ECONOMYNEXT – Sri Lanka has a plethora of tax, energy problems and other regulations that have blocked export diversification, and discriminates against services exports which is the next big thing where there is an innovation frontier and big margins.
The Trump taxes, which are based on a completely mistaken ideology – that trade deficits are bad or that taxes can reduce imports and trade deficits, something that Sri Lanka’s policy makers also believe – has nevertheless made the case to make the economy more efficient and exports more diverse more urgent.
Export Diversification
Sri Lanka’s exports cannot diversify because only industries in the Board of Investment zones which can get tax free imports can survive.
They operate like hothouse plants, without being harmed by import duties on their inputs.
Even those firms have to get some inputs, including chemicals for which Sri Lankan firms have agencies, at duty paid prices.
No company, no SME outside the zone can hope to become export competitive and become a big company, like companies in East Asia which operated outside zones did after the entire nations were made a ‘free trade zone.’
In Sri Lanka, due to excessive taxes on steel, tiles and other building materials, even building a hotel is prohibitively expensive.
Singapore in the 1960s, and Viet Nam most recently, are examples. Viet Nam’s booming agriculture sector, backed by SMEs outside zones are an example.
Taiwan saw a second wave export boom in the late 1970s after import duties were cut as deflationary policy led to zooming foreign reserves after the collapse of the Bretton Woods. Cutting import duties is a quick fix; results will come over a period.
Services Diversification and Tax Hit
Sri Lanka’s services export tax has come at a bad time. Sri Lanka has started taxing before the sector is fully developed.
Taxing individuals who are exporting is also counterproductive, as they are likely to keep money in Dubai or other locations. It is individual savings that will ultimately drive investments and also the ability to repay debt.
The tax is likely to contribute to lower inflows to the country and loss of 18 percent VAT when the money is spent here.
The money may end up in Dubai (there are visa systems in the state) and elsewhere. When these people set up SMEs and grow, they are likely to be in Dubai.
A lot of companies and people moved to Dubai during the last currency crisis and the ecosystem of friends and relatives are now in place.
The government should at least make it a final tax. Dubai’s income tax rate is 9 percent, (there was no tax earlier), and Sri Lanka’s 15 percent is not too bad, if it is a single rate.
In any case, due to inflation reducing their salaries and general instability, qualified services talent with globally marketable skills, will continue to move out, as their aspirations are different and it is the next big global growth area.
The most productive citizens engaged in the frontiers of innovation should not be punished.
At least making the services tax a final tax is a quick fix.
End Apartheid Energy Pricing
Sri Lanka now has discriminatory and complicated energy pricing where services are charged higher prices than industry in extremely discriminatory pricing.
The regulator has taken apartheid energy pricing too far. What sins services or commercial businesses have committed to be punished by the regulator in this fashion nobody knows.
Services are the next big thing in exports, but not yet recognized. All the academic papers are based on global supply chains (hard goods) that developed from the 1960s to 1990.
Services developed primarily after tariff rebalancing of the 1990s (led by the US to be sure to stop ludicrous out payments) that reduced international telecom costs.
Like ‘cash crops’ were at one time opposed by traditional agriculturists and (opposed by nationalists), industry (opposed by rural nationalism/agrarianism) services are now opposed or at least viewed with disdain by those with a manufacturing fetish, including Trump.
One advantage of manufacturing is that due to division of labour, it is easy to move thousands of people with a couple of weeks of training into the factory floor to do a few specific tasks.
Services need higher levels of skills even for the lower level workers, so that is not so easy. AI may change things, but even so.
Sri Lanka has steeply lower electricity prices for industry than services. That does not make sense even if the services were not the next big thing in exports, purely on equity considerations. The gap should be reduced.
Move energy to VAT to make exports as competitive as East Asia
Sri Lanka also has imports taxes on fuel, coal and also numerous excise taxes on fuel.
Remove import duties on coal, crude oil or refined energy products. Sell diesel, furnace oil or any other fuel to the CEB without excise duty so that the CEB can get fuel and lubricants at clean prices.
Maintain some level of excise taxes on road fuel (exporters also use roads so they have to pay) but impose 18 percent VAT on the fuel and reduce excise tax accordingly.
Then export manufacturers and export services would be able to reclaim VAT at least for both electricity and furnace oil and diesel or industrial kerosene.
That will reduce their energy costs.
If there is a deflationary collapse in the US, even a smaller one, coal and fuel prices would fall further.
Reforming energy pricing and moving some excise to VAT is a quick fix. If there is a deflationary collapse in the US pushing down coal prices, the shift will be easier.
Lower tariffs for renewables based on competitive bidding – something that East Asian nations are also doing – is a step in the right direction which, however, has to be carefully managed.
Sri Lanka should not keep energy prices high when global coal prices fall, as the country will lose to East Asian nations with a coal base and lower priced renewables.
Food Processing Exports
Eliminate food taxes, particularly maize and soybean which go for animal feed. Sri Lanka can also import feed grain from the US and reduce the trade deficit.
More importantly, however, Sri Lanka can reduce or completely eliminate protein malnutrition among poor children as soon as maize, soybean and sorghum is allowed tax free.
In Viet Nam an entire generation has grown taller, after self-sufficiency in food was abandoned.
Children’s or anyone else’s nutrition is a combination of food prices and real incomes.
If the central bank continues to depreciate the currency, and destroy real wages, malnutrition of poor or marginal income brackets will set in.
Due to self-sufficiency ideology, dairy products are also extremely expensive in Sri Lanka.
Sri Lanka can become an exporter of poultry, and farmed fish.
Sri Lanka has a lot of waterways and also coastal regimes, but its use is highly restricted or regulated. People in villages also do not have water rights like in East Asia where some people actually live on the water.
Agricultural Land Reform
The Paddy Land Act is another draconian piece of legislation that has harmed freehold rights of farmers and prevented them from going into alternative crops let alone moving agricultural land to industry.
In the Wet Zone where low sunlight has made rice yields lower and there is high urbanization, paddy is no longer practical. There are pockets of fallow land due to labour shortages and other problems.
There is no sense in blocking these land – many of which are now in isolated blocks – from moving to other areas.
The entire East Asia developed by transferring former agricultural land to industry and commercial use.
Even outside of Paddy there are severe restrictions on moving land to other uses.
Logistics Reforms
Due to Sri Lanka’s location, logistics is a low hanging fruit. Unlike Singapore, Sri Lanka is neither a shipping hub nor a logistics hub, except for transshipment.
Sri Lanka has restrictions in foreign ownership of warehouses and shipping agencies.
Once a regional office has been set up in India for example, Sri Lanka will not be able to get it to move.
Sri Lanka also has restrictions in other areas, including blending tea. UAE has become a centre for tea blending, and now claims the top spot in re-exports.
Regional Hub
Sri Lanka can be made into a regional hub like Singapore or Hong Kong or Dubai, going beyond logistics.
But companies will not set up regional offices if there is a central bank pushing 5 percent inflation and currency crises every 3 years based on spurious monetary doctrines, also triggering social unrest.
It is difficult to get companies to set up regional offices in Sri Lanka if there are exchange controls.
Visas are another problem. Regional offices in particular need senior officers as well as mid-level management and executive offices to be moved around fast. Their spouses should also be able to work when they go there and send children to school.
This type of business sector could boost demand for real estate and other services.
Monetary stability is a must for regional offices or ‘hub’ operations. Singapore, Dubai and Hong Kong have monetary stability due to currency board style regimes.
Colombo Port City is offering monetary stability with currency competition. With more relaxed visas it could be a location for regional offices.
However, buildings are yet to come up.
There is no need to make only the Port City a hothouse with monetary stability. Property in other tax paying areas could also be made attractive.
Government Spending and Tax
Sri Lanka’s income tax rates in general are too high. East Asian countries with monetary stability have 20 percent income tax rates in general, with Singapore lower.
Value added tax rates are also lower.
Until recently Dubai had no income tax, leading to high generation of jobs and investment. One can sympathise with Donald Trump for harking back to pre-1913 US when there was no Federal Income tax.
The strategy should be to move from direct to indirect tax as the UK realized and acted as far back as 1979 after coming to the brink of default.
The key to lower tax rates is to keep government expansion in check and stop giving jobs to unemployed graduates. Salaries have to be raised, no question, but the number of workers has to be brought down.
Viet Nam is slashing the public service by 20 percent. This year, 100,000 persons will be moved out to lower the salary bill according to the strategy unveiled by new President To Lam.
Every government agency has been asked to reduce the workforce by 15 to 20 percent by the Prime Minister. About 5 ministries will be eliminated. This goes counter to the revenue-based fiscal consolidation ideology of the International Monetary Fund.
Sri Lanka is planning to hire 30,000 persons, while having 100,000 development officers with no office space to sit in.
The deficit will be protected by curbing spending, rather than taxing productive people to be spent on unproductive expenses.
The agriculture sector and fisheries sector is getting fertilizer and fuel subsidies while IT freelancers, who developed a business sector without government help, are getting taxed.
It makes no sense.
There will be some help needed for dislocated workers, which should be the priority of the government.
People in distress should be helped, and tax money should not be given for production subsidies or to give jobs to able bodied young people who are unwilling to work in the productive sector.
The government should scrap pensions and move to a contributory pension system for new workers so that government finances are more transparent.
Strong Man Syndrome
There is a strong likelihood that President Donald Trump will get kicked out like Gotabaya Rajapaksa. He has upset powerful business interests. The public will feel the heat shortly.
They will soon realize he is not the savior that they thought he was.
He was elected amid inflation and monetary instability, excessive leftism and intervention including green policies, which has led to the loss of confidence in liberalism.
It is the standard ‘strong man’ syndrome that grips countries with monetary instability (depreciation/inflation) which also brought Hitler into power.
Even if Trump loses power, in trying to solve a non-existent problem – the trade or current account deficit – there will be a fallout in Sri Lanka as it will not happen very fast.
In the meantime, Sri Lanka should remove the obstacles that kept the country from progressing. There are a lot of regulations that need to be cut.
However, if there is rotten money with an abundance reserve regime of excess liquidity and flexible high inflation targeting, all bets are off.
Another default and another Trump/Gota will be the outcome. Unless flexible average inflation targeting (FAIT) is scrapped in America, there is no hope for the US also. (Colombo/Apr07/2025)