ECONOMYNEXT – Sri Lanka’s President Gotabaya Rajapaksa knew revenue will be lost by tax cuts but he considered it an investment, and an 8 percent tax rate slashed from 15 percent, will remain unchanged for 5 -years, a top official said.

“The President promised this nation a new taxation strategy,” President’s Secretary P B Jayasundera said at a seminar titled Colombo Development Forum this month.

“He knew the revenue will be lost but he considers that lost revenue as an investment in the country.

“Therefore, outdated archaic taxes have been given up. Singe rate VAT has been introduced. New corporate structure has been introduced.”

Sri Lanka’s last administration came to power promising to simplify the tax system but got caught up in an International Monetary Fund drive to increase revenue to GDP to some arbitrary number and put more money in the hands of politicians and bureaucrats.

Illiberal Consolidation

The IMF’s ‘revenue based fiscal consolidation’ was unusually illiberal or statist in that it placed no emphasis on cutting spending, in a country where the public sector was already unaffordable to the working productive sectors.

The lack of emphasis on cutting spending anti-austerity style went against all principles of natural justice where the burden of fiscal consolidation has to be spread at least partly on the state workers and not only on the general public, in a full sellout to the anti-austerity brigade some critics say.

Under the illiberal ‘revenue based fiscal consolidation’ spending was ratcheted up from 17.3 percent of Gross Domestic Product in 2014 to 18.7 percent by 2018, reversing trend of steady contraction seen since the end of a civil-war in 2009 when spending was close to 24 percent.

Revenues were raised from 11.6 percent of GDP to 13.5 percent with a plethora of niggling withholding taxes and royalties added despite as the hten administration which promised to reduce total number of taxes and simplify the system watched on the sidelines.

Personal income tax which was a 15 percent proportionate tax was ratcheted up to progressive rate close to 30 percent in giving way to the left, with predictable results on the electorate.

Un-anchored Monetary Policy

What remained of rule based monetary policy was jettisoned with ‘flexibility’ being given priority under the IMF program.

Monetary instability worsened with a highly unstable peg labeled the ‘flexible’ exchange rate (no-credible external anchor) was combined with ‘flexible’ inflation targeting (no credible domestic anchor) leading to currency crises in 2015/16 and 2018, triggering output shocks.

Under flexible inflation targeting, inflation, the real effective exchange rate, the call money rate, the yield curve and an output gap was targeted with large volumes of excess liquidity injected. In 2018 buy/sell dollar rupee swaps were used to inject liquidity and pressure the peg.

Under flexible exchange rate and call money rate targeting, the administration was forced to firefight the external imbalances, imposing import controls Nixon shock style, and de-railing a plan by the then-administration to have freer trade.

RelatedSri Lanka controls imports in ‘Nixon-shock’ move to protect soft-pegged rupee

In December 2019, a new administration cut taxes without going to parliament. The taxes are expected to be legislated shortly.

2019 ended with spending to GDP rising to 19.4 percent of GDP and the deficit had worsened to 6.8 percent, with the IMF program already on hold.

In 2020 with tax cuts, a Coronavirus crises and more monetary instability, growth and tax revenues had taken another hit. The current administration is also focused on firefighting the balance of payments, with money printing worsened.

5 Year Tax Fix

The budget deficit is estimated to be in the double digits in 2020, though some spending has been cut by putting on hold state worker salary hikes proposed by the last administration.

However tens of thousands of under-educated workers and unemployable graduates are being hired.

Meanwhile Jayasundera said the value added tax cut from 15 to 8 percent will stay for another 5 years and income taxes will not be changed, but the deficit will be brought down to percent in the medium term with economic growth.

“We are assuring the tax regime that we have instituted will not change. For the next 5 years VAT is 8 percent,” Jayasundera said.

“Income tax is whatever the rate we have gazetted. No other taxes will be brought in. Custom base taxes will be rationalized. We need much more efficient, transparent, compliance, friendly, tax regime and that is given.”

“If you want raise the turnover, raise the volume, raise the GDP. That is what this is all about. The Treasury secretary is not allowed to make any changes in taxes.”

In the meantime revenue shortfalls are being covered with monetized debt (liquidity injections), leading to a steady run on forex reserves, despite sweeping import controls. (Colombo/Apr03/2021)