Sri Lanka lowers tariffs to increase trade volumes and investment

Flat export growth and a widening trade deficit have prompted Sri Lanka to launch a series of trade policy reforms aimed at boosting domestic competitiveness and export-oriented investment. A new trade strategy, announced in early 2017, is expected to shift the focus towards value-added manufacturing offerings and support programmes for exporters.

Tariff reforms have been identified as a critical first-step, with the Ministry of Development Strategies and International Trade (MODSIT) emphasising elimination of para-tariffs, a charge levied on imports in addition to, or in place of, a tariff. Although removal of protectionist tariffs could put local producers at risk of significantly increased competition and a flood of cheaper imports, domestic and international stakeholders have both argued that the long-term benefits of tariff reform would outweigh any near-term losses. This is reflected in the 2018 budget statement, which calls for substantial tariff rationalisation in the coming years, with local industry to be protected by the introduction of robust anti-dumping and quality-control legislation.

Trade Challenges

Sri Lanka has struggled to boost international trade in recent years, with export growth remaining relatively flat and rising fuel imports driving the trade deficit to new highs. According to the Central Bank of Sri Lanka, the value of total exports contracted by 5.2% in 2015 to $10.55bn and again by 2.2% to $10.31bn in 2016; the Department of Commerce reported that the deficit rose to a five-year high of $9.3bn that year. However, per provisional figures, the total value of exports rose by 10.2% to $11.36bn in 2017.

The World Bank reports that while Sri Lanka’s economic growth has been strong in recent years, it has also relied on public investment and non-tradeable industries over private investment and the tradeable sector. Noting that the country attracts much lower volumes of foreign direct investment (FDI) than its peer economies – less than 2% of GDP in 2016 – the bank writes that the adoption of protectionist trade policies beginning in the early 2000s has created a “strong anti-export bias”, with exports as a share of GDP falling to 48% in 2016, against 89% in 2000.

National Trade Policy

The government recognises the challenges facing sustainable long-term export growth, and in February 2017 the MODSIT unveiled a new National Trade Policy (NTP). The NTP’s main objective is to establish a more liberal, simple, transparent and predictable trade regime. It also aims to stimulate growth and job creation, improve firms’ abilities to export and compete domestically, attract export-oriented FDI, improve trade logistics, and streamline and simplify Customs procedures.

The MODSIT states that a simplified, open trade policy would likely entail enacting two or three ad valorem tariffs bands, that is, based on the estimated value of goods; replacing specific levies with the ad valorem duties; and eliminating para-tariffs. Taxes applying to domestic and imported products, including value-added tax (VAT) and excise tax, would continue as before or be adjusted based on state revenue needs.

World Bank Support

The World Bank strongly supports tariff reform as a key pillar of Sri Lanka’s trade overhaul agenda, reporting in November 2017, “Sri Lanka’s import tax structure has become a complex web of tariffs and para-tariffs that have been revised frequently during the last decade”, and characterising revisions as ad hoc, inconsistent and following different directions. According to the organisation, convoluted import taxes have impaired the development of competitive firms, industries and exports in Sri Lanka.

Tariff reform should have a positive impact on macroeconomic growth in the country, with the World Bank writing that gains in GDP, exports and imports, as well as lower price points for consumers, will outweigh any negative affects on less-competitive sectors. The bank argues that tariff rationalisation is a manageable process and is considered a normal part of the transition to becoming an upper-middle-income economy – a key goal of the Vision 2025 economic development agenda. Thailand, for example, reduced average tariffs from 40.4% in 1991 to 8.2% in 2014, while Malaysia dropped its average import tariffs from 13.6% to 3.4% over the same period. In contrast, Sri Lanka’s average tariff rates rose from 13.4% in 2004 to 21.9% in 2016.

The MODSIT, for its part, projects tariff and para-tariff reform would significantly improve investment in export-oriented activities by reducing the cost of domestic inputs, including labour, which will in turn displace less-efficient industries, freeing up investment and labour for more competitive businesses. According to the ministry, a large portion of the labour force is engaged in the lower-productivity agriculture sector, with trade liberalisation holding the potential to accelerate the transformation into a knowledge-based economy – another key goal of Vision 2025. Export activity expansion would boost employment in supporting services, according to the NTP, and would also increase female labour market participation.

Para-Tariffs

The World Bank has identified the Ports and Airports Development Levy (PAL) and cess as two para-tariffs with high potential for reform. As of October 2017 Sri Lanka’s import regime included Customs duty rates of 0%, 15%, 30% and 37%, as well as the PAL and cess, which are levied on imports in excess of Customs duties. PAL rates are set at 0%, 2.5% and 7.5%, while cess is levied ad valorem, with the World Bank reporting that cess rates can vary from 1% to 465%. Three additional taxes are charged on select imports and domestic production, including VAT, a nation-building tax (NBT) and a composite tax – the Special Commodity Levy (SCL) – which is charged on a small number of agricultural products.

In its November 2017 Sri Lanka Development Update, the World Bank reported that the country relies heavily on trade taxes, with import-related taxes accounting for 40% of all tax revenue and protective taxes for an additional 13% of the total, complicating trade reform. It argues, however, that boosting the country’s tradeto-GDP ratio to the 2000 level of 89% – or to the level of regional peers, such as Vietnam’s 160% – would allow Sri Lanka to yield significant import revenue.

Recommendations

The World Bank recommended that future trade reforms “incorporate a gradual but firm liberalisation schedule, allowing time for adjustment, with a fixed phase-out schedule,” adding that the need to consolidate, reduce and eventually eliminate para-tariffs is also clear, owing to their opaque nature and ad hoc imposition. The organisation wrote that para-tariffs are seen as an “easy go-to” for revenue generation, which is detrimental to predictability and dampens investor appetite. Para-tariffs are also problematic because they are often applied non-uniformally across sectors, with the “average protection implied”, or cost of the cess, generally higher for sectors such as foodstuffs, footwear, glass and vegetables, while the revenues they generate are relatively low.

In 2016, for example, cess and the PAL accounted for less than 10% of government revenues, while the World Bank reported that excise taxes, VAT, NBT and the SCL accounted for a combined 28% of tax revenues. According to the bank, this makes tariff rationalisation “manageable from a revenue standpoint”.

World Bank officials also recommended the government review its export tax regime, particularly for agricultural commodities, stating that policies should be revisited because the rationale behind them is no longer clear. Any losses from reduced tariffs and para-tariffs would be offset by increased economic activity, trade and other ongoing tax reforms, the organisation says.

Steady Progress

In October 2017 the government announced plans to intensify efforts to reduce import and export taxes, with local media reporting cess export charges – which currently average LKR6 ($0.04) per kilogram of product – could be eliminated under upcoming reforms. Sujeewa Senasinghe, the state minister of international trade, said that the government is also working to draft a new export policy, which would remove investment barriers, improve trade efficiency, boost credit access and strengthen the country’s financial market infrastructure.

The 2018 budget statement, released in November 2017, also signalled a shift in mindset, with the Ministry of Finance (MoF) stressing the importance of trade reforms and stating that the removal of para-tariffs should not be seen as a threat to local industry. According to the MoF, any para-tariffs on imports that are not currently subject to Customs duties will be abolished within the next three years, in keeping with Vision 2025’s broader liberalisation and globalisation imperatives. The MoF reports that it removed over 100 applicable para-tariffs in 2016, and up to 1200 additional para-tariffs were expected to be removed by the end of 2017. Noting that doing away para-tariffs is also in line with Sri Lanka’s World Trade Organisation commitments, the MoF reported that the government plans to develop a trade adjustment programme to support the local private sector, which will include anti-dumping, countervailing and consumer protection legislation.