Finance Ministry Q&A: Comprehensive Analysis of Tax and Expenditure Policies

The Ministry of Finance recently addressed a series of questions regarding the government’s tax policy and expenditure management measures. This comprehensive analysis delves into the rationale behind these policies, the current tax structure, proposed reforms, and the future outlook for Sri Lanka’s fiscal landscape.

I. Tax Policy Rationale

A. Urgent Revenue Measures

The government’s decision to increase tax rates as a primary measure to address fiscal weakness stems from several critical factors:

1. Historical Context: Sri Lanka has experienced a declining trend in government revenue for over three decades. This long-term issue was exacerbated by ill-timed tax reductions announced at the end of 2019, which significantly contributed to the country’s credit rating downgrades and subsequent sovereign debt default.
2. Revenue-Expenditure Mismatch: By 2021, government revenue had plummeted to a mere 8.3% of GDP, while public expenditure remained at 20% of GDP. This substantial gap necessitated inflationary monetary financing (money printing) to cover the resulting budget deficit of 11.7% of GDP.
3. Inflation Control: The urgent implementation of revenue measures was essential to phase out monetary financing and bring inflation under control. At its peak in 2022, inflation reached a staggering 70%, disproportionately affecting the poor.
4. Fiscal Consolidation: These measures form a key component of the overall macroeconomic reform programme, including the debt sustainability framework. The government aims to achieve a primary budget surplus of 2.3% of GDP by 2025, which will be a crucial contribution to the debt restructuring effort.

B. Tax as Primary Revenue Source

In countries like Sri Lanka, which lack abundant natural resources such as oil or minerals, tax revenue serves as the cornerstone of government income. Key points include:

1. Historical Contribution: Typically, tax revenue accounts for approximately 80% of Sri Lanka’s government revenue.
2. Common Misconceptions: There’s a prevalent misunderstanding that exports, tourism, and other external inflows directly contribute to government revenue. In reality, these revenues are collected by private enterprises, with the government only receiving the corporate tax component of their profits.
3. Limited Non-Tax Revenue: While dividends and levies from state enterprises contribute to non-tax revenue, historically, this has been a net drain on Sri Lanka’s fiscal balances due to losses incurred by state enterprises. Other sources such as fines, fees, and rents contribute only marginally to government revenue.

C. Tax Administration Improvements

While enhancing tax administration and compliance is crucial for long-term revenue growth, these measures typically have a delayed impact:

1. Time-Intensive Process: Improvements in tax administration require administrative, technological, and process-related reforms, which take considerable time to implement and yield results.
2. Parallel Implementation: In Sri Lanka’s case, tax administration measures were implemented alongside tax rate increases. However, the short-term revenue boost is primarily attributed to the tax rate adjustments.
3. IMF Perspective: The International Monetary Fund (IMF) does not consider revenue gains from improvements in tax administration and compliance as tangible short-term revenue measures. This underscores the necessity of concrete tax policy changes, especially when considering primary budget balance inputs for the Debt Sustainability Analysis (DSA) framework.
4. Cash Flow Realities: The pressing nature of Sri Lanka’s Treasury cash flow, dominated by mandatory payments on interest, salaries, and essential welfare, necessitates immediate and reliable revenue streams. Relying solely on addressing “tax leakages” is not feasible to meet these critical payment obligations.

II. Tax Structure and Reforms

A. Personal Income Tax

The current personal income tax structure in Sri Lanka has been a subject of much discussion:

1. Progressive Rate Structure: The top marginal rate of 36% applies only to the highest income brackets. For instance:
   • A person earning Rs. 200,000 per month pays an effective tax rate of 5.3%.
   • An individual with a monthly income of Rs. 450,000 faces an effective tax rate of 19.7%.
   • Even at an income level of Rs. 1 million per month, the effective tax rate is 28.7%, still below the top marginal rate.
2. Regional Comparison: Sri Lanka’s top tax rate of 36% is comparable to regional peers. Countries like Thailand, Indonesia, and Vietnam all have a top personal tax rate of 35%.
3. Proposed Reforms: The government has suggested broadening each tax band to Rs. 720,000 from the current Rs. 500,000. This adjustment aims to provide targeted relief, particularly benefiting those most affected by the tax increases:
   • A person earning Rs. 300,000 per month would receive a 25% tax relief compared to present levels.
   • The relief diminishes at higher income levels, with someone earning Rs. 750,000 per month gaining a smaller relief of around 8%.
4. Fiscal Impact: The revenue impact of this proposal is estimated to be limited, at around 0.08% of 2025 GDP. Compensating measures have already been discussed with the IMF to offset this minimal reduction.

B. Tax-Free Threshold

The current tax-free threshold is set at Rs. 100,000 per month, a level that has sparked some debate:

1. Income Distribution: This threshold results in only the top 20% of income earners being subject to income tax, as established in the Supreme Court judgment on the amendments to the Inland Revenue Act in 2022.
2. Progressive Entry: As income earners cross the tax threshold, the effective tax rate starts very low at a 6% marginal rate. For example, a person earning Rs. 125,000 per month would only pay Rs. 1,500 in tax, or 1.2% of their total income.
3. Economic Indicators: The skewed income structure is further evidenced by the fact that the total number of active credit cards in Sri Lanka is under 2 million, less than 10% of the total population.

C. Corporate Taxation

The government’s approach to corporate taxation is evolving, moving away from sector-specific preferential rates:

1. Historical Context: In the past, Sri Lanka used preferential tax rates to encourage strategic sectors. This led to a proliferation of exemptions and preferential rates across various industries.
2. Shift in Policy: The current stance is to treat profit equally across all sectors. The government argues that once a company is profitable, it should contribute its fair share in taxation, regardless of the sector it operates in.
3. Future Considerations: As tax administration and compliance measures enable revenue growth and tax targets to be met, the government may consider across-the-board reductions in standard corporate tax rates, rather than providing concessional rates to specific sectors.

D. VAT Policy

The Value Added Tax (VAT) policy in Sri Lanka aims to balance revenue generation with social considerations:

1. Exemptions: The government maintains VAT exemptions on essential goods and services, including healthcare, education, public transport, and essential food items.
2. Fuel Products: While fuel products were long exempt from VAT, their inclusion from January 2024 has not led to the feared inflationary pressures. In fact, the Colombo Consumer Price Index saw a decline from December 2023 to August 2024.
3. Unified Rate: Sri Lanka has shifted to a unified VAT rate, moving away from multiple rates for different products. This simplifies the tax structure and reduces vulnerabilities to corruption.
4. Future Adjustments: While there are no immediate plans to reduce VAT rates, the government is considering reviewing turnover-based taxes such as the Social Security Contribution Levy (SSCL) in the future, as these are more distortive than VAT.

III. Expenditure Management

The government has implemented several measures to curtail and optimize public expenditure:

A. Fiscal Discipline Measures

1. Expenditure Restrictions: Since early 2022, the Treasury has issued circulars imposing significant restrictions on public expenditure, including:
   • Enhanced disciplines on new hiring
   • Limitations on overtime payments
   • Controls on fuel consumption and vehicle usage
   • Restrictions on expenditure for events and foreign travel
2. Digital Measures: Increased use of digital tools to control expenditure, including:
   • Completion of the roll-out of the Integrated Treasury Management Information System (ITMIS)
   • Expansion of e-procurement to enhance transparency and improve price discovery
   • Implementation of the Electronic Government Procurement (eGP) System
3. Unique Digital Identification: The implementation of SL-UDI (Sri Lanka Unique Digital Identification) is expected to generate significant savings in public expenditure.

B. Zero-Based Budgeting

1. Targeted Implementation: Introduced for the 10 largest spending ministries, requiring these agencies to justify all expenditures, including legacy spending.
2. Objectives: This approach aims to:
   • Eliminate wastage
   • Identify and remove duplicate spending
   • Pinpoint redundant processes
3. Broader Application: The principles of zero-based budgeting have been incorporated into the 2024 and 2025 budget calls.

C. Public Service Right-Sizing

1. Salary Expenditure Reduction: Government expenditure on public sector salaries has declined from 4.8% of GDP in 2021 to 3.4% of GDP in 2023.
2. Wage Adjustments: This reduction has enabled the government to adjust public sector wages gradually in 2024 and propose further adjustments in 2025 without compromising overall fiscal targets.
3. Ongoing Efforts: Continued digitization is expected to support further right-sizing of the public service, along with sector-specific initiatives such as the Defence 2030 review.

D. State-Owned Enterprise Reform

1. Loss Curtailment: A key expenditure reduction measure has been the curtailment of losses in State Owned Enterprises, which have historically been a significant drain on public finances.

IV. Future Outlook

The Ministry of Finance has outlined several key objectives and strategies for the future:

A. Revenue Targets

1. Ambitious Growth: The government aims to increase revenue from 8.3% of GDP in 2021 to 15.1% by 2025.
2. Long-Term Vision: Ideally, in the longer term, revenue should exceed 15% of GDP to enable high-quality public expenditure and support long-term sustainable economic growth.

B. Tax Administration Enhancements

Several measures are underway to improve tax administration and compliance:

1. Digitization: Mandatory e-filing of tax returns and upgrading of the Revenue Administration Management Information System (RAMIS).
2. Information Sharing: Mandatory information sharing between key government agencies and tax collection agencies.
3. Risk-Based Audits: Expansion of risk-based audit processes.
4. TIN Registration: Expanded Tax Identification Number (TIN) registration, with steps towards making it mandatory for key economic transactions.
5. Point of Sale Devices: Expanding the use of POS devices to support VAT collection.

C. Potential Tax Adjustments

1. Revenue-Dependent Approach: Once tax administration and compliance measures enable consistent achievement of revenue targets, the government may consider:
   • Downward revisions of standard corporate tax rates across the board
   • Adjustments to personal income tax structures
   • Review of turnover-based taxes like the Social Security Contribution Levy (SSCL)
2. Balanced Approach: Any tax adjustments will be carefully considered to ensure they do not compromise overall revenue targets or fiscal consolidation efforts.

Conclusion

The Ministry of Finance emphasizes that these comprehensive measures are part of a broader macroeconomic reform program aimed at achieving fiscal consolidation and debt sustainability. While acknowledging the challenges and potential short-term difficulties, the government maintains that these policies are necessary for long-term economic stability and growth in Sri Lanka.

The success of these measures will depend on consistent implementation, continuous monitoring, and the ability to adapt to changing economic conditions. As the country navigates through this period of fiscal reform, the government’s commitment to transparency and regular communication with the public will be crucial in maintaining trust and support for these challenging but necessary economic policies.