The tax changes included in the Inland Revenue (Amendment) Bill propose to make major revisions to Sri Lanka’s corporate tax structure and interestingly, to substantially reduce the income tax rate on the so-called sin industries.
The amendments propose to reduce the corporate income tax rate on liquor, tobacco, betting and gaming to 28 percent, from April 1, 2020, from the current 40 percent. At the same time, the standard tax rate on trading, banking, finance, insurance, etc. is proposed to be reduced to 24 percent.
Thus, the difference between the standard corporate tax rate and the tax rate charged on the sin industries is proposed to be reduced to just 4 percent, from the earlier 12 percent.
The government plans to continue with the 14 percent corporate income tax rate on exports, tourism, education, medicare, construction and agro processing.
However, a new corporate income tax tier is proposed to be introduced for the manufacturing sector, at 18 percent.
As of now, Sri Lanka’s corporate income tax structure has three tiers—40 percent sin tax, 28 percent standard tax and 14 percent tax on exports, tourism, construction, etc.
Apart from slashing of corporate income taxes, the amendments cover a wide range of tax cuts while proposing to abolish certain taxes, such as the Economic Service Charge (ESC).
The bill is to be presented to Parliament for approval, shortly.
The economic stimulus package introduced by the new administration also includes lowering the Value-Added Tax (VAT) rate to 8 percent, from 15 percent for most sectors, increasing the turnover threshold for VAT by fourfold and removing the 2 percent National Building Tax (NBT).
Both Fitch and S&P have already revised down Sri Lanka’s credit outlook over the tax cuts, citing increased risks to debt sustainability, due to a possible hole in government revenue amid clear deviation from the revenue-based fiscal consolidation path.
The Inland Revenue (Amendment) Bill could also jeopardise Sri Lanka’s relationship with the International Monetary Fund (IMF), which counts the Inland Revenue Act enacted in 2018 as a key achievement in improving the country’s fiscal settings.
Fitch said its preliminary estimates showed the VAT rate change, scrapping of NBT could alone lower government revenue by as much as 2 percent of GDP. VAT accounted for 24 percent of government revenue in 2018.
Moody’s, which said the tax cuts were credit negative, estimates the hit from the tax reductions to government revenue to be around 1 to 1.5 percent of gross domestic product (GDP).
The tax cuts are also expected to expand Sri Lanka’s budget deficit by 0.8-1 percent.
However, the government maintains that the tax cuts would augment the aggregate demand in the economy and thereby boost economic growth and the offsetting measures undertaken would largely meet any revenue loss.
Fiscal woes surface, but still no cause for alarm
According to the latest fiscal data available up to October 2019, the government revenue as a percentage of gross domestic product (GDP) has slipped to 10.2 percent, from 11 percent, during the same period in 2018, the data released by the Central Bank showed.
This is amid the previous government’s International Monetary Fund (IMF)-prescribed agenda towards revenue-based fiscal consolidation.
The previous government led by the United Freedom Front was very much keen on increasing the tax-to-GDP but it eventually took a toll on all economic actors rendering the opposite effect to the intended effect.
The increase in the Value-Added Tax (VAT) in 2016 and the complete overhaul of the tax code in the following year, gave rise to many new and higher taxes, causing stress to both businesses and consumers alike, squeezing the economic activities.
This resulted in the fiscal deficit for the first 10 months hitting 5.3 percent of GDP, overshooting 4.4 percent recorded for the same period in the same period.
However, one bright spot was expenditure, which was kept under check at 15.5 percent of GDP, similar to the corresponding period’s figure in 2018.
The new government led by President Gotabaya Rajapaksa gave effect to sweeping tax cuts in December 2019, in a bid to provide stimulus to the business and consumer segments.
The government in December said they expect the fiscal deficit to expand to around 6-6.5 percent for 2019 but confided that it would not exceed 4.0 percent during the next five years, an uphill task, given the sheer magnitude of the tax cuts.
However, if the tax cuts could increase business and consumer activities in the economy, it has the potential to generate higher revenues to the state.
According to economic analyst Waruna Singappuli, fiscal deficits are not essentially evil.
He is of the view that Sri Lanka can afford to run fiscal deficits at least for the next five years, provided the government spending channelled towards the necessary structural reforms and providing stimulus to few key priority economic sectors.
“We can let the fiscal deficit expand not to give goodies to the people but to put the key infrastructure in place, such as setting up universities, providing tax incentives to the identified industries, etc.
Over a period of five years, you can see the labour force being developed, markets being developed and exports taking place from Sri Lanka and we will have locked up investors into Sri Lanka. And then beyond the fifth year, we can certainly look at improving the fiscal situation,” Singappuli said.
