Taxation and Sharing the Fruits of Growth

By Priyanga Dunusinghe

Article published in Ceylon Today on 18^th, Oct. 2014

Economic theory argues that there are three essential features in a sound taxation system; namely (a) it causes minimum distortions in the allocation of resources, (b) it is equitable or helps in redistribution, and (c)it is relatively easy to administer. This article attempts to examines, on the eve of 2015 budget to be presented, to what extent existing tax and tariff system conform to some of those essential features.

Fiscal data clearly show that tax revenue to GDP ratio has continued to fall during the last two decades. For instance, tax revenue to GDP ratio in the early 90s was 19 per cent and it had declined to 11.6 per cent by 2013. This indicates that tax elasticity (relative responsiveness of tax revenue to GDP increase) has remained less than one (less responsive) during 1990-2013. This could happen due to a number of reasons. One possibility is that tax base has not sufficiently broadened in line with increase in income or economic activities in the economy. This can happen due to administrative deficiencies in revenue collection institutions or due to lack of willingness, on the part of political establishments, to tax people who make a good buck owing to political economy considerations. Other reasons include weak tax base coupled with multitude of tax exemptions, tax evasion, many discretionary tax measures in operation.

Does our tax system cause minimum distortions?

As in many other developing countries, tax system in Sri Lanka is relatively complicated and it creates substantial amount of distortion in resources allocations. There are tax exceptions, different rates applied, ‘add on’ taxes over and above the VAT and tariff rates thereby making much complications. On the other hands, in recent years, government has given a certain level of protection to domestic entrepreneurs resulting multitude of different rates applying to different people on the basis of the sector one operates. For instance, firms under BOI and firms falling into the category of small and medium industry category enjoy special tax regimes while other business are subject to standard rates. On the other hand government introduced several new taxes in recent years for different reasons. These include (a) Nation Building Tax, (b) Port and Airport Development Levy, (c) Regional Infrastructure Development Levy, and (d) Social Responsibility Levy. Moreover, Commodity Export Subsidy Scheme (CESS) and Special Commodity Levy were introduced for developing certain commodities. As the theory argue a complicated tax regime work negatively on several fronts such as (a) evading taxes, (b) administrative difficulties, and (c) reallocation of resources to less productive activities. Hence, it is imperative that policy makers pay serious attention in simplifying the existing tax system for improved revenue collection and better resources allocation.

Is our tax system equitable?

When taxing rich, it is argued that there should be a delicate balance because such taxation could discourage investors and/or professionals engaging in productive activities though it helps in attaining redistribution goals. Fiscal data clearly indicate that tax burden on rich has declined over the years (Table 1). Policy-makers often ascertain that high income and cooperate taxes discourage new investment in physical and human capital. Nevertheless, evidence from developing world suggests that tax incentives (or having lower tax rates) always do not end up with high investment. Rather high income earners tend to spend on ‘conspicuous consumption’ activities. It is relatively easy that we witness this phenomenon around us today. As argued in a previous article the share of the income accrued to top 10 per cent of income earners has increased during the last two decades. More importantly, income share of top 1 per cent of income earners has ballooned during the last two decades while their tax burden falling down (compare Income tax rates between 2004 and 2014).

Direct Tax Structure
Personal tax (%)
2004			2009			2014
Tax free allowance  Rs. 180,000			Tax free allowance Rs. 300,000			Tax free allowance  Rs. 500,000
Tax on taxable income			Tax on taxable income			Tax on taxable income
First Rs.0-180,000	10		First Rs. 0-300,000	5		First Rs. 0-500,000	4
Next Rs. 180,000	20		Next Rs. 200,000	10		Next Rs. 500,000	8
Balance	30		Next Rs. 200,000	15		Next Rs. 500,000	12
			Next Rs. 200,000	20		Next Rs. 500,000	16
			Next Rs. 200,000	25		Next Rs. 1,000,000	20
			Next Rs. 200,000	30		Balance	24
			Balance	35
Corporate Tax (%)
Standard rate	35			35			28
Taxable income less than Rs. 5 Mn	20			15			12
Export income	15			15			12
Source: Ministry of Finance

On the other hand, a large number of taxable entrepreneurs, such as professionals and businessmen operating in the informal sector, evade paying taxes. Political establishments do not attempt purposely to get those businessmen into tax net due to political economy considerations. It is argued that many businessmen operating in the informal sector fund political campaign of local politicians expecting some protection in return. This has become a lucrative opportunity for local politicians to get their campaign funded. Any political party that is in power does not attempt to get all those businessmen into tax net knowing that funding for their political activities would drastically be faded away once businesses get properly legalized.

The ratio of indirect tax revenue to total tax revenue has increased over the years and at present this ratio remained around 80 per cent, which is relatively higher compared to many other developing countries. In recent years, it has witnessed that indirect taxes becoming main revenue generators, among them tobacco and alcohol being the frequent target. Heavy reliance on indirect taxes is against one of the fundamental principles of taxation, namely the system being equitable (progressive). Though indirect taxation helps revenue collection with relative ease, it erodes the sense of social justice.

Conclusion

It is imperative that proper policies are crafted to increase the tax revenue to GDP ratio in the medium term. Policy makers often neglect the decline in revenue to GDP ratio claiming that government expenditure to GDP ratio has also declined much faster than the former ratio. This is absurd because government needs more funds to finance essential investment in number of areas that help in sustaining present high growth rate. It is imperative to invest more money on education, health, research & developing so as to make sure that people in every corner get equal chances to access to better education and health as well as finding quality jobs in Sri Lanka rather than happening to migrate to some other countries to undertake substandard jobs. It is imperative that tax system becoming equitable so that people pay a sense of social justice and society seeing a sense of humility. Sharing the fruits of growth is essential for creating a just and healthy society. Hope the government makes budget proposals to this end.