Sri Lanka’s economic landscape has witnessed a roller-coaster ride in its quest for development. Amidst this tumultuous journey, the Government has often resorted to offering tax holidays as a lure for investors and catalyst for business activity. While these tax incentives have successfully attracted investment, the nation now grapples with their long-term implications and the pressing need for fiscal responsibility. Amidst this, reports have emerged that the Ministry of Finance is considering tax holidays for big investors.
Speaking to The Sunday Morning Business, a source from the Ministry of Finance stated that the ministry was contemplating such a decision in order to boost large-scale investments into the country from potential international players. However, the source confirmed that no concrete decision had been taken in this regard.
“There has been a discussion but the feasibility of introducing tax holidays is yet to be determined,” the source stated.
Evolution of policy landscape
KPMG Sri Lanka Tax and Regulatory Principal Suresh Perera shared his insights with The Sunday Morning Business on the evolving policy landscape and its potential impact on investment.
Historically, Sri Lanka, like many countries, embraced tax holidays as a means to attract investments. Perera observed: “When the Greater Colombo Economic Commission was established in 1978, tax holidays were the norm.”
Investors were offered generous tax breaks that could span up to 25 years. However, this policy approach has undergone significant transformations over the years.
Perera highlighted the shifting sands of Government policies: “In 2013, there was a noticeable reduction in the duration of tax holidays.” The Government decided to limit tax holidays to a maximum of three years, a substantial departure from the extended decades of the previous years. By 2015, Sri Lanka took a bolder step, deciding to abandon tax holidays altogether.
One of the most significant policy changes came with the introduction of the new Inland Revenue Act which came into effect in 2018. This legislation marked a clear departure from tax holidays. Instead, it introduced enhanced capital allowances as incentives for investors, offering substantial tax reductions, ranging from 100% to 200%.
Perera argued that Sri Lanka’s approach to tax incentives lacked consistency, which could be confusing for investors. He emphasised: “The Government’s frequent policy changes raise questions about the effectiveness of tax holidays in attracting investments.”
Research into the actual impact of tax holidays is notably absent, leaving policymakers without a clear understanding of their benefits. Investors, Perera suggested, prioritised factors beyond tax holidays when deciding where to invest. Stability, infrastructure, and overall business conditions take precedence over tax incentives. “Concrete stability and other conditions are what investors look at,” he noted.
Another concern is the ‘race to the bottom’ phenomenon, where countries compete by offering increasingly generous tax holidays to lure Foreign Direct Investment (FDI). Critics argue that this strategy may not yield the expected benefits and that countries would end up compromising their tax revenues.
An intriguing aspect of Sri Lanka’s current situation is the contradiction within its own legislation. Section 9(2) of the Inland Revenue Act explicitly discourages tax holidays. However, the Government has been moving towards reintroducing them.
Perera pointed out: “It’s a directive statement – don’t give tax holidays. But the Parliament has the power to do that.”
Sri Lanka’s evolving stance on tax holidays raises questions about the country’s long-term strategy for attracting investment. As Perera emphasised, the lack of research on the effectiveness of such incentives and the shifting policy landscape challenge the country’s ability to provide a stable and attractive investment environment.
Comparative view with regional counterparts
1. India: India’s Special Economic Zones (SEZs) offer tax benefits, including income tax exemptions for a stipulated period. This strategy has fostered foreign investment and bolstered India’s manufacturing sector.
2. Malaysia: Malaysia’s Investment Promotion Agencies extend tax incentives to investors, primarily in sectors like manufacturing, biotechnology, and green technology. These incentives are typically tied to qualifying capital expenditures.
3. Vietnam: Vietnam’s tax incentives revolve around specific regions and industries. Investors in designated economic zones can enjoy corporate income tax deductions or exemptions over several years.
However, Sri Lanka’s rendezvous with tax holidays will come with a fair share of challenges.
1. Revenue haemorrhage: Prolonged tax holidays invariably translate into significant revenue losses for the Government. Striking a balance between attracting investments and maintaining fiscal prudence remains an uphill task.
2. Inequitable impact: Critics argue that tax holidays often disproportionately favour large corporations, potentially exacerbating income inequality in the country.
3.Sustainability conundrum: Ensuring that investments drawn through tax incentives translate into long-term economic growth, job creation, and technology transfer is a perennial challenge.
Sri Lanka’s flirtation with tax holidays, while successful in stimulating investment, raises pertinent questions about their long-term sustainability and the need for a more equitable distribution of their benefits. As the nation continues its quest for economic prosperity, striking the right balance between attracting investments and maintaining fiscal responsibility remains an arduous task for policymakers.
Revenue falls short
However, according to the International Monetary Fund (IMF), revenue mobilisation gains, while improved relative to last year, are expected to fall short of initial projections by nearly 15% by year end.
While partially due to economic factors, the onus of fiscal adjustment would fall on public expenditure if there were no efforts to recoup this shortfall. This could weaken the Government’s ability to provide essential public services and undermine the path to debt sustainability. To increase revenues and signal better governance, it is important to strengthen tax administration, remove tax exemptions, and actively eliminate tax evasion.
Sri Lanka’s efforts to enhance tax collection and implement crucial economic reforms have fallen short of the expectations needed for the fund to disburse the second tranche of $ 330 million from the country’s $ 2.9 billion bailout aimed at averting bankruptcy, as reported by the IMF.
A delegation from the IMF, led by Peter Breuer and Katsiaryna Svirydzenka, recently concluded a visit to Sri Lanka. In a statement issued on Wednesday (27), they announced that discussions would persist, focusing on sustaining the momentum of ongoing reforms and releasing the second instalment of funding, which had been scheduled for the end of the current month.
“While there have been initial signs of stabilisation, complete economic recovery remains uncertain,” the statement noted. It highlighted that Sri Lanka’s accumulation of foreign exchange reserves had decelerated due to lower-than-projected tax collection.
The statement emphasised on the need for revenue augmentation and improved governance, stating: “To boost revenues and demonstrate enhanced governance, it is imperative to bolster tax administration, eliminate tax exemptions, and actively combat tax evasion.”
Sri Lanka confronted its most severe economic crisis last year, characterised by acute shortages and widespread protests that ultimately led to the removal of then President Gotabaya Rajapaksa. In April 2022, the nation declared bankruptcy with a debt burden exceeding $ 83 billion, with over half of it owed to foreign creditors.
In March of this year, the IMF consented to a $ 2.9 billion bailout package for Sri Lanka as the country engaged in negotiations with its creditors to restructure the substantial debt, with the aim of reducing it by $ 17 billion. The IMF disbursed the initial $ 330 million shortly after reaching this agreement.