Taxation in Sri Lanka: A misused tool?

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This research article looks at Taxation and the taxation system presently in force in Sri Lanka. At its simplest, Taxation is a tool of a Government’s fiscal policy which can be used to raise Government revenue which in turn is used to finance the country’s economy and Government spending on projects. Taxation is of two types broadly – direct and indirect taxes.

Direct taxes are directly imposed on the consumer, for example income tax which each citizen of Sri Lanka has to pay. Indirect taxes are imposed on the consumer in less obvious ways- for example VAT on goods and services purchased at a store. This research article makes a central argument – that taxation has been misused and improperly manipulated as a tool by successive Sri Lankan Governments for political purposes and is one (among other factors) that has contributed to the economic and financial deterioration Sri Lanka faces today.

Developing the ‘misuse and manipulation’ argument

Let us first set out the basic theory behind taxation. The standard theory of optimal taxation posits that a tax system should be chosen to maximize a social welfare function subject to a set of constraints. The literature on optimal taxation typically treats the social planner as a utilitarian: that is, the social welfare function is based on the utilities of individuals in the society. In its most general analyses, this literature uses a social welfare function that is a nonlinear function of individual utilities. Nonlinearity allows for a social planner who prefers, for example, more equal distributions of utility.

However, some studies in this literature assume that the social planner cares solely about average utility, implying a social welfare function that is linear in individual utilities. For our purposes in this essay, these differences are of secondary importance, and one would not go far wrong in thinking of the social planner as a classic “linear” utilitarian.1 To simplify the problem facing the social planner, it is often assumed that everyone in society has the same preferences over, say, consumption and leisure.

Sometimes this homogeneity assumption is taken one step further by assuming the economy is populated by completely identical individuals. The social planner’s goal is to choose the tax system that maximizes the representative consumer’s welfare, knowing that the consumer will respond to whatever incentives the tax system provides. In some studies of taxation, assuming a representative consumer may be a useful simplification. However, as we will see, drawing policy conclusions from a model with a representative consumer can also in some cases lead to trouble.

After determining an objective function, the next step is to specify the constraints that the social planner faces in setting up a tax system. In a major early contribution, Frank Ramsey (1927) suggested one line of attack: suppose the planner must raise a given amount of tax revenue through taxes on commodities only. Ramsey showed that such taxes should be imposed in inverse proportion to the representative consumer’s elasticity of demand for the good, so that commodities which experience inelastic demand are taxed more heavily.

Ramsey’s efforts have had a profound impact on tax theory as well as other fields such as public goods pricing and 1 Stiglitz (1987) addressed the more restricted agenda of identifying Pareto-efficient taxation, an approach taken up recently by Werning (2007). This approach is important because it suggests that many of the general prescriptions of the optimal taxation models that use utilitarian social welfare functions survive being recast in Pareto terms, which in turn suggests that the precise form of the social welfare function (at least in the class of all Pareto functions) is not very important for some findings. 

Let us attempt to develop this argument by using a recent example from Sri Lanka politics. Ahead of the November 2019 Presidential election, then candidate Gotabaya Rajapaksa proposed sweeping tax cuts in his election promises. As soon as Rajapaksa won the election and became the President he introduced a VAT tax cut from 15% to 8% and abolished several other taxes including a “2% nation-building tax” intended to finance infrastructure projects. The objective of this tax cut was simple- political populism.

Rajapaksa hoped to activate the Sri Lankan economy, reduce the costs of businesses and the tax burden on consumers and keep the electorate happy, at least in the short-term. The first point to note about this tax cut is it will significantly reduce Government revenue. This means the Government will need to raise revenue from other sources or reduce its spending in the budget. The second point is that this particular tax cut which is expected to cost the Sri Lankan economy USD 2 billion will put Sri Lanka in a heated argument with the International Monetary Fund (IMF) – a key actor in Sri Lanka’s economic restructuring programme.

The IMF restructuring programme is based on one core policy and that is fiscal consolidation. Ineffective budget policies of past Sri Lankan Governments have at least in part led to the fiscal mess the country is in and has contributed to the challenging debt scenario. This type of tax manipulation could cause Sri Lanka’s fiscal consolidation to slip and trigger a suspension of the IMF restructuring programme and financial assistance which would be devastating to the Sri Lankan economy. 

Prior to the tax cut in 2019 Sri Lanka’s fiscal deficit was expected to exceed the original IMF target of 4.6% of GDP.  Finance Minister Ali Sabry conceded in a high-profile interview that the tax cut of 2019 was a mistake and Sri Lanka needs to revert. The tax cut also resulted in a credit downgrade for Sri Lanka and as a result Sri Lanka began to lose access to international financial markets. Sri Lanka started dipping into its foreign reserves to meet its debt obligations. This resulted in foreign reserves plummeting from a healthy level of USD 8,864 million in June 2019 to USD 2,361 million in January 2022.

Conclusion

In conclusion, this research article restates the central argument made in the introduction that the ‘misuse and manipulation’ of taxation by successive Sri Lankan Governments has contributed to economic and financial imbalance in Sri Lanka. This argument was developed by analyzing the taxation systems in place in Sri Lanka in the recent past. To end our story, we must note that future Sri Lankan Governments must learn the lessons of the past with respect to taxation and change their taxation policy to align it with Sri Lanka’s short and long-run economic interests.

This research article was prepared by the One Text Initiative (OTI) research unit. The One Text Initiative (OTI) is an independent, non-partisan research institute The website of OTI can be located at onetext.org and the team leader for this project can be contacted at [email protected]

By The One Text Initiative (OTI) research unit