Reforming Sri Lanka's Tax System: A Path to Fiscal Stability and Economic Growth

Originally appeared on Daily FT

By Dr Roshan Perera, Thashikala Mendis, Janani Wanigaratne

This article provides an insight on the Personal Income Tax structure in Sri Lanka as the second part of a series discussing potential tax reforms

Raising government revenue is critical for Sri Lanka to recover from the current economic crisis and create a more sustainable economic environment. However, taxes should be paid by those who can bear the burden. 

Personal Income Taxes (PIT) is an effective instrument in generating revenue as well as in reducing inequality through revenue redistribution.  In Sri Lanka, there has been a steady decline in revenue from PIT from 0.9% of GDP in 2000 to 0.2% of GDP in 2022. Revenue collection is  lower than that of even other low income economies. Furthermore, PIT tax revenue as a percentage of direct tax revenue declined from 40% in 2000 to 9.3% in 2022, although GDP per capita increased from USD 869 in 2000 to USD 3,474 in 2022. 

Advanced economies raise approximately 9% of GDP from PIT, while emerging economies and low income economies raise only 3.1% and 2.1% of GDP, respectively. (1)  Sri Lanka reports the  lowest contribution of PIT as a percentage of GDP in 2021, both among  advanced economies in Asia such as South Korea, as well as developing economies such as Bangladesh, Malaysia and Vietnam (See Figure 1).

Figure 1: Performance of Personal Income Tax Collection among Selected Countries

Source : IMF Data Library, OECD

Narrow Tax Base

The narrow tax base is one of the main reasons for Sri Lanka’s low PIT revenue performance. A narrow base not only limits revenue generation but it also makes revenue collection reliant on a small segment of the population. 

The number of income tax payers under the  Pay As You Earn (PAYE)/Advanced Personal Income Tax (APIT) Scheme (2) as a percentage of the total employed population shows  a relatively small proportion of the workforce contributing to income taxes (see Table 1). In 2019,  the proportion of tax paying employees was 33%. This proportion declined to less than 1% in 2021 due to abolishing of PAYE taxes with effect from 1st January 2020.  A voluntary APIT System was introduced with effect from April 1, 2020, where employees can opt in. This shift not only led to a revenue decline but also created monitoring gaps. With effect from January 1, 2023, it was mandated for employers to deduct APIT from employees' income, reverting to the original PAYE scheme.

(2 ) Note: PAYE/APIT is where employers deduct income tax on employment income of employees at the time of payment of remuneration.  PAYE was replaced by APIT with effect from April 2020. This measure of replacing PAYE with APIT essentially made PAYE optional. However, with effect from January 2023, deduction of Withholding Tax (WHT), Advanced Income Tax (AIT)  and APIT has been made mandatory.

Table 1: Employee Contribution to PIT

Source: IRD Performance Reports, Labour Force Survey

The large informal sector also contributes to the narrow tax base and low PIT performance. According to the Labor Force Survey (3) 2022,  the informal sector accounts for around 58% of total employment (see Table 1).  A large portion of the economy operating  outside formal regulation enables tax evasion and avoidance. Transforming the current informal self-employment system to a modern formal employee-employment system would be one way to improve tax revenue collection. 

Two alternative recommendations are proposed to capture informal economic activities into the tax net.  Establishing a universal online payments system would reduce cash transactions in the economy enabling better monitoring; and secondly, by introducing a unique digital identification system that connects tax accounts with income sources, bank accounts, motor vehicle and land registration etc. Authorities could cross check information provided in income tax returns as well as identify individuals who do not file returns. 

Tax Free Threshold and Tax slabs/Brackets

In the recent amendment to the Inland Revenue Act (4),  the tax free threshold for income was reduced from Rs.3 million per annum to Rs.1.2 million per annum. Further, the tax brackets were reduced  from Rs.3 mn to Rs.0.5 million.  Accordingly, the incremental tax rate for each additional Rs. 0.5 million of income was set at 6% (see Table 2).

Table 2:  Tax Threshold and Tax Brackets

Source :Inland  Revenue (Amendment) Act, No. 4 of  2023

Applying the current tax free threshold, income taxes are applicable to  approximately the top 15% of households where around  36% of total  income is concentrated (see figure 2) (5).

(5) Note This is based on the Household Income and Expenditure Survey 2019

Figure 2: Share of Income by Population 2019

Source : HIES Survey Annual Report 2019

According to the national poverty line (6) for  July 2023, the minimum monthly expenditure per person required to meet basic needs is Rs. 15,978. Hence, the total cost for a family of four is approximately Rs. 65,000 per month. Assuming salaries and wages remain unchanged at 2019 levels,  more than two-thirds of income is spent by households up to the 9th decile, (see Table 3).  Any additional financial burden including income taxes could further reduce the disposable income of households up to the 9th income decile. Hence, information on household income and expenditure patterns must be considered when setting income tax thresholds.

Table 3 :  Mean Household Expenditure as a % of Mean Household Income

Source : HIES Survey Annual Report 2019 (7)

Although the current tax system applies differential tax rates based on income brackets, an analysis of the effective tax rates paid within these brackets indicates a less than progressive tax system.  An individual crossing the tax free threshold of Rs.1.2 million per annum (equivalent to a monthly income of Rs. 100,000) pays an effectives tax rate of 1%, which gradually increases to 12% until the highest income bracket is reached at over Rs. 3.7 million (which is equivalent to a monthly income of Rs. 308,333). All the income levels above this income would be taxed at the highest nominal marginal rate of 36%.  However, after a particular income level the effective tax rate flattens (see Table 4). This implies that individuals in the highest income categories effectively pay less taxes. Expanding the income tax brackets would introduce more fairness and progressivity into the tax system.

Table 4 :  Effective Rate of Tax

Source :  Author’s Calculation

Figure 3: Personal Income Tax as a percentage of Annual Income

Source : Authors’ Calculation

The fairness of the tax system is further exacerbated as those whose main income sources are subject to capital gains are taxed at only 10% versus those whose income are subject to PIT who are taxed at a higher rate of 36%. 

As wages and salaries rise to keep up with inflation, individuals may find themselves earning more in nominal terms, but their purchasing power remains relatively unchanged.  Adjusting thresholds for inflation ensures that employees are not disproportionately burdened by bracket creep where taxpayers are pushed into higher brackets due to inflation. A proper rationale and scientific basis for determining thresholds, tax slabs, and tax rates is needed to increase revenue collection and ensure fairness in the tax system.Also, the proposed tax system should generate the estimated tax revenue by the end of the year.

Frequent ad hoc policy changes

Tax policy is frequently subjected to change, without proper economic rationale. For instance, the tax slabs for PIT have been revised 9 times while the tax free threshold was revised 5 times since 2000. Frequent and ad hoc policy changes complicate tax administration and reduce tax compliance.

Conclusion

The country has failed to meet  the first quarter targets for revenue under the IMF’s Extended Fund Facility Program. Raising government revenue will be critical to remaining within the program. Improving revenue collection from income taxes will be critical to achieving the revenue targets, while broadening the tax base will ensure the burden of taxation falls on the broadest shoulders.

Part one of the OPED series on Reforming Sri Lanka's Tax System: A Path to Macroeconomic Stability and Sustainable Economic Growth can be found here

Is Wealth Tax the Solution to Sri Lanka’s Low Tax Revenue Collection

Originally appeared on Daily FT, Biz Adaderana , The Morning, Daily Mirror, The Island and Lanka Business Online

By Sathya Karunarathne

Successive governments have run fiscal deficits. Inadequate revenue collection and unrestrained government expenditure have worsened the country’s fiscal position.  

Tax revenue which averaged over 20% of GDP in 1990 has declined to under 10% of GDP in 2020. Ad hoc tax policy changes have significantly eroded the tax base. Weak tax administration has also contributed to the sharp decline in tax collection.

While tax revenue has contracted, government expenditure has ballooned over time. Today, government revenue is not sufficient even to meet its expenditure on salaries and wages and transfers and subsidies to households which include pension payments and social welfare payments such as Samurdhi.  

In this context, there are various proposals put forward to raise government revenue. One proposal is the reintroduction of the wealth tax.  

A wealth tax is expected to bridge the gap between the rich and the poor, achieving equality. This tax shifts the tax burden to affluent households, taxing an individual’s net wealth, which is the market value of total owned assets. Proponents of wealth taxation argue that this is a progressive system of taxation and is a more powerful tool in comparison to income, estate or corporate taxes as it addresses the issue of wealth concentration.  

Moreover, a tax should ideally satisfy basic characteristics of taxation: it should not be distortionary; it should be fair, and it should not be difficult to collect. 

The rationale for a wealth tax

One of the earliest proponents of the wealth tax for developing countries was Nicholas Kaldor.  Based on his recommendation, a wealth tax together with an income tax, expenditure tax and a gift tax were introduced in Sri Lanka in 1958. However, these new taxes yielded little revenue due to difficulties in determining the tax base and problems in administration.  Following the recommendation of the Tax Commission in 1990, the government abolished the wealth tax from the year of assessment 1992/1993.

Wealth taxes have mainly been implemented in European countries. In 1990, twelve countries in Europe had a wealth tax. Today, there are only three: Norway, Spain, and Switzerland.  Several non-European countries have also imposed wealth taxes from time to time including such as Argentina, Bangladesh, Colombia, India, Indonesia, Pakistan 

In recent times there has been renewed interest in wealth taxes. Presidential candidates in the US proposed various forms of a wealth tax. In the UK and France, there were proposals to impose “super taxes” on the rich. The primary justification was to address the increasing inequality in society.  

Issues with a wealth tax

Despite renewed interest in the wealth tax as a progressive tax based on equity, it scores poorly on the criteria of efficiency, and administrative feasibility.  

Many factors have justified the repeal of wealth taxes in OECD countries. The reasons cited are related to efficiency costs, risk of capital flight particularly in light of increased capital mobility and wealthy taxpayers' access to tax havens, failure to meet redistributive goals as a result of narrow tax bases, tax avoidance and evasion, high administrative and compliance costs compared to limited revenues (high cost yield ratio).  

To understand the efficiency costs of wealth taxes one can look at taxing a person’s wealth accumulated through savings. Despite the common consensus that taxing savings is an effective way to redistribute, a person’s saving decisions reveal little about their underlying lifetime resources and wellbeing. It only reveals their preference to consume tomorrow rather than today. Thereby a wealth tax imposes a tax on those who prefer to spend their money later as opposed to taxing the wealthy. Efficiency costs refer to the reduction of the welfare of the taxed individuals by more than $1 to generate $1 of revenue. Therefore, the efficiency cost of a wealth tax in terms of taxing savings is a reduction of  future consumption that can be bought with earnings, reducing incentive to work for those who prefer to consume the proceeds later and reducing incentive for young people to save for their retirement.

Capital flight is the possibility of holding assets outside of one's resident country without declaring them.As wealth taxes are imposed on residents it increases the risk of the wealthy

reallocating their assets to avoid taxation. Therefore a high tax burden encourages taxpayers to change their tax residence to a lower tax jurisdiction or tax havens.

Both income-generating and non-income generating assets are taxed under wealth taxation. They can include land, real estate, bank accounts, investment funds, intellectual or industrial property rights, bonds, shares, and even jewellery, vehicles, art and antiques. However, this tax base for wealth taxes has often been narrowed through exemptions. These exemptions have been justified most commonly on the grounds of social concerns such as the negative social implications of taxing  pension assets. Further liquidity issues (eg - farm assets), supporting entrepreneurship and investment (eg- business assets), avoiding valuation difficulties ( eg- artwork and jewellery) and preserving countries cultural heritage (eg - artwork and antiques) have also been cited as reasons for wealth tax reliefs. While some of these exemptions can be justified, they have led to the reduction of revenue raised from wealth taxes. They have also contributed to wealth taxes being less equitable as the wealthiest such as businesses benefit from these exemptions defeating the very purpose of imposing a wealth tax which is to meet its redistributive goals.

Narrow tax bases in wealth taxation often leads to tax avoidance and evasion opportunities. For example, Spain's 1994 wealth tax exemption for the shares of owner managers resulted in wealthy businesses reorganizing their activities to reap benefits of the exemption resulting in a significant erosion of the wealth tax base. 

Further, several other factors have also discouraged countries to sustain a wealth tax. They are namely, the difficulty in determining the tax base or what assets to be taxed, underreporting and undervaluation of assets, difficulty in measuring wealth taxes, distinguishing between individuals who are asset rich but cash poor, the constant need to value assets and audit returns increasing administrative and enforcement costs

Low revenue collection as well as the other reasons discussed have led to the abolishing of wealth taxes in most countries  (See Table 1 for details) . Tax revenue from individual net wealth taxes in 2016 ranged from only 0.2% of GDP in Spain to 1.0% of GDP in Switzerland. Sri Lanka’s experience with wealth taxation was no different with the tax yielding low revenue as reported by the 1990 Tax Commission.

Table 1: Implementation of Wealth Taxes in Selected Countries

Conclusion 

Taxing the wealth of the rich to generate income and to eliminate economic inequality sounds promising in terms of political debate. However, wealth taxes have failed to generate adequate revenue, failed to meet redistributive goals as a result of narrow tax bases, proven to have high administrative and enforcement costs, resulted in tax evasion and avoidance due to underreporting and undervaluation of assets, increased the risk of capital flight and access to tax havens and may have contributed to the reduction of investment and employment. 

Therefore, imposing a wealth tax may not be the ideal policy response to Sri Lanka’s low tax revenue, especially given the country’s previous experience with the tax yielding low revenue.

Sathya Karunarathne is the Research Analyst at the Advocata Institute and can be contacted at sathya@advocata.org. Learn more about Advocata’s work at www.advocata.org. 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.