Sri Lanka Plans Company Tax Cuts to Fuel Economic Growth After Civil War

Sri Lanka said it will cut taxes on banks and builders, adopt an inflation target and ease foreign- exchange rules to accelerate growth and curb prices in the South Asian nation emerging from a 26-year civil war.

President Mahinda Rajapaksa, unveiling the 2011 budget in Colombo yesterday, announced plans to lower the value added tax for lenders to 12 percent from 20 percent, reduce the levy on construction companies to 12 percent and offer breaks to tea and rubber companies. He forecast the budget deficit to narrow to 6.8 percent of gross domestic product from 8 percent in 2010.

The changes to the nation’s fiscal and monetary frameworks mark the biggest overhaul of economic policy since Rajapaksa’s government defeated a separatist group that had fought for independence. The dividend from peace has already helped make Sri Lanka’s benchmark stock-market index the world’s second-best performer this year.

“The broader objective is better macro management after peace returned,” said Prakriti Sofat, a Singapore-based economist at Barclays Plc. “By inflation targeting they want to ensure that inflation expectations are anchored, which will benefit economic growth.”

Sri Lanka’s benchmark Colombo All-Share Index, which has climbed more than 90 percent this year, lagging behind only Mongolia, fell 0.8 percent to 6515.8 yesterday. The Sri Lankan rupee was little changed and closed at 111.38 per dollar, after rising about 3 percent since the war against the Liberation Tigers of Tamil Eelam ended in May 2009.

Photographer: Pankaj Nangia/Bloomberg

Mahinda Rajapaksa, president of Sri Lanka. Close

Mahinda Rajapaksa, president of Sri Lanka.

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Photographer: Pankaj Nangia/Bloomberg

Mahinda Rajapaksa, president of Sri Lanka.

Inflation Targeting

The government will allow foreign investors to buy corporate debt in the country, let local residents purchase shares of foreign companies and insurers will be able to invest up to 20 percent of their “long-term fund and technical reserves” abroad, according to technical notes in Rajapaksa’s budget speech. The changes will “promote exports and develop local capital markets,” according to the notes.

Before the budget statement, the Central Bank of Sri Lanka said it plans to introduce inflation targeting in an effort to lower long-run changes in consumer prices, joining Southeast Asian counterparts including Indonesia, Thailand and the Philippines.

“Both advanced as well as emerging economies have also moved into an inflation-targeting regime in order to secure price stability on a sustainable basis,” the central bank said in a report on its website. “Recent achievements on the price front have placed the monetary authorities in an advantageous position in terms of inflation expectations.”

‘Firm Handle’

Inflation in Sri Lanka is about half the average rate of the five years through 2009, after an expansion in farm cultivation, following the end of the war, boosted production. Consumer prices in the capital, Colombo, rose 6.6 percent in October from a year earlier.

“The central bank wants to get a firm handle over inflation and make sure that it doesn’t get out of hand,” said Samantha Amerasinghe, a Colombo-based economist at Standard Chartered Plc. “Given the government’s broader objective toward sustaining growth, it’s essential that inflation remains under control.”

Sri Lanka’s central bank said it intends to put in place the “new monetary policy framework during the forthcoming months.” It didn’t specify the target rate it plans to adopt.

Philippines, Thailand

The central bank in the Philippines aims to keep inflation between 3.5 percent and 5.5 percent. Indonesia’s central bank has a target of between 4 percent and 6 percent for 2010, while Thailand’s central bank intends to maintain the core inflation rate, which excludes food and fuel prices, in a range of 0.5 percent to 3 percent.

Rajapaksa’s tax reductions are aimed at boosting economic growth, betting an increase in consumption will help increase revenue and cut the budget shortfall. Tax collections may rise about 20 percent to 862 billion rupees ($7.7 billion) in 2011 from the previous year, the president estimated. Spending is projected to grow 11 percent to 1.42 trillion rupees during the same period, he said.

Lower taxes will help free funds for lending at commercial banks including Commercial Bank of Ceylon Plc. and Haton National Bank Plc., said Sanjeewa Fernando, an analyst at CT Smith Stockbrokers Pvt. in Colombo. Tax cuts for construction companies will spur sales at Tokyo Cement Lanka Plc, Lanka Tiles Plc and Lanka Ceramics Plc, he said.

Russian Precedence

The island’s $42 billion economy may grow about 8 percent in 2011 after an estimated 7.6 percent expansion in the current year, the central bank report showed yesterday.

Rajapaksa’s strategy finds precedence in Russia, which credits the adoption of a 13 percent flat income-tax rate with helping boost revenue 12-fold over eight years. In the U.S., tax reductions during the administrations of John F. Kennedy and Ronald Reagan might have helped bolster revenue because they reduced relatively high marginal rates, according to the Washington-based Tax Foundation.

By contrast, reductions from lower levels enacted by former President George W. Bush added about $1.7 trillion to deficits between 2001 and 2008, according to the Center on Budget and Policy Priorities.

“Sri Lanka is embarking on a fiscal and monetary policy aimed at faster economic growth,” said Sarath Rajapakse, director of research at Capital Trust Securities Pvt. in Colombo. “The expanding economy will bring in more revenue and make the budget-deficit target achievable.”

To contact the reporter on this story: Anusha Ondaatjie in Colombo at anushao@bloomberg.net Kartik Goyal in New Delhi at kgoyal@bloomberg.net

To contact the editor responsible for this story: Stephen Foxwell at sfoxwell@bloomberg.net Chris Anstey at canstey@bloomberg.net

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