The World Bank published a Systematic Country Diagnostic on Sri Lanka on 1 February 2016. This looks at the key obstacles to sustained progress in ending poverty and increasing prosperity. The study identifies the low tax to GDP ratio as an important factor in restricting the government’s ability to invest in health, education and other important services and makes recommendations on improving the position.

In Sri Lanka the ratio of tax to GDP has fallen from 14.5% in 2000 to 10.7% in 2014. This has led to fiscal deficits although over the past five years the government has aimed at fiscal consolidation and brought the budget deficit down to 6% in 2014.

Indirect taxes bring in 80% of the tax revenue in Sri Lanka. The revenue raised from international trade and taxes on goods and services is high as a share of total taxes and as a share of GDP compared with comparable countries in the region. Revenue collected from taxes on income, profits and capital is lower than would be expected by comparison with similar countries.

The dependence on indirect taxes limits Sri Lanka’s ability to expand its tax base and also has implications for the equity of the system and the distribution of the tax burden in society. The decrease in the tax burden is due to trade liberalization, problems with recent tax reforms, the numerous exemptions granted and difficulties in tax administration.

The decline in value added tax (VAT) collection has been a major cause of the reduction in the tax revenue to GDP ratio in recent years. The unification of the VAT rates in recent tax reforms set the VAT at a relatively low rate, and the corporate and income tax rates were lowered without a corresponding broadening of the tax base.

Another factor in low revenue collection is the large number of tax exemptions given to boost foreign investment or to support particular industries or activities. This has caused an erosion of the tax base and has made tax administration more difficult by discouraging tax compliance. Also the tax administration generally does not score well on indicators of tax collection in arrears, clarity of tax liabilities and effectiveness of penalties for non-compliance.

Another problem is that there are multiple institutions concerned with tax compliance. The Department of Customs, Department of Excise and Inland Revenue Department (IRD) are all concerned with tax collection. There is also significant overlap with other government agencies such as the Board of Investment. There are more than forty broad types of exemption from corporate and individual income tax and around five hundred VAT exemptions for various types of goods. The Board of Investment also provides additional incentives and ad hoc incentives apply to entities implementing projects under the 2010 Strategic Development Act.

Tax expenditure analysis is not conducted before or after the introduction of incentives and statements of tax expenditures are not prepared or published. Firms granted incentives by the Board of Investment are generally not monitored by the IRD (except for corporate income tax since 2013) and there is no formal system of sharing information between the two agencies. There has not been enough follow-up to ensure that firms begin to pay taxes after tax holidays end.

Other countries in the region have improved their tax administration by implementing IT systems. Sri Lanka is launching the first phase of a Revenue Administration Management Information System to enable information sharing, integrate taxpayer information and to provide for online filing. However experience in other countries suggests that the process of implementation is complex.

The World Bank considers that continued strong commitment to fiscal sustainability requires long term domestic revenue mobilization. Greater analysis of the problems is required, particularly relating to tax exemptions and enforcement of the tax rules. Among other measures Sri Lanka must review trade related policies, simplify the VAT and corporate tax regimes and reduce or eliminate export taxes on agricultural commodities.