Economy: Nosediving or sailing towards safer waters?
Posted on April 24th, 2016

By Dr. Janaka Ratnasiri Courtesy The Island

Two news items on the economy of the country which appeared in The Island recently prompted me to write this. One was a press release issued by the leader of an IMF team, Todd Schneider, who visited Colombo during March 31- April 11 to hold discussions with the government on its request for a loan. The other was a news item on a statement made by the Governor of the Central Bank at a press briefing.

IMF Mission recommendations

The IMF team has observed: “Macroeconomic performance in 2015 reflected a mix of positive underlying growth momentum, the impact of domestic policies, and an increasingly difficult external environment. The fiscal deficit expanded, public debt increased, and the balance of payments position deteriorated despite an improvement in the terms of trade”.

The team has made several recommendations, among which was “other near-term steps include a clear strategy to define and address outstanding obligations of state enterprises, start broadening the tax base by reducing tax exemptions, and introduction of a new Inland Revenue Act.” The key recommendation is the reduction of tax exemptions.

Central Bank and bonds

The Central Bank Governor’s view on the economy has been that “government finances are out of sync. There is a chronic tax-shortfall and as a consequence of the vast wage increase given to public servants, our recurrent expenditure has ballooned. Thus, the need for borrowing has increased. On top of that, the external environment is less benign for emerging markets. These factors have combined to create a volatile situation. Our borrowing rates are quite high.”

Although he complains that the borrowing rates are quite high, isn’t it the Central Bank which is responsible for borrowing at high rates with the current system of depending on Treasury Bonds offered by a few finance companies called primary dealers? Previously, the government used to auction Treasury bills, in which the public could invest through commercial banks at a reasonable rate of interest. But, currently interest rates on Treasury Bills are very minimal as decided by the Central Bank and a very few would invest in them. As a result, the primary dealers have a monopoly over loans to the government and amass huge sums of money annually.

Finance minister’s stand

While the IMF team leader and the Central Bank Governor think that the country’s economy is in a bad state, the Minister of Finance thinks otherwise. At a recent function held at the Defence Services Command and Staff College at Sapugaskanda, he has said that the government is confident of steering the country’s economy towards safer waters and ushering an all-round growth within the next five years, according to a posting in the Treasury website. He has further said: “A budget is an income and expenditure statement of the government. Here we have to think of ways and means to bridge the budget deficit. A very salient factor is efficient tax collection. But, I have to state that this is a most difficult task”.

The Minister, while recognising that efficient tax collection is necessary for bridging the budget deficit, has done away with it almost totally apparently because he thinks that “tax collection is a most difficult task”. This is what he did while presenting the 2016 budget last November. There is an entire department responsible for collecting income tax and other taxes from individuals and businesses with hundreds of professionals and thousands of other staff.

Simplification of income tax

I believe these officers are provided with the latest computer hardware and software necessary for keeping track of businessmen, professionals and other wage earners and their income levels. These officers have been doing their job of collecting tax over so many decades boosting the government revenue. Therefore, how can the present minister say that it is a most difficult task? Even if it is a difficult task, as claimed can it be done away with? He has justified his proposal for reducing the tax structure to two slabs saying that it will simplify tax computation. In fact, he has given the title, ‘Simplification of Income Taxation’ for the section on income tax in his budget speech.

In the budget speech, the Finance Minister has proposed to restructure the present corporate income tax rate structure to introduce a two-rate band system with a higher rate of 30 percent and a standard rate of 15 percent. Higher rate will be applicable to the profit and income of betting and gaming, liquor, tobacco and banking and financial services, including insurance and leasing industry and the trading activities. All the other sectors will be subject to the standard rate of 15 percent irrespective of the income level. The Appendix to the budget speech shows a loss of revenue amounting to LKR 6 billion annually due to this restructuring.

For individual tax payers, the Finance Minister has proposed to increase the tax free annual threshold to Rs. 2.4 million. The PAYE tax over and above this limit to be charged at a uniform 15 percent and the taxable income will be inclusive of all the earnings by the employee with no exemptions. This method and rate will also be applied to individual income earners instead of the present progressive rate of up to 24 percent. The loss of revenue due to this restructuring is estimated as LKR 4 billion annually.

Enhancing VAT regime

To compensate for these losses, what the minister has been doing is to increase the rate for value added tax (VAT) and bring new items under it. Prime Minister Ranil Wickremesinghe, while the Finance Minister was out of the country, tabled in Parliament some amendments to the Minister’s proposals and that was tantamount to expressing no confidence in the Minister. One amendment was to suspend the proposals on Corporate and Non Corporate income tax revisions by one year. Existing 2015 rates will apply to these two taxes in 2016, but the new proposals will be applied next year. Another amendment was to increase the VAT rates. There is much public outcry against this decision and President Maithripala Sirsena himself has taken exception to it.

As the its very name suggests, VAT is expected to be computed on the value added to the product sold, and I believe this is how it is computed in other countries. However, in Sri Lanka, the computation of VAT according to procedures laid down in the VAT Act is very complex; some items are exempted and it is imposed on services where no value addition takes place. Further, the present system has so many opportunities for people both inside and outside the department to siphon off money from the state coffers.

According to the Ministry of Finance Annual Report for 2014, the VAT collected in 2012, 2013 and 2014 has been LKR 230 billion, 250 billion and 275 billion respectively. With the total government revenue for the same period being LKR 1,061 billion, 1,137 billion and 1,195 billion respectively the average VAT collected during this period has been 22.27%. With the new enhanced rate, the government may want to rake in about LKR 400-500 billion as VAT from the rich and the poor.

According to latest media reports, imposing taxes like VAT will be decided by a committee including the President, the PM and apparently the proposal for the 15% VAT will be put on hold till then. This committee should also consider restructuring the income tax collection from both individuals and the corporate sector, enabling a larger section of the higher income earners to contribute to the government revenue by this means, as described below.

Enhanced income tax in place of VAT

If the Finance Minister wishes to make the tax system simple, the first thing he should do is to do away with the present VAT system and restructure the income tax collection where the higher earners both individual and corporate are required to pay higher taxes, which is the norm in most countries. Also, the exemption limit should be brought down to a figure that prevailed a few years back and the balance taxed on a progressive scale rather than at a flat rate as proposed in the last budget. The lowest slab could be 5 or 10% while the highest slab is, say, 40%.

The income tax collected from individuals and the corporate sector during 2012, 2013 and 2014, according to the Finance Ministry’s Annual Report has been LKR 98.1 billion, 121.1 billion and 122.3 billion respectively with an average collection of 10.0% only. Most countries, both developed and developing, income tax is one of the key sources of revenue to the government and contribute much more. However, for reasons best known to the Minister, he is proposing that the income tax be further reduced with the exemption limit raised to LKR 2,400,000 a year, making the richer folk happy. It is difficult to understand why the Minister wants to mollycoddle the rich.

If the Finance Minister maintains the income tax structure at the level it was before he took over and adopts measures to get more individuals and businesses earning more than the exempted amount to pay their tax dues, the government can increase its income tax revenue substantially. If he did that the people would accept it without any protests. Considering the huge amounts of profits some companies are making as reported in business pages of print media occasionally, to tax them on a flat rate of 15% is a disservice to the country. It may be a difficult task, but the government has to do it if it is to survive. If the IR Department can do this efficiently, it may not be necessary to levy indirect taxes like VAT on everybody.

Improving the external trade

The IMF team has also referred to “increasingly difficult external environment”, probably meaning reduced revenue from exports. In a series of articles on the national economy published by the writer in The Island of 10, 11, 14 and 28 of August, 2015, several ways and means of increasing the export revenue were shown, particularly in the areas such as tea, fisheries, electronics and energy, where all other countries in the region are far ahead of us in generating export revenues. Lack of vision, lack of political will and unethical practices are among the barriers for Sri Lanka achieving such targets.

Our political leaders have to go on mission to multinational agencies and foreign governments and depend on local financiers seeking bailout funding for want of any long term programmes to improve the economy.

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