What happened to our debt?

By Dhananath Fernando

Sri Lanka’s debt situation is still a mystery for some. During a panel discussion, I pointed out that Sri Lanka’s State Owned Enterprises (SOEs) have amassed a staggering 1.8 trillion in debt, all guaranteed by the Treasury and classified as ‘Public Debt’. One question from the audience was, “What did we do with the money we borrowed?” The simple answer is that money was borrowed primarily to service the interest on the initial loans Sri Lanka took out. Therefore,  despite borrowing substantial amounts, there is nothing tangible or visible to show for it, as a majority was essentially sunk into interest. 

To provide context, since 1999, approximately 74% of the increase in debt can be attributed to interest payments and currency depreciation. Interest payments accounted for a substantial 40% of the debt accumulated since the 1990’s, while the exchange rate depreciation contributed to 33%. 

What Sri Lanka faced was a precarious combination in terms of borrowing and our monetary policy. Our expansionary monetary policy played a significant role in the depreciation of the currency over the years, exacerbating the situation further. Compounding this issue was the fact that approximately 50% of our borrowing was in foreign currency. As it is indicated in 2022, with Modern Monetary theory in play, the significant depreciation of the exchange rate since 2020 led to an accumulation of debt beyond our repayment capacity.

Printing more money artificially increases the demand for foreign exchange.  However, after depleting our reserves in an attempt to defend the currency, the only option left was to allow the currency to float, leading to a sharp depreciation. In the case for Sri Lanka, it was not just the currency depreciation; social unrest, debt default, and numerous other crises followed when the government resorted to borrowing from the Central Bank through money printing.

As at the end of June 2023, our total public debt has increased to USD 96.5 billion, with approximately 50% of it in domestic debt. The country’s public debt now stands at about 127.4% of GDP. Even if debt restructuring is successful after negotiations with the Paris Club and separate discussions with China, we only anticipate a reduction to 95% of GDP by 2032. 

Undoubtedly, expediting the debt restructuring process is crucial, especially given the unpredictable twists in geopolitics. While the tentative agreement with China Exim Bank to restructure the debt is a positive development for Sri Lanka, we must fast track negotiations with our other foreign creditors. Complicating matters, as we approach an election year, there is a significant risk of derailing the process as unfortunately, there is a lack of consensus among political parties regarding the economic stabilization program for the next few years. This further exacerbates the challenges Sri Lanka faces.

Solution 

If Sri Lanka is genuinely committed to resolving its debt crisis, a crucial step is to establish a consensus on public finance across the major political parties. At the very least, adherence to a single plan, such as the IMF program, is necessary. However, even the IMF program alone will be insufficient to take Sri Lanka to the next stage of economic stability. Therefore, there must be a fundamental agreement on specific reforms across party lines. For example, there exists a common minimum program in Parliament, shaped with contributions from the business community and organizations like Advocata. It is not too late to revisit and endorse this document. Committing to these agreed-upon reforms before political parties develop their individual manifestos in the coming years could provide a stable foundation for Sri Lanka's economic future.

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.)

Shaping Sri Lanka’s growth narrative

Originally appeared on The Morning

By Dhananath Fernando

Securing the second tranche from the International Monetary Fund (IMF) is an important step, especially to support our ability to successfully carry out the debt restructuring process. It is not just about the $ 330 million that this tranche brings; it is about the credibility it gives to the reform process and the confidence it instils in the international community, including bilateral and multilateral creditors. 

The moment we deviate from the IMF programme and allow our debt to remain unsustainable, we risk regressing to square one. However, we should not get our aims and priorities mixed up. Our aim is not to secure IMF tranches. We need to prioritise achieving deep and meaningful reforms. The IMF tranche will follow as a result. 

Ultimately, our goal should be to ensure that, in the future, we never find ourselves in a position where we need to turn to the IMF for assistance.

As this column has discussed many times, it is essential to recognise that the IMF can only stabilise the economy and facilitate credit access, which is a crucial element in our debt restructuring process. The responsibility to clear out the roadblocks that stand in the way of economic growth rests solely on our shoulders. We have to carry out reforms that go beyond the scope of the IMF programme. 

Three key reforms aiming to boost economic growth will be discussed below.

Reforms to attract more tourists 

Focusing on tourism can significantly contribute to the country’s economic recovery. In addition to bringing in foreign exchange, their spending in domestic markets contributes significantly to Government revenue through VAT. Instead of fixating on the number of inbound tourists, our focus should be on the number of nights a tourist stays in the hotel/country. Simplifying the entry process will attract more tourists, and more importantly, entice them to prolong their stay. 

In line with Daniel Alphonsus’ recent article, making the visa process more flexible for tourists is crucial. Our focus should not be on visa fees, but rather to encourage tourists to spend more. This allows local industries to capture the revenue and enhances Government revenue through VAT and various other forms of fees and indirect taxes.

Offering a two-year multiple-entry visa for citizens from countries with a per capita GDP four times higher than Sri Lanka’s is a strategic move to attract high-income tourists. Given our current fiscal situation, carrying out extensive global promotional campaigns are beyond our financial capacity. Therefore, our focus should shift to initiatives that can be implemented effectively with just a stroke of a pen.

Addressing labour force shortages 

Retaining skilled talent within Sri Lanka is a challenge faced by many industries, including blue chip companies. These labour shortages are anticipated to affect us from next year onwards, jeopardising the sustainability of existing businesses.

To address this issue and prevent businesses from relocating, it is essential to allow companies the flexibility to recruit from international markets. This approach is crucial to sustaining businesses and their supply chains. Permitting companies to hire skilled labour from outside Sri Lanka will not only alleviate pressure on the country’s labour market, but also offer advantages to consumers and businesses competing in global markets.

Further, it encourages the transfer of knowledge and skills, leading to improved productivity. For example, collaborating with professionals from countries like Japan could introduce advanced productivity management techniques, enhancing overall efficiency. Free movement of people is a crucial step in improving our productivity and driving the economic growth of the country.  

If relaxing labour market regulations proves too complicated, a pragmatic alternative is to permit foreign spouses of Sri Lankans to work in Sri Lanka. This measure could help in attracting more skilled workers, providing an incentive for Sri Lankans with families of mixed citizenship to return and settle here. Importantly, this reform won’t incur any costs for the Government; it simply involves changing existing regulations.

Industrial zones for private sector and simplifying tariffs  

For us to emerge from this crisis, our primary focus should be on global trade. The complicated tariff structure that is currently in place enables corruption and is a source of frustration for both exporters and importers. Simplifying the tariff structure into three to four tariff bands is essential to streamlining Government revenue administration. 

The existing high and complicated tariffs lead to massive leakages of tariff revenue. Moreover, these tariffs discourage imports, hampering productivity and burdening consumers. Implementing a straightforward tariff structure is imperative, removing para-tariffs such as CESS and PAL. Furthermore, we must ensure that the tariff structure for any HS Code is easy to compute and has minimal deviations.

A significant bottleneck in our system that hinders investments and export growth is the shortage of land for industrial activities. Currently, 95% of the land in Board of Investment (BOI) industrial zones in the Western Province is occupied. Investors are required to obtain approximately 17 approvals in order to set up operations and this process can take more than two years. 

Regrettably, the BOI has not initiated any development projects in the last 15 years. A viable solution that the Government should consider is utilising State-Owned Enterprise (SOE)-owned land and allowing the private sector to develop industrial zones on it. 

Private sector-run industrial zones can operate as a plug-and-play model, where the private sector attracts investors and secures the necessary approvals in advance. This approach does not require any Government investments; in fact, it can generate more revenue for the Government through leasing or selling the land for development. 

If Sri Lanka is genuinely committed to economic growth and recovery from the crisis, our primary focus should be on implementing these reforms rather than solely relying on the IMF.  While the IMF can provide us with short-term stability, it’s our responsibility as Sri Lankan citizens to shape our own growth narrative.

Borders & the Budget

Originally appeared on the Daily FT, Daily Mirror

By Daniel Alphonsus

Visa reform will boost tourism and reverse brain drain

Three million tourists are set to visit our shores next year. We will issue nearly as many online visas - millions too many. ETAs are a tourist's bane: rather than dreamy sun, sea and sand, the weary salaryman’s getaway begins with the tedium of forms. 

The tourist’s ayubowan to Sri Lanka begins with ferreting for flight details and credit cards. Warm-up complete, the ordeal begins in earnest: 20 clicks to navigate through the ETA form and countless key strokes to fill out the 27 form fields. Each question brings forth its own miseries, and sometimes mind-reading feats: “They’re asking me for my address in Sri Lanka. Hmm, does this mean my first address, my last address…but I haven’t even booked my hotel..dear, dear maybe I should book the Maldives instead. They’ve got a visa-on-arrival.” Followed, naturally, by web-pages reloading with unsaved data and vindictive payment gateways rejecting credit cards for arcane and esoteric reasons. Rather than a Small Miracle, they experience So Sri Lanka. 

This charade costs us millions of dollars every year. We are losing tens of thousands of tourists to our competitors.

Based on the three scenarios below, switching from ETA to visa-on-arrival à la the Maldives or Singapore should generate between $24 million to $145 million in additional tourism revenue.

The precise number is not especially relevant. The point is that these roughly right numbers are substantial enough to generate a robust prima facie case for experimenting with opening up visa-on-arrival and optimising the ETA experience

For workings click here.

Visas-on-arrival

Sri Lanka already operates visa-on-arrival for Singapore, Maldives and Seychelles citizens. In light of the tens of millions of dollars we’re losing in the absence of visas-on-arrival, very compelling reasons must be provided for not opening-up visa-on-arrival for citizens of our main tourism markets (such as the EU, China, Russia and UK). Plus those who have passed extensive checks in the process of traveling to other countries. For example, travelers holding multiple entry visas to the US can visit about 51 countries visa free. 

The burden of proof is therefore on those who say we ought not have a visa-on-arrival regime. All the more so because it appears that, even though not advertised, in a pinch, obtaining a visa-on-arrival is possible at BIA. Also note that airlines share passenger records with governments 24 hours before arrival. It takes seconds for our border agencies to check the relevant blacklists as they already have API integrations in place. The response time of an Interpol database query is half a second.

In addition, immigration department annual reports show that almost all rejections and deportations are from a handful of countries, mainly India. Other than a German and an Australian, no UK, EU, ASEAN or Australian national was rejected or deported in 2022. This suggests a risk-based, optimized approach is very much possible, and prudent.

Many of us have experienced this personally. We are more likely to tour Singapore because Sri Lankans enjoy visa-on-arrival. In fact, on average it only takes us 10 minsto enter Singapore. As shown in the picture above, for passport holders of 50+ countries, the experience is even more smooth. Using automated immigration gates, they clear border control in less than two minutes.

Optimize the ETA process

Some tourists may still prefer to secure an ETA before arrival. Therefore, we should do our best to ensure the application is seamless. Currently it is not. Of the 27 fields requested on the ETA, about 20 can be found in passenger record details airlines share with immigration authorities. They are redundant. Questions on the ETA should be limited to around seven fields. The amount of information gathered should be commensurate with the risk: those from high risk countries could be subject to additional questions.

Eliminate the ETA fee

Credit card payments are often an even greater source of friction. Tourists need to pay $20 via credit card for an ETA. This deters potential tourists; it's another step in the journey and credit card payments often fail. So much so, the our embassy in Germany issued the following notice:

“On Arrival Visa at the Port of Entry to Sri Lanka: submit visa application and payment at Colombo International Airport. A fee of USD 60 will be charged for this service. Please observe that this option of obtaining a visa is available only for German passport holders, who have tried to obtain a visa via the ETA-system www.eta.gov.lk, but failed due to not being able to pay the fees with credit card.” 

It's not only card friction that is the problem. Many Chinese citizens no longer own cards and use Alipay instead.

Wiser countries like Singapore understand that reducing friction encourages more tourists to arrive, and thereby spend more. Which is why they don’t charge tourists a fee.

*Note the ETA fee is $20 for SAARC and $50 for other nationalities. $40 is a rough weighted average. For workings click here.

Based on the rough estimates above, if the ETA fee or friction puts off even three percent of tourists, then Sri Lanka stands to unequivocally benefit from eliminating the ETA fee. The exchequer will be worse off for now. But the Treasury still recoups some of the lost visa fees by higher VAT revenue directly, and indirectly via higher income tax from tourism sector firms and employees. (1)

Brain Gain

Since Independence Sri Lanka has lost or chased away lakhs of skilled workers. Many middle class families can proudly count at least one doctor, accountant and engineer (among many other species of the middle bourgeoisie) among their relations overseas. Between 2005 and 2015, the BOI estimated that around 20% of STEM graduates left the country every year. With COVID and the economic crisis, emigration was particularly acute the last few years. But it's not new. Skilled emigration is a chronic problem we’ve faced for decades.

(2 ) This report offers a rigorous treatment of the topic from the 1970s.

We desperately need to reverse brain drain. Of course, the central challenge is building a Sri Lanka in which Sri Lankans want to stay. But that is beyond the scope of this article. Here we shall only discuss how we can make it easier for skilled talents to come, and contribute. 

Some readers may be perplexed that even a handful of skilled non-Sri Lankans want to live and work on our island. But we live in a nomadic, connected and occasionally romantic age. These rare souls exist. 

We must do everything in our power to welcome and encourage them. Above all, by simply removing barriers to them legally working here. For the path to prosperity is paved by productivity growth. Therefore, it makes absolutely no sense for us to create barriers for skilled migration. It is the opposite of what smart countries do - especially via human capital theft aka points-based migration. There are three main ways foreign talent raises Sri Lanka’s productivity, growth and thereby prosperity. Foreign talent:

1. Adds human capital: whenever someone who has higher productivity than the average Sri lankan worker moves to Sri Lanka, they raise Sri Lanka’s average productivity directly. We already have huge talent shortages in key sectors like IT. 

2. Upgrades existing human capital: foreign talent, directly or by osmosis, teaches their skills to others.  

3. Increases existing human capital productivity: the whole is often greater than the sum of its parts. Skilled talent enables others to be more productive. For example, having access to a pediatric neurosurgeon makes all pediatricians more productive as knowledge is shared from expert to generalist. Alternatively, having a Japanese team-member makes the whole team more effective when working with Japanese clients. 

Per capita GDP is a good proxy for average worker productivity. Therefore, if someone from a richer country moves to a poorer country, then the average productivity of the poorer country will improve. How do we do this? The Harvard Centre for International Development has some ideas from which I borrow liberally. 

The fastest way for Sri Lanka to have brain gain to compensate for some of the brain drain is to:

Offer a two-year visa-on-arrival for those from countries that are 4x richer than Sri Lanka

1. Offer a two-year renewable visa-on-arrival for citizens or permanent residents of countries which have per capita incomes at least four times that of Sri Lanka. (3)

2. Amend the Citizenship Act such that any person who has at least two Sri Lankan grandparents is eligible for citizenship. ()4 

3. Regularize employment of all foreign spouses of Sri Lankan nationals, including a path to permanent residency and citizenship. (5) 

The first of these measures can be implemented by the stroke of the minister’s pen.(6) Sri Lanka’s immigration act provides for broad ministerial discretion. The minister is empowered to make entry regulations for visas upto five years in length. He or she can implement Point A above without requiring primary legislation.

We have little to lose, and all to gain. Try these measures for a year, try them for a few countries. Then roll-back or amend accordingly. Sri Lanka has a long history of policy-instability, but we should not confuse the many cases of foolish equivocation with genuine experimentation. That is what this budget should propose: bold measures to breakthrough our malaise and initiate the process of transitioning from stabilisation to recovery.

(1) As this article is solely on matters related to the immigration act, I’m not going to discuss this in detail. But it's worth noting that levying a flat (dis)embarkation levy is also a deterrent against short-haul traffic. Instead, the airports authority should price the levy based on the distance between Sri Lanka and the origin/destination airport.

 (2) Diaspora remittances do little to compensate: Sri Lankans remit more from the Maldives than Australia.

(3) For those that ask why a per capita GDP based criterion rather than points-based criteria, my answer is simple. A points-based system inherently involves discretion, and in the context of our state (in)capacity and corruption, will result in friction (countless people will not bother applying with all the documents that will be required), many false positives (as the assessors of points, e.g. a degree certificate’s legitimacy, will be corrupt) and false negatives (because those with skills we want may not have the right paper to demonstrate it). Considering this range of incentive problems and Type I/II errors, a very conservative threshold like the 4x per capita GDP one suggested is most optimal.

(4) For further details on this point and the next point, see page 14 of this study on Sri Lanka’s immigration framework.

(5) Reaching consensus in Parliament on this point should be easy. Sajith Premadasa’s manifesto promises dual citizenship after three years of residence for foreign spouses of Sri Lankans. See page 39.

 (6) Soon, one hopes, his or her digital signature. In fact, the President should announce that he will only sign documents via a digital signature from 31 December 2023 onward.

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.

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

Securing Food Security

Originally appeared on The Morning

By Dhananath Fernando

World Food Day falls on 16 October. In Sri Lanka, food security has been a topic of discussion for a considerable period of time, especially gaining prominence during the Covid-19 pandemic. 

During that period, there was confusion between food security and self-sufficiency. Instead of focusing on ensuring food security, the emphasis was placed on self-sufficiency, with the belief that all food consumed in Sri Lanka should be produced within the country. There were even discussions among Sri Lankans about shifting from using lentils (dhal) to locally-grown maize.

After approximately two years, when we assess the Global Food Security Index report, Sri Lanka is ranked 79th out of 113 countries. Food security isn’t solely about achieving self-sufficiency by producing all the food within the country; it encompasses the affordability, availability, quality and safety, as well as a nation’s exposure and resilience to natural resource risks.

Prior to the inclusion of the natural resources and resilience component, Singapore led the Global Food Security Index. However, after adding this component in 2022, Singapore dropped to the 28th position, with Finland now topping the Index. India is in the 68th position, Nepal in the 74th position, and Bangladesh in the 80th position, just one spot below Sri Lanka.

Due to the economic crisis, characterised by high inflation rates, particularly in food prices, the number of people who were food insecure exceeded six million. This number has now decreased to less than four million, emphasising the significant role economic stability plays in ensuring people’s food security.

Sri Lanka’s food security has always been a challenge due to economic policies that have been against market dynamics. Monetary instability resulting from the unfettered levels of money printing led to food inflation, affecting the affordability of food. 

The Government’s imposition of price controls led to shortages of protein sources such as eggs and chicken, further impacting the availability of food. Additionally, the Government imposed a Special Commodity Levy (SCL) on selected food items as a protectionist measure, maize being a prime example, driving up prices. 

Maize is a key raw material for the aquaculture and poultry industries. Price volatility in maize also affects the prices of poultry products and other locally consumed protein sources, sometimes impacting the competitiveness of our agricultural exports. 

The Government’s approach, whether through higher tariffs or import bans, is equally detrimental. Our food security structure is simply unsustainable, with weak and unpredictable supply chains and inconsistent policies.

Ensuring food security involves addressing both macro and micro issues. A holistic approach, taking into account land rights, is essential. The documentary recently released by the Advocata Institute titled ‘Land, Freedom and Life’ highlights the challenges faced by farmers due to the absence of land rights, hindering their access to capital or technology to enhance productivity.

In addition to land rights, water management is another critical aspect that needs serious consideration. Currently, our water usage in paddy cultivation is unsustainable. We consume approximately 1,400 litres of water to produce 1 kg of rice. Even if we price a litre of water at 50 cents, the cost of the rice we consume would significantly surpass current prices. 

With the challenges posed by climate change, future water availability cannot be guaranteed. Despite the number of people experiencing food insecurity declining, our approach in food production is not sustainable. Another local or global shock could easily set us back.

The Government has attempted various approaches such as providing subsidies for farmers, free meals for school children, and free nutritional packages for women during maternity. However, in order to truly  address Sri Lanka’s food security crisis, a multifaceted approach is required. 

This should begin with macroeconomic stabilisation, providing land titles for farmers and agro-companies to enhance agricultural productivity, reducing labour costs in agriculture, recognising the interconnectedness of markets, and allowing market forces to operate.

Until these issues are resolved, World Food Day will remain a day for discussing problems without implementing solutions.

Why was the IMF Tranche Delayed?

Originally appeared on The Morning

By Dhananath Fernando

There is some uncertainty in the market regarding the reasons for the delay in the IMF's second tranche. The simple reason is that although we have made some progress, given the depth of the crisis, our speed of reforms is inadequate for a swift recovery, particularly in revenue collection.

A shortfall in revenue collection, expected to be about 15% compared to initial projections by the year end, has been cited as a key reason. Secondly, until we finalize debt restructuring, especially external debt restructuring, the risk factors remain high in achieving our desired debt-to-GDP ratio. Even after the expected debt restructuring, in 10 years, our debt-to-GDP ratio will still be above 90% according to estimates.

Thirdly, the Central Bank's reserve collection has slowed down. Consequently, with our macroeconomic indicators sending mixed signals, it can not be assured that the economic recovery is still on the right path. Furthermore, at the press briefing held on the 27th of September IMF officials reiterated that more work needs to be done to sustain the reform momentum.

It is crucial to identify the reasons for the delay in reforms. Our framework for driving reforms is not well-established. The current structure, where the President acts in the capacity of the Minister of Finance, appoints committees, and delegates tasks, is flawed. Some tasks are interconnected, and the entire drive must come from the Finance Minister alone.

Further, these two roles can have contradictory interests. The Finance Minister holds an unpopular job, requiring revenue increases through taxation and expenditure reduction. Conversely, when the President, a politician expecting re-election, occupies the role, there's a natural tendency to make popular decisions, deviating from essential reforms.

Our reform process is highly complicated, demanding direct involvement of the Finance Minister in debt negotiations with external creditors in several categories, namely multilateral, bilateral, and private creditors. This task alone is equivalent to a few full-time jobs. Additionally, structural reforms are expected to focus on State-Owned Enterprises, where considerable trade union influence will come into play with appointments made by fellow cabinet ministers. Thus, driving such unpopular yet critical reforms becomes nearly impossible, especially when the finance minister is also the President or vice versa. More importantly, for key appointments such as the Central Bank Monetary Board and Governance Board, the President nominates with the Minister of Finance's approval and the Constitutional Council's endorsement. When the President and the Finance Minister are the same, the objective of checks and balances significantly diminishes.

In the case of India's reforms in the 1990s, it was Dr. Manmohan Singh who spearheaded reforms. He had Dr. Montek Singh Alhuwalia as the Chairman of the National Planning Committee to drive reforms. With his experience working with the IMF and a keen understanding of the Indian perspective, the reforms initiated in the 1990s continue to fuel India's growth, making it one of the countries with the highest economic growth rate.

The IMF Governance Diagnosis report, subsequently released, provided numerous recommendations out of which approximately 16 recommendations have been prioritized, mainly focusing on governance and transparency.

One reason this column advocates moving beyond IMF reforms is that corruption cannot be curtailed solely through governance structures. The size of the government must be limited in conjunction with effective governance structures. Aligning governance structures with the vast expanse of the government is nearly impossible.

Furthermore, the IMF primarily brings stability; the responsibility for growth lies in our hands. We must unlock our growth potential through necessary reforms, extending beyond the IMF program. This underscores the urgency of accelerating comprehensive reforms and establishing a dedicated team to drive these changes. Regrettably, what we observe is mere enactment of legislation without robust mechanisms to execute and ensure continuity of the process, and this leading to delays in the IMF's second tranche.

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.

Understanding the Gender Gap in the Workforce

Originally appeared on Groundviews, Daily Mirror and Lanka Business Online

By Thathsarani Siriwardana

The issue of female labor force participation in Sri Lanka has remained a subject of discussion for several decades, yet tangible progress in improving it has been elusive. As the country grapples with its most severe economic crisis since gaining independence,it is important to take a hard look at our labour force to maximize its potential in overcoming the economic crisis. 

Sri Lanka is approaching its last stages of its demographic dividend characterized by a significant proportion of its population falling within the working age bracket (typically aged 15-64) in relation to the dependent age categories,the aged and the children. According to the Asian Development Bank, Sri Lanka's working-age population is expected to reach its peak around 2027. This presents a unique opportunity for us to strengthen our economic prospects by using the right socioeconomic policy mix, similar to how the Tiger economies like Singapore, Hong Kong etc. have harnessed their demographic dividends to advance their economic growth. 

Importantly, a substantial portion of this working-age population comprises highly educated and women who are living longer. Hence necessary interventions must be made to harness their economic potential.

Current status of the labour market

According to the 2021 Labour Force Survey, Sri Lanka's total labor force comprises 8.5 million individuals, with 65% of them being male. The overall labor force participation rate (LFPR) in Sri Lanka hovers around 50%, revealing a significant gender gap that has persisted since the early 2000s. As of 2021, the male labor force participation rate in the country stands at 71%, whereas the female labor force participation rate is considerably lower at 31.8%. This enduringly low female labor force participation rate, spanning almost a decade, necessitates increased attention and intervention from the government. It represents an untapped potential within our economy that demands harnessing for the nation's benefit.

When examining the female labor force participation, it becomes evident that a significant proportion of females are employed in the estate sector, constituting 42.6% of the female workforce. In the year 2021, a substantial majority of the economically inactive population were females, accounting for approximately 73.3%. Interestingly, among these economically inactive women, 59.4% cited engagement in household work as their primary reason for not participating in the labor force. This sheds a light on household responsibilities as the main contributing factor, preventing women from entering the workforce.

Education status of the labour market
Sri Lankan women tend to achieve higher levels of education compared to men. However, this educational advantage hasn't  translated into higher levels of participation in the labor force. To illustrate this relationship between labor force participation and education, the chart below provides a clear visual representation of the situation.

This diagram highlights two important points. Firstly, it reveals that a significant majority of women who participate in the labor force (83.2%) possess degrees or higher levels of education. This suggests that women are more likely to apply for jobs that align with their skill set and education level. 

Secondly, it underscores a distinct contrast when it comes to men. Even if men have an education level of grade 5 or below, a substantial portion (65.7%) still actively contribute to the economy. This disparity suggests that women with lower levels of education face greater challenges or barriers when it comes to workforce participation compared to their male counterparts.

This statistic also serves as a clear illustration of the traditional societal norm of men being the breadwinner, which leads to men having higher labor force participation rates, irrespective of their educational levels. On the other hand, women, despite their advanced educational qualifications, may encounter societal pressures or constraints that discourage them from seeking or maintaining employment. Unemployment remains a significant challenge in Sri Lanka, with the highest rates observed among women holding education levels at Advanced Level and above. This represents a substantial untapped pool of potential in the Sri Lankan labor market.

Reasons for low Female Labour Force Participation despite having a high education level 

The low female labor force participation rate in Sri Lanka can be attributed to a range of socioeconomic factors. 

A primary factor that discourages women from actively contributing to the economy is the significant burden of care responsibilities they bear. This care work encompasses a broad range of household tasks, from cooking and cleaning to childcare and caring for the elderly. According to the 2017 Time Use Survey, women spent nearly four hours more per day on unpaid care work and domestic services compared to men. For many decades, there has been a prevailing societal stereotype that women are primarily responsible for managing households, while men are expected to be the breadwinners outside the household. This division of labor is a key reason why women with the qualifications and capabilities to pursue employment opportunities often choose to stay at home, while men even with lower levels of education enter the labor market.

Another significant factor is the existing legal barriers in Sri Lanka. The two prominent legal constraints are restrictions on night-time work and the absence of recognition for part-time employment. While these legal provisions may have initially aimed to protect women, they inadvertently discriminate by limiting their employment opportunities and earning potential. For example IT/BPM sector employment is affected by the 1954 Act which only permits women over the age of 18, to work till 8 pm. The current statutory regimes governing employee rights fail to recognize part time-work. This oversight leads to a reluctance by employers to hire part-time workers as they are entitled to the same benefits as full time workers.

Moreover, the absence of adequate social infrastructure, such as quality child care centers and comprehensive parental leave policies, contributes significantly to the low female labor force participation rate. Presently, in Sri Lanka, approximately 80% of child care centers are privately operated. This situation creates a barrier to accessing quality and affordable child care facilities, making it financially challenging for skilled women to participate in the labor force, as many opt to stay at home to care for their children due to these constraints.

As highlighted in an ILO report the presence of skill mismatch in Sri Lanka's labor market since the early 1970s contributes as another reason. This skill mismatch exists because the country's education system does not adequately prepare graduates with the skills required by the job market. There is a notable disconnect between the courses offered by universities and the competencies needed by the private sector. 

This mismatch also contributes as a reason for the high levels of youth unemployment and the prevalent issue of arts degree holders struggling to find employment. A staggering 43.9% of unemployed graduates possess degrees in the arts. Notably, the majority of arts degree holders are women. This situation underscores a disconnect between the demand and supply within the labor market. It suggests that the current education system is not adequately preparing graduates with the skills and qualifications needed to meet the demands of available job opportunities.

Addressing these barriers are vital to improving the labor force participation rates, especially among women.

Policy Recommendations

• Recognise part time work under the existing statutes and provide needed benefits such as annual leave and remove provisions which restricts women from working at night.

• Utilize local government mandates via by-laws to enact local legislation to set up standardized and regularized day care centers while encouraging Public-Private partnerships in providing care for children by utilizing existing infrastructure.   

• Introduce more courses and degrees which are required by the private sector. This should be specially done by focusing on arts graduates. 

The effectiveness of the aforementioned policies would be limited if we do not address the need for a shift in people's mindsets. While Sri Lanka has made progress in challenging gender stereotypes there is still much work to be done. Initiating change, particularly within the education system, presents a promising starting point. The prevailing patriarchal system can be challenged and dismantled through education, which has the power to instill in both men and women the belief that predefined gender roles are unnecessary.

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.

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.

Sri Lanka’s talent drain: From dreams to departures

Originally appeared on The Morning

By Dhananath Fernando

Every day, news stories emerge about skilled labour from Sri Lanka migrating out of the country. It’s not only doctors, engineers, bankers, and teachers who are leaving, but also individuals with institutional knowledge from small and medium enterprises.

This outflow of talent is undeniably going to adversely affect businesses next year. Many attribute this migration to the economic crisis, and often, the debate revolves around the ethical aspect of people leaving after benefiting from investments in education and healthcare funded by taxpayers.

The crisis we currently face is multidimensional. We are dealing with a Balance of Payments crisis, debt crisis, currency crisis, economic governance crisis, and a humanitarian crisis. Amidst all these crises, the issue of why people are leaving the country is primarily a crisis of an economy unable to accommodate its citizens’ dreams and aspirations.

Unfortunately, the dreams of many Sri Lankans, especially those with high-reaching aspirations, have consistently been at the receiving end of various Government policies over the years, even before the economic crisis truly struck. The economic crisis was merely the final blow that compelled people to make the decision to finally leave.

If you recall, many political campaigns targeted youth and professionals with visuals of young people buying vehicles, enjoying family life, having access to better schools, and other attributes of a middle-income lifestyle. In fact, during the Yahapalana Government, the then Finance Minister Mangala Samaraweera understood the needs of the youth and introduced special loan schemes aimed at them under his flagship project ‘Enterprise Sri Lanka’.

High tariff rates

However, our policies over the years have largely stifled the aspirations of an aspirational society. If you take a stroll in urban areas, it becomes apparent that there are many unfinished houses. Often, you can see rusting steel bars protruding from concrete beams and the primary use of the slabs seems to be for drying clothes.

Many people are unaware that the dream of owning a decent house in Sri Lanka has been hindered by very high tariff rates on steel, tiles, bathware, and practically all construction material. People’s right to access reasonably-priced construction materials has been obstructed, resulting in our construction costs being higher than other countries in the region.

Additionally, people pay interest rates of 14-18% on their housing loans due to the extra 40% cost they incur. Consequently, the funds people could have invested into building their second floor have already been spent on the ground floor. This situation affects masons, carpenters, architects, designers, and the entire supply chain, crushing their dreams as well.

Further, certain products imported to the country incur effective tariff rates of over 100%. Sadly, the Government doesn’t even generate significant revenue from these high tariffs, as they are so exorbitant that importing at an effective tariff of over 100% makes no sense. This form of corruption is hidden, as certain individuals benefit from maintaining high tariffs for personal gain, while consumers suffer. The significant reason for professionals considering migration, despite the hardships, is the crisis of shattered aspirations, which the Aragalaya represented.

This type of corruption is challenging to capture, but in people’s minds, the notion that a few people are stealing their dreams holds true when they understand how tariff rates have diminished their quality of life.

Subpar transport system

Another major factor affecting people’s lives is transportation. Our public transport service is abysmal due to a lack of market openness and market restrictions through a permit system. State-owned train services are not only unprofitable but also fall far below average service levels. Thus, for the middle class, the logical choice is to purchase a personal vehicle.

However, personal vehicles are also subject to tariffs of over 100%. Remarkably, the Sri Lankan Government earns a greater profit margin than the automobile manufacturers themselves by imposing tariffs exceeding 100% of the vehicle’s value. Essentially, this means buyers are paying a value of more than double the price of the vehicle.

The extra cost is often funded by borrowing through vehicle leases, incurring interest rates of over 14% on top of everything else. Further, they pay an additional Rs. 50-70 for every litre of fuel, and the cycle continues with spare parts, revenue licences, etc.

For professionals, their aspirations are once again ignored, making it unsurprising that people consider migrating. The Government’s solution to the vehicle issue over the years has been a vehicle permit system which has exacerbated the problem rather than solving it.

Crisis of unrealised dreams

In summary, the migration of people represents a crisis of unrealised dreams, with the economic crisis serving as a significant trigger.

The solution lies in allowing the private sector to recruit skilled individuals from other markets and establishing a scheme that permits skill migration into Sri Lanka. This approach would help fill vacancies, promote knowledge transfer, and stabilise the business environment.

If Sri Lankans can migrate overseas and compete in Toronto, New York, London, Dubai, and Stockholm, they can undoubtedly compete with anyone else in Sri Lanka. Knowledge transfer would be enhanced and salaries would increase over time, even for local staff.

Given that we have already shattered people’s dreams, we shouldn’t obstruct the remaining dreams of those considering staying in Sri Lanka. The best way to retain them is by ensuring the sustainability of the remaining business ecosystem. But to ensure the ability to realise the dreams of an aspirational society, the cause of the problem must be fixed at the root.

A facelift for the railway

Originally appeared on The Morning

By Dhananath Fernando

I am a frequent train traveller, whether it’s a short or long distance journey. Often, I book railway tickets from Colombo to Anuradhapura, especially for my mother when she goes to attend religious observances. Many years ago, the process of booking train tickets used to be quite complicated, requiring a visit to the station. However, things have changed over the years. Nowadays, we have the option of booking train tickets online or through our mobile phones.

I usually make the booking by calling my mobile service provider and providing the National Identity Card (NIC) details of the passenger. The fare is then directly charged to my mobile phone. If I am booking for multiple passengers, I need to provide the NIC numbers for all of them. While this method is convenient in some ways, I did have a few concerns.

Despite booking the ticket over the phone, the passenger still needs to physically collect the ticket from a designated counter by presenting their NIC. This seems to defeat the purpose of online/phone booking, as the passenger ultimately has to go and get a physical ticket. The only advantage is that I can ensure that a seat is available before all seats are taken.

Another concern is that online/phone ticket booking opens just two weeks before the departure date. This means that if my mother is travelling on a Sunday and returning on a Tuesday, I need to call on a Saturday two weeks prior for the departure ticket and then again the following Monday for the return ticket. If I wait until Monday to book both tickets, there is a high chance that the Sunday train tickets may be sold out.

Recently, I had the chance to speak with a senior officer from Sri Lanka Railways, who shed light on some of these concerns and suggested ways the railway sector could be transformed. The officer explained that passengers were required to collect tickets in person because the railway ticket inspectors lacked QR-code scanners as well as funding for this investment. Essentially, the requirement to collect the tickets physically stems from the inability to verify the authenticity of online tickets. However, mobile phones could easily scan QR codes, similar to what is done at fuel stations in Sri Lanka.

The limitation of ticket schedules opening only two weeks before departure aims to prevent early bookings that may lead to ticket resales at higher prices, which can disadvantage regular travellers. However, in my view, no business can ask for a better deal than the payment of a service months before even providing it. A ticket shortage also indicates an incapacity to supply services for certain routes on the rail routes that have excess demand.

Another concern I had was why we could not rent out prime railway properties, such as the land owned by Sri Lanka Railways, for development. Regarding this, the officer pointed out that according to the Sri Lanka Railways Authority Act, properties under the railway could only be rented for five years, discouraging larger investments.

This highlights the need for ‘property rights’ to attract investors and promote property development. A key pillar of a market system is ‘property rights’ and most railway stations situated in prime locations are poorly maintained due to a lack of investment. Offering long-term leases to investors could provide funds for essential improvements, including implementing QR code readers for ticket checking.

Developing Sri Lanka’s railway system is not just about receiving train compartments from other countries. Nor is it about having QR codes or simply developing railway stations. We must address pricing incentives for road and train travel while maintaining the benefits for passengers at the core. A customer-centred approach and the right investments are crucial for meeting their expectations. That is why when markets are allowed to develop with space for specialisation, it solves people’s problems.

A master strategy for railway development should aim to fulfil people’s commuting needs. Economics plays a role at both micro and macro levels, emphasising the need to get the economics right for meaningful progress in our railway system.

Fixing policy failures in trade and tariff

Originally appeared on The Morning

By Dhananath Fernando

In Sri Lanka, we have often faced the consequences of two types of failures – ones of those who acted without proper thought and ones of those who had great ideas but never put them into action. This holds true for many of the policies we have implemented, especially when it comes to trade and tariff structures.

Recently, there was a parliamentary discussion on wheat flour prices. While global flour prices have decreased, Sri Lanka’s wheat prices have remained high. Common sense tells us that if prices are not adjusting accordingly, there must be some market intervention or manipulation. We need to return to first principles to better understand this.

The price of any resource represents its scarcity value. Increasing prices indicate a higher scarcity value, while decreasing prices suggest declining scarcity. Wheat flour prices in Sri Lanka have been wielded as a political tool over the years, making them a matter of great significance, particularly for vulnerable communities, such as those in the estate sector. As wheat flour serves as a primary carbohydrate source for many due to income limitations, its price carries immense importance.

In the past, the Government managed wheat flour distribution at heavily subsidised rates, similar to the situation with petroleum products, due to its political value. During the time of President J.R. Jayewardene, wheat flour was imported under the PL 480 agreement and many subsidies were granted under this programme. When Chandrika Bandaranaike Kumaratunga assumed power, she promised to provide a loaf of bread for Rs. 3.50, highlighting the significant political importance attached to the pricing of wheat flour.

Later, a monopoly licence was granted to one company to convert wheat grains into flour. This would have been acceptable if, simultaneously, wheat flour imports were also permitted. However, the Government imposed high tariffs on wheat flour imports while keeping tariffs for wheat grains significantly lower.

This created a lopsided tariff structure that discouraged wheat flour imports, favouring the two companies already engaged in wheat grain to flour conversion. According to the numbers quoted in Parliament, the import tariff for wheat grains is Rs. 3 and the import tariff for wheat flour is about Rs. 35. With this tariff structure, wheat flour importers cannot compete in the market as the tariff rate on flour is about 10 times higher than the tariff on wheat grains.

Additionally, the Government’s practice of issuing licences to selected wheat flour importers has often led to corruption. This combination of higher tariffs, licences, and limited competition has resulted in an advantageous situation for the two domestic companies currently operating in the market, but it has hindered fair market dynamics.

Similar issues exist in the fuel importation process. The tariff on crude oil is lower than that on refined fuel. The crude oil refinery in Sri Lanka, donated by Iran long ago, operates with low efficiency, giving an advantage to inefficient fuel refining processes. This inefficiency in the refining process can impact fuel prices, potentially leading to higher costs for consumers.

In Parliament, the proposed solutions appeared more disastrous than the problem itself. One suggestion involved imposing a special tax on specific companies. However, targeting individual companies with such taxes would be viewed unfavourably by investors. Companies need to be encouraged to make profits through healthy competition and efficiency, rather than through tariff protection and government policies that create problems for all in the long run.

An ideal solution would involve a uniform tariff rate and only a few tariff slabs for all imports, thereby eliminating room for tariff manipulation. Such a system would also minimise corruption at Customs and other government authorities, as importers would find it more economical to pay the standard tariff rates than to resort to corrupt practices.

Let us remember the wisdom of John Charles Salak: “Failures are divided into two classes: those who thought and never did, and those who did and never thought.” We must strive for well-thought-out policies and meaningful actions to foster a fair and prosperous Sri Lanka for all.

Addressing the land problem

Originally appeared on The Morning

By Dhananath Fernando

Decades ago, when tasked with writing an essay about my country, I emphasised its vast potential for production, ranging from agriculture to technology. Since then, Sri Lanka’s need to produce and export goods has been incessantly highlighted in panel discussions, TV debates, and interviews.

However, the real challenge lies not in recognising this need but in understanding why we remain lethargic when it comes to production. While the blame often falls on corrupt politicians and misused public funds, the economic reasons behind our sluggishness go deeper.

In our Grade 9 lessons, we were introduced to the main factors of production: land, labour, capital, and entrepreneurship. Have we ever considered the current status of these factors in Sri Lanka, which are essential for fostering production?

Let’s begin with land. Whether local or foreign, any investor will attest to the difficulty of securing a plot of land for production. Around 95% of the Board of Investment (BOI) zones in the Western Province are already occupied and the BOI has struggled to establish new zones for the past 15 years.

Initiating any production venture typically requires an average of 16 approvals, paving the way for corruption. Investors seek land that is ready for swift set-up and operation, as delays translate to significant costs. They need land equipped with electricity, water, telecom, waste management, and other essential services to minimise the time between investment and production.

Image Credit: JB Securities

Regrettably, the absence of available land turns our aspirations for a production-based economy into mere talk, without any tangible action. Approximately 82% of the land in Sri Lanka is State-owned, encompassing forest reserves and sanctuaries, while only 18% remains in private hands. Resolving land issues is a cumbersome process due to physical documentations that are prone to tearing and misplacement.

Poor utilisation of land by SOEs

State-Owned Enterprises (SOEs) occupy most of our land, and their utilisation has been rather poor. For instance, Sri Lanka Railways monopolises a stretch of land without exploring additional opportunities like real estate development. The Marine Drive land stretch, which offers beautiful sunset views, remains underutilised, discouraging tourists from visiting after 7.30 p.m. due to inadequate street lighting and lack of economic activity.

Private ownership of the railway could have not only transformed that stretch, but also attracted more tourists. SOEs are reluctant to relinquish land, leaving it to the discretion of the respective minister. While occasional rentals or long-term leases may occur, the full potential of the land cannot be unlocked without ownership.

In the present set-up, banks won’t grant loans without land titles and investors won’t risk their entire capital without a proper land base to support their technological advancements. Small-scale, scattered lands are available, but large-scale productions require sizeable plots with appropriate infrastructure. Unfortunately, the Government is losing substantial revenue in taxes and rents due to the underutilisation of land.

Addressing the land problem is imperative for attracting investments and Foreign Direct Investments (FDIs), as highlighted in the Harvard CID team study on Sri Lanka. In the global competition for investors, the land issue remains a key concern for potential stakeholders, as indicated by the World Bank Enterprise Survey.

Image Credit: JB Securities

Solutions

A potential short-term solution involves the Government acquiring land from SOEs that have development potential, converting them into BOI zones, and opening private industrial parks. Private companies can then develop industrial zones and present diverse value propositions to attract investors.

This arrangement would enable the Government to earn revenue through taxes and leasing fees while ensuring efficient land usage. Nonetheless, this is a temporary fix, and we must remain focused on real, long-term solutions.

Looking ahead, the establishment of a digital land registry with accessible and searchable documentation would streamline transactions and promote transparency. Although this vision may appear distant, it should not deter us from pursuing lasting solutions for Sri Lanka’s economic growth.

Rough seas make good sailors: Embracing competition in trade

Originally appeared on The Morning

By Dhananath Fernando

When I first started my career, my boss shared two valuable pieces of advice with me. “There are only two ways to secure a promotion,” he said. “First, you can develop your subordinates to replace you, allowing you to move up the career ladder. Second, you can help your boss get a promotion, positioning yourself to take their place.” 

The essence of his advice was that the key to advancing in one’s career lay in competitiveness. By being competitive, we not only benefit ourselves but also contribute to the entire ecosystem. This principle forms the basis of global trade. Unfortunately, for a long time, Sri Lankans have had a different perspective. We believed that imposing higher tariffs or even banning certain imports would make us competitive. This notion is akin to arguing against hiring smarter individuals to make existing employees more competitive.

For a considerable period, Sri Lankans have embraced this flawed argument at a national level without understanding its fundamental flaw. Many Government policy documents emphasise making local industries competitive through import controls, even using terms like ‘import substitution’.

If this argument were true, why were there no industries developed during the time when most imports remained banned? Even after the recent lifting of some import restrictions, a significant number of imports, including vehicles, still remain on the restricted list. In 2020, imports such as vehicles and turmeric were banned. 

After three years, have we witnessed any local industries becoming globally competitive and gaining market share? By restricting imports of tyres and vehicles, we did not witness the establishment of vehicle or tyre manufacturing for export markets in Sri Lanka. Instead, those who were already competitive in the global market for tyres and rubber continued to thrive, while some competitive players became uncompetitive due to import controls.

There is no formula for becoming competitive by avoiding competition. Just as the saying goes, “rough seas make good sailors”; it is competition that makes any local industry globally competitive.

Another common misconception in Sri Lanka is the belief that we are already an open economy. The truth is that we have become a more closed economy compared to the 1990s and possibly even more closed than in the 1970s. Our imports and exports are constantly declining in relation to our GDP. Instead of becoming a trading hub, we have isolated ourselves over the years, distancing from global economic integration.

Yet another popular argument gaining traction is the need to develop more industries to boost exports. Occasionally, this argument is used to advocate for import restrictions, suggesting that industries can be developed without external competition. In Sri Lanka, the main obstacle to industrial development lies in concerns related to the main factors of production: land, labour, and capital.

Most land slots in the Board of Investment (BOI) zones are already occupied, making it nearly impossible for new investors to secure a plot of land with access to electricity, water, and waste management. Land and property rights are fundamental for unlocking capital. Banks are hesitant to extend credit facilities without land as collateral. Such distortions in factor markets are the reasons behind the poor industrialisation we currently observe.

A commonly cited example for industrialisation is Vietnam, with some falsely claiming that Vietnam became an export hub by avoiding competition. The truth is quite the opposite. If we compare the Free Trade Agreements (FTAs) signed by Vietnam, Sri Lanka, and Thailand, Vietnam has actively embraced Foreign Direct Investment (FDI) and competition, allowing the private sector to drive export development. It was not achieved through a State-led policy of developing industries; rather, industries flourished as a result of market forces.

Competition is the driving force behind trade growth. There is no formula for improving trade by moving away from competition. Just as rough seas make good sailors, it is through competition that our trade can truly thrive.

Investing in Public Transport

Originally appeared on The Morning

By Dhananath Fernando

As a schoolboy, one promise that I remember being consistently made in Budget speeches was the development of the Marine Drive up to Moratuwa. But now, even in 2023, it has only been developed up to Dehiwala.

When the project was announced, I remember Sri Lankans celebrating. When the project was cancelled, we still celebrated. After leaving school, I often took the train to work, so I practically grew up with the Sri Lankan railway system and the Marine Drive. While the Marine Drive has progressed at a snail’s pace, the Sri Lankan Railway remains almost the same.

Later, when the Light Rail Transit (LRT) project was approved, there was renewed hope and celebrations. Consultants were hired and feasibility studies were done. TV commercials were aired on the impact it could create. However, following some back and forth, a new set of consultants were paid, who then cancelled the project. Again, we celebrated the cancellation, and now once again, we are in discussions to resume the project.

One does not need to be an economist to understand the importance of developing a solid public transport system which helps to improve efficiency, minimise pollution levels, and increase convenience for commuters.

As an initial incentive to get more commuters to consider using buses, the Government attempted to implement bus lanes. The provision of a dedicated lane for vehicles shuttling a large number of passengers would have reduced commute time and congestion, and also incentivised commuters to switch from private vehicles to public transport. Unfortunately, the actual adherence to bus lanes was short-lived; if you look at buses today, they move all over the lanes.

Further, there is a route permit system which effectively blocks the entrance of new players. This has created an oligopolistic market system, with a higher chance for cartelisation of the market. Additionally, the Government has imposed a price ceiling which stunts the space for innovation and value-added services.

For example, the 138 Kottawa-Pettah route – considered to be a route utilised by a significant proportion of the middle class – has no air-conditioned bus service. The lack of an efficient market system has led the players to not even be incentivised enough to employ air-conditioned buses.

The market system works when there are no entry and exit barriers and when room is created for innovation through the pricing mechanism to reflect the scarcity value of the product or service. In the current system, nothing is possible. And yet, modifying the public transport system is not a difficult task and will provide significant relief for the people.

One main problem in Sri Lanka for any type of investment is the ownership of land. Unfortunately, this is not an easy puzzle to resolve. There is no digitised land registry and more than 80% of land (including the forest cover) is owned by the Government – this land can be efficiently used for urban development.

Efficient public transportation with greater accessibility and affordability will create urban living hubs around it. One way to solve this puzzle is to start the digitisation of registration of lands in commercial areas within Colombo and Gampaha. Often, these projects tend to progress at a sluggish pace, falling significantly short of the required speed. The delays have not only driven up the cost but have also resulted in a loss of credibility.

Unfortunately, politicians often prioritise projects with short-term timelines, typically ranging from three to five years, as they require something tangible to showcase before the next election. Therefore, with the current governance structures, even these projects that are scheduled to take place would simply be an attempt to build political capital, instead of improving public transport in order to generate value for the people of Sri Lanka.

Debt restructuring: What’s next?

Originally appeared on The Morning

By Dhananath Fernando

Sri Lanka is passing through a crucial week in its history. The details of the final domestic debt restructuring are yet to be known, but we will soon come to know the final details. However, domestic debt restructuring won’t be the be-all and end-all that will confer the expected level of economic growth – we need reforms across the board for a growth trajectory. Progress can only be achieved through a comprehensive reform plan.

Domestic debt restructuring

No debt restructuring plan is easy. Debt restructuring itself is a very painful process. The ideal solution is to have a sound economy in order to avoid any type of debt restructuring, but we are far from such a scenario. The consequences of any type of debt restructuring would be broadly negative. It would only be positive compared to consequences of not undergoing debt restructuring.

When someone borrows money and later says that they cannot pay it back as promised, it is never a pleasant experience. Sri Lanka’s debt restructuring is no exception. The debt restructuring will have consequences at this stage; it is just a matter of who will bear the burden and whether the relief will be enough for Sri Lanka to at least settle the remainder of its debts.

In the proposed plan by the Central Bank of Sri Lanka (CBSL), it has been suggested the Central Bank, superannuation funds, and the holders of Sri Lanka sovereign bonds and other USD bond holders (issued under Sri Lankan Law) bear the burden of local debt. International sovereign bond holders and bilateral creditors are expected to primarily bear the burden of foreign debt.

Although technically it seems as if bond holders and other creditor segments bear the burden, the truth is that most of the burden has already been shared by people of Sri Lanka through inflation.

In the initial plan, the banking sector was excluded from the debt restructuring process. The CBSL has provided four broad reasons to justify this exclusion.

The banking sector pays about 48% taxes (after tax revisions) (30% corporate tax and 18% VAT on financial services) as opposed to previous taxes of 39% (24% corporate tax and 15% VAT on financial services)

The Non-Performing Loan (NPL) ratio of banks is on the rise (8.4% NPLs in 2022 Q2 to 13.3% in May 2023)

Banks are expected to be impacted by International Sovereign Bond (ISB) restructuring as well as Sri Lanka Development Bond (SLDB) restructuring (banks hold 17% in ISBs and SLDBs)

Many concessions and moratoriums were already provided during Covid, Easter attacks, and the economic crisis, where about Rs. 1.6 trillion worth of loans were under concessions, amounting to about 15% of total loans

The main question is whether the provided debt restructuring is adequate for Sri Lanka to reach its target of 13% Gross Financing Needs (GFNs), 2.5% primary surplus, and 95% of debt to GDP ratio by 2032.

If the restructuring is not adequate enough for us to settle our debts, we will likely have to undergo another restructuring. Most countries which have gone through sovereign debt restructuring have to go through two subsequent debt restructurings on average. We are yet to see the analysis by the CBSL on how to ensure that this restructuring plan is adequate for us to achieve targets.

Ideally, we should avoid any further debt restructuring, because further restructuring would be more difficult, economically and socially.

Impact on superannuation funds

With the proposed restructuring, the social conversation is on the impact on superannuation funds. The Government has assured a minimum of 12% until 2025 and a 9% interest until maturity for the EPF. This is projected to amount to an average of 9.1% in rate of returns.

However, we have to keep in mind that any interest rate needs to be compared to inflation. There is no value in getting a 9% interest rate if inflation is 12%. If so, the Central Bank has to ensure that inflation remains around 5% for the real interest to be 4%.

However, the key impact of the proposed debt optimisation plan on superannuation funds would be that as per the Government’s projections, the rate of return would be 9.1%, which is slightly lower (0.3%) than the current returns. This means that if the status quo continues (for instance with no DDO) at 9.4%, the rate of return will be 0.4% higher than if superannuation funds took part in DDO.

The EPF is a nearly Rs. 3 trillion fund where withdrawals per year are less than Rs. 150 billion. Its collection was approximately Rs. 170 billion in 2022 and generally there is a Rs. 30 billion surplus between collections and refunds every year. People can still withdraw the money and their balance will not be affected, instead, it will result in the forgoing of the additional returns the fund could have made.

Domestic debt restructuring to be considered with other reforms

This debt restructuring will only bring partial relief, even if we undertake the necessary reforms. Even if this debt restructuring is successful, our debt to GDP ratio will be 95% in 2032 as per predictions. That is still a very high number. Ideally, an emerging market like Sri Lanka should remain in the range of 60%.

Sri Lanka will only be able to emerge from this crisis if we move forward with State-Owned Enterprises (SOEs) reforms, monetary sector and monetary reforms, and trade reforms. For us to grow our economy, we have to engage in trade. Secondly, we have to avoid growing our debt further through unproductive SOEs. If we fail to fix the rest, we will most likely return to square one, with a much difficult context.

What we, the common people, can do is push our policymakers to allow the market system to operate and limit the size of the Government while pushing for key reforms.

Competition: The way forward

Originally appeared on The Morning

By Dhananath Fernando

The recent conversation on taxi services at the Bandaranaike International Airport brought back memories of one of the times I travelled overseas as a youth. The Colombo-Katunayake Highway construction was not yet completed and I had just finished university.

I did not have the means to hire a vehicle to travel from Moratuwa to Katunayake in order to catch a flight, nor did Sri Lanka have the infrastructure or many affordable choices for a poor boy like me to reach the airport quickly at a reasonable cost. There was no PickMe nor Uber, and neither did I have a smartphone.

I left home early with my borrowed luggage from a friend and came to the Moratuwa Railway Station. I took the train from there to Pettah. From Pettah, I took an air-conditioned bus, paying extra to keep my luggage in the front of the bus and took a tuk from the bus depot to the airport departure terminal. I think the time I took to travel from home to the airport was just about 30 minutes less than the travel time of my flight.

All that I went through was due to unaffordability as well as the unavailability of affordable choices to travel. If there had been proper modes of public transport available connecting trains and airports, the lives of people like me, who could not afford a taxi to the airport, could have been easier. In the context of the availability of choices, we have to evaluate whether to allow mobile app-based and registered taxi services at the airport.

It is obvious why registered taxi services at the airport charge a higher rate. Their reasons to charge a higher rate include the cost to operate at the airport by paying rent for their operating offices and keeping an adequate fleet of vehicles. Further, their cost also includes licence fees and bribes that they have to pay to obtain the licence to operate at the airport.

However, their business model has been challenged by a more technologically-advanced operation where customers can choose the type of vehicle they want and are given the ability to check the rate for the journey prior to booking the taxi. This offers many more options including safety measures, such as the ability to contact the driver after the ride in case something is left behind after long hours of travel time.

While the operation of registered taxi services is perfectly reasonable, preventing someone else with an alternative solution from entering the market will make the lives of people more difficult. In a competitive world, competition should be encouraged.

The solutions suggested by our policymakers are absurd. Certain policymakers have wished to prevent the operation of mobile app-based taxi services at the airport. Others have suggested that the airport registered taxis should also register with mobile app-based taxi services. While the second option is somewhat reasonable, a business model being rendered uncompetitive due to the development of technology is not a problem for policymakers in the first place. Imagine bullock cart owners claiming that they are being impacted by engine-driven vehicles?

Simply, this is the evolution of the world and we have to adapt or we will lose in the market. Unfortunately, airport-based taxi services are becoming uncompetitive and more importantly, customers do not see any value in their services. If a customer sees the comparative value of one service being better than the other, they should be given the opportunity to make a choice based on the available options. This service should be valid even for customers whose hotel travel is coordinated directly.

Once we look beyond this and decide to connect our airport to multimodal transportation systems (such as connecting railways and highway buses to the airport), the airport-registered vehicles as well as Uber and PickMe taxis will witness an impact on the number of hires they receive.

Will policymakers delay connecting the airport to multimodal transport systems merely in order to protect our taxi services and drivers, overlooking affordable options for consumers?

In most airports around the world, the terminals are connected to some form of public transport while any type of taxi service is allowed. In fact, the infrastructure and signage enables mobile app-based taxis and other taxi services to pick up and drop off passengers at specific points. All modifications have been undertaken to make the lives of travellers easy, affordable, and safe, instead of protecting a group of politically-affiliated rent-seekers.

The manner in which our policymakers treat this issue is a good indication of how the majority’s choices have been compromised for political reasons, for the benefit of a few who are unproductive and uncompetitive.

This norm is not only seen in this particular scenario, but everywhere in our economy, including the State sector. Similar to how registered taxi drivers are objecting to mobile app-based taxi services, the Ceylon Petroleum Corporation wishes to keep other private companies out of the market. Some tile and bathroom fitting manufacturers wish for import bans on tiles and bathroom fittings, simply for their own benefit, as do aluminium manufacturers.

Things are the same in politics. They are all basically asking Sri Lankans and tourists who arrive in the country to take long journeys, wasting a lot of their precious time and call it a ‘beautiful life in the paradise island or Asia’s little miracle’.

‘So Sri Lanka’; is it actually a miracle?