Incidence of Commodity Taxation on Income Distribution in Sri Lanka
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Poverty Monitoring, Measurement and Analysis (PMMA) Network Incidence of Commodity Taxation on Income Distribution in Sri Lanka Pahan Prasada Sri Lanka A paper presented during the 4th PEP Research Network General Meeting, June 13-17, 2005, Colombo, Sri Lanka. An Analysis of Incidence of Commodity Taxation on the Income Distribution in Sri Lanka Pahan Prasada, Ranmuthumalie de Silva and Jeevika Weerahewa1 Abstract Commodity taxation constitutes an important component of the overall government revenue. In most developing countries where the formal tax base is not well established, taxation of goods and services via indirect tax instruments play a significant role in sustaining the state revenue flow. The objective of this paper was to assess whether some commodity tax instruments were progressive or regressive on the income distribution in Sri Lanka, with reference to the year in which Sri Lanka Integrated Survey was conducted. Analysis was conducted using the food and non-food expenditure data extracted from the said household survey (1999/2000). The concept of welfare dominance was adopted and Lorenz and Tax Concentration curves were used as analytical tools. The empirical analysis was concentrated on total of 49 commodities where 23 commodities were used to analyze the incidence of GST, 34 commodities to analyze the incidence of NSL and 14 commodities to analyze the incidence of Import Tariff. Commodities were selected according to the frequency of usage. The results revealed that GST on 16 items which epitomize 24.02 percent total households expenditure was progressive while seven items which represent 4.43 percent total household expenditure was regressive, NSL on 11 items which denote 22.66 percent total expenditure was progressive whereas 22 items which account for 19.75 percent total expenditure was regressive and NSL on wheat displayed a special situation where the share of taxable consumption was exactly similar to the share of income. Import Tariff on six commodities which embody 10.69 percent total household expenditure was progressive and eight commodities which represent 14.43 percent total household expenditure was regressive. Wide provincial variation was visible among commodities when incidence of taxation was considered. These findings highlight the fact that targeting of indirect tax instruments with wide coverage could have a momentous impact on already significant inequality in Sri Lanka. 1 Paper to be presented at the Poverty and Economic Policy (PEP) meeting, Colombo, Sri Lanka, June 13-17, 2005. Pahan Prasada and Ranmuthumali de Silva are assistant lecturers and Jeevika Weerahewa is a senior lecturer at the Department of Agricultural Economics and Business Management, Faculty of Agriculture, University of Peradeniya Sri Lanka. Authors acknowledge the financial assistance provided by the International Development Research Center (IDRC) to carry out the study 1. Introduction Tax revenue plays a vital role in the budgets of most countries where it is the dominant source of revenue for financing public expenditure. This is a fact that needs no elaboration since the developing world is grappling continuously with the challenge of meeting increasing expenditure burdens, with budget deficits escalating each year and facing the grim picture of comparatively low tax revenue to GDP ratios. On average, the ratio is 0.18 for most developing countries while it is as high as 0.30 in the developed world (Gemmell and Morrissey, 2003). Indirect commodity taxation, without detailed reference to the consumption patterns and profiles of the respective income classes, is widely used to address this issue. Such tax instruments could prove detrimental in terms of equity considerations because inappropriate commodities and services are selected as potential sources of tax revenue. A possible argument against indirect tax is that it contradicts the state’s own welfare aims. Governments of developing countries in general have numerous, elaborate, pro-poor transfer payment schemes that constitute a significant proportion of annual budgetary allocations, aiming to strengthen the livelihoods of the poor masses. Indirect tax covering items consumed by all income classes bear disproportionately on people with low income. In such an instance, the effect of indirect taxes offsets the purchasing power offered through the transfer payments. This contradiction of its own interest by the state would, in fact, lead to a wastage of public money (by way of an unnecessary transaction cost) spent on implementing the transfer payments as well as tax collection. Historically, Policy makers have not given their attention to the concept of redistribution when designing taxes. This may be because there are numerous subsidies and direct transfer payments which are conventionally identified as pro-poor instruments. Another issue that should be addressed is the prevalence of “implicit” forms of taxation in most developing countries. Price controls, punitive exchange rates and other consequences of economic liberalisation discriminate against the agricultural sector, (still the main source of employment for the rural poor) and tend to act as implicit forms of taxation, adding to the burden of indirect commodity taxes targeting daily consumption, irrespective of income class. Impacts of fiscal interventions are usually examined quite critically in developed countries. Tax structure and tax reform in developing countries in general have received much less attention. Nevertheless, taxation is a theme that needs to be considered seriously since governments of developing countries always need to balance the need to raise revenue against the social burden of taxes on the poor. This balance is bound to be politically sensitive. The direct impacts of a tax manifest in terms of revenue, producer and consumer surpluses in a partial equilibrium setting while the indirect impacts could create pressures on the income distribution. The subject of income distribution is inextricably linked to that of taxation, because virtually every tax system changes or attempts to change the proportion of income enjoyed by different groups in society. It is common knowledge that when the demand for items subject to indirect tax is inelastic, retail prices tend to include the ultimate tax burden, which is passed on to the consumer. For essential goods and services, such price increases will be imposed on all consumers whatever their income, an apparent violation of the vertical equity principle in tax design. Refaquat, 2003 attempts to determine the incidence of the said tax on the economy as a whole and on different individual commodities. The author points out that the individual commodity analysis has no bearing on the overall estimation and as such can be performed independently. According to the results obtained, the study concludes that the General Sales Tax (a form of indirect taxation) has been ‘progressive’ and ascribes the outcome to the particular selection of taxable items and exemptions. That is, the author believes under an alternative set of commodities the results could have been entirely different. Munoz and Cho, 2003 consider the case of replacing the sales tax with a value added tax (VAT) in Ethiopia and conclude that VAT is progressive contrary to the common presumption, reinforcing the findings by Sahn and Younger (2001) on eight other African countries using welfare dominance approach. Rajemison et.al, (2001) have made a novel attempt at determining the incidence of tax on intermediate goods. The technique used for the analysis is the input-output table and this study is unique in comparison to the general approach of focusing only on final goods and services. The case of Sri Lanka The contribution of tax revenue to the total government revenue in Sri Lanka was 86.32 percent in the year 2000. There were five major contributors to this revenue namely, income tax, stamp duties, tax on Treasury bills held by Central Bank, taxes on goods and services and taxes on international trade. The year 2000 witnessed the implementation of several measures aimed at enhancing the revenue mobilization efforts. These efforts resulted in raising the revenue collected from domestic goods and services through Goods and Services Tax (GST), National Security Levy (NSL), Excise Tax, License Fees and Turnover Tax. The total contribution of indirect commodity taxes GST, NSL and import tariff to the total tax revenue was 55.59 percent, implying that Sri Lankan tax revenue has a higher dependency on commodity taxes. In accordance with the trend towards globalization and tax liberalization, a shift from import tariff to tax on domestic goods and services was visible and this was evident from the changes in the tax collection. The revenue from domestic goods and services as a percentage of total tax revenue rose from 36 percent in 1999 to 39 percent in 2000, while the share of international trade-oriented taxes as a percentage of total tax revenue declined to 41 percent in 2000 from 43 percent in 1999. Tax structure of Sri Lanka is restructured yearly at the planning of the budget and even throughout the year via certain amendments. Therefore, it is important to investigate the impact of different tax instruments if we are to decide required amendments to the tax structure to be able to achieve a sustainable flow of income in an equitable manner, which is the ultimate objective of a tax instrument. According to the recent literature, the distributional impact of tax instruments has