ECONOMYNEXT – Sri Lankaâ€s new administration wants to cut personal income taxes, take away value added taxes on some processed food items and education materials, without harming revenue targets in the International Monetary Fund program.
The IMF is fixated on revenues, so they are likely to require alternative taxes to make up for any tax losses.
It should also be kept in mind that under the current system where VAT is not separately billed at retail level and only an inclusive tax is displayed any VAT cuts will be pocketed by businesses as it had happened in 2019.
Amid Tax Fatigue New Taxes Have Political Costs
The political costs of value added tax has already been borne by the last administration.
Any new taxes on a population that has been hit by multiple taxes, is likely to have a political cost to the new administration.
With the central bank allowing the rupee to appreciate, many food and educational goods prices have started to fall.
Cutting VAT is also a sensitive subject. People know that cutting VAT was one reason for the default and the IMF classifying the countryâ€s debt as unsustainable in 2020.
Any default in the future coming from monetary instability, is likely to be blamed on any VAT cuts by the current administration by their own supporters.
Capital Decaying Taxes
Cutting income tax rates is a laudable move. Income taxes are highly damaging to capital accumulation and they also take away choice from the people.
Countries like the UK escaped the IMF after 11 programs by cutting income taxes and expanding VAT.
High income tax rates were developed as part of efforts to fight wars in the West after it was possible to track incomes closely. It did not help develop countries.
Many countries which gained monetary stability, developed after high income tax rates were cut after the end of a war.
Sudden high taxes in IMF programs  – which stem from inflationary rate cuts – undermine rule of law (regime uncertainty) and make it difficult for companies to plan any investments long term.
IMF programs and sudden tax change is also a symptomatic of monetary instability from central bank open market operations driven rate cuts. The high income tax rates (as high as 98 Â percent) regime uncertainty that came to the US during the Great Depression is a case in point.
Central bank inflationary rate cuts in peacetime, whether to promote growth (potential output) or employment or price rises themselves under a high positive inflation target, have the same or worse outcomes as printing money for war.
The way to have stable long term tax rates is to impose binding constraints on the central bank and block its ability to trigger currency crises and asset price bubbles, with their attendant banking crises and bloating state debt.
Income Tax
The NPP plans to expand income tax thresholds is a laudable move given the inflation and bracket creep compared to levels seen in 2018.
As the fiscal picture improves attempts must be made to reduce income tax and allow people greater freedom and choice in what they spend on and collect tax from consumption taxes as they exercise the freedom.
However, for that the VAT system must be in place to capture the taxes when goods are consumed according to their free choice. Â VAT is superior to income taxes not only because it gives people choice, but it is also paid in small amounts and not in lump sums.
Any taxes like wealth taxes that are not accompanied by cash flows will put tax payers in difficulty.
They bring little revenue, hurt taxpayers, and are designed to achieve some leftist political objectives of US ‘progressivesâ€.
For example, the IMF backed property tax is expected to bring only 0.2 percent of GDP but will do enormous damage to future housing stock of the country as property taxes have done in a number of US cities. Â People do not repair houses because the value goes up increasing their liability.
The income tax hikes under the IMF program after the last currency crises have hit some families, especially those who send children to private schools, and young families that were paying car leases and housing loans particularly hard.
Unlike in the West, Sri Lanka has low salaries, so they hurt.
Having said that companies will now try to pay higher salaries to expand take home pay to match the tax hikes. In banks and some state enterprises it has already happened.
When people have to write large cheques, attempts will be made to avoid tax.
Tax Credits
According to earlier reports the IMF has displayed a willingness to widen tax slabs but not raising the threshold across the board. If the IMF is unwilling to raise the threshold to 200,000 rupees immediately, the new administration could negotiate tax credits.
Before macro-economists destroyed the rupee from around 150 to 360, Sri Lanka had a threshold of around 100,000 rupees, and no one complained.
A 200,000-rupee tax credit is not unreasonable given the inflation since then, but extra taxes must be paid by the private individuals for a time to support the large public sector and various state enterprises and regulatory agencies that block private sector activity through various controls.
The shock to some wage earners has been big, since a complete exemption was made from 2020 by macro-economists working for President Gotabaya Rajapaksa and it came back at around the same rate in nominal terms and half the rate in real terms.
One option is to negotiate a fixed tax credit for dependents. A dependentâ€s credit is standard in many well managed countries where joint filing is also available. Or they could be given to families or one parent where children study in private schools.
Similarly, a tax credit could be given for medical insurance. Or a credit can be given for medical expenses.
Any parent that sends a child to a private school, or any person who goes to a private hospital reduces the burden on the budget for education and health expenditure.
Any VAT reductions will be pocketed by businesses under current system
The biggest problem with cutting VAT is that Sri Lanka does not have a law where shops and other establishments display the net price and show the VAT separately in bills. Instead, they show a rounded off price where the VAT is hidden.
Until the VAT law is changed and supermarkets and other establishments, medical or educational are made to display the VAT-less price, all VAT reductions will be pocketed by businesses as they were in 2020.
If prices are displayed net of VAT, and billed separately, then there is no need for businesses to change prices.
Only the retailers have to make adjustments to POS terminals to the tax charge. This is how several East Asian nations cut VAT during covid and re-instated them earlier.
It is in general not a good practice to meddle with value added tax. If exemptions are made, there will be more calls for exemptions from other sectors.
Macro-economists working for several Rajapaksa regimes systematically undermined the VAT regime and made it practically useless. Sri Lanka should not go down that path again.
It is also not a good practice to zero rate items other than exports. Some countries have zero rated healthcare.
In fact, VAT could be considered for electricity and fuel as prices are brought down (some execise could also be switched over time), which will make Sri Lanka more export competitive and eliminate the need to give special electricity pricing for industries.
This will make all services produced in Sri Lanka export competitive.
Multiple VAT rates are also not a good idea as they could lead to fraud and lost revenue. Sri Lanka should also go ahead and consolidate the Social Security Levy with VAT.
Sri Lankaâ€s problem with foods are excessive protectionists import duties and cess taxes. They make foods up to 50 percent, sometimes 100 percent higher than the US and East Asia and also create so-called ‘mafias†or oligopolies. Rice is an example.
Capital Decaying Taxes
The IMF, since it is a US-based agency, tends to push income and wealth taxes. The US does not have an 18 to 20 percent value added tax regime but only small state level sales taxes. Import duties are also low and there are free trade agreements to improve consumer sovereignty.
The IMFâ€s tax recommendations have a  cookie cutter resemblance to the Carl Shoup mission taxes made to Japan after World War II to back up monetary and fiscal tightening under Joseph Dodge, other than VAT.
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Due to its less regulated economy and heightened economic freedoms and productivity, the US attracts large volumes of capital (That is why the country has a current account deficit). So taxes on capital and a low savings rate is not a problem for the US for the moment. Plus the low consumption taxes and lack of VAT also make disposable incomes higher.
Central banks of Asian countries like Sri Lanka also buy US securities to build reserves so the US government also did not have problems financing its budget deficit due to investment securities – at least up to now. The picture is changing due to its own goals involving sanctions.
Japan for example did not carry out some of the recommendations of the Shoup mission that would have led to capital decay, including taxes on bank saving deposits and tightening rules for stocks and reduced some from 1953 onwards.
While capital gains tax on stocks along with capital losses, are based on actual cash flows, Japan decided not to go down that path also.
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Instead of printing money via the Bank of Japan and injecting to businesses through the discount window which hits the exchange rate, equity allowed the yen to be kept at 360 to the US dollar with some hiccups from time to time.
The only way cut taxes is to cut expenditure
Any tax cuts will be cosmetic. There is no real lasting way to cut taxes, unless government spending is cut. They will boomerang at unsustainable debt a few years later.
The IMFâ€s revenue based fiscal consolidation is a bit silly.
Parkinsonâ€s Second Law (incomes will rise to meet expenditure) is as real as the examples in his book relating to government spending ((Parkinsonâ€s Law and Other Studies in Administration).
The fuel subsidies for millionaire multi-day boat owners, the fertilizer subsidies for farmers (who get import protection to keep rice prices 200 dollars a tonne above the rest of the world) announced by the last president and carried out by the current one is a case in point.
President Anura Dissanayake in his last campaign rally however said subsidies should not be permanent.
Commodity subsidies are usually given (as are price controls imposed) because the central bank prints money (either the Fed or CBSL or both) and pushes up commodity prices including through depreciation.
From the 1960s as the Fed got more activist with macro-economists claiming there was a trade-off between inflation and employment, subsidies and what are quaintly called ‘administered prices†proliferated around the world. Foreign petroleum companies were also nationalized.
Sri Lanka has had monetary and budget troubles even when revenues were 23 percent of GDP in the 1960s, 1970s and 1980s.
Classical economist B R Shenoy in 1966 warned Sri Lanka in a report to the government that raising revenues was only a ‘statistical method†of cutting deficits and expenditure had to be contained and the central bank operating framework changed.
There is not even a statistical link with revenues and deficits or debt to GDP ratio either in Sri Lanka.
The debt to GDP did not go up during the 1990s and was stable, despite a war and despite revenues falling as import duties were cut. Spending was contained and SOEs were reduced, until the 2000 currency crisis pushed up debt above 100 percent of GDP.
In the US, some of the money collected from IMF-style wealth and other taxes are spent on foreign wars and the military and not health, for which people have to pay insurance separately.
Having said that, income tax has the salutary benefit of making people feel the weight of government and increase the understanding of the weight of the state. However the rates must be low.
Instead of pushing up revenues to match state spending, the government must adjust to the ability of the people to pay taxes. In the long term the target should be to contain the government to 20 percent VAT and 20 percent income tax. Singapore has brought corporate income tax below 20 percent progressively.
Most East Asian nations with free trade and monetary stability operate on 15 percent (or less) VAT and 20 percent income tax.
Any tax changes could be made incremental, as revenues and debt improve. That will happen only if monetary stability is maintained. (Colombo/Nov19/2024)
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