This piece was written by Yolani Fernando, the Executive Director at Arutha.
There are very few things that unite Sri Lankans as passionately as our love for tea and now our hatred of taxes. These past years of constant tax reforms have kept taxes in the public eye much more than usual. And while we wish we could pay less tax and go back to our pre-2022 reality, such a reversal is very likely to set us back on the road to crisis.
This article will not discuss the specifics of the current tax reforms but rather investigate whether more taxation (rather than debt) leads to more citizenship participation and better governance. The question on citizens’ minds when asked to pay higher taxes is, ‘But what am I getting for my taxes?’ There are genuine concerns about the quality of Government services and widespread corruption. Any government that wants citizens to pay more taxes should take these concerns seriously.
More tax = better governance?
The tax cuts in 2019 was the first domino to fall in our road to crisis. Sri Lanka’s first-ever sovereign default in April 2022 and economic crisis prompted widespread people’s protests demanding greater accountability and transparency from the State. As part of its recovery, Sri Lanka has embarked on ambitious tax reforms as perennially low taxation was a significant contributor to the crisis.
It makes sense that the Sri Lankan State, which had been answerable to external creditors due to a heavy reliance on foreign debt, would become more accountable to its taxpayers if tax collection were to increase. There’s an argument made that more (visible) taxation leads to citizens demanding more from the State.
The logic is straightforward: the more of your money the State takes, the more you care about how it is spent. It is natural that the citizen-taxpayer should then want the State to be more accountable and provide better public services. Reality is not that simple. However, there are some avenues to improve citizenship engagement and Government communication for greater buy-in and sustainability of reforms.
Tax bargaining
Tax bargaining is one way in which citizens can engage with the Government on tax reforms. In Sri Lanka, tax bargaining under the current reforms would ideally lead to better public services, but given the nature of the tax increase, especially that of income taxes, it may not necessarily bring this about.
In 2020, Sri Lanka’s income taxes only accounted for 22% of tax revenue. This points to a heavy reliance on other indirect forms of taxation such as border taxes, which makes Sri Lanka’s tax system extremely inequitable. Increasing income tax rates and lowering the thresholds was thus one of the priorities of the current tax reforms.
While this increases visibility of taxation, these income tax reforms only apply to approximately the higher bracket of income earners. These taxpayers are the most unlikely group to use public services such as public healthcare and education and are not affected by inefficiencies in social security schemes.
For example, car ownership is restricted to the same high-income bracket which indicates that these taxpayers will not be users of public transport. Direct tax bargaining then becomes less likely as taxpayer-citizens have no incentive to use their leverage to bargain for better public services.
Further, in the absence of formal means of tax bargaining, the poor do not have access to informal means of tax bargaining, unlike those in the upper income brackets. One caveat to this is that, considering the decimation of real incomes, some segments of income taxpayers who previously used private means of health, education, and transport may change behaviour now and use public services.
On the side of indirect tax reform, tax bargaining is slightly more complex as the amount of tax paid by citizens often remains invisible. This is especially true of taxes such as Value-Added Tax (VAT), which is a major part of the Sri Lankan tax reform agenda. There are of course examples of citizen mobilisation against indirect taxation such as Ghana’s 1995 anti-VAT protests. But the Ghanaian case study is more of an exception than a rule in the area of state-citizen engagement on taxation.
The major factor here is of course that citizens will be less attuned to how much tax they are actually paying through VAT. This makes it more difficult for citizens to mobilise and demand state responsiveness. The one caveat that should be noted is that for enterprises, VAT is a visible burden and thus one that would prompt negotiating with the state.
Sri Lankan enterprises have already raised concerns on tax reforms with special reference to increasing Government accountability and transparency, signalling that the space for tax bargaining may be available to them. As the Sri Lankan Government is facing severe pressure to raise revenues, it should negotiate and communicate compromises to ensure sustainability of these reforms.
A broken fiscal social contract
There’s an idea at the heart of the tax-governance debate called the fiscal social contract; simply put, increased taxation can lead to better performance of the state and better state-citizen relationships. But tax reforms do not inherently ensure a stronger social contract and are determined by several factors.
The first of these is that successful tax reforms require changes in government expenditure patterns. Sometimes this entails earmarking the revenue for specific expenditure such as social spending.
Ghana’s anti-VAT protests prompted the Government to earmark subsequent tax increases for social programmes such as the Ghana Education Trust Fund and a National Health Insurance Scheme. This may prove to be a crucial factor in whether or not Sri Lanka creates a new fiscal social contract through its tax reform process.
Sri Lanka’s decades-long revenue problem reduced social spending and drastically affected the quality of public services. This is in direct contrast to Sri Lanka’s reputation as a model welfare state in the 1950s to 1980s.
Sri Lanka’s pre-reform tax regime was not reliant on income taxes and decades of low income taxes have created a psyche of receiving free public goods such as healthcare and education as well as a plethora of subsidies without the burden of taxation.
With tax reforms at the forefront of the reform agenda, the spotlight has inevitably been shone on Government expenditure, especially social spending. One major criticism that has already been levied is the increase in defence spending, which is part of a trend of inefficient overspending on defence that has continued despite the end of Sri Lanka’s civil war in 2009.
This manner of Government spending is in contradiction to the needs of the wider population and can have a negative impact on trust in public institutions. Strengthening fiscal social contracts to ensure better State responsiveness thus requires tax reforms to be accompanied by expenditure reforms reflective of the needs of citizen-taxpayers, especially in relation to social spending.
The future of the tax reforms
If current and future governments are serious about changing Sri Lanka’s public finance situation, they must commit to changing our tax culture. This is, however, not possible without rebuilding trust in State institutions and showcasing a willingness to change the State-citizen relationship.
This means committing to creating buy-in for the reforms among taxpayers by proactively creating spaces for tax bargaining and changing spending to rebuild a broken fiscal social contract. Part of fixing this contract is reigning in Government spending but also earmarking funds for social programmes.
While we cannot, unfortunately, wish for a tax-free life, we can perhaps wish for a government that is more willing to communicate with its citizens and be more transparent about how it spends public funds.
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