By Anis Chowdhury and Jomo Kwame Sundaram: Once deemed a basic human needs success story, Sri Lanka (SL) is now in its worst economic crisis since independence in 1948. Nonetheless, SL’s ‘moment of truth’ now offers lessons for other developing countries. The country has just defaulted on its foreign debt for the very first time. Attributing its current predicament to a Chinese ‘debt-trap’ is a new Cold War propaganda distraction – which we will undoubtedly hear much more of. The ethno-populist policies of the Gotabaya Rajapaksa government – which came to power in 2019 – have added fuel to fire. Successfully mobilizing majority Buddhist Singhala sentiment – against Tamils, Muslims and Christians – he sought political support by cutting taxes. His government cut taxes across the board, collecting only 12.7% of GDP in revenue in 2017-19 – one of the lowest shares among middle-income countries. Losing about 2% of GDP in revenue, its tax-GDP ratio fell to 8.4% in 2020.
SL’s value-added tax rate was cut from 15% to 8%, while the VAT registration threshold was raised from one to 25 million SL rupees monthly. Other indirect taxes and the ‘pay-as-you-earn’ system were abolished. The minimum income tax threshold was raised from 500,000 SL rupees annually to three million, with few earning that much! Personal income tax rates were not only reduced, but also became even less progressive. The corporate income tax rate was cut from 28% to 24%. With a 33.5% drop in registered taxpayers (corporate and individual) between 2019 and 2020, SL’s tax base shrank. Thus, even more of the population became exempt from direct taxes, increasing government popularity. But tax cuts failed to spur investment and growth.
Successive SL governments thus failed to increase tax collection, squeezing government revenue. To finance budget deficits, they increasingly borrowed from international capital markets – at higher commercial rates, with shorter maturities. As the government cut tax rates and exempted most from paying income tax, government revenue fell. Due to its falling revenue and deteriorating credit rating, the government had to borrow more, at higher interest rates. Evidently, the SL government addressed the economic challenges it faced with ‘populist’ policy choices. Instead of addressing longstanding problems faced, this effectively ‘kicked the can’ down the road, worsening the inevitable meltdown.