Opinion: Will the “tax shock” kill Sri Lankan economy?

By Indika Hettiarachchi

“Current IMF backed tax policy framework likely to slowdown economic growth and increase poverty.”

Under the latest IMF extended fund facility program, Sri Lanka has achieved substantial increase in tax revenue – to a level never seen in the history. Data show that for the first quarter of 2026, tax collections increased by an impressive 49 percent compared to same period last year. With GDP growing at 5.1 percent, and inflation below 2.5 percent, first quarter economic performance looks good on “IMF report card!”

But underneath this achievement, a major economic risk is building up steadily. This is because taxes are growing at an extremely faster rate than the economy itself. Such scenarios eventually lead to gradual economic decline. This is because increasingly larger chunk of economic value addition is absorbed by the state in the form of taxes.

Taxes growing faster than economy

Economists measure the relationship between the economic performance (value addition), and taxes, with an indication called Tax Buoyancy Ratio (“TBR”). TBR is calculated as a ratio between the growth rate of taxes in response to growth rate in economic activity (or economic value addition).

Many countries use TBR in planning economic policies (but it is unlikely that Sri Lanka consider these aspects in planning tax reforms). Countries try to achieve a TBR marginally above one (1) enabling tax collection to grow in proportion to the expansion of economic activities. A TBR of one (1) implies that taxes grow in same proportion to the expansion of country’s economic activities. Higher TBR implies, a country’s tax revenues are growing at faster rate than the growth of real economic activities. High TBRs are not considered healthy as such situations can reduce economic output overtime

Data reveal that during the last three years Sri Lanka’s TBR skyrocketed to “extremely high” level compared to globally accepted rate closer to one (1). However, high TBR helped Sri Lanka to improve on the tax to GDP ratio which is a main target under any IMF support program.

Source: Dept. of Census and Statistics

As shown above, Sri Lanka’s TBR exceeded eight (8) in 2025. Historically Sri Lanka’s TBR has remained below one (1) throughout, reflecting Sri Lanka’s struggle to keep tax revenues in proportion to economic expansion.

Source: Advocata presentation (2022)

Based on trends observed in the first quarter of 2026, and government plans to further increase tax collections, it is likely that the TBR will remain high during 2026 and beyond.

Countries like India target a long term TBR of around 1.2 to 1.5 to achieve a stable growth rate of around 6.5 to 7 percent while collecting enough taxes to support state spending plan. In fact India’s latest budget proposes to bring down TBR to 0.8 to stimulate economic growth.

Adjustment phase for the “tax shock”

Above discussed situation implies that at present Sri Lanka is going through a major adjustment phase for a “very high tax regime”. Adjusting from a TBR of below one (1) to a TBR in excess of eight (8) is more like facing “an economic shock” rather than going through an economic transformation as described by policy makers.

Moreover, recently issued Fiscal Strategy Statement by the President states that the estimated tax revenue growth for the year 2026 is only a 7 percent, whereas the actual tax collections up to date shows a growth close to 50 percent – which could be interpreted as an economic shock, rather than an fiscal achievement.

Impact of high tax buoyancy

It is difficult to find examples of countries that have gone through phases of extreme high TBRs such as Sri Lanka as such cases are exceedingly rare (and probably nonexistent). Hence forecasting the outcome of Sri Lanka’s current scenario is very difficult.

However, the medium term impact of high TBR is likely to be gradual decline in economic activities or value addition resulting in economic contraction. This will result in gradual business closures, rise in unemployment, etc. Already there are signs many SMEs are going out of businesses – especially in trades related to construction, retail, etc.

Perhaps the most dangerous impact of high TBR is the negative impact on low-income households. As Sri Lanka relies heavily on indirect taxes, even government (short term) efforts to stimulate economic activities will automatically reduce the living standards of low and middle income households. This is because any increase in economic activity results in disproportionate increase in taxes. This increase in taxes are transferred to low and middle income households disproportionately. When government relies heavily on indirect taxes, high TBRs impact poor consumers disproportionately. Gradually rising poverty level and associated developments such as surge in gold pawning are some indications of this reality. In fact, World Bank survey itself showed the indirect tax reforms in 2024 resulted in 2.2 percent increase in country’s poverty.

The writer is an Investment, Project and Strategy Advisory professional. He has a Master’s degree in Economics from the University of Colombo, undergraduate degree in Business from the University of Wisconsin (USA), and is also a Chartered Financial Analyst (USA). Indika.h@jupitercapitalpartners.com