Undertaxation and overspending | Print edition

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Last Sunday, I had to chair a webinar on “Tax Reforms for Economic Recovery in Sri Lanka”. While RHS Samarathunga, former Secretary at the Ministry of Finance spoke on Sri Lanka’s tax problem from a macroeconomic perspective, Murtaza Jafferjee, CEO of JB Securities Ltd. presented its microeconomic anomalies from a business perspective.

Coincidentally, I had already written in this column last week about the country’s “overspending” problem as the ultimate source of the current economic crisis. And, as we discussed there, this “spending beyond capacity” problem has two aspects: public finance and external finance. The webinar presentations above inspired me to address both issues briefly and separately; Accordingly, I thought of focusing on the public finance issue today and, perhaps, leaving the external finance issue for next week.

Tax revisions

Food prices will rise with the increase in taxation.

It was this week that the government announced an immediate increase in VAT from its current rate of 8% to 12% and the telecommunications tax from 11.25% to 15%. Apart from this, there will be a downward revision of the income tax threshold, the corporate tax threshold and the VAT registration, which will result in an expansion of the tax base, as well as other forms of tax revisions. Technically, the tax reforms mean undoing late-2019 “tax cuts” that cut government tax revenue by almost a third.

We understand that the government must strengthen its “spending capacity” in order to prevent new borrowing and printing money from fueling the crisis. However, in times of crisis where incomes have fallen and demand has diminished (due to shortages of raw materials, currency depreciation and soaring prices), the effectiveness of tax reforms remains to be demonstrated. In addition to all of this, as we will see below, there are effective ways to be added to public funding in the medium term, in order to solve the problem of spending beyond capacity.

Public finance consists of “taxing people” as the main source of revenue necessary for government spending needs. The problem of excessive spending arises when tax revenues are too low to finance public spending; this results in annual budget deficits, which should be covered by borrowing.

Open, inverted economy

One of the puzzling questions has been why government tax revenues have declined while the country has grown richer. Tax revenues, which represented around 25% of GDP in the early years of trade liberalisation, fell to less than 20% in the early 1990s, to less than 15% in the early 2000s, to less than 12% in the early 2010s; with tax cuts in 2019, apparently because a “political decision” reduced it from 11.6% of GDP in 2019 to 8.1% at the end of 2020 and 7.7% in 2021 in the midst of the problem of the COVID-19 pandemic.

Why did Sri Lanka pay higher taxes when its per capita income was low and lower taxes when income was higher? Tax collection has not improved, tax policies have become more complicated, tax compliance has deteriorated and tax exemptions have multiplied. It was also a period when the initial attempt at liberalization was reversed with the introduction of complicated para-tariffs, resulting in a biased policy against exports – a source of the growing external financing problem. As a result, with 17.6% of tax revenue coming from international trade by 2019, Sri Lanka has become a more “protected economy” than its neighboring countries. Compared to Sri Lanka, trade taxes as a percentage of total tax revenue were 4.5% in India, 3% in Thailand, 1.9% in China, 1.5% in Malaysia and 0% in Singapore.

Taxes and debt service

As public spending against falling tax revenues became unsustainable, politicians kept pledging more and more handouts, unsure how to give more unavailable resources; for example, consider the last election campaign in which they all participated in making unsustainable campaign promises to give more grants, more tax cuts, more government jobs, more pay raises, etc.

Over the past few decades, the government has continued to borrow to fill the growing gap between actual expenditures and tax revenues to be spent. Gradually, annual debt service payments even exceeded tax revenues; for example, in 2019, the debt service payment was Rs. 2,022 million, compared to the government tax revenue of Rs. 1,735 million, of which the debt has to be paid.

Additionally, there was the Rs. 533 million current account deficit, indicating that the government needs to borrow even to meet day-to-day recurrent expenditure. Let’s not forget that more than 50% of tax revenue was used only to pay interest on past loans, which has increased further to more than 80% in the last two years.

Share of direct and indirect taxes

One of the major tax anomalies is the skewed distribution of direct and indirect taxes. While direct taxes are income taxes, which account for less than 25% of total tax revenue. Most years it has even been below 20%. In 2018, Sri Lanka’s share of direct taxes was 18%, compared to 37% in China, 50% in India, 68% in Malaysia, 47% in Singapore and 40% in Thailand.

This implies that Sri Lanka, unlike many other countries in Asia, relies heavily on indirect taxes (VAT, import duties, excise duties and other commodity taxes) to generate government tax revenue. So what is the problem? The problem is that the government doesn’t know, or doesn’t want to know, people’s incomes and wealth! The current income tax system is based on inefficient ad hoc selection criteria and self-declared tax returns, both of which result in a lower income tax share.

An efficient, technology-enabled income tax system can answer many other questions that require information about people’s income and wealth. Nevertheless, one of the significant issues would be that many, including many politicians and bureaucrats, will find it difficult to expose or explain their income and wealth. Perhaps, for the same reason, we have ignored its necessity as part of an efficient and effective tax administration system, and attempted to maximize tax revenue through more comfortable indirect tax systems. As a result, our indirect tax system has become a complex system of multiple taxation that has overburdened the public and stunted economic growth.

In terms of increasing direct tax revenue, there are other important areas such as property tax and non-tax revenue for the government. With regard to non-tax revenues, the government, as the largest landowner in the country, has the option of allocating its land to private companies charging rent and introducing a fee for many government services, replacing the practice commonly referred to as the “bribery system” for these services.

Spoon for other people’s money

The problem of “overspending” in public finances cannot be solved simply by increasing tax revenues, especially in the midst of severe economic difficulties. This certainly requires a ruthless reduction in expenditure. It’s not just about cutting spending for the poor, but designing a comprehensive spending reduction program that spans from top to bottom.

Finally, I want to recall an important question that can sometimes bother us: Why should we pay taxes? Obviously, the answer depends on the purpose of the tax. According to one argument, “we pay taxes to live in a civilized society”. Another argument is that “companies that pay taxes will have better governance”.

In fact, conceptually, both arguments are correct. But their practical application does not seem as simple as that; those who have the spoons, of course of different sizes, know how to share by the size of the spoon they are holding. This is because “tax money is someone else’s money” that others have the rightful power to share with. And we have massively practiced the habit of sharing other people’s money without accountability – one of the main reasons for the current crisis.

(The author is a professor of economics at the University of Colombo and can be reached at [email protected] and follow @SirimalAshoka on Twitter).

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