Some tax reform issues facing Lanka

D. D. M. Waidyasekera

In the background of the global recession affecting both developed and developing countries resulting in the recourse to various countervailing measures like stimulus packages, lower interest rates, easier finance, bailout packages etc., many countries are also in the process of providing fiscal and tax incentives to stimulate economic recovery. In this background some countries have embarked on tax reform to revamp their tax systems and increase government revenue in the face of mounting government expenditure and declining tax revenues.

Some of the countries that have embarked on such tax reform include the U.S., India, Singapore, Mexico and Sri Lanka among others.

United States

In the US President Obama on March 25, 2009 announced the establishment of a special task force to review the shortcomings of the US tax system. This is part of the President's Economic Recovery Advisory Board and which has come to be known as the Volcker Task Force due to Paul Volcker being the Board's Chairman.

Its mission is to foster a tax system that is fairer, simpler and more economically efficient. Its major goals include:

(a) reducing tax evasion and loopholes,

(b) simplifying the tax code and

(c) Reducing corporate welfare.

These include both enforcement of existing tax laws on US residents earning income overseas and reforming deferral for US based multinational enterprises.

India

India announced in the second week of August 2009 revisions to the Direct Tax Code to be implemented by April 2011. This to replace the Indian Income Tax Act enacted in 1961. Its main objectives are to enlarge the tax base, increase the tax/GDP ratio, enhance revenue productivity, improve horizontal equity and increase compliance. In order to achieve these objectives the proposed revisions include the following:

(a) Eliminating exemptions and other incentives that have been blamed for eroding the tax base

(b) Reducing the corporate tax rate from 30% to 25%.

(c) Increasing the threshold for personal income tax but retaining maximum tax rate at 30%

(d) Home loan interest for owner - occupied property not to be a deduction from rental income

(e) Perks to be subject to taxation.

(f) Withdrawals from provident funds and life insurance accounts from April 2011 to be made taxable.

(g) Business losses to be carried forward indefinitely.

(h) Dividend distribution tax limited to 15%.

(i) Foreign based companies in India would be treated as resident companies if control and management takes place in India at any time during the year.

(j) Foreign companies' branches in India to pay a Branch Profits tax at 15 percent.

(k) Minimum alternate tax (MAT) to be the final tax.

These proposals are currently being subject to public discussion in India.

The draft direct tax code (DTC) was presented for public comment in mid-August 2009. The government has acknowledged some areas of concern and agreed to clarify them. Apparently there is still more debate going on in the run-up to the introduction of the new DTC as well as the GST due to be implemented from next year April 2011. These will constitute the most radical tax laws India enacted since its Independence in 1948.

Singapore

In Singapore a number of changes have been proposed as part of its tax reform. These include:

(a) Corporate rate to be reduced from 18 percent to 17 percent from year of assessment 2010.

(b) Accelerated depreciating allowances for plant and machinery.

(c) Loss carry back rates rules to be liberalized.

(d) Liberalization of laws in respect of corporate mergers and acquisitions.

(e) Incentives for fund management particularly family-owned investment holding companies.

(f) No capital gains taxation for real estate transactions.

Mexico

In Mexico a reform bill was submitted to Congress on September 8,2009 to be implemented from January 2010. Its main provisions include:

(i) Maximum individual tax rate to be 30 percent

(ii) Corporate tax rate increased from 28 percent to 30 percent supposed to be temporary till 2014.

(iii) Tax changes for sale of dwelling houses and limitation to deductibility of interest on house mortgage finance.

(iv) A new indirect tax to control poverty based on the current VAT system at 2 percent.

(v) Additional excise taxes on liquor, betting, lotteries etc.,

(vi) Measures to strengthen tax audit and collection powers of the tax authorities.

The Mexico Reform Bill after intensive legislative debate was finally approved by the Mexican Senate on November 5, 2009 and became law from January 01, 2010.

There were however some changes made in the final approved draft in respect of

(a) Income tax rates: the rates will be increased to 30 percent for 2010-2012; reduced to 29 percent in 2013; and then to 28 percent in 2014

(b) VAT increase: the proposed VAT increase of 2 percent was reduced to 1 percent and would not extend to food and medicine.

Sri Lanka

1. In Sri Lanka a 10 member Presidential Commission on Taxation was appointed in May 2009 to examine the overall performance and deficiencies in the existing taxation system and recommend measures to revamp and overhaul the entire system to enhance tax revenue. There were three earlier Commissions in 1955, 1967 and 1990 which examined periodically the existing anomalies and recommended radical changes to the then existing tax system.

The problem with all these Commissions and Task Forces is that the conditions both internal and external change so rapidly that very soon the system again becomes complicated and outdated. Further, the recommendations enumerated in Reports are often not implemented in full but in a piecemeal or distorted manner or sometimes not implemented at all.

Changing fiscal circumstances bring forth ad hoc responses and measures periodically so that within a few years the-taxation system again becomes complicated and outdated requiring another overhaul.

Unlike in other countries like USA and India etc., which are currently re-examining their tax system the terms of reference of the Commission in Sri Lanka are very broad and involves an across the board review and reform of virtually the entire system. It involves an examination and review of not only the direct taxes both individual and corporate but also the indirect taxes such as VAT, import duties, excises, tax incentives, as well as provincial taxation and the overall tax administration.

This article attempts to examine some of the main issues and areas which the Commission would have to focus its attention on and make recommendations.

2. Terms of Reference:

As mentioned, the terms of reference (TOR) of the Commission are very broad and relatively exhaustive. They can be divided into six main categories:

(i) declining tax revenue ratio to GDP, reasons and measures to reverse this trend, and enhance government tax revenue.

(ii) Direct taxes both personal and corporate, their base and rates, and coverage.

(iii) Tax incentive structure, its pros and cons, defects and anomalies.

(iv) Indirect taxes such as VAT including its performance and deficiencies, customs tariffs, excises, cesses.

(v) Devolved taxation in respect of Provinces and local government institutions.

(vi) Administration of revenue departments. This involves procedures, collection, compliance, use of Information Technology, staff, training as well as co-ordination between revenue departments and the Finance Ministry, supervisory and control functions.

3. Fiscal background

While government expenditure has been steadily increasing over time, government revenue has steadily declined resulting in recurrent fiscal deficits. In 1998 government expenditure was Rs. 268 billion which increased to Rs. 476 billion in 2004 and Rs. 996 billion in 2008. Government revenue on the other hand was in 1998 only Rs. 175 billion, in 2004 Rs. 311 billion, and Rs. 655 billion in 2008.

In terms of GDP the overall fiscal deficits were 9.2 percent in 1998, 9.7 percent in 2004 and 7.7 percent in 2008 (Central Bank, Annual Reports).

The decline in total government revenue has been conspicuous over the last two decades declining from 21.1 percent, of GDP in 1990 to 16.8 percent in 2000 and 14 percent in 2008. Correspondingly, tax revenue has fallen from 19.0 percent, in 1990 to 14.5 percent in 2000 and 13.3 percent in 2008. These ratios are very low compared to other countries and are perhaps the lowest in South Asia.

The primary task of the Taxation Commission therefore is to analyse the reasons for this continuous decline in tax revenue and recommend measures to reverse this trend commencing from an increase to 16.9 percent of total revenue targeted by the government by 2011.

Direct taxes

One of the conspicuous features of the tax system in Sri Lanka is the relative insignificance of the direct taxes in total tax revenue. Over the past five years income tax including personal, corporate and withholding taxes have generated on the average around 2.4 percent of GDP in contrast to around 5.4 percent in much of the Asia-Pacific region.

Some of the main reasons for this situation is the narrow base of the income tax, the low coverage, the rate structure low compliance and tax evasion.

The large number of tax holidays and exemptions tend to narrow the tax base. One example is that in Sri Lanka civil servants have been exempted from income tax on the salaries and emoluments from 1977, the only country in the world to do so.

Civil servants constitute about 1.2 million of Sri Lanka's seven million workforce and by definition it extends to parliamentarians, provincial councillors and semi-government officers as well. Though the per capital income has been increasing, the number of taxpayers is relatively low. Per capita/GNP in Sri Lanka has increased from US $ 469 in 1990 to US $ 1051 in 2004 and in US $ 1969 in 2008. The number of individual taxpayers in 2007 however was only around 487,000 or less than 2.5 percent of the population.

The total number of companies and corporate bodies registered for income tax was around 42,000 for the same year. It will be one of the tasks of the Tax Commission to make recommendation to enlarge the base of the income tax and increase the coverage in relation to the potential taxpaying population.

The rate structure too needs a look. The present income tax rate structure is complicated with the existence of a number of different rates.

The standard corporate rate is 35 percent which is higher than certain other Asian countries like India (33.9 percent), Thailand (30 percent) Malaysia (26 percent) and Indonesia (30 percent). It is complicated by the fact that companies having a taxable income of less than Rs 5 million pay a lower rate of 15 percent while even those over Rs 5 million are divided again into listed and non-listed companies, the former paying 33 1/3 percent while the latter is taxed at 35 percent. Apart from these, there are special rates for specialized housing banks, exports, tourism and construction, venture capital companies etc. It will be the task of the commission therefore to examine the rate structure in relation to its competitiveness, revenue generation and rationalization.

Fiscal incentive structure

One of the main items in the terms of reference is an examination of the prevailing fiscal incentive structure, the pros and cons of granting such incentives, its cost benefit and its rationalization. There is no doubt that one of the main reasons for the narrow tax base and declining tax revenue is the plethora of fiscal concessions granted to promote both domestic private investment and foreign direct investment (FDI). These have largely been unplanned and ad hoc concessions operating under different regimes, including both the Inland Revenue (IRD) and Board of Investment (BOI).

There are both pros and cons in granting tax incentives, and several developing countries have in place incentive schemes to attract private investment and channel them into the desired areas of economic activity.

However, there is little international evidence either from econometric studies or investor surveys that fiscal incentives are effective in promoting private investment in a cost effective manner.

While corporate tax holidays can raise the after tax rate of returns to investors, this is only among many factors which influence investment decisions.

They cannot make an unviable project profitable and other factors like the expected demand for the output of a Project, the cost and availability of labour and infrastructure, access to markets and political stability have greater influence on investment decisions than fiscal incentives.

Fiscal incentives are also costly. While FDI inflows to Sri Lanka is about 1.5 percent of GDP, the cost of fiscal concessions in terms of lost revenue is estimated to have been 0.4 percent of GDP in lost corporate income tax revenue am 0.5 percent in, lost customs duty revenue in the early 2000s. (IMF, 2004).

There is therefore the need to introduce stronger cost-benefit considerations in granting fiscal incentives. There is also the need to improve the monitoring of the BOI and other enterprises granting these incentives which would require greater co-ordination between the institutions involved.

There is therefore a need to examine alternative ways of stimulating investment rather than ad hoc and unplanned concessions. Such alternative methods include measures such as granting accelerated depreciation and capital allowances on capital investment, a lower corporate rate regime, and improving the investment climate among others.

(To be continued)