Balancing IMF Commitments and Domestic Priorities – The Diplomat

In a speech on February 17, Sri Lanka’s President Anura Kumara Dissanayake presented the 2025 budget – the first budget of his government, which took office in September 2024. As Sri Lanka continues under an IMF-supported Extended Fund Facility (EFF) – initiated in response to the country’s macroeconomic crisis in 2022 – it is crucial to examine how the proposed budget aligns with the IMF program’s requirements and what potential challenges may arise in achieving its goals.

Given that a national budget primarily reflects how the government manages public finances, it is essential to compare the 2025 budget proposals against the public financial management objectives outlined in the IMF-supported program. One of the central fiscal targets in the ongoing EFF is achieving a primary budget surplus of 2.3 percent of GDP from 2025 onwards. The 2025 budget aims to meet this surplus target in alignment with the IMF program. The figure below illustrates the trajectory of Sri Lanka’s primary budget balance since 2021, the year before the country entered its worst-ever economic crisis. (The budget deficit total also factors in Sri Lanka’s ongoing debt service payments.)

Maintaining this surplus is critical for Sri Lanka to reduce its public debt to below 95 percent of GDP by 2032. Failure to sustain the primary surplus would force the country to rely on further borrowing, even for essential public goods and services.

Additionally, the 2025 budget targets collecting 13.9 percent of GDP in tax revenue, matching IMF expectations. With these revenue-based targets, the government demonstrates its commitment to the IMF program.

However, a closer look at the expenditure side reveals challenges. The figure below compares the IMF’s projections for government spending – including total expenditure, recurrent spending, capital expenditure, subsidies and transfers, and salaries and wages – as a percentage of GDP against the 2025 budget allocations. Notably, in all categories, except capital expenditure, the government’s proposed spending exceeds IMF projections. 

As a result, the 2025 budget is set to record a budget deficit equivalent to 6.7 percent of GDP – higher than the 5 percent anticipated in the IMF program. This signals that Sri Lanka must exercise greater caution in rationalizing its expenditure.

Among its expenses, the 2025 budget has proposed a salary increase for public sector employees, providing a considerable allocation compared to the 2024 budget. While this adjustment may aim to preserve the purchasing power of employees affected by post-pandemic inflation, the government must focus on enhancing public sector productivity alongside wage increases. If wage growth exceeds inflation, it may risk triggering additional inflationary pressures.

The 2025 budget allocates nearly 4 percent of GDP to capital expenditure, a significant increase from the previous year. However, simply increasing capital expenditure is not enough. It is vital to ensure that this spending translates into effective public investment, as capital expenditure may also include non-productive spending that does not directly boost economic growth.

Boosting public investment is crucial for Sri Lanka’s medium- to long-term economic growth. According to the latest Global Economic Prospects report, scaling up public investment by 1 percent of GDP could raise output in emerging markets and developing economies (EMDEs) by up to 1.6 percent over five years. For Sri Lanka, which is still recovering from the recent crisis and has not yet regained its pre-crisis output level, focusing on inclusive and transformative growth is essential.

While the 2025 budget aligns with a projected 5 percent GDP growth rate, the government must remain vigilant in its growth strategies to sustain recovery.

Despite its commitments, the 2025 budget faces challenges from a narrow revenue base and social pressures. In December 2024, the government raised the tax-free monthly income threshold from 100,000 to 150,000 Sri Lankan rupees and adjusted tax brackets, offering substantial savings for taxpayers. However, this move effectively reduced the tax base, which had been expanded through recent reforms. If the government intended to provide relief to taxpayers, lowering tax rates – rather than expanding exemptions – might have been a more effective strategy.

Additionally, in January 2025, the government lifted the import ban on vehicles imposed during the foreign reserves crisis. While it expects increased tax revenue from high excise duties (ranging from 200 percent to 300 percent based on engine size) and 18 percent VAT on imported vehicles, the steep taxes could suppress demand, making it unlikely that the expected revenues will materialize.

The 2025 budget reveals a delicate balancing act between adhering to IMF mandates and addressing domestic economic realities. While the government has made strides in achieving revenue targets, expenditure pressures, policy missteps, and social constraints pose significant challenges.

To ensure the success of the 2025 budget and meet IMF conditions, the government must maintain price formulas for electricity and fuel, strengthen reforms in state-owned enterprises (SOEs), and rationalize its expenditure to align more closely with IMF targets. Balancing IMF commitments with domestic needs will be key to ensuring sustainable economic recovery and long-term growth.