The topic of Sri Lanka’s budget deficit never fails to materialise frequently, thanks to the poor financial management of consecutive governments. The relationship between Sri Lankan governments and yearly budget deficits is anything but short-lived; rather, it is more like a stubborn stain on the balance sheet.
Verité Research recently revealed that this year too would be no exception as Sri Lanka would fail to meet its budget revenue targets for the 33rd consecutive year, showcasing years of borrowing to meet the deficit.
The 2024 Budget set forth an ambitious goal, aiming for a total revenue of Rs. 4,164 billion, marking a 42% surge from the adjusted figures of 2023. However, Verité Research offers a more conservative estimate, projecting a total revenue of Rs. 3,570 billion, which stands 14% below the Government’s optimistic forecast for the fiscal year.
The International Monetary Fund (IMF) foresees a substantial 43% surge in revenue for this year, a figure that closely mirrors the Government’s projections. This forecast suggests that revenue will escalate from Rs. 2,847 billion in 2023 to Rs. 4,081 billion. Consequently, Verité’s estimate for 2024 falls 13% below the IMF’s projection.
According to Government estimates, the total expenditure for the year is projected to reach Rs. 6,558 billion. This represents a 12% rise from the revised figures of 2023, excluding bank recapitalisation and public debt amortisation. Notably, interest payments constitute 66% of the increased expenditure allocations for this year, which is a massive percentage.
As Verité’s ‘State of the Budget: 2024’ report aptly puts it, the Fiscal Management (Responsibility) Act (FMRA) No.3 of 2003 serves as a key piece of legislation aimed at embedding responsible fiscal management principles within the legislative framework. Enacted to facilitate active public engagement and oversight of the country’s fiscal policy and performance, the FMRA lays down measures to ensure transparency and accountability.
Initially implemented in 2003, the FMRA mandated that the budget deficit should not exceed 5% of GDP from 2006 onwards. However, despite this stipulation, budget deficits have persistently surpassed the prescribed limit in 18 out of the 22 years since the act’s inception, thus contravening the FMRA.
Notably, the proposed budget deficit for 2024 stands at 7.6% of GDP, a significant deviation from the legally permitted threshold of 5% of GDP, once again highlighting non-compliance with the FMRA.
How do we bridge the deficit?
Verité Research Lead Economist Raj Prabu Rajakulendran, speaking to The Sunday Morning Business, addressed Sri Lanka’s persistent revenue deficits over the past three decades.
“For the past 32 years, Sri Lanka has consistently missed its revenue targets. The reliance on Value-Added Tax (VAT) this year poses a significant risk. If VAT underperforms, we will likely miss our revenue target.”
Comparing the current fiscal year to 2023, Rajakulendran noted that revenue-based options were limited due to previous tax increases. “In 2023, we saw a substantial increase in revenues, but in 2024, we’ve exhausted our classic revenue options,” he explained.
Rajakulendran stressed upon the need to improve revenue collection without resorting to further tax rate hikes. “Sri Lanka’s issue lies in inefficient revenue collection and poor administration, not tax rates,” he added.
He further highlighted the importance of financing and cited Sri Lanka’s high interest-to-revenue ratio as a significant concern. “With 80% of revenue allocated to interest payments in 2023, Sri Lanka faces a pressing challenge,” he said.
Rajakulendran also addressed the possibility of running long-term budget deficits, noting the importance of manageable deficits and low borrowing costs. “Many countries run deficits, but the ability to borrow at lower interest rates is crucial,” he noted.
“High budget deficits coupled with soaring interest costs are unsustainable in the long run. Addressing revenue collection and managing deficits effectively are critical steps towards fiscal stability.”
Verité Research recommendations
Corporate Income Taxes: Despite an anticipated 30% growth (Rs. 155 billion) in 2024, no adjustments to corporate tax rates or tax-free thresholds have been proposed. Hence, it is advised to revise the estimate downward to Rs. 561 billion for 2024. This reflects only the nominal GDP growth of 9.2%, representing a 9% increase from the 2023 revised estimate, contrasting the Government’s projection of a 30% increase.
Personal Income Taxes: Expected to rise by 100% (Rs. 40 billion) in 2024, without any new tax policies or administration measures. Therefore, it is recommended to adjust the estimate to Rs. 48 billion for 2024, representing a 20% increase from the 2023 revised estimate, instead of the Government’s estimate of a 100% increase.
Value-Added Tax: Projections indicate a 106% increase to Rs. 1,400 billion in 2024, attributed to rate adjustments and the removal of VAT exemptions. However, considering the inflation target of 7% and an estimated VAT-induced inflation of 2.3%, the Budget’s VAT revenue estimates appear overstated. It is advised to revise the estimate to Rs. 1,039 billion, reflecting a 53% increase from the 2023 revised estimate, in contrast to the Government’s projected 106% increase.
Social Security Contribution Levy (SSCL): Anticipated to grow by 19% (Rs. 40 billion) in 2024, without proposed changes to tax rates or thresholds. Therefore, it is recommended to revise the estimate downward to Rs. 229 billion for the year. This represents a 9% increase from the 2023 revised estimate, differing from the Government’s estimate of a 19% increase.
Customs Import Duty (CID): Projected to grow by 99% in 2024, with no administrative or policy measures introduced. Hence, it is advisable to adjust the estimate to Rs. 102 billion, reflecting a 16% increase from the 2023 revised estimate, instead of the Government’s projection of a 99% increase.
Focus on revenue generation
Speaking to The Sunday Morning Business, University of Colombo Department of Economics Head Professor Sirimal Abeyratne highlighted the difficulty of cutting down expenditure overnight, emphasising on the necessity of addressing the unprecedented expansion in the public sector over the last two decades.
“In the medium term, it’s more feasible to focus on revenue generation,” Prof. Abeyratne stated. “Expanding the tax base is a viable option that Sri Lanka has overlooked for many years. Utilising technology to establish a real-time database covering the entire population could significantly enhance tax compliance.”
He stressed on the importance of implementing an efficient database system to better understand people’s income, wealth, and expenditure. “This technological solution not only broadens the tax net but also facilitates improved governance and targeted policy interventions,” he added.
Highlighting the potential benefits, Prof. Abeyratne suggested that over time, increased revenue could lead to a reduction in the prevailing high tax rates, making them more manageable for taxpayers.
Addressing successful models in the region, Prof. Abeyratne acknowledged that budget deficits were not uncommon in developing countries. However, he emphasised on the need for manageable deficits to prevent a debt crisis. Sri Lanka’s declining Government revenue as a percentage of the GDP over the years has contributed to its fiscal challenges, leading to unsustainable borrowing and debt accumulation.
“It’s essential to strike a balance between revenue generation and expenditure management to ensure sustainable economic growth,” he said, adding: “While budget deficits may persist, they must be within manageable limits to avoid adverse economic consequences.”