In VAT Hike in Sri Lanka: Who Pays the Price?, Priyanka Jayawardena, a Research Economist at the Institute of Policy Studies, presents a critical view of the recent VAT revisions in Sri Lanka. Her analysis highlights how the revisions, notably the increase from 15% to 18% and the removal of tax exemptions on 97 essential items, disproportionately impact the poorest households.
According to Jayawardena, these changes have escalated the VAT burden on low-income groups, with the poorest 10% of households now allocating 10% of their income to VAT—an increase from 6% under the prior tax structure. The VAT burden, she argues, is regressive, intensifying the economic strain on vulnerable populations who dedicate a larger share of their income to essential items now subject to VAT.
While VAT covers a wide array of goods and services, the burden of this indirect tax is not equally distributed. Lower-income households are more affected due to their higher spending on essential goods. Meanwhile, excise taxes on non-essential items like alcohol and tobacco, which contribute to public health risks, are less burdensome for these groups. Here, Jayawardena suggests that increasing excise taxes could mitigate the unequal impact of VAT by redistributing the tax burden more equitably.
Jayawardena’s insights underscore a longstanding fiscal debate: the fairness of indirect taxes like VAT, which are consumption-based, versus direct income taxes, which are progressive. Proponents of indirect taxation argue it is equitable, taxing individuals based on their consumption levels. Conversely, progressive taxes align with the ability-to-pay principle, imposing higher rates on those with higher income, an approach that has faced criticism for discouraging productivity and investment. While economists such as Friedrich Hayek argued against using progressive taxation to address inequality, even he conceded its necessity in existential circumstances.
A dependency on donor aid, debt, and monetary expansion to sustain a large public sector and inefficient state enterprises led to unsustainable practices and policies becoming the norm. Successive governments since independence funded a bloated public service, subsidy programmes including utilities, free education and healthcare, and welfare while eroding the tax collection with incentives to attract investments and protecting local industries through import taxes, reinforcing a culture of entitlement and dependency.
The economic crisis post-COVID-19 has now driven calls for systemic reform, including a reassessment of the tax structure to ensure the sustainability of the economy.
Income tax collection has historically underperformed. In 2015, tax collection had fallen to 12% of GDP, while income tax-to-GDP was just 2%. By 2020, the overall tax-to-GDP ratio reached a low of 8.1%, prompting external recommendations, including from the IMF, to reform the tax system to boost revenue. Comparatively low personal and corporate tax rates and widespread tax exemptions eroded the base. Indirect taxes on goods and services remained the primary revenue source, exacerbating the tax burden on lower-income groups.
The former regime implemented tax reforms to elevate the tax-to-GDP ratio to 14% by 2026. The reform plan entailed increasing the top personal income tax rate, eliminating exemptions, and restructuring the VAT system to reduce its regressiveness.
The requirement for all citizens over 18 to obtain a taxpayer identification number (TIN) could mark a significant step toward accountability. By broadening the tax base and compelling citizens to engage in tax matters, the new administration can foster a culture where citizens willingly pay taxes if it delivers on transparent, corruption-free governance as promised and expected.
Many are now obsessed with idealogy with a left-leaning administration in office, although previous regimes were also socialist for the most part.
In his work, free-market proponent Ludwig von Mises critiques the notion of inherent equality, arguing that biological and intellectual differences among individuals naturally result in diverse social and economic roles. Recognizing these differences is essential for understanding society and the progress of human civilization.
Mises presents capitalism as a unique system that leverages individual talents for societal benefit. Unlike previous hierarchical structures where elites held power, capitalism requires businesses to serve the needs and preferences of consumers to succeed. In this model, consumer demand dictates market behaviour, fostering innovation and efficiency, which, according to Mises, ultimately benefits society.
However, Mises is critical of government intervention as a threat to economic efficiency and personal freedom. He argues that when governments supplant market mechanisms with centralized control, they risk concentrating power, stifling innovation, and diminishing individual autonomy. For Mises, self-regulate markets driven by consumer choices are superior to government oversight.
Responding to concerns that advertising manipulates consumers, Mises defends the rationality of individuals in the marketplace. While he acknowledges the existence of advertising, he contends that consumers can make informed decisions about value and quality, suggesting that a successful product ultimately depends on meeting real consumer needs.
Critics of Mises point out that capitalism does not guarantee equality of opportunity. Wealth, education, and resources often concentrate on particular social classes, making it harder for those from disadvantaged backgrounds to succeed. Thomas Piketty in Capital in the Twenty-First Century illustrates this through data showing that wealth accumulation often outpaces economic growth in capitalist systems, which can increase inequality and challenge the ideal of equal opportunity (Piketty, 2014).
Moreover, critics argue that markets frequently ignore external costs, such as environmental degradation and public health risks. Businesses may prioritize profit over public welfare, leading to broader societal harm. Economist Joseph Stiglitz, in The Price of Inequality, contends that government intervention is essential for managing such issues, as markets alone may not address large-scale challenges like climate change.
Others highlight that advertising can shape consumer desires, potentially creating artificial needs and reducing consumer autonomy. In The Affluent Society, economist John Kenneth Galbraith argues that producers influence consumer preferences through advertising, questioning whether market choices genuinely reflect consumer interests (Galbraith, 1958). Sociologist Thorstein Veblen conceptualized conspicuous consumption to show how social pressures often influence purchasing decisions.
Some scholars maintain that government intervention is necessary to address social inequalities and provide essential public goods. Governments can enhance individual freedoms and create a more equitable society by redistributing resources and funding services like education and healthcare. Amartya Sen in Development as Freedom proposes that true freedom requires not only the absence of constraints but also access to resources and opportunities, which government policies can help provide.
Mises associates socialism with authoritarianism, yet proponents of democratic socialism argue for a system where markets operate alongside robust social safety nets. The Nordic countries serve as a model of this approach, balancing market freedoms with extensive welfare programmes that help ensure individual liberties and high living standards. Economist Assar Lindbeck has examined how Sweden combines a market-based economy with social welfare to support broad economic and social benefits.
Economic disparities can also limit the ability to exercise civil and political rights. For many, access to resources like education and healthcare are fundamental rights. They enable personal autonomy and participation in society. The United Nations Universal Declaration of Human Rights underscores the importance of economic rights for human dignity, a perspective further developed by Martha Nussbaum and Amartya Sen in Capabilities Approach, which argues that true freedom includes access to essential resources for well-being.
Finally, some critics contend that the tendency to focus on short-term profits can overlook long-term societal and environmental welfare. Tim Jackson, in Prosperity Without Growth, argues that perpetual economic growth may be unsustainable, urging a redefinition of prosperity that includes ecological and social factors, reflecting the need for policies for sustainable development.
These counterpoints highlight important considerations regarding equality, market limitations, and the role of government in balancing individual freedoms with collective well-being, contributing to an ongoing debate about the best path for societal progress. It also explains why prosperous countries are neither capitalist nor socialist. It also explains why the IMF has endorsed Sri Lanka’s plan to reset the economy and adopt measures to protect vulnerable groups, both unfulfilled.
Should the new administration cave in on demands to reduce the income tax threshold and increase public sector wages, it will only delay or derail the economic recovery. However, indications point to a President and NPP being aware of the challenges ahead and could reign in the overenthusiastic leftists in the JVP to get things done. But it will need revenue. With Sri Lanka locked out of capital markets until 2027, individuals must contribute a fair share and ensure some do not suffer more than others. Many people were willing to ignore the excesses of previous regimes, including the corruption, as long as the heavy interventions, incentives and subsidies prevailed. A fact not lost on the new administration.