By Visvalingam Muralithas –

Visvalingam Muralithas

An economy is primarily guided by two key policy instruments: monetary policy and fiscal policy. Monetary policy regulates the money supply, interest rates, and inflation, while fiscal policy focuses on government revenue, public expenditure, and overall budgetary management.

Economic Stabilization Post-Crisis

Sri Lanka’s economy began to stabilize in mid-2023 following its most severe post-independence economic crisis. The collapse was driven by years of macroeconomic mismanagement, structural weaknesses, and external shocks—culminating in a sovereign default and near depletion of foreign reserves in 2022.

Between 2021 and 2022, poverty surged by 10 percentage points due to plunging real incomes, job losses, and high inflation. However, economic reforms under the IMF Extended Fund Facility (EFF) helped mitigate further deterioration, limiting the cumulative GDP contraction to 9.5% between 2021 and 2023.

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Key macroeconomic improvements followed

* Headline inflation fell dramatically from 69.8% (Sep 2022) to 4.0% (Dec 2023).

* Usable reserves rose from 0.3 months to 2.1 months of imports by end-2023.

* Public and publicly guaranteed (PPG) debt dropped from 119.2% to 111.7% of GDP over the same period.

By May 2025, disinflation was still easing. Headline deflation slowed to 0.7% (Y-o-Y), while food inflation surged to 5.2%, offsetting continued non-food deflation at 3.3%. The CCPI rose 0.82% month-on-month, driven mostly by food prices. Core inflation rose from 0.8% in April to 1.2% in May, signaling early signs of underlying price pressures. Inflation is expected to turn positive by early Q3 2025, converging toward the Central Bank’s 5% target.

Revenue and Expenditure Trends: Persistent Fiscal Imbalances

* Revenue and Grants (% of GDP) fell from over 17% (2000–2007) to around 12% (2010–2018), plunging to 8.0–8.8% during 2020–2022. A rebound was observed in 2023 (11.2%) and 2024 (13.5%), thanks to improved tax efforts and donor support.

* Recurrent Expenditure remained structurally high—17–21% of GDP in the early 2000s, reduced to 12–14% by 2018, but surged again to 16–18% in 2023–2024 due to rising public sector wages, subsidies, and interest payments.

* Capital Investment witnessed a steep decline, dropping from 6–7% of GDP in the early 2000s to just 2.7% by 2024, signaling a worrisome cutback in infrastructure and development spending.

Despite some revenue recovery, the dominance of recurrent expenses and declining capital budgets illustrate a structurally weak fiscal composition, hampering long-term economic resilience.

Budget Deficit and Debt

* The budget deficit narrowed steadily from 10.4% of GDP in 2001 to 5% by 2018. It then surged to 11.7% in 2021, easing to 6.8% in 2024, reflecting ongoing fiscal stress.

* Government debt declined from 105.6% of GDP in 2002 to around 67–70% in 2010–2014, but rose again to 96.6% (2020), 100% (2021), and peaked at 114.2% (2022). A decline to 96.1% in 2024 followed debt restructuring efforts. Post-April 2022 debt figures exclude unpaid obligations due to the default, likely underestimating the actual debt burden.

Fiscal Policy Challenges

1. Structural Imbalance: Revenue recovery lags behind the rise in recurrent expenditure, while capital spending has been disproportionately cut—limiting growth potential.

2. Crisis-Driven Deficits: Though higher deficits were necessary for crisis response, they remain elevated post-crisis, indicating weak fiscal consolidation.

3. Debt Vulnerability: Rapid debt accumulation and default have constrained fiscal flexibility, with off-balance-sheet obligations still looming large.

Policy Recommendations

Enhance Revenue Mobilization

* Broaden the tax base

* Improve compliance mechanisms

* Reintroduce state-owned enterprise (SOE)

Control Recurrent Spending

* Rationalize public wages and subsidies

* Lower debt service via liability management

Revive Capital Investment

* Restore public investment to at least 4–5% of GDP to support growth and infrastructure

Gradual Deficit Reduction

* Target a fiscal deficit below 4% of GDP through a phased approach

Ensure Debt Sustainability

* Aim to reduce debt to below 80% of GDP in the medium term, supported by growth and fiscal discipline

Conclusion

Sri Lanka’s fiscal policy in 2025 reflects a country striving to rebuild after crisis. The government has made progress in revenue collection and macroeconomic stabilization, but challenges remain in managing rising recurrent costs and reviving investment. Sustainable recovery will require difficult but necessary reforms—including enhancing revenue, improving fiscal discipline, and ensuring debt sustainability—while supporting the fragile economic rebound.

* Visvalingam Muralithas is a researcher in the legislative sector, specializing in policy analysis and economic research. He is currently pursuing a PhD in Economics at the University of Colombo, with a research focus on governance, development, and sustainable growth.