In a recent tweet, SJB MP Harsha De Silva highlighted a significant aspect of the proposed tax reforms under the International Monetary Fund (IMF) programme. De Silva says the imputed rent tax is essentially an income tax, not a property tax. He explained that a monthly salary of Rs150,000 would incur a tax of Rs3,500. However, with an imputed rental income of Rs100,000 a month, the tax would jump to Rs21,000 unless tax thresholds and rates are adjusted. This tweet has sparked widespread discussion about the fairness and impact of the proposed tax measures. However, the economist-turned-politician acknowledges the fundamental problem as he ends his tweet: “Need wide net to collect LKR 150b by 2026!”

A few days after the tweet, President Ranil Wickremesinghe announced in Parliament that one house per person would be exempt from imputed rental income tax which he proposes to be a wealth tax. He told Parliament in June, “Most people shouldn’t worry about their homes. Your house will be safe.” Opposition legislator Harsha de Silva welcomed the President’s statement. But until there is more clarity and certainty, homeowners will remain anxious.

On the surface, this imputed rent income tax is the height of unfairness: a tax on non-existing income! But more about that later.

Verité Research Executive Director Dr Nishan de Mel was scathing in a tweet about the Imputed Rental Income Tax: “It has no known analytical basis for its design as an efficient and effective tax measure for Sri Lanka. This is unfortunately the case for many other tax measures as well, under the current IMF program. Verité Research has published many pieces of analysis since 2022, showing a better set of tax/revenue policies than several in the IMF program. But there has been too little take up of such rationally supported publicly available analysis. (Plus, some of the rationally supported measures are now being reversed after being previously adopted — vested interests are prevailing over public interest,” he said, going on to suggest that the IMF was now a problem for Sri Lanka and not the solution.

The Ministry Clarifies 

The Ministry of Finance issued a press release to address speculations and misconceptions about the proposed property tax, which is part of the IMF-supported Extended Fund Facility (EFF) programme. Echoing the IMF, the ministry emphasized that one of the main reasons for the severe economic crisis is the drastic drop in government tax revenue, leading to high budget deficits and unsustainable public debt levels. To mitigate this crisis, the government has implemented revenue-based fiscal consolidation over the past two years, aiming to increase government revenue from 8.3% of GDP in 2022 to 15% by the end of 2025.

In 2023, tax reforms focused on progressive corporate and personal income tax measures. For 2024, revenue enhancement will come from Value Added Tax (VAT) reforms and the elimination of most exemptions and rate adjustments.

Sri Lanka met most of the revenue targets for 2023, and the target for 2024 is on track to reach 13.5% of GDP. The additional 1.5% of GDP revenue gains needed for 2025 will come from wealth taxes on property, but the imputed rental tax is not a property tax.

Defending the imputed rental tax, the Finance Ministry said it would target high-wealth individuals, not average-income earners. The ministry assured that there would be a suitable tax-free threshold to ensure the tax applies to very high-value properties or multiple properties owned by wealthy individuals and generate 0.2% of GDP by 2025 and 0.4% of GDP in 2026. The ministry also mentioned that property taxes are considered efficient, progressive, and a non-distortive means of generating revenue in many countries.

What is Imputed Rental Income Tax

An imputed rental income tax taxes the potential income homeowners could earn if they rented their property instead of living in it. The government estimates the fair market rental value of a property, adds this value to the homeowner’s taxable income, and taxes it accordingly.

The argument for imputed rent taxes is that it creates tax equity between renters and homeowners, as renters cannot deduct their rent from taxable income.

Friedrich Hayek, an Austrian economist (1899-1992), who championed free markets, small governments and despised progressive income taxes and money-printing central banks, feared Europe would be swept by socialism. He would have loathed imputed rental income taxes. It’s hard to understand why some countries introduced them unless their citizens understood someone had to pay for democracy, the rule of law and freedom. 

The countries that have imputed rental income taxes include Belgium, Iceland, Luxembourg, the Netherlands, Slovenia, Spain, and Switzerland. The methods and rates vary, but the goal is to balance the tax burden between homeowners and renters. For instance, in Switzerland, where imputed rental income taxes were introduced in the 1930s, homeowners must report a percentage of their property’s value as imputed rent, which is then added to their taxable income.

However, in the US where economic philosophy is generally different from Europe, homeowners do not pay tax on imputed rental income, which is a key tax benefit of owning a home. Instead, homeowners can deduct mortgage interest, property tax payments, and other expenses from their federal taxable income. This means that while homeowners benefit from living in their property (akin to receiving rental income), this ‘income’ is not taxed. Instead, they can reduce their taxable income through homeownership-related deductions.

Proponents of imputed rental income taxes argue that homeowners have a tax advantage because they save money by not paying rent and can deduct mortgage interest and maintenance costs. Imputed rental value is proposed as a countermeasure to prevent this potential tax advantage.

No one likes the tax. In Switzerland where homeowners have been trying for decades, the government in 2023 agreed to phase out the tax. But now all homeowners are happy. Many current tax advantages, such as the deductibility of maintenance expenses and mortgage interest, will largely disappear to make up for the revenue. The tax is controversial and divisive in Switzerland, or politicians would have voted it out long ago.

In Spain, homeowners renting out a property as a holiday home must pay income tax on the rental income. If the property is not rented out, they are taxed on the imputed income. During the COVID-19 pandemic, many homeowners who typically rented out their property were surprised to learn they still had to pay imputed income tax even when the property was empty. 

Poirot’s compatriots have taken things further. Belgium has something called cadastral income, a fictitious rental income assigned to buildings and land, even if they are not rented out. It represents the average net income the property would generate annually, based on 1975 values. This value serves as the basis for property tax and determining property income for personal income tax, which distinguishes it from imputed rental income tax.

A significant concern is whether the property rented out would be taxed twice, or who pays the tax, the leaser or the lessee? However, the imputed rental income tax applies only to the benefits homeowners receive from living in their property. If the property is rented out, the owner pays tax on the actual rental income and not on imputed rental income, that is the general rule.

Like any system (or tax), the imputed rental income tax has both advantages and disadvantages that are crucial to consider.

Conceptually, on the positive side, the tax promotes equity by levelling the playing field between homeowners and renters. Homeowners are taxed on the benefit of living in their owned property, ensuring they contribute similarly to renters, who cannot deduct their rent from taxable income. This approach also has the potential to generate significant revenue for governments without directly increasing the cash taxes that homeowners need to pay. Additionally, it may incentivize homeowners to rent out unused properties, thereby increasing the housing supply.

However, there are notable drawbacks. One significant concern is the increased tax liability for homeowners. Adding imputed income to taxable income can push taxpayers into higher tax brackets, leading to a higher overall tax bill. The complexity of accurately calculating the fair market rental value of properties poses another challenge, as it may require substantial administrative resources. Moreover, there is a risk of potential inequity, as the tax could disproportionately impact those with lower incomes or individuals living in high-value properties but with limited cash flow.

These pros and cons illustrate the delicate balance between fairness and practicality in implementing an imputed rental income tax system.

A Tax on Temple Trees?

Will the imputed rental income tax apply to official residences, from Temple Trees onwards? In principle?

In a blog post published on the Mises Institute website, Stephan Kinsella aims at the concept of imputed income. He notes that while imputed income from personal activities (like growing vegetables) isn’t taxed due to valuation and enforcement difficulties, barter transactions and unreasonably low self-salaries are taxable. Kinsella argues sarcastically that if non-monetary benefits were taxed, roles like the President or astronauts would be impractical for anyone but the wealthy. Kinsella points out that the President’s perks (e.g., living in the White House) should, under this logic, be taxed, meaning only millionaires could afford the office. Similarly, astronauts need to be taxed for the privilege of going to space, which only the wealthy can afford if NASA was not government-run. Kinsella’s criticism highlights the absurdity of taxing such benefits, stating that such taxation “makes no sense or is ethically or economically justifiable.”

Walking on Eggshells

Sri Lanka’s proposed imputed rental income tax is a critical component of its economic recovery plan, aiming to increase government revenue and prevent another economic crisis. While there are concerns about fairness and complexity, the tax is designed to target high-wealth individuals and create equity between homeowners and renters. The successful implementation of this tax, supported by robust data infrastructure, will be crucial for achieving Sri Lanka’s fiscal goals.

The bottom line is that Sri Lanka has a severe fiscal problem, the root cause of our balance of payments and debt crisis. Expenditure-side reforms will be arduous given the bloated public service who have powerful unions. Plugging losses at state-run enterprises is another option, and work is ongoing. Building cases to recover stolen assets will also take time. What can be fixed quickly is the revenue side – widening the base and cleaning up the corruption-prone administration.

The IMF’s June 2024 review underscores the importance of the imputed rental income tax in sustaining Sri Lanka’s revenue mobilization efforts. Initially planned for 2025, the property tax faced institutional challenges but is now set to be introduced by April 1, 2025. This tax will apply to the deemed income homeowners could earn if they rented out their homes, targeting owner-occupied and vacant residential properties.

To ensure progressivity, the tax will feature an exemption threshold and a graduated tax rate schedule. The IMF projects that the tax will yield 0.4% of GDP by 2026, with a partial yield of 0.2% in 2025. Establishing a comprehensive property valuation database and a digital Sales Price and Rents Register (SPRR) are crucial steps for implementing this tax. The SPRR will be a key resource for assessing property values and imputed rental income tax.

This tax aims to address fiscal problems by boosting revenue but carries risks of increased tax liability and administrative challenges. Monitoring its implementation and effects is crucial to ensure it meets its goals without disproportionately impacting vulnerable populations. 

It will likely be implemented, or not, after elections, and the nation must decide how these measures unfold and what we want to achieve for our economic future. Sri Lanka needs a big government because people are lazy, dependent and entitled, or plenty of people and businesses cannot pull up their bootstraps because they do not have boots. But over-taxing the rich will destroy savings and investment. The proposed new tax on property raises several questions, but the fundamental questions will be how it will work and how the rates and exemptions are clearly defined.

Related:

• Tax Administration and the Proclivity for Corruption
• Why Personal Income Tax is Crucial for Resetting the Economy