Political Economy of Taxation in Sri Lanka

1. Political Economy of Taxation in Sri Lanka Saman Kelegama Institute of Policy Studies of Sri Lanka www.ips.lk

2. Presentation Format • Background and Events influencing the Taxation System • Direct Taxation: Personal Income Tax and Corporate Tax • Political Economy of Tax Incentives • Indirect Taxation: VAT and Customs Duties • Decentralized Taxation • Tax Administration • Presidential Taxation Commission

3. Background • Sri Lanka had a closed economy for two decades before 1977 • Since independence in 1948, the plantation sector (largest foreign exchange earner) was taxed to maintain ambitious social welfare programmes • Export taxes amounted to nearly 4.5 % of GDP during the 1950s although it declined to about 2% of GDP by 1970-1975 period • In 1963, a major tax called Business Turnover Tax was introduced • At the time of liberalization, tax revenue per GDP was 15 % of GDP

4. Background: Post-1977 • With liberalizing the economy, some social welfare programmes were trimmed down and export taxes were gradually reduced and finally abolished in 1992 • However, revenue from import taxation increased from 2% GDP in the mid-1970s to 4% by the early 1990s due to the volume effect offsetting the low rate effect • With export taxes no longer in operation after 1992 and the BOI (formed in 1992) granting tax holidays and duty free importation, there was some revenue losses, but the government managed to offset this by initiating a privatization programme in the early 1990s

5. Taxation Milestones during 1980s to 2000s • In 1988, under the 13th amendment to the Constitution, turnover tax on the wholesale and retail sectors was made a devolved subject and allocated to the Provincial Councils. • With WTO commitments and SAPTA tariff cuts in the mid-1990s, import duties fell from 4% of GDP in the early 1990s to 3% of GDP in the late 1990s. • In 1998, the BTT (with 3 bands: 6,8, & 18) was replaced with a GST with a 12.5% single band, which could not bring the same amount of revenue as the BTT (ideally the GST rate should have been about 14% for revenue neutrality but the government did not go for this rate fearing inflationary implications). • The idea was to move to a non-cascading tax system, but the existence of a National Security Levy (1992-2002) diluted non-cascading effect of GST • In 2002, as a conditionality of the IMF Stand By package, the GST was replaced by VAT with two bands (10 & 20) and VAT’s ability to collect revenue was assumed to be stronger than GST. • With revenue losses both from external trade taxes and the major indirect tax of VAT, the government resorted to all forms of ad hoc taxes to make up for lost revenue

6. Key Characteristics of the Current Tax System • Consequently, the number of taxes operating in the economy has increased to about 25 • The taxation structure is lop sided with indirect taxes amounting to 80% of tax revenue • In 2009, tax revenue amounted to 13% of GDP • Sri Lanka’s taxation has not increased with per capita income. Why ? Tax evasion, poor tax administration, a plethora of tax exemptions, discretionary and ad hoc tax changes have contributed to this situation

7. Revenue to GDP Declining while Per Capita Income is Increasing • Tax elasticity, which measures the extent to which the tax structure generates revenues in response to increases in income without a change in statutory rates, is less than one. • Tax base has not broadened in line with increase in income or economic activities. • The reasons for this situation may be : • Rampant tax evasion • Poor tax administration • Plethora of tax exemptions • Many discretionary measures being prevalent

8. Poor Performance of Direct Taxation: Personal Income Tax • It has been estimated that only 8% of the 8 million labour force pay taxes • Public servants (including parliamentarians) that account for 1.2 million of the labour force do not pay taxes – in 1979 public servants were excemptedfrom paying taxes as the government could not afford a salary increase to public servants in line with the private sector • Only the additional incomes of the public servants were liable to taxation, but that too often not paid • Public servants are a solid voting bloc – in 2002 when attempts were made to trim down the public sector via strict hiring and VRS it was vehemently opposed and was reflected in their voting pattern at the 2004 Elections • This seems to be influencing the government when it comes to imposing taxes on public servants • Many private sector professionals (doctors, lawyers, accountants, etc.) evade paying taxes --- disincentive to fully declare income due to the fear of being harassed by the authorities and the low value placed on getting caught • Successive governments implementing Tax Amnesties have also led to tax avoidance

9. Poor Performance of Direct Taxation: Corporate Tax • Income Tax amounts to 15-20 % of tax revenue or 3% of GDP. Out of this corporate income tax amounts to 1.5% of GDP and personal income tax amounts to 1 % of GDP • Many cooperates too evade taxation • Out of the 18,000 companies registered with the Company Registrar, only 235 are listed in the share market – due to tax officials harassment if information is divulged. Thus corporate disclosure is weak • When a particular sector shows high profit during a year, they become vulnerable to taxation; e.g., mobile phone companies and banks • Banks overall taxation amounts to 60% of their profit (inclusive of a VAT !) • Such aggressive taxation has further discouraged disclosure by companies

10. Incentives and Tax Erosion • The GCEC Act superseded the Inland Revenue Act and was empowered (under Section 17) to grant tax holidays and tax concessions for FDI • In 1992, the BOI absorbed the GCEC with wider powers to grant tax holidays and concessions for local investors that satisfy BOI qualifying criteria in terms of the level of investment, export and employment creation. • Rationale was to create a market-plus incentives to offset the disincentives generated by the war related uncertainties • The powers of the BOI have been used in a very discretionary manner • Revenue losses due to BOI tax concession amounted to 1 % of GDP per annum and this was a large sum when compared to annual attraction of FDI which amounted to 1.5 % of GDP • Recognizing this, the IMF under its 2001 Stand By Package to Sri Lanka recommended that all BOI incentives should be streamlined under IRD • Up-to-date, this has not been implemented -- Why ?

11. Political Economy of the Incentive Regime • BOI incentives used to offset barriers to “Doing Business” due to political economy problems of implementing reforms in factor markets to remove such rigidities • In order to retain its authority, BOI keeps saying that in 1994 when attempts were made to streamline tax incentives there was an abrupt decline in FDI. This has been noted seriously by the political establishment • Inherent weakness in the IRD administration and the belief that the BOI incentives may get diluted due to IRD bureaucracy • A call has once again come from the IMF to streamline BOI incentives but the status-quo remains

12. Indirect Taxation:Custom Duty • With Bilateral FTAs signed with India and Pakistan, fulfilling WTO commitments, BOI granting duty free importation, tariff revenue declined to 2% of GDP by 2007-2009 • Meanwhile protectionist lobbies got stronger, development expenditures increased, and export sector demands for subsidies increased. The government saw the external border as an area where taxes could be imposed to accommodate such demands • To meet certain development expenditures following taxes were imposed on the border: (1) Nation Building Tax, (2) Port and Airport Levy, (3) Road Infrastructure Development Levy, and (4) Social Responsibility Levy • To develop certain export commodities the following taxes were implemented: (1) Commodity Export Subsidy Scheme (CESS), and (2) Special Commodity Levy • To meet demands of protectionist lobbies the following were used: (1) Custom Duty Surcharge, and (2) CESS • Very high specific duties were imposed on motor vehicles, alcohol and tobacco

13. Indirect Taxation: Custom Duty • Consequent to these taxes the overall custom duty revenue amounted to 8% of GDP by 2009 • The border taxes have got complicated and non-transparent as a result of these different taxes which operates under different tax bases • While this was a reversal of earlier liberalization to some extent, the importers did not complain much because they were benefitting from an appreciated Rupee • As a result of these high taxes, a lot of undervaluation of imports took place to evade custom duties • Revenue losses due to illegal flows at import entry points is estimated at Rs. 300 million a day

14. Indirect Taxes: VAT • VAT combined GST and NSL and came into operation in 2002 as a non-cascading tax system with two bands: 10 & 20 • The non-cascading nature once again got diluted with Nation Building Tax (NBT) coming into operation in 2008 • The rates underwent frequent changes due to industrial lobbying and revenue considerations; in 2004 rates changed to 3 bands: 5 (basic), 15 (standard), and 18 (luxury). Rates kept changing over the years and today the structure is as follows: 0% (exports), 5% (optional VAT), 12% (standard) and 20% (luxury) • Many exemptions were put into effect to please industrial lobbies • VAT brings in 33% of tax revenue and amounts to 5.5 % of GDP revenue. The BTT brought in average 6.5% GDP revenue and GST brought in on average 6% GDP revenue and VAT is yet to achievethis target after 8 years of operation

15. Other Issues on VAT • Sri Lanka is still in a learning curve in regard to VAT. Training of personnel and institutional frameworks were not put into place before VAT came into operation • This can be seen from the fact that 8 amendments were made to the VAT Act over the last 8 years • VAT threshold is an issue that is hotly debated • VAT refund is also an issue – there are computation problems and identification issues • A major VAT fraud took place in 2004 and the government lost billions of rupees as a result of it

16. Decentralized Taxes: Poor Show • As stated, Turnover Tax at the wholesale and retail level was devolved to the Provincial Councils (PCs) • Turnover Tax is the highest revenue earner to PCs – accounts for 44% of revenue (license fee from motor vehicles and excise – 13%, stamp duty – 28%, others – 15%) • But the reality is that the tax sources devolved to the PCs accounts for only 4% of the central government revenue (0.6% of GDP); in comparison, province/state revenue is above 50% of central government revenue in India/Australia and above 15% in Malaysia/Thailand • Why this situation ? – Apart from legal and constitutional provisions, the provinces lack tax administration capacity and specialized technical skills that IRD enjoys. There is a lack of motivation among PC revenue collectors in seeking new and innovative sources of revenue • This situation is partly due to the dependence on an annual grant received from the centre which almost/always ensure PCs that recurrent expenditure needs will be met

17. Problems due to Decentralization of Taxes • The existing format of fiscal decentralization to PCs has created another serious problem, i.e., inability to extend VAT to wholesale and retail trade • At present ,the VAT operates only for manufacturing, services and imports • VAT imposed on wholesale and retail trade and thereafter sharing revenue with PCs will not be possible under the current Constitutional set up. Thus there is a legal impediment to extending VAT to the wholesale and retail level • A tax system part levied by the centre and part devolved to PCs has resulted in the discontinuity in the tax system and has opened up more avenues for tax evasion and avoidance • Any increase in PC powers to collect more taxes (additional fiscal decentralization) should go with reduction in allocation of central government funds and improvement of tax collection capacity of PCs

18. Political Economy of Tax Administration • Tax payers are time and again requested to provide additional information • The IRD does not possess an entirely up-to-date information index of the existing tax payers • It is said that there are only 8 data entry operators for 1500 revenue officers • Hardly any links with the Telecom and Electricity Departments, Land Registry and Motor Vehicle Department; stronger links would have increased the information base • Full computerization is on the way – ADB Fiscal management Reform programme

19. Other Problems of Tax Administration • Several user-unfriendly forms are sent to tax payers to fill up • Payers are harassed in order to extract more taxes from them whereas evaders get away scot-free • Discretion for tax officers quite high, thus incentives for rent seeking is equally high • The need to protect their ‘empire’ is high. An attempt to form a Revenue Authority by merging the IRD with Customs Department and Excise Department in 2003 was vehemently opposed • Basic principle of “cost of non-compliance higher than cost of compliance” is yet to be put into operation

20. Presidential Taxation Commission • Recognizing these anomalies of the taxation system, a Presidential Taxation Commission was appointed in 2009 • Mandate was to simplify the tax system, rationalize tax concessions, broaden the tax base, improve coordination among revenue collecting agencies, etc. The report will be out in September 2010 • In 1990, the last Presidential Taxation Commission came out with a number of recommendations but only about 40% of them were implemented • Political economy factors always gain priority in a tax rationalization exercise • Strong political leadership can ensure that most of the recommendations of the 2009 report will be implemented • If implemented enhancing revenue in the medium term to about 20% of GDP will not be difficult.

21. Thank you