High debt burden to limit uplift from tax reforms

Sri Lanka’s high debt burden is likely to limit the benefits of recent tax reforms, rating agency Moody’s Investors Service has said in a new report.

“For many sovereigns, measures to broaden the tax base are unlikely to boost fiscal strength unless accompanied by enhanced tax administration and measures that effectively manage expenditure growth,” said William Foster, a Moody’s Vice President and Senior Credit Officer.

Moody’s conclusions are contained in its just-released report “Sovereigns — Developing Asia Pacific: Tax base broadening most likely to be effective in countries with strong tax administration”.

The report looks at the extent to which tax reforms are likely to support the sovereign credit profiles of 11 developing Asia Pacific economies that have underdeveloped tax systems. The 11 are Bangladesh, Cambodia, India, Indonesia, Maldives, Mongolia, Pakistan, the Philippines, Sri Lanka, Thailand and Vietnam.

By constraining revenue-generation potential, the narrow tax bases of many of these sovereigns increase their fiscal vulnerability, while also limiting the financial resources available to develop the social and infrastructure services needed for greater economic development.

“Pakistan and Sri Lanka have not experienced material reductions in their debt burdens, despite relatively robust economic growth,” Moody’s said.

“That fact is likely to limit the uplift from tax reforms on their fiscal strength, particularly if their historically high rates of growth were to slow materially.”

Especially in an environment of rising interest rates globally, Pakistan and Sri Lanka also face government liquidity and external vulnerability risks related to the servicing of relatively high debt burdens, which could offset some of the positive credit impact from revenue reforms, Moody’s said.

Among sovereigns with more modest government expenditure, Pakistan and Sri Lanka both have continued to run quite wide fiscal deficits, in part driven by growing interest payments from relatively large debt burdens.

Moody’s said that Sri Lanka’s recent tax reforms, especially the new Inland Revenue Act (IRA) which took effect on 1 April 2018, should help improve tax revenue.

Similar to many developing APAC peers, Sri Lanka currently relies on a large share of indirect taxes as a share of total taxes, which are estimated to be around 80%.

With the act’s initiation of a new taxpayer identification number system, the government aims to increase the proportion of direct taxes to 40% of total revenues.

“Overall, as a result of these various measures, we expect government revenues to rise close to 16% of GDP by the end of 2020 from around 14% of GDP in 2017,” Moody’s said.

However, the rating agency said sustained GDP growth will be crucial for success of the IRA, as adverse weather over the last year hindered agricultural output and weighed on nominal GDP growth to the detriment of tax revenues. (Telo)

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