Under-taxing and over-spending
View(s):Last Sunday I had to chair a webinar on ‘Tax Reforms for Economic Recovery in Sri Lanka’. While R.H.S. Samarathunga, former Secretary to the Ministry of Finance spoke on the taxation problem of Sri Lanka from a macroeconomic perspective, Murtaza Jafferjee, CEO of JB Securities Ltd. presented its microeconomic anomalies from a business perspective.
Coincidently, I had already written in this column last week about the “over-spending” problem of the country as the ultimate source of the current economic crisis. And, as we discussed there, this problem of “spending beyond capacity” has two sides – government finance and external finance. The above webinar presentations inspired me to take up the two issues briefly and separately; Accordingly, I thought of focusing on the government finance problem today and, perhaps, leave the external finance problem for next week.
Tax revisions
Food prices will rise with increased taxation.
It was this week that the government announced an immediate increase in VAT from its current rate of 8 per cent to 12 per cent and the Telecommunications Tax from 11.25 percent to 15 percent. Apart from that, there will be a downward revision in income tax threshold, corporate tax threshold, and VAT registration, all resulting in a widened tax base, along with other forms of tax revisions. Technically, tax reforms mean reversing the “tax cuts” in late 2019 that reduced the government’s tax revenue almost by one-third.
We understand that the government needs to enhance its “spending-capacity” in order to avoid further borrowing and money-printing fueling the crisis. Nevertheless, in a crisis time when incomes have fallen and the demand has declined (due to commodity shortages, currency depreciation and the sky-rocketing prices), the effectiveness of tax reforms is yet to be seen. Besides all that, as we will discuss below, there are effective ways to be added into medium-term government financing, in order to address the problem of spending beyond capacity.
Government finance comprises “taxing people” as the main source of revenue which is needed for the government’s spending requirements. The over-spending problem arises when the tax revenue is too small to finance government spending; it results in annual budget deficits, which should be covered with borrowings.
Open economy, reversed
One of the puzzling questions has been why the government’s tax revenue became lower, when the country became richer? The tax revenue, which was around 25 per cent of GDP in the early years of trade liberalisation, declined to below 20 per cent in the early 1990s, below 15 per cent in the early 2000s, below 12 per cent in the early 2010s; with tax cuts in 2019, apparently as a “political decision” brought it down from 11.6 per cent of GDP in 2019 to 8.1 per cent in late 2020 and to 7.7 percent in 2021 in the midst of the COVID-19 pandemic issue.
Why did Sri Lanka pay higher taxes when its per capita income was poor, and lower taxes when the income was higher? Tax collection didn’t improve, tax policies became complicated, tax compliance became poorer, and the tax exemptions became multiple. This was also a period that the initial liberalisation attempt was reversed with the introduction of complicated para-tariffs, causing policy bias against exports – a source of the growing external finance problem. As a result, with 17.6 per cent tax revenue deriving from international trade by 2019, Sri Lanka has become a “protected economy” more than its neighbouring countries. Compared with Sri Lanka, taxes of trade as a percentage of total tax revenue was 4.5 per cent in India, 3 per cent in Thailand, 1.9 per cent in China, 1.5 per cent in Malaysia and, zero per cent in Singapore.
Taxes and debt service
While government spending against declining tax revenue became unsustainable, politicians continued to keep promising more and more handouts, not knowing how to give more out of unavailable resources; for instance, consider the last election campaign at which they all competed making unsustainable election promises to give more subsidies, more tax cuts, more government jobs, more salary increases etc.
Over the past few decades, the government continued to borrow in order to bridge the widening gap between actual spending and tax revenue to spend. Gradually, the annual debt service payments rose even above the tax revenue; for instance, in 2019 debt service payment was Rs. 2,022 million, compared to the government’s tax revenue of Rs. 1,735 million, out of which the debt has to be paid.
Moreover, there was the Rs. 533 million current account deficit, indicating that the government must borrow even to meet day-to-day recurrent expenses. We should not forget the fact that, out of the tax revenue more than 50 per cent was just to make the interest payments for previous borrowings which has further increased to over 80 per cent during the past two years.
Direct-indirect tax shares
One of the important tax anomalies is the distorted direct and indirect tax shares. While direct taxes are the income taxes, which account for less than 25 per cent of the total tax revenue. In most of the years, it has been even below 20 per cent. In 2018, Sri Lanka’s direct tax share was 18 per cent, compared to 37 per cent in China, 50 per cent in India, 68 per cent in Malaysia, 47 per cent in Singapore and, 40 per cent in Thailand.
This implies that Sri Lanka, unlike many other countries in Asia, depends overwhelmingly on indirect taxes (VAT, import duties, excise taxes and other commodity taxes) for generating government’s tax revenue. So, what’s the problem? The problem is that the government doesn’t know, or doesn’t want to know, people’s income and wealth! The current income tax system is based on inefficient ad hoc selection criteria and self-declared income statements, both causing a lower income tax share.
A technology-based, and effective income tax system may be an answer to many other questions that require information on people’s income and wealth. Nevertheless, one of the important problems would be that many, including many politicians and bureaucrats, will have a problem of exposing or explaining their income and wealth. Perhaps, for the same reason, we have ignored its need as part of an efficient and effective tax administration system, and attempted to maximise tax revenue through more-comfortable indirect tax systems. As a result, our indirect tax system has become a complicated multiple tax system that has over-burdened the public and deters economic growth.
As far as raising direct tax revenue is concerned, there are other important areas such as property tax and non-tax revenue for the government. With respect to the non-tax revenue, the government as the biggest land-owner of the country has the ability to allocate its land for private businesses charging rent and introducing a fee for numerous government services, replacing the current practice commonly known as the “bribery system” for such services.
Spoon for others’ money
The problem of “over-spending” with respect to government finance cannot be solved just by raising the tax revenue, particularly in the midst of a severe economic hardship. It definitely requires a ruthless expenditure cut. It is not only cutting down the expenditure for the poor, but designing an overall expenditure-cutting programme covering from the top to bottom.
Finally, I want to recall an important question that might bother us sometimes: Why should we pay tax? Obviously, the answer depends on the purpose of tax. According to one argument, “we pay taxes to live in a civilized society”. Another argument is that “the societies which pay taxes will have a better governance”.
As a matter of fact, conceptually both arguments are correct. But their practical application doesn’t seem as simple as that; those who have got the spoons, of course in different sizes, know how to share themselves by the size of the spoon they hold. It is because, “tax money is someone else’s money” for which others have the legitimate power to share with. And we have overwhelmingly practiced the habit of sharing others’ money without accountability – one of the important reasons for the current crisis.
(The writer is a Professor of Economics at the University of Colombo and can be reached at sirimal@econ.cmb.ac.lk and follow on Twitter @SirimalAshoka).
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