SL’s tax reforms will positively impact direct tax revenue mobilisation: Moody’s

• However, positive credit impact is likely to be off-set by high debt burden and rising interest rates
• Expects Sri Lanka’s government revenue to increase to 16% of GDP with new Inland Revenue Act
• Say large informal economy accounting for 45.6 percent of the SL’ GDP, limits tax potential

The ongoing tax reforms in Sri Lanka have a good chance of succeeding by broadening the tax base, particularly in terms  of direct tax revenue mobilisation, although the high debt burden combined with rising interest rates in the present  global market is likely to offset the positive credit impact from revenue reforms, according to Moody’s Investors Service.

Releasing a report titled ‘Sovereigns- Developing Asia Pacific: Tax base broadening most likely to be effective in countries with strong tax administration’ on 11 developing Asia Pacific (APAC) economies, Moody’s Vice President and Senior Credit Officer, William Foster said: “For many sovereigns, measures to broaden the tax base are unlikely to boost fiscal strength unless accompanied by enhanced tax administration and measures that effectively manage expenditure growth.”
Moody’s expect Sri Lanka’s government revenue to increase to around 16 percent of GDP by the end of 2020 from around 14 percent of GDP in 2017 with the new Inland Revenue Act (IRA) coming into effect from last April.

However, the report noted: “Sustained GDP growth will be crucial for success of the IRA, as adverse weather over the last year hindered agricultural output and weighed on nominal GDP growth to the detriment of tax revenues.” 

The authors of the report emphasised that Pakistan and Sri Lanka have continued to run quite wide fiscal deficits due to more modest government expenditure among the 11 developing APAC nations, in part driven by growing interest payments from relatively large debt burdens.

Moody’s pointed out that several structural characteristics such as size of the country’s informal economy and low levels of government effectiveness are the major factors which undermine the effectiveness of tax reforms to expand the tax base.

Moody’s also stated that Sri Lanka’s large informal ‘shadow economy’ accounting for 45.6 percent of the country’s GDP, limits the tax potential. 

“Countries with weaker scores on government effectiveness, which is a characteristic among many developing APAC sovereigns, tend to have weaker tax administration, which inhibits tax generation,” the authors noted. 

Among the 11 developing APAC nations, only Pakistan’s tax administration had performed worse than Sri Lanka’s tax administration.

In terms of positive factors, Moody’s noted that corporation tax and contribution rate which is at 55.2 percent and satisfactory levels of controlling of corruption are helping the government to implement the tax reforms effectively. 

Though Sri Lanka was ranked the highest in the World Bank’s Control of Corruption Index among developing APAC countries, from 2007 to 2016, Sri Lanka’s score in the index has declined by over 5 percent weakening the instructional strength, which was translated to a decline of 2.2 percent in tax to GDP ratio. 

Moody’s stated that IRA will rationalize the existing income tax structure and attempt to broaden the income tax base by removing current exemptions and introducing new taxes, including a capital gains tax. 

In addition, the government also increased the VAT rate in 2016 and has implemented new information technology systems to improve system-wide tax compliance and administration. 

Moody’s noted that indirect revenue mobilization is likely to be most effective in the Philippines, India and Sri Lanka, as these economies benefit from ongoing reforms.

Sri Lanka currently relies on a large share of indirect taxes as a share of total taxes, which are estimated to be around 80 percent. With the Act’s initiation of a new taxpayer identification number system, the government aims to increase the proportion of direct taxes to 40 percent of total revenues. The report looked at the extent to which tax reforms are likely to support the sovereign credit profiles of the 11 developing Asia Pacific economies that have underdeveloped tax systems.

 The 11 countries are Bangladesh, Cambodia, India, Indonesia, Maldives, Mongolia, Pakistan, the Philippines, Sri Lanka, Thailand and Vietnam.