Tax without tricks

By Dhananath Fernando

Originally appeared on the Morning

Any budget is about two things. How much the government spends and how it raises the money.

In a national budget, most revenue comes through taxes and tariffs. Ahead of budget day, it helps to revisit the basic principles of good taxation, because businesses and households worry not only about new taxes, but also about shifts to thresholds, exemptions, holidays, and border tariffs.

The President has indicated that the new Budget does not plan to impose new taxes, which is welcome. But tax is a technical field. Even without new taxes, changes to rates, bands, and holidays can reshape the burden. All this happens while Sri Lanka is in its 17th International Monetary Fund (IMF) programme with agreed benchmarks.

Govt. spending today is tax tomorrow

There is a blunt truth about public finance. Every rupee the Government spends must be paid for by someone. If it is not collected this year, it will be collected in the future. When we borrow to fill the deficit, interest and repayments still come from taxpayers.

Unlike a household, a sovereign can also create money. That route does not make costs disappear. It shifts them into inflation, which works like a hidden tax. This is why every expenditure line in a budget is, in effect, a future claim on citizens. Discipline on spending is the foundation for a lighter, fairer tax system.

Taxes at the border are the worst kind

Among ways to raise revenue, tariffs at the border are generally the most damaging. They raise prices for consumers, protect inefficiency, invite lobbying, and complicate trade.

This column has often examined tariff policy, so today the focus is on core tax principles that should guide the Budget.

Simplicity

Tax rules should be simple to understand and simple to administer. Complexity breeds loopholes, evasion, and higher compliance costs. Multiple bands, special cases, and technical fine print frustrate honest payers and overwhelm administrators.

Sri Lanka’s personal income tax already has several thresholds and special treatments, including differences by source and currency. The direction of travel should be towards fewer bands, clearer definitions, and straightforward filing.

Transparency

People comply more willingly when they can see the rules and the results. Transparency has two sides.

First, taxpayers must know what is taxed, how it is calculated, and how decisions are interpreted. Second, citizens should see where the money goes.

Publishing timely, readable accounts of ministries, departments, and State enterprises is part of this. Clarity in the law and clarity in spending both strengthen trust.

Neutrality

A good tax system does not pick winners or punish losers. It does not tilt the field with ad hoc holidays, selective exemptions, or retroactive changes.

Sri Lanka has seen cases of both, and we paid a price in credibility and lost revenue. Neutrality means the same rules for all, with limited, clearly justified exceptions. When policy favours the connected or penalises the unfavoured, investment shifts from serving customers to seeking favours.

Stability

Frequent tinkering is costly. When rates and thresholds change too often, compliance burdens rise and planning becomes guesswork.

Sri Lanka has repeatedly altered Value-Added Tax (VAT) rates and income tax thresholds in short spans. Stability does not mean never changing. It means changing seldom, with notice, and for clear reasons. Bad policy made in haste is expensive to unwind. The economy needs a steady hand more than clever new tweaks.

Tax competitiveness

Firms and talent look across borders. Our personal and corporate tax burdens should be in line with the region if we want to attract investment and retain skills.

Competitiveness cannot be achieved by wishful thinking. It comes from controlling spending so that rates can be kept moderate. If outlays keep rising, taxes must follow, or inflation will. Either way, growth suffers.

The Sri Lankan context

We are living with the bill for years of high spending and borrowing. Interest costs crowd out other priorities and the system leans on distortionary tools such as border taxes.

The Budget must therefore do three things at once. Hold the line on expenditure, simplify and stabilise the core taxes, and reduce reliance on tariffs and discretionary incentives that undermine neutrality and transparency.

A checklist for the Budget

Are spending commitments realistic, prioritised, and affordable without hidden inflation taxes later?

Do the tax proposals reduce bands, special cases, and compliance steps?

Are all changes clearly explained, with drafts and guidance published early?

Do measures avoid retroactivity and selective holidays?

Do the overall rates and rules keep Sri Lanka competitive in the region?

The bottom line

Revenue matters, but expenditure discipline matters more. If we keep spending under control and align with the basic principles of simplicity, transparency, neutrality, stability, and competitiveness, Sri Lanka can raise what it needs with less harm to growth. If we ignore these principles, we will pay through weaker investment, fewer jobs, and slower incomes.

As the Budget approaches, the call is simple. Keep taxes clean and predictable. Keep spending honestly and affordably. Keep Sri Lanka competitive. That is how a budget serves the people, not just the balance sheet.

Nearing debt negotiation deal amid economic uncertainty

By Dhananath Fernando

Originally appeared on the Morning

Sri Lanka is hopeful that we can reach a debt negotiation before the first half of the year. Many are focused on the potential for reductions in principal and interest rates or extensions of debt maturities.

According to a recent update from the Ministry of Finance, we are yet to finalise a settlement with our bondholders, although we are close to an agreement. The Internal Rate of Return (IRR) for the Sri Lankan Government’s proposal is about 9.7%, while the bondholders’ proposal is 11.51%. The total cash outflow according to the bondholder proposal for 2024-2028 is approximately $ 16.6 billion, compared to $ 14.7 billion for the Government’s proposal. Ideally, we should reach a settlement close to the Government’s proposal if all goes well.

Both the initial and revised proposals indicate that bondholders are reluctant to reduce the interest accrued during the suspension of debt repayments. In both proposals, there have been no haircuts on $ 1,678 million of accumulated interest. Only a 4% interest rate has been proposed for 2024-2028.

Bondholders have suggested a 28% reduction on existing bonds, reducing the total bond value from $ 12,550 million to $ 9,036 million. Both parties appreciate the depth of the haircut, particularly with respect to economic growth. These adjustments depend heavily on adhering to the International Monetary Fund’s (IMF) baseline projections. If we fail to achieve the necessary growth rates, we will receive a deeper concession, and vice versa.

Achieving the best debt restructuring plan for Sri Lanka is crucial and our future hinges on economic growth. The debt level must be compared with the size and growth of the economy because only growth can ensure our ability to repay our debt. Our debt sustainability can only be secured through high growth rates, not solely through the debt relief offered by bondholders.

Economic and governance reforms are essential for growth. Notably, bondholders have proposed an innovative idea called Governance-Linked Bonds (GLB), where Sri Lanka would receive an additional benefit of 50 basis points on two selected bonds, each worth $ 800 million, if we implement two key governance reforms – one qualitative and one quantitative. The quantitative target is to reach a 14% tax-to-GDP ratio in 2026 and 14.1% in 2027.

A list of qualitative targets primarily focuses on publishing procurement contracts and tax exemptions, both of which are included in the IMF Staff-Level Agreement. However, the governance linked bonds, according to the proposal, would only apply to two bonds maturing in 2034 and 2035, each worth about $ 800 million.

While GLBs are an excellent idea, it is questionable whether the incentive is sufficient to encourage a strong governance programme. The savings from a 50 basis point cut in interest for $ 1,600 million would be about $ 80 million. Given that our accumulated interest is also about $ 1,600 million, there is a risk that governments could easily deviate.

Nevertheless, GLBs would send a strong signal to the market that the Sri Lankan administration is committed to governance reforms, which would enhance confidence in Sri Lanka.

Sri Lanka’s real challenge is avoiding a second debt restructuring. We can only achieve this by taking necessary steps and reforms to grow the economy, not solely relying on debt restructuring agreements.

Even if we secure a 30% haircut, our debt-to-GDP ratio in 2032 would still be approximately 95%. Over 50% of countries that have undergone a first debt restructuring have experienced a second. In Sri Lanka’s case, a second debt restructuring would be extremely painful for the population.

Moreover, our interest rates must remain high to meet the Government’s debt servicing requirements, attracting more funds. However, high interest rates discourage investment as people prefer to deposit their money in banks, leading to a low investment environment that could slow down growth. This slowdown would bring us back to the challenge of managing debt sustainability. This vicious cycle must be avoided.

Growth can only be achieved through improved productivity in a competitive environment, which arises when people are incentivised to perform. When the State dominates business and we try to manage everything independently, people do not become competitive.

Ultimately, growth is the only viable solution. Sadly, it is the only solution. Growth occurs when markets function effectively.