Sri Lanka’s Economic Recovery: IMF Pressures, Tax Reforms, and Monetary Policy Challenges

WEEKLY ECONOMIC REVIEW :

Sri Lanka’s economy has shown signs of stabilization and recovery in the early months of 2025 following the severe financial crisis of 2022. The International Monetary Fund (IMF) has acknowledged this progress, approving a $334 million tranche under Sri Lanka’s economic reform program. However, the IMF has emphasized the need for sustained reforms, efficient tax collection, and cost-reflective pricing for state-run energy enterprises.

IMF’s Recommendations and Economic Policies

Kenji Okamura, Deputy Managing Director of the IMF, stated that while the economy is improving, it remains vulnerable. He stressed the importance of maintaining reform momentum to ensure macroeconomic stability, debt sustainability, and long-term inclusive growth. The IMF also urged the government to strengthen tax compliance and avoid tax exemptions to support economic reforms.

Additionally, the IMF recommended that Sri Lanka focus on well-targeted social support programs for the most disadvantaged while managing limited fiscal space. The organization emphasized the need to restore cost-recovery electricity pricing to mitigate financial risks from state-owned enterprises. The IMF further urged Sri Lanka to finalize agreements with its remaining bilateral creditors and prioritize price stability through its monetary policy.

Monetary Policy Challenges and Inflation Control

Sri Lanka’s monetary policy has faced criticism from analysts regarding its ability to maintain price stability. Concerns persist about the country’s 5% inflation target, which in the past has contributed to currency crises and external defaults. Inflationary open-market operations and monetary financing have historically led to economic instability, weakening the credibility of IMF programs and reforms.

Sri Lanka’s economic policies have resulted in mixed outcomes in previous IMF programs. In both the 2009 (2012) and 2016 (2018) programs, reserve targets were missed due to inflationary measures that sought to reduce interest rates. These missteps led to currency depreciation, rising energy costs, and political instability. Analysts attribute Sri Lanka’s recurring economic crises to poor monetary anchors and conflicts between inflation targeting and foreign reserve accumulation.

Despite these challenges, Sri Lanka’s program performance has been strong. The country has successfully restructured $25 billion in debt and committed to achieving a primary budget surplus of 2.3% of GDP by 2025. Inflation has fallen from 70% to zero, currency depreciation has slowed to 1.3% against the dollar, and economic growth is expected to reach 5% in 2025.

Budget 2025: Key Tax Reforms and Economic Goals

On February 17, 2025, President Anura Kumara Dissanayake presented the budget for the upcoming fiscal year, outlining a roadmap to economic recovery. The budget focuses on achieving a 5% GDP growth rate and maintaining a primary budget surplus. The government aims to resume debt repayments by 2028 while balancing IMF mandates with domestic economic needs.

As part of its fiscal strategy, Sri Lanka introduced several tax reforms to increase government revenue. These include a new 15% tax on service exports, affecting businesses and freelancers in the IT sector. This tax, effective from April 1, 2025, applies to Foreign Service earnings repatriated through local banks. Previously, such income was tax-exempt to encourage foreign exchange inflows.

Sri Lanka’s tax system relies heavily on indirect taxes like Value Added Tax (VAT) and excise duties, which contribute approximately 80% of total tax revenue. This approach has been criticized for disproportionately impacting low-income groups by increasing the cost of essential goods and services. While indirect taxes may support short-term economic growth, they can also exacerbate income inequality.

Breakdown of Tax Reforms

Personal Income Tax Changes

Increased Tax-Free Allowance: The monthly tax-free allowance will rise from LKR 100,000 to LKR 150,000, easing the financial burden on low- and middle-income earners.

Adjusted Tax Slabs: The 6% tax rate bracket will expand from LKR 500,000 to LKR 1,000,000 annually, increasing disposable income for taxpayers.

Corporate Tax Adjustments

Sector-Specific Tax Hikes: The corporate tax rate for businesses in the cigarette, liquor, and gaming industries will increase from 40% to 45%.

Service Export Tax: The removal of previous tax exemptions means export-oriented industries such as IT and BPO will now be subject to a 15% tax.

Capital Gains and VAT Adjustments

Higher Capital Gains Tax: The tax rate will rise to 15% for individuals and partnerships and 30% for other entities.

VAT on Digital Services: An 18% VAT will be imposed on digital platform services from April 2025, potentially raising costs for consumers.

Dairy Industry Exemptions: Locally produced liquid milk and yogurt will be VAT-exempt to support the domestic dairy sector.

Administrative and Compliance Measures

Shorter Refund Request Period: The deadline for tax refund requests will be reduced from four years to two and a half years.

Mandatory Electronic Filing: Most taxpayers must submit returns electronically, although senior citizens may file manually.

Economic Indicators and Government Performance

Inflation in Sri Lanka has significantly declined, with national consumer price inflation dropping to 0.9% in January 2025 from 1.1% in December 2024. However, prices for the 12-month period leading up to January decreased by 4.0%, marking the fifth consecutive month of deflation. The Central Bank projects inflation to return to the 5-7% target range by late 2025.

Public confidence in the government has improved. A February 2025 survey by Verité Research found that the administration’s approval rating rose to 62%, up from 24% before the July 2024 elections.

Foreign Exchange Reserves and Export Growth

Sri Lanka’s foreign exchange reserves stood at $6.065 billion in January 2025, slightly declining for the third consecutive month. Analysts have warned that excess liquidity and money printing in late 2024 contributed to this decline. The country’s monetary framework needs to maintain a careful balance between interest rates and external debt repayments to sustain reserve levels.

Despite concerns, Sri Lanka’s export earnings have grown. In January 2025, merchandise exports reached $1.334 billion, reflecting a 10.3% year-on-year increase.

Key contributors to this growth included apparel, textiles, tea, coconut-based products, and precious gems. Services exports also performed well, rising 37.87% year-on-year to $329.37 million. Major export markets, including the United States, India, the United Kingdom, and the European Union, showed positive growth.

Conclusion: A Path Forward

Sri Lanka’s economic recovery is progressing, supported by policy reforms and international assistance. However, maintaining stability will require consistent adherence to IMF guidelines, efficient monetary policies, and sustainable fiscal management.

The government’s focus on revenue generation, inflation control, and debt restructuring will be critical in ensuring long-term economic resilience. As Sri Lanka continues its reform journey, balancing domestic economic needs with external obligations will determine the success of its recovery efforts.

 

Spread the love
Tags:

Leave A Comment

Social