Sri Lanka’s economy, still rebuilding after its worst crisis in decades, faces a defining challenge, how to raise sustainable government revenue without crushing enterprise. The tax system sits at the centre of this balancing act. With IMF-backed fiscal reforms under way, the next two years will determine whether taxation becomes a platform for growth or a drag on recovery.
A narrow base and heavy burden
Sri Lanka’s tax-to-GDP ratio, at roughly 11–12 per cent, remains among the lowest in Asia. More than 80 per cent of state revenue comes from indirect taxes such as VAT, excise duties, and import levies. Direct taxes corporate and personal income taxes make up a small share.
This imbalance fuels inequity. A household buying essentials pays the same VAT rate as a high-income professional, while businesses bear cascading costs through supply chains.
The standard corporate income-tax rate of 30 per cent, coupled with 15 per cent VAT, social security contributions, and stamp duties, leaves many firms, especially SMEs, complaining that compliance has become costlier than competition itself.
Despite these taxes, revenue growth lags because the system captures too few payers. The Inland Revenue Department (IRD) estimates that fewer than one in ten working adults file returns. Weak enforcement, overlapping exemptions, and informal economic activity keep the base narrow.
Reform pressure under IMF oversight
The IMF programme approved in 2023 tied its tranches to revenue mobilisation, fiscal transparency, and anti-corruption. The government committed to expanding the tax base, phasing out exemptions, and digitalising collection.
Recent budgets increased personal tax thresholds and tightened corporate deductions. The 2026 Budget, now in preparation, is expected to push further: fewer sectoral exemptions, higher sin-taxes, and improved enforcement through e-filing and data analytics.
Officials argue that without stable domestic revenue, debt restructuring and social spending cannot hold. But reform fatigue is real. After years of crisis, both consumers and entrepreneurs view new taxes with scepticism, seeing them as punishment rather than progress.
What businesses are experiencing
1. Rising costs and shrinking margins
Manufacturers face higher input costs as VAT exemptions on raw materials narrow. Service firms in tourism and logistics have seen concessionary rates withdrawn. The overall effect: thinner margins and reduced ability to reinvest.
2. SMEs under strain
Small and medium enterprises, which employ over 45 per cent of the workforce, often operate semi-informally. For them, multiple filings income tax, VAT, social-security contribution levy, create disproportionate compliance loads. Many remain outside the formal net entirely, reducing overall productivity and competitiveness.
3. Uncertain incentives
Tax holidays and investment allowances introduced in earlier years are being reviewed. Firms that structured expansion plans around them now face uncertainty. Investors seek policy predictability as much as low rates; abrupt shifts undermine confidence even when headline rates stay unchanged.
4. Competitive disadvantage
Global corporations can absorb compliance through regional hubs. Local businesses cannot. Analysts warn of an emerging “two-tier economy” where multinational subsidiaries enjoy economies of scale while domestic firms shoulder compliance risk.
The fiscal credibility dilemma
Sri Lanka’s debt-service ratio remains above 40 per cent of revenue. This leaves little fiscal room. When revenue falters, the government often resorts to ad-hoc tax changes surcharges, rate revisions, or import duties which distort planning cycles.
Without consistent policy, capital formation slows. Investors delay decisions; banks hesitate to lend. Each episode of uncertainty erodes the credibility that the IMF programme aims to rebuild.
Businesses interpret fiscal unpredictability as currency and inflation risk by another name. Both feed into higher cost of capital, discouraging long-term investment.
Reform priorities
1. Broaden the base
Reducing exemptions can yield more stability than raising rates. For instance, trimming redundant import-duty waivers or revising Board of Investment (BOI) concessions would widen coverage without burdening compliant taxpayers.
2. Simplify compliance
Digital filing and unified tax accounts could cut hours spent on administration. A single portal integrating IRD, Customs, and Labour Department payments would particularly help SMEs.
3. Balance equity
Shifting towards direct taxes improves fairness and signals maturity. As incomes rise and data systems strengthen, broadening personal-income tax coverage can gradually offset dependence on VAT.
4. Strengthen governance
Transparent publication of tax-expenditure statements — detailing what exemptions cost the state — would enhance accountability and public trust. The IRD’s collaboration with the Auditor-General and the newly formed Public Finance Oversight Committee can make enforcement less discretionary.
5. Clarify incentives
Sri Lanka needs targeted, time-bound incentives linked to measurable outcomes: export revenue, technology transfer, or employment. Automatic sunset clauses ensure that concessions do not turn into permanent leakages.
What businesses should do now
- Audit exposure: Map every tax obligation income, VAT, withholding, social contribution — and estimate compliance cost.
- Scenario-plan: Test profitability under potential rate changes (e.g., VAT +2 points or reduced exemptions).
- Revisit structure: Evaluate whether supply-chain or export orientation mitigates risk.
- Engage early: Participate in consultations via chambers or industry associations. Early dialogue influences policy more than post-budget lobbying.
- Invest in digital compliance: E-invoicing, automated accounting, and data-linked filings will soon be mandatory. Early adopters will avoid penalties and audits.
- Treat tax as strategy: Integrate fiscal planning into pricing, cash-flow, and investment decisions instead of relegating it to accounting year-end tasks.
Broader implications for the investment climate
Reform success could reshape Sri Lanka’s perception among investors. A credible, broad-based tax system signals discipline and governance prerequisites for attracting capital.
Conversely, if enforcement remains arbitrary or politically driven, reform will stall. Investors will price in instability, demanding higher returns or bypassing the market.
The IMF has emphasised that fiscal transparency must go hand in hand with anti-corruption. Each revenue gain must be matched by visible spending efficiency. Businesses will back reform only if they see tax rupees translate into infrastructure, energy reliability, and public services that support growth.
Outlook
The coming fiscal year is decisive. The government targets a tax-to-GDP ratio of 15 per cent by 2027, ambitious but achievable if compliance improves and economic growth stabilises around 4–5 per cent.
If managed well, reforms could shift Sri Lanka from crisis-response to credible growth path. That would allow lower borrowing costs, stronger investor confidence, and a fairer tax share between citizens and the state.
For business, the takeaway is clear: policy volatility may persist, but preparation can turn risk into resilience. Firms that integrate fiscal awareness into decision-making will be best positioned to ride the recovery wave.
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