Praising the Budget, businessmen see no pitfalls

By the Economist

What have been the reactions of the business community to the Budget proposals? These have been variously expressed, though businessmen appear to have been cautious in what they say for whatever reason. Some have even praised it and curiously commended some of the tax measures that are adverse to their own interests. The most important impacts of any Budget are in the overall outcome of the Budget on the economic environment in which business has to be conducted. Therefore the macroeconomic effects of the budget are important. Among these the effect of the budget on inflation, interest rates and exchange rates are of paramount significance.

In the preceding weeks these were discussed in these columns. The stark truth is that the budget is unlikely to result in an improvement in the overall fiscal situation and consequently inflation is likely to grow rather than abate. As a result the Central Bank would be compelled to follow monetary policies that would raise interest rates and the cost of borrowed funds. Inflation implies deterioration in the exchange rate and consequently further inflationary effects through higher import prices.

It is not these macro economic impacts that we discuss this week. What about the specific impacts of the Budget proposals on business? We turn to the effects of specific proposals that could have some bearing on business decisions and business interests. One of the adverse decisions taken in the previous Budget (2006) was to raise the rate of company taxation. It is not the issue of the particular tax rate, but the desirability of keeping the rate of corporate taxation steady so as to encourage long term planning of business investments that is important. Fortunately Budget 2007 did not increase corporate taxation further.

Most businessmen commented on Budget 2007 favourably. There were a few critics who mostly criticised the budget for having a large fiscal deficit. Even here they took the figures as presented without questioning their reliability or the realism in the estimates of revenue and expenditure.

Even some of the specific issues that affect company matters were hardly touched on or accepted. A few even commented favourably on them. What appears to be happening is that businessmen are keener to curry favour with the government than be candid in their assessments. They are probably having some favours in mind and do not want to prejudice themselves. Such is a weakness of the business community that their narrow self-interest far supersedes their broader interests.

The SLFP-JVP coalition prior to the last election sent shivers in the business community. Fortunately nothing much of a fundamental difference occurred, except that the economic reforms, particularly the privatisation of the loss making enterprises, were stalled. The agreement of the government with the UNP brought more hope to the business community. Yet once again nothing much happened. The privatisation programme was kept on hold. There was an implied admission that the privatisation of several state enterprises that were a burden should be privatised, but the government reiterated that it cannot privatise state enterprises for political reasons.

One particular item of company taxation requires to be commented on. This is the budget proposal to encourage companies to distribute their profits as dividends. If companies distribute less than 25 percent of their distributable profits, they are liable to a 15 per cent additional tax on the difference between one-third of the distributable profit and the distributed profit. Is it a clever and disguised piece of taxation to raise revenue from the corporate sector or a great concern of the government about shareholders? Whichever it is, the fact is that it is a bad piece of taxation. The government is taking upon itself the role of determining company dividend policy.

If shareholders of any company are of the view that the directors of the company are not acting reasonably, then they have the option of taking their money away from the particular company and investing it elsewhere. The directors of the company should determine what the company does with its profits, whether it distributes it as dividends or ploughs it back into investment. When a company ploughs back profits for investment and increases the assets of the company it increases its intrinsic share value. This results in the value of the share rising.

Therefore shareholders reap a benefit as a capital gain in their share values. It is well known that most shareholders invest in the share market to obtain capital gains rather than income through dividends.

Most dividend incomes are low in relation to the capital invested, but many shareholders prefer to receive their incomes through capital gains that are not taxed rather than as dividends that attract a withholding tax of 10 percent from all dividends irrespective of whether the investor is a tax payer or not.

Therefore it is argued that the new move by the government is an incentive for companies to declare higher dividends thereby increasing shareholder income. This is not necessarily so as they could get higher returns through the appreciation of their share values and by way of bonuses. These would not be taxable. The government's intent is therefore not to help the small investor in shares but to get higher tax revenue.

However this tax is a bad one from the point of view of corporate investment. Higher investment by companies increase production.

A further adverse effect of such taxation is on company investment, as these funds are low cost, while in the current context of an increasing budget deficit, companies are likely to be starved of funds from the market at reasonable rates of interest. The government's intention of increasing its revenue could have been better served by increasing the withholding tax of shareholders rather than attempting to interfere with company decision making on dividend policy. Such interferences are not conducive to business investment.

Many observers of Sri Lanka's business matters are of the view that companies would opt to pay the additional 15 per cent on the undistributed profit rather than increase dividend payments. Whether such a move would defeat the government's expected revenue collection is left to be seen.

The particular tax could result in less investment and thereby reduce company profits in the coming years. However companies are clever enough to circumvent these through creative accounting practices. Thereby they may frustrate the objective of additional tax revenue from this proposal for 2007. This approach of taxation on private companies that interferes with company decision-making on investment is inimical to development of the private sector that is often described as the engine of growth.