Fiscal reforms are needed for a progressive tax system
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The persistent budget deficits are a major source of economic instability in Sri Lanka. These imbalances have not only exerted domino effects on the cost of living, balance of payments and debt burden but also preempted resources of the private sector restraining economic growth.
Inadequate growth of government revenue to keep pace with the rapidly increasing expenditure has made deficit reduction extremely difficult year after year. As the tax system does not have a built-in mechanism to generate resources in tandem with GDP growth, discretionary revenue changes have been adopted in successive budgets to raise the revenue. In the process, indirect taxes such as value added taxes, excise taxes and import duties have become increasingly important as revenue sources over the years.
Equity objective of taxation undermined
The total government expenditure for 2016 is projected to be 22.3 per cent of GDP as against the total revenue of only 16.4 per cent resulting in a budget deficit of 5.9 per cent of GDP. Around four fifths of the total revenue is generated from taxes. Meanwhile, the revenue generated from income taxes is only 15 per cent of the total tax revenue, and thus the balance 85 per cent of total tax revenue is collected through indirect taxes.
The burden of indirect taxes is passed on to individuals who consume the goods and services subject to such taxes irrespective of their income levels.
Indirect taxes are considered as a regressive form of taxation since the low-income earners are overburdened by indirect taxes imposed on essential consumer goods and services such as food, pharmaceuticals, clothing and public utilities. Given the difficulties in collecting income taxes which are a direct form of taxation, the goods and services consumed by masses have been increasingly subject to various forms of indirect taxes, thus, exerting enormous pressures on the cost of living of the poor. As a result, the equity objective of taxation has been somewhat subdued over time.
Tax revenue growth too slow
The total tax revenue as a ratio of GDP declined from 19.2 per cent in 1990 to 12.9 percent in 2010 and to 10.1 per cent in 2014. This indicates that the tax revenue has not kept with GDP growth. It is also a reflection of the inefficiency of the tax system, which was caused by a multiple of factors including tax evasion, tax exemptions, tax holidays and administrative constraints. At present, the total number of personal taxpayers is around 500,000 accounting for only 2.5 per cent of the total population.
The efficiency of a tax system could be gauged by the measure of ‘tax buoyancy’. If the tax buoyancy is greater than 1, it indicates more than proportionate response of the tax revenue to GDP growth, reflecting built-in efficiency in the tax structure, and vice-versa. In the case of Sri Lanka, the coefficient of tax buoyancy with respect to total tax revenue is only 0.54 for the period 2010-2014, according to our estimates. For the same period, the buoyancy coefficients for income taxes and sales taxes are only 0.67 per cent and 0.51 per cent, respectively.
As the tax system is less-buoyant, the government does not have a sustained fiscal resource base to finance its outlays. This compels the fiscal authorities to make discretionary changes frequently in both the tax base and tax rates in order to meet the rising public expenditure. Such frequent adjustments create uncertainty in the market exerting adverse consequences on private investment. The discretionary changes have invariably led to increase the share of indirect taxes in the revenue structure over the years.
Tax structure regressive
Currently, the proportion of direct tax revenue to indirect tax revenue is at 20:80. This indicates the extent of the burden borne by indirect tax payers who are the consumers of goods and services subject to such taxes, as mentioned earlier. Indirect taxes such as general sales and turnover tax, value added tax, selective sales tax and import duty are levied on the relevant goods and services without considering the income levels of those who consume them.
Most of the food items are subject to various types of indirect taxes including VAT, sales taxes and import duties. As the poor households spend a larger share of their income for food, the burden of taxes on food items is much heavier for them, compared with the burden borne by the rich. The poorest 10 per cent of the population spend as much as 64 per cent of their total household expenditure for food items, whereas the richest 10 per cent spend only 19 per cent for food, according to the Household Income and Expenditure Survey 2012/13 of the Department of Census and Statistics.
Need for tax policy reforms
Far reaching fiscal policy reforms are essential to raise the revenue share of income taxes so as to reduce the burden of regressive indirect taxes falling on the poor. A built-in mechanism needs to be evolved to mobilise direct tax revenue effectively in line with economic growth so as to make the tax system more progressive. Also, various forms of income tax incentives given to certain sectors for prolonged periods need to be reassessed with a view to ease the fiscal burden.
(The writer, an economist, academic and former central banker, can be reached at
sscolom@gmail.com)