Sri Lanka is facing significant challenges in managing its fiscal space amid ongoing debates over tax exemptions and reforms ahead of the upcoming budget. President Aruna Kumara Disanayake indicated that the government is considering removing certain tax exemptions to stabilize revenue collections, though concerns remain about the overall capacity for further tax relief.
The country’s tax revenue target for 2023 was set at Rs 3,074 billion; however, the Inland Revenue Department (IRD) reported collections of only Rs 2,091 billion, reflecting a substantial shortfall of nearly 34%. Experts attribute this gap to a combination of tax relief programs and exemptions extended to various economic sectors, which have strained government finances during a period of high public debt and fiscal deficits.
Economic indicators in the third quarter of 2023 highlight the challenges. Gross Domestic Product (GDP) grew by 3.6%, down from 5% in the same quarter of 2021 and 5.7% previously, suggesting a slowing economy. When adjusted for inflation, real GDP growth is estimated at less than 1.6%. Inflation remains elevated, contributing to an output deficit and a balance of payments crisis. Rising interest rates and increased borrowing costs further complicate fiscal management.
Officials note that despite the economic pressures, recent tax increases, including an additional Rs 1.8 billion related to certain non-essential goods and fuel products, have yielded only marginal revenue gains. Fuel, liquefied gas, and industrial sectors remain key targets for taxation, with some relief measures aimed at sustaining small and medium enterprises (SMEs) in these industries. Value Added Tax (VAT) and sales tax on higher income brackets account for a significant portion of revenue, although a VAT gap persists due to exemptions and evasion.
Finance officials acknowledge the need for a balanced approach to tax policy, emphasizing the importance of protecting revenue streams while avoiding further exacerbation of the economic downturn. Measures under consideration include rationalizing tax exemptions, improving collection efficiency, and implementing broader reforms such as capital income tax adjustments.
Concerns have been raised regarding the impact of tax reliefs on revenue sustainability, with some analysts warning that continued exemptions could worsen fiscal deficits. Conversely, proponents argue that targeted reliefs are necessary to support economic recovery and protect vulnerable households from escalating costs, particularly in the energy sector where global commodity prices remain volatile.
The government is also grappling with the challenge of increasing tax compliance and addressing gaps in the tax system. Experts highlight the need for coordinated efforts to enhance productivity, strengthen regulatory frameworks, and improve business confidence. The fiscal outlook depends heavily on the government's ability to balance tax policy with efforts to spur growth and maintain financial stability amid external pressures.
As the budget preparation progresses, Sri Lanka faces critical decisions on how to manage its tax base effectively without further undermining economic recovery or fiscal health. Officials emphasize that any reforms will need to be carefully calibrated to support both revenue generation and the broader economic objectives for 2024 and beyond.