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Insider dealing and corporate ethics
The Securities and Exchange Commission (SEC), the financial markets watchdog, must be commended for its bold and fearless action to investigate its own chairman, Michael Mack, in a case concerning transactions in shares of Aitken Spence. There cannot be a better demonstration of the independence of the watchdog than this investigation, which is certainly unprecedented in this market and probably elsewhere too also because of the alleged involvement of the chairman of the Colombo Stock Exchange.

Small investors, who have repeatedly complained about what they see as the SEC's seeming reluctance to take more stringent action against errant companies and their directors, would no doubt be encouraged by this move. The parties under investigation have maintained that they are not guilty of any wrongdoing. They are deemed innocent until proved guilty.

But this investigation, as we report elsewhere in this newspaper, raises a host of issues about the conflict of interest in having businessmen with their own private business interests serving in such a sensitive watchdog body. A question that is being asked by the investing public is why those officials in the regulatory body who are under investigation have not resigned until their names are cleared. After all, justice must not only be done but be seen to be done. A good example in the public sector is that of Thilan Wijesinghe, the former head of the Board of Investment who resigned when he was being investigated by the Bribery Commission.

It may be necessary to appoint private sector people to the SEC given the need for their skills in promoting the stock market. But shouldn't there be a better mechanism to avoid conflicts of interest that are bound to arise when leading businessmen with interests in many companies through interlocking directorates hold sensitive positions in regulatory organisations? According to the SEC Act no employee of the Commission, including the director-general, can engage in share transactions while employed by the SEC. But this restriction does not apply to the SEC chairman or other Commissioners. Perhaps it is time to extend it to them as well.

The decision of the Commission to review the advice of the Attorney-General's Department is also unusual and has given rise to speculation of a possible attempt to sweep the whole affair under the carpet. The SEC's statement that the investigation is being considered "with the utmost seriousness" is certainly encouraging but it would have been more so had the announcement been made earlier.

The media has a duty to report both the good news as well as the bad. A free market economy cannot thrive without a free media and a critical and watchful financial news media - which must provide the investing public the information they require to make informed decisions about where and how to invest their money.
In this context, the SEC's attitude towards divulging information about its investigations and its own internal operations seems archaic, and does nothing to enhance the public's confidence in it. True, the SEC may be prevented from divulging information about ongoing inquiries under its existing rules. Perhaps the rules should be changed to ensure the public gets the information it needs to gain confidence in the market.

What is most disturbing is that the SEC, at the behest of the Commissioners, actually launched an internal inquiry to see whether any of its officers had leaked information to the media. This in an era of so-called transparency and good governance when the trend, driven by corporate scandals in more mature markets, is towards more openness, not less. It even went to the extent of questioning journalists covering the story.

We reported the case, first because we believe the public has a right to know, especially the investing public who are being asked to take the risk of putting their money into stocks, and also because of the unprecedented nature of this inquiry. A scandal of this nature in the very organisation that is supposed to safeguard the interests of investors is bad for the market and could undermine the public's confidence in the system.

VAT and the retailer
(An assessment from a retailer's perspective!)
So VAT is finally coming to the retail and wholesale trade. And the threshold is only Rs. 150,000 per month or about Rs. 5,000 per day. This is not a high value. Most business establishments in the Greater Colombo area and in other small towns will easily exceed this threshold and so will be liable for VAT. This is an analysis of VAT from a retailer's perspective.

To start, let us take three imaginary businesses that are located side by side. Mr. P, Mr. F and Mr. S are the proprietors of these three businesses. All three deal in the same products - a mixture of garments, shoes, bags, umbrellas, plasticware, etc. Just like any of the thousands of shops that line any street in Sri Lanka. For the purpose of this story, let us further imagine that they each purchase goods for Rs. 300,000 per month and adding 30 percent to their cost price sell these goods for Rs 390,000 per month. These figures are not out of the top of a hat but is representative of the actual situation existing in this country.

Thus they each make a monthly gross profit of about Rs. 90,000 from which they pay their employees salaries, rent for the premises, phone bills, electricity bills, etc. The balance gives them an income with which they live a fairly comfortable life.

Come 1st of July 2003 and the extended VAT will become efective. For the purpose of this story, we are only going to look at VAT on the goods purchased and sold. Taking into account VAT on other inputs such as electricity, telephone, etc. will make only a marginal difference and for the sake of clarity, are ignored.

Honesty
Of the three proprietors, Mr. P is the most honest. He has been showing his turnover accurately in his accounts. He thus has to register for VAT and on his purchases of goods for Rs. 300,000 he gets a VAT credit of Rs. 50,000.

If he continues to sell his goods for Rs. 390,000 (without changing the selling price) he has to pay a VAT of Rs. 65,000. Thus taking into account the VAT credit of Rs. 50,000 he has to pay the balance of Rs 15,000. But now his gross profit does not continue to remain at Rs. 90,000. It drops to Rs. 75,000. He does a quick calculation and discovers that if he sells the same goods for Rs. 408,000 and pays the VAT on the new sale price, he continues to have the same gross profit of Rs. 90,000 per month.

Thus for him to continue earning the same amount, goods which earlier were sold at Rs. 390,000 now have to be sold at Rs. 408,000/-. That is an increase of Rs. 18,000 or 4.6 percent. So whatever your government might say about rapacious shopkeepers, the extended VAT is definitely going to increase prices for the consumers. This is the first point I would like to make.

The second shopkeeper, Mr. F is less honest. He shows only half of his turnover in his accounts. The turnover he shows is Rs. 195,000 per month and he also has to register for VAT. After Mr. P increases his prices, Mr. F realizes that he too can sell his goods for Rs. 408,000.

After doing the relevant calculations for Mr. F, we find that his gross profit (both in black and white) is now Rs. 99,000, an increase of Rs. 9,000. Thus the impact of VAT on dishonest Mr. F is to push up his earnings by an extra Rs. 9,000 or 10 percent per month. Mr. S is even less honest. He has been getting away by showing only 1/3 of his turnover or Rs. 130,000 per month. He thus have to register for VAT.

Tax evasion
Mr. S sees the opportunity to make a little more money. He decides to follows the example set by Mr. P and Mr. F and sells his goods at the higher post-VAT price. He continues to buy his goods for Rs. 300,000 but now sells them for Rs. 408,000. He thus makes an extra Rs. 18,000 or 20 percent more per month.

Thus we see that once the extended VAT regime is in place, the more a retailer evades reporting his actual turnover, the more he will make. VAT at the retail and wholesale level, it appears, has an in-built mechanism to encourage and reward the evader. This is the second point I would like to make. Now let us take our story a little more forward in time to October 2003. Here is a likely scenario:

The euphoria generated by the peace process has worn off. There is a lot of anger against the government because of the increase in prices. The government is scared that the president might use this as an excuse to dissolve parliament. The situation is uneasy and retail sales of all non-essentials have slumped.

Mr. S now decides to forego the extra margin, for as high as it might be, if he has no sales, he has no profit. So he decides to cut his prices back to the old pre-VAT level. But mind you, at this level he will still have his earlier gross profit of Rs. 90,000.

This is in no way a far-fetched scenario. The trader mentality in this country is such. When the going is good, the trader jacks up, and when the going is tough, he undercuts his competitors. And this is exactly what our Mr. S is going to do.
Being located adjacent to each other, Mr. F and Mr. P have no choice but to follow suit.

So they too cut their prices to the pre-VAT levels. But now unlike Mr. S, Mr. F is earning Rs. 9,000 less than before and Mr. P, Rs. 18,000 less than before.
This hits Mr. P very hard. His own personal expenses have increased with the new extended VAT regime. And now his earnings are also down. He has got to somehow make his living from his business. And so what do you think he is going to do?
The easiest option open to him is to start under reporting his sales and evading taxes.

Thus we see that,
a) under reporting sales is common,
b) the mechanism to enforce VAT weak, and
c) the VAT rate high (as is the case in Sri Lanka).
Then the extended VAT regime will give a big competitive advantage to the evader. The uneven playing field that results may even force the honest retailer to start evading taxes in order to survive.
This is the third point I would like to make.

One of the cardinal rules of tax administration is that if enforcement of a tax is going to be difficult and hence unequal, then the impact of the tax should be as light as possible. The current BTT regime (with BTT at 1 percent) meets this requirement. VAT at 20 percent is going to violate this outright. I cannot foresee a situation where VAT inspectors are stationed in each and every sales point in the country to see that all sales are invoiced and then reported accurately. It is physically impossible. Nor is it possible to track it from the supplier invoices. The volume of data will be huge. Payment by cash or 3rd party cheques will further obscure the trail.

Lessons from the past
My father has been a keen observer of the business environment over the decades. He has an interesting tale about BTT. He tells me that BTT was first introduced at 1/4 percent. It was subsequently raised in steps to 0.5 percent, 1 percent, 2 percent and finally to 4 percent. When it was at the lower levels, evasion was not rampant. However, when it went to 2 percent and then to 4 percent, the revenue growth was not commensurate. Revenue picked up initially but then it declined as more and more people learned to evade. Finally sense prevailed and it was reduced to 1 percent by one of Mr. Choksy's predecessors in the post-1977 UNP era.

Why do we choose to ignore the lessons of the past? VAT at 20 percent on wholesale and retail will definitely bring about a whole new generation of tax evaders.
Now we bring a small cottage industry to the picture.

Dayawathie had once worked in a garment factory as a Juki operator. In her spare time she learnt a little about cutting garments. After the birth of her child she decided to give up her job and sew clothes from home. She buys fabrics, which she and her sister sew into garments. These are then sold to Mr. P and Mr. S. This arrangement functioned smoothly for several years. But after July 2003, Mr. P finds that it was no longer feasible to buy goods from her for resale.

This was because, as Dayawathi was not VAT registered, he could not claim input credit on the goods she sold him. So he would have to sell these garments at a full 20 percent more than he would have earlier in order to pay the VAT. On the other hand when Dayawathi sells to Mr. S (who was not VAT registered) there was no such problem. He could still sell at the old price. Thus the introduction of VAT discourages retailers like Mr. P from dealing with the products of the cottage sector. And the other side of the coin is that it reduces the marketing avenues for people like Dayawathi. Then there is a further implication that arises when Mr. P buys garments from Dayawathi for resale.

Dayawathi's tale
Remember that Dayawathi has paid VAT when she bought her inputs (the fabric, thread, electricity, etc). And without this being claimed, VAT is being paid once again on the full selling price of her garment. This leads to an effective rate of more than 20 percent.

Thus when Mr. P sells the product of a multinational manufacturer the government gets a 20 percent tax of the retail price, but when he sells the products of the cottage industry the tax is more than 20 percent. Irony indeed! The multinationals and large businesses have their lobbies and trade chambers to look after their interests. Poor Dayawathi on the other hand has no choice, she has to put up and shut up.

The solution for this, you might say, is for Dayawathi to register for VAT. But can you imagine the poor uneducated Dayawathi battling the bureaucrats and doing the paperwork that VAT will entail?

The government has for years being trying to promote self-employment and to develop the cottage sector. For instance, Janasaviya was directed towards this end. When GST was brought in, the self-employed and the cottage sector were badly affected. GST registered businesses would avoid buying from small non-registered businesses because of the lack of input credit. For example, using the services of a small printing press or an auto garage. This reduced the demand for their services. Now the self-employed and cottage industry sector is going to get hit once again.
The first impact will come from the fact that the VAT registered retailer would not like to use the products and services of the cottage sector because of the lack of input credit. The second and larger impact will come because the VAT registered retailer cannot now market the products of the cottage sector because of the lack of this input credit.

Cottage industry
This is very unfortunate as it reduces the avenues for the marketing of the products of the small-scale sector. Also, the larger retailer is in a better position to help the small manufacturer. He can provide credit and is also in a position to give orders through slack periods to build up stocks for peak periods. But this new VAT regime puts an end to all this. It sets up a tax barrier for the VAT registered retailer in dealing with the products of the cottage sector.

Thus we see that VAT works contrary to the government's aim of promoting and developing self-employment and the cottage sector. This is the fourth point I would like to make.

I am aware that that VAT came in on the insistence of the IMF. I am also aware that the IMF is pushing the government to control its expenditure and reduce the budget deficit. But the government is unable to control its expenditure.
So the end result of these two forces is VAT at 20 percent - a very high rate for a developing country like Sri Lanka. And a rate that is unenforceable at the retail and wholesale level.

This country has seen many governments. Some of these governments believed in socialism and others believed in capitalism- but the "ism" they all practiced is "adhoc-ism".

We saw this even in Mr. Choksy's last budget. Where "strange" new taxes were introduced and some tax benefits given earlier were withdrawn retroactively.
I end with a word of advice to the Government.
Look before you leap!
Think 10 times and be at least 5 steps ahead before you act!
(See related story)

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