IMF Country Report No.

24/162

SRI LANKA
SELECTED ISSUES
June 2024
This Selected Issues paper on Sri Lanka was prepared by a staff team of the International
Monetary Fund as background documentation for the periodic consultation with the
member country. It is based on the information available at the time it was completed on
May 29, 2024.

Copies of this report are available to the public from

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© 2024 International Monetary Fund

 SRI LANKA
SELECTED ISSUES
May 29, 2024

Approved By Prepared by Yuanyan Sophia Zhang (APD), Dmitriy Rozhkov

Sanjaya Panth (FAD), Joel Turkewitz, Paula Zarazinski (both LEG), and
Azar Sultanov (RES).

CONTENTS

GOVERNANCE AND GROWTH: LESSONS AND POLICY IMPLICATIONS ____________ 2

A. Introduction __________________________________________________________________________ 2
B. Overview of Corruption Vulnerabilities and Governance Weaknesses in Sri Lanka ___ 4
C. Channels: Macroeconomic Impact of Anti-corruption and Governance Reforms ____ 8
D. Quantitative Illustration: Macroeconomic Impact of Governance Reforms __________ 9
E. International Experience _____________________________________________________________ 17
F. Conclusions and Policy implications _________________________________________________ 21
References _____________________________________________________________________________ 23

BOX
1. Debt, Investment and Growth (DIG Series) Model ___________________________________ 11

FIGURES
1. Corruption Vulnerabilities, 2012–2022/23 ____________________________________________ 5
2. Fiscal Governance ____________________________________________________________________ 6
3. Central Scenario: Macroeconomic Impact of Governance Reforms _________________ 14
4. Central Scenario: Impact of Governance Reforms on Income Distribution __________ 15
5. Alternative Scenarios: Growth Impact of Governance Reforms ______________________ 16
6. Alternative Scenarios: Growth Impact of Structural and Governance Reforms ______ 17
7. A Turnaround Story: Tax Revenue and Control of Corruption _______________________ 18

TABLES
1. Corruption Vulnerability Indices ______________________________________________________ 4
2. Mapping Governance Reforms to Economic Distortions ____________________________ 12
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GOVERNANCE AND GROWTH: LESSONS AND POLICY

IMPLICATIONS 1

The crisis uncovered Sri Lanka’s deep-rooted governance issues and corruption vulnerabilities. The
authorities are committed to addressing these challenges and have taken initial steps on governance
reforms under the EFF program, following recommendations from the IMF Governance Diagnostic
Report. General equilibrium simulations imply significant macroeconomic benefits from these reforms,
especially when they are implemented in a comprehensive and coherent manner. International
experience highlights that sustained anti-corruption and governance reform efforts, supported by
strong political ownership, civil society engagement, and technical and financial assistance can
improve the state capacity to perform core functions, fostering a conducive environment for
sustainable growth.

A. Introduction

1. The crisis opened a window of opportunity for Sri Lanka to address its corruption
vulnerabilities and governance weaknesses. Since the economy was hit by a severe economic
crisis, the authorities have adjusted macroeconomic policies and introduced important reforms in
their effort to put the country on a sustainable recovery path. Despite recent signs of stabilization,
the economy is still facing significant challenges that could derail its early recovery and hinder long-
term growth potential. Most notably, Sri Lanka faces systemic and severe corruption vulnerabilities
and governance weaknesses, which have caused economic inefficiencies in the areas of tax
collection, public investment, credit allocation Addressing these structural challenges is particularly
important to lock in the hard-earned economic gains from the policy correction and to promote
long run prosperity.

2. Important steps have been taken to kickstart a comprehensive governance reform

agenda. The authorities’ IMF-supported EFF program embarked on important anti-corruption and
governance reforms. For example, the new Anti-corruption Bill, enacted in August 2023, strengthens
the asset declaration system and the Commission to Investigate Allegations of Bribery or Corruption
(CIABOC)’s investigative powers. The Governance Diagnostic Report (GD report), the first in Asia, was
published in September 2023, followed by the authorities’ publication of their action plan to
implement the key recommendations highlighted in the GD report. These initial steps are important
to set the stage for effectively implementing more comprehensive and sustainable reforms going
forward.

3. The literature highlights the economic benefits of improving governance and tackling
corruption vulnerabilities. Cross-country analysis (IMF 1998) shows that deterioration in corruption
or governance quality is associated with lower investment and fiscal revenue, higher inequality, and

1
Prepared by Yuanyan Sophia Zhang (APD), Dmitriy Rozhkov (FAD), Joel Turkewitz, Paula Zarazinski (LEG), and
Azar Sultanov (RES). Ruihua Yang provided excellent inputs and research assistance. Authors thank Peter Breuer and
Katsiaryna Svirydzenka for guidance and the authorities and participants for helpful feedback at the seminar during
the Article IV Consultation and Second Review mission.

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less inclusive growth. Sandri (2017) and Markevych and Marinkov (2023) estimated that if corruption
is reduced to the levels seen elsewhere in the region, Ukraine and Moldova could raise per capita
GDP growth by about 0.85 and 0.6 percent respectively, which could significantly contribute to
speeding up economic convergence towards the European Union. Many recent papers also analyze
the impact of governance reforms on the macroeconomy using the dynamic general equilibrium
model (DIG-series: Debt, Investment Growth Models) which captures the channels of reform impact.
For example, Gurara et al (2019), Melina (2019), and IMF policy paper (2023) show that governance
reforms boost growth through enhancing public investment efficiency, revenue mobilization, and
reducing firms’ distortions. In the case of Congo (Melina et al 2019) and Iraq (Melina and Cantelmo
2019), depending on the magnitude of the implemented reforms, growth could increase by about
0.8 to 2 percent per year over the next 10 years, and debt could decline by 2 to 3 percent of GDP
annually over the same period.

4. The literature finds that comprehensive reforms, for example fiscal and legal reforms,
are associated with improving governance and reducing corruption. Cross-country empirical
analysis (IMF 2023, IMF 2019) reveals that several indicators of good fiscal governance are
significantly associated with improved control of corruption. For instance, indicators of fiscal
transparency 2, quality of public financial management 3, and tax administration processes 4 are
significantly correlated with a perceptions-based indicator of control of corruption. These results
confirm findings from individual-level studies (usually based on information at the level of an
individual country, reform, or project), which linked good practices in public financial management,
procurement, audit agencies, and tax administration to lower corruption (Johnson and others, 2012;
World Bank 2012, DIFD 2015). On legal reforms, Lorenzani and Lucidi (2014) found that the judicial
reforms that rationalize the organization of courts, foster investment in in-court ICT and introduce
incentives to reduce excessive litigation rates could enhance entrepreneurial activity and promote
FDI.

5. This paper aims at quantifying the economic benefits of comprehensive governance

reforms through model simulations, supported by selected case studies. Section B provides an
overview of the corruption vulnerabilities and governance weaknesses in Sri Lanka. Following the
discussion of a theoretical framework that illustrates the channels through which governance
reforms generate economic gains in section C, Section D quantitatively simulates the
macroeconomic impact of governance reforms using a dynamic general equilibrium model under
alternative reform scenarios. Section E complements the simulation with case studies. Section F
concludes with policy implications.

2
Constructed by staff from systematic questionnaires assessing public access to comprehensive fiscal information;
independence and quality of audit processes; etc.
3
From questions about the quality of expenditure controls and procurement, etc.
4
Based on questions about limits to personal interactions between taxpayers and officials, limits to discretionary
powers of tax officials, etc.

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B. Overview of Corruption Vulnerabilities and Governance Weaknesses in

Sri Lanka

6. Published Governance Diagnostic Report and Third-party indicators (TPI) point to the
systemic nature of corruption in Sri Lanka. Corruption encompasses various forms, ranging from
petty corruption, which involves small-scale bribes to officials by individuals or firms for specific
transactions, to corruption at the regime level across the political system and public institutions,
involving more extensive networks of public and private actors. Perception-based TPIs from well-
known sources (Figure 1) and the 2023 Governance Diagnostic Assessment suggest that corruption
vulnerabilities in Sri Lanka are not limited to petty corruption but also reflects systemic abuse of
public power across the political system and government agencies 5. Systemic corruption in
Sri Lanka, captured by the Regime Corruption Index (RCI), was higher than an average Asian country
in 2022. In addition, corruption vulnerabilities in Sri Lanka appeared to have increased from 2012 to
2022. While comparable to lower-middle income countries and South Asian peers, corruption in Sri
Lanka was perceived to be more prevalent than average higher-middle income countries and Asian
peers in 2022. Sri Lanka has implemented key governance reforms recently under the EFF, but
sustained change takes time to be achieved and accurately captured by TPIs after 2023.

Table 1. Sri Lanka: Corruption Vulnerability Indices

(lower value higher corruption for ICRG, CPI and WGI; higher value lower corruption for RCI)

Corruption Index from the International Country Risk Guide (ICRG) ranges between 1 and 6 and
captures actual or potential corruption in the form of excessive patronage, nepotism, job reservations,
‘favor-for-favors’, secret party funding, and suspiciously close ties between politics and business.

Corruption Perception Index from Transparency International (CPI) ranges from 0 to 100 and is
constructed by averaging 12 different data sources that capture the perceptions of businesspeople and
country experts about the level of corruption in the public sector.

Control of Corruption indicator from the Worldwide Governance Indicators (WGI) ranges from -2.5 to
+2.5 and is constructed by aggregating multiple underlying data sources. It captures “perceptions of the
extent to which public power is exercised for private gain, including both petty and grand forms of
corruption, as well as capture of the state by elites and private interests.”

Regime corruption index from V-DEM Database (RCI), based on expert judgement from a pool of 3700
country experts, ranges from 0 to 1 and captures systemic (grand) corruption in the political system and
public sector, which can be broken down to executive, judicial, legislative, and public sector corruption.

5
Sri Lanka Governance Diagnostic Report by IMF 2023 provides elaborate assessment of corruption vulnerabilities
and governance weaknesses. Sri Lanka: Technical Assistance Report-Governance Diagnostic Assessment in: IMF Staff
Country Reports Volume 2023 Issue 340 (2023)

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Figure 1. Sri Lanka : Corruption Vulnerabilities, 2012–2022/23

World Bank Control of Corruption, 2022 Corruption Perception Index, 2022

(Lower values indicate higher corruption) (Lower values indicate higher corruption)
2.0 80

70
1.5
60
1.0
50

0.5 40

30
0.0
20
-0.5 10

0
-1.0
Lower Sri Lanka South Upper World APD AE AE Asia
Lower South Sri Lanka Upper World APD AE AE Asia
middle Asia middle
middle Asia middle
income income
income income

ICRG Corruption Index, 2023 Regime Corruption

(Lower value indicate higher corruption)
Sri Lanka Lower Middle Income
5 Upper Middle income Asia
World
Regime
4 0.8

3 0.6

0.4
2 Judicial Executive
0.2

1 0

0
Lower Sri Upper South World APD AE AE Asia
middle Lanka middle Asia
income income Legislative Public sector

Corruption Perception Index, 2012-22 ICRG Corruption Index, 2012-22

(Lower values indicate higher corruption) (Lower values indicate higher corruption)
60 3.5
Lower middle income Upper middle income Lower middle income Sri Lanka

55 Sri Lanka World Upper middle income World

Asia 3.0 Asia

50

45 2.5

40
2.0

35

30 1.5
2012 2017 2022 2012 2017 2022

Sources: World Bank, Transparency International, PSG Group, V-DEM.

1/ Use of these indicators should be considered carefully, as they derived from perceptions-based data.
2/ The WGI aggregates information from various sources, including surveys of households and firms, commercial business information providers,
non-governmental organizations, and public sector organizations. Transparency International’s Corruption Perception Index (CPI) aggregates data
from a variety of different sources, including expert assessments and opinion surveys from institutions such as the World Bank, World Economic
Forum, and private risk assessment firms. The International Country Risk Guide (ICRG) Corruption Index combines expert analysis and survey
responses, considering factors such as the presence of corruption in the political system, the degree to which government officials are held
accountable for their actions, and the impact of corruption on business operations and economic stability. V-Dem gathers data from expert surveys,
typically involving five experts per country-year observation, to assess various democracy indicators. These expert judgments are aggregated using
a Bayesian measurement model, which accounts for biases and uncertainties, converting ordinal expert ratings into continuous latent scales to
provide reliable point estimates and credible intervals for each indicator. The Regime Corruption indicator uses V-Dem data to assess to what extent
do political actors use political office for private or political gain.

3/ Lower value indicates higher corruption for all indicators except for regime corruption where lower scores indicate a normatively better situation.

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7. Pervasive corruption and fundamental governance weaknesses could imply significant

fiscal and economic costs. Based on the TPIs, corruption is perceived to have increased from 2012
to 2022. Tax revenue declined sharply from the pre-crisis 10-12 percent on average to less than
8 percent in 2022 as many taxpayers dropped out of the tax net (Hellwig and Vitek 2021) 6. Weak
fiscal performance can be linked to the governance challenges associated with limited transparency
and low tax collection efficiency (Figure 2), that may lead to questionable policy choices, limited
capacity, and weak accountability. A Governance Diagnostic Assessment (GDA) identified severe
corruption vulnerabilities in revenue administration associated with weak accountability, lack of
systemic approach to promote integrity, human interaction between taxpayers and tax officials, and
fragmented tax expenditure management. The GDA and Public Investment Management
Assessment (PIMA) 2017 also highlighted weaknesses in budget credibility and inefficient public
investment management (PIM) due to lack of transparency, accountability, and competitiveness in
all stages of PIM.

Figure 2. Sri Lanka: Fiscal Governance

Sri Lanka: Tax Revenue and Control of Corruption Fiscal transparency
16 60 (Budget transparency score. Higher score indicates the
country is publish more sufficient information to the
14 public)
50 80

12 70

40
(In percent of GDP)

60
10
(Percentile)

50
8 30
40
6
Tax Revenue (LHS) 20 30

4 20
Control of Corruption (RHS)
10
2 10

0
0 0 Sri Lanka South Lower World Upper APD AE AE Asia
1996
1998
2000
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022

Asia middle middle

income income

Tax collection C-efficiency Public Investment Efficiency

(0: lowest efficiency, 1: highest efficiency) (relative to the frontier)

0.9 Emerging Market Economies All Other Countries Frontier

PIT CIT VAT 160
0.8
Infrastructure index - Physical indicator (Output)

140
0.7

0.6 120

0.5 100

0.4
80
0.3
60 Sri Lanka
0.2
40
0.1

20
Sri Lanka: 74.5 percent
0
(2021 update)
Sri South Lower Upper APD AE
0
Lanka Asia middle middle 0 10,000 20,000 30,000 40,000
income income Public Capital Stock per Capita (Input)

Sources: Sri Lanka Ministry of Finance, Worldwide Governance Indicators, IMF FAD Tax Efficiency Database, PIMA Report, Open Budget Survey, IMF
Staff Calculations.

6
VAT registrations declined by over 70 percent and non-corporate income tax by about 30 percent in 2020.

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8. Addressing governance weaknesses and corruption vulnerabilities across macro-

critical areas, in a comprehensive manner, is particularly important. The GDA points to key
governance weaknesses and corruption vulnerabilities across six main areas (anti-corruption legal
framework, AML/CFT mechanisms, fiscal governance, financial oversight, rule of law, and Central
Bank governance) with important macroeconomic implications including on budget credibility and
transparency, public investment management, SOE oversight, revenue administration, and financial
regulation. Common themes highlight critical governance gaps in the areas of accountability,
transparency, and independence in governance practices. These gaps need to be addressed with a
holistic approach supported by engagements with civil society and international partners. The
Worldwide Governance Indicators (WGI) 7 and Varieties of Democracy (V-DEM) indicators also
confirm governance gaps in the above areas with particular emphasis on policy continuity,
accountability framework, regulatory framework, and civil society (CSO)’s participation and influence
on policy decisions.

Governance Indicators IMF GD Assessment

Lower middle income Sri Lanka
Upper middle income Asia Anti-
World corruption
legal
Framework
Accountability
0.6
0.4 Fiscal
0.2 AML/CFT
Civil Society Rules of Law Governance
0
-0.2
-0.4
-0.6
Governance
-0.8 and Anti-
Control of
Regulatory Quality
corruption
Corruption

Financial
Rule of Law
oversight
Government
Political Stability
Effectiveness

Central bank
governance

Sources: World Bank and V-DEM. Sources: 2023 IMF Governance Diagnostic Report on Sri Lanka.

7
Among the governance indicators, accountability, rules of laws, control of corruption, government effectiveness,
political stability, regulatory quality are from the WGI. Civil society and regime corruption are from V-DEM (1)
Accountability captures perceptions of the extent to which a country's citizens are able to participate in selecting
their government, as well as freedom of expression, freedom of association, and a free media; (2) Regulatory quality
captures perceptions of the ability of the government to formulate and implement sound policies and regulations
that permit and promote private sector development. Political Stability measures perceptions of the likelihood of
political instability and/or politically motivated violence, including terrorism. Rule of law captures perceptions of the
extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract
enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence. Government
effectiveness captures perceptions of the quality of public services, the quality of the civil service and the degree of
its independence from political pressures, the quality of policy formulation and implementation, and the credibility of
the government's commitment to such policies. Control of corruption is explained above. Civil society captures
whether major CSOs routinely consulted by policymaker; how large is the involvement of people in CSOs; are women
prevented from participating; and is legislative candidate nomination within party organization highly decentralized
or made through party primaries?

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C. Channels: Macroeconomic Impact of Anti-corruption and Governance

Reforms

9. Corruption is costly. Corruption reduces the government’s ability to perform core functions
that are relevant to the economic activity. It can undermine taxpayers’ willingness to comply with the
tax system and reduce the efficiency of spending
programs. Corruption can also lead to inefficient
resource allocation. For instance, it distorts the
level playing field for productive firms to access
credit and other public resources. Besides the
economic costs, pervasive corruption weakens
social cohesion and reduces trust in the
government, which can result in economic,
social, and political instability. The negative
relationship between corruption and growth is
well-documented in the literature.

10. Comprehensive anti-corruption and governance reforms can improve growth potential
through several channels (Diagram 1).

• Tax collection efficiency. Fiscal governance and anti-corruption reforms that aim at improving
tax revenue collection efficiency (for example on-line tax portal, anticorruption measures across
revenue agencies) help increase fiscal revenue to support inclusive and growth-enhancing
expenditures (e.g., capital expenditure or targeted social support). The rest can be used to pay
down debt. Improved fiscal sustainability in turn lowers sovereign risk premium and borrowing
costs.

• Public investment efficiency. By improving the public investment efficiency (for example
through PFM reform), more public infrastructure can be built to support economic activity for
example by attracting tourism, improving labor mobility, and increasing industrial production
capacity.

• Efficient access to credit and public resources. Reforms that aim at facilitating a level playing
field for the private sector to access credit and public resources (e.g., strengthening the anti-
corruption legal framework and Commission to Investigate Allegations of Bribery and
Corruption (CIABOC)’s operational capacity, improving governance structure of state-owned
banks and creating rules for allocations of rights on public assets) can help promote private
investment.

• Better business environment. Comprehensive governance reform package, including to

strengthen contract enforcement and property rights protection, helps rebuild public trust in the
government and improve the business environment. This can help attract foreign investment
and facilitate technology transfer through trade and FDI, leading to higher productivity and
more opportunities to integrate in the global value chain and upgrade value added.

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Macroeconomic Impact of Anti-corruption and Governance Reforms

Labor Market Product Market

reform Trade reform reform

Increase labor Increase exports Increase firm

supply and FDIs productivity

Fiscal governance to increase tax Increase fiscal revenue from tax collection (direct tax
collection efficiency collection amplified by efficiency)
Broader improvement of control
Governance Fiscal governance to increase Higher public investment (both due to higher fiscal of corruption,
Reforms public investment efficiency space and higher investment efficiency) accountability,regulatory quality,
policy stability and rule of laws
Financial governance to improve
credit allocation Private investment efficiency

Higher fiscal balance Higher private investment Higher public investment Higher consumption

Higher growth

Lower interest rates, easing financing condition

Lower debt

D. Quantitative Illustration: Macroeconomic Impact of Governance

Reforms

11. The macroeconomic implications of governance reforms can be assessed using the
Debt, Investment, Growth (DIG-series) model. The general equilibrium model, which captures
interactions across economic agents, estimates the impact of governance reforms on
macroeconomic outcomes (Box 1) by reducing economic distortions in three main areas: (i) a
reduction in bribes and other distortions that discourage private firms from investing and
expanding; (ii) an improvement in public investment efficiency that facilitates an increase in the
public capital stock; and (iii) an improvement in tax revenue mobilization that reduces evasion and
widens the tax base.

12. The model, including three main economic distortions, is calibrated based on
Sri Lanka’s country-specific conditions. Steady states are set to historical averages before the start
of the COVID period. Three distortions are calibrated in the following ways. First, private investment
distortion is calibrated to reflect the difference between actual and benchmark private-investment-
to-GDP ratio (average for EMs based on Aligishiev et al. 2023) conditional on steady state of other
variables). Second, public investment efficiency is 74.5 percent based on 2017 PIMA report. Third, tax
collection efficiency is estimated at 32 percent for VAT based on IMF FAD tax efficiency database.
Key indicators of economic structure, such as exports-to-GDP ratio and the share of consumption
tax in total fiscal revenue, are based on the latest available data.

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13. The model demonstrates how comprehensive governance reforms could contribute to
reducing economic distortions. The model does not simulate the impact of specific governance
reforms; rather, it considers a set of governance reforms that could jointly contribute to lowering the
economic distortions to benchmark levels. For example, a combination of fiscal governance reforms
that improves revenue administration and reduces corruption across revenue agencies supported by
a stronger legal framework and accountability of public institutions serves to improve the tax
collection efficiency (specific mapping methodology in Table 2). The model then simulates the
macroeconomic impact of improving tax collection efficiency to the benchmark level assuming these
reforms are successfully implemented. Table 2 is not an exclusive list of reforms that would
contribute to reducing economic distortions; for example, institutional challenges associated with
human capacity across revenue agencies, regulatory and administrative challenges, and technology
adoption are not captured in the model. However, governance reforms play crucial roles.

14. Multiple scenarios illustrate the economic gains from different types of governance
reforms that are phased in at different paces and depths.

• Central scenario assumes that reforms are gradually phased in over 5 years with economic
distortions reduced to benchmark levels. That is, tax collection efficiency is improved to higher-
middle income class, public investment efficiency increased to 95 percent, and private
investment distortion reduced by half.

• Alternative scenario 1 (Alt S1) assumes slower reform progress; that is, distortions are
gradually reduced over 10 years rather than 5 years (the central scenario).

• Alternative scenario 2 (Alt S2) simulates deeper and more ambitious reforms that close all
private investment distortion gaps and increase the tax collection efficiency to advanced
economy level.

• Alternative scenario 3 (Alt S3) assumes immediate partial reversal, reversing half of the reform
efforts in the first 5 years.

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Box 1. Debt, Investment and Growth (DIG Series) Model

The Debt, Investment, Growth (DIG model) is extended to analyze macroeconomic impact of
governance reforms accounting for country-specific characteristics.1 Over the past decade, the DIG
model and its extensions such as DIGNAR and DIGNAD2 have been widely used among emerging and
developing countries (over 70 countries) to analyze the macroeconomic impact of governance and other
structural reforms.
The DIG-series model captures the channels through which reforms affect economic outcomes by
capturing the interactions among the main economic players. Two types of households decide the
amount of consumption and labor
supply. The hand-to-mouth or Model: Building Blocks
poor households’ budget is Provide labor

constrained by wage income and Private Demand Block:

Pay wage income;
Sell goods Private Supply Block:

government transfers net of tax Decides private

consumption
Decides output supply,
labor and capital demand

payable; and the Ricardian or rich

for production

households have access to capital Household Pay PIT, VAT Public capital
Government
(Poor) Investment Firms
markets on top of wage income.
Distortions:
Transfers Distortion:
- Tax collection efficiency
- Private investment
- Public investment

Firms optimally choose their

efficiency led by Credit
Pay capital
efficiency market distortions
income tax
Sell goods
private capital and labor inputs Household
(Rich)
and leverage public capital to
produce tradable and non- Pay wage income;
Provide labor
tradable goods. The government
levies income taxes to finance
public investment and pay off debt.
Three economic distortions generate economic loss, which can be mitigated by governance reforms.
• First, standard profit maximization implies that the return to private capital equals to the marginal
product of capital, which can be distorted (private investment distortion is (𝞳𝞳)) by the additional cost
associated with the time and resources wasted by entrepreneurs to bribe government officials to obtain
access to credit and public resources (e.g., electricity, infrastructure, etc.). 𝑅𝑅𝑡𝑡𝑘𝑘 = (1 − 𝞳𝞳)
𝝏𝝏𝝏𝝏(.)
𝝏𝝏𝑲𝑲𝒕𝒕

• Second, public investment efficiency (𝜖𝜖𝑡𝑡 ) determines the fraction of government capital expenditures
that translates into productive public capital. Weak governance reduces the efficiency of public
investment which translates into a lower stock of public capital being accumulated and lower output.
𝐺𝐺
𝐾𝐾𝑡𝑡+1 = (1 − 𝛿𝛿 𝐺𝐺 )𝐾𝐾𝑡𝑡𝐺𝐺 + 𝜖𝜖𝑡𝑡 𝐼𝐼𝑡𝑡𝐺𝐺
• Third, inefficiencies in revenue administration and tax policies lead to loss of tax revenue. Tax collection
inefficiency (𝜗𝜗) reduces government resources for financing growth enhancing expenditures such as
capital investment and targeted social transfers, and to improve debt dynamics.
𝐵𝐵𝑡𝑡+1 = 𝑅𝑅𝑡𝑡 𝐵𝐵𝑡𝑡 + 𝐼𝐼𝑡𝑡𝐺𝐺 − (1 − 𝜗𝜗)𝜏𝜏𝑡𝑡𝐶𝐶 𝐶𝐶𝑡𝑡

1
DIGNAR (Debt, Investment, Growth and Natural Resources) was based on Debt, Investment, Growth (DIG) model developed by Buffie et
al. (2012).
2
DIGNAD (Debt, Investment, Growth and Natural Disasters) builds on the extension of the DIG model of Buffie et al. (2012) to natural
disasters following Marto, Papageorgiou and Klyuev (2018) that captures the challenges of closing infrastructure gaps in developing
countries that frequently face natural disasters.

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Table 2. Sri Lanka: Mapping Governance Reforms to Economic Distortions

Distortions Governance Reform Goal Priority Recommendation Under GDA and Current
EFF Program

Tax Collection Strengthen rule of laws Restrict ministerial authority to make discretionary
Efficiency changes to tax policy.

Enhance accountability Institute anti-corruption measures across revenue

agencies (IRD, custom, and excise).

Strengthen revenue Rollout of RAMIS 2.0

administration Implement, track and report KPIs on tax compliance.

Public Investment Strengthen transparency Enact public financial framework (PFM) law.
Efficiency Enact public procurement Law.

Enhance fiscal governance Publish public procurement contracts and tax exemption
framework information online.
Implement SOE reforms.
Abolish and suspend SDP Act until transparent process
is in place.
Private Investment Strengthen financial Revise the Banking Act and the regulations, including
Distortion oversight. strengthening corporate governance of state-owned
banks.

Strengthen transparency, Develop a government policy to regulate allocations of

accountability, and rule of public assets.
law Establish digital land registry.
Enact revised Central Bank Act to ensure CBSL
independence.
Strengthen mandate and functions of the Judicial
Services Commission
Apply to all Strengthen anti-corruption Publish asset declarations for senior officials.
distortions legal framework. Enact Proceeds of Crime legislation.

Strengthen accountability, Amend and National Audit Act levy surcharges for
transparency, and rule of misuse of public assets.
laws Implement regulations to support the provision of
beneficial ownership information and establish registry.
Establish and operationalize independent CIABOC to
fulfill new mandates.
Establish and implement plan to expand resources for
Judicial Services Commissions.

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Results

15. Simulation results suggest that governance reforms help improve fiscal performance
and stimulate private consumption and investment; and the impact is optimized with
coherent reform efforts.

• By improving the tax collection efficiency, the government gains more resources to spend on
public capital and social transfers which benefit firms and households, stimulating private
investment and consumption by about 1-2 percent and reducing debt-to-GDP ratio by about
1 ppts from the steady state over 10 years (Figure 3). The magnitude of economic gains is
relatively small, but comparable to cross-country analysis (IMF 1998) due to near-term
dampening effect of higher tax collection on economic activity.

• Higher public investment efficiency allows government to build more infrastructure that
supports business production, which in turn promotes private investment and consumption by
1-2 percent from the steady state over 10 years.

• Mitigating private investment distortion effectively increases firm productivity and hence the
potential to hire, expand and contribute to fiscal revenue. The impact is more sizable than
individual fiscal reforms, with private investment and consumption up by about 6 and 4 percent
respectively over 10 years, possibly reflecting large private investment gaps and more direct
impact on business and household activity featured in the model.

• Individual reform efforts may not generate notable impact quantitatively, but combined reforms
could increase growth by more than 7 percent and reduce debt-to-GDP ratio by more than
6 percent over 10 years.

16. Governance reforms also contribute to reducing inequality. Two types of households
captured in the model face different dynamics in response to the governance reforms. For instance,
rising tax collection efficiency benefits the poor households (2-3 percent) more than the rich
(1-2 percent) as the latter pay higher marginal tax, which dampens consumption temporarily while
the poor would benefit from higher targeted social transfers (Figure 4). Higher private efficiency also
benefits poor households (around 5 percent) more due to better job market and higher government
transfers, while gains in wage incomes are partially offset by higher taxes paid on consumption and
capital gains for the rich (around 3 percent). Private income efficiency improvement generates most
distributional benefits, followed by improvements in tax collection and public investment efficiency.
Combined reforms can generate an aggregate decline in consumption inequality by more than
15 percent over 10 years.

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Figure 3. Sri Lanka: Central Scenario: Macroeconomic Impact of Governance Reforms

Real GDP Private Investment
8
10
Public investment efficiency
7 9
Tax efficiency
6 Private firm distortion 8
All 7
5
6
4
5
3 4
2 3
2
1
1
0
0
1 2 3 4 5 6 7 8 9 10 11
-1 1 2 3 4 5 6 7 8 9 10 11

Private Consumption Public Debt

12 (in percent of GDP)
Public investment efficiency 1
10 Tax efficiency
0
Private firm distortion
1 2 3 4 5 6 7 8 9 10 11
8 All -1

-2
6
-3
4 -4

2 -5

-6
0
1 2 3 4 5 6 7 8 9 10 11 -7

Source: IMF Staff Calculations

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Figure 4. Sri Lanka: Central Scenario: Impact of Governance Reforms on Income Distribution
Private Consumption, Poor Private Consumption, Rich
14 8
Public investment efficiency Public investment efficiency
12 7
Tax efficiency Tax efficiency
Private firm distortion 6 Private firm distortion
10
All All
5
8
4
6
3
4 2

2 1

0 0
1 2 3 4 5 6 7 8 9 10 11 1 2 3 4 5 6 7 8 9 10 11

Private Consumption Consumption Inequality

12
0.02
Public investment efficiency
10 Tax efficiency 0
Private firm distortion -0.02 1 2 3 4 5 6 7 8 9 10 11
8 All -0.04
-0.06
6
-0.08
4 -0.1
-0.12
2
-0.14
-0.16
0
1 2 3 4 5 6 7 8 9 10 11 -0.18

Source: IMF Staff Calculations

17. Besides the direct channels, governance reforms also support other structural reforms
indirectly by creating a conducive environment. An IMF structural reform database (Alesina and
others 2020, IMF 2023) provides the indices that reflect the degree of regulatory stance in several
policy areas across countries. Blue dots show the position of the regulatory system between the
open/liberal and closed/conservative stances. Using Panel regressions, the database estimates an
average annual growth increase of around 1 ppts for Sri Lanka (bars), if structural gaps in the areas
of external finance, trade, product market and labor market are reduced to the EM frontier level.
With governance reforms, combined growth gain amounts to 1.7 percent, thanks to better business
environment to attract
Annual Growth Gain from Structural and Governance Reforms
foreign investors and
(in percent)
trading partners, and 1.8 1.7 percent
1.6 GDP gains (to EM frontier)
stronger legal and 1.4 Structural gap (to EM frontier)
accountability 1.2
1 percent
framework to facilitate 1
0.8
domestic reforms (e.g., 0.6
labor and product 0.4
market). The caveat to 0.2
0
the growth gain External Trade Product Labor Market Governance Structural Structural and

estimate is that the Finance Market Reform Reforms Governance

Reform
amplifying effect from Sources: IMF Structural Reform Database, Staff Calculations

the interaction of

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governance and other structural reforms are not captured here; therefore, the estimate is on the
conservative side.

18. While the economic gains vary with the depth and pace of reforms, the key is the
commitment to sustain the reform efforts. Alternative scenarios with deeper (Alt S2) and faster
reforms (Central Scenario) show higher growth gains than otherwise (Alt S1) (Figure 5). In Alt S2,
governance reforms can increase medium term growth from 3.1 percent in the baseline to
4.2 percent and facilitate faster transition to higher income status. In ten years, GDP per capita could
increase to 7000 US$, almost 1000 US$ higher than the baseline. In the meantime, sustained reform
effort is more important than speeding up ambitious yet unrealistic reforms without a coherent
strategy supported by strong political ownership and international partners. In a scenario with
reforms reversed in half (Alt S3), efforts in the first five years would be mostly wasted. The economic
loss would be even larger if the reforms are fully reversed. Accounting for the economic impact of
other structural reforms, the growth potential can be increased by another 1 ppts (Figure 6, ¶17).

Figure 5. Sri Lanka: Alternative Scenarios: Growth Impact of Governance Reforms

GDP per Capita

Real GDP Growth
(in current USD)
(in percent)
7500
6
7000
5

4 6500

3 6000

2
5500
1
5000
0
2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 4500
-1
Central Scenario
-2 4000
Alt S1 (10 year)
Alt S2 (close all gap)
-3 Alt S3 (Partial Reversal) 3500
Baseline 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
-4

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Figure 6. Sri Lanka: Alternative Scenarios: Growth Impact of Structural and Governance
Reforms

GDP per Capita

Real GDP Growth
(in current USD)
(in percent)
7500
7
7000
6

5 6500

4
6000
3
5500
2

1 5000

0 4500
2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
-1
Central Scenario 4000
-2 Alt S1 (10 year)
Alt S2 (close all gap) 3500
-3 Alt S3 (Partial Reversal)
2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
Baseline
-4

Source: IMF Staff Calculations

E. International Experience

This section draws key lessons from the cross-country experience of some governance reforms listed in
Table 1, with a focus on reforms that strengthen fiscal governance, Anti-Corruption Commissions, and
asset declaration systems.

19. Sustained efforts to tackle corruption and strengthen fiscal governance are crucial to
break the vicious circle that undermines fiscal performance. Corruption reduces the public’s
willingness to pay taxes (there is a common perception that public assets get stolen), while weak
fiscal governance facilitates corruption, making it easier to divert public funds. Reforms therefore
need to tackle corruption and fiscal governance simultaneously, helping to turn this vicious circle
into a virtuous one. Georgia is a prime example of a country that successfully tackled both
corruption and fiscal governance in a reform drive that started in 2003(IMF 2019). Prior to that,
Georgia was generally considered one of the most corrupt countries in the world, where corruption
was aided by the complex tax system, with numerous special regimes, exemptions, and loopholes.
The anti-corruption campaign focused on eliminating corruption in the civil service, reducing the
number of regulations, and improving the business environment. At the same time, significant
reforms were implemented in tax administration. As a result, tax revenues increased significantly
over a short period of time, from 12 percent of GDP in 2003 to 22 percent in 2007 (Figure 7). These
reforms were followed by improvements in fiscal transparency and public investment management,
which helped to preserve the gains of improved tax collection. Rwanda is another country that
achieved remarkable success in improving control of corruption, strengthening fiscal governance
and reforming tax administration to raise tax revenues over a relatively short period of time.

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Figure 7. Sri Lanka: A Turnaround Story: Tax Revenue and Control of Corruption
Georgia: Tax Revenue and Control of Corruption Rwanda: Tax Revenue and Control of Corruption

30 90 18 80

80 16 70
25
70 14
60

(In percent of GDP)

12
(In percent of GDP)

20 60
50

(Percentile)
(Percentile)
50 10
15 40
40 8
Tax Revenue (LHS)
30
10 30 6
Tax Revenue (LHS)
Control of Corruption (RHS) 20
20 4
5 Control of Corruption (RHS)
2 10
10

0 0 0 0

1996
1998
2000
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
1996
1998
2000
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022 Sources: IMF World Economic Outlook Database; and World Governance Indicators.
Sources: IMF World Economic Outlook Database; and World Governance Indicators.

20. Fiscal governance reforms often require significant efforts across several dimensions.
Georgia addressed many aspects of fiscal governance weaknesses simultaneously. There are also
other countries that have successfully implemented fiscal governance reforms on a more selective
basis:

• Tax Policy and Revenue Administration. A key element of the 2003 reforms in Georgia was
simplifying the tax code and procedures and removing exemptions. This helped to level the
playing field and eliminate the incentive to lobby for tax exemptions and special regimes, which
was a major source of corruption. In parallel, broadening the tax base by shutting down
unlicensed vendors, requiring cash registers and opening one-stop windows for businesses to
deal with tax authorities contributed to a sharp increase in tax collection. Other examples of
countries that undertook reforms of revenue institutions include Rwanda and Liberia.

• Fiscal Transparency. Reforms in this area generally focus on better disclosing the budget
information and promoting accountability, both of which are essential to reduce corruption.
Many countries go further in improving their budgetary frameworks, by developing government
balance sheets and income statements, introducing the medium-term budget frameworks
(MTBF) and publishing detailed statements on fiscal risks. The MTBF, fiscal risks statement and
scenario analysis are then included in the budget documents, which improves transparency and
helps show the public that the budget is well justified and thought through. Examples of
successful reforms in this area are Georgia, Chile, and Brazil.

• Public Investment Management. Having a strong public investment management system

strengthens public confidence that tax revenue is not misused and can also improve
predictability of public funding. Many countries found that well-functioning and transparent
e-procurement systems help track spending and assure the public that the procurement process
is fair and not biased in favor of politically connected businesses (Chile, Bangladesh, North

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Macedonia). Experience also shows the importance of having a sound process for project
appraisal (Mexico, Slovakia, Timor-Leste).

21. Effective and independent Anti-corruption Commissions (ACCs) play a pivotal role in
combating corruption. Inspired by the successes in Hong Kong Special Administrative Region and
Singapore, many economies have established anti-corruption commissions (ACCs). They function as
independent institutions with a specialized mandate to investigate, prosecute, and prevent
corruption. Effective models often have a clear legal framework, independence, adequate resources,
transparency in operations, and collaborative efforts with other domestic and international entities.
These are widely recognized practices reflected in the United Nations Convention Against
Corruption (UNCAC) as well as the Jakarta Principles for anti-corruption agencies.

• Selection and Recruitment Process. Based on international good practice, commissioners are
appointed through a merit-based and independent process. For some cases, initial recruitment
can be conducted by a pre-selection committee in collaboration with civil society organizations
and/or experts with international Countries with Public Availability of Declared Information
experience. by Law, by Region
(In percentage)
Public by Law Not Public by Law

• Institutional and Operational OECD high income

Framework. Bhutan Anti-Corruption Europe and Central Asia

Commission (ACC) has a well- Asia

structured institutional and operational
Sub-Saharan Africa
framework (World Bank 2020) including
Latin America and the Caribbean
a well-articulated mandate, strong
institutional capacity, and a
Middle East and North Africa

development strategy focused on 0 20 40 60 80 100

Sources: "Getting the Full Picture on Public Officials: A How-to Guide for Effective
education, investigation, and Financial Disclore," World Bank.
Note: Aprroximate percentages based on the analysis of 153 countries.
prevention, real time analysis of
evidence from investigation, and an accessible and open management approach with detailed
and documented procedures.

• Public Support and Political Ownership. The ACC in Bhutan gained wide trust and support
from the Bhutanese society following significant outreach and awareness raising campaigns,
including through public opinion surveys. World Bank studies show that its success can be
challenged by political resistance to changing elite privileges and traditional norms (World Bank
2020). Bhutan is not an isolated case, highlighting the importance of political ownership and
aligned incentives to sustain anti-corruption reforms.

22. The publication of comprehensive public officials’ asset declarations has been an
important vehicle to increase transparency and accountability. Since 1996, asset declaration
systems have been implemented in over 160 countries, reflecting a global trend towards greater
public accountability and transparency. However, these systems are often underutilized.
International frameworks, such as the UNCAC, recognize asset declaration systems as a critical
element of anticorruption efforts. Additionally, regional, and international documents have provided

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valuable guidance for implementation, including the G-20 high level principles on asset disclosure
by public officials.. Ukraine and Romania’s experience suggests the importance of public access, and
institutional autonomy for the success of asset declaration systems.

• Public access. The benefits of publication have been well-documented in literature (Kotlyar and
Pop 2017, Djankov et al. 2009). Indeed, 97 percent of OECD high-income countries as well as
70 percent of countries in Europe and Central Asia require publication of asset declarations. In
Romania, mandatory public access to asset declarations has been critical to the success of ANI
(National Integrity Agency)’s system, which established a large and regularly updated database.
According to the European Commission, ANI has taken important steps towards more efficient
disclosure and verification of asset declarations. By end 2022, more than 10 million asset and
interest disclosures were published. In Ukraine, the asset declaration system ensures
comprehensive data coverage, strong sanctions for non-compliance and wide public access to
disclosed information. By 2019, four million e-declarations have been made available to the
public in Ukraine (World Bank 2021). Public access to asset declarations has been reinstated
despite the ongoing war, including through IMF conditionality and public demands for
transparency. 8 By early 2024, more than 1,5 million asset declarations had been submitted for
2021-22 according to the National Agency on Corruption Prevention (NACP). 9 The level of
transparency has empowered civil society groups and journalists to conduct investigations on
public officials’ assets that strengthens authorities’ accountability, as well as provided banks and
other regulated entities useful information in complying with AML/CFT obligations. Public
participation and engagement have also helped build public trust in the system.

• Preventive Measures in Procurement Process. PREVENT, launched in Romania in 2017, is an

automated system designed to flag potential conflicts of interest in the procurement processes.
During the initial phase from June 2017 to December 2019, PREVENT reviewed more than
43,000 procurement procedures and gave 117 integrity warnings.

• Institutional Autonomy. Additionally, institutional autonomy of Romania’s ANI is important.

Integrity inspectors are selected through a competitive process and provided with full autonomy
and independence to conduct their investigations. Their work is subject to annual evaluation by
an independent external auditor as well as judicial scrutiny. ANI’s president and vice-president
are also appointed following a merit-based competitive process. Moreover, because ANI has the
mandate to proactively start investigations ex-officio, the institution does not need to rely on
law enforcement or the judiciary to sanction corruption or impose disciplinary measures on
public officials. Similarly in Ukraine, efforts to revamp the NACP with a revamped organization
set up in 2019 and new leadership selected (in 2020 and now in 2024) through a highly
competitive process has also contributed to building a more effective system.

8
See IMF Staff Report 2023 AIV and 2nd EFF Review (end-October 2023 Structural Benchmark).
9
https://nazk.gov.ua/en/news/almost-1-5-million-declarations-submitted-for-2021-and-2022-results-of-the-
declaration-campaign/

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23. Engagement of civil society and support from international partners play an important
catalytic role in facilitating the reform progress. Civil society played a key role in the adoption
and implementation of Ukraine‘s electronic asset and interest disclosure system in 2014, which has
been recognized as one of the most comprehensive models worldwide. Support from international
partners, including the IMF, UNDP, and the World Bank through technical and financial assistance
was also important in ensuring the successful design and implementation of the system. Civil society
also played important roles in appointing anticorruption commissioners (e.g., Bhutan), and
investigating published asset declarations (e.g., Ukraine and Bhutan). The electronic publicly
accessible asset declaration system allowed civil society organizations to leverage the information to
create a Politically Exposed Persons database (pep.org.ua), which used other publicly databases to
verify the information in the asset declaration and identify discrepancies. However, owing to the war,
the PEP database is temporarily closed.

F. Conclusions and Policy implications

24. Corruption vulnerabilities reflect fundamental challenges to Sri Lanka’s governance

framework, which need to be tackled by a comprehensive set of reforms. Various indicators
point to severe and systemic corruption vulnerabilities affecting the economy in Sri Lanka. The GDA
highlighted key governance weaknesses associated with transparency and accountability in the
areas of fiscal governance, financial oversight, AML/CFT, anti-corruption legal framework, rule of law,
and Central Bank independence. In response, the authorities set out a reform agenda, including as
part of the EFF program, taking on board important recommendations from the GDA. Some early
steps have been taken. Going forward, reforms need to be designed and implemented in a coherent
approach that account for reinforcing effects across reform areas (e.g., fiscal reforms supported by
anti-corruption measures, etc.), prioritization from near-term to medium-term horizon, and
corresponding resource allocations.

25. Dynamic general equilibrium simulations suggest significant macroeconomic gains

from governance reforms through various channels. Comprehensive reforms are found to
increase the growth potential by improving the state capacity to perform core functions, the
business environment, service delivery, and human capital, which reflects better fiscal performance
(by enhancing tax collection and public investment efficiency), and more efficient resource allocation
(by reducing private investment distortions). Depending on the pace and depth of the reforms, real
growth gain could increase from 0.6 to 1.2 percent per year, accelerating Sri Lanka’s move to higher
income status. Governance reforms can also improve Sri Lanka’s income distribution and debt
dynamics.

26. International experience highlights the macro-criticality of these governance reforms

and the importance of civil society engagement and international support. Success stories
underscore the importance of tackling fiscal governance challenges using a multi-pronged
approach, supported by anti-corruption efforts. Good practices for anti-corruption commissions are
normally guided by common principles, exemplified by international standards; and the
commissioner appointment and staff recruitment process follow a merit-based and independent
process. Effective asset declaration system ensures transparency, institutional autonomy, and

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preventive measures during procurement process. International experience also underscores the
importance of civil society and international partners in facilitating the implementation process.

27. Reforms need to be phased in systematically, with strategies in place to address

implementation challenges. Empirical evidence highlights the importance of adopting the reforms
in a coherent manner, which requires strategic planning and prioritization. While initial reforms help
stimulate the momentum and start establishing important anti-corruption and governance legal
frameworks, sustaining the reform efforts remains the key to success. Most importantly, effective
implementation requires capacity development, broader and stronger commitment to transparency
and accountability, and consistent support by multiple stakeholders.

28. Efforts to improve governance need to be sustained over the long run to bear fruit.
History is full of examples of short-lived, one-off anti-corruption drives that end without making a
perceptible impact on governance. As shown by the simulation exercise, reform reversal can be
quite costly. Successful governance reforms typically continue for long periods of time. Addressing
multiple aspects of governance in a coherent manner requires time. In all successful country
examples that we mentioned, there are still governance improvements to be implemented, and
further governance reforms are still underway. Time is also needed to ensure that reforms are
entrenched and the level of tolerance for corruption in society has fallen to a sufficiently low levels,
so that a full reversal is difficult, even with political changes.

29. Support from the highest political level is crucial to ensure durable success of
governance reforms. In countries with widespread corruption, many groups may feel that they are
benefitting from it. If anti-corruption efforts are limited to fighting petty theft and small bribes by
low-level officials, while high-level corruption remains unabated, it may contribute to the feeling of
injustice. Active involvement by the highest level of government can help create a perception that
the rules of the game have changed, and corruption is no longer tolerated at any level. Efforts to
strengthen fiscal governance are helpful in this regard, as they show that the government budget is
becoming clean and transparent, reducing opportunities for high-level theft. The case studies show
the importance of leading the governance reforms from the top.

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