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Sri Lanka’s mid day shares gain on IMF and currency appreciation

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ECONOMYNEXT – Sri Lanka’s recently leftist style progressive tax transferring more potential investible savings to the hands of the political class, had been defended by the International Monetary Fund.

The IMF said creditors and investors will not support Sri Lanka because tax to GDP had fallen steeply. Taxes, including value added taxes were slashed in 2019 December to target a ‘persistent output gap’, after serial currency crises from flexible inflation targeting reduced growth.

Taxes fell and deficits soared from 2020 onwards, worsened by a Coronavirus crisis.

“Tax reforms are needed to correct this imbalance,” the IMF’s Peter Brauer said in a statement.

“Only with appropriate tax receipts will the Government will be able to fund essential expenditures, and avoid further slashing of critically important outlays.

“These reforms will also help regain confidence of creditors.”

The current protests however relates mostly to leftist style progressive taxes not all taxes. Among key protestors are state enterprise workers whose payroll taxes were previously paid for by the SOE.

The IMF is trying to help Sri Lanka stabilize the country after the central bank triggered serial currency crisis in the pursuit of flexible inflation targeting with a flexible exchange rate and output gap targeting, where money is printed for growth.

Sri Lanka’s most serious currency crisis in 2020-2022 ended in external sovereign default.

Up to December 2019 Sri Lanka also pursued a previously unheard of strategy called ‘revenue based fiscal consolidation’ where spending based consolidation (cost cutting) was abandoned, leading to a rise in state spending to GDP from 17 to 20 percent of GDP, according to critics.

The abandoning of the spending based consolidation predictably failed to bring down the budget deficit, while monetary instability under flexible inflation targeting triggered currency crises and output shocks as stabilization brakes were hit.

Meanwhile, foreign borrowings also soared, including at state-run Ceylon Petroleum Corporation as the country lost the ability settle foreign debt and petroleum repayments with domestically collected revenues or resources due to monetary instability.

Higher progressive taxes in the original revenue based fiscal consolidation led to a backlash against the then government from so-called ‘professionals’ as the highest progressive tax rate was raised to 24 percent from 18 percent.

The new government then slashed taxes, including value added tax, for ‘stimulus’ under the claim that there was a ‘persistent output gap’, in the wake of the currency crisis, leading to a steep fall revenues.

An even bigger currency crisis resulted as more money was printed to target an output gap, and the country eventually defaulted in April 2022. Now a new monetary law, legalizing output gap targeting is to be brought to parliament.

Sri Lankas triggered currency trouble for 72 years and gone to the IMF 16 times, without bringing laws to curb the powers to the central bank to create monetary instability, critics says leading to the failure of any and all economic strategies of all administrations.

The progressive income tax, the actual revenues of which are unclear, had led to opposition as they come on top of high import duties and value added tax of 18 percent and another cascading tax, unlike the US which was import duties around 3 percent or less and not value added tax.

The full IMF statement is reproduced below:

In response to recent media questions around income tax hikes in Sri Lanka, the answer below is attributable to Peter Breuer, Senior Mission Chief for Sri Lanka, and Masahiro Nozaki, Mission Chief for Sri Lanka, IMF:

• We understand the hardship people of Sri Lanka are experiencing at this time. Increases in the cost of living, loss of employment and livelihood, and falling real incomes have hit large parts of the population, and particularly the poor and vulnerable who have no buffers to withstand these hardships.

• The current economic crisis has a number of origins, including the government’s inability to meet government spending needs through its revenue collections. Sri Lanka is among the countries to collect the least amount of fiscal revenue in the world, with tax revenue to GDP ratio at only 7.3 percent in 2021. External creditors are not willing to provide financing to fill this gap.

• Tax reforms are needed to correct this imbalance. Only with appropriate tax receipts will the Government will be able to fund essential expenditures, and avoid further slashing of critically important outlays. These reforms will also help regain confidence of creditors.

• Efforts to increase tax revenues should be pursued in a growth-friendly manner while protecting the poor and most vulnerable. It is however also important that those who can most afford it, make commensurate contributions to the financing of the necessary government expenditures.

The tax package the authorities have introduced, including the new tax rate schedule for the personal income tax, helps to meet these objectives. The tax rates proposed under the authorities’ program are also in line with international comparison.

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