Sri Lanka is a country in South Asia. Colombo is its capital city. It has an area of 65,610 sq kms. Sinhala, Tamil and English are its principal languages. It is an island in the Indian Ocean that lies at a distance of about 80 kms east of the southern tip of India. !!History Known to the ancient world as Taprobane and later as Serendip, the island was also known as Lanka, Sinhala Dvipa or Deepa and Seelan. In recent past, until 1972 it was Ceylon. !!Governance Sri Lanka is a small island surrounded by the Indian Ocean with a population of 19 million. A low-income country, Sri Lanka has achieved human development outcomes comparable to those of high income countries. The country has been growing at 5 percent annually over the past two decades. Although macroeconomic conditions have stabilized following corrective measures and additional external aid for tsunami recovery, tighter fiscal and monetary policies will be needed to contain inflationary pressures. The quality of the public administration in Sri Lanka has declined over the past decades due to political patronage, overstaffing, administrative overlap and duplication, and excessive salary compression. The Public Service Commission was re-established with the objective of depoliticizing the civil service and reducing political patronage, but its role has remained limited. A hiring freeze was enforced to control overstaffing, and a draft Public Finance Act to improve public expenditur4e management and fiscal accountability was submitted to the Cabinet. The government’s implementation capacity, particularly at the local level, will be substantially over-stretched by additional emergency and reconstruction activities as a result of the tsunami. Coordination between the national and district levels need to improve, including a better allocation of responsibilities between the various levels of Government. Sri Lanka’s tax administration has been weakened by the coexistence of parallel regimes and the existence of legal provisions enabling the Board of Investment (BOI) to override Inland Revenue and Customs laws in granting tax concessions and limited experience with modern taxes. Proposed administrative measures to strengthen tax administration include establishing a well integrated revenue administration; establishing a separate tax audit unit for carrying out tax audits; and for the large taxpayer unit of the Inland Revenue Department to proactively pursue potential revenue. While not significant, corruption nevertheless exists in Sri Lanka. Around 11 percent of rural enterprises that dealt with government agencies for registration, and 8 percent that dealt with agencies for licensing, reported making unofficial payments. These payments were equivalent to 5-6 percent of the official licensing or registration fee. Rural entrepreneurs also reported that laws and regulations are occasionally misinterpreted or manipulated by officials as a result of a lack of knowledge among officials or because of ethnic, social, or income biases. The World Bank has been involved in recent years in assisting Sri Lanka with strengthening the legal and judicial system. The achievements of a recently closed Legal and Judicial Reforms Project will be consolidated through follow-on work in three areas: judicial training; court computerization; and professional development for the Attorney-General’s office and the Legal Draftman’s office. To manage public finances, public expenditures will have to be rationalized by establishing a policy driven, output based and consultative budget formulation system under a medium term budget framework. The Ministry of Finance is developing a medium term budget framework, which could potentially combine macro (i.e., attaining fiscal sustainability) and micro objectives (i.e., enhancing the development impact of public spending). Building on the recent introduction of budget ceilings and a three-year planning horizon, the budget formulation process needs to better align policy priorities with resource allocation within and across sectors. In general, there is a need to reorient expenditures from recurrent to investment to support faster economic growth.