Moody’s says VAT hike credit positive

The increase in the value-added tax (VAT) rate from 11 percent to 15 percent will be credit positive for Sri Lanka as it will support the government’s fiscal consolidation agenda and will also put the derailed International Monetary Fund (IMF) programme back on track, according to a global credit rating agency.  

After a more than four-month delay, Sri Lanka’s parliament last week passed the VAT amendment bill to increase the tax rate effective from November 1 after being blocked by the court of law for not following the due constitutional framework. 

“This is credit positive because a higher VAT rate will facilitate fiscal consolidation by strengthening Sri Lanka’s low revenue-to-GDP ratio, which is a key credit constraint,” Moody’s Investors Service said in a brief note. 

Despite being hailed, the move will further make Sri Lanka’s tax system regressive hurting the poor and the vulnerable, further widening the income inequality,

as the poor spend most of their incomes on food and basic commodities, on which the VAT is largely imposed. 

The share of direct taxes, which was 61 percent of total tax revenue in the pre-1977 era, fell to just 22 percent in 2015 with the corresponding rise in indirect taxes, while the taxes on domestic goods and services rose from 20 percent to 40 percent during this period. 

However, the continuity of the IMF programme was a higher priority for the government for which the passage of the VAT bill was a key condition as the three-year programme was held in abeyance with the multilateral lender being unable to complete a review.  The higher VAT is expected to bring in an additional Rs.15 billion during the balance two months of 2016 and Rs.100 billion a year from 2017 onwards. 

Fiscal consolidation is a major focus of the IMF programme and the government targets to achieve this by raising revenue as the government has no headroom for international borrowings to bridge larger budget deficits.  

The space for curtailing expenditure is also very limited as most of such expenditure is either committed or cannot be slashed without affecting the needy segments in society. The government can also not afford to cut the public expenditure as it is used to because that adversely affects the growth. 

Meanwhile, despite the primary deficit in the budget, which excludes the interest payments, came in at Rs.38.6 billion by June 2016, ahead of the IMF’s target of Rs.46 billion, the primary deficit had widened markedly in July due to the suspension of the VAT. 

“The VAT hiatus makes meeting primary deficit targets challenging, at Rs.85 billion for September and Rs.97 billion for December. In particular, salary and pension payments accounting for about 36 percent of primary expenditure and interest payments amounting to around a quarter of total expenditures constrain room to cut expenditures,” Moody’s said. 

Sri Lanka spends over 90 percent of its revenue on debt servicing – interest and capital repayment – and is forced to borrow even for other recurrent expenditure. 

The government targets a budget deficit of 5.4 percent of gross domestic product (GDP) this year, 4.7 percent in 2017 and further 3.5 percent in 2020, which according to Moody’s, is an “ambitious and would be the smallest deficit in the past 25 years and indeed in most years since 1950.”  Moody’s forecasts for budget deficits remain conservative as they project 6.0 percent for this year and 5.5 percent for 2017.   

The government wants to achieve these deficit targets by increasing the revenue-to-GDP up to 15.8 percent by 2020 from 13.0 percent expected for this year but the revenues of some of the Southeast Asian peers hover above 20 percent of GDP.