Tax composition and income inequality in Sri Lanka

Abstract

Introduction:

Tax revenue is an instrumental objective of fiscal policy. Depending on the nature of the tax, it is differently felt as a tax burden by the tax payer. With this regard, many of the existing academic discourses have focused on tax composition because it causes particular effects. Tax composition affects net inequality in two ways: first, taxes have a different degree of progressiveness, and therefore the mixture of taxes is responsible for part of inequality. Second, the tax composition affects economic incentives (e.g. labor market incentives, savings and investment), and thus indirectly affects net inequality (Drucker et. al, 2017). In the Sri Lankan context tax revenue which largely consists of indirect taxes, is the major source of financing the fiscal deficit and the means of meeting other public expenditure needs. According to the Central Bank of Sri Lanka, income taxes amounted to 16 per cent of the total tax income of the government, and indirect taxes amounted to 71 per cent in 2016 (CBSL, 2016). In fact, the poorest 20 per cent pay as much as 13 per cent and the poorest 10 per cent pays as much as 23 per cent of their income in the form of indirect taxes while the richest 10 per cent pay less than 1 per cent as indirect taxes (Ranasinghe, 2018). This evidence tells us that the tax system of Sri Lanka does not act as a helpful instrument in mitigating the income inequality.

The impact of tax composition on income inequality has gained interest among existing academic discourses in recent years. Among those, Drucker et al. (2017) revealed that income taxes on individuals and non-recurrent property taxes are negatively correlated with inequality and economic growth; corporate tax impedes economic growth and has no clear impact on inequality; taxes on consumption increase both inequality and growth in developed countries. Similarly, Troiano (2017) shows that income inequality is raised after all the tax policy reforms; especially, introducing new income taxes on existing income tax has caused an increase in the inequality index. Meanwhile, "with a few exceptions the impact of tax allowances and tax credits on inequality is small and tax concessions appear ill-suited to target resources towards households in the bottom part of the income distribution in European countries" (Avram, 2014). Further, "statutory corporate income tax rates are strongly negatively associated with income inequality by controlling for various other determinants of income distribution while personal income tax rates have no impact on income inequality" (Immanuel et.al 2012). However, "progressivity of national income tax reduces inequality in observed income, but has a significantly smaller impact on actual inequality in selected developed and developing countries" (Duncan and Peter, 2017). Thus, empirical evidence suggests how tax composition affects income inequality under different scenarios. Regarding the Sri Lankan context there is a dearth of research in quantitative studies on tax composition and income inequality but, investigating the relationship is necessary due to income equality in Sri Lanka not being satisfactory compared to other countries in the region. Thus, income inequality should be minimized by means of better policies especially through simplifying the tax composition and broadening the tax basis.