Sri Lanka’s reform drive faces tariff risks

10 July 2025 12:10 am Views - {{hitsCtrl.values.hits}} 1 Bookmark

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Based on projected tax losses due to reduced export volumes, Sri Lanka could face annual revenue losses ranging from USD 60 to 78 million in the case of a 20% drop in exports, and USD 131 to 172 million if exports decline by 30%

Sri Lanka’s fragile fiscal recovery could stall if pending U.S. tariffs erode tax revenue and unsettle investors. Trade uncertainty may delay tax hikes, stall subsidy reforms, and disrupt bond offerings—widening deficits and prompting higher risk premiums from lenders. Sri Lanka, still rebuilding its credit after default, now faces this predicament as even relatively favourable tariff terms could trim up to 162 million dollars from annual revenue, or around 25 % of the near term ISB payments. Most of this loss stems from tax exemptions on U.S. imports, not from reduced export tax revenue.

The challenge underscores a key lesson: the best way to steady the budget and reassure investors is to advance fiscal, trade, and economic reforms.

Directly in the Line of fire

On April 2nd, the U.S. imposed a 44% duty on nearly all Sri Lankan exports, then suspended it two days later pending a court review. In 2024, Sri Lanka exported $2.9 billion to the U.S.—23% of total exports. Apparel and rubber products make up 75% of this, contributing 64% and 11% respectively.

To determine the effect on government revenue, there are two avenues by which revenues would decrease:

1. The reduction in tax revenue through domestic value-added.

2. The reduction in tax revenue if the import tariff is set at zero on US goods.

According to Publicfinance.lk, a 44% tariff on Sri Lankan exports to the United States would likely reduce exports by 20% for apparel and 28% for rubber-based products. Based on these numbers, I analyse the reduction in tax revenue through domestic value-added under a 20% or 30% reduction in exports from the current level and then identify the revenue loss under each scenario.

The domestic value-added is taken by subtracting the import component of exports (the import component is taken as 33%). Export figures are taken from the IMF Fourth Review, and the US component is assumed to remain at 23%. The import component reflects the value of foreign inputs used in exports. Value-added represents the domestic portion—such as labour and profits—subject to income taxes.

Since most sector workers earn below the Rs. 150,000 tax threshold, I apply a 15% average tax to domestic value-added by exporting firms. The 15% reflects a mix of tax revenue from profits, labour income, and taxes paid by domestic suppliers (but does not include tax revenue from spending of employees which would be collected by VAT). Based on projected tax losses due to reduced export volumes, Sri Lanka could face annual revenue losses ranging from USD 60 to 78 million in the case of a 20% drop in exports, and USD 131 to 172 million if exports decline by 30%. Averaged over the next six years, the annual revenue loss is estimated to be around USD 100 million. This represents only the direct loss from domestic value-added and does not account for indirect tax losses, such as VAT reductions.

The government would lose revenue of around USD 100 million per annum (LKR29 billion – 0.7% of total revenue in 2024) from the local value-added. Indirect taxes like VAT could push total losses even higher.

A second potential loss could arise if Sri Lanka lowers tariffs on U.S. imports, as this may result in American goods receiving zero-tariff access, similar to what appears to have happened with Vietnam. If Sri Lanka follows the same approach, Publicfinance.lk estimates that it would likely lose another USD 112 million in tariff revenue.

Even a negotiated deal, such as lowering export tariffs in exchange for zero tariffs on U.S. imports, would result in significant losses. Assuming a 50% reduction in the tariff rate (i.e., to 22%), the total annual revenue loss to Sri Lanka would amount to around USD 162 million (i.e., 50% of USD 100 million + USD 112 million), which is approximately 32 billion rupees per year (1.2% of total revenue in 2024)

Sri Lanka resumed payments on its ISBs after the debt restructuring was finalised at the end of 2024. Until it regains market access in 2027, Sri Lanka is expected to pay an average of USD 647 million per annum, of which the revenue loss accounts for around 25%.

Bond Market Movements

Following the tariff announcement in early April, bond markets reacted with notable shifts. In countries such as the United States, Vietnam, the Philippines, Malaysia, and Singapore, the spread between 10-year and 1-year government bond yields widened by around 10 to 15 basis points from March to June. Conversely, China experienced a narrowing of this spread by about 10 basis points. This divergence suggests that the tariff announcement tightened financial conditions in some economies while loosening them in others.

A Practical Response Strategy

Sri Lanka can act independently rather than waiting for external decisions that may never provide needed certainty. Three domestic measures can protect the fiscal position and restore confidence.

First, stress-test the budget against multiple tariff scenarios. A transparent budget annex with automatic spending adjustments under various tariff scenarios would reassure lenders of Sri Lanka’s fiscal discipline.
Second, complete long-promised trade facilitation reforms. The single-window customs platform and faster port clearance would cut logistics costs for all exporters, offsetting potential tariff impacts. These require no external approvals.
Additionally, the recommendations made by Subhashini Abeysinghe and Mathisha Arangala of Verité Research in their April 8, 2025 Daily FT article, ‘Trump tariffs: How can Sri Lanka mitigate the pain?’, should be incorporated into a comprehensive long-term strategy:
Reduce Domestic Trade and Investment Barriers. Address high import taxes and non-tariff barriers, such as burdensome regulations, to enhance trade competitiveness. Implement long-delayed reforms like a trade single window and a one-stop shop for investments to boost exports and attract foreign direct investment (FDI).
Strengthen Government Procurement Framework. Align procurement with global best practices—by enacting transparent laws, eliminating unsolicited proposals, and disclosing contracts—to reduce corruption and improve U.S. engagement.
Diversify Export Markets (Pivot to Asia). Reduce reliance on the U.S. and EU by expanding into dynamic Asian markets, leveraging Sri Lanka’s location amid shifting trade patterns.
Pursue Strategic Trade Agreements. Negotiate trade deals with Asia and beyond, backed by strong institutions to reduce barriers for Sri Lankan firms.
Enhance Economic Diplomacy. Support firms entering new markets through better information, guidance, and networking—especially for SMEs.
Address Supply-Side Constraints. Enhance workforce skills, investment zones, and agricultural productivity to boost global competitiveness.
This approach both shields recovery from shocks and signals policy credibility to international markets.

Prof M. Udara Peiris is an Associate Professor of Financial Economics at Oberlin College, USA, and a Global Academic Fellow at Verite Research. Research support for this article was provided by Harshana Wickramaarachchi, who is a Research Analyst at Verité Research.

Comments - 1

Rafeek Thursday, 10 July 2025 04:07 PM

To counter the 30% tariff, Sri Lanka must strategically leverage the surge in overseas employment. In 2024, the country is experiencing an unprecedented demand for foreign jobs, with record numbers of Sri Lankans seeking employment abroad. This growing trend presents an opportunity to boost foreign remittances, stabilize the rupee, and offset the negative impact of rising import costs due to the tariff. Encouraging skill development, expanding safe migration channels, and forming bilateral labor agreements will ensure that this workforce movement becomes a powerful tool in strengthening Sri Lanka’s economic resilience.

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