ECONOMYNEXT – Sri Lanka has made laudable progress in tax collections especially in operating a better value added tax system to help pay the salaries of state workers, provide education and health, and generate cashflows to pay interest on past debt.

It is necessary to tax the people now after aggressive macro-economic policy under a 5 percent inflation target led to serial currency crises and multiple IMF programs, after the end of a civil war and an eventual external default.

However, there are limits to how people can be taxed, especially through income and other taxes on savings (capital decumulation taxes) which will destroy investible capital and the aspiration to put Sri Lanka on a higher growth path.

People’s savings and investments are made out of already taxed earnings. Some taxes may also discourage investments and investors themselves.

Some taxes, like wealth taxes are charged on assets without cashflow which can discourage housing, push up rents. In the US, wealth taxes on housing has also undermined housing maintenance which pushes up values and triggers higher taxes.

Taxes, which are always coercive, may become confiscatory and undermine property rights which is absolutely necessary for a market economy to function.

“The element of coercion distinguishes taxation from charity but the same element makes it difficult to distinguish the coercion of taxation from confiscation,” explains analyst Ravi Rathnasabapathy.

“If tax rates are set so high that the taxpayer is forced to dispose of the specific property being taxed or turn it over to the government in order to satisfy the tax obligation there would be little distinction between the two, giving rise to the notion of confiscatory taxation.

“The paradox is that even where taxation is not considered confiscatory it violates the fundamental principle of private property: that it cannot be taken for public purposes without just compensation. Nevertheless, the law confers the power to tax.

“The concepts of property and tax are intertwined, since without private property there is no economic substance to tax. However if the state is also obligated to uphold the right to property, it requires resources, which flow from taxation.”

“The element of coercion that exists in tax puts the tax administrator in a position of power, vis-a-vis the citizen. The eternal problem with power is that it may be abused.

“Preventing abuse requires that the use of power is limited by strong institutions: the rule of law and the system of justice. Where these are weak, citizens face oppression.

In Sri Lanka institutions and citizens rights have weakened due the lack of permanent secretaries, among other reasons.

The Asian Human Rights Commission has consistently pointed out the exceptional collapse of the rule of law that has taken place in Sri Lanka a view echoed by analysts and other international bodies. The World Justice Project ranked Sri Lanka 74th from 143 Countries in 2025.

“One investor described being subjected to audits in multiple consecutive years creating stress and uncertainty,” he writes.

“In one instance matters 15 years old were raised. Faced with this experience, he ultimately chose to simplify his affairs, retreating from active business involvement into passive investment income, an outcome that illustrates how aggressive administration can distort economic behaviour.”

Basic principles of justice require that whenever the state exercises powers that can deprive a person of property, liberty or livelihood those powers must be constrained.

“The power to tax falls firmly within this category,” explains Rathnasabapathy.

“Because taxation directly affects people’s property and means of livelihood due process is essential.

“Errors in tax administration by both the tax officials and taxpayers are inevitable so safeguards need to be in place to correct such errors, fairly and without fear.

“In Sri Lanka, the legal safeguards exist largely on paper. The inner workings that give effect to legal principles:independent oversight, timely appeals and accessible remedies are weak or non-functional.

“For most taxpayers, mounting a successful challenge to Revenue authorities is all but impossible.

“Under intense pressure to collect revenue, officials can act with relative impunity, secure in the knowledge that most people are unable to challenge them. Under such conditions, taxation can become a source of oppression.

“This experience cannot be viewed in isolation. The difficulties of taxpayers reflect the broader breakdown of the rule of law in Sri Lanka, frequently discussed in the context of human rights and rooted in the same failures in accountability.

“Where the system of justice is weak, administrative power, whether exercised by police, regulators, or revenue authorities tends to operate without effective constraint.”

Sri Lanka is raising some taxes that fritter away capital at a time when Western nations, which had engaged in stimulus and shattered their fiscal metrics, are pushing for higher income taxes, preventing more efficient, less harmless and growth friendly tax systems from evolving.

Higher tax collections do not necessarily lead to lower debt, specially if monetary stability is not maintained and rates cuts trigger crises which lead to lower growth or contractions, and sharp spikes in debt and interest rates as Sri Lanka saw after the end of a civil war.

The experience of UK from World War II to 1980 and Germany until the end of World War II, shows the problems of high tax rates and monetary instability.

On the opposite spectrum are East Asian nations with low tax rates (both VAT and income tax) and very high growth with monetary stability and GCC countries with monetary stability that have low or no income tax until recently, and import labour.

Sri Lanka’s first steep tax hikes came after the maiden balance of payments crisis of the central bank which started in 1952, when national debt was only less than 20 percent of GDP.

The full analysis is give below:

From Revenue to Repression: Tax Administration and Justice

By Ravi Ratnasabapathy

Increasing tax revenue is a key plank of the IMF programme. Since May 2022 the government has introduced new taxes, adjusted rates and significantly expanded the tax net. The number of income tax files has more than tripled, from 333,313 in 2022 to 1,093,134 in 2024, while VAT registrations doubled, from10,604 to 21,227 in the same period. These measures have produced a sharp increase in collections: tax revenues grew 55% in 2023, a further 25% in 2024. Revenues in the first half of 2025 rose by a further 25%.

The relationship between the citizen and the Inland Revenue

The dramatic increase in collection has drawn praise from many quarters but a fundamental question remains unasked: is the tax being collected justly? In the rush to collect revenue, are enforcement powers being applied in ways that place undue pressure on taxpayers; through wide interpretations of tax law or arbitrary assessments to extract payments that may not, in fact, be legally due?

This is not a question of administrative efficiency but of power: how a society reconciles the coercive authority of the state with the rights and freedoms of its citizens.

To understand the issues clearly, it is useful to contrast taxation with charity. The two are similar in the sense that both are private contributions towards some broader social end. The difference is that charitable contributions are voluntary, while taxes are exacted by law. Citizens have no choice in tax; compliance is ensured by penalties.

The IRD’s powers are extensive. In the event of default, property can be seized and bank accounts frozen. Under certain conditions, company officers, including directors, CEOs, and CFOs, can be personally held liable for a company’s tax defaults. While these powers are intended to deter non-compliance but in a country where oversight is inadequate and redress mechanisms weak, they create real fear.

The element of coercion distinguishes taxation from charity but the same element makes it difficult to distinguish the coercion of taxation from confiscation. If tax rates are set so high that the taxpayer is forced to dispose of the specific property being taxed or turn it over to the government in order to satisfy the tax obligation there would be little distinction between the two, giving rise to the notion of confiscatory taxation.

The paradox is that even where taxation is not considered confiscatory it violates the fundamental principle of private property: that it cannot be taken for public purposes without just compensation. Nevertheless, the law confers the power to tax.

The concepts of property and tax are intertwined, since without private property¹ there is no economic substance to tax. However if the state is also obligated to uphold the right to property, it requires resources, which flow from taxation.

The element of coercion that exists in tax puts the tax administrator in a position of power, vis-a-vis the citizen. The eternal problem with power is that it may be abused. Preventing abuse requires that the use of power is limited by strong institutions: the rule of law and the system of justice. Where these are weak, citizens face oppression.

The role of the Rule of Law and system of justice in limiting power

The rule of law is not upheld by good intentions but by systems that limit power. Adhering to the Rule of Law requires that people in positions of authority should only exercise power within a constraining framework of well-established public norms rather than in an arbitrary or ad hoc manner. If questions of unauthorised action arise, they should be accountable through law.

Some important procedural safeguards that limit the arbitrary use of power include:

• adequate notice before action,
• reasons for decisions,
• fair opportunity to be heard,
• right to appeal.

The Inland Revenue Act incorporates provisions intended to uphold these principles which are also found in the Taxpayer Charter adopted by the IRD but how can compliance be ensured? This depends on (1) the quality of oversight mechanisms and (2) the effectiveness of redress procedures.

For example in the UK, HM Revenue & Customs (HMRC) is subject to multiple levels of institutional oversight designed to reinforce the rule of law and protect taxpayers from arbitrary treatment. First, HMRC is constituted as a non-ministerial department, a status intended to insulate tax administration from political pressure and to promote impartiality in enforcement² . Although accountable to Parliament, HMRC operates at arm’s length from ministers, reflecting a constitutional recognition that the power to tax must be exercised according to law rather than political expediency.

Oversight of HMRC is exercised through both internal governance³ and external scrutiny. HMRC is accountable to a Board that includes a majority of independent non-executive directors whose role is to challenge strategy, performance and organisational culture. A dedicated Charter Committee which includes representatives of different taxpayer groups monitors compliance with the Taxpayer Charter⁴ . The Charter committee conducts reviews of HMRC’s performance at its bi-monthly meeting and also oversees an annual customer survey of HMRC’s performance against its Charter standards, differentiated by customer type. The HMRC is required to report annually on its performance against Charter standards.

Externally, parliamentary committees, including the House of Lords Economic Affairs Committee and the House of Commons Public Accounts Committee have conducted detailed inquiries into HMRC’s powers and their use⁵ , taxpayer safeguards, access to justice⁶ , customer service and institutional culture. These mechanisms reflect an understanding that legal protections must be enforceable: sustained oversight, transparency, and independent challenge are necessary to ensure that the administration of tax remains consistent with the rule of law.

Such comprehensive oversight is absent in Sri Lanka and the redress procedures are very costly and subject to long delays.

Redress procedures in Sri Lanka: Costly and ineffective

The redress procedure in Sri Lanka involves three stages: an internal administrative review from the Commissioner General of Inland Revenue (CGIR) an appeal to the Tax Appeals Commission (TAC) and then to the courts.

Unlike in the UK where taxpayers can either request an internal review or go direct to an independent tribunal, Sri Lankan taxpayers must follow each stage in sequence, adhering to set time limits in filing appeals.

Administrative review by the Commissioner General of Inland Revenue may take up to two years. The TAC is supposed to conclude appeals within nine months but this is often exceeded.

As an internal process, the Administrative review lacks the independence to provide an effective safeguard. The TAC is independent of the IRD but when the TAC rules in favour of the taxpayer the IRD almost invariably appeals to the courts which then delays the process by years. In practice, therefore, even the TAC does not operate as an effective check on power.

Even if the court of appeal holds in favour of the taxpayer, the IRD will more often than not, appeal to the Supreme Court. Moreover, in interpreting provisions of the law, the IRD does not follow precedents set by the Courts.

The financial burden imposed on the taxpayer during the appeal process compounds this problem. For income tax under the 2017 Act (though not for VAT or SSCL), where the IRD rejects a return and issues its own assessment, penalties are imposed and interest accrues at 1.5% per month from the original due date of payment. (Interest was not charged under the 2006 Act). Assessments may be issued up to 30 months after the return is filed, yet interest is calculated retrospectively from the original due date and there is no cap on the interest. As a result, before any redress process can even begin, the taxpayer may face an immediate claim for substantial accumulated interest and penalties. According to retired officials, some assessments are deliberately issued close to the time bar⁷ , maximising interest accrual and placing intense pressure on taxpayers to settle.

Should a taxpayer seek to challenge an assessment before the TAC, they must first make either a non-refundable deposit of 10% or a refundable deposit of 25% of the disputed tax (or provide an equivalent bank guarantee). If the matter proceeds further, appeals to the courts are effectively costless for the IRD, as cases are handled by the Attorney General’s Department. The taxpayer, however, must pay additional legal costs while interest continues to accrue. Because the interest forms part of the IRD’s collections and staff incentives are partly linked to revenue performance, this creates a perverse incentive to prolong disputes.

The result is that, in many cases, the cost of challenging an assessment far exceeds the disputed tax itself. Practitioners observe that only large companies or multinationals, often seeking to establish a legal principle rather than immediate relief are able to pursue litigation. For most taxpayers, negotiation and settlement, even of questionable assessments, becomes the only realistic option.

The redress process as a whole is prolonged, costly and beyond the reach of most taxpayers which undermines the right to appeal and erodes the rule of law by insulating the IRD from meaningful accountability.

From Institutional Failure to Administrative Abuse

The weaknesses in oversight and redress described above translate directly into day-to-day administrative practices that undermine taxpayer rights and depart from basic requirements of legality and fairness. Taxpayers report numerous instances of harassment, including arbitrary assessments, excessive and intrusive audits, disregard of statutory time limits and the imposition of disproportionate penalties which seem designed to maximise collection.

Lack of finality in tax assessments

Taxes are a charge on income. Finality in this is essential for individuals and businesses to plan and invest with confidence. An important safeguard for taxpayers is the statutory time bar in respect of collection, which provides financial certainty by preventing the indefinite reopening of past tax periods. Yet taxpayers frequently complain that they receive no finality in practice. Weaknesses in the IRD’s IT system have resulted in demands for arrears and penalties relating to periods many years and in some cases decades old. There have even been instances where companies long since wound up have received claims for alleged tax defaults dating back to the 1960s.

Serious problems arise when errors within the IRD’s own systems are treated as taxes in default, with the burden placed on the taxpayer to prove otherwise. Where records have not been retained indefinitely, taxpayers are left with no practical means of disputing such claims. Similarly, demands are sometimes issued for tax disputes that were settled years before, again placing the onus on the taxpayer to produce proof of settlement. In one recent case, a garment exporter received a demand relating to a dispute resolved a decade earlier and chose to settle, making a second payment of tax, rather than contest it, solely because the relevant records were not available.

When tax positions that were settled years earlier can be reopened the result is chronic uncertainty: balance sheets cannot be closed, risks cannot be priced and business decisions are distorted by the possibility of retrospective tax claims.

Assessments Without Clear Rules

Sri Lanka operates a self-assessment system, under which taxpayers calculate and declare their own tax liabilities. Unless there is evidence of error or fraud, returns should not be contested. In practice, however, there are instances where officials reject self-assessment returns merely because income is low, providing no reasons for their conclusions, contrary to legal requirements. Case law including New Portman Ltd v. W. Jayawardane and Fernando v. Ismail has established that these must be supported by proper reasons. Statements such as “profit margins are insufficient” or “expenses are not deductible” amount to conclusions, not reasons and fail to meet the standard required by law.

The consequences of this approach are illustrated by a case in which a firm’s return was rejected on the ground that its margins were “too low”. The company reported losses due to the recent economic crisis and submitted audited accounts to the IRD. The IRD did not accept the explanation, rejected the audited accounts and raised an assessment. Due to the cost and uncertainty of appeal, the company opted to negotiate a settlement and paid income tax despite incurring a loss. The following year with economic recovery, losses reduced but there was still no tax liability. The IRD proposed taxation based on the previous settlement rather than actual results, an entirely arbitrary assessment.

Compliance as a Tool of Pressure

IRD Audit practices impose heavy burdens on taxpayers. Companies are routinely required to produce extensive reconciliations: bank deposits to sales, sales quantities to values, VAT returns to turnover etc. Some of these do not naturally reconcile due to differences in accounting bases, timing, exemptions and pricing variations. The exercise can occupy accounting staff for weeks or months, diverting resources from productive activity. Even minor discrepancies are sometimes treated as grounds to disallow entire categories of expenditure with little effort to distinguish between genuine errors or oversights and deliberate actions, despite explicit commitment to do so in the Charter. In extreme cases, all bank deposits including fund transfers and non-income items have been treated as turnover.

IRD audits are conducted mostly on businesses and high-net-worth individuals, for whom tax administration can become an ordeal. One investor described being subjected to audits in multiple consecutive years creating stress and uncertainty. In one instance matters 15 years old were raised. Faced with this experience, he ultimately chose to simplify his affairs, retreating from active business involvement into passive investment income, an outcome that illustrates how aggressive administration can distort economic behaviour.

Similar concerns arise in technically complex areas such as capital gains taxation, where valuations are frequently disputed. Another source of contention is the treatment of interest-free advances, where the IRD imputes “notional interest” and adds it to taxable income despite the absence of any actual receipt.

Similar problems are present in other revenue agencies, particularly in Customs, where extensive detention powers and the ability to disrupt supply chains magnify the economic impact of arbitrary actions. BOI firms were until recently insulated from routine customs investigation for this reason. In the current drive to prevent alleged “leakages”, BOI firms are now being subject to extensive customs audits. This shift introduces new operational and regulatory risks which are particularly problematic for exporters who rely on predictable timelines and logistics.

In a recent case, a penalty exceeding 100 times the duty was imposed on an otherwise compliant firm for a single offence resulting from a technical miscalculation. In comparison, Singapore’s maximum penalty is capped at 20 times the duty and applies only upon a third offence (for a first offence the maximum penalty is only 10 times)

Taken together, these practices reveal a system in which procedural safeguards exist on paper but are largely absent in practice.

Conclusion

Basic principles of justice require that whenever the state exercises powers that can deprive a person of property, liberty or livelihood those powers must be constrained. The power to tax falls firmly within this category. Because taxation directly affects people’s property and means of livelihood due process is essential. Errors in tax administration by both the tax officials and taxpayers are inevitable so safeguards need to be in place to correct such errors, fairly and without fear.

In Sri Lanka, the legal safeguards exist largely on paper. The inner workings that give effect to legal principles:independent oversight, timely appeals and accessible remedies are weak or non-functional. For most taxpayers, mounting a successful challenge to Revenue authorities is all but impossible. Under intense pressure to collect revenue, officials can act with relative impunity, secure in the knowledge that most people are unable to challenge them. Under such conditions, taxation can become a source of oppression.

This experience cannot be viewed in isolation. The difficulties of taxpayers reflect the broader breakdown of the rule of law in Sri Lanka, frequently discussed in the context of human rights and rooted in the same failures in accountability. Where the system of justice is weak, administrative power, whether exercised by police, regulators, or revenue authorities tends to operate without effective constraint. The Asian Human Rights Commission has consistently pointed out the exceptional collapse of the rule of law that has taken place in Sri Lanka⁸ a view echoed by analysts⁹ and other international bodies¹⁰ . The World Justice Project ranked Sri Lanka 74th from 143 Countries in 2025¹¹ .

In this context, remedies through administrative measures alone are unlikely to succeed. The failure of measures such as the Taxpayer Charter and circulars issued in 2023 that set guidelines to prevent unnecessary and unreasonable tax assessments remain unimplemented¹² , testify to this.

These realities also call into question the political economy assumptions underlying revenue based fiscal consolidation. While some tax increases were unavoidable, a strategy that relies mainly on extracting additional revenue in a weak legal environment is self-defeating. Economics cannot be divorced from politics: where taxation is perceived as arbitrary and enforcement as punitive, higher rates and aggressive administration will deter investment, suppress growth and erode the tax base itself.

Sri Lanka is already a difficult place to do business; investors cite concerns about opaque and complex regulations, abrupt policy shifts, slow decision making and inadequate support for established businesses. Arbitrary and aggressive administration by IRD and Customs will only add to these problems, deterring long term investment and growth. This can turn into a self-reinforcing destructive cycle: lower investment and growth resulting in lower revenues leading to further rate increases and arbitrary actions to extract revenue, deterring investment even further. At a point the whole scheme will unravel.

Signs that the limits of taxation may have been reached are becoming evident. The imposition of 15% tax on service exports in April 2025 has resulted in several firms in the IT/BPO sector downsizing. This process is still ongoing, some firms have shut down completely others are downsizing or attempting to relocate either in the Port City or overseas. The most vulnerable firms are those that operate in the export markets where competition is high and margins are thin. The import-substituting domestic firms cannot move elsewhere so will probably react lower net returns caused by higher taxes by lobbying for further extension in protectionism.

If Sri Lanka proceeds on this path, its already small export sector will slowly wither, lowering overall productivity and leaving growth permanently stunted.