Indirect Taxation in The Development Challenge

1 Abstract distribution. Taxation, inter alia, can Kopalapillai Amirthalingam be used as a tool to ensure such Senior Lecturer, ri Lanka is seeking rapid income distribution across Department of Economics, economic growth targeting geographical demarcations and University of Colombo. S at doubling per capita income deciles. income by 2016. Nonetheless, inequality is at its historical In the past three decades, a highest and thus the development number of developing countries the country. This situation challenge is to ensure that rapid have experienced major episodes of necessitates comprehensive policy economic growth is achieved financial crisis that were brought measures either to reduce while better ensuring equitable about by unsustainable fiscal expenditure or to increase the income distribution. Since fiscal deficits. As in the case of a number revenue base of the country, so deficit is significantly high in of other developing countries, the that the government need not Sri Lanka, taxation is crucial in fiscal deficit in Sri Lanka too has depend overwhelmingly on debt. generating been high for a long period. Though However, given the security because of the harmful the fiscal deficit was at its peak at situation and the need for rapid macroeconomic repercussions of 23 per cent of GDP in 1980, it development of the country, other means. However, ratio averaged 13 per cent during 1977- expenditure cuts could be harmful is on the decline and the decline 1991 and 9 per cent during 1992- not only economically, but also is closely related to the decline 2009 (Central Bank of Sri Lanka). politically. of the indirect . However, even a 9 per cent deficit Therefore, enhancement of could be a dangerous phenomenon Therefore, focusing on taxation is indirect taxation is vital. as it could act as a catalyst for crucial since alternative ways of Efficiency and productivity of financial instability in the country. financing government expenditure, VAT should be improved while For example, Brazil's financial such as, money creation, mandating taking measures to ensure equity. crisis in 1999 was closely related larger required reserves, domestic This will be an important to its high budget deficit, which was borrowing and foreign loans can development challenge to the 8.4 per cent of its GDP (Woo, 2003). have harmful macroeconomic country. When government revenue is repercussions. International insufficient to offset expenditure, empirical evidence on tax ratio Introduction the country is forced to depend on (total tax revenue as a percentage foreign and domestic sources to of GDP) has 40 per cent, 25 per cent Development can be defined as bridge the fiscal deficit. As a result, and 18 per cent as the average tax economic progress shared by all, government's debt as a percentage ratios for high-, middle- and low- and is particularly so if one focuses of GDP (Gross Domestic Product) income countries respectively on sustainable development. Sri rises. High levels of debt in turn (Gallagher, 2005). Nonetheless, tax Lanka is seeking a rapid economic will increase the pressure on the ratio in Sri Lanka has been growth after ending the thirty-year government's ability to meet its declining and remains well short of old civil war. The current target is other commitments. This is of the average rate of developing to double per capita income from particular concern when these countries. It is important to note the current level of USD 2053 to commitments involve essential and that the tax ratio has declined from USD 4106 by 2016. Inequality, as development-oriented expenditure. 21 per cent in 1979 to 12.8 per cent measured by the Gini coefficient Government borrowing also tends in 2009. as a however, is at its historical highest, to reduce the quantum of resources percentage of GDP has declined 0.49 in 2006/2007, compared to available to the private sector and from 15.7 per cent in 1980 to 9.9 0.43, 0.46 and 0.48 in 1978/79, results in higher interest rates in per cent in 2009. During the same 1986/87, and 1996/97 respectively. the domestic market. This will period, as a percentage of GDP, Thus, the development challenge is increase the cost of borrowing for has also declined to ensure that rapid economic the private sector, thereby crowding marginally, from 3.1 per cent to 2.9 growth is achieved while better out private investment, adversely percent (Central Bank of Sri Lanka). ensuring equitable income affecting the economic growth of Here, we can notice that the decline 11 — Economic Review: Oct./ Nov. 2010 of tax ratio has been closely related developing countries usually wish consumers by way of increasing the to the decline of indirect as to increase development-oriented price of goods and services. The a percentage of GDP. services such as education and most important single fact about training, agricultural extension and indirect taxes in developing Thus there is a need, as well as research. Thus, government economies is the dominant role room to increase the tax ratio in revenue may need to grow at a rate that they play in the revenue Sri Lanka because increasing tax that exceeds the growth of national system of almost every country. revenue as a percentage of GDP is income to provide resources for Historically, indirect taxes have vital for the economic development. recurrent government expenditure. been an important element in Lewis (1984) argues that an As a result, countries are stabilisation tax packages that aim increasing share of tax revenue in constantly trying to formulate a at raising revenue in the short run national income or in GDP is an better and frequently in many countries. instrumental objective of economic reforming their tax structure with development policy. High-income a view to increasing tax revenue. Musgrave (1969) divided the period countries have had rising shares of of economic development into two: tax revenue and government Though the main target of a country the early period when an economy expenditures to income as they is to increase total tax revenue, is relatively underdeveloped and have become more indirect and direct taxes play the later period when the economy economically advanced. Similarly, different roles in developing and is developed. During the early comparison among countries at developed countries. Developing period, there is limited scope for different levels of per capita income countries tend to rely on indirect the use of direct taxes because the generally show higher shares of taxation as a revenue source, since majority of the populace resides in government expenditure and such taxes are easier to administer rural areas and is engaged in tax revenue in national income of in countries that have poorer subsistence agriculture, and higher-income countries than in income and asset recording therefore their incomes are difficult poor countries. There appears to be systems. High direct taxes are also to be estimated. Therefore, indirect a relative increase in the demand thought to discourage taxes play an important role during for government services as per entrepreneurship and effort, and the early stage of economic capita income increases. At very hence lower direct tax rates are development. The difference in low levels of per capita income, the proposed in a bid for greater direct and indirect tax shares in principal needs are for "private" economic growth. Thus clearly, the developed and developing countries goods, such as food, clothing and growth in tax revenue has to be confirms Musgrave's theory. He shelter. The income elasticity of largely through the expansion of further states that the ratio of demand for those products falls as indirect taxation. However, since indirect taxes to total taxes is per capita income increases, and indirect taxes act as regressive related inversely to per capita there is an increased demand for taxes in which the tax burden may income, because the economic "public" goods at higher levels of fall on everyone equally, regardless structure of low-income economies income. The increased demand is of their income (or ability to pay), is not suited to the imposition of for government services in the areas further enhancement of the direct taxes. The following Table of transportation, communication indirect taxes might aggravate the clearly shows the difference and general government equity concerns encompassed in between Sri Lanka and some administration, to deal with the development objective. This developed countries, such as, increased complexities. Further, necessitates indirect tax reforms to Canada, New Zealand and Australia the demands for certain welfare be sensitive both to equity and and even some other developing services and transfer payments to growth objectives in the country. countries with regard to the various poorer sections of the capacity for raising tax revenue

population are felt much more Defining Indirect Taxation through direct taxes (Taxes on strongly at higher levels of per income, profits and capital gains). capita income than at lower ones. Indirect taxation is defined as All these pressures to increase the taxation that may be imposed upon Table 1, shows that Sri Lanka has level of government expenditures the persons other than those who raised less revenue from direct and transfer payments generate a are intended to bear the final taxes (taxes on income, profits and need to increase tax revenue to burden. Unlike direct taxes, capital gains). This indicates that release real resources for the indirect taxes are the same for all, even in contrast to Thailand, provision of these government irrespective of the income level of Malaysia, India and Kenya, Sri services. In addition to the consumer and are therefore Lanka has relied excessively on general government consumption regressive. These taxes imposed on expenditure, the governments of indirect taxation. Other countries producers, can be shifted on to the 12 have expanded their direct tax Economic Review: Oct./Nov. 2010 Table 1: Taxes on Income, profits and capital gains (% of total taxes) in selected countries VAT Country 1990 1992 1994 1996 1998 2000 2002 2004 2006 2007 2008 efficiency (sometimes Sri Lanka 12 14 15 16 14 15 17 15 19 21 21 called 'C- Canada 72 71 71 73 74 76 72 74 77 77 efficiency') New Zealand 62 62 67 66 and Australia 75 67 70 productivity are the two Thailand 39 44 45 48 indicators Malaysia 43 47 44 46 60 55 62 used to Korea, Rep 40 40 39 37 41 38 37 41 44 46 measure India 19 23 29 30 32 36 38 43 47 51 52 t h e Pakistan 13 18 21 20 29 28 31 28 28 38 37 collection efficiency of Uganda 15 16 21 25 27 28 27 VAT in Kenya 29 33 40 38 33 33 36 39 40 42 many Source: World Development Indicators—Not Available countries. The revenue proportion over time Tax development in the world as efficiency is the ratio of the VAT significantly unlike Sri Lanka, well as the successful experience revenue to aggregate consumption, which began from a lower base and of other countries with different tax divided by the standard VAT rate. has grown more slowly. Given the systems, induced Sri Lanka too to The productivity is the ratio of VAT revenue to GDP, divided by the regressive nature of indirect shift from Business standard VAT rate. The closer these taxation, the tax structure is likely (BTT, 1964-1981) to Turnover Tax ratios are to zero (one), the lower to be detrimental to Sri Lanka's (TT.1981-1998) to Goods and (higher) the collection efficiency of progress towards the achievement Services Tax (GST, 1998-2002) and of social and economic justice. the VAT (Bird and Gendron, 2006; finally to Value-Added Tax (VAT, While a major development Aizenman and Jinjarak, 2008; Ebrill 2002). In Sri Lanka, the VAT challenge is to shift the Sri Lankan etal, 2002 and Correia, 1999). The involves a multiple rate structure. tax system more towards direct VAT could be the most productive Apart from zero rate and exemption, taxation, given the current fiscal source of revenue for developing there was a 10 per cent deficit problems, it is also countries. To achieve this objective, concessionary rate and a 20 per important to focus on improving the its efficiency and productivity must cent standard rate when the VAT earnings from indirect taxation in be high. was introduced in 2002. a manner that is least regressive. Subsequently, there were changes According to Table 2, the efficiency almost every year with regard to Efficiency and productivity of in Sri Lanka does not show a clear the rates. At present, VAT rates the VAT trend: it increased from 0.40 in adopted in Sri Lanka are 20 per cent 2003 to 0.61 in 2004 but after 2004 Value-Added Taxes (VAT) can be luxury rate, 12 per defined as a tax on the value that cent standard rate, 5 Table 2: Efficiency and productivity of VAT is added to goods and services by per cent optional rate, in Sri Lanka enterprises at each stage of the zero rates for production and distribution process and exemption for Year Efficiency Productivity (Shoup, 1988). After the first specific items 2003 0.40 0.27 adoption in France in 1954, VAT has (Government of Sri indeed proved itself an effective 2004 0.61 0.38 Lanka). form of taxation and its growth is 2005 0.55 0.38 unprecedented by any other concept In Sri Lanka, the VAT in taxation (Keen, 2007; Ebrill et al, 2006 0.55 0.37 has contributed 35.7 2002; Keen and Lockwood, 2009). per cent to total 2007 0.52 0.35 Moreover, the VAT has now become indirect taxes in 2009. 2008 0.44 a central tool of tax policy in most Since VAT plays a 0.31 countries, with the exception of the pivotal role in the 2009 0.46 0.30 United States. The extent and pace entire indirect tax of the spread of the VAT around the system, it is important world has been one of the most to examine the Central Bank of Sri Lanka (Various Annual Reports) and striking international tax efficiency and (publications with regard to Value Added Tax Act developments in recent history. productivity of VAT. and subsequent amendments)

Economic Review: Oct/ Nov. 2010 13 • there has been significant decline Lanka has collected just 3.6 per than turnover tax because under till 2008 and then a slight cent of GDP in revenue from VAT. VAT, the is clearly specified improvement in 2009. The efficiency The revenue productivity of the VAT and as a result there is no hidden of the VAT in the world varies in the world is as high as 0.70 (for element in tax. country to county. For example, it New Zealand) and as low as less is very high in some countries than 0.20 for some countries. Impacts on equity (Jamaica: 0.93 and Canada: 0.67) Within Latin America the range in and very low in others (Brazil: 0.16 productivity varies from around 0.20 Equity is, of course, a central issue and Argentina: 0.27) (Bird and (in Haiti, Mexico and Venezuela) in taxation almost everywhere. Gendron, 2006). about to 0.50 (for Chile and Ecuador) Equity in taxation implies that (Bird and Gendron, 2006). To taxes should be imposed in VAT collection efficiency can be improve the level of revenue accordance with the ability to pay. improved with the resources spent productivity of the VAT, total Equity normally has two on enforcement, and with the revenue from VAT as a percentage dimensions: horizontal and efficiency of monitoring, collecting of GDP should be increased. To vertical. Horizontal equity holds and processing information. Theory achieve this goal, government can that taxpayers with equal income suggests that the enforceability of take many measures including; should pay equal taxes regardless taxes is impacted by political of the source or nature of that economy considerations - greater i) more taxation on the growing income. Vertical equity means that polarisation and political instability economic sectors (e.g. - mobile taxpayers with greater ability to pay phones), would tend to reduce the efficiency should pay more (Musgrave, 1976; of tax collection, reducing the ii) heavier taxation on income- Musgrave and Musgrave, 1989; resources devoted to tax elastic items (e.g. - vehicles, Plotnick, 1982). A good tax system enforcement. In addition, collection petroleum products), must be both equitable and is impacted by structural factors iii) bringing informal economic efficient. It is widely recognised that that affect the ease of , activities into tax net, and these goals may conflict. Efficient like the urbanisation level, the taxes may be inequitable in their iv) heavier taxation on price- share of agriculture in GDP and effect on the distribution of income. inelastic items (e.g. - alcoholic openness (measured as the On the other hand, equitable taxes beverages and tobacco products). ratio of imports plus exports to may not be efficient taxes. GDP). Empirical studies on several If Sri Lanka manages to improve the Efficiency demands that necessities countries show that both productivity of VAT, it can ensure should be taxed more heavily than urbanisation and trade openness greater government expenditures luxuries. This is of course the will be significantly and positively for development objectives. opposite of what one would hope related to the tax collection However, the country faces for from the equity point of view. efficiency but in contrast the share challenges here too, because VAT Therefore, it is argued that of agriculture in GDP will be has clearly not achieved its greater distributive (equity) policies are negatively correlated to the tax revenue-generating objective; this implemented at a cost in efficiency collection efficiency. So with the may be due to several reasons such in almost all countries. prevailing peaceful situation in the as its complicated structure, country, it is necessary to have administrative weaknesses, Theory suggests that if a country meaningful industrialisation and political influence, does not have a well-developed, trade liberalisation with increased and evasion, complexities in the effective and optimally- adjusted resources devoted to tax , lack of application of and transfer system to administration, efficient modern information technology, etc. tackle equity concerns with the monitoring, and better usage of VAT, in fact, has performed worse direct tax system, indirect taxes modern information technology than the previously adopted should be differentiated to (MIT) to enhance VAT collection Business Turnover Tax in terms of incorporate the distributional efficiency in the coming years. revenue generation. However, consideration in addition to the compared to turnover taxes, VAT is usual efficiency concerns (Stern, If we look at the productivity of VAT, an ideal tax to address the equity 1987). That is why most countries not only is it relatively low, but it concern, because unlike turnover tend to keep many essential goods has been declining during the period taxes, there is no cascading effect and services - which are largely 2004 and 2009 (Table 2). This figure under VAT and zero rate and consumed by the poor presents the percentage of GDP exemption of essential goods can disproportionate to their income - that each percentage point of the be used effectively to achieve the out of the tax net by the ways of distributional objective under VAT. standard VAT rate collects. zero rate or lower rate or exemption. Moreover, VAT is more equitable Therefore, we can conclude that Sri Furthennore, there is a common 14 Economic Review: Oct/Nov. 2010 argument that equity could be reduce the over dependency on Government of Sri Lanka (Various improved by the greater use of food indirect taxes in the long run and Issues) Publications with regard to Value Added Tax Act and subsequent subsidies accompanied by much should continue to address the amendments), Government higher taxes on luxuries and equity concern by way of zero rating Publication Bureau, Colombo. alcoholic beverages and tobacco and exemption under VAT. The Hossain, Shahabuddin M., (1995). products. Indeed, alcoholic major consumption basket (such as "The Equity Impact of the Value-Added beverages and tobacco products are food, milk powder, pharmaceuticals, Tax in Bangladesh". Staff Papers- not beneficial for either their users etc.) of low-income group should International Monetary Fund or for society and could actually be not be taxed even indirectly. At the 42(2):411-430. harmful, especially for the same time, comprehensive consumer and the family, and measures should be taken to Keen, M. and Lockwood, B., (2009). "The Value Added Tax: Its Causes and therefore it is argued they could be improve the efficiency and Consequences". Journal of heavily taxed with no ill effects. productivity of the VAT. Only then Development Economics Further, since they have less will the country be able to harness Doi: 10.1016 /J.Jdeveco.2009.01.012 elasticity, they provide a better its indirect tax system as an basis for taxation than most other instrument in attaining sustainable Keen, M., (2007). "VAT Attacksl". International Tax and Public Finance commodities. Therefore, in practice, development. In fact, this will be 14:365-381. different rates are imposed on an important development different goods to ensure equity challenge to the country. Lewis, S.R. (1984). Taxation for under VAT. With the view Development: Principles and addressing equity concerns, higher Applications, Oxford University Press. References: tax rates are imposed on alcoholic Musgrave, R. A. (1969). Fiscal System. beverages, tobacco products, Ahmad, E, and Stern, N., (1987). New Haven: Yale. petroleum products and other "Alternative sources of government luxuries in Sri Lanka too. Revenue: Illustration from India, 1979- Musgrave, R. A., (1976) "Optimal 80," in the theory of taxation for Taxation, Equitable Taxation and developing countries, ed. By David Second-Best Taxation". Journal of According to the theory, the VAT Newbery and Nicholas Stern, Oxford: Public Economics 6: 3-16. provides a potentially more Oxford University Press for the World Musgrave, R.A and Musgrave, P. B., equitable and efficient means of Bank. (1989) Public Finance in Theory and taxation. In practice, under the Practice, McGraw, Singapore. VAT, different mechanisms are Aizenmana, Joshua and Jinjarak, Yothin, (2008). "The collection Plotnick, Robert, (1982). The Concept adopted to address the equity efficiency of the Value Added Tax: and Measurement of Horizontal concern. Hossain (1995) notes that Theory and international evidence" Inequity". Journal of Public Economics a selective VAT with some zero The Journal of International Trade & 17: 373-391. Economic Development. 17(3): 391- ratings (or exemptions) and Shoup, Carl, (1988). "The Value 410. additional is clearly Added Tax and Developing Countries". preferable to a completely uniform The World Bank Research Observer Bird, Richard M. and Gendron, Pierre- VAT, if distributional issues are of 3(2): 139-156. Pascal, (2006). "Is VAT the Best Way dominant concern. Ahmad and to Impose a General Stern, Nicholas, (1987). The Theory Stern (1987) indicate, in a study in in Developing Countries?" ITP Paper of Optimal Commodity and Income India, that a uniform VAT on all 0602, International Tax Program, Taxation: An Introduction," In The final goods is clearly regressive and Institute for International Business, Theory of Taxation for Developing undesirable. However, they Joseph L. Rotman School of Countries, ed. by David Newbery and Management, University of Toronto, conclude that a uniform VAT with Nicholas Stern, Oxford University Toronto, Ontario, Canada. Press. exemptions or zero rates on certain items to allow for "distributional Central Bank of Sri Lanka (Various Woo, J. (2003). 'Economic, Political, consideration" is much less Issues), Annual Reports, Central Bank and Institutional Determinants of regressive than a proportional VAT. of Sri Lanka, Colombo. Public Deficits'. Journal of Public Therefore, it is true that greater Economics 87:387-426. Correia, Isabel H., (1999). "On the equity can be achieved under VAT Contact Details: using zero rating and exemption. Efficiency and Equity Trade-OfT, Journal of Monetary Economics, K. A mirth a tin gam, 198 A, Wasala Road, Conclusion Kotahena, Colombo-13. Ebrill, L., M. Keen, J-P. Bod in, and TP: 0777411547 Even though the primary focus of V. Summers, (2002). "The Allure of the Sri Lanka is to achieve a rapid Value-Added Tax". Finance and Email: [email protected] Development 39(2): 44-47. economic growth rate in the coming Footnote: years and to double per capita Gallagher, M. (2005). Benchmarking 11 am grateful for the constructive comments income by 2016, the country should Tax Systems'. Public Administration made by Prof. Amala de Silva. _ take comprehensive measures to and Development 25:125-144.

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