23 October, 2017

Fiscal Decentralisation: A Stepping Stone Towards Conflict Resolution

By Muttukrishna Sarvananthan

Dr. Muttukrishna Saravananthan

Dr. Muttukrishna Saravananthan

For too long, the political processes in Sri Lanka to resolve minority grievances have been preoccupied with the nature of the state (unitary versus federal), unit of devolution of political and administrative power (village, district, or province), language, land, police, and other administrative issues. Very little discussions have taken place regarding the division of financial/fiscal powers between the centre and the peripheries. All the previous political processes have failed on one political and/or administrative issue or the other.

Even the externally imposed provincial council system under the Thirteenth Amendment to the Constitution has not lived up to the expectation of the minority communities because of the lack of devolution of land, law & order, and fiscal powers. Though land and law & order power devolution continues to be contested, the matter of fiscal devolution has not attracted the attention of the protagonists or the opponents of the Thirteenth Amendment thus far. So, this window of opportunity should be made use of to promote fiscal devolution as a stepping stone towards a durable political solution to the grievances of the minorities, particularly the Tamils of East and North.

Internationally, the sub-national government revenue as a percentage of the central government revenue has been high as circa 50 per cent in Brazil (in 1998) and India (in 1999), moderate in Malaysia (15.4 per cent in 1997) and Thailand (17.0 per cent in 2002), and low in Indonesia (3.2 per cent in 1993), Philippines (2.7 per cent in 1993), and Sri Lanka (4.3 per cent in 2004) (Waidyasekera, 2005: 5). The sub-national government expenditure as a percentage of the central government expenditure has been high as 88.7 per cent in India (in 1999), moderate in Indonesia (13.7 per cent in 1993), Malaysia (12.4 per cent in 1997), and Sri Lanka (11.7 per cent in 2003), and low in Philippines (5.5 per cent in 1993) and Thailand (6.0 per cent in 2002) (Waidyasekera 2005: 20) The foregoing international comparison data is based on different years and therefore should be considered cautiously.

Rationale for Fiscal Decentralisation

Fiscal decentralisation has gained momentum in capitalist and communist/socialist countries (such as China and Myanmar, for instance) and in unitary and federal states alike since the last quarter of the twentieth century. Country experiences have shown that fiscal decentralisation does enhance public goods and services delivery and poverty reduction (Ehtisham and Brosio 2009). However, designing of fiscal decentralisation should be country-specific (Fedelino and Ter-Minassian 2009). This author’s case for fiscal devolution is not based on the dichotomy of unitary versus federal constitutional cum political models, but stems from the evolving business model globally towards subcontracting and outsourcing the production line and the supply chain (Sarvananthan 2009a: 7). However, not everyone agrees that administrative, political and fiscal decentralisation is the panacea for economic efficiency (see, for e.g. Hewavitharana 1997).

Public administration is most effective when it is closer to the people, which apply to tax administration as well. The closer the revenue authorities are to the people, the higher the revenue collection. Therefore, the present Inland Revenue Department and Excise Department should be decentralised. Provincial and local Inland Revenue and excise departments should be set up in order to collect direct and indirect taxes effectively at the lowest possible public administration unit. Information on local businesses and professions could be gathered more effectively by the local offices of the Inland Revenue and excise departments rather than by the centralised departments located in Colombo.

The devolved government revenue raising departments should have appropriate incentives and penalties for performance or lack thereof. That is, the national government should set annual target of revenue at each level of devolved units of revenue mobilisation. Incentive payments should be paid to those units that overshoot the target. Conversely, penalties should be imposed to those units that fall short of the target. By doing this, the national government could incentivise the revenue collection at the provincial and local levels with rewards and penalties.

Tax Reform Propositions

Presently, income tax collection is based on self-assessment made by the payee (either individual or corporate entity), which is not satisfactory. Instead, income tax should be collected at source (PAYE – pay as you earn) as much as practically possible in order to improve compliance.

Tax reforms in Sri Lanka should be based on streamlining and reducing the number of direct and indirect taxes payable by individuals and corporations, reducing the rates of such taxes, and increasing the number of individual and corporate tax payers. That is, widening the tax base is the need of the hour, rather than deepening the number of taxes and their rates. Imposition of income tax on public sector employees and professionals is sine qua non for the widening of the tax base. Public sector employees in Sri Lanka are in an envious position, vis-à-vis most other countries, because their income is not subjected to PAYE tax. In India, for instance, the income of public sector employees (including armed forces personnel) is subjected to PAYE tax. Similarly, professionals such as doctors (who work privately in addition to their government job), lawyers, accountants, and teachers should be brought under the PAYE tax scheme.

The foregoing propositions could be best achieved under a devolved taxation system where tax avoidance and evasion could be minimised by being closer to the people. Bribery and corruption involved in tax evasion could also be minimised when the unit of surveillance is smaller and local.

In post-war Sri Lanka, the national government should abdicate most of its functions and responsibilities to all nine provinces and local authorities, except monetary currency, defence, and foreign affairs. The national government’s primary function should be regulator of the provincial and local governments under a unified country, such as imposing a cap on provincial budget deficit. In order to fulfil its functions and responsibilities, provincial and local governments should be given fiscal autonomy. That is, the provinces and local governments should be vested with the powers to raise and earn income and spend on public goods and services within the respective province and local authority (municipal, urban and village councils). Each province should impose and collect taxes, except import duty and excise duty and value added tax on imports. Hence, the national government’s revenue should primarily accrue from duties and taxes on international trade. Businesses within each province should register with and pay taxes (both direct and indirect) to their respective provincial government. Both the public and private sector employees within each province should pay income tax to their respective provincial government. At the same time, national government employees (such as the Central Bank staff, employees of the three armed forces, Ministry of Finance employees, and semi-government employees) should pay income tax to the national government. Appropriate mechanism could be devised to share the consumption (indirect) and income (direct) taxes earned by the provincial and local governments with the national government. As a corollary, public utilities such as electricity, water, road and rail transport, etc., should be regionalised.

By providing fiscal autonomy to the provincial and local governments, the national government could promote competition among provinces and local authorities to attract businesses and investments (both domestic and foreign). The fiscal space opened-up (or envisaged) for the provinces and local authorities by the aforementioned method would create an environment for productive competition among provincial and local governments. The national government should do away with the nanny state it currently operates, vis-à-vis the provinces and local authorities, by way of providing annual grants to the provinces and local authorities based on various criteria. Present financial transfers from the centre to the provinces are barely adequate to pay for salaries, pensions, and recurrent expenditures of the provinces. On the contrary, provinces should be encouraged to earn and spend their own money based on their priorities and decisions.

The foregoing propositions would require amendments to the present Constitution. Alternatively, if there is no political or bureaucratic will to transfer fiscal powers to the provinces and local authorities, economic rationalism would suggest to abolish the second (provincial councils) and third (municipal, urban, and village councils) tiers of government despite the fact that the savings in public expenditure would be only small.

Conclusion

There is a lot of concern about the lop-sided economic growth and wealth concentration in Sri Lanka whereby the Western Province (Colombo, Gampaha, and Kalutara districts) accounts for almost half of the national GDP. There could be several causes for this concentration of economic output and wealth in just one out of the nine provinces in the country. The tax incidence or the sources of tax revenue is one of the principal factors affecting income inequality among the population and the regional dispersion of economic growth and wealth. When a tax system overwhelmingly depends on consumption taxes, income will be concentrated in the hands of the wealthy individuals, institutions, and regions of the country. After 1977, indirect or consumption tax as a proportion of the total tax revenue has increased at the same time that direct or income tax has decreased. This is one of the primary causes of the skewed production and wealth among the people and places in Sri Lanka. Moreover, the consumption tax revenue and savings of people from the provinces are transferred to the centre (part of Western Province) which promotes regional inequality. Therefore, giving freedom to the provinces to retain their respective consumption tax revenue and savings of the respective populations and increasing the proportion of the direct or income taxes in the total tax revenue would significantly disperse production, income, and wealth to the regions away from the Western Province. Therefore, fiscal devolution is proposed for inclusive equitable growth among the different provinces as well as a means of conflict resolution in Sri Lanka.

Not only spatial economics but institutional economics is also necessary to understand the dichotomy between the ‘leading’ and ‘lagging’ regions within nation states. Whilst physical infrastructure (roads, transportation services, etc) and information and communication infrastructure (telecommunications, internet, etc) connect places, it is the institutions such as rule of law, property rights for land, political, administrative, and fiscal devolution, financial integration, education and skills development, and development of inter-regional markets that connect peoples across the national boundary (The Cities Alliance 2007: 19; Nallari, Griffith and Yusuf 2012: 8). Thus, connectivity in terms of physical distance and connectivity in terms of human distance are sine qua non for spreading economic growth and competitiveness to the regions and integrating the national economy.

There is empirical evidence to show that democratisation and fiscal decentralisation dilutes primary cities and promotes secondary cities. Davis and Henderson (2003), using panel data from 1960 to 1995 with instrumental variable estimation, find that moving from most centralised to least centralised government reduces primacy by 5 per cent. Similarly, moving from least democratic to most democratic form of government reduces primacy by 8 per cent (cited in Nallari, Griffith and Yusuf 2012: 3)

Although the Thirteenth Amendment to the current Constitution has vested some powers of revenue mobilisation to the provinces, it falls short of an effective and efficient mechanism to make the provinces financially viable and minimise their dependence on the national government. The tendency in the past twenty five years of the operation of the provincial councils (1988-2013) has been the monopolisation of taxation by the national government.

The political establishment of Sri Lanka and the psyche of the masses at present appear to be incapable of undertaking radical changes to the political and administrative architecture. Therefore, incremental devolution appears to be the pragmatic way forward for durable conflict resolution in Sri Lanka. Fiscal devolution, one such step in the incremental devolution process, could presumably attract stronger government and public support (than the devolution of political and administrative powers) under the present Unitarian government.

*Muttukrishna Sarvananthan is the Principal Researcher, Point Pedro Institute of Development, Point Pedro, Northern Province, Sri Lanka. E-mail: sarvi@pointpedro.org. This is an abridged version of an article published in the academic journal South Asian Survey, Volume19. No.1 

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Latest comments

  • 1
    4

    Stateless people advising how to run states!

  • 0
    4

    I cannot see why financial devolution is not acceptable. Again, these things need to be discussed on terms stipulated by the president.

  • 0
    0

    This is a very enlightening article. Indeed, now I realize that provincial councils are not white elephants as the popular media is trying to make it.It indeed is a myth. Provincial councils or no provincial councils, at the end of the day, salaries of the provincial public servants will have to be paid by the tax-payers. So, I feel that fiscal devolution will make devolution of power work.

  • 0
    0

    Excellent article and a very practical idea. The author must educate out NP leaders.

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