Mind the Gap: How Will Sri Lanka Finance its Development Needs?

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As Sri Lanka gears up for the third full budget since the end of the war, Anushka Wijesinha (Research Economist – IPS) looks at the formidable challenge for Sri Lanka’s development – finding the money to finance it. Taxation, he argues, must be a major policy priority in strengthening the capacity of the Sri Lankan state.

While Sri Lanka has made strong progress on many social indicators, significant development gaps remain. This is one of the core messages of the Sri Lanka Human Development Report 2012 launched at IPS recently. Sri Lanka’s health and education sectors demonstrate notable gaps and heightened investment by the state would be required to bridge them, the report argues. In the past, Sri Lanka found it easier to finance these needs with generous donor aid flowing into the country. Sri Lanka was considered a “donor darling” as one of the first countries in South Asia to embark on market-oriented reforms following economic liberalization in 1977 and concessional loans from international aid donors soared for decades since then.

But this is changing. Sri Lanka is moving away from low-income country status to the middle-income bracket. This means that it has less access to cheap/concessionary funds from international aid donors. Based on an ongoing survey of local and international development agencies that rely on foreign funding, it is becoming clear that Sri Lanka’s access to concessionary funding from abroad is rapidly shrinking. This comes at a time when there is a heightened pressure on public finances with the continued massive, and no doubt vital, post-war reconstruction and rehabilitation efforts. In this backdrop, strengthening the spending capacity of the state, to finance the bridging of the gaps and the provision of social services is vital.

Contracting Foreign Aid

This situation is changing, as Sri Lanka moves into middle income country status. The country is becoming increasingly less eligible for concessionary loans from sources like IDA (International Development Association) – which carry low interest rates, long tenors and grace periods and a high grant element – to finance its public investments[i].

IPS spoke with several aid missions. The Deputy Head of Mission of a leading European aid donor told me that, “Since 2010, Sri Lanka no longer qualifies for bilateral development assistance due to the Low Middle Income status of the country”. This sums it up well. Many of the aid donors surveyed noted that in the last 2-3 years there has been a reduction in their funding to Sri Lanka (mainly due to contraction of humanitarian assistance, but extending to development assistance too), and this trend is likely to continue. They noted that the changes have been in: ‘the volume of the funds received/disbursed’; ‘the type of funding’; ‘how the funding is being allocated and the nature of projects’; and ‘the sources of the donors (countries/agencies) themselves’. They added that the top reasons for these changes/reductions were: ‘change in the country’s economic situation (MIC) and change in the types of needs’, ‘economic growth of the country’, ‘status of the global economy’.

The head of a UN agency reported that “the funds we have traditionally accessed have contracted by 70%”; while a leading European bilateral donor indicated a more than 60% contraction in funds between 2009 and 2011. Another UN agency chief remarked that “in 2012, [institution name removed] has only been able to resource less than one third of what it mobilized from donor sources in 2009”. Meanwhile, a leading donor agency added that “[as] Sri Lanka graduated to a middle income country, many donors feel that there is some responsibility on the part of the government to undertake a larger role…”

Development Gaps and State Capacity

The Sri Lankan state continues to be a key provider of social services, such as education and health but has been invested less and less in both sectors over the years.

Investment by the Sri Lankan state in education is low and has declined steadily over time. Public expenditure in education has averaged at 2.3% of GDP during the 2000 to 2010 period, falling to a 10-year low of 1.9% of GDP in 2012[ii]. This is smaller than the average of middle income countries. As a percentage of GDP, the average upper middle income country spent 5% of GDP, and the average lower middle income country spent 4% of GDP on education. Meanwhile, access to better schooling facilities is grossly insufficient, with only 10% of all schools in the country able to offer A/L science, and those, too, concentrated in urban areas only.

Similar issues prevail in the health sector. Health investments by the Sri Lankan state have reduced, threatening to compromise the impressive gains made in the past. Total expenditure on health remained below 5% of GDP between 1995 and 2008, and is low compared to the global average of around 8%. Within this, the contribution from the state was only around 45.8% (2009) – the rest came from private sources (private sector health providers as well as Out-Of-Pocket-Expenditure – OOPE). The proportion of out-of-pocket expenditure (out of private health expenditure) has grown remarkably over time – Sri Lankans spent Rs. 70 billion more out-of-pocket on healthcare in 2009 than 20 years ago.

Tackling the development challenge of building a skilled and healthy workforce crucially hinges on investing more in health and education. Funding this will now depend more than ever on government finance through tax revenue.

Financing Human Development: Taxation Imperative

One way of financing it is through loans – Sri Lanka has, of late, been increasing its volumes of borrowing from international debt capital markets. But as highlighted in the forthcoming ‘State of the Economy 2012’ report by IPS, this comes with its own set of concerns. Therefore, a stronger domestic revenue mobilization effort must be underway to strengthen the capacity of the state to address the critical development challenges, whether it is in health, education or infrastructure.

Lewis (1984) argued that ‘an increasing share of tax revenue in national income or in GDP is an instrumental objective of economic development policy’ (p.6). High-income countries have had rising shares of tax revenue and government expenditures to income as they have become more advanced. As developing countries need to spend more on public infrastructure, education, health services, etc., they need to increase their tax ratio in order to grow and improve human development outcomes of its people (Bird et al., 2008). Almost half a century ago, Kaldor (1963) argued that for a country to become “developed” it needed to collect taxes at 25-30% of GDP. Though Sri Lanka is classified as a lower middle-income economy by the World Bank, clearly Sri Lanka’s tax ratio does not correspond to one.

Tax revenue as a share of GDP (the ‘tax ratio’) dropped to around 15% during 2003-2008, compared to about 19% before 1995. The benchmark tax-GDP ratio for a low-income country is 18%, and is 25% for a middle-income country (Gallagher, 2005)[iii]. Sri Lanka’s was just 12.4% in 2011 (Figure 1). Sri Lanka’s performance compares poorly with countries like Vietnam, Thailand, Malaysia, Singapore, Ghana, and South Africa, but better than other South Asian neighbours, including India, Pakistan and Bangladesh and marginally better than Indonesia and Philippines.

Figure 1: Sri Lanka’s Declining Tax Revenue to GDP Ratio (1977-2010)

Source: Prepared based on Central Bank of Sri Lanka Annual Report (various years); Department of Inland Revenue Performance Reports (various years).

Sri Lanka performs particularly poor on collection of direct taxes – i.e., taxes on income and profits – collecting just around one fourth of total taxes from direct sources. The rest is from indirect taxes (mainly consumption-based taxes like VAT), which hurt the poor disproportionately as they are inherently regressive. Many other countries’ tax collection is more from direct taxes, for example Malaysia (over 60%), India (over 50%), Pakistan (around 40%), Thailand (50%), Uganda (just under 30%), and Kenya (just above 42%)[iv].

Tax Policy Reforms

Meanwhile, the fiscal system in the country constantly undergoes ad hoc tax changes, which have excessively complicated the tax system. It is uncertain whether these complications are related to the weak revenue-raising performance of the country. According to Waidyasekera (2004, IPS) unplanned and ad hoc fiscal measures including tax exemptions, tax amnesties and tax concessions; the increase in the exemption threshold for income tax and the reduction of import duty rates; lack of elasticity and buoyancy of the fiscal system; complexity in tax legislation and lack of fiscal consistency; and weaknesses in tax revenue administration, has caused the level of tax collection to be lower than optimal in Sri Lanka.

A report by the Presidential Commission on Taxation 2009 identified all these issues and provided comprehensive recommendations to address them in a phased manner – especially with the objective of expanding the tax base[v]. However, full implementation of the recommendations, particularly those on reforming of tax administration to make it more effective and efficient in collecting more tax, have not taken place – possibly due to competing stakeholder interests and political sensitivities.

Yet, some reforms aimed at expanding the direct tax base have begun. For instance, in an unprecedented reform measure, the 2011 Budget extended PAYE income tax to public sector employees, stripping away the income tax exemption that they enjoyed since the late 1970s. Additionally, corporate and personal income tax rates were reduced with a view to induce private economic activity – particularly firms – and thus generate more total tax revenues and encourage greater compliance. But the revenue effect of these reforms is still uncertain. For instance, a recent simulation study by the IPS has showed that although adding the previously exempt public servants to the tax base certainly corrects the horizontal inequity between public and private sectors employees, the structural changes that came with the new tax scheme may result in a decline in tax revenues. According to the study results, the amount of tax revenues is reduced, from LKR 12.2 billion in 2007 to LKR 6.3 billion in 2011. Two main reasons are cited for the decline under the new 2011 tax system: i) the new tax brackets induced an increase of the “tax free” threshold from LKR.300,000 in 2007 to LKR.600,000 in 2011, and ii) the tax rates were also reduced to 4%-24% from 5%-35% in 2007[vi].

Mind the Gap!

With steadily declining international aid, resources to finance Sri Lanka’s development needs would increasingly have to come from within. There is of course always the option of raising riskier and costlier funds from international capital markets or friendly nations, but this is neither ideal nor stable. The capacity of the state to deliver services to the broader population and address human development gaps would depend on greater and better availability of financial resources to the state. In this context, improving the state’s tax revenue becomes a critical public policy issue.

The author wishes to acknowledge Fathima Munas (Project Intern, IPS) for her contribution to this article.