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Populist Agenda in Sri Lanka and Economic Impact

Published Dec 23, 2019
Updated Feb 05, 2020

Measures by the newly anointed government headed by President Gotabaya Rajapaksa with elder brother Prime Minister Mahinda Rajapaksa also a two time President to provide tax relief have led to concerns by ratings agencies.

Fitch Ratings has revised the Outlook on Sri Lanka’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to Negative from Stable and has affirmed the IDR at ‘B’.

While the new government has possibly revised the tax rates keeping parliamentary elections in April in view, where it hopes to exploit the current mood of the people to advantage, the impact on the economy is reflected in the downgrade by Fitch ratings.

“We believe the departure from the previous revenue-based fiscal consolidation path has created policy uncertainty and increased external financing risk for the sovereign, particularly given the large external debt repayments due in 2020 and beyond,” the rating agency said in a statement.

Newly appointed President Gotabaya Rajapaksa announced sweeping tax cuts soon after taking office, including a revision of the value-added tax (VAT) rate to 8% from 15% (the rate applicable to financial services has been kept at 15%, an increase in the liable limit for VAT registration to LKR300 million, scrapping of the nation building tax, lowering the income tax rate for the highest income bracket to 18%, from 24%, and changing the withholding tax regime, among others.

Fitch’s preliminary estimates show that the VAT rate change and the scrapping of the nation building tax could alone lower revenue by as much as 2% of GDP in the absence of off-setting measures; VAT accounted for 24% of government revenues in 2018. The authorities have identified offsetting revenue and expenditure measures that they believe would make these tax cuts revenue neutral.

These include a hike in the excise duty on liquor and cigarettes, which accounts for about 10% of VAT revenue, and an increase in the Ports and Airports Development Levy to 10.0%, from 7.5%. In addition, financial services, which account for 15% of VAT, will not be affected by the rate cut. The authorities project the expenditure adjustment to come mainly from a cutback in public investment.

Fitch expects these offsetting measures, such as adjustments to excise taxes and spending cuts on non-priority public investment and recurrent expenditure, to mitigate part of the revenue loss from the tax announcement. However, the agency nevertheless expects the deficit to widen by about 1.5% of GDP relative to our previous forecasts.

Fitch has revised its budget deficit projection to 6.5% of GDP for 2020 and 6.2% for 2021, which are higher than the authorities’ estimates, from 5.0% previously in both years.

Meanwhile in a detailed statement the Ministry of Finance in Sri Lanka has refuted the Fitch Ratings statements indicating that the impact on the economy of measures taken by the government will remain miniminal.