As post-war Sri Lanka gears itself towards sustained fast growth and achieving upper-middle income status, the importance of attracting greater investment from abroad – Foreign Direct Investment (FDI) – has risen to the fore. Although Sri Lanka has seen a steady inflow of foreign investment projects into the country over time, the record has been less than impressive when compared with many emerging economies. Like many developing countries, Sri Lanka has offered, and continues to offer, generous tax holidays and other tax-based incentives and exemptions to incentivize FDI inflows to the country. But it is widely acknowledged that they erode the government’s tax revenue base significantly. This paper argues that the key medium-term challenge facing the country is to find a balance between providing a competitive tax incentives regime to attract FDI and keeping tax foregone to a minimum in order to preserve domestic revenue. The paper also argues that aside from tax incentives, other factors like the trade policy regime, openness to international markets, the investment policy regime, and institutional and governance set-up, are important as well.
Due to severe data limitations, this paper has not undertaken a comprehensive econometric analysis of the effectiveness of tax incentives in enhancing investment and promoting growth in Sri Lanka. Rather, it provides a critical overview of the use of tax incentives in incentivizing investment, reviews some of the available tools, and presents an agenda. While this paper does acknowledge that tax incentives are not the only factor in determining the foreign investment attractiveness of the country, that tax incentives violate the equity principle of taxation, that the evidence supporting the effectiveness of tax incentives is contentious, and are a drain on the country’s exchequer, it also acknowledges that Sri Lanka would need to maintain some form of tax incentives regime to remain competitive in attracting good quality FDI. The key argument of this paper is that this tax incentives regime must be designed, implemented, and monitored in a smarter and more cost-effective way so that the impact on revenue is minimized and economic policy objectives can be realized.