2022 October taxes: A signal why suspending democracy will not save the economy

30 Oct 2022

2022 October taxes: A signal why suspending democracy will not save the economy

30 Oct 2022

By Nishan de Mel Democracy in Sri Lanka is in partial suspension. Two modalities of this suspension are widely discussed. One, Provincial Council Elections are long overdue and continue to be evaded. Two, the Legislature and Cabinet are dominated by individuals who don’t enjoy democratic legitimacy to govern. There is a less-discussed third modality, which is the focus of this article. The anatomy of this third modality is explained by examining the recent increase in income taxes. The Government on 11 October 2022 gazetted a significant revision of taxes. The third modality of democratic suspension arises from the manner in which important national decisions are made. The 2022 October tax increase is a typical example (even if it may not be the most egregious example). Perhaps the simplest explication of democracy is that it is ‘government by conversation’. That is, the evidence of democracy is not simply the occurrence of regular elections; it is also that the decisions of a government are based on (a) public discussion, and (b) the force of reason. In Sri Lanka, democracy has also been suspended by the decision-making of the Government flouting this basic democratic foundation. Disregarding the democratic discussion Firstly, the 2022 October tax increase suspended the basic expectation of public discussion. The Government had, in May 2022, proposed a particular structure of increased taxation. It was a reversion to an approximation of the personal income tax structure in 2019 but in real terms, that is, the same structure with an approximate inflation-based adjustment to the tax thresholds. This was subject to much public discussion over many months and that particular structure was once again affirmed in the interim Budget that was adopted by the Parliament on 30 August 2022. Through discussion in Parliament and media, significant societal acceptance (democratic consensus) was forged for that particular structure of increased income tax. However, the tax structure that was gazetted in October, just 42 days after the affirmation provided in the interim Budget, disregarded this democratic consensus. The huge difference between the 2022 October tax increase and what was previously affirmed in the interim Budget is shown in Exhibit 1 (first published on the platform Publicfinance.lk). For some ranges of income, the tax payable increases by over 15% of total income. The undiscussed increase is so significant that it doubles, triples, and even increases by five-fold the tax payable at mid-levels of income. The main sense of ‘wrong’ that pervades the reception of the 2022 October tax arises not simply from the increase in the amount of tax payable but also from the shock of democratic suspension – the callous way in which the previous decision, which had wide social consensus, was suddenly dispensed with, without public discussion. Disregarding the force of reason Secondly, the 2022 October tax increase suspended the basic democratic expectation of a reasoned justification. There are at least two ways in which the force of reason has been disregarded in the introduction of the new tax system – (i) Setting up a regressive tax outcome on the middle-class, and (ii) Confusing direct vs. indirect taxation with progressive vs. regressive taxation. Regressive tax outcome on the middle class The threshold for taxation starts at Rs. 100,000. This is also equal to $ 3,306 a year, and compares reasonably as a starting threshold, even with countries with a higher level of per capita GDP. Thailand for instance, with a per capita GDP that is now 2.4 times greater than Sri Lanka, still has a starting threshold of $ 3,911 a year. What is odd in the Sri Lankan tax structure proposed is how quickly the marginal tax rises, with small increases in income. Income above the threshold is initially taxed at a marginal rate of 6%. Thereafter, the marginal rate increases by an extra 6% for every increase of income of Rs. 41,667 ($ 115) a month. This increment structure focuses the full increase of marginal taxes all the way to 36% on the band of middle-class incomes. In Thailand, the 30% level of marginal tax is reached at an income of over 12 times the starting threshold, in Sri Lanka now it is reached at three times the starting threshold. Those whose incomes are above 3.5 times the starting threshold see no further increase in marginal taxes in the 2022 October tax structure in Sri Lanka. There is a second aspect to why this tax structure will result in being regressive. On the standard economic assumption that marginal propensity to save increases with income, the largest amount of savings/investment is likely to be with those who are also the richest. But the With-Holding Tax (WHT), which is an effective way of collecting taxes from savings/investment instruments, has been brought back at a mere 5%. This is despite published research and analysis, available at (https://bit.ly/3NffOft) demonstrating the revenue benefit to the Government of bringing back WHT at a minimum of 10%. A further reason to maximise tax collection through WHT is the proven incompetence of the Government in finding and taxing (a) those who have high incomes from non-wage sources, and (b) those who receive high incomes from interest on savings. Therefore, this 2022 October tax structure, if implemented, is tipped to be regressive on the middle-class – effectively collecting a larger share of income from the middle class than from the upper class. Confusing direct vs. indirect taxation with progressive vs. regressive taxation In terms of the popular discussion, direct taxes refer to taxes on incomes of people and corporates, and indirect taxes refer to taxes collected at the point of sale or consumption. The main argument that has been popularised with regard to increasing income taxes on wage-earners is that Sri Lanka has a tax collection ratio of 80:20 in terms of indirect to direct taxes and that this needs to be adjusted to a more recommended ratio of 60:40. This argument falls prey to a classic mistake of confusing the means and the ends. This argument – to have a better ratio of indirect to direct taxes – is based on the assumption that direct (income) taxes can be designed to be progressive (where those who are earning more pay a larger share of their income as taxes), while indirect taxes are likely to be regressive (the opposite of progressive). This is because those at lower incomes are expected to spend a greater part of their income on consumption and thereby, when consumption taxes dominate, the lower income strata might have a larger part of their income taxed than the higher income strata. The application of this logic, however, depends on the design of indirect/consumption taxes. In Sri Lanka, due to perennially poor tax administration, it is consumption taxes that the Government has been able to collect. Within the category of consumption taxes, it is taxes collected at the border that have proved easiest to collect. So much so that it was the case that even prior to the income tax reduction in 2020, taxes collected at the border (on mostly imports) accounted for around 50% of the total tax collection of the Government. However, the consumption tax structure in Sri Lanka is designed to be progressive, not regressive. This progressivity in consumption taxes in Sri Lanka is achieved mainly through the product level application of specific taxes. For instance, much of the excise taxes have been designed to allow the Government to tax at a higher amount those goods that are consumed more by those with higher incomes. The application of these taxes range from vehicles to high-value cigarettes and alcohol, to other status-oriented luxury goods. The analysts at Verité Research estimate the ratio of other taxes to progressive taxes to be approximately 55:45 (which is better than the targeted 60:40 ratio). The main problem for progressive taxation in Sri Lanka is poor tax collection methods (including a low level of WHT tax). Failing to recognise that, and introducing tax rates that are instead regressive on the middle-class, makes the 2022 October tax change very much lacking in the force of reason. Sri Lankan economy needs a democratic course correction The foundational democratic concern for decision making based on public discussion arbitered by the force of reason should not be thought of as a decorative or instrumental aspect of democracy. It is both intrinsically and substantively important in achieving better policies and economic development. This insight is well recognised in economic literature, and also well popularised. (e.g. ‘Development as Freedom,’ 1999, by Nobel Prize winning economist Amartya Sen). Sri Lanka’s economic crisis arises from a prior crisis of governance and democratic suspension. The misdirected design of the 2022 October tax structure is only one of the many signs that Sri Lanka is attempting to find a solution to the economic crisis without fixing the crisis of governance. The indicators are piling up, that without a democratic course correction, Sri Lanka is not likely to bounce back from its economic crisis in a sensible manner. (The writer is an economist and the Executive Director of Verité Research)

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2022 October taxes: A signal why suspending democracy will not save the economy

2022 October taxes: A signal why suspending democracy will not save the economy

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