ECONOMYNEXT – Sri Lanka’s steep income tax hikes are seen as a gamble with the corporate sector and individuals are expected to be hit hard by the move as investable capital turning into government current spending.
The move could discourage and strangle investments, analysts say, though they see increasing tax revenue as well as cutting state spending as the key tools to reduce deficits and debt in the medium term.
The tax hikes come after Sri Lanka declared sovereign debt default in April this year. Sri Lanka ran out of reserves after authorities cut taxes and printed money for stimulus for two years ignoring repeated warnings on debt and external viability.
The new tax hikes will take the country beyond a pre-2019 tax regime with higher corporate income tax rates and higher marginal personal income tax rates though value added tax at back at 15 percent.
Spectacular bracket creep
The tax free threshold is 100,000 rupees a month, as in pre-2019, but the rupee is now worth about half its previous value, with the dollar collapsing from 182 to 360 to the US dollar in a spectacular case of bracket creep.
The highest marginal rate is 36 percent from 24 percent in 2019.
The corporate taxes which were at a 28 percent have been increased to 30 percent under the new amendments. The concessional 14 percent for exports will no longer be available.
Former President Gotabaya Rajapaksa soon after his election in 2019 slashed Value Added Tax (VAT) to 8 percent from a 15 percent along with several other tax cuts like Pay As You Earn (PAYE) tax, withholding tax on interest, debit tax on banks and financial institutes and Nation Building Tax (NBT) on household goods.
However analysts say some tax hikes are necessary.
“If you bring in any reforms, there must be a consensus with the people. If you forcefully go to do this then it's going to backfire abundantly,” Umesh Moramudali, an economic analyst, told EconomyNext.
“In an overall view, everyone in general is benefiting. Without the tax increases there will be no IMF finalization and we won’t move on to recovery.”
Moramudali further stated that, without tax hike Sri Lanka will further print money or borrow more, which has more adverse impacts compared to higher tax rates in an economy.
“For the smooth functioning of the economy, it’s a huge task,” he said.
“But in the absence (of tax), the situation is likely to be much worse,” he said, adding that the policy errors are the main reason for the current situation of the country.
While the public took news of value added tax hikes with little protest, there has been heavy push back on income tax. People pay value added tax as they spend, little by little, but income taxes are charged on unspent money and they have to be paid in lump sums.
Burden of the State
Members of the public see a bloated public service stuffed with unemployed graduates, and dozens of ministers and state ministers are questioning why they should pay tax for an inefficient state.
However the other side of the coin is that, when people pay income tax and feel it, they may become more conscious of expanding state spending such as giving free jobs to unemployed graduates and loss making state enterprises in the future, according to some observers.
One of the problems in that led to the current crisis, some critics have said was “revenue based fiscal consolidation”, an unusual strategy where spending based consolidation (cost cutting) a necessary part of what is generally referred to as fiscal consolidation was abandoned.
As a result spending to GDP went up from 17 to around 20 percent of GDP from 2015 to now.
Trevor Mendis, an economic strategist, said the people of Sri Lanka have inadequate income with escalating costs of living, that creates a burden to a certain sector in the economy mainly for parents with children sent for education overseas and senior citizens.
“In the long term, the tax base, tax files and tax rates must be increased to sustain economic recovery,” Mendis said.
Sri Lanka’s government revenue to gross domestic product (GDP) has fallen to a record low of 8.7 percent in 2021 compared to over 20 percent in the 1980s, according to official data.
“Kimbula Bunis”
The opposition claims the taxes are too high at this time.
Opposition legislator and the Chairman of the Committee on Public Finance (COPF), Harsha De Silva said the government should implement affordable tax rates to do further reforms before people get into the streets.
“What the government is doing is similar to shoving a kimbula banis down the throat of the people which is like choking and dying,” Silva told a media briefing last week.
Others say businesses also need a better environment to operate and it is balancing at.
Murtaza Jaferjee, the Chairman of Colombo based think tank Advocata said that incentives for private business firms to generate profits is more important than paying taxes after profits are earned.
“Government’s incentives should be focused on reducing regulatory hurdles and minimizing the time to complete projects and reduce upfront taxation,” Jaferjee told EconomyNext on the downfall of taxation.
“If it is discouraging risk taking, the focus should be on expanding the economy of the country,” he said.
One problem with income tax is that they the government takes away investible capital before the investment decision is made.
As a result in countries with little or no income tax, such as in the GCC area and Middle East and at one time in the Maldives where there was no income tax, employment exceeds the population by many times. Sri Lankans seek jobs in such countries.
Unlike turnover based taxes, corporate income taxes can be volatile and pro-cyclical.
In countries like the US income tax including personal income tax form a large share of taxes. However the US does not have value added tax (some states have value added tax with California highest at 7.25 percent) and import duties are around 3 percent.
Sri Lanka however has VAT, another cascading tax called social security levy, very high import duties and another border tax called cess to give high profits to political powerful domestic producers living very little money in the hands of individuals. In Europe which has VAT, import duties are low.
The income tax proposals will be presented to the parliament to be voted on and it is not clear whether changes will be made given the critical state of state revenues.
President Wickremesinghe has said wealth tax may also be on the way, another potential minefield where people may be forced to pay tax on assets that do not generate cashflow. (Colombo/Oct13/2022)