Sri Lanka’s tax conundrum

by Sanjeewa Jayaweera-January 11, 2020, 5:11 pm

The many tax concessions promised by Gotabaya Rajapaksa in the run-up to the presidential election have now been granted. The need to honour promises is inevitable when a general election is around the corner, despite the fact that some of them may seem highly contentious. The various tax concessions granted are estimated to result in a revenue decline to the government.

The international credit rating agency, Fitch Ratings has, in a release, stated that tax concessions granted are "credit negative" and revised the outlook on Sri Lanka’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to Negative from Stable. The Treasury and the Central Bank of Sri Lanka released statements sharply rebuking the Fitch statement.

The government is yet to release a detailed statement as to how it intends to bridge the revenue deficit other than stating that it expects the tax concessions granted to act as a stimulus, which would increase consumer demand and business activity. It believes that this would increase aggregate demand resulting in a higher growth rate of GDP, which has been declining over several years.

There have been instances where governments used lower tax rates to stimulate the economy. As a Sri Lankan, I do hope that the stimulus does work as anticipated, and Sri Lanka will witness a sustained period of economic growth over 5 per cent per annum. Some Economists have expressed concern that increased consumer demand would result in higher inflation, which could cause the Sri Lankan rupee to depreciate and lead to a foreign exchange crisis. In case the government is unable to bridge the revenue shortfall and thus needs to borrow from overseas, there will be further concerns. If there is a sharp increase in the world oil price due to tensions in the Middle East, the government may well have to reconsider some of the concessions unless it passes the full impact on to the consumer.

I am no economist, and as such, I am unable to either support or criticise the government economic policies. However, based on 25 years of experience in the private sector of Sri Lanka in the field of business, finance, and taxation, the following is my take on the issue:

Reduction of VAT Rate and Abolishing of NBT

Value Added Tax (VAT) rate was reduced from 15 per cent to 8 per cent while the Nation Building Tax (NBT), levied at 2 per cent, was abolished. As per the Department of Inland Revenue performance report for 2018, net collections from VAT and NBT were Rs. 462 Bn and Rs. 71 Bn respectively.

Ideally, VAT and NBT liable goods and services should come down in price by approximately 8% if the full benefit of the tax concessions is to the benefit of the consumer. The question is how many manufacturers and traders would feel inclined to do so. In defence of some manufacturers and importers, they may have previously absorbed costs while eroding their margins and might not, therefore, be able to pass on the full benefit. The government is not in a position to mandate price reductions other than for items deemed to be essential, which are price-controlled.

We recently witnessed the manner in which the prices of varieties of rice increased significantly for no apparent reason over a short period being a price-controlled item. It required a Presidential market visit to highlight that most traders were not adhering to the maximum retail price. It was all blamed on the "Rice Mafia." I recall being part of a delegation in around 2012/2013 from supermarkets. The then Secretary to the Treasury invited us for a discussion of the need to sell rice as per the government-mandated price despite the supermarkets selling rice at cost or even loss. At that meeting too, the subject of the "Rice Mafia" was discussed. However, successive governments have failed to take action against them. One can only presume that both the main political parties are beneficiaries of monetary donations from these organisations during elections, and as such, taking stern action is not a possibility!

Due to the significant increase in vegetable prices in the last month or so, I have not been a beneficiary of a lower bill value when shopping at the supermarket. This, I am sure, will be temporary. However, what most people might not aware of is that many of the items purchased in a supermarket are not liable to VAT. Approximately 45 per cent of the revenue of a supermarket is not liable to VAT. While this is in rupee terms, however, if it is in terms of units and kilograms sold, then a much higher percentage of items purchased by a consumer at a supermarket would not be liable to VAT and, as such, there would be no reduction in the bill value. However, items purchased by the more affluent segment of the customer base, including imported items and other "non-essential" items, should see the 8% price reduction. When I say "non-essential" items, it all depends on the income strata to which a consumer belongs. A household with an average monthly income of over Rs. 500,000 might consider imported cereals as an essential item. However, a household with monthly average income of less than Rs. 100,000 might never purchase a box of imported corn flakes.

The Household Income and Expenditure survey of 2016 reveals the average monthly expenditure per Household was Rs. 54,999. According to the survey, Food accounts for 35 per cent; Housing 12.5 per cent, Fuel and Light 3.2 per cent, Transport 8.1 per cent, and Education 3.8 per cent. Most average household food items usually purchased are VATexempt. Combined with all other expenditure items which are not VAT liable, nearly 63 per cent of average household expenditure falls into the VAT exempt category.

According to the survey, the richest 20 per cent of households (monthly income of more than Rs. 81,372) enjoy more than 50% of the total household income of the country, while the poorest 20 per cent (monthly income less than Rs. 36,500) get only 5 per cent. The situation of the poorest 10 per cent of the households is worse with the share of household income being just 1.8 per cent or less.

Based on the above statistics, a justifiable question is what percentage of households would benefit from the VAT rate reduction and contribute to the increase in aggregate demand?.

Increase in Taxable Supply threshold to be VAT Registered

The Inland Revenue website carries the names of over 54,000 establishments and individuals engaged in business activity who have had their VAT Registration cancelled effective 1st January 2020. The cancellation is a result of the increase in the threshold of the taxable supply (turnover) of a business to be liable to VAT from Rs. 12 million for a year to Rs. 360 million.

While this may benefit some businesses, it also adversely impacts many others who are engaged in purchasing raw materials and services from VAT liable suppliers, those who are engaged in importing as well as those selling to exporters. The adverse impact is as a result of VAT paid to suppliers and the government at the point of clearing imported goods not being refunded by the government. These businesses need to either absorb the unclaimable VAT as a cost, thus impacting their profitability or pass the unclaimable VAT portion to the consumer. Also, establishments with an annual turnover of over Rs. 360 million for a year and therefore liable for VAT may no longer wish to purchase goods from non VAT registered suppliers due to the additional cost.

In my view, when a business establishment or an individual is registered for VAT, then the probability of them being part of the Tax Net is significantly higher. When registered for VAT, most business establishments and individuals need to maintain accurate and up to date accounting records to facilitate the submission of tax returns and payments. In a country where many small and medium enterprises (SME’s) are reluctant to be part of the Tax Net, the delisting of over 54,000 establishments seems to be regressive.

Reduction of Rate of Income Tax and Increase in the Single Person Tax-Free Allowance

The annual tax-free allowance of a single employed person has been increased from Rs. 1,200,000 per year to Rs. 3,000,000. The annual tax-free allowance for those without employment income has been raised from Rs. 500,000 for a year to Rs. 3,000,000. These increases are significant. The highest rate of tax, known as the marginal rate, has been reduced to 18 per cent from 24 per cent. The bands at 6 per cent and 12 per cent, have also been increased. It is my understanding that for a person with a monthly salary of Rs. 1,500,000 the tax benefit would be around Rs. 125,000 per month.

Based on the Household Income and Expenditure Survey of 2016 and the dispersion of the average household income, the recently introduced tax rates and increase in threshold will only benefit a smaller segment of the population who in all probability do not need this type of assistance from the government!. I say this at the risk of getting a sharp poke on my ribs from some of my former colleagues still in employment!. In my case, had I been in employment, the incremental income would most probably be spent on a few additional overseas trips, buying a few expensive imported branded gadgets and a higher class BMW!. I am not sure I would have contributed to the increase in aggregate demand for our GDP. As to how a household spends, the incremental income would certainly depend on their income level. However, there is no doubt the greatest beneficiaries would be those who are not currently struggling to make ends meet!

I recall reading a brilliant article written by a leading Lawyer, Naomal Goonewardena, captioned "Ashamed to be a Professional" to The Island of 16th June 2018.

http://island.lk/index.php?page_cat=article-details&page=article-details&code_title=186392.

It was at a time when several professional bodies, including the GMOA and the Bar Association and several others, were lobbying the government to reduce their income tax rate from 24% to 16%. Having had their appeal to the Supreme Court dismissed their plea to the Government was to include Professionals within the definition of SME who enjoyed a tax rate of 14%. The GMOA, in particular, has been at the forefront of lobbying for a reduced income tax rate and going to the extent of saying that many Doctors would otherwise decide to migrate to overseas countries!. This, despite the marginal tax rate being as much as 45% in Australia, the UK, and the USA!. Based on the consultation charges and other charges levied, such as Surgery and hospital visitations, many of our doctors are in the super-rich category. It seems the government has got it wrong when reducing the marginal rate.(See table)

According to the United Nations, the ten happiest countries in 2019 are Finland (52 per cent), Denmark (56 per cent), Norway (39 per cent), Iceland (46 per cent), Netherlands (52 per cent), Switzerland (40 per cent), Sweden (57 per cent), New Zealand (33 per cent), Canada (33 per cent) and Austria (55 per cent). I have within brackets indicated the marginal income tax rate in each of the countries. It seems in those countries' state of happiness is not correlated to the rate of income tax!

Unfortunately, in Sri Lanka, our DNA is not agreeable with the concept of paying taxes despite availing ourselves of free education and free health care and subsidised essentials. I was flabbergasted when a couple of years back the uproar caused when the government proposed a carbon tax be paid by those owing vehicles. As usual, under pressure, the proposal was withdrawn. One would think that the owner of a vehicle could easily pay a few thousand rupees. The fault lies with successive governments who pander to various interest groups and cave into their demands.

Abolishing of Withholding Tax (WHT) and Self Payment

The decision to abolish WHT on fixed deposits and other interest-earning instruments like debentures and Dividend Income effective 01 April 2020, will result in these sources of income being now taxed at normal tax rates depending on your total income liable for income tax. Previously, WHT of 5% on interest income and 14% on Dividends were the final tax. The abolition of WHT should increase tax revenue.

However, the decision not to collect any tax at the point of payment is fraught with issues due to what I stated in the previous paragraph that our DNA is not tax-compliant. In my view, the government should continue with the concept of WHT, and some amount of tax collected at the point of payment. However, the WHT rate to be deducted should be on a self-declaration just as much as at present those not liable to tax do so.

Presently Income Taxpayers are expected to estimate their annual Income Tax liability and make quarterly payments. In that scenario, every taxpayer should know at what rate of tax their bank interest should be subject to WHT. It would be at 6 per cent, 12 per cent, or 18 per cent or, in some instances at multiple rates.

In my experience, tax collected at the source is an effective mechanism compared to self-payment. The IRD should improve the refund process when a taxpayer has paid excess tax. The waiting period for a refund should not be for several years.

The Inland Revenue Performance Report for 2018 sets out statistics of low compliance by businesses and individuals when filing their tax returns from 2013-14. In such a scenario to expect individuals to be compliant with their tax returns and payment of quarterly tax is being optimistic.(See table)

Moratorium for Loans obtained by Small and Medium Enterprises(SMEs)

The proposed moratorium for loans obtained from banks by Small and Medium Enterprises (SMEs) below Rs. 300 million, by SMEs, is to be submitted for Cabinet approval shortly. I read in a newspaper an unnamed banker expressing serious reservations about the proposal. He has stated that the 12-month moratorium would result in poor financial discipline amongst the SMEs who would in all probability use the cash for extravagant consumption and thereby deepen their financial indebtedness. Based on my experience, I wholeheartedly agree that most SMEs manage their cash flow very poorly, and this move will cause further headaches to both the banks as well as the SMEs. Also, it appears that the government by mandating such policies are also not mindful of the fact that the monies risked are those that belong to depositors who have worked hard to save.

I understand that the Department of Inland Revenue has released a note stating that any businesses that wish to retain their VAT Registration despite the taxable supply (turnover) being less than Rs. 360 million for a year can do so voluntarily. They need to make a written submission to this effect to the IRD. While welcoming this move, I would state, a change of policy less than a week after implementation is due to valid concerns of those engaged in business activity. In this instance, stakeholders have neither been considered nor consulted.

This article is written precisely in this vein. My experience of 25 years in the private sector has been that policymakers, may it be politicians or government servants working in the Treasury, the Inland Revenue, lack the practical knowledge due to not having hands-on experience in the field of business. They fail to anticipate issues and constraints when making proposals for policy changes. I have been a part of various delegations for decades post the Annual Budget to submit and canvass for changes in newly announced policies.