SL’s tax strategy risks backfiring as illicit cigarette trade gains ground

Sri Lanka’s reliance on tobacco taxes is facing a growing policy contradiction, with Ceylon Tobacco Company (CTC) warning that repeated excise hikes are accelerating a shift toward illicit cigarettes, potentially undermining Government revenue even as the sector remains a major fiscal pillar.

CTC, in its latest Annual Report said it contributed Rs.173.8 billion to the Treasury in 2025, around 4 percent of total tax revenue, highlighting the State’s continued dependence on tobacco at a time when revenue mobilisation remains central to IMF-backed fiscal consolidation. However, the company cautioned that the current tax trajectory is distorting the market, widening the price gap between legal and illegal products and eroding demand for duty-paid cigarettes.

“The persistent threat posed by the illicit market, driven by the widening price gap between legal cigarettes and their illicit counterparts remained a challenge during the year,” CTC Chairman Suresh Shah said, flagging structural risks within the sector.

“Sri Lanka’s economy recorded a strong recovery in 2025… however, persisting pressure on consumer discretionary spending continued to impact demand conditions for CTC,” Shah added, noting that a 6 percent excise duty increase in January further pushed up retail prices.

While higher tobacco taxes have been a key lever in boosting Government revenue in the post-crisis period, industry signals suggest that beyond a point, incremental hikes may prove counterproductive, accelerating downtrading to illicit products that escape taxation entirely.

This risk is particularly sensitive given Sri Lanka’s ongoing fiscal adjustment programme, where sustaining revenue gains is critical. A widening illicit market could not only weaken tax collections but also complicate enforcement, shifting consumption outside the formal economy.

Despite the demand pressures, CTC reported a 6 percent increase in revenue and a 10 percent rise in profit before tax for 2025. However, the company warned that the operating environment is likely to become more complex, citing global uncertainties and domestic tax and regulatory unpredictability.

“While the Sri Lankan economy has shown steady progress towards stabilisation, escalating global tensions could give rise to renewed uncertainty, making the operating environment increasingly complex and challenging,” Shah said.