A statement was released recently to the media by 182 internationally reputed, eminent economists on dealing with “Sri Lankan debt”. The list of academics involved in the statement includes Paris School of Economics Professor of Economics and author of Capital in the Twenty-First Century Thomas Piketty, SOAS – University of London Research Professor in Economics Ha-Joon Chang, London School of Economics Professor of Political Economy and Development Robert H. Wade, and many others.
Their contention is that the role of international financial institutions (IFIs), such as the International Monetary Fund (IMF) and the World Bank (WB) were founded to assist sovereign nations. This is to ensure financial stability, reduce the impact of financial crises, and provide resources for crucial investments required to meet the social and developmental needs of nations. They, however, argued that the IFIs are not currently living up to these responsibilities at a time when they are most urgently required.
“In Sri Lanka, they [IFIs] encouraged the very policies of more open capital accounts and deregulation that have led to the current crisis. The implications are already evident in the recent Budget of the Sri Lankan Government, which has unrealistic revenue assumptions that are unlikely to be met. Revenue shortfalls would then necessitate further ‘austerity’ and likely cuts in essential public spending. The Budget also proposes public asset stripping and privatisation of strategic lands etc… These policies will harm the most vulnerable groups in Sri Lanka, exacerbate poverty and inequality, and lead to further economic decline,” the statement read.
According to the latest statistics published by the Ministry of Finance, the budget deficit at the end of November 2022 was Rs. 1.6 trillion (Rs. 1.7 trillion by the end of November 2021), having a total expenditure of Rs. 3,411 billion and a total income of Rs. 1,806 billion, which is an increase in revenue compared to the year 2021. (Total revenue in 2021 was Rs. 1,457 billion only)
Tax revenue and investment in education and social welfare
As for Prof. Piketty, the prestigious The Economist magazine once hailed his book Capital in the Twenty-First Century as the economics book that took the world by storm. “The pile of data allows Piketty to sketch out the evolution of inequality since the beginning of the industrial revolution,” it read. This book has provided enough analytical data and empirical evidence to compare and improve the Sri Lankan situation.
Prof. Piketty has done research beginning from 1870 up to 2010. As per his studies, total tax revenues were less than 10% of the national income in countries such as the US, the UK, France, and Sweden during the nineteenth century (1900–1910) up to World War I. Now, they represent a national income of between 30-55% during the period 2000–2010. This reflects the fact that the State, at that time, had very little involvement in economic and social life (police, courts, foreign affairs, etc.) In just half a century, the share of taxes in national income increased by a factor of at least 3-5, where, just over 30% of national income in the United States, around 40% in Britain, and between 45-55% on the European continent (45% in Germany, 50% in France, and nearly 55% in Sweden).
The important point is that the tax collection of those rich countries is mainly from direct taxes, which is around 75% of gross domestic product (GDP) and they, in turn, invest 16-18% on health and education, whereas in Sri Lanka, our tax revenue is around 12-14%. Unfortunately, our income tax (direct taxes) component as a percentage of total tax collection is only around 20%, and indirect taxes are around 80%. Further, how much do we spend on education and health? According to a research study conducted recently by the Institute of Policy Studies (IPS) of Sri Lanka, the public spending on education has historically declined, and our Government expenditure on education is low compared to Nepal, India, and Malaysia, although research indications are that private, non-state actor participation in the sector is growing – but, without proper monitoring system in place.
The income tax collections (direct tax) as a percentage of total tax revenue have been ranging from lower 16% (in 2017) to higher 24% in 2019 and 2021 of the tax revenue, which should have been at least 40%. The serious negative effect of this imbalance is that, according to available research papers, the poorest 10% of society pays 23% of their income in the form of indirect taxes whereas the rich 10% pay less than 1% of their income as indirect taxes (Ranasinghe, 2018). As can be seen from Table 1, the percentage of tax revenue from direct taxes against such indirect taxes is approximately in the ratio of 20:80, thus creating massive distortion.
Recently increased indirect taxes such as VAT of 15% and social security contribution levy of 2.5% make the distribution of income more unequal because of their regressive effects. The poor and lower-middle-class segment of the people get a higher proportion of their income taxed than the rich, making it a regressive tax.
Equity vs. equality in policy making
“The route to achieving equity will not be accomplished through treating everyone equally. It will be achieved by treating everyone justly according to their circumstances”
– Paula Dressel, Race Matters Institute
It appears that policymakers do not consider the importance of the equity principle, whereas treating everyone equally may not achieve equity. Equitable distribution does not mean that income is distributed equally. Equity represents impartiality, as such the distribution is made in such a way as to provide even opportunities for all the people, which is important. Conversely, equality indicates uniformity – everything is equally or evenly distributed or charged.
Examples of equality: All public schools in a given area in the community have computer labs with the same number of computers and hours of operation during school hours. However, some students do not have access to computers or the internet at home. Another example is that local government authorities may cut the budget for all the community centres by reducing the operational hours for all centres by the same amount at the same time. That’s the issue with the equality principle. On the other hand, one example of equity is where computer labs in lower-income neighbourhoods have more computers and printers as well as longer hours of operation, as some students don’t have access to computers or the internet at home.
This equity principle provides greater justice and fairness than the equality principle. A classic example is the present taxation policy itself. As we have already seen above, the poor get taxed at a higher proportion of their income than the rich, making it a regressive tax. Another negative effect of the current taxation policy is that imposing higher indirect taxes (VAT SSCL etc.) can cause cost-push inflation, which can lead to a rise in inflation expectations.
Let us review and understand some important and relevant recommendations based on the findings of comprehensive research studies. (“The effect of tax composition on income inequality: Sri Lankan Experience” by H.R.A.C. Thilanka, J.G.S. Ranjith, which was published in Sri Lanka Journal of Economic Research 8(2) in March 2021). The above research paper recommends vital and necessary structural reforms to tax composition itself; for example, 60:40% balance between indirect and direct taxes (presently it’s 76:24%) respectively, which was already suggested by the Inland Revenue Act (IRA) in 2017, but is not in practice. Some policy recommendations have been made for the consideration of increasing tax revenues and minimising persistently high income inequality in Sri Lanka.
“The tax policy should not merely target to achieve the required or estimated tax revenue regardless of the fairness of the incidence of taxes to make it less regressive. In order to achieve the results of our recommendations, with the view of improving tax compliance, simplifying and broadening the tax base of the direct taxes and strengthening best practices of tax administration are the necessary measures to be taken.”
Existing regressive tax system and economic growth – ‘deadweight loss’ principle
It goes without saying that improving economic growth in terms of GDP has become a necessary prerequisite to enhance the quality of life of our people. In Sri Lanka, the situation is totally different. As we are aware, Sri Lankan economic growth figures are much lower than in many other countries, including South Asian countries. One important aspect of excessive taxes is the possible adverse impact on the country’s economic growth itself, as many academics and professionals, including other key opinion leaders (KOLs) seem to pay less attention to this vital area.
Let us very briefly explain and understand the economic principle known as “deadweight loss”, which is a valid economic theory in actual practice. It explains that imposing excessive taxes will affect economic growth in the immediate and short run and could even cause a reduction in tax revenue collection to the treasury on a relative basis. We need to understand how it negatively affects the people in society and the economy as a whole.
In general, imposing excessive taxes reduces the welfare of buyers and sellers of those goods. The reduction of consumer and producer surpluses usually exceeds the tax revenue raised by the Government. The fall in total surplus of consumers and producers and the tax revenue is called “deadweight loss”. Taxes have “deadweight losses” because they cause buyers to consume less and sellers to produce less, and these changes in their behaviour shrink the size of the market below the levels of optimum total surplus or net economic value addition.
In view of the fact that imposing a tax reduces the size of the market, its tax revenue doesn’t continually increase. The larger the elasticities, the larger the deadweight losses. Now, the tax rates are already high and economic growth rates have been negative since the end of 2019, except in 2021 – which was at 3.7% positive, partly due to relaxed monetary and fiscal policies including lower taxes in 2020 and 2021.
Research studies indicate that raising tax rates further will significantly reduce economic growth and increase income inequality. Now that the Government has been following a tight monetary policy, where the money supply and Government money printing are under scrutiny, there seems to be no logic in imposing high taxes as well at the expense of overall economic activities. The tight monetary policy has taken care of demand-pull inflationary tendencies; however, high taxation will affect cost-push inflation.
Conclusion
Therefore, it is of paramount importance to address income inequality and redistribution of income due to the existing regressive tax system. This requires much-needed “tax reforms” and eliminates serious structural weaknesses in the tax system, thus moving towards a progressive tax system. However, most academics and professionals, who are now opposing high taxes imposed on them do not aggressively offer critical reviews on this aspect of serious imbalance on account of imposing high indirect taxes, such as VAT and SSCL, whereas the taxes so collected do not even get credited to a separate fund in order to mobilise such money thus investing on peoples’ welfare and social security aspects.
As can be seen, due to the regressive nature of our taxation policy, both the incremental tax revenue, as well as economic value addition decline and GDP comes down at a faster rate with serious inequality of household income. These proposals which are aimed at (a) increasing tax revenues with less regressive tax composition, and at the same time (b) increasing economic growth and (c) minimising the effect on income inequality should be viewed in that context.
Further, there is massive social unrest because of the imposing of high taxes. The authorities must consider overall socioeconomic factors, especially the declining disposable income of middle-class people and negative economic growth. Those who are involved in the formulation and implementation of the tax policy must consider many important aspects and economic principles. If not, much talked about words “system change” by addressing persistent structural weaknesses in the society and economy at large become only buzzwords.
(Jayampathy Molligoda is a former Chairman of the Sri Lanka Tea Board)
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The views and opinions expressed in this article are those of the author, and do not necessarily reflect those of this publication.