Income Tax Share To Reach 2.5% In 2017

by Dinesh Isuru

The United National Front for Good Governance (UNFGG) anticipates the income direct tax i.e. income tax share, which has been steadily dropping during the Rajapaksa Regime to reach 2.5% as a percentage of the GDP (Gross domestic production) in 2017.

The falling share of income tax, both corporate and individual income taxes, which reached an all-time low of 1.9% in 2016 is to increase to 2.5% in 2017, 2.6% in 2018, 2.8% in 2019 and 2.9% in 2020. Around the time Rajapaksa took over the income tax share was an astonishing 2.7% in 2006  and even all-time high of three per cent in 2007.

State revenue is also slated to surpass recurrent expenditure in 2017 and beyond whilst ensuring government income performance bringing the revenue / GDP ratio back into an upward trajectory portraying a notable shift from the Rajapaksa regime.

According to Finance Minister Ravi Karunanayake, total state revenue increase by 27% to reach Rs 2,020 billion whilst non tax and tax revenue expected to bring in Rs 199 and 1,821 billion respectively, in 2017.

Economists and policymakers have highlighted that it was high time that the Sri Lankan Government shifts to direct taxes instead of indirect taxes because of the contraption going on adding an extra burden and putting pressure on the general public. (http://www.thesundayleader.lk/2016/07/10/high-time-to-enforce-direct-taxes/ )

With the amendment to increase the Value Added Tax (VAT) from 11% to 15% effective from 2 May 2016, the middle class sector got  adversely affected since they were the ultimate victims with the burden of soaring prices of essential goods due to increasing the VAT. The extent of the burden and the pressure on the public is showcased by the recent regional hartals conducted against the VAT increase at Weeraketiya, Tangalle, Angunakolapelessa etc.

In most developing countries tax is the primary source of revenue for the government. In such a case, we could see that not only Sri Lanka, but, developing countries like Bangladesh have taken measures in implementing the VAT since 1991. Advanced economies such as France introduced VAT way back in 1954.

Although developing countries impose taxes through indirect taxes like VAT, the majority of economists around the world, believe that the VAT is not suitable for developing countries.

According to Shoup (1988) the VAT is not ideal for all developing countries where (a) foreign trade plays a minor role; (b) small-scale agriculture is important; (c) retail trade is fragmented among very small sellers; (d) basic accounting is not widespread, and (e) efficient and impartial tax administration has not been achieved.

However, many academics including Dr K. Amirthalingam and former Central Bank Governor ArjunMahendran believe that Sri Lanka’s tax system is regressive as 80% of tax revenue is from indirect taxes which mostly affect the poor whilst the current level of 20% tax revenue from direct taxes was highly inadequate.

A recent IMF survey shows that the VAT performs relatively well in small countries and islands (with population of less than 5 million).  The C-efficiency ratio reaches 65 percent, on average, in small countries and is especially high in small islands (83 percent), whereas the world average is 58 percent. However, a relatively high C-efficiency ratio does not necessarily guarantee that being small is advantageous for adoption of the VAT.

Indirect taxes including the VAT are likely to perform better in countries which rely more on foreign trade.  Prest (1979) further argues that the overall tax capacity of a country is positively correlated with the size of trade.  On the other hand, as Alesina and Wacziarg (1998) empirically demonstrate, trade and country sizes are negatively correlated a smaller country is more likely to have more trade.  Therefore, the high C-efficiency ratio, observed in small countries and islands, may simply indicate the following sequence of correlation:  being small tends to raise importance of trade, which in turn favorably improves the VAT productivity.

When a country relies more on foreign trade, the tax administration may shift its focus to a few check points at the border, thereby reduce collection cost, and raise more tax revenues.  In general, for smaller countries with more trade, any type of indirect taxes—be it trade tax, or excise, or VAT—tends to be more efficient.  Also, note that in small countries, consumption-to-import ratio is typically low, and a broad-based tariff system may well capture most of the consumption base.  From the collection efficiency perspective, trade taxes may even be superior to other types of consumption taxes including the VAT. On the other hand, the VAT, being a general tax (imposed on both imports and domestically produced goods), possess some important advantages:  the VAT is less distortionary and has more revenue potential than tariff alone.   In addition, the VAT may help jumpstart the construction of an efficient tax administration.

In certain extreme cases, the consumption-to-imports ratio converges to one:  this is the case for small islands that virtually have no domestic manufacturing base.  Then, the revenue and efficiency implications of tariff, VAT, and any other type of consumption tax (retail sales tax or excise) are, in theory, expected to be the same (the original, before-tax supply curve is simply horizontal at the world price).  A legitimate question for the practicality of the tax policy design is, whether the VAT is necessarily a better choice for taxing consumption?

Typically, the VAT is an option when (1) a country has domestic manufacturing base with multiple production stages or has distribution stage generating significant value added; (2) if the first condition is currently missed, the country has sufficient growth potential for domestic manufacturing.  For small islands without either of these two conditions, the VAT may not be a sensible choice, whereas a single-stage sales tax on border entry or at factory gate supplemented by an excise on selected services may be more suitable, administratively and economically.