Sri Lanka tax regime too complex; fresh reforms needed: IMF

COLOMBO (EconomyNext) – Sri Lanka has to simplify taxes and make a new generation of reforms to allow the private citizens to engage in more economic activities, an International Monetary Fund official said.

"Sri Lanka is at a critical stage of transition where private-sector led growth must start," International Monetary Fund (IMF) Resident Representative to Sri Lanka Eteri Kvintradze told members of National Chamber of Commerce of Sri Lanka in Colombo.

Sri Lanka has made significant macroeconomic gains over the last few years but the business environment has to be liberalized and private sector has to play crucial roles, she said.

Rent Seeking

Critics say under former president Mahinda Rajapaksa’s rule the private citizens played a secondary role with a coercive state driving economic growth through heavy infrastructure development and consumption.

The military also engaged in business activities such as building and operating hotels, operating shops, eateries, running airlines with taxes taken from the people.

Big businesses had to invest time and money just to get close to the administration with many analysts warning that rent-seeking had become the norm, critics say.

Under cover of trade protectionism and ‘domestic production’, others amassed vast wealth at the expense of the poorest of the society, building monopolies.

While the state got involved in many activities, it was unable to deliver the absolute minimal service to the people in return for their taxes, which is rule of law and justice.

Though a comprehensive tax reform program was devised under an IMF program, the report was not made public and it is not known how much of it was actually implemented.

Economic Freedom

"Sri Lanka needs to liberalize its business environment," Kvintradz said. "To do this, Sri Lanka needs to go for a second phase of taxation reforms.

"The IMF has always maintained that tax revenue was weak (falling as a percentage of GDP for over a decade) with too many tax concessions.

"The tax system is still very complicated. The tax system needs to be predictable, consistent and fair. Sri Lanka needs to have fewer taxes.

"This will help attract more investors because they will find more comfort in a predictable and fair tax system rather than in a complicated system even with the concessions."

Other analysts and economists however have pointed out that the supposed reduction of the revenue gross domestic product ratio (if it is correct, as there are doubts whether the GDP number is inflated) would be a significant achievement of the Rajapaksa administration.

The revenue to GDP ratio is shows the ultimate burden of the state on the people, reducing the total share of their earnings people are free to spend or more importantly save to be invested in the creation of future jobs.

Tax Burden

Any taxes taken from citizens, will reduce savings and money will be diverted to state consumption or low return or loss making state enterprises reducing capital formation for investment and the citizen’s own discretionary spending.

Top Indian economist B R Shenoy (who also worked in the IMF) in a report in the 1960s to Sri Lanka’s then administration pointed out that a revenue to GDP ratio at 22 percent at the time was too high to allow for private citizens to grow business.

"Taxation in Ceylon is too high and needs to be scaled down," Shenoy wrote in his report, ‘The Economic Situation and Trends in Ceylon – A program for Reform."

"Currently revenues appropriate about 22 percent of GDP which is double the average in India and well above the average in Germany, Italy and the US."

In West Germany at the time, revenue to GDP was 13.7 percent and Japan 13.9 percent the document said.

Analysts say it is important not to increase state revenues to GDP if more freedom economic freedom is to be given to citizens, especially if there are any intentions to create a style ‘social market economy which gave birth to the so-called German Economic Miracle.

Shenoy was the only economist in India to show the dangers of Nehru’s Soviet-style heavy industry based economic planning financed with printed money. Unfortunately all his predictions came true, though he was ostracized at home for saying so at the time.

The current delayed economic recovery in Europe compared to the US is also partly due to higher state taxation and spending, critics say though some countries have become surprisingly efficient at delivering state services to the people.

Spending Pace

The problem with raising revenue to GDP is that expenses will keep pace or increase. In the 1960s during Shenoy’s time expenditure item of Sri Lanka’s rulers’ were food subsidies.

Now the main expense of the rulers is salaries and pensions of state workers which account for about half the tax revenues.

While state salaries have to be raised to make up for the loss of purchasing power especially from the sharp currency depreciation in 2012 – the overall public sector, especially the security apparatus has to be trimmed or allowed to reduce with retirements, analysts say.

When revenue go up, the elected ruling classes will think up more programs and agencies to spend the taxes on.

Shenoy aptly pointed out the danger of rulers raising more taxes from the people.   

"Past experience in Ceylon, which is in line with the experience in virtually all parts of the word is that under a democratic set up political and other pressures are heavily on the side of spending by the government.

"When revenues increase, under the weight of these pressure, expenditures too increase to meet, or even exceed, Revenue collection.

"There is a real danger that any program for increased Revenue collection may be attended by a corresponding increase in the expenditures of the government and little may be left of the additional Revenue to cover Budget deficit.

"..[A]ny program on increased revenue collection would impinge heavily on national savings," Shenoy added.

Predictable Regime

Meanwhile the Kvintradz said the private sector should stop asking for tax concessions and lobby as a group for a predictable, consistent and fair tax regime.

"That the tax system is very complicated is because individually, businesses lobby for different concessions and the government has tried to balance all these expectations," she said.

"It is better to lobby for fewer taxes keeping in mind the need to maintain macroeconomic and fiscal stability."

President Maithripla Sirisena’s administration is expected to present a budget on January 29 where protectionist Nazi autarky style taxes (Ernährungsautarkie) on several foods is to be cut.

The administration is also expected to raise salaries and pensions, as predicted by economists like Shenoy and others, though a 2012 currency depreciation has made life difficult for workers in the state and private sector alike analysts say.

"I hope the IMF won’t mind us for proposing all these measures, but we will do this without increasing expenditure, but by putting an end to wasteful and corrupt projects of the previous government," minister for democratic governance Karu Jayasuriya told the same forum.

Jayasuriya was a former president of the chamber and top corporate leader before he took to politics in the 90s.

"We need to do this. It’s not just about rising incomes but bringing down the cost of living. I have met several people who couldn’t afford to three meals a day," he said.

Jayasuriya said the private sector need no longer spend time and resources to get in to the good books of ruling politicians.

"We promised good governance, rule of law, a right to information bill and transparency," Jayasuriya said.

"But we cannot do this alone. The private sector must embrace these concepts too."