Not only is it expensive to buy a car in Sri Lanka, owning and running a car is also extraordinarily costly. Sri Lanka’s fuel prices are some of the highest in the world, and much of this expensive gas is wasted in Colombo’s epic traffic jams. Now, traffic offense fines are also some of the highest in the world. Still, middle class families everywhere in the country aspire to own a car, and families that already have a clunker may be looking to upgrade to a shinier car with a dashboard lit with Japanese characters.
Most used cars imported here have once had another life in Japan. As well as being right-hand drive, used Japanese cars are favoured for their build quality-related value for money. This is just as well for the government, as imported car buyers contributed 17% to its revenue in 2015, the last year for which full data is available. Based on an estimate that 60% of fuel imported is for private transport (and the rest used for public transport and electricity generation), this portion generates 2% of government revenue.So-called sin taxes on tobacco and alcohol – on imports and local production – made up 13% of 2015’s tax revenue. The telecommunication levy earned Rs33.4 billion or the equivalent of 2.5% of 2015 tax revenue.
Taxes on private vehicle imports, fuel, sin taxes and the telecom levy accounted for a third of 2015’s government revenue. Many of these products generate nation building tax, airport and port development levy, and VAT at import and their share of revenue by these amounts. Without disaggregation, it’s not possible to estimate the full contribution of these imports to government revenue. However, the totals will be higher than amounts estimated here. Neither do these totals include income taxes paid by the tobacco and alcohol businesses.
In 2015, vehicle imports alone generated Rs232 billion in tax revenue, according to the finance minister. This is nearly as much as the Rs262 billion tax on income and profit the government earned that year.
Provisional government revenue in September 2016 shows a similar trend to 2015, with the exception of a decline in vehicle taxes and levies due to lower import volumes.
The government’s budget revenue is classified in two formats. First, it’s categorised by tax collecting agencies the Inland Revenue, and Customs and Excise departments; and second, by tax type, tax on consumption (VAT), tax on income and external trade taxes.
The analysis that more than a third of government revenue is earned by private vehicle imports, fuel, sin taxes and the telecom levy is based on limited data published under each of these budget revenue classifications.
The problem with government revenue is easily identified as over reliance on taxing vehicles and their use, alcohol and tobacco, and levies on telecom. It’s not unusual for developing countries to clobber their smokers and alcohol consumers, and raise significant revenue from these. However, the high share of tax on buying and running a private vehicle, and on phone calls and internet use indicates that Sri Lanka’s ability to equitably generate taxes from a wide segment of its population is impaired.
Sri Lanka’s government has ended any residual dithering about clobbering the middle class in general. Reducing spending, which hurts the poor by weakening social safety nets, was never a shining option. The rich pay relatively little tax because most of their income, like capital gains and qualifying dividends, are charged lower rates or not taxed at all. Since an incompetent political class with little regard for the law has successively led Sri Lanka, many people feel justified dodging income tax because, if paid, it will be stolen or squandered.
Faced with fiscal crises, governments have cornered the section easiest to tax: the middle class.
Recently, sales taxes were slapped on private healthcare and education, an unprecedented clobbering of the middle class. The poor are satisfied with free government health and education services, and taxes on private healthcare and education are a thin slice of income for the rich.
Sri Lanka’s tax take has been declining steadily as a percentage of GDP from the equivalent of 20% in 1990 to 10.1% in 2014. Income tax as a portion of GDP at 2% is also low. International Monetary Fund data show that the income tax-to-GDP ratio of other lower middle-income countries like Egypt, Georgia and Mongolia are three to four times higher than in Sri Lanka. As a result, the government has come to rely on taxing consumption.
The Sri Lankan prime minister’s assertion that the income tax contribution to government revenue must rise from the current 16% to 40% signals the direction for tax policy and highlights the scale of the crisis. One of the critical paths towards this new equilibrium will be to broaden the tax net to include tax dodgers and currently low tax-yielding investment incomes.
Besides income taxes – that generate 16% of government income – the remaining 84% of income-generating taxation is mostly regressive; in that it does not levy higher rates of tax on higher income earners. The middle class here also pays a much greater share of their income in consumption taxes (VAT) and excise taxes as the rich because they cannot afford to save.
Income tax is generally progressive – levying higher rates on the top slices of earnings. However, it becomes extremely regressive because of the low rates or the tax-free status of qualified dividends and capital gains. For the rich, investment income from capital markets and real estate are significant.
What is striking is that tax policy has been changed frequently over the last 50 years. From a top income tax rate of 85% in the 1960s to the introduction of VAT (first called Goods and Services Tax) in the 1990s, Sri Lanka has transitioned to a modern tax system. However, over the last 20 years, the productivity of this system has come undone. While incomes rose, these didn’t translate to higher income taxes. A precipitous collapse occurred after 2009, when income tax collections declined permanently from the equivalent of 3% of GDP to 2%.
Experts contend that widening the net – to rope in tax dodgers and improving yields on low-taxed areas or adding untaxed ones – is the solution to the challenge.
Sri Lanka’s recent budget appeared to take hesitant tender steps towards a progressive tax system to introduce a crude and limited capital gains tax, narrowing the differential in tax rates charged on small businesses and export companies versus the rest of the firms, and bringing more wholesale trade under VAT.
Casting the tax net wider as the sole solution underestimates the importance of a progressive system that is applied fairly. In a society where the powerful are above the law and even an ostentatious show of wealth isn’t able to trigger an inquiry at the tax office, others will also feel they needn’t comply.
Naturally, expectations are higher in Sri Lanka than can be met by low economic growth, which is inadequate to deliver the benefits of a conflict-free economy. A number of maladies have afflicted the economy, including large budget deficits, which sucks resources more productive in private hands. Of those maladies, the one that isn’t receiving enough attention is the relation to rule of law around taxation compliance.