Higher tax revenue likely to be crucial rating driver over next few years: Moody’s

• Acknowledges that revenue raising amid pandemic’s effects remains challenging 
• But says constraints to cut spending make a more compelling case for bolstering revenues 
• Says Sri Lanka among those who already struggled to raise tax intake before pandemic 
• Data shows Sri Lanka’s tax revenues on the up with Aug. revenues nearly at 2019 levels 

The pandemic-induced economic damage could cause long-lasting revenue losses for emerging market (EM) sovereigns, including Sri Lanka, causing a stretched budget deficit but the constraints to cut spending amid the pandemic should amplify the need for generating more revenues, which will act as an important credit driver over the next few years, says Moody’s Investors Service.

Moody’s cut Sri Lanka’s sovereign credit rating on September 28, to Caa1, from B2, with a Stable outlook, on elevated refinancing risks, higher fiscal deficits and on possible deterioration of the country’s governance system. 
In a fresh report titled ‘Recovering revenue post-coronavirus crisis will be crucial but challenging’, the rating agency estimated that the EMs would lose revenues worth 2.1 percent of their gross domestic product in 2020, exceeding the 1.0 percent loss in the advance economies (AE) and almost all EMs would record deficits in their budgets. 
“The coronavirus crisis has underlined the importance of revenue generation for emerging market governments,” said Moody’s Vice President, Senior Credit Officer and the report’s author Lucie Villa. 

“For EMs, any fall in revenue is particularly important for creditworthiness because their government spending needs – social, infrastructure and debt financing – are often more urgent than for advanced economies and they have a generally narrower revenue base,” she added. 

The rating agency expects that the EM governments will seek support from development financial institutions to implement or resume tax raising measures. 

“…EM governments will, with the support of development finance institutions, look to implement or resume tax-raising measures,” the rating agency said.

However, raising taxes in the middle of a global economic downturn could further dampen the recovery efforts, as times such as these call for more relief by way of tax cuts for both businesses for investments and create jobs and for consumers to spend on goods and services.

Sri Lanka last week said it doesn’t seek the International Monetary Fund support, whose course of action typically contains raising taxes on both consumers and businesses, with a singular objective of tightening the budget.  That standard playbook approach crippled Sri Lanka’s growth from 2016 onwards, when the country started raising the Value Added Tax (VAT) and then passed a new tax code in 2017, raising income tax and slapping various new taxes while removing exemptions, killing concessions for consumption and investments.

“In Sri Lanka, despite the implementation of the Inland Revenue Act in 2018 and other reforms to improve overall tax administration, revenue declined to 12.7 percent of GDP in 2019, from 14.1 percent in 2016 and a far cry from the 2019 budget target of close to 16 percent,” Moody’s said.  John Keells Stock Brokers in a recent report said the tax incentives are crucial to support the economy beset by the pandemic and expected the current tax rates to stay even after the November budget, albeit the taxation could be rationalised.   

While Sri Lanka’s tax revenues lagged during the first six months, mainly due to the pandemic, it picked up from July onwards with the August revenue reaching a high of Rs.144 billion, just shy of the Rs.150 billion in the same month in 2019.

A section of the economic analysts say Sri Lanka should not be too bogged down into closing the budget gap, instead should focus on closing the gap or generating a surplus in the external current account in the medium term.  According to them, an external current account surplus will generate adequate foreign earnings via merchandise exports and services exports and minimise the government’s external borrowing needs. 

Such will accrue benefits to the budget by way of lower debt finance costs and higher tax revenues from businesses, which are set up to manufacture for the foreign markets. The empirical evidence shows that Sri Lanka’s annual external borrowings roughly match with the deficit in the external current account.