Anomalies in the Taxation System in Sri Lanka:

Need for Reform and Restructuring

Saman Kelegama
Executive Director
Institute of Policy Studies of Sri Lanka
(www.ips.lk)
Colombo

1
1. Introduction

Sri Lanka is on the verge of entering a new era of growth. As the country moves from
a war economy to a peace economy, its development challenges will be many. If we
are to leverage on this new opportunity and secure a sustained growth trajectory,
embarking on urgent policy reforms is the need of the hour.

As the government continues to invest in the reconstruction of the conflict-affected

regions, raising government revenue without stifling the business environment will
surely be a challenging task. In this context, improving tax revenue generation from
the current 14.9% of GDP to 16.9% of GDP by 2011, a target set by the Government of
Sri Lanka, will require a range of reforms to the current tax structure and tax
administration.

Sri Lanka’s revenue to GDP ratio lags well behind Newly Industrialised Countries in
East Asia, South Africa, China and of course countries in the developed world.

From 20.4% in 1995, Sri Lanka’s revenue to GDP ratio has steadily declined to a low
14.9% in 20081. This, however, has only been a recent trend as all throughout from
1952 to the early 1990s the ratio remained at or above 20%. This decline has occurred
despite a steady increase in real per capita income in the country, as the tax base did
not sufficiently broaden in line with increases in income or economic activity. Tax
evasion, poor tax administration, a gamut of tax exemptions and discretionary and ad-
hoc tax policy changes have contributed to this.

Revenue consists of tax and non-tax revenue. Tax revenue in particular has seen a
decline just in the last 2 years alone – 14.2% in 2007, down to 13.3% in 2008 2. In
countries like Vietnam the tax revenue to GDP ratio stands at 21.1%, Thailand at 17.7%
and Malaysia at 16.6%.

The contribution from direct taxes to total tax revenue, as well as a percentage of GDP,
is low, and has largely been because the tax base has remained narrow. At present, the
number of direct tax payers (corporates, non-corporates and PAYE scheme employees)
is just under 600,000. Several legal and administrative measures have already been
instituted to widen the tax base and encourage and reward voluntary compliance, for
example the issuing of privilege cards to compliant tax payers, discounts for speedy
compliance and in some cases even duty concessions for vehicle imports. However,
the efficacy of these schemes needs to be evaluated more closely.

1
Source: Ministry of Finance and Planning
2
Inland Revenue Department

2
Anomalies in the tax structure and deficiencies in tax administration have not only led
to a steady decline in tax revenues, but also to a poor public perception of tax
authorities. Compliance levels are unsatisfactory, as tax evaders assign a very low
value to the cost of non-compliance. Repeated tax amnesties have weakened existing
deterrents, and did not result in the expected gains.

Sri Lanka has the capacity to raise revenue to 17% of GDP by end 2011, and thereafter
by about 0.75% each year for the next three years3. Let us now look at a few key areas
of concern in the Sri Lankan tax system, and require attention if we are to get closer to
this goal.

3
CBSL presentation, September 2009

3
2. Anomalies of the VAT system in Sri Lanka

VAT is in use in over 160 countries around the world, and largely involves paying a
tax on a firm’s sales, net of any tax paid on inputs of goods and services purchased for
production.

SL graduated from a turnover tax to a GST in 1998, and subsequently graduated to a

VAT in 2002. However, it is widely believed that the administrative mechanism did
not evolve sufficiently and the current system is not fully capable of effectively
administering a VAT. Sri Lanka’s VAT Revenue Productivity4 is low in relation to
developed and developing countries. A score of 1.0 indicates a perfect VAT revenue
productivity. Sri Lanka has a score of 0.315, whereas in Vietnam it is 0.562, Thailand
0.560, Nepal 0.398, Indonesia 0.353 and Singapore 0.4155.

Sri Lanka has also a VAT on imports, which is collected at the time of importation,
together with other duties. Sri Lanka raised less VAT revenue in 2008, compared to the
previous year, largely owing to the decline in import volumes last year. In addition to
VAT, Sri Lanka has multiple other indirect taxes, including the Nation Building Tax
(NBT). However, the NBT is also a VAT-like tax and taps the same tax base as the
VAT.

Although adopting a VAT, like many other countries did in recent decades, Sri Lanka
has since then regressed from the principals of a traditional VAT. Various
amendments, exemptions and nuances have been introduced which has made VAT
payments, as well as administration, a challenging task. This sentiment is expressed
not only by VAT paying enterprises, but also VAT administration authorities and
seasoned tax experts. These nuances have meant that the flow-through economic
benefits, inherent in a traditional VAT, is undermined.

Amendments, exemptions and refunds

Recent years have seen a plethora of amendments to the VAT law. While some of
them were incorporated for revenue considerations and also to prevent abuse of
certain provisions (particularly relating to VAT refunds), the frequent amendments
have made the country’s VAT system unwieldy and opaque. The complicated and
lengthy list of exemptions has also resulted in an eroding of the VAT base. Various
differential rates and exemptions prevent the smooth operation of a VAT, and leads to

4
Revenue Productivity = Total VAT Revenue as percentage of GDP (or consumption), divided by the VAT
standard rate. In other words, what every 1% of VAT rate raises in terms of VAT revenue share of GDP.
5
Taxes and Investment in Asia and the Pacific (IBFD), Corporate Taxes Worldwide Summary (PWC), World
Economic Outlook (IMF)

4
problems not only in interpretation by the tax payer, but also to administrative
bottlenecks and lengthy refunds procedures.

Effective VAT administration requires proper processing of tax returns and processing
refund claims while also providing guidance and advice to enterprises. The current
refund mechanism is fraught with gaps and leakages, and has been the victim of
scams, as we saw exposed recently.

There is increasing agreement that all export sales ought to be zero-rated, to avoid
lengthy refund procedures, so long as exporters receive full credits on input VAT
paid. Administrative procedures have often been blamed for the delay in VAT
refunds, and some claim that the number of details requested in these procedures is
irrelevant and merely bureaucratic. In past months, exporters have complained that
their cash flow was seriously affected as they didn’t receive VAT refunds in a timely
manner. But now it appears that this issue has somewhat eased up.

Much of the checking mechanisms rely on the input-output system. However, due to
limitations in the existing database system, this input-output checking mechanism is
not complete. While this mechanism has been widely touted as being the first-best
solution, and moves are underway to further strengthen it, more resources must be
equally employed to carry out effective, targeted audits as a means for fraud detection.

Financial Services VAT

A severe gripe expressed by the financial sector is the VAT on Financial Services – an
additional 20% tax. This is in effect an entity based tax and is hardly seen in other
competitive economies around the world because of the complexity in administering a
VAT on financial flows. This specific VAT has an adverse effect on banks, as it raises
the effective tax rate on entity profits to around 60-65% in many cases. Also, even
though technically the amount paid as financial services VAT is a cost of earning
income, banks are not allowed it as a deductible expense.

As this special of VAT is purely borne by financial entities, it violates the basic tenets
of a traditional VAT. For larger banks it can be argued that they pass this cost on to its
customers through the rates of interest offered. But the financial services VAT is felt
particularly strongly by micro-finance institutions, that operate on much thinner
margins.

A taxation system, particularly one affecting the productive sectors of the economy,
must not be too complicated, must be user friendly, and must be based on modern tax
concepts and principles. Sri Lanka may need to revisit the current VAT legislation to
see if such principles are embodied in it, and if not, effect the necessary changes.

5
3. Problems with income tax in Sri Lanka

A growing need is to broaden the income tax base, as a means of raising revenue to
finance this new growth phase of the country. In this context, the government needs to
closely look at which areas have caused a narrowing of the tax base, for instance the
exemptions of particular groups of individuals (i.e. public employees), as well as
companies (BOI enterprises) and poor compliance by firms and professionals.

Lower yield from income tax vis a vis indirect taxes

The Sri Lankan economy generated income taxes (personal, corporate and
withholdings) amounting to around 2.4% of GDP on average per year in the past five
years, whereas in much of the Asia-Pacific region, this figure was close to 5.4% of
GDP6. Although it has been gradually increasing in the last 10 years, income tax
revenue (personal and corporate) as a percentage of total tax revenue remains low in
comparison to indirect tax revenue. VAT contributed nearly 35% of total tax revenue
in 2008 and income tax, around 22%7. This is largely due to the narrow tax base that
Sri Lanka’s income tax captures because of the high incidence of evasion and partial-
compliance, certain groups being exempt from income tax by design, and also the
multitude of tax holidays granted within the system.

It can be argued that even though Sri Lanka’s GDP per capita has been increasing, the
tax revenue or the number of tax payers has not risen proportionately. In the case of
income tax, around 25,775 corporate entities contributed 46 billion rupees in 2008,
while 219,166 non-corporate tax payers (individuals, partnerships, bodies of persons)
contributed 47 bn rupees and 351,726 PAYE tax payers (employees) paid up 14.3 bn
rupees8. Individual (non-PAYE) income tax has the potential to be a valuable revenue
source, but has remained slim for years. The low value placed on getting caught and
the disincentives to fully declare income for fear of being harassed by the authorities
are just two of many reasons for not being able to attract new tax payers, and the
limited revenue collected from existing ones.

The role of the informal sector in Sri Lanka is strong, and the number and value of
unrecorded transactions taking place on a daily basis is significant. This is particularly
visible in trading centres like the Pettah merchants. Measures need to be undertaken to
bring more enterprises into the main tax fold, into the organised private sector,
through more field inspections and surveys as well as nation-wide education and
awareness campaigns.

6
Inland Revenue Department and IMF
7
Inland Revenue Department
8
ibid

6
Improving global relevance

As Sri Lanka integrates more and more with global business systems, her tax structure
and tax rules must also closely mirror globally-accepted concepts and modern
principles. Other countries, including India, have instituted modern tax reforms over
the past few years. In fact, India is currently in the process of adopting a new Direct
Tax Code. Updating our tax legislation will make domestic tax laws more user-
friendly to new domestic investors and foreign investors alike. It will also ensure that
cross-national players do not take advantage of our ageing tax laws for tax arbitrage
and other tax avoidance means. Sri Lanka’s tax laws also need to be updated to keep
up with the gamut of new commercial transactions types that a modern economy
generates.

Withholding tax on interest

Deduction of income tax from interest payments is also an area to investigate as some
data suggests that out of the total interest paid to deposit holders by banks and other
financial institutions, less than 20% is in fact subject to withholding tax. Individuals
may open several savings instruments in the same bank, in order to spread out WHT
liability. Banks are not agreeable to deduct WHT on the aggregate amount of interest
accrued by the same person from all his/her savings instruments. It has also been
observed that the non-deductibility of WHT has been used as a marketing tool by
certain banks and NBFIs to attract more depositors to their institution. This has been
particularly true in the case of un-regulated financial institutions, which the Central
Bank has recently sought to crack down upon.

Lower rate for SMEs

Currently there exists a lower rate (15%) of corporate tax for small corporations
(generating income below LKR 5 million), so that they may retain more earnings for
expansion. However, this requires complex monitoring, as firms could resort to
dividing their enterprise into smaller profit making units as a means of tax avoidance
and encourage subsidiarisation. It may be more effective, both in revenue generation
terms, as well as monitoring-cost terms, to instead include these firms under the basic
rate, but to provide more targeted incentives to subsidise and incentivise small
enterprises.

Looking to the future

Struggling to meet revenue targets with a consistently narrow personal income tax
base has been a feature of our tax system. However, if new and innovative ways can
be introduced to bring more people into the tax realm, thus widening the base,

7
eventually it might be possible to reduce overall tax rates. But unless key income
groups like professionals and public employees are fully brought into the fold, this
will remain elusive.

With regards to corporate tax, if Sri Lanka is to become a regionally competitive

business hub, we would need to progressively move towards a lower corporate tax
regime. In the last decade there has been a dramatic decrease in statutory corporate
taxes around the world, from close to 50% in the mid-1980s to around 25% last year9.
Sri Lanka’s corporate tax rate of 35% is high, considering her competitors like
Malaysia (26%), India (33.9), Indonesia (30%), Thailand (30%) and Vietnam (28%)10.

But any reduction in tax rates here is only feasible if it is accompanied by a broadening
of the tax base – limiting exemptions and tax concessions - as well as encouraging
more enterprises to enter the formal sector.

9
World Economic Outlook (IMF), various issues
10
Inland Revenue Department

8
4. Why public servants and politicians should pay taxes

It was in 1979 that the then Minister of Finance, Ronnie De Mel, exempted the public
servants from paying taxes. This was done because after opening up the economy in
1977 public sector wages could not keep up with the increasing private sector wages.
It was given as a temporary relief measure but unfortunately in this country such
measures tend to become permanent. Sri Lanka is the only country in the world where
public servants are exempted from taxes.

Public sector employees constitute around 1 million of Sri Lanka’s 7 million strong
labour force. One is hard-pressed to come up with a strong rationale as to why this
entire group of income earners should be excluded from paying tax, when they utilise
public services as much as private employees do. Thus, the strongest contention is on
equity grounds.

Although technically public sector employees, including public servants,

parliamentarians, provincial councillors and semi-government officers, are within the
scope of income tax, the tax attributable to their remunerations is removed from their
total tax liability by application of a final formula. Hence, only additional income
(outside basic salary) is liable to tax. This too is often manipulated.

The principle of excluding state workers from tax may have been valid before, but
with recent across-the-board pay revisions in the public sector, the pay gap (except at
higher levels) between public and private sector employees has narrowed. The vast
proportion of non-state sector tax payers resent the exemption of state sector wages
from income tax. There cannot be any tax policy justification for it. It would also be
morally difficult for the government to promote greater tax payer compliance, while
maintaining tax exempt status for its own employees.

If a suitable income threshold is set, then there should be no reason to exclude public
employees from tax liabilities, but such a dramatic policy shift will have to be
managed well owing to its political sensitivity.

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5. Anomalies of the super incentive structure of the BOI

After moving into an open market economy in 1977, an array of tax holidays was
granted to attract foreign investment and promote export-oriented enterprises. In 1992
the GCEC was merged with FIAC was transformed into the BOI, and since then, the
incentives regime administered by the IRD and by the BOI has existed in parallel;
leading to complexity, lack of transparency and an erosion of the tax base. Although
attempts were made both in 1994 and 2001 to streamline the incentive regime and
bring it all under the purview of the IRD, subsequent policy reversals saw a
continuation of broad tax holidays and exemptions being granted under the BOI Law.

Performance of the BOI

Currently, Sri Lanka has 1,543 BOI enterprises in active operation, while 601 of those
enjoy tax holidays. The performance of the BOI sector has been relatively strong, with
65% of Sri Lanka’s total exports coming from BOI enterprises in 2008 (US$ 5.8 bn), and
86% of industrial exports attributable to BOI enterprises11. In 2004, Sri Lanka attracted
just over US$ 200 Mn in FDI, while in 2008 it attracted nearly US$ 900 Mn, despite the
continuation, and eventual escalation, of the war12. The BOI largely attributes this to
the various internal reforms and innovative approaches it adopted to attract foreign
investors.

However, it has also been estimated that while FDI flows to the Sri Lankan economy
amounts to just 1.5% of GDP, revenue losses due to BOI tax exemptions cost as much
as 1% of GDP. So, while it certainly has promoted greater investment and more
export-orientation the BOI tax incentive regime has resulted in an erosion of tax
revenue as it has granted, and continues to grant, broad tax incentives.

Re-thinking the current incentive regime

Several areas of the current incentive structure will need re-examination, particularly
in the context of the end of the war, the reduced investor risk that accompanies it and
renewed investor confidence and interest by global players.

Corporate tax rates are relatively high in Sri Lanka, compared to those of some other
Asian countries. India, Vietnam, China, Malaysia, Singapore and Hong Kong have all
reduced their tax rates to 25% or below, and have attracted significant foreign private
investment in the last decades. However, Sri Lanka’s corporate tax rate remains at a
regional high of 35%, along with Pakistan and the Philippines. Not only are corporate

11
Statistical Unit, Board of Investment of Sri Lanka - BOI
12
ibid

10
tax rates high, but firms are also subject to other taxes including the Social
Responsibility Levy. Even though it is advertised that BOI companies are entitled to
duty free importation of capital goods, in effect manufacturing firms pay an effective
tax rate of 15.5% once the plethora of other taxes and levies are factored in (e.g. PAL,
NBT, ESC, SRL etc)13.

If we are to reduce the number of tax exemptions, tax holidays and concessionary tax
rates given to foreign investors we would need to move into a regime of lower overall
corporate tax rates. The BOI suggests that a 1% reduction in corporate tax increases
FDI by approximately 2%14. The elimination of tax incentives in 1994 without a
simultaneous reduction in corporate taxes spelt disaster for FDI inflows in 1995. The
incentives were reintroduced in 1996. In Indonesia, the elimination of tax incentives in
1994 was accompanied by a slashing of corporate tax rates from 45% to 35%.

Parallel structures

As mentioned previously, this continues to be a key issue. The BOI Act currently
supersedes the IRD Act when it comes to tax treatment of BOI companies. BOI tax
holiday companies are not exempt from having to submit tax returns, but this
requirement has not been fully enforced. To iron out these issues, all tax incentives
should be brought under the purview of the IRD, with the BOI continuing to act
purely as an investment promotion agency. The IRD could also set up a joint committee
with the BOI to review tax concessions being granted to prospective investors.

More scrutiny needed

It is contended that the BOI incentive granting regime is too liberal. Incentives are
being offered to projects raising small amounts of capital, relative to the tax
advantages enjoyed. There is a need to introduce stronger cost-benefit considerations
when looking at new foreign investments, as some may be getting incentives
disproportionate to the overall contribution to the economy. During the time of the
GCEC such a system was in place, but with the pressure to increase FDI, and meet
investment promotion targets this appears to have taken a back seat. It will also be
important to analyse what proportion of FDI is the actual capital component, as there
is a contention that some investments enjoying BOI incentives because of foreign
capital have in fact raised much of the stipulated capital from domestic commercial
borrowing. Incentives ought to be granted according to the amount of foreign capital
brought in and also the size of the investment so as to encourage only the right type of
capital, and not the footloose, ‘fly by night’ kind.

13
As estimated by the BOI
14
Statistical Unit, BOI

11
Better monitoring, more coordination

There is also a need to improving the monitoring of BOI enterprises, particularly to

arrest the issue of leakages to the domestic market and the abuse of import duty
concessions. BOI enterprises which are entitled to duty free imports of raw materials
and capital goods have at times been found to be selling raw material or intermediate
goods in the domestic market. These goods have an inherent cost advantage over
those of other suppliers, owing to the zero duty under which they were imported. This
would require a concerted effort between the BOI and customs. More generally also,
the coordination and cooperation between the BOI, IRD and Customs must be
strengthened and institutionalised.

Improving the general investment climate

Policy makers must bear in mind that investment decisions by local and foreign
players, do not exclusively depend on fiscal incentives but also on a range of non-tax
aspects. An improved investment climate is foremost of these; a streamlined tax
system, lower corporate tax rates, faster granting of approvals related to setting up
businesses and so on.

According to the ‘Doing Business Report 2009’, Sri Lanka is ranked poorly in many of
these indicators. We fare particularly poorly in areas like ‘paying taxes’ (164th out of
171 countries) and ‘dealing with licenses’ (161st). In paying taxes, a business must go
through 62 payments, 256 hours and is taxed close to 64% of profit. In Singapore it
takes just 5 payments, 84 hours, and a 28% total tax rate. Malaysia, Indonesia,
Thailand, Vietnam and even Bangladesh rank higher than Sri Lanka. All these impose
severe costs on businesses, and are factors strongly considered by investors when
looking to set up in a country – not just fiscal incentives.

Heavy reliance on generous tax concessions as the alternative to undertaking key

reforms in these areas is a slippery slope down which we cannot afford to go.

12
6. Can we earn more revenue by reducing import taxes,
particularly for motor vehicles?

High duty rates lead to more illegality?

Revenue from import duties has gradually declined, while the system has become
more complex. In addition to standard import duties, there are over 20 other taxes in
place on imports. High import duties on certain goods have fuelled a growing illegal
importation trade. Moreover, high duties on the final product and low duties on
components has encouraged CKD (Completely Knocked Down) importation and later
assembling the product locally. The Central Bank estimates that revenue losses at
import entry points due to illegal importation and under valuation of imports are in
the region of 300 million rupees a day15. The BOI has estimated than in the mobile
phone market alone illegal imports, spurred by high duty rates, have cost revenue
losses in the magnitude of 600 million rupees. A lower flat duty rate may bring in
some of this illegal importation into legal channels, and earn more revenue. There are
also proposals to position Sri Lanka, like Dubai, as an entrêpot trade hub for portable
consumer items, including mobile phones and other electronics by imposing a lower
flat tariff rate on such items. However, this requires more analysis before concrete
conclusions can be drawn.

High duties on vehicles

Demand for imported motor vehicles have contracted sharply recently, mainly
because of high duties on imported vehicles, and compounded by the global economic
fallout, and the follow-through impacts on the domestic sector. It is widely identified
that import taxes were raised due to a mix of reasons, mainly led by the need for
higher government revenue and to discourage fuel consumption at a time when oil
prices were rapidly rising. The Motor Traders’ Association has noted that the brand
new automobile market has been severely impacted due to the recent duty increases.
They report that while in 2006 25,382 brand new vehicles were imported, by 2008 this
had dropped to 15,460 and this year it is estimated to be 5,000. Standard passenger
cars now cost 3 times as much as in Thailand or Malaysia, with duty rates standing
between 200-300%.

For a fledgling economy like Sri Lanka’s, particularly as it moves into a new growth
phase, automobile requirements will continue to rise. The government can capitalise
on this by reducing duty rates on new vehicles, and potentially seeing a volume-led
rise in revenue.

15
CBSL presentation, September 2009

13
7. Making Provincial Councils less dependent on government
transfers

As the country looks more closely at options to decentralise functions to the provinces,
an area of contention is the revenue generation ability of Provincial Councils. Under
the Ninth schedule of the 13th amendment, a formidable list of revenue sources are
enumerated in sections 36.1 to 36.20. However in reality only a limited number of
these actually bring in revenue - Turnover Taxes on the wholesale and retail sector
contribute 44% of provincial revenue, license fees (which include motor vehicle and
excises) bring in 13% and stamp duties contribute 28%. The rest of the long list of
sources brings in a mere 15%16.

These sources devolved to the Provincial Councils account for only 4% of total central
government revenue17, and provincial tax revenue also averages at around 4% of total
tax revenue. In countries such as India and Australia provincial revenues are over 50%
of central government revenue, and even in countries like Malaysia and Thailand it is
more than 15%. Moreover, total provincial revenue is only 0.6% of GDP and provincial
tax revenue is only 0.5% of GDP.

Although statutory legislation and gazetted regulations restrict Provincial Councils

from tapping certain revenue sources reserved for the central government, according
to a ruling by the AG with a simply majority in Parliament PCs can be given the right
to levy additional taxation so long as they do not overlap with sources on the
Reserved List.

Provincial revenue performance is weak

Several reasons can be propounded for the weak performance of provincial revenue;
some due to the inherent nature and size of the provincial economy and some due to
legal and constitutional provisions that restrict certain revenue sources.

Apart from these factors that have been dealt with often, there appears to be a serious
human resources constraint at the provincial revenue administration level. When
carried out effectively, tax administration is a complex task. The provinces lack the tax
administration capacity and specialised technical skills that the central tax authorities
enjoy. An investment in skills training and capacity development will have to precede
any meaningful decentralisation of fiscal authority to the provincial level.

16
State of the Economy 2008 (IPS)
17
An average of 4% during 2001-2007, Source: ibid.

14
There also appears to be a lack of motivation among the provincial revenue authorities
in seeking new and innovative sources of revenue. This is in a large part due to the
dependence on annual grants received from the centre which almost always assure
PCs that recurrent spending needs will be met.

Extending the reach of the VAT

Currently, the VAT only applies at the national level to manufacturing, imports and
services, and the Provincial Councils administer a Turnover Tax on wholesale and
retail sector. Thus, the system of taxes part levied by the centre and part devolved to
the Provincial Councils has resulted in discontinuity in the tax system and opens up
more avenues for tax avoidance and evasion. It is contented by some tax professionals
that enforcing the VAT at the wholesale and retail is not a feasible option at this stage.

The most suitable solution of course would be to mainstream the VAT to include the
wholesale and retail sector, accompanied by a revenue-sharing mechanism between
the centre and the devolved bodies. However, as the current constitution does not
provide for revenue-sharing, this would have to await the results of the APRC
deliberations on the amendments to the constitution. This also throws up the issue of
PCs collecting revenue but still obtaining funds from the centre. Any increase in
taxation power of the PCs ought to be matched by a simultaneous and appropriately-
sized reduction in central government grants.

In addition to putting in place clear demarcation of taxation authority to avoid any

duplication, we may need to wait until the current VAT system is suitably streamlined
and the tax administration is strengthened. If not, the current gaps may become
compounded. Even once more revenue generation authority is granted to the PCs, the
question of how much capacity is available at the local level in administering tax
collection will arise. It is presumed that the centre may have better technical capacities
to redistribute funds.

Increasing provincial revenue

If greater decentralisation of revenue collection is considered at any stage, it will

surely involve considering some or all of the following:

 Introducing a full scale VAT at the national level to include all sectors from
manufacturing through to retail, but with a levy which can be retained by the
provinces;
 A levy on income tax by the provinces
 A multi-rate provincial turnover tax instead of the current flat rate of 5%

15
  Fully utilising revenue sources already devolved to the provinces but not being
sufficiently tapped at present18
 Stamp duty fees for re-examination of deeds
 Looking at new and innovative sources like licensing of mineral and other
natural resource rights
 And closer coordination and information sharing between tax authorities at the
centre and those in the provinces

18
These include fees under the Medical Ordinance, charges under the Weights and Measures Ordinance, fees
under the Flora and Fauna Protection Ordinance, toll collections, taxes on prize competitions and lotteries, license
fees on properties and rent from buildings and land

16
8. Problems and constraints of the current tax administration

The current tax administration is strained by limited automation, insufficient

investment in staff skills development and specialised training.

Of urgent importance is to continue the technology-enhancement of revenue

authorities. It has been reported that the Information Index, that retains all key
information on tax payers, is not entirely up to date. In many instances, the
Information Branch of the IRD would routinely request a tax payer to furnish this
information when it’s required in relation to a transaction. Several forms are sent;
burdening the tax payer, when this information could have been very easily obtained
from the database had it been up to date and more user-friendly to the units’ officers.
There is also some anecdotal evidence suggesting a severe lack of data entry staff to
support revenue officers, for instance just 8 data entry operators for 1,500 revenue
officers!

But steady progress is being made on the technology front. The Inland Revenue
reports that the ADB’s Fiscal Management Reform programme (FRMP) project is due
to complete full computerisation of the department’s systems by January 2010.

With regards to improving compliance and increasing deterrence, tax administrators

can take many steps (Some may already have been initiated). The first of these would
be better sharing of information between revenue agencies, but also linking these
databases with other agencies like telecoms, electricity, land registry and the motor
vehicle registrars department. This would strengthen the information bank available
to income tax authorities and assist in their monitoring and auditing. The need for
better coordination between the Customs and IRD cannot be emphasised enough. For
example, in order to accurately process tax returns of exporters, in particular, accurate
and up to date data is required from Customs on a regular basis. The mechanism for
these information-sharing channels needs to be institutionalised and streamlined.

Overall, the key philosophy of making the cost of non-compliance (i.e. the cost of tax
evasion) higher than the cost of compliance must be strengthened. Taking legal action
against defaulters must be stronger in order to send a clear message. Also, amnesty’s
like providing penalty waivers to defaulters must be removed. Currently penalty
waivers are granted at the discretion of commissioners, which gives rise to rent-
seeking behaviour. There must also be a strengthening of the rules and transparency
governing the tax system, so that it leaves little room for discretion by tax officers,
minimises incentives for rent-seeking, and builds investor and tax payer confidence in
the tax authorities. As a corollary, a more comprehensive ‘Performance Evaluation
Criteria’ for tax administrators ought to be established, and the indicators should be

17
expanded from the current ones which focus heavily on revenue-raising, to broader
themes like minimum service standards and customer satisfaction.

Reforms measures should also include a stronger focus on making the tax service
more ‘people friendly’. A good recent example comes from Uganda, where a recent
overhaul of the Ugandan Revenue Authority (URA) saw the adoption of a ‘Tax payer
Charter’; through which tax administrators treat tax payers as ‘clients’ instead of
‘targets’. To increase voluntary compliance, the URA carried out a nation-wide
campaign tagged ‘Developing Uganda Together’ aimed at increasing voluntary
compliance. It was also accompanied by vast public awareness programmes to make
tax concepts and rules better known, and educate the public on how and where to pay
taxes. Regulations were made easier to understand and unnecessary lengthy
procedures were done away with. Sri Lanka may be able to learn some important
lessons from this, and other international examples in reforming her own tax
administration system.

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Concluding remarks

Sri Lanka today has a tax structure that has outlived its usefulness. Any add-on taxes
to the existing tax structure leads to diminishing returns. A recent study titled ‘Paying
Taxes 2009’ by the World Bank and Pricewaterhouse Coopers (PWC) ranked 181
countries on various indicators of taxation. Overall, Sri Lanka came in at 164th on ‘the
ease of paying taxes’ and 170th on ‘the number of tax payments’. Hence, rationalising
the number of taxes may be the most important step that needs to be taken. Over 30
types of taxes, levies and their variants exist in Sri Lanka. That is too many for a small
country that needs to encourage private sector growth and spur post-war economic
development. Some taxes overlap in the base that they tap, for example the VAT and
NBT, while others are meant to serve a specific purpose but may be ultimately going
into the general coffers, like the CESS and the Environment Conservation Levy. Some
contend that the Social Responsibility Levy is a ‘nuisance tax’, and in fact one retired
Inland Revenue Officer remarked that, “in some cases where the tax payable is small,
the cost of the cheque leaf used to pay the SRL is more than the levy itself!”. Although
in previous budgets there was a policy effort to reduce the overall tax burden, there
have been subsequent increases in the rate and/or number of taxes imposed, and
especially for growing sectors in the economy like banking, mobile phones, etc. This
feature of inconsistent policy direction must be avoided.

Ad hoc changes to tax laws must also not be repeated. Changes to tax legislation must
be preceded by rigorous research and analysis on the consequences and impacts,
otherwise new laws are introduced in an ad-hoc manner and once found to be
ineffective, are repealed. This complicates matters not only for tax payers, but also for
the IRD. Moreover, industry groups and chambers of commerce have strongly
advocated that a simplification of the tax code can greatly improve compliance.

When we look at our revenue performance relative to comparator countries, Sri Lanka
lags behind many countries, like Thailand, Indonesia and the Philippines. In the
context of dual pressures - rising government expenditure and stagnant revenue
generation, decisive steps are required to reform the tax system in this country. The
key elements to positioning Sri Lanka’s tax system to deal with the new development
challenges that face will be - a rationalised and streamlined tax structure, broadening
the tax base to include all those who are liable, rethinking the BOI incentive regime,
better tax administration with IRD taking a ‘client-oriented approach’, more use of IT
to enhance productivity, stronger coordination between our revenue authorities and
more investment in the technical skills training and capacity development of officials
in these authorities.

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