Optimising tax revenue and encouraging better tax compliance

In 2010, Dr. Saman Kelegama, Executive Director of the Institute of Policy and a member of the Taxation Commission was quoted in the media as stating: “The tax system is not delivering the potential revenue in Sri Lanka. As income increases in a country, the revenue also increases although the rate of increase will decline after some time. This is not happening in Sri Lanka. Sri Lanka’s per capita income has increased from $ 720 in 1995 to $ 2053 in 2009 but our tax revenue has declined from 20.4% GDP to 14.6% GDP during this period. Almost 90% of revenue comes from taxes (10% is accounted by non-tax sources). Tax elasticity measures the extent to which the tax system generates revenue in response to increase in income without change in the tax rates. This is less than unity or one and not a healthy sign. The key reason for this is that the tax base has not broadened in line with the increase in income or economic activities. The reason for the weak tax base is the multitude of tax exemptions, tax evasion, many discretionary tax measures in operation, and weak tax administration.”

Five years later, in 2015, the Minister of Finance, delivering the 2016 Budget stated: “It is obvious that the strength of any fiscal system depends on the ability to generate a sufficient amount of revenue to meet the planned and necessary expenditure. Unfortunately, it is not the case in Sri Lanka, and the situation has aggravated in the past decade and the action taken has not brought about meaningful results.

Declining Government revenue to GDP ratio portrays a major macroeconomic concern for the country and this trend has to be reversed on a priority basis. Sri Lanka’s tax revenue was 19% of GDP in 1990 falling drastically to 10.2% of GDP by 2014. Ironically, the growth of tax revenue in absolute terms was just 4.4% in 2014 much below the nominal GDP growth rate of 7.3%. Thus, tax revenue had been unable to keep pace with economic expansion evidenced in recent years which is a serious phenomenon. It is also unfortunate to note that previous attempts to enhance fiscal revenue, have failed miserably during the past. Unbelievably, there are about 35 taxes and levies in the system. Some of the laws are outdated and not readily understood by the taxpayers and only a few who are conversant about tax laws could fathom the intricate nature of the system of taxation in Sri Lanka.

Falling VAT collection is the main cause of the decline in tax revenue in recent years and the figures depict the malady in no uncertain terms. Revenue from VAT accounted for 41% of total tax collection in 2005, and it falls to 26% in 2014. Further, VAT collection as a share of GDP has decreased sharply from 5.8% in 2004 to 2.7% by 2014. Income tax dilution also had kept pace, falling from a 2.7% of GDP in 2006 to 1.9% of GDP in 2014. As such, although the national income had increased there is no commensurate tax income. Several inherent features are noteworthy as to why tax revenue is falling. The main culprit could be weak compliance due to tax administration issues. A multitude of tax exemptions granted by various institutions also had been hindering positive administration of tax.

A majority of the revenue is derived from indirect taxes and the revenue from direct taxes is very low. At the same time, many who could afford to pay taxes and also who are liable for payment of taxes are not in the tax system. It is a well-known fact that tax compliance methodology has to improve in an endeavour to eliminate evasion. Further, tax administration also needs strengthening.

Speaker, you would recall that during the last few months, we took some efforts to address these issues opting for innovative measures of taxation. However, it is time to deviate from temporary solutions but endeavour to create a tax regime based on strong reforms to move forward, implementing such reforms which will have far reaching benefits to the country”.

The Mission Head for Sri Lanka’s post IMF lending program, Todd Schneider, is quoted as stating: “Sri Lanka’s 2016 Budget raises questions about its ambitious revenue and capital expenditure targets as the Government is falling far short of steps needed to improve the tax system. The country’s tax – GDP ratio is one of the lowest in the world, and tax efficiency is low compared with its peers. The fundamental solution to this problem involves restructuring the tax framework and tax administration to make the system simple, fair and efficient. The proposed Budget falls short of steps needed to move the Sri Lankan tax system in this direction.”

Following a ‘think tank’ review involving a leading tax lawyer and assessing the priority tax reform initiatives now required to address the above challenges, especially address the issues connected with;

1.Optimising tax revenue

2.Encouraging better compliance 

3.Minimising tax evasion, non declaration, under declaration and misrepresentation

4.Improving the tax administration

5.Minimising tax leakage due to purported  corruption

6.Raising the professional bar, benchmarked to international best practices

We concluded that;

• The enhancement of the capability of all participant stakeholders, especially revenue officials and those engaged in appeal processes including adjudicating judges and prosecutors
• Having in place internal procedures of rigorous professional reviews being associated with assessment processes and appeal processes
• Having in place internal departmental oversight processes; quality control processes; fairness and professionalism checks embedded tax audits
• The enhancement of the credibility, integrity, independence and professionalism of revenue official, prosecutors and judicial officers associated with tax/revenue assessments and appeal processes (i.e. customs, excise and Inland Revenue assessments and appeals)
• The need for competent, professional persons (assessors/commissioners, judicial officers, State prosecutors etc.) to be always fair and reasonable, in the discharge of their duties 

will be amongst the most urgent priority reforms essential in overcoming the identified challenges.

This hypothesis was tested with several leading professional tax practitioners and professional firms and a majority of them endorsed the stated proposition. They also stressed on the need for enhanced awareness of tax/revenue laws/regulations and applicable methodologies in self assessment processes, valuation principles and associated penal provisions for evasion or deliberate avoidance by taxpayers and practitioners.

It is believed that a revenue assessment and recovery of due taxes, based on a framework revenue administration, which assures tax payers, of a credible and professional appeal process, driven with integrity and independent professional decision making, in the finalisation of awards at each stage of the appeal process, including

1. Appeals before an assessor or equivalent customs officer

2. Appeals before a commissioner or equivalent customs inquiry panel

3. Appeals before the Tax Appeals Commission and determinations on appeal by the Director General

4. Appeals adjudicated in the Court of Appeal

5. Appeals adjudicated in the Supreme Court

will go a long way in the overcoming of the challenges identified earlier.

It is essential that all revenue officers, especially those engaged in raising additional assessments, adjudicating in tax/customs appeal hearings (including Tax Appeals Commissioners), as well as prosecutors and judges in superior courts hearing appeal cases, must possess requisite capability (knowledge, skills attitudes and values), and display qualities of fairness, independence of thought, integrity and professionalism in the discharge of their duties.

The undernoted submission made by the Irish Tax and Customs Commissioners to the “Consultation on the Reform of the Appeal System for Tax Matters” further amplify, the submission made above;

“An effective appeals process is a necessary part of a good tax and duty administration system. The appeals process should be fair, easily accessible, expeditious and efficient. As a major stakeholder in the appeals process, revenue has a particular interest in having a system that: 

•     Is accepted as independent by all stakeholders
•     Has procedures that are as simple as possible but are adaptable enough to deal efficiently with appeals of varying importance and complexity
•     Minimises delays
• Through transparency, ensures that identical issues are not appealed unnecessarily by different taxpayers

To the extent that the system lacks these qualities, there can be adverse consequences for tax administration, such as:

• A threat to the legitimacy of the tax system due to a perception that the appeals process is either biased in revenue’s favour or gives an unfair advantage to revenue
• A lack of fairness to taxpayers as a whole if the appeals process is capable of being used tactically by some taxpayers to delay or avoid payment
• Additional costs of administration in dealing with a cumbersome system
• Loss of revenue, due to delays in resolving disputes, with the result that the resources that were available at an earlier stage to pay the tax, have been dissipated.”

In the context of the background and issues as set out above, it is recommend that a the Ceylon Chamber of Commerce and the Institute of Chartered Accountants, appoint a joint committee to examine the hypothesis outlined above and if found to be valid in overcoming at least some of the challenges as identified, to develop a formal detailed ‘Way Forward Reform Submission to the Government’ for consideration and implementation early.