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Taxing errors

31 May 2022

While citizens are praying that the prevailing economic crisis does not worsen, the Government yesterday (31) admitted that its income has fallen to historic lows, and that the existing budget deficit is impossible to bear, as spending is more difficult now than before. This was stated by Cabinet Spokesman Bandula Gunawardana, who announced that the Cabinet of Ministers has arrived at a decision to amend several tax-related Acts – namely, the Inland Revenue Act, the Value Added Tax (VAT) Act, the Telecommunication Levy Act, the Betting and Gaming Levy Act, and the Fiscal Management (Responsibility) Act – in a bid to increase Government revenue to the levels seen in 2019. Among other amendments, the decision to increase the VAT rate to 12% from the current 8% is a notable one, as the slashing of this tax rate to 8% from 15% in 2019 was a decision that many economists claimed to be unwise, and was one of the major reasons that led to the severe decline in domestic revenue.  The Government’s reversal of this much-criticised decision is a welcome move, and if implemented properly and without delay, the new VAT rate should technically help alleviate the country’s economic burden to some extent. However, times have changed. During the past two years, Sri Lanka’s economy has taken a turn for the worse, and this includes factors that have a direct impact on collecting the VAT. For example, people’s purchasing power, which was at a considerably higher level in the latter part of 2019, has declined sharply with the rapid rise in inflation that began in the latter part of last year, and not too many people are in a position to purchase goods from sellers that charge VAT. At the same time, even if the Government managed to collect a similar amount in VAT revenue as in 2019, what it can do with this amount is questionable, considering the significant devaluation of the rupee. In this context, expecting VAT to benefit the economy the same way it did in 2019 is impractical. Most importantly, despite the prudence of this decision, it cannot reverse the adverse economic impacts from the reduction in the VAT rate in 2019. At the same time, there is criticism that top-level businessmen in the country, who were frustrated by the Yahapalana Government’s high taxation policy, greatly benefitted from and welcomed the 2019 tax cuts. The Government may have been counting on the trickle down theory of economics, which is based on the premise that big corporations which benefit from tax relied pass on that benefit to the rest of the country and the economy. This could be through the expansion of their companies and the resultant job creation, the hiking of salaries in their companies which helps raise the per capita income or the investment of the greater profit margins in Research and Development, which develops those local industries and can even increase exports and thereby foreign exchange earnings. Unfortunately, trickle down economics has often proven a good theory on paper, but far less effective in practical terms. This is mostly because it fails to account for the profit maximisation mindset of business leaders, who do not often reinvest their increased profit margins in their companies but invest it in themselves. As it happened in the case of the organic fertiliser plan, which caused unfathomable damage to the country’s agricultural economy and food security, this comes down to the Government not taking into account whether other countries had benefitted from tax rate cuts, especially at the highest levels of business. If other countries’ experiences had been studied and the cuts planned accordingly, perhaps the Government would have been able to achieve something from the VAT rate cut, instead of only now waking up to the dent in revenue. Even though the damage caused by the reduction of VAT rates cannot be reversed, the impacts of the 2019 decision can teach Sri Lanka a good lesson. At least now, the Government and the policymakers should learn to study the experiences of others who have taken similar decisions, before making one of its own – or it will only serve as a warning and a negative example to any other nations that wish to follow suit.  

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