Colombo Telegraph

Tax Reforms: Should The VAT Be Abolished?

By Hema Senanayake

Hema Senanayake

Sri Lanka needs complete and meaningful tax reforms. Where should we begin? I suggest that we should begin from economic fundamentals not from ad-hoc adjustments of VAT. If you need a quick solution, then, I would say again, you have to begin from fundamentals by correcting what you put wrong from the budget for the year 2016. Let me explain this matter very briefly.

What kind of money in the economic system should we tax basically? We should always tax part of the consumable income allocated in the system. This is the fundamental principle. For a moment if you ignore the consumable income allocated from stock market share trading transactions, in general, consumable income is allocated by revenue generating production based enterprises only. This means that producers of revenue generating enterprises pay all the taxes, no matter taxes are collected at various points and various names. For example if a government employee pays tax then his or her tax is truly paid by the producers of revenue generating enterprises. When you understand how the system works, you may easily understand this process.

When we tax, we deprive certain consumable income to individual producers (in revenue generating enterprises which produce goods and tangible services), but they are in turn benefited as members of the larger society, when we use that tax money to produce common interests such as education, judicial service, general administration, research and development, infrastructure development etc. Therefore, if a highly paid government employee pays tax he or she pays it from the money collected by depriving certain income to producers. So, you may understand now that taxes can truly paid only by producers. However, if this government employee does not produce anything that can be defined as common interest then producers are not get benefitted as members of society by paying taxes. In this regard, the best example is our Jumbo Cabinet.

However, when taxes are collected the economic efficiency of the system must be a concern. For an example, remove the VAT from all economic produce (goods and services). Then economic produce represent the true price of present day economic relations. These prices reflect the present day economic efficiency of production. Isn’t this important? It is important. VAT distorts these prices. It is bad. It is bad even if all countries in the world use VAT. However, the United States, one of the biggest economies in the world does not use VAT. I guess State Minister of Finance Lakshman Yapa Abeywardena might well understand this point now.

VAT is an anomaly in tax collection. As I mentioned above, it is a part of the consumable income that we need to tax. The consumable income is the income that goes to the households as salaries, wages, distributable profit, etc. There is another part too. It is the un-invested component of the capital reserve (profit reserve) accumulated in the balance sheets of businesses. These are the two main income components that should be taxed. Usually, these two kinds of entities (households and businesses) are reluctant to pay taxes, but we could change that phycology if any unperceived risk is absorbed in proportion to the taxes they pay. That is one area we need reforms. Instead of doing it what the new government did was that it ignored the fundamental principles of taxation from the approved budget for 2016.

From the 2016 budget, the government reduced personal income tax which is household income tax to 15% and corporate tax was reduced to 15%. What does this mean? The government proposed to reduce taxing household consumable income and un-invested income of businesses. This error was glorified as a prudent action of the new government, in a post budget symposium organized in Colombo by Ernst & Young. In the forum it was mentioned that Sri Lanka’s 15% corporate tax rate is the third best or equaling with Germany and only behind Ireland’s 12.5%. In personal taxation of 15% flat rate, Sri Lanka remained lowest among selected countries compiled by E&Y. It was further pointed out that, “In a personal tax view point Sri Lanka is the most attractive for people to work in terms of tax. In the region we are paying the lowest tax rate.” Amazing! Isn’t it? Where are the concerns for the fundamentals of economics? The budget for 2016 failed to tax the due part of the consumable income from both entities mentioned above. When you do that you need VAT and VAT is a bad tax. Even a retail sales tax is a better tax than VAT because retail sales tax does not distort the true prices of economic produce.

Our closest neighbor, India’s corporate tax rate is 30% and targeting near double digit GDP growth while Sri Lanka’s GDP for the year 2016 has been downgraded to 5.7% by the Central Bank of Sri Lanka. In regard to the personal taxes (household taxes) the United States provides a better example. It targets to tax un-spent savings of wealthy households; this is consumable income un-used for consumption and is well agreed with economic fundamentals. For example, the U.S. tax 39.6% from households which earn more than USD 466,951, while families earn around USD 18,550 are taxed at 10% rate. (Pl. note that the U.S. tax system is complex and as such even though low income families are taxed at 10%, usually they get something known as tax credits which exceed the amount of tax they pay. Hence they in fact benefit by paying taxes).

The above mentioned two taxation examples go in line with economic fundamentals. This government ignored it and even did not explain as to why they did it. When the government does ignore good taxes and reduce the collection of such taxes ignoring economic fundamentals, you need to increase VAT and lower the compliance threshold. This was what happened.

Now, let us get back to Rajitha’s tobacco tax. Will it tax a part of consumable income allocated in the economic system? No. Then it is not a solution. But if the government thinks that such a punitive tax on tobacco helps to prevent people from smoking such a tax would be beneficial. But it is different from taxing part of the consumable income in order to produce common interests by the government.

My point is that the country needs far reaching tax reforms. This should include a mechanism in absorbing of unperceived future risks of the tax payers. If we introduce such a mechanism the major component of tax could be collected from direct consumable income allocated to households and from the un-invested profit reserves from businesses. The other best option is to expand the revenue generating enterprise base in the economy so that it could allocate more consumable income out of which taxes are collected.

In view of above, now I may ask from readers, where should we begin reforming taxes? Hopefully you may say, from fundamentals.

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