Balancing the scales: Tax policies for prosperity

Ministry of finance

As citizens, why do we need to pay taxes? The simple answer is, taxation is the means of collecting revenue for Government spending for the goods and services we need as a populace. However, developing tax policies that are both fair and efficient are far from simple. The difficulties are especially multiplied, being a developing country like Sri Lanka, and having to compete in the world economy. Taxation should raise essential revenue for the Government to function, without depending too heavily on government borrowing. It should also not hinder economic activity in the country or discourage entrepreneurship.

Unfortunately, the fiscal and tax policies adopted in Sri Lanka in the recent past have not been able to achieve any of the ideals of an effective tax system. The picture presented by the Prime Minister in his speech during the second reading of the Appropriation Act, stated that the budget deficit in the country has increased from 5.7% of Gross Domestic Product (GDP) in 2014 to over 9.6% of GDP by 2019. The budget deficit has been bridged through non-settlement of dues to suppliers and beneficiaries from whom the Government had procured goods and services, which is unsustainable in the long run. The public debt that stood at 70% of GDP in 2014 has increased to 85% of GDP. The state of affairs currently, paints a very dismal picture about our economy, and it also poses a severe challenge to the incumbent Government to reverse this adverse situation.

This is the reason we are eagerly awaiting the reading of the first Budget of the present Government. It will outline the tax proposals and other fiscal measures that the lawmakers will have to take, to revive and revitalise our economy. It needs to be done amid the added challenges that are being posed by the global pandemic. The International Monetary Fund (IMF) recently forecasted that almost all countries in the world are under a massive contraction and that all major economies have recorded negative growth rates. [World Economic Outlook – 20 October 2020]. With heavy spending allocated to the health sector, the Government needs to collect revenues not only to finance its spending but also to service the country’s tall debt bill.   

We need to take cognisance of the inherent limitations in our system, when devising efficient tax policies. Firstly, most of our workforce are employed in the agriculture sector or in small, informal enterprises. They are not paid fixed wages and their earnings fluctuate. The base for an income tax is therefore hard to calculate. They will also spend their earnings at small informal stores that do not usually keep accurate records of sales and inventories. Therefore, collecting revenue such as income taxes and consumer taxes become a challenge. 

Secondly, is it difficult to create an efficient tax administration without well trained staff and computerised operations for revenue collection. The Government has made significant investments in improving these areas, but there is still room for improvement. Without a strong tax administration, the Government will be compelled to take the path of least resistance that allows the taxpayers to often exploit the loopholes. 

Thirdly, the income is unevenly distributed among the people. This would mean that high tax revenues should be collected from the rich. However, the tax system in Sri Lanka is such that this does not happen. The policymakers should revisit the personal income taxes and property taxes and devise proposals in these areas to achieve higher tax revenues.

Therefore, tax policy in Sri Lanka is often the art of the possible rather than the pursuit of the optimal. The Government needs to balance the scales between Government spending vs revenue collection in this backdrop when presenting its budget for 2021; ‘Vistas for Prosperity’.

Level of tax revenue

First and foremost, the Government needs to decide what level of public spending is sustainable given the level of national income. Here again, it needs to prioritise essential items of spending and rationalise its budgets. When the level of spending has been determined, then the amount of tax that needs to be collected to facilitate that spend can be calculated.

Data shows that the tax level in major industrialised countries is about double the tax level in a representative sample of developing countries. Economic development and growth often generate additional tax revenues to finance an increase in public spending. But at the same time, it increases the country’s ability to collect higher revenues to meet these needs. Therefore, it is crucial to identify the level of tax revenue needed to finance Government spending.

Composition of tax revenue

This deals with questions at a policy level as to whether the Government should tax income or tax consumption of the people. Should the Government tax imports or domestic consumption? The central issues that need to be looked at are whether the tax enhances the overall welfare of those who are being taxed and also whether the tax is fair and equitable to everyone.

Taxing consumption has traditionally been thought to be inherently more regressive than taxing income (i.e. it places a higher tax burden on the poor than the rich). When you look at the statistics provided in the Central Bank Annual Report for 2019, tax revenue amounts to 12.6% of GDP, of which only 2.8% has been collected by way of income tax. 5.7% has been collected by way of Value Added Tax and Excise taxes which are both consumption taxes. This reflects the trend in Sri Lanka to tax consumption rather than income.

We saw a significant change in collecting tax revenues with effect from 1 January 2020, where the incumbent Government announced a host of sweeping changes to the tax system in Sri Lanka. The objective of this move was to simplify the tax structure with several taxes like Nation Building tax, Economic Service Charge being scrapped and providing tax concessions, thereby enhancing the disposable income of the people to support the revival of the subdued economic activity. 

Unforeseen at the time of introducing these changes, the COVID-19 pandemic took grip of the country’s economy in March 2020 and according to statistics, tax revenue has dropped by 26% up to April 2020. Therefore, we are unable to say whether the changes implemented in January 2020 had their intended outcome. In certain cases, the reduction in taxes has increased the disposable income in the hands of the taxpayers but with wage cuts, the effects of these benefits have not truly been felt by individuals.

The decision to reduce taxes on imports has two competing evils. Lowering these taxes will lead to more competition from foreign enterprises while reducing the protection for domestic industries. Therefore, balancing the sentiments of the domestic producers and counteracting the benefits for trade liberalisation needs to be carefully analysed.

Data from industrial and developing countries show that compared with developing countries industrial countries derive proportionally twice as much revenue from income tax than from consumption tax. The data also reveal a notable difference in the ratio of corporate income tax to personal income tax. Industrial countries raise about four times as much from personal income tax than from corporate income tax. On the other hand, revenue from trade taxes is significantly higher in developing countries than in industrial countries.

A compelling fact in the comparison is that economic development tends to lead to a relative shift in the composition of revenue from consumption to personal income taxes. While it is difficult to draw a clear policy prescription on the income-consumption tax mix for Sri Lanka, the policy makers need to assess the economic consequences that a shift will have on the efficiency and equity of the tax system in Sri Lanka. 

Different tax types

Personal income tax

The contribution from personal income tax vs. corporate income tax is not readily ascertainable as the publicly available statistics have grouped both under income tax. The general understanding is that personal income tax has yielded relatively little revenue and the number of individuals subject to tax is small as some individuals manage to stay below the radar. The Annual Performance report released by the Department of Inland Revenue for the year 2019 has indicated that it has 281,105 files for individuals and 1,149,883 files for Employees paying Income tax under PAYE scheme. This is a very minor fraction of a population of 21 million.

The rate structure on how personal income tax is imposed is the most visible policy instrument to justify the commitment to social justice and equitable nature of taxation by maintaining a progressive rate structure. The progressive nature of this tax however is diluted by exemptions and deductions that benefit people with high income. If we take a few examples, exemptions on capital gain tax, deductions for medical and educational expenses, lower tax rates on interest income, all support high income earners to reduce their tax burden. 

Sri Lanka being a country which provides free healthcare and free education should consider the rationale for these additional deductions. We have seen that in certain cases medical expenses are incurred overseas or on health insurance schemes provided by foreign companies. In these cases, the deduction is allowing for a loss of tax revenue to the Government as well as supporting foreign currency flowing out of the country. Therefore, in order to establish clear progressive tax rates among different income earners, various exemptions and deductions should not be encouraged.

In certain countries, the higher tax slabs applicable on personal income tax is higher than the corporate income tax rates. This provides a strong incentive for individuals to choose to do business through a formal company structure. In Sri Lanka, professionals and small entrepreneurs generally siphon off profits through expense deductions and escape tax at higher rates. Therefore, it is good to encourage businesses to operate through companies, which are regulated under the Companies Act which mandates that the financials need to be audited and other monitoring mechanisms are in place.

Value added tax, excise and import tariffs

Value Added Tax (VAT) is a cascading tax where the tax burden is shifted along the supply chain and the tax is borne by the final consumer. It is also the highest revenue generating tax for the Government. The Cabinet of Ministers in December 2019 reduced the VAT rate from 15% to 8% and also increased the VAT registration threshold to Rs. 25 million a month from Rs. 1 million a month. These effectively reduced the cost of goods and services for the end consumer and it also reduced the number of taxpayers coming within the VAT net.

There are several shortcomings in the administration of this tax. Most often taxpayers are denied their tax credits due to system issues with the RAMIS. There are also issues with VAT paid at the point of import and the information provided by the Customs to the Department of Inland Revenue. This again results in the tax credits being denied to the taxpayer. VAT refunds are not processed expeditiously, and the taxpayers have to face severe cash flow issues because of this. Necessary measures to improve the administration of VAT need to be put in place for it to be an effective revenue collection tool for the Government.

The economic rationale for imposing excise taxes is very different from that for imposing a general consumption tax. Excise is highly selective, narrowly targeting a few goods mainly due to the fact that their consumption entails a negative impact on society. The goods deemed to be excisable are few and inelastic in demand. A good excise system should generate revenue from a narrow base with a relatively low administration cost.

Reducing import tariffs will affect domestic industries and its prices. The present Government is encouraging local businesses and also promoting exports of value-added products from Sri Lanka. Therefore, in the present circumstances, it is not likely that there will be a reduction in import tariffs.

Tax incentives

Countries around the world, grant tax incentives to promote investment into the country. However, evidence suggests that their effectiveness in attracting incremental investments beyond what would have been reached is questionable. Most foreign investors consider ease of doing business, ease of repatriating the returns, infrastructure available to do business, labour costs and cost of other inputs, political stability, transparent regulatory systems, etc. to be more important than whether there are tax incentives. Therefore, more focus should be given to these other areas in order to attract foreign investments.

Tax incentives can however be justified in a situation where it addresses some form of market drawbacks. For example, tax incentives given to industries that introduce high technology or innovation can be justified on the basis that this will confer significant benefits to the rest of the economy. These incentives however have to be structured in a way that is suited for achieving the objectives set for itself.

Tax holidays

Tax holidays are easier to administer but they have numerous shortcomings. Tax holidays tend to benefit an investor who expects high profits and would have any way made the investment even if this tax holiday was not offered. Further, tax holidays provide a strong incentive for tax avoidance, as taxed enterprises enter into economic relationships with exempt enterprises to shift their profits through transfer pricing. 

The duration of the tax holiday is also prone to be abused by re-designating existing investments as new investments. Time bound tax holidays tend to attract short term projects, which are generally not so beneficial to the economy as longer terms projects. Therefore, tax holidays should necessarily be granted to only larger projects with a longer life span. 

The tax authorities should also allocate time and resources to audit these entities to avoid tax evasion and abuse of its benefits, which yields no revenue to the Government. Therefore, tax holidays are not a very effective tool to attract investments.

Accelerated depreciation

Providing tax incentives in the form of accelerated depreciation is an effective tool in the hands of the policy makers. Accelerating the depreciation of an asset does not increase the depreciation of the asset beyond its original cost. It is merely a slight distortion done in the short term to reduce the taxable profits. This method is least costly to the Government as the revenue foregone in the early years is at least partially recovered in subsequent years of the asset’s life. Also, if acceleration is made available only temporarily, it could induce a surge in investment in the short run. Therefore, this is an effective method to grant tax incentives to promote investments.

Tax credits and investment allowances

Tax credits and investment allowances are better targeted than tax holidays for promoting particular types of investment. Their revenue cost is more transparent and easier to control. A simple and effective way to administer a tax credit system is to determine the amount of credit granted to a qualified enterprise and to recognise this amount in a special tax account notionally. In all other respects the enterprise will be treated as an ordinary taxpayer but the only difference would be that its income tax liabilities would be paid from the credits in the special tax account.  This mechanism allows the tax officers to have all the necessary information at hand, and it is a more transparent way of granting tax incentives to promote investment. A system of investment allowances is also administered in much the same way as tax credits and will achieve similar results. This also can be used by the Government to attract investments into preferred sectors.

In summary

Winston Churchill has very eloquently said: “For a nation to tax itself to prosperity is like a man standing in a bucket and trying to lift himself up by the handle.” Therefore, the best approach for sustained investment promotion is to provide a stable and transparent legal and regulatory framework and to have a tax system in line with international norms.

(The writer is Associate Director, Tax Services at BDO Partners and is an ACA, LLB (Hons) (Colombo), Attorney-at-Law and Chartered Tax Advisor.)