## 1. Reserve Adequacy and Parallel Market Premium

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### Background
- Parallel market premium dynamics:
  - Premium increased steadily from early 2013 to mid-2022, rising sharply from late 2022; by November 2023, it had surpassed 100 percent and remained elevated through the end of June 2024.
  - Adoption of a market-determined exchange rate in July 2024 and removal of most distortive exchange restrictions led to rapid convergence between official and parallel market rates:
    - Premium collapsed, reaching near-zero by early September 2024 as the official rate aligned with market conditions.
    - Premium increased to approximately 16 percent by late October 2024.
    - Premium narrowed and stabilized in the single digits until the end of December 2024.
    - By early May 2025, the premium gradually widened again to around 17 percent.
- FX reserves and import coverage:
  - NBE’s FX reserves were below one month of import coverage from November 2021 to June 2024, except for a brief recovery in October 2023.
  - FX reserves increased to approximately US$4 billion in April 2025, covering nearly two months of prospective imports.
- Channels and consequences:
  - Widening premium coincided with acute FX shortages and FX controls; imports of durable consumer goods contracted.
  - FX allocations prioritized essential imports (fuel), contributing to reserve depletion.

### Comparative analysis of post-reform parallel market premia (Angola, Egypt, Ethiopia, Nigeria)
- Six months after major exchange rate adjustment, parallel market premium:
  - Angola: 48 percent
  - Egypt: 0.2 percent
  - Ethiopia: 12.4 percent
  - Nigeria: 0.3 percent
- Dynamics and patterns:
  - Angola: premium declined to 15 percent by 34 months after the reform but experienced two episodes of increase (to a post-reform high of 44 percent 21 months after adjustment), indicating protracted adjustment.
  - Egypt: premium remained below 1 percent for 11 months following adjustment, signaling smoother stabilization.
  - Ethiopia: post-unification experience most closely resembled Angola during its transition, with a more protracted premium.

### Remaining exchange restrictions for current account transactions (Ethiopia, post-reform)
- Examples of retained restrictions:
  - Hard ceilings on access to and use of FX for travel purposes.
  - Prohibition of access to and use of FX for cross-border payment of moderate family remittances.
  - 2.5% NBE exchange commission.
  - Tax clearance certificate requirement for repatriation of dividend and other investment income.
  - Requirement to provide a clearance certificate from the NBE to obtain import permit.
  - Restriction on access and use of FX for repatriation of backlog dividends.
- Macroeconomic impact:
  - The macroeconomic impact of such remaining current account restrictions appears modest:
    - The REER remained stable for Egypt, Ethiopia, and Nigeria while it continued to depreciate slowly in Angola after unification.
    - The affected current account transaction types typically represent a small proportion of consumer spending and carry low CPI weights.

### Financial account restrictions and relative attractiveness of local currency assets
- Financial Account Restriction Index (FARI) indicators:
  - Angola and Ethiopia: regulations on approximately 70 to 80 percent of total capital account transactions.
  - Egypt and Nigeria: regulations on 10–20 percent of total capital account transactions.
- Incentives for capital outflows:
  - A positive Δ (difference in expected real yield between overseas and domestic investments) raises incentives for capital outflows via the parallel market.
  - A positive Δ continued in Ethiopia for five months for which data are available following the FX reforms, reflecting low nominal yields domestically while inflation was in the mid-to-high teens.
  - Policy implication: to eliminate expectation of depreciation, domestic interest rates need to compensate for the inflation differential plus some risk premium as well as the nominal yield from foreign investment.

### Financial market underdevelopment and banking concentration
- Financial development:
  - Ethiopia ranks lowest on the financial development index among Angola, Egypt, Ethiopia, and Nigeria, slightly below Angola.
  - Lack of hedging instruments and absence of foreign investors reduce hedging and market depth; importers cite lack of hedging as reason to resort to the parallel market (risk between opening LCs and settling payments; widespread use of deferred LCs).
- One-bank concentration:
  - Commercial Bank of Ethiopia (CBE) accounts for approximately half of the total bank assets in the sector.
  - CBE has a net short FX position stemming from its legacy as a policy bank, which may reduce incentives to mobilize FX given depreciation risks and the bank’s dominant market position.
  - Other banks may prefer high-fee, low-volume business models rather than compete on volume, potentially limiting FX mobilization from exporters and inward remittances and leaving unmet FX demand.

### Key findings and exact observed metrics (preserve numeric values)
- Parallel market premium surpassed 100 percent by November 2023 and remained elevated through end-June 2024.
- Premium reached near-zero by early September 2024.
- Premium approximately 16 percent by late October 2024; around 17 percent by early May 2025.
- FX reserves below one month of import coverage from November 2021 to June 2024, except October 2023.
- FX reserves approximately US$4 billion in April 2025, covering nearly two months of prospective imports.
- FARI: Angola and Ethiopia regulations on approximately 70 to 80 percent of capital account transactions; Egypt and Nigeria 10–20 percent.
- CBE accounts for approximately half of total bank assets.
- A positive Δ persisted for five months post-reform in Ethiopia.
- 2.5% NBE exchange commission remains as a cost to access official FX.

### Policy-relevant technical implication
- Domestic interest rates must compensate for the inflation differential plus some risk premium and the nominal yield from foreign investment to remove expectations of depreciation and reduce incentives for capital outflows via the parallel market.

---

### Drivers of a persistent parallel market in Ethiopia
- Structural drivers:
  - Exchange rate restrictions.
  - Tightly closed financial account.
  - Limited financial instruments.
  - High bank concentration.
- Deeper contributing factors:
  - Concerns about property rights, security, and conflict encouraging outflows of wealth through the parallel market.
- Comparative observation:
  - Ethiopia shares several characteristics with Angola during its transition to a floating exchange rate regime — a period when Angola’s parallel market premium was higher than in Egypt and Nigeria.

### Policy recommendations to develop a well-functioning and unified FX market
- Priorities and sequencing:
  - Phased removal of remaining exchange rate restrictions on current account transactions to reduce costs of using the formal market and to satisfy FX demand.
  - Positive real interest rates to make holding Birr-denominated assets more attractive and reduce incentives to hold wealth in FX via the parallel market.
  - Well-sequenced opening of the financial account over the longer term:
    - Focus first on strong regulatory and supervisory capacity.
    - Ensure the financial sector can manage cross-border flows soundly.
    - Attract long-term capital flows before facilitating shorter-term investors.
- Regulatory prerequisites for safe financial account liberalization:
  - Effective enforcement of net open position (NOP) limits.
  - Robust FX exposure monitoring.
- Financial market deepening measures:
  - Grow liquidity in interbank money and FX markets.
  - Create pre-conditions to develop hedging instruments.
- Competition and transparency in banking:
  - Enhance competition in the banking sector, notably through more transparency on fees, commissions, and pricing.
  - Consider possible participation by foreign banks to improve price discovery and the efficiency of FX intermediation.

*Source: IMF staff estimates.*

### Transition to an interest-rate based monetary policy framework
- Context and milestones:
  - Modernizing monetary policy is a key part of the Homegrown Economic Reform Agenda (HGER), launched in 2020.
  - Objective: correct macroeconomic imbalances and support private sector–led growth.
  - Monetary and fiscal policy tightened to gradually reduce, and in FY2024/25 eliminate, the use of direct NBE advances to finance the budget.
- Operational shift:
  - Prior to July 2024, NBE operated under a monetary targeting (MT) framework using reserve money as the operational target.
  - Since July 2024, NBE began using market-based interest rates to guide monetary conditions.

### Operational design choices and market development
- Measures introduced:
  - Full allotment liquidity-absorbing open market operations (OMOs).
  - Standing lending and deposit facilities to form a policy corridor at ±300 basis points.
  - Overnight interbank lending rate set as the operational target.
  - October: launch of a new interbank market to support banks’ liquidity management.
  - Complementary reforms: improvements to the T-bill market and introduction of an Emergency Liquidity Assistance framework.
- Rationale and sequencing:
  - Fixed-rate full-allotment framework is robust to changes in banks’ demands for excess reserves and does not require short-term forecasts of autonomous factors.
  - Initial OMO was liquidity absorbing given the structural liquidity surplus and absence of widely available collateral.
  - Wide policy corridor initially (±300 basis points), with narrowing over time as operational experience builds.
- Ongoing reforms needed:
  - Phase out quantitative restrictions on lending, including the cap on private credit growth.
  - Launch and operationalize a Central Securities Depository (CSD) and fully dematerialize government securities.
  - Transition to a secured money market to encourage broader participation and support government securities market growth.
  - Strengthen inflation forecasting and analytical tools with IMF technical assistance.

### Early signs of transmission and outstanding uncertainties
- Observed developments:
  - Both interbank and Treasury bill rates have risen above inflation.
  - Treasury bill yields exceeded the policy rate and inflation.
  - Some banks increased lending rates in March 2025, the first sign of transmission through the bank lending channel.
- Outstanding uncertainty:
  - With inflation declining quickly and considerable uncertainty following the exchange rate reform, the strength of the exchange rate channel remains uncertain.

### Foundations and prerequisites for an effective interest-rate based framework
- Central bank independence:
  - End to NBE direct advances.
  - NBE Proclamation and internal organization changes.
  - Establishment of the Monetary Policy Committee (MPC).
- Commitment to price stability:
  - NBE mandate enhanced to prioritize price stability.
  - Exchange rate reform and strengthened communication policy.
- Strong financial sector and technical capacity:
  - Gradual reduction in financial repression and development of money and bond markets.
  - Ongoing technical assistance (e.g., FPAS, liquidity forecasting).

### Near-term priorities for Ethiopia’s modernization of the monetary policy framework
- Continue to develop a clear, well-communicated policy framework.
- Move to a single operating target (the policy rate), including phase-out of the cap on private credit.
- Strengthen analytical capacity for policy making (support FPAS, data improvements).
- Strengthen NBE’s operational autonomy and financial position; support NBE independence (e.g., appointing Board members in accordance with the reformed law).
- Complementary structural reforms: develop money and bond markets, expand financial inclusion, and implement financial regulations aimed at reducing financial repression.

*Source: IMF staff estimates.*

### 1. Reserve Adequacy and Parallel Market Premium  ___________________________________ 5

### 1. Reserve Adequacy and Parallel Market Premium

### Background
- Before the FX reform, the parallel market premium increased steadily from early 2013 to mid-2022, rising sharply from late 2022; by November 2023, it had surpassed 100 percent and remained elevated through the end of June 2024.
- The widening premium coincided with acute FX shortages and FX controls; imports of durable consumer goods contracted.
- NBE’s FX reserves declined as FX allocations prioritized essential imports (fuel); FX reserves remained below one month of import coverage from November 2021 to June 2024, except for a brief recovery in October 2023.
- Adoption of a market-determined exchange rate in July 2024 and removal of most distortive exchange restrictions led to a rapid convergence between official and parallel market rates:
  - The parallel market premium collapsed, reaching near-zero by early September 2024 as the official rate aligned with market conditions.
  - The premium increased to approximately 16 percent by late October 2024, narrowed and stabilized in the single digits until the end of December 2024, and by early May 2025 gradually widened again to around 17 percent.
- FX reserves increased to approximately US$4 billion in April 2025, covering nearly two months of prospective imports.

### Comparative analysis of post-reform parallel market premia (Angola, Egypt, Ethiopia, Nigeria)
- Six months after major exchange rate adjustment, parallel market premium:
  - Angola: 48 percent
  - Egypt: 0.2 percent
  - Ethiopia: 12.4 percent
  - Nigeria: 0.3 percent
- Angola’s premium declined to 15 percent by 34 months after the reform but experienced two episodes of increase (to a post-reform high of 44 percent 21 months after adjustment), indicating protracted adjustment.
- Egypt’s premium remained below 1 percent for 11 months following adjustment, indicating smoother stabilization.
- Ethiopia’s post-unification experience most closely resembled Angola during its transition, with a more protracted premium.

### Remaining exchange restrictions for current account transactions
- Some exchange rate restrictions on current account transactions were retained after reforms; these typically:
  - Limit access to FX for specific current account transactions, or
  - Increase the cost of securing official FX.
- Examples of remaining restrictions cited for Ethiopia (post-reform):
  - Hard ceilings on access to and use of FX for travel purposes
  - Prohibition of access to and use of FX for the purposes of cross-border payment of moderate family remittances
  - 2.5% NBE exchange commission
  - Tax clearance certificate requirement for repatriation of dividend and other investment income
  - Requirement to provide a clearance certificate from the NBE to obtain import permit
  - Restriction imposed on the access and use of FX for the repatriation of backlog dividends
- The macroeconomic impact of such remaining current account restrictions appears modest:
  - The REER remained stable for Egypt, Ethiopia, and Nigeria while it continued to depreciate slowly in Angola after unification.
  - The affected current account transaction types typically represent a small proportion of consumer spending and carry low CPI weights.

### Tightly closed financial account and relative attractiveness of local currency asset
- Post-reform variation in capital/financial account restrictions:
  - The Financial Account Restriction Index (FARI) indicates Angola and Ethiopia have regulations on approximately 70 to 80 percent of total capital account transactions.
  - Egypt and Nigeria have regulations on only 10–20 percent of total capital account transactions.
- Incentives for capital outflows via the parallel market increase when expected returns from overseas investments exceed expected domestic real returns:
  - A positive Δ (difference in expected real yield between overseas and domestic investments) raises incentives for capital outflows.
  - A positive delta continued in Ethiopia for five months for which data are available following the FX reforms, reflecting low nominal yields domestically while inflation was in the mid-to-high teens.
  - To eliminate expectation of depreciation, domestic interest rates need to compensate for the inflation differential plus some risk premium as well as the nominal yield from foreign investment.

### Financial market underdevelopment and banking concentration
- Ethiopia ranks lowest on the financial development index among Angola, Egypt, Ethiopia, and Nigeria, slightly below Angola.
  - Lack of hedging instruments against exchange rate risk is cited by importers as a reason to resort to the parallel market (risk between opening LCs and settling payments; widespread use of deferred LCs).
  - Lack of natural counterparties and absence of foreign investors (due to capital account restrictions) reduce hedging and market depth.
- One-bank concentration:
  - Ethiopia has the highest one bank concentration ratio among the sample, with the state-owned Commercial Bank of Ethiopia (CBE) accounting for approximately half of the total bank assets in the sector.
  - CBE has a net short FX position stemming from its legacy as a policy bank, which may reduce incentives to mobilize FX given depreciation risks and the bank’s dominant market position.
  - Other banks may prefer business models with high fees on low volumes rather than compete on volume, potentially limiting FX mobilization from exporters and inward remittances and leaving unmet FX demand.

### Key findings and implications
- Structural factors sustaining residual parallel market premium after exchange rate unification:
  - Remaining current account restrictions and high costs to access official FX channels (including a 2.5% NBE exchange commission).
  - Tightly closed capital and financial account coupled with low returns on Birr-denominated assets relative to foreign assets.
  - Underdeveloped financial markets lacking hedging instruments and dominated by a single large bank, weakening competition and market efficiency.
- Observed metrics and time points to preserve exactly:
  - Parallel market premium surpassed 100 percent by November 2023 and remained elevated through end-June 2024.
  - Premium reached near-zero by early September 2024.
  - Premium approximately 16 percent by late October 2024; around 17 percent by early May 2025.
  - FX reserves below one month of import coverage from November 2021 to June 2024, except October 2023.
  - FX reserves approximately US$4 billion in April 2025, covering nearly two months of prospective imports.
  - FARI: Angola and Ethiopia regulations on approximately 70 to 80 percent of capital account transactions; Egypt and Nigeria 10–20 percent.
  - CBE accounts for approximately half of total bank assets.
  - A positive Δ persisted for five months post-reform in Ethiopia.

### Policy-relevant technical implication (from analysis)
- Domestic interest rates need to compensate for the inflation differential plus some risk premium and the nominal yield from foreign investment to remove expectations of depreciation and reduce incentives for capital outflows via the parallel market.

*Sources: IMF staff estimates.*

### 10.      Comparative analysis of structural features suggests that a moderate parallel market

### 10.      Comparative analysis of structural features suggests that a moderate parallel market

### Drivers of a persistent parallel market in Ethiopia
- Structural features driving unmet FX demand into the parallel market:
  - exchange rate restrictions
  - tightly closed financial account
  - limited financial instruments
  - high bank concentration
- Other contributing deeper structural factors:
  - concerns about property rights, security, and conflict encouraging outflows of wealth through the parallel market
- Comparative observation:
  - Ethiopia shares several characteristics with Angola during its transition to a floating exchange rate regime — a period when Angola’s parallel market premium was higher than in Egypt and Nigeria
- Figures referenced:
  - Figure 9. Selected African Countries: One Bank Concentration Ratio
  - Figure 10. Ethiopia: Range of Bank’s Daily Weighted Average Rate (Birr per US$)
- Numeric/statistical sources cited: IMF staff estimates.

### Policy recommendations to develop a well-functioning and unified FX market
- Priorities and sequencing:
  - Phased removal of remaining exchange rate restrictions on current account transactions to reduce costs of using the formal market and to satisfy FX demand
  - Positive real interest rates to make holding Birr-denominated assets more attractive and reduce incentives to hold wealth in FX via the parallel market
  - Well-sequenced opening of the financial account over the longer term:
    - focus first on strong regulatory and supervisory capacity
    - ensure the financial sector can manage cross-border flows soundly
    - attract long-term capital flows before facilitating shorter-term investors
- Regulatory prerequisites for safe financial account liberalization:
  - Effective enforcement of net open position (NOP) limits
  - Robust FX exposure monitoring
- Financial market deepening measures to reduce parallel market demand:
  - grow liquidity in interbank money and FX markets
  - create pre-conditions to develop hedging instruments
- Competition and transparency in banking:
  - enhance competition in the banking sector, notably through more transparency on fees, commissions, and pricing
  - consider possible participation by foreign banks to improve price discovery and the efficiency of FX intermediation

*Source: IMF staff estimates.*

### Transition to an interest-rate based monetary policy framework
- Reform milestones and context:
  - Modernizing monetary policy is a key part of the Homegrown Economic Reform Agenda (HGER), launched in 2020
  - Objective: correct macroeconomic imbalances and support private sector–led growth
  - Both monetary and fiscal policy tightened to gradually reduce, and in FY2024/25 eliminate, the use of direct NBE advances to finance the budget
- Shift in operational framework:
  - Prior to July 2024, the NBE operated under a monetary targeting (MT) framework using reserve money as the operational target
  - Money demand has shifted over time, reflected in changes in both the money multiplier and velocity of money
  - Since July 2024, the NBE began using market-based interest rates to guide monetary conditions

### Operational design choices and market development
- Operational measures introduced:
  - full allotment liquidity absorbing open market operations (OMOs)
  - standing lending and deposit facilities to form a policy corridor at ±300 basis points
  - overnight interbank lending rate set as the operational target
  - October (year implied by context): launch of a new interbank market to support banks’ liquidity management
  - complementary reforms: improvements to the T-bill market and introduction of an Emergency Liquidity Assistance framework
- Rationale for design:
  - Fixed-rate full-allotment operational framework is robust to changes in banks’ demands for excess reserves and does not require short-term forecasts of autonomous factors
  - Initial OMO was liquidity absorbing given the structural liquidity surplus and absence of widely available collateral
  - Decision to begin with a wide policy corridor, gradually narrowing over time as operational experience builds
- Ongoing market and institutional reforms needed:
  - phase out quantitative restrictions on lending, including the cap on private credit growth
  - launch and operationalize a Central Securities Depository (CSD) and fully dematerialize government securities
  - transition to a secured money market to encourage broader participation and support government securities market growth
  - strengthen inflation forecasting and analytical tools with IMF technical assistance

### Foundations required for an effective interest-rate based framework (Table 1 highlights)
- Central bank independence:
  - end to NBE direct advances
  - NBE Proclamation
  - NBE internal organization changes
  - establishment of the Monetary Policy Committee (MPC)
- Clear commitment to price stability:
  - NBE mandate enhanced to prioritize price stability over other goals
  - exchange rate reform
  - strengthened communication policy
- Strong financial sector:
  - gradual reduction in financial repression (phasing out mandatory purchases of T-bonds, ensuring better functioning Treasury bill markets)
- Technical capacity:
  - ongoing technical assistance (e.g., FPAS, liquidity forecasting)

### Transmission channels and their current strength in Ethiopia
- Key channels described:
  - Interest rate channel:
    - monetary policy rate changes transmit to interbank rates, Treasury bill rates, deposit and lending rates
    - currently likely weak in Ethiopia due to low private credit base and history of financial repression
  - Expectations channel:
    - central bank communication and credibility can anchor expectations and influence price-setting behavior
  - Credit channel:
    - impact on aggregate credit may be limited because banks do not borrow from capital markets and firms have limited borrowing options; bank credit has historically been rationed at low interest rates
  - Exchange rate channel:
    - relevant despite a closed capital account; transmission may occur through exchange rate expectations, price-setting, and the parallel market where interest rate differentials affect unofficial capital flows
- Characteristics of LIC transmission:
  - transmission channels tend to be weaker, more volatile, and less predictable in low-income countries (LICs) with shallow financial markets
  - constraints include absence of market-based debt issuance, overreliance on central bank financing, and weak institutional capacity to forecast and manage inflation
- Empirical note:
  - standard empirical methods often find limited evidence of transmission (Mishra and Montiel, 2013) while more granular analyses show clearer effects (e.g., Berg et al., 2013)

### Early signs of transmission and outstanding uncertainties
- Observed developments since the new framework:
  - both interbank and Treasury bill rates have risen above inflation
  - Treasury bill yields also exceeded the policy rate and inflation
  - some banks increased lending rates in March 2025, the first sign of transmission through the bank lending channel
- Outstanding uncertainty:
  - with inflation declining quickly and still considerable uncertainty following the exchange rate reform, the strength of the exchange rate channel remains uncertain

### Peer country experience and lessons
- Peer examples considered instructive:
  - regional peers: Kenya, Tanzania, Rwanda, Uganda
  - transition case: Uzbekistan
- Key lessons:
  - building monetary transmission is a process that takes time
  - clarity, consistency, and predictability in the monetary policy framework are essential
  - communication improvements: NBE has begun publishing MPC statements after meetings to improve transparency and clarity
  - consistency between the policy signal (policy rate) and policy actions (OMOs) is critical to guide short-term rates and influence lending rates
  - NBE has set the operating target as the interbank rate and will phase out the use of quantitative restrictions on bank lending

*Source: IMF staff estimates.*

### 12. Credible and consistent implementation is essential for effective monetary policy

### 12. Credible and consistent implementation is essential for effective monetary policy

### Core requirements for effective transmission
- Central banks must be able to influence short-term interest rates and keep them aligned to the policy rate.
- Three core areas require progress:
  - Effective monetary policy instruments:
    - NBE is building operational tools (OMOs), standing facilities, and liquidity forecasting.
    - The policy rate must be complemented by a transparent, market-based reference rate that reflects actual interbank activity and serves as a benchmark (examples: Kenya, Rwanda, Uganda).
  - Operational autonomy and a sound financial position:
    - Without enough capital, the central bank may need government support to cover losses (e.g., from sterilization or exchange rate changes), weakening credibility and exposing monetary policy to fiscal and political influence. (IMF, 2015)
    - Peer actions: central bank capital improvements in Uzbekistan, Rwanda; Ethiopia strengthened governance under the revised NBE Proclamation to limit fiscal dominance and enhance financial resilience.
  - Analytical capacity for forward-looking policy:
    - Monitoring links between the policy rate and inflation outcomes requires technical capacity, tools, and data.
    - Ethiopia faces inflation often driven by supply side shocks (e.g. drought and floods) and food prices which make up a large share of the CPI index (IMF, 2015) (Figure 4).
    - Responding to negative supply shocks requires balancing the inflation shock with the negative impact on output; sufficient data and analytical capacity are needed to distinguish temporary shocks from persistent inflationary pressures.
    - NBE is updating their quantitative framework through the Forecasting and Policy Analysis System (FPAS).
    - Recommendation: complement FPAS with investment in data compilation and quality, especially to better capture high-frequency and disaggregated inflation drivers.
    - Peer example: Kenya institutionalized FPAS to support policy formulation and communication.

### Structural features that weaken transmission
- Shallow money and bond markets:
  - Deepening debt and money markets helps develop transmission and is affected by the effectiveness of the monetary policy framework in controlling inflation.
  - A more liquid market enhances NBE’s ability to manage liquidity through OMOs and helps transmit monetary policy rates to broader market interest rates.
  - Recommendation: develop a collateralized repo market and encourage interbank trading beyond overnight and 1-week maturities to support demand for longer maturities and the formation of a yield curve.
  - Peer action: Kenya, Uganda, and Rwanda have stepped up efforts to develop local currency bond markets.
- Limited financial sector development:
  - Financial sector development increases the share of households and firms affected by interest rates.
  - Ethiopia’s financial sector is small with relatively low (and declining in recent years) levels of private sector lending compared with peers (Figure 5).
  - Studies indicate interest elasticity of private consumption and investment increases with financial development (IMF, 2015).
  - Recommendation: central bank can support market infrastructure, policy instruments, financial literacy, and access to formal financial services (example: Rwanda).
- Risk management and loan pricing:
  - Transmission requires banks to make risk-based lending decisions responsive to interest rate changes.
  - Poor loan quality (e.g., evergreening) distorts lending decisions and creates capital constraints that limit banks’ ability to lend.
  - NBE reforms: updated rules on asset classification and provisioning, closer monitoring of loan pricing practices, alignment with Basel II/III and IFRS.
- Banking sector competition:
  - Limited competition can weaken transmission if dominant banks are less responsive to policy rate changes.
  - Lending decisions influenced by non-price factors undermine responsiveness to interest rates.
  - Recommendation: strengthen competition and ensure state-owned banks operate on a commercial basis with explicitly recognized public service obligations where needed.
  - Ongoing measures: reforms of CBE to ensure commercial orientation, supported by the World Bank’s FSSP project.
- Capital mobility and exchange rate adjustment:
  - Limited capital mobility and exchange rate flexibility can weaken the exchange rate channel of monetary policy (IMF, 2015).
  - When capital flows are unresponsive to interest rate differentials and FX interventions limit exchange rate movement, interest rate parity breaks down and dampens policy impact.
  - Recommendation: greater exchange rate flexibility and smoother FX market functioning will strengthen transmission even without near-term capital account liberalization.
  - Peer example: Rwanda conducted a diagnostic assessment of the FX market to strengthen FX intervention framework, aiming to limit interventions to preventing disorderly adjustments and curbing excess volatility.
- Central bank fiscal financing/policy-based lending:
  - Significant central bank financing of government or directed lending to public bodies dilutes monetary policy signals (example: policy lending in Uzbekistan).
  - NBE has eliminated monetary financing of fiscal deficits and is developing market-based debt issuance.
  - Recommendation: develop and publish predictable government financing plans and coordinate fiscal policy with the new monetary policy framework to ensure government financing needs do not undermine inflation control and interest-rate stabilization.

### Near-term priorities for Ethiopia’s modernization of the monetary policy framework
- Continue to develop a clear, well-communicated policy framework.
- Move to a single operating target (the policy rate), including phase-out of the cap on private credit.
- Strengthen analytical capacity for policy making (support FPAS, data improvements).
- Strengthen NBE’s operational autonomy and financial position; support NBE independence (e.g., appointing Board members in accordance with the reformed law).
- Complementary structural reforms:
  - Develop money and bond markets.
  - Expand financial inclusion.
  - Implement financial regulations aimed at reducing financial repression and ensuring a market-oriented financial sector.
- Over time, these reforms will lay the foundation for more effective and independent monetary policy.

### Lessons from peer-country experience (selected highlights from Table 2 and Table 3)
- Communication:
  - Uganda: Clear policy statements helped strengthen transmission.
  - Tanzania: Published a communication strategy in 2023 including an annual calendar of MPC meetings and monetary policy statements.
- Consistency and predictability:
  - Uganda: Commitment to a single operating target (policy rate) while experimenting with implementation tools aided control over short-term rates.
- Effective instruments:
  - Uganda: Introduced a Central Bank Rate (CBR) in 2011 to guide overnight interbank rates via a policy corridor and liquidity operations.
  - Kenya introduced an interest rate corridor around the policy rate in 2023, lowering the discount window rate in tandem.
- Central bank autonomy and balance sheet:
  - Uzbekistan: major capital injection in 2019 to support sterilization and reinforce independence; note: Authorized capital of the Central Bank to increase by 500 times.
  - Rwanda: 2017 law allows National Bank of Rwanda capital to be raised.
- Analytical capacity:
  - Kenya: Adopted FPAS in 2013; FPAS outputs form a key part of MPC information, supplemented by market expectation surveys.
- Transition experiences (Table 3):
  - Kenya: Moved away from monetary aggregate targeting in 2008; forward-looking inflation targeting using the policy rate; transmission weak but improving after removal of interest rate controls and introduction/narrowing of interest rate corridor.
  - Rwanda: Transition announced 2019; medium-term inflation target of 5 percent with an inflation target band of +/- 3 percent; operational target to keep interbank rate close to policy rate; transmission improved but exchange rate channel remains limited.
  - Tanzania: Formally adopted interest-rate based framework in January 2024; medium-term inflation target of 5 percent; operational target to keep the 7-day cash rate within a ±200 bps corridor with the policy rate.
  - Uganda: Shifted to inflation targeting in 2011; policy rate set based on medium-term forecast deviations; studies show transmission to lending rates only in the long run, stronger through T-bill and exchange rate channels.
  - Uzbekistan: Transition to inflation targeting began January 2020; inflation target of 5 percent; operational objective to keep overnight rates close to policy rate; transmission constrained but improving with reforms.

*Source: IMF staff synthesis of chapter "12. Credible and consistent implementation is essential for effective monetary policy" from the supplied PDF content.*

### 1.      The process of fiscal decentralization in Ethiopia started three decades ago. The

### The process of fiscal decentralization in Ethiopia started three decades ago.

### Institutional and constitutional foundations
- National Constitution approved in December 1994 enshrines foundational elements of revenue-sharing, regional self-governance, spending mandates, and fiscal responsibility.
- Ethiopia’s federal structures reflect ethnic or linguistics groups; initial setup of nine states expanded to twelve, with the most recent change in 2023 (three new regions formed from the previously Southern Nations, Nationalities, and Peoples’ Region (SNNPR)).
- Addis Ababa and Dire Dawa are under federal government jurisdiction.
- The Constitution provides a mechanism to establish revenue assignment (a two-thirds majority vote of the joint session of the House of the Federation and the House of Peoples’ Representatives). This applies to several new taxes envisaged under the National Medium-Term Revenue Strategy, namely property and motor vehicle circulation taxes.
- Recent legislative reform: Proclamation 1250/2021:
  - Limit on revisions of the grant formula to once in five years, with possibility of incorporating data updates.
  - Creation of the House of Federation Secretariat as an independent technical body with parliamentary oversight to design grant and joint revenue sharing formula recommendations and implementation of monitoring and evaluation activities.
  - Status of implementation and technical capabilities of the autonomous body are unclear.

### Tax assignment, revenue shares, and administration
- Revenue categorization: federal, state, or joint.
  - Federal government has exclusive right to tax international trade.
  - Domestic indirect taxes (VAT and excise) are split according to joint revenue sharing formulas.
  - Regional governments collect direct taxes (including PIT) and certain royalties and fees.
- Revenue assignment and administration design points:
  - Division of tax administration between federal and regional governments should balance minimizing administration and compliance costs with fiscal sovereignty of states and inter-regional equalization concerns.
  - Inter-regional equalization argues for central taxation of unequally distributed bases (e.g., large corporate entities, mineral wealth), but that objective is balanced by preserving regional economic policy autonomy.
- Recent revenue-sharing methodology reforms:
  - Joint revenue sharing formula revised eight times.
  - Federal government’s share of joint revenues declined from 70 percent in 2010/10 to 45 percent by 2023/24.
  - FY2020/21 formula revision:
    - Regions’ share for VAT increased from 30 to 50 percent.
    - Regions’ share for royalties increased from 40 to 75.
    - Joint revenue sharing committed 50 percent of income taxes to regional states where businesses operate, while leaving tax assignment of the two federal cities unchanged.
- Direct taxes and progressivity constraints:
  - Decentralized, schedular income tax system fragments taxation of total personal income (salary, rental income, self-employment taxed under separate schedules and potentially by different jurisdictions).
  - Regions’ direct tax revenues rely heavily on employment income tax and unincorporated business income tax, which together account for almost 90 percent of regions’ direct tax revenues.
  - Introducing progressive unified income at regional level could be feasible but would be administratively challenging and require robust tax filing systems and inter-jurisdictional coordination.
  - Policy option: regions could apply a surtax to turnover tax revenues (example suggested: 10 percent); surcharges on excises also considered.
- Indirect taxes (VAT) features and implications:
  - Nationwide uniform VAT rate of 15 percent applied across all regions; 2024 VAT Proclamation widened the tax base to include services, removed various VAT exemptions, and modernized administration arrangements.
  - Key distinct features with implications:
    - VAT is administered at federal level; Ministry of Revenue or Customs Commission assesses and collects VAT but may delegate Regional and City Administration Revenue Bureaus to assess and collect VAT on its behalf—requiring strong coordination and information flow.
    - Legal form of small businesses affects revenue assignment:
      - Regional governments entitled to revenue from unincorporated businesses; revenues from incorporated businesses are joint and subject to sharing.
      - Turnover taxes (VAT counterpart for establishments below VAT registration threshold) are assigned to regional governments; VAT from larger entities are joint revenues.
      - The 2024 VAT Proclamation raised the mandatory VAT registration annual turnover threshold from 1 to 2 million birr but allowed voluntary registration otherwise (Article 13).
    - Ethiopia’s VAT is based on the origin principle (assignment to region where seller is registered). Large corporates headquartered in Addis Ababa selling across the country can cause fiscal transfers from poorer regions to wealthier regions or federal government.
  - Expansion of e-commerce and remote services subject to VAT increases importance of periodic public debate on centralization vs local taxation and effectiveness of the block grant.
- Property tax and natural resource taxation:
  - Almost all tax revenues sourced in Addis Ababa and Dire Dawa are channeled to federal coffers; property tax and municipal fees are main own revenue sources for the two cities.
  - Two federal cities expected to lead property tax reform and reform of presumptive tax (local authority tax) offers additional mobilization opportunity.
  - Ethiopia does not earn significant revenues from high-value extractive operations; gold is the most significant mined commodity; other industrial materials and fertilizers under consideration.

### Expenditure responsibilities and fiscal decentralization outcomes
- Expenditure assignment:
  - Federal government responsible for national defense, national infrastructure (air, rail, major roads, post, telecom), and formulating country’s overall economic and social development.
  - Regional governments responsible for basic education and health, tailored to local populations.
- Degree of decentralization:
  - Ethiopia is relatively decentralized compared to Sub-Saharan African countries.
  - In Ethiopia, subnational spending accounts for about half or more of general government spending (shared with Nigeria and South Africa); in Kenya, Rwanda, Tanzania, and Uganda subnational spending amounts to about 15–20 percent of general government spending.
  - Share of regions in total public expenditure increased from about 35 percent of consolidated expenditure in mid-1990’s to around 55 percent in the last decade.
- Evolution of vertical fiscal imbalances:
  - Initially, regions could cover only about 1/3 of expenditure mandates with own revenue, necessitating sizable federal grants.
  - Regions’ share of concurrent revenues increased in recent decade to reduce vertical imbalances.
  - Regional block (general purpose) grant has shrunk relative to the federal government’s resource envelope.

### Regional grant framework, equalization, and allocation mechanics
- Purpose of General Purpose Grants (GPGs):
  - Intended to fill vertical fiscal gaps and limit horizontal imbalances across regions; support comparable levels of essential public services while preserving regional decision-making autonomy.
- Targeted grants:
  - Unconditional budget grants are complemented by targeted regional grants for capital investment toward Sustainable Development Goals (SDG).
  - SDG grants relatively small compared to general pool; used for agro-industrial parks and small-scale irrigation infrastructure; other sizable specific transfers include urban and rural Productive Safety Net Programs (PSNP).
- Institutional roles and process:
  - Size of GPG pool formulated by the Ministry of Finance; allocation criteria responsibility rests with the House of Federation.
  - Size of grant pool set as part of annual federal budget cycle and subject to parliamentary approval; in practice regions lack direct input and feedback on pool size and amounts of regional grants.
- Allocation formula and changes:
  - Grant allocation formula has seen eight modifications over three decades.
  - Current formula (last modified in 2017) builds on three pillars:
    - Difference in regional tax revenue (income, turnover, and VAT taxes).
    - Regional government expenditure (primary and secondary education, agriculture and rural development, rural roads).
    - A small sub-pool currently set at one percent of total pool to support catch-up of four least developed regions (Benishangul-Gumuz, Afar, Gambela, and Somali).
  - FY2024/25 work plan foresees revision of regional state budget allocation formula based on empirical data.
  - No rule or procedural trigger guiding periodicity of formula revisions; constrained by lack of timely and adequate regional data and limited technical capacity.
  - Formula yet to be established for the three new regions previously SNNPR.
- Weakening of equalization function and fiscal gap mechanics:
  - Region’s Fiscal Gap = Region’s Fiscal Capacity (tax revenue norm) + Region’s Concurrent Revenue – Region’s Expenditure Needs (expenditure norm).
  - Overall size of grant pool is set by the Ministry of Finance and in practice independently of intended gap-filling objective.
  - Constrained fiscal space and decline in federal tax-to-GDP ratio have contributed to shrinking of the pool, risking regions’ essential public service delivery and weakening interregional equity.
  - Fiscal gap formula components aggregate multiple subcomponents, leading to complex, data-intensive calculations that reduce transparency and raise fairness questions.
- Considerations for medium term grant setting:
  - Equalization principles imply taxes collected from higher revenue potential states should be shared with regions with less revenue potential; current practice bases fiscal capacity calculation primarily on actual revenue collection rather than potential tax base and administration capacity.
  - Near-term macroeconomic and domestic revenue mobilization reforms will disproportionately benefit tax base assigned to federal government (gains concentrated in customs due to exchange rate and excise reform, and VAT and income taxes from SOEs and businesses headquartered in Addis Ababa), while expenditure pressures remain with regions.
  - Federally financed programs (PSNP, rural development capital spending, SDG grant) can help narrow fiscal gaps; setting block grant size should consider absolute fiscal gaps and share federal revenue windfall equitably with regions.
  - Sub-pool for four less developed regions could decline further and may need reconsideration.
  - Increasing concurrent revenue shares has incentivized regions to mobilize revenue; overcoming regional revenue administration weaknesses will require support from federal tax administration.
  - Regular, data-driven grant formula updates and establishment of simple, fair, transparent grant systems are critical; lack of timely statistics and outdated data penalize faster urbanizing regions.
  - Large fiscal gaps (horizontal and vertical) can be politically divisive; simplicity, objectivity, and transparency of grant allocations are important for policy effectiveness, accountability, and public acceptance.

*Source: IMF staff summary of chapter on Ethiopia fiscal decentralization.*

### 17.      Analysis of recent regional fiscal accounts and socio-economic indicators confirms that

### 17.      Analysis of recent regional fiscal accounts and socio-economic indicators confirms that

### Fiscal transfers, multidimensional poverty, and regional fiscal capacity
- Finding: Budget grants have been effective at reducing regional fiscal gaps but have not fully offset the impact of regional disparities in fiscal capacity on multidimensional socio-economic poverty.
- Data and metrics:
  - Multidimensional poverty indicator (MPI) (World Bank Ethiopia Poverty and Equity Assessment, 2024) ranges from 0 to 1, with higher value representing a higher level of deprivation. For methodology, see Alkire et al. (2021).
  - Analysis uses FY2023/24 regional government budget execution combined with the MPI (covers health, education, and living standards at the regional level).
- Empirical relationships identified:
  - Positive correlation between a region’s dependence on general-purpose grants (spending financed by budget grants, FY2023/24, in percent) and that region’s MPI: regions with higher MPIs tend to have greater shares of their budget expenditure covered by general-purpose grants.
  - Negative correlation between per capita spending on recurrent social services (education, health) and multidimensional poverty outcomes: higher social spending per capita (thousand birr, FY2023/24) is associated with lower MPI.
  - Regions with higher MPIs collect less own revenue per capita (own revenue per capita, thousand birr, FY2023/24).
  - No clear statistical link between the per capita amount of the general-purpose grant (thousand birr, FY2023/24) and (a) a region’s own revenue or (b) the degree of severity of multidimensional poverty.
- Interpretation: Federal budget grants reduce interregional fiscal gaps that stem from socio-economic expenditure needs, but grants do not fully compensate for disparities in regional fiscal capacity nor fully translate into uniform multidimensional poverty reductions across regions.

### Macroeconomic implications and policy recommendations
- Strengthening federal macroeconomic stabilization:
  - The federal government’s macroeconomic stabilization function should be strengthened.
  - General-purpose grant pool, set in the annual budget cycle, can harmonize macroeconomic stabilization across federal and regional budgets but has faced strong national budget constraints.
  - Strengthening federal and regional budgetary frameworks and rebuilding fiscal space are needed to support macro-stabilization.
  - Policy recommendations from recent macro-fiscal TA: modernize forecasting techniques, improve institutional coordination, and strengthen links between medium-term fiscal frameworks (MFF) and annual budgets.
  - Further MFF information could inform budget preparation, including impacts of budget decisions on debt and sustainability indicators.
- Policy coordination:
  - Federal government should encourage and support common best practices for replication at regional level.
  - Improve coordination of investment plans across government entities to ensure public infrastructure is delivered in the right areas with appropriate funding.
  - 2024 Public Investment Management Assessment (PIMA) and Climate PIMA recommendations: better investment and budgetary resource planning, project implementation monitoring, systematic disclosure, and improved alignment of regional frameworks with federal climate priorities.
- Insurance and shock response:
  - Insurance against regional macroeconomic shocks primarily works through federal safety nets programs; other channels are limited.
  - General-purpose grant formula is linked to revenue and expenditure norms, with 3-year averaging limiting responsiveness of grant shares to temporary shocks.
  - Regional grant allocation shares are unaffected by temporary shocks and market borrowing is precluded.
  - Effective channels for idiosyncratic shocks: federal shock response facilities, namely PSNP and programs administered by the Disaster Risk Management Commission for localized shocks (e.g., drought, livestock disease outbreaks).
  - Curtailment of overseas development assistance would disproportionately affect regions with large humanitarian and disaster risk expenditure requirements and increase the value of a stronger framework to manage regional macroeconomic shocks.
  - Proposed measures: set up an adequately funded national disaster risk management fund (as envisaged by the authorities) to strengthen response and transparently channel international resources; broaden geographic reach of safety nets; enhance focus on livelihoods; improve efficiency through e-payments, digitalization, and establishing National Social Registry; produce timely and adequate regional data to inform periodic updates of regional grant shares.
- Regional borrowing and fiscal responsibility:
  - Reinforce fiscal responsibility framework by maintaining tight control over regional borrowing.
  - Although regions are legally empowered to borrow domestically subject to federal terms and approval, there has been no regional borrowing except Addis Ababa, constrained by scarce financial system capacity, potentially high risks, and federal government control via required approval.
  - Legislative safeguards preclude budget or project financing by regions; the only possibility for regions to borrow provided by law is for projects requiring a feasibility study showing capacity to repay and Ministry of Finance approval; external borrowing by regions is not permitted; NBE or commercial banks are not permitted to lend to regional governments.
  - Recommendation: continue tight control over regional borrowing until revenue mobilization capacity and fiscal space are rebuilt and domestic debt market preconditions are established.

### Ethiopia’s tax system: structure, performance, and benchmarking (selected findings)
- Motivation: Despite high real GDP growth over past two decades, Ethiopia’s tax-to-GDP ratio remains among the lowest in Sub-Saharan Africa (SSA), constraining the government’s ability to finance infrastructure, social programs, and development priorities.
- Key stylized facts:
  - Ethiopia’s tax-to-GDP ratio is among the lowest in SSA, ranking below the 10th percentile of the regional distribution.
  - Over the period 2021-2023:
    - Direct taxes on income, profits, and capital gains accounted for approximately 3.5 percent of GDP.
    - Taxes on international trade and transactions generated around 2.2 percent of GDP.
    - Taxes on goods and services—primarily VAT and excise duties—contributed approximately 2.0 percent of GDP.
  - The federal government collects more than 70 percent of total tax revenues.
  - Large Taxpayers Office (LTO) and Medium Taxpayers Office (MTO) contributions: on average, LTOs have accounted for around 70 percent of federal tax revenues over the past five years, while MTOs and small taxpayer offices have contributed approximately 15 percent each.
  - State-owned enterprises (SOEs) have, on average, accounted for approximately 45 percent of total LTO tax collections.
- Structural features and implications:
  - Ethiopia’s tax composition reflects constitutionally divided tax rights between federal and regional governments; federal exclusives include import/export duties and certain income taxes, while states tax private sector employees, agricultural income, property rents, and small traders. Some taxes (profits, sales, excise of jointly established enterprises, large-scale mining and petroleum operations) are concurrently administered.
  - The divergence between strong economic growth and weak tax performance highlights narrow tax base, high informality, and inefficiencies in tax administration; PIT and CIT contributions are low by regional standards and consumption tax collection weaknesses constrain revenue potential.
- Policy imperative: Strengthening domestic revenue mobilization is essential for macroeconomic stability and long-term development; addressing structural weaknesses in tax policy and administration is crucial to expand fiscal space.

*Sources: Ministry of Finance, Ethiopian Statistical Service, World Bank, and IMF staff calculations.*

### 9.      Tax revenues in Ethiopia are distributed across direct, indirect, and trade-related

### 9.      Tax revenues in Ethiopia are distributed across direct, indirect, and trade-related categories

### Tax structure and shares
- Business profit taxes: 1.7 percent of GDP.
- Personal income taxes: 1.4 percent of GDP.
- Customs duties (import-related): 0.8 percent of GDP.
- VAT on imports: 0.8 percent of GDP.
- Surtax on imports: 0.3 percent of GDP.
- Domestic VAT (consumption taxes): 1.2 percent of GDP.
- Excise duties (domestic consumption taxes): 0.4 percent of GDP.

### Trends and regional comparisons
- Until 2019, tax revenues from income, profits, and capital gains remained near the SSA median; since then they have declined, diverging from regional trends.
- SSA median income tax revenue increased to 5 percent of GDP; Ethiopia’s income tax revenue fell to 2.9 percent of GDP in 2024.
- Ethiopia’s revenue from goods and services taxes hovered around the 25th percentile between 2000–19 and fell below the 10th percentile in 2024.
- Trade-related tax revenues peaked at 6 percent of GDP in 2005 (above the 90th percentile in SSA) and declined to 1.5 percent of GDP in 2024 (slightly below the SSA median).
- Ethiopia’s import-to-GDP ratio was above the 75th percentile in SSA between 2005–07 and fell to below the 10th percentile by 2024.

### Personal Income Tax (PIT)
- Statutory PIT rates range from 10 to 35 percent (excluding exemptions).
- PIT average rates in Ethiopia are near the regional median, but PIT revenue as a share of GDP falls in the 25th percentile among low-income SSA countries.
- Design issues: the threshold for the zero rate is low; the top marginal rate applies at relatively modest income levels, causing a large share of formal wages to be taxed at the highest rate and potentially weakening compliance and formalization incentives.

### Corporate Income Tax (CIT)
- Statutory top CIT rate: 30 percent.
- Ethiopia’s CIT rate is higher than the median for low-income SSA economies and on par with closest geographic neighbors.
- Actual CIT revenue collection ranks between the 10th and 25th percentile in the region, indicating a substantial gap between statutory rates and realized revenues.

### Value-Added Tax (VAT)
- Standard VAT rate: 15 percent.
- VAT rate places Ethiopia near the lower end of SSA low-income countries.
- VAT revenue collection as a share of GDP is substantially lower than peers applying similar VAT rates.
- VAT C-efficiency ratio has fluctuated around the 25th percentile historically, improved from 2010 to 2015 nearing the SSA median, and has since declined to near the 10th percentile.
- Drivers of weak VAT C-efficiency: policy gaps (such as exemptions), compliance challenges, widespread informality, and weak enforcement mechanisms.

### Tax responsiveness to the business cycle (elasticities)
- Output gap turned positive in 2023 after years of disruptions (COVID-19 pandemic and internal conflicts).
- Elasticity of income, profits, and capital gains tax revenues to the output gap is negative for Ethiopia (although not statistically significantly different from zero), diverging from benchmark country groups where elasticity is generally positive.
- Elasticity of tax revenues on goods and services to the output gap is broadly in line with other country averages; consumption taxes remain structurally low despite positive cyclicality.
- Tax revenues from international trade and transactions exhibit the highest elasticity to both the output gap and import fluctuations; trade taxes have historically been an important and efficient revenue source for Ethiopia.
- Despite shrinking trade openness, Ethiopia continues to generate above-median trade tax revenues relative to its trade base.

### Structural constraints on tax potential
- Large agricultural sector and low trade openness reduce taxable base and constrain tax revenue potential.
- Ethiopia has one of the highest agricultural shares of GDP among low-income SSA economies, with many small producers limiting enforceability.
- Trade openness in Ethiopia is among the lowest in SSA, constraining customs duties, VAT on imports, and excise revenues.
- Ethiopia collects trade taxes relatively efficiently compared to the size of its trade sector, but limited import/export volume caps overall contribution.

### Institutional and governance context
- Ethiopia ranks above the LIC average in government effectiveness and corruption control indicators but below emerging and advanced economies.
- Improving governance, rule of law, and corruption control could strengthen tax compliance, enforcement, and overall revenue performance.

### Estimated tax potential and gaps
- Stochastic Frontier Analysis estimates Ethiopia could achieve a tax-to-GDP ratio of about 17 percent.
- Ethiopia’s average tax-to-GDP ratio: about 8 percent.
- Implied tax gap: around 9 percentage points of GDP (17 percent potential − about 8 percent actual).
- Previous IMF research identifies a 15 percent tax-to-GDP benchmark as a critical threshold for accelerating growth and development; Ethiopia’s ~8 percent average remains well below this level.
- Tax effort (Actual Tax Revenue / (Actual Revenue + Tax Gap)) is estimated at 51 percent for Ethiopia, indicating Ethiopia collects about half of its potential tax revenues and is broadly in line with the LIC average but below the SSA average.

### Methodological note: Stochastic Frontier Analysis (SFA)
- SFA models the tax-to-GDP ratio as a function of structural determinants (GDP per capita, GDP per capita squared, share of agriculture in GDP, trade openness, corruption control, government effectiveness), with one-sided inefficiency term 푢푢 and symmetric shock term 푣푣.
- Efficiency score = exp(−푢푢).
- Tax potential computed as 푦푦 / exp(−푢푢); tax gap defined as tax potential minus actual tax revenue.
- Data cover 1990–2022 and include 191 countries, drawn from WEO, WoRLD, VDEM, and WDI databases.

*Source: IMF staff calculations and analysis as presented in the cited chapter.*

### 29.      The Ethiopian authorities are implementing ambitious reforms to address

### The Ethiopian authorities are implementing ambitious reforms to address macroeconomic imbalances and enhance revenue mobilization.

### Fiscal reform framework and program support
- Homegrown Economic Reform Agenda (HGER) supported by the IMF Extended Credit Facility (ECF) program approved in July 2024 aims to strengthen fiscal sustainability and promote economic stability.
- A key pillar of the fiscal strategy is the National Medium-Term Revenue Strategy (NMTRS), which provides a comprehensive framework for improving tax policy and administration.

### Recent tax policy measures (NMTRS priorities)
- NMTRS prioritizes reforms in VAT, excise, corporate income tax, presumptive income taxes, and property taxation.
- New VAT Proclamation, approved in July 2024, introduces:
  - reducing exemptions,
  - limiting zero-rating to exports,
  - expanding voluntary registration,
  - clarifying federal and regional tax mandates.
- Revised excise duties on alcohol and tobacco, and stricter enforcement of the excise stamp regime, are expected to boost domestic revenue.
- Import duty collections have strengthened following adjustments to align customs declarations with daily exchange rate fluctuations.

### Tax administration progress and diagnostics
- The 2024 TADAT assessment reflects a marked improvement over the 2016 evaluation, when Ethiopia received predominantly very low scores.
- Ethiopia has narrowed gaps across various tax administration performance areas and is more aligned with peer countries, even surpassing them in some evaluated metrics.
- Notable advancements are reported in:
  - dispute resolution,
  - taxpayer registration,
  - voluntary compliance.
- Despite progress, Ethiopia still falls short of international top standards in some areas, particularly:
  - accurate reporting,
  - risk management,
  signaling the need for continued reforms.

### Revenue projections, thresholds, and gaps
- Projections suggest increases across all major tax categories, supported by policy measures and administrative improvements.
- Total tax revenue is expected to remain below the 15 percent tax-to -GDP benchmark identified as necessary to support long-term economic growth and achieve the Sustainable Development Goals (SDGs).
- Ethiopia’s tax-to-GDP ratio is among the lowest in Sub-Saharan Africa.
- Compared to similar economies, Ethiopia’s tax effort is among the lowest, indicating considerable scope to enhance revenue mobilization through improved efficiency and policy adjustments.

### Comparative diagnostics and policy implications
- While income and profit tax rates are relatively high, their contribution to total revenue remains limited.
- VAT revenues are significantly lower than in peer economies, pointing to:
  - administrative inefficiencies,
  - exemptions that narrow the tax base.
- Trade taxes have declined as Ethiopia’s trade openness has contracted, reducing an historically important revenue stream.
- Authorities have established a National Tax Reform Taskforce to steer implementation and monitoring of tax policy and tax administration reforms, including reflecting the findings of the recent TADAT assessment.
- The authorities will continue to rely on technical assistance from the IMF, World Bank, and other development partners to support design and implementation.

### Policy recommendations and priorities
- Combine tax policy refinements and strengthened administration to:
  - broaden the tax base,
  - formalize the economy,
  - improve compliance,
  - enhance governance.
- A well-functioning tax system is critical for long-term fiscal sustainability and economic development to fund infrastructure, social programs, and inclusive and sustainable growth.

### Annex I — Stochastic Frontier Model estimation results (TRE with Half-Normal Inefficiency)
- Tax Revenue regression coefficients and significance:
  - GDP per capita 2.060 ***
    - (0.368)
  - GDP per capita sq. -0.103 ***
    - (0.021)
  - Agriculture share in GDP -0.087 ***
    - (0.032)
  - Trade share in GDP 0.102 ***
    - (0.031)
  - Public Sector Corruption -0.032 ***
    - (0.011)
  - Constant -16.885 ***
    - (1.476)
  - Usigma -0.776 **
    - (0.330)
  - Vsigma -4.838 ***
    - (0.715)
  - Theta 1.102 ***
    - (0.033)
- Sample and model fit:
  - Obs. 3025.000
  - Log-Likelihood 943.828
  - AIC -1881.657
  - BIC -1863.613
- Standard errors in parentheses
- Significance notation:
  - * p < 0.10,
  - ** p < 0.05,
  - *** p < 0.01

*Source: Excerpt from IMF country document.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2025/english/1ethea2025003-source-pdf.pdf_