Negative Impact of Add-On VAT (Value Added Tax) : Perspective of Sri Lanka

Value Added Tax is a determined percentage (%) taxed on consumer spendings. In the face of a struggling economy, many countries including Sri Lanka have been focusing on add-on VATs. The listing of the Economic Census report 2013/14 recognized the approx. 1.02 million establishments that were involved in various economic activities encompassing industry, trade, construction and service sectors in Sri Lanka. While Small & Medium-scale Enterprises play a pivotal role, the increasing number of business start-ups is a notable economic variable used by economists. The recent increase add-on VAT that is ‘supposed’ to moderate the consequences of the fiscal deficit will affect businesses as well as consumers.

More than 140 countries globally have a value added tax. In order to achieve deficit reduction, the government recently hiked the VAT rate, which was previously 11% to 15% with affect from 1^st November 2016. However, increasing VAT rates imposes a serious risk. Most countries would reduce government spendings instead, and not increase their VATs in times of economic struggle. Lessening deficit by reducing government spending will have slightly more favorable outcomes relatively; more jobs, increase in GDP and standard of living etc. Reduced government spendings’ will have a significant impact on the Aggregated Demand (AD) and Aggregated Supply (AS) of the economy.

What does the government spend money on?
1. Debt Interest	5. Defense
2. Public Order & Safety	6. Education
3. Housing & Environment	7. Social Protection
4. Industry/Agriculture/Employment	8. Health
Other

While which areas’ government spending should be reduced is a controversial question that need not be discussed here, from an economic perspective reducing capital investments will be comparatively the easiest way to reduce government spendings’.

The drastic increase in government spendings’ can be observed in the line chart given below.

Now that I have made my point regarding the need to cut down government expenditure and not necessarily add-on VAT, let me explain the negative consequences of increasing VAT.

Reduced Retail Spending

The increase in VAT would lower household consumption due to the amplified tax charged on good and services consumed. Especially during the initial stages since the enactment of the new VAT rate, there will be a steep decline in consumer spending although over a period of 10 years the impact will be less aggressive.

This leads to the second negative outcome, which affects the macroeconomic environment of the country.

Adverse Macroeconomic Impact

With the reduction in consumer spending, there will be a noticeable fall in GDP. To support this argument as stated by the World Bank, Sri Lanka’s GDP is to remain flat this year with the GDP just above 5% in 2017. The marginal increase in GDP could be improved if the policymakers focused primarily on cutting down government spending while keeping consumption tax rates lower, which would increase Aggregated Demand in the economy.

The deficit-reducing VAT would not only negatively affect GDP but it will continue to impact employment rates. An increase in unemployment rates resulted by the lowered business spending will lead to a decline in real wages and their inability to consume as much.

The tough economic conditions will drastically affect the poorer.

Economic Impact on Middle-Income Families

The increase VAT rate would be an additional tax apart from the existing taxes including individual income tax, corporate income tax and the payroll Taxes. This could act as a burden and have a negative impact on the health of the population with many indirect effects occurring (Anxiety, violence, crime/theft etc).

It could be expected for the VAT rates to be increased over the next few years due to the continued political pressure and the need to reduce the horrendous budget deficit the country is currently experiencing. While the VAT rates in UK and Japan are 20% and 8% respectively, there is no mandatory policy for the rates to increase considerably in order to reduce deficits. While Japan has a higher budget deficit compared to United Kingdom, Japan has focused on cutting down public expenditure rather than increasing the VAT rate to a double digit. It could be perceived that focusing on government spending instead of increasing consumption taxes will have more favorable outcomes in the economy.  

Bibliography

Taylor, P. (2003). Book-keeping & accounting for the small business. Oxford: How To Books.

Carroll, R., Cline, R. & Neubig, T. (2010). The Macroeconomic Effects of an Add-on Value Added Tax. [Online]. Washington DC: Ernst & Young LLP. Available from: http://www.bakerinstitute.org/media/files/Research/bbb83cf0/TEPP-pub-NRFValueAddedTax-100710.pdf. [Accessed: 3 November 2016].

Department of Census & Statistics, (2015). Key Indicators of Industry Trade & Service Sector. [Online]. Available from: http://www.statistics.gov.lk/PressReleases/Files/en/EC_20150714E.pdf. [Accessed: 2 November 2016].

Tradingeconomics, (2016). Sri Lanka Government Spending | 1950-2016. [Online]. 2016. Tradingeconomics. Available from: http://www.tradingeconomics.com/sri-lanka/government-spending. [Accessed: 2 November 2016].

Dailymirror, (2016). Sri Lanka’s GDP to remain flat this year, just above 5% next year: WB. [Online]. 2016. Dailymirror. Available from: http://www.dailymirror.lk/article/Sri-Lanka-s-GDP-to-remain-flat-this-year-just-above-next-year-WB-118382.html. [Accessed: 2 November 2016].