The Effect of Tax Composition on Income Inequality: Sri Lankan Experience

Abstract

The main purpose of this research paper is to identify the effect of tax composition and tax compliance among other variables on the income inequality in Sri Lanka. Taxes may affect income inequality depending on tax composition, progressivity and tax compliance. In the Sri Lankan context, the existing tax structure largely consists of indirect taxes and a higher level of tax non-compliance leading to a regressive tax system. Persistent high level income inequality and declining tax revenue buoyancy have been considerable issues experienced by the Sri Lanka government nearly over the last three decades that weakening fiscal operation and performance is an important empirical question to be addressed. This study adopts a time-series econometric method -- Johansen Cointegration and Vector Error Correction model to capture the long-run and dynamic relationships of selected variables. The data for the study were collected from Annual Reports and Economic and Social Statistics of Sri Lanka published by the Central Bank of Sri Lanka for the period of 1985 -2018. The key findings show a negative impact of direct taxes and a positive impact of indirect tax- VAT and tax noncompliance on income inequality. It suggests the necessity of broadening income tax base and strengthening tax compliance to reduce income inequality while improving buoyancy of tax revenues through best practices of taxation. Our findings provide more precise and feasible policy directives for the path to realize revenue-based fiscal consolidation with a more equitable and rationalized tax system in Sri Lanka. The impact on economic growth is not clear and left for future research.