ECONOMYNEXT – Import duties on finished vehicles brought to Sri Lanka, apparently as part of a balance of payments measure, has triggered fears of an expansion of a brand new rent seeking business sector and tax losses, though its extent is unclear as yet.
Sri Lanka imposed a 30 percent tax on vehicles this year over fears that car imports may lead to loss of reserves or hurt the exchange rate or foreign reserves.
It is not known why macro-economists believe car imports should hurt the exchange rate more than some other type of import, but such Mercantilist doctrines have driven Sri Lanka’s policy for many decades, with oil and gold also being targets of such beliefs at different times, analysts have pointed out.
“The introduction of an import duty will help moderate the impact on the exchange rate,” according to documents released on policy discussions with the International Monetary Fund.
Sri Lanka now has a large number of sectors where domestic producers are selling goods at high prices under cover of import duties gauging the public, arbitraging the tax difference as profits.
Vehicles were earlier taxed through value added and excise taxes, which are neutral between imports and domestic production, and do not involve arbitraged tax losses to the state, which people effectively pay through higher than world prices.
“Is there some import substitution? I can’t answer that,” IMF’s outgoing Senior Mission Chief for Sri Lanka Peter Breuer said in a recent press briefing in response to a question on whether domestic assembly would increase after import duties, and whether a ‘tax expenditure’ statement would be published on arbitraged taxes lost to the state.
“I would assume that after five years or so of a ban of imported cars that there will be some demand for finished cars from overseas.
“I do take your point that it’s possible that there may be some assembly of cars domestically.”
Analysts have pointed out using economics (then called political economy) as developed by classicals including David Ricardo, Adam Smith and David Hume that exchange rate pressure or reserve losses can only come from money printed by a note-issue bank to cut rates for refinance credit.
Unsterilized liquidity from central bank swaps with domestic counter parties can also lead to net reserve losses if newly issued money is used by banks to re-finance credit and is redeemed through forex interventions.
Extreme Mercantilism
Sri Lanka’s macroeconomists banned 3,000 imports including cars in 2020 after printing vast amounts of money to cut rates to target potential output. The complete bans also failed to stop either forex shortages or reserve losses.
Sri Lanka went on an accelerated ‘de-liberalization’ with import duties and import cesses, following a landmark gazette issued in November 2024 designed by macroeconomists who were running the Treasury, for ‘balance of payments’ purposes.
The sweeping trade restrictions came after money printed to mis-targeted rates in 2004 (mostly gilt yields) triggered forex shortages and reserve losses amid a strong private credit recovery.
Ironically, the 25-page gazette was signed by then President Chandrika Kumaratunga, who as Finance Minister had initiated sweeping trade liberalization in the 1990s and started valued added tax, advised by A S Jayewardene, an LSE educated classical economist.
“…[D]eparting from the previous liberalization path, the Sri Lankan government imposed a new import tax on selected items by way of a levy (referred to as a “cess” in Sri Lanka) in light of a decline in foreign reserves,” a report by the US Trade Representative noted sometime after the gazette.
“The government also hopes this new tax will protect domestic agriculture and industry. Despite an improvement in the foreign reserve position, the government has not revoked the tax.”
“Together with import tariffs, the EDB levy effectively increases charges on most finished good imports to over 48 percent of the import value, with the highest charges on goods subject to specific duties.”
“The United States Embassy has received complaints from affected U.S. exporters and US companies in Sri Lanka regarding the new “prohibitive” tariff regime.”
Barely two years earlier the US Trade report had noted as follows.
“Sri Lanka has one of the most liberal trade regimes in South Asia. Sri Lanka’s main trade policy instrument is the import tariff.
“A few years ago, Sri Lanka set out to have a simplified transparent two band tariff system.
“The country has deviated from this policy recently and the tariff structure is now subject to an increasing number of changes. Currently, there are 6 tariff bands of 2.5percent, 5 percent,10 percent, 15 percent, 20 percent and 25 percent.”
In subsequent years, Cess and other taxes rose dramatically in Sri Lanka with politically connected rent seeking businesses who were not export competitive pushing for greater protection through a variety of border taxes, including in basic cereals, maize and tinned fish despite malnutrition of young children.
(Colombo/Mar15/2025)
