President Anura Kumara Dissanayake announced in his Budget 2026 speech that the Government would reduce the Value-Added Tax (VAT) threshold from Rs. 60 million to Rs. 36 million. There are claims that this move, which would largely affect Small and Medium-sized Enterprises (SMEs), will lead to an inflationary impact because of its cost implications. 

First, let us understand the objective behind reducing the VAT threshold to Rs. 36 million per annum. The Government announced prior to the Budget that it would take measures to “widen the tax net,” which means making more people and businesses liable to pay and file their taxes. This is a commendable move. 

After the disastrous tax cuts of 2019, which saw the VAT threshold increase from Rs. 12 million per annum to Rs. 300 million per annum – a 25-fold increase – the number of VAT-registered taxpayers fell from approximately 29,151 to 8,391 – a 71% reduction. 

In October 2022, a few months after Sri Lanka’s first sovereign default, the VAT threshold was once again brought down, this time to Rs. 80 million per annum. The number of VAT-registered taxpayers increased to 14,128 in 2023.

Many tax experts note that the relatively generous threshold of Rs. 60 million encourages businesses to engage in tax avoidance strategies like splitting their operations into multiple entities, keeping each individual entity under the threshold. 

Tax avoidance is technically not illegal; it is when taxpayers use legal loopholes to reduce their tax liabilities. Therefore, reducing the VAT threshold to Rs. 36 million means more are liable and it also becomes harder to avoid, effectively widening the tax net.

What will be the impact on prices and inflation? 

It is important to understand the difference between the price level and inflation. Price level refers to the average cost of all goods and services in an economy at a given time, while inflation is the rate at which this price level changes over time. 

The change in the price level from one point in time to another is called the inflation rate. The price level and inflation capture many different types of goods and services, from many different sectors.

A higher inflation rate means the price level is increasing faster. A lower inflation rate means the price level is increasing but at a slow pace. A negative inflation rate means the price level is decreasing. 

Let us take a look at the effect that the previous VAT threshold reductions have had on prices and inflation. The Colombo Consumer Price Index (CCPI) and the National Consumer Price Index (NCPI) track the prices of a basket of selected goods on a monthly basis. 

These were the VAT threshold changes that occurred from 2022 onwards:

• Mid-December 2022: the threshold was reduced from Rs. 300 million to Rs. 80 million per annum on 1 October 2022. However, it was implemented only after 14 December 2022 when it was passed in Parliament.
• 1 January 2024: the threshold was reduced from Rs. 80 million to Rs. 60 million per annum.

As we can observe from the data in Figure 1, the VAT threshold reductions in both mid-December 2022 and January 2024 did not contribute to an acceleration in the inflation rate (month-to-month inflation) nor did it have a significant impact on the general price level (price index). There is a slight peak in the month-to-month inflation rates in January 2024, but this is negated with negative inflation in subsequent periods.

This is further supported by an International Monetary Fund (IMF) study on the impact of VAT on prices. The study is based on observations from 35 countries for two years. It finds that in 63% of the instances (22 countries), VAT had little to no effect at all on prices or inflation. 

The Ceylon Federation of Micro, Small, and Medium-sized Enterprises (MSMEs) has criticised the proposal to reduce VAT thresholds, claiming that it would “push more small retailers into the tax net and pass an 18% VAT burden on to the end consumers,” as reported in a leading daily newspaper. 

In another report in a leading Sunday newspaper, a senior Inland Revenue Department official is quoted as saying “although the traders are not expected to pass on the tax to the consumers, it is inevitable”. 

A report on a local business news website states: “Newly liable distributors and suppliers will see tighter margins and possible retail price increases. Consumer purchasing power may face renewed pressure in early 2026.” Some SME sectors and associations are already calling for exemptions and concessions.

This implies that the VAT threshold reduction could likely have an impact on price levels. But fears of an inflationary effect – which is an increase in the rate of inflation – may be unfounded. 

An unfounded claim

The increase in costs resulting from the VAT threshold reduction can either be passed onto consumers or be absorbed into the business’s profit margins. 

In case many businesses decide to pass this onto consumers, there will be a one-off increase in the price levels. In that case, we will observe a spike in month-to-month and year-to-year inflation when the change takes effect. If many businesses decide not to pass this onto consumers, then there will be no impact on price levels.

There are several reasons why small businesses may decide not to pass on the cost effect of the 18% VAT to consumers. We must also consider the environment in which these new VAT-liable taxpayers, which are small businesses, are setting prices. 

If we take, for instance, small retail shops selling grocery items, they are more likely to set prices in line with the big supermarkets. 

• Big supermarkets are already VAT liable on account of being above the threshold, so their prices already reflect the VAT component. 
• Small retail shops then are already selling their goods at the prices which reflect VAT, allowing them a sufficient buffer to absorb the VAT cost. 
• On the other hand, if they are already selling at supermarket prices, they may not wish to raise prices even further for fears of losing market share.
• Prices are dynamic, and if retailers are unhappy with the impact the price increase has on demand, they can reduce the prices subsequently. 

There are also many other factors that influence price levels and inflation, beyond tax rates. In recent times, Sri Lanka has been in a deflationary situation due to reductions in fuel and electricity tariffs, which are major cost drivers. So while the tax liability may kick in, there might be relief from other ends which allow businesses to balance things off.

Therefore, all in all, the claim of an inflationary impact is unfounded as evidenced by both Sri Lanka as well as other countries. As prices are dynamic and businesses are not a monolith, they may react differently to the cost implications of the VAT threshold reduction; some may absorb the cost, some may pass it on. The net effect, however, on prices and inflation are likely to be marginal. 

(The writer is the Co-Founder and Director – Civic Education of Arutha. Arutha is an economic research and civic education organisation with an interest in public finance)

(The views and opinions expressed in this article are those of the writer and do not necessarily reflect the official position of this publication)

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