Increasing tax revenue vital for fiscal consolidation

By the Economist

There can be no doubt that income taxation has always remained low. Although there has been a slight increase in recent years, direct taxation has been inadequate. The government, partly on the advice of multilateral agencies, have redoubled their efforts to gather in a higher amount of income taxes. Revenue collection increased from 15.4 percent of GDP in 2004 to 16.1 percent of GDP in 2005.

In spite of this increase it is low even for a developing country. Revenue to GDP ratio of about 20 percent is around the acceptable level for a developing country like Sri Lanka.

Total tax revenue comes from various sources such as customs duties, stamp fees, corporate taxes and personal income taxes. Income tax revenue was 14.2 percent in 2005, slightly higher than in 2004, when it was only 13.4 percent. The bulk of direct taxation is from corporate entities that account for about two-thirds of direct taxes. Indirect taxes have therefore been the main source of tax revenues in Sri Lanka. The current thrust is to increase personal taxation in particular. We are told that there are only 300,000 tax files. Even among these files there are a number who are not taxable and have files for the purpose of tax refunds. Others are of moderate income earners who do not pay much in taxes. It appears that the tax net has not caught the big fish. Therefore those who pay taxes have a grudge that the big fish are not caught up in the tax net. The correction of this anomaly is imperative.

The latest manifestation of the government's resolve to bring in more taxes was evident from the ceremony at Temple Trees to give new recruits to the Inland Revenue service their letters of appointment.

Never before has the President or the head of the government given appointment letters personally to such recruits. At another ceremony the Secretary to the Treasury Dr. P.B.Jayasundera, who addressed the new recruits, said that it was the aim of the government to increase the number of tax files from the current 300,000 to a million by 2009. A million tax files are no doubt a reasonable number in a population of 20 million. However the per capita income level of only a little above Rs. 100,000 or about Rs. 9000 a month, with the taxation threshold of 300,000, does not suggest much hope. In fact the problem is not in the number of tax files but the fact that there is gross evasion and avoidance of personal taxation by the rich and the affluent.

The reasons for low tax revenues are many. They fall into the two categories of tax avoidance and tax evasion. Tax avoidance is the utilization of the tax regime to one's own advantage, in order to reduce by innovative means the amount of tax that is payable. This is within the law, but could account for a large amount of tax income being lost. Examples of tax avoidance include the use of tax deductions like entertainment allowances and exemptions, changing one's tax status by setting up charitable trusts and foundations. Some Sri Lankans also avoid taxes through the use of dual citizenship and double taxation agreement provisions.

Over the years tax exemptions have proliferated and many of the richest persons have found legal ways and means by which to circumvent taxation. In contrast tax evasion is the illegal means whereby taxpayers deliberately misrepresent or conceal incomes. This includes dishonest tax reporting such as declaring less income, profits or gains than actually earned and adding bogus expenditures in their accounts to reduce income.

This is undoubtedly a widespread practice, especially among professionals and business persons. Medical consultants and prominent lawyers are among those who practice such means of tax evasion. The fact is that many of those who earn very high incomes disclose only a fraction of it.

The Inland Revenue Department has devised a new form of personal taxation used in the declarations for the income tax year 2005-2006. This is a very complicated form. Tax payers found it very difficult to fill the asset declaration form. There are three issues of significance that the introduction of this form raises. One is that this form is only required of tax payers and therefore the improvement in tax collection may not be commensurate with the harassment of those who are already paying taxes.

The second issue is that this form was sent to tax payers after the deadline of September 30 for the payment of taxes. Was it fair for the Inland Revenue Department to have sent such a new form after the deadline for the payment of taxes? We trust that the Inland Revenue Department would not place a surcharge for the delay in payment and would accept the deadline of November 30.

The third issue is why the Department did not give tax payers adequate time to fill such a complicated form. When a new form of the type that was sent for 2005-/2006 is introduced, tax payers should have been given enough time to gather the data. In fact the required information was difficult to obtain as late as October, when the forms were sent. The reasons for this "unfriendly act" was perhaps implied by the Commissioner General of Inland Revenue, who said the Department was grossly understaffed with as much as 62 percent of vacancies. The bottom line is that the Department of Inland Revenue introduced the form in a very tax payer unfriendly manner. Will the Department be magnanimous to ignore incompleteness in the filling of this form for 2005/2006 and begin in earnest from 2006/2007?

On the other hand, if a serious effort in increasing tax collection is to be made, then every person of a certain level of income and professionals, business men and politicians should be asked to fill this form. Then it may be possible to widen the tax net. In fact the filling of this form accurately could be an indirect means of tracking down bribery and corruption.

There are several issues of tax administration that are crucial for the government's effort to increase personal income tax revenues to succeed. One is the efficiency and integrity of the officers in the department. It is well-known that the technical capabilities of staff leave much to be desired.

There is considerable doubt about the integrity of the officers. It is observed that it is easier and beneficial to bribe officers through intermediaries than to get an honest statement to be passed. Of course the fact is that businessmen rarely submit a correct statement and the evasion of taxes is rampant. What makes it possible to pay lesser taxes is the possibility of bribing officers.

One way of tracking this down is to require all Inland Revenue officers themselves to fill the income tax form irrespective of whether they are taxable or not. An independent unit, perhaps with some connection to the Bribery Commission, should screen these forms. Whatever devices are used, there must be a means of reducing bribery and corruption in order to increase the efficacy of tax collection.

Time will tell whether the efforts to increase personal taxation would bring in substantial revenues. If it does not, it is best to devise systems and broaden strategies that are already in place, like withholding taxes and those at source that would bring in higher revenue. It is also vitally important for the department to act in a friendly manner and make tax compliance easy and convenient.