Key Takeaways
- Sri Lanka’s Board of Investment is addressing VAT issues impacting local input manufacturing for exporters.
- The removal of the SVAT system has created cashflow challenges and increased costs for Sri Lankan exporters, particularly in the apparel sector.
- Competitor nations like Vietnam and Taiwan offer zero-rated VAT on sales to export firms, providing crucial support for backward integration.
- The apparel industry warns that current VAT policies could force a halt to backward integration efforts and potentially lead to relocation of buying offices.
- Similar VAT-related cashflow pressures are affecting Sri Lanka’s tea producers.
VAT Anomalies Discouraging Local Production in Sri Lanka
Sri Lanka’s Board of Investment (BOI) is actively working to resolve issues related to the value-added tax (VAT) on locally produced inputs, which is currently hindering backward integration efforts within the country’s export industries. The Chairman of the BOI, Arjuna Herath, stated that the board is committed to finding solutions to mitigate the negative impacts of these tax policies.
The apparel industry, a significant contributor to Sri Lanka’s export earnings, has voiced strong concerns. A key issue is the removal of the Specialized Value Added Tax (SVAT) system. This system previously allowed local producers to supply goods to exporters under a VAT-exempt framework, effectively easing cashflow for exporting businesses. Its removal has led to increased working capital requirements and higher interest costs for exporters, impacting their competitiveness.
International Benchmarks for Export Support
In contrast to Sri Lanka’s current situation, countries like Vietnam and Taiwan have adopted more supportive tax structures for their export sectors. In these nations, sales to firms within free trade zones, including intermediate goods and services, are zero-rated for VAT. This means no VAT is charged on these transactions, and suppliers are also eligible to claim input tax credits, similar to final exports.
Internationally, imported inputs are typically exempt from VAT in competing East Asian nations. This global practice ensures that local producers facing similar VAT conditions to their international counterparts are not at a disadvantage.
Impact on Sri Lanka’s Apparel Industry and Backward Integration
The Sri Lankan apparel industry has warned that the current VAT regime could force them to abandon crucial backward integration strategies. These strategies are essential for enhancing efficiency and maintaining competitiveness in the global market.
Significant investments have already been made by the apparel sector in backward integration. An example is the establishment of a textile production zone in Eravur, aimed at strengthening the local supply chain. Herath confirmed that the BOI views this issue with great importance.
Government Actions and Tax Department Engagement
“We have actually submitted a budget proposal this time for the budget to avoid this anomaly,” Herath stated, indicating proactive steps are being taken at the policy level. The BOI has also been in discussions with the Inland Revenue Department (IRD) to find a resolution.
The IRD has reportedly acknowledged the problem and is exploring potential solutions within existing legal provisions. The focus is on finding ways to assist deemed exporters, particularly within special economic zones, by addressing the VAT anomaly on local inputs.
Historical Context of Free Trade Zones and VAT
The concept of free trade zones, often credited to Taiwan in the early 1960s, aimed to circumvent protectionist trade policies. Initially, before the widespread adoption of VAT, export powerhouses in Europe did not face VAT-related issues. Modern VAT systems, pioneered in France and adopted by many European nations, later became a significant factor in international trade taxation.
Taiwan’s experience in the 1950s, similar to Sri Lanka’s current challenges with monetary instability impacting its export sector, highlights the difficulties posed by import taxes on essential production inputs. After exploring tax rebates, Taiwan established free trade zones near its ports to foster exports and mitigate the impact of protectionism.
Knowledge of VAT application in international trade appears varied. For instance, former U.S. President Trump has been critical of VAT, viewing it as an unfair export subsidy. This suggests differing international perspectives on how VAT systems interact with global trade dynamics.
Broader Economic Repercussions
The removal of the SVAT system is not only affecting local production but also impacting local buying offices that serve international clients. Analysts suggest that if these issues persist, buying offices might consider relocating abroad to mitigate the financial strain.
While some sectors might absorb the increased costs, industries with notoriously thin profit margins, such as the apparel sector, are particularly vulnerable to these adverse effects. The financial strain could disproportionately affect their ability to compete internationally.
Challenges for Sri Lanka’s Tea Industry
Sri Lanka’s tea producers are also facing similar cashflow constraints and increased costs due to the VAT changes. They anticipate needing to absorb interest costs stemming from reduced selling prices, a consequence of exporters bearing VAT expenses upfront, even with efforts to shorten VAT refund periods.
Following the SVAT removal, tea prices reportedly saw a decline of approximately 100 rupees per kilogram. Market participants are hopeful for a price recovery once VAT refunds are processed, but the immediate impact on cashflow remains a concern.
Unlike manufactured goods, where exporters can readily switch to imported inputs if local sourcing becomes too costly, Sri Lanka’s tea plantations and smallholder farmers remain tied to the domestic market. While they will continue to have buyers, the prices may be adjusted to reflect the increased financial burden on exporters.
Sri Lanka’s Tax Environment Amidst Economic Crises
Sri Lanka has a history of increasing taxes in response to balance of payments crises, often exacerbated by a central bank’s monetary policies. Critics often refer to these as monetary accommodation or eased monetary policy, which can lead to inflationary pressures.
Currency crises have frequently led to higher income tax rates. This, in turn, has created a perceived need for lower corporate taxes to attract foreign investment and support export-oriented businesses. However, Sri Lanka’s current corporate tax rate of 30 percent is significantly higher than the 20 percent seen in more economically stable East Asian and Scandinavian countries.
Final Thoughts
The Sri Lankan government, through the Board of Investment, is actively addressing VAT anomalies that are negatively impacting local input manufacturing and the competitiveness of its export sector. The current tax structure, particularly the removal of the SVAT system, is creating significant financial challenges that mirror issues faced by international competitors employing more supportive export policies.