# **1. Introduction**

Beginning with the peace agreement in 2002, Sri Lanka experienced strong growth throughout the decade, with only some decline during the international financial crisis. This growth was accompanied by significant poverty reduction, reflecting growth in consumption, particularly at the bottom of the distribution. However, economic growth was not the only factor that changed over the course of the decade in Sri Lanka. For instance, there was a shift in the demographic structure following the conflict, with an increase in the number of young adults moving into the labor force, but also a slight increase in the number of children. In addition, there were policy changes over the size of pubic transfers to the poor, as well as increases in remittances which could have also had an impact on poverty. Moreover, it is unclear how the transmission channels between growth and household welfare played out, and how heterogeneous these impacts were across the distribution. For instance, we know this was a period in which there were modest gains in education, and shifts away from agriculture and into nonfarm employment, both of which could have influenced the welfare of the poor.

The objective of this paper is to quantify, based on a series of counterfactual simulations, the contributions of different factors towards poverty reduction in Sri Lanka over the last decade. In contrast to methods that focus on aggregate summary statistics, the methods adopted in this paper generate entire counterfactual distributions, allowing us to decompose the contributions of changes in different sources of income and in individual and household characteristics to the observed distributional changes. Although these decompositions do not allow identification of causal effects, they are useful as a diagnostic that can help focus attention on the elements that are quantitatively more important in describing changes in poverty.<sup>1</sup> For instance, to the extent that growth in real wages of farm workers was a main contributor to poverty reduction, it would be important to understand whether this was due to productivity increases, or if this is simply a result of higher commodity and relative food prices, which could just as easily fall over time, thus reversing their impact on the poor.

In particular, we implement a micro-decomposition approach which adapts the Bourguignon, Ferreira, and Lustig (2005) methodology to further distinguish between distributional changes on account of changes in endowments or/and returns to those endowments, changes in occupational choice, changes in geographical, age, and gender structure of the population, along with the non-labor dimensions mentioned above. This paper contributes with an innovative extension of the decomposition methodology implemented in the literature (Bourguignon, Ferreira and Lustig (2005), Bourguignon, Ferreira and Leite (2008) and Inchauste et al. (2014)) tailored for the Sri Lanka case.

The remainder of the paper is organized as follows. Section 2 briefly discusses the data used for the analysis. Section 3 describes the evolution of poverty and economic growth in Sri Lanka between 2002 and 2013 and the hypothetical sources that may explain the observed distributional changes over the period. Section 4 presents the model of consumption and earnings, using an underlying labor model to further distinguish why labor incomes grew. Section 5 presents and discusses the results. Section 6 concludes.

# **2. Data**

We use the 2002 and 2012/13 rounds of the Sri Lanka Household Income and Expenditure Survey (HIES) conducted by the Department of Census and Statistics (DCS) under the National Household Sample Survey Program.<sup>2</sup> The HIES is a year-long sample survey which is conducted in 12 consecutive monthly rounds

> 1 Similar analysis in Bangladesh led to additional work on food price and wage increases. See World Bank, 2013. 2 We also use the 2006/07 and 2009/10 rounds in two tables, Table 1 and Table 3.

2