Show me the money: a magic trick waiting to backfire

Originally appeared on The Morning

By Dhananath Fernando

Will the new tax amnesty really help us in the long run?

This is the humorous storyline of a video I watched some time ago by the famous Sinhala comedian duo “Podi malli and Chooti malli”. A father was very worried that his little son had swallowed a two rupee coin. The son and father struggled to get rid of the coin. Then the father patted the son’s back and asked him to vomit, but he couldn’t. 

A gentleman passing by saw this entire incident, and asked: “Can I help you?” Helpless, the father allowed him to take control of the situation. The stranger glared at the son and ordered him to give him the two rupee coin. Suddenly, the son threw up the two rupee coin. 

The father was very happy and surprised. He asked the stranger: “How did you do it and where do you work? Are you a doctor?” The stranger replied: “No, I work for the Inland Revenue Department”. 

This story is definitely not to underestimate our inland revenue officers. But given the proposed Tax Amnesty Bill, this discussion has come back into the limelight. It is not a secret that most current and retired Inland Revenue officers are taken care of by the payroll from small, medium, and even some large corporations, as tax advisors who always find smart ways to go through existing tax laws. So what are the pros and cons of the Tax Amnesty Bill and what would be the aftermath of the proposed Bill? 

The proposed Tax Amnesty Bill provides a wide range of benefits for tax evaders who haven’t abided by tax law. Accordingly, they can pay just a 1% nominal tax and disclose taxable income or assets, and become a legal taxpayer. 

On the plus side, the expectation of the Government is to increase its revenue, which is now required to finance government expenditure, given the extremely tight fiscal situation of our balance sheet. The Government expects to increase the tax base by providing this tax amnesty, and then improve government revenue in the coming years.

Secondly, the Government requires a sudden cash inflow to our economy to manage the expenditure on the fiscal side and a US dollar inflow to manage trade and our mounting debt repayments.

However, if we look at history, in 2002/2003, then-Finance Minister K.N. Choksy proposed a similar tax amnesty, which was reversed in 2004 again.

In recent history, on 2 April 2020, the current Governor of the Central Bank appealed to domestic and international well-wishers on behalf of the Sri Lankan Government to deposit foreign exchange into Sri Lankan banks, with an assurance that no questions would be asked on the financial trail of the funds. In the appeal, the Governor of the Central Bank mentioned that the money would be accepted without any hindrance from the Central Bank and the banking system, and would be exempt from exchange control regulations and taxes for three months from 2 April 2020 onwards. This request was made when our foreign currency earnings came to a standstill with the Covid lockdown last year. However, this did not bring the expected results. 

After spending more than one year without any sustainable solution, we are now back to square one with a similar proposal. In my opinion, this would further generate negative signals to our markets and international donors on multiple aspects. 

In the first place, no tax hikes or tax amnesties will work without a significant expenditure cut. Markets work based on information and signals. When we spend about $ 50 million on buying fighter jets, and when there was a heated discussion on parliamentarians importing duty-free vehicles, the signal system does not work right when we bring about revenue collection proposals. Simply put, markets won’t adjust, and people will not be willing to fasten their seatbelts.

During the pandemic, many companies had announced salary cuts, and the CEO was first to take the salary cut, at a higher percentage, before announcing salary cuts for staff and factory workers. Otherwise – it is not rocket science – resentment and resistance would build within. It may be only a little money we would save from a 15% salary cut for a CEO, opposed to the total savings from 10% Salary cuts for 2,000 workers. But the message has to be right – the policy is moving towards a purpose and the leadership is walking the talk. 

Secondly, on the market front, this move to grant amnesty would first discourage and discriminate against genuine taxpayers. It is true that there are only very few tax files opened in Sri Lanka, but the people who have made an effort to pay tax would be now thinking: “What is the point? Why do I pay taxes while the evaders get an amnesty?” 

This sentiment would have long term implications on eroding our tax revenue further. This would be a double-whammy if we do not get enough tax evaders joining the proposed scheme, because then we have given the wrong signals to the market. In this case, even genuine taxpayers will be discouraged, while at the same time we fail to collect adequate revenue from the tax amnesty.

Thirdly, though the Government has provided assurances that the information would be kept secret, even tax evaders are aware of the absence of proper institutions and transparency measures making it hard to assure confidentiality. This would increase the risk of getting the tax evaders exposed to certain corrupt politicians and causing future problems in terms of bribery to keep their names under the radar. 

Finally, and very importantly, the announced Tax Amnesty Bill and the recent announcement by the Central Bank Governor will again expose Sri Lanka to the grey list of the Financial Action Task Force (FATF), which Sri Lanka was delisted from only in 2019 October. The FATF is the global policy setter on anti-money laundering and countering the financing of terrorism. 

A delisting from the FATF grey list is a positive indication to the market to attract quality investments that look for a credible financial system. The delisting from the grey list was achieved through hard work by the Central Bank and its officials. So they should be the first to stand up against the threat of losing it again. 

At the same time, we have to be vigilant to not breach the codes of conduct and ethical guidelines of international donor agencies, as there is a high possibility of Sri Lanka having to knock on their door as a fallback option. 

So there is simply no magic formula for us like the story of the comedic duo, to just throw up the coins people have swallowed. It has to start from consolidating our expenditure and giving the right signals to the market if we are serious about raising government revenue. Otherwise, by trying to provide tax amnesties and implement unorthodox methods, we would only end up further exposed to unexpected risks.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Coming out a winner

Originally appeared on The Morning

By Dhananath Fernando

Can the Finance Minister come out on top of this crisis?

There are winners and losers for every crisis. The new Finance Minister can definitely be a winner if he understands the problem and tackles the economic crisis upfront. He can become a success story if he does the right thing at the right time. Kumar Sangakkara in his Colin Cowdrey lecture said “In cricket, timing is everything”. It is the same for an economy. Sri Lanka is at the doorstep of an unprecedented economic crisis since independence. Both the Government and opposition have expressed views on this matter. However, if we fail to act now and make the right decisions, it is most likely that the crisis will fail us fair and square. 

So today I am looking at discussing the possible solutions the new Finance Minister has at hand to overcome the situation. 

First, we have to understand that we are already in a crisis. Importers and exporters are having obvious difficulties opening letters of credit (LCs) and people are buying gold to reduce the impact of currency depreciation and inflation on their money. Under these circumstances there is very little rationale in creating a picture that things are rosy. Our supply chains are also under severe turbulence due to adhoc Government interventions. This is further affecting our export capabilities. In our debt servicing, we have resorted to borrowing more with short term liquidity tools such as swaps and short term borrowings to repay our creditors. 

Understanding the problem 

As this column always highlighted, our economic problems are beyond debt serving and opening LCs. Those are just symptoms of the problem. Our economy is like a diabetic patient who has been living on high sugar with no exercise with a bad lifestyle for more than a few decades. Now the patient is in a coma and completely unconscious. This is a serious situation where we need some strong medication and a lifestyle change. Just a few pills of Vitamin C is not going to be sufficient to bring the patient back to some sort of normalcy. 

The patient is diabetic because of a high inflow of sugar. Similarly, our economy is in the present crisis because of excessive Government expenditure on non-available resources. Simply, we do not have money to pay approximately 1.5 million Government workers, run an airline which costs about Rs. 24 billion just for four months which is almost half of our Samurdhi allocation for the year. We further do not have resources to run a petroleum corporation with losses of more than Rs. 100 billion, while continuing to depend on subsidised prices. Comparatively, the losses of the CPC are twice as high as our Samurdhi allocation which is an essential safety net for the country. 

Secondly, we do not have the right institutions to manage economic governance. For example the debt numbers are parked all over SOEs (State Owned Enterprises). Such is the cost of mismanagement. 

Thirdly, our economy is significantly unproductive. All our factor markets (Labour, Land, Capital) are completely inefficient with excessive regulation and protectionism coupled with rent seeking. As a result, in most industries our incentive structures are largely inefficient. Just take our judicial system. All stakeholders are incentivised to postpone the cases rather than reaching resolution quickly. Across other sectors the situation is the same or worse. 

Short-term solutions 

Like with the diabetic patient who is in a coma, in order to become better there has to be a  lifestyle change. However before all that the patient has to be given immediate care to come out of the coma. This involves hospitalised care and the immediate medical treatment in order for the patient to be properly conscious. It is the same with our economy. At present no one is willing to lend us money as we haven’t proved that we are good for our money. Markets are not lending to us. Even the countries we have good relationships with and our decades-old international organisations are requesting some sort of an assurance to work with us. The only organisation who can provide some credibility and assistance is the IMF (International Monetary Fund). The IMF is not an alien body. Sri Lanka is a member of the IMF, and since the next day we formed our Central Bank and our Governor and the Minister of Finance, who are the representatives of this global body. The IMF has no magic formula but the Governor and the Finance Minister have to agree on an economic programme to establish transparency, accountability and make immediate but necessary adjustments. Simply, they will ask us to take measures to increase revenue and reduce expenditure.  However, what is important is to make sure that the programme implemented by us is  good enough and well disciplined and effective in order to prevent us going to the IMF again. We have gone to the IMF 16 times since we became a member of the IMF. 

Secondly, in the short-term we have to let the price system work in the energy markets. Import of oil is our largest import and this needs to be priced properly. The market economy is nothing complex but is simply allowing the price system to work. There cannot be any magic formula for us to keep prices lower when the world market pieces are rising. Therefore allowing market prices to work will allocate the optimum utility for our resources. 

Thirdly, we have to freeze Government recruitments and even offer a scheme for unproductive workers to leave which may help in some level to control expenditure. Currently 86 cents of every 1 rupee collected is taken away by the Government employees as their salaries. Needless to mention that it is not sustainable. 

Medium-term solutions 

Implementing the above will give us some short term breathing space and prevent a full blown crisis. Same as the diabetes patient who was in a coma now became a little conscious. Then we have to make sure the patient does not go back to his old habits. So in the medium term setting up the right institutions for management of SOEs and restructuring and privatising some SOEs are of paramount importance. 

At the same time allowing the price system to work requires strengthening our safety nets. The current Samurdhi programme is our main safety net programme which is a politically driven list. Those who deserve the Samurdhi are not in the list while those who have moved out of poverty are still in the list. So we have to have a digital Samurdhi system where cash transfers are prioritised. When market prices change there will be additional allowances added based on the price change and when prices go downwards those benefits will come down proportionately. So even the poorest in the society are given an opportunity to catch up and contribute back to the society and markets. 

In the meantime deregulation of our factor markets as well as our product markets have to continue. The President appointed a commission to look into this and create a collective effort on deregulation of existing bureaucratic structures, regulations and  proceedings. 

By implementing these reforms the image and reputation of the country will be improved. As a result there will be a significant inflow of FDI. 

Long-term solutions 

Longer term solutions are similar to getting the diabetic patient to a healthy lifestyle. In the long run we have to provide a solution for our lands. Simply a digital land registry and transferring Government-owned land for productive use must be prioritised. Giving proper land titles will infuse more capital into the market and make our precious land more productive. 

Similarly, our judiciary system has to be digitised and the resolving cases and contract enforcement has to be strengthened. Currently needless to mention our court system is very unproductive and inefficiency is rewarded. 

In the meantime there has to be a better governance structure within the Central Bank to protect our currency. If we fail in our monetary policy the rest of the policies will fall apart. 

Above are just a few recommendations. Given the nature of our problem there has to be strong medication. Serious economic reform along with making structural economic changes have to take place. Without reforms the chances of an economic recovery is unforeseeable. If the finance minister becomes a reformer, then all Sri Lankans will succeed and emerge victorious, when coming out of this crisis.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.