THE COLONIAL ROOTS OF SRI LANKA’S TAX REGIME
Shiran Illanperuma
One of Colombo’s oldest institutions is the ‘Battle of the Blues’—an annual cricket match between Royal College and St. Thomas’ College; two boys schools established under colonial rule and modelled after England’s Eton College. Both have long served as incubators for much of Sri Lanka’s political and business elite.
In a speech during this year’s post-match celebrations, President Ranil Wickremesinghe, an old boy of Royal College, quipped: “I like that all of you have beers in your hand. Very good, because that means you’re paying Value Added Tax (VAT) at 18 per cent!”
In a half-drunken stupor, the audience roared in a mixture of jeers and laughter.
“I like that all of you have beers in your hand. Very good, because that means you’re paying Value Added Tax (VAT) at 18 per cent!”
— President Ranil Wickremesinghe, ‘Battle of the Blues’ cricket match
Having defaulted on its external debt in April 2022, Sri Lanka is currently undergoing painful austerity as part of its 17th IMF program. The country has implemented a host of measures to reduce its chronic budget deficit. These include the withdrawal of subsidies on fuel, water, and electricity, the raising of value-added taxes from 15 per cent to 18 per cent, and the lowering of the minimum tax threshold from 150,000 to 100,000 Sri Lankan rupees (about US$327) per month.
Trade unions have characterised these and other measures as an attack on working people. Meanwhile, business leaders have raised concerns about a brain drain of educated professionals. Opposition parties on both the left and the right have raised the growing tax burden as part of their slogans and campaigns, linking it to the broader cost of living crisis.
As for President Wickremesinghe, he has gone on record stating, “It may be bitter, but any medicine for recovery is bitter.”
Tax revenue has been a perennial problem in Sri Lanka, which has seen its tax-to-GDP ratio decline dramatically from 19 per cent in 1990 to 7.4 per cent in 2021—one of the lowest among peers of similar income levels. Mainstream economists have pinned the country’s current economic crisis on fiscal profligacy, though heterodox thinkers have pointed to a more complex array of external and structural causes.
However, most economists can agree that Sri Lanka’s tax structure is regressive. In 2019, on the eve of the economic crisis, the majority of Sri Lanka’s state revenue was from indirect taxes on consumption (56 per cent), and trade (19 per cent). Meanwhile, direct taxes on income and profits comprised just 25 per cent of revenue.
Free trade advocates argue that excessive reliance on taxes on trade, particularly import tariffs, has distorted market prices, leading to an inward-looking, rent-seeking elite, and a bias against exports. The prescription is to eliminate trade taxes, broaden the tax base, and directly tax incomes.
As articulated by the IMF and its fellow travellers, the question of fiscal policy is therefore implicitly tied to trade (and industrial) policy. This is often framed in progressive and populist ways, pointing out how import tariffs lead to a loss in consumer welfare, while higher taxes on the rich could help fuel social services.
In this way, a politics of free trade and austerity is married to a pseudo-populist anti-elite discourse that resonates among sections of the middle-class who are frustrated by corruption and underdevelopment. Yet these narratives fail to engage with the legacy of colonialism and neocolonialism, which shapes the political economy of fiscal policy in decolonising countries like Sri Lanka.
Colonial Tax Regimes
The economist Mick Moore has argued that Sri Lanka’s tax system emerged as a byproduct of the colonial plantation economy and the colonial state. Since the bulk of economic activity in colonial Sri Lanka (then known as Ceylon) involved bulk imports of commodities for consumption (particularly food grains) as well as exports of cash crops like tea, rubber, and coconut, indirect taxes on trade were considered an efficient and feasible method to raise revenue.
The need for revenue was itself driven by a sprawling bureaucracy designed to facilitate the plantation economy. To quote Moore:
Imagine the colonial administration as a machine for ensuring the continual flow of plantation exports and profits. To achieve that goal, it had to develop and operate road, port, railway and electricity facilities; control the ever-present threat of tropical diseases; manage extensive movement of labour to and from India; make it possible for land to be sold or leased with secure title; establish effective court and police systems; and keep the social peace.
Moore later acknowledges that, due to the class nature of the colonial state, taxes were more likely to be placed on consumer imports than the export revenues of European planters. However, he fails to point out that even taxes on imports had to navigate English industrial interests.
“ …due to the class nature of the colonial state, taxes were more likely to be placed on consumer imports than the export revenues of European planters.”
For example, taxes proposed on salt imports were shot down to allow English salt to compete with locally produced salt. Similarly, import taxes were designed to provide English cloth manufacturers with a competitive advantage over Indian imports.
Moreover, Moore fixates on the period after the establishment of the plantation economy when trade volumes were high enough to justify indirect taxation. This glosses over the early decades of colonisation when the colonial state imposed direct taxes on the local peasantry to establish the plantation infrastructure.
S.B.D. de Silva argues that the early colonial taxation regime favoured the plantation economy over the village economy:
The infrastructure facilities, geared overwhelmingly to the needs of the export sector, not merely failed to benefit village interests but involved a repudiation of these interests. In the allocation of expenditure on the construction and maintenance of roads, village roads were discriminated against… the road tax was paid almost entirely by the villagers, plantation labour being exempt. The repair and maintenance of existing irrigation works were neglected.
These tax policies pauperized the peasantry and fuelled two wars of liberation. First, following the English annexure of the Kandyan Kingdom in 1815, the punitive use of grain taxes and the co-option of traditional corvée to build colonial infrastructure led to the Great Rebellion of 1818. Those who collaborated with the British were rewarded with tax concessions and exemptions. Second, during the economic depression in the 1840s, the colonial administration raised direct taxes on the local population while slashing taxes for European planters, culminating in the Matale Rebellion of 1848.
The dilemma for colonial fiscal policy was that the colony had to serve as both a captive market for the mother country’s manufactures, as well as a site of profiteering for European planters. Both required an expensive state machinery, which the local population was opposed to, let alone willing to pay for.
There were alternatives available. ‘Progressive’ elements in the colonial bureaucracy. like Colonial Secretary of Ceylon Sir James Emmerson Tenet, had lobbied for a general land tax as a substitute for taxes on paddy and customs duties on imported rice. Such a tax would have placed a greater burden on European planters of cash crops, than on the production and consumption patterns of peasants and workers. However, native and European landed interests colluded to oppose this proposition. Indirect taxes on imports became the political settlement that allowed the colonial government to collect revenue for its self-perpetuation.
The colonial state’s taxation regime was not shaped by a Rousseauian social contract between free citizen and sovereign state. Rather, taxes were levied by a foreign power to build and sustain the colonial enterprise, while simultaneously pauperizing the peasantry. This “original sin” shaped post-independence state-building and fiscal policy.
Labourers at a Coffee plantation in colonial Ceylon (present day Sri Lanka) in the 1870s. Image: Lankapura.com
Nationalist Gains and Neoliberal Retreats
The rise of anti-colonial nationalist and socialist movements in the 1930s gave way to political independence in 1948 and the dawn of a new political settlement. The Ceylonese elites’ vested interests in the plantation economy were curtailed by universal franchise and demands for greater expenditures on education, healthcare, irrigation, settlement of landless peasants, and state-led industrialization.
To raise revenue for these objectives, national elites had to tax plantation exports—previously unthinkable in the colonial era. This converged with the rise of a dirigiste regime in the 1960s and 1970s, which sought to tackle diminishing terms of trade through nationalisation of foreign assets, import-substitution, and raising income and corporate tax rates.
The combination of higher taxes with the threat of nationalisation instigated capital flight of foreign tea planters, particularly during the 1970s, highlighting the limitations of this model in the context of international political economy. While taxing and expropriating the peasant economy may have helped build and sustain the colonial enterprise, the opposite—expropriating and taxing colonial enterprises to build a national economy—could not so easily be achieved.
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The dirigiste experiment was brought to a screeching halt by its internal and external contradictions in the late 1970s. Internally, the measures taken by the nationalist, left-leaning United Front government were insufficient to challenge merchant and landed interests and to initiate a social transformation necessary for industrialization. Externally, the 1970s food and oil crises placed severe pressure on the balance of payments, and the capacity to provision basic needs, let alone import the capital goods required for industrialization. In the wake of these crises, a new government elected in 1977 initiated a ‘shock therapy’ style market liberalisation, which had serious repercussions for fiscal policies.
“First, import liberalisation destroyed the tax base created by tariff-protected infant industries. Second, in order to facilitate foreign investment, a race to the bottom began in terms of tax concessions.”
First, import liberalisation destroyed the tax base created by tariff-protected infant industries. Second, in order to facilitate foreign investment, a race to the bottom began in terms of tax concessions. Institutions like the Greater Colombo Economic Commission, later renamed the Board of Investment, were given extensive powers to provide tax breaks for foreign investment in special economic zones. As political economist and former Governor of the Central Bank of Sri Lanka, Prof W.D. Lakshman has argued:
Neoliberalism encourages Foreign Direct Investment (FDI)…policy action to promote FDI was strongly dependent on tax holidays, accelerated depreciation allowances and such other income tax-related incentives. As time passed, these tax exemptions became more or less a permanent feature in the country’s tax structure and the incentives environment.
A second wave of liberalisation in the 1990s saw the abolition of wealth and capital gains taxes. Privatisation of SOEs built up in the dirigiste era was briefly a major source of revenue, which echoed the early years of English colonial rule when sales and leases of enclosed lands provided supplemental government revenue.
Far from being an era of unbridled austerity, neocolonialism required new infrastructural development to stabilise itself. Financed by aid and foreign loans, the government ran significant budget deficits to undertake large-scale infrastructure projects like the Accelerated Mahaweli Programme (AMP). The AMP was the flagship project of the neoliberal government of 1977. It sought to compress a pre-existing 30-year plan for the development of irrigation and hydroelectric power into a mere six years. Despite deviating from the neoliberal template of balanced budgets, the AMP nonetheless fits within the broader paradigm of neoliberalism. First, it primarily benefited foreign capital through lucrative contracts for construction, and the import of seeds, agrochemicals, and agricultural machinery. Second, the project continued to prop up the same old comprador landlord and merchant classes that prevent modern industrialization. And third, the accumulation of foreign debt to finance the budget deficit helped reassert neocolonial control over the economy.
Like the colonial era before it, the neoliberal regime combined fiscal incentives and infrastructure development to facilitate the interests of foreign and domestic merchant capital. This entailed the (relative) preservation of the post-independence welfare state, the dismantling of the dirigiste developmental state, and a larger role for foreign debt to plug the resulting budget deficit.
Neocolonial Continuities
These major changes in the fiscal policy of post-independence Sri Lanka are reflected in the income tax rates for individuals and corporations. Table 1 shows that in 1977, the last year of dirigiste economic policies, corporate taxes peaked at 70 percent. By 1987, after a decade of shock therapy, these had declined to 40 percent. By 2014, corporate tax stood at just 28 per cent as the neoliberal status quo was more or less stabilised.
“The tax regime in Sri Lanka has come full circle back to the colonial era.”
The tax regime in Sri Lanka has come full circle back to the colonial era. Table 2 shows that the revenue structure during the colonial and neoliberal eras remained relatively unchanged. In 1938-39, when the plantation economy was dominant, government revenue was predominantly raised from import taxes (47 percent), income taxes (15 percent), and excise taxes on liquor and alcohol (13 percent). Around 75 years later, import taxes contribute 43 percent of tax revenue, income taxes contribute 19 percent and excise taxes contribute 13 percent.
The point is not that there are parallels in fiscal policy in the colonial and neoliberal eras, but that fiscal policies are strongly shaped by the structure of the economic base (i.e., investment patterns and the nature of accumulation), the balance of power between classes within the country, and between countries in the world capitalist system.
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The IMF has often been accused of swooping into distressed countries with a cookie-cutter, box-ticking approach to reform that ignores historical realities. In the case of countries like Sri Lanka, recommendations to simply increase direct taxation presuppose the existence of a Fordist industrial regime with full and formal employment, which made such fiscal policies possible in the Global North.
On the contrary, nearly 70 per cent of employment in Sri Lanka is in the informal sector—a legacy of the enclave nature of both colonial and neoliberal investment patterns, which exclude the majority of the population from productive economic activity. The formal sector itself comprises a narrow group of banks, trading companies, and exporters with few links to the domestic economy. The labour and capital invested in these sectors have greater bargaining power with the state, such that taxation beyond certain threshold risks triggering both brain drain and capital flight, as it did during the era of dirigisme.
Sri Lanka’s lock-in to indirect taxes on trade and consumption is a perfectly rational outcome of colonial and neoliberal underdevelopment.
The colonial project created an international division of labour to ensure that the colonised would never achieve modern industrialisation and development. Though some post-independence governments attempted to chart another course, neoliberalism often violently sought to reinstate this division. Sri Lanka’s fiscal policies cannot be thought of in isolation from these factors, and from the historical development of its economic base.
The conditionalities attached to Sri Lanka’s current IMF programme entail heavy and extractive taxation of the local population, primarily for the purpose of serving foreign debt. The fetters placed on Sri Lanka’s fiscal and monetary sovereignty appear almost tailor made to perpetuate its underdevelopment and prevent modern industrialization. Taxes now extend to not just consumption, but also production goods. Meanwhile, public services such as transport and energy—the foundation of any productive economy—are on the privatisation chopping block. While foreign investment is expected to deliver growth, it is clear that within the current incentive structure, foreign capital is only interested in old enclave-type rentier activities that cannot deliver structural transformation. As such, the IMF is serving as an enforcer of the old colonial division of labour. To add salt to the wound, it is doing this just as its Western backers are dropping the facade of free trade and adopting increasingly protectionist industrial policies.
The question of taxation and fiscal policy continues to dominate both right- and left-wing imaginaries of dealing with the current crisis in Sri Lanka. While progressive solutions are needed, be they taxes on wealth or more radical demands for debt cancellation, there is a more urgent need for Sri Lanka to rethink its entire development model from the ground up. Like many other decolonizing countries, Sri Lanka has struggled to develop a unifying national project of industrialization. This would necessarily entail breaking from the legacy of colonial underdevelopment and reasserting sovereignty over trade and industrial policies. Fiscal policies must be seen as part and parcel of such a project, and not simply an accounting exercise to be conducted at the offices of the Treasury in Colombo or the IMF headquarters in Washington.