Middle class Sri Lankans forced to migrate due to proposed new income tax policy?

- island.lk

by Prof. Aruna Shanthaarchch
(Department of Economics and Statistics
Sabaragamuwa University of Sri Lanka)

Who are the Middle Class?

The term, middle class, has been defined in a variety of ways. Historically, it was a social class characterised by intellectuals, who were neither capitalists nor workers. They were the well-educated service providers and small-scale entrepreneurs, who were hard working and had relatively secure and substantial incomes that enabled them to own houses, demand better quality services, and enjoy comfortable lifestyles. Despite its initial classification on social terms in recent times, economists have chosen to define the middle class using economic terms such as income or consumption to better quantify it. These definitions are based on two approaches: the relative approach, and the absolute approach. The literature defining the middle class by using an absolute approach, defines it as those earning some benchmark income range. For example, Bhalla (2021) defines middle class to be those earning more than US$ 3,658 (in 2020 prices) a year or US$ 10 a day in purchasing power parity terms. Kharas and Gertz (2020), taking the absolute approach, defines the middle class as those households with daily expenditure between US$ 10 and US$ 100 per person per day in purchasing parity terms.

Sri Lankan middle class

For ease of exposition, those individuals living in households, spending $2 to $10 (not including $10), will be referred to as the ‘local middle class’; those individuals living in households, spending less than $2 a day per person, will be referred to as the ‘poor,’ and those individuals spending $100 or more per person per day will be referred to as the ‘rich’. The middle class accounted for 10 percent of Sri Lankan population in 2020/21. The majority of Sri Lankans belong to the local middle class, which was 75.2% in 2010 and it has significantly decreased due to the economic crisis and, according to the World Bank it was 48% in 2021. There are three categories of middle class, Low middle ($2 to $4), middle class ($4 to $6) and upper middle class ($6 to $10).

Middle class and economic development

The middle class consumers have received greater attention in recent times due to the belief that a strong and large middle class is a prerequisite for sustained economic growth and development. Demand-led growth, as opposed to export-led growth, has also been seen as a means of steering an economy out of the middle income trap, which is the phenomenon of an economy stagnating at the middle income level. The size and the wealth of the middle class determine its power over the economy and governance structures. As such, the size of the middle class has become an important indicator signalling growth and development of an economy. The middle class is credited for stimulating growth in several ways. Primarily, the middle class drive economic growth through shifting aggregate demand. But that is not its only channel for promoting growth. The middle class, primarily depending on labour for their incomes, promotes values such as savings and human capital accumulation which are beneficial for growth. The middle class consumers are also credited for supporting meritocratic systems of governance which allows them the opportunity for promotion and self-improvement through hard work. Those in the middle class being more selective consumers have fostered innovation in affordable but efficient products. These products range from service goods such as insurances and banking to manufacturing goods such as hygiene products. What is different about this new wave of innovation trends is that it caters to a more fastidious set of consumers who are harder to please

Literature shows that expanding global middle class will open avenues for new businesses. For example, unlike the local middle class, the global middle class is seen to spend money on travelling overseas and new technology. The global middle class demand for private medical facilities and professionals, as well as private education facilities, is also higher. There are signs that this is happening in Sri Lanka already. However, along with these positive aspects, a growing global middle class can exert pressure on existing social infrastructure as well. This will be partly due to rising taste for better quality and more convenient services. Literature shows that the demand for electricity, water, roads and other infrastructure are higher amongst the global middle class consumers. Already, there are signs that improving living standards in Sri Lanka are putting pressure on the physical infrastructure and natural resources of the country. The demand for electricity and energy in the country has increased in recent decades. The demand for electricity has grown at a much higher rate than envisaged. To avoid constraints on economic development, the country will have to carefully study the increasing trends in demand for infrastructure and plan well ahead to meet this demand in the most effective manner.

Tax revenue in Sri Lanka

The tax ratio is generally regarded as a sort of “national virility symbol.” It indicates the proportion or share of national income transferred to the government sector to meet budgetary requirements so as to increase the tempo of economic development without causing inflation. (Zuhair, 1985). In higher income countries, the ratio is about 42%, middle income countries, about 25-29% and developing countries around 20%. Sri Lanka’s performance compares poorly with countries like Vietnam (21.1%), Thailand (22.6%), and Malaysia (22.2%) but better than its South Asian neighbours, such as Bangladesh (7.6%). The irony of the situation is that while overall GDP as well as per capita income in Sri Lanka has been steadily increasing over the years, the total revenue and tax revenue of the state have been steadily decreasing. Table 01 shows the relationship between the growth of GDP and per capita income and government revenue. It is seen that total government revenue as a percentage of GDP has steadily declined from 21.1% in 1990 to 16.8% in 2000, 12.7% in 2010 and 11.4% in 2014. Tax revenue ratio has declined from 19.0% in 1990 to 14.5% in 2000, 11.3% in 2010 and 10.1% in 2014 and 7.7% in 2021.

New income tax policy

A person who earns more than Rs 100,000 will have to pay taxes, depending on the additional amount he or she earns. This means the annual threshold-free income is 1,200,000 rupees. This threshold level was 3,000,000 rupees earlier and now has been cut by 60 percent. The tax slabs of 3,000,000 after the threshold-free income is now reduced by over 83 percent to 500,000 rupees. For each 500,000 tax slab, there is an incremental six percent tax. If a person annually earns three million rupees, which was tax-free earlier, the first 500,000 rupees after the 1,200,000 rupee tax-free threshold, he will be charged six percent, next 500,000 at 12 percent, next 500,000 at 18 percent and the remaining 300,000 at 24 percent. However, according to the new tax policy, monthly income tax commencing from over Rs 100,000, and 6% income tax for monthly income from 100,000 to 141,667 and for each additional slot of Rs 41,667, the tax improvement is 6% until the tax rate is 36%. The person whose gross income exceeds Rs, 308,335, should pay 36% tax rate. The proposed tax shown in Table 01, based on gross income.

Table 01: Gross Income and Tax Payment

Are they forced to migrate due to proposed new income tax policy?

The proposed income tax policy would significantly damage the purchasing power of local and global middle class families in the country. The sharp increase in personal income tax rates would discourage employment, negatively affect the lives of the middle-class families and, especially, in an environment of high inflation, could increase brain drain. Employees are disproportionately affected since they are taxed at source with a sharp drop in disposable incomes which could also create a problem in personal debt servicing. Middle class income will be limited to consumption and all other investment will be controlled. Since middle class income is substantially reduced with new tax, the natural income flow from the middle class to the poor income category will be limited. This will be a medium-long term negative for the country. A flat personal tax rate would have been more equitable; it would not have discouraged growth in incomes.

The new tax rates will reduce people’s disposable income and this will be a huge burden on the people who have been paying tax genuinely. Many professionals who want to stay in Sri Lanka and contribute to the economy will leave the country. Sri Lanka has already seen many professionals leaving the country due to the unprecedented economic crisis. This should be examined against the backdrop of semi-literate politicians dictating terms to the educated.

With prices of fuel, cooking gas, electricity, and water having increased along with a over 50 percent depreciation of the rupee, many professionals have adjusted their consumption to suit the shrinking disposable income. These new tax hikes without considering the current inflation and cost of living will be the final nail in the coffin of the careers of professionals locally. They will try to migrate at any cost.

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