By Hema Senanayake –

Hema Senanayake

Global Economic Revolution Is Overdue: Part 4

Sri Lanka intends to make strong reforms to tax regime. This was told by the Minister of Finance, Ravi Karunanayake during his budget speech of 2016. He said that, “…However, it is time to deviate from temporary solutions but endeavor to create a tax regime based on strong reforms to move forward, implementing such reforms which will have far reaching benefits to the country.” (Paragraph 63, Budget speech -2016)

We agree that strong reforms of taxation are needed. There is no argument about the need of reforms. Yet, the argument is about the basis or the principles of reforms. In fact this is one of the topics I intended to discuss through this column. I guess it is appropriate to discuss it now. I like to begin from fundamentals of economics. These fundamentals may vary from text book fundamentals.

Since, I have been discussing through this column about developing a new economic model let me first submit the possible objectives of taxation under the new model. Basically it is twofold. One objective is to find money for the government to produce common interests for the society. In regard to this objective of taxation I have written previously, hence in this article I will not discuss about it.

The second objective of taxation is to make businesses more viable – and this means that we are going to reform the tax regime in order to make businesses more viable. This does not necessarily mean that we are going to reduce taxes or give more tax concessions to businesses, instead this intimates that we are going to tax, subjected to a small adjustment, the unutilized consumable income in the economic system no matter such money accumulates in rich private households or under the balance sheets of businesses. Once we do this the income redistribution will not be an issue any more hence as at now I ignore “income redistribution” as an objective of taxation.

Therefore, in regard to “strong reforms” we should be interested not about determining the percentage of indirect taxes and direct taxes. Instead our goal must be to bring in necessary reforms in order to achieve above mentioned two objectives namely to collect revenue for the government in order to produce common interests and to make businesses more viable.

Let us investigate as to how we can make businesses more viable. In this regard, we can turn to renowned economist Keynes because his explanation on this particular point is basically accurate. He says that, “When employment increases, aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased aggregate consumption increased, but not by so much as income.” Why?

He explains that people begin to save more and more as income increases after their basic needs and wants are satisfied. Then what happens due to increased savings? Keynes explains that employers would make a loss. In order to avoid making losses, employers must make investments subjected to one important condition. That important condition is that the new investments should not produce products for immediate consumption. Or else there should be a change in communities’ propensity to consume. In other words consumers must increase consumption as the income increases. What does this mean?

First, let me put it straight. Consumers must use their income for consumption and employers must use their profit reserves to increase investments in real sector if we want to make businesses viable. These two things require taking place due to a contradiction or a gap exists in the economic system. Therefore, what really should be done is to remove the savings and un-invested reserves respectively from rich households and from businesses and use that money to increase consumption through the government by producing products for common interests in filling the gap. This is the absolute amount that we should tax but it requires a small adjustment. No economy can’t tax or should not tax more than this theoretical amount.

Now, let us consider the small adjustment mentioned above. Even though the total savings are invested the said contradiction or the gap existed in the economic system would not disappear fully. But for the time being let us focus on what Keynes had observed. He saw that a gap exists between the income and consumption. Keynes observed it as follows.

Since consumers will spend less as income increases, “… higher absolute level of income will tend, as a rule, to widen the gap between income and consumption.” This observation is not accurate but for the time being let us presume that it is true. Then, Keynes further concludes that, “… the increased employment will prove unprofitable unless there is an increase in investment to fill the gap.” This is interesting. We increase the investment and as a result we increase employment. Now, the increased employment will not be profitable unless there is further increase in investment to fill the gap between income and consumption.

In fact there is a gap in the economy. It does not arise due to the reasons explained by Keynes. We will discuss about it in a separate column in the future. But a gap exists. It is true. This gap is partially being bridged by increased investments. This is also true. Also, another big part of the gap is being filled through the credit market and through stock market.

If the theoretical amount of tax mentioned above was levied then the credit market shrinks. Yet, the opposite would take place if we levy fewer amounts from the unutilized consumable income and from corporate reserves. As a result extreme expansion of debt must take place. Extreme expansion of credit cannot be positive either. Hence, there should be a balance in between. This is the adjustment we require and mentioned above.

The said balance cannot be achieved without progressive direct tax regime because higher absolute income and higher absolute corporate reserves would cause employers to make losses. If we do not do it, then the problem of filling the gap would be shifted to the credit and stock market. It means both would be unsustainable due to a “credit bubble.”

What we prove here is that high taxes and high growth can co-exist. American billionaire and entrepreneur Bill Gates said that, “The highest economic growth decade was the 1960s. Income tax rates were 90 percent.” — Bill Gates on Sunday, May 17th, 2015 on CNN.

The goal of having progressive tax regime is not to make businesses more vulnerable, instead the objective is to fill an important gap which we have discussed above and by doing it we would make businesses more viable. However, as a measure of encouragement, the government can extend a refundable tax credit over a certain limit for those individuals and businesses pay higher taxes, if they face an unexpected personal or business risk in the future.

However, there was a post Budget Forum in Colombo, organized by the 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 is economics? What about the filling of “gap.” What about making businesses more viable? What about preventing unsustainable credit growth – private and public? Our closest neighbor, India’s corporate tax rate is 30% and targeting double digit GDP growth while Sri Lanka’s GDP for the year 2016 has been downgraded to 5.7% by the CBSL.

Finally, I conclude that capitalist or socialist or any other economic model there is one important rule in common. That rule is that entrepreneurs have to earn more than what they spend or invest. Without doing it no enterprise can prevail. Macroeconomic system must be designed to achieve that goal. This must be the bottom line in our tax reforms.