By Piyadasa Edirisuriya –

President Anura Kumara Dissanayake recently announced that the government expects to provide tax relief and introduction of certain tax exemptions in the upcoming budget. As Sri Lanka moves towards the 2027 Budget, the question of taxation is likely to become one of the most important economic policy issues facing the country. After the severe fiscal and balance-of-payments crisis of 2022, the Government has undertaken a substantial programme of fiscal consolidation. Tax revenue has increased, the primary balance has moved into surplus, and the country’s debt trajectory has begun to improve. But this recovery has also imposed a considerable burden on households and businesses. Therefore, the central question for the 2027 Budget is therefore not simply whether taxes can be reduced. It is whether Sri Lanka can provide meaningful tax relief without reversing the fiscal consolidation that has been achieved since the crisis. The answer is potentially yes—but only if tax reduction is accompanied by a fundamental improvement in the efficiency of tax collection.

The fiscal constraint

Sri Lanka enters the 2027 Budget process with a clear fiscal commitment under the International Monetary Fund programme. The latest IMF projections put real GDP growth at 3.2 per cent in 2027 and nominal GDP growth at 8.5 per cent. Government revenue and grants are projected at 15.1 per cent of GDP, while expenditure is projected at 18.7 per cent. The primary surplus target is 2.3 per cent of GDP, and the central government deficit is projected at 3.7 per cent of GDP. Public debt is projected at 96.9 per cent of GDP.

These numbers illustrate the fundamental constraint. Sri Lanka still has a high public-debt burden and substantial financing requirements. The IMF has therefore stressed that sustained revenue mobilisation remains essential and that fiscal overperformance should be used to reduce debt. A tax cut financed through additional borrowing would consequently be difficult to justify. A revenue-neutral tax reform, however, is a different proposition.

A possible alternative tax package

One possible approach would be to provide approximately Rs.135 billion of targeted tax relief in 2027, equivalent to roughly 0.35 per cent of projected GDP.

The package could consist of four principal elements:

Proposed measure	Indicative annual cost
Personal income-tax reform	Rs.58 billion
Targeted VAT relief	Rs.39 billion
SME and productive-investment incentives	Rs.19 billion
Reduction of selected taxes on productive inputs	Rs.19 billion
Total	Rs.135 billion

These are only illustrative policy estimates and not official Treasury costings. A final Budget proposal would require detailed taxpayer, consumption and business data. Nevertheless, the numbers provide a useful framework for considering what a fiscally responsible tax reduction might look like.

Personal income tax: relief where the burden is greatest

Personal income tax is one of the areas where targeted relief could have a direct effect on household disposable income. Under the current rules, the personal relief is Rs.1.8 million from the 2025/26 year of assessment. The progressive rates are 6 per cent on the first Rs.1 million of taxable income, followed by 18, 24 and 30 per cent bands, with a 36 per cent rate applying to the balance. A possible 2027 reform could increase the personal relief to Rs.2.1 million and adjust the lower bands as follows:

Taxable-income band	Current rate	Illustrative 2027 rate
First Rs.1 million	6%	4%
Next Rs.500,000	18%	12%
Next Rs.500,000	24%	20%
Next Rs.500,000	30%	28%
Balance	36%	36%

The maximum marginal rate would therefore remain unchanged. The policy objective would be to provide relief principally to lower- and middle-income taxpayers rather than providing a large tax reduction to those at the top of the income distribution. The estimated cost could be around Rs.58 billion. For example, subject to individual circumstances and other allowable deductions, an employee earning Rs.300,000 a month could potentially receive a substantial reduction in annual income tax under such a structure. The precise household impact, however, would depend on the individual’s taxable income rather than gross salary alone.

VAT: resist the temptation of a general rate cut

The case for reducing VAT requires greater caution. The standard VAT rate is currently 18 per cent. A reduction in the standard rate would be highly visible and politically attractive, but it would also be expensive. The better option may be to retain the 18 per cent standard rate while providing targeted VAT relief on carefully selected essential goods. An indicative allocation of Rs.39 billion could be established for this purpose. This approach has two advantages. First, it limits the fiscal cost. Second, it directs the benefit towards household expenditure that is more difficult to avoid, rather than providing an identical tax reduction on luxury consumption. However, the Government should recognise that a reduction in VAT does not automatically translate into an equivalent reduction in retail prices. The extent of the benefit depends on how much of the tax reduction is passed through by producers, importers, wholesalers and retailers. The Budget should therefore include a mechanism for monitoring price transmission.

Tax relief for investment rather than simply for profits

A second major element should be business taxation. The objective should not necessarily be to reduce the general corporate tax rate. A blanket reduction could increase after-tax profits without necessarily generating additional investment. A more targeted approach would link tax concessions to new productive investment. Qualifying small and medium-sized enterprises could receive a reduced tax rate—for example, 28 per cent instead of 30 per cent—on qualifying investment-related income, subject to clearly defined conditions.

Eligibility could depend on:

• new capital investment;
• employment creation;
• export expansion;
• technological upgrading;
• research and development;
• energy efficiency.

An indicative fiscal cost of Rs.19 billion could be established. Such a policy would make the tax concession conditional on an economic outcome rather than simply on ownership of a business.

Reduce the tax burden on production

Sri Lanka’s tax structure also needs to distinguish between taxes on production and taxes on consumption.

Taxes on machinery, raw materials and intermediate inputs can raise the cost of domestic production and reduce international competitiveness. Sri Lanka has already begun moving away from para-tariffs. The IMF has noted the reform of CESS and related measures and has stressed the need for compensatory revenue measures as para-tariffs are phased out. The 2027 Budget could therefore provide approximately Rs.19 billion in further targeted relief on:

• industrial machinery;
• agricultural equipment;
• export-related inputs;
• raw materials not adequately produced domestically;
• technology and productivity-enhancing equipment.

Luxury and non-essential consumption imports would not receive the same treatment. The objective should be clear: make it cheaper to produce in Sri Lanka, not simply cheaper to consume imported goods.

The difficult question: who finances the tax cuts?

This is where the credibility of the proposal will ultimately be tested. A Government cannot responsibly announce Rs.135 billion of tax relief without explaining where the replacement revenue will come from. A possible compensating package could seek approximately Rs.145 billion through improved tax administration and enforcement:

Revenue measure	Indicative additional revenue
Improved VAT compliance	Rs.39 billion
Recovery of tax arrears	Rs.29 billion
Rationalisation of tax exemptions	Rs.29 billion
Improved customs administration	Rs.19 billion
Higher-income taxpayer compliance	Rs.19 billion
Other tax-expenditure reforms	Rs.10 billion
Total	Rs.145 billion

This is the part of the proposal that requires the greatest caution. These figures should be treated as targets, not guaranteed revenue.

Better tax collection could create the room for tax reduction

Sri Lanka’s tax problem has never been solely a question of tax rates. It is also a question of the size and efficiency of the tax base. The IMF reports that Sri Lanka is strengthening VAT compliance, cleaning and validating the taxpayer registry, modernising the Inland Revenue Department’s systems and implementing risk-based audits, including a programme focused on high-wealth individuals. These reforms provide an opportunity to change the nature of the tax debate. Instead of continually increasing rates on taxpayers who already comply, the Government could seek to improve compliance across the economy. If the tax administration can collect a greater proportion of the revenue already legally due, there may be room to reduce selected tax rates without reducing the Government’s overall revenue capacity. That is the essence of a sustainable tax reform.

The debt question cannot be ignored

Sri Lanka’s debt burden remains the principal reason why tax reductions must be approached cautiously. The IMF projects public debt at 96.9 per cent of GDP in 2027, down from 100.1 per cent in 2026. Central government debt is projected at 93.5 per cent of GDP. These figures show that the direction of travel is improving, but the debt burden remains exceptionally high. An unfunded Rs.135 billion tax reduction would increase the Government’s financing requirement by approximately 0.35 per cent of GDP. On a purely mechanical basis, this could weaken the fiscal balance by a similar amount. The alternative proposed here is different. If Rs.135 billion of tax relief is accompanied by Rs.145 billion of additional revenue, the Government would have a net fiscal improvement of approximately Rs.10 billion. The resulting fiscal position would therefore be broadly unchanged or marginally stronger, assuming the revenue measures actually deliver.

A tax-relief mechanism with safeguards

There is, however, a danger in relying on projected compliance gains. Revenue collection may fall short of expectations. Economic growth may be weaker than projected. Imports may decline. Tax arrears may prove difficult to recover. The Budget should therefore incorporate a revenue-performance mechanism. For example, the Government could establish quarterly monitoring of the additional revenue expected from compliance and administrative reforms. If the realised revenue falls materially below the target, tax concessions scheduled for later in the year could be deferred. If revenue exceeds expectations, the additional resources could be directed towards debt reduction. This would protect the credibility of the fiscal framework.

What would the alternative Budget achieve?

The proposed structure would alter the composition of taxation rather than simply reducing taxation across the board.

Lower taxation would be concentrated on:

• lower- and middle-income earners;
• selected essential goods;
• productive investment;
• machinery and intermediate inputs.

Additional revenue would come principally from:

• improved VAT compliance;
• recovery of tax arrears;
• better customs administration;
• review of tax exemptions;
• improved compliance among high-income taxpayers.

The approach is consistent with the broader direction of Sri Lanka’s current revenue reform agenda, which places emphasis on improving tax efficiency, broadening the tax base and strengthening administration.

The economic dividend

The case for carefully designed tax relief goes beyond immediate household savings. Lower personal taxes can increase disposable income. Lower taxes on productive investment can improve the return on capital. Lower taxes on intermediate inputs can reduce production costs. If these measures increase economic activity, the resulting expansion of the tax base could generate additional revenue over time. However, such second-round effects should not be used to balance the 2027 Budget on paper. The prudent approach is to count only revenue that can reasonably be demonstrated through tax administration and other identifiable measures. Any additional revenue generated by stronger economic growth should be treated as an upside rather than as a certainty.

The choice before the 2027 Budget

Sri Lanka therefore faces a more nuanced choice than simply “tax cuts versus fiscal discipline”. The real question is whether the country can move from a system that relies heavily on increasing the tax burden on existing taxpayers towards one that collects taxes more efficiently, broadens the tax base and reduces taxes that unnecessarily constrain household purchasing power and productive investment. A carefully constructed package of approximately Rs.135 billion in targeted tax relief, accompanied by approximately Rs.145 billion in credible revenue-enhancing measures, provides one possible model. It would not solve Sri Lanka’s fiscal problems. Nor would it eliminate the need for expenditure discipline, public-sector reform, better state-owned enterprise management or continued debt management. But it could demonstrate that fiscal consolidation and tax reform need not be mutually exclusive.

The central principle should be simple:

Sri Lanka should not borrow to finance tax cuts. It should create the fiscal space for tax cuts by collecting existing taxes more effectively, eliminating inefficient concessions and encouraging investment and economic growth. For a country still carrying a public debt burden close to the size of annual national output, that distinction is fundamental. The success of the 2027 Budget should therefore not be judged simply by whether taxes go up or down. It should be judged by whether Sri Lanka collects revenue more fairly and efficiently, provides targeted relief where it is economically justified, protects essential public services, and continues to reduce its debt burden. That would make tax reform—not merely tax reduction—the defining economic issue of the 2027 Budget.

Data sources:

https://www.imf.org/ 

https://www.cbsl.gov.lk/

https://www.treasury.gov.lk/

*Author is a former academic at Monash Business School in Australia and previously worked at the Ministry of Finance in Colombo.