Sri Lanka’s Budget Tightens Taxes, Trims Discretion, and Seeks Space for China-India-IMF Balancing

Sri Lankan President Anura Kumara Dissanayake presented the National People’s Power (NPP) government’s second budget on November 7. When Dissanayake and his party came into power in late 2024, almost all major opposition political parties insisted that the government would collapse within 6-12 months. While this was partly a coping mechanism, there were also genuine concerns about the NPP’s capability to rule the country. Not only is it the party’s first time in power, but Sri Lanka is also facing unprecedented economic challenges.

The NPP took a cautious approach in its first year in power. Despite strong ideological convictions that neoliberal economic policies are wrong, it remained within the framework agreement with the International Monetary Fund (IMF), while trying to strengthen state capacity, improve state-owned businesses, provide much-needed capital for agriculture and industry, and increase social spending.

The 2026 budget is a reflection of this attitude and was guided by NPP’s medium-term plan to take the country beyond immediate crisis-management measures of the post-default years and toward a more predictable and sustainable growth path.

The budget intends to maintain a primary surplus and targets a budget deficit of 5.1 percent of GDP – goals that are in line with commitments under the IMF program. The government also wants to spend 4 percent of GDP on public investment, which is an attempt to roll back the contractionary effects created by previous austerity cycles.

In his budget speech, Dissanayake said that the government’s macroeconomic goal is to increase growth to 7 percent over the medium term, while raising revenue collection to levels closer to 20 percent of GDP. To achieve these goals, the government will rely on ongoing reforms to the tax system, state expenditure management, and investment climate. These are focus areas of the government in 2026.

The 2026 budget continues to tighten tax loopholes and broaden the tax base. The government has reduced the annual threshold for VAT and Social Security Contribution Levy (SSCL) registration from  60 million Sri Lankan rupees or LKR (about $200,000) to 36 million LKR (about $120,000), effective April 1, 2026. The government also wants to standardize customs duty bands at 0 percent, 10 percent, 20 percent, and 30 percent, and has signaled a phased removal of para-tariffs, including cess (a levy imposed on certain imports based on the Sri Lanka Export Development Act), in several sectors. These are measures aimed at simplifying the tax structure, improving predictability, and increasing revenue collection.

However, these changes will also draw more small and medium enterprises (SMEs) into the formal tax net. This is something that can test political and business support, especially among small-scale traders and manufacturers, who are struggling to keep their businesses afloat in the current tough economic environment. To help these smaller players, the budget has proposed the reduction of the capital allowance incentive threshold from $3 million to $250,000. This is expected to allow SMEs to access investment-related tax benefits previously limited to large firms.

The NPP administration has tried to distinguish itself from previous administrations by being more transparent. In recent weeks, they have tried to do this with regards to tax concessions. A number of acts have been amended or are being amended to create clear, rule-governed frameworks for exemptions and investment incentives.

There is also a modest increase in welfare payments, including expanded support for vulnerable households. However, there is no broad-based subsidy expansion, reflecting the fiscal constraints Sri Lanka faces as it prepares for debt servicing in 2028.

The government is walking a tightrope, from a political-economy standpoint. Given Sri Lanka’s tight fiscal space it must adhere to IMF policies that have stabilized the economy at great social costs. These stabilization policies also thwart the country’s future development. On the other hand, the government has to maintain political legitimacy. Economists insist that raising revenue through broader taxation is rational, but these taxes risk social and business sector resistance, particularly amid slow real income recovery.

KPMG and Deloitte, in their analyses, converge on several key observations. First, they note that the reduction in the VAT/SSCL threshold is a meaningful shift in the distribution of the tax burden, especially for SMEs and service-sector firms that had previously operated outside the formal net. Both firms highlight the importance of administrative capacity in realizing the expected revenue gains. They say that without reliable e-invoicing, audit capacity, and data integration, the broadened tax net could result in uneven compliance and disputes.

KPMG and Deloitte also say reforms to the Port City and Strategic Development Projects Acts would improve investor confidence by predictable concession frameworks.  Finally, both KPMG and Deloitte highlight the need for careful sequencing. Revenue measures take effect in April 2026, while several administrative reforms begin earlier in the year. This staggered timeline is intended to allow firms to adjust and systems to synchronize, but the success of the approach depends on execution.

At the geopolitical level, the budget also fits into Sri Lanka’s broader effort to rebalance its external relationships while managing its ongoing debt restructuring. The government must cooperate with the IMF to maintain access to concessional financing and investor confidence. At the same time, the NPP wants to improve economic and technological ties with China, while assuaging Indian paranoia. As things stand, India views any investments and agreements with China unfavorably. The NPP believes a more predictable fiscal and regulatory environment will reduce the need for crisis diplomacy and allow Sri Lanka to negotiate from a position of normalcy rather than vulnerability.

Whether Sri Lanka can achieve these shifts will depend on the credibility of reform implementation over the next 12 to 18 months, the period during which the political and social costs of broader taxation and administrative centralization will become most visible.