ECONOMYNEXT – A World Bank report on Sri Lanka’s tax has slammed value added tax hike, though rate cuts and money printing for potential output targeting by macro-economists led to a collapse of the rupee and inflation that was the core reason for a dramatic rise in poverty.
The rhetoric against VAT may have negative consequences for Sri Lanka for which the poor will eventually pay a higher price if it leads to a repeat of tax cuts like in 2019, observers say.
The recent steep rise in Sri Lanka VAT was also a result of having to pay the salaries of a bloated public sector, including 100,000 development officers and other unemployed graduates hired into public service, who apparently do not have offices to sit and work according to statements made in parliament as well as a legacy large military from a civil war.
Currency Collapse
Sri Lanka’s dramatic rise in poverty came after a cut in value added tax which partly helped trigger a currency crisis, as open market operations replaced lost taxes, not an increase in VAT.
Sri Lanka also has draconian protectionist taxes on rice, maize and grains that are keeping food prices up 50 percent or higher than the region for the poor in particular.
The impact on cigarette and alcohol taxes are not known, but many poorer households and not so poor have shifted to moonshine and beedi.
The World Bank report has advocated more direct taxes (such as income taxes) which critics say takes spending choices away from the people and gives discretion to government officials and bureaucrats.
Sri Lanka’s hike in value added tax has “contributed to rising costs for poorer households”, the report said, repeating a narrative often pushed by the political class and socialists in Sri Lanka.
The tax measures may have increased poverty by 3.9 percent between 2022 and mid 2023, the report said.
“Moreover, fiscal reforms led to rising living costs and declining incomes,” the report said.
“In particular, removing electricity subsidies and shifting to cost-recovery utility pricing had a greater impact on poorer households, contributing to a 5 percent decrease in disposable income for households in the poorest decile, and a 1.9 percentage point increase in poverty.”
The rise in utility prices was required because macroeconomists depreciated the currency after printing money raising cost of production.
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In countries with currency instability, classical economics, primarily Hume’s price specie flow mechanism is rejected and currency defence is blamed.
However currency defence is deflationary in the first instance, and is usually offset by newly printed money by macro-economists to maintain a policy rate, leading to more credit and reserve losses.
Sri Lanka also has a 5 percent inflation target which was devised by macroeconomists to push up the cost of living of the poor each year which will reduce disposable incomes unless salaries go up faster. Amid deflationary policy the 5 percent inflation target was not met.
The compounding effect of a 5 percent inflation target on the poor is not known.
In Sri Lanka ‘competitive exchange rates’, also pushed by macroeconomists, has triggered industrial strife and social unrest for decades.
Socialist Taxes
The World Bank report mentioned the gini coefficient, however analysts say advocating taxes not for revenue but Western socialist ideology of flattening people’s incomes through re-distribution and government spending has had bad repercussions in the past.
Sri Lanka has ‘taxed the rich’ for decades since independence under more socialist administrations in line with the doctrine advocated by the World Bank and International Monetary Fund in recent years including housing taxes, but got nowhere while East Asian nations that did the opposite with lower tax rates including VAT but with monetary stability have got ahead.
Shantayanan Devaranjan, now a professor at Georgetown University, who was a senior World Bank economist for many years and has wide experience in developing countries, has said there is scant evidence to support that VAT is generally regressive.
“But the fact of the matter is that if you look at the way most VATs are administered, first of all they tend to have exemption on some basic items that the poor consume, such as food,” explained Devaranjan in an interview with EconomyNext in 2023.
“So the poor are paying less VAT because of the nature of the goods that they consume, than the rich.
“I’ve done studies, in Thailand, Philippines and Indonesia, and several other people have done studies all over the world, where we look at the effect of the VAT.
“We look at the net effect of the tax, we take into account the fact that certain goods are exempt, and what people are paying on net terms and what we find is that VAT is moderately progressive or neutral.”
RELATED : Sri Lanka benefits from VAT, no evidence to support regressive claims
The World Bank report gave an analysis saying VAT formed a lower percentage of higher income groups, though there was no clarity whether the total VAT they paid was higher in volume.
There was also no clarity whether the lower incidence (percentage share) of taxes of higher income groups was due to savings, which reduces the consumed part of income with consumption being the base on which VAT is charged.
Savings or foregone consumption is the basis of investment, which brings jobs and lasting reductions in poverty.
VAT is also superior to income tax in another way in that it generates more revenue than income tax.
“This is true around the world,” Devaranjan says. “In most countries income ranges about 1 or 2 percent of GDP including in Sri Lanka.
“Whereas VAT can raise 6, 7, 8 percent of revenue. Simply as a tool for revenue, the VAT is therefore an efficient tool.”
A person who buys a car in Sri Lanka for example will pay more taxes in a single transaction than a poorer person may spend in many years.
However there is a socialist-ideological belief that higher income earners should pay an increasingly higher share of taxes for the state and bureaucrats before an economic decision to spend is made by the earner.
Income tax for example is charged before an economic decision is made by people who earn the money unlike VAT which is charged after economic freedom is exercised to boost economic activity.
East Asian countries have monetary stability and have eschewed competitive exchange rates for lower inflation, have lower rates of tax overall, including corporate income tax of around 20 percent and VAT around 14 percent, analysts have pointed out.
“East Asia is heavily into VAT,” Devaranjan also explained at the time. “They rely much more on VAT than income tax. Europe is mostly VAT. The US is the one exception. The US has a very elaborate income tax structure that catches a large number of tax evaders. Sri Lanka cannot afford that kind of machinery.”
Unlike income tax – corporate income tax in particular – which can have wide swings in the credit cycles perpetuated by rate cuts and inflationary policy, VAT brings steady revenues to meet state expenditure.
The World report made no mention of import taxes which keeps food prices high and does not give any taxes to the government but diverts potential taxes to the producers and collector oligopolies through arbitrage.
A reference was made to ‘indirect taxes’ which presumably includes import duties.
Food Taxes
In the first half of 2025, Sri Lanka earned 77 billion rupees from a special commodity levy which is charged on most foods. The SCL was originally started by then Finance Minister Bandula Gunawardene in the run up to the Fed’s housing bubble to stop various import duties from cascading as commodity prices shot up.
In Sri Lanka rice is taxed at 65 rupees kilogram or 65,000 rupees a tonne which is about 215 dollars a tonne at an exchange rate of 302 rupees per US dollar.
According to the FAO, in August Indian 5 percent broken rice was quoted at 377 dollars a tonne, Pakistan 5 percent broken 361 dollars, Indian 5 percent parboiled 368 dollars and Thai parboiled 100 percent 392 dollars.
In Sri Lanka Nadu rice (a parboiled rice) is wholesaled around 200 rupees kilogram or around 662 dollars amid the taxes and an import ban which is a difference of around 300 dollars a tonne.
Even if only SCL of 65,000 rupees a tonne is considered, the ‘tax’ which Adam Smith called an ‘absurd tax’ that is paid by the people for basic rice amounts to around 300 billion rupees, for last year’s domestic rice production of 4.63 million kilograms.
He pointed out that import controls would reduce competition and “by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens.”
Corporate Tax
The report advocated a minimum corporate tax rate of 15 percent. Other than firms that get tax holidays, Sri Lanka’s corporate tax rates are around 30 percent.
Sri Lanka engages in ad hoc tax hikes under IMF programs each time inflationary policy triggers currency crises.
In the first currency crisis triggered by the central bank around 1953, (part of the inflation came from the US money printing to buy Liberty Bonds) which was fixed without an actual IMF program, Sri Lanka steeply raised taxes including corporate taxes.
The central bank then advocated tax incentives.
“In the past, Government has had to raise taxes primarily with the object of securing more revenues,” the central bank report for 1953 said when the current ideology on income distribution was not prevalent.
“The view is now widely held that the present tax rates on personal and corporate incomes are so high as to deter enterprise. If these high rates are maintained, it will be desirable to grant suitable tax reliefs on approved investment expenditures as an incentive to enterprise.”
A range of import duties were also raised, some as a surcharge which were then absorbed into new tax rates, the 1953 report said.
Unlike now however, in the age of ‘revenue based fiscal consolidation’ where no restraint is placed on the state, bureaucrats or politicians to spend prudently, but only tax the public, the central bank report also urged cutting spending. (Colombo/Sept 12/2025)