Gotabaya’s tax cuts: Case of VAT

By Dr. Sirimewan Dharmaratne

With the dawn of a new era in Sri Lanka, there is a noticeable revival in the country. It is the duty of expatriates and former citizens, who helped in many ways to usher in this regime, to lend continued support. This does not mean concurring with every decision made or justifying every action taken, but provide constructive critique of the new Government’s policies and decisions. 

The scale of recently-announced tax cuts are phenomenal.  This would be a dream for consumers in any country and certainly in the UK, where VAT is 20% and highest rate income tax is 45%. Therefore, it is crucial for the public to understand how this policy would work out in the wider economy. As such, it is prudent to anticipate what would be the short-term and long-term impacts of the VAT cut.

VAT cuts

The cutting of combine VAT and NBT from 17% to 8% represents over a 50% reduction. Typically, tax cuts of this magnitude are phased in over several years, with marginal increases in each year. This will allow the economy to adjust to the new tax regime without major short-term shocks. 

Presumably, the thinking behind these cuts is to expand production and widen the base on which the tax is imposed. Lower input prices would decrease the marginal cost of production and result in lower output prices. Consumers would respond though increased demand. It is rational to expect tax on this expanded demand would generate the same or more tax VAT. 

According to media reports, loss of VAT revenue could amount to about Rs. 300 b. Based on this estimate, to collect the same amount under the new VAT regime, the production of goods and services should increase by about 108%, or a tax cut elasticity is over two. This would require a massive response from producers. That response is heavily reliant on how organised and fluid the input and labour markets are in Sri Lanka.

Pros and cons

Increasing production by over 100% would impart significant pressure on input and labour markets. Therefore, the swiftness of the response would depend on whether the production process is labour or capital intensive. Labour intensive industries would be able to respond faster. However, if labour lacks directly transferrable skills and require training, then there will be a time lag to achieve the full production potential. If the production process is more capital-intensive, then then there will be a longer lag in response. 

The question is whether Sri Lanka’s input market is flexible and responsive enough to benefit from these bold initiatives. Either way, it is not difficult to anticipate a wage inflation due to increased demand. This will have a second-round effect on the general price levels. However, all tax cuts in combination will leave people with more disposable income. Therefore, both consumer and producer welfare should increase.

Scorecard

There is a justifiable concern of a Government revenue shortfall due to the tax cuts. Generally, governments implement policy changes in a revenue-neutral manner. This requires compensation of lost revenue through VAT in some other manner. They could be cuts in Government expenditure and/or through non-tax revenue. To this extent, there are reports that the Government has the leeway to increase rents of real estate that it owns. 

Regardless of how the Government is planning to balance its finances, it is important to do a full analysis of each policy for the Government’s own benefit as well as for public information. This is the purpose of a scorecard. This scorecard sets out what would be the effect of the policy over a period, typically a five-year period. 

It should make clear what would be the position in each year. Such a scorecard would show a drastic reduction intake in VAT in the following financial year and picking up in later years, once the full effects of the policy starts to kick-in.  What is important is that the overall position within the scorecard period, which would presumably show the intended effect.

This scorecard needs to cover ‘side-effects’ of the tax cut as well. In the UK this scorecard comprises environmental impacts and impacts of income distribution as well as social costs, all monetised as much as possible. With the increased demand on inputs, for example for building material, there could be some environmental impacts. In addition, there could be social issues arising from labour transition as well as regional impacts. There should be a commentary on the plans attenuate these ‘side-effects’.

In an earlier post on this forum, I advocated the need to establish a skilled team of Government analysts exactly for this purpose. They should analyse each policy objectively using available data and forecasts without any political influence or partiality. Their job would be work on behalf of the populace and not the Government of the day. Their work should be of highest quality and open for public scrutiny. 

Politicians should not have access to these analysts and their work should conveyed to the ministers though senior managers of the department. This is to give proper credence to their work and instil confidence on the Government’s policy-making process.

Prognosis

It is more than likely the President solicited sound fiscal advice for this policy.  Yet, it is unlikely that the economy would see the full benefits of VAT rate cuts in the immediate future. This should not cause and undue alarm. Full benefits will only show when the economy has had time to adjust and make necessary structural changes to increase production.

 It is the duty of the progressive Sri Lankan entrepreneurs to seize an opportunity such as this, which is rarely available in many other countries. 

(The writer is Senior Analyst, HM Revenue and Customs, UK. He can be reached through [email protected])