Govt faces challenges managing 2025 budget deficit amid economic reforms.

• 5opn1
• January 4, 2025
• Weekly Economic Review
• Govt faces challenges managing 2025 budget deficit amid economic reforms.
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Weekly Economic Revie

Sri Lanka’s political landscape has undergone a dramatic shift with the election of Anura Kumara Dissanayake as President and the National People’s Power (NPP) alliance securing a parliamentary landslide.

While these victories symbolize hope for change, the economic challenges facing the new administration are daunting.

Confronted by a legacy of excessive taxation, skyrocketing living costs, and crippling debt, the government is tasked with restoring stability while meeting high public expectations.

As the new government prepares for the 2025 fiscal year, the Appropriation Bill is set to play a critical role in navigating these economic difficulties.

Scheduled for presentation on January 9, 2025, the bill outlines planned expenditures and revenues, emphasizing the government’s intention to bring the fiscal deficit below 5% of GDP.

The administration is also striving to achieve a primary surplus of 2.3% of GDP to address debt management, while simultaneously aiming to increase government revenue to 15.1% of GDP—approximately Rs. 3.9 trillion—and cap total government expenditure at 20% of GDP, or about Rs. 5.2 trillion.

These ambitious targets are supplemented by plans to allocate over 4% of GDP to capital investments, fostering long-term economic growth.

To meet these objectives, the government has embarked on significant tax reforms closely aligned with recommendations from the International Monetary Fund (IMF).

Among these reforms is the introduction of the Imputed Rental Income Tax (IRIT), which imposes progressive taxation on owner-occupied and vacant properties beginning in April 2025.

Additionally, the government plans to replace the Special Commodity Levy with an 18% Value-Added Tax (VAT) and expand VAT coverage to digital services.

Corporate income tax rates are also set to rise from 40% to 45% for high-revenue sectors such as gaming, tobacco, and alcohol, while higher stamp duties on land leases will contribute to revenue generation.

Furthermore, the administration intends to implement a more efficient VAT refund system for exporters by replacing the simplified VAT system, a move expected to improve compliance and broaden the tax base.

These reforms are projected to raise the tax-to-GDP ratio to 14% by 2026.

However, their implementation has drawn criticism from several veteran economists who argues that these IMF-driven policies prioritize debt sustainability over public welfare.

For instance, taxpayers in 2025 are expected to contribute an additional Rs. 136,000 compared to 2020, and withholding tax on bank deposits has doubled to 10%.

Additionally, export-oriented professionals now face a 15% tax.

Critics warn that these measures could deter savings and investments, destabilizing the banking sector.

Reports suggesting plans to reduce the public workforce by 600,000 employees have further fueled concerns about job security and social stability.

While grappling with these domestic challenges, the government has managed to attract renewed interest from foreign investors.

Over US $100 million was invested in Sri Lanka’s government securities during the last quarter of 2024, signaling growing confidence in the country’s economic reforms. This influx follows stringent deflationary policies, including import restrictions and lowered interest rates after inflation peaked at 70% in 2022.

Despite significant outflows earlier in 2024, effective deflationary strategies and expectations of interest rate cuts have contributed to this late-year surge in investor activity.

In addition to investor interest, the government is pioneering innovative debt restructuring mechanisms to manage its $12.5 billion default from 2022.

One of these mechanisms includes governance-linked bonds, which tie coupon rates to the achievement of specific governance reforms.

By meeting these targets, Sri Lanka could save up to $80 million in interest payments.

However, the complexity of these new bond instruments has posed challenges for investors, with some selling off holdings to avoid navigating the intricate terms.

The Inland Revenue Department (IRD) has also played a pivotal role in bolstering Sri Lanka’s fiscal performance.

In 2024, the IRD reported a record tax collection of Rs. 1.98 trillion, marking a 25.1% increase from the previous year.

This growth was driven by higher income tax rates, an increase in VAT from 15% to 18%, and the removal of VAT exemptions on numerous items.

Excise taxes, particularly on petroleum products, further contributed to the revenue surge.

Efforts to improve compliance, such as mandatory electronic tax filing and data-sharing between financial institutions and the IRD, streamlined the tax collection process.

These reforms were supported by favorable macroeconomic trends in 2024. Sri Lanka’s economy grew by 5% in the first half of the year, with inflation falling to -0.5% by September.

Gross official reserves reached $6 billion, aided by a currency swap agreement with China.

Government revenue, including grants, increased by 40.5% during the first eight months of 2024, achieving 62.2% of the annual target of Rs. 4.13 trillion.

Despite a modest rise in government spending, the budget deficit narrowed significantly to Rs. 911 billion, a reduction of Rs. 559.7 billion compared to the same period in 2023.

However, as 2025 begins, the government faces an uphill battle in maintaining these gains.

The challenges of implementing IMF-backed reforms while ensuring social equity remain formidable. Public dissatisfaction with tax burdens and potential job cuts poses risks to political stability.

Additionally, the complexity of debt restructuring mechanisms and investor hesitation could undermine the long-term success of governance-linked bonds.

President Dissanayake and his administration have emphasized transparency and anti-corruption efforts as central to their governance strategy.

However, the true test lies in their ability to balance fiscal consolidation with public welfare, restore debt sustainability, and fulfill the high expectations of a hopeful electorate.

As the new leadership navigates these complexities, 2025 will be a defining year for Sri Lanka’s economic and political trajectory.