Sri Lanka’s taxation at a glance

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2017-08-27

with Umesh Moramudali

Tax is often considered one of those evil words that scare people. When I hear the word tax, I used to recall how much hate the Sheriff of Nottingham in Robin Hood inspired for collecting tax from the people and making them miserable. However, as I grew up, I was made to understand that tax is an essential part of everyone's life for the simple reason that it is the major source of government revenue which provides for public amenities.

In recent past, as the new Inland Revenue Bill was presented to the Parliament, the talks about taxation were renewed. For many Sri Lankans, just like I used to think in my childhood, tax brings fear. People are afraid to be taxed and it is very rare to meet someone who appreciates the importance of taxation.

Given the significance of taxation and the vital role it plays in any economy, father of capitalism, Adam Smith specified four major principles of taxation. Those are named Canon of Equity, Canon of Certainty, Canon of Convenience and Canon of Economy.
Canon of equity refers to the importance of taxing citizens based on their ability to pay. In other words, those who earn more should pay higher amounts of tax. In the words of Adam Smith "The subjects of every State ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities, that is, in proportion to their revenue which they respectively enjoy under the protection of the State."

Canon of Certainty refers to the certainty of the amount of tax paid by the individual, when and how. It further implies the importance of a certain method to pay tax. Canon of Convenience or Ease dictates, the tax payer should be able to pay the tax without much hassle. Canon of Economy refers to the minimization of expenditure in the tax collecting process, emphasizing the need for efficiency in collecting tax.

Taxation in Sri Lanka has a number of issues. Major concerns regarding taxation of Sri Lanka are threefold. One is that the tax revenue is extremely low as a percentage of the GDP, second, country's tax structure is extremely complex, making it cumbersome and hectic for tax payers and the third concerns composition, as majority of the tax revenue is generated through indirect taxes such as Value Added Tax (VAT)

Low tax revenue
Over the years, country's tax revenue has been declining as a percentage of the GDP and by now the tax revenue to GDP ratio in Sri Lanka is one of the lowest in the globe. ln 2014, it was as low as 11.6% of the GDP, although there was a sharp rise of tax revenue during the last two years, which resulted in increasing tax revenue to GDP up to 14.3% by 2016.

The country's tax revenue to GDP ratio was as high as 20% during mid 1990s. It was 19.7% in 1993 and increased to 20.5% in 1995. However, ever since then it was consistently declining at a substantial rate and by 2003 it had dropped to 15.7%.
Let alone developed countries, which has tax to GDP ratios exceeding 30% (In Denmark tax revenue to GDP ratio is 46.6%), the Lanka figure is very low even comparing with the countries in the region. In order to maintain expenditure level around 20% without sustaining a budget deficit, the tax revenue needs to be increased.

Composition of tax
One of the serious problems regarding taxation in Sri Lanka is the composition of tax. More than 80% of the tax revenue is generated through indirect taxes which violates the fundamental tax principle of equity. In the case of a country having a colossal amount of indirect tax, every citizen pays the same amount of taxes despite their income or ability to pay tax.

It appears that things had got worse for Sri Lanka over the last two decades. According to the IPS State of the Economy Report 1994, nearly 45% of the tax revenue was generated through indirect taxes in 1994. By now, the figure has risen above 80% subsequent to the introduction of the Goods and Services Tax (GST) which later was replaced by VAT. By 2016, VAT amounted to 17% of the total tax revenue. During 1971-1975, tax on goods and services amounted to 28% of total revenue, and the figure has soared to 46% during the period 2011-2015.

Need to increase tax net and informal sector
Although GDP has grown over the years, the number of direct tax payers has not increased correspondingly. That has resulted in the stagnation of tax base which is the major reason for the inability of the government to increase direct tax revenue.
One of the major reasons for the inability to increase the tax base is the strong presence of the informal sector. According to the Department of Statistics, nearly 60% of the labour force is in the informal sector, making it impossible to tax the income as such, income is not recorded officially. For example, as per new amendments, a person who earns more than Rs 100,000 per month who is in the formal sector will be liable to pay Pay As You Earn (PAYE), while a person who is in the informal sector who may earn more than Rs 100,000 will not be liable for PAYE.

Complex tax system
Another concern is the complex nature of taxation in the country. There are too many types of taxes and duties in Sri Lanka. That makes it very difficult for the tax payers and acts as a barrier to business facilitation due to cumbersome process. For example, there are certain para tariffs such as Port and Airport Levy (PAL) which make the import process more complex. It is proposed to implement a uniform tariff at a higher rate making the process more simple, instead of making people pay tax for importing the same item several times.

Regarding VAT, at present there are over 150 exemptions as mentioned earlier, making the concept of tax on value addition ineffective. Ideally there should be only a single rate as multiple rates tend to make the system complicated. Therefore the situation that prevailed, with distinct rates for standard goods / services, luxuries and essentials, is not advisable.

Recent trends
CBSL Annual Report 2016 notes that in order to rectify the structural weaknesses persistent in the government budget during the recent past, the government committed to a revenue based fiscal consolidation process, rather than merely pursuing expenditure cuts.

"Although the declining trend in the revenue to GDP ratio observed during the recent past, which is a key concern on the fiscal front, was reversed in 2015, further measures were warranted to maintain this momentum on a sustainable basis, given the issues in the country's tax system. Accordingly, several reforms were undertaken during the year to streamline and simplify the tax system, broaden the tax base, rationalize tax exemptions and concessions, and strengthen tax administration. The measures taken during the year included the Value Added Tax (VAT) rate hike, removal of several exemptions granted on VAT and Nation Building Tax (NBT), broadening of the VAT base by introducing new items into the tax net, reducing the threshold level of NBT, rationalization of incentives granted through the Board of Investment (BOI), upward rate revisions of other taxes, such as Economic Service Charge (ESC), and the removal of exemptions granted under several taxes," Annual report notes.

It was further revealed that during the year, by regulating tax audits, undisclosed income and turnover amounting to Rs 225,424 million could be taxed. Additional taxes imposed during the year based on that were Rs 17,023 million. Actions and steps for recovery of tax have been taken continuously as stipulated in respective enactments in addition to the Default Tax Recovery Act. The Committee for Interpretation of Tax Laws issued interpretations on 38 cases during the year, in addition to necessary guidelines and instructions on certain provisions of the legislation.

Umesh holds a B.A. (Hons) in Economics from the University of Colombo and can be contacted via [email protected]

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