The Value Added Tax (VAT) rate hike from 11 per cent to 15 per cent from  May 2, this year and the interim order of the courts suspending the increase have led many parties to stage protests around the country. The objective of the VAT increase, according to authorities, was to increase revenue, try to settle the currently huge debt burden of the country and survive the Balance of Payments crisis. Global economic uncertainty affecting Sri Lankan economy, Brexit as well aschanged demand conditions in major export destinations are some other reasons the proponents bring out in favor of high VAT rates. However, opponents view the increased taxes as a further burden on the low and middle income groups due to the inflationary effect VAT has on essential commodities consumed by the middle and low income groups.

economicsNothing is ever completely one-sided. Apart from the positive aspect highlighted by the authorities and the simplified tax rate through the increase, high VAT rates are a disincentive for investment and productive activities. Consumers need to spend more due to the inflationary effect created in the economy. Not only prices of essential commodities, but prices of almost every good increases due to VAT rate hikes. The recent reduced demand of motor vehicles is clear evidence of this. Due to increased consumer spending, individual savings are low which in turn lead to reduced economic growth, as savings are a main determinant of growth of a country. As a result, the investment climate of the country is seen as a low incentive for investment.

Nevertheless, we should admit that there is a massive tax net when VAT is implemented. It is a fast approach to increased revenues. Here, too, the negative side is the increased administrative cost to manage the massive tax net. The foremost point the authorities should keep in mind is that VAT increases should never be an incentive for higher government borrowing. Imposing taxes should not be taken for granted. If the reverse happens, Sri Lanka will forever be lost in the vicious debt trap we are already faced with.
The argument for reducing VAT rates is that the reduction could only be compensated via reduced government borrowings and limited government spending. Of the above, reduced government borrowings is the only option sustainable in the long-term. In a country like ours where the state sector is massive and people are used to depend on the government to fulfill their requirements, the ability to reduce government spending is doubtful. If the above could be properly handled by the government, tax rate reductions will not be a problem for Sri Lanka.However, if the government has no option other than increasing public spending for its people, and going for borrowings to fund its various requirements, we are left with none other than increasing VAT rates whether we like it or not.

Public debt outstanding as at 2015 is Rs. 8.5 billion. VAT is the largest contributor to the overall tax revenue in Sri Lanka, but as a percentage of tax revenue, it has largely declined from 30 percent in 2010 to just 16 per cent in 2015. A constructive decision regarding VAT and other taxes is therefore vital at this point in time.

The need to improve tax revenue in the coming years could be enhanced by measures like expanding the tax base, eliminating tax exemptions and tightening regulations to reduce tax avoidance. These require a more efficient and effective tax administration than at present.Other sources of revenue the government could definitely think of are: direct investment in profitable sectors, reduce wasteful expenses and losses of public enterprises,dispose unproductive government assets, and shift from public expenditure towards social expenditure. These would qualitatively improve the fiscal space in the Sri Lankan economy. Proper administration and regulation are essential with regard to the above.However, the decision whether to increase the rate of VAT may have to be made given the socio-political conditions prevailing in Sri Lanka.