The immediate policy priority should be to restore emphasis on exports: Liberalise the trade and investment framework to attract FDI.
Public sector reforms to cut costs are vital. While tax increases may be unavoidable, the additional burden on the public must be minimised: Reforms for the public sector to reduce its size, cut corruption and improve efficiency are essential.
The current tax structure is incoherent and chaotic. It must be reviewed and policy grounded on sound fiscal and tax principles including fiscal adequacy, administrative feasibility, simplicity, transparency and stability.
Despite a significant improvement in the first half of the year, meeting Sri Lanka’s budget deficit for 2016 will be challenging. A significant amount of fiscal consolidation will still be needed over the next few years if the government is to achieve its stated goal of reducing the budget deficit to 3.5% of GDP by 2020 or indeed meet its commitments to the International Monetary Fund (IMF), which is likely to create considerable uncertainty over the likelihood of further tax increases.
Given the difficult environment and ambitious targets, the government may be tempted to resort to ad hoc, short-term measures to deal with fiscal crises as they arise, creating a volatile business environment, eroding confidence and leading to a lack of predictability in revenue targets. This, in turn, results in further ‘quick fixes’.
This is a vicious cycle that must be broken if consistency and predictability is to be restored to the tax system. This is possible if the government adopts a framework of evidence-based policymaking, and we urge that this be done as a matter of priority.
Making policy that is based on evidence is not easy, but it is possible to draw on the experience of countries such as the UK, which have adopted such an approach. Frameworks that governments can follow to build and support a system of evidence-based policymaking are available, and the government should seek specialised assistance to implement a structured approach. This will help ensure consistency and predictability in policy, improving business confidence.
Policy making must be an ongoing process, and consultation and assessment should not be limited to a period a few weeks before the budget. Poorly researched policy may cause unintended consequences and result in policy reversals. While all suggestions must be considered, many are likely to come from sectors seeking privileges. These must be carefully researched, subjected to wider consultation and adopted only if overall benefits to society outweigh costs. Some of the complexity and anomalies in the tax code may be traced to the accommodation of various special interest groups.
In achieving its fiscal targets, the government cannot limit its focus to raising taxes. Breaking from the pattern of the past, equal or even greater emphasis must be placed on the reduction of expenditure, reviewing not only the scale of spending but also the scope of the government.
An economy drive eschewing extravagance, the elimination of corruption and waste through increased transparency, and open processes must necessarily form a part of this exercise. Sri Lanka’s leaders frequently cite the example of Singapore. Fiscal prudence has been a hallmark of Singapore’s governing philosophy and successful management of the economy – an ethos that must become a watchword for Sri Lanka’s rulers. The Singapore Civil Service’s “Cut Waste Panel” and “Economy Drive” offer useful practical lessons in managing costs and could be adapted for Sri Lanka.
The tax system must be simplified, widening the base and increasing compliance. The finance minister’s commitment to this is laudable. The remainder of this submission seeks to outline a few key issues and offer avenues for the administration to explore. We believe these ideas are worthy of careful study and could yield outcomes that will assist in stimulating growth, reducing the budget deficit, and simplifying and rationalising the tax system.
Rethink the development strategy
Restore policy emphasis on exports
Lacking a large domestic market and possessing few natural resources, exports offer the best opportunity for rapid development.
Successful integration of the manufacturing sector into global production networks has played a key role in employment generation and poverty reduction in China and other high-performing East Asian countries.
The market-oriented policy reforms of 1977/8 were based on this rationale and served the country well, resulting in a notable diversification of the commodity composition of Sri Lanka’s exports and a consistent improvement in share of world manufacturing exports until the late 1990’s.
However, protectionist pressures began to build in 2001, and from 2004, the relatively open trade policies of the past were explicitly and systematically reversed. A policy paper by the World Bank titled “Increase in Protectionism and Its Impact on Sri Lanka’s Performance in Global Markets” shows that, today, through the proliferation of a variety of para-tariffs, Sri Lanka’s tariff policies are just as protective as they had been more than 20 years earlier.
The present protectionist import tax structure has serious costs for Sri Lanka’s economic welfare and growth; Sri Lanka’s exports relative to GDP have declined, as has its share of world exports. Sri Lanka has fallen significantly behind its competitors. Vietnam, which was on par with Sri Lankan exports in 1990 with $2 billion per annum, today exports $162 billion versus Sri Lanka’s $10.5 billion.
A bulk of Vietnam’s exports is driven by foreign investment and a globally competitive agriculture sector that emerged in the wake of a liberalisation drive that moved away from ‘self-sufficiency’. FDI firms account for 71% of Vietnam’s and 44% of China’s exports. The lesson is clear: To boost growth and create productive employment, Sri Lanka should cut barriers to trade and investment, and focus on attracting export-oriented FDI.
The most important reforms needed are listed as follows:
1. Trade policy reforms: Move from the present chaotic tariff structure towards a transparent, uniform tariff structure
• Unify the existing Customs duty and the plethora of para-tariffs (PAL, VAT, CESS, Customs Surcharge) into a single Customs duty at the individual Customs code level, and then reduce Customs duties across the board to a uniform nominal rate of 15%. Moving towards a low, uniform tariff structure has the potential to increase tariff revenues. This would speed up Customs clearance and reduce the potential for corruption as it reduces the discretion of Customs officials and makes the trade regime predictable.
• On the export side, remove all cess as it reduces the effective price received by exporters, and thereby discourages exports. There is no evidence to suggest that these cesses promote local downstream processing of primary products that are now exported in ‘raw’ (unprocessed) form.
• Join the Information Technology Agreement of the WTO to create free trade in electronics, which will attract FDI to this sector.
2. Foreign direct investment reforms
• Restore the role of the Board of Investment as the ‘one-stop shop’ for investment approval/promotion (as envisaged in the BOI charter). This requires repealing the Revival of Underperforming Enterprises and Underutilized Assets Act (2011) and the Strategic Development Projects Act (2011), or passing new legislation to supersede these two acts.
• It is, of course, necessary to rationalise the fiscal incentives offered to investors, but there is a strong case for providing export-oriented foreign investors with time-bound tax holidays and investment tax allowances beyond the tax holiday period.
There is evidence that tax incentives play an important role in influencing location decisions of export-oriented (efficiency-seeking) FDI, especially where competing countries still offer them, provided of course that the other preconditions are ‘reasonably’ met. (The evidence used in recent policy reports by the World Bank to argue against tax incentives comes from studies that have not made a distinction between ‘market seeking’ and ‘export-oriented’ FDI). Removing all tax incentives, while other negatives continue to weigh on the overall competitiveness in investment and trade, may be counterproductive.
• Sri Lanka has to improve property rights to draw investment. The guarantee against nationalisation of foreign assets without compensation provided under the Article 157 of the present Constitution needs to be maintained under the ongoing constitutional reforms.
• Avoid the current practice of ‘domestic value added’ [which is defined as per unit of domestic retained value (wages + profit + domestically procured intermediate inputs) as a percentage of growth output] as an evaluation criteria in approving investment projects.