BOOM AND BUST CYCLES

Shiran Fernando discusses the fiscal shortfalls due to an erratic tax regime

In April, the World Bank released its South Asia Development Update titled Taxing Times, which highlighted the fiscal challenges facing the region. The report was followed by a thought-provoking webinar featuring panellists from Pakistan, Bangladesh and myself representing private sector perspectives in Sri Lanka.

A common thread was that tax revenue collections remain below potential, and weaknesses in tax administration and base broadening continue to hinder the ability of governments to finance growth enhancing public investment.

FISCAL JOURNEY In the face of a historic economic crisis, Sri Lanka is carefully restoring macroeconomic stability and unlocking long-term growth.

Among the most urgent challenges is the need to mobilise domestic revenue. For too long, Sri Lanka’s tax-GDP ratio has remained low, largely due to frequent and ad hoc changes in related policies. As a result, both public trust in the tax system and investor confidence have suffered.

Before the 2000s, Sri Lanka’s tax-GDP ratio was over 15 percent, underpinned by a relatively coherent and stable system. Since then, repeated policy shifts, frequent exemptions and changes in tax regimes have eroded the taxpayer base, and created an atmosphere of uncertainty.

The resulting fiscal shortfalls have contributed to debt accumulation, macroeconomic instability and a loss of investor confidence.

Recent reforms, most notably under the IMF supported programme, have emphasised raising revenue through increases in VAT and income taxes. These measures have helped Sri Lanka achieve a primary budget surplus for the first time in years and marked a significant step forward.

But the real challenge lies in sustaining progress without undermining growth or worsening the already heavy burden on formal businesses.

The answer lies in structural reforms and fixing the architecture of our tax system.

This includes improving tax administration especially through inland revenue and customs reforms, broadening the tax base by formalising the informal sector and simplifying compliance for existing taxpayers.

Encouragingly, there is growing private sector support for such measures.

DIGITISATION This is essential not only for improving tax collections and reducing leakages but also for bringing informal actors into the formal economy.

E-payments, digital IDs and online public services can dramatically reduce friction, increase transparency and help build a more inclusive tax culture. Equally important is strengthening the social contract where citizens and businesses are more willing to pay taxes, if they see those revenues being spent efficiently and equitably.

But tax reform can’t be viewed in isolation; it must be aligned with a broader strategy to attract investments and support enterprise led growth.

For decades, Sri Lanka has tried to compensate for its difficult business environment by offering tax holi­days and incentives. Yet, our FDI inflows remain consistently low, averaging less than one percent of GDP, and concentrated in a few sectors such as telecom and real estate.

What this suggests is clear: tax incentives aren’t a substitute for a sound and predictable investment climate.

If Sri Lanka had better policy consistency, the trade-off between offering incentives and maintaining revenue will be less severe. In fact, most businesses would prefer a clear long-term road map over ad hoc sweeteners.

Reassuringly, the current administration has begun to build credibility through the consistent implementation of IMF reforms. There are early signs of macroeconomic stability and this momentum must be sustained.

Our investment strategy needs to focus on export oriented FDIs that drive productivity and create high quality jobs. That means addressing deeper structural bottlenecks, land and labour market rigidities, high logistics and energy costs, and inefficient customs procedures. It also means tackling corruption and improving regulatory predictability.

The proposed Economic Transformation Act could be a game changer if it is properly implemented. It includes provisions for a new productivity commission to evaluate the impact of reforms and ensure long-term policy coherence. The law also envisions a trade adjustment programme to help industries adapt as tariffs are rationalised.

TRADE TAXES With nearly a fifth of government revenue currently coming from trade taxes, embracing trade liberalisation while maintaining fiscal discipline will require a careful balancing act.

But it is possible with the right tools and phased implementation.

One promising area is the use of targeted temporary incentives in high priority sectors or lagging regions. These can complement broader reforms and help attract strategic investments without greatly eroding the revenue base.

Additionally, Sri Lanka must leverage its global diaspora, bilateral trade agreements and regional connectivity to unlock new markets and financing channels.

The goal should be to break the vicious boom and bust cycles that have plagued the country’s economy for decades. This happens when weak exchange rates drive up debt and inflation, and trigger demands for wage increases, and more spending and taxation.

This must give way to a virtuous cycle of stability, investment and inclusive growth.

Prosperity requires a new mindset that prizes consistency over expediency, transparency over discretion and long-term competitiveness over short-term fixes.