ECONOMYNEXT – Sri Lanka’s plan to hike value added tax to 18 percent to help maintain a large public sector and military is a better option that raising income tax which will kill consumption (killing a recovery), kill investment (killing long term growth).

A hike in value added tax still leaves money in the hands of wage earners and others giving them the freedom to make economic decisions and spend.

A 3 percent hike in VAT to 18 percent is less damaging on the people than a 5 percent inflation tax, which the country’s inflationist central bank imposes on the people at a minimum.

It must be remembered that the central bank’s 5 percent inflation tax or currency depreciation through flexible exchange rate is imposed to on the very poor through higher food prices while foods are exempted from VAT.

Indirect value added taxes are collected after an economic transaction is made. Income and wealth taxes prevent a gainful economic decision from being made.

Value added tax however is somewhat complex for businesses to operate.

Thought retail businesses operate on cash, businesses that operate on credit will have to borrow 18 percent of revenue to pay the tax on the 20th of the next month.

Businesses operating on credit therefore will have to borrow to pay VAT encouraging false accounting or raising costs.

This may not be a problem in countries with legally controlled central banks with tight inflation targets, sound money and low interest rates, but it is problem in flexible inflation targeting countries where inflation and interest rates are high.

Giving Power to Rulers to Decide Through Income Tax

Capital consumption taxes like income taxes and wealth taxes transfers economic decisions to bureaucrats and the political class, and tends to mis-direct the economy.

The US, which is heavily focused on income tax has no VAT and small state level final sales taxes are found.

The IMF, perhaps due it US progressive (read socialist) or New Dealer origins may favour income tax like most socialists.

However, in Sri Lanka people are whacked with both income and value added tax.

All capital consumption taxes destroy investible resources which are then frittered away in bureaucratic current spending.

The very sudden tax hike, involving a low threshold, and no deductions, is also contributing to brain drain.

However, the heavily socialist thinking behind income tax – tax the rich – does not help anyone.

High progressive taxes were a feature of Roosevelts New Deal interventions – which delayed a recovery from the depression, as well as Hitlers program. The Social Market economy architects cut the marginal tax rate.

Post 1980 IMF programs which do not stabilize the currency unlike before the Second Amendment when the agency was less vilified but attempts other reforms, are supposedly based on Thatcher era reforms.

But Thatcher not only stabilized the currency (in parallel US also raised rates strengthening the dollar), reducing fuel and energy prices, helping public acceptance of the power sector privatization (but hurting coal miners).

Giving Freedom for People to Choose through VAT

A key reform was raising VAT while cutting income tax.

Unlike in Sri Lanka, Thatcher campaigned on cutting high progressive taxes and giving freedom for people to choose after they came to power.

This is how Thatcher’s finance minister, Geoffrey Howe boldly gave choice to the people on the street and a boost to economic decisions of the community vs the bureaucrats, hiking VAT and cutting income tax.

“We made it clear in our manifesto that we intended to switch some of the tax burden from taxes on earnings to taxes on spending,” Howe said in his budget speech in 1979, where the clarity of thought, reason and interconnected logic was worthy of any 19th century classical liberal.

“This is the only way that we can restore incentives and make it more worthwhile to work and, at the same time, increase the freedom of choice of the individual. We must make a start now.”

In the late 1970s the UK was also in the same position as Sri Lanka. High income taxes were hitting skilled workers.

In fact the ‘brain drain’ originally started in the UK during its period of monetary instability.
“The upper rates no longer affect only those on very high incomes,” Howe said.

“They apply – and Labour Members may find this surprising – not only to senior executives and middle managers in industry but increasingly to skilled workers, as well as to professional people and the proprietors of small businesses.

“These are the people upon whom so many of our hopes for initiative, greater enterprise and national prosperity must depend.

“Our long-term aim should surely be to reduce the basic rate of income tax to no more than 25 per cent.”
The basic rate is now 20 percent.

This column said before the IMF program started that Sri Lanka should go for 20 percent VAT and eventually 15 percent corporate income tax eventually (The Yellen Tax). If 15 percent tax is given for new companies the IMF cannot object since that is official US policy.

However spending must be brought down.

READ MOREWhat Sri Lanka’s IMF program should look like

Thatcher also raised the slabs to account for inflation. A five percent inflation target should lead broadening tax slabs.

Eliminate the Social Security Contribution Levy

In the next tax reform, the cascading social security levy should be eliminated and the VAT raised to 20 percent.

The SSCL should be eliminated simultaneously with the raising of VAT so that market prices will remain the same and the government will recoup some of the money lost from the cascading tax.

Charge VAT on Fuel and Electricity

Value added tax should also be charged on electricity and the turnover taxes the excise taxes on diesel and coal should be removed or reduced.

Fuel taxes are in the nature of road taxes and should not be charged from electricity. Import duties on fuel should not be passed on to exporters. Zero rating and charging VAT will eliminate the problem.

This will allow exporters to reclaim VAT on energy, making the country competitive.

As a result, industries will not have to be given a different electricity tariff.

Vat should not be charged on electricity while excise taxes on diesel remains. Import duties on coal should be converted to VAT.

Brain Drain and Dependents

Sri Lankan politicians and politicians look at East Asia with envy, but does not follow their policies either on central bank control, or taxes.

Countries in East Asia that have good monetary regimes and do not go to the IMF regularly tend to have low value added taxes (about 10 percent) and corporate tax rates (about 20 percent).

Anecdotal evidence show that professionals are migrating because they are unable to pay school fees and medical expenses in addition to being unable to make mortgage and lease payments.

In social media there are posts of migrating families seeking good homes for pets.

Though politician claim that people are taxed for education and health, income tax payers end up sending their children to private schools and they go to private hospital.

One way out is to give tax credits for dependents and housing mortages like in East Asian countries, whose policies IMF countries do not follow.

The state should be limited to 20-pct VAT

World Bank and IMF claims that 20 percent spending to GDP is not a problem should be rejected.

Sri Lankans know how the state was bloated due to giving jobs to unemployed graduates by both the JVP ideology and the Rajapaksa regimes which put them to practice.

After raising VAT to 20 percent and with income tax at 20 percent, the rulers will take about 40 percent of a persons’ income.

That should be enough for the rulers and state workers to survive.

The state should be limited to the taxes than people can pay.

The government should also impose a 2 percent inflation target on the central bank. Putting on inflation tax on top of VAT increases is an invitation to disaster.

The 5 percent inflation tax is to be imposed on the people every year. An annual 5 percent inflation tax is worse than a one time VAT hike.

However unless the central bank is restrained printing money for growth, preferably with an exchange rate target as it is simple and transparent, no other reform in taxes will either stop the out-migration nor investment driven growth. (Colombo/Nov08/2023 – Update IV)