ECONOMIC REVIEW

THE LITMUS TEST

FOR SRI LANKA’S FISCAL RESET

Sri Lanka’s fiscal story is evolving much faster than many expected

Shiran Fernando surveys the road that the country’s economy has travelled

Only four years after the country’s worst economic crisis in decades, public finances have moved from chronic primary deficits and collapsing revenue streams to sustained primary surpluses, a sharply reduced budget deficit and a credible medium-term framework for reducing debt.

ACHIEVEMENTS In 2025, Sri Lanka recorded a primary surplus of 5.4 percent of GDP – more than double the 2.3 percent programme target under the IMF’s Extended Fund Facility (EFF). 

It was the highest primary surplus in the nation’s history and exceeded the International Monetary Fund’s target by 3.1 percent. 

Its overall budget deficit narrowed to 2.3 percent of GDP compared with 6.8 percent in 2024 and a budget estimate of 6.7 percent. The fiscal current account also recorded a surplus of 0.7 percent of GDP, the first such surplus in the country’s history.

This improvement has been fundamentally revenue driven. 

Government revenue and grants reached 16.7 percent of GDP in 2025, compared with only around 8.4 percent at the depths of the 2022 crisis. Tax revenue alone reached 15.4 percent of GDP – its highest level in decades. 

Tax policy changes, stronger administration, the expansion of VAT and excise collections, and the reopening of vehicle imports have all contributed to increasing state revenue.

But there’s an important qualification as not all of the 2025 fiscal improvement can be assumed to be permanent. 

Vehicle related taxation provided an unusually large boost to revenue while capital expenditure was substantially below budget. The challenge for the next phase therefore, is to institutionalise the improvement rather than mistake a particularly strong year for a new permanent normal.

EARLY EVIDENCE The Central Bank of Sri Lanka’s Weekly Economic Indicators show that in the first six months of this year, government revenue and grants accelerated by 27.1 percent year on year to Rs. 2.96 trillion. 

And tax revenue increased 25.9 percent while total expenditure rose by a much more modest 7.9 percent. 

The result was a primary surplus of 1.24 trillion rupees – up 44.8 percent from a year earlier. 

Most remarkably, the overall budget still registered a small surplus of Rs. 9.5 billion at end-June compared with a deficit of 405.6 billion rupees in the first half of 2025. This is despite a much more difficult external environment but driven by a lack of capital expenditure spending in the first half of the year.

Sri Lanka’s new rules based fiscal architecture moves the discussion beyond annual budgets and towards a rolling five year plan. 

The 2027 Fiscal Strategy Statement targets government revenue and grants at around 15.5 percent of GDP, a primary surplus of 2.6 percent of GDP, primary expenditure of 12.9 percent of GDP and public investment of more than four percent of GDP from 2027 onwards. 

And the overall deficit is projected to gradually decline to 3.5 percent of GDP by 2031.

This framework is significant because it attempts to solve Sri Lanka’s old problem: fiscal policy that was too often driven by the immediate pressures of the annual budget rather than a credible debt strategy. 

The Public Financial Management Act establishes three key anchors: debt reduction, a primary balance target and a primary expenditure ceiling. The latter is set at no more than 13 percent of GDP with the 2027 ceiling being set at 12.9 percent.

Public debt fell from 103.2 percent of GDP in 2024 to 98.3 percent in 2025. The government retains the IMF linked objective of reducing debt below 95 percent of GDP by 2032 while the latest projections suggest that this threshold could be reached earlier. 

But the longer-term objective of bringing debt below 60 percent of GDP is projected to take until the early 2040s.

BUDGET 2027 November’s 2027 national budget will be the first major policy presentation after the fiscal shock of 2026, and will come as Sri Lanka approaches the final two reviews and associated disbursements of the current IMF’s EFF programme. 

Therefore, the test for the budget should not be whether it produces another spectacular headline surplus; instead, the question is whether it converts the extraordinary fiscal gains of the past two years into a durable fiscal system that will support growth.

This means protecting revenue mobilisation without continually increasing the tax burden on the formal economy; controlling recurrent expenditure while improving the quality of public services; and crucially moving from under execution of capital expenditure towards productive public investment. 

The government’s own framework is targeting public investment to be above four percent of GDP from next year.

Sri Lanka has done the hard part of stabilisation by demonstrating that fiscal consolidation is possible without undermining an economic recovery. The next challenge for Sri Lanka is to turn fiscal consolidation into capacity.

Budget 2027 will be the first major test of whether Sri Lanka’s fiscal reset is merely an IMF era adjustment or the beginning of a new rules based fiscal culture that can endure long after the International Monetary Fund programme ends.