Moody’s says VAT hike will keep IMF program on track

MoodysThe Moody’s rating agency says the amendments to the value added tax (VAT) bill, which will increase the VAT tax rate to 15% from 11%, will pave the way for higher government revenues and adherence to International Monetary Fund (IMF) program commitments.

Moody’s says the move is positive because a higher VAT rate will facilitate fiscal consolidation by strengthening Sri Lanka’s low revenue-toGDP ratio, which is a key credit constraint.

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. 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 program and loan disbursements, which would have strained the balance of payments and harmed investor confidence.

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 program 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% (Exhibit 1). Revenue growth was broad-based, with increases in VAT, the national building tax and custom duties. As a result, the primary balance, which excludes interest payments, was in deficit of LKR38.6 billion by June 2016, ahead of the IMF program target of LKR46 billion.

Despite a favorable first half of the year, the primary deficit widened markedly in July. 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.

The IMF forecasts an increase in Sri Lanka’s revenue-to-GDP ratio to 15.8% by 2020 from 13.0% this year. Moody’s says reinstating the VAT rate hike is an important step toward achieving the Government’s revenue objectives, but meeting the IMF or Government objectives will involve additional revenue measures. The Government aims to broaden the tax base via a new Inland Revenue Act and strengthen revenue collection and administration.

Moody’s expects fiscal consolidation to 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. (Colombo Gazette)