Tax

Will the sugar tax leave a bad taste in your mouth?

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In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning


By Aneetha Warusavitarana

Rising rates of obesity and incidence of non-communicable diseases (NCDs) have long been a point of concern for the Sri Lankan health sector. As a country, we have made significant strides in addressing the challenge of communicable diseases, and now policymakers are shifting focus onto NCDs. The imposition of a tax on sweetened drinks in 2018 was a point of serious debate. It was both lauded as an admirable step in tackling the issue of NCDs, while simultaneously facing serious protest from the soft drink industry.

In 2018, the 51-day Government reduced this tax, and now the present Government stated that it will re-impose the tax, citing health concerns as the motivation behind it. While a final decision is yet to be taken on this, given that this is the same Government that imposed the tax, it seems likely that we will be seeing a tax increase.

Political packaging

Sugar tax

Imposing this tax is an easy way to gain some political mileage. The narrative presented is simple – obesity and non-communicable diseases are a serious health concern for the Sri Lankan population. Sugar consumption is a contributor to this problem and as a responsible Government, they need to take steps to discourage consumption – this will be done through a tax per gram of sugar in carbonated drinks. In essence, the tax is packaged as a health-positive policy measure. Indeed, at face value, the tax does present as such. However, there are a few questions which can be raised.

Is this tax fair?

There are two things in life that are certain – death and taxes. While it may be that we will have to continue paying taxes, these taxes should be sensible, effective, and should not be prohibitively burdensome. This idea has been espoused in basic principles of taxation to ensure the tax is effective and equitable. One of the principles the OECD expounds is that of neutrality: “Taxation should seek to be neutral and equitable between forms of business activities.” Neutrality also means that the tax system will raise revenue while minimising discrimination in favour of or against an economic choice.

In the case of the sugar tax being imposed by the Sri Lankan Government, it is clear that the principle of neutrality is not adhered to. At a fundamental level, it is a “sin tax” or a “fat tax” – a tax being imposed to change the economic choices of the population – the aim of the tax is not to raise revenue, but to shift consumer behaviour away to more healthy options. Given that the sugar tax is applicable only to carbonated drinks, and excludes other sweetened drinks like fruit juice or milk packets, it is clear that the principle of neutrality has been ignored here.

Does unfair equal ineffective?

The principle of neutrality in taxation is all well and good, but does this affect people? The answer is yes. When the principle of neutrality is violated and a tax is imposed in a manner that is inequitable to business activities, it loses its effectiveness. The objective of this tax is to discourage the consumption of carbonated drinks with a high sugar content, to achieve a higher goal of good health. When the tax is imposed unfairly only on carbonated drinks, it means the consumers which simply substitute a carbonated drink with an alternative – and there is no guarantee that the alternative will be a sugar-free, healthy one. In fact, the likelihood is that people will switch to a different product with a similar calorie/sugar count – if a bottle of fruit juice is cheaper than a bottle of Sprite in the supermarket, you don’t want to pay more for the bottle of Sprite and you are likely to buy the juice instead. The health concerns will not end up being addressed because consumers will simply substitute one drink which is high in sugar with another drink that is also high in sugar.

Unfortunately, in the case of taxing food and beverages, the issue is that consumers can simply choose to continue to consume a similar level of sugar, just from a different source. Given that this tax only applies to one category of sweetened beverages, consumers can easily substitute it with another, cheaper beverage. There is also the question of whether sales of carbonated beverages drop; international evidence has mixed results. While the WHO (World Health Organisation) applauds these taxes, other studies question whether the tax affects sales of carbonated drinks to an extent that it would have an effect on overall health, or whether consumers are simply shifting preference to an alternative which is an equally sugary substitute.

The final word on this is that there is, at best, uncertainty about whether this tax creates a positive health externality; and at worst, consumers switch to unhealthy alternatives while businesses lose out on revenue.

Tariffs and the law of unintended consequences

Originally appeared on Sunday Times

By Aneetha Warusavitarana

The law of unintended consequences is a theory that dates back to Adam Smith, but was popularised by the sociologist Robert K. Merton. In short, the law explains the reality that when governments intervene to create a set of outcomes, as the theory of cetris paribus (holding other factors constant) cannot be achieved in a market situation - the result is a series of unintended consequences.

Colonial India and Cobras

This law is also known as the ‘Cobra Effect’, dating all the way back to when the British first colonised India. The British were understandably concerned about poisonous snakes in India, Cobras apparently being a source of some worry. The solution they presented was to provide a reward for every Cobra that was killed, creating a clear incentive for locals to capture and kill any Cobras in the vicinity. While this worked well in the short term, the British slowly realised that enterprising individuals were actively breeding Cobras; creating a very profitable business out of collecting bounties. Once this was clear, the British removed the bounty, and now as this was no longer a profitable venture, the breeders released all their Cobras. The final outcome of this was an increase in the general Cobra population, completely the opposite of what the intervention set out to achieve.

While this makes for a good anecdote, the economic realities of the law of unintended consequences are often more dire. Interventions into the market are often well-intended, but have the potential to backfire. A shining example of this is the case of tariffs. Forbes recently published an article which detailed the unintended consequences of a washing machine tariff imposed in the US. This well-meaning tariff was introduced to protect domestic producers in the US, and boost employment in that industry. If one evaluates the effectiveness of the tariff simply on those two criteria, then the tariff has been a resounding success; US washer and dryer industry created around 1,800 new jobs. This could easily be written off as a success story.

The Cobra effect on washing machines

However, the focus here is only on the producer, and the consumer has been removed from the narrative. The first unintended consequence was that as imported machines were now more expensive, domestic manufacturers could safely raise their prices, without fear of losing out on sales. The second unintended consequence was that dryers also became more expensive. As a complementary good to washing machines in the US, manufacturers of dryers saw this as the perfect window in which to raise their prices and increase their profits (clotheslines would save Sri Lanka from this unintended consequence).

Taking all this into account, according to Forbes, this has cost American consumers around USD 1.5 billion. One could argue that this increase in prices and resultant cost to consumers can be justified by the 1,800 jobs that were created. The reality is that each job is equivalent to USD 815,000 in increased consumer costs. This tariff policy effectively protects the local industry at the cost of their own consumers.

Why should Sri Lankans care about washing machine prices in the US?

While we can agree that this does appear to be an unfortunate example of unintended consequences, and that it is pretty clear that domestic consumers got a bad deal here, why should the average Sri Lankan care? After all, we have sunlight soap and clotheslines.

Sri Lankan consumers should care because the same unintended consequences that took place oceans away in the United States is happening here, in our little island nation. Tariffs have long been the favoured tool of successive governments. Tariffs sound really good on paper, and better if said paper is an election manifesto. ‘We will protect our domestic producers’ is a statement that tugs at the heartstrings of too many voters. The fine print ‘at the cost of domestic consumers’ is not something that is publicised, but it should be.

Tariffs have been imposed on goods ranging from household care, personal care and food. The price of items as diverse as school shoes and construction material are affected by this. The entire country complains about how the cost of living is too high, and unreasonably high tariffs are one of the drivers behind this. Unfortunately for us, the imposition of these tariffs create exactly the same series of unintended consequences that American consumers have to face. The price of the weekly shop an average Sri Lankan does whether it is from the delkanda pola, the closest supermarket or the handiye kade is affected by tariffs. A potato, even if it is locally produced is more expensive than it needs to be, because tariffs push the price of imported tomatoes up, allowing domestic producers to raise prices with the consumer losing out.

Tariffs on essential goods in Sri Lanka can range from 45% to 107.6%. There needs to be a serious re-evaluation of the role of tariffs in our economy – the rationale behind imposing them, the consequences of the tariff (which are well understood and cannot be discounted or ignored), and ideally a faster regime for phasing them out.

How import taxes drive up the cost of living

Originally appeared on Daily News

By Ravi Ratnasabapathy

“The Lanka Confectionery Manufacturers Association (LCMA) is actively seeking Government intervention to introduce a ‘negative list of manufacturing’ to safeguard local firms engaged in the industry before opening up the economy to giants like India and China.” - DailyFT 25 September, 2017

The above is an illustration of a phenomenon that is common in Sri Lanka – an industry seeking protection from foreign competition. This protection generally takes the form of a tariff – a tax that is imposed on the imported product that is not applied to the domestic equivalent. In the above instance the LCMA is requesting that the existing tariff protection enjoyed by the industry is continued even if a Free Trade Agreement (FTA) is signed. (An item in the “negative list” of an FTA is not subject to the FTA). For example imported biscuits are taxed at a total of around 107% of price, if biscuits are on the negative list this tax would continue, despite the FTA.

Although a tariff is imposed, this does not generally cause foreign exporters to reduce the price that they charge for the product. Therefore the domestic price of the imported product rises by the amount of the tariff.

Domestic producers competing with these imports do not have to pay the import tax so have an advantage over the imported product. As the price of imported products rise, domestic producers have the opportunity to raise their own selling prices because competing imported products now cost more.

Will the domestic producer raise his prices? Yes, it makes no sense otherwise. If the domestic producer were to set his prices at exactly the same level he would if imports were not taxed there would be no point in seeking tariff protection from imports. They very purpose of the tariff is to enable the domestic producer to sell his product at a higher price. The domestic producer is thus better off as a result of the tariff.

What happens to consumers?

Domestic consumers of the product are equally affected by the imposition of the tariff. They must pay a higher price for both imported and local products.

In other words, the protection for domestic industry is actually paid for by domestic consumers, in the form of higher prices.

What of the Government that imposes the tariff?

The government collects tariff revenue, on whatever quantity is imported, although they do not collect it on the local product. The benefit that the Government creates for the local producer by raising the price of imports is collected by the producer. This surplus is called a “rent”, of which more below.

We thus have two domestic winners (domestic producers and the government) and one domestic loser (domestic consumers) because of the imposition of a tariff.

The local producer who is able to charge a higher price from the consumer thanks to the tariff on competing imports is said to enjoy a “rent”. In economics, a “rent”, is an unearned reward. The producer is able to charge a higher price not because of superior quality or service but because a tax imposed by the Government.

If the producer was able to charge a higher price because of better quality, even while cheaper imports were available the producer would be earning the premium price. There is an important distinction here.

Consumers would only buy a more expensive product while lower priced products are available is if they valued what they were getting. The producer must do something extra to persuade consumers that his product is superior and worth paying a higher price.

When a tariff raises the price of imports, local producers are able to charge higher prices with no increase in value to the consumers. Given a choice consumers may well chose cheaper alternatives – but the tariff makes sure that the alternative is no longer cheap. Consumers are thus forced to pay a higher price, not because they want to but because there is no alternative. This is why the premium in this instance is said to be unearned. Consumers do not perceive better value but pay more.

Thus producers gain at the expense of consumers. As noted before, it is domestic consumers (not foreign producers) who pay for the protection of domestic industries. The net impact is a transfer of wealth, from consumer to producer that is facilitated by the tariff.  Is this good policy?

If it were confined to a handful of industries it may not matter much, but in Sri Lanka it is all-pervasive. Over thirty common household items affected are listed below. This is only a selection-many others are affected. It explains why Sri Lanka’s cost of living is so high. All necessities from food (fruit, meats, pasta, jams) to toiletries (soap, shampoo, toothpaste) to household products attract taxes from 62%-101%.

Food Items total tax

Sri Lankan consumers suffer a high cost of living in order to support domestic industries. There is an argument that supporting local producers to build an industrial base will accelerate growth in the long run.

Japan, Korea and Taiwan practiced industrial policy(IP), but even proponents of the policy admit that care is needed to pick the right industries. In Japan and Korea the main industries were steel, shipbuilding, heavy electrical equipment, chemicals and later cars. Taiwan had light manufacturing (electrical appliances, textiles) before moving to heavy and chemical industries and electronics.

Sri Lanka seems to want to emulate this in toiletries, household cleaning products and food: soap, shampoo, washing powder, floor polish, pasta, cheese and biscuits.

Personal Care items tax

To succeed, industrial policies need to foster a structural transformation in the economy that leads to rapid creation of jobs, especially more productive and better jobs. Selecting the right industries is important.

“it matters how realistically the target industries are selected in light of the country’s technological capabilities and world market conditions” [1]

Krugman [2] summarises some criteria advanced by proponents of IP in selecting sectors:

  1. High value-added per worker. Real income can rise only if resources flow to businesses that add greater value per employee.

  2. Linkage industries-such as steel and semiconductors. Industries whose outputs are used as inputs by other industries can create a cycle of industrialization. In Japan cheap, high quality steel gave downstream industries-ships, automobiles, rails, locomotives, heavy electrical equipment-a competitive advantage.

  3. Present or future competitiveness on world markets. If the industry can meet this test, we can presume that resources are being allocated efficiently. Competitiveness is critical for linkage benefits to flow.

The selected industries need to target exports (albeit not exclusively)– to achieve scale economies and because it provides a “tangible criterion for the policy makers to judge the performances of the enterprises promoted by the government” [3]. The failure to promote exports is the key reason for failure of industrial policy in Latin America. (Chang, 2009)

The exports focus also ensures competitiveness. The purpose of policy is not to protect inefficiency but improve productivity.

Therefore support for industry must be conditional-on meeting performance targets.

“The results of industrial policy (or indeed of any policy in general) depends critically on how effectively the state can monitor the outcome that is desired, and change the allocation and terms of support in the light of emerging  results” [4]

Deliberation Councils were set up in Japan and Korea which would set targets together with industry. To ensure targets were stringent they also involved independent technical experts, academics and others.

Performance would be monitored and targets revised. Where a policy was seen to be ineffective it would be revised. Industrial policy is not only about picking winners but also phasing out losers.

“The success of industrial policy depends critically on how willing and able the government is to discipline the recipients of the rents that it creates through various policy means (tariffs, subsidies, entry barriers). The point is that the suspension of market discipline, which is inevitable in the conduct of industrial policy, means that the government has to play the role of a disciplinarian” [5].

This requires a bureaucracy insulated from political pressure to take impartial decisions on the support to industry-and change or withdraw support, depending on performance.

“How closely the government interacts with the private sector while not becoming its hostage is very important.” [6]

It becomes clear that successful industrial policy is a sophisticated partnership between industry and state, governed by the underlying principles of competitiveness and productivity. Unfortunately what takes place in Sri Lanka is unlike that of East Asia but similar to Latin America.

“Import substitution policies got a bad name, especially in Latin America, because the industries that were created often only survived as the result of protection. It was particularly costly when countries protected intermediate goods, because that made goods farther down the production chain less competitive. Countries often paid a high price for this kind of protectionism, and the maintenance of this protection was often associated with corruption.” [7]


[1] Chang, H. J, 2006. Industrial policy in East Asia – lessons for Europe. An industrial policy for Europe? From concepts to action EIB Papers, [Online]. Vol 2 No.6, 106-132. (Accessed 07 January 2019)

[2] Paul R. Krugman, 1983. Targeted Industrial Policies: Theory and Evidence. [Online] (Accessed 07 January 2019)

[3] Ibid

[4] M Khan, 2018. The Role of Industrial Policy:Lessons from Asia. [Online] (Accessed 07 January 2019)

[5] Ibid

[6] Ibid

[7] Joseph E. Stiglitz. Industrial Policy, Learning, and Development. [Online] (Accessed 07 January 2019)


For the full list of taxes on Food Items, Household Items and Personal Care items, click here.

Import Taxes and the Cost of Living

Originally appeared on Echelon

By Ravi Ratnasabapathy

The Encylopaedia Brittanica defines the cost of living as the “monetary cost of maintaining a particular standard of living, usually measured by calculating the average cost of a number of specific goods and services required by a particular group.”

Cost of Living is the most fundamental measure of well-being; how good a life we can lead, the degree of comfort we have, and the number and types of products and services that we can buy.

In a modern society everybody is a consumer, no one is self-sufficient. The prices we pay for our food and clothing, our necessities and luxuries, and everything else in between are what determine our cost of living.

Naturally, for anyone other than a committed ascetic this is the most important aspect of life. For any politician sensitive to the public it should top the list of priorities.

A lot of our daily necessities, from food to household products are imported. This should allow us to take advantage global efficiencies to source the cheapest or best products, depending what people want. Unfortunately high taxes and poor trade policies drive up end-costs for consumers in Sri Lanka.

Sri Lanka imposes a variety of taxes on imports: customs duty, VAT, Port and Airport Levy, Nation Building Tax and Cess. Although the maximum customs duty is only 30%, once these other taxes are added the total tax can increase to anywhere from 50% to 100%.

Heavy taxes are imposed on food (meat, dairy, vegetables, fruit, coffee, cocoa, pasta, breakfast cereal, biscuits, jams); personal care (soap, shampoo, toothpaste, diapers, sanitary napkins, shaving cream, razors), household care ( washing powder, wet wipes, polishes, brooms, brushes),  children’s needs (diapers, pens, pencils, pencil sharpeners, toys).

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Older generations who experienced pre-1970s Sri Lanka may recall people cleaning their teeth with fingers (using charcoal or something called ‘tooth powder’), scrubbing dishes with a pol-mudda (coconut husk) or washing clothes by dashing them on a rock.

Toothpaste, washing powder, soap and shampoo are no longer luxuries; if they were a high tax may be understandable but they are necessities, even for the less well-off. Perversely luxuries like perfumes, wristwatches sunglasses are taxed the most lightly.

Personal Care taxes.jpg

This has a significant impact on overall household budgets and the standard of living.

Household Taxes. jpg

Voters need to ask our politicians why they need to tax these items so heavily. Baloo, the bear in the Disney cartoon sang of the bare necessities of life. Our leaders need to understand just how far their tax and trade policies are putting necessities out of reach for ordinary people; the main reason why so many seek opportunities overseas. Local salaries cannot keep up with the cost of living.

For full list of taxes, click here.

Some of the tariffs generate revenue for the government but many are imposed to protect local industry. Tariff protection for local industry comes at a cost: high prices for consumers. Supporting local industry is laudable but instead of protection the support should be targeted to help improve competitiveness and productivity. Firm level productivity depends on:

  1. the sophistication with which domestic companies or foreign subsidiaries operating in the country compete, and

  2.  the quality of the microeconomic business environment in which they operate.

Government support to upgrade technology, worker skills, improve access to capital, R&D and infrastructure is positive. These, together with more efficient government processes, improved infrastructure, more advanced research institutions-in short a healthier business environment; can yield long term productivity gains for the economy and the firm. Competitive pressure provides the incentive to improve productivity; the Government needs to work with firms to help this happen.  

Price protection for local industry is a blunt tool that hurts consumers and incubates inefficiency. Industry has demanded this for centuries; the French economist Frederic Bastiat explored this in satirical essay in 1845 that addresses the essence protection. It is reproduced, in an edited form, below:

A PETITION

From the Manufacturers of Candles, Tapers, Lanterns, sticks, Street Lamps, Snuffers, and Extinguishers, and from Producers of Tallow, Oil, Resin, Alcohol, and Generally of Everything Connected with Lighting.

To the Honourable Members of the Chamber of Deputies.

Open letter to the French Parliament, originally published in 1845

Gentlemen:

You are on the right track. You reject abstract theories and have little regard for abundance and low prices. You concern yourselves mainly with the fate of the producer. You wish to free him from foreign competition, that is, to reserve the domestic market for domestic industry.

.....We are suffering from the ruinous competition of a rival who apparently works under conditions so far superior to our own for the production of light that he is flooding the domestic market with it at an incredibly low price; for the moment he appears, our sales cease, all the consumers turn to him, and a branch of French industry whose ramifications are innumerable is all at once reduced to complete stagnation. This rival, which is none other than the sun, is waging war on us so mercilessly we suspect he is being stirred up against us by perfidious Albion (excellent diplomacy nowadays!), particularly because he has for that haughty island a respect that he does not show for us. 

We ask you to be so good as to pass a law requiring the closing of all windows, dormers, skylights, inside and outside shutters, curtains, casements, bull's-eyes, deadlights, and blinds — in short, all openings, holes, chinks, and fissures through which the light of the sun is wont to enter houses, to the detriment of the fair industries with which, we are proud to say, we have endowed the country, a country that cannot, without betraying ingratitude, abandon us today to so unequal a combat.

Be good enough, honourable deputies, to take our request seriously, and do not reject it without at least hearing the reasons that we have to advance in its support. 

First, if you shut off as much as possible all access to natural light, and thereby create a need for artificial light, what industry in France will not ultimately be encouraged? 

If France consumes more tallow, there will have to be more cattle and sheep, and, consequently, we shall see an increase in cleared fields, meat, wool, leather, and especially manure, the basis of all agricultural wealth. 

If France consumes more oil, we shall see an expansion in the cultivation of the poppy, the olive, and rapeseed. These rich yet soil-exhausting plants will come at just the right time to enable us to put to profitable use the increased fertility that the breeding of cattle will impart to the land. 

Our moors will be covered with resinous trees. Numerous swarms of bees will gather from our mountains the perfumed treasures that today waste their fragrance, like the flowers from which they emanate. Thus, there is not one branch of agriculture that would not undergo a great expansion. 

The same holds true of shipping. Thousands of vessels will engage in whaling, and in a short time we shall have a fleet capable of upholding the honour of France and of gratifying the patriotic aspirations of the undersigned petitioners, chandlers, etc. 

But what shall we say of the specialities of Parisian manufacture? Henceforth you will behold gilding, bronze, and crystal in candlesticks, in lamps, in chandeliers, in candelabra sparkling in spacious emporia compared with which those of today are but stalls. 

......Will you tell us that, though we may gain by this protection, France will not gain at all, because the consumer will bear the expense? 

We have our answer ready: 

You no longer have the right to invoke the interests of the consumer. You have sacrificed him whenever you have found his interests opposed to those of the producer. You have done so in order to encourage industry and to increase employment. For the same reason you ought to do so this time too. 

....The question, and we pose it formally, is whether what you desire for France is the benefit of consumption free of charge or the alleged advantages of onerous production. Make your choice, but be logical; for as long as you ban, as you do, foreign coal, iron, wheat, and textiles, in proportion as their price approaches zero, how inconsistent it would be to admit the light of the sun, whose price is zero all day long!


For the full list of taxes, click here.

The cost of being a Sri Lankan (woman)

Originally appeared on Sunday Observer

By Anuki Premachandra

Being a Sri Lankan woman is not easy. From having to constantly battle gender stereotypes and rebel gender roles, women also have to burden the financial cost of something that is beyond them; the exorbitant costs of sanitary pads and tampons. With a population that is 52% women, you’d think that we’d know better than to tax a woman’s necessity, but we don't.

Earlier this year, the Advocata Institute revealed some data and statistics on the import taxes on sanitary napkins, which were being taxed at a total of 101.2%. It was our Fellow, Deane Jayamanne who shed light on the absurdity of taxes on diapers and sanitary napkins, both practical necessities. This tax structure is not only a reflection of poor public policy, but also a testament to how little we’ve progressed as a society. Taxing a women’s necessity so heavily (it is treated as a luxury) does not reflect well on our policy choices, especially when our progressive neighbor, India recently scrapped a 12% GST (Goods and Services Tax) on sanitary towels.

A breakdown of the tax system is as follows:

Pink tax infographic.png

At least one could say that we know better now. On that revolutionary note, in a statement last week, the Finance Minister has stated that the CESS on sanitary pads will finally be removed. However, the issue of protective taxes is much larger than just this, and needs immediate attention.

HOW TAXES WORK

In Sri Lanka, a lot of our daily necessities, from food to household products are imported. This is true in the case of sanitary napkins and tampons as well. In an ideal sense, this should allow us to take advantage of global efficiencies to source the cheapest or best products, depending on what people want. Unfortunately high taxes and poor trade policies only end in driving up the price of these products in the market.

Some of the taxes generate revenue for the government but many are imposed to protect local industry. Tariff protection for local industry comes at a cost: high prices for consumers.

In textbook terms, higher prices of imports means that consumers switch to locally produced products, boosting local business. However, a ripple effect of import taxes is that local producers can now sell their products at high profit margins because the selling price of the competing imported product is raised by the taxes - this is unfortunately the case of sanitary towels and many other household products in Sri Lanka.

Our Resident fellow, Ravi Ratnasabapathy highlighted the absurdity of taxes on commonly used household products in his latest column on the Echelon Business Magazine. Import taxes for cereal adds up to 101%, fruit juices to 107%, noodles to 101%, aftershave to 120% , toothpaste to 107%, etc etc. The list continues.

Lifting the taxes on sanitary pads is a signal that as consumers and citizens, we still have hope. Hope, that government authorities realise the absurdity of taxing daily consumption. Sri Lankan’s are literally taxed to go about their daily lives, from the toothpaste you use to brush your teeth in the morning to the ingredients that go into your daily buth packet, our taxes are absurd.

Price protection for local industry is a blunt tool that hurts consumers and incubates inefficiency.

Government support for industry should be directed away from tariff protection towards efficiency improvements: to  upgrade technology, worker skills, improve access to capital, R&D and infrastructure.

These, together with more efficient government processes, improved infrastructure, more advanced research institutions-in short a healthier business environment; can yield long term productivity gains for the economy and the firm.

 

Attracting FDI: Sorting out contradictions in policy

By Ravi Ratnasabapathy

The article originally appeared on the Daily News on 15 May 2015

The BOI is reportedly developing a new investment policy for Sri Lanka with the help of a panel of experts.

This is a welcome move, but the investment policy needs take a broad view in order to remove some of the impediments to investment that stem from different sources. Two in particular, the policy on land ownership by foreigners and the visas for foreigners have become a source of confusion and a barrier to investment.

Foreign Direct Investment (FDI) is widely used by developing countries as a tool to solve their economic problems. FDI can create employment and result in the transfer of technology which contributes to long term growth.

In countries where unemployment or underemployment is a prevalent the creation of new jobs is a priority and a good enough reason to attract FDI.

Even more important is technology transfer, a broad term that encompasses not only equipment but technical know-how, organisational, managerial, marketing practices and other skills that the employees of a firm learn while working with a foreign partner. When employees move to other firms they take these skills with them, which results in the skills being diffused into the local labour market, improving its productivity.

The transfer of knowledge is not limited to direct employees; foreign affiliates can also diffuse technology and skills to domestic suppliers, customers and entities with which they have direct and indirect dealings.

To ensure that local inputs meet their stringent technical requirements, foreign affiliates often provide the local suppliers not just with specifications but sometimes also with assistance in raising their technological capabilities.

Naturally, as countries have become more aware of the benefits of FDI an intense 'global race' for foreign investment has developed and Sri Lanka should ensure that it is not left behind.

In order for a country to be more attractive to investors (both local and foreign), there is a need to put in place measures to ensure an enabling environment by reducing so-called hassle costs, which is why the BOI was set up as a central point for all paperwork.

Access to land is necessary for investment but recent shifts in policy on land have caused concern.

The purchase of land by foreigners was prohibited in 1963, under the Finance Act. In 1992, the Exchange Control Act repealed the Finance Act allowing the purchase of land by non-residents on payment of a 100% tax.

The growth of tourism in Galle and the southern coast since the mid 1990's, particularly the development of a new concept of 'boutique hotels' may be traced to this event. Prior to this Sri Lanka focused mainly on mass tourism, the change in land ownership policy attracted a different type of investor, who brought with them a new concept of selling to niche markets. The 100% transfer tax on land was repealed in 2002. This, together with the tax amnesty of 2003 created a boom in property.

Up to that point the policy on land followed a clear trajectory towards greater liberalisation. Then followed a series of policy flip flops. First the 100% land tax was re-imposed in 2004. The tax was initially applied only to foreign nationals but was later extended to local companies owned by foreigners.

Then an announcement was made in November 2012, during the budget speech, that the sale of land would be banned. No legislation was enacted but the land registry simply refused to register any transfers due to the uncertainty causing much annoyance and confusion amongst investors.

Parliament finally enacted the Land (Restrictions on Alienation) Act No. 38 of 2014 in October 2014. This banned the sale of land to foreigners and companies where 50% or more of the shares were held by foreigners. Foreigners were allowed to lease land but a 15% tax was to be imposed on the lease rental for the entire term of the lease.

If a firm entered into a 99 year lease, it would be required to pay 15% of the total lease rental payable over the 99 years immediately as tax. In effect the firm would be asked to pay 15 years rent, up front as tax. Moreover, the tax was applied retrospectively, from January 2013.

On a short term lease of a year or two, a 15% tax may be tolerable but for any investor who is here for the long term, the type of investor that the country needs, the tax is prohibitive. Should investment slow there may be knock-on effects on areas such as tourism. Boutique hotels, being small, sell through word of mouth, to friends and associates of the owners. If foreigners are made to feel unwelcome they, along with their friends and family, are likely to start looking elsewhere for their annual holidays and winter escapes.

The spirit of the new Act appears aimed at restricting the access to land for foreigners, first by outright prohibition on sale and second by imposing an extortionate tax on leases, creating an effective barrier to investment.

Inconsistent with such a restrictive law is provision for the Minister with the approval of cabinet to grant exemptions to the Act. Therefore in practice foreigners can buy whatever they want, provided they have the blessings of the appropriate politicians and government officials. Analysts say that such wide discretion is designed to encourage what economists call 'rent-seeking' behaviour or in common parlance, corruption. Similarly confusing are the visa rules. On one hand the country wants to attract talent from overseas, initiatives such as Work In Sri Lanka have been launched to encourage skilled people from overseas to relocate but the country still denies work visas to foreign spouses of citizens. These are foreigners already resident in the country, many have skills that can be utilised productively, yet they are denied the right to work.

Although the sale of land is restricted, the Government still seems interested in promoting the sale of flats in high rises to foreigners-flats situated on or above the fourth floor of a building are specifically exempt from the restriction on the sale of land to foreigners. It does not seem to have struck anyone in authority that foreigners may not be interested in buying flats if residency visas and dual citizenship are hard to get. If the foreign spouse of a Sri Lankan has to give up a career in order to relocate the attractiveness of the country will diminish.

Some countries do restrict ownership of land and work permits are required almost everywhere but the rules need to be sensible investment is not to be deterred. Coherence, consistency and simplicity in policy will promote investment. 


Ravi Ratnasabapathy trained as a management accountant and has broad industry experience in finance. He is interested in economic policy and governance issues. 

Plans to impose a Rs 10,000 Minimum wage: Will it improve welfare?

By Ravi Ratnasabapathy 

The article originally appeared on Dailynews on 7 May 2015

It is reported that the Government intends to legislate a minimum monthly wage of Rs.10,000 with an increment of 25% to be imposed over the next year. An increment of Rs.1,500 is to be effective from May 1 2015, while the rest will be effected from May 1 2016.

The legislation is probably founded in good intent: improvement of the welfare of citizens. Improving the welfare of people should be one of the fundamental objectives of a Government and one that few, if any, would question.

In simple terms we may measure welfare as the standard of living or in economics, the amount of goods and services that a person can enjoy. To the average person it may appear obvious that there is a minimum that one needs to earn to pay for basic foodstuffs, rent, electricity and utility bills and other expenses to live as a human being.

The standard of living is dependent on two factors: the income of people and the cost of goods and services. If the cost of goods and services is low then people do not need a high income.

A price list from Ceylon Cold Stores dating from the 1950's or 1960's lists the price of an imported Australian chicken at Rs.3.10 per pound, haddock fillet from Scotland at Rs.3.00 per pound and ice cream at Rs.10.00 per gallon. The author recalls paying a rupee for bread and 15 cents for the bus fare to school. If costs had remained at those levels people could have lived comfortably on a few hundred rupees a month.

Therefore in striving to improve the welfare of people there are two approaches that may be taken: the increase of wages or the reduction in the cost of living. Moreover if the cost of living increases faster than wages, people will be worse off, even if wages keep rising.

Sri Lanka has a highly distorted tax structure with essential commodities and foodstuffs being taxed at high rates. The previous regime excelled at the art of taxation by stealth with “special commodity levies” being imposed on milk powder, dhal, canned fish, potatoes, onions, chillies and a host of other foodstuffs. Milk powder is taxed at Rs.135 per kg, dried fish at Rs. 102 per kg, butter at Rs.880 per kg, cooking oil at Rs.110 per litre.

This is quite apart from VAT and other levies that add a further 15%-16% to costs. The taxes form a significant part of the final price of the goods. The current regime has cut some of the taxes but there is much more that could be done.

The problem that the Government faces in cutting taxes is that they have no means of paying for the bloated public service. The Government spends 54% of the tax revenue just paying the salaries and pensions of public servants.

Due to high levels of debt, interest cost takes up a further 38% of tax revenue.There are also huge inefficiencies and waste in the public sector. Sri Lankan Airlines lost Rs.30 bn in 2013, the cost of which is passed on to people as higher taxes.

The cost of living can be reduced significantly, with consequent improvement in welfare of the people, if taxes were cut but in order to do so waste and inefficiency in the public sector must be reduced.

Returning to the minimum wage, in order to impose a minimum wage, there needs to be employment.

The Government can impose minimum wages but this will have little effect in improving welfare if people are unemployed. There is no point in absorbing the unemployed into public service, as the previous regime did on grand scale because paying for this means taxing-and impoverishing the population at large.

Therefore the first step in poverty reduction is to ensure that jobs are created in the private sector, the second step being to control the cost of living.

The problem is that if the minimum wage is set too high and economic activity that takes place at low wage levels may become unviable.

Low wage jobs generally employ unskilled labour; if jobs are lost it is the poor who will suffer. It is better to have a low-paying job and some income rather than no job and no income.

As liberal economist Paul A. Samuelson wrote in 1973, “What good does it do a black youth to know that an employer must pay him $2.00 per hour if the fact that he must be paid that amount is what keeps him from getting a job?

In 2003, South Africa imposed minimum wages in agriculture to provide protection for workers to a sector with lowest average wages in the country.

A study on the impact of this by Bhorat, Kanbur and Stanwix concluded that while farmworker wages rose by approximately 17% as a result of the minimum wage, employment fell significantly, by over 20% within the first year.

A study of the impact of minimum wages in Indonesia by Asep Suryahadi, Wenefrida Widyanti, Daniel Perwira and Sudarno Sumarto reached similar conclusions. Since the late 1980's minimum wages had become an important plank of Indonesian government policy. While minimum wages succeeded in increasing average wages employment declined.

According to the study, a 10% increase in minimum wages resulted in a more than one per cent reduction in employment for all categories of workers except white collar workers.

Given the evidence available, the Government's decision to impose a minimum wage must be viewed with caution. If the minimum wage is significantly above market rates it will cause a decline in employment. The current wage level of Rs.10,000 is fairly low and anecdotal evidence suggests that its impact on employment will be small but once such legislation is in place the question of increments comes up.

A politician looking for quick votes in an election year may promise a high increase to the minimum wage which may reduce employment in the long term, to the detriment of the poor.

This policy, taken together with the ill-conceived taxes imposed in the budget sends a negative signal to investors. Investment in new business is needed to create employment, so sending the right signals is important. Not only could this policy destroy existing employment it could also be a dis-incentive to the creation of employment in the future.

It is advisable that the Government reconsider this policy. 


Ravi Ratnasabapathy trained as a management accountant and has broad industry experience in finance. He is interested in economic policy and governance issues.