Taxing the taxed

By Dr Sirimewan Dharmaratne,
Senior Research Officer, HMRC, UK.

Years of laissez-faire attitude towards taxation has finally caught up. Withal lack of sensible fiscal policies, the political phobia of a sensible tax regime has left Sri Lanka facing the quandary of large tax increases, which the public must now acquiesce. Unbridled taxation however will leave deep economic and social scars. This is why it should be approached with caution to prevent a regressive effect on the economy. There are many ways the government could take intelligent, fair, and justified approach to taxation especially at a time of widespread privation. The focus should be on clamping down on tax avoidance and evasion, before considering tax increases.

While the government has taken some meaningful steps, it may have also left the door open for large scale tax avoidance. This is because capital gains from selling shares or dividends are apparently and inexplicably exempt from income tax. High income individuals could be paid in shares, which they could immediately sell and avoid paying income tax. The government cannot allow such avoidance schemes without compunction at a time of a national crisis.

Reducing Tax Evasion – Ghosts and Moonlighters

In tax jargon moonlighters are those who work in second jobs but report income from only one source. Those who just hide in plain sight are tax ‘Ghosts’. Moonlighters pay tax, but their day job, but moonlighting income is likely to be off the books. Those who work primarily on cash basis, operating completely under the tax radar are tax ghosts. These individuals generate a vast amount income that could go completely untaxed. There are a few initiatives that the government could take to capture these individuals in the tax net.

Having a tax record for all those over 18 appears to be step in the right direction. However, this will create unnecessary records without clear benefits. The objective should be to create a record that will yield some tax. These are a few measures that are taken by the UK tax authorities that could be useful for the Sri Lankan Revenue as well.

Employer Database

Require all employers to register with the Revenue. Each employer is given a unique employer reference number and all employees will have their unique TIN. If an employer has 10 employees, there will be 10 records for this employer under the same employer reference, showing the payments paid to each of the ten employees. Every time an employee change employment or engage in more than one employment, each employer has the obligation to supply that information to the Revenue. Therefore, a record is created only when triggered by a potential tax liability. This database will capture all employments. By bring in all SMEs into this network of employers, the tax net could be stretched far and wider.

Finding Unearned Income

Large part of the rental income probably goes untax. Search for a holiday accommodation returns hundreds of properties available all over the country, often for eye-watering rates, especially in Colombo and its purlieu. Most of these properties are likely to be rented out through estate agents. The Revenue should have the authority to contact the agents and require them to submit lists of their clients along with rental incomes. This is much more efficient than approaching each property through the mailbox. Holiday rentals are more than likely to be not occupied throughout the year, but the estate agent would be able to provide accurate assessment of occupation rates and income.

Accredit trades and Services

Requiring that traders belong it an accredited professional body is one way of formalising various trades. Plumbers, electricians, builders, those in health and beauty industry, should all be required to register with a professional body. This body should make sure that members have required qualifications to practice the trade. Although, they will be self-employed sole traders, they will no longer be ghosts as the government will have access to their membership information. Customers should be encouraged to hire only those who are able to show their trade credentials. Traders could be made to accredit by making it illegal to practice a trade without a proper license. More positive incentives can be given through access various government incentive such as training subsidies, favourable credit, import tax concessions, etc.

Contractors

For those individuals who work on contract basis, on demand or on call basis, similar information is obtained through the hiring companies. If a builder or a plumber is hired on a contract basis, then company should be required to provide that information to the Revenue. Especially, for labour providers, which has become commonplace in Sri Lanka, this is a must.

Since they are not regular employers, they should be considered as a different category, but record keeping as far as Revenue is concerned would be similar. An employee in one company may work as a contractor for another. Therefore, different types of income records for the same individual (same TIN) could be compiled in an efficient manner to calculate the total tax liability.

Slipping through the net

Despite all these there will be a large group who will still fall through the tax net. This is a seminal feature in mostly cash-based economies, where even major transactions, like house purchases occur through cash payments. Although income maybe hidden or transactions unrecorded, it is difficult to hide consumption. It is a known economic theory that propensity to consume is similar across similar income groups. Such theories are used by UK tax authorities to determine unreported income. Using various methods and data to match income and consumption, millions of taxpayers have been asked to justify their spending.

Spending Event Triggers

Large spending events or incidences should trigger investigations. In Sri Lanka there is ample opportunity for this. Extravagant functions such as weddings, religious ceremonies, birthday parties are prevalent without any visible income. Then there are all other events where people seem to conjure up money out of thin air. In settling fines, paying bills, making contributions, reporting losses due shady investments or simply reporting burglaries and thefts, very nondescript individuals seem to have fantastic amounts of cash just laying around.

These events should immediately trigger investigations. When unaccounted money is discovered, the Revenue has the first shot at getting the right amount of tax. The question of legality is a matter of indifference to the Revenue. Once that is recovered, all the others, such as banks, creditors and the judiciary could do as they please.

Establish a High-Net-Worth Individual Unit (HNWIU)

Most Sri Lankans have the opinion, probably justified, that very wealthy individuals hardly pay any tax. This has led to widespread discontent and recrimination of government’s tax policies. Therefore, it is important that the public see those who are well-off paying their dues. Once of the initiatives that the UK government has taking is to establish a High-Net-Worth Individual Unit (HNWIU).

This unit exclusively deals with those who apparently have considerable income based on their consumption patterns but not paying tax to commensurate with the lifestyle. This unit should have highly trained professional who are sworn to carry out their duties. The identity of this unit should be available only to the senior managers in the Revenue to protect and maintain their integrity.

Tax Gap – Measure of Evasion

Widespread evasion, sanctioned by politicians and others will only make honest people rogues. Therefore, it is necessary that the public see objective evidence of reduction in tax evasion and not just anecdotes. This is done by measuring the tax gap. Tax gap is the difference between theoretical or the actual amount of tax that should have been collected and the amount that was collected. This can be done by different taxes such as income tax, corporation tax, VAT, etc to see where the gaps are larger and hance more evasion. UK tax authorities calculate the tax gap every year to measure the efficacy of their evasion tackling measures. Tax gap has been brought down from 20% over a few years ago to the current 5%. Calculating the tax gap should be part of plan by the Revenue for modernising taxation in Sri Lanka.

Future of Taxation on Sri Lanka

A strong tax base is a quintessential feature of a vibrant economy. Without it, essential public services and public good cannot be provided. However, taxes should be fair and just. Tax burden should be proportionally distributed based on income. Those who can be easily targeted tax should not get the brunt of the tax burden. Indirect taxes, other than ‘sin taxes’ affect less well-off disproportionally. Feature of a good tax system is to reduce indirect taxes and increase direct taxes.

This can only be achieved by de-coupling the taxation process from politics. An independent tax authority should be established giving vast powers to go after anyone as they deem necessary. Strong tax laws will enable to drastically reduce crime as well. Many famous or infamous people have been indited or jail for tax evasion rather than crimes committed, the latest causality being the US President’s son. While the burden of proof of a crime maybe harder to gather tax evasion is much more straightforward.

Objective evasion measures should be calculated to give more credibility to the tax collection process. Honest tax paying public should be content that it is working fairly for everyone. Focus should be more on direct taxes and not on consumption taxes. Convoluted indirect taxes almost never yield the expected revenue because of simple demand and supply forces. Further, most consumption taxes unfairly affect the poor. If they are implemented, at the least, all basic goods and services should be exempted, and higher rates imposed on luxury goods and services.

A proud nation should be supporting itself and not begging for other people’s tax money while living extravagant and pretentious lifestyles. At the end of the day, one is identified by the country and not by their domestic lifestyle. To outsides all are Sri Lankans and carry that identity everywhere. Unless steps are taken to restore and protect this identity, it will remain confined to the dustbin of failed nations despite empty rhetoric of clueless leaders.