The Covid-19 pandemic, conflict in Ukraine, or the ‘Chinese debt trap’: most initial media reports incorrectly attributed Sri Lanka’s economic woes to these contemporary issues, glossing over the serious, long-standing issues that brought it to a head. These include years of structural inefficiencies, unsustainable policies, and financial mismanagement which left the country vulnerable to both domestic and external shocks.
The crisis has also exposed significant flaws in Sri Lanka’s economic model, including its dependence on debt-driven consumption and an overreliance on indirect taxation. These systemic weaknesses have been further exacerbated by political decisions prioritising short-term popularity over long-term sustainability, creating a cycle of budget deficits, mounting debt, and declining revenue.
This crisis exposed deep-rooted flaws in Sri Lanka’s economic model and, more importantly, the erosion of trust between the Government and its citizens – the very foundation of a healthy social contract.
Flawed social contract
The fiscal social contract underpins the tax-governance relationship, where citizens pay taxes and the government provides public goods such as education, healthcare, and infrastructure. This mutual responsibility relies on trust, with citizens expecting efficient use of tax revenues and governments depending on compliance.
Sri Lanka’s welfare-based economy, historically marked by high social indicators, has relied heavily on subsidies, particularly in energy. This fostered a dependency on State support without a concurrent increase in tax contributions.
This practice is not unique to Sri Lanka. Pakistan, another country battling a debt crisis, continues to subsidise State-Owned Enterprises (SOEs), especially in the power sector, offering electricity to consumers at discounted rates.
As populist policies gained prominence in the political arena, successive governments resorted to increased subsidies and generous tax regimes to maintain popularity, especially among the growing middle class.
The middle class expanded with the country’s transition to middle-income status, becoming a powerful voting bloc. This growing segment fuelled short-term consumption growth, bolstered by low tax rates and high subsidies. Yet, successive governments continued to neglect the deeper structural issues, such as the need for a sustainable tax system.
However, subsidies had paradoxical effects. While intended to support low-income earners, wealthier households benefited more due to higher energy consumption through appliances and vehicles. Lower income earners use less energy-expensive options in their households and public transport to commute.
Therefore, a disproportionate amount of the subsidy is channelled towards these richer households. In some instances, very low-income earners, especially in rural areas, do not even have access to electricity due to the high connection cost associated with being far from the national grid.
Tax culture and low revenue
Paradoxically, as Sri Lanka’s economy grew, tax revenue declined. Despite a 26-year civil war ending in 2009, the country maintained strong social indicators compared to its regional neighbours, thanks to a robust welfare system supported by a healthy revenue base.
However, since the 1980s, revenue has steadily fallen, creating a mismatch between financial resources and development indicators. Notably, tax revenue per capita rose from Rs. 35,000 in 2010 to Rs. 123,000 in 2023.
Over the past three decades, Sri Lanka’s tax-to-GDP ratio has declined significantly. By 2020, income taxes made up only 22% of tax revenue, with 80% coming from indirect taxes like border tariffs. This has made the tax system inequitable.
This reliance on indirect taxation stems from easier administration. However, frequent Value-Added Tax (VAT) changes and the Inland Revenue Department’s (IRD) limited capacity have hindered consistent implementation and compliance monitoring.
Despite being one of the oldest revenue authorities in South Asia, the IRD has struggled to adapt to the complexities of a modern economy, limiting its ability to enhance tax compliance and collections. Political reluctance to raise income taxes has further perpetuated an inequitable and regressive tax culture that has failed to adequately address the revenue gap.
Sri Lanka’s Foreign Direct Investment (FDI) revenue has been influenced by politics, focusing on tax breaks to attract investors. Since 1977, laws have expanded these benefits, offering long-term tax exemptions to big projects like ports and hotels. While these investments increased GDP, they contributed little to tax revenue, weakening the country’s financial stability.
The political economy of borrowing
Since independence, Sri Lankan governments have consistently run budget deficits to fulfil election pledges and maintain popularity, leading to significant public debt. Until the mid-2000s, public investments and welfare programmes were primarily financed by concessional loans.
After achieving middle-income status, these loans decreased, and Sri Lanka increasingly turned to commercial loans for infrastructure development. Since 2007, the country has issued International Sovereign Bonds (ISBs) at commercial interest rates with short maturities.
In the post-2000 era, Sri Lanka’s reliance on Chinese loans grew with its infrastructure-driven growth strategy. It was seen as a potential market for exports of Chinese SOEs which are often financed through loans from State banks such as the Export-Import Bank of China (Chexim) and China Development Bank (CDB).
The media coverage given to these Chinese loan-funded projects drove the Chinese debt trap narrative, although it has since been disproven. When Sri Lanka defaulted in April 2022, only 20% of its foreign debt was owed to China. The largest share, 36%, came from ISBs, which accounted for nearly 50% of foreign debt repayments in 2021.
Sri Lanka’s consumption-driven economy has also significantly contributed to debt accumulation. The middle class, benefiting from low taxes and State support, drove consumption of non-tradables like vehicles and homes, increasing debt dependency.
In 2023, the trade deficit reached $ 4.9 billion. Losses incurred by SOEs like the Ceylon Electricity Board (CEB) and Ceylon Petroleum Corporation (CPC) due to fuel and electricity subsidies strain the banking system, as these SOEs rely on loans to maintain operations. In 2022 alone, the CEB reported an operating loss of Rs. 167.2 billion, while the CPC reported a loss of Rs. 617.6 billion.
The Government’s concessionary car permit system for State officials further strained finances, costing Rs. 94 billion annually – nearly equal to the Rs. 97 billion collected from car import taxes. These permits often lead to the import of expensive, fuel-inefficient vehicles due to their higher resale value, further increasing import costs.
The way forward: A new economic model
To emerge from the current crisis and prevent future economic instability, Sri Lanka must implement fundamental structural reforms. This requires a decisive shift from consumption-driven growth to a production-oriented model, prioritising investment and export promotion over debt-fuelled consumption.
Vietnam offers a valuable example, where openness to trade and foreign investment has driven economic growth and attracting FDI has boosted capital, created jobs, raised incomes, and enhanced labour productivity through technology transfer and management expertise.
Sri Lanka must also reform its tax culture by rebuilding trust in State institutions and fostering fiscal discipline. Fiscal discipline and debt management are essential, with measures to ensure that future borrowing supports productive sectors and avoids creating further fiscal burdens. Replacing blanket subsidies with targeted welfare programmes is vital to protecting vulnerable groups while preventing disproportionate drains on public resources.
A shift in societal mindset is crucial. The pre-2019 model of low taxes and widespread subsidies is unsustainable today. However, citizens need to know how their taxes are being spent. They also hold the right to hold their Government accountable. A strong fiscal social contract is vital, providing resources for essential services while promoting transparency and citizen participation in economic processes.
(The writer is a Research Assistant at Arutha. Arutha is a Colombo-based policy think tank focused on economic research and communication with a special interest in public debt and taxation. Its economic civic education initiative, Default LK, was established during Sri Lanka’s first-ever sovereign default in 2022)
(The views expressed are those of the author and do not necessarily reflect the views of Arutha)