CBSL 73rd Anniversary Oration The Way Forward: Price stability and prosperity need good governance: Part 2

Dr. Sharmini Coorey

This is the Part 2 of the oration delivered by Dr. Sharmini Coorey, Advisor to President Ranil Wickremesinghe and former Director at IMF at the 73rd Anniversary of the Central Bank of Sri Lanka last week. Part 1 was published yesterday and available at https://www.ft.lk/opinion/The-Way-Forward-Price-stability-and-prosperity-need-good-governance-Part-1/14-754861

Let me now turn to good governance to meet the second policy objective, namely, achieving fiscal sustainability. 

Prof Lawrence Summers of Harvard University likes to say that IMF stands for “It’s Mostly Fiscal.” That could certainly be said of Sri Lanka. The source of almost all of our economic problems is our collective inability to impose fiscal discipline and adequate standards of governance on both the central government and the larger public sector. Our successful Asian neighbours who have had IMF-supported programs, India, Korea, Thailand, Malaysia, have avoided resorting repeatedly to the IMF. We, on the other hand, have gone 17 times to the world’s lender of last resort. 

The bottom line is that we need to stop relying on the lender of last resort. We are like a diabetes patient who refuses to give up the sugar-laden diet and repeatedly ends up in the emergency room. And then some people even blame the emergency room doctor, the IMF, for the severity of the treatment needed to save us. Having achieved some semblance of macro stability, the biggest danger now is that we will do what we have often done in the past, that is, as soon as some stabilisation is achieved, abandon or drag our feet on the serious restructuring needed to address the underlying fiscal and governance problems. Many of the reforms promised under the current program are similar to what we have promised before but never implemented. We need to change our diet by strengthening governance to achieve fiscal sustainability, not because the IMF or external creditors require it, but because if we don’t, we will be in crisis again.

To achieve fiscal sustainability, we need better taxation.

Adam Smith in his treatise on the Wealth of Nations wrote that tax policy should adhere to four principles: fairness, certainty, convenience, and efficiency, principles that are consistent with the principles of good governance. The OECD has established similar criteria, with the added criterion of neutrality, meaning a tax system should raise revenue without distorting incentives vis-à-vis any particular economic activity or choice. Although Sri Lanka’s tax regime was improved by the 2022 tax reforms, it is fair to say that it still violates all five of these principles. Let me

provide three examples:

(i) First, Sri Lanka relies excessively on indirect taxes rather than direct taxes and on taxing labour rather than capital. Both aspects violate the principle of fairness as indirect taxes shift the tax burden towards the poor who spend more of their income on goods and services, while capital income accrues mainly to the rich. In 2021, Sri Lanka collected 77 % of its taxes through indirect taxes such as VAT, excise, and trade taxes, which is notably more than the regional average of 66 % and the global average of 53 %. The recent increases in personal and corporate taxes, which are direct taxes, are a step in the right direction, but indirect taxes still account for 11 % of pre-tax income for households in the bottom income decile, more than the 8 % share for households in the top decile. Personal tax collections rely on the PAYE system which ensures many professionals pay taxes, but most income from business profits remains outside the tax net because IRD has only a very small number of personal tax files. Capital income from capital gains, interest, and dividends is subject to lower flat tax rates, instead of progressive rates. And capital gains on property other than stocks are taxed at a very low rate of 10 %.

(ii) Second, corporations have for decades enjoyed extensive tax holidays, which violate all five principles of good taxation. Commendably, with the tax reform of October 2022, most companies are now subject to a standard 30 % corporate tax rate. However, projects continue to receive wide-ranging tax exemptions under the Strategic Development Projects Act. Under this Act, based on vague criteria, projects can negotiate exemptions from eight different tax laws, including corporate, personal, VAT, excise, and customs for as long as 25 years. The 17 beneficiary projects so far enjoy corporate income tax exemptions for 10 to 25 years, typically followed by time-bound reduced rates and exemptions from many other taxes and fees. Moreover, tax concessions can be granted to companies operating in three zones, Colombo Port City, a pharmaceutical manufacturing zone, and a textile manufacturing zone. The Port City Act allows exemptions from 13 different tax acts, covering casinos, the betting and gaming levy, and practically all other taxes, for up to 40 years without the approval of Parliament, which raises the question of the constitutionality of these exemptions.

Tax holidays, tax exemptions

Such extensive tax holidays cannot be justified. Let’s be clear that tax exemptions are the equivalent of a cash payment from the government to special interests. It’s as if the corporation paid the standard tax and the government gave an equivalent amount to the corporation instead of spending it on social needs or repaying public debt. Tax exemptions mainly benefit the shareholders of corporations who I guess are not merely rich, but super rich. So in Sri Lanka we have welfare for the rich and the super-rich that far outweighs the small amounts the Government transfers to the poor through programs like Aswesuma. Although tax concessions are often claimed to be necessary to encourage investment, particularly foreign direct investment, there is plenty of survey evidence to show that foreign companies do not choose their location based mainly on tax considerations. Factors that truly matter include a stable macro-economic environment, reliable electricity and physical infrastructure, the rule of law, an efficient dispute resolution system, secure access to land, and a high-quality labour force. As the IMF’s GDA points out, tax exemptions also create opportunities for corruption, after all someone has to grant them and the selection criteria, amounts, and beneficiaries are not transparent.

(iii) A third example of poor governance in taxation is the reliance on Gazette notifications for implementing major policy changes. This makes the tax system uncertain and increases opportunities for corruption. In principle, the primary tax laws that Parliament enacts should contain all the necessary provisions to ensure taxes can be calculated and collected fairly and efficiently. All subsidiary instruments, such as Ordinances, Gazette notifications and other regulations, should merely provide technical details to ensure effective administration of the law. In Sri Lanka, however, tax rates, the scope of existing taxes, and the granting of tax concessions can be implemented through Gazette notifications. Take, for instance, the Special Commodity Levy. A Minister can change this levy arbitrarily with immediate effect without parliamentary approval, which one would think is a violation of the Constitution that vests the power of taxation exclusively with Parliament. Customs duties can also be changed without parliamentary approval. Such arbitrary changes in the Special Commodity Levy and import duties, not to mention quantitative restrictions on imports, not only create uncertainty, but also opportunities for corruption, for instance, through temporary reductions that create rents for connected individuals.

Better governance with tax policy 

Transparency and simplicity of the tax system are critical for ensuring good governance. Complex tax systems with multiple rates, exemptions, and scope for arbitrary decision-making open room for the abuse of power and mainly serve vested interests. By contrast, a tax system that is uniform, rules based, and grounded in clear, simple principles promotes not only fairness, but also fiscal sustainability through higher tax revenues because of limited leakages and increased compliance. Two aspects of the tax system, tax policy and tax administration, need to be considered. But generalisations are not enough, we need specifics. So here are 10 proposals, six on tax policy and four on tax administration.

To improve governance on tax policy, we should:

(i) First, pass an overarching tax law requiring tax rates to be set in a uniform, non-distortionary manner. Any deviations or exemptions from standard schedules would need to be justified through an impartial cost-benefit analysis by the Finance Ministry, published and presented to Parliament for approval. All corporations, foreign and domestic, including those operating in special zones such as Port City, should be subject to the internationally-agreed Global Minimum Tax rate of 15 %. It is time to end Sri Lanka’s misguided and irrational addiction to tax holidays. The legislation should eliminate ministerial authority to introduce tax changes, including of customs and commodity levies, through Gazettes and other regulations without prior parliamentary approval. It should require revenue losses from tax changes to be matched by offsetting fiscal measures. The legislation should also mandate a single tax policy department within the Finance Ministry. This department should be the unique tax policy arm of the Government with the responsibility to recommend rates of taxation and any exemptions or deviations from standard tax schedules. Bodies such as the BoI and the Port City Commission should not be given power over tax or tariff exemptions.

Until such legislation is passed, in the immediate term: 

(ii) Second, sunset existing tax exemptions to end in 3-5 years. If performance criteria in terms of investment and job creation had been set at the time the exemption was granted, discontinue the exemption until the corporation has proved it has met all criteria.

(iii) Third, abolish the Strategic Development Projects Act and the Special Commodity Levy Act. They are both terrible pieces of legislation.

(iv) Fourth, suspend granting tax concessions under the Colombo Port City Act and bring any proposals for new tax concessions under the Finance Ministry. Amend the Port City Act to make this a permanent feature.

(v) Fifth, create a single tax policy department within the Finance Ministry even before formal legislation is passed. Transfer authority to that department to design and evaluate customs duties, excise taxes, and any new tax concessions, including in Port City, based on clearly defined criteria. Require the department’s prior approval for any tax change implemented through Gazettes or other regulations until the overarching tax law is passed. Also publish on a public website the department’s impartial cost-benefit assessment of every tax law amendment, concession, or new tax Act.

(vi) Sixth, the Finance Ministry should independently quantify all existing and new tax expenditure under the various tax acts every year, including revenue foregone in each Port City or other project, and report them in a transparent, disaggregated format on a public website.

 Tax administration

Turning to tax administration, Sri Lanka will never achieve fiscal sustainability and inclusive prosperity without better tax administration, including tackling tax evasion. 

To quote the GDA: “Sri Lankan revenue administration has a reputation of being highly prone to corruption and rent-seeking… Both Customs and IRD officials acknowledge the rampant state of corruption in their institutions with little risk or consequence of exposure, and similarly few if any consequences when corruption allegations are made.” The report goes on to say [quote] “There is virtually no culture of integrity observed, with corruption allegedly found at every level. The revenue departments, that is, IRD, Excise, and Customs, are predominantly closed institutions with little, if any, employment mobility into and out…(they) are reluctant to change, particularly given strong union influences.... (and) hamstrung from building skills and expertise needed for the modern economy, with IRD unable to recruit specialist information technology staff and data analysts needed to move away from the corruption-prone embedded work practices.” 

Given that IRD and Customs together employ more than 4,000 staff, it is not a matter of staffing levels, but a question of modernising skill and expertise levels. This assessment is probably hard for some to hear, but it is critical for the nation’s future that corrective action is not postponed.

 Seventh, strengthening the management of the revenue departments and oversight by the Treasury Secretary and the Auditor General. The three revenue departments, IRD, Customs, and Excise, are after all departments within the Finance Ministry. It is, ultimately, the responsibility of the Finance Minister and the Secretary to the Treasury to supervise them properly.

Eight, prioritising the Large Taxpayers’ Unit. Staffing and empowering this unit with the skills needed to track and minimise tax evasion by the super-rich is essential. Sri Lanka is not short of the skilled accountants, auditors, IT and finance professionals needed, but successive governments have for years dragged their feet on this matter.

Nine, reducing opportunities for corruption by digitising tax collections by Customs, Excise, and IRD, including by fully operationalising the RAMIS system. Tax audits should be based on transparent compliance risk criteria.

Finally, passing a Tax Administration Act that applies to all taxes and contains provisions to effectively deter corruption by imposing strict penalties, including criminal charges, on taxpayers as well as tax officials for offering or taking bribes or aiding tax evasion.

Reducing size and role of public sector

Let’s move on to good governance on the third policy objective of enabling market-oriented growth by reducing the size and role of the public sector.

Sri Lanka’s public sector is large and two areas in particular, public procurement and state-owned enterprises hinder growth by distorting relative prices and obstructing market competition. They also divert fiscal resources from social and anti-poverty needs.

The Government is the largest purchaser of goods and services in the domestic market and public procurement affects the pricing and availability of key items, such as fuel, electricity, and medicines. It also accounts for a significant part of government spending, estimated at over 5 % of GDP. Yet, shockingly, Sri Lanka has no public procurement law. Instead, in principle, all government procurement needs to be carried out in line with the Cabinet-approved 2006 Procurement Guidelines. But given ad hoc and frequent revisions, there is no unified, updated version of the Guidelines and Manual. The National Procurement Commission is mandated to formulate effective procedures and monitor their implementation, but it has started to function only recently after being reinstated last year. Procurement processes are complex, but in the end, Cabinet essentially has unconstrained discretion on procurement.

The practice of accepting unsolicited Private-Public Partnership (PPP) proposals for large infrastructure projects also contributes to poor governance. These are often approved outside the budget process without assessing the fiscal implications and outside the four-year Public Investment Program that is supposed to reflect the Government’s policy priorities. Unsolicited proposals typically involve a single bidder while the Procurement Guidelines do not cover PPPs.

The GDA notes that procurement irregularities include [quote] “(the) lack of procurement planning, not using relevant procurement procedures stipulated by the Procurement Guidelines, inadequate competitiveness in the selection procedure, accepting unsolicited proposals for high value projects, poor contract management, lack of knowledge and capacity of the officials in procurement, poor monitoring and weak external oversight, and the incomplete coverage of independent complaints mechanisms.” [unquote] Procurement irregularities by state-owned enterprises have also been identified by COPE.

All these governance deficiencies not only create significant corruption opportunities, but also thwart the development of competitive markets and firms.

Some steps to improve governance in 

procurement would be to:

• Most importantly, enact a Public Procurement Law that reflects international good practice.

• Move all public procurement transactions to an e-Government Procurement System by end-2024.

• Empower the National Procurement Commission with a clear mandate, authority, and responsibilities, including oversight of unsolicited PPP proposals.

• Finally, increase transparency by publishing information, updated every six months, on public procurement contracts above a certain threshold, identifying those that were assigned without a competitive tendering process.

Restructuring SOEs 

There are over 400 state-owned enterprises that engage, some would say interfere, in practically every sphere of economic life, employ a sizable part of the labour force, constitute a significant drain on public finances, and pose risks to the financial system because of non- performing loans. Four SOEs in particular, the CPC, the CEB, SriLankan Airlines, and the Road Authority, have required large subsidies from the budget. About 130 SOEs are engaged in commercial activities that are likely better done in the private sector.

There is general agreement that the large SOE sector inhibits the development of competitive private markets and the proper allocation of public resources. Quoting the National Transformation Road Map of June 2023, “Many of these enterprises have garnered a monopolistic position in the market, hindering private investment. Price fixing, inefficient management, and poor entrepreneurship have weakened public finances, turning these institutions into national burdens that are dependent on the taxpayer.” [unquote] As the Secretary to the Treasury said in a recent public speech, [quote] “SOEs are vulnerable to mismanagement and corruption as well because of potential conflicts of interest between the ownership and policy-making functions of the government, and the undue political influence on their policies, appointments, and business practices. It is observed that their internal control, monitoring and governance frameworks are inadequate to deal with these problems.”

 The GDA also notes [quote] “(e)xtensive government regulation in core sectors, such as agriculture, electricity, and construction, restricts market-based accountability and generates extensive opportunities for top officials to direct state resources to privileged private parties.” [unquote]

Fundamental reform of the governance of SOEs is urgently needed to address these problems. The SOE Reform Policy that Cabinet approved earlier this year establishes a sound basis to improve SOE governance. It envisages a two-prong approach to divest majority shares in commercially oriented SOEs while operating those that need to remain in government ownership under a holding company on a fully commercial basis. The key priority now is to implement this reform policy without delay, including by enacting the corresponding SOE Law. The proposed reforms should not be diluted as they go through the parliamentary process.

Some areas of the envisaged SOE Law are worth close consideration:

First, to define strictly when the government would retain a majority stake in an SOE. Objective and specific criteria need to be developed to determine whether there is a national security interest. It might also be better to use the criterion of an “economic externality”, which can be clearly defined, rather than whether a product or service is deemed “essential,” which could be interpreted too broadly.

(ii) Second, the expected norm should be that SOEs that engage in commercial activities are fully divested so that the government doesn’t end up holding minority stakes in companies without a strong reason.

(iii) Third and most critically, the SOE law should ensure the political independence, professional competence, and personal integrity of the Holding Company Board and the Advisory Committee that would oversee the Board. It would be important to ensure that line ministries cannot be involved in managing and influencing SOEs or in any privatisation process. Requiring SOEs to float at least some shares in the Colombo Stock Exchange, or even stock exchanges abroad, may be an effective way to ensure that they conform to governance and financial reporting norms required of listed private companies.

In conclusion, I have discussed today the importance of good governance to achieve durable price stability and prosperity, which is an aspiration of all Sri Lankans. A main point I want to make is that this crisis really is different. The path ahead is narrow because our debt will remain high for many years. It is fraught with risks of political backsliding, resistance from vested interests, reform fatigue, and exogenous shocks. There is no room for complacency and slacking off on reforms if we are to avoid another, potentially more devastating crisis. As we mark the 73rd anniversary of the CBSL, we can be encouraged by the progress made in achieving price stability and good governance over the conduct of monetary policy. But the Central Bank Law and fostering an independent transparent CBSL culture do not guarantee that the CBSL’s independence will be safeguarded in the future. It needs to be supported by a sustainable fiscal position and a market-oriented economy that delivers strong inclusive growth. I have focused today on three areas where I believe progress is critical. I have suggested 17 practical actions to strengthen governance—3 on central bank independence, 10 on the tax system, and 4 on public procurement—in addition to implementing the 2023 SOE Reform Policy. That might seem like a lot. Well, think of it as only one action for each time we have resorted to the world’s lender of last resort. 

I do believe though that this crisis is also an opportunity. It is an opportunity to take on vested interests that have blocked good governance for so long and to undertake the reforms needed to achieve inclusive prosperity. The challenge is to strengthen our economic institutions and governance so that economic policies will remain sound even when the country is subject to exogenous and political shocks. Other countries—like India, Thailand, and Korea—have suffered crises and emerged stronger and more resilient by strengthening their institutions and governance. We must do so as well.

Part 1

The Way Forward: Price stability and prosperity need good governance