Mini Budget 2016 and VAT

by P. Guruge

The finalised amended proposals for ‘Budget - 2016’ are yet to be presented in Parliament. However, of the two main proposals, the proposal regarding the increase of miscellaneous income tax rate from the originally proposed 15% to 17.5%, for the year of assessment 2016/17, may not produce any additional revenue, this year as explained, in my previous article titled ‘Mini Budget 2016 and its modifications’. (Sunday Observer Business - 24.4.2016)

As a result, the entire additional revenue needed may have to be extracted through the Value Added Tax (VAT).

The illustration, using the statistics from Annexure-I to the original 2016-Budget shows the importance of the additional VAT revenue to bridge the Budget gap.

Accordingly, to maintain the original Budget deficit there is a need to mobilise around Rs. 65,000 million (108,000 less 43,000) in additional revenue, subject to any other changes in the original estimates.

On the basis of a calculation made taking VAT revenue for 2015 (as explained in my previous article), the VAT rate increase from 11% to 15%, from May 2016 to December 2016, may generate additional VAT revenue of around Rs. 49 billion.

But the amount needed may be around Rs. 65 billion. The proposed removal of exemptions may not generate additional revenue sufficient to cover the deficit and if any other additional revenue is not be generated then the original Budget deficit may not be maintained.

Amendments

Recent amendments to the VAT Act have drastically eroded the VAT base:

Certain amendments effected by the Amendment Act No. 11 of 2015, have greatly reduced the VAT revenue and made it difficult to implement the proposed VAT rate increase in the relevant areas. As a result of this amendment, there is no VAT liability on motor vehicles, cigarettes, liquor and ethyl alcohol.

The relevant amendments are given below -

The VAT liability on certain motor vehicles imported and locally manufactured has been removed from October 25, 2014.
The VAT liability on cigarettes was removed from October 25, 2014.
The VAT liability on liquor imported and locally manufactured was removed from October 25, 2014.
The VAT liability on ethyl alcohol imported or manufactured and supply was removed from January 1, 2015.

As a result of these exemptions, the VAT revenue which was Rs. 102 billion on imports in 2014, dropped to Rs. 75 billion in 2015.

The removal of these items from the VAT was a part of the grand plan of ‘the previous financial authorities’ to dilute the importance of VAT in our fiscal system.

Strange

However, it is very strange that the government did not reconsider these matters before incorporating the relevant provisions in the amended legislation which was certified on October 30, 2015.

Now, the question is whether the proposed VAT rate increase will be applicable to the above items as well and if not why? Irrespective of the formula adopted to arrive at the tax base of the above items, it should be revised to include this increase in the VAT rate.

It was not clear how these ‘all inclusive tax bases’ for the above items were revised to accommodate the Customs Duty increase and PAL increase proposed in Budget - 2016.

Exemption relating to leasing activities –

The finance leasing facilities and operating leasing facilities which were liable to normal VAT have been classified as items liable to Financial VAT, from October 25, 2014, under the same amendment.

By this change, the VAT revenue collectible by the IRD may have been greatly reduced and it may be appropriate to make a proper inquiry on this matter and make changes to ensure increased VAT revenue collection from this sector.

This is important because the taxable VAT base of leasing transactions under the normal VAT system was always higher than that of the financial VAT system. Although the rate increase will be applicable to both, (Normal VAT and Financial VAT) the difference in the taxable base will give less revenue under the financial VAT system.

Unimpressive revenue collection

For example, in 1978 the tax revenue was 24.2% of the GDP. But, after 30 years, in 2008 with a much higher level of development, the tax revenue had dropped to 14% of the GDP and the country experienced the lowest rate of tax revenue in 2014 which was10.7% of the GDP. This is how the ‘previous regime’ achieved their fiscal consolidation.

Inadequate revenue collection in all areas of taxation in Sri Lanka is mainly due to the inadequate political support to set up a suitable tax system which generates adequate revenue.

As a result, an unbelievable level of exemptions has crept into the tax system. For example, under the VAT, the tax base is the consumption expenditure within Sri Lanka.

Of the total consumption, it was estimated that over 60% had been exempted. Even in income taxation, a major portion of economic activities has been exempted either fully or partly. It is natural that a higher rate of tax should be applied when the relevant tax base has been narrowed, to collect the revenue needed. If the tax base can be expanded then the rates can be lowered.

In Sri Lanka, the highest VAT of 20% was applied at the inception of the VAT on August 1, 2002, along with 10% for certain supplies. However, this was reduced to 15% on January 1, 2004.

Ad-hoc basis

Again from January 1, 2005, the 18% was introduced along with 5% for certain supplies. On January 1, 2009, 12% was introduced. All these changes in the VAT rate were implemented on an ad-hoc basis without any systematic analysis of the VAT base and revenue needs.

Although, there were fluctuations in the relevant VAT rates, no steps taken to arrest the ever increasing exemptions in Sri Lanka’s VAT system.

Setting up an ideal fiscal policy for the country is a major responsibility of the Yahapalana government.

Without adequate revenue to meet expenditure, in a country where the revenue collection is barely sufficient to pay salaries and wages to public sector employees, massive interest payments, and other subsidies and grants to State-owned enterprises to cover their recurring losses, the economic prosperity may be another distant dawn.

Another, important area is the tax administration. Any well drafted legal framework may not produce results, if the administration is weak. The VAT administration should be handled by well trained and efficient officials, else it will produce revenue losses.

The VAT fraud in our VAT administration was a good example. This should have been an eye-opener to the officials and policy makers. The steps taken following this massive fraud has further weakened our VAT system. Even the Paranagama Commission Report which dealt with this VAT fraud was not published.

Procedural aspects of the VAT administration need to be improved. For example, let us consider the VAT payment system applicable to non-manufacturers now. They should pay VAT twice a month. But many VAT registered persons do not follow this payment system. Even the officials ignore this need.

It is doubtful whether lethargic tax administration will implement this VAT rate increase in a proper manner, to collect the anticipated additional tax for the government. There should be extraordinary supervision of payments at least for the first three months and proper monitoring thereafter.

The writer is a Senior Tax and Investment Consultant