Recent and Upcoming Fiscal Reforms: Sri Lanka Dushni Weerakoon Institute of Policy Studies of Sri Lanka

Fiscal Challenges Fiscal situation remains weak in the face of post-conflict reconstruction challenges Revenue as a percentage of GDP has been declining consistently from the mid-1990s –From 20% of GDP to 14.5% by 2009 –90% of revenue from taxes Sri Lanka has been grappling with fiscal deficits in the range of 8-10 per cent on average over time Source: Central Bank of Sri Lanka.

Institute of Policy Studies of Sri Lanka Past Fiscal Reforms Fiscal decentralization –Decentralization of fiscal responsibility at provincial level in 1987 –Rationale political rather than economic –Provincial revenue accounts for 4% of total central govt. revenue; by contrast, provincial expenditure 20% of total central govt. revenue –Created additional layer of govt.; 80% of expenditure of recurrent nature (bulk on personal emoluments) Tax reforms – moved from turnover to Goods & Services Tax (GST) in 1998 –Introduced at ‘less than neutral’ rate, plus exemptions –National Savings Levy (NSL) introduced to compensate for revenue loss –GST and NSL amalgamated to Value Added Tax (VAT) in 2002

Institute of Policy Studies of Sri Lanka Past Fiscal Reforms Other –Introduction of indirect taxes such as Nation Building Tax (NBT) –Tax concessions to both domestic and foreign investors –Periodic tax amnesties (11 amnesties since 1964) Fiscal Management Responsibility Act (FMRA) 2003 –Provides necessary legal framework to meet transparency practices –However, implementation/enforcement of FMRA incomplete –Some due to recovery costs of 2004 Tsunami –Some improvement in budgetary information (Annual Report, Mid-year Review, etc.)

Institute of Policy Studies of Sri Lanka Progressivity Some improvement in ‘progressivity’ of tax system –Share of taxes on income on the rise Other measures –VAT offers exemptions on basic commodities –High import duties on ‘luxury’ goods, etc.

Institute of Policy Studies of Sri Lanka Weaknesses in Expenditure Cutting current spending has proved difficult –Salaries, transfers and subsidies and interest payments on debt take 1/3 each of govt. revenue Capital expenditure has borne brunt of cuts –Realized capital expenditure has consistently been below budgeted amounts –Capital spending largely financed through borrowing

Institute of Policy Studies of Sri Lanka Impacts on Promoting ‘Inclusive’ Growth Fiscal constraints have imposed limits on expenditure in key sectors such as health and education Sri Lanka has also experienced growing regional ‘imbalances’ in economic growth and poverty across sectors/provinces –amongst other causes, lack of investment in infrastructure has been identified as a key bottleneck Source: Central Bank of Sri Lanka

Institute of Policy Studies of Sri Lanka Impact on Macro Stability Partly in response to fiscal developments, Sri Lanka has faced high and volatile inflation rates Of even greater concern, is long run fiscal stability in the face of growing debt dynamics –While total debt has declined from a high of 105% of GDP in 2002, decline was partly in response to galloping inflation –The decline in foreign debt to GDP masks Sri Lanka’s increased exposure to external debt servicing obligations

Institute of Policy Studies of Sri Lanka Impact on Macro Stability Sri Lanka is resorting to costlier commercial borrowing to meet its fiscal needs –Share of such borrowing risen from 4.4% in 2006 to over 23% by 2009 –Ratio of foreign debt service to exports risen from 7.1% to 14.6% over the same period Foreign Debt Dynamics ( ) Concessional% share Non-concessional% share Commercial% share Total foreign debt/exports% Foreign debt service/exports% Source: Central Bank of Sri Lanka, Annual Report, various issues.

Institute of Policy Studies of Sri Lanka Future Areas of Reform: Tax Presidential Taxation Commission –Simplify/rationalize tax system –Broaden tax base –Improve tax administration Simplify/rationalize tax system –Has over 20 taxes at national level –A relatively high corporate tax of 35% compounded by different rates Problems with VAT –Exemptions –Periodic change to rates/differential rates –Large refund element –Administrative weaknesses

Institute of Policy Studies of Sri Lanka Future Areas of Reform: Tax Broaden tax base –Narrow base, low coverage, low compliance, etc. –Exemptions for groups (1.2 million public servants) –Exemptions for companies (local and foreign investors) –Poor compliance due to anomalies, tax ‘culture’, amnesties, etc. Improve tax administration –Organizational structures, audit, human resources, etc. –Coordination between Inland Revenue, Excise and Customs –Significant discretionary powers that can lead to corruption –Some reforms under way under ADB supported Fiscal Management Reforms Program

Institute of Policy Studies of Sri Lanka Thank You