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Business

Coming soon! Operation Economic Development
Prime Minister Ranil Wickremesinghe's much-heralded statement on the state of the economy turned out to be thoroughly disappointing, a boring litany of woes that has been repeated many times before, so often that by now the public has got sick and tired of listening to it. This is more or less the same number played by the previous People's Alliance regime when it ousted the United National Party government, in which Wickremesinghe was an influential minister, in the mid-1990s, ending 17 years of misrule.

It appears to be in response to a growing sense of unease among the people - over the direction in which the economy is heading - given the series of unprecedented price hikes that have heaped more burdens on them - and the lack of progress in the peace process.

The peace initiative appears to be well and truly stuck. The start of the peace talks to put a permanent end to almost 20 years of fighting has been repeatedly postponed - from April to May to June to July and now to August, and even that is not certain. Despite the repeated concessions granted to the Tigers, under the policy of appeasement that the Prime Minister is pursuing, the rebels are still playing hard to get.

What is clear from the Prime Minister's statement is that the government cannot fund the war any longer - certainly not in the unprofessional manner in which it has been fought by successive governments and not at the current levels of defence spending - almost a billion dollars a year. For a developing country wallowing in a sea of debt and extreme poverty, Sri Lanka has developed a thoroughly modern military. But the hi-tech weaponry that have been acquired over the years, as the Eelam war rose inexorably up the technological intensity scale, failed to deliver the bang for the buck and only resulted in the country going bankrupt. All that sophisticated hardware turned out to be mere expensive toys for the generals, air marshals and admirals to play with.

Wickremesinghe's claim to be honest about our present plight or what he calls "the true state of the country's economy", his declared willingness to be unpopular by prescribing the medicine required to restore the island's economic health, and his exhortation to the people to "bear with us" and put up with hardship just a little longer might sound more convincing if he has taken genuine steps to fight corruption and waste, and discourage the obscene kind of conspicuous consumption that we see around us today. This is in stark contrast to what President Chandrika Kumaratunga has called "the poverty-ridden pockets" in the provinces or the "distant rural areas" of the country which she said require urgent attention.

We know that the Prime Minister cannot wave a magic wand to turn around the economy. But we certainly can expect a more professional performance from a regime that has styled itself, and was seen, as being more competent, efficient and technocratic than the previous lot of rulers.

Despite the horrors that the prime minister revealed about the state of our public finances, this government does not seem to be short of money to support a parliament whose members enjoy the kind of lifestyle subsidised at public expense that would make Samurdhi recipients go green with envy. It also seems to have enough money to fund a jumbo cabinet with a penchant for globe-trotting. To be sure, no one expected miracles from the new regime. The people understand the difficult situation the United National Front government found itself in on coming to power, partly as a result of the Kumaratunga regime's reckless spending spree that was a desperate attempt to cling on to power in the run-up to last year's general election. They also acknowledge the efforts being made to put the economy back on track and revive growth, the UNF's success in ending the power cuts, and its willingness to take the unpopular steps required to reform state enterprises and institutions. Recent moves to provide essential commodities like rice and milk powder at reduced rates through state outlets are also appreciated.

But there is a limit to the people's patience, especially when they see themselves being called upon to bear an unequal share of the burden. It simply does not seem proper that in a country which the prime minister himself has declared bankrupt, a small coterie of the rich and powerful appear to be having a ball while the vast majority are being asked to put up with more and more hardship.

Time may be running out. There are ominous rumblings that President Kumaratunga, who is seen to have made a strategic retreat following her People's Alliance coalition government's humiliating defeat at the December polls, is waiting to dissolve parliament when it completes one year in less than six month's time.

The UNF regime's only answer appears to be to swallow the advice of Western nations and lending agencies led by Washington and open up the economy to be exploited by foreign multinationals, deregulate the labour and land markets, and sell off state assets in the hope that these moves would create enough wealth to trickle down to the masses. The danger here is that if the government fails to meet people's expectations, it could lead to the kind of social explosion that we saw in countries like Argentina. What is required is a more equitable distribution of the little wealth this country has, as a tax expert points out in an interview on this page - one that puts fewer burdens on the poor and more on the super-rich. But that might be unrealistic to expect from a regime that is so unabashedly capitalist and pro-free market.

The Prime Minister did not really say anything new in his speech on the economy. One can only hope that Finance Minister K.N. Choksy's statement that is expected today would be better and offer some relief to a hard-pressed populace.

Levy multiple rates of taxation
Raise additional revenue from the affluent only
A developing country like Sri Lanka needs multiple rates of taxation because it has a diverse society - with different levels of income, says N.R. Gajendran, a tax expert who is a member of the Revenue Management Advisory Council, which is advising the government on reforms to the tax administration. Revenue, he says, cannot be raised from people to whom you should be giving relief. Revenue should be raised from the people who have the capacity to pay.

* What are the main features of the proposed VAT system and how does it differ from the existing system? Can you describe the main advantages and disadvantages?

The VAT system is a consumption tax. We have followed, like in the case of the Goods and Services Tax (GST), the destination principle in the implementation process under which all inputs and consumption in the country are taxed whereas exports are not taxed. That's a fundamental principle of the VAT system and the GST system. The principles of VAT and GST are by and large the same. There's no significant difference between the two. One of the advantages of the two systems is that the cascading effect is avoided. That means prices are not pushed up because of the cascading effect of the consumption tax. The significant departure in VAT compared to GST is the two rates. Under the GST system there was only one rate. Under the VAT system there are two rates and the zero rate. This is certainly a good move because we have a diverse society and there are people who need certain basic, essential goods and services that should be taxed at a lower rate.

Any consumption tax affects the masses as it is on consumption and unless it is fairly well managed it can have a severe impact on the lesser-privileged people who are bound to bear the tax as and when they consume goods and services.

The VAT system, like any form of indirect tax system, has a very regressive nature because when the income level drops you consume a higher proportion of your income in the form of consumption tax.

That is not a tax that should be encouraged over a longer period of time, especially in a developing country where the capacity to buy goods and services by the lesser-privileged people is not that strong.

* Can you explain the differences between zero-rating and exemptions?
Under the destination principle all exports are zero-rated and all input tax is refunded. So these goods will reach another country without any consumption taxes attached to them. The input tax is what is charged by the suppliers of goods and services to a company. Output tax is the tax that you pay on your sales. Under the VAT system you are allowed to deduct your input tax from your output tax and pay the balance. That's why it is called a value-added tax - you pay tax only on the value added. That's why we say that the cascading effect is eliminated if the VAT system is properly implemented. Similarly, services consumed outside Sri Lanka where payment is received in foreign currency will be zero-rated.

Exemptions are to ensure that most of the essential goods and services, which are a sort of prerequisite for an individual to enjoy a minimum quality of life, reach them without being taxed. But when a good or service is exempt, the input tax is not relieved. So there is an affect on prices when an exemption is given. But certainly, a product or service being exempt is far better than it being taxed at a lower rate.

* Has the government explained adequately to the public and the business community how the new tax system is going to work?
When the GST was introduced there was a longer gestation period and there were widespread information and education programmes conducted by many institutions including the Inland Revenue Department. With the introduction of VAT the government had a challenge, because I believe the introduction of VAT was the result of a pledge given by the government that it will abolish the GST which became unpopular for unnecessary reasons. So the alternative system, the VAT, had to be introduced in a very expeditious manner. Because of the lack of time, and it is a different form of tax there is a lack of information and education. At all these seminars that are being conducted on VAT there is an overrun of participants. Furthermore, these programmes at the moment are conducted in Colombo only. They need to be done in the outstations as well.

* How is the VAT system going to affect businesses? Also, what would be the impact on consumers?
Under the VAT system, the business on which the tax is imposed is a collecting agent. Other than in instances where goods are exempt, when there is a product or service liable to VAT, in theory it does not cost the company anything. When it sells the goods to the customer it collects the tax from the customer. But it does not mean a business can fix the price and say, collect VAT at 20 percent and expect the consumer to buy it. It depends on the elasticity of the product. You have to see who is going to bear the VAT component. If the business cannot sell at Rs. 120 to the consumer (Rs. 100 is the price of the product based on the cost and profit margin and Rs. 20 is the VAT), it has to bring down the price and bear part of the VAT. At that stage the business starts to bear part of the VAT in reality and its profits will get affected. That is one of the potential impacts of the VAT. But if I have a product that the consumer will buy at any price then I can dictate terms to the consumer.

The tax is basically not a cost to the business entity because it can get input credit and, on the output tax, recover from the consumer. All the money it receives from the consumer is given to the government. But in practice it might not work.

For businesses it would only be a cash flow issue. Say, when I buy at Rs. 100, I will pay Rs. 120 because of the 20 percent VAT. So I have to find an extra Rs. 20 to pay now. My cost of the product is only Rs. 100. There are supposed to be companies that have gone out of business because of GST because people who are not in the tax system may sell the product without charging the tax. So there is an unequal playing field. These are the characteristics of a developing country where there is a fairly sizeable informal sector.

Even turnover tax is a consumption tax. In all consumption taxes, the principles are the same. The VAT is not a new concept. The only difference under the turnover tax, compared with VAT or GST, is that they did not relieve the cascading effect - the tax on tax. The relief was in a limited form for manufacturers. But otherwise it was a very good system with multiple rates.

This society needs multiple rates of taxation because we have a diverse society - with different levels of income. Administration problems will be there but you can't help it. You can't make the administrators comfortable and make the masses uncomfortable. You want to relieve the administration or you want to relieve the people? Basic things like water, sanitation, power, transport, shelter should be affordable.

In my opinion there must be more than two rates - there must be a luxury rate. That is what will yield revenue. A multiple rate system would be more equitable than a single rate system. Then a diverse society is treated in a diverse manner.

Say for a well-to-do person to buy a shirt for Rs. 2,000 - for him to pay 20 percent it is alright and if he doesn't buy it doesn't make a difference either. But for someone who buys a shirt at Rs. 350 - if he is also asked to pay at 20 percent and if he decides not to buy - it is a question whether he will have a shirt or not.

So you must price shirts over a certain price at 20 percent and less expensive shirts at 10 percent - it is a difficult proposition but we have to bring in some creative mechanism - otherwise there is a mismatch being created and the poorer man gets hit more. Revenue cannot be raised from people to whom you should be giving relief. Revenue should be raised from the people who have the capacity to pay. That's the reason for all this agitation. No one agitates against income tax, which is a direct form of tax. Developing societies like ours should place greater emphasis for revenue on direct taxes and not on indirect taxes. Because if you have the greater proportion of your revenue coming from indirect taxes and not from direct taxes, then you are taking your problems to the street. But if you get the bulk of your revenue from income taxes then you contain your problems in the rooms. If you want to give relief to the people who need relief you must confine your emphasis on revenue collection to income tax.

The government said in its last budget that the long-term aim is direct taxes. But there may be conflicting signals given in the current proposals because there is a reduction in income taxes. So when you lower income tax, revenue is foregone, you have to collect that from elsewhere. So when you reduce direct taxes you rely on indirect taxes which is a consumption tax. That means going to the masses.

It is a question of balancing the revenue and the relief.

* Will VAT result in price increases?
We had a system of a combined NSL and GST. GST was at 12.5 percent. NSL was finally at 6.5 percent - down from 7.5 percent earlier. Now if a product was liable at 12.5 percent GST and liable for NSL at 6.5 percent - when it is taxed at 20 percent under VAT - the VAT is an amalgamation of GST and NSL - basically there will be no price increase. But by chance say there is a product or service, which was taxed for GST at 12.5 percent, and say, it was exempt from NSL, then if it is going to be taxed at 20 percent then the price will go up. Taking the same example, if the VAT is 10 percent then the price should come down. The ideal objective is to make it price neutral initially. So if you don't achieve price neutrality and in some cases the VAT is more than the GST and NSL combined previously, then the price will go up.

Another example - earlier in electricity consumption - up to 90 kilowatts was exempt from GST. But now only up to 30 kilowatts is exempt for VAT. So the small consumer who consumes that 60 units -earlier he wouldn't have paid GST - would now have to pay VAT at 10 percent. So that means a slight increase. But for larger consumers - the cost should come down.

Any consumption tax will have an impact on the consumer because it is they who will have to pay it. VAT will certainly have an impact on consumers. For example - water was exempt earlier. Now it is going to be taxed at 10 percent under the VAT. So the consumer will have to bear it.

n When the VAT is lower than the combined GST and NSL, how can the government ensure that retailers will actually pass on the benefit to consumers - that they will actually reduce prices?

I will go back to the fundamentals of market principles - demand and supply. If the product is such that they can maintain the price - retailers will continue to maintain that price. But if other things are equal, if VAT is lower than the combined GST/ NSL, then the price will definitely come down.

* n Will VAT increase tax revenue?
The government said that under VAT, revenue will go up by Rs. 3.7 billion. That itself indicates that there will be certain things that will go up in price, certain things will come down.

But overall, it will go up. So what has been pronounced is that revenue will go up. That remains to be seen. If tax revenue is going up in a consumption tax, we mustn't forget, the people are paying for it.

* A large number of goods classified as capital goods were liable to a NSL of 0.5 percent. If they now fall into the 20 percent category of VAT wouldn't it result in price hikes?
Earlier under NSL, plant, machinery and equipment were liable only at 0.5 percent.

Under GST they were liable at 12.5 percent, so effectively the tax was 13 percent. Now, only industrial machinery and certain agricultural equipment are liable at the lower rate of 10 percent. So any plant or machinery that does not fall into the category of industrial machinery or agricultural equipment will be taxed at 10 percent.

This should not have happened because all these plant, machinery and equipment in most cases are business assets. Earlier the reduced rate of 0.5 percent was relieving the initial cash flow problem of businesses. Say when I buy a capital asset if I have to pay 13 percent - I can set it off against my output tax. The government does not lose. It is a timing difference. But inconvenience is caused to the business entity because they have to find more money. Earlier they needed Rs. 113. Now they need Rs. 120 to buy that capital asset. This could have been managed better. If you imposed VAT at 10 percent for all plant, machinery and equipment, then the difficulties that are emerging now could be avoided. In the case of bicycles, prices are likely to come down because they would be taxed at 10 percent under VAT, compared with 13 percent earlier. But in say, cement blocks, prices are likely to go up because they will be taxed at 20 percent under the VAT system.

*There is some concern about transparency over the issue of invoices?
We must understand consumer psychology. The transparency of VAT or GST in the invoice is not warranted. Because in the case of the consumer, what finally matters is the price.

The transparency of VAT in the invoice is only for input tax purposes. If a business entity buys a good or service it must know how much tax is paid in order to be able to get relief. But for the ordinary consumer, the transparency does not matter. The GST failed because of the transparency, because people revolted against the tax being seen on the invoice. Because when GST was introduced, turnover tax was 18 percent. It was brought down to 12.5 percent.

What has been proposed is - if a business entity sells to another business entity it must issue a VAT invoice. If it sells to a non-business entity, which is not registered for VAT, you cannot issue a VAT invoice, only an ordinary invoice with the price. But if it is to issue a VAT invoice it must identify the recipient's VAT registration number for the latter to be able to claim input credit. There are certain practical problems in issuing invoices. One option is - when a business sells a good or service, it simply issues an ordinary invoice.

Then when the recipient writes and ask for an invoice, at that stage the business can issue an invoice, because the recipient will have to give his registration number. Even in the United Kingdom or New Zealand a similar approach is adopted.

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