Sri Lanka’s VAT hike will keep IMF on track, credit positive: Moody’s

Oct 31, 2016 (LBO) - Sri Lanka's Value Added Tax (VAT) hike 15 percent from 11 percent will make the island credit positive as it will facilitate fiscal consolidation by strengthening low revenue-to GDP ratio, Moody's Investors Service said. "The government originally implemented the VAT hike in May, but retracted it in July after a legal challenge by the main political opposition party in parliament. Backsliding on VAT reform demonstrates the implementation risks surrounding fiscal reforms." "Had the implementation delay been prolonged, Sri Lanka would have been at risk of derailing its IMF program and loan disbursements, which would have strained the balance of payments and harmed investor confidence." The full statement follows On 26 October, the Sri Lanka (B1 negative) parliament voted in favor of amendments to the value added tax (VAT) bill, which will increase the VAT tax rate to 15% from 11%, paving the way for higher government revenues and adherence to International Monetary Fund (IMF) program commitments. This is credit positive because a higher VAT rate will facilitate fiscal consolidation by strengthening Sri Lanka’s low revenue-to GDP ratio, which is a key credit constraint.

The government originally implemented the VAT hike in May, but retracted it in July after a legal challenge by the main political opposition party in parliament. Backsliding on VAT reform demonstrates the implementation risks surrounding fiscal reforms. Had the implementation delay been prolonged, Sri Lanka would have been at risk of derailing its IMF program and loan disbursements, which would have strained the balance of payments and harmed investor confidence. The VAT parliamentary vote took place immediately following a Supreme Court ruling that deemed the tax hike permissible under Sri Lankan law. In addition, parliament approved amendments that increase the nation building tax rate on importers, manufactures and service providers to 4% from 2%. Fiscal consolidation is a major focus of the IMF program with a reduction in the deficit to 5.4% of GDP this year and 3.5% by 2020, from 6.9% in 2015, or 7.4% including one-off expenses. In first-half 2016, government revenues including grants rose a robust 27.

3% year on year while expenditures increased 7.1% (Exhibit 1). Revenue growth was broad-based, with increases in VAT, the national building tax and custom duties. As a result, the primary balance, which excludes interest payments, was in deficit of LKR38.6 billion by June 2016, ahead of the IMF program target of LKR46 billion.