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The sudden imposition of excise duties last week was not surprising. The deteriorating fiscal situation this year made such taxation measures inevitable. These unplanned and unimaginative excise duty hikes, together with the finance bills presented to parliament, were financial patchwork for the government’s fiscal survival. What is needed is not such unplanned taxation to tide over difficulties from time to time but a rational comprehensive taxation system that is capable of yielding higher tax revenues.

Taxation must garner about 14 to 15 percent of GDP in 2016 and increase progressively to reach 20 percent of GDP by 2020. Without such increases in revenue the government will not be able to reduce the threatening increasing debt and debt servicing costs. It will also not have the fiscal space to enhance expenditures on health and education as promised.

Impulsive taxation measures
Even with the crisis taxation measures and a curtailment of some current and capital expenditures, the fiscal deficit may turn out to be closer to 6 per cent of GDP than the anticipated 5 per cent for this year. The IMF pointed out recently that the fiscal target of 5 per cent of GDP this year was “highly optimistic”. The fiscal deficit must be brought down to below 5 per cent of GDP next year and gradually reduced thereafter. Otherwise the continuing large fiscal deficits would be required to be financed through further domestic and foreign borrowing that would increase debt servicing costs.

Serious thinking
There is a need for serious thinking and formulation of a comprehensive taxation system before the Budget for 2016 is presented on November 20th. The political gimmick of getting tax proposals from various interests are hardly likely to enhance the capacity of the Finance Ministry in its task of developing a comprehensive and systematic taxation system that enhances revenue. Most proposals are likely to seek relief and subsidies that aggravate the fiscal problem rather than resolve it.

Tax Commission Report
In the first instance it is essential to get the Presidential Tax Commission Report out into the open for discussion. A panel of tax experts, including former Commissioners and high officials of Inland Revenue, economists and past Treasury officials must be tasked to provide a taxation policy document with specific proposals. Unless such a serious effort is made to ensure that revenue is enhanced, an amateurish and politically popular budget would aggravate rather than alleviates the fiscal problem.

Strategy
The reduction of the large fiscal deficit requires a two pronged strategy of increasing revenue, on the one hand, and decreasing expenditure on the other. Both these are undoubtedly difficult to achieve in the current fiscal context but remains a fundamental requirement for economic stabilization and economic growth.

Government expenditure is difficult to contain owing to the large debt servicing costs; huge expenditure on public service salaries and pensions; big losses in public enterprises; a large built in defence expenditure; promises of higher expenditure on health and education and expenditure on subsidies and welfare. Many of these expenditures are committed expenditures that cannot be reduced.

Fiscal measures both in the Budget of 2015 and the interim budget of January 2015 increased expenditure. The only realistic large expenditure cut is the new government’s reduction of wasteful conspicuous state consumption that increased exponentially during the last regime. In order to make a dent in public expenditure, it is essential for the government to have a strong resolve to desist from imprudent expenditure for political advantages. Public money must be spent on the basis of national priorities.

In spite of the end of the war defence expenditure has increased. Military hardware expenditure could be brought down and fresh recruitment of personnel should be minimal. If the expenditure on defence can be brought down by even 1 percent of GDP, then its burden on the public finances could be eased significantly.

Losses incurred by public enterprises like the Ceylon Electricity Board (CEB), Ceylon Petroleum Corporation (CPC), the national airlines and other state enterprises must be reduced by enhancing their efficiency. Without reforming these public enterprises an important means of expenditure cuts would be unavailable. In the past, the privatisation of loss making enterprises, such as the estates, provided both relief to public expenditure as well as revenue from the privatisation proceeds to offset the deficit. This is a pragmatic policy that must be explored without ideological prejudices.

Increasing revenue
The rigidity and difficulty in reducing expenditure necessitates increasing government revenue from as low as 12 per cent of GDP at present to about 14 to 15 per cent next year. The revenue to GDP ratio of even 14 per cent of GDP is below the levels of countries with Sri Lanka’s per capita income. Although, government revenue has increased in value, it has fallen as a proportion of GDP in recent years, from 20 per cent of GDP in 2005 to 12 percent of GDP in 2014.

Taxation
Furthermore, the ratio of direct to indirect taxes of 20:80 means that this taxation mix tends to be regressive, falling more on the less affluent section of the population. Taxes on basic food items are illustrative of this regressive nature. In many other countries, this ratio is weighted more towards direct taxes. In Malaysia, for instance, it is 40:60.

Tax avoidance and tax evasion are important reasons for this shortfall in revenue. The Presidential Taxation Commission Report that was submitted in 2010 suggested comprehensive taxation reforms to increase revenue to 18-20 percent of GDP in five years. However, this report has not been made public and its recommendations have not been implemented.

Reforms in trade and excise taxes, a broader tax base and more effective tax collection could achieve higher revenue collection that would reduce the fiscal deficit. Increasing revenue depends very much on the realistic nature of the tax reforms, the administrative capacity and honesty of tax gatherers. The government should tax luxury consumption of the affluent who avoid direct income taxation in diverse ways instead of taxing basic food items that affect the livelihoods of the poor.

Bottom-line
The Treasury and the Central Bank must make bold proposals for tax reforms without consideration of political popularity. Good fiscal policy is politically unpopular in the short run but will be good politics in the long run. Without much higher tax revenues the economy’s fundamental problems cannot be resolved.