Indirect taxes favour the rich

by Lalinda Sugathadasa

Nobody likes being taxed. Subsidies and tax cuts are what we all pretty much like to hear in a Budget speech.

Taxes are the opposite of subsidies. They are compulsory payments imposed by the government on certain people or entities. Nobody can escape taxes. If you try to evade it directly, the government will find a way to make you pay indirectly. What gives the government the right to collect taxes from people or entities?

The answer is 'nobody knows for sure'. It's a deeply philosophical question. A government can tax anyone or anything, limited only by its own imagination.

For example, in 1705, Russian Emperor Peter the Great placed a tax on beards, to force men to adopt the clean-shaven look.

During ancient times Sri Lanka practised Marala Badda or 'death duty'. This tax was applied on wealth inherited by person after the death of a person, who owned property. The history of taxation in Sri Lanka is quite interesting. The ancient tax system we had was well organised and quite sophisticated. Historical records go back as far as 3 BC, where taxes were imposed on the consumption of water which was used for agricultural purposes called Dakapathi and Bojakapathi.

During the Anuradhapura era, import and export duties were collected at Mannar and Hambantota harbours. Second century BC inscriptions describe the existence of a land tax. Lands were graded and were charged different rates. There is evidence of taxation of commercial activities. Carts carrying grain paid taxes at the point of entry to cities.

According to the records of Robert Knox, taxes were collected three times a year. Knox also explained variations in tax rates and nature of taxes in great detail in his book. Many of these taxes were paid in the form of a commodity such as gems, wine, oil, corn, honey, wax, cloth, iron, tobacco and even elephant teeth.

Fundamental reasons

There are three fundamental reasons why a government may impose a tax. The first is to raise revenue for its activities. Tax money is used to pay the salaries of government employees, build roads, or pay for government purchases.

Second, to discourage certain actions such as smoking. By imposing a tobacco tax on cigarettes, the government hopes to discourage people from smoking. Recently, British lawmakers called on the government to introduce a tax on sugary drinks to fight growing childhood obesity.

Third, to redistribute income from the rich to the poor. For example, income tax is applied in such a way that as income increases the tax rate applicable will also increase. This is called 'progressive taxing.' The government can redirect this money towards lower income groups through programs such as fertilizer subsidy for farmers.

However, when taxes are imposed people will do just about anything to avoid it. Japan imposed a tax on whisky based on the percentage of alcohol by volume. To avoid the tax, manufacturers diluting their whisky with water. In 1660, England placed a tax on fireplaces. People started covering fireplaces with bricks to conceal them. Sometimes these counter actions by people can create other issues.

For example in 1969, England imposed a tax on houses based on the number of windows they had. This led people to build houses with fewer windows to avoid the tax. Eventually this became a health issue and the tax was removed in 1851. Taxes can be applied directly and indirectly on the final bearer. The difference between the two is when taxes are applied directly the tax amount is obvious whereas when taxes are applied indirectly the tax is hidden. Direct taxes are applied on income, profits, or wealth whereas indirect taxes are applied on goods or services. The best example of a direct tax is income tax. The recently introduced Mansion Tax is a direct tax applied on wealth.

When we talk about direct tax, we can't leave aside corporate income tax. The government can tax a company in the same way it taxes a person. Perhaps the best example is the controversial Super Gains Tax introduced by the previous Budget. Some economists argue when the government taxes companies it discourages investments. That's why many developing countries provide tax holidays and exemptions to attract large scale investments. These will boost the economy by creating more jobs and bringing more income to the country.

As a result individual income levels will go up. When people's income level goes up the government tax revenue will also go up due to two reasons. First, at higher income levels people will consume more. So the revenue received from indirect taxation will increase. Second, since the people's income has increased the government will receive more revenue from income tax. Therefore, tax holidays and exceptions help the government to increase revenue in the long run.

Unlike direct tax, indirect tax is difficult to avoid. Value Added Tax or VAT is an indirect tax. In many cases people are unaware of how much they pay as tax when it comes to indirect tax. Calculating the amount of indirect tax paid by the final consumer is not as straightforward as direct tax. For example if you purchase a locally manufactured push-cycle you will bear the tax passed down to you by the seller of the cycle and a fraction of the tax passed down to seller by the producer of the cycle.

'Regressive'

Most economists are not in favour of indirect taxation including myself. The main reason is that indirect taxes tend to be what economists call 'regressive' in nature. It means that people with lower income might pay a greater tax rate than people with higher income.

If you recall the description about progressive tax, you can see that regressive tax is just the opposite. We know that milk powder carries import duties, which is a form of indirect tax. If both the rich and poor pay the same price for this packet of milk powder, how come poor will end up being worse off? At first the answer might not be very obvious. Let's look at an hypothetical example to understand this.

Let's say Kamal on average pays Rs. 1,000 per month as tax, indirectly via VAT, import duty and NBT. If his monthly income is Rs. 10,000, then he has to spend 10% of his income on taxes per month. Let's say another person, Sunil, who also has a similar lifestyle to Kamal, has to spend Rs. 1,000 per month as indirect taxes. But his monthly income is Rs. 20,000.

In this instance, Sunil has to spend only 5% of his income on taxes. This means that lower the monthly income greater the proportion of the income spent on taxes. So when indirect tax is imposed on essential goods, the burden is felt more at lower income levels. Unfortunately almost all essential goods in Sri Lanka are indirectly taxed. These taxes are then passed down to the consumers.

Elasticity

Depending on the 'elasticity' of demand, that is how sensitive consumers are to a change in price for a particular item, sellers can pass down the tax burden to consumers. If elasticity is high, that means consumers will change the amount they consume in a large quantities in response to a small change in price. If the elasticity is low, that means consumers will change the amount they consume in a small quantities in response to a large change in price.

To illustrate how elasticity affects tax burden let's say that the government decides to increase tax on vegetable oil by 50%. As a result people will reduce the consumption of vegetable oil as they can easily substitute vegetable oil with already cheaper coconut oil. The seller knows that he can't set the price too high to cover the tax completely from consumer. In this instance he decides to bear the most of the cost by increasing the price, but not too high.

Now imagine the government imposes a 50% tax on milk powder. The only substitute for milk powder is fresh milk which is far more expensive than milk powder. This leaves consumers with little option but to buy it at a higher cost. The seller knows this and can set the price high enough so that he can pass down the most of the tax to the consumer.

However, we cannot blame the policy makers alone for using indirect taxes on essential goods. In Sri Lanka direct tax revenue has not been growing fast enough to keep up with the level of economic development. The reason is that many avoid and evade tax. This has led policy makers to look at a much more effective alternative, indirect tax.

According to Central Bank sources, during the first half of 2015, only 13.6% of the government revenue came from direct tax while the rest was from indirect tax. Even with all indirect and direct taxes, the government cannot cover its expenses. In the first half of this year, government tax revenue was only Rs. 663.2 bn while government expenditure for the same period was about as twice as total revenue. Therefore, the more people evade income tax, the more inclined the government is to use taxes on goods and services resulting in undesirable consequences for poor.