Tax cuts: Control the damage before the unconventional stimulus backfires

Damage control exercise by Finance Ministry

In a background of some contrasting signals from various parties regarding the generous tax cuts introduced by the Government, the Finance Ministry has attempted to do a damage control exercise by issuing a press notice last week. The confusion was on its short- and medium-term outcome, specifically how it would serve as a stimulus package. 

Cabinet co-spokesperson Dr. Bandula Gunawardena, hailing the new tax cuts asserted, among others, that it would in fact leave more cash in the hands of both individuals and businesses enabling them to overcome the economic hardships they had been undergoing for some time. 

The public at large welcomed it because they thought that they would have more cash to spend. The business sector, including the chambers, watched the developments cautiously without making a too quick judgment. At the same time, Moody’s Rating Services branded the stimulus package as ‘credit negative’ implying that it would lead to a downgrading of the country’s present rating of B1/Stable unless it is managed properly. 

Fitch Rating warned that the stimulus package would derail the budget disciplining exercise started by the previous Government. A similar view was opined by IMF’s Sri Lanka Country Head too. In a similar note, the outgoing Central Bank Governor Dr. Indrajit Coomaraswamy has indicated that the stimulus should not undermine the debt sustainability exercise being carried out by the Government. 

The World Bank’s Chief Economist for South Asia, Hans Timmer, delivering a public lecture at the Central Bank’s Centre for Banking Studies was more polite in expressing his concerns. He said that though there may be reason for fiscal stimulus, there is no space for it in Sri Lanka and the policy makers should strike a proper balance between fiscal stimulus and the need for preventing the overheating of the economy – a situation where the aggregate demand rising faster than the aggregate supply. 

What it means is that if Sri Lanka’s potential growth is low, stimulating the economy either through fiscal policy or through monetary policy would simply increase the demand causing the prices to increase and the exchange rate to fall. Bothe these outcomes are what the Government wants to prevent from happening at any cost. 

Meanwhile, Sri Lanka sovereign bonds maturing in 2027 and 2028 witnessed a fall in market prices by about 4 US cents raising market interest rates from 6.8% to 8%. Against these contrasting signals, Finance Ministry, to its credit, has assured that the programme to consolidate the budget will not be halted and the Government will stick to its budgetary targets by cutting down the unnecessary expenses It had also reiterated that it would continue to negotiate with IMF to save the present Extended Fund Facility or EFF of which the final instalment is due to be released in mid-2020. 

The irrelevant Laffer Curve for Sri Lanka  

As pronounced by the Cabinet co-spokesperson Dr. Gunawardena, the rationale for the tax cuts has been to lower the rates and rope in more taxpayers so that the overall revenue of the Government would increase over the time. 

This logic is indeed in line with what is known as the Laffer Curve, named after the American economist Arthur Laffer. According to Laffer, there is an optimal income tax rate up to which the revenue will increase and if the rate shoots over that optimal rate, revenue will begin to fall. Hence, when a country is in the revenue falling region, the reduction of the income tax rate would certainly increase revenue instead of reducing it.  

Empirical studies have shown that this optimal income tax rate stands at around 70% for most of the countries. Sri Lanka’s marginal income tax rate is just 24% and therefore, it has not yet reached the level of taxation that prompts an increase in revenue if the rate is cut. 

Hence, it is not the Laffer Curve which may have prompted Sri Lankan authorities to cut tax rates but some other consideration. That is to provide an additional income to the hands of the taxpayers, catch more liable people into the tax net and increase the tax revenue by getting more people to pay taxes. This last goal had been expressly mentioned in the election manifesto.

According to press reports, the tax cut is intended to address both the individual taxpayers and the corporate taxpayers. 

Promised relief to individuals may backfire

In the case of individuals, the presently available tax-free allowance of Rs. 1.2 million in two slots, namely, Rs. 700,000 for employment income and Rs. 500,000 for non-employment income, will be increased to Rs. 3 million. The applicable marginal tax rate will be reduced from the current 24% to 18%. 

At the same time, the advance tax collection mechanisms involving the Pay-As-You-Earn or PAYE out of employment income and the withholding taxes or WHTs on interest, dividend, and non-employment income at 5% at source will be abolished. All these are final taxes at present and therefore, once they are abolished, all individual taxpayers are required to pay income tax on those incomes too provided the total income is higher than Rs. 250,000 per month or Rs. 3 million per annum. 

The applicable tax rates are 6% on the first Rs. 250,000, 12% on the next Rs. 250,000 and 18% on the balance. The current timeline introduced by the Inland Revenue Department or IRD is to pay the due tax at the end of every quarter and make a final adjustment tax payment at the end of the year. Hence, individual taxpayers who receive both employment and non-employment income will have to make the due tax payment to IRD quarterly. 

According to the current law, it is mandatory for every taxpayer to inform IRD in advance the estimated tax liability in every quarter and pay the taxes accordingly. Hence, the abolition of PAYE and WHTs will pass the burden of remitting the due taxes to IRD from employers, banks and other payment agencies to individual taxpayers. In the case of employers and so on, the payment software used by them have already been adjusted to deduct these taxes and remit to IRD. Hence, it is not a burden for them to make those payments. However, the individual taxpayers, especially those of the small retail type, will have to make an extra effort to meet the tax payment obligations in time. 

Expansion of VAT coverage

With regard to businesses, the most explosive tax cut has been for the Value-Added Tax or VAT. That tax had been introduced as an improvement to the Business Turnover Tax or BTT which had reigned the country’s indirect taxes since the early 1960s. BTT was a multi stage tax which taxed businesses again and again when they moved from one stage of production to another. For instance, consider the tyre industry. 

Assume that it has four stages of production just for clarity of explanation: rubber manufacturing as a raw material, wholesale trading of rubber, tyre manufacturing and retailing those tyres to final users. If input rubber worth of Rs. 100 is sold by  wholesalers to tyre manufacturers for Rs. 150 and the tyre manufacturer converts it to a tyre worth of Rs. 200 and the retailer sells it to the final user for Rs. 250, a BTT of 10% would impose taxes in the following manner causing higher prices for each of the users in the production and consumption chain: The rubber producer Rs. 10 which is added to the price which he charges to the wholesaler; the latter prices it at Rs. 160 charging a BTT of Rs. 16 from the tyre manufacturer. His price is not Rs. 200 but Rs. 216 over which he collects a BTT of Rs. 21.60 from the retailer by adding it to the price. The retailer’s buying price is now Rs. 237.60 and comes up with a selling price of Rs. 287.60 over which he collects a BTT of Rs. 28.76 from the final user. Accordingly, the price payable by the final user is Rs. 316.26. The total BTT collected by the Government is Rs. 76.36. If it is a value added tax of 10%, it is equivalent to a tax on the final product which is simply Rs. 25. 

Because of this position, if the governments are to earn a higher tax revenue, they have to adopt a multitude of strategies. That was what each successive government did in the past: increasing the rate, expanding the number of VAT payers by lowering the turnover limit to Rs. 12 million per annum for eligibility and bringing more economic activities under its base. 

Will VAT changes help the Government?

It in fact did the trick and the revenue increased from Rs. 171 billion in 2009 to an estimated Rs. 600 billion in 2019. The yield also increased from 3.5% of GDP to 4% of GDP during this period. From the Government’s point, VAT has, therefore, been an efficient tax. However, more tax revenue means more resentment by taxpayers. The present Government appears to have yielded to that resentment and introduced a sweeping change to VAT. Thus, the rate has been reduced from 15% to 8% with the exception of VAT on banking, insurance and financial services. 

At the same time, the eligibility threshold of turnover has been increased from Rs. 12 billion per annum to Rs. 300 billion taking out a large number of small businesses from the tax net. It is not a relief to businesses but a relief to consumers since VAT, being an indirect tax, is supposed to be passed on to the latter. 

In addition, condominium property has been exempted from VAT, while tourism sector businesses have been exempted for five years provided they increase the use of local inputs to 60% of their revenue. The former will boost condominium sales which are not doing well due to general economic slowdown. 

The latter will not help tourism sector businesses since VAT is, as a general rule, passed onto the tourists. It will therefore reduce the costs of tourists and encourage them to seek Sri Lanka as a tourist destination. Thus, it could have been implemented as an incentive for tourists without bringing the 60% input requirement into it. The revenue loss due to VAT reduction is estimated to be around Rs. 300 billion in 2020. 

Relief to businesses

The other business-related tax cuts are the abolition of Economic Services Charge or ESC, Nation Building Tax or NBT and the Capital Gains Tax or CGT. The Telecommunication Levy which stands at 15% now has been cut by a fourth so that new Levy rate becomes 11.25%. It is not a revenue earning by the Government but by the Telecommunication Regulatory Authority or TRC. 

Further, the Debt Repayment Levy which had been imposed on banking and financial institutions as a way to get their support to repay debt has been abolished. There have been production related tax cuts as well. Accordingly, income from agriculture, fishing and livestock has been exempted from income tax. Similarly, income from Information Technology or IT enabling services has also been exempted from taxes. Professional income being received by Sri Lankans in foreign exchange and interest income on foreign currency deposits have also been exempted from income tax. 

The estimated loss in revenue

Based on the estimated revenue of the Government in 2019 from the taxes which have been abolished or reduced, the immediate loss of revenue to the Government ranges between Rs. 650 billion and Rs. 680 billion. This loss amounts to a third of the Government revenue or about 4% of GDP. In the medium term, a part of this could be recovered by roping in more taxpayers into the tax net, but in the short term, the Government will have to raise these funds by borrowing from the market after increasing the Government’s borrowing limits through Parliament. 

But when such a large amount is put on the market, there will be pressure for interest rates to rise, defeating the Government’s objective of keeping interest rates below 10%. The immediate jump in the interest rates could be avoided if the same is borrowed from the Central Bank but it would amount to increasing the money supply putting pressure for domestic prices to increase and exchange rate to depreciate. It thus will defeat the Government’s objective of keeping inflation below 5% and strengthening the exchange rate. This is a policy paradox which brings in harmful outcomes whatever the course of action the policy makers would be taking. 

The plight of individual taxpayers

The abolition of the PAYE tax and the WHT on interest and non-employment income will have a dubious effect on individual taxpayers. At present, the PAYE tax collected at the time of earning income and WHT collected at 5% at source are considered as final tax payments. Hence, after they are abolished, the individual taxpayers are required to indicate them in the annual tax returns and pay taxes at the normal tax rates if they have a tax file or open up a file and pay taxes if they do not have a tax file provided the amalgamation of incomes from all these three sources exceed the minimum tax-free allowance of Rs. 3 million. 

There is a relief by way of a reduction in the marginal tax rate from 24% to 18%. However, this relief is being subsumed by two factors. One is the addition of two income sources which had been declared as final tax payments earlier to income which is now subject to income tax. The other is the reduction of the tax slabs from Rs. 600,000 earlier to Rs. 250,000 now. As a result, even at lower rates, a taxpayer will have to pay more now compared to the previous system. It would in fact increase the total tax income as expected by the Government.

Conditions for success

The success of the present tax reduction in raising revenue in the medium term will therefore depend on the efficiency of the Inland Revenue Department in roping in more taxpayers and collecting taxes from them.

With the new Revenue Administration Management Information System or RAMIS and the arrangement to pay taxes through LankaPay operated by LankaClear, it is not a serious issue for IRD to upgrade its systems and handle more tax files with the available human resource base. But it takes time and unless it is handled carefully, the stimulus package will backfire causing a large gap in the budgetary financing. Avoiding this pitfall should be the topmost priority of the Gotabaya Rajapaksa administration.

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected])