sri lanka urged to cut tax breaks

7/31/2019 Sri Lanka Urged to Cut Tax Breaks

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Sri Lanka urged to cut tax breaksOct 23, 2009 (LBO) Sri Lanka should cut down on tax incentives to attract ForeignDirect Investments (FDI) and concentrate on improving the business climate to maximizethe benefits of peace, a senior economist said.

"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 on non-tax aspects,"Saman Kelegama, executive director at the think tank, Institute of Policy Studies, said.

"An improved investment climate is foremost of these; a streamlined tax system, lowercorporate tax rates, fasted granting of approvals related to setting up businesses and soon."

Kelegama's comments came during a speech at the 14th tax oration seminar onanomalies of the tax system in Sri Lanka, organized by the Institute of Chartered

Accountants of Sri Lanka.

Sri Lanka's investment climate has improved after government forces defeated TamilTiger separatists in May, ending a 30-year war that had forced the island to givegenerous tax breaks to attract investors.

Kelegama said according to the World Bank's 'Doing Business Report 2009', out of the171 countries featured, Sri Lanka way behind others in many business indicators.

Sri Lanka has one of the highest corporate tax structures in the region with a high of 35percent, when competing regional economies such as China, India, Malaysia, HongKong and Vietnam charge just 25 percent as corporate tax.

Only Pakistan and Philippines charge the same rate of corporate tax from its

businesses, Kelegama said.

Despite vast concessions offered to investors Sri Lanka could only muster 900 milliondollars in FDI in 2008. Most direct investments came as upgrades in the celco sector,while FDI to the real economy still remains low.

The Board of Investment (BOI) investment promotion agency estimates a one percentreduction in corporate taxes increases FDI's by two percent.

"FDI flows to the Sri Lankan economy amount to just 1.5 percent of Gross DomesticProduct (GDP) while revenues losses due to BOI tax exemptions cost as much as onepercent of GDP," Kelegama said.

"So while it certainly has promoted greater investment and more export orientation theBOI tax incentive regime has resulted in an erosion of tax revenue as it has granted, andcontinues to grant, broad tax incentives."

In paying taxes, Sri Lankan businesses must go through 62 payments that take 256hours, Kelegama said.


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In Singapore, one of the most efficient economies in the world, company's are taxed at28 percent. The tax process can be completed in five payments that take 84 hours tocomplete, Kelegama said.

"Malaysia, Indonesia, Thailand, Vietnam and even Bangladesh rank higher than SriLanka," Kelegama said.

"All these impose severe costs on businesses and are factors strongly considered byinvestors when looking to set up in a country, not just fiscal incentives."

A few days before President Mahinda Rajapaksa presents the 2011 national

budget (takes place tomorrow), Dr. Saman Kelegama, Executive Director,

Institute of Policy Studies of Sri Lanka and Member of the Presidential Taxation

Commission, spoke to the Business Times on the serious issues that confront tax

reform in the country.

Today, approximately 80% of tax revenue comes from indirect taxes and only

20% comes from direct taxation. In other words, the bulk of the taxation has

fallen on the less well-off people. Pic shows a small outlet in Galle

Q: What are the key recommendations of the Presidential Taxation

Commission?

The final report of the Commission was submitted to the President on October

26. The Commissioners consider the contents as confidential until the report

becomes a public document. Thus, I am not in a position to speak about the

specific recommendations but I can speak on the overall perspective and raise
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issues that are of interest in the context of tax policy.

Q: What is the most fundamental problem in regard to the taxation system

in Sri Lanka?

The tax system is not delivering the potential revenue in Sri Lanka. As income

increases in a country, the revenue also increases although the rate of increase

will decline after some time. This is not happening in Sri Lanka. Sri Lankas per

capita income has increased from US$ 720 in 1995 to US$ 2053 in 2009 but our

tax revenue has declined from 20.4 % GDP to 14.6 % GDP during this period.

Almost 90% of revenue comes from taxes (10% is accounted by non-tax

sources). Tax elasticity measures the extent to which the tax system generates

revenue in response to increase in income without change in the tax rates. This

is less than unity or one and not a healthy sign.

The key reason for this is that the tax base has not broadened in line with the

increase in income or economic activities. The reason for the weak tax base is

the multitude of tax exemptions, tax evasion, many discretionary tax measures in

operation, and weak tax administration.

Q: Are there any other outstanding specific problems in the Sri Lankan

taxation system?

The weak tax revenue over the years has led successive governments to impose

ad hoc taxes from time to time, so much so there are about 25 taxes in operation

in the Sri Lankan economic system. This is a large number of taxes compared to

other developing countries and has made the tax system very complicated. With

8 to 10 taxes in the system, some developing countries have managed to collect

a larger per cent of revenue per GDP than Sri Lanka.

Secondly, successive governments have heavily depended on indirect taxes for

tax revenue instead of working out a reasonable balance between indirect and

direct taxation. Today, approximately 80% of tax revenue comes from indirect

taxes and only 20% come from direct taxation. In other words, the bulk of the

taxation has fallen on the less well-off people. A better balance would be 60:40.

The contribution from direct taxes to total tax revenue is low largely because the

tax base has remained narrow.


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Q: Any statistics with regard to the direct tax base?

At present, the number of direct tax payers (corporates, non-corporates and

PAYE scheme employees) is just under 600,000. Around 25,775 corporate

entities contributed Rs 46 billion in 2008, while 219,166 non-corporate tax payers(individuals, partnerships, bodies of persons) contributed Rs 47 billion and

351,726 PAYE tax payers (employees) paid Rs 14.3 billion.

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 Sri Lankan

economy generated income taxes (personal, corporate and withholdings)

amounting to 2.4% of GDP on average per year in the past five years, whereas inmuch of the Asia-Pacific region, this figure was close to 5.4% of GDP.

Q: Can you elaborate on tax exemptions and tax evasion?

First on tax exemptions, (a) take the 1.2 million labour force in the public sector

do they pay taxes? No. In 1979 public servants were exempted from taxation

because the government could not afford to grant a salary increase to public

servants in line with the private sector. Ever since then, this has become a rigid

policy and Sri Lanka may be the only country in the world where public servantsdo not pay taxes; (b) BOI tax exemptions and tax holidays have led to

approximately 1% of GDP revenue losses per annum, and (c) various

exemptions on VAT and import duty from time to time have also contributed to

eroding the revenue.

Second, tax evasion happens in many ways: (a) some professionals (doctors,

lawyers, accountants, etc.) do not disclose their true income and pay less taxes

or completely evade paying taxes, (b) successive governments implementing tax

amnesties have also led to tax avoidance, (c) under-invoicing of imports is also

an evasion of paying correct taxes, (d) over-stating of expenses and transfer

pricing, and (e) illegal flows of imports to the country has contributed to losses

close to Rs. 300 million a day. These areas have to be seriously examined if we

are to strengthen the revenue flows to the government and these areas have

been closely examined by the Presidential Taxation Commission (PTC).


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Q: There is a lot of discussion on the future of BOI incentives what is

happening?

The rationale of incentives offered by BOI were: (a) offset the investment risks

generated by the North/East war related uncertainties, (b) offset the negativeimpact of problems of doing business in Sri Lanka. As is well known, Sri Lanka

ranks low in many of the Doing Business indicators produced by the World

Bank. To offset these problems, the generous tax incentives were offered, and

(c) to keep up with Sri Lankas competitors such as Bangladesh, Vietnam,

Indonesia, Mauritius, etc., in attracting FDI. The BOI incentives came under

scrutiny during the IMF Stand By Arrangement (SBA) of 2001 but nothing was

done to streamline BOI incentives with the Inland Revenue Department as was

suggested in the SBA. The BOI incentives came under scrutiny again under the

new IMF package of 2009 but before that, the PTC had identified this area for fullexamination and it was an item in the PTC terms of reference.

Let us examine the real situation. The country loses 1% GDP of revenue per year

as stated earlier to attract about 1.5% GDP worth of FDI every year (BOI

contribution to promoting large domestic investment is another matter). This year

we will not be able to achieve 1.5% GDP level FDI. Recent international literature

has found that the most important factors for attracting FDI are consistency and

predictability of policies, stable economic and political environment, and an easy

doing business environment. Incentives matter but they do not rank in the topamong large multinational investors. Moreover, many countries today are shifting

towards non-tax incentives for FDI, like offering investment relief, accelerated

depreciation allowances, etc. It is in this context that we have to have a fresh

look at BOI incentives.

First, should we use BOI incentives to offset the negative aspects doing

business environment? If there are problems in getting land or terminating

employment, should we use tax incentives to offset their negative side or address

these problems head-on and sort them out once and for all? The latter should be

the correct way forward. Second, the war is over and there is no war related

uncertainty in the investment regime for incentives to offset. Third, the fact that

competitors are offering tax holidays should not bother us too much. As stated

earlier, consistency and predictability of policy, ease of doing business, etc., are

more important for business decisions than tax incentives. Thus, the logic for BOI


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incentives has to be looked at again to see where changes need to take place.

The existing BOI incentive commitment should continue and should not be

changed. However, it is high time for the BOI to consider a new incentive system

that would be more cost-effective than the existing one for all new investmentprojects.

Q: What are the issues in regard to VAT?

VAT still does not bring the same revenue as the former BTT (Business Turnover

Tax) and GST (Goods and Services Tax) did when they were in operation. VAT

brings in 33% of tax revenue which amounts to 5.5% of GDP. The BTT brought

an average 6.5 % of GDP revenue and GST brought an average 6% of GDP

revenue. VAT is yet to achieve this after eight years of operation. Sri Lanka is stillon a learning curve in regard to VAT. This can be seen from the fact that eight

amendments were made to the VAT Act over the last eight years and a major

VAT fraud costing about Rs. 4 billion took place in 2004. Training personnel,

adequate public education, and institutional frameworks were not put in place

before VAT came into operation. VAT threshold is a hotly debated topic and VAT

refunds are also an issue there are computational problems and identification

issues. The application of VAT to the financial sector is also an issue.

These are by no means arguments for abolition of VAT. VAT is an internationallyaccepted non-cascading tax system and operates in more than 100 countries in

the world. We have to do more groundwork to firmly establish the VAT in the Sri

Lankan economy and gradually extend VAT to the wholesale and retail sectors.

Q: What are the issues in regard to import duty?

I highlighted some of them in my address at the AGM of the Import Section of the

Ceylon Chamber of Commerce in August this year. Basically, our import duty

structure has got complicated by various add on taxes over and above tariffs

and VAT (and Excise where applicable). These add on taxes are revenue

generators to the Treasury and additional protection for some domestic

manufacturers but they are basically nuisance taxes for import traders and

importers of manufacturing inputs.


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To meet certain development expenditures, the following taxes were imposed

and they are applicable at the border: (a) Nation Building Tax, (b) Port and

Airport Development Levy, (C) Regional Infrastructure Development Levy, and

(d) Social Responsibility Levy. To develop certain commodities the following

taxes were imposed: (1) Commodity Export Subsidy Scheme (CESS), and (2)Special Commodity Levy. In 2009, import tariff revenue was close to 2% of GDP

but the customs border revenue was 8% of GDP, thus nearly 6% GDP revenue

has come from these additional taxes.

All these minor taxes are an irritant to the importer although they fulfill some

revenue and protection objectives. These taxes have made the tax structure

more complicated and less transparent. And above all, these taxes operate

under different tax bases. One reason for illegal imports and undervaluation of

imports is due to these taxes. What Sri Lanka should aim at is a less complicatedborder tariff structure which gives reasonable protection and revenue.

Q: What about further decentralization of taxation to the provinces?

When the Provincial Council (PC) system came into operation after the 13th

Amendment to the Constitution in 1987, turnover tax at the wholesale and retail

levels was devolved to the PCs. Turnover tax is the highest revenue earner to

PCs accounting for 44% of revenue. This is followed by stamp duty 28%,

licensing fees from motor vehicles and excise -13%, and others -15%. In SriLanka, tax sources devolved to the PCs account for only 4% of the central

government revenue (0.6% of GDP). In comparison, province/state revenue is

above 50% of central government revenue in India and Australia, and above 15%

in Malaysia and Thailand. Apart from limited fiscal decentralization, the provinces

lack adequate tax administration capacity and specialized technical skills that the

Inland Revenue Department enjoys. There is a lack of motivation among PC

revenue collectors in seeking new and innovative sources of revenue. This

situation was partly due to the dependence on an annual grant received from the

Centre which almost/always ensures PCs that recurrent expenditure needs will

be met.

Any increase in PC powers to collect more taxes (i.e., additional fiscal

decentralization) should go with a reduction in the allocation of Central

government grants (particularly the Block Grant) and improvement of the tax


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collection capacity of the PCs.

Q: Does the government plan to increase revenue to 20% of GDP during the

next 4 to 5 years?

Yes, this should be the final aim. China, India, Korea, Vietnam, and others all

have revenue levels at 20% of GDP or more. Such revenue will facilitate Sri

Lanka to maintain current expenditure at around 18% of GDP and capital

expenditure at 6% of GDP ad keep a budget deficit of about 4% GDP. This is the

type of budgetary balance we should aim at in the future.

In the PTC report we have recommended a strategy to broaden the tax base,

lower the tax rates and make the tax system less complicated. We have argued

the case for a business and people-friendly taxation system. Yet, restores private-public employee tax equity and helps expand the tax base

Sri Lanka began to impose taxes on income in 1932, and witnessed several

amendments to these regulations over the years. Among these, one of the more

prominent changes was in 1979 when public servants were made exempt from

paying any income tax on their official salary emoluments. Over three decades

have passed since this was introduced, and the issue emerged strongly in the

national debate last year in the context of a new post-war budget, the severe

strains on government finances, the fiscal tightening required under the IMF

package, and the appointment of a Presidential Commission on Taxation to lookat ways of increasing tax revenue and expanding the tax base. It became a key

moot point in the context of the Government needing to broaden the tax base to

bolster revenue, bridge the continuously high budget deficits of the recent past,

and provide more elbow room for the post-war reconstruction and recovery

efforts.

The announcement in the Budget 2011 presented in November, to extend the

income tax net to include public servants, is a decisive move towards

broadening the base and re-introducing tax equity between public sector and

private sector workers. This article takes a brief look at the historical context of

the initial exemption, how the exemption affects government revenue, and makes

a preliminary assessment of what the extension could do towards improving the

countrys fiscal position.

A Thirty Year Exemption


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(click image to view full size)

As per previous tax regulations (pre-budget), the tax-free annual allowance of an

employee was Rs.300,000, and thus, all employees whose monthly taxable

income (after making relevant adjustments to earned income based on Inland

Revenue guides) exceeded Rs.25,000 became liable to tax. The public

employees tax contribution was waived by the tax exemption, where a rough

estimation according to Labour Force Survey 2006 indicates that tax contribution

has been made only by the semi-government and private sector employees who

have accounted for around 74% of all employees earning over Rs.25,000

monthly salary (Table 1).


With the new tax reforms, the government employees falling into the tax liable

category, currently accounting for 26% of the labour force and thus far been

excluded from income taxation, will become liable.

Impact of the Change Preliminary Assessment**

The impact of including public servants in income tax on revenue generation and

the number of newly tax liable employees can be examined using the data in the

latest available Household Income and Expenditure Survey (HIES) 2006/07 and

analysed using the statistical software STATA.

For the purpose of our analysis, we can look at three scenarios, using the datafrom the HIES 2006/07.

Scenario A: What was the PAYE tax situation (number of persons and revenue

generated) under the previous tax policy which exempts public servants from

PAYE tax?
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Scenario B: What is the change in the PAYE tax situation by extending PAYE

tax to cover public servants (as per Budget 2011 announcement) with

the existing taxable income thresholds?

Scenario C: What is the change in the PAYE tax situation by extending PAYE

tax to cover public servants along with the new taxable income thresholds (as perBudget 2011 announcement)?

Accordingly, an initial assessment shows the following.


Under Scenario A, 4% of private sector employees (amounting to 123,747) and

17% of semi-government employees (amounting to 38,617) were liable to pay

PAYE tax, resulting in revenue of approximately LKR 6.5 bn (Table 2).

Moving from Scenario A to B, in addition to those liable under Scenario A, 11% of

public sector employees are liable to pay PAYE tax. Under this scenario, the

improvement on tax revenue is evident. The total number of tax liable employees

increases from 162,364 to 244, 731 (a 51% increase), which in turn raises tax

revenue from LKR 6.5 bn to LKR 8.0 bn (a 23% increase in revenue).

Distributional analysis within this preliminary assessment further reveals that the

distribution of tax contributions among all tax liable employees becomes more

progressive, i.e., the rich paying a larger share relative to the poor, highlightingthe positive impact of tax reforms on improving equality in taxation and income

distribution.

However, according to the Budget 2011 announcement, the tax liable thresholds

will also be revised, taking us to Scenario C. The tax free income threshold per

month has been raised from LKR 27,000 to LKR 50,000 and tax rate bands have

been reduced from 5%-35% to 4%-24%. Accordingly, only 3.5% of all employees

are liable for PAYE taxes. Under this scenario, tax revenue falls dramatically

from the initial LKR 6.5 bn to LKR 4.0 bn (a near 40% drop), and the number of

tax liable employees falls from the original 162,364 to 148,080.Revenue Hit, but Equity and Expansion Achieved

Hence it is clear that the tax policy reform announced in the Budget 2011 to

extend PAYE tax liability to public sector employees, combined with the overall

raising of the tax free threshold for all employees results in a decline in tax

revenue compared to the status quo of the pre-Budget scenario. However, the
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key anomaly under the previous tax policy regime the lack of tax equity is

corrected under the new policy. This provides a positive signal to private sector

employees that they are no longer treated in a discriminatory manner with regard

to tax liability. The question that arises, though, is will this positive signal

incentivize more people to comply with taxes, as a key contention earlier byprivate employees was why should we accurately declare tax liability, when

public servants are completely exempt from tax?

Additionally, under this reform, a key objective of the government will be

achieved, which is expanding the tax base and ensuring that more people

become compliant with their tax obligations to contribute to national

development.

The key question, moving forward is, given the reduction in revenue with this

proposed policy change, coupled with the reductions in corporate and individual

income tax rates, can the government bridge the immediate drop in revenuebuoyancy? Raising sufficient revenue to fund post-war reconstruction is a

pressing need, and it will be interesting to see how these progressive reforms

impact on it

The synopsis of Dr. N.M. Pereras 106th Birth Anniversary Memorial Lecture

delivered at the Dr. N.M. Perera Centre on 6 June 2011 by Dr. Saman Kelegama

is produced below:

Sri Lanka is at a threshold of economic

growth and development in the aftermath of three decades of war and conflict.

Slogans such as winning the economic war and making the nation the Wonder

of Asia have been frequently used to describe the priority that economic

development has received in recent years.

Sri Lankas current strategy as articulated in the Mahinda Chinthana: Vision for

the Future is to achieve growth rates of above eight per cent per annum and

thereby aim at doubling the current per capita income to reach around US$ 4000


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by 2016. Mention is also made that Sri Lanka will aim at achieving US$ 18 b

exports by 2016.

My focus today will be on achieving growth rates above eight per cent in the next

five years. If we examine Sri Lankas growth rates during the last decade, the

following facts become clear. The average growth that the country achieved

during 2000-2005 was four per cent (could have been more if not for the -1.6 per

cent very low growth the country saw in 2001), whereas during 2006-2010 Sri

Lanka achieved an average growth of 6.4 per cent (could have been more if not

for 3.5 per cent growth in 2009). The high growth rate in the latter period was a

significant achievement despite the war inflicting the economy from 2006 to partof 2009.

A closer examination shows that the following factors contributed to the high

growth during the period: rapid growth of the global economy during this period,

especially during 2006-2008; increasing public investment to average close to six

per cent of GDP and the fiscal stimulus associated with it; improved connectivity

associated with rapid progress in infrastructure: road development, telecom and

electricity sectors; stimulus from underdeveloped areas of the north and east

rapidly taking off in the aftermath of the war, etc.

These achievements have clearly shown that the mixed economy model based

on the twin engines of growth (both private and public sectors) is workable in Sri

Lanka as was the case in most East Asian countries during the 1980s and

1990s. The current economic model of Sri Lanka has all the features of a mixed

economy with elements of neo-liberalism, state intervention, Keynesian fiscal

stimulus, and so on.

The private sector performance as indicated in the annual reports of various

companies show record profits, where 45 companies showed profits over Rs. 1 b

in 2010/11 compared to 20 companies in 2009, clearly indicating that no


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crowding out is taking place due to the relatively larger presence of the public

sector.

We are seeing today US$ 6 b worth of infrastructure projects on the move the

second infrastructure revolution in the country after the accelerated Mahaweli

Development Programme and the Urban and Housing Development we saw from

late-1970s to mid-1980s. Just like during that period, large public investment and

foreign assistance are playing a key role in the infrastructure drive although we

could see some differences in regard to sources and quantity of foreign

assistance then and now.

Boosting investment to 33% of GDPWe have seen a growth of eight per cent in 2010 and sustaining high growth

momentum in the first quarter of 2011. The question remains whether we could

sustain this trend and aim at a higher level of growth under the current economic

strategy. The aggregate level of growth is mostly determined by the level of

investment in the economy and the efficiency of the economy in converting that

investment to output (called the incremental capital output ratio or ICOR).

The current ICOR in the economy is close to five but if we assume that with all

the improvements made in economy and with better connectivity that the ICOR

reduces close to four, then with a level of investment between 32-35 per cent of

GDP, Sri Lanka will be able to sustain a growth rate of above eight per cent. The

challenge therefore is to increase the level of investment to this level from the

current 27.8 per cent of GDP (the 2010 level).

If we disaggregate this 27.8 per cent of GDP investment level, we find that 21.6

per cent of GDP investment has come from the private sector and the remainder

of 6.2 per cent of GDP from the public sector. I will show later that there are limits

to increasing public investment above the current average of six per cent of GDP.

Therefore the increase in investment has to come from both the domestic and


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external private sector, in other words, from the local private sector and FDI.

For overall investment to reach the level of say 33 per cent of GDP, the

additional investment should be around five per cent of GDP and realistically

three per cent GDP of this additional investment has to come from the local

private sector and the remaining two per cent of GDP from FDI. The current FDI

level of 1.5 per cent of GDP should therefore increase to a level of 3.5 per cent of

GDP. Can we enhance both local private investment and FDI in the coming years

and what are the key impediments? This is the challenge for Sri Lanka.

The traditional determinants of investment are well known: macroeconomic

stability, consistent and predictable economic policy, low interest rates andtaxation, stable exchange rates, investment friendly labour and other laws,

minimum red tape and bureaucracy, etc. The investors always examine these

areas before they put their money on risky long-term ventures. And it is all the

more in the case of FDI.

It is unfortunate that Sri Lanka does not rank highly in Doing Business Indicators

(DBIs) report produced by the World Bank and neither does Sri Lanka rank

favourably in the World Competitiveness Report produced by the World

Economic Forum. Sri Lanka ranked 102 out of 181 countries in the Ease of Doing

Business Index prepared by the World Bank.

A recently released World Banks Logistical Performance Index (LPI) report ranks

Sri Lanka 137 out of 154 countries and Sri Lanka ranks lower than a least

developed country like Bangladesh. We can criticise these reports as we usually

do, and say that they are not accurate and they have not considered various

other factors, but at the end of the day it is the ranking of these reports that the

potential investors take into account before taking a decision to invest.

While infrastructure development improves connectivity and improves DBIs, that

alone is inadequate. Specific problems in regard to delays in doing business


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have to be addressed at the root. The initiative taken by the Central Bank to

release the document called Step-by-Step Guide to Doing Business in Sri Lanka

in April this year is a positive step. The aim seems to be to take Sri Lanka among

the top 30 in DBIs by the next two to three years. Improving DBIs will not only

enhance investment but it will also contribute to improving the efficiency in the

economy, i.e., lowering ICOR.

Equally important is the consistency and predictability of policy. Ad hoc policy

reversals and frequent change of policy have to be avoided as far as possible to

give the best signals to the private sector. Perceptions matter in regard to

attracting FDI and in this context, managing perceptions on governance becomesa vital area to focus in the coming months.

Limitation on enhancing public investment

I mentioned earlier the limitations of enhancing public investment. Sri Lankas

revenue (with grants) amounts to 15 per cent of GDP, while the current

expenditure amounts to 17 per cent of GDP. So the overall revenue is still not

adequate to cover the current expenditure, thus leaving a current account deficit

in the Budget. Late Dr. N.M. Perera used to say that good budgeting means

producing a surplus in the current account so that you borrow only for your

capital expenditure, but today you borrow not only to meet capital expenditure

but also to meet part of your current expenditure.

The Presidential Taxation Commission report was submitted in October last year

and it came with a number of proposals to enhance revenue to a level close to

18-20 per cent of GDP. Some of its recommendations (in adjusted form) were

implemented in the 2011 Budget presented in November last year but a lot more

needs to be done.

While implementing the rest of the recommendations, concerted effort must be

made to restructure current expenditure. Wages and salaries (5.4 per cent of


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GDP), interest payments (5.6 per cent of GDP), and subsidies and transfers (3.3

per cent of GDP) amounted to 14.3 per cent of GDP overall in 2010.

This is almost 95 per cent of the revenue earned and in some years they

accounted for the entire revenue collected. This means that three expenditure

items are cutting into all other areas of current expenditure and dominating the

expenditure patterns in Sri Lanka. It is high time this anomaly is rectified. Interest

payment on public debt has thankfully come down from a level of 6.4 per cent of

GDP in 2009 to 5.6 per cent of GDP due to the lower interest rates, if not it would

have remained a burden on the expenditure side.

Subsidies and transfers occupy a significant position because of the large sumsallocated to the loss making state owned enterprises (SOEs). In 2007, the losses

in these SOEs amounted to 1.7 per cent of GDP and there are reasons to believe

that this level has not come down significantly by 2010. In this context, the recent

announcement by the Secretary of the Ministry of SOE restructuring that six

SOEs will be leased out for 30 years to the private sector and that a Voluntary

Retrenchment Scheme will be introduced to some other SOEs is a positive step.

Wages and salaries are also a large expenditure item with a 1.2 million large

public sector work force. This expenditure is bound to go up with recent demands

for wage increases by University academics and others. As long as public sector

workers are productively engaged and contributing to economic activities, such

large sums can be justified but not otherwise. In this regard the recent

deployment of armed forces for urban development and infrastructure

development activities is a positive step.

Given this situation in regard to lopsided current expenditure and borrowing to

meet all capital expenditures, there are limits to borrowing to enhance public

investment especially when the debt to GDP ratio is still above 80 per cent. Thus,

the government has to seriously look at various public-private partnerships (PPP)


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the US dollar against other major currencies. In this context, the appreciation of

the Sri Lanka rupee vis--vis the US dollar is a concern because the value of the

rupee against the US dollar is more important for Sri Lankas exports, as over 70

per cent of trade takes place in US dollars and even exports to other regions

such as Euro are priced in US dollars. There are some who argue that the Sri

Lankan rupee has depreciated against some major currencies but these are not

our major trading currencies and therefore such depreciation does not give much

benefit to exporters. Amidst large capital inflows, managing the exchange rate is

not easy.

What is important here is to make a clear distinction between appreciationsagainst maintaining a stable currency and some flexibility. It is the latter that

needs attention in the context of sustaining the growth momentum of the export

sector which is vital in the long run.

Missing the demographic dividend but all is not lost

While speaking about investments contribution to growth, we must not forget

about social transformations taking place in Sri Lanka and their impact on the

growth process. Here, I would like to speak a few words about the demographic

dividend. What do economists mean by a demographic dividend? It is meant to

indicate the gains to a nation consequent to the change in the age-wise

composition in the population.

For example, if youth workers are urgently required in a large number at a

particular juncture in economic development and they are readily available in the

market due to demographic transition, then the situation will generate a

demographic dividend. The magnitude of the demographic dividend appears to

be dependent on the ability of the economy to absorb and productively employ

the extra workers, rather than be a pure demographic gift.

ADB analysis shows that a large part of East Asias spectacular economic growth


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derives from a working-age population bulge. This bulge represented a

demographic dividend or a demographic gift because it carried with it an

increased space for economic growth. East Asia has had relatively more workers

(and savers) and relatively fewer non-workers (and non-savers) compared with

other parts of Asia, and with the rest of the world at the time of economic take-off

(Emerging Asia: Changes and Challenges, ADB, 1997).

According to Ghani (2011), demographic dividend impacts growth through five

different channels. First, swelling of the labour force, as baby boomers reach

working age. Second, society being able to divert resources from spending on

children, to investing on physical capital, job training, and technological progress.Third, rise in womens workforce activity that naturally accompanies a decline in

fertility. Fourth, working age also happens to be the prime years for savings,

which are key to accumulation of physical and human capital and technological

innovation. Fifth, boost to savings that occur as an incentive to save for longer

periods of retirement increases with greater longevity.

Sri Lanka missed the demographic dividend when the workforce was at a peak

level due to a number of factors and the country is now witnessing a rapid ageing

of the population. The above 60 years population is going to increase from the

current 11.5 per cent to 18.6 per cent by 2021. Thus, the working force is ageing

and growing slowly than in the past compared to competitor countries in the

neighbourhood. The ratio on working population to total population peaked in

2005 and it will now only decline. The dependency ratio is projected to increase

over the next 40 years while the rest of South Asia, especially India, will benefit

from a decrease in dependency ratio and a demographic dividend. But there are

two redeeming aspects for Sri Lanka. First, is the relatively low female

participation rate of about 35 per cent. Second, a large stock of skilled migrants

will return if improved growth generates new opportunities. So there exists scope


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to offset some of the loss of the demographic dividend by policies aimed at

raising the female labour force participation rate and number of returned

migrants.

Five hubs need more opening of the economy and stronger regional linkages

My next submission is to address an equally important area where the growth in

the next half a decade will be enhanced by other frameworks that the

government is intending to promote. The area that immediately comes to mind

are the five hubs: knowledge, maritime, aviation, energy, and commercial. The

hubs will certainly boost the overall economic growth but there are a number of

questions that we must ponder about. Can we promote Sri Lanka as a hubwithout selectively liberalising the economy in specific sectors? Can we bypass

regional powers like India and become a hub in shipping and aviation?

Take for instance the objective of promoting a knowledge hub. Can we create a

knowledge hub by just inviting foreign universities and the ongoing higher

education reforms? How are we going to promote more of the IT industry, and

encourage more BPOs? Are we increasing R&D expenditure with focus on

Ayurvedic medicine, bio-technology, nanotechnology, etc.? We will have to

seriously look at various global models and take a cue and should not assume

that the geographical location per se will be adequate for the hubs to take off.

Concluding remarks

Moving from a middle-income country to a high income country is more

complicated than moving from a low-income to middle-income range. Moreover,

growth strategies that proved successful in the early stages of development are

less effective when moving up to high income level.

While focusing on strategies to enhance growth, Sri Lanka should ensure that it

does not get into a middle income trap where reliance on cheap labour based

competitiveness and traditional ways of doing business no longer work. Many


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sri lanka urged to cut tax breaks

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