Sri Lanka: Selected Issues and Statistical Appendix

This Selected Issues paper on Sri Lanka reviews several issues that highlight both Sri Lanka’s accomplishments and their policy constraints amidst a protracted period of civil conflict and political instability. High intermediation costs have held back development of the financial sector and could also frustrate Sri Lanka’s quest for higher growth. The main constraints to achieving higher growth include the civil conflict, political instability, high fiscal deficits and inflation, and underdeveloped financial markets.


This Selected Issues paper on Sri Lanka reviews several issues that highlight both Sri Lanka’s accomplishments and their policy constraints amidst a protracted period of civil conflict and political instability. High intermediation costs have held back development of the financial sector and could also frustrate Sri Lanka’s quest for higher growth. The main constraints to achieving higher growth include the civil conflict, political instability, high fiscal deficits and inflation, and underdeveloped financial markets.

II. Tax Policy Reform: Macroeconomic and Microeconomic Considerations1

1. The key medium-term macroeconomic priority in Sri Lanka is revenue enhancement. This is particularly important due to high government debt levels and the large expenditure requirements for poverty reduction. The authorities’ medium-term objectives rely on ambitious revenue projections that are unlikely to be realized purely through gains in revenue administration. This chapter reviews the tax policy options and challenges facing the authorities in both the short and medium term. The first section considers trends in the level and composition of revenue in Sri Lanka relative to a set of international comparators. Based on this analysis, it then considers key areas from a more microeconomic perspective, identifying the advantages and disadvantages of current and potential future policy measures to increase tax yield.

A. The Level and Composition of Revenue

2. Despite large and continuing expenditure pressures, revenue yield has been declining in recent years. Overall central government revenue has fallen from 19 percent of GDP in 1996 to 15.3 percent in 2004 (Table II.1). Falls in revenue from trade taxes associated with trade policy reforms have not been compensated by increasing yield from other tax sources. On the contrary, all other sources have also fallen as a share of GDP. Nontax revenue has varied, with 2004 a particularly poor year.

Table II.1.

Revenue Performance 1996¬2004

article image
Sources: Sri Lankan authorities; and Fund staff estimates.

3. A lack of buoyancy of tax revenues is a common problem in developing economies.

Keen and Simone (2004) show that the pattern of revenue performance in these countries over the 1990s has been one of stagnation or slight decline. While declining trade taxes have often been compensated for by increases in taxes on domestic consumption, corporate income tax yields have generally declined. Nevertheless, as they note, the rate of decline in Sri Lanka is striking—a decline of over 5 percent of GDP in total revenue compared to the average for lower-middle income countries of a 0.3 percent of GDP decline. This reflects both underlying poor elasticity of revenues to income, due in part to poor administration and widespread tax evasion, and the effect of discretionary tax measures that exempt from taxation the companies, industries or sectors that are driving economic growth.

4. Revenue performance in Sri Lanka compares poorly against its peers and competitors. Figure II.1 shows Sri Lanka’s revenue collection against key emerging and low-income economies, with a particular focus on its Asian peers. Care is required when interpreting such international comparisons. In particular, one needs to take into account the particular structure of the economies in question. Unlike some of the countries in the sample, Sri Lanka is a relatively small, open economy with few captive sources of revenue that generate high rents—such as oil or minerals. Some of the countries in the charts below include revenues collected at lower levels of government, whereas Sri Lanka does not, however, these were only 0.7 percent of GDP in 2004 and so do not change the picture markedly.

Figure II.1.
Figure II.1.

Revenue Indicators in Selected Emerging and Low-Income Economies

Citation: IMF Staff Country Reports 2005, 337; 10.5089/9781451972542.002.A002

5. Sri Lanka’s overall revenue yield remains comparatively low compared with an average of 19 percent of GDP in Asian emerging markets. Sri Lanka’s overall revenue performance is better than its low-income neighbors in South and East Asia with Cambodia, Bangladesh and Nepal all having current yields more than 3 percentage points of GDP below current Sri Lankan performance. However, when compared with its middle-income and emerging market peers within and beyond the region, only the Philippines performs worse with a yield of only 14.5 percent.

6. Sri Lanka’s central government revenue is unusually dependant on taxes on domestic goods and services. These taxes account for over 60 percent of central government revenue as compared to only 25 percent in the ASEAN countries. At almost 10 percent of GDP, the taxation of this sector is at levels comparable to OECD countries. In contrast, taxes on income and profits remain very low by international standards. Although low yields from these sources are to be expected in low-income countries, Sri Lanka’s level is still extremely low. The average in low and lower-middle income countries in the early 2000s was around 4 percent of GDP compared to Sri Lanka’s 2–2.5 percent. Sri Lanka’s decline in corporate income tax is consistent with experience across developing countries, who saw revenues from this source decline by about 20 percent from the early 1990s to the early 2000s as a result of reduction both in rates (to induce supply side effects) and bases (to improve investment incentives) (Keen and Simone).

B. Revenue Policy Reform


7. The key principle behind revenue policy should be to place the lowest rate on the broadest base so as to minimize distortionary effects. It should also be efficient, yielding maximum revenue for the minimum cost. Although progress has been made in streamlining the tax structure through the introduction of the VAT and some rationalization of the grounds for granting tax holidays and exemptions, the Sri Lankan tax base remains extremely narrow. This reflects weak administration and a widespread network of exemptions and preferences.2 All of these issues need to be addressed to improve revenue performance.

8. This chapter focuses on the priority areas of VAT and direct taxes. As the VAT

underpins revenue collection in Sri Lanka, it is crucial to ensure it is operating at maximum efficiency. Tax yields from personal and corporate income are particularly low by international standards, which suggest efforts should be made to increase the yield from them—taking note of the fact that these taxes can introduce some of the most severe distortionary and competitive effects.

The Value Added Tax (VAT)

9. The VAT is an important source of revenue in Sri Lanka. It was established

in 2002 by merging the previous Goods and Services Tax (GST) and the National Security Levy (NSL; a simple broad based sales tax with very few exemptions). The intention on establishment was revenue neutrality. However, this has not occurred, in part because it inherited the widespread exemptions of the GST rather than the broad base of the NSL. Additionally, given these exemptions, the rate was set too low for revenue neutrality, particularly given the more sophisticated administration required for the VAT. Nevertheless, the efficiency of Sri Lanka’s VAT is in line with the regional average in Asia and Eastern and Central Europe (Table II.2). Its coverage, however, remains partial with many specific exemptions causing cascading effects. In particular, wholesale and retail trade remains outside of the VAT net and are taxed on the basis of turnover by the provincial governments.

Table II.2.

VAT Rates, Revenue and Efficiency

article image
Sources: Internal IMF note based on data from Government Finance Statistics (IMF); International Financial Statistics (IMF); World Economic Outlook (IMF); Taxes and Investment in Asia and the Pacific (IBFD); and Corporate Taxes 2003–2004, Worldwide Summaries (PricewaterhouseCoopers).

May include some revenue from other general sales taxes.

Efficiency ratio = Total VAT revenue as a percentage of GDP divided by the standard VAT rates.

10. The VAT is a crucial component of a modern tax system. It is less distortionary than most taxes and can play an important role in tax enforcement by creating a paper trail that facilitates audit. Introducing and enforcing a well-designed VAT can therefore serve as a basis for increasing other revenue sources in the medium term. The key principle underlying a VAT is that it is a broad based tax levied at multiple stages of production with taxes on inputs credited against taxes on outputs a crucial part of the process. Best practice suggests that a single positive rate (with only exports zero-rated) should be adopted and exemptions should be used sparingly, ideally only in areas where the output is hard to observe or administer (e.g., small firms).

11. Recent VAT policy reforms depart from these principles. Many of these reforms were revenue enhancing in the short term but undermined the cleanliness of the VAT, adversely affected economic incentives, and complicated administration. The main measures were:

  • Introducing a lower rate of 5 percent for essential goods (but abolishing refunds under this rate) and a higher rate of 18 percent for luxury goods.

  • Introducing further exemptions for agricultural products and imported capital goods. In some cases, in particular the agricultural export sectors, these measures were revenue enhancing as exemption removes the right to claim refunds for inputs.

  • Imposing a 5 percent surcharge on the valuation of imported goods for VAT purposes.

12. The VAT is the most efficient vehicle for delivering short-term revenue gains.

Policy measures can either increase the rate or widen the base, either through including previously exempted sectors or through better administration of existing sectors. In the short term, the latter route is unlikely to lead to large revenue yields.

13. Raising the average VAT rate would provide immediate revenue gains, particularly given its relatively good productivity. The current headline rate of 15 percent is about average by international standards. The Asian average is 11 percent while the average in Eastern and Central European countries (and the OECD) is around 20 percent. These averages, however, are affected by countries that can afford lower rates because of significant other revenue sources, such as mineral revenue. International evidence is clear that increases in rates generally translate into higher revenues even if these gains may not be fully proportional to the rate rise. A rise in the average rate could be achieved in a number of ways but would ideally involve unifying the VAT rate, probably at the 18 percent rate. Alternatively, abolishing (or increasing) the 5 percent rate or moving more items to the 18 percent rate would have a similar effect but would produce a less attractive tax structure.

14. Broadening the base should, however, be the key priority. A broader base would enable a lower rate to be charged. This should have two features: including major sectors that are not currently covered—wholesale and retail trade—and removing the patchwork of specific exemptions. The authorities have estimated that the effect of the specific exemptions (not including the costs of excluding the wholesale and retail sectors from the base) could be on the order of 1 percent of GDP a year. Extending the VAT to wholesale and retail trade would produce some offsetting effect on general government revenue as the provincial governments would lose their main revenue source, and this would have to be compensated for by an increase in central government transfers. A high threshold for VAT qualification should be retained to address concerns for the small business sector without favoring any particular industry.

Personal Income Taxes

15. Personal income tax yields tend to be low in developing economies. This reflects low formal sector participation and administrative priorities—setting a high threshold to minimize administrative burdens and disincentives to work. Nevertheless, Sri Lanka’s income tax yield is low even by the standards of low-income countries who average around double the Sri Lankan level in percent of GDP.

16. The personal income tax base in Sri Lanka is particularly narrow. This, in part, reflects sensible policy but also reflects widespread exemptions and evasion. Most notably, the effective exemption of civil servants from the income tax net significantly decreases the base in a country with such a large public sector (accounting for around 15 percent of formal employment). The number of current contributors to the Employers Provident Fund (EPF), a mandatory contributory retirement scheme for formal sector employees, represents the upper bound of potential income tax payers. This number currently stands at 2 million, compared to the number of income taxpayers of around 1 million (ADB, 2004 and Stern, 1997).

17. Recent policy reforms have acted to extend the base and reduce the average rate charged on it. The 2005 budget extended the tax base by making government employees liable for income. Although this measure was initially notional (it made only 50 percent of income liable and introduced an allowance for those few public servants who would have to pay tax on their salaries), it is an important first step to correcting the long-standing anomaly. The base was also extended by restricting deductions. Administrative reforms to bring taxpayers into the net were also introduced, although their enforceability is questionable. However, the structure of the tax was significantly complicated and the average rate reduced, by increasing the number of bands from 3 to 6 with the unchanged top rate applying at an income almost double that in 2004.

18. Increasing the yield of the personal income tax over the medium term is crucial. The policy environment for the PIT is broadly appropriate; therefore the focus in this area should primarily be on reinforced administration. Policy measures should concentrate on maintaining the base at an appropriate size taking into account administrative, redistributive and revenue objectives. Measure in this regard could be:

  • Reducing the number of bands for income tax. The current rate structure is unnecessarily complicated and could be revised to improve simplicity and increase revenue. Guiding principles should be maintaining a high threshold for liability, retaining the top rate around current levels, and minimizing the number of intermediate rates.

  • Increasing the amount of government income considered for income tax purposes. Provided that the minimum threshold for income tax liability is set at an appropriate level to protect low-income earners, there is very little policy rationale for providing public servants with the current generous level of exemptions.

Corporate Income Tax

19. Sri Lanka does not have a captive source of corporate income tax (CIT).

The high yields seen in other developing countries often reflect receipts from high-margin enterprises such as extractive industries. The predominant form of industry in Sri Lanka however is the low-margin garment sector. This, combined with increased global tax competition, suggests that the CIT is unlikely to show a large yield in the short term. Nevertheless, the low yields currently realized suggest that there is scope for improvement.

20. Theoretically, the CIT should be a single rate tax not significantly different from the top rate of personal income tax. This minimizes potential distortions and incentives for evasion. The aim should be to have a simple structure with minimal exemptions that will enable increasing yields to be captured automatically with growth. There are currently 5 CIT rates in Sri Lanka (see Annex II.1 for details):

  • A mainstream rate of 32.5 percent, close to the top rate of personal income tax of 30 percent and a reduced rate of 20 percent for companies with annual income of below Rs. 5 million.

  • Four preferential rates of 10, 15, 20 and 30 percent that apply to specific sectors and activities.

  • Various tax holidays for Board of Investment (BOI) companies and selected firms and industries.

21. A key issue in Sri Lanka is the widespread use of exemptions and incentives.3 A government study in 2002 estimated that the cost of CIT exemptions, predominately to the BOI companies, was around 1 percent of GDP. The effectiveness of these exemptions in attracting FDI or promoting the growth of domestic industries is yet to be proven. International evidence suggests that, in addition to tax rates, the key determinants are infrastructure, institutions, stability and labor skills/costs (Zee and Tanzi, 2001). A recent UNCTAD study suggests that it is Sri Lanka’s labor laws that are in fact the greatest disincentive to investment. In these circumstances, there is a risk that tax holidays and exemptions may in fact be merely granting rents to investors or benefiting their home treasury rather than acting as effective investment incentives.

22. The economic service charge (ESC) has been the key policy reform with respect to CIT in recent years. This charge effectively sets a minimum CIT payment of 1 percent of turnover. The payment is creditable against CIT but not refundable. Since April 2005 it has close to full coverage of the corporate sector, with BOI companies and the retail and wholesale trade included but with reduced rates of 0.25 percent and 0.5 percent, respectively. The application to the BOI companies, who currently enjoy tax holidays, is significant, particularly in terms of the number of companies it brings into the tax net. The current number of corporate taxpayers is around 20,000. There are 1,400 BOI companies, who tend to be larger than average (there are currently only 10,000 companies with more than 10 employees in Sri Lanka).

23. In the medium term, however, the ESC is not a solid basis for corporate income taxation. In a situation of poor administration and widespread evasion a tax such as the ESC can be justified. It ensures a tax contribution from ongoing concerns and allows the revenue administration to begin to build up documentation on its clients. However, there are important problems associated with it, particularly as it adds to the costs of doing business, particularly for those who are not liable for CIT.

24. In the medium term, CIT reform should promote more effective taxation of a broader base. In addition to further movement away from the use of tax holidays and exemptions, key measures should be:

  • Eliminate preferential rates to create a more streamlined structure. The medium-term aim should be to move to a two-rate CIT structure based solely on a fair definition of income applied uniformly to the corporate sector.

  • Reform the current rate structure to remove the high marginal tax rate effect. The current policy of two rates differentiated by annual income creates high marginal tax rates as companies move beyond the threshold. This either discourages growth or promotes tax evasion. The system should be revised to a structure similar to the income tax structure of changing marginal rates of taxation, with thresholds and rates being set to preserve revenue neutrality in the short term.

25. Privatize/restructure SOEs to ensure profitability. This would have both a direct effect, increased tax payments from these companies, and an indirect effect, through a cheaper and more responsive business environment that enhances corporate profitability.

other Taxes

26. While the VAT and direct taxes should be the primary area of focus, other taxes can also contribute to improved revenue performance.

  • Import duties. Recent reforms to the headline rates of import duty, which streamline the number of bands and reduce the average rate levied are consistent with good practice in revenue and trade policy. However, additions to these headline rates in the form of surcharges, cesses, excises and surcharges on valuation for VAT purposes, while revenue enhancing, are inconsistent with stated trade policy and need to be gradually rolled back as increases in other revenue sources allow.

  • Excise duties. Excise rates are already high by international standards and yield relatively high amounts. These taxes should continue to be used primarily for microeconomic purposes on a limited selection of goods with low price elasticity. However, overall revenue effects should not be neglected. Care should be taken in setting rates as they can have unintended negative consequences for revenue collection. The recent hike in vehicle excises (raising the overall tax on an imported vehicle by 100 percentage points to around 275 percent) was so successful in discouraging demand that revenues actually fell. Similarly, high excises on tobacco and alcohol can encourage smuggling, reducing revenues and diminishing welfare enhancing effects.

  • Nontax revenue. Aside from fees and charges, nontax revenue is primarily affected by the operating profits of state-owned enterprises. To the extent that restructuring of state-owned enterprises leads to increased viability and profitability, revenue performance would be enhanced.

C. Final Remarks

27. More effective enforcement of the existing tax structure is crucial in improving revenue performance. Although additional tax policy measures are essential to improve the buoyancy and efficiency of the revenue system, these will only be effective if existing and new polices are properly implemented. This requires improved revenue administration focused on improved registration, to ensure the effective base is as close as possible to the legislated one, and enforcement, to ensure that assessed taxes are collected.

28. Improvements in administration are, however, not enough to meet the authorities’ ambitious revenue targets. There is substantial scope for policy reforms to improve both the yield and efficiency of the current tax system. Focus should be given to:

  • VAT: Given its dominance in revenue yield, this should be the primary focus for short-term measures. If key base broadening measures, such as including the wholesale and retail trade in the VAT base, cannot be implemented in the near-term then average rates will need to increase.

  • Direct taxes: In particular, by removing the system of preferential rates from the corporate income tax.

29. Policy changes should be supported by rigorous analysis of their revenue and poverty impact. The real cost of changing rates and bases, in particular through the exemption process is often not intuitive. It is crucial to ensure that the poor are not priced out of necessities through tax measures, and equally it is important to ensure that exemptions granted in the interests of poverty reduction are not primarily benefiting more affluent groups.


Sri Lanka: Summary of the Tax System (As of April 1, 2005)

article image
article image
article image
article image
article image
article image
article image


  • Asian Development Bank, 2004, Report and Recommendation of the President to the Board of Directors on Proposed Loans to the Democratic Socialist Republic of Sri Lanka for the Fiscal Management Reform Program, November (Manila).

    • Search Google Scholar
    • Export Citation
  • Balakrishnan, Ravi, 2004, “Sri Lanka’s Tax Incentive Regime,” Sri Lanka: Selected Issues and Statistical Appendix, IMF Country Report No. 04/69 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Keen, Michael and Alejandro Simone, 2004, “Tax Policy in Developing Countries: Some Lessons from the 1990s and Some Challenges Ahead,”in Helping Countries to Develop: The Role of Fiscal Policy, eds. by Gupta, Inchauste and Clement (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Stern, Nicholas, 1997, “Tax Reform and Stabilization in Sri Lanka,”in Macroeconomic Dimensions of Public Finance; Essays in Honor of Vito Tanzi, eds. by Mario I. Blejer and Teresa Ter-Minassian (London: Routledge).

    • Search Google Scholar
    • Export Citation
  • Tanzi, Vito and Howell H. Zee, 2000, “Tax Policy for Emerging Markets: Developing Countries,” IMF Working Paper 00/35 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

Prepared by Matt Davies.


Annex II.1 provides a detailed summary of the current tax structure in Sri Lanka.


See, in particular, the previous Article IV discussion (IMF 2003).

Sri Lanka: Selected Issues and Statistical Appendix
Author: International Monetary Fund