In the decades between independence and the COVID-19 pandemic, Sri Lanka has depended on donor funding (which dried up after the country was elevated to middle-income status), debt and money printing to finance a bloated state machinery that dominated and dictated economic activity in a country where dependency, entitlement and rent-seeking flourished.
Although it hurt many people’s prospects, they could not see it. They cheered when jobs were created in the state sector every election cycle. They demanded more taxes on imports to protect and coddle local producers even though they could not afford to buy their kids shoes or build a decent toilet. They protested against any attempts to improve productivity at the state enterprises or improve trade with leading economies in the region.
After the post-COVID economic debacle, everyone is talking about a system change, a complete overhaul of the political elite and corruption snuffed out, once and for all. But responsibility for much of the economic malaise lies at the doorstep of over 21 million citizens, not 225 politicians. Proof of that is our egregious attitude towards income taxes. Doctors, lawyers, engineers and academics, those in the pinnacle of professions educated with taxpayer money, dodged taxes leaving the poor increasingly vulnerable to indirect taxes like VAT and productive private sector companies and individuals to shoulder the burden of direct taxes.
From 2000 to 2015, Sri Lanka faced significant challenges in tax collection. In 2015, tax collection dropped to 12% of GDP, lower than many Sub-Saharan African countries. However, countries in Sub-Saharan Africa had managed to increase their tax-to-GDP ratio from 12% in 1990 to 15% by 2010 through the implementation of value-added tax (VAT) and autonomous tax agencies.
Sri Lanka’s income tax-to-GDP ratio in 2015 was a mere 2%, significantly lower than similar middle-income countries like Georgia (9%), Mongolia (9%), Bhutan (7.7%), Samoa (5.6%), and even Egypt (6%). Overall tax income as a percentage of GDP had declined from nearly 20% in the 1970s to 11.4% in 2014, lagging developing country peers such as Georgia (24%), Samoa (23%), Ukraine (18%), Armenia (17.5%), and Tunisia (21%), as per IMF data.
The Auditor General of Sri Lanka revealed that the Inland Revenue Department (IRD) had not collected default taxes and penalties amounting to over Rs3.3 trillion as of June 2019, an astonishing figure compared to the total collected tax revenue of Rs1.7 trillion in 2019. The AG’s audit, conducted in July 2020, found that default taxes were increasing annually, and the IRD had not taken timely measures to address the reasons behind these significant defaults.
Income tax evasion was identified as a major problem in Sri Lanka, with the income tax-to-GDP ratio at a mere 2.8%. This evasion was attributed to widespread tax evasion practices, complex tax codes with numerous loopholes, and the lack of autonomy in the revenue department. Sri Lanka’s tax collection, which averaged 21% of GDP from 1950 to 1989, had dwindled to 12.6% in 2019, falling behind its developing country counterparts and even Sub-Saharan African nations, which averaged 15% in 2018.
To improve tax collection, Sri Lanka needed to combat income tax evasion, address tax code complexities, and consider granting more autonomy to the revenue department. Tougher measures and investigations into lapses at the IRD were recommended, along with action against tax officials not fulfilling their duties.
Tax evasion in Sri Lanka was prevalent among various groups, including companies maintaining two sets of books, traders running front stores to conceal larger operations, professionals like doctors and lawyers underreporting income, and family-owned businesses charging personal expenses to the company to reduce tax liability.
The IRD’s capacity to audit tax files was limited, with only 3% audited annually, leaving little room to uncover tax evaders beyond the income tax base. Furthermore, tax evaders faced lenient penalties in Sri Lanka compared to other countries.
Sri Lanka’s complex and ever-changing tax code allowed for legal tax avoidance, where individuals and businesses exploited legal loopholes to minimize their tax obligations.
Why Pay Taxes?
What comes first? Better governance or higher tax compliance? Given the poor state of governance in Sri Lanka, many ask why pay taxes at all but understanding the relationship between governance and tax compliance is crucial.
In a 2007 study conducted by Georgia State University, tax compliance refers to individuals paying their taxes even when the chances of fines or audits are low. Tax morale, on the other hand, is the inherent motivation that drives people to willingly fulfil their tax obligations. The study’s central finding is that tax morale significantly boosts tax compliance, regardless of the research approach used.
This implies that, beyond traditional enforcement methods, policies aimed at enhancing tax morale can effectively increase tax compliance. Key factors influencing tax morale include voice and accountability, the rule of law, political stability, absence of violence, regulatory quality, control of corruption, trust in the justice system, and trust in the parliament.
According to observations by the International Centre for Tax and Development in 2019, taxation goes beyond revenue generation; it is intricately linked with state-building and politics.
Increased taxation has the potential to generate demand for government accountability among the public, ultimately leading to improved governance. This connection between taxation and accountability has historical roots in the 17th and 18th-century revolutions in the West. The theory suggests that when citizens pay taxes, they feel a sense of ownership over government revenues and, in turn, demand benefits and concessions from the government to encourage tax compliance. This process, known as tax bargaining, can result in more responsive and accountable governance.
However, in contemporary developing countries, this link is less evident due to differing circumstances. Many African countries have alternative revenue sources like natural resource rents or aid, and governments have various tax policy tools with varying degrees of relevance to taxpayers. This can affect taxpayer engagement significantly. For instance, in Nigeria, where 65% of government revenue comes from the oil and gas sector, tax morale among citizens is extremely low. The data reveals that more than a fifth of Nigerians believe it’s ‘not wrong at all’ to evade income taxes, while over half find it ‘wrong but understandable.’
To enhance tax morale and compliance, taxpayers need clear information about the taxes they owe, why they owe them, and how the revenues are utilized. Such awareness and information can motivate them to make demands on the government. Unfortunately, in many African countries, taxpayers face difficulties: 48% of Nigerians find it challenging to obtain information about their tax obligations; In Rwanda, 60% of new taxpayers (mostly businesses) struggle to file returns, and 33% face difficulties in contacting the revenue authority; In Sierra Leone, 59% of respondents at the ward level struggle to learn how the government spends public funds, with even higher percentages at the local and central government levels.
To address these challenges, increasing transparency and engagement around taxes is essential. Research conducted in Sierra Leone and Ghana explored the effectiveness of initiatives to boost transparency and public involvement in tax matters. The findings highlight that meaningful transparency should involve timely, accessible, taxpayer-specific information on rates and payment due dates, and expenditure-linked information related to local public services.
For Sri Lanka, improving tax compliance is imperative for improving governance and placing the economy on a sustainable path towards recovery and inclusive growth. As we will show, the fiscal problem is not so much about government spending but falling tax revenue, as the IMF also says. Low tax revenue has compelled the state to borrow heavily to maintain a bloated, unproductive public sector workforce, bankroll loss-making state enterprises, provide utilities below cost, provide cheap essentials and finance public infrastructure.
The Economic Problem is a Tax Problem
Our debt crisis is the result of borrowing not just for capital expenditures like ports and highways, but also to bridge the current account deficit.
Consider this: Complain about taxes, by all means. The estimated tax revenue for 2024 is Rs3.8 trillion. Recurrent expenditure is Rs5.3 trillion, with public sector wages at Rs1.1 trillion, debt servicing at Rs2.6 trillion, and subsidy transfers at Rs1.2 trillion. We are not mere victims of circumstance. We are active participants in what befalls our economy. What would you cut? Taxes? Public sector wages or subsidies? You can’t stop servicing debt. Send unproductive state-sector workers packing? Privatize state enterprises? Stop doctors and other professionals from leaving overseas in droves to serve and pay taxes in their adopted countries. Limit free education? Healthcare? Cull the military?
Direct taxes are payments made by individuals directly to the government, and they are calculated based on the ability to pay principle, meaning they are proportionate to a person’s income or wealth. These taxes are progressive, with rates increasing as income or wealth rises. While direct taxes can help reduce income inequality and inflation, they are also complex to administer.
In contrast, indirect taxes are collected by intermediaries, like businesses, and then passed on to consumers. These taxes are based on the benefit principle, meaning they are proportional to consumption. Indirect taxes are regressive, as the rates decrease as income or wealth increases. They can contribute to income inequality and inflation but are generally easier to collect and harder to evade.
The advantages of direct taxes include their fairness, efficiency, and stability. However, they come with drawbacks such as high administrative costs and inflexibility. On the other hand, indirect taxes offer simplicity, flexibility, and the ability to influence certain types of consumption, but they are often viewed as unfair and inefficient.
Wood for the Trees
Let us pause here to counter the arguments against progressive income taxes. Friedrich Hayek, an economist almost venerated in our newsroom as a proponent of economic freedom, money printing central banks and progressive taxes. While he does make a valid point about the dangers of progressive taxation, missing the nuances could lead to misleading conclusions.
He begins an impressive laborious censure of progressive taxation in his treatise The Constitution of Liberty with these words: Individual taxes, and especially the income tax, may be graduated for a good reason—that is, to compensate for the tendency of many indirect taxes to place a proportionally heavier burden on the smaller incomes, (and that) is the only valid argument in favour of progression. It applies, however, only to particular taxes as part of a given tax structure and cannot extend to the tax system as a whole.
Perhaps by Hayek’s standards, Sri Lanka did not err in hiking income tax rates. Of course, Hayek points out the limitation to the argument in favour of progression, suggesting that the compensatory effect of progressive income taxation is specific to certain taxes within the broader tax structure and not to the entire tax system. Therefore, a fundamentalist rejection of income taxes is to cast out the tub, the flower-petal-perfumed soapy water, and the baby, this magazine said in its June 2023 editorial.
In Sri Lanka, direct tax evasion is alarmingly high, while indirect taxes disproportionately affect vulnerable groups and are sometimes used to protect special-interest businesses. This situation highlights the challenges and complexities of tax policies and their impact on different segments of the population. Therefore, it seems logical to widen the tax net on direct taxes just to meet the current account deficit of the government so it can maintain the public sector cadre and subsidies. Or, increase borrowing.
According to the IMF Country Report of November 2022, the persistent large fiscal deficits in Sri Lanka are primarily attributed to relatively low tax revenues rather than excessively high government expenditures. To stimulate production and alleviate the cost of living, the current government undertook a significant overhaul of the tax structure shortly after assuming office. This overhaul involved the enactment of several measures, including reductions in tax rates and increases in exemptions for the Personal Income Tax (PIT), Corporate Income Tax (CIT), and Value Added Tax (VAT) in December 2019. Consequently, Sri Lanka’s tax-to-GDP ratio experienced a significant decline, reaching a historic low of 8.1% in 2020, now ranking among the lowest globally.
The IMF noted that Sri Lanka possessed a significant opportunity to boost its revenue collection by bolstering income taxes and Value Added Tax (VAT). In 2022, Sri Lanka’s tax-to-GDP ratio ranks among the lowest globally, and its tax system stands out for its combination of low rates, limited tax base, and complexity. To address this, aligning Sri Lanka’s Personal Income Tax (PIT) rate schedule with that of other emerging Asian economies and eliminating sector-specific Corporate Income Tax (CIT) exemptions could result in an additional revenue gain equivalent to 0.7% of the GDP.
Moreover, considering Sri Lanka’s comparatively low VAT rate in comparison to its peers, there exists room for generating supplementary revenue through rate adjustments, the IMF noted. However, any such reform should be accompanied by measures to broaden the tax base and enhance the efficiency of revenue collection. A comprehensive overhaul of indirect taxes is also necessary to simplify the system, entailing the removal of VAT exemptions and a gradual phasing-out of para-tariffs.
Sri Lanka’s tax revenue performance has consistently lagged behind its comparator countries, and this situation worsened significantly in 2020 (Figure 1). Tax revenue had remained relatively stable at approximately 10 to 12% of GDP from 2000 to 2019, displaying resilience even during economic downturns in 2001, 2009, and 2013. However, the year 2020, marked by the COVID-19 pandemic-induced recession, saw a sharp decline in total tax revenue to 8% of GDP. This decline was attributed to a combination of factors, including tax cuts, cyclical economic effects, the suspension of non-priority imports, and the implementation of lockdown measures. Throughout this period, Sri Lanka’s tax-to-GDP ratio remained below the average observed in comparator countries, and the trend of revenue underperformance has been on the rise.
Taxes on goods and services have traditionally constituted the primary source of tax revenue in Sri Lanka (Figure 2). On average, from 2000 to 2020, taxes on goods and services accounted for 58% of the total tax revenue. In contrast, taxes on international trade represented the secondary revenue source, contributing an average of 19% of total tax revenue during the same period. Notably, in 2020, Sri Lanka became increasingly reliant on taxes on international trade as a revenue source relative to its comparator countries. Concurrently, there was a reduced reliance on Personal Income Tax (PIT) and Corporate Income Tax (CIT), which collectively contributed just 1.3% of GDP in revenue.
The aftermath of the 2019 tax reforms had a profound impact on the number of registered taxpayers in Sri Lanka. These reforms, characterized by higher tax exemptions and more lenient registration thresholds, included relatively few individuals and businesses in the tax system. Notably, changes in the PIT rate structure and withholding regime led to a substantial 32% decline in the number of registered income taxpayers in 2020. The number of registered PAYE taxpayers fell by 42%. Additionally, over three-quarters of previously registered Value Added Tax (VAT) payers no longer fell within the tax net. Furthermore, many businesses, which had previously been subject only to the Nation Building Tax, are no longer registered taxpayers.
According to the IMF, Sri Lanka’s revenue productivity in terms of Personal Income Tax (PIT) and Corporate Income Tax (CIT) is notably low (Figure 3). In 2020, Sri Lanka exhibited the lowest PIT revenue-to-GDP ratio among its comparator countries, even though it had the lowest top marginal PIT rate. Similarly, its CIT revenue-to-GDP ratio was lower than that of all comparators, despite having a standard CIT rate that was close to the average. Figure 3 illustrates that both CIT and PIT revenue productivity in Sri Lanka lags behind those of peer economies, indicating a combination of high tax exemptions and inefficient tax collection practices.
There is considerable scope to increase revenue collection in Sri Lanka through PIT reforms. Based on Sri Lanka’s relative revenue performance, the IMF estimated that adopting a marginal PIT rate schedule aligned with its comparators could generate an additional 0.2% of GDP in PIT revenue, up from the 2020 level of 0.3% of GDP.
This hypothetical schedule would set the tax-free allowance at Rs600,000 and incrementally raise the marginal tax rate by 10 percentage points for each additional Rs600,000 taxable income, culminating in a top marginal tax rate of 30%, the IMF claims. Based on the distribution of household income in Sri Lanka, it is projected that this revised schedule would exhibit strong progressivity, imposing approximately 82% of the tax burden on households in the top 10% of the income distribution while exempting those in the bottom 60%, the IMF 2022 Country Report noted.
Realization Dawns
The government has recognized the challenges of taxation, as indicated in the Letter of Intent dated March 2023. In pursuit of the necessary fiscal consolidation, Sri Lanka introduced an ambitious and progressive tax reform plan. In 2021, Sri Lanka’s tax revenue-to-GDP ratio was a mere 7.3%, one of the lowest globally, and the government pledged to elevate this ratio to a minimum of 14% by 2026, through a well-structured sequence of tax measures.
It began by initiating a comprehensive tax reform package on May 30, 2022, amounting to approximately 0.5% of GDP in 2022 (equivalent to 1.2% of GDP on an annual basis). This package included measures such as raising the top marginal Personal Income Tax (PIT) rate to 32% and reducing the tax-free allowance to Rs1.8 million, along with adjustments to the Corporate Income Tax (CIT) and Value Added Tax (VAT) rates. The VAT rate increase took effect on June 1.
However, recognizing the need for additional and more ambitious revenue measures to reduce the primary fiscal deficit to 0.7% of GDP by 2023, the government implemented further tax measures. These included higher PIT rates, the reintroduction of withholding taxes, the removal of sector-specific CIT exemptions, additional VAT rate hikes, increased excise on alcohol and tobacco, and higher fuel excise. Legislative revisions necessary for the 2023 revenue measures were approved by Parliament in December 2022.
To achieve a primary fiscal surplus of 0.8% of GDP by 2024, Sri Lanka planned to reform the VAT system by eliminating most exemptions, expediting valid VAT refunds, and abolishing the Simplified VAT (SVAT) system. In its pursuit of a primary fiscal surplus of 2.3% of GDP by 2025, Sri Lanka pledged to revamp the property tax system and introduce a wealth transfer tax, including a nationwide real property tax and a gift and inheritance tax. In parallel, Sri Lanka recognized the need for tax administration reforms to enhance tax compliance, fiscal transparency, and the progressivity of the tax system.
To complement these revenue-based fiscal consolidation efforts, the government proposed to rationalize expenditures, prioritizing essential areas like health, education, and social protection while seeking ways to limit growth in the public sector wage bill and public pension spending without salary cuts. Additionally, it agreed to enhance public investment efficiency in light of fiscal constraints on capital expenditure, aligning with the 2018 IMF Public Investment Management Assessment recommendations.
Sri Lanka has grappled with economic challenges, relying on external funding, debt, and monetary expansion. The COVID-19 pandemic has highlighted the need for systemic change in governance and tax compliance.
Tax evasion, complex tax codes, and a lack of autonomy in the revenue department have hindered tax collection, impacting the government’s ability to provide essential services and stimulate economic growth.
To address these issues, Sri Lanka must enhance tax morale through factors like accountability, the rule of law, and trust in the justice system. Reforms in income and VAT taxes, along with transparency and public engagement, are essential to improve revenue collection. However, we argue that these reforms can only happen if people pay taxes.
In the wake of fiscal challenges worsened by the pandemic, Sri Lanka has an opportunity to steer its economy towards recovery, focusing on responsible government spending and a revamped tax system to ensure long-term prosperity.
Now that everyone over 18 has to apply for a TIN (taxpayer identification number), instead of public sector jobs, salary increments for unproductive work, subsidies, import protections and price controls, citizens would be compelled to be more engaging, ask the right questions and demand transparency and good governance in exchange for votes.