CHAPTER 2 SRI LANKAN EXPOSURE VALUE ADDED TAX AND COLOMBO CONSUMER PRICE INDEX

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1 Chapter 21 Sri Lankan Exposure Value Added Tax and Colombo Consumer I'rice Index CHAPTER 2 SRI LANKAN EXPOSURE VALUE ADDED TAX AND COLOMBO CONSUMER PRICE INDEX 2.1 Introduction This chapter focuses on the Sri Lankan practice on the VAT and CCPI which were used as main variables in this analysis. Here it is briefly discussed about the history of VAT and Sri Lankan practice of the VAT and further examples on the calculation of the VAT. It further, explains the comparison between total tax revenue and GDP using graphical interpretation. Here it is, graphically presented how the VAT revenue contributes to Sri Lankan tax revenue and contribution to the GDP. Secondly, it discusses about CCPI and Inflation as well. 2.2 Value Added Tax In general, value added tax (VAT) is a form of consumption tax. From the perspective of the buyer, it is a tax on the purchase price. From that of the seller, it is a tax only on the "value added" to a product, material or service, from an'accounting view, by his stage of its manufacture or distribution. The buyer remits to the government the difference between these two amounts, and retains the rest for themselves to offset the taxes he had previously paid on the inputs. The "value added" to a product by a business is the sale price charged to its customer, minus the cost of materials and other taxable inputs. A VAT is like a sales tax in that ultimately only the end consumer is taxed. It differs from the sales tax in that, with the latter, the tax is collected and remitted to the government only once, at the point of purchase by the end consumer. With the VAT, collections, remittances to the government, and credits for taxes already paid occur each time a business in the supply chain purchases products from another business. Maurice Laure, Joint Director of the French Tax Authority, was first to introduce VAT on April 10, although German industrialist Wilhelm von Siemens proposed the concept in Initially directed at large businesses, it was extended 5

2 Chapter 2 \Sri Lankan Exposure Value Added Tax and Colombo Consumer Price Index over time to include all business sectors. In France, it is the most important source of state finance, accounting for nearly 50% of state revenues. In France, VAT was implemented in the national level in 1955(555), and adopted by the European Economic Community in Subsequently, it spread across all developed countries. Presently, about 120 countries in the world adopt the VAT system in some form. However, out of the developed countries US has not adopted VAT as yet Value Added Tax in Sri Lanka Value Added Tax, popularly known as 'VAT', is a special type of indirect tax in which a sum of money is levied at a particular stage in the sale of a product or service. Value Added Tax (VAT) in Sri Lanka was introduced by the Act No. 14 of 2002 and is imposed from 1st August, VAT Act replaced the Goods and Services Tax (GST) which was almost similar tax on the consumption of goods and services. It is a tax on domestic consumption of goods and services. The goods imported into Sri Lanka and goods and services supplied within the territorial limits of Sri Lanka are the subject matter of this tax. It is a multi stage tax levied on the incremental Value at every stage in the production and distribution chain of goods and services. The tax is borne by the final or the ultimate consumer of goods or services. It is an indirect tax and the Government will receive at the end, through all the intermediary suppliers in the chain of production and distribution, an amount equal to the amount paid by the final consumer. VAT is not charged on certain imports and on retail and wholesale supply of goods. There are certain supplies of goods and services, which is exempt from VAT. For any taxable period commencing on or after January 1st, 2009, the VAT is charged at the rate of 12 percent. For any taxable period commencing on or after January I. 2011, the VAT on motor vehicles, luxury goods and liquor will be changed 20 percent to 12 percent. Thus, after January 1st, 201 I VAT rate applicable for all the goods and services is 12 percent. 6

3 Chapter 2\Sri Lankan Exposure Value Added Tax and Colombo Consumer Price Index The government estimates the current rate of VAT will provide a substantial relief to tourism, industries, leasing, construction insurance and telecommunication sectors and also to the entire production sector. With reduced production costs, the overall cost-of-living will also come down. The registration limit applicable to VAT will be increased from Rs. 1.8 million to Rs. 2.5 million after January 1st, 2009 to simplify VAT administration and also to provide relief to small and medium entrepreneurs VAT with total tax revenue Prior to implementation of Value Added Tax in Sri Lankan tax system three types of indirect taxes were operated in Sri Lanka. They are Turnover Tax (TT). National Security Levy (NSL) and Goods and Services Tax (GST). -Turnover Tax(TT) The tax is charged on the turnover of the person, and there were multiple rates applied. This was administrated by the Central Government and in 1991 the administration was taken over by the Provincial Council. However, in the North- East it is still administrated by the Central Government, since there is no Provincial Council in that area. -National Security Levy (NSL) NSL was introduced in 1992, as a levy in order to cover up security expenses. This was charged as an indirect tax on turnover of the manufacturers and certain categories of services. Apart from that it was chargeable on importation of goods too. The rate applicable was varied from 1% to 7.5%. - Goods and Services Tax (GST) Goods and Services tax was introduced in Sri Lanka with effect from April 1, It was a tax on value addition. GST was similar to VAT and introduced to overcome the defects identified in the turnover tax system. At the time of implementation of VAT, the NSL and GST was abolished and Turnover Tax is still operating in Sri Lanka. The following Table shows the tax revenues achieved by the Department of Inland Revenue in the past decade. 7

4 Chapter 2 \Sri Lankan Exposure Value Added Tax and Colombo Consumer l'rice Index Table 2.1: Total tax revenue in Millions Tax Type Income Tax 33,614 37,682 38,602 37,904 42,154 71,481 96,354 69,440 73,996 80,898 VAT with Imports 35,181 97, , , , , , , ,249 ESC 4,052 7,283 8,852 12,203 14,475 14,147 18,000 Debit Tax 1,310 3,601 4,488 5,700 6,254 7,187 8,410 8,045 10,845 Stamp Duty 8,415 2, ,495 4,026 3,750 2,616 3,467 GST/NS1/TT 90,164 61,048-1,039 1, NBT 25,797 45,642 Other Taxes 1, ,314 54,954 42,454 Total 133, , , , , , , , , ,621 Source: performance report 2005 to 2010 department of Inland Revenue Table 2.2: Percentages of tax revenue Tax Type Income Tax 25.2% 27.4% 27.8% 23.0% 21.3% 28.2% 31.3% 20.2% 20.8% 18.9% VAT with Imports 25.6% 70.3% 71.0% 71.5% 64.8% 60.7% 58.9% 49.5% 53.0% ESC 2.5% 3.7% 3.5% 4.0% 4.2% 4.0% 4.2% Debit Tax 1.0% 2.6% 2.7% 2.9% 2.5% 2.3% 2.4% 2.3% 2.5% Stamp Duty 6.3% 1.7% 0.05% 0.0% 0.0% 0.6% 1.3% 1.1% 0.7% 0.8% GST/NSL/TT 67.7% 44.4% -0.7% 0.7% 0.3% 0.2% 0.2% 0.1% 0.0% 0.0% NBT 7.3% 10.6% Other Taxes 1 0.8% 0.0% 0.0% 0.0% 0.3% 0.3% 0.2% 13.2% 15.5% 9.9% Total 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% Source: performance report 2005 to 2010 department of Inland Revenue As shown in the above Tables, in year 2001 Indirect taxes such as GST, NSL and TT contribute 67.7% of total tax revenue (See Figure 2.1). In year 2002 above three taxes covered only 44.4 % of total revenue collection (See Figure 2.2). Reason behind this revenue reduction is GST and NSL operated only during January, 2002 to July, Turnover Tax is still functioning in Sri Lanka. Department of Inland Revenue is collecting turnover tax in the North and East provinces of Sri Lanka on behalf of the North and East provincial councils. After implementing VAT on 1st August 2002 very little amount of GST and NSL was collected as default taxes. During the period of I st August 2002 to 31 st December 2002 Rs. 35,181 Million was 1 Share Transaction Levy. Betting & Gaming Levy, Withholding Tax.Save the Nation Contribution.Construction Industry Levy 8

5 Chapter 2ISri Lankan Exposure Value Added Tax and Colombo Consumer Price Index collected as VAT. In 2003 Rs. 95,754 Million was recorded as VAT revenue and it contributes 70.3% of total tax revenue. During that particular year minus Rs. 1,039 Million was recorded as GST/NSL/TT revenue. The reason behind this negative figure is the total default taxes and turnover tax collected was lesser than the total refunded paid to the tax payers Other Taxes Figure 2.1: IRD Tax revenue collection Other Taxes Figure 2.2: IRD Tax revenue collection

6 Chapter 2\Sri Lankan Exposure Value Added Tax and Colombo Consumer Price Inde In year 2004 Rs.l 17, Million VAT was collected and it contributes to 71% of the total tax revenue (See Figure 2.3). Economic Service Charge (ESC) was implemented in same year and Rs. 4,053 Million was collected in particular year % Figure 2.3: IRD Tax revenue collection 2004 From year 2005 to 2009 VAT revenue contributions is gradually decreased due to increase of Import Duty on certain luxury goods like motor vehicles, electrical items etc. In the year 2008 withholding tax system was introduced and by using this method taxes were withheld from banks on interest and certain payments from government institutes like local authorities, divisional secretariats etc. The other tax revenue was increased up to 13% due to withholding tax after 2008 (See Figure 2.4) GST/NSL/TT 2008 VAT 59% Figure 2.4: IRD Tax revenue collection

7 Chapter 2/Sri Lankan Exposure Value Added Tax and Colombo Consumer Price Inde In the year 2009 Nation Building Tax was introduced with effect from 1st February 2009 and VAT rate was reduced from 15% to 12% for normal goods effecting from 1st January Therefore, VAT revenue was decreased in that particular year and the lack of consumption of community due to economic recession is another reason for this reduction (See Figure 2.5) I!22 I Figure 2.5: IRD Tax revenue collection 2009 In the year 2010 VAT revenue increased due to the decreased rate of Import Duty on certain luxury goods like motor vehicles, electrical items etc. Another reason for this revenue increment is the economic development after the civil war (See Figure 2.6). VAT 53% Figure 2.6: IRD Tax revenue collection

8 Chapter 2ISri Lankan Exposure Value Added Tax and Colombo Consumer Price Index VAT Revenue with GDP Contribution of VAT revenue to the Gross Domestic Product (GDP2) of Sri Lanka is illustrated by the following Table Year Table 2.3: VAT and IRD revenue contribution to GDP GDP Rs. Million IRD Revenue Rs. Million VAT Revenue Rs. Million IRD Revenue %to GDP VAT Revenue %to GDP ,407, , % ,636, ,609 35, % 2.15% ,822, ,043 97, % 5.36% ,090, , , % 5.60% ,452, , , % 5.78% ,938, , , % 5.58% ,578, , , % 5.23% ,410, , , % 4.60% ,825, , , % 3.65% Source: Performance Reports-Department of Inland Revenue 7.00% VAT Revenue contribution to GDP 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% VAT Revenue % to GDP 2.15% 5.36% 5.60% 5.78% 5.58% 5.23% 4.60% 3.65% Figure 2.7: VAT Revenue contribution to GDP The GDP is the market value of all final goods and services produced within a country in a given period of time. It is often positively correlated with the standard of living, although there are alternative measures to GDP for that purpose. 12

9 Chapter 2\Sri Lankan Exposure Value Added Tax and Colombo Consumer Price Index Figure 2.7 illustrates VAT revenue contribution to GDP of Sri Lanka in year 2002 to VAT was introduced on 1st August During the period of 1st August 2002 to 31st December 2002 Rs. 35,181 Million was collected as VAT. That amount is 2.15% of nominal GDP value of In year 2003 VAT was collected during the whole year, as a result of that VAT revenue contribution to GDP was increased up to 5.36%. Year 2005 recorded the highest contribution of VAT to GDP. That was recorded as 5.78% of GDP. During the period of 2005 to 2009 although, the VAT revenue increased from 141,878 Million to 176,031 Million, the contribution to GDP was gradually decreased from 5.78% to 3.65%. The reason behind this was that VAT revenue gradually decreased due to increase of Import Duty on certain luxury goods like motor vehicles, electrical items etc. Other reason for this reduction in 2009 was that, VAT rate was reduced from 15% to 12% for normal goods effecting from 1st January Therefore, VAT revenue was decreased in that particular year and the lack of consumption of community due to economic recession is another reason for this reduction Calculating VAT in Sri Lanka. Registered persons are required to furnish returns' 1 and pay VAT for each taxable period.vat is therefore calculated in respect of a taxable period. Registered persons who are required to submit monthly returns have to calculate VAT payable 4 /refundable every month. Others, must calculate quarterly. The VAT payable in respect of a taxable period is calculated by deducting input tax applicable to that period from the output tax applicable to that period. VAT payable = Output tax - Input tax The applicable taxable period depends on the basis of accounting. If a person is approved to declare tax on cash basis he must declare output tax for the taxable period in which cash is received and input tax for the taxable period in which the payment is made. 3 The form which declares input and output vat and vat payable to the government 4 The theory behind the calculation. In a production/distribution process. Input +Wages + Profit = Output Wages + Profit = Output - Input But 'Wages + Profit" means the "added value' to the "factors of production" Value Added = Output - Input 13

10 Chapter 2\Sri Lankan Exposure Value Added Tax and Colombo Consumer Price Index If the input tax exceeds the output tax a refund will arise. The tax on value addition can be calculated by calculating the tax on (output - input). This can be done either by applying the tax rate to the (output value - input value) or by computing (output tax - input tax). Sri Lanka follows the latter method which is the method adopted by OECD 5 countries. From the above mentioned method of calculation of VAT, it can be seen that the burden of VAT falls on the "final consumer" only. Final consumer means the last person in the chain of production and distribution who receives (buys) the goods or services but does not use it in any taxable activity. He pays the VAT to his supplier and not directly to the government but the amount paid by him is received by the government through various stages of production and distribution of that goods or service. This can be illustrated by a trivial example. Example : If A is an ice-cream vendor who buys ice-cream in "Cans* put them in 'Cones' and sells them to final consumers; He buys the ice-cream in containers (cans) from X and 'cones' from Y. Assume all are Registered Persons, and VAT on all goods and services is 20% X sells Cans at 100/- and charges VAT at - 20% Y sells Cones at I/- per Cone and charges VAT at 20% Then A spends as follows Value Supply VAT Total X sel Is a Can of ice-cream to A Y sells 10 Cones to A Thus A pays I 10/- on goods and 20/- as VAT to X and 21- as VAT to Y. If he sells Cones at 12/- each, then 5 The Organization for Economic Co-operation and Development (OECD) is an international economic organization of 34 countries founded in 1961 to stimulate economic progress and world trade. It dellnes itself as a forum of countries committed to democracy and the market economy, providing a platform to compare policy experiences, seeking answers to common problems, identifying good practices, and co-coordinating domestic and international policies of its members 14

11 Chapter 2\Sri Lankan Exposure Value Added Tax and Colombo Consumer Price Index A sells 10 12/- per Cone _I2 As output tax 24 A's input tax = 22 Tax payable by A Thus A's Customers pay 24/- as VAT to "A* but -'A' pays only 21- to the government. But the other 22/- has already been received by the government; 20/- through X and 21- through Y. We can look back further in this chain of production and distribution with the following details. If X is a manufacturer of ice cream who buys raw materials from P and Containers from Q then he should pay VAT on his raw material and on the purchase of Containers as follows. Value of Supply VAT Total X buys raw material to make ice cream, from P X buys containers from Q 10 _ X sells ice-cream with container to A Ji _i 18 Then X's output tax is 20 but input tax is 17 X pays to the department only (20-17) =3 The balance III- is coming from P (15/-) and Q (2/-) The value addition by A = = 10 15

12 Chapter 2\Sri Lankan Exposure Value Added Tax and Colombo Consumer Price Index Tax on value 20% = 10@20% = 2 Which is the same as his (output tax - Input tax) =24-22 = 2 The value addition by X= = 15 Tax on value 20% = 15@20% = 3 Which is the same as his (output tax - Input tax) =20-17 = 3 Thus the tax on value addition at each point in the chain of production and distribution is equal to the (Output tax - Input tax) at each point. This is the amount payable by the Registered Person at that point. He does not pay anything out of his own profits or turnover. The set off of input tax at each stage ensures that tax on tax is not charged and the ultimate consumer bears the full burden of tax. 2.3 Price index A consumer price index (CPI) measures changes through time in the price level of consumer goods and services purchased by households. The CPI is defined by the United States Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services". The CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically. Sub-indexes and subsub-indexes are computed for different categories and sub-categories of goods and services, being combined to produce the overall index with weights reflecting their shares in the total of the consumer expenditures covered by the index. It is one of several price indices calculated by most national statistical agencies. The annual percentage change in a CPI is used as a measure of inflation. A CPI can be used to index (i.e., adjust for the effect of inflation) the real value of wages, salaries, pensions, for regulating prices and for deflating monetary magnitudes to show changes in real values. In most countries, the CPI is. along with the population census and the USA National Income and Product Accounts, one of the most closely watched national economic statistics. 16

13 Chanter 2\Sri Ijinkan Exposure Value Added lax and Colombo Consumer I'rice Index Alternately, the CPI can be performed as; CPI _ updated cost ^ ^ base period cost The "updated cost" is the price of an item at a given year, divided by the initial (base) year, multiplied by one hundred Price indices of Sri Lanka Many countries have chosen the CPI (Consumer Price Index) as the indicator of price level due to several reasons. It is usually the best and most up-to-date price index available this index is easily understood by the public; and is less susceptible to manipulation. In Sri Lanka, there are several measured price indices, namely the Colombo Consumer Price Index(CCPI),the Greater Colombo Consumers* Price Index (GCCPI),the Wholesale Price Index(WPI), the Colombo district Consumers" Price Index(CDCPI), the Western Province Consumers* Price Index(WPCPI), the gross Domestic Product Deflator(GDPDF) & the Sri Lanka Consumers" Price Index(SLCPI). These measures are different in terms of the number of items in the basket, weights assigned to these items geographic area of price collection population and the base year Selection of a price index Among the above indices the most widely used price index in Sri Lanka is the Colombo Consumers' Price Index (CCPI). It is simply a measure expressed in index form price data for the CCPI collected only in the city of Colombo and covers the prices on consumption for low-income earners. Furthermore, this index uses weight based on the consumption basket in The CCPI is published by the department of Census and Statistics. However, WPCPI & SLCPI have broader geographical & demographical coverage than the other indices. Calculations of these indices have been stated in the recent past, & these indices have followed the same pattern of the official price index. 17

14 Chapter 2 \Sri Lankan Exposure Value Added Tax and Colombo Consumer Price Index Method of the price collection for CCPI An index based on the Household Income and Expenditure Survey of 2002 has now been constructed by the DCS (Department of Census & Statistics), addressing the main deficiencies of the CCPI. The new index, known as the New Colombo Consumers' Price Index (termed CCPI (N)) is based on a more recent household expenditure survey, representing contemporaneous purchasing habits. The weighting pattern of this index is based on the expenditure of all urban households in the Colombo district. The coverage of price collection has been widened to 12 centers in Pettah, Maradana, Wellawatte, Dematagoda, Grandpass. Borella, Kirulapone. Dehivvala, Kotte, Nugegoda, Kolonnawa and Ratmalana compared to 7 centers used before. The new index compiled by the DCS with a base year of 2002 is released to the public today and is to be done on a monthly basis in the future (Shown in Appendix v). The CCPI (N) will therefore be used as the official index for measuring inflation in Sri Lanka CCPI in Sri Lanka Year 2003 to ID <" ero s 1 a. ^ LO 2 1 a. "ro 'a :c ii i2> ro 0) 2 1 E OJ D. " (U ro <u S 1 ro <u 2 1.Q ro I I ro ai a) I Q. QJ Figure 2.8: CCPI in Sri Lanka 2003 to

15 Chapter 2\Sri Lankan Exposure VaJtfej^Qfljtff.x and Colombo Consumer Price lnde.\ "flhwasity OF MORATUWA. SBI LAN* Computation of CCPI j i l ^ i ti LLr 1 = ~^rn h = Index of the i 1 major group Li=x w i Wi = Weight of the major group m = number of major group included in CCPI The Associated weights are 6 Food and Non Alcoholic Beverages index 46.71% Clothing and Footwear index 3.08% Housing, Water, Electricity Gas and Other Fuels index 18.29% Furnishing, Household Equipment and Routine Household Maintenance index 3.22 % Health index 4.18% Transport index 9.47% Communication index 4.42% Recreation and Culture index 2.18% Education index 5.79 % Miscellaneous Goods and Services index 2.65% Index of the major group i Z PniQoi n. f. -ti,. / P ni = Current price or the i item LPoiQoi 2.4 Inflation 100 P 0 i base year price of the i 11 item Q oi = base year weight of the i,h item The term "inflation" originally referred to increases in the amount of money in circulation, and some economists still use the word in this way. However, most economists today use the term "inflation" to refer to a rise in the price level. An increase in the money supply may be called monetary inflation, to distinguish it from rising prices, which may also for clarity be called 'price inflation'. Economists generally agree that in the long run, inflation is caused by increases in the money supply. However, in the short and medium term, inflation is largely dependent on supply and demand pressures in the economy. Other economic concepts related to inflation include: deflation - a fall in the general price level; disinflation - a decrease in the rate of inflation; hyperinflation - an out- 5 Source: Department of Census and Statistics

16 Chapter 2 \Sri Lankan Exposure Value Added Tax and Colombo Consumer Price Index of-control inflationary spiral; stagflation - a combination of inflation, slow economic growth and high unemployment; and reflation - an attempt to raise the general level of prices to counteract deflationary pressures. Since there are many possible measures of the price level, there are many possible measures of price inflation. Most frequently, the term "inflation" refers to a rise in a broad price index representing the overall price level for goods and services in the economy. The Consumer Price Index (CPI), the Personal Consumption Expenditures Price Index (PCEPI) and the GDP deflator are some examples of broad price indices. However, "inflation" may also be used to describe a rising price level within a narrower set of assets, goods or services within the economy, such as commodities (including food, fuel, metals), financial assets (such as stocks, bonds and real estate), services (such as entertainment and health care), or labor. The Reuters-CRB Index (CCI), the Producer Price Index, and Employment Cost Index (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy. Core inflation is a measure of inflation for a subset of consumer prices that excludes food and energy prices, which rise and fall more than other prices in the short term. The Federal Reserve Board pays particular attention to the core inflation rate to get a better estimate of long-term future inflation trends overall Inflation measurements In economics, the inflation rate is a measure of inflation, the rate of increase of a price index (for example, a consumer price index). It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal. The inflation rate is used to calculate the real interest rate, as well as real increases in wages. The rate is usually expressed in annualized terms, though the measurement periods are usually different from one year. Inflation rates are often given in seasonally adjusted terms, removing systematic quarter-to-quarter variation. If Pq is the current average price level and P - \ is the price level a year ago, the rate of inflation during the year might be measured as follows: Inflation rate = ^-=1 x 100% 20

17 Chapter 2ISri Lankan Exposure Value Added Tax and Colombo Consumer Price Index After the year the purchasing power of a unit of money is multiplied by a factor 1/(1+ inflation rate ). There are other ways of defining the inflation rate, such as logpn log P - l (using the natural log), again stated as a percentage. In this case after the year the purchasing power of a unit of money is multiplied by a factor e inflation rate. There are two general methods for calculating inflation rates - one is to use a base period, the other is to use "chained" measurements. Chained measurements adjust not only the prices, but the contents of the market basket involved, with each price period. More common, however, is the base period reference. This can be seen from inflation reports from the "relative weight" assigned to each component, and by looking at the technical notes to see what each item in an inflation basket represents and how it is calculated Inflation in Sri Lanka Following Figure 2.9 illustrates the inflation in Sri Lanka from 2004 to The data set related to this graph is presented in Appendix III. Highest Inflation is recorded as 28.2% in June 2008 while the lowest is recorded as 0.7% in 2009 September between selected ranges. The method of calculation of inflation is by calculating percentage increase of CCPI relative to the values recorded in the same month in the previous year. Inflation in Sri Lanka Year Figure 2.9: Inflation in Sri Lanka 2004 to