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 export sectors.
- The removal of the Special Value Added Tax (SVAT) system has created cash flow issues and increased interest costs for exporters, particularly in the apparel and tea industries.
- Competitor nations like Vietnam and Taiwan offer VAT exemptions or zero-rated sales into export zones, providing a competitive advantage.
- Industry stakeholders are concerned that if the VAT issue is not resolved, it could lead to exporters moving operations abroad or halting backward integration investments.
- BOI has submitted budget proposals and is in discussions with the Inland Revenue Department to find a solution for this anomaly.
Sri Lanka’s VAT Anomaly Discouraging Export Growth
Sri Lanka’s Board of Investment (BOI) is actively working to mitigate the adverse effects of Value Added Tax (VAT) imposed on locally produced inputs. This tax policy is discouraging crucial backward integration efforts within the country’s export-oriented industries, potentially impacting their global competitiveness.
The apparel industry, a significant contributor to Sri Lanka’s export economy, has voiced strong concerns. The discontinuation of the SVAT system, which previously allowed local producers to supply exporters under a VAT-exempt framework, has created substantial cashflow demands and increased interest expenses for these businesses. This operational burden makes it difficult for Sri Lankan exporters to compete effectively with international counterparts.
💡 In key competitor nations such as Vietnam and Taiwan, sales into export firms within free trade zones are treated as zero-rated, mirroring the treatment of final exports. Under a zero-rated system, no VAT is levied, and suppliers are also eligible for input tax credits, fostering a more favorable business environment.
Unlike imported inputs, which are VAT-exempt in Sri Lanka, similar to practices in other East Asian economies, the tax applied to locally sourced materials presents a distinct disadvantage. This disparity is a growing concern for industries looking to enhance their supply chains through backward integration.
Impact on Backward Integration and Competitiveness
The apparel sector has issued a stark warning: without a resolution to the VAT issue, they may be forced to halt further investments in backward integration. This strategic move, which involves developing local capabilities for raw material production and processing, is vital for enhancing efficiency and reducing reliance on imported components.
Chairman Arjuna Herath highlighted that the apparel industry has made significant investments in backward integration, including the establishment of a textile production zone in Eravur. The current VAT policy threatens to undermine these substantial investments and future expansion plans.
“We have actually submitted a budget proposal this time for the budget to avoid this anomaly,” Herath stated, underscoring the urgency of the situation. The BOI is not only seeking legislative changes but is also actively engaging with the Inland Revenue Department to explore existing provisions that might offer relief.
“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,” he added. “So, we are actively engaged on this.”
International Practices and Historical Context
The practice of zero-rating sales into export-oriented zones is not unique to Sri Lanka’s competitors. In countries like Vietnam and Taiwan, which pioneered the concept of free trade zones, sales into firms within these zones, including for services, are zero-rated, not just final exports.
Historically, Taiwan, much like Sri Lanka, faced monetary challenges in the 1950s due to central bank policies. High import taxes hindered export manufacturing. After initially providing tax rebates, Taiwan established a free trade zone near Kaohsiung port to help exporters overcome protectionist measures. At that time, VAT was not yet prevalent outside Europe, so it wasn’t an immediate issue for European export powerhouses.
The modern VAT system originated in France, with initial trials in Ivory Coast in 1954 and its adoption in France in 1958. VAT later spread throughout the European Economic Community, with the UK adopting it in 1972. Notably, understanding and application of VAT can vary; for instance, former US President Trump has criticized it as an unfair export subsidy.
Broader Economic Ramifications
The removal of the SVAT system has also impacted local buying offices, according to Sri Lankan exporters. These offices play a crucial role in aggregating local production for export markets.
Analysts suggest that if the VAT anomaly persists, buying offices might be compelled to relocate abroad, mirroring the potential halt in backward integration factories and a reduced demand for suppliers outside designated export zones. While some export sectors with healthier margins might absorb the financial strain, industries with thin margins, such as apparel, are likely to suffer more severe consequences.
Sri Lanka’s tea producers have also reported similar hardships. They anticipate increased interest costs due to reduced selling prices, stemming from the cashflow burden of paying VAT upfront, even with reduced refund periods. Following the removal of SVAT, tea prices saw a dip of approximately 100 rupees per kilogram, with expectations of a partial recovery once VAT refunds are processed.
💡 Unlike in industrial goods, where exporters can readily switch to imported inputs, the unique nature of tea plantations and smallholder farming means these producers will still face a market, albeit with potentially reduced prices to reflect exporters’ increased cashflow costs.
Sri Lanka has a historical pattern of increasing taxes in response to balance of payments crises, often triggered by central bank policies critics describe as ‘monetary accommodation’ or ‘eased monetary policy’—terms seen as euphemisms for inflationary rate cuts or money printing. Currency crises have historically led to higher income taxes, which in turn necessitates attractive low-tax environments for foreign investors and export firms. Sri Lanka’s current corporate tax rate stands at 30 percent, considerably higher than the 20 percent seen in East Asian and Scandinavian countries with greater monetary stability.
Expert Summary
The Sri Lankan government, through its Board of Investment, is actively addressing a critical VAT issue impacting its export sector. The removal of the SVAT system on locally sourced inputs is creating significant financial strain and deterring essential backward integration investments, particularly within the apparel and tea industries.
As competitors like Vietnam and Taiwan offer more favorable VAT treatments, Sri Lanka risks losing its competitive edge and potentially seeing export-related operations shift abroad. Urgent fiscal adjustments and policy reviews are underway to rectify this anomaly and support the resilience of Sri Lanka’s export economy.