Political economy of taxation and tax reform

Following are excerpts from a paper presented by Chairman, Presidential Commission on Taxation Deshamanya Prof. W. D. Lakshman at this year’s Institute of Chartered Accountants of Sri Lanka (ICASL) Tax Oration held on Thursday:

It was with great pleasure I accepted your invitation to deliver this year’s tax oration. When you extended this invitation to me last year, it was a few months after we had commenced our work in the Taxation Commission. I did not want to accept your invitation at that time and promised to oblige this year. I thought by this time we would have wound up the work of the Commission, having submitted the final report to the appointing authority.

That expectation has not yet been realised and the Commission’s analytical work and policy recommendations are still in the realm of confidentiality. I have chosen the topic “political economy of taxation and tax reform” for this oration because ‘political economy’ rather than just ‘economics’ or ‘politics’ makes me think more rigorously about determinants of tax revenues and about constraints affecting taxation policy and its reform. A tax system, to be effective and sustainable within the institutions of governance, has to fit well within the existing conditions of political economy.

Let me begin by briefly indicating to you what I understand by political economy. It is not just some loose combination of economics and politics. Several ideas together would characterise an analysis in political economy:

• Recognition of historical time and the interaction of social, political and economic forces, particularly the association between politics and economics, believing that economies do not operate in social, cultural and historical vacuums. The possibilities for adjustment or change within an economic system, particularly during a given short period, are conditioned by what has been inherited from the past.

• Recognition of the significance of power in determining socioeconomic phenomena and the existence of conflict between different interest groups. Property relationships and institutions thus become significant. The behaviour of an economic system reflects, in part, the deliberate exercise of power, not only individualistically, but by a broad class of people in response to particular situations.

• Political economy incorporates a theory of the state as an influential force which is as effective in ordering the economic system as the market. The control of markets is much more significant than the control by the market. The Government is not external to the economic system but an integral part of that system.

• Further, political economy examines interconnections among states, communities and individuals, casting doubt upon simple and rigid distinction between the domestic and the international.

An analysis of taxation, tax policy and reforms in tax policy and tax administration are subjects which cannot be understood and analysed as purely technical subjects. Any study of taxation related themes, carried out within a framework of political economy, is bound to be richer in content, than a mere technical analysis.

The four points noted above as principal elements in a political economy analysis are all of significance in a study of taxation related subjects. My presentation from this point onwards would aim at expanding on the above four themes in respect of taxation and tax policy.

My talk on political economy of taxation and tax reform today, as you all would expect, is to be on Sri Lanka. There are certain important taxation-related problems, we in our Taxation Commission deliberations, have tried to grapple with over the last fifteen months or so. These present day problems emerged through an historical evolution.

Let me try to take you to the early 1970s – not too far away, I hope, in recent history. We were then in what is widely described as a “control regime” or as the Indians would have said, under a “control raj” or a “permit raj”.

These controls were over a wide-ranging subject area – price controls, investment controls, industrial permit controls, trade controls, foreign exchange controls, and so on. There were many reasons for these multifarious controls.

Of these, the guiding principle of development, which lay behind them, was “national” development, with the word national highlighted. It was national development through protecting domestic enterprises from foreign competition and nurturing them to gradually be able to compete effectively with foreign producers of comparable products.

This import substitution framework is a well tried out national development strategy, which succeeded in almost every country that has achieved successful development in the past, as authors like Cambridge’s Ha-Joon Chang so effectively argue using the European (including the British), American and East Asian experiences in his ‘Kicking Away the Ladders’.

For many reasons, the details of which I do not have the time here to bore you with, this import substitution strategy did not work effectively here and the very expression had become a dirty word. It is thus understandable why the Government of J. R. Jayewardene elected in 1977 “opened up” and “liberalised,” I would argue, even throwing the baby with the bath water.

The earlier strategy viewed the state as occupying (or that regime wanted to make it so) the lead position (sometimes called the “commanding heights”) in the Sri Lanka economy. The state took over many different types of activities and in the process, the government revenue to GDP ratio at the time was maintained around 25 per cent.

The bulk of this revenue came from taxes levied on the private economy as normally happens in a market economy. There were also Government revenues raised from public enterprises, many of which were making profits at the time.

The policy framework established at end of 1977 remained stable in terms of the major policy elements but went through numerous changes over time. The following different phases could be identified: (i) 1977-82, (ii) 1983-89, (iii) 1990-1994, (iv) 1995-2005 and (v) 2005 to date.

During most of this period, the rhetoric was that the “private sector” was the principal engine of growth and market mechanism the main resource allocation and mobilisation mechanism. Yet the role of the state sector remained significant and powerful, particularly during 1977-1990 and after 2005.

There were two sub-periods which witnessed a “Government expenditure led” or simply “State led” process of economic growth. No privatisation of State-owned enterprises took place during these two sub-periods. The SOEs were not privatised in the earlier period because of various practical constraints which the underlying political economy gave rise to.

After 2005, privatisation has been abandoned as a declared policy position. The evolution and transformation of post 1977 policies of liberalisation moved gradually towards the prototype neo-liberal policy package advocated by the international financial institutions like the IMF and World Bank.

It was during the early 1990s that the two IMF structural adjustment facilities, SAF and ESAF, operated subject to relevant policy conditionality. I do not wish to talk about the economic and social consequences of these neoliberal policies of excessive liberalisation, privatisation, and globalisation plus of course the contemporary conditions of violence and insecurity.

What I wish to focus on here is the impact of these policies on tax revenues. The excessive liberalisation and “small” Government policies after 1995 led to a gradual relative drop in government revenues. The decline in the revenue GDP ratio from the 20-25 percent range that was familiar in Sri Lanka began during this period. It reached the 14-15 percent ratio by the mid-2000s.

There has been a decisive shift in the development policy framework since 2005. The revenue decline noted above has drawn serious attention of authorities as hampering this post 2005 policy shift.

=The State was made to acquire a greater leadership role in the economy, including the lead role in investments for infrastructure development. Privatisation of State owned enterprises was abandoned. None of this implied any abandonment of the market orientation of the economy and the importance of private sector (both domestic and foreign) investments in directly productive activity areas.

=“Indigenous” enterprise, big and small, has begun to receive greater thrust and promotion within the new development strategy in an apparent policy of building up a strong national bourgeoisie.

=The vision of Sri Lanka to become important as a five-fold global hub (naval, aviation, commercial, energy and knowledge) provides the basis for the extensive investment and activities of the government.

=Enhanced economic growth has become the priority, but together with equitable distribution, regionally and in terms of income groups. The slogan of Sri Lanka to become the ‘Next Asian Miracle’ guides the growth acceleration initiative – the “economic war” – while there is commitment to poverty alleviation and MDGs and the developmental work in the formerly conflict-affected areas of the country in the east and the north.

The widened role of the Government within the economy produces a tendency for both recurrent and capital expenditures of the government to increase consistently. A widely felt concern can be seen in government circles about the need to raise Government revenues.

Taxation is the overwhelmingly dominant component among revenue sources of the Government. Buoyancy in tax revenues is therefore critical in the financing of many Government-sponsored capital expenditure programmes, as well as many other necessary recurrent expenditure programmes.

Resource mobilisation lies at the heart of economic development. And among various means of resource mobilisation (e.g., forced savings, inflation tax, manipulation of terms of trade, etc.), taxation is the mechanism which helps raising revenues without attendant repayment obligations, dependent however on state capability.

The maintenance of economic stability helps in sustained economic development and matters of taxation are of critical significance here. I do not believe that budget balancing is the best fiscal policy for a government irrespective of underlying conditions and the prevailing dynamics of the economy.

The adoption of a balanced budget strategy would imply that the Government places itself on an unnecessary straitjacket. Deficit financing figured in the Government budgets in Sri Lanka almost every year during the 60-odd years since political independence.

Yet fiscal prudence demands that budget deficits are maintained at manageable levels, in harmony with requirements of reasonable conditions of domestic price stability and external equilibrium. This again leads to a highlight on the significance of revenue buoyancy.

Of the two sides of the budget equation, the revenue side and the expenditure side, the easier would perhaps be for a government to operate on the latter. My reading of fiscal advice from international financial institutions was that, during much of the post-independence period, the government was advised mostly to cut down on the so called welfare expenditures – either to cut down on consumer subsidies like those on essential food items or to charge user fees for freely offered Government services.

In the kind of holistic development that was pursued in Sri Lanka no Government had practiced this advice seriously. There is no dispute, a lot of slack exists in government expenditures and action to reduce such waste could help expenditure reduction without adverse effects on desired popular objectives. This path to achieve fiscal consolidation has not been pursued with any serious intent by any government so far. So the attention now is on raising revenues and the need to do this is seriously felt and action is being envisaged for achieving this objective.

Any important change in taxation involves a change in the existing pattern of income distribution. So taxation is not just a technical issue of defining the tax base, determining the tax rates and setting up tax free allowances.

Administration of the tax is important but issues of taxation go beyond this subject and beyond issues of its collectability. It raises important distributional issues and some social group is bound to be adversely affected in any significant tax reform. It could affect the popularity of political decision makers and could thus influence elections.

Tax policy may be viewed as raising issues of “class” conflict. As different income groups are differently affected, the imposition of a new tax or the widening of the coverage of an existing tax is bound to generate opposition from the groups that will suffer income losses and support from those that will benefit from the tax.

We have heard many talking of Government as a neutral arbiter or a benevolent agent. But, even if one does not go as far as Marx to argue that the state is an instrument of the social class in power and works to the benefit of this class, there is no difficulty whatsoever to see that the Government serves the interests of certain groups more than those of others.

The influence of interest groups and lobby groups on tax policy is well known. Regarding any controversial tax measure, a decision is eventually arrived at often after balancing of the size and strength of the interest and lobby groups who favour it and the size and strength of those who oppose it.

Another important aspect of the distribution issue associated with taxation and tax reform is the pattern of distribution of incomes or other tax bases like imports, in terms of elements like ethnicity or race, religion etc. in divided societies. Regional distribution issues also can become relevant in taxation-related discussions.

Tax policy decisions may have been taken with neutral perceptions about these divisions but when the relevant decisions are implemented they may be seen as affecting these different groups and different regions in a discriminatory manner. The society may be divided in terms of occupations/ jobs, e.g. public sector workers versus private sector workers.

In respect of issues of taxation in Sri Lanka, a good example for tax policy decisions based on such occupation-based social divisions is the income tax exemption of official remunerations of public officials since 1979.

This group has become a strong interest group working to preserve this privilege. Working on the principle of equal tax treatment of those in similar position, there were recommendations made against this special favour extended to public servants in the 1990 Presidential Commission on Taxation. Perhaps because of the lobbying power of public servants as an interest group, or because of some other reasons seen as of significant relevance against implementation of this recommendation, the official emoluments of public servants continue to be income tax exempt to date.

From the point of view of national development, taxation plays a very significant role in resource mobilisation for capital accumulation and promoting human development. The political economy aspect here is the state capacity to raise the required resources through taxation.

The success or failure of raising required taxes provides one of the principal indicators and measurements of state capacity, power and political settlements in a society. Fiscal crises that emerge in some countries are indicative of state capacity constraints in raising required revenues.

Designing tax systems that can provide incentives for growth, can meet distributional demands and can increase revenue collection is central to state viability and effectiveness. It has been argued in the general context that “in post-war economies, reconstruction of the revenue base is essential for the reconstruction of a viable state and sustained peace” (Jonathan Di John in ‘The Political Economy of Taxation and Tax Reform in Developing Countries’). The significance of this statement appears strongly in the present Sri Lankan context.

The question of a developing country’s tax capacity can be analysed using any one or a combination of three approaches – economic, administrative, and political economy approaches. The first approach may focus on the nature and structure of the economy – e.g. the size of agriculture in total output and employment, extent of informal activities and occupations, extent of presence of small establishments, a share of wages in total national income, and so on.

The administrative approach focuses on the efficiency and effectiveness of the tax administration system, with efficiency referring to costs of tax collection and effectiveness to the extent to which taxes are predictable, transparent, and enforced by a fair judicial system. The political economy approach to tax, briefly discussed above considers taxation system as a product of history and the institutional capacity of states.

In a country like Sri Lanka, an important political economy factor influencing resources that could be mobilised through taxation is the role political party organisations. These political parties play a mediating role in conflicts among different groups in the society.

Political parties operate in the milieu that links state and civil society. Depending on where their allegiance lies, they could either provide political support in favour of or organise antagonistic movements against tax-based resource mobilisation efforts of a Government. Tax struggles are seen by some scholars as the oldest type of class struggle. Ideological commitments of political parties seem to determine how successful the government of a political party would be in raising tax revenues.

It is said that according to historical evidence, in present day advanced countries historically, governments run by leftist parties could mobilise and support higher tax levels and more progressive tax systems than those run by conservative parties. There is perhaps some truth in this argument in our context as well.

The last set of points which I would raise here before my concluding remarks later refer to the global context of taxation. First, having graduated to a “lower middle income” position in the well known World Bank country classification, Sri Lanka does not any more qualify for ready access to development assistance funds in the form of grants and loans on easy conditions from the donor community, as it used to be a few years ago when it was in the “low income” category.

In order to finance the “economic war” the government has turned to certain bilateral country sources for project funding. Certain strategic changes in the country’s international political relations have also been brought about in the process.

In addition, funds have been raised from international capital markets by means of sovereign bonds. In this exercise, the relatively large Standby Arrangement of the IMF, approved in July 2009, has helped by improving the country’s creditworthiness internationally.

In spite of criticisms of the opposition groups and some independent financial analysts, these fund raising practices do not appear to have led to any serious threat to financial stability. Because of stronger income or revenue side improvements, it is forecast that the overall balance-of-payments and public finances would improve in the short and medium terms.

Sri Lanka’s long-term foreign currency sovereign credit ratings have been raised by relevant international agencies. Whatever the methods adopted in the short run to mobilise the required funds for financing development projects, eventually it is tax revenue buoyancy that is required because tax revenues are needed to repay in future the loans taken today with interest as well as to meet the continually rising new resource needs of the Government.

The other aspect of global tax influences emanate from commitments made in numerous agreements the country has signed with international organisations and mutually with a number of different countries in respect of regional country groupings. The influence of WTO regulations and the commitments made under bilateral free trade agreements on foreign trade taxes is of particular importance in this regard.

To sum up, the Government is faced with the need to raise revenues from the current level of 14-15 per cent of GDP to higher levels of above 20 per cent of GDP that are visible in more developed countries in the world and were familiar to Sri Lanka itself prior to the early 1990s.

Given the widened role taken up by the Government in the economy, such stronger resource mobilisation effort is essential. This ought to be done without adverse impacts on the processes of investment and on living conditions of the low and middle income groups. The best that can be done is to widen the tax base rather than increasing tax rates.

The main theme emerging from a political economy perspective on taxation, including as an essential ingredient an historical view, is that while technical and administrative aspects of tax reform are crucial, an understanding of the sustainability of reforms requires an understanding of how reforms become legitimate and accepted by the people.

Because taxation affects incentives and distribution simultaneously, tax reform requires either a degree of social consensus that such policies are in the collective interest and/or it requires a State with the ability to coerce those who challenge its tax reform proposals. The focus on institutional designs and other technical issues of tax would be incomplete if the political nature of taxation is ignored. Of critical importance is the development of bargaining mechanisms between the State and elite groups, who generally control much of the economy’s production activities.

FT Quotes

• ·         The Government is faced with the need to raise revenues from the current level of 14-15 per cent of GDP to higher levels of above 20 per cent of GDP that are visible in more developed countries in the world and were familiar to Sri Lanka itself prior to the early 1990s. Given the widened role taken up by the Government in the economy, such stronger resource mobilisation effort is essential. This ought to be done without adverse impacts on the processes of investment and on living conditions of the low and middle income groups. The best that can be done is to widen the tax base rather than increasing tax rates. The main theme emerging from a political economy perspective on taxation, including as an essential ingredient an historical view, is that while technical and administrative aspects of tax reform are crucial, an understanding of the sustainability of reforms requires an understanding of how reforms become legitimate and accepted by the people
  
   
• ·         In order to finance the “economic war” the Government has turned to certain bilateral country sources for project funding. Certain strategic changes in the country’s international political relations have also been brought about in the process. In addition, funds have been raised from international capital markets by means of sovereign bonds. In this exercise, the relatively large Stand-By Arrangement of the IMF, approved in July 2009, has helped by improving the country’s creditworthiness internationally. In spite of criticisms of the opposition groups and some independent financial analysts, these fund raising practices do not appear to have led to any serious threat to financial stability... Whatever the methods adopted in the short run to mobilise the required funds for financing development projects, eventually it is tax revenue buoyancy that is required because tax revenues are needed to repay in future the loans taken today with interest as well as to meet the continually rising new resource needs of the Government
  
  
  
   
• ·         My reading of fiscal advice from international financial institutions was that, during much of the post-independence period, the Government was advised mostly to cut down on the so called welfare expenditures – either to cut down on consumer subsidies like those on essential food items or to charge user fees for freely offered Government services. In the kind of holistic development that was pursued in Sri Lanka no Government had practiced this advice seriously. There is no dispute, a lot of slack exists in Government expenditures and action to reduce such waste could help expenditure reduction without adverse effects on desired popular objectives. This path to achieve fiscal consolidation has not been pursued with any serious intent by any government so far. So the attention now is on raising revenues and the need to do this is seriously felt and action is being envisaged for achieving this objective