Tax Reforms in Sri Lanka: will a Tax on Public Servants Improve Progressivity?

The Sri Lankan government implemented tax reforms in 2011, including removal of the tax exemption given to public servants and reduction of personal income tax rates in order to improve tax compliance from pay-as-you-earn (PAYE) tax payers. This study evaluates the 2007 and 2011 tax systems in order to examine the effects that taxing the income of public sector employees has on total tax revenues and the tax base. The study also compares the distributional effects of the different tax systems. Study further conducts simulation analyses to assess the most progressive means of achieving the 2007 tax revenue levels. Implications for tax evasion are also examined under different tax systems. The study finds that the 2011 tax reforms reduce tax revenue by 48 percent relative to the structure of income taxation in 2007. This decline in tax revenues occurs even though income taxes are extended to public sector workers because the 2011 tax reforms reduced the rate of income taxes across the board and increased the tax-free threshold. Our simulations show that tax revenues would have risen if the reforms were limited to introducing income taxes to public servants. The resulting (hypothetical) tax system would also have been more progressive than the tax structure resulting from the 2011 reforms. The study evaluated the distributional impacts of modifications to the 2011 tax system which would increase tax revenue to their level in 2007. More specifically, the present study finds that the most progressive way to attain this tax revenue target would be to increase tax rates on taxable income by 6 percentage points and to lower the tax-free threshold from LKR 600,000 to LKR 400,000.