Undeclared wealth and banking secrecy
The raid by the Criminal Investigations Department on a bank safety deposit locker maintained by former deputy defence minister Anuruddha Ratwatte and the discovery of Rs 43 million in certificates of deposits raises a host of issues about undeclared wealth and banking secrecy. It also raises interesting questions about how many other public figures - politicians, businessmen, and military officers - would have such undeclared wealth hidden from public view.

Ratwatte, the People's Alliance strongman, ran the war machine at a time when there were widespread allegations of corruption, kickbacks and commissions and the purchase of useless weapons and equipment. As a public figure, Ratwatte certainly owes an explanation as to how he came to be in possession of such a huge amount of money stashed away in a secret bank vault, if only to clear his name. Obviously he could not have acquired such wealth on his income as a Member of Parliament and a cabinet minister.

Depositors now would have legitimate concerns about the confidentiality of their transactions, although, as commercial bank officials point out, those who abide by the law would naturally have no need to fear.

And commercial banks now would naturally be worried that the CID raid on Ratwatte's vault and the blaze of publicity that accompanied it - the media were obviously tipped off in advance - would spoil their business if it makes people reluctant to rent safety deposit lockers.

However, there are exemptions to the confidentiality provisions of the banking secrecy laws. Under Section 77 of the Banking Act commercial banks have to divulge information about their customers if a court orders them to do so. And the public which deposits money with banks are expected to be aware of the law.

Commercial banks and other financial institutions that accept money from the public have an obligation to report suspicious transactions, even if only a moral one at the moment, if the laws that would compel them to do so are still not in place. The guidelines issued by the Bank Supervision Department of the Central Bank also require commercial banks to "know your customer" and report any transactions or deposits whose legitimacy they may have reason to suspect.

Under the present banking regulations, even the banks do not know the contents of the vaults they rent to customers. Customers are not required to tell the bank what is in their vaults. One key to the vault is with the bank and the other with the depositor. Both are required to open the locker. The bank does not have a spare key and in the event a key is lost the manufacturer of the safe would have to be called in to open it.

Certificates of deposits were originally issued as a means of drawing in black money. Banks were allowed to issue CDs where the anonymity of the depositor is maintained. CDs can be transferred to another party just like currency. So far there has been no requirement to declare the ownership of CDs but this might change under the anti-money laundering laws that are being contemplated. The anti-money laundering initiative now gathering pace is a global one, especially with international concerns about terrorist groups and their funds. It is an issue that is very much in the spotlight today.

Under the anti-money laundering law that is in the offing, commercial banks would have to ensure that the money they accept is legitimate and would have to report to the regulatory authorities any transactions that raise suspicion.

It is believed that all the exertions and fuss about Ratwatte's stash of CDs may come to naught if he makes a disclosure under the tax amnesty that is now in force. As our story on the previous page says, the amnesty was declared by a cash-strapped government in its maiden budget in an obviously desperate effort to draw in the billions of rupees believed to be floating in the black economy.

It is true the government is in need of funds, that it is staggering under an unbearable debt burden, and needs to urgently revive economic growth if we are not to witness another social explosion of the type that has rocked this island more than once in the past 30 years.

But allowing those with ill-gotten gains to get away scot-free with their crimes is certainly not the right signal to send to foreign investors or a public that has seen a surfeit of corruption scandals with hardly anyone being brought to book. It does no good to the image of the country which could be lumped together with those other nations that have acquired a dubious reputation as being havens for tax dodgers and assorted criminals.

It remains to be seen how successful this amnesty is - previous ones have not been too successful. Black money is usually known to be spent on consumption, and rarely goes into productive investment. The huge expansion in the black economy in recent years - acknowledged by no less a person than the deputy finance minister himself and by the former head of the Treasury - has resulted in a big increase in money supply and helped fuel inflation.

Understanding the Value Added Tax
By P. Guruge, Tax Consultant to the Finance Ministry
The Value Added Tax (VAT) is a tax on value addition in the process of supplying goods and services. Certain goods may be basic products while others may have been processed further before reaching the final stage. The import of goods is also considered as a component of value addition. Such goods may be supplied without further processing or may be used as raw materials or semi-manufactured items which may be processed further. In the case of services it may be difficult to identify such different stages of processing.

The basic feature of any VAT, which is considered as a tax on consumption, is the provision to leave out consumption outside the country. In such a situation the export of goods or services will not be subjected to any tax. Its main feature is to tax imports and to exempt exports. This is called the destination principle. In many cases the exemption of exports is effected through zero-rating. There can be other variations as well. A country may tax exports and exempt imports. This is called the origin principle. In such a situation the tax will fall on the production and not on the consumption.

The value addition may be computed by using the "addition" method or the "subtraction" method. The addition method equals the sum total of factor income. The subtraction method can be divided into two sub categories:

(a) Value subtraction
In this case the value of purchases is deducted from the value of sales and the tax rate is applied to the balance. This requires completed accounts on sales and purchases. This method is used in Japan to calculate the tax.

(b) Tax subtraction or tax credit method

In this case the tax on purchases is deducted from the tax on sales. Sometimes this method is called "invoice" method since the invoices are used as base documents. Many countries use this method of calculation.

The treatment of capital goods is also an important aspect of this calculation. If a "consumption type tax" is to be implemented the tax on capital goods should be eliminated. This is done by giving full tax credit for capital goods. However, such credit may be limited to the amount depreciated each year. In such situations the tax credit on capital goods will be distributed over a number of years. This method is called "income" type tax. If no deduction is allowed on capital goods such tax is called a "gross product" type tax.

Now let us consider a particular model and examine how it works.

Destination principle, tax credit or invoice method, consumption type:

Since the tax will fall
only on local consumption, the goods/services consumed outside the country will be zero-rated. Since it is a consumption type tax full credit will be allowed on all capital goods. The tax on value addition will be ascertained by using tax invoices. This is the most important document in the calculation of tax. Each person who supplies goods and services will issue invoices showing the value of supply and the tax due on such supply. If you take a particular supplier the position may be summarised as follows:

These purchases may be capital goods or non-capital goods. If 1,000,000 of supplies are exports then the tax on such amount will be zero and in such a situation the value-added tax will be only 100,000. This will clearly show that exports or zero-rated supplies will not contribute anything towards the value-added tax.

In practice due to various reasons no country collects VAT on the total value addition. Due to administrative, social or economic reasons a portion of value addition may be exempted.

This can happen as a threshold exemption where the suppliers below such limit need not account for VAT or as specific exemption where certain goods and services have been exempted. In Sri Lanka in addition to both these exemptions a portion of wholesale/retail (local buying and selling) has been excluded from the tax base.

Now let us briefly consider a few other consumption or manufacturing taxes and compare them with a VAT.

(a) Manufacturer's sales tax: Here the tax base is the ex-factory price of the manufacturer and the wholesale and retail margins will escape taxation. Further, it is difficult to distinguish between the intermediate consumption and final consumption.
(b) Wholesaler's sales tax: Here the tax base includes the wholesaler's margin as well but still the retailer's margin is not captured. In addition to the difficulty with regard to the intermediate and final consumption the identification of pure wholesale may also be problem.

(c) Retailer's sale tax: Here the tax base is somewhat closer to a VAT base. However, the main difficulty in this type is the administration. It is very difficult to administer a large number of small retailers and as a result tax evasion and revenue leaks will take place. The identification of intermediate and final consumption may also be a problem.

(d) Turnover Tax: This is the tax adopted by many countries before they introduced a VAT. The main problem of the turnover tax is the "cascading effect" or the imposition of tax on tax. This tax gave much needed revenue for many countries including Sri Lanka but the cascading effect was a great threat to the economic development.
Implemented all over

Today there are about
120 big and small countries around the world implementing VAT successfully. The other important point is that only five countries have abolished this tax. Out of them three countries have re-introduced it with modifications. In recent times the IMF has also been instrumental in propagating VAT. In many structural adjustment programmes, they insist on the introduction of a VAT.

Then certain other countries that discussed the introduction of VAT have not done so up to now. In USA there was a big debate on this. In India they have introduced so called "MOD-VAT" which is really not a VAT. I think the main problem in the implementation of a VAT in these countries is their federal structure. In a federal structure it is very difficult to harmonise the taxes between states and the centre. There should be an acceptable arrangement of "fiscal federalism". I think this has been achieved to a certain extent in Canada where they have sorted out problems between the states and the centre satisfactorily.

Main Features of VAT
The value addition is
calculated through an indirect method by using "output tax" and "input tax". Output tax is the tax chargeable on the supplies made. Input tax is the tax paid by the supplier on the acquisition of goods and services to make such supplies. The difference between these two amounts is the tax on value addition. Therefore, the correct calculation of output tax and input tax is crucial for the VAT system. As explained earlier if the credit system is adopted the calculation of output tax and input tax will be done on the basis of relevant invoices. That's why the tax invoice has become so important in this method of taxation.

Another important aspect is the coverage and the appropriate rates of tax. Nowhere in the world has the total consumption expenditure been covered under VAT. It is practically impossible. However, many countries have reached nearly 80 percent of the private consumption expenditure under their VATs. The limitation on the coverage will depend on the level of threshold exemption, other specific exemptions and exclusions and probably on the level of evasion.

The appropriate rate or rates will depend onthe coverage and the revenue requirements. We have decided to apply two rates. The 10 percent rate will be applied to certain goods and services where the base may be 1/5 of the total coverage. The balance 4/5 of the coverage will be at the 20 percent rate.

Social reasons
Then, it will be impor
tant to determine the number of rates. Some favour multiple rates for social reasons. Multiple rates will not only complicate the tax administration but also make tax compliance difficult. Therefore, the best system may be a single rate system and if necessary two rates. Social concerns may be addressed outside the VAT system. Today 63 countries have got single rate systems and 26 countries two rates.

Many countries try to maintain the status quo that prevailed before the VAT by adopting multiple rates and a large number of exemptions. However, many countries, especially European countries have realised that by having multiple rates and more exemptions they have not achieved the expected results but their VAT systems have become complicated. Many countries that adopted VAT in the recent past have opted for a single rate most probably due to the experiences of the countries having multiple rates.

Another important feature in any VAT system is the exemptions and zero ratings. The UK has adopted both exemptions and zero ratings for local consumption. But many countries zero-rate only the consumption outside the country.

The idea of zero rating is to provide the goods and services entirely free of tax. When the local consumption is also zero-rated it goes against the basic principle of consumption tax. It should be a tax on the consumption of goods and services within the country. Therefore, any zero rating should be limited to the consumption outside the country.

Tax-free
On the other hand the
exemption will not entirely provide tax-free goods as believed by many. Depending on the nature of exemption a certain amount of tax will be included in the final price of such goods or services. That's why it is said, "exemption means a lower rate of tax". Therefore, the goods/services to be exempted should be selected very carefully. As far as possible the exemption should be granted to the final consumer items. If the exemption is given to intermediate goods/services while the final supply is liable to tax, it may create a "cascading" effect and as a result there may be a price increase.

Finally, I wish to touch on two other important aspects of a VAT. No taxpayer likes to pay tax. But some taxpayers do not mind paying VAT. Businessmen prefer a VAT to the other taxes. That is because VAT does not impose any additional burden on businesses if they can claim all their input taxes. Although they may incur some cost on compliance in many cases they enjoy a hidden cash flow benefit as well.

The tax administration will also find the VAT is easier to administer than most other taxes. However, this will also depend on the systems and procedures adopted. The so-called "self policing" nature of a VAT will help the tax administration to a great extent.

Issues
A key concern about
VAT is its regressive nature. Whether the VAT is regressive has to be examined in the context of the overall fiscal regime. This question should not be answered by considering only the VAT. If you consider only the VAT, naturally it would look regressive in relation to the income of the people. Since the same tax rate may be applied to all goods and services an element of regression can be seen when one compares the tax with the income of the consumers. That means those with lower incomes may be paying more tax as a percentage of income than those with higher incomes.

However, the VAT may be less regressive than other consumption taxes such as excise duties and turnover taxes. It may be appropriate to quote from the Taxation Commission Report -1990.

"There is no conclusive evidence showing regressive incidence in the overall tax system, except perhaps in the area of specific indirect taxes such as excise duties.
The overall fiscal incidence tends to produce progressive results in the Sri Lankan context, particularly due to large current transfers including subsidies to low income groups".

That was the situation under more regressive indirect taxes.

Inflationary
The next issue is
whether the VAT is inflationary. Since the VAT in Sri Lanka will replace the existing GST and NSL in a revenue neutral manner the inflationary impact may not be there. There may be a change in relative prices but not in the overall price level. The experience of countries that introduced VAT to replace more regressive consumption taxes has indicated that no considerable increase in price levels had taken place. However, certain countries such as France, Korea, the Netherlands and Norway adopted price controls for short periods while certain other countries entered into agreements with major producers and dealers to avoid unnecessary price increases.

Another general issue raised by many countries was whether the VAT will become a money machine? (However, in Sri Lanka we may not worry about this) Since the VAT will generate a steady flow of revenue for any government it is assumed that a VAT will create strong governments with a wide area of control. Average revenue yield is 25 percent of total tax revenue and over five percent of GDP.

A major issue is the exclusion of wholesale/retail activities from the VAT. In fact this exclusion is limited to the local buying and selling of goods. This has affected the smooth implementation of a comprehensive VAT.

Another major issue has arisen as a result of invoicing requirements. The law has stipulated two distinct invoices. One to the VAT registered persons and the other to the normal consumers. Many registered persons have expressed their inability to comply with these requirements. Even if they comply with these requirements huge additional costs have to be incurred to change the operating systems.

Then, there was some criticism about the level of lower and higher rate (i.e. 10 percent and 20 percent). Since the gap is fairly wide there may be problems in administra tion. Many suppliers will try to get the lower rate instead of the higher rate. The administration will face "border disputes" due to this situation.

Although a considerable reduction has been effected in the area of exemptions still a considerable portion of private consumption comes under exemptions. This will create problems for policy makers, since the underlying assumptions may not be that clear. If the exemptions can be further reduced, then the VAT rates can be lowered. Further, the complete elimination of the cascading effect may not be achieved with such exemptions in the system.

The last issue may be the effect of the VAT on the consumer. This is a very complicated issue. It may not be possible to make a decision by just looking at the previous and current tax rates of a particular item. Consumer prices will depend entirely on the actions of producers and suppliers of taxable goods and services. Business culture will also play a vital role in this respect. If they decided to make hay while the sun shines then the expected benefits may not be passed down to the consumers. It should not be forgotten that a cascading tax - i.e. NSL would be abolished. This should reduce production and supply costs of many producers and suppliers. This change should be taken into consideration in reviewing their cost structures. When the overall impact of the change is considered it should be a consumer friendly change as well.

Finally, let us remember that no tax is perfect.

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