Financial Times

Massive Rs 257 bln state revenue loss in tax breaks
Sri Lanka is estimated to have forgone a massive Rs. 257 billion in state revenue owing to numerous corporate tax and customs duty exemptions given to investors since the economy was opened up in the late 1970s, the Board of Investment chairman Saliya Wickramasuriya said.

This indicates a cost of some Rs 233,000 per employment opportunity, he said giving a cost-benefit analysis of investment while delivering the annual oration on taxation organized by the faculty of taxation of the Institute of Chartered Accountants of Sri Lanka recently.

The true total cost can be much higher since the apparent total cost of incentives, Rs 257 billion, assumes no tax evasion or leakage. "We all know that this is hardly the case. I therefore appeal to the financial community to be vigilant and take action." It is widely acknowledged that much of the local investment would have taken place without tax incentives in place.

"This simply means that we have rewarded investors at cost to state, and unconfirmed benefit to the end-users," Wickramasuriya said. "To make matters worse, the qualifying companies were typically larger organizations, and the benefits denied the smaller players allowed them to grow even more. An unnatural state of affairs in a nation where more than half of its GDP comes from more than 125,000 small and medium enterprises."

The BOI currently has 1,695 commercially active projects, exporting nearly US$2.5 billion a year, amounting to just over half of Sri Lanka's exports, and providing employment for 434,000 direct, and 651,000 indirect workers. Cumulative exports from 1978 to 2003 amount to Rs 2.25 trillion, in order to do which Rs 1.67 trillion worth of capital goods and raw material were imported, Wickramasuriya said.

The cumulative FDI realized to effect the above business is Rs 186 billion equivalent, which when combined with Rs 91 billion of local investment, totals Rs 277 billion. "We have analyzed the structure of our current tax incentives and found them to be wanting in both the areas of local investment promotion and FDI quality," Wickramasuriya said. "We have realized that the revenue losses to state they cause may be unsustainable for long-term economic growth, and have recognized the need to revise both the type and application of tax incentives offered if we are to achieve our development goals."

A regional comparison of economies in terms of their corporate income tax regime, revenue collection, and attracted investment shows that Sri Lanka is the worst performer by a good margin in terms of both revenue to GDP and efficiency ratio (defined as revenue to GDP divided by the standard tax rate, expressed as a percentage).

The countries sampled include Sri Lanka, Singapore, India, Indonesia, Malaysia, Philippines, Thailand and Vietnam. "The above discussion leads us to the clear conclusion that the general fiscal incentive regime Sri Lanka has practiced over the years may not have been in our best long-term interests," Wickramasuriya said. "We therefore need to use the benefit of hindsight to make the necessary rationalization."

Much study has been done to recommend different methods of tax incentives other than straight corporate income tax holidays and blanket duty exemption, and these should be evaluated carefully for the correct mix, possibly on a time variant sector-by-sector basis, he said.

Wickramasuriya also said Sri Lanka could consider "tax shifting" - lowering income taxes while raising taxes on environmentally or socially destructive activities. "This forces the market to tell the truth, and reflects the indirect cost to society of an economic activity," he said. "For example, a tax on coal would incorporate the increased healthcare costs associated with breathing polluted air, the costs of damage from acid rain, and the costs of climate disruption and ground water pollution."

Environmental tax reform is spreading, along with other forms of tax like congestion tax, Wickramasuriya said. "Introduced effectively by Singapore decades ago, London implemented it in early 2003. Since then, traffic in the city has been reduced by 24 percent, permitting freer flow, less pollution, and more revenue from public transportation mechanisms."

Other forms of such taxes include a stumpage tax in Bulgaria and Lithuania where anyone wishing to cut a tree would have to pay a tax equal to the value of services provided by the tree. "This will force the market to decide, as forest services may be worth many times more than the timber or pulp, which will in turn encourage wood and paper recycling."

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