The Dynamic Impact of Taxation on the Economic Growth of Sri Lanka: An ARDL bounds testing approach

Abstract

Discussions on how a government can stimulate an economy through non-distortionary taxation and productive government expenditures have become prominent during the past three decades. Against this backdrop, this paper aims to analyse the short-run and long-run impacts of taxation on the economic growth of Sri Lanka. Some taxes can be distortionary, while others are not. Therefore, while analysing the effect of overall tax level on economic growth, we also estimated the distortionary nature of major tax categories on the economic growth of Sri Lanka. Sri Lanka presents a unique case to analyse the nexus between taxation and economic growth, as the economy was liberalized in 1977. Therefore, the impact of taxation level on economic growth was estimated using a linear Auto-Regressive Distributed Lag (ARDL) model under two scenarios: without controlling for economic liberalization (from 1960 to 2018) and the post-liberalized period (from 1980 to 2018).  The results of both pre-and post-economic liberalization conditions suggest a significant long-run positive impact of tax level on economic growth. Similarly, the impact of consumption tax on short-run economic growth was significant.  In addition, personal and corporate income taxes were non-distortionary, both in the short-run and the long-run, while consumption taxes were non-distortionary in the long-run. This suggests that increasing taxes is a viable policy option in achieving fiscal independence without compromising Sri Lanka's growth potential.

 Keywords: ARDL, Economic Growth, Fiscal policy, Public Sector, Tax Levels, Tax Structure