WHAT IS THE COST OF A BOWL OF RICE?documents.worldbank.org/curated/en/...The Sri Lanka National...

A G R I C U LT U R E A N D E N V I R O N M E N TA L S E R V I C E S D I S C U S S I O N PA P E R 0 2

OCTOBER 2013

WHAT IS THE COST OF A BOWL OF RICE? The Impact of Sri Lanka’s Current Trade and Price Policies on the Incentive Framework for Agriculture

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WHAT IS THE COST OF A BOWL OF RICE?The Impact of Sri Lanka’s Current Trade and Price Policies on the Incentive Framework for Agriculture

A G R I C U LT U R E A N D E N V I R O N M E N TA L S E R V I C E S D I S C U S S I O N PA P E R 0 2

© 2013 International Bank for Reconstruction and Development / International Development Association orThe World Bank1818 H Street NWWashington, DC 20433Telephone: 202-473-1000Internet: www.worldbank.org

This work is a product of the staff of The World Bank with external contributions. The fi ndings, interpretations, and conclusions expressed in this work do not necessarily refl ect the views of The World Bank, its Board of Executive Directors, or the governments they represent.

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Cover Photo: Sri Lankan red rice. Shutterstock, LLC.

I I I

A G R I C U LT U R E A N D E N V I R O N M E N TA L S E R V I C E S D I S C U S S I O N PA P E R

CO N T E N T S

CONTENTS

Boxes, Figures, and Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

Acronyms and Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii

Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix

Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi

Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiii

Chapter 1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Chapter 2. Background: Sri Lanka Trade Policy and Agriculture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2.1 Brief Introduction to the Complexity of Sri Lankan Import Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2.2 Export Policy Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2.3 Brief Note on the Composition of Government Revenue and Expenditure . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Chapter 3. Discussion and Interpretation of Agriculture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

3.1 Approach, Defi nitions, and Data Sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

3.2 The Case of Agricultural Imports and Exports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

3.3 Measuring Support to Agriculture: NRP and ERP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

3.4 Additional Observations on the Treatment of Various Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17

Chapter 4. Cost-eff ectiveness of Fertilizer Subsidies in Sri Lanka . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

4.1 Rationale for Subsidizing Fertilizers in Sri Lanka. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

4.2 Analytical Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

4.3 Fertilizer Demand and Supply Elasticities with Respect to Fertilizer Price . . . . . . . . . . . . . . . . . . . . . . . . . . 22

4.4 Policy Simulation to Estimate the Cost-eff ectiveness of the Fertilizer Subsidy . . . . . . . . . . . . . . . . . . . . . . . 23

Chapter 5. Income Distributional Implications of Agricultural Trade Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

5.1 General Characteristics of Paddy Farmers in Sri Lanka . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

5.2 Eff ects of Trade and Price Policy on Real Household Income of Paddy Farmers . . . . . . . . . . . . . . . . . . . . . . . 30

Chapter 6. What Does It All Mean? Concluding Comments and Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . 33

6.1 In the Short Term, Who Wins and Who Loses Under Current Policies? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

6.2 Implications for World Bank Engagement in Sri Lanka . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

Appendix Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

V


B OX E S , F I G U R E S , A N D TA B L E S

BOXES, FIGURES, AND TABLES

BOXES

Box 2.1: Variation in Sri Lanka’s External Policy Framework, 2007–11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4

Box 2.2: Impact of Value Added Tax on Agricultural Commodities in Sri Lanka . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

FIGURES

Figure 4.1: Farmers’ Gains from Subsidized Fertilizer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Figure 4.2: Cost-eff ectiveness of Fertilizer Subsidy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

TABLES

Table 2.1: Primary Imported and Exported Agricultural Products, Selected Subsectors, 2009 . . . . . . . . . . . . . . . . . . . . . .3

Table 2.2: Government Expenditures and Revenues (Rs million) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Table 3.1: Protective Taxes on Agricultural Importables, 2009 and 2011 (percentages) . . . . . . . . . . . . . . . . . . . . . . . . . 13

Table 3.2: Implicit Ad Valorem Import Tariff (percent) Based on Average Import Duty Collection Rate for Food and Nonfood Consumer Goods, 2008–11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

Table 3.3: Hidden Cost of a Complex System: Unweighted Average Import and Other Taxes (percent) by Broad Commodity Groups, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

Table 3.4: Weighted Average Import and Other Taxes (percent) by Commodity Group, 2009 . . . . . . . . . . . . . . . . . . . . . 15

Table 3.5: NRPs and ERPs Calculated for 2009/10, Using the TPR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Table 3.6: NRPs and ERPs Calculated for 2010/11, Using the TPR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Table 4.1: Fertilizer Price With and Without Subsidy, 2009–10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Table 4.2: Implied Transfer Effi ciency of Fertilizer Subsidy in Paddy Rice (2009–10), Without Binding Quota and Assuming That Farm Fertilizer Purchases Are Used in Production (Not Resold at Market Prices) . . . . . . . . . . . . . 24

Table 5.1: Food Balance Sheet, Sri Lanka, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

Table 5.2: Incomes and Expenditures of Paddy Farming Households by Sector (Rural or Urban) and Province . . . . . . . . . . 27

Table 5.3: Incomes and Expenditures of Paddy Farming Households by Farm Size and Poverty Status . . . . . . . . . . . . . . . 27

Table 5.4: Incomes and Expenditures of Paddy Farming Households by District . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

Table 5.5: I ncome Share from Rice and Expenditure Shares on Rice of Paddy Farming Households by Sector (Urban, Rural, Estate) and Province . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

Table 5.6: Income Share from Rice and Expenditure Shares on Rice of Paddy Farming Households by Poverty Status and Farm Size. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

Table 5.7: Income Share from Rice and Expenditure Shares on Rice of Paddy Farming Households by District . . . . . . . . . . 29

V I

W H AT I S T H E CO S T O F A B O W L O F R I C E ? T H E I M PA C T O F S R I L A N K A' S C U R R E N T T R A D E A N D P R I C E P O L I C I E S

B OX E S , F I G U R E S , A N D TA B L E S

Table 5.8: Eff ect of Policy Changes on Paddy Farmer Net Income over Tradable Input Costs, 2010/11 . . . . . . . . . . . . . . . 32

Table 5.9: Simulated Impact of Price and Trade Policies in 2009/10 and 2010/11 on Rice Growers’ Net Household Income and Rice Expenditures, by Poverty Status and Farm Size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Table 6.1: Simulation on the Impact of Price and Trade Policies on (a) Farm Income, (b) Real Household Income, and (c) Government Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

Appendix Table 1: Unweighted Average Import and Other Taxes (percent) by Commodity Group . . . . . . . . . . . . . . . . . 39

Appendix Table 2: Estimated Fertilizer Consumption by Crop Sector and Imports of Fertilizer, 2009 (mt) . . . . . . . . . . . . . 40

Appendix Table 3: Cost Share of Tradable Inputs, 2009. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

Appendix Table 4: Import Taxes on Agricultural Inputs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

Appendix Table 5: Items Subject to Specifi c Commodity Levies (SCLs) and Their Tariff Equivalents, 2009 . . . . . . . . . . . . . 42

Appendix Table 6A: Trade Policy Measures on Rice, Potato, Onion, and Chilies, 2007–11 . . . . . . . . . . . . . . . . . . . . . . . 43

Appendix Table 6B: Trade Policy Measures on Coconuts and Related Products, Milk and Milk Products, Sugar, and Wheat, 2007–12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

Appendix Table 7: Changes in Levels of Special Commodity Levy, 2008–12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

A C R O N Y M S A N D A B B R E V I AT I O N S V I I


ACRONYMS AND ABBREVIATIONS

CD Customs duty

CESS Commodity Export Subsidy Scheme

CIF Cost, insurance, and freight

DRC Domestic Resource Cost

EPZ Export Processing Zones

ERP Eff ective rate of protection

g gram

GDP Gross domestic product

ha Hectare

HIES Household Income and Expenditure Survey

HS Harmonized Commodity Description and Coding System

kg Kilogram

m million

mt metric ton

NBT Nation Building Tax

NRP Nominal Rate of Protection

PAL Port and Airport Development Levy

RIDL Regional Infrastructure Development Levy

Rs Sri Lanka rupees

SCL Special Commodity Levy

SRL Social Responsibility Levy

TPR Total protection rate

WTO World Trade Organization

VAT Value Added Tax

P R E FA C E I X


PREFACE

This report provides empirical evidence to inform the policy dialogue over the impact of current trade and price policies on the incentive framework for agriculture in Sri Lanka. This information is meant as an input to the policy dialogue; it complements a previous note (SASDA, September 2011) on the role of Sri Lanka’s agricultural sector as the country graduates to middle-income status.

This analysis provides a quantitative assessments of: (1) the level of support to farmers producing import-competing products; (2) the degree to which fi nal consumers are indirectly taxed by those policies; (3) the extent to which agricultural exports are taxed; (4) the contribution of trade policy to government revenue through tariff s on imports and taxes on exports; (5) an evaluation of the cost-eff ectiveness of the current fertilizer subsidy scheme; and (6) a better understanding of the web of income transfers between producers, consumers, and government accounts.

The report is structured as follows. The introduction is followed by an overview in Section 2 of the current (2009–11) import and export policy framework and a brief analysis of government revenues and expenditures for agriculture. Section 3 reviews the data sources and methods used in calculating the degree of protection, followed by summary statistics on the degree of protection for 10 agricultural commodities. Section 4 looks closely at the cost-eff ectiveness of fertilizer subsidies, which represent a large share of the government agriculture budget. Section 5 focuses on how agricultural trade policies infl uence income distribution, particularly among diff erent groups of rice producers. The last section recapitulates the main fi ndings and highlights their implications, with an emphasis on the often implicit and unintended income transfers among producers, consumers, and the government.

A C K N O W L E D G M E N T S X I


ACKNOWLEDGMENTS

The report has been prepared by a team lead by Norman Piccioni (Lead Rural Development Specialist, SASDA), under the supervision and

with the assistance of Madhur Gautam (Lead Economist, SASDA). The note is based on a background report and fi ndings by Alberto Valdes

and Jeevika Weerahewa (consultants to SASDA). The study was carried out under the overall guidance of Simeon Ehui (Sector Manager,

SASDA). The peer reviewers for the study were Willem G. Janssen (Lead Agriculturist, LCSAR), Mona Sur (Senior Agriculture Economist,

EASNS), Grahame Dixie (Senior Agribusiness Specialist, ARD), and Will Martin (Research Manager, DECAR). The team would like to thank

Susan Razzaz, Rajish Wijeweera, Dan Biller, and Seenithamby Manoharan for feedback and comments. The team would like to thank all

of the government offi cials and stakeholders met during several visits to Sri Lanka. Overall support to the team was provided by Shane

Ferdinandus and Priyantha Jayasuriya Arachchi (SASDO).

E X E C U T I V E S U M MA R Y X I I I


EXECUTIVE SUMMARY

In Sri Lanka over the next 10–20 years, agriculture’s contribution to the economy through export revenues, employment generation, and forward/backward linkages will remain signifi cant, even as agriculture’s relative contribution to gross domestic product (GDP) continues to decrease. Poverty is overwhelmingly rural. While it has been steadily declining over the years, further reductions in rural poverty will require a comprehensive approach, such as shifting to high-value agriculture, promoting nonfarm economic activities in rural areas, and assisting people to move out of agriculture. In addition, natural resources will become increasingly scarce and complex to manage. With mounting environmental externalities, agricultural development will become even more closely intertwined with environmental protection. It will be vital to reduce agriculture’s large environmental footprint, make farming systems less vulnerable to climate change, and harness agriculture to deliver more environmental services. Innovative policy initiatives and strong political commitment will be needed to implement such strategies, which are likely to benefi t sectors other than agriculture, including tourism.

The Sri Lanka National Development Plan—the Mahinda Chintana—envisages agriculture as playing a primary role in the development of rural areas and the economy as a whole. In the Sri Lanka of the 21st century, agriculture can work in concert with other sectors to produce faster growth, reduce poverty, and sustain the environment. The Mahinda Chintana off ers a coherent vision of a modern agricultural sector in an export-oriented, competitive economy, which is consistent with the experience in other transforming economies that rapidly rising rural-urban income disparities and continuing extreme rural poverty can be major sources of social and political tension. The important lessons emerging from these experiences indicate that these problems cannot be addressed sustainably through agricultural protection, which raises the price of food, because large numbers of poor people are net buyers of food. Nor can they be addressed through subsidies, which distort resource allocation and prevent a smooth transition to a high performing sector.

As Sri Lanka consolidates its agricultural transformation in the next 10–15 years, a key area of interest will be whether the policy and insti-tutional framework is conducive to implementing the vision of the Mahinda Chintana, and doing so in a fi scally manageable and effi cient manner. By examining current trade and price policies in relation to agriculture, this analysis contributes to a better understanding of the implications and trade-off s of policy-induced changes to the incentives facing agriculture.

CURRENT TRADE AND PRICE POLICY FOR AGRICULTURE

Sri Lanka took a noteworthy step when it became the fi rst South Asian country to open its economy for international trade. Since 2004 poli-cies have become more complex and inward looking, encouraging import substitution, especially with respect to agricultural commodities. The high levels of protection to importables in Sri Lankan agriculture create an incentive framework that arguably lowers investments in producing exportables, potentially preventing the best use of resources in the agricultural sector. In particular, this analysis fi nds that they tend to reorient the mix of crops toward protected activities and discourage the development of new products and export diversifi ca-tion. Experiences from other countries show that a discretionary and complex trade regime can generate considerable uncertainty about expected returns. Uncertainty signifi cantly deters private investment, both in primary agriculture as well as in agro-processing.

The study shows that under the current policies producers of farm products that compete with imports gain at the expense of consumers, while export crop producers and taxpayers lose. The eff ective rate of protection, representing the trade regime’s overall income eff ect per unit of farm output, is positive and high for import-competing products such as rice, potatoes, and milk, meaning that Sri Lankan producers of those commodities receive artifi cially higher incomes from them. The trade regime’s overall income eff ect for exportable products is negative, implying that producers’ incomes are lower than they would be without the policy. For some exportable products, such as tea and rubber, the potentially lower income is off set by a generous fertilizer subsidy.

E X E C U T I V E S U M MA R YX I V


A preliminary and partial analysis indicate that in 2011, buyers of rice were implicitly taxed an estimated 34 percent; milk and potato buyers, 45 percent; maize buyers, 39 percent; and chili buyers about 52 percent—based on the protective taxes (considering both import tariff s and para-tariff s charged on them—calculated for 2011 for broad commodity groups). While a more complete analysis with broader and more general economic eff ects on the impacts of the policies is warranted, these fi ndings show that elevated prices can negatively aff ect the real incomes of lower- and middle-income households, especially in urban areas. Households that spend about 50 percent of their incomes on food and pay 40 percent or more on basic foods suff er a real income loss of 20 percent. It follows that there is an implicit and large income transfer from consumers to the import-competing farm sector.

These simulations show signifi cant diff erences across provinces and districts, as well as across income classes (poor and nonpoor) and farm-size classes. In absolute terms, the removal of border protection results in smaller losses for the poor than for the nonpoor, but rela-tive to their income the poor suff er larger losses on the income side and larger gains on the consumption side. With respect to farm size, households with larger land holdings suff er the largest absolute and relative income loss. The net real income loss on average for farms larger than 10 acres reaches 36 percent of revenues from paddy production and 20 percent of total household income. Small farms of up to 3 acres have losses relative to total income of approximately 5 percent.

Substantial revenues generated from imports and exports through the border measures just mentioned are also experienced in the agri-cultural sector, mostly through farm input subsidies, mainly for fertilizer. The fertilizer subsidy comes at a high fi scal and opportunity cost, representing 68 percent of the combined agriculture/irrigation budget in 2009 and 59 percent in 2010. These funds are diverted from other activities, possibly funding for public goods in agriculture and other sectors.

The increase in farmers’ net income is small relative to the fi scal cost of the fertilizer subsidy, with an effi ciency ratio ranging between 1.37 and 2.38. In other words, on average, the government spends between 1.4 and 2.4 rupees per acre to increase farm income by only 1 rupee per acre.

The distortions brought about by the current trade regime go beyond product markets, aff ecting the demand for purchased inputs, land, water, and labor.

TAKE-AWAY MESSAGES

The current incentive framework has to be interpreted in the context of the government’s multiple policy objectives, which are (1) the generation of fi scal revenue from trade taxes, (2) the promotion of a higher degree of food self-suffi ciency, (3) the reduction of poverty in rural areas, and (4) support to the political base within the farming community.

Border taxes on imports and exports of agricultural products and on tradable inputs have been the principal policy instruments to gener-ate fi scal revenue. These instruments support producers in the case of import-competing activities and tax producers of export-oriented products.

In contrast to agricultural products, nonagricultural tradables have seen some decline in border protection since the trade reforms of the early 1990s. In the past, such protection acted as a signifi cant indirect (implicit) tax on agricultural production.

The combined impact of import duties plus other taxes at the border results in nominal protection rates for importables for most agricultural products on the order of 30–50 percent. The results indicate high protection of import-competing activities (farmers are shielded from external competition), a slight tax on export products like tea and rubber (and thus a slight disincentive to produce exportables), and a heavier tax on coconuts for export (note: export taxes are in the form of export cesses).

Given that the Mahinda Chintana aims at improving Sri Lanka’s competitiveness and promoting exports, the de-facto disincentives created against export are most likely the unintentional outcome of a complex system in which trade policy initiatives have been added on an ad hoc basis over time. Nevertheless, this system is having a very signifi cant impact on the agricultural sector and the economy as a whole. From a sector perspective, it would be useful to reassess the highly complex system of taxes, levies and other measures in light of a fuller analysis of its impact on producers and consumers, and determine whether changes are warranted to attain the overall policy goals.

E X E C U T I V E S U M MA R Y X V


From a public investment perspective, one area for consideration is the removal of the current distortions and their consequences on the sectoral incentive framework to maximize the social returns to public investments. Public investments focused on promoting public goods with positive externalities (for example, agricultural research, rural roads, sanitary and phyto-sanitary services, and the like) tend to yield much higher returns to the economy as a whole.

From a strategic perspective, it would be important (but challenging) to link trade and price policy reforms (in the medium term) with complementary reforms (over the long term) in markets for production factors, such as land and irrigation to allow a smooth transition toward an economy as envisioned in the Mahinda Chintana. As agriculture is a highly tradable activity, trade reforms, if implemented, will aff ect—and increase—the average returns to land and water in agriculture. Together, such reforms would also probably cause land and water to be reallocated to higher-value crops. To capture the benefi ts of reforms more fully, land and water markets should allow enough fl exibility to facilitate changes in the crop mix and tenure arrangements.

C H A P T E R 1 — I N T R O D U C T I O N 1


Chapter 1 INTRODUCTION

PURPOSE OF THE STUDY

The fi rst country in South Asia to open its economy to interna-

tional trade, Sri Lanka was regarded until recently as the most open

economy in South Asia. Since 2004, however, Sri Lanka has pursued

inward looking policies that have encouraged import substitution,

especially with respect to agricultural commodities.

Why are the results of this analysis of Sri Lankan trade and price poli-

cies relevant? They are relevant because high levels of protection

for importables and export taxes in agriculture often have a num-

ber of implicit and unintended eff ects throughout the economy.

High levels of protection on food products raise farm incomes for

producers of protected activities and also raise fi scal revenue, but

they constitute an implicit tax on consumers, particularly lower-

income families who spend a large share of the household budget

on food. High levels of protection on food products also implicitly

create disincentives for exports. The mix of crops is not diversifi ed

but artifi cially reoriented to protected activities; the development of

new products and export diversifi cation are discouraged. Although

export taxes raise fi scal revenues, they reduce investment in export-

oriented activities. In the longer term, policies that protect import-

competing activities and tax exportables can reduce overall invest-

ment and growth in the agricultural sector.

Presently agriculture’s share of national GDP is about 12 percent, a

proportion which, as in most countries, has been declining in Sri

Lanka as the economy grows. Agriculture employs about 32 percent

of the workforce in a nation that remains overwhelmingly (80 per-

cent) rural; the Household Income and Expenditure Survey (HIES)

of the Department of Census and Statistics for 2009/10 records a

total population of 20.3 million and a rural population of 16.3 mil-

lion. In other words, agriculture’s share of employment remains

disproportionately high, having declined far more slowly than agri-

culture’s share in GDP. This diff erence suggests a growing wedge be-

tween relative incomes in agriculture and the rest of the economy.

The HIES 2009/10 reports that Sri Lanka’s rural poverty headcount is

9.4 percent and the national poverty headcount is 8.9 percent.

Agricultural and processed foods average 30 percent of total mer-

chandise exports (Central Bank of Sri Lanka 2008; Annual Report 2007;

Anderson and Martin 2009) report that the value of exports of primary

agricultural products as a share of the value of all primary production

averaged about 39 percent during 2000–04, the highest such share in

Asia in those years. Imports of primary agricultural products accounted

for only a small share of apparent consumption (5 percent), and the

“self-suffi ciency” ratio (the value of agricultural production relative to

apparent consumption) was 1.57, the highest in the region.

Sri Lanka’s agricultural trade regimes have been well documented

over the years. The fi rst study, by Surjit Bhalla for 1960–84, was part of

the Krueger, Schiff , and Valdes comparative study for the World Bank

(1992). Another World Bank study (1996), “Sri Lanka Nonplantation

Crop Sector Policy Alternatives,” covered the situation in the mid-

1990s. A study by Bandara and Jayasuriya (2009) was also done for

the World Bank (as part of research led by Kym Anderson on distor-

tions to agricultural incentives) and included data up to 2004. More

recently, Pursell (2011) provided a useful description of the com-

plexities of trade policy in Sri Lanka, although not specifi c to agricul-

ture. The World Trade Organization (WTO) Trade Policy Review on Sri

Lanka (Central Bank of Sri Lanka 2009, Annual Report 2008) has also

described more recent developments in the nation’s trade regime.

All of these publications provide some historical perspective on

how Sri Lanka’s agricultural trade policy has evolved and how the

inherent trade-off s have changed over time.

C H A P T E R 1 — I N T R O D U C T I O N2


Using a Domestic Resource Cost (DRC) approach, some analysts

have sought to understand whether Sri Lanka has a comparative ad-

vantage in rice production. For example, Rafeek and Samarathunga

(2000), in a review through 1992, reported nominal rates of pro-

tection (NRPs) and eff ective rates of protection (ERPs) for rice and

demonstrated positive protection to rice farmers. In 2002, the

Department of Census and Statistics reported that more than 80

percent of paddy holdings were less than 1 hectare; fewer than

5 percent of farmers had a holding greater than 2 hectares

(Department of Census and Statistics 2002). Several studies con-

cluded that the income earned from paddy was not suffi cient to

meet the basic needs of a family, so poverty was prevalent among

small-scale growers (Ranaweera et al. 1990; Gunawardena 2000;

Weerahewa et al. 2002). Shilipi (1995), using 1993 data in a DRC ap-

proach, concluded that Sri Lanka had no comparative advantage

in growing paddy rice. Similarly, Rafeek and Samarathunga (2000)

concluded that US$ 1 of resources was used to produce only

US$ 0.56 worth of rice. Wijayaratna et al. (1996), however, showed

that in 1993, when irrigation and land costs were excluded from

the accounting—two peculiar assumptions—rice growing in Sri

Lanka could be competitive. Kikuchi et al. (2000, 2001) concluded

that although Sri Lanka’s comparative advantage in paddy farm-

ing had been declining over the years, the country was still com-

petitive in paddy cultivation under major irrigation schemes. Finally,

Weerahewa et al. (2002) and Thibbotuwawa and Weerahewa (2004)

showed a comparative advantage in growing paddy on relatively

larger farms. Weerahewa (2004), who assessed household-level

impacts of rice trade liberalization, concluded that the poor would

reap the benefi ts of rice trade liberalization—a fi nding contrary to

the general expectation.

The main objectives of this analysis on the impact of current trade

and price policies on agricultural incentives is to provide a quanti-

tative assessment of (1) the level of support to farmers producing

import-competing products, (2) the degree to which fi nal con-

sumers are taxed, (4) the extent to which agricultural exports are

taxed, (5) the contribution of trade policy to government revenue

through tariff s on imports and taxes on exports, and (6) the cost-

eff ectiveness of the current fertilizer subsidy scheme. This informa-

tion should improve our understanding of the complicated web of

income transfers among producers, consumers, and government

accounts.

No recent quantitative evaluation has been available for this ex-

tremely complex system, which has been subject to continuous

revision. Experiences from other countries show that when a trade

regime is so discretionary and complex, it can generate consider-

able uncertainty about expected returns. Such uncertainty acts

as a signifi cant deterrent to private investment, both in primary

agriculture as well as in agro-processing, which in turn stifl es the

diversifi cation of agricultural production and exports.

From the longer-term perspective, reforms in trade and price policy

can be linked with complementary reforms in factor markets (such

as markets for land and irrigation water). Certainly trade reforms

would aff ect (and probably increase) the average returns to land

and water in agriculture, because they would induce the realloca-

tion of those resources to higher-value uses. Improved markets for

land and water would enable producers to benefi t more fully from

trade policy reform by giving producers greater fl exibility to adopt

more competitive crop mixes and tenure arrangements. Experience

with trade liberalization and deregulation in agriculture in other

middle-income countries (for example, in Latin America during

the 1990s) shows that there were signifi cant—and often unantici-

pated—adjustments to output composition, often in response to

export market potential. In many cases, the product mix evolved

to include high-value products aimed at foreign markets. Examples

include certain regions of Brazil, the central valley of Chile, parts of

northern Mexico, and the coastal range of Peru. In light of the con-

tinuing food security discussion in Sri Lanka, it is noteworthy that

those countries are net importers of several important food prod-

ucts. It is also notable (although not necessarily the most important

criterion for pursuing similar policies) that these countries show a

net agricultural trade surplus.

3


C H A P T E R 2 — B A C K G R O U N D : S R I L A N K A T R A D E P O L I C Y A N D A G R I C U LT U R E

This section offers considerable detail on the evolution of trade

policy and agriculture in Sri Lanka in recent years. It describes

the structure of trade in agricultural products and the prevailing

import/export policy framework. It concludes with an examina-

tion of overall trade policy in relation to government revenues

and expenditures, particularly with respect to agriculture.

2.1 BRIEF INTRODUCTION TO THE COMPLEXITY OF SRI LANKAN IMPORT POLICY

In 1994, under the Uruguay Round WTO agreement, Sri Lanka

signaled the opening of its trade regime by committing to

“bound” tariffs on agricultural products that were considerably

lower than those of its neighbors in South Asia. More recently,

Chapter 2 BACKGROUND: SRI LANKA TRADE POLICY AND AGRICULTURE

TABLE 2.1: Primary Imported and Exported Agricultural Products, Selected Subsectors, 2009

PRIMARY COMMODITY AREA (HA) YIELD (KG/HA)

TOTAL PRODUCTION (MT)

IMPORT VALUE(US$ 000S)

EXPORT VALUE(US$ 000S)

CONTRIBUTION TO AGRICULTURAL GDP (%)

Import-competing activities

Paddy 977,561 4,336 3,651,674 22,392 2,903 16.75

Potato 4,139 14,910 61,705 22,973 11 8.54(all other

fi eld crops)Maize 50,857 2,550 129,769 6,352 0

Chilies 13,554 3,420 46,414 42,728 727

Red onions 4,498 10,280 46,234 50,264 11

Green gram 8,569 1,080 9,258 13,364 61

Milk 1,136,860* 19,443,024** 140,226 48 7.45 (all livestock)

Export products

Tea 222,000 1,515# 291,000 22,038 661,825 10.51

Rubber 124,000 1,437 136,900 523 115,989 3.14

Coconuts 395,000 3,000 2,853 145 50,040 8.57

Purchased inputs

Machinery – – – 60,088 – –

Seed – – – 4,552 – –

Fertilizer – – – 181,493 – –

Fuel*** – – – 754,075 – –

Chemicals – – – 32,261 – –

Source: AgStat, Central Bank, Trade Map.*Stock of cattle.**Total milk production in liters. *** All users, not only agriculture.# Tea production is 291 m kg, and total tea area is 192,000 ha, according to the Central Bank of Sri Lanka.

(rice)

4



while maintaining its commitments within WTO (and perhaps

as a reaction to the global food crisis and subsequent export

restrictions by its trading partners), Sri Lanka introduced para-

tariffs and other de facto protective measures on agricultural

imports, along with import duty waivers on a few essential

goods to contain inflationary pressures.

Before describing import and export policies more fully, how-

ever, it is relevant to discuss the structure of Sri Lanka’s trade in

agricultural products in recent years. In U.S. dollar values, the na-

tion’s primary agricultural exports are tea, rubber, and, to a lesser

extent, coconuts (table 2.1). Milk, red onions, and chilies are the

main agricultural imports, followed by potatoes, rice, and tea

(wheat is not produced in Sri Lanka and the entire requirement

is imported). Tea is notable because Sri Lanka, a traditional tea

exporter, imports some varieties of tea for blending and subse-

quent exportation. Additional agricultural imports include palm

oil, sugar and sugar confectionary, onions, soybeans, and wheat.

The import bill for fertilizer and fuel is high. Table 2.1 also shows

the high share of rice in agricultural GDP.

The complexity of Sri Lanka’s system of trade taxes and tariffs re-

flects not only the multiplicity of taxes but the year-to-year vari-

ation and lack of uniformity in taxes and tariffs across products.

Box 2.1 presents a year-by-year account of trade policy changes

relevant to agriculture. For example, in 2009, on customs duties

Sri Lanka maintained a five-band tariff structure: 0 percent for

imports of essential goods, 2.5 percent for basic raw materials,

6 percent for semiprocessed goods, 15 percent for intermedi-

ate products, and 28 percent for other finished products. This

structure was revised to four bands in June 2010 (0, 5, 15, and

30 percent) (Central Bank of Sri Lanka 2010).

Sri Lanka also applies several para-tariffs under an extremely in-

tricate system that influences the level, dispersion, and predict-

ability of the structure of prices in the economy. As a result, Sri

Lanka’s import regime presently is cited as one of the most com-

plex and protectionist in the world (Pursell 2011), with a reputa-

tion for ad hoc policy changes (as seen in the frequent changes

in border charges). The WTO (2010) Trade Policy Review of Sri

Lanka recommended rationalizing the incentive regime to im-

prove resource allocation, improve overall economic efficiency,

BOX 2.1: VARIATION IN SRI LANKA’S EXTERNAL POLICY FRAMEWORK, 2007–11

2007: The fi ve-band tariff structure of 0, 2.5, 6, 15, and 28 per-cent continued, but duty rates on consumer goods were sub-ject to frequent changes. Surcharges on customs duty (10 per-cent of customs duty), Value Added Tax (VAT), Port and Airport Development Levy (PAL), Social Responsibility Levy (SRL), ex-cise duty (on alcohol, tobacco products, and vehicles), and a cess on nonessential consumer items prevailed. Single specifi c customs duty rates were introduced on 10 food items, instead of the surcharge, VAT, SRL, cess, and other charges.

2008: Wide fl uctuations in prices of essential consumer items on the world market necessitated temporary measures to re-duce the impact on domestic prices. Measures included duty waivers on a few essential goods to contain infl ationary pres-sures. To curtail pressure on the trade defi cit to expand, mea-sures were taken to adjust tariff s and impose margin deposit requirements on certain imports that were deemed nones-sential. Such measures were removed or reversed to recoup the government’s tax revenue. The fi ve-band tariff structure continued. The surcharge on customs duty was increased to 15 percent from 10 percent. To contain rising prices of essential food items, the customs duty, VAT, PAL, SRL, and other charges applicable at the customs point for 11 essential food items were replaced by a lower, single Special Commodity Levy (SCL).

2009: The key policies implemented included introduction of a Simplifi ed Value Added Tax scheme, reduction of VAT from 15 percent to 12 percent, and the introduction of an Export Development Reward Scheme, with the objective of securing existing markets, penetrating new markets, and establishing and promoting forward and backward linkages during times of crisis. Though the fi ve-band tariff structure introduced in 2004 continued until 2009, several other trade-related taxes were imposed during 2009 to generate revenue and protect domestic industries, in addition to customs duty. They includ-ed a cess, SCL, Nation Building Tax (NBT), and VAT. The average import duty collection rate was 7.8 percent in 2009. With the escalation of prices of certain essential commodities, the gov-ernment revised taxes on imports of some items. Accordingly, customs duty, PAL, NTB, SRL, VAT, and surcharges were replaced by a lower SCL.

2010: Policies in 2010 focused on promoting trade through diversifying the export product base and markets. The govern-ment took decisive steps to encourage exports of value-added and fi nished goods and to minimize the adverse impact of supply constraints and price increases in international markets

5



Excise (special provisions) duties: A tax on CIF value, plus

the CESS levy, plus the PAL. Alternatively excise tax can be a

specifi c tax on the quantity of imports.

The Social Responsibility Levy (SRL) is a rate applied

to the sum of the customs duty, plus surcharges, plus the

excise (special provisions) duty.

A Value Added Tax (VAT) is applied to the total value of the

import after it passes through the previous system of charges

and levies—that is, a rate of the CIF value, times the customs

duty, plus the CESS, plus the PAL, plus the excise tax.

The Nation Building Tax (NBT) is an additional rate mul-

tiplied by the same value of the good used in determining

the VAT.

Finally, a Regional Infrastructure Development Levy

(RIDL) was based on a rate that, in 2009, mercifully was zero,

and was repealed in 2011.

The cascading eff ect of this multiplicity of taxes and duties can be

seen from the following:

Total customs duties = CIF value in dollars * duty rate.

SUR = Surcharge = total customs duty * surcharge rate.

CESS levy = (CIF value + 10% CIF value) * Cess rate or CESS

levy = quantity * unit rate of CESS (per ton).

PAL = CIF value * PAL rate.

Excise duty = (CIF value + 15% CIF value + customs duty +

Cess under EDB + PAL) * rate of excise duty, or Excise duty =

Quantity * Unit rate of excise duty.

SRL = (customs duty + surcharge + excise duty) * SRL rate.

VAT = (CIF value + 10% CIF + customs duty + Cess under EDB

+ PAL + excise duty) * rate of VAT.

NBT = (CIF value + 10% CIF value + customs duty + Cess

under EDB + PAL + excise duty) * rate of NBT.

RIDL was zero in 2009 and was repealed January 1, 2011,

with some remaining taxes on motor vehicles (ending 2012).

Total taxes = NRP = customs duty + surcharge+ CESS levy +

excise duty + VAT + NBT + PAL+SRL + RIDL.

In years of domestic production shortfalls and/or higher than

average world prices, the government has revised taxes on

imports of some consumer items such as rice, potatoes, red on-

ions, big onions, garlic, sugar, and chilies. For example, in 2009

import taxes were lowered to make food items more affordable.

A lower SCL tax was charged in place of customs duty, PAL, NBT,

and SRL.

on the domestic market. Tariff bands were reduced to a four-band customs duty structure of 0, 5, 15, and 30 percent. The customs duty and SCL applicable on selected consumer and intermediate goods such as petrol, diesel, milk powder, maize, palm oil, wheat grain, malt extract, and PVC leather cloth were reduced to stabilize price fl uctuations in the domestic econo-my. A cess was imposed on several exports of raw and semi-processed items.

2011: The 2011 budget included far-reaching reforms to sim-plify the tax structure while broadening the tax base to im-prove revenue mobilization. Measures were taken to rational-ize the income tax structure by reducing marginal tax rates for personal income tax and raising the tax-free threshold, with a goal of improving tax collection. The base for income taxation was widened with the extension of the PAYE tax to public sec-tor employees. To create a level playing fi eld, all tax incentives were brought under the Inland Revenue Act, other than those that are identifi ed as strategically important and approved by the Cabinet of Ministers. Meanwhile, the VAT system was sim-plifi ed by replacing multiple tax rates with a single tax rate of 12 percent. Several other initiatives were also taken to improve tax administration. A Tax Appeals Commission was set up to expedite the appeal process.

Source: Central Bank of Sri Lanka 2007, 2008, 2009, 2010.

eliminate distortions, and diversify production and trade. The

WTO report suggested reductions in import protection, the

rationalization of domestic support, and the implementation

of a more consistent trade policy to increase productivity and

farmers’ incomes.

At the base of the tax structure is the total Customs Duty (CD),

which is a percentage of the CIF (cost, insurance, and freight)

value. In Sri Lanka (as in many other countries) these tariff

rates vary significantly across tariff lines. In addition, for some

goods there are specific duties per unit of quantity imported.

On top of that, a wide variety of other charges and levies exists:

CESS levies (assessments under the Commodity Export Subsidy Scheme) applied to both imports and exports, defi ned either ad valorem or as a specifi c charge per unit quantity.

Port and Airport Development Levy (PAL), which acts as

a simple tariff on the CIF value of the imports.

6



In this report, the total protection rate (TPR) on imports is de-

fined as: CD + PAL+ SUR + Cess + RIDL, expressed as percent-

ages of the CIF price. Excise Duty, RIDL, and SRL were excluded

because they do not apply to agricultural imports. VAT is a com-

plex case, because in principle it applies to both domestic and

international trade, but in practice it is seldom charged in the

domestic trade of farm products. In discussions of the prelimi-

nary results of the TPR analysis, questions were raised about the

VAT’s importance to the outcomes. Box 2.2 discusses the VAT in

relation to agricultural products and inputs in Sir Lanka.

The SCL also requires special attention. It is applicable to select-

ed, “essential” food items, and when applied it replaces all other

border taxes on those specific goods. The original list of items

covered by the SCL included maldive fish and sprats, potatoes,

onions (red and Bombay onions and garlic), peas (chickpeas,

BOX 2.2: IMPACT OF VALUE ADDED TAX ON AGRICULTURAL COMMODITIES IN SRI LANKA

The Value Added Tax (VAT) was introduced by Act No.14 of 2002 and has been in force since August 1, 2002. The VAT Act replaced the nearly identical Goods and Services Tax (GST) on the consumption of goods and services. Every person who carries out a taxable activ-ity should register for VAT if the value of his/her taxable supplies exceeds or is likely to exceed Rs 500,000 per any quarter of the year or Rs 1,800,000 per year. Certain products are exempt from VAT (including certain imports). The customs agency has identifi ed the VAT-exempt goods by their HS code classifi cation*, in consultation with Inland Revenue: unprocessed agricultural produce, unprocessed horticultural produce, unprocessed fi shing products, bread, milk, and agricultural tractors.

Under the VAT Act No. 14 of 2002, the sole power to change the VAT lies with the Ministry of Finance; the Director General of Customs is not permitted to make any changes, as per recommendations made by other ministries and authorities. Exports are within the offi cial scope of the VAT system but are subject to VAT at zero-percent. As the table shows, trade in agricultural products and, importantly, their tradable inputs is, for the most part, exempt from VAT. VAT was not incorporated into the calculations of total protection rate in this note.

* HS code is the Harmonized Commodity Description and Coding System for tariff nomenclature.

VAT ON IMPORTED AND EXPORTED AGRICULTURAL PRODUCTS AND THEIR TRADED INPUTS

ITEMOUTPUT TAX

CATEGORY

INPUTS

FERTILIZERSEED/PLANTING

MATERIAL MACHINERY PESTICIDES

Imports

Rice Exempt Exempt Exempt Exempt Paid

Wheat Exempt n.a. n.a. n.a. n.a.

Potatoes 12% Exempt Exempt Exempt Paid

Onions 12% Exempt Exempt Exempt Paid

Chilies 12% Exempt Exempt Exempt Paid

Liquid milk, infant milk Exempt n.a. n.a. Exempt n.a.

Powdered milk Exempt n.a. n.a. Exempt n.a.

Exports

Coconuts 0% Exempt Exempt Exempt Paid

Tea 0% Exempt Exempt Exempt Paid

Dried fi sh Exempt n.a. n.a. Exempt n.a.

Rubber 0% Exempt n.a. Exempt n.a.

Condiments (cardamom, cinnamon, cloves, nutmeg, pepper)

0% Exempt Exempt Exempt Paid

Source: Central Bank of Sri Lanka.Note: n.a. refers to “not applicable”; the inputs are not used in production of the corresponding product.

7



gram, dhal, and similar), some fruits (oranges, grapes and apples),

chilies, condiments (coriander, cumin, and others), and tinned

fish. Palm oil, coconut oil, sugar, and fish were added to the list

in a revision, and recently milk powder and rice were included.

The SCL can and has been applied and removed on individual

products, even during the same year. For example, in February

2009, the SCL on milk was increased from 35 to 55 Sri Lanka rupees

(Rs) per kilogram, but then removed entirely on March 31 of 2009,

which meant that other duties and taxes were applicable begin-

ning in April. Although the SCL might act as a discretionary vari-

able levy to stabilize the domestic price of a product, the evidence

is unclear as to whether SCL revisions in fact have been made to

absorb fl uctuations in world market prices (at least based on an in-

spection of the correlation of SCL rates with CIF prices). Appendix

table 3.5 shows a brief history of apparently ad hoc changes in SCL

levels. The SCL is applied as a specifi c duty, which for the purpose

of calculating the TPR is converted into an ad valorem equivalent.

Historically, import and price policy related to agriculture has been

associated with concerns about food security. This note does not

attempt to address the multiple facets of the food security issue,

which is much broader then the trade policy focus here. The pro-

duction (supply) side and its many related issues would require a

more comprehensive analysis of factors, including factors aff ecting

productivity such as technology (research and extension services),

markets and marketing, and land and labor issues. Food security

concerns are discussed by Vishwanath and Serajuddin (2010) and

Kelegama (2010).1 Kelegama is explicit is his conclusion (p. 247):

“Priority should be given to production of food for the people of

Sri Lanka over commercial export-oriented agriculture in allocation

of land and resources.” This notion is refl ected in the government’s

National Policy on Agriculture from 2007, which presents initiatives

to increase domestic production and restrain the rising cost of food.

Beyond attempting to stimulate staple production, one such initia-

tive, the Api Vavamu–Rata Nagamu plan, is a “cultivation drive,” with

the objective of gaining self-suffi ciency within three years in onion,

chili, soybean, kurakkan, grape, orange, and potato production.

Political and policy concerns about food availability are not unique

1 In the volume edited by Ahmed and Jansen (2010).

to Sri Lanka. Even so, the main fi ndings of this note suggest that

the current policy framework might in fact be working against the

government’s stated objective of greater food security.

2.2 EXPORT POLICY FRAMEWORK

Agricultural exports have been taxed in Sri Lanka in different

periods in different forms. Broadly speaking, four main argu-

ments are used to justify taxing agricultural exports. The first

is to generate revenue for the government. The second argu-

ment is made when the product is a major staple in the diet of

urban consumers, and the tax is intended to reduce the price of

food. The third applies to countries that are major exporters of

a specific product in world markets—that is, when the country

is not a “price taker.” An economist’s response to this condition

is to adopt an “optimum export tax.” The fourth argument is to

lower the domestic price of raw materials used by higher-value

industries to encourage further processing of local materials.

The first argument most likely applies to the taxation of ag-

ricultural products in Sri Lanka. The second is not likely to be

relevant, because Sri Lanka’s agricultural exports are not staple

crops. If it applies, the third argument would apply only to tea,

but this note does not examine its application to Sri Lanka to-

day. Determining the level of that export tax requires agreement

on the import demand elasticities in foreign markets, which is

seldom reached. The fourth argument could be considered a

kind of “infant industry” argument to promote the development

of the agro-processing industry. The literature on applied inter-

national trade suggests that the effectiveness of this fourth mo-

tive for export taxes is questionable. The industry-specific data

required to support or refute this argument for Sri Lanka are

beyond the scope of this study.

Sri Lanka imposes border charges (export cesses) on certain

exports, and a few items are under quantitative export restric-

tions (export bans and export licenses). Sri Lankan legislation

allows export duties and cesses to be used to meet the following

stated objectives: to assure the availability of raw materials for

higher-value-added industries and to promote further process-

ing of local materials; to finance export promotion activities;

and to protect national security, archaeological items, and the

8



environment. Legislation also allows export duties to be im-

posed in response to increases in world market prices. Section

10(a) of the Customs Ordinance provides for the levying of ex-

port duties, and Section 10(c) provides for any royalty or cess

leviable on the exportation of such goods under other laws. The

Export Development Act No. 40 of 1979 provides details of the

export cesses charged for various items, and the Gazette issued

on May 31, 2010 provides detailed export cess rates. The rates are

ad valorem for certain items and have specific duties for certain

others. A third category can have ad valorem or specific rates,

depending on which is greater. Unweighted average export

cess rates in percentage terms for the agricultural commodity

categories were computed based on the ad valorem rates in the

first or third categories. Similarly, using the specific rates in the

second and third categories, unweighted average specific cess

rates were computed in relevant units. When an item was not

listed in the gazette, the export cess rate was assumed to be zero,

both ad valorem and specific. When a rate was not applicable, it

was considered a missing value (Appendix table 8).

As shown in Bandara and Jayasuriya (2009), export taxes for

rubber, coconuts, and tea were high from the 1960s to approxi-

mately the mid-1990s, when they fell significantly until 2004.

Although export taxes for these three traditional agricultural

products remain low, broadly speaking, they remain surprisingly

high for nontraditional exports. The ad valorem export tax rates

are relatively high for such products as fruits, vegetables, milk,

and chilies, with a mode of 30 percent; maize, cinnamon, and

cloves have a mode of 10 percent. Sri Lanka traditionally has

used export taxes as a source of government revenue, but as

countries modernize, they typically move toward other, more

broad-based tax sources. As noted, export taxes discourage in-

vestment in export-oriented agriculture and reduce the diversity

of exports. These taxes on exports contrast sharply with the fairly

high protection of the import-competing sector, which implies a

strong disincentive against exports in agriculture.

With respect to positive export incentives, a complex system

comprising several export incentive programs is available in Sri

Lanka. Customs operates three schemes: a duty rebate (drawback)

scheme, a temporary importation for export processing scheme,

and the manufacture-in-bond scheme. The system is designed

for manufacturing and processing and is unlikely to be accessible

for the farm sector. Like many countries, Sri Lanka implements a

duty rebate scheme, through which duties paid on imported raw

materials and intermediate inputs used in the manufacture of

products for export may be partially or fully rebated or refunded

once the fi nal good is exported. Exporters who incur fi scal levies

on imported inputs and use these items to manufacture products

for export directly or indirectly are eligible. Exporters who intend

to use the scheme must register with the Duty Rebate Unit of the

Sri Lanka Customs Export Division. Registration is required for each

export shipment and must be accompanied by an export invoice,

receipt or air waybill, and parties’ copy of the export shipment.

Under the duty rebate scheme, only customs duties and the

import surcharge are rebatable; the cess, excise duties, PAL, and

other duties levied on imports are not included. Likewise, the

VAT does not qualify for payment of duty rebate. Locally pur-

chased imported items that have been used to manufacture

export products are considered for duty rebate.2

Although not specifically related to the agricultural sector, Sri

Lanka also has a scheme for Export Processing Zones (EPZs).

In these 11 free-trade zones, administered by the Board of

Investment, some 220 enterprises employ over 75,000 persons.

Locating an enterprise in an EPZ entitles a company to tax holi-

days, duty-free imports, and concessionary land prices.

Exporters of nontraditional goods or services also enjoy a num-

ber of tax concessions, such as a preferential income tax rate

on profits from those exports and a full tax holiday for three

to seven years for new investments. These companies are re-

quired to export at least 80 percent of their goods production

and 70 percent of services. An earlier program, which appears

to have been discontinued, subsidized the cost of international

2 Exporters must submit a claim to the commercial bank that received the remittance for the exported products, along with relevant export documents. The rate of rebate, a percentage of the FOB value, is de-termined by the Director General of Customs, based on the cost state-ments submitted and approved by the Deputy Secretary to the Treasury. Products eligible for duty rebates approved by the Minister of Finance are gazetted periodically. Exporters dissatisfi ed with a decision may ap-peal within 30 days. The rebate can be claimed within six months from the date of export.

9



transport/freight of goods such as fresh fruits and vegetables,

foliage, live plants and preparatory materials, gherkins, cut flow-

ers, floricultural products, and betel leaves.3

In seeking to understand the most recent agricultural export

regime, it is particularly instructive to examine the 2011 budget

proposal on the treatment of agricultural exportables. At least in

terms of the number of policy initiatives, the 2011 government

budget shows a desire to promote export agriculture, but it also

manifests a degree of complexity and discretion that could act as

an obstacle to farmers and agro-processers operating at a small

and medium scale. There also seems to be a mix of public goods

and private subsidies. While fi ghting the spread of crop disease

or promoting new technologies might be public goods, subsidies

for replanting and credit are not. To what degree do these private

subsidies compensate for the export tax? Is balancing export taxes

the object of some of these subsidies? The 2011 budget proposes:

Reducing the concessionary tax rate on exports of nontradi-

tional products from 15 percent to 12 percent.

Imposing a cess on most exports in raw and semiprocessed

form (tea, coconuts, rubber, cashews, raw hides) to encour-

age the exportation of value-added products.

Reducing duties and taxes on machinery and equipment

used in value-added activities.

Reducing the income tax rate to 10 percent for industries

with over 65 percent value addition and brand names with

patent rights reserved in Sri Lanka.

Reducing the corporate tax rate to 28 percent for domestic

manufacturing industries.

Tea industry

• Increasing the subsidy for replanting and new planting to Rs 50,000 per hectare for smallholders producing tea.

• Establishing a revolving fund through the banking system to provide related credit facilities to plantation companies for replanting.

• Distributing unused Regional Plantation Company land among small growers for replanting.

• Supporting the Tea Research Institute to promote technology and research to improve the quality of tea through high-yielding varieties and reductions in postharvest losses.

3 WTO document G/AG/N/LKA/1, May 20, 1999.

• Increasing the export cess on bulk tea to Rs 10 per kilo-gram from Rs 4 per kilogram.

Coconut subsector

• Allocating Rs 500 million for replanting, new planting, in-tercropping, and productivity improvement in the coconut industry.

• Allocating Rs 200 million to curtail the spread of crop disease in the Weligama area.

• Encouraging coconut cultivation in Northern and Eastern Provinces.

• Leasing of unused land by government authorities (unless such land is developed by June 2011).

Rubber industry

• Allocating Rs 750 million to the Department of Rubber Development to increase the replanting and new planting subsidy and to grant a 50 percent subsidy to popularize the use of rain guards.

• Increasing the export cess on raw rubber to Rs 8 per kilo-gram from Rs 4 per kilogram.

Spice subsector

• Implementing a fi ve-year subsidy scheme for planting and replanting.

• Providing fi nancial assistance for industrial spice proces-sors to promote value addition.

• Funding a special program to develop hybrid planting materials.

• Promoting infrastructure to support smallholders in the spice subsector.

2.3 BRIEF NOTE ON THE COMPOSITION OF GOVERNMENT REVENUE AND EXPENDITURE

Sri Lanka’s trade policy has relied mostly on price-based rather

than nontariff-based measures and has been guided to a large

extent by revenue considerations, according to the Central Bank

of Sri Lanka (2009). In 2009 tax revenue constituted 90 percent

of total government revenue (nontax revenue accounted for

the remaining 10 percent). The tax revenue came from VAT (26

percent), income tax (21 percent), other taxes (20 percent), im-

port duties (18 percent), and excise taxes (15 percent).

Table 2.2 reports government revenue and expenditures for 2009,

2010, and 2011. Excluding VAT, border-related taxes represent

between 30 percent and 35 percent of tax revenues, a signifi-

cant level, consistent with the claim that border measures in

Sri Lanka are in part designed to raise government funds and

10



not merely to provide protection to local production. In 2010,

export taxes on tea and coconuts represented half of all border

tax revenue; import duties represented 29 percent of revenues

raised at the border. Evidently domestic agriculture in Sri Lanka

is a significant contributor to public revenues.4

Import duties represented approximately 9 percent of total tax

revenues in 2010. It is relevant to note (based on data from the

Central Bank of Sri Lanka 2009) that the “other taxes” category

includes the cess, SCL, NBT, and VAT. As discussed in Sri Lanka’s

Central Bank Annual Report for 2010, trade-related taxes included

import duties, excise taxes, and taxes under the category of “other”

(SCL, PAL, and others). The Central Bank report outlines temporary

4 In 2010 tea had a cess rate of 2.5 percent and coconuts of 11.82 percent. Is it possible that Sri Lanka is not a price taker in world markets for these two products, which might justify an “optimal export tax” policy? This is unlikely, but the authors leave this question for further examination.

removals and waivers on border taxes on specifi c products, includ-

ing the customs duty waiver on wheat grain, a reduction in taxes

on milk powder, removal of the SCL on rice, and the removal of

the cess on selected imports. These new and temporary changes

demonstrate the high variability in the level of border taxes ap-

plied by Sri Lanka from year to year. In computing the actual bor-

der taxes charged for the subset of activities studied in this note,

the authors adjusted the various categories of border taxes follow-

ing the Central Bank’s reported changes each year.

On the expenditure side, it is relevant to mention that the

fertilizer subsidy (discussed in greater detail in Section 4) rep-

resented 68 percent of current expenditures on agriculture in

2009, 59 percent in 2010, and 39 percent in 2011. Though still

absorbing a very high proportion of the public sector budget

for agriculture, the fertilizer subsidy appears to be declining.

Fertilizer subsidies represented approximately 3 percent of total

government expenditures in 2010.

TABLE 2.2: Government Expenditures and Revenues (Rs millions)

CATEGORY SUBCATEGORY ITEM 20092010

(PROVISIONAL)2011

(APPROVED ESTIMATE)

Import-competing activities

Tax revenue* 618,933 725,671 861,943

Income taxes 139,558 135,623 154,883

VAT 171,510 220,168 238,390

Excise taxes 97,604 129,749 152,250

Border measures Import duties 79,560 64,369 92,803

PAL 36,286 49,650 63,000

Other border-related taxes* 83,013 109,713 153,595

Other taxes 11,402 16,400 7,022

Revenues from border measures as % of total tax revenue 32.1% 30.8% 35.9%

Nontax revenue 80,711 92,549 101,377

Total revenue 669,644 818,220 963,320

Current expenditure 879,575 937,094 1,017,155

Agriculture and irrigation 43,963 44,081 51,678

Fertilizer subsidy 26,935 26,028 20,000

Capital expenditure 277,416 302,087 351,899

Lending repayment 44,936 41,025 50,609

Total expenditure and net lending

1,201,927 1,280,205 1,419,663

Source: Central Bank of Sri Lanka. * Note that the cess on tea and coconuts in 2010 was Rs 100,490 million, or 91.6% of other border taxes.** Includes stamp duties, cess, SRL, RIDL, SCL, and others.

11


C H A P T E R 3 — D I S C U S S I O N A N D I N T E R P R E TAT I O N O F A G R I C U LT U R E

This section reviews the data sources and methods used to measure

how border taxes infl uence levels of protection and taxation and

presents statistics summarizing the degree of protection for 10

agricultural commodities. The discussion highlights how support to

agriculture varies by commodity.

3.1 APPROACH, DEFINITIONS, AND DATA SOURCES

Two complementary approaches can be used to measure the impact

of border taxes on levels of protection and taxation. One approach

is to estimate the “ad-valorem tariff equivalent” of the various import

and export taxes applied per ton of a given commodity at the border.

This approach allows us to synthesize the considerable variety of bor-

der taxes in Sri Lanka (described in the previous section) into a single

measurement for each commodity in each year. Another approach

used in the literature is to compute the “ad-valorem tariff equivalent”

following a direct price comparison between border and farm gate

prices. The resulting fi gure is often referred to as the “import parity

price” or “export parity price.” The second approach is used to capture

nontariff restrictions on imports or exports, such as quantitative re-

strictions in the form of import quotas, licenses, export prohibitions,

pre-import deposits, and administrative measures. The fi rst approach

does not capture border measures unrelated to price, although such

measures restrict imports and exports and infl uence domestic prices.

Many countries imposed quantitative restrictions in the 1970s and

1980s, but partly as a result of the WTO Uruguay Round Agreement

on agriculture, the legal scope for applying quantitative restrictions

has been signifi cantly reduced. Such restrictions are less signifi cant

today, but they are sometimes applied in a subtle or disguised way.

In addition to these complementary approaches, a third approach

captures the implicit import duty or export tax from the revenue

from border taxes and expresses it as a percentage of the border

price. All three methods have been applied in this study, but the

main results reported are based on the fi rst approach.

These three methods allow the estimation of a “nominal rate of pro-

tection,” which is defi ned as a price wedge between the border and

domestic price of a given product. The diff erence between these

two prices, given the exchange rate, is adjusted for quality diff er-

ences between the domestically produced and imported product.

The fi rst method gives a more direct measure of the government

interventions aff ecting domestic prices. The second method, the

direct price comparison approach, also requires an adjustment for

domestic marketing margins so that the border and the farm gate

price can be compared at the common point of competition. This

adjustment captures the structure of marketing, which in some

markets could be highly competitive and in others could be subject

to monopsonist and monopolistic forces, which in themselves are

not necessarily the result of government policies. A complexity in

calculating the price comparisons occurs with products that un-

dergo processing before reaching the fi nal consumer. For example,

a farmer sells a primary product, such as paddy rice or fresh milk, but

the import equivalent of those products is processed (polished rice,

powdered milk and other milk products). The analyst has to obtain

the various transformation coeffi cients to arrive at the price equiva-

lent at a given point in the marketing channel.

The nominal rate of protection (NRP) is the relevant measurement

to examine the impact of trade policy on the price paid by agro-pro-

cessors for primary products or by the fi nal consumer at retail. The

NRP is not always an appropriate indicator of incentives for agricul-

tural producers, however, because it does not capture the impact of

price and trade policy on the domestic price of intermediate inputs

Chapter 3 DISCUSSION AND INTERPRETATION OF AGRICULTURE

12


C H A P T E R 3 — D I S C U S S I O N A N D I N T E R P R E TAT I O N O F A G R I C U LT U R E

such as agrochemicals, machinery, equipment, fuel, and seed. For

a more accurate measure of the impact of trade policy on farmer

incentives, we look at the value added at the farm level. The eff ec-

tive rate of protection (ERP) is defi ned as the ratio between value

added at domestic prices to value added at world reference prices,

that is (Vj – Vj*)/ Vj*), where Vj* represents value added per unit of

output at border prices for the output and tradable inputs, given

the exchange rate.

This note reports nominal and eff ective rates of protection. It does

not compute produce subsidy equivalents. This common measure

of agricultural support, used by the Organisation for Economic Co-

operation and Development for developed countries, represents a

measure of income support and is particularly relevant in countries

with income transfers and decoupled payments to farmers.

The analysis was performed using tariff and para-tariff rates for

2009 and 2011 (no customs tariff guide was available for 2010, so

the import tax analysis for 2010 was not performed). An important

data source was the Customs Tariff Guide, which includes changes

made within the year as announced by the gazette notifi cations

and reported on the Sri Lanka Customs website. Tariff and para-tariff

data for 2009 were kindly provided by G. Pursell, who downloaded

the 2009 database from the website at one point in time in 2009.

Tariff and para-tariff data for 2011 were obtained from the hard copy

of the Customs Tariff Guide, which was published in the beginning

of year. The export cess rates were from the government notifi ca-

tion of Sri Lanka Export Development Act No. 40 of 1979, issued in

May 2010.

To estimate the NRP and its equivalent—referred to as the total

protection rate (TPR)—the total taxes were fi rst calculated using the

formula applied by the Sri Lanka Customs authority. As explained

in Section 2, this formula imposes certain taxes on taxes, rendering

the total taxes greater than the fi gure obtained from a simple sum

of taxes. As Pursell (2011) points out, the Sri Lankan tax system af-

fecting imports is one of the most complex in the world. The WTO

Uruguay-Round agreement aims for simplicity, transparency, and

predictability. The WTO does not favor specifi c import taxes, be-

cause they insulate domestic prices from border prices and make

protectionist measures diffi cult for traders and analysts to discern.

The complexity of Sri Lanka’s import tax regime, as the reader will

appreciate from the subsequent discussion, makes it diffi cult to gain

a good understanding of the impacts on incentives.5

As explained in Section 2, at the base of the tax structure is the total

customs duty, which is simply the CIF value of the imported good

multiplied by the duty rate, a proportion of the CIF value. These tariff

rates vary signifi cantly across tariff lines. In addition, some goods are

subject to specifi c duties per unit of quantity imported. On top of this

otherwise simple tariff , a variety of other charges and levies is added.

There are surcharges over the normal duty rate. Under the authority

of the act establishing the Export Development Board, there are cess

levies (assessments under the Commodity Export Subsidy Scheme)

either calculated ad valorem as 110 percent of total CIF value multi-

plied by an assessment rate, or calculated as a charge per unit quan-

tity. The Port and Airport Development Levy (PAL) acts as a simple

tariff on the CIF value of the imports. An excise duty is a complicated

tax on CIF value adjusted upward for customs duties plus the cess

levy plus the PAL. Alternatively, the excise tax can be a specifi c tax

on the quantity of imports multiplied by a simple rate per quantity

unit. The Social Responsibility Levy (SRL) is a rate multiplied by the

sum of the customs duty plus surcharges plus the excise duty. Then

there is the more familiar Value Added Tax (VAT) on the total value

of the import after it passes through the previous system of charges

and levies (that is, a rate multiplied by 110 percent of the CIF value

5 Interviewed in the Sunday Times of Sri Lanka in 2010, Saman Kelegama, Executive Director of the Institute of Policy Studies of Sri Lanka and Member of the Presidential Taxation Commission, said, “Basically, our import duty structure has got complicated by various ‘add on’ taxes over and above tariff s and VAT (and Excise where applicable). These ‘add on’ taxes are revenue generators to the Treasury and additional protection for some domestic manufacturers but they are basically nuisance taxes for import traders and importers of manufacturing inputs…. To meet certain development expenditures, the following taxes were imposed and they are applicable at the border: (a) Nation Building Tax, (b) Port and Airport Development Levy, (c) Regional Infrastructure Development Levy, and (d) Social Responsibility Levy. To develop certain commodi-ties the following taxes were imposed: (1) Commodity Export Subsidy Scheme (CESS), and (2) Special Commodity Levy. In 2009, import tariff revenue was close to 2 percent of GDP but the customs border revenue was 8 percent of GDP, thus nearly 6 percent GDP revenue has come from these additional taxes…. All these minor taxes are an irritant to the importer although they fulfi ll some revenue and protection objectives. These taxes have made the tax structure more complicated and less transparent. And above all, these taxes operate under diff erent tax bases. One reason for illegal imports and undervaluation of imports is due to these taxes. What Sri Lanka should aim at is a less complicated border tariff structure which gives reasonable protection and revenue.” (See “Tax Issues: Current System Not Delivering Needed Revenue,” Sunday Times, November 21, 2010, http://sundaytimes.lk/101121/BusinessTimes/bt10.html, accessed April 2012).

13


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