Professor of Economics University of Colombo Sirimal Abeyratne said the new government certainly must be aware of the implications of the tax reforms on the budget and would address that challenge.
The country is faced with the twin challenges of bridging the budget and trade deficit that has been widening over the years due to revenue shortfall and the increase in imports. The depreciation of the rupee though had some cushioning effect with export income rising it has been a short lived relief as exports have not grown as expected during the year. “Sri Lanka has a very under developed tax system. The people and businesses are heavily taxed and there are multiple taxes which are complicating. The policy makers should slash the tax rates and simplify the tax system widening the direct tax base if the country is looking forward to be a competitive economic enclave in the region,” Prof. Abeyratne said.
The new Cabinet slashed the Value Added Tax to eight percent from its current 15 percent to stimulate the economy which had been growing at a sluggish pace during the year. The revised tax rates will come into force from the next month.
Among other tax reforms are the tax-free threshold for VAT has been increased from Rs. 1 million to Rs. 25 million turnover per month.
The Cabinet decided that the VAT on banking, financial services and insurance to be maintained at 15 percent and the income from agriculture, fishing and livestock to be made income tax free. The withdrawal of taxes include the Capital Gains Tax, VAT on condominiums, Nation Building Tax on domestic production, Economic Service Charge, Bank Debit Tax, Pay as You Earn Tax and Withholding Tax on interest while the telecommunications levy has been slashed by 25 percent and the income tax on the construction industry brought down from 28 percent to 14 percent.
The indices of Colombo Stock Exchange recorded an upward movement following the tax changes last week with major indices improving by around 1.5 percent.
The tax reductions are seen as a move that will result in some fiscal stimulus that would give a new boost to the GDP which has been growing below potential.
Colombo Stock Brokers Association Past President Ravi Abeysuriya said the reduction of VAT to eight percent, PAYE and telecommunication levy and the abolishing of several other taxes such as NBT, WHT on interest and debt repayment levy is likely to trigger an immediate boost to economic growth due to the multiplier effect on increased consumer spending.
The proposed VAT reduction from 15 to 8 percent and the increase of the VAT threshold from Rs. 1 million to 25 million per month will result in a decline in broader consumer prices of goods and services and possibly imported goods including vehicles.
The tax relief will improve profits of listed firms exposed to sectors such as consumption, banking and insurance, construction, tourism, agriculture and information technology.
However, the question remains how the government will be able to fund the budget deficit given the extent of the tax relief, which could total to over Rs. 450 billion, of which VAT reduction alone being Rs. 215 billion. No doubt part of the loss of revenue would be recovered with additional tax revenue that would accrue with the substantial increase in economic activity expected.
Gajma and Company Partner N.R. Gajendran said the government has made far-reaching tax reforms, a pledge made in the election manifesto. The tax concessions will spur business growth and will lead to robust economic activity. It will also result in more consumer spending and saving and from a people and business point of view will be a proactive move.
“However, the immediate concern would be the drop in revenue to the State which should focus on broadening the tax base to boost revenue,” Gajendran said.
Senior Lecturer, Department of Accounting, University of Sri Jayawardenapura, Dr. Anil Jayantha Fernando said while the reduction in the corporate tax seems good to boost economic activity there is no assurance that the money saved from the reduction will be reinvested in the company’s future activities.
He said the VAT reduction will be beneficial to banks and financial institutions which will gain from the move. “The removal of the PAYE tax which is a method of collecting tax will increase administrative expenditure in addition to the loss of revenue to the government.”
PAYE taxes are to be removed on the all inclusive monthly income of Rs. 250,000 in place of current ceiling of Rs. 125,000 per month for all public and private sector employees.
However, the long term implications on widening the budget deficit to around eight percent of the GDP would have negative impact on the economy.
Former Central Bank Deputy Governor W.A. Wijewardena said the tax concessions will cause the Treasury to lose about Rs. 650 billion to Rs. 700 billion or about a third of the government’s revenue.
The adjustment should be a compensatory cut in government expenditure but since it cannot be done, the other alternative is to borrow from the market immediately that would involve allowing interest rates to go up and since it’s not the government’s intention, the most likely source would be to borrow from the Central Bank by issuing Treasury Bills after increasing the Treasury Bill limit through Parliament.
This would involve compromising the future inflation rate and if the Central Bank wants to stick to the present inflation target of four to six percent, it has to sell those Treasury Bills at a higher interest rate; hence, an increase in interest rates is inevitable.
“This is an unconventional stimulus package by using tax cuts to increase cash holdings with individuals and businesses; the caveat there is that individuals increasing consumption of imported goods and foreign travel putting pressure on the exchange rate to depreciate; that has to be avoided by resorting to exchange controls or import controls; whether companies reinvest those moneys will depend on their own reading of market prospects,” Wijewardena said.
In the short to medium term, the government has to recoup the lost revenue by roping in more people into the tax net; it would automatically happen since abolition of Pay As You Earn (PAYE) and Withholding Taxes (WHT) on interest income which are final tax payments now will make those involved to file a tax return and pay income tax at 15 percent if the marginal tax rate is reduced to that rate or at 24 percent if it’s not done immediately; so, with regard to WHT, it is a choice between 5% and 15/24%; with regard to PAYE, it is a choice between monthly payment and quarterly/annual payment; about VAT which will reduce revenue by Rs. 300 billion, a special tax on goods and services will have to be imposed and excise tax on alcohol and tobacco will have to be raised. If the latter is used, those so called ‘sinners’ will be called upon to bear the brunt.