Key Takeaways
- Sri Lanka’s Board of Investment (BOI) is addressing the negative impact of Value Added Tax (VAT) on locally produced inputs, which is hindering backward integration in key industries like apparel.
- The removal of the Special VAT (SVAT) system has created significant cashflow challenges and increased interest costs for exporters, unlike competitor nations where exports to free trade zones are zero-rated.
- Industry leaders warn that Sri Lanka’s apparel sector may halt backward integration efforts, impacting crucial investments in facilities like textile production zones.
- The government is actively seeking budget proposals and liaising with the Inland Revenue Department to resolve this VAT anomaly, particularly for deemed exporters.
- Similar VAT-related financial strains are affecting other productive sectors, such as tea production, leading to reduced prices and increased financial burdens for producers.
Addressing VAT’s Impact on Local Inputs
The Sri Lankan Board of Investment (BOI) is actively working to mitigate the adverse effects of Value Added Tax (VAT) applied to locally sourced inputs. Chairman Arjuna Herath highlighted that this tax imposition is discouraging crucial backward integration within the country’s manufacturing sectors.
Impact on Sri Lanka’s Export Industries
Sri Lanka’s vital apparel industry has voiced significant concerns regarding the removal of the Special VAT (SVAT) system. This system previously allowed local producers to supply goods to exporters under a VAT-exempt framework. Its removal now necessitates exporters to manage increased cashflow demands and associated interest expenses.
In contrast, competitor nations such as Vietnam and Taiwan implement a zero-rated VAT system for sales into free trade zones, mirroring the treatment of final exports. Under this model, no VAT is charged, and suppliers are eligible for input tax credits, creating a more favorable environment for exporters.
Simultaneously, imported inputs in Sri Lanka remain VAT-free, aligning with practices in other competing East Asian economies. However, the tax on locally sourced inputs creates a disparity that threatens competitiveness.
Industry representatives have cautioned that the current VAT structure may compel them to cease backward integration efforts, a move that is essential for maintaining global competitiveness.
The apparel industry has made substantial investments in backward integration facilities. Herath pointed to the establishment of a zone in Eravur specifically designed for textile production as an example of this commitment.
“We have actually submitted a budget proposal this time for the budget to avoid this anomaly,” Herath stated, indicating proactive steps being taken to address the issue.
“We have taken up with the Inland Revenue Department as well. They have recognized that, within the provisions, whether they may have some leeway to look at this within the zone for deemed exporters on a deemed exporters basis to do this.
“So, we are actively engaged on this.”
International Precedents and VAT Evolution
The practice of zero-rating sales within zones, not just final exports, is a well-established model in countries like Vietnam and Taiwan. Taiwan, which pioneered the concept of free trade zones in the early 1960s, applies this to sales to firms within these zones, including services.
Taiwan’s economic journey offers a parallel to Sri Lanka’s historical challenges. In the 1950s, Taiwan faced monetary instability due to its central bank’s policies, hindering export manufacturing due to import tax protection that adversely affected essential inputs.
Initially, Taiwan provided tax rebates to overcome protectionist barriers. Subsequently, the establishment of a free trade zone near the Kaohsiung port allowed exporters to circumvent these protectionist measures. At that time, VAT was not prevalent outside Europe, so it did not pose a challenge to European export powerhouses.
The modern VAT system originated in France, with initial testing in Ivory Coast in 1954 before its adoption in France in 1958. VAT later spread throughout the European Economic Community, with the UK implementing it in 1972.
The understanding of VAT appears less developed in some regions, such as the US, where former President Trump criticized it as an unfair export subsidy.
Broader Economic Implications of VAT Policy
The impact of the SVAT removal extends beyond the apparel sector, affecting local buying offices as well. Analysts suggest that the removal of SVAT could force these offices to relocate abroad, similar to the potential halt in backward integration factories and reduced purchases from suppliers outside of designated zones.
While some export sectors might absorb the financial strain, industries with thinner profit margins, such as apparel, are likely to face more severe consequences.
Sri Lanka’s tea producers have also reported incurring additional interest costs due to reduced selling prices. This cashflow burden arises from paying VAT upfront, even with reduced refund periods.
Following the removal of SVAT, tea prices saw a decline of approximately 100 rupees per kilogram. However, there is an expectation of some price recovery once VAT refunds are processed.
Unlike in industrial goods, where manufacturers can easily switch to importing inputs and discontinue local sourcing, tea plantations and smallholders remain tied to the local market. While prices may adjust to offset the cashflow costs for exporters, these producers will still have a market, albeit at potentially lower rates.
Sri Lanka has a history of increasing taxes in response to balance of payments crises. These crises are often triggered by central bank actions perceived as ‘monetary accommodation’ or ‘eased monetary policy,’ terms critics suggest are euphemisms for inflationary rate cuts or money printing.
Currency crises have also led to retaliatory increases in income tax. This, in turn, has created a recognized need for lower tax regimes to attract foreign investors and support export-oriented businesses.
Sri Lanka’s corporate tax rate stands at 30 percent, which is considerably higher than the 20 percent rates found in East Asian and Scandinavian countries that maintain monetary stability.
Concluding Remarks on Export Competitiveness
The current VAT regime on local inputs poses a significant threat to Sri Lanka’s export competitiveness by hindering backward integration. Addressing this issue is critical for industries like apparel and tea, as well as for retaining vital support functions like local buying offices within the country.
International comparisons highlight more favourable VAT treatments available in competitor nations, underscoring the need for Sri Lanka to re-evaluate its policies to foster a more supportive environment for its export sector.