By Sankalpa Marasinghe –

Dr. Sankalpa Marasinghe MD

The massive protest rally at Hyde Park on 7th February was not simply just another gathering of anti-government factions who would prefer to have a different political party in power. Members of trade unions who have never come together under a common banner in recent history had come in their numbers to show solidarity in the commonly shared struggle. What echoed at Hyde Park that day was the combined angry voice of professionals who were not against taxation but were against the unjustifiable percentage of tax on their take-home salary.

The economic pundits of the Government have decided that the way out from the deep economic pit we are in would be to impose a heavy tax on people who earn more than Rs 100,000/= per month. Crushed by soaring inflation and the ever-depreciating buying power of the Rupee, the middle class of the country has its own share of economic hardships to face already. Contrary to the popular belief, it was recently revealed that the country’s middle-income category exceeds 70% of the population and as a result, bears the burden of the largest portion of the country’s production of services and goods. However, the eroding value of the Rupee and the increased cost of living has diminished the disposable income of the majority of households. The revised tax regulations were implemented in the above context from 1st January 2023.

It is no secret that the IMF’s prescription for economic stabilization highlights the significance of increasing government revenue and decreasing government expenditure to maintain fiscal discipline. However, the formula to generate government revenue could not be as simple as dividing the expected revenue by the number of “taxable” individuals in the country. In fact, the potency of the increasing tax percentage to generate government revenue has been well explained by Arthur Laffer, who was a member of President Reagan’s Economic Policy Advisory Board for both of his terms (1981–1989) and was a founding member of the Reagan Executive Advisory Committee for the presidential race of 1980.

Arthur Laffer explained the relationship of the tax rate to the potential government revenue plotted in a bell curve which is commonly known as the “Laffer curve”

What Arthur Laffer demonstrated was that the rising tax rate could yield an increase in government revenue up to a point (T*) where the maximum tax revenue could be achieved. However, beyond a point (T*) the revenue generated becomes progressively reduced as the tax rate increase.

Laffer postulated three main reasons for the reduction of income with the raise of taxes beyond the critical point (T*). 

1. The disincentive for those who work hard and for those entrepreneurs who strive to generate more income by increasing production.

The incentive for increased productivity is the monetary return you get. However, beyond a certain limit, taxation acts as a disincentive where people are discouraged to work hard to earn more. The more you earn the more you are taxed. It should be noted that the reduced government income is just one of the many ails that brought us down as a country to the deep pit of the economy we are in. Dwindling productivity and the slow growth of GDP which could not sustain the projected economic growth which was funded by foreign debt was a major cause of the downfall. In terms of the macroeconomy, the disincentive for productivity will not help the country to improve its GDP and resurrect itself from the debt burden.

2. Emigration of highly skilled professionals and highly talented entrepreneurs.

The burden of taxation which is beyond the tolerable limit to sustain daily necessities will push the affected categories to migrate to countries that offer better income and more comfort in living. What is interesting here is that these very individuals who are leaving the country are the ones who contribute the largest portion of tax revenue to the government. While attempting to generate more revenue, the country is not only losing the highest-skilled professionals and best entrepreneurs but also losing the projected tax revenue.

3. Tax evasion and tax avoidance.

As the percentage of income returned as tax increases the general tendency to evade tax and avoid tax also increases. People resort to hiding their earnings and at times place them abroad while some people resort to exploiting loopholes in the system to avoid being taxed.

Surely, the experts in macroeconomy at the government’s disposal must know the Laffer curve as the back of their palm. But, why the decision did not consider the repercussions and especially the economic as well as the social cost of such a high rate of taxation is a puzzle.  Obviously, what Arthur Laffer proposed was on the pretext of a normal economy where the government is looking for ways to increase revenue. What we experience in Sri Lanka is a situation where the country is bankrupt with no foreign reserves and a 46 billion USD debt to pay. Therefore, the implications of the Laffer curve would be that much more profound.

It is important to note that Arthur Laffer’s postulation is not without its fair share of criticism. Dr W. A. Wijewardena, in his article points out that the Laffer curve is irrelevant in the Sri Lankan context, and the critical point (T*) was found to be 70% through empirical studies. He points out that the current rate (in 2019) is 24% and hence, the argument by the then government to support its drastic tax cut does not hold water.

Furthermore, one of the main criticisms of the Laffer curve is that it is too simple and considers only one kind of tax and people could be motivated to work for reasons other than money. Laffer himself has stated that the curve should not be the only reason for a government to raise or reduce taxes.

The most valuable point, in this author’s opinion, is that the 3 reasons Laffer described for a lesser tax revenue than projected when the tax rate becomes unbearable is strongly relevant to the current status of Sri Lanka. The critical point (T*) applicable to Sri Lanka today is yet to be clearly defined. However, the confounding factors described earlier must surely have brought the percentage below 36%, which is the current PAYE tax rate (Highest slab).

What is more disturbing for the country is that brewing social unrest which could blow out anytime will push any hope of recovery further away from our grasp.