Tax for poverty alleviation or elevation

Sri Lanka, as a country now in the midst of an IMF (International Monetary Fund) programme, has largely achieved macroeconomic stability.  

The latest World Bank report titled “Sri Lanka Public Finance Review: Towards a Balanced Fiscal Adjustment,” acknowledged it.  The revenue adjustment since 2022 has been significant, with a near 5-percentage-point increase in tax-to-GDP to 12.3 percent in 2024. This was driven by sharp increases in tax rates from a low base, the report said.

The government aims to raise it to 15 percent. Yet the same World Bank report sheds light on a stark reality: the revenue target has been met, but at what cost?

Sri Lanka’s aggressive Value-Added Tax (VAT) reforms in 2024, a key component of its post-crisis fiscal stabilisation, has single-handedly contributed to a 2.2 percentage point increase in the nation’s poverty rate, the report says.

Sri Lanka’s poverty rate continued to rise for the fourth year in a row, with an estimated 25.9 percent   of Sri Lankans living below the poverty line in 2023. That is the end result of the economic crisis, the worst ever in post-independence Sri Lanka.  In the recent report, the World Bank is critical of   the country’s heavy and “regressive” reliance on indirect taxes and tables urgent proposals for a fundamental shift towards a more equitable system of direct taxation to ensure a sustainable and fair economic recovery.

The findings highlight the severe social cost of the government’s revenue-led fiscal adjustment. Over 75 percent of this adjustment has been derived from indirect taxes that disproportionately burden the poor. Following the 2024 reforms, VAT now consumes 5.3 percent of the pre-fiscal income of households in the poorest decile, compared to just 3.3 percent for those in the richest decile.

“The revenue adjustment since 2022 has been significant,” the report states, but it “has strained a narrow tax base” and its reliance on indirect taxes “disproportionately affected the poor”.

This strategy of “squeezing the existing, narrow base” is seen as unsustainable and detrimental to both equity and long-term growth. The number of registered taxpayers in 2023, for instance, had still not recovered to pre-2019 levels, indicating that the increased revenue has come from higher rates on existing payers rather than a broadening of the tax net.

It reflects a novel challenge for the current government in the pursuit of its socialist agenda. The government believes in a market driven approach to resolve economic woes of the country, but, at times, it tends to look at issues through the prism of socialism.  If its tax policy burdens the poor, it will go against the grain as a result.

The Achilles heel of Sri Lanka’s taxation is non-compliance.  This is not a new story for the current government. For decades, successive governments have struggled to expand direct taxation. Instead, they relied on import duties, excise taxes and VAT to fill   the Treasury.  

The new government faces a difficult balancing act. On the one hand, it must meet IMF targets to secure continued revenue flow to prevent the fragile economy from being more fragile.  It should address poverty, and regressive taxation that worsens it should be avoided in the meantime.   

The World Bank’s prescription is clear: Sri Lanka needs a “fundamental shift” toward a more equitable system of direct taxation. That means expanding the personal and corporate income-tax base, improving compliance, and reducing exemptions that allow high-income groups to escape their fair share. It also calls for strengthening social safety nets to cushion the poorest households against the impact of necessary fiscal consolidation.

What the government should do is to improve its administrative capacity and political will to undertake reforms. Then only  can it achieve the target. A real public discourse is also needed since reforming the tax mix must go hand in hand with strengthening social safety nets.  A continuation of the path of robust and credible structural reforms is absolutely needed. But the poor and vulnerable should not be left out.  What has happened so far is difficult to justify since VAT reforms have pushed the national poverty level higher.

In effect, some people who are unable to bear additional burdens have been compelled to shoulder a disproportionate share of the country’s recovery costs. Indirect taxes such as VAT are always regressive in nature since they extract the same rate from every consumer, regardless of income. Ahead of the upcoming budget, the government should lay down its policy steps towards rectification of such grey areas in taxation, of course, without any compromise on revenue targets.