Transcript Political Economy of Taxation in Sri Lanka

Saman Kelegama
Institute of Policy Studies of Sri Lanka
www.ips.lk
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Background and Events influencing the
Taxation System
Direct Taxation: Personal Income Tax and
Corporate Tax
Political Economy of Tax Incentives
Indirect Taxation: VAT and Customs Duties
Decentralized Taxation
Tax Administration
Presidential Taxation Commission
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Sri Lanka had a closed economy for two decades
before 1977
Since independence in 1948, the plantation
sector (largest foreign exchange earner) was
taxed to maintain ambitious social welfare
programmes
Export taxes amounted to nearly 4.5 % of GDP
during the 1950s although it declined to about
2% of GDP by 1970-1975 period
In 1963, a major tax called Business Turnover
Tax was introduced
At the time of liberalization, tax revenue per GDP
was 15 % of GDP
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With liberalizing the economy, some social
welfare programmes were trimmed down and
export taxes were gradually reduced and finally
abolished in 1992
However, revenue from import taxation
increased from 2% GDP in the mid-1970s to 4%
by the early 1990s due to the volume effect
offsetting the low rate effect
With export taxes no longer in operation after
1992 and the BOI (formed in 1992) granting tax
holidays and duty free importation, there was
some revenue losses, but the government
managed to offset this by initiating a
privatization programme in the early 1990s
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In 1988, under the 13th amendment to the Constitution, turnover tax on
the wholesale and retail sectors was made a devolved subject and
allocated to the Provincial Councils.
With WTO commitments and SAPTA tariff cuts in the mid-1990s, import
duties fell from 4% of GDP in the early 1990s to 3% of GDP in the late
1990s.
In 1998, the BTT (with 3 bands: 6,8, & 18) was replaced with a GST with
a 12.5% single band, which could not bring the same amount of revenue
as the BTT (ideally the GST rate should have been about 14% for revenue
neutrality but the government did not go for this rate fearing inflationary
implications).
The idea was to move to a non-cascading tax system, but the existence
of a National Security Levy (1992-2002) diluted non-cascading effect of
GST
In 2002, as a conditionality of the IMF Stand By package, the GST was
replaced by VAT with two bands (10 & 20) and VAT’s ability to collect
revenue was assumed to be stronger than GST.
With revenue losses both from external trade taxes and the major
indirect tax of VAT, the government resorted to all forms of ad hoc taxes
to make up for lost revenue
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Consequently, the number of taxes operating in
the economy has increased to about 25
The taxation structure is lop sided with indirect
taxes amounting to 80% of tax revenue
In 2009, tax revenue amounted to 13% of GDP
Sri Lanka’s taxation has not increased with per
capita income. Why ? Tax evasion, poor tax
administration, a plethora of tax exemptions,
discretionary and ad hoc tax changes have
contributed to this situation
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Tax elasticity, which measures
the extent to which the tax
structure generates revenues
in response to increases in
income without a change in
statutory rates, is less than
one.
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Tax base has not broadened
in line with increase in income
or economic activities.
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The reasons for this situation
may be :
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Rampant tax evasion
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Poor tax administration
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Plethora of tax
exemptions
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Many discretionary
measures being prevalent
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It has been estimated that only 8% of the 8 million labour force pay taxes
Public servants (including parliamentarians) that account for 1.2 million
of the labour force do not pay taxes – in 1979 public servants were
excempted from paying taxes as the government could not afford a
salary increase to public servants in line with the private sector
Only the additional incomes of the public servants were liable to
taxation, but that too often not paid
Public servants are a solid voting bloc – in 2002 when attempts were
made to trim down the public sector via strict hiring and VRS it was
vehemently opposed and was reflected in their voting pattern at the
2004 Elections
This seems to be influencing the government when it comes to imposing
taxes on public servants
Many private sector professionals (doctors, lawyers, accountants, etc.)
evade paying taxes --- disincentive to fully declare income due to the
fear of being harassed by the authorities and the low value placed on
getting caught
Successive governments implementing Tax Amnesties have also led to
tax avoidance
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Income Tax amounts to 15-20 % of tax revenue or 3% of
GDP. Out of this corporate income tax amounts to 1.5% of
GDP and personal income tax amounts to 1 % of GDP
Many cooperates too evade taxation
Out of the 18,000 companies registered with the Company
Registrar, only 235 are listed in the share market – due to
tax officials harassment if information is divulged. Thus
corporate disclosure is weak
When a particular sector shows high profit during a year,
they become vulnerable to taxation; e.g., mobile phone
companies and banks
Banks overall taxation amounts to 60% of their profit
(inclusive of a VAT !)
Such aggressive taxation has further discouraged
disclosure by companies
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The GCEC Act superseded the Inland Revenue Act and was
empowered (under Section 17) to grant tax holidays and tax
concessions for FDI
In 1992, the BOI absorbed the GCEC with wider powers to grant tax
holidays and concessions for local investors that satisfy BOI
qualifying criteria in terms of the level of investment, export and
employment creation.
Rationale was to create a market-plus incentives to offset the
disincentives generated by the war related uncertainties
The powers of the BOI have been used in a very discretionary
manner
Revenue losses due to BOI tax concession amounted to 1 % of GDP
per annum and this was a large sum when compared to annual
attraction of FDI which amounted to 1.5 % of GDP
Recognizing this, the IMF under its 2001 Stand By Package to Sri
Lanka recommended that all BOI incentives should be streamlined
under IRD
Up-to-date, this has not been implemented -- Why ?
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BOI incentives used to offset barriers to “Doing
Business” due to political economy problems of
implementing reforms in factor markets to remove
such rigidities
In order to retain its authority, BOI keeps saying that
in 1994 when attempts were made to streamline tax
incentives there was an abrupt decline in FDI. This
has been noted seriously by the political
establishment
Inherent weakness in the IRD administration and the
belief that the BOI incentives may get diluted due to
IRD bureaucracy
A call has once again come from the IMF to
streamline BOI incentives but the status-quo remains
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With Bilateral FTAs signed with India and Pakistan, fulfilling WTO
commitments, BOI granting duty free importation, tariff revenue declined to
2% of GDP by 2007-2009
Meanwhile protectionist lobbies got stronger, development expenditures
increased, and export sector demands for subsidies increased. The
government saw the external border as an area where taxes could be
imposed to accommodate such demands
To meet certain development expenditures following taxes were imposed on
the border: (1) Nation Building Tax, (2) Port and Airport Levy, (3) Road
Infrastructure Development Levy, and (4) Social Responsibility Levy
To develop certain export commodities the following taxes were
implemented: (1) Commodity Export Subsidy Scheme (CESS), and (2) Special
Commodity Levy
To meet demands of protectionist lobbies the following were used: (1)
Custom Duty Surcharge, and (2) CESS
Very high specific duties were imposed on motor vehicles, alcohol and
tobacco
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Consequent to these taxes the overall custom duty
revenue amounted to 8% of GDP by 2009
The border taxes have got complicated and nontransparent as a result of these different taxes
which operates under different tax bases
While this was a reversal of earlier liberalization to
some extent, the importers did not complain much
because they were benefitting from an appreciated
Rupee
As a result of these high taxes, a lot of
undervaluation of imports took place to evade
custom duties
Revenue losses due to illegal flows at import entry
points is estimated at Rs. 300 million a day
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VAT combined GST and NSL and came into operation in 2002 as a
non-cascading tax system with two bands: 10 & 20
The non-cascading nature once again got diluted with Nation
Building Tax (NBT) coming into operation in 2008
The rates underwent frequent changes due to industrial lobbying
and revenue considerations; in 2004 rates changed to 3 bands: 5
(basic), 15 (standard), and 18 (luxury). Rates kept changing over the
years and today the structure is as follows: 0% (exports), 5%
(optional VAT), 12% (standard) and 20% (luxury)
Many exemptions were put into effect to please industrial lobbies
VAT brings in 33% of tax revenue and amounts to 5.5 % of GDP
revenue. The BTT brought in average 6.5% GDP revenue and GST
brought in on average 6% GDP revenue and VAT is yet to achieve this
target after 8 years of operation
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Sri Lanka is still in a learning curve in regard to
VAT. Training of personnel and institutional
frameworks were not put into place before VAT
came into operation
This can be seen from the fact that 8
amendments were made to the VAT Act over the
last 8 years
VAT threshold is an issue that is hotly debated
VAT refund is also an issue – there are
computation problems and identification issues
A major VAT fraud took place in 2004 and the
government lost billions of rupees as a result of
it
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As stated, Turnover Tax at the wholesale and retail level was
devolved to the Provincial Councils (PCs)
Turnover Tax is the highest revenue earner to PCs – accounts for
44% of revenue (license fee from motor vehicles and excise –
13%, stamp duty – 28%, others – 15%)
But the reality is that the tax sources devolved to the PCs
accounts for only 4% of the central government revenue (0.6% of
GDP); in comparison, province/state revenue is above 50% of
central government revenue in India/Australia and above 15% in
Malaysia/Thailand
Why this situation ? – Apart from legal and constitutional
provisions, the provinces lack tax administration capacity and
specialized technical skills that IRD enjoys. There is a lack of
motivation among PC revenue collectors in seeking new and
innovative sources of revenue
This situation is partly due to the dependence on an annual
grant received from the centre which almost/always ensure PCs
that recurrent expenditure needs will be met
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The existing format of fiscal decentralization to PCs has created
another serious problem, i.e., inability to extend VAT to
wholesale and retail trade
At present ,the VAT operates only for manufacturing, services
and imports
VAT imposed on wholesale and retail trade and thereafter
sharing revenue with PCs will not be possible under the current
Constitutional set up. Thus there is a legal impediment to
extending VAT to the wholesale and retail level
A tax system part levied by the centre and part devolved to PCs
has resulted in the discontinuity in the tax system and has
opened up more avenues for tax evasion and avoidance
Any increase in PC powers to collect more taxes (additional fiscal
decentralization) should go with reduction in allocation of central
government funds and improvement of tax collection capacity of
PCs
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Tax payers are time and again requested to
provide additional information
The IRD does not possess an entirely up-to-date
information index of the existing tax payers
It is said that there are only 8 data entry
operators for 1500 revenue officers
Hardly any links with the Telecom and Electricity
Departments, Land Registry and Motor Vehicle
Department; stronger links would have increased
the information base
Full computerization is on the way – ADB Fiscal
management Reform programme
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Several user-unfriendly forms are sent to tax payers
to fill up
Payers are harassed in order to extract more taxes
from them whereas evaders get away scot-free
Discretion for tax officers quite high, thus incentives
for rent seeking is equally high
The need to protect their ‘empire’ is high. An attempt
to form a Revenue Authority by merging the IRD with
Customs Department and Excise Department in 2003
was vehemently opposed
Basic principle of “cost of non-compliance higher
than cost of compliance” is yet to be put into
operation
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Recognizing these anomalies of the taxation system, a
Presidential Taxation Commission was appointed in 2009
Mandate was to simplify the tax system, rationalize tax
concessions, broaden the tax base, improve coordination
among revenue collecting agencies, etc. The report will be
out in September 2010
In 1990, the last Presidential Taxation Commission came
out with a number of recommendations but only about
40% of them were implemented
Political economy factors always gain priority in a tax
rationalization exercise
Strong political leadership can ensure that most of the
recommendations of the 2009 report will be implemented
If implemented enhancing revenue in the medium term to
about 20% of GDP will not be difficult.
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Thank you