Declining Tax Revenue and Vital Need to Reverse Trend



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by D. D. M. Waidyasekera


The focus of economists and financial policy experts is currently being laid on the declining tax ratio to GDP and its serious consequences on government revenue and the realization of the objectives of the economic development plans as envisaged in the Mahinda Chinthanaya and the five hubs concept. This has been pointed out in numerous articles such as in the Sri Lanka Tax Review of 2012, Talking Economics Digest of the IPS, December 2012, and even recently by the Senior Minister D. E. W. Gunasekera in his discussions with the IMF. This article attempts to examine the nature of this decline, the reasons for the decline and some suggestions to reverse this trend and bring it back to a healthy situation.


Background Sri Lanka’s fundamental economic indicators continued to be relatively favourable considering the global economic downturn with successive growth rates of 8% in 2010 and 2011 though it reduced to 6.4% in 2012; inflation was maintained at single digits; overall fiscal deficit from 6.9% of GDP in 2011to 6.4% in 2012; unemployment at 4% in 2012; gross official reserves US$ 7,104 million equivalent to 4.4 months of imports in 2012; and government debt reduced to 79% of GDP from 105% in 2002.


Nevertheless, the number of negative features are worrisome. A sectoral analysis of the GDP indicates that almost 60% of the growth is in the services sector with 23% being in wholesale and retail trade and only 11% being in the vital agricultural sector. While the debt ratio in terms of GDP has reduced from a record 105% in 2002 to 79.1% in 2012, in nominal terms it has increased from Rs.1670 billion in 2002 to Rs. 6,000 billion in 2012 with domestic debt at Rs.3232 billion (42.6%) and foreign debt Rs.2767 billion (36.5%). Interest payments on public debt amount 37% of annual current expenditure. The foreign reserves should be looked at from the non-loan point of view to ensure stability. And the trade balance shows an alarming trend with a negative balance of US$3122 in 2009 increasing to US$ 9409 in 2012.


Maintaining the pace of economic development including rehabilitation of the North and East as well as providing social services such as health, education and poverty alleviation in the context of diminishing concessionary loans therefore, involves a stronger domestic revenue mobilization effort by the state particularly government finance through tax revenue.


Declining Trend of Tax/GDP Ratio


In 1963 Nicholas Kaldor argued that for a country to become "developed", it needed to collect taxes at 25-30% of GDP. In higher income countries the ratio is about 42%, middle income countries about 25-29% and developing countries around 20%. Sri Lankaperformance compares poorly with countries like Vietnam (21.1%), Thailand (17.7%) Malaysia (16.6%) but better than South Asian neighbours like India (10.4%), Pakistan and Bangadesh (7.6%).


The Table below shows the relationship between the growth of GDP and per capita income and government revenue.


(See Table I).


Total Government Revenue has steadily declined from 21 % in 1990 to 16.3% in 2006, 14.6% in 2010 and 13% in 2012. Tax revenue has dropped for the corresponding years from 19%, 14.6%, 12.9% and 11.1% in 2012. Even non-tax revenue in the form of dividends and transfers of profits from public institutions has declined from 2.3% in 2000 to 1.9% in 2012.


The irony of the situation is that while overall GDP as well as per capita income in Sri Lanka has been steadily increasing, government total revenue and tax revenue has been steadily decreasing! Obviously there is basically something wrong somewhere.


Another factor that is discernible in the tax revenue is the disproportionate share of indirect taxes to direct taxes. Direct taxes bring in only about 20% of tax revenue while the indirect taxes mainly consumption taxes like VAT, bring in 80%. The latter are inherently regressive and tend to hurt the poor disproportionately. Many other countries’ tax collection is more from direct taxes for example, Malaysia (over 60%), India (over 50%), Pakistan (around 40%), Thailand (50%) and Kenya (above 42%).


Reasons for the Decline


There are many reasons for this declining trend in government tax revenue in spite of the overall increase in GDP and per capita income. Some of these include the following.


1. Unplanned ad hoc tax incentives in the form of various tax holidays, reliefs, duty waivers etc. which is estimated to account for a tax loss of around ¼ percent of annual GDP.


2. Narrow tax base and coverage, the total number of direct tax payers in Sri Lanka being less than 3% of the population.


3. Increase in allowable expenses under Sections 25 and 26 of the Inland Revenue Act.


4. Periodic increase in tax free allowances and ad hoc reductions in rates of tax.


5. Lack of elasticity and buoyancy in the tax system, both being less than unity.


6. The grant of periodic tax amnesties. There have been 11 tax amnesties since 1964.


7. A complicated tax system and weaknesses in the tax administration system.


Policy Perspectives


In spite of the government’s efforts towards fiscal consolidation, the continued revenue shortfall has led to increased reliance of the public sector on the banking system, crowding out the resources available for private sector activity. The decline in revenue collection has raised concerns over the sustainability of the fiscal consolidation process. The expected positive fiscal outcome of recent reforms are yet to be fully realized and further efforts are needed to widen the tax base, strengthen tax compliance and simplify tax collection mechanisms. As per the government’s medium term macro economic framework, total revenue is envisaged to increase to 14.5% in 2013, 14.6% in 2014, 15.1% in 2015 and 15.03% by 2016. Overall budget deficit is expected to reduce to 4.6% and government debt 64.3% by 2016 while per capita GDP is to move toward US$ 4000.


The reversal of the declining tax revenue ratio was in fact one of the main terms of Reference of the 2009 Presidential Commission on Taxation appointed by the government.


The first item in the TOR goes as follows.


"2.1 Study the country’s tax system and make an assessment as to why revenue in relation to GDP has declined over the years and make proposals as to how a tax/GDP ratio that is comparable with other emerging economies could be achieved through a buoyant performance in tax revenue and that will also prevent the need to make to make frequent changes to taxation".


The Taxation Commission’s Report was finalized and handed to His Excellency the President in October 2010 but up to now (over 1 ½ years) has not been published and is not available to the public. This may be contrasted with the previous 1990 Taxation Commission Report of which the writer was the Secretary, which was finalized and handed over to the President on 21 November 1990 and published as Sessional Paper No 1 of 1991 within 7 months!


Tax Changes


Nevertheless the Budget proposals of 2011 appear to be largely based on the Tax Commission’s recommendation and legislated under 15 amending Acts. These were further consolidated in the succeeding Budgets of 2012 and 2013 where 21 amending Acts were passed in Parliament recently. The desired results envisaged in the Commission’s recommendations would however not be achieved if the government picks and chooses some recommendations leaving out others. Many of the recommendations across the chapters are interdependent and this should be taken into account while implementing reforms. The Commission appears to have taken into consideration the overall development priorities of the government, the projected economic future and growth sectors and the broader economic prospects of a post-war Sri Lanka. For instance, in respect of tax incentives it focuses towards a more accountable and holistic incentive regime in line with national priorities and a level playing field between BOI and non- BOI projects.


The recent tax changes made through the Budgets for 2011 to 2013 are basically based on the presumption of the efficacy of a low tax regime to promote savings and investment and particularly attract foreign direct investment (FDI) from its current 1.5% of GDP to 5% of GDP and thereby achieve a sustainable growth rate of 8-9%. The main features of these tax changes are as follows.


1. Reduction of tax rates


* Corporate tax rates reduced from 35% to 28% (other than liquor and tobacco 40%)


* Concessionary corporate rates (taxable income not exceeding Rs. 5 million) reduced from 15% to 12%


* Partnership tax rate reduced from 10% to 8%


* VAT rate at a single reduced rate of 12%


*NBT reduced to 2%


* Individuals – slabs enlarged and maximum rate reduced to 24%


* Emoluments of public servants hitherto not taxed were made subject to income tax


* PAYE tax was made the final tax for those with only employment income.


2. Tax free allowances. Increased from Rs. 300,000 to Rs. 500,000 and extended to non-resident Sri Lankan citizens.


* For those with only employment income the threshold was raised to Rs. 600,000.


* The threshold for the applicability of the Economic Service Charge (ESC) was raised to Rs.25 million per quarter from Rs.7.5 million per quarter.


3. Deductible expenses in computing assessable income enlarged such as


* Increase of depreciation allowances on plant & machinery and other assets.


* Expenses on R+D increased to 300%.


* Expenses on advertisement, foreign training etc. made fully allowable.


* The net income concept consequently enlarged.


* VAT input tax refund restriction to 85% was removed and a net set off mechanism introduced.


Continued next week


 
 
 
 
 
 
 
 
 
 
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