The Government has proposed to reduce Pay As You Earn (PAYE) Tax from next year as part of ongoing efforts to support economic recovery. The proposal, which has received approval from the International Monetary Fund (IMF) and subsequently by the Cabinet of Ministers, is intended to ease the tax burden on middle-income earners while maintaining fiscal responsibility.
The approved amendment of the personal income tax structure proposes tax bands to increase from Rs. 500,000 to Rs. 720,000, while the tax-free threshold of Rs. 1.2 million and existing marginal tax rates would remain unchanged, including the marginal tax rate at each band remaining at 6% and the top rate remaining at 36%.
These changes are expected to be implemented in April 2025 through amendments to the Inland Revenue Act No.24 of 2017.
The focus of the adjustment is on reducing the tax burden for those in the middle-income bracket. For example, a person earning Rs. 150,000 per month would see a 14% decrease in their tax liability, while higher earners would experience less relief.
The estimated revenue impact of these changes is 0.07% of Gross Domestic Product (GDP), which will be offset by compensatory measures such as revenue generated from the anticipated liberalisation of vehicle imports in 2025.
Part of the IMF agreement
Speaking to The Sunday Morning, State Minister of Finance Shehan Semasinghe explained that the recent tax cuts were a result of detailed discussions with the IMF, stating: “The proposed tax cuts were agreed upon under the IMF programme.”
He acknowledged that the changes would lead to a revenue loss of nearly Rs. 24 billion, or approximately 2.4% of total revenue and around 0.07% of GDP. However, he reassured that compensating measures would be ensured without imposing a burden on the people.
“A tax reduction of little over 20% is ensured, especially for those earning between Rs. 200,000 and Rs. 500,000.”
He further noted that the discussions with the IMF had commenced in September 2023, aligning with the country’s Debt Sustainability Analysis (DSA).
“The vehicle import restrictions will be relaxed in October, December, and February, which will also generate additional revenue. This will help offset the loss by generating revenue,” he said.
Semasinghe assured that the entire community paying PAYE and income taxes would benefit, stressing that the tax cuts were part of the broader IMF agreement, with a key focus on maintaining the budget deficit and primary surplus. He added that an IMF review was expected by October to ensure the country remained on track.
Implications of tax adjustments
Offering insight into broader implications of tax adjustments, First Capital Chief Research and Strategy Officer Dimantha Mathew told The Sunday Morning that Sri Lanka was broadly aligned with the target for the year for taxation but underscored that expanding the tax base would be a slow process.
“Expanding the tax base cannot happen fast, as it could take one to two years to fully integrate the necessary systems and identify non-payers. Digitising itself will take time,” Mathew said.
He pointed out that while reducing tax costs may create some room for relief, it would not be sufficient for enacting meaningful tax cuts immediately.
“If interest rates are not sustainable, it won’t be beneficial to create business and economic activity,” he said, stressing the importance of lowering interest rates to foster business confidence and ultimately reduce the budget deficit.
“What will improve investor confidence is the continuation of the IMF agreement and moving forward with external debt restructuring. The continuation of the IMF programme is significant; maintaining it for the next six months to one year before any negotiation and then implementing the conditions planned would be a safe option,” he explained.
Moreover, he highlighted that while tax cuts may improve disposable income and market sentiment in the short term, they could risk spiking long-term interest rates if the budget deficit increased, emphasising the need for careful implementation of these measures.
“Tax cuts can only be implemented properly once income starts improving. I believe it is not possible for any immediate tax cut measures unless there are specific and significant cost-saving areas that can enable fast implementation.
“Tax cuts can have an immediate impact on increasing the budget deficit and it is important to implement these measures with the agreement of the IMF without derailing the programme. Any complications with the IMF could lead to issues with the World Bank and the Asian Development Bank (ADB), all of which are funding part of Sri Lanka’s budget. If there are any complications with one party, it could lead to complications with all parties,” he noted.
Sri Lanka’s PAYE Tax files saw a significant increase from 41,636 in 2019 to 242,679 by 2023. However, the proportion of tax-paying employees was 33% in 2019 but declined to less than 1% in 2021 following the abolition of PAYE Taxes from 1 January 2020.
In 2019, the Inland Revenue Department (IRD) collected Rs. 1,025 billion, but revenue dropped to Rs. 500 billion in 2020. However, by 2023, this figure was raised to Rs. 1,500 billion through a combination of widening the tax base and adjusting tax rates.
Focus on revenue generation
Speaking to The Sunday Morning, University of Colombo (UOC) Department of Economics Professor Priyanga Dunusinghe shared his perspective on the revision of PAYE Taxes, noting that initially in 2023 the threshold level had been lowered while the rates had been increased.
“However, under the current proposals, the threshold has been revised upward from Rs. 100,000 to Rs. 150,000 and the rates have been revised downward marginally.”
He explained that this upward revision was understandable given the high inflation, which had caused a decline in both the purchasing power of the currency and real income. “In that sense, revising this upward is understandable and this should be recognised,” he observed.
Prof. Dunusinghe also highlighted the importance of focusing on generating revenue to offset the loss from lowered tax rates, pointing out that it was important to recover the loss of income through practical revenue-generating sources.
“The tax threshold should gradually increase to between Rs. 200,000-250,000 while also expanding the tax base. Until then, there will be a burden to share, because it is important that the Government earns tax revenue in order to limit additional borrowings.”
Impact on private and public consumption
Further discussing the impact of inflation and lower private consumption, Prof. Dunusinghe said: “Inflation has lowered, but purchasing power has come down as a result of the demand in the market.”
He underscored that private and public consumption levels remained low, leaving little room for investment in the short term. However, he expressed the belief that there would be a gradual recovery in sectors such as small-scale investments, consumer durables, and real estate, provided that interest rates in the market were to come down.
“Currently, people are barely able to cover their monthly expenses, but the tax revision will create some additional income that can go into savings, loan payments, and eventually translate into investments and even recreation,” Prof. Dunusinghe added.
He stated this could also lead to the acceleration of certain economic activities, such as the inland tourism sector. “Recreational travel has slowed due to the tax-related burden, but those sectors will expand,” he noted.
“I don’t believe there will be a significant negative impact on the economy from tax cuts alone, but maintaining the parameters of the IMF agreement and debt restructuring are critical. Sri Lanka must start repayments in 2027, and to do so, we need to achieve at least 5% annual growth. If we don’t get there, it will be difficult,” he stated, adding that some creditors had already filed lawsuits in the US over the debt.