Sri Lanka revenue reform a step toward stronger finances: Fitch

Nov 16, 2016 (LBO) – Sri Lanka’s budget 2017 proposed tax hikes will strengthen the revenue base although some of the revenue assumptions look optimistic and pose risks to projections, the Fitch rating agency said.

“Sri Lanka’s budget for 2017 is broadly in line with the targets set out under its IMF programme, and contains a number of positive measures to boost the very weak revenue base.”

“Fiscal consolidation will be helped by tax reforms that should go some way to bolstering the weak revenue base, which is a key reason for the sovereign’s weak fiscal finances,” the rating agency said.

“However, Fitch Ratings believes that the impact of the revenue reforms will depend on implementation; and some of the budget assumptions look optimistic, posing risks to the projections.”

Sri Lanka hopes to reduce the budget deficit to 4.6 percent of gross domestic product in 2017 from 5.4 percent in 2016.

The reforms include a hike in the VAT rate from 11 – 15 percent along with tax measures announced in the budget – such as a 10 percent capital gains tax that is scheduled to be introduced next year and an increase in the top personal income tax rate.

The full statement follows

The Fitch Ratings-Hong Kong/Singapore-16 November 2016: Sri Lanka’s budget for 2017 is broadly in line with the targets set out under its IMF programme, and contains a number of positive measures to boost the very weak revenue base.

However, Fitch Ratings believes that the impact of the revenue reforms will depend on implementation; and some of the budget assumptions look optimistic, posing risks to the projections.

The 2017 budget targets a fiscal deficit equivalent to 4.6% of GDP, down from an expected 5.4% in 2016 and 7.4% in 2015, when the deficit widened mainly as a result of sharp public-sector wage rises. Fiscal consolidation will be helped by tax reforms that should go some way to bolstering the weak revenue base, which is a key reason for the sovereign’s weak fiscal finances.

The reforms include a hike in the VAT rate from 11% to 15%, along with tax measures announced in the budget – such as a 10% capital gains tax that is scheduled to be introduced next year and an increase in the top personal income tax rate. The government also expects to generate more revenue from the simplification of the tax system and removal of some tax exemptions and concessions. The government projects that revenue will increase by close to 27% in 2017, pushing the revenue/GDP ratio up to nearly 15% of GDP from an estimated 12.9% in 2016.

Fitch views the new measures as a positive step, but there is a risk of a shortfall. The impact of the tax reforms will hinge on effective implementation. Moreover, the government’s GDP growth forecast for 2017 of between 6%–7% is higher than what Fitch believes is likely, given the expected drag from fiscal consolidation. Our growth forecast for 2017 is around 5%.

Efforts to restrain expenditure growth next year appear limited. Salaries and wages are to be increased at a less rapid pace than in 2016, but nominal expenditure is still forecast to grow by 17% to finance an ongoing infrastructure drive and meet the rising cost of debt-servicing and subsidies. Fitch expects spending may be cut back in the event that revenue disappoints.

The government has a medium-term target of reducing the budget deficit to 3.5% of GDP by 2020, which is aligned with the IMF programme. It expects to achieve this deficit reduction mainly through a combination of further tax reform and efficiency gains in public expenditure. Some of the revenue measures announced in the 2017 budget are part of this medium-term fiscal strategy.

High government debt is, in any case, likely to remain a weakness in Sri Lanka’s sovereign profile. Fitch estimates the level of debt at 76.5% of GDP as of end-2016 – which is significantly above the ‘B’ median of 52%.

Fitch downgraded Sri Lanka’s sovereign rating by one notch to ‘B+’ in February, and placed it on Negative Outlook. A three-year IMF programme that began in June has helped to ease balance-of-payments problems, but long-standing weaknesses in public finances will persist without sustained commitment from the authorities .