Sri Lanka’s ICT industry – often hailed as a beacon of modernisation, export growth, and skilled employment – is warning of a major setback in the wake of the government’s plan to impose a new 18% VAT on IT and software services.
Industry leaders argue this tax threatens not only their competitiveness but the country’s broader economic vision to be a digital hub. At the heart of their warning is a concern that Sri Lanka risks slipping into digital isolation just when regional rivals are accelerating their own investments in technology, AI, and digital exports.
This post dives deep into the new VAT policy, the industry’s concerns, the government’s motives, and what this clash really says about Sri Lanka’s development priorities.
A Fast-Growing Industry Faces a Sudden Barrier
For over two decades, Sri Lanka’s ICT sector has been a rare success story. In 2022, ICT/BPM exports were estimated at over US$ 1.5 billion, employing more than 125,000 skilled professionals. This is not a footnote in the economy: it’s a critical, knowledge-based industry that produces foreign exchange and well-paying jobs, keeping talent in the country.
But the newly proposed Value Added Tax (VAT) expansion includes software and IT-enabled services. Previously exempt, these services will now see an 18% tax added to bills for local clients.
Industry leaders argue that this change risks:
Driving up costs for local businesses, who are already struggling with high inflation, power costs, and import taxes.
Pushing local firms to foreign suppliers who may not face the same VAT burden.
Forcing small and medium IT providers to shut down or go informal to avoid the tax.
Undermining the country’s export competitiveness, as companies will have less cash to invest in R&D, staff training, or marketing.
Government’s View: Broadening the Tax Base
From the government’s perspective, expanding VAT is part of the IMF-backed fiscal consolidation strategy. Sri Lanka’s public finances remain under severe strain following the 2022 crisis and default. VAT is one of the most reliable taxes to collect, and the logic is clear: the country cannot keep exempting sectors indefinitely when trying to stabilise revenue.
Officials have defended the move by saying:
It brings consistency and fairness by treating services uniformly.
It helps raise much-needed revenue without distorting trade tariffs or raising corporate income tax.
Exports themselves remain zero-rated for VAT, so the real burden falls on local sales.
But for ICT industry stakeholders, this argument ignores the unique role tech plays in development.
The Threat of “Digital Isolation”
One of the most striking warnings comes from the industry’s suggestion that Sri Lanka risks “digital isolation.”
What does this mean in practical terms?
Reduced digital adoption by local businesses – If software and IT services become 18% more expensive, SMEs may cut back on automation, e-commerce, or cloud solutions. That hurts their productivity and competitiveness.
Talent drain – ICT jobs have been one of the best ways to retain skilled youth. If firms downsize or close, the best engineers and developers will move to Dubai, Singapore, or remote jobs for foreign firms.
Losing investment – Investors and multinational firms will reconsider setting up in Sri Lanka if the tax system penalises local software production or adds uncertainty.
Falling behind regional peers – India, Bangladesh, Vietnam, and the Philippines are not adding new VAT barriers to their IT industries. Instead, they are offering incentives to attract outsourcing contracts and foreign investment.
SMEs at Risk
While large IT companies may be able to navigate VAT with accountants and pass costs onto clients, smaller firms will struggle.
Consider the local software house with 10 developers that builds inventory systems for shops or schools. Their customers may balk at paying 18% more. They may turn to unlicensed software or overseas freelancers who don’t add local VAT.
This risks pushing the small-scale local IT market into informality, reducing tax compliance overall – ironically undermining the very revenue goals the VAT expansion is meant to serve.
“We Can’t Tax Our Way to Innovation”
Industry leaders have been vocal: while they recognise the state’s desperate need for revenue, they argue the government is targeting the wrong area.
ICT is not a protected rent-seeking industry. It is a globally traded, highly mobile sector where price competitiveness matters.
Countries from Ireland to India have treated software as a strategic industry. They provided tax holidays, training grants, infrastructure, and incentives.
Sri Lanka, in contrast, risks making local software and IT services less competitive, disincentivising local adoption, and harming a source of foreign exchange.
As one industry executive put it:
“We cannot tax our way to innovation. We have to invest in it.”
Government’s Challenge: Short-Term Revenue vs Long-Term Growth
The dilemma here is real.
Sri Lanka urgently needs to increase tax revenue to meet IMF targets, repay debt, and restore credibility with lenders.
But many experts warn that taxing productive, export-capable, knowledge industries is the worst way to do it.
The IMF itself has said Sri Lanka should broaden its tax base and remove exemptions. But it is up to policymakers to decide which exemptions to keep in the national interest.
One possibility: the government could have kept VAT exemptions for locally developed software while cracking down on tax evasion in other sectors or broadening the personal income tax net among high earners.
Alternative Solutions
Stakeholders are not simply saying “no tax ever.” Many industry leaders suggest more nuanced options:
Exempt local development, tax imported software – This would protect local firms from unfair competition while still raising revenue from foreign software.
Introduce a reduced VAT rate for ICT services – Many countries use tiered VAT rates for essential or strategic sectors.
Phase in the tax over several years – Giving businesses time to adapt.
Use VAT revenue to fund industry development – Such as grants for IT training, R&D credits, or connectivity improvements.
Is This a Sign of Policy Shortsightedness?
Sri Lanka’s struggle with debt is forcing hard choices, but this VAT debate reveals a broader challenge in policymaking:
A tendency to focus on short-term revenue, ignoring long-term economic strategy.
Weak consultation with industries that have genuine global potential.
A lack of coordination between fiscal policy and sectoral development goals.
Sri Lanka cannot rely on tea, tourism, and textiles forever. The ICT sector is one of the few industries with high growth potential that isn’t tied to physical resources or vulnerable to climate shocks.
Punishing it with a sudden 18% VAT on local services sends the wrong signal to investors, local firms, and talent.
A Call for Dialogue
What’s clear is that this VAT debate is not just a technical tax issue. It is a choice about Sri Lanka’s economic future.
Does the country want to be a low-wage outsourcing backwater or a genuine digital hub?
Will it invest in the sectors with the most potential or stifle them to plug a budget gap?
The government and the industry need genuine dialogue, not an adversarial standoff.
Sri Lanka has limited room for error. Getting this wrong risks pushing the country further into economic stagnation – and digital isolation – just when it most needs transformation.
Final Thoughts for Lanka Biz News Readers
For Lanka Biz News readers – business owners, investors, policymakers – the lesson here is clear:
Digital development is not a luxury. It is the foundation for competitiveness in every sector, from tourism to agriculture.
Policies need to recognise that taxing innovation is self-defeating.
Sustainable growth means balancing revenue needs with incentives for the right industries.
It is time for a smarter, more strategic approach to taxation – one that sees ICT not as a cash cow, but as a catalyst for Sri Lanka’s recovery and future prosperity.
