President Anura Kumara Dissanayake’s indication that the Government is considering removing certain taxes through the upcoming budget has brought renewed attention to the question of how much fiscal space Sri Lanka has for further tax relief.
While such measures could ease some of the tax burden on households, they also come at a time when the Government is seeking to maintain revenue collection and meet fiscal and debt obligations under its ongoing economic reform programme.
Recent figures show that tax collection has improved, with the Inland Revenue Department (IRD) stating that around 61% of its Rs. 2,402 billion tax revenue target for 2026 had been collected. The IRD has also said that around 1.2 million individual income tax files have been opened as part of efforts to expand the tax base.
At the same time, Sri Lanka’s economic recovery has continued, although growth has moderated. According to the Department of Census and Statistics, Gross Domestic Product (GDP) grew by 4.2% in the second quarter of 2026, compared to 5% in the corresponding quarter of 2025 and 5.1% in the first quarter of this year. Further, GDP at constant 2015 prices increased to Rs. 3,029.6 billion from Rs. 2,908.6 billion a year earlier.
The quarter was affected by fuel rationing, higher energy costs, and uncertainty stemming from the escalation in the Middle East. Despite the slower pace, the expansion marks a sustained recovery from the sharp economic contraction recorded during the crisis, including the 10.6% contraction recorded in the first quarter of 2023.
The country has also received a more favourable assessment from Fitch Ratings, which upgraded Sri Lanka’s Long-Term Issuer Default Ratings to ‘B-’ from ‘CCC+’ with a Stable Outlook. Fitch cited improvements in fiscal and external balances, revenue mobilisation, and the rebuilding of foreign exchange reserves, while also noting that Sri Lanka’s high Government debt and debt service ratios and relatively modest foreign exchange reserves continued to constrain its credit profile.
Against this backdrop, the question is whether Sri Lanka is fiscally in a position to provide further tax relief without weakening Government revenue at a time when higher collections are still needed, and what such a move could mean for the country’s ability to meet its debt obligations in 2028. More broadly, with growth slowing to 4.2% in the second quarter, how much fiscal room does the economy have for tax cuts and how will the economy look in the years ahead if revenue collection is reduced?
Tax relief and fiscal realities
Speaking to The Sunday Morning, tax expert and KPMG Sri Lanka Principal – Head of Tax and Regulatory Suresh Perera noted that the President’s announcement of tax relief in the upcoming budget must be assessed against Sri Lanka’s fiscal realities and recent history.
He explained that the key issue was not whether tax relief was inherently good or bad, but whether the country could afford the revenue loss without undermining debt sustainability. He added that Sri Lanka must sustain revenue mobilisation, broaden the tax base, rationalise exemptions, and strengthen administration, as emphasised by the International Monetary Fund’s (IMF) September 2026 mission.
“Sri Lanka’s experience with the sweeping tax cuts in 2019 is a cautionary tale. Those measures dismantled the revenue base, slashed Value-Added Tax (VAT), and abolished key taxes, directly precipitating the 2022 default. The lesson is clear: permanent tax reductions without credible replacement revenue are dangerous when the state is fiscally constrained,” he said.
That said, Perera noted that today’s context was different. He pointed out that revenue mobilisation had improved, debt restructuring was largely complete, reserves had risen, and fiscal performance in 2025–’26 exceeded IMF targets, with a primary surplus of 5.4% of GDP.
“This creates some space for targeted relief. But the IMF has been explicit: from 2027 onwards, Sri Lanka must maintain a primary surplus of 2.3% of GDP and any revenue-affecting reforms must be offset by compensatory measures. The impact on Government revenue and debt repayment in 2028 is particularly sensitive. That year marks a ‘debt cliff,’ when external debt service rises sharply as concessionary relief phases out.”
Furthermore, Perera noted that a permanent Rs. 100 billion annual tax reduction would not only erode revenue but also weaken the primary surplus, increase borrowing needs, and undermine investor confidence at the very moment Sri Lanka must re-enter capital markets to cover an estimated $ 3 billion financing gap.
In this context, he noted that tax relief was not automatically inconsistent with the IMF programme. The fund recognises reforms that improve efficiency and fairness. However, he said that broad-based cuts that created a permanent revenue hole would sit uneasily with the programme’s fiscal objectives.
Perera further stated that the safer path was “intelligent tax reform”: lowering distortionary taxes while broadening the base, removing exemptions, improving compliance, and strengthening administration. He added that digital economy taxation, crypto tax, tax reforms to capture indirect offshore share transfers in relation to Sri Lankan business, and anti-avoidance measures were all areas where revenue could be stabilised without overburdening the middle class.
“My overall assessment is that Sri Lanka can afford tax reform, but not another unfunded tax-cutting cycle. The Government must avoid repeating the mistake of 2019. Relief that is targeted, modest, and offset by stronger compliance could ease the burden on households and Small and Medium-sized Enterprises (SMEs) while preserving fiscal stability. But if cuts erode the structural tax-to-GDP ratio, they risk jeopardising debt repayment capacity in 2028 and beyond,” he warned.
Protecting revenue
Meanwhile, speaking to The Sunday Morning, economist Umesh Moramudali said that although Sri Lanka’s tax revenue had increased substantially over the past couple of years, much of the increase had come from vehicle taxation following the lifting of import restrictions.
He explained that this was largely due to pent-up demand, as Sri Lanka had not imported vehicles for around 5–6 years, leaving many people waiting to make purchases. Once import restrictions were lifted, this accumulated demand resulted in a large number of vehicle purchases and, consequently, higher tax revenue.
However, he noted that this source of revenue was unlikely to provide the same gains in 2027 and 2028, as many of those who had been waiting to purchase vehicles had already done so.
“Moreover, Sri Lanka imposed an additional surcharge imposed on vehicle imports. Some have pre-ordered vehicles before the surcharge while others have placed orders with the surcharge in place. This has also contributed to increased revenue from vehicle imports. However, again, this surcharge is not expected to be permanent and its removal would further reduce vehicle-related tax revenue in 2027 and 2028,” he said.
In light of this revenue outlook, he stated that Sri Lanka could not afford a substantial loss of revenue, especially given the country’s primary balance target of 2.3%. While the IMF has adjusted the target slightly for this year in recognition of the global shock, Moramudali said it would return to 2.3% in 2027. He added that maintaining this target required Government revenue to stay above 15% of GDP.
“If significant tax relief is provided, then further tax reduction will notably affect revenue. Thus, we cannot allow the revenue-to-GDP ratio to fall below 15%. That is why we have to maintain each revenue avenue and product,” he said.
Viability of tax relief
On whether tax relief measures would align with the IMF programme, Moramudali noted that the programme required Sri Lanka to meet targets relating to Government revenue and the primary surplus, which would become difficult if tax revenue were substantially reduced.
He said the Government would therefore need to introduce any tax deductions in a way that did not result in an overall decline in tax revenue. In particular, he urged against substantial reductions in income taxes, as reversing such reductions later could prove difficult.
Rather than providing significant tax relief through broad income tax cuts, he suggested adjusting income tax slabs each year to account for inflation and changes in the economy. This, he said, could provide some tax relief to those earning fixed salaries without affecting the country’s overall revenue target.
Moramudali added that he was opposed to reducing VAT, arguing that the tax was relatively easy to collect and brought businesses across the value chain into the tax net. He noted that VAT was paid at different stages of production and distribution based on the value added at each stage, which helped keep the entire chain within the tax system, adding that VAT had a good design and could bring a large number of businesses into the tax net.
He also noted that reducing VAT by around 3–5% would not lead to a substantial reduction in the prices of essential goods, while it would result in a significant reduction in Government revenue.
“Reducing VAT marginally is not a solution to the high level of prices. To bring down high prices, especially of essential items, the focus should instead be on reducing or completely eliminating the Special Commodity Levy imposed on items like dhal, onions, potatoes, rice, etc.,” he said.
On income tax changes affecting professionals, he said such measures should also be considered carefully rather than through significant tax relief. He emphasised that the Government should instead focus on expanding the tax net.
Moramudali acknowledged that several regulations and measures had been introduced by both the incumbent and previous governments, especially through amendments to the Inland Revenue Act. However, he said the main obstacle was the capacity of the IRD to implement these measures and expand the tax net.
“Currently, the laws are in place, but simply introducing laws will not resolve the issues. What is needed is the capacity to expand the tax net. That’s where the obstacle lies,” he said.
He added that the issue required more attention, warning that tax revenue could stagnate without improvements to IRD capacity.