Opinion: Should Sri Lanka Raise Its Income Tax-Free Threshold Again?

By Advocata Institute

Recently, the government announced a proposal to increase the personal income tax-free threshold from LKR 150,000 to LKR 200,000 per month with the upcoming Budget, raises questions about Sri Lanka’s tax policy priorities. While reducing the tax burden on individuals may be justified under certain circumstances, another substantial increase so soon after the previous revision in April 2025 requires a clear justification. At a time when the government is seeking to strengthen public revenue and increase the contribution of direct taxation, the policy’s implications for the tax base, the distribution of tax relief and fiscal sustainability deserve closer scrutiny.

A narrow tax base

Sri Lanka’s employment-related personal income tax base remains relatively narrow. Published data from the Inland Revenue Department (Table 1 below) indicate that, under the previous tax framework, which had an annual tax-free threshold of LKR 1.2 million, only 24% of registered employees had Advance Personal Income Tax (APIT) deducted in FY 2024/25. These employees accounted for 59% of total gross income earned and paid LKR 191 billion in APIT in total. Although published data on the proportion of employees subject to APIT under the current framework, where the annual tax-free threshold is LKR 1.8 million, are not available, it can be estimated that only around 20% of formal-sector employees are now subject to APIT. These figures do not represent the entire personal income tax base, as they exclude individuals who pay personal income tax through other mechanisms. Nevertheless, they provide an indication of the limited reach of employment-related income taxation in Sri Lanka. 

Table 1: Distribution of Employees, Gross Remuneration and APIT Deductions by Annual Income Bracket, FY 2024/25

Source: Inland Revenue Department (IRD) Performance Report, 2025

This concentration of tax contributions among a relatively small proportion of formal-sector employees raises questions about the implications of further narrowing the personal income tax base. Increasing the annual tax-free threshold from LKR 1.8 million to LKR 2.4 million would mean that individuals earning between LKR 150,000 and LKR 200,000 per month would no longer be liable for personal income tax, subject to the applicable tax rules. The government should establish how many taxpayers would be removed from the tax net and how much revenue would be lost before proceeding.

The proposed increase also needs to be considered in the context of the previous reform. In April 2025, the annual tax-free threshold was raised from LKR 1.2 million to LKR 1.8 million. The reform also widened the first taxable income band from LKR 500,000 to LKR 1 million and removed the 12% tax band. With a further increase now proposed, the government should explain why such a substantial adjustment is warranted so soon after the previous revision.

One consideration is whether the proposed increase is intended to compensate for inflation or to provide additional tax relief. If the objective is to prevent bracket creep, tax thresholds and bands should be adjusted in line with inflation so that increases in nominal incomes do not lead to higher tax liabilities without corresponding growth in real income. A simple linear projection based on average monthly inflation between March 2025 and September 2026 estimates an inflation adjustment of approximately 12.13% by April 2027 [1]. Applying this adjustment to the current monthly tax-free threshold of LKR 150,000 would raise it to approximately LKR 168,200. By comparison, the proposed threshold of LKR 200,000 represents a 33.3% increase. If the inflation estimate is supported by the underlying calculation, this suggests that the proposal would provide relief beyond an inflation-based adjustment, making it important for the government to justify the additional increase.

Rather than relying solely on a higher tax-free threshold, the government could also reconsider the structure of the tax bands. Under the current schedule, the first LKR 1 million of taxable income is taxed at 6%, while the next LKR 500,000 is taxed at 18%. Reintroducing a 12% band between these rates could create a more gradual progression in marginal tax rates. This would provide an alternative approach to reconsidering the distribution of the tax burden across income levels while retaining the principle of progressive taxation.

The headline tax rate does not tell the whole story

The case for further tax relief should also be assessed by looking beyond the headline tax rates. Under Sri Lanka’s progressive income tax system, individuals pay no tax on income within the tax-free threshold, while income above that threshold is taxed at different rates across successive tax bands. Although the highest marginal tax rate is 36%, it applies only to the portion of taxable income falling within that band, rather than to an individual’s entire income. Consequently, the proportion of total income paid in tax is lower than the highest marginal rate faced by the taxpayer. This distinction is important when assessing the actual tax burden on employees and determining whether a further increase in the tax-free threshold is justified.

The distribution of tax relief also depends on how household income is earned. Unlike many other countries, Sri Lanka taxes individuals separately rather than requiring couples to file joint tax returns as a single household. As a result, two partners earning LKR 150,000 each per month can have a combined household income of LKR 300,000 without either exceeding the current monthly tax-free threshold.

Consider a household in which both partners earn LKR 500,000 per month, giving the household a combined monthly income of LKR 1 million. Assuming both earn employment income, are taxed separately under the current schedule, and have no additional deductions or reliefs, their combined effective income tax rate would be approximately 18%, despite each facing a marginal tax rate of up to 36%. This illustrates how households with relatively high combined incomes can benefit from separate individual tax-free thresholds.

This distinction matters because a further increase in the individual tax-free threshold would provide additional relief to eligible taxpayers regardless of whether they are the sole earner in a household or share household expenses with another income earner. Assessing the proposal solely on the basis of individual incomes could therefore overlook how tax relief is distributed across households with different levels of overall resources.

Who benefits from a higher threshold?

Raising the tax-free threshold is often presented as a way to ease the burden on lower-income earners. However, an increase in the threshold can also reduce the tax liability of existing taxpayers across different income groups, depending on how the tax bands are adjusted. While some lower-income earners may become exempt from income tax altogether, higher-income earners who remain liable for tax may also benefit from paying less.

Under the current tax framework, an individual earning approximately LKR 233,333 per month would pay around LKR 5,000 in income tax, equivalent to an effective tax rate of approximately 2.1%. This reflects the tax-free threshold of LKR 150,000 per month and the 6% rate applied to the next portion of taxable income. Similarly, an individual earning LKR 1 million per month would pay approximately LKR 266,000 in income tax, equivalent to an effective tax rate of 26.6%, while facing the highest marginal tax rate of 36%. A higher tax-free threshold could therefore also reduce this individual’s tax liability, depending on how the tax bands are revised. This highlights the need to assess not only the relief provided to those who become exempt from tax, but also the additional tax savings that accrue to existing taxpayers across different income levels.

This does not mean that tax relief is inherently undesirable. Rather, the government should establish whether raising the threshold is the most effective way to achieve its intended objective. If the primary aim is to support lower-income earners facing higher living costs, the distribution of the resulting tax savings should be examined to determine how much relief reaches those households and how much benefits higher-income taxpayers.

The treatment of employment remuneration and savings is another consideration in assessing the overall tax burden. Employer contributions to the Employees’ Provident Fund (EPF) and Employees’ Trust Fund (ETF), typically amounting to 12% and 3% of base salary respectively, form part of an employee’s remuneration but are fully exempted from taxation. Income earned within provident funds is also taxed at a preferential rate of 14%, irrespective of the individual’s marginal income tax rate. In contrast, investment income earned outside these arrangements may be taxed at the applicable rate, which can be as high as 36%, depending on the nature of the income and the applicable tax rules.

These arrangements are relevant when assessing the overall tax treatment of employment income and savings. A debate focused exclusively on the personal income tax-free threshold risks overlooking other provisions that already affect the amount of income individuals retain and the tax treatment of their savings.

The fiscal trade-off

Revenue figures for the first half of 2026 highlight the challenge of shifting towards greater reliance on direct taxation. Total government revenue, including grants, increased by 26% to LKR 2.955 trillion between January and June 2026, compared with LKR 2.342 trillion in the same period of 2025. However, income tax revenue, comprising corporate and non-corporate income tax, grew by 16% to LKR 612 billion. Within this, Pay As You Earn (PAYE) revenue declined from LKR 76.5 billion to LKR 74.5 billion over the same period. Meanwhile, Value Added Tax (VAT), which accounted for the largest share of total government revenue, increased by 22% to LKR 964 billion.

These figures highlight the differences in growth across revenue categories. While they do not, on their own, establish the fiscal impact of the proposed threshold increase, they underscore the importance of examining the composition of government revenue alongside its overall growth. VAT revenue grew faster than income tax revenue during the first half of 2026, reinforcing the challenge of strengthening direct taxation as the government seeks to reduce its relative reliance on indirect taxes. A further increase in the personal income tax-free threshold could complicate this effort if it leads to significant revenue losses that are not offset by improved tax compliance or other revenue measures. Any reduction in personal income tax revenue must therefore be assessed against the government’s objective of strengthening direct taxation and maintaining its capacity to finance public expenditure.

A higher tax-free threshold would not, by itself, address the problem of individuals and businesses with taxable income remaining outside the tax system. Broadening the tax base also requires effective taxpayer registration, income reporting, compliance and tax administration, including measures to identify taxable income beyond conventional salaried employment. Providing additional relief to existing taxpayers and improving compliance among those who should be paying tax are separate policy questions and should be addressed accordingly.

Broadening the direct-tax base is also relevant to the wider balance of Sri Lanka’s tax system. While taxes on vehicle imports may serve fiscal and other policy objectives, the total tax burden on some vehicles is reported to reach 200% or even 300% of their value. Such high taxes on particular purchases raise questions about the distribution of the overall tax burden, particularly when a relatively small share of formal-sector employees contributes through employment-related income tax. The objective should be to broaden direct-tax participation according to taxpayers’ ability to pay, improve compliance and ensure that revenue is raised through a more balanced and sustainable tax system.

A decision that requires evidence

International comparisons offer some additional context. Sri Lanka’s GDP per capita is approximately USD 5,002, while its annual tax-free threshold of LKR 1.8 million is equivalent to approximately 120% of GDP per capita. Countries with similar GDP per capita, including Vietnam, Indonesia, Morocco and Jordan, have different approaches to taxing personal income. While Morocco has an explicit tax-free threshold, Vietnam and Indonesia provide personal deductions or allowances that reduce taxable income but are not directly equivalent to a tax-free threshold. This comparison suggests that Sri Lanka’s current threshold is relatively generous in relation to its income level, particularly given that some economies with similar GDP per capita do not offer an equivalent universal tax-free threshold [2]. This provides a reason to carefully assess the justification for increasing the threshold further.

The government should therefore publish a clear assessment of the proposed increase before implementing it. This should include the number and income distribution of taxpayers who would benefit, the estimated revenue foregone, the distribution of relief across households and the measures that would be taken to offset any revenue shortfall. The assessment should also explain how the proposal relates to inflation, income growth and the government’s medium-term revenue strategy.

The question is not whether Sri Lanka should adjust its personal income tax thresholds as economic conditions change, but whether another substantial increase so soon after the April 2025 revision is justified by the available evidence. Given the relatively small share of formal-sector employees contributing through employment-related income tax, the government should demonstrate that the proposed increase is consistent with its revenue objectives, distributes relief appropriately and forms part of a coherent, sustainable tax policy.

[1] The estimated inflation adjustment is calculated by adding cumulative CCPI inflation of 9.1% between March 2025 and September 2026 to an estimated 3.03% inflation over the subsequent six months. The latter is derived by dividing the cumulative inflation rate of 9.1% by the 18-month period to obtain a simple average monthly rate, then multiplying this by six, assuming no significant changes in price trends. This produces an estimated cumulative inflation adjustment of approximately 12.13% by March 2027.
[2] GDP per capita data for 2025 were obtained from the World Bank Open Data database. Personal income tax-free threshold information for countries with comparable GDP per capita was sourced from PwC’s country-specific tax summaries.