit report on the investigation of the presidential commission appointed for the bond scam.

Imposing a special tax to correct the super profits of insider trading may start a vicious cycle of unethical trading and business operations.

Investors will consider the occurrence of a similar circumstance if they make better profits – that they too will be liable for a special tax in addition to the corporate tax they pay.

More importantly, it dilutes the principles of an aspirational society. Assuming that someone should pay a higher tax simply because they made a profit is discriminatory and acts as a disincentive for generating wealth and profit. Those who made a higher profit are already paying a higher tax proportionately, compared to those who made less profit, at a rate of 30%.

Taxes have to be imposed based on principles of simplicity, transparency, neutrality, and stability. These are referred to as ‘principles’ because there is a rationale behind it. Statistics without principles and principles without statistics are both dangerous.

Reforming Sri Lanka's Tax System: A Path to Macroeconomic Stability and Sustainable Economic Growth

Originally appeared on The Morning

By Dr Roshan Perera, Thashikala Mendis, Janani Wanigaratne

This article provides an overview of the current tax system in Sri Lanka as part of a series discussing potential tax reforms.

Sri Lanka is recovering from the worst economic crisis in its history. Continuous high fiscal deficits due to insufficient government revenue to finance growing government expenditure has resulted in an unsustainable level of debt. This has hindered the government's ability to make capital investments and allocate sufficient funds for essential services such as education and healthcare. A large proportion of revenue (77.7% in 2022) goes to finance interest payments, It is also one of the largest items of recurrent expenditure accounting for 44.5% of recurrent expenditure in 2022.  In comparison expenditure on education, health and social protection (Samurdhi) accounted for only 9.3%, 7.9% and 3.4% of recurrent expenditure, respectively, in 2022.  

Getting back on a path of macroeconomic stability requires a significant boost in revenue.Revenue based fiscal consolidation is one of the key pillars of the stabilization program agreed with the International Monetary Fund (IMF).  The program sets a target of raising tax revenue to 14% of GDP (at the minimum) by 2026 through tax policy reforms and revenue administration reforms.

Taxation as a social contract

The main purpose of taxes is to provide funding for public services. Moreover, it redistributes income through transfer payments to low income households. Taxation is a classic example of the social contract between the citizens of a country and their government but also between citizens. This unwritten agreement influences the willingness of citizens to pay taxes in return for the services they receive from the government. Tax compliance rates in countries indicate a correlation between the payment of taxes and public service delivery. Dissatisfaction with public service delivery is found to be associated with low tax compliance. In Sri Lanka, the state is responsible for providing a wide range of public services such as education and healthcare.  However, the collection of taxes required to finance these public services is woefully inadequate. This could be due to lack of awareness of the role of citizens in the social contract or a lack of quality and availability of public services.  This leads to citizens abandoning public services in favour of the private provision of such services and being unwilling to pay for public services they  feel they don’t use. A robust tax system is necessary for a government to deliver high-quality public services to all its citizens.

The current state of taxes in Sri Lanka

Sri Lanka’s tax revenue collection  has steadily declined from 19% of Gross Domestic Product (GDP) in 1990 to 7.3% in 2022. Although national income has increased over time with  GDP per capita rising from US $ 472 in 1990 to US $ 3,474 in 2022 there has not been a corresponding rise in tax collection (See figure 1).

Figure 1: Declining Tax to GDP

Source : Central Bank Annual Reports

Revenue collection in the country is also highly skewed, with 69.5% of tax revenue collected from indirect taxes. Undue reliance on indirect taxes is due to the large informal sector which is ‘difficult to tax’.  The direct to indirect tax ratio has consistently remained around 20:80 over time. Although direct taxes as a proportion of total tax has gradually increased from around 15% revenue in 2000 to 31.5% in 2022, as a percentage of GDP it has remained at a low level of around 2% for the last two decades, implying that it has not kept pace with the growth in the economy.

Figure 2: Composition of tax revenue

Source : Central Bank Annual Reports

The steady decline in revenue is due to inherent weaknesses in the tax system. One of the key issues is ad hoc policy changes relating to tax rates, thresholds, and exemptions, with little or no economic rationale. The frequency of these tax policy changes worsens the existing compliance issues as well as administrative issues. The resulting loss of government revenue, worsens income inequalities and reduces funds available for essential public services.

These concerns need to be addressed through comprehensive reforms in all 3 broad bases of tax, namely, (1) taxes on earnings such as personal and corporate income taxes; (2) taxes on what is purchased such as the value added taxes (VAT); and (3) taxes on what is owned such as land and property taxes. Identifying the issues in each of these taxes will be key to reforming the tax system and optimizing revenue collection which is vital for ensuring macroeconomic stability.

Conclusion

Building an effective fiscal social contract through taxation is as equally important as addressing the issues prevalent in the current tax system. It requires the government  to use the taxpayers’ money in a responsible and effective manner. Lack of transparency and accountability for the way a government uses the taxes it collects will make it very difficult for the government to convince its citizens to pay their taxes.  On the other hand, citizens are responsible for holding the government accountable and ensuring taxes are utilised for providing good quality public services for the benefit of society as a whole.

Bank interest rates: The A-Z

Originally appeared on The Morning

By Dhananath Fernando

As the Annual Budget approaches in November, there lies the risk of introducing price controls again. Budgets are usually like auctions of resources that don’t actually exist, often used by governments for publicity. In the 2015 Budget, there was a salary increase for Government workers and price controls were placed on items like hoppers and plain tea.

Budgets that come around election periods more often include giveaways and price controls, which cannot be maintained sustainably.

Meanwhile, the Central Bank, in a recent Monetary Policy meeting, hinted at controlling interest rates for certain banking services like pawning, credit cards, and pre-arranged temporary overdrafts.

The Central Bank appears to be in a tough spot, facing pressure from political authorities, the people, and other stakeholders. People and businesses are still struggling with the economic crisis, the aftermath of the Easter attacks, and the after-effects of Covid-19. People need loans (credit facilities and services) during this tough time. Unfortunately, the banking sector is slow to respond by lowering interest rates, even with the Central Bank’s new policies.

Recently, the Central Bank has been lowering interest rates – the Standard Lending Facility Rate and the Standard Deposit Facility Rate. The Statutory Reserve Ratio (SRR) has also been brought down by 2% and changes have been made, but this hasn’t led to a proportional decrease in lending rates by banks.

Unique situations for different banks

Some banks have responded more than others. For example, some banks charge higher interest rates for pawning (27% compared to 20% in other banks) and credit cards (33% compared to 28% in other banks). The same goes for personal loans (4% vs. 2%).

Let’s try to understand why some banks offer higher rates while others don’t.

Each bank’s lending and deposit portfolio is unique. Some banks generally have a higher percentage of Non-Performing Loans (NPLs). For them, bringing interest rates drastically down may be difficult. Since interest income is the key income for banks, if a particular bank has a higher NPL ratio, it would be difficult to adjust the interest rates.

On the other hand, with domestic debt restructuring, certain banks had higher exposure to Treasury bonds. Prior to debt restructuring, these banks faced higher risk, yet as they have been excluded from restructuring, this same exposure became a blessing later. For them there is greater room to adjust the interest rates while others may not have the same leeway.

Different banks have different types of loans. Some focus on small businesses, while others offer pawning. Pawning is safer because there is something valuable as collateral. Each bank’s situation is unique, and ideally in a market system people should switch to banks with lower rates, assuming everyone has the same information.

Options with consequences

However, these changes take time, especially when the country’s monetary system isn’t stable due to debt restructuring and weak economic policy. Also, due to instability, in most cases banks aren’t offering fixed interest rate loans anymore; most loans have flexible rates.

Mounting pressure on the Central Bank has left a few options, each with its own consequences. One option is offering special low-interest credit lines (e.g.: special credit lines with the support of the Asian Development Bank, etc.), like the Enterprise Sri Lanka loan scheme introduced before by former Finance Minister Mangala Samaraweera. This could lead to unintended consequences, like people using the loans for non-productive purposes.

For instance, many bank managers disbursed the loans to their existing customers, who basically settled their previous high-interest loans with the new loan at a concessional rate. Some loans were taken for consumption purposes, such as weddings and buying vehicles. There were reports that existing companies, including large companies, set up new entities just to obtain a loan to cover their previous debts. However, this is a solution that can be tested with the least impact within a strict monetary system, but unintended consequences should be expected.

Another option is the Central Bank artificially lowering rates by printing more money. This could worsen the economic situation, causing problems for the exchange rate and later on for inflation and the entire financial system.

Alternatively, the Central Bank could use its influence for the funds it manages (e.g.: Employees’ Provident Fund) and buy Government bonds at lower rates, attempting to push rates down. This also has downsides and is not advisable.

No simple solutions

When a country’s monetary system isn’t stable, these complex situations arise. This column has warned, time and time again, against the monetary instability caused by money printing that led to these situations.

Setting a cap on interest rates is like controlling prices, which isn’t a good idea. It could set a bad precedent and cause further problems. On the previous occasion the Central Bank controlled the exchange rate and forex repatriation, the Balance of Payments (BoP) crisis got worse. Though interest rate caps may have good intentions, the fallout could be tricky. In response, banks with portfolios that don’t support lower rates may reduce their lending, affecting people who need loans.

People who have credit needs may have to settle for further high interest options, making their situation worse on one side. More fake microfinance solutions with very high interest rates may emerge and people will have to depend on informal financial borrowing if the banks impose more restrictions on pawning and selected operations.

Social costs can be seen as there were multiple incidents of conflict in recovering debt and in extreme cases, even the loss of life. The experience over years has been for the Government to provide debt cancellation and relief for people by taking responsibility for the debt when people suffer from bad loans.

Unfortunately, there is no simple solution. The best approach is understanding the issue and its consequences before taking action.