Sri Lanka: Budget 2011 - The Challenge ahead

A Challenge Ahead…

• President in his budget speech underscored that production drive in this decade should aim at expanding exports and replacing imports.
• The reallocation of the wealth of nation via altering the tax system seems pro investor as well as pro consumer, which is in line with our previous forecasts.
• The newly introduced tax measures will wet the investor appetite for further investments and increase future cash flows of the corporate.
• Given the inward nature of Sri Lanka’s capital formation, demand for luxury imports such as motor cars (therefore crude oil) will also scrape the skies, compelling the government to remain cautious on the BOP situation.

Synopsis

The 2011 budget proposal of the Government of Sri Lanka was unfolded before the general public yesterday. The overall outlook of the fiscal plan suggests that latter’s main aim is to achieve rapid economic development through import substitution and export expansion while attaining GDP growth and simultaneously curbing the deficit position of the government. President in his budget speech underscored that production drive in this decade should aim at expanding exports and replacing imports. The international trade strategy must aim at phasing out the trade deficit, improved marketing strategies coupled up with improvement in productivity and efficiency of labour and increasing the competitiveness of country’s export and imports.

Performing an active role as the facilitator of free economic activity the government imposed major changes in taxation and transfers as a measure to assist the private sector in achieving above mentioned macroeconomic challenges. The reallocation of the wealth of nation via altering the tax system seems pro investor as well as pro consumer, which is in line with our previous forecasts.

The major tax reforms and subsidies include the exemption of PAYE tax for annual incomes less than LKR 600,000, decreasing the corporate tax from 35% to 28%, reduction of income tax on Venture Capital corporations up to 12%, exemption of Economic Service Charge for investment trusts, reduction of Value Added Tax (VAT) from 20% to 12% for financial services, providing a subsidy of LKR 50,000 to small holder tea growers cultivating in excess of one hectare of land, removal of the Social Responsibility Levy, imposing CESS on primary goods and raw material exports.

The newly introduced tax measures will wet the investor appetite for further investments and increase future cash flows of the corporates. Consequently, it bears the propensity to enforce downward pressure on interest rates as the credit dependency of the corporates will shrink when non-debt based cash flows ooze in to the businesses with newly imposed tax cuts. The deposit base of the banking sector could also expand as a result, increasing the liquidity in the market. The downward pressure on interest rates as well as the tendency for the deposit base to grow could create upward pressure on urban land & property prices (drumming up the demand for construction material as well as home appliances and furniture) and gold prices with the high net worth investors preferring land and gold as a hedge against inflation. Also, given the inward nature of Sri Lanka’s capital formation, demand for luxury imports such as motor cars and all other passenger transport vehicles which benefited via the dip in vehicle tax (therefore crude oil) will also scrape the skies, compelling the government to remain cautious on the BOP situation.

Meanwhile, domestic and foreign investments would further flow into sectors supplying luxury and semi-luxury goods and services such as leisure and processed food, exploiting the newly created potential in the home market. Exemption of PAYE taxes for middle income earners and 5% pay hike for state employees (non pensionablewill also feed the effective demand in the system and further increase profitability of the corporate sector. In addition, an Employees’ Pension Fund to provide post retirement pension benefits to employees in the private and corporate sectors was proposed and 2% contribution from employees and a 2% contribution from employers to this fund were commissioned. Also it was proposed to set up an Overseas Employees’ Pension Fund (OEPF). Each employee is required to contribute at least Rs. 12,000 per annum to this fund. Hence, these funds would invariably creat a low cost funding tool for the government.

Further, the government targets the fiscal deficit to be LKR 433.7 billion, amounting to 6.8% of the 2011 GDP which is currently hovering at 8%. The revenue is expected to grow by LKR 157.8 billion which is 2.8% of 2010 revised GDP. The major portion of the increase in government revenue is expected to be derived from taxes on goods and services (up by LKR 66 bn ) and taxes on external trade (up by LKR 56.3 bn) which is expected to account for LKR 122.3 bn out of the LKR 157.8 billion revenue growth. The rest will be generated through income taxes and non tax revenue. Therefore, it is clear that government is expecting to increase its indirect tax incomes via shrinking its hold on the income taxes.

Furthermore, the figures revealed by the government demonstrate that total foreign financing of the fiscal deficit is expected to contract from LKR 205.5 bn to LKR 94.5 bn recording a staggering 54% YoY fall. In connection, the domestic financing is expected to increase by LKR 98 bn to LKR 339.2 bn from LKR 241.2 bn, marking a 40.6% YoY rise. This would have a positive impact on the banking sector loan book growth creating risk free lending avenue for the commercial banks and activate the excess liquidity of circa LKR 143 bn which is currently lying idle in the system. We forecast the interest rates to remain unaffected albeit the increase of credit demand by the government since the supply of credit remains unexhausted.

The Revenue at 15.2% of GDP

Tax Revenue

The government expects to achieve an increase in tax revenue from LKR 720bn in 2010 to LKR 862.1bn.for 2011

Direct tax revenue

Historically income tax together with the VAT has been the key contributor of government’s tax income. However, the 2011 budgetary proposals suggest a drastic reduction of tax rates in both these components. Tax rates on personal income has reduced from 5%-35% to 4%-24% while the tax free income threshold has increased from Rs.300, 000 to Rs.500,000 .The employee earnings of SLR 600,000 per year would also be exempted from the PAYE tax. However, the budget aims to generate further revenue by subjecting the public sector incomes to the PAYE tax system.

The reduction in tax rates will in turn create an increase in disposable income. This would contribute to an increase in consumption resulting in expansion of the consumer tax income. In this regard, the tax reforms are aligned with the government’s objective of increasing tax revenue by broadening the tax base while reducing the tax rates.

The increase of tax base together with the measures of incorporating tax evaders to the system would further enhance governments revenue generation thereby increasing the possibility of expected tax revenue increase by LKR142.1bn

The income generated by means of Grants has been estimated to increase from LKR16.2bn to LKR22.6bn further facilitating the Revenue generation.

The Cost at 22.4% of GDP

The expected salaries and wages bill for 2011 is forecasted to reach LKR 344.0 bn from LKR 295.3 bn recorded in 2010, stamping an increase of16.5% YoY. The increase in salaries and wages is most welcome as it will ease off the cost of living pressure of the fixed income earners.

The interest expenses have also demonstrated a negligible increase from LKR 350.3 bn to LKR 352.9 bn explicating the positive impact of reduced deficit targets for 2011. In addition, the sharp reduction in interest rates on Government securities from September 2009 coupled with initiatives taken by the government to restructure debt profile to longer maturities help to reduce the growth in interest cost.

The total payments on subsidies for 2011 have recorded an increase of LKR 10.1 bn from LKR 197.2 bn to LKR 207.3 bn marking a growth of 5.1% YoY. The challenge of resettlement of IDPs and demining activities in the North and East and development of basic infrastructure facilities in those areas become the prime objectives of the transfer payments for 2011. Government has allocated budgetary resources further 80,000 houses. Initiatives such as ‘Gama Naguma’ will target building 80,000 housing units for low income rural households each year.

Education and public health allocation for 2011 has increased from LKR 29.4 bn to LKR 54.0 bn marking a YoY growth of 83.7%. The government expects to increase efficiency and productivity of the work force through vocational training and providing technological knowledge. In this regard government expects to train and provide technological knowhow to 300,000 youth with a cost of LKR 16 bn over the course of next three years. Also 500 secondary schools will be constructed as a measure to increase the rural education levels of the country. In addition, further LKR 750 mn will be allocated to establish English as a life skill.

The allocated Defence expenditure for 2011 has witnessed a marginal increase up to LKR 214 bn LKR although the reasons behind the increase are not clearly stated.

Capital expenditure

Infrastructure development has received an increase from LKR 359.0 bn to LKR 413.7 bn marking a YoY growth of LKR 30.1 bn (+ 9.1%). For public investments in roads, electricity, water, irrigation, ports and aviation activities, capital investment in power generation and distribution is likely to exceed LKR 64 bn over the two years. There is also further allocation of LKR 20 bn in support of the provisional road development initiative.

Funding Mix

Furthermore, the figures revealed by the government demonstrates that total foreign financing of the fiscal deficit is expected to contract from LKR 205.5 bn to LKR 94.5 bn recording a staggering 54% YoY fall. The lower dependency on external debt as a measure of financing the fiscal deficit is most welcomed as it will reduce the outflow of foreign exchange from the economy.

In connection, the domestic financing is expected to increase by LKR 98 bn to LKR 339.2 bn from LKR 241.2 bn, marking a 40.6% YoY rise. This would have a positive impact on the banking sector loan book growth creating risk free lending avenue for the commercial banks and activate the excess liquidity of circa LKR 143 bn which is currently lying idle in the system. We forecast the interest rates to remain unaffected albeit the increase of credit demand by the government since the supply of credit remains unexhausted.

Impact on CSE

The first comprehensive budget to be released after the 3 decade war is expected to induce corporate profits via the reduction of several tax revisions. The commercial entities are bound to benefit with the overall reduction in corporate taxation by 7%, to 28%, support lent for SMEs and tax holiday for fresh investments (for investments less than USD5,000 but not more than USD10 mn).

With the current market capitalization capped at LKR2.2 trillion, the government focuses to increase the entities listed on the CSE via Initial Public Offers (IPO). Thus, 1% of the value of IPO has been allowed as a deductible expense for tax purposes. Furthermore, the snap shot below shows the overall cost changes proposed on transactions on CSE:

We view the effective increase in the overall cost of transactions to 1.12% from 1.02% will not majorly restrict investor participation as the capital gains tax still is pegged at 0%. With the YTD foreign interest being an outflow of LKR28.3 bn, we can expect foreigners to revert their attention to Sri Lankan investment market with the relaxation of exchange control restrictions for foreign entities investing in unit trusts coupled with the favorable exchange control facilitation to promote and develop local equity market .

Affected Counters

With the abolition of bank debit tax, reduction in VAT on financial services from 20% to 12%, removal of VAT on leasing assets and the reduction in overall income taxation to 28%; banks and the financial sector stands out as a clear beneficiary of the tax revision.

Tourism, viewed to be a billion dollar business, the government is making moves in charging better rates whilst also reducing taxation by 3% to 12%. We expect the hotel & travels portion of CSE listed entities to post better earnings in the periods to come, as sufficient accommodation to cater the targeted tourists is taken. Thus we believe, the hotel sector counters will have a further run despite being currently expensive.

Most of the counters in the manufacturing sector operate in construction related fields. Thus, counters such as the tile sector (Lanka Tiles, Lanka Walltile, Parquet Ceylon and Royal Ceramics), cable industry (ACL Cables, Kelani Cables and Sierra Cables) and the cement manufactures (Tokyo Cement and Lanka Cement) are all expected to be direct/indirect beneficiaries of the planned rehabilitation and construction programs strongly shouldered by the support lent by international organizations and neighboring countries.

The spirits industry was already hit by the recent upward revision in excise duties, and now with the increase in taxation on profits to 40% from 35%, counters such as Ceylon Tobacco, Lion Brewery and Distilleries, will find their Net Profit margins thinning.

The tax structure of the telecommunication has been simplified favouring local consumption than international calls and tax exemption on imported high tech equipment, the telco sector is bound to face the changes with a general levy of 20% in lieu of the existing levies which are narrowed.

After a general cut on motor vehicle taxes in June 2011, a further reduction of 25% has been proposed on passenger vehicles. However, the annual revenue license fee for motor vehicle is moved up by 10%. Motor sector counters such as Diesel & Motor Engineering, Sathosa Motors, United Motors and Ashok Leyland in specific is expected to benefit.

Export oriented counters such as Haycarb, Richard Exports, Hayleys Exports, Kuruwita Textiles, Dankotuwan Porcelain and printcare are all expected to benefit from the export friendly move in reducing income tax of such entities to 12% from 15% for businesses carrying value additions in the country and holding patent rights in Sri Lanka whilst also benefiting from the moves to mitigate the loss of GSP Plus concessionary scheme.

The overall Plantation sector will be highly affected by the proposed CESS on both bulk tea and rubber exports, which amounts to LKR10 and LKR8 per kg respectively, which is proposed by the government with the intention of enhancing the value added export segment in the industry.

The proposed expansion of Laksathosa and Co-op city outlets signals competition for Cargills Ceylon, though the outcome still cannot be quantified.

Entities such as Lanka Milk Foods and Kotmale Holdings investing heavily in capitalizing on the transformation from powdered to liquid milk; are further supported by the government encouraging the import of high yielding diary animals.

Effects on the Banking Finance & Insurance

The most discussed area throughout the budget was, empowering the village & facilitating the rural areas to contribute to economic prosperity. This has opened up avenues for banking finance & insurance sector to expand. The emphasis on micro finance was a key element throughout the post war era in the banking finance and insurance sector which the 2011 budget has taken initiative.

The favorable contributions to the sector from the 2011 budget were basically via abolishing the bank Debit Tax, reducing VAT on financial services from 20% to 12%, reduce tax on profits of banking & finance institutions from 35% to 28%( the reduction of tax on profits is applicable to all offshore & domestic banks, finance companies, leasing, insurance & other specialized banking & financial companies)

Even though the government has brought down the tax rates the banks would not get much benefited in terms of profitability & returns available for fund providers. This is due to the necessity of creating a separate investment fund account with the Central Bank, where all the tax savings to be transferred in to it.

The Central Bank & the Department of Inland Revenue will issue specific regulations requiring banks to adopt low interest rates & longer term maturity for lending.

The higher per capita income, stabilized inflation (6%), reduced poverty, reduced unemployment levels, lower personnel income taxes, reduction of PAYE tax would lead people to save more & there is potential for banks to expand their deposit base, and this will enhance the lending capabilities of banks.

Referring to the government statistics the commercial bank advances to the private sector in June 2010 are as follows- agriculture & fishing 14%, industry 38%, services 21%. Since the agricultural, industrial, & service sectors are to expand with the new budget, the growth potential in the advances to these sectors would also be high.

Leasing companies are to be majorly benefited from the 2011 budget. VAT on leasing of three wheelers, Lorries, trucks, & private busses being removed.

With the aid of the proposed Presidential Commission on Banking & Financial service the government is focusing on transforming Sir Lanka as a regional financial hub.

The budget 2011 is supportive to mobilize savings on unit trust with the exemption of the economic services charge. Further the exchange control restrictions on foreigners & foreign funds investing in Units Trusts are also exempted to promote more funds flowing to the economy.

Fueling Travel & Tourism

Budget adding value

The 2011 Budget has identified Tourism as a “Billion Dollar Business”, as the country has immense potential over achieving such an outcome. Despite the steep growth in arrivals, the income from this segment has been moderate. In order to overcome such a situation a levy of US$20 (App: LKR2,220) is imposed on a per bed basis on all 5 star hotels offering less than US$ 125 per guest nigh from January 2011.Invariably targeting the high caliber tourist by 2016 targeting 2.5mn.

The industry should be enriched with the addition of star class hotels chains, to accommodate such an inflow. Sri Lanka currently has a total room capacity of 14,461 of which the 5 star accounts only a mere 3080. From a hotel income point of view, it has been proposed to reduce tax on income earnings from tourism and related business from 15% to 12%.

It has also being proposed by the government to upgrade and refurbish all the rest-houses and all government circuit bungalows in order to spur the tourism segment locally. 

In addition the budget further emphasizes on benefiting other industries related to the tourism sector such as :

• Local agriculture and industries
• Motor vehicle sector with the reduction in taxes on passenger transportation vehicles by 25%: exempt importation of electric and hybrid vehicles from Excise tax and VAT.
• Reduction of Custom duties and VAT on various machinery and equipment not available locally, this will facilitate the expansion and refurbishment process.
• Reduce excessive taxes on branded consumer durables which will popularize local and tourist shopping.

Meanwhile from a financial perspective lifting up exchange control restrictions on foreigners and foreign funds investing in unit trust etc, will not only attract the leisure crowd but encourage the business oriented to visit Sri Lanka.

Construction Sector

The construction sector contributes approximately 6 percent of the country’s Gross Domestic Production (GDP).In accordance to Central Bank of Sri Lanka this sector grew at an average rate of 7.5 percent during the 3 years ended 2010.

Further the 2011 Fiscal Budget has identified the importance of providing tax benefits to the construction sector; to invariably elevate construction in the economy. Below mentioned are the tax/fiscal benefits the 2011 budget address.

• Reduction of income taxes on construction.
• Reduction in custom duties in selected goods and raw materials.
• Capital allowances granted at a rate of 33 1/3 percent on the cost of acquisition of plant and machinery and a rate of 10 percent on the cost of construction on new buildings.

The above mentioned tax and fiscal benefits are expected to favorably facilitate;

• Reconstruction of electricity and irrigation facilities.
• Construction of road and bridges.
• Reconstruction of schools, health facilities and other public places. (Especially in the north and east areas)

Furthermore, with the tourist arrivals to the country accelerating, the room capacity of hotels needs to be tripled from a current level of around 15,000 rooms. Therefore, we believe that this would also have favorable impact on the construction sector.

Land & Property

Overall Land & Property segment seems to foresee a growth a in value as a result of the recent developments taking place in the construction sector together with favorable macro economic factors (Low interest rates and inflation).

A large scale construction is taking place within Colombo city limits and other parts of the country with the growth in the construction sector. This would accelerate demand for land. In addition the low interest rates would further strengthen demand for land.

Manufacturing Sector Overview

Budget 2011 has focused heavily to elevate Sri Lanka’s manufacturing sector to a highly diversified and value adding segment. In pursuing this strategy government has taken a major strategic initiative of imposing a CESS on all exports of raw & semi processed form, where all exports of finished goods will be free from such CESS. This would encourage manufacturing organizations to focus more on value added exports whilst the counters already focusing more on value added exports will be highly benefited. This would also lead the domestic manufacturing entities to put more emphasis on building their own brands rather than exporting in bulks.

According to government estimates, the export potential of value added, branded exports exceed US$ 5 bn over the medium term. Subsequently, government has made a provision to reduce Income tax from 15% to 10% for all export companies encouraging export oriented production in general. At the same time government has taken an initiative to reduce the income tax from 15% to 10% for industries with domestic value addition in excess of 65%, and Sri Lankan brand names with patent rights reserved in Sri Lanka. This will encourage the manufacturing entities to base their production facilities mainly within the country itself whilst the counters which are already having a high domestic value addition would benefit immediately.

Budget also includes a provision for reducing duties and taxes on machinery, equipment and raw materials, making modern technology more affordable to manufacturing entities. Furthermore, it will encourage expansion and modernization which will in turn improve the profitability of the counters in the long run. The Government also has decided to reduce the corporate tax from 35% to 28% which will invariably benefit the domestic manufacturers as a whole.

Furthermore the 5 year tax holiday proposed on any company which is undertaking new projects with a minimum investment of US$ 5000 (but not more than US$ 10 mn), would definitely encourage new investments in manufacturing industry particularly with many manufacturing companies looking to take advantage of the construction sector boom.

Powering through tariff empowerment

The pro investor budget seems to have a major emphasis on the infrastructural development in the island in lieu of a total investment target of circa 32%-35% of GDP over the next 6 years. The said budget has allocated LKR413bn for public investments in roads, electricity, water, irrigation ports and aviation activities. A sum exceeding LKR64 bn over the next two years is said to be assign towards capital investments in the expansions of power generation and distribution in the country with a target of electrifying the country 100% by 2015.

Over the years access to electricity in the rural sector has increased from 78.5% in 2006 to 83.2% in 2009 while it has risen from 62.3% to 84% in the estate sector. Further with the development in the power sector the government has been able energize the country with no blackouts since 2006.

Together with the capital improvement in the power and energy segment an 8% increase in tariff was imposed on the consumption excluding small businesses and SME. This would have an impact on the corporate and household sector in the island whilst driving the expenditure high. The manufacturing organizations with high emphasis on power would witness a surge in cost of sales with the above price movement. Further the CCPI index would be negatively affected as clothing electricity and gas sub index reflects 18.3% of the major the index.

Towards a leading information era

With a percept towards a digital future and technologically savvy nation, the government has implemented various projects to usher in the information era to Sri Lanka. Whilst the island is ranked 7th among the 50 best emerging global cities that attract outsourcing, IT and BPO services are ranked as the 5th largest export segment in the country.

With regard to ICT literacy, the government targets to achieve a rate of 75% (literacy) by 2016 in lieu of making the island an emerging IT hub (with USD2 bn exports by 2016).

The telecommunication sector also showed an above average growth comparative to other regional countries (witnessed an YoY incline of 25% in 1st half of 2010) together with a high telephone density (telephone per 100 persons) of 94 in 2010.

A VAT exemption on the high tech equipment and machinery which the telecommunication segment is highly dependent on would attract capital investments further strengthening the industry. Technological growth in telecommunication sector is pivotal to elevating the ICT in an economy.

Thus, the fiscal benefits granted to telecommunication sector would shoulder the growth in the ICT industry as well. Further, a telecommunication levy of 20% together with a 2% license fee on the gross revenue would simplify the previous complex tax structure.

The increased taxation on the industry would be offset by the developments in the technological arena together with the increased literacy rate in ICT. Further the 25% decrease in local call charges would induce the number of local units whilst generating a higher rate of economic activity in the island.