• A closer look at financial struggles of households and potential solutions

If you are earning over Rs. 100,000 a month, you will likely be familiar with the Pay As You Earn (PAYE) Tax that comes straight out of your paycheck. Managed to save a little? The interest from your savings gets hit with Advance Income Tax (AIT). Dining out? You will find Value-Added Tax (VAT) included in the bill, along with the Social Security Contribution Levy (SSCL) and the Tourism Development Levy (TDL) in some cases. 

Even when you are simply buying groceries or household items, you are contributing through indirect taxes such as VAT. When you pump fuel into your vehicle, you are paying taxes without even realising it. In fact, taxes – both direct and indirect – have become so deeply woven into our daily lives that even a beggar buying food from a shop ends up indirectly paying taxes.

Recent hikes in VAT rates and the removal of several exemptions have disproportionately impacted the poorest households, according to research from the Institute of Policy Studies (IPS). 

IPS Research Economist Priyanka Jayawardena, during the launch of the ‘State of the Economy 2024’ report on Tuesday (8), noted that households in the lowest income decile now spent around 10% of their income on VAT, compared to just 6% for higher-income groups. 

In contrast, direct taxes like PAYE and Personal Income Tax (PIT) were found to be more progressive. The richest 10% of households contributed as much as 95% of PAYE and PIT, Jayawardena explained. 

‘VAT should not be replaced by direct taxes’

However, this does not mean that VAT should be replaced by direct taxes, as Advocata Institute Chairman Murtaza Jafferjee explained to The Sunday Morning Business. 

“In fact, I argue that we should broaden the VAT base as much as possible because it is the least distortionary tax. When you start exempting certain items from VAT, it creates price distortions. For instance, you can get protein from eggs, milk, poultry, and fish. Eggs, milk, and poultry have VAT, but fish doesn’t. Therefore, when consumers decide what to buy, VAT influences their choices. If you exempt some items, relative prices become distorted.”  

In a market economy, prices reflect the scarcity of resources and the tax system should not interfere with this, according to Jafferjee. By exempting items from VAT, these relative prices become distorted, which is why markets are affected. For example, he observed that fish was VAT-exempt, while prawns, eggs, milk, poultry, and even fuel such as diesel and petrol were taxed although kerosene was not. This skews the market and impacts consumer behaviour.  

Secondly, exempting items benefited richer households more because they consumed more than the poor, Jafferjee noted. 

“The principle of taxation is to tax higher-income earners. Exemptions act as a tax subsidy, which disproportionately helps the rich. Instead, we should have a broad-based VAT system, and to help poorer households, the Government can offer cash transfers to compensate for the VAT impact, similar to what is done through ‘Aswesuma’.”  

According to him, the focus should be on the net effect – subsidies minus taxes. The bottom 20% of households should receive more in subsidies than they pay in taxes. The next 20% should break even, paying minor taxes but receiving subsidies in return. The top 60% should be net contributors to Government revenue. 

A troubling trend 

When income levels fall and household expenses rise, families often find themselves in difficult positions, forced to adopt strategies to cope with the financial strain. 

Interestingly, a significant 74% of households that experienced reduced income reported that they did not adopt any specific coping mechanism to manage this drop, according to an IPS article published early this year. Only 7% sought a secondary job or additional income source to mitigate the impact.

However, when faced with rising expenditures, the majority of households took more decisive action. The most common coping mechanisms included limiting or controlling expenses (75%), making dietary changes (75%), and reducing or withdrawing savings (46.4%). 

This indicates that while income loss was widespread, the primary focus was on managing expenses rather than increasing income – perhaps a reflection of limited opportunities for alternative income streams.

In the absence of savings, especially for poor and vulnerable households, borrowing became the go-to strategy to meet basic needs. According to recent survey data incorporated by the IPS in its article, 55% of households in Sri Lanka are currently in debt, with 22% of these borrowing specifically to cover daily food requirements. 

This financial strain is exacerbated by the economic crisis, with 22% of households attributing their outstanding debts directly to the crisis. The remaining 78%, however, were already managing debt, suggesting that the crisis had simply worsened pre-existing financial vulnerabilities.

A worrisome aspect of this borrowing trend is that indebtedness is increasing, particularly among the poorest households. IPS stated that the introduction of VAT reforms, which will increase the cost of living, could further strain these households by pushing them to borrow more, either from formal financial institutions or from informal, often riskier, sources. 

As borrowing increases, so does the likelihood of repayment challenges, meaning that households may remain stuck in cycles of debt even as the economic crisis stabilises. This means that beyond their current financial struggles, many of the most vulnerable families are at risk of prolonged financial hardship, making recovery much harder in the long run. 

‘Those unable to save will become a State burden’

Meanwhile, former Deputy Governor of the Central Bank of Sri Lanka Dr. W.A. Wijewardena told The Sunday Morning Business that the IPS report highlighted that low-income and lower-middle-income groups had been significantly affected by the new tax regime, especially through income taxes. 

“These groups need relief because their real consumption, investment, and savings have already declined due to inflation and heavy taxes. If these people are unable to save now, they will eventually become a burden on the State. They are paying taxes today, but the State will need to support them in the future.”  

Dr. Wijewardena explained that when real savings declined – i.e. when the amount one could purchase with one’s money decreased – people lost the ability to invest in future income-generating activities, which was a growing trend in Sri Lanka.  

In order to address this issue, firstly, the Government has to reduce the tax burden on these people, according to Dr. Wijewardena. Further, the lost income should be compensated by having the wealthy pay more and by expanding the tax net to catch those evading taxes.  

“However, the Government faces a big challenge. By 2025, under the Economic Transformation Act, it needs to raise the tax-to-GDP ratio to 15%. Currently, this is at 11%. The Government will either have to violate the act’s benchmarks or increase taxes further.  

“It’s a tough situation. Former President Ranil Wickremesinghe smartly rushed the approval of this act, which sets quantitative benchmarks for any future government. One benchmark is achieving 5% economic growth, alongside fiscal targets like a balanced primary account. These are strict requirements and they pose significant challenges for any government after 14 November,” he said.   

Targeted transfers a popular solution

Local think tanks and global institutions alike are increasingly advocating targeted cash transfers as a more effective solution for addressing poverty and inequality. This approach is gaining momentum, especially in developing nations, where poorly targeted subsidies have long dominated fiscal policy, often at the expense of more efficient and equitable mechanisms.

According to the World Bank, in many non-Organisation for Economic Co-operation and Development (OECD) countries, subsidies consume a large share of fiscal resources despite their inefficiencies. On average, countries allocate 2.5-3% of their GDP to energy and agricultural subsidies, which are poorly targeted, benefiting wealthier households disproportionately. 

In contrast, social protection spending, which includes targeted transfers, is much lower, being just 1% of GDP in low-income countries and 4% in lower-middle-income countries. The misallocation is evident as only 20% of subsidy spending reaches the poorest 40% of households, while cash transfers are far more effective, directing around 60% of their benefits to these households, according to economists at the World Bank. 

Many countries also attempt to ease the tax burden on poorer households by implementing VAT exemptions or reduced rates on essential items such as food staples. While these policies aim to help low-income families, they inadvertently benefit wealthier households, which tend to consume more of these goods in absolute terms. As a result, much of the revenue lost through these exemptions ends up benefiting richer segments of society.

To achieve a truly pro-poor fiscal policy, both tax reform and better targeting of subsidies are necessary. Reallocating resources from broad, inefficient subsidies to targeted cash transfers can ensure that the poor benefit more directly without sacrificing fiscal sustainability, as these economists note.

Roadblocks in implementing an efficient cash transfer system in Sri Lanka is a topic for another day.