1. Progressivity and Horizontal equity of 2011 Tax Reforms in Sri Lanka Mandarin Orchard Hotel, Singapore/ August 6-8 / Singapore Economic Review Conference/ Nisha Arunatilake (Institute of Policy Studies of Sri Lanka)

2. 1.0Introduction The need to reduce budget deficits by increasing government revenues is a challenge that has long faced the Sri Lankan government. Taxes are an important source of public revenues (87 %, 2011), and about 17 percent from income taxes. The 2010 parliamentary budget sought to simplify the tax system, broaden the tax base and improve tax compliance. One major change in the reforms was to remove the tax exemption status of the public servants. Further, the income tax rates have also been reduced with the goal of improving tax compliance.

3. Prior to 2011, public sector employees (18 % of formal employees) were exempted from income taxes But, average income higher in the public sector (PS - LKR 15,322 vs FPS - LKR 7,796) Presidential commission on taxation recommends taxing the, previously tax exempt, public servants in the country 1.0Background

4. 2.0Objectives Objectives To examine how taxing the public servants affect tax revenue and the tax base How the proposed reforms redistribute taxes and incomes. The study will also examine how the proposed changes will affect inequity, both horizontal and vertical, in the distribution of incomes. Data Household Income and Expenditure Survey 2006/07

5. 3.0Methodology A progressive tax - redistributes income such that the poor benefit more. - makes the distribution of net incomes more equal than gross incomes. This study uses Concentration Curves and Dominance (CDD) concepts to examine the progressivity of taxes and tax systems. 3.1 Progressivity of taxes 3.2 Progressivity of taxes under CCD Tax Redistribution (TR) approach Income Redistribution (IR) approach Using Lorenz and concentration curves Progressivity indices (Duclos and Araar, 2006)

6. 3.0Methodology A tax is progressive when the tax concentration curve sits below the Lorenz curve, A tax T1 is more progressive when the concentration curve for tax T1 sits below the concentration curve for tax T2. That is -- poorer individuals pay proportionally less taxes and the tax is progressive. 3.3 Progressivity of taxes – TR approach 3.4 Progressivity of taxes – IR approach The net income concentration curve of a tax T is above the Lorenz curve, then tax T is IR progressive. Finally, net tax T1 is more IR progressive than tax T2 if for all, when the concentration curve for net incomes of a tax T1 is above the concentration curve for net incomes of a tax T2 then tax T1 is IR more progressive.

7. Subtitle 4.1. Welfare indicator Income or Consumption? Adjusting for household size – adult equivalent AE = (A+ α K) θ α (cost of children)= 0.5; θ (economies of scale) = 0.75 4.0Measuring living standards Subtitle 4.2. Imputing taxes Inland Revenue Department (IRD) calculates taxes on each employee's gross salary, inclusive of all allowances. The sum of employment income and other payments (bonuses, arrears) found in HIES data are considered as the gross salary in our analysis. PAYE taxes are calculated on a monthly basis using tax bands and rates.

8. Subtitle 5.1. Adjusting for underreported income Estimate of 2006/07 revenues lower than actual revenues. Possibly due to under reported income … Adjust income to be consistent with monthly household expenditures. - Use Colombo Consumer Price index to estimate 2011 incomes 5.0Measuring living standards Subtitle 5.1. 2011 income

9. Tax system 1 (TS2007-1) – The actual 2006/07 PAYE tax system Tax system 2 (TS2011-1) – The actual 2011 PAYE tax system (includes both public, semi-public and private sector employees) Tax system 3 (TS2007-2) – The hypothetical tax system which is similar to the 2006/07 tax system but public sector employees is also taxed. 5.0Tax systems

10. 5.0Results –revenue and tax base Formal sector workers paying taxes TS2007-1 9% TS2011-1 3.3% TS2007-2 15.8% -Reduction in 2011 despite PS workers paying taxes due to increasing of threshold to LKR 600,000 from LKR 300,000 Tax revenue Tax base Tax revenue billions of LKR TS2007-1 12.2 TS2011-1 6.3 TS2007-2 16.5 - Reduction in 2011 due to increased tax-free threshold and lowered tax rates

11. All tax systems progressive. L – C > 0 TS2011-1 is most progressive under TR approach. (only the very rich are taxed) Results – Progressivity, TR approach

12. All tax systems are progressive. NI-L > 0 TS2007-2 is most progressive. (most people taxed under TS2007-2, all those under TS2007-1 and public sector workers.) Results – Progressivity, IR approach

13. K index - TS2011-1 most progressive RS index – TS2007-2 most progressive (nearly zero values, as very few people are taxed) APl index - None of the tax systems analyzed in the present study lead to re-ranking ; effect on horizontal equity is minimal Results – Progressivity, indices Progressivity indicesTS2007-1TS2007-2TS2011 Kakwani Progressivity index (TR)0.56610.56080.5814 Reynolds-Smolensky progressivity index (IR) 0.00780.01050.0041 Atkinson-Plotnick horiz. Inequity (re- ranking) 0.0000 Tax progressivity indices, formal sector workers

14. Conclusions 2011 tax reforms reduced tax revenues and tax base (due to reduced income tax rates and increased the tax-free threshold) Tax revenues are highest under (TS2007-2). Each of the three tax systems considered are progressive in terms of both the redistribution of income and taxation. TS2011-1 is more progressive according to the tax redistribution (TR) approach, Whereas TS2007-2 is more progressive according to the income redistribution (IR) approach. The results failed to identify any change in horizontal inequity due to tax reforms.

16. Acknowledgements This work was carried out with financial and scientific support from the Poverty and Economic Policy (PEP) Research Network, which is financed by the Australian Agency for International Development (AusAID) and the Government of Canada through the International Development Research Center (IDRC) and the Canadian International Development Agency (CIDA). The authors would like to thank the Poverty and Economic Policy (PEP) Research Network for funding and technical advice. The authors greatly acknowledge Araar Abdelkrim for excellent research guidance provided throughout this project. The authors are grateful to Jean Yves Ducols for overall guidance and reviewers and participants of the 9th PEP Network General Meeting for their very helpful comments. We also acknowledge competent research assistance by Nethmini Perera, research assistant Institute of Policy Studies. Presentation is based on the paper “Effect of Tax reforms on Progressivity and Horizontal equity - in Sri Lanka” By Nisha Arunatilake, Priyanka Jayawardena, and Anushka Wijesinha