Sri Lanka’s reinstated Value Added Tax (VAT) hike will keep the island’s External Fund Facility (EFF) programme with the International Monetary Fund (IMF) on track and is therefore a credit positive, a top rating agency said last week. Issuing a Credit Outlook report, Moody’s Investors Service however pointed out that the delay in implementing the VAT hike has now made achieving Sri Lanka’s primary deficit targets challenging.

“The VAT hiatus makes meeting primary deficit targets challenging, at LKR85 billion for September and LKR97 billion for December. In particular, salary and pension payments accounting for about 36% of primary expenditure and interest payments amounting to around a quarter of total expenditures constrain room to cut expenditures,” William Foster and Amelia Tan, both attached to the Sovereign Risk Group of Moody’s Investors Service said in their analysis.

The report also noted that in the longer term, the objective of reducing the deficit to 3.5% of GDP by 2020 is ambitious and would be the smallest deficit in the past 25 years, and indeed in most years since 1950.

“Backsliding on VAT reform demonstrates the implementation risks surrounding fiscal reforms. Had the implementation delay been prolonged, Sri Lanka would have been at risk of derailing its IMF programme and loan disbursements, which would have strained the balance of payments and harmed investor confidence,” the report said.

According to Moody’s, fiscal consolidation will continue, although at a gradual pace, given implementation risks and the country’s long track record of poor revenue collection and tax exemptions, which will take several years to change significantly. Moody’s projects a budget deficit of 6.0% of GDP this year and 5.5% in 2017.

On 26th October, the Sri Lanka parliament voted in favour of amendments to the VAT bill, increasing the VAT tax rate to 15% from 11%, paving the way for higher government revenues and adherence to International Monetary Fund (IMF) programme commitments. The government originally implemented the VAT hike in May, but retracted it in July after a legal challenge by the main political opposition party in parliament.

“This is credit positive because a higher VAT rate will facilitate fiscal consolidation by strengthening Sri Lanka’s low revenue-to GDP ratio, which is a key credit constraint,” the analysis said.

The VAT parliamentary vote took place immediately following a Supreme Court ruling that deemed the tax hike permissible under Sri Lankan law. In addition, parliament approved amendments that increase the nation building tax rate on importers, manufactures and service providers to 4% from 2%.

Fiscal consolidation is a major focus of the IMF programme with a reduction in the deficit to 5.4% of GDP this year and 3.5% by 2020, from 6.9% in 2015, or 7.4% including one-off expenses. In first-half 2016, government revenues including grants rose a robust 27.3% year-on-year while expenditures increased 7.1%.