Sri Lanka's vehicle tax regime may be affecting the adoption of cleaner and more fuel-efficient vehicles, with a policy proposal submitted to the government calling for a shift away from engine-capacity-based taxation towards a progressive value-based system.

The proposal, submitted by the Advocata Institute in response to the Finance Ministry's call for revenue enhancement measures, states that the current framework creates market distortions, penalises modern hybrid technology, and influences consumer purchasing decisions in ways that may be economically inefficient.

Sri Lanka currently imposes a combination of customs duties, excise taxes, VAT, and luxury taxes on imported vehicles. For internal combustion and hybrid vehicles, excise duties are largely determined by engine size, while electric vehicles are taxed according to motor output. JB Securities Chief Executive Officer and Advocata Institute Chairman Murtaza Jafferjee stated that engine displacement is not an accurate measure of vehicle performance and efficiency.

"Engine displacement, in particular, is an imperfect proxy for engine performance, as advances in engineering allow vehicles with similar engine capacities to generate different levels of power and efficiency," Jafferjee said.

It was further stated that the current structure creates abrupt increases in tax liabilities that may influence both importer and consumer behaviour.

"Many of these taxes are applied through threshold-based structures under which crossing a specified band results in a higher rate being applied to the entire taxable value or quantity, rather than only to the incremental amount above the threshold, this creates discontinuities in tax liabilities and can influence consumer and importer behaviour," Jafferjee stated.

Hybrid vehicles highlighted as an example of tax distortions

The submission identified modern hybrid vehicles as an example of how engine-capacity-based taxation may affect the adoption of cleaner technologies.

Unlike conventional engines, Atkinson-cycle engines prioritise thermal efficiency and fuel economy, often requiring larger engine capacities despite delivering lower emissions and better fuel consumption. The Toyota RAV4 Hybrid, one of the world's best-selling sport utility vehicles, was cited as an example of how the current system may be producing unintended outcomes. While the vehicle's import cost is estimated at around Rs. 11 million, taxes can exceed Rs. 32 million due to excise duties increasing sharply once engine capacity exceeds certain thresholds.

Only 16 hybrid RAV4s were registered in Sri Lanka between January 2025 and May 2026.

"In this example, a tax policy designed to address concerns about customs corruption and importer under-invoicing may produce unintended outcomes, by heavily penalising larger engine capacities without recognising the efficiency gains of modern hybrid technology, the policy can reduce consumer welfare, discourage the adoption of cleaner and more fuel-efficient vehicles, and increase environmental costs," it was stated.

The institute has proposed placing greater emphasis on ad valorem taxation based on vehicle value while maintaining progressivity through marginal tax bands, rather than applying higher tax rates to the entire taxable amount once a threshold is crossed.

"A progressive value-based system would better align tax liabilities with the value of the imported asset, improve transparency, reduce opportunities for manipulation, and minimise distortions in consumer and market behaviour, importantly, the reform could be designed to be revenue-neutral while improving the efficiency, simplicity, and fairness of the vehicle taxation regime," it was stated.

A market shaped by imports and taxation

Sri Lanka's automotive market has historically been dominated by imported vehicles, particularly second-hand vehicles sourced from Japan. A key factor behind this trend is Japan's Shaken vehicle inspection system, which imposes increasing ownership costs on older vehicles, encouraging many owners to replace their cars before they reach three years of age.

These relatively new used vehicles are then exported to several right-hand-drive markets, including Sri Lanka, where high taxes on vehicle imports have traditionally made reconditioned Japanese vehicles attractive to buyers. All vehicles imported into Sri Lanka must be less than three years old, resulting in a market populated by contemporary Japanese models. Japanese imports include vehicles not officially sold in India, such as the Japanese-market Suzuki WagonR Hybrid and Suzuki Spacia, along with hybrid variants of models such as the Honda Fit Shuttle, an estate version of the Honda Jazz.

Although Indian-made vehicles, including the Tata Nano and Maruti Suzuki Alto, are present in Sri Lanka, Japanese imports have historically dominated the market. With vehicle import taxes often ranging between 200% and 300%, many consumers have preferred reconditioned Japanese vehicles over new imports.

Chinese brands gain ground after import restrictions ease

Following Sri Lanka's foreign exchange crisis and sovereign debt default, the government imposed a near-total ban on vehicle imports. However, as restrictions began to ease in 2025 and private vehicle imports resumed, market dynamics began to shift.

Among buyers able to afford new vehicles, brand-new Chinese models have increasingly replaced second-hand Japanese imports. Chinese manufacturers gaining traction in the market include BYD, Aion, Chery through its Jetour brand, SAIC, and Great Wall Motor (GWM). A notable feature of this shift has been the growing adoption of plug-in hybrid vehicles (PHEVs) rather than fully electric vehicles.

Why plug-in hybrids are gaining popularity

Plug-in hybrid vehicles combine an internal combustion engine with a larger battery pack that can be charged using home or public charging infrastructure. They differ from conventional strong hybrids by offering greater electric-only driving capability. The technology generally falls into two categories.

Parallel plug-in hybrids, such as the BYD Seal U equipped with the company's Dual-Mode Intelligent (DM-i) system, can use both the internal combustion engine and electric motor to drive the wheels. This configuration can deliver strong performance while allowing manufacturers to optimise engine and battery sizes.

The second category is the series hybrid, also known as a range extender or Extended Range Electric Vehicle (EREV). In these vehicles, the internal combustion engine does not directly power the wheels but operates as a generator to recharge the battery. As the engine can run at its most efficient operating speed, these systems can improve fuel efficiency while reducing dependence on charging infrastructure.

Industry observers have suggested that range-extender technology could be relevant in markets where charging networks remain underdeveloped.

Infrastructure and energy concerns support PHEV demand

The popularity of plug-in hybrids in Sri Lanka is partly linked to the country's limited charging infrastructure. While urban areas such as Colombo have seen increasing adoption of electrified vehicles, charging stations remain relatively limited in other parts of the country.

For many consumers, plug-in hybrids provide flexibility by enabling electric driving in cities while retaining the ability to operate on petrol during longer journeys where charging facilities may not be available. Sri Lanka's recent experience with fuel and electricity shortages following its economic crisis has also influenced consumer preferences. Many plug-in hybrid vehicles, including both parallel and series hybrid configurations, can offer driving ranges exceeding 1,000 km, with some models capable of travelling up to 1,500 km on a full tank of fuel and a fully charged battery.

With petrol prices in Sri Lanka equivalent to approximately Rs. 120 per litre in Indian currency, the fuel-efficiency advantages of plug-in hybrids have become increasingly relevant for consumers.

Potential implications for India

The developments in Sri Lanka come as several manufacturers prepare to introduce plug-in hybrid vehicles in India. Mercedes-Benz has already launched the facelifted S-Class with a plug-in hybrid powertrain, while additional models are expected to enter the market.

Although India's charging infrastructure is more extensive than Sri Lanka's, concerns remain regarding the capacity and reliability of the electricity grid in certain regions. Periods of high electricity demand have placed pressure on power networks in several cities, highlighting challenges related to electricity generation, transmission, and distribution as vehicle electrification expands.

Supporters of plug-in hybrid technology argue that it can provide consumers with additional flexibility and reduce range anxiety, particularly in areas where charging infrastructure is still developing. Critics, however, contend that plug-in hybrids can be more expensive to produce, may not always be charged regularly by owners, and require internal combustion engines to carry the additional weight of large battery packs.

As India prepares for a broader range of electrified vehicle options, Sri Lanka's evolving market illustrates how taxation policies, charging infrastructure, fuel costs, and energy security considerations can collectively influence consumer adoption of different vehicle technologies.