339.5 • 1575 W-76 INSTITUTE • FOR POLICY 4400 REFORM • • • WAITE • MEMORIAL BOOK COLLECT" DEPT. OF AG. AND APPLIED ECONn" 1994 BUFORD AVE. - 232 COL- UNIVERSITY OF MINNESOT/: ST. PAUL, MN 55108 U.S.A • Working Paper Series The objective of the Institute for Policy Reform is to enhance the foundation for broad based • economic growth in developing countries. Through its research, education and training activities the Institute encourages active participation in the dialogue on policy reform, focusing on changes that stimulate and sustain economic development. At the core of these activities is the search for creative ideas that can be used to design constitutional, institutional and policy reforms. Research fellows and policy practitioners Ase engaged by IPR to expand • the analytical core of the reform process. This includes all elements of comprehensive and customized reforms packages, recognizing cultural, political, economic and environmental elements as crucial dimensions of societies. • 1400 16th Street, NW / Suite 350 Washington, DC 20036 (202) 939 - 3450 • 339.5 • 1575 W-76 INSTITUTE • FOR POLICY REFORM • IPR76 • Tax Reform in Sri Lanka Nicholas Stern • WAITE • MEMORIAL BOOK COLLECT!' DEPT. OF AG. AND APPLIED ECowy 1994 BUFORD AVE..232 CO c• UNIVERSITY OF MINNESOTA ST. PAUL, MN 55108 U.S.A • Working Paper Series The objective of the Institute for Policy Reform is to enhance the foundation for broad based • economic growth in developing countries. Through its research, education and training activities the Institute encourages active participation in the dialogue on policy reform, focusing on changes that stimulate and sustain economic development. At the core of these activities is the search for creative ideas that can be used to design constitutional, institutional and policy reforms. Research fellows and policy practitioners are engaged by IPR to expand • the analytical core of the reform process. This includes all elements of comprehensive and customized reforms packages, recognizing cultural, political, economic and environmental elements as crucial dimensions of societies. • 1400 16th Street, NW / Suite 350 Washington, DC 20036 (202) 939 - 3450 • INSTITUTE FOR ALrAJJ POLICY REFORM I IPR76 • Tax Reform in Sri Lanka Nicholas Stern STICERD London School of Economics • and Senior Research Fellow Institute for Policy Reform September, 1993 • Sri Lanka stands at a crucial stage in a programme of stabilisation and adjustment which started in the late 1980s. Fiscal pressures are severe with government revenue around 21% and expenditures around 31% of GDP in 1990 and 1991 (although expenditure has been reduced to around 28% in 1992, largely through cuts on the capital side). A programme of fiscal adjustment would seem to require both a substantial decrease in expenditure and a substantial increase in revenue. The purpose of the paper is to describe possible sources of revenue expansion, in part by • drawing on international comparisons. Sri Lanka's direct taxes contribute very weakly, as a fraction of both GDP and revenue, relative to other countries. Expansion of the personal income tax could provide a major contribution to extra revenue. Advance on corporate tax tevenue will depend on the closing of loopholes from exemptions and holidays which have proliferated. The VAT previously announced for April 1994 (now postponed to April 1995) would be a positive development but cannot by itself be expected to raise the extra revenue which appears necessary, and indeed will have to be well administered to replace revenue from existing turnover taxes. The introduction of • the VAT, if well-planned, can help in the collection of the personal income tax. • • Author's Acknowledgements This paper sets out some reflections on tax policy in Sri Lanka following visits in September 1992 and June 1993. I am very grateful to Paul Crowe, Aneela de Soyza and Janaka Biyanwila of USAID, Sri Lanka for organising the visits and for the support of the Institute for Policy Reform and the Suntory-Toyota International Centre for Economics and Related • Disciplines at the LSE. I have benefitted greatly from discussions with a number of officials at the Inland Revenue Department, the Research Department of the Central Bank, and the IMF and the World Bank and from the participants at seminars at the Institute of Policy Studies in Colombo, organised by its Executive Director, Chandi Chanmugam and a seminar at the Research Department at the Central Bank organised by Dr. W. Hettiarachi. Very helpful • guidance was provided by P.B. Jayasundera and D.D.M. Waidyasekara. Sandeep Kunte of STICERD has provided valuable research assistance and Robin Burgess and Samarjit Shankar Helpful comments. Thanks are due to all the above. I am responsible for all opinions and errors. • Disclaimer This publication was made possible through support provided by the Office of Education and Institutional Development, Bureau for Research and Development, U.S. Agency for International Development, under the terms of Grant No. PDC# 0095-A-00-1126-00. The opinions expressed herein are those of the author(s) and do not necessarily reflect the views of the U.S. Agency for International Development or the Institute for Policy Reform. • • • • 11 • SUMMARY Fiscal pressures in Sri Lanka are severe, with government revenue around 21% of GDP and expenditure around 31% in 1990 and • 1991 (although expenditure has been reduced to around 28% in 1992, largely through, possibly temporary, reductions on the capital side). The fiscal challenge is to make substantial • inroads into this deficit. Whilst this paper has not discussed expenditure in detail it seems that the fiscal change required will be unlikely to arise solely from expenditure reduction. This position, taken together with the deficiencies in the • current tax system and desires for greater liberalisation, indicates that the task for tax policy is to raise substantial extra revenue, whilst restructuring the system to provide greater simplicity, efficiency and consistency with more trade- and • a market- oriented economy. The paper provides reflections on the possibilities for extra revenue, following visits to Sri Lanka in September 1992 and June 1993. • The Sri Lankan government is fortunate in having before it the valuable report of the Tax Commission of 1990 and much of the way ahead would seem to be charted in that report. The government has made a start in implementing the proposals but some of those recommended policies which might raise substantial extra revenue have not yet been vigorously pursued. • Given Sri Lanka's high debt to GDP ratio, real interest rates and growth rate it is argued that a primary surplus is necessary to stop the debt to GDP ratio from rising still further. Interest payments are currently around 6% of national income and the underlying primary deficit (the deficit excluding • • iii interest payments) is of the order of 5% (based on the 1990 and 1991 position). Hence an apparently necessary (if the debt to GDP ratio is to be held at current levels) target would be to reduce the deficit by at least 5 percentage points (relative to 1990 and 1991). Given the size of the debt to GDP ratio (around • 100%) and the burden of interest payments Sri Lanka should be looking for a reduction in this ratio over the medium-term and serious inroads would involve cutting the deficit by a few • percentage points above 5%. Some of the reduction in the deficit would have to come, no doubt, from pruning expenditure but there are major dangers to the type of growth Sri Lanka envisages. A 'newly-industrialising country' needs physical infrastructure and • a healthy, well-educated population. Sri Lanka's achievements in health, education and social welfare are striking amongst developing countries and there is understandably a desire to see • them preserved both as ends in themselves and as contributors to growth. Whilst the size and generosity of some of the welfare programmes do, however, suggest some scope for economy, a target of 5% for extra revenue would seem to be a prudent one. • Building on the recommendations of the Tax Commission Report and drawing on comparisons with other fairly poor countries a • number of areas for extra revenue which look to be possibilities are described. As potential major sources of extra revenue the discussion identifies the personal income tax (possibly an extra 2 percentage points), the value-added tax (½-1), excises (around • 1 percentage point), corporate income tax (11-1 pgrcentage points) and, as a short-run measure, customs (h-1 percentage point). Together such a strategy might yield the extra resources required whilst being consistent with simplicity, growth and efficiency objectives. Not all of these measures could be expected to yield • • iv speedy results, hence the need for especially tight expenditure I control in the short term. It is possible that some short-run pressures could be partially relieved by privatisation proceeds. Advance in the personal income tax collections of the order indicated is likely to come from improved enforcement and compliance. These can be helped by the VAT, by computerisation and by the taxation of public-sector emoluments. In this respect • the close integration of VAT and income tax administration is important. Improvement in corporate tax revenues should be available from the rolling back of exemptions and holidays. • Excise taxation could be increased by expansion of the base to motor fuel, cars and some luxury goods. • • • • 1 51. Introduction Sri Lanka stands at a crucial stage in a programme of stabilisation and adjustment. From one perspective this process • started in 1977 when the change of government brought a reorientation towards market forces in contrast to the policies of nationalisation and state control pursued by its predecessor. A period of more rapid growth followed but by the mid 1980s this had faltered. The late 1970s and early 1980s saw a rapid fall in public revenues from export duties on the main plantation • crops which were cut sharply as profit margins on tea declined under the twin pressures of weak tea prices and productivity problems associated with poor management in earlier periods.