Milking the Tax System: Why VAT Exemptions Sour the Market

By Tormalli Francis, Research Analyst at Advocata Institute

A VAT-free litre of milk or cup of yoghurt may feel like relief at the checkout, which is in fact a silent distortion of lost revenue, stifled competition, and a marketplace where not all producers compete on an equal playing field. The government’s VAT exemption on locally produced milk and yoghurt is presented as a move to improve child nutrition and support local dairy farmers. On the surface, it appears humane and sensible — after all, what government wouldn’t want to make nutritious food more affordable while reducing dependence on imports?

But public policy, like milk, can curdle if left unchecked.

Milk production in Sri Lanka is a long-standing traditional industry that has endured for thousands of years producing over 500 million litres of milk [1] annually (Figure 1) with more than 130,000 farmers [2] (Figure 2) contributing to the production of milk islandwide. Yet this exemption, packaged with its good intentions highlights a recurring policymaking problem in the Sri Lankan economy: sacrificing long-term efficiency for short-term optics. In reality, VAT exemptions — however well-intentioned often distort the tax system, weaken the fiscal base, and may ultimately harm both consumers and the very farmers they are meant to protect.

Figure 1: Trend of total annual local milk production (Million Litres), 2015 - 2024

Source: Livestock Statistics, Department of Census and Statistics.

Figure 2: Number of dairy farmers by district, 2024

Source: Livestock Statistics, Department of Census and Statistics.

Equal Tax, Equal Opportunity

In a sound tax system, neutrality is essential — similar goods should be taxed in similar ways, and the system should not favor one product or producer over another. Exempting only locally sourced milk and yoghurt breaks this principle. It grants preferential treatment to domestic producers, while imported milk powder which is still a staple in many urban Sri Lankan households remains subjected to VAT. This selective exemption can hinder fair competition, discourage innovation, misallocate resources, ultimately compromising market efficiency.

This distorts market dynamics. Producers of other dairy products such as cheese, butter especially curd face a cost disadvantage, not because of inefficiency, but because of policy. The exemption becomes a de facto subsidy, not through open direct government expenditure but through hidden distortion in the tax system.

A country case example of a similar situation is seen in Georgia [3], where VAT exemptions apply to domestically produced milk and dairy products, but not to imported or reconstituted alternatives.  While intended to support local farmers and consumers, this approach creates an uneven competitive environment. Producers who rely on imported inputs including those making value-added dairy products face rising costs without benefiting from the exemption. 

Such policies also break the VAT chain, as inputs are subjected to VAT and outputs are exempted. This raises production costs, especially for downstream manufacturers, distorts price signals, and leads to inefficient resource allocation across the sector. 

Undermining Revenue for Reform

In the context of Sri Lanka's fiscal challenges and commitments to international financial institutions like the IMF, the Advocata institute emphasizes the importance of broadening the tax base. VAT exemptions reduce potential government revenue, which could otherwise be allocated to essential public services or targeted welfare programs. Maintaining a wide array of exemptions complicates tax administration and undermines efforts to achieve long-term fiscal sustainability.

When tax revenue is eroded by such sector-specific exemptions, this shifts the burden elsewhere — either to other goods or services or to government borrowing. Sri Lanka is in a period of fiscal crisis, with IMF-backed reforms requiring revenue generation. Exemptions reduce tax income from a high-volume essential product, limiting funds for healthcare, education, or infrastructure. Ad hoc policy changes and weak tax administration have been the major contributors towards the decline in tax revenue which have brought in fiscal challenges. A well developed tax system is an efficient revenue instrument, but exemptions and reduced rates erodes its performance. Basic commodities as milk and yoghurt are often the options for exemptions or reductions in most Low Income Developing Countries (LDICs), in 2020 the VAT exemptions in these countries amounted to 1.3 percent of GDP [4]. Revenue loss from such policies tends to outweigh the actual gains for the vulnerable groups.

Better Tools for Better Targets

A key justification for exemption on milk and yoghurt is to improve nutrition and support dairy farmers — by making these products more affordable for vulnerable groups and increasing farmer incomes. The dairy industry has been identified as the priority sector for development among the other livestock sub sectors in the country [5] for its crucial role reducing nutritional deficiencies across all age groups, and serving as a key source of affordable, high-quality nutrition for the population. 

But VAT exemptions are an imprecise way to deliver support. While they aim to make basic commodities more affordable, the Advocata institute highlights that such blanket policies often result in an imbalance as higher-income households benefit more than the intended low-income groups. As a greater proportion of basic commodities are consumed by the richer households, with greater purchasing power as they are likely to capitalise on these tax breaks. This misalignment highlights the inefficiency of VAT exemptions as a tool for social welfare. It is, in essence, a regressive subsidy disguised in the language of progressivism.

With exemptions having a progressive impact, they are poorly targeted ways to help low-income households, showcasing that directly targeted mechanisms will be better tools to address distributional concerns [6]. If the goal is to improve nutrition among the most vulnerable and farmers' livelihoods – Sri Lanka should focus on strengthening targeted, transparent support systems. Direct transfers to low-income households, investment in school milk programs, input subsidies to farmers, and upgrading the dairy industry infrastructure would deliver an efficient and equitable alternative. These measures ensure that support reaches those who need it most—without distorting market signals or undermining long-term efficiency.

Conclusion

Sri Lanka’s VAT exemption on locally produced milk and yoghurt may feel like a compassionate move — and in some ways, it is. But ultimately, it’s a fiscal quick fix, not a structural solution. A neutral tax system with broad based rates and minimal carve outs helps maintain fairness, supports productive specialisation and sustains government revenue. 

If we want to nourish our economy as well as our children, we must move from tax distortion to targeted policy. Milk can be good for the bones, but only when it doesn’t weaken the backbone of the economy.

[1]  Milk Production Statistics. Livestock Statistics. Department of Census and Statistics. Available at: https://www.statistics.gov.lk/Agriculture/StaticalInformation/MilkProduction#gsc.tab=0

[2] Milk Producing Farmers. Livestock Statistics. Department of Census and Statistics. Available at:https://www.statistics.gov.lk/Agriculture/StaticalInformation/MilkProducingFarmers#gsc.tab=0

[3]  Study of Value Added Tax (VAT) Exemption Impact for Increasing the Competitiveness of the Georgian Dairy Sector. Available at: chrome-extension://efaidnbmnnnibpcajpcglclefindmkaj/https://iset-pi.ge/storage/media/other/2021-10-06/32dcec80-2670-11ec-9a47-851d3f3d5dcf.pdf

[4] The Global Tax Expenditures Database (GTED) Companion Paper. A. Redonda et. al. Available at: https://www.researchgate.net/profile/Christian-Von-Haldenwang/publication/352539392_The_Global_Tax_Expenditures_Database_GTED_Companion_Paper/links/61291b602b40ec7d8bca280d/The-Global-Tax-Expenditures-Database-GTED-Companion-Paper.pdf

[5] Sri Lanka’s Dairy Sector: Where to Move and What to Do – Prediction and a Trend Analysis. D. A. P. R. Damunupola. Available at: chrome-extension://efaidnbmnnnibpcajpcglclefindmkaj/https://sljae.sljol.info/articles/74/files/submission/proof/74-1-413-1-10-20220706.pdf

[6] VAT Exemptions, Embedded Tax,  and Unintended Consequences. World Bank Group. Available at: chrome-extension://efaidnbmnnnibpcajpcglclefindmkaj/https://www.joserobertoafonso.com.br/wp-content/uploads/2025/05/IDU-8b2c8bb9-1d8f-4d67-b704-8dec2f14a832.pdf

Rethinking tax policy in Sri Lanka

By Dhananath Fernando

Originally appeared on the Morning

• The case for adhering to tax principles

Many Sri Lankan budget speeches are essentially discussions on Government expenditure. Revenue proposals are often introduced piecemeal before the budget and frequently fail to align with basic principles of taxation. 

Under the current International Monetary Fund (IMF) programme, Sri Lanka has committed to achieving a revenue target of 15% of Gross Domestic Product (GDP) by 2025, increasing to 15.5% by 2026. Additionally, a primary balance target of 2.3% in 2025 must be met and maintained. 

While we have already exceeded the primary balance target, this achievement has come at the cost of cutting capital expenditure, which will likely impede long-term growth.

Tax revenue has met targets, primarily through record-high import tariffs collected at the border by Sri Lanka Customs, amounting to Rs. 1,500 billion. However, relying on such high border tariffs impacts both the cost of living and the cost of raw materials, adversely affecting exports and local production.

The need for adhering to tax principles

It is crucial that the Government prioritises adherence to fundamental principles of taxation when implementing revenue measures. Over-reliance on border taxes is not a sustainable strategy for achieving a higher tax-to-GDP ratio.

Why border taxes are problematic

Generating revenue through border taxes disproportionately affects importers, as they incur significant costs upfront, even before generating profits. In contrast, profit-based taxes are levied only after profits are realised, making them less burdensome from a cash flow perspective. The time value of money amplifies the impact of upfront border tariffs on profitability.

Sri Lanka’s import basket comprises approximately 80% intermediate and capital goods, with only 20% being consumer goods. Tariffs on these critical imports drive up production costs, ultimately increasing the price of exports and even domestic goods. For example, the Rs. 65 tariff on rice accounts for about 50% of its production cost, leading to a nationwide increase in meal costs by approximately the same margin.

A tax base built on three pillars

Globally, taxes are traditionally levied on three bases:

What you earn (e.g. income tax, corporate tax)

What you buy (e.g. Value-Added Tax, or VAT)

What you own (e.g. property tax)

Principles for an effective tax system

Simplicity: Taxes must be simple for taxpayers to understand and for authorities to collect and enforce. Overly complex tax structures with numerous thresholds lead to lower compliance, reduced revenue, and enforcement challenges. A standard and straightforward tax system is key to maximising efficiency and minimising leakage.

Transparency: Transparency in taxation fosters trust and reduces opportunities for corruption. For instance, Sri Lanka’s import tariff system, based on Harmonised System (HS) codes, lacks transparency due to its cascading structure. Similarly, ambiguities in income tax policies create doubts and complications. Transparency is especially critical for tariffs, which, even when necessary, must be clear and predictable.

Neutrality: Taxes should not create winners and losers by favouring or penalising specific industries, products, or sectors. For example, in 2015, Sri Lanka imposed taxes on profits from the previous year, undermining the fairness of the system. The primary purpose of taxation is revenue generation, not market distortion. Lowering tax rates can expand the tax base, ultimately increasing revenue and minimising evasion.

Stability: Tax rates should remain consistent over time to provide predictability for taxpayers. Frequent changes to tax rates, such as the numerous adjustments to VAT in Sri Lanka, create uncertainty, open avenues for corruption, and undermine economic stability. Temporary taxes and tax holidays should also be avoided to maintain consistency and fairness.

Taxes on property: A case for caution

Among all forms of taxation, taxes on property ownership are particularly burdensome. This is because taxpayers often have to forgo another revenue source to meet their property tax obligations. 

If a property generates income, that income is already taxed under income tax laws. Imposing an additional property tax not only constitutes double taxation but also discourages wealth creation. Such policies can deter investment and economic growth, undermining broader development objectives

Balancing revenue generation and expenditure

Sri Lanka urgently needs to increase tax revenue due to its high expenditure, particularly on interest payments, which account for approximately 50% of total expenditure. This is not repayment of debt but merely the cost of servicing bad debt. While room for expenditure cuts is limited due to the predominance of recurrent spending, hard restructuring is necessary to reduce this burden.

Although the Government has achieved a primary surplus by reducing capital expenditure, this strategy will have adverse long-term effects on growth. Therefore, adhering to fundamental tax principles is critical to improving Government revenue sustainably without jeopardising the country’s economic prospects.

Source: CBSL, Advocata research 

Source: CBSL, Advocata research 

Why focusing on trade is paramount

By Dhananath Fernando

Originally appeared on the Morning

If you were to ask the average Sri Lankan what Sri Lanka’s economic problems are, you are most likely to hear three answers. The most common and popular answer would be corruption, a likely second would be high imports, and some may even say there is a lack of exports.

This article will address the second and third answers.

Contrary to popular belief, many Sri Lankans are unaware that our imports are declining compared to the size of our economy. Many make the mistake of checking the total value of imports and claiming that our imports are increasing.

That is correct, but import value can increase for many reasons. It could be due to a significant price fluctuation of certain imported commodities (fuel), a consumption hype due to a growing population over the years, or many other reasons.

Accordingly, imports and exports both have to be evaluated in comparison to the size of the economy – commonly known as the Gross Domestic Product (GDP). It is the same as considering a person’s weight relative to their height and age: weight as an absolute number has no meaning without comparing it with height and age.

Since the 1990s, Sri Lanka’s imports as well as exports have been declining compared to our economy. In recent years, exports have increased because our economy contracted steeply with the economic crisis while our exports remained fairly constant.

This indicates that the claim of our imports being a problem is a complete myth and misleading. Instead, our problem is that our imports are low because our exports are low. We need to export more so we can import more of the things that are being produced competitively and efficiently in other parts of the world.

For instance, let us consider the example of food items. There are many food items with a high range of protein sources and variety that food insecure people can afford, which face a high tariff rate in order to discourage consumption. The final victims of this process are the poorest people in the country who cannot afford a variety of food.

The impoverished spending more on food means they are left with little money to spend on non-food items such as education and health. Therefore, discouragement of imports through tariffs will affect the poor.

Another common myth in Sri Lanka is that Free Trade Agreements (FTAs) increase imports while drying out our USD reserves. Sri Lanka hasn’t signed many FTAs to begin with. Even when we analyse the data, trade primarily takes place outside FTAs.

Let us evaluate the Indo-Sri Lanka Free Trade Agreement (ISFTA). Imports are declining or stagnant from India to Sri Lanka under the ISFTA and we have undertaken more exports than imports under the agreement. However, more trade has taken place outside the ISFTA.

One potential reason for this could be the cost for companies to comply with the ISFTA and the complicated nature of FTAs. However, we have done more exports than imports under the ISFTA, indicating that trade agreements are not necessarily conspiracies by other countries to push their products but that Sri Lanka has done well in exports under FTAs in absolute numbers. As such, the claim that trade agreements push imports and discourage exports is also misleading and the data fails to support the claim.

Even if we check the numbers for the Pakistan-Sri Lanka Free Trade Agreement (PSFTA), we export more under the FTA in absolute numbers than we import. However, compared to our GDP, our trade is very weak, which is one of the main constraints to our economic growth.

Our barriers to trade are beyond trade agreements. Most barriers are internally driven by Sri Lanka Customs, the complicated tariff structure, necessary regulatory barriers, and related to ease of doing business. Blaming FTAs or imports for our economic crisis is meaningless. Instead, our growth potential lies in when we import and export and simplifying the tariff structure unilaterally is the first intervention to minimise corruption and boost trade.

Joining global trade will not only make our country wealthier but position us strongly in Indo-Pacific geopolitics.

As it was famously said: “When goods and services don’t cross borders, soldiers will.”

(Special thank you to Advocata Institute Research Analyst Araliya Weerakoon)