Equity in Sri Lankan Tax System


What Is Equity in Taxation?

One of the most influential writings in our history- Wealth of Nations by Adam Smith outlines four principles that should feature in a citizen-friendly tax system which are equity, certainty, efficiency, and economy. Although it has been centuries since these concepts were introduced, the principles prove to be even more relevant now. Looking at Sri Lankan tax system and laws governing it, there are multiple occasions where the equity principle is violated. As the government relies on indirect taxes to raise tax revenues, which violates the equity principle, Sri Lanka’s direct tax level has dipped to an abysmal low, sitting at 17%. The experts say that it is so low even by the standards of developing countries.


The Status-Quo

A tax system is said to adhere to the equity principle if the tax burden is distributed fairly among the citizens. It is the first principle of taxation laid down by Adam Smith. More recent writers such as Amrtya Sen warns that less pragmatic approach to taxation could potentially lead to social injustice. Equity entails vertical and horizontal equity. It follows that the wealthy should pay more than the poor and the equally well-off should pay equal amounts. The indirect taxes such as the value added tax (VAT) is considered regressive since the amount of tax paid does not take into account the individual’s income level. Income taxes where the wealthy pay a higher percentage of taxes is a good example for a progressive tax system. With the administrative ease the indirect taxes have become the more attractive option for the successive  governments to exploit in order to bridge the ballooning fiscal deficit. Having introduced different ad-hoc taxes from time-to-time, the Sri Lankan tax system now has 25 different taxes which not only make it very complex, but also increasingly regressive. Therefore, the tax system favors the rich and further expands the income inequality.

As the citizens earn more, the governments need to provide more and better public services. This rationalizes the wealthier paying a higher tax rate than the less privileged. However, according to the Central Bank of Sri Lanka, tax to GDP ratio is on a downward spiral since 1990. Direct tax to the total tax ratio also has not been able to keep pace with the growing personal income. Coupled with the historic-high Gini Coefficient of 0.49, indicates widespread tax evasions and the inability of the tax system to capture growing sections of the economy.


Economies have higher direct tax ratios for higher per-capita GDP levels. The tax system should be geared to encompass novel economic activities and impose direct taxes appropriately. Especially the services sector of an economy which typically experiences the biggest growth at periods of economic growth has to contribute more to the tax revenue. The government has failed to include the growing parts of the services sector in the country into the tax base. As an example, branches of tourism industry, which experiences dividend after the civil war, has been gifted with generous tax exemptions that the rest of the industries do not enjoy. The private medical services are still operating in ways that are difficult to be monitored. Policy makers are also blind to certain private education services that sprung up recently and are enjoying a good 10 to 15 years of tax avoidance. This gives rise to the problem of undeclared economic activities at large. It is of utmost importance that the government taxes the industries appropriately without relying on indirect taxes alone. I find this tendency increasingly regressive since the thriving industries are allowed to operate tax free while the struggling industries are being taxed exorbitantly. The excessive tax avoidances hurt the economy while creating a regressive tax system.

The corporate laws are hotbeds of inequity. It is not uncommon to frequently hear cases where companies avoiding taxes or company executives receiving lucrative benefits during  economic recessions. Sri Lankan corporate law is yet to be made sophisticated to detect inequitable benefits received by top executives. In Sri Lanka corporate law has made it compulsory for the listed companies to report the salaries of directors. Yet it is not required to report the benefits, bonuses and long-term incentives while the rest of the South Asian countries are required to do so in their countries. This has created a major loophole in our tax system where they can avoid taxes by disclosing a smaller remuneration and receiving millions in bonuses and benefits.

A recent inclusion to the corporate law became a topic of widespread discussion. Imposing an annual tax of 60,000 rupees and a closing tax of 250,000 rupees is another example for ad-hoc taxes which undermine equity in the tax system. This is clearly a regressive tax where a bigger company could easily bear the tax while it could be a big burden on a smaller company. The impact on economic efficiency of this law is unmistakable. The biggest impact will be on Small and Medium Enterprises (SME). According to the Central Bank, SMEs constitute 35 percent of total employment and 50 percent of GDP. Therefore, such laws are also to make an alarming impact on GDP, unemployment rate and private investment.

The successive  governments are guilty of employing the tax exemptions as a tool to entice Foreign Direct Investment (FDI) for decades. Sri Lanka has been engrossed in attracting FDI that they are losing the basic principles of taxation. It is calculated that the loss of tax revenue due to Board of Investment’s (BOI) tax incentives is around 1% of GDP. Whereas the country is able to attract only around 1.5% worth of FDI. While a tax incentive for a short period is justifiable, having such incentives for over 40 years poses a serious equity problem in taxation. Several companies are enjoying free rides at the expense of taxpayer money. The governments have failed to exploit  diverse avenues to attract FDI. According to the World Bank, political stability, consistency in economic policies, better institutional trust and infrastructure attract more FDI than tax holidays. It is also noted that having had the same tax holidays for FDI for decades, it has allowed companies to operate in competition-free environment which makes them extremely inefficient. This has become a boon for few companies and a bane for the rest of the firms who have to pay a higher tax rate.


While raising taxes and increasing government revenue are matters of imminent attention, there are more equitable ways of generating wealth. The government should not lose focus on equity or any other tax principle since the impact on the society could be detrimental. As Amrtya Sen puts


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