Direct Taxation and Economic Growth in Sri Lanka: Testing the Nonlinear Effects of Taxation and the Moderating Roles of Institutional Quality and Tax Compliance

Background Direct taxation is a key instrument for revenue mobilization, fiscal sustainability, and economic development. However, its impact on economic growth remains debated, particularly in developing economies where institutional quality and taxpayer compliance vary significantly. This study examines the relationship between direct taxation and economic growth in Sri Lanka, focusing on nonlinear taxation effects and the moderating roles of institutional quality and tax compliance. Methods Annual time-series data for 1990–2024 were obtained from national and international databases. Economic growth was measured using GDP growth, while direct taxation was proxied by direct tax revenue as a percentage of GDP. Institutional quality and tax compliance were incorporated as moderating variables. The Autoregressive Distributed Lag (ARDL) approach was employed to estimate short-run and long-run relationships. Robustness was assessed using Fully Modified Ordinary Least Squares (FMOLS) and Dynamic Ordinary Least Squares (DOLS) estimators. Results The ARDL bounds test confirmed a long-run cointegrating relationship among the variables. Direct taxation had a positive and statistically significant effect on economic growth. The negative and significant coefficient of the squared taxation term indicated an inverted-U relationship, supporting the Laffer Curve hypothesis. Institutional quality and tax compliance strengthened the positive impact of direct taxation on growth through significant interaction effects. The error correction term was negative and significant, confirming convergence toward long-run equilibrium. FMOLS and DOLS results were consistent with the ARDL estimates. Conclusions Direct taxation promotes economic growth up to an optimal threshold, beyond which excessive taxation may impede economic performance. Strong institutions and improved tax compliance enhance the effectiveness of taxation, highlighting the need for integrated fiscal and governance reforms to support sustainable economic development in Sri Lanka.