The new income tax bill, among other things, will simplify the sources of income, introduce a three-tier tax structure with reduced exemptions and reintroduce the capital gains tax, says Moody’s Investors Service.
The act also proposes modernizing rules related to cross-border transactions to address base erosion and tax avoidance, broadening the tax base by removing excess tax incentives and expanding income tax sources.
The proposed revisions to the Inland Revenue Act, will contribute to increasing Sri Lanka’s very low level of government revenues, a key constraint on the sovereign credit profile.
The gazetting of the proposed tax reforms also paves the way for the International Monetary Fund (IMF) to approve a pending third loan tranche from Sri Lanka’s three-year, US$1.5 billion Extended Fund Facility (EFF) programme.
The continuity of the IMF programme will support the authorities’ ongoing fiscal and structural reform efforts while the disbursement of the US$168 million loan will boost Sri Lanka’s external liquidity position.
Sri Lanka’s current Inland Revenue Act is a complicated tax scheme that hinders the transparency of taxes for potential investors in fixed and financial assets, limits the effectiveness of local tax officials’ supervision efforts and contributes to a very low tax-to-GDP ratio.
In particular, the current Act does not efficiently deal with modern business structures and commercial transactions, including cross-border transactions.
The implementation of revenue reforms that foster long-term fiscal consolidation will be critical to shoring up Sri Lanka’s credit profile.
The country’s large debt burden and weak debt affordability weigh significantly on its creditworthiness. The government’s debt burden of 79.3% of GDP in 2016 was higher than the median of 53% for B-rated sovereigns.
The debt burden has risen from a low of 68.7% of GDP in 2012. With nominal GDP growth forecast to be slower in coming years than over the past decade, persistent and sizeable fiscal deficits would further increase Sri Lanka’s debt stock.
Sri Lanka’s low income tax efficiency and tax collection provide significant scope for revenue reforms that target broadening of the tax base and increasing the tax revenue-to-GDP ratio, which was only 12.4% in 2016.
Total government revenues (combined tax and non-tax) are also very low, with a general government revenue-to-GDP ratio of only 14.3% in 2016, one of the lowest among B-rated sovereigns.
Implementation of the value-added tax (VAT) rate hike in late 2016 will contribute to higher revenue generation in 2017. Moving forward, if the government’s revenue reforms, including the new Inland Revenue Act, are implemented successfully, we expect general government revenues to increase to about 14.7% of GDP in 2017 and 15.0% by 2018. The IMF projects revenues to rise further to about 16% of GDP by 2021.
Given Sri Lanka’s weak fiscal position and need for growth-enhancing public expenditure on infrastructure and development programmes, the government’s plans to increase revenues will play an important role in bolstering debt sustainability and fiscal consolidation.
Revenue mobilization efforts will help create fiscal space for such increased spending and deficit reduction, while also tempering external vulnerabilities. If successful, these measures will contribute to the strengthening of Sri Lanka’s credit profile. However, we expect the benefits of revenue reforms to accrue slowly over time.
Beside the impact of fiscal reform on revenue collection, continuity of the IMF programme will provide ongoing support to the authorities’ future fiscal and structural reform efforts.
Meanwhile, disbursement of Sri Lanka’s third IMF EFF loan tranche will help support the country’s external liquidity position. The government’s high debt levels and large financing needs - we estimate borrowing requirements at 17.8% of GDP in 2017 - has resulted in significant external vulnerability and government liquidity risk. Continuation of the IMF programme will provide direct liquidity and policy support through 2019.
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