This Selected Issues paper focuses on the fiscal position of Sri Lanka. The standard analysis shows that, prior to the adjustment announced in the 2002 budget, fiscal policy was clearly unsustainable, leading to a rising debt-to-GDP ratio. The paper looks at external debt and complements the analysis of the public debt dynamics. The baseline scenario shows that debt ratios decline significantly in the medium term, as a result of strong growth founded on renewed peace and political stability, far-reaching structural reforms, and stable macroeconomic conditions.

Abstract

This Selected Issues paper focuses on the fiscal position of Sri Lanka. The standard analysis shows that, prior to the adjustment announced in the 2002 budget, fiscal policy was clearly unsustainable, leading to a rising debt-to-GDP ratio. The paper looks at external debt and complements the analysis of the public debt dynamics. The baseline scenario shows that debt ratios decline significantly in the medium term, as a result of strong growth founded on renewed peace and political stability, far-reaching structural reforms, and stable macroeconomic conditions.

V. Tax Policy Developments, 200238

1. The government embarked on a major reform of tax policy in 2002, aimed at making the tax system simpler and more transparent. Prior to this, the tax system was becoming increasingly complex: the authorities yielded persistently to pressure for exemptions and resorted to ad hoc initiatives, an ever narrower tax base, and an array of different taxes, often on the same transaction. Consequently, tax administration became increasingly difficult. These developments led the revenue-GDP ratio to decline by 4 percentage points between 1995-2001. The new government recognized that urgent tax reform was needed. Most of the reforms announced in the budget (March 22, 2002) are consistent with the recommendations of a November 2001 FAD technical assistance report.

A. Value Added Tax

2. Before the recent reform, Sri Lanka operated parallel taxes on goods and services. The Goods and Services Tax (GST), was a tax on value added. Its single rate was 12½ percent, although its efficiency was hampered by wide-ranging exemptions. The National Security Levy (NSL) was a cascading turnover tax, with a 6½ percent rate including a 25 percent markup for imports. It had a wide base with few exemptions.

3. The government announced that these two taxes would be eliminated, and replaced by a dual rate VAT. There would be two rates: 20 percent and 10 percent, with the lower rate designed to cover those goods and services which had been subject to NSL, but exempt from GST. This category includes petroleum products, electricity exceeding 30 kwh, fertilizer, water, and most basic foodstuffs (including coconut poonac, tea, spices, eggs, coconut oil, potatoes, onions, chilies, lentils, powdered and condensed milk, dried fish, Maldives fish, and sugar).39 The exempt category would still include a number of basic food items-unprocessed agricultural goods, unprocessed farm or poultry products, desiccated coconuts, rice, rice flour, wheat, wheat flour, bread, liquid milk, and infants milk powder-as well as crude petroleum, kerosene, financial services, public transportation, electricity below 30 kwh, gems, health services, and medical equipment.40 The budget speech also announced the intention of the authorities to extend the VAT to the retail sector in 2003. Based on a June 1 introduction, the authorities anticipated a small (Rs 3.5 billion) revenue gain from replacing with GST and NSL with the VAT. The aim of the reform was not to raise significantly more revenue, but to simplify the tax system and broaden the VAT base.

4. The VAT was not introduced as planned on June 1, 2002. The authorities decided to wait until July, so as not to burden taxpayers and the tax administration with both GST and VAT quarterly returns. The introduction was postponed further, as a consumer group issued a court challenge to the new tax. After minor modifications to the law, the VAT was introduced on August 1. The two month delayed led to an estimated revenue loss of Rs 1 billion.

5. The authorities also made some changes to the schedules. A number of goods-eggs; pharmaceutical products; spices; bunker and aviation fuel; and agricultural tractors and equipment-were removed from the 10 percent schedule to the exempt schedule. Another group of goods had their rate lowered from 20 percent to 10 percent; these include motor bikes and bicycles, poultry feed and prawn feed, unprocessed meat and chicken; CFL and solar batteries; professions and vacations; leasing; goods transport; LP gas; and agricultural tractors and equipment. The estimated loss from these additional changes is Rs 0.8 billion.

B. Individual Income Tax

6. The budget introduced a number of reforms aimed at simplifying the personal income tax system. The personal income tax bands were reduced from 4 to 3; the two middle bands of 15 percent and 25 percent were merged into a 20 percent band, while the upper and lower bands remain unchanged at 35 percent and 10 percent respectively. The tax exemption threshold was raised from Rs 144,000 to Rs 240,000. The tax threshold for retirement benefits was also raised; from Rs 500,000 to Rs 1,000,000. However, the government opted not to extend income taxation to civil servants, but left the option open for 2003. The medium-term strategy is to eliminate the top band and reduce the top personal tax rate to 20 percent by 2004. The Save the Nation Contribution, an income tax surcharge, was eliminated prior to the budget by the previous government, toward the end of 2001.

7. A number of other changes were made. For individuals, the 10 percent tax on interest earnings was made a final withholding tax. Similarly, individuals’ dividend income became subject to a 10 percent final withholding tax. A 10 percent withholding tax was also introduced on nonresidential rent above Rs 500,000 per year.

C. Corporate Income Tax

8. The budget also announced plans to simplify the corporate tax regime, based on a uniform low rate. The government eliminated the 20 percent corporate income tax surcharge and announced plans for a low general rate in the medium term. Specifically, the rate will be reduced from 35 percent to 30 percent in 2003, and again to 20 percent in 2004. Given that many enterprises enjoying tax holidays receive long–term concessional corporate tax rates upon expiration of the holiday, reducing the standard rate was seen as a way of to level the playing field. The 20 percent rate was introduced this year for companies with taxable income below Rs 5 million. The Advance Corporate Tax and the capital gains tax were also eliminated. The provisions allowing accelerated depreciation over two years were maintained, and reduced to one year for investment in information technology and software.

9. The budget proposed to rationalize, but not eliminate, tax incentives. While honoring all existing commitments, the government committed to grant no new exemptions under either the Board of Investment (BOI) or Inland Revenue department (IRD) regimes. There are two exceptions to this policy, however. First, limited incentives will be allowed for a number of sectors—including nontraditional exports, agriculture, information technology, electronics, industrial and machine tool manufacture, and food processing—as well as for “other designated enterprises” and investments in excess of Rs 500 million in specified industrial and agricultural services. These incentives will take the form of a three year tax holiday, a concessionary 10 percent rate for two years, followed by the standard 20 percent rate. Second, there will be 5-10 year tax holidays for “pioneering investment” in power generation, transmission and distribution and the development of highways, seaports and airports, railways and water services. These enterprises will be taxed at 15 percent upon expiration of the tax holiday.

D. Taxes on Financial Transactions

10. A debit tax was introduced to compensate for the loss of stamp duty revenue. The government abolished stamp duty-widely regarded as a nuisance tax-on April 30, 2002. A residual turnover tax on banking and finance was abolished by the previous government toward the end of 2001. To compensate for these changes, a debit tax was introduced on May 1, 2002, at a rate of 0.1 percent on debits including checks, credit cards, travelers’ checks, and bank debit transactions on accounts maintained with banks and other financial institutions. The authorities regard this as a transitional measure, designed to compensate for the loss of stamp duty and turnover tax on financial transactions.

E. Trade Taxes

11. A number of trade tax reforms were implemented. The budget announced the immediate halving of the import surcharge, from 40 percent to 20 percent, with a commitment to eliminate it entirely at the beginning of 2003. Partly to compensate for the loss of stamp duty on imports, a “Port and Airport Development Levy” was introduced at a general 1 percent rate, and a concessionary 0.75 percent rate for exporters. Part of the rationale for this levy was the need to bring BOI imports into the tax net. The budget also replaced a number of ad valorem duties and import licenses on certain agricultural imports- mainly rice, chilies, onions, potatoes and edible oil-with specific duties equivalent to a 60 percent tariff. The customs duty on maize and textile fabrics was eliminated. To facilitate trade policy reform, a permanent Tariff Commission was established. Duty reductions consistent with the Indo-Sri Lanka free trade agreement were also implemented.

F. Excise Taxes

12. Some rationalization of excise taxes took place. The collection of excises on beer and liquor was rationalized by unifying the excise rate and assigning responsibility to a single department. Prior to this, these goods were taxed separately by the Excise Department, and by the Excise (Special Provisions) unit of the Customs Department. The budget announced the elimination of the Excise (Special Provisions) 10 percent duty on beer, and 30 percent on liquor, while adjusting the excise duty on domestic liquor and the customs duty on imported liquor to ensure revenue-neutrality. The excise duty on wine was increased, as was the customs duty. A new excise was imposed on aerated water. To facilitate the automatic petroleum pricing formula, the excises on gasoline and diesel were transformed from ad valorem to specific duties before the budget, on February 1, 2002.

G. Other Tax Policy Changes

  • Annual levies of Rs 12 million and Rs ½ million, to be paid quarterly, were imposed on casinos and off-course betting, respectively.

  • With respect to importation of used vehicles, the depreciation was reduced by 2½ percent for cars more than 2½ years old, and other vehicles more than 4 years old.

  • All duties, surcharges, and levies on imports with a value of less than Rs 10,000 sent through parcel post were removed.

  • A tax amnesty was announced.

  • The Rs 20,000 resident visa tax was abolished.

  • Rent on government property was increased and all administrative fees and charges were raised by 15 percent.

  • A flat fee of Rs 25 per piece will be charged on garments sold in the local market.

  • The 100 percent transfer tax on the purchase of immovable property by nonresidents was abolished.

H. Tax Administration

13. The need to simplify tax administration underpins the government’s tax reform strategy. Some measures to improve tax administration directly were also announced. All of the administrative functions of the Large Taxpayers Unit (LTU) were placed under a single commissioner with responsibility for administering all taxes owed by large taxpayers. The Inland Revenue Department registered an additional 30,000 taxpayers over the past year. Moreover, efforts are underway to strengthen the LTU audit program and intensify the collection of tax arrears; all of this was recommended by the November 2001 FAD technical assistance report. On the customs front, the authorities intend to shift toward a system of pre-clearance based on risk analysis.

14. The linchpin of the government’s tax administration strategy is the creation of a single revenue authority, comprising the Inland Revenue department, the Customs department, the Excise department and the tax administration component of the BOI. A seven member Revenue Management Advisory Committee was established on May 21, with a mandate to advise on the steps needed to set up a revenue authority. The government intends to pass enabling legislation in August, so its initiation can be announced with the 2003 budget (scheduled for November 6, 2002). It has also advertised for a CEO, outside the civil service pay scales. An FAD mission visited Colombo in August 2002 to provide technical assistance on this issue. The AsDB has also pledged to provide $500,000, mainly in the form of consultants; it will work closely with FAD.

15. Following the creation of the revenue authority, the BOI can be turned into a pure investment promotion agency, without tax or customs functions. The main reason for the continued existence of the BOI, especially after its incentives granting powers are being curtailed, is the perceived inefficiency by investors of customs administration. The government views amalgamation of all tax administration entities-including the BOI-into a single unified revenue authority as a politically acceptable way out of this impasse.

ANNEX V.1 Tax Summary

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ANNEX V.2

Tax Incentives Under Inland Revenue Act

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Overview of Tax Incentives Under Section 17 of BOI Law 1/

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These rationalized BOI incentives will be administered under the Inland Revenue Act.

Statistical Appendix

Table 1.

Sri Lanka: Gross Domestic Product and Expenditure Components, 1996–2001 1/

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Sources: Data provided by the Sri Lankan authorities; and Fund staff estimates.

At market prices.

Includes changes in stocks and investment by public corporations not financed through the government budget.

Including statistical discrepancy.

New series of GDP estimates, with 1996 as the base year. Estimates for 1995 and before have not been compiled on the new basis.

Growth rates for 1995-96 are based on the accounts at 1982 constant prices. See SM/98/183 for details.

Table 2.

Sri Lanka: Saving, Investment, and Current Account, 1996-2001

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Sources: Data provided by the Sri Lankan authorities.

Total revenue minus current expenditure.

Includes investment by public corporations not financed through the government budget.

Includes net factor income and transfers from abroad.

Table 3.

Sri Lanka: Gross Domestic Product by Industrial Origin at Current Prices, 1996–2001

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Sources: Data provided by the Sri Lankan authorities; and Fund staff estimates.

Including forestry and fishing.

Tea, rubber, and coconuts.

Based on factor costs.

Table 4.

Sri Lanka: Gross Domestic Product by Industrial Origin at Constant Prices, 1996–2001 1/

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New series of GDP estimates, with 1996 as the base year. Estimates for 1995 and before have not been compiled on the new basis. Growth rates for 1995-96 are based on the accounts at 1982 constant prices. See SM/98/183 for details.

Including forestry and fishing.

Tea, rubber, and coconuts.

Table 5.

Sri Lanka: Trends in Principal Agricultural Crops, 1992-2001

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Sources: Sri Lanka Tea Board, Rubber Development Department, Coconut Development Authority, Department of Census and Statistics, Ministry of Agriculture, Paddy Marketing Board, National Fertiliser Secretarial, Plantation Companies, Central Bank of Sri Lanka.

Up to 1992, registered extent. Tea Commissioner’s Division (TCD) terminated the registration of new extents under tea from 1 January 1993. Data for 1993, are based on the Department of Census and Statistics Survey on Agricultural Crops and Livestock, 1993. Since 1994, data is based on a Tea and Land Survey conducted in 1994/1995 by the T.C.D (Excluding extents in abandoned tea lands). Extents in 1999 onwards, are revised based on the 1999 estate sector survey.

Since 1992, the weighted average cost of production of public sector estates and private plantation companies. Includes green leaf suppliers profit margin.

Three major coconut kernel products only.

On a cultivation year basis.

20.9 kg. of paddy =1 bushel of paddy.

Includes paddy purchased by the PMB above the guaranteed price in 1996.

Table 6.

Sri Lanka: Consumption and Prices of Petroleum and Electricity, 1996-2001

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Source: Data provided by the Sri Lanka authorities; Ceylon Petroleum Corporation; and Ceylon Electricity Board.

Including use for electricity generation.

End of period.

Price includes taxes.

Period average.

Unit cost of production including customs duty (all customs duties are charged to domestic sales), turnover taxes, and ail other expenses,

Basic rate on household consumption of electricity between 50 and 500 kilowatt hours per month, excluding fuel surcharge levied on all users of electricity exceeding 150 kwh per month, in SL Rs per Kwh.

Table 7.

Sri Lanka: Price Indicators, 1996-2002

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Source: Data provided by the Sri Lanka authorities.

Based on market prices.

Low-income housing is under rent control.

2002 data are for January-May.

Table 8.

Sri Lanka; Selected Wage and Employment Developments, 1996-2001

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Source: Data provided by the Sri Lanka authorities.

Weighted average nominal wage for workers covered by Wage Boards; weights are based on the number employed in each trade as of end-December 1978.

Average of initial salary grades for non-executive and minor employees, skilled and non-skilled; excludes school teachers.

Takes into account the changes since 1987 owing to the Government’s privatization program.

Includes employees of government ministries, school teachers, and defense personnel.

Includes universities, public corporations, boards, and state-owned banks.

The large increase in 1998 was partly due to the increase in coverage of female unpaid family workers in the agricultural sector. This is shown in the private sector ‘other’ category.

Table 9.

Sri Lanka: Labor Force, Employment, and Unemployment, 1996-2001 1/2/

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Source: Department of Census and Statistics, Labor Force Survey.

Annual data as of April, excluding northern and eastern provinces.

Less than General Certificate of Education (Ordinary Level).