Echelon - December 2016

A Capital Issue

Large differences in wealth tend to focus the debate on making the tax system more progressive. Sri Lanka’s anemic 16% of tax revenue contributed by taxing income focuses the debate on addressing this challenge. After scrapping taxes on capital gains decades ago, Sri Lanka re-introduced it from 2017 for gains on sales within 10 years of purchase.

Of course, taxing capital gains isn’t necessarily the place to start when looking for new revenue – not when Sri Lankan income tax dodging is so widespread, and the system inefficient and corrupt.

By taxing capital gains on real estate, the government expects to raise Rs5 billion in 2017 or just 0.27% of the forecast tax revenue for the year. Previously, the government claimed gains on stocks would also be taxed, but backed down in the face of lobbying by the capital markets. Investor behaviour is influenced by taxes on capital gains and they will now be closely watching developments.

No tax that is introduced under a dysfunctional tax administration will succeed wonderfully. However, putting those challenges aside for the moment, it is important to start considering the future of taxing gains. For the tax to make any sense and in the interest of a progress tax policy, it makes sense for Sri Lanka to widen the application of these taxes.

But the favourable treatment of capital gains – by not taking these or applying far lower rates than those charged on income – scores badly on the test of good fiscal policy. It complicates rather than simplifies the tax code. So, the natural progression may be to widen the types of capital gains taxed to include shares and other widely held assets. Of course, fixing the tax administration – as a priority – trumps all else.