36154 February 7, 2006 CURRENCY EQUIVALENTS (as of December 20, 2005) Currency Unit = Afghani US$1 = AFS 50.05 GOVERNMENT FISCAL YEAR March 21 - March 20 ABBREVIATIONSANDACRONYMS ACD Afghanistan Customs Department MoF Ministry of Finance ADB Asian Development Bank MTBF Medium-Term Budget Framework AEP Afghan Expatriate Program MTEF Medium-Term Expenditure Framework AFMIS Afghanistan Financial Information System MTFF Medium-Term Fiscal Framework ANA Afghan National Army NDF National Development Framework ANDS Afghanistan National Development Agency NGOs Non-government Organizations ARTF Afghanistan Reconstruction Trust Fund NRVA National Rural Vulnerability Assessment ASYCUDA Automated System for Customs Data NSC National Security Council BPHS Basic Package of Health Services NSP National Solidarity Program BOT Build Operate Transfer OECD Organization for Economic CAO Control and Audit Office Cooperation and Development CDCs Community Development Councils OED Operations Evaluation Department DABM Da Afghanistan Breshna Moasessa O&M Operation and Maintenance DFID Department for International PEFA Public Expenditure and Financial Development Accountability DDR Disarmament, Demobilization and PER Public Expenditure Review Reintegration PETS Public Expenditure Tracking Survey EU European Union PFEM Public Finance and Expenditure GDP Gross Domestic Product Management Law GoA Government of Afghanistan PFM Public Financial Management GPR General Presidency of Revenue PIU Program Implementation Unit HR Human Resources PMUs Program Management Units I-ANDS Interim Afghanistan National PPAs Performance-based Partnership Agreements Development Strategy PRR Priority Restructuring and Reform IARCSC Independent Administration Reform & PRSP Poverty Reduction Strategy Papers Civil Service Commission SAF Securing Afghanistan's Future IDA International Development Association SOE State Owned Enterprises IMF International Monetary Fund TA Technical Assistance IT Information Technology TIN Taxpayer Identification Number LEP Lateral Entry Program TSA Treasury Single Account LTO Large Taxpayer Office UK United Kingdom M&E Monitoring and Evaluation UNODC United Nations Office on Drugs and MoE Ministry of Education Crime MoEW Ministry of Energy and Water VAT Value Added Tax A C K N O W L E D G E M E N T S This report, a product of the World Bank's Public Finance Management (PFM) Review for Afghanistan, was prepared by William Byrd and Stéphane Guimbert. The PFM Review as a whole was carried out by a team led by the authors of this report and also including Julia Fraser, Soraya Goga, M. Qahir Haidari, Michael Haney, Quamrul Hasan, Wali Ibrahimi, Masami Kojima, Benjamin Loevinsohn, Peter Middlebrook, Keiko Miwa, Kayhan Natiq, Asta Olesen, Habib Rab, Arlene Reyes, Robert Rothery, Paul Sisk, Michael Stanley, Juliet Teodosio, Theo Thomas, Nicole Ball, Robert Batt, Anne Evans, Kimo Karini, Yasin Osmani, Peter Trepte, Christopher Ward, and David Webber. Invaluable support was received throughout the process from William Dorotinsky, Satendra Prasad, and Nicola Smithers. Peer Reviewers for the PFM Review, whose comments are greatly appreciated, include: Richard Bontjer, Santhanam Krishnan, Rajat Narula, Zmarak Shalizi, Vinaya Swaroop, and Steven Symansky. This work was carried out with guidance and supervision from Kapil Kapoor and on procurement and financial manage- ment from Els Hinderdael and Robert Saum, respectively. Overall leadership was provided by Sadiq Ahmed and Alastair McKechnie. Comments received at the Concept Review meeting (September 27, 2004), during a mid-term review, at a Review meeting (October 24, 2005), and at various times on the different background papers prepared for the PFM Review are gratefully acknowledged. This report was processed by Juliet Teodosio. The collaboration of the following agencies with the World Bank in working on specific parts of the PFM Review is gratefully acknowledged: IMF (revenue), DFID (state-owned enterprises, security), the European Commission (highways), and ADB (procurement). The process of carrying out the PFM Review involved extensive interactions with the Ministry of Finance and other Government agencies, whose valuable cooperation and support was indispensable for completing the review and also greatly benefited this report. T A B L E O F C O N T E N T S EXECUTIVE SUMMARY i CHAPTER 1. PUBLIC FINANCE IN AFGHANISTAN'S DEVELOPMENT 1 A. Economic Performance and Challenges and Development Strategy 5 Progress and Problems 5 Development Strategy 7 B. The Contribution of Public Finance 7 C. Key Public Finance Issues 9 CHAPTER 2. ASSESSING PERFORMANCE IN PUBLIC FINANCIAL MANAGEMENT 15 A. A Framework for Analysis and Action 17 B. The Performance of Afghanistan's PFM System 18 CHAPTER 3. PROGRESSING TOWARD OVERALL FISCAL SUSTAINABILITY 23 A. Fiscal Structure and Trends 25 Budget Structure and Recent Trends 25 Implications 26 B. A Framework for Achieving Fiscal Sustainability 28 Fiscal Sustainability in the Context of Afghanistan 28 Medium-Term Fiscal Framework: What It Means, How It Works 29 C. Managing Expenditures from a Medium-term Perspective 29 The Government Non-Security Payroll ($187 million in 2004/05) 31 Non-wage Operating Expenditures ($96 million in 2004/05, excluding security) 33 The Development Program ($300 million Core, $1,467 million External in 2004/05) 34 Security Sector Spending ($1,328 million in 2004/05, of which $292 million Core) 35 D. Financing Reconstruction and Managing Fiscal Risks 39 Managing Budget Financing over the Medium Term 39 Strengthening Municipal Finances 40 Managing National Assets including State-Owned Enterprises 41 E. Medium-term Fiscal Scenarios 43 T A B L E O F C O N T E N T S CHAPTER 4. MOBILIZING DOMESTIC REVENUES 47 A. Revenue Structure 49 B. Improving Revenue Policy and Tax Administration 52 General Approach 52 Customs Administration Reform 53 Domestic Tax Administration Reform 53 Moving Toward a Broad-based Consumption Tax 54 Taxation and Investment Incentives 55 C. Medium-term Revenue Projections 56 CHAPTER 5. PRIORITIZING EXPENDITURES 59 A. Sectoral Expenditure Patterns: Why It is Important to Prioritize 61 The Allocation of Spending Across Sectors and Recent Trends 61 Why Prioritize? Key Trade-Offs 61 B. How to Prioritize: Allocating Expenditures Across Sectors 63 C. How To Prioritize: Allocating Expenditures Within Sectors 66 CHAPTER 6. MAKING THE NATIONAL BUDGET THE CENTRAL INSTRUMENT OF POLICY AND REFORM 71 A. Budget Preparation Process 73 B. Policy Orientation of the Budget 74 Comprehensiveness and Classification 74 From Policy to Budget 76 C. Enhancing Ownership and Political Buy-In 77 D. Role of Donors in Improving the Budget Process 78 CHAPTER 7. ENHANCING THE EFFECTIVENESS OF BUDGET EXECUTION 83 A. Getting Funds to Service Delivery Units 85 B. Controlling the Use of Public Funds 87 Treasury Functions 87 Internal Audit Functions 89 C. Procuring Goods and Services 90 D. Holding Government Accountable for the Use of Public Funds 92 External Scrutiny of the Budget 92 Fighting Against Corruption 92 T A B L E O F C O N T E N T S CHAPTER 8. DELIVERING SERVICES TO THE AFGHAN PEOPLE 97 A. Six Models of Public Service Delivery 99 Centralized Government Service Delivery 100 Outside Government 102 Government Outsourcing to NGOs/Private Sector 103 Regulation and/or Contracting of the Private Sector 104 Community-based 106 Municipal Services 107 B. Lessons and Implications 108 Financing of Service Delivery and the Role of Cost Recovery 109 Monitoring and Evaluation 111 C. Sub-National Strategy 112 CHAPTER 9. INSTITUTIONAL REFORMS AND CAPACITY DEVELOPMENT 115 A. Developing the Government's Capacity 117 Three Strategic Components 117 Two Key Challenges 119 B. Reforming the Ministry of Finance 121 C. Building PFM Capacity Throughout Government 121 CHAPTER 10. KEY CHALLENGES AND A ROADMAP FOR PFM REFORM 125 A. Eight Main Challenges 127 B. A Five-Point Reform Agenda 129 STATISTICAL APPENDIX 141 Table A.1: Macroeconomic Indicators 141 Table A.2: Social Indicators (2003) 142 Table A.3: Fiscal Summary (Afs Million) 143 Table A.4: Expenditure Comparisons 144 Table A.5: Revenue comparisons 145 Table A.6: Fiscal Scenarios 146 Table A.7: Expenditures by Program from 2003/04 to 2005/06 149 LIST OF ADDITIONAL DOCUMENTS PREPARED AS PART OF THE PFM REVIEW 151 REFERENCES 153 T A B L E O F C O N T E N T S BOXES Chapter 1 Box 1.1: Highlights of the PFM Review Process 4 Box 1.2: Bad Public Finance Management is Bad for Development 9 Box 1.3: The Challenges of Increasing Aid Effectiveness 13 Chapter 3 Box 3.1: Possible Elements of a Medium-Term Fiscal Framework for Afghanistan 30 Box 3.2: Salient Features of Afghanistan's Security Sector 36 Box 3.3: Recommended Guidelines for Responding to Budget Proposals for SOEs 42 Chapter 4 Box 4.1: Summary of Major Tax Instruments in Afghanistan 51 Box 4.2: Afghanistan's Trade Regime 54 Chapter 5 Box 5.1: Prioritizing When Everything is Critical 68 Chapter 6 Box 6.1: Who Decides on the Budget? 77 Box 6.2: The Critical Role of the Afghanistan Reconstruction Trust Fund 80 Chapter 7 Box 7.1: Tracking Public Expenditures in Education 86 Box 7.2: Can E-Government Play a Role in Afghanistan? 89 Box 7.3: Procurement for Highways 90 Box 7.4: Vulnerabilities to Corruption 94 Chapter 8 Box 8.1: Forms of Private Sector Participation in Infrastructure/Utility Sectors 105 Box 8.2: Natural Gas Pricing 111 Box 8.3: Improvements and Challenges in Subnational Administration 114 Chapter 9 Box 9.1: Harnessing Afghan Expertise 118 Box 9.2: Using Technical Assistance Effectively 120 T A B L E O F C O N T E N T S FIGURES Chapter 1 Figure 1.1: Economic Growth and Inflation 6 Figure 1.2: Linkages between Public Finance and Strategic Objectives 8 Figure 1.3: Domestic Revenues and External Assistance, $ million 11 Figure 1.4: Expenditure Structure and Financing, 2004/05 Estimates 12 Chapter 2 Figure 2.1: Linkages Among the Six Core Dimensions of PFM Performance 18 Chapter 3 Figure 3.1: Budget Implementation (2004/05 actuals as % of budget) 27 Figure 3.2: Key Drivers of Afghanistan's Public Expenditures, 2004/05 (% of total budget) 31 Figure 3.3: Pay Scales ($/month) 33 Figure 3.4: Forecast Security Sector Spending Against Projected Revenues 37 Figure 3.5: Three Illustrative Fiscal Scenarios (% of GDP) 44 Chapter 4 Figure 4.1: Total Tax Payable (% of gross profits) 55 Figure 4.2: Medium-term Revenue Forecast (% of GDP) 57 Figure 4.3: Comparative Growth in Revenue Collection (% of GDP) 58 Chapter 5 Figure 5.1: 2004/05 Expenditure Composition (% of total of each category) 62 Figure 5.2: Composition of Security Expenditures, 2002/03-2004/05 65 Figure 5.3: Net Enrollment Ratios, Grades 1-6 (2003) 67 Chapter 6 Figure 6.1: Comprehensiveness of Budget and External Assistance (% GDP) 75 Figure 6.2: Operating and Development Budgets ($ million) 76 Chapter 7 Figure 7.1: Share of Budget Allocated to Provinces (% of Total Expenditures) 87 Figure 7.2: Share of Expenditures Reimbursed by ARTF 88 Figure 7.3: Six Dimensions of Governance 93 T A B L E O F C O N T E N T S Chapter 8 Figure 8.1: Service Delivery Framework 99 Figure 8.2: Service Delivery by Central Government (Education) 100 Figure 8.3: Enrollment Growth (Grades 1-12) 101 Figure 8.4: Service Delivery Outside Government (Humanitarian) 102 Figure 8.5: Service Delivery by Outsourcing to NGOs (part of Health services) 103 Figure 8.6: Service Delivery by Private Sector (Telecommunications) 104 Figure 8.7: Service Delivery by Communities (National Solidarity Program) 106 Figure 8.8: Service Delivery by Municipalities 107 Figure 8.9: Administrative and Political Structure of Afghanistan 112 TABLES Chapter 1 Table 1.1: Fiscal Outcomes ($ million) 10 Chapter 2 Table 2.1: Public Finance Management Performance Indicators 19 Chapter 3 Table 3.1: Wage Bill in Afghanistan 32 Table 3.2: Three Illustrative Fiscal Scenarios ($ million) 45 Chapter 4 Table 4.1: Central Government Revenues (% of GDP) 49 Table 4.2: Domestic Revenue Collection 50 Chapter 5 Table 5.1: 2004/05 National Budget Expenditures by Program ($ million) 63 Table 5.2: Cost-Effectiveness of Different Health Interventions 67 Chapter 6 Table 6.1: Key Steps and Issues in Budget Preparation 74 Table 6.2: Using National Budget Systems 80 Chapter 7 Table 7.1: Constraints on Local Private Sector Participation in Public Procurement 91 Chapter 8 Table 8.1: Contracted Costs for Delivering BPHS ($ per capita of population served) 103 Table 8.2: DABM: Effective Tariffs and Costs by Region, 2004/05 110 Chapter 10 Table 10.1: Roadmap to Strengthen PFM Performance 132 EXECUTIVE SUMMARY Afghanistan's reconstruction has made consider- and current reconstruction activities (very high able progress during the past four years. Led by the spending) and priorities (e.g. massive expenditures Government with international support but relying on security). More specifically: most on the energy and initiative of the Afghan Public expenditures are extraordinarily people, reconstruction has resulted in solid high; total budgetary expenditures in achievements ­ rapid economic growth, unprece- 2004/05 were equivalent to 57% of GDP dented primary school enrollments including for (excluding the drug economy). girls, great expansion of immunization, rehabilita- This is accounted for by extremely high tion of major highways, a new and stable currency, development spending; unlike in most promulgation of a new Constitution, Presidential countries, the development budget ($2.8 and Parliamentary elections, return of refugees, billion in 2004/05) dwarfs the operating and demobilization of militias. Public Finance budget ($0.6 billion). Management (PFM) has made a major contribution Operating expenditures (9% of GDP in to these successes. Yet the challenges remain 2004/05) are well within international enormous. patterns. There are however large recurrent expendi- The main objective of the Afghanistan PFM Review, tures in the development budget, including conducted by the World Bank and partner agencies health services, technical assistance, salary in close cooperation with the Government of payments, and grants, among others. Afghanistan, is to consolidate, deepen, and present There is substantial underspending on non- in an accessible, action-oriented form the knowl- wage operation and maintenance (O&M). edge base on Afghanistan's public finance system, review recent progress, analyze key challenges, Most spending (three quarters in 2004/05) and put forward options and recommendations for occurs outside Government channels and moving forward. oversight through the External Budget (as opposed to the Government-controlled Core Budget). Public Finance Management and The security sector (39% of total expenditures Afghanistan's Development in 2004/05) is a major driver of spending. Fiscal structure and trends. Afghanistan has an A disproportionate share of public unusual fiscal structure reflecting its historical spending occurs in Kabul (e.g. 70% of legacy (e.g. traditionally low revenue mobilization), non-wage O&M). the long period of conflict (e.g. civil service wages Domestic revenues (5% of GDP) are very greatly eroded and compressed by hyperinflation), low (likely the lowest ratio in the world for a iv Afghanistan: Managing Public Finances for Development sizable country) and pay for only about 8% harm development. Poor fiscal management can of total expenditures. result in hyperinflation (as occurred in Afghanistan The fiscal deficit is extremely high and in the 1990s). Failure to prioritize spending among entirely financed by aid, mostly grants. programs or problems in budget execution (payments, procurement, accounting, etc.) can Turning to fiscal trends since 2001/02, (i) budg- result in waste of resources and poor value for etary expenditures have increased sharply during money. And lack of accountability and transparency 2002/03 to 2004/05, with operating expenditures can result in corruption and loss of public support. almost doubling and development spending This is an area of serious concern for many growing even faster; (ii) revenues also have risen Afghans; there are widespread allegations of rapidly, more than doubling during the same various kinds of corruption, including massive period; (iii) since revenues started out from a much corruption associated with the drug industry as well lower base, the absolute gap between recurrent as petty corruption. spending and revenues more than tripled; (iv) this means that external financing of recurrent expendi- Facing a difficult post-conflict situation, tures has been a fast-growing component of the Afghanistan has achieved remarkable progress on budget; (v) the budget deficit (before grants) has the fiscal front. Despite pressures, fiscal discipline increased sharply, reflecting large inflows of has been strictly enforced and maintained, notably external assistance predominantly on a grant basis; through control over the Government wage bill. and finally, (vi) actual development expenditures (in This has been the essential ingredient of macro- both Core and External budgets) have fallen far economic stability. Domestic revenues have short of budget targets (reflecting past inclusion of increased substantially, growing at an average unfunded projects in the development budget, con- annual rate of 60% per year during 2002/03- fusion in some cases between commitments and 2004/05 and rising from 3.2% of GDP to 4.5% in disbursements, overly optimistic projections of this period. Major efforts have been made to disbursements, insufficient project screening, large improve the budget process, and it has come a contingencies in earlier budgets, and implementa- long way since the first post-Taliban budget of tion constraints). 2002/03. Budget execution also has greatly improved in many respects ­ not least, most civil Contribution of PFM to Afghanistan's development. servants are now being paid, on time. Finally, the Public finance has played and will continue to play Government has made a strong commitment to a critical role contributing to economic stability, financial transparency and accountability, resulting state-building, growth, and poverty reduction, in improving fiduciary performance. There have including in particular enabling the Government to also been institutional improvements and capacity perform effectively and deliver public services to the development, especially in the Ministry of Finance Afghan people (Chapter 1). To support these (MoF). These achievements have provided objectives, public finances must be: (i) affordable; confidence to donors resulting in mobilization of (ii) well-prioritized in accordance with the national high levels of external support for the national strategy; (iii) efficient in terms of value for money budget, mainly through the Afghanistan and service delivery; and (iv) fair, accountable, and Reconstruction Trust Fund (ARTF) which finances transparently reported to the Afghan public, private most of the civilian recurrent budget. These business, and other stakeholders. On the negative achievements are commendable compared to side, weaknesses in public finance can enormously experience in other post-conflict countries. Executive Summary v However, improvements have been to a large contributed to aggregate fiscal discipline. The expen- extent dependent on external capacity brought in ditures and financial position of the Government are on an "emergency" basis to get things going. The reported regularly in an understandable format. shift from this situation to sustainable core Performance regarding the allocation of spending Government capacity for key public finance across programs and agencies and the efficiency of functions has barely begun for the most part, and operations is not as good, however. Given that the there are also daunting weaknesses in PFM starting point in 2001 was extremely weak, this is capacity in the line ministries. overall a remarkable achievement ­ yet pointing to the need for further progress. Using these ratings as PFM performance measurement framework and a baseline, future progress in improving the per- assessment. As discussed in Chapter 2, a PFM per- formance of the PFM system can be monitored. formance rating system has been recently devel- However, measurable progress in terms of changes oped by the Public Expenditure and Financial in ratings is more likely to occur over periods of a Accountability (PEFA) multi-agency partnership year or longer than on a short-term basis. Moreover, program (including the World Bank, IMF, EC, and a since the ratings assess the system's current perform- number of other agencies). It is intended to provide ance with external support (both advisory and oper- an objective, internationally comparable framework ational), questions arise about sustainability. Further for assessing the performance of a country's PFM improvements in many cases may be manifested not system. This does not attempt to measure fiscal in higher ratings but rather in maintenance of outcomes, the substantive appropriateness of public current ratings based on sustainable national expenditure policies and decisions, or the actual capacity and with declining levels of external impacts and value for money achieved through support. The ratings also provide an assessment for public expenditures. The PFM performance the donor community of the potential capacity of measurement framework instead should be seen as Government systems (currently supported by external assessing the PFM system, which is a crucial assistance) to implement the operations which are enabling factor for achieving broader development now occurring outside Government systems. goals and substantive outcomes. Structured around six core dimensions of PFM performance (budget Eight Challenges for Public Finance credibility; comprehensiveness and transparency; Management policy-based budgeting; predictability and control in budget execution; accounting, recording, and Despite recent progress, Afghanistan's PFM system reporting; and external scrutiny and audit), the faces daunting challenges, which can be summa- framework includes 28 high-level PFM performance rized as follows. indicators and three indicators of donors' performance. The performance of Afghanistan's Progressing toward fiscal sustainability. Afghanistan's PFM system against this framework as of June 2005 annual budgets have been prudent, and the has been assessed as part of the PFM Review (see Government has a strong policy to avoid domestic Table 2.1). borrowing (relying instead primarily on external assistance and on growing domestic revenues to pay This assessment generally portrays a public sector for its expenditures). From a medium-term perspec- where financial resources are, by and large, being tive, however, progressing toward fiscal sustainability used for their intended purposes as authorized by a (defined very simply in this report as reaching a fiscal budget which is processed with transparency and has position where domestic revenues are large enough vi Afghanistan: Managing Public Finances for Development to cover total recurrent expenditures) will be a sustained basis ­ most likely at least twice as fast. daunting challenge (discussed in Chapter 3). Right At the same time, a sound revenue system should now, domestic revenues cover less than half of total be conducive to development of the private sector. recurrent budgetary expenditures and only a quarter Key challenges in raising revenues include: (i) lack of all recurrent expenditures (if the large amounts of of capacity in the tax administration system as well recurrent expenditures in the entirely donor-financed as among taxpayers to calculate and pay taxes; (ii) Core Development Budget and External Budget are the existence of numerous, low-yielding "nuisance included). Failing to keep public expenditures within taxes", illicit revenue collection by many local affordable limits would have dire consequences. A authorities, instances of double-taxation (mainly large influx of aid, combined with lack of domestic between municipal and national taxation), and capacity and low domestic revenues, can result in an ambiguities in the tax laws; (iii) the dominance of unaffordable pattern of expenditures if not well- agriculture and the informal sector in the economy, managed. While international support gives which are difficult to tax in any country; and (iv) Afghanistan an opportunity to temporarily soften its widely perceived corruption in the tax administra- national budget constraint, a visionary medium-term tion. The Government has already made progress framework (i.e. a Medium-Term Fiscal Framework, in reforming the Customs tariff structure and MTFF) is needed to ensure that the country moves improving the income tax system. Further progress toward a sustainable fiscal position. Afghanistan has will depend on focusing efforts on larger taxpayers taken the first step in this regard by approving its first and high-yielding revenue sources; eliminating MTFF in October 2005. Progressing toward fiscal "nuisance taxes" and cracking down on illicit levies sustainability will require, inter alia, (i) sustained as well as clarifying ambiguities in the tax code; rapid growth of domestic revenues (discussed and building capacity in the form of a well- below); (ii) containment of overall expenditures ­ managed professional tax cadre with integrity and notably for non-discretionary expenditures such as associated physical, IT (information technology), wage bill and pensions ­ in line with medium-term and business process assets. Increasing domestic resource constraints; (iii) ensuring that downstream revenue mobilization needs to be given very high expenditure liabilities created by public investments priority: it will reduce aid dependence over time, and other spending decisions are affordable; and (iv) create fiscal space for development, and send a incorporating recurrent expenditures funded directly very strong signal of the Government's commitment by donors through the External Budget (notably those to progressing toward fiscal sustainability. Full in the security sector) in the fiscal sustainability implementation of the current policy and adminis- equation and bringing these expenditures progres- trative reform plans would raise the revenue to sively into national budget channels. GDP ratio from 5% to 8% by 2010. More forceful implementation of administrative reforms, reaching Mobilizing domestic revenues. Sustained rapid quickly to provinces, and additional revenue growth of domestic revenues will be the lynchpin of measures could bring this ratio to 10-11% in 2010. progress toward fiscal sustainability (Chapter 4). Afghanistan's revenue-to-GDP ratio at around 5% Prioritizing expenditures. Strategically prioritizing is well below half the level even in other very poor expenditures so they effectively support national countries. In order for revenues to catch up with development objectives is both one of the most recurrent expenditures within a decade in line with important and one of the most difficult aspects of the Government's objectives, revenues will have to public finance management (Chapter 5). grow much more rapidly than expenditures on a Prioritization is critical because: (i) like any country, Executive Summary vii Afghanistan faces major resource constraints over on another activity) and sequencing issues also can the medium term; (ii) with the bulk of public help guide intra-sectoral prioritization. spending externally financed and most of it donor-executed, if the Government does not priori- Making the national budget the central instrument of tize the allocation of expenditures, priorities will be policy and reform. While much progress has been determined in an ad hoc manner by the made in strengthening the budget formulation fragmented priorities of others; and (iii) capacity is process, there is a long way to go toward a policy- limited. Prioritization is a political process; an orderly based, well-prioritized budget with strong political budget process (see below) is the means by which buy-in. As discussed in Chapter 6, key constraints decision makers (Cabinet, Parliament) make trade- include: (i) limited capacity in MoF and especially in offs under the constraint of limited resources. This line ministries; (ii) the dominant share of expendi- process must be anchored in national and tures directly by donors outside Government sectoral strategies and based on solid evidence systems; (iii) serious timing dilemmas and a coming out of the monitoring and evaluation system. compressed budget schedule which weakens the quality of the budget; and (iv) lack of a medium- There are no easy answers on how to prioritize term strategic and fiscal perspective to guide annual expenditures across sectors. Simple rules of thumb budget formulation. The Government has prepared (identifying and mitigating gross anomalies, looking an initial MTFF (Medium-Term Fiscal Framework) at international patterns of spending and outcomes, which, integrally linked to annual budgeting, will be identifying bottlenecks and directing expenditures to critical to further improve the budget process. Key alleviate them) are likely to work better than cross-cutting issues such as gender and counter- sophisticated technical approaches. For example, the narcotics need to be mainstreamed in budgetary allocation to the justice sector appears to have been decision-making. Meaningful processes of political grossly inadequate in recent years. It is very important engagement and approval (including by Parliament) that inter-sectoral prioritization be comprehensive ­ and public communications are required. There no sector (e.g. defense) should be considered is also an urgent need for greater inputs and partic- sacrosanct or immune from scrutiny. Prioritization of ipation in budget formulation by lower levels of the expenditures within sectors and major programs Government administration (provinces and districts). needs to be firmly anchored in sector strategies. Within sectors, prioritization can rely on analysis of Enhancing the effectiveness of budget execution. the costs and benefits of various interventions (e.g. While considerable progress has been made in highways, dams). Of particular importance is the some areas of budget execution, a great deal review of the costs of operating and maintaining remains to be done in four respects ­ which would (O&M) public investments (e.g. hospitals, roads). For improve the quality of spending and the trust that instance, new investments are being made in the the Afghan people, the private sector, and donors power sector, even while existing power supply in place in the Government's systems (Chapter 7). Kabul depends on off-budget provision of fuel by an First, financial management processes need to external donor. A simple rule of thumb suggests that ensure that funds reach service delivery units; this is investments made in 2004/05 could generate an a serious weakness in most sectors (e.g. additional $100 million in annual O&M costs (i.e. education). Second, further strengthening of the 40% of all domestic revenues collected in that year). control framework for public spending in particular Taking into account complementarities (where the requires implementing the new Public Expenditure effectiveness of spending on one activity is dependent and Financial Management Law and creating a viii Afghanistan: Managing Public Finances for Development strong internal audit function. Third, while the on outcome indicators, giving rise to frustrations existing procurement framework includes basic and weakening the credibility of the Government. financial controls and stresses competitive bidding, it places an excessive emphasis on price (at the The experience in Afghanistan provides some expense of quality of goods and services), and important lessons. Performance-based contracts in there is too limited participation from the private the health sector appear to be a promising way to sector. Progressive implementation of the new deliver services effectively, while keeping full Procurement Law, combined with substantial regulatory control and sufficient visibility for training of civil servants as well as private firms, will the Government. Private sector participation, create the foundations for a fair, transparent, and supported by direct payments from users, has effective procurement system. Finally, external stimulated rapid growth of telecommunication scrutiny and audit are necessary to hold services, while state-owned enterprises have been Government accountable for the use of public much less successful. Through the National funds. Much remains to be done to build the Solidarity Program, half of the villages of external auditor's capacity. The election of the Afghanistan now have elected development coun- Parliament also creates an opportunity ­ with its cils empowered to make local investment decisions own challenges ­ to further strengthen accounta- using block grants. Afghanistan can also learn from bility and participation. Progress in these four areas less positive experiences, such as the failure to will help greatly in the fight against corruption, and provide non-salary budgets to most schools and should be a key part of a holistic anti-corruption the unsustainability of financing for electricity. Some strategy. Corruption is considered to be a symptom key lessons include: (i) the critical need to focus on of poor governance, and international experience service delivery, put people at the center, and get demonstrates that anti-corruption strategies work accountability and incentives right; (ii) choices and better through addressing the underlying expenditures should depend on sector strategies governance problems (e.g. in the PFM system), and circumstances and be guided by adequate rather than mainly through investigation and monitoring and evaluation; and (iii) sustainable prosecution of individual corruption cases. financing and, where appropriate, cost recovery are essential. Delivering services to the Afghan people. As discussed in Chapter 8, the ultimate outcome of Institutional reforms and capacity development. the PFM system is service delivery, essential for Meeting the challenge of sustainable national public spending to achieve results and extremely capacity development is critical for success in important for the credibility and legitimacy of the improving Afghanistan's PFM system (Chapter 9). At State. However, as recognized by the Government's present, national capacity in the PFM system is strategy documents, it is not required for the limited, virtually non-existent in many areas. External Government to deliver all public services itself. capacity has been brought in to support core func- Other possible Government roles include tions on an "emergency" basis, and large amounts of financing, setting policy, contracting/regulating, technical assistance ($400 million per year according and monitoring. Various stakeholders ­ non- to OECD data) injected (for all areas of activity, not Government providers, private sector, users, and just PFM). But this is not sustainable, and there are citizens ­ also have important roles to play. With a serious risks that slower but more sustainable national few exceptions, public service delivery in most capacity development will be undermined, making sectors is poor, as demonstrated by available data Afghanistan highly vulnerable to a reduction in aid Executive Summary ix flows. Developing capacity requires public adminis- improvements leading to better compliance as well tration reforms (recruitment, pay, human resources), as sound tax policies); (ii) maintaining control over organizational restructuring and improvements, and aggregate expenditures within the overall resource training. Better management of external technical envelope; (iii) setting and implementing clear assistance is needed to ensure that it supports longer- policies for key expenditure components notably the term national capacity development Government wage bill (including the non-civilian component, much of which is currently outside the Finally, underlying all these challenges is the need Core Budget); (iv) monitoring and controlling fiscal for coordination and donor alignment, within an risks (including pension liabilities, external debt, and overall national strategic and budgetary frame- liabilities of SOEs); and (v) ensuring that strategic work. Coordination within the Government needs and public expenditure decisions are affordable to be improved (this can be accomplished around over the medium-term, including downstream O&M a widely-owned national development strategy and implications. Progress toward fiscal sustainability will a sound budget process), and public communica- be measured by achievements against fiscal targets tions and transparency will be extremely important under the MTFF. in fostering Government accountability vis-à-vis cit- izens and their elected representatives. Second, a number of policy decisions and actions are Coordination is a major challenge for donors as needed to improve service delivery. This will require well, which also needs to occur around the national clarifying the roles of the State (operational, financing, development strategy and budget process; the low policy, and regulation) in service delivery in different share of external assistance going through national sectors; strengthening accountability; ensuring budget and treasury channels is a serious constraint sustainable financing arrangements including cost in this regard. Improving aid effectiveness requires recovery where appropriate; and determining the a continuing and deepening partnership between responsibilities of various levels of Government the Government and the donors. administration (central ministries, provinces, districts). A variety of different models of service delivery are A Five PointAgenda forAction possible within Afghanistan's Constitutionally- mandated unitary state structure, and the choice The Government has fully recognized these chal- among them should depend on sector-specific condi- lenges and the centrality of the budget process and tions. Although "one size does not fit all," the effective- PFM performance for Afghanistan's future. It has ness of service delivery depends largely on the degree prepared its Interim Afghanistan National of ownership and the coherence of the models in Development Strategy (I-ANDS), in which the PFM terms of accountability, incentives, and financing. agenda needs to be anchored. In this regard, a Donors also need to ensure that their interventions five-point agenda to improve PFM is put forward strengthen rather than undermine national service for consideration (Chapter 10). delivery mechanisms. Progress in improving service delivery will be measured by the articulation of the First, the path toward fiscal sustainability needs to be Government's strategy ­ with a clear set of indicators, mapped out and steady progress in this direction baseline data, and targets ­ and achievements achieved. Based on a sound MTFF (rudimentary at against these indicators. the outset but improved over time), this will require particular attention to (i) increasing domestic Third, the capacity of the key PFM institutions should revenue mobilization (through administrative be developed. Priority areas include training, recruit- x Afghanistan: Managing Public Finances for Development ment practices, pay structures, organizational Finally, continuing and further deepening collabo- reforms, detailed business processes, specific IT ration between the Government and the inter- systems, etc. While these issues cut across all levels of national community will be critical for the success of Government, MoF's capacity is of particular impor- the reform program. The Government's develop- tance. As chief custodian of the PFM system, its ment strategy ­ including plans toward fiscal capacity to develop and implement policies is at the sustainability, more effective service delivery, core of PFM performance. Progress toward an MoF capacity development, and strengthened PFM Strategic Plan ­ initiated in May 2005 ­ will be very performance ­ should serve as the basis for a important in developing MoF's capacity and framework of mutual accountability. Donors would performance. PFM capacity development in line align their support to national strategic objectives ministries also is very important but will take more and the national budget and increasingly use the time. Progress in this area will be measured by the Government's systems, while the Government finalization of an MoF Strategic Plan with monitoring would implement the decisions it has announced indicators and achievements against these indicators. and further improve the performance of the PFM system. In addition, the content, mode, and Fourth, and related to the previous recommenda- capacity-building contribution of technical tions, the Government should adopt a clear action assistance will be very important and needs to be plan to improve PFM performance, with time-bound well-managed and well-coordinated in line with milestones, quantified objectives, and clearly Government leadership and national budgetary identified responsible agencies. This proposed PFM and other capacity-building processes. action plan would consist of a set of mutually supportive measures that are feasible, realistic, and Way forward. Not surprisingly in view of the major sustainable, and that can generate a step-change challenges that Afghanistan faces, this is a multi- in PFM performance each year. The action plan faceted, demanding, and ambitious medium-term should in addition include (i) a reform communica- agenda. Each of the five elements includes difficult tion plan (with staff in MoF, with the Cabinet and sub-agendas and important actions required for other Government agencies, with the Afghan success. This points to the need to prioritize and people, and with the international community); (ii) focus on a set of realistic yet meaningful short-term a solid organizational and institutional plan; and measures that will achieve significant improvements (iii) a process to monitor actions and performance, and step-changes, thereby setting the stage for review progress, and adjust the program. A further progress. A package of prioritized short-run detailed roadmap for improving PFM performance, actions could thus comprise a "platform" from which is linked to the PFM performance indicators which the next set of actions would take off, with and could form the basis for annual action plans, monitoring and feedback to guide the process at is presented in the form of a matrix at the end each stage. Moreover the package, rather than any of this report (see Table 10.1). Progress in single measure or mechanical target, would be implementing the action plan could be measured what the Government takes responsibility for and by the key fiscal outcomes as well as progressive could form the basis for dialogue and agreements improvement of the MTFF, and by the PFM per- with the international community. formance indicators presented in this report. Monitoring of progress, along with a meaningful In each of the five points of the agenda outlined feedback loop into subsequent decision-making, above, a small number of key elements stand out will be as important as the action plan itself. as critical for a first platform (see table below). For Executive Summary xi instance, the MTFF provides a foundation on of this package (not necessarily all of the measures which the Government can subsequently anchor but at least a critical mass of most of them) would fully costed sector strategies. With implementation build the "platform" on which the following year's of the PFEM Law and Procurement Law, the action plan could be based, leading to further Government will be able to establish its credibility progress subsequently. This type of process would in terms of managing public funds, better analyze help in coordinating the expectations of partners as patterns of public expenditures, and introduce to what the Government realistically will be able to more sophisticated PFM practices over time. achieve each year and, with adequate monitoring, Following the establishment of a track record of would help the Government establish a strong track mutual accountability with donors, a higher share record of implementation. Adequate monitoring of external assistance could be channeled through and evaluation should also feed back into the next the Government's systems. year's annual plan and revisions to the overall strategy ­ this requires significant development of In this process, the Government first needs to statistical and analytical capacity. develop and reach agreement on its strategy. The recently completed I-ANDS marks a major achieve- This proposed way forward would fit appropriately ment in this regard and includes the Government's within the overall umbrella of the Government's initial MTFF. The I-ANDS and MTFF need to be I-ANDS and its preparation of a full ANDS. It is also supported by a PFM action plan that would be fully consistent with, and would support the adopted by the Government, as well as an MoF implementation of, the Afghanistan Compact reform strategy. Clear sector strategies also are agreed between the Government and donors at the needed to guide prioritization and sector expendi- London Conference on Afghanistan (January 31 ­ ture programs. The ANDS and sector strategies February 1, 2006). need to specify the roles of the State and put forward sound approaches to ensure effective In conclusion, the five-point reform agenda service delivery, differentiated by sector as outlined above is ambitious, requiring sustained appropriate (see Chapter 8). The sector strategies efforts over a considerable period of time based on will take varying amounts of time to develop and, meaningful steps each year. But, as seen earlier, the like the interim ANDS, MTFF, and PFM action plan, challenges in building an effective, accountable, will need to be improved over time and adjusted in financially self-sufficient State that facilitates sus- the light of experience. It is critically important that tained economic growth, ensures adequate delivery these strategies have wide national ownership, both of services to the Afghan people, and reduces within and outside Government. poverty are enormous and pressing ­ requiring a commensurate response. The Government, with The strategy as it applies to Public Finance strong support from the international community, Management would then be translated each year has demonstrated its willingness and commitment into annual plans that would consist of three to embrace an agenda along these lines and move building blocks: (i) an updated medium-term view forward with implementation in a determined yet of the fiscal path (MTFF); (ii) an annual budget con- realistic manner. Building on the achievements of sistent with the MTFF and ANDS; and (iii) an the past several years, the table below suggests key "annual action plan" (a list of a small number ­ short-term priorities, progress indicators, and certainly less than 20 ­ of key actions to be accom- responsible entities to move toward the next level of plished during the year). Successful implementation strengthened PFM performance. xii Afghanistan: Managing Public Finances for Development Key Priorities and Progress Indicators for Improving Public Finance Management 1. Moving Toward Fiscal Sustainability Progress will be measured by: Suggested short-term priorities include: Implemented by: Increase in revenue to GDP ratio Further improve MTFF over time and Cabinet Decline in ratio of operating expen- use it for setting budget envelopes MoF ditures to revenues (Chapter 3) Progress according to fiscal targets Implement tax measures already in MTFF gazetted, focus administrative reform on Customs and Large Taxpayer Office (Chapter 4) 2. Improving Service Delivery Progress will be measured by: Suggested short-term priorities include: Implemented by: Adoption of I-ANDS with monitoring Improve alignment of budget and Cabinet framework ANDS by correcting significant mis- Line ministries Progress according to indicators in matches (Chapter 5) CSO ANDS monitoring framework Develop selected sector strategies with Improved alignment between budget a service delivery focus (Chapter 8) and ANDS Enhance statistical capacity for mon- Progress against monitoring indica- itoring and evaluation (Chapter 8) tors in sector strategies 3. Developing Capacity of PFM Institutions Progress will be measured by: Suggested short-term priorities include: Implemented by: Adoption of MoF reform strategy with Further develop and adopt MoF MoF monitoring framework Reform Strategy (Chapter 9) MoF Progress according to indicators in Pilot reform of administrative (finance MoF reform strategy / HR) department (including budget process) in MoF 4. Improving PFM Performance Progress will be measured by: Suggested short-term priorities include: Implemented by: PFM Performance indicators (Chapter 2) Adopt PFM action plan (to be devel- Cabinet Progress according to fiscal targets oped by MoF, Chapters 6, 7, 10); Parliament and civil in MTFF this would include inter alia imple- society, supported by Progress will be measured by: mentation of PFEM Law (notably Government and Proportion of external assistance development of internal and external donors through budget channels audit) and Procurement Law Develop means for public engage- ment on budget matters (formulation and implementation) 5. Deepening the Collaboration between the Government and the International Community Progress will be measured by: Suggested short-term priorities include: Implemented by: Proportion of external assistance Agree on a framework of mutual Cabinet and donors through budget channels accountability Donors Agree on good principles for TA management, use of Government systems (Chapters 6, 7, 9) 1 PUBLIC FINANCE IN AFGHANISTAN'S DEVELOPMENT This report is the product of the Afghanistan Public of interest to the Government (see World Bank, Finance Management (PFM) Review. The main goal 2005b, and the list of additional documents pre- is to consolidate, deepen, and present in an pared, p.151). Specific stages and activities during accessible, action-oriented form the knowledge the PFM Review process are outlined in Box 1.1. base on Afghanistan's public finance system, review recent progress, analyze key challenges, and put The scope of the PFM Review is intended to be forward options and recommendations for moving comprehensive, including revenue, procurement, forward. The full PFM Review report (World Bank, financial management, and fiduciary issues as well 2005b) consists of the main report (Volume I) on as more traditional Public Expenditure Review (PER) which this report is based, plus four other volumes, topics. There is also a focus on institutional and covering PFM performance and procurement capacity aspects. The coverage of different sectors, (Volume II); key cross-cutting issues (Volume III); however, is not complete but is intended to provide selected sector case studies (Volume IV); and secu- selected examples. Given the comprehensive scope rity sector expenditures (Volume V). of the PFM Review, this report inevitably is highly condensed; more details are available in World This work has been carried out by the World Bank Bank (2005b, Volumes II - V) and in the additional in collaboration with other agencies working on background papers. specific areas: IMF (revenue), DFID (state-owned enterprises, security), the European Commission This report has ten chapters. This first chapter (highways), and ADB (procurement). The team has discusses the contribution of public finance to worked closely with the Government of Afghanistan, Afghanistan's reconstruction and development and especially the Ministry of Finance (MoF). key challenges. Chapter 2 provides a framework for assessing the performance of a country's PFM The objectives of the PFM Review as a whole have system and an evaluation of Afghanistan's current been to (i) respond to specific Government requests, PFM performance. Chapter 3 focuses on the key in particular by MoF; (ii) provide inputs for and imperative of progressing toward fiscal sustainability support to Afghanistan's annual budget cycle; and in the medium-term, highlighting possible fiscal (iii) consolidate and deepen knowledge of scenarios and fiscal risks. Given the critical impor- Afghanistan's public finances, including assessment tance of mobilizing domestic revenue, Chapter 4 is of fiduciary aspects (financial management and devoted to this issue. Moving from the aggregate procurement). The process involved extensive level to the sectoral and subsectoral level, Chapter interactions with MoF and other Government 5 looks at prioritization and allocation of expendi- agencies, and produced numerous intermediate tures across and within sectors. Turning to process products providing technical inputs on specific topics issues, Chapter 6 discusses budget formulation and 4 Afghanistan: Managing Public Finances for Development Box 1.1:Highlights of the PFM Review Process The Afghanistan PFM Review has been very much oriented toward real-time learning and interactions in partnership with the Government, particularly MoF In this regard, responding in a timely manner with technical inputs and discussions on topics of immediate relevance to Afghanistan from a PFM perspective was given highest priority. Selected activities which occurred as part of the PFM Review are listed below, along with some key milestones. Initial discussions with MoF and other Government agencies on PFM Review (July-September 2004): The concept, content, and rationale for a PFM Review by the World Bank were discussed with Government officials, and feedback was obtained. Specifically, MoF requested that the PFM Review include analysis of the security and mining sectors. Initiation of PFM Review task (September 27, 2004): Internal World Bank meeting reviewed the concept paper for the PFM Review, endorsed moving ahead, and provided guidance from Peer Reviewers. Terms of reference for each component of the Review were subsequently prepared and agreed with MoF. PFM Review mission (November 28-December 19, 2004): A sizable team of World Bank staff, joined by team members provided by DFID, the EC, and other agencies, visited Afghanistan during this period for information gathering and discussions on the whole range of topics covered in the PFM Review, including institutional, cross-cut- ting, sectoral, and financial management/procurement aspects. In particular, in response to a request from MoF, a World Bank member of the PFM Review team worked intensively with MoF officials on the restructuring of MoF's Treasury and Accounting Departments and prepared a technical paper outlining issues and options. Discussions on security sector expenditures (December 2004 ­ May 2005): Analysis of security sector expenditures was initiated during the December 2004 mission and continued thereafter. Major findings, in particular related to fiscal sustainability issues, were shared with the Government, and a short paper was prepared. Inputs for 1384 (2005/06) Budget (January-March 2005): During this period, the team produced and shared with the Government several technical papers on relevant topics for the 1384 Budget then under preparation. Examples include papers on budget formulation, the Government wage bill, medium-term fiscal issues, and state-owned enterprises. Internal reviews (mid-term: February 6, 2005 and final: October 24, 2005) to assess progress and outcomes. Meetings and workshops on MoF strategic planning and reform (May 22-30, 2005): At the request of the Ministry, World Bank staff helped facilitate a series of meetings on the development of a strategic planning/reform process in MoF.Earlier a draft "vision paper" for MoF had been prepared, and in May-June a more detailed paper outlining a possible approach to MoF strategic planning/reform was drafted and shared with MoF. Ongoing discussions on the PFM Performance Assessment (January-August 2005): a draft of the assessment (see Chapter 2) was shared and discussed with the Government, which decided to release it on the website of the Afghanistan Development Forum (April 2005). Further discussions were held in May and August around this assess- ment, and it was subsequently presented by MoF to donors at a Consultative Group meeting in Kabul. making the national budget the central instrument from a service delivery perspective. Chapter 9 ana- of policy and reform. Chapter 7 is about the budget lyzes the critical issues of institutional reforms and execution process, including getting funds to service capacity development in relation to public finance delivery units, controlling use of public funds, management. Chapter 10 provides a closing improving public sector procurement, and summary of key challenges along with a roadmap enhancing accountability. Chapter 8 looks at for improving the performance of Afghanistan's PFM service delivery, presenting some models and system. The Statistical Appendix presents key macro- examples and also discussing subnational strategy economic, social, and fiscal data. Public Finance in Afghanistan's Development 5 Afghanistan's reconstruction has made consider- been concentrated in urban areas, notably Kabul. able progress during the past three years. Led by Moreover, the predominantly informal Afghan the Government with international support but economy (outside the formal legal framework and relying most on the energy and initiative of the largely outside the tax base) is also a constraint on Afghan people, reconstruction has already resulted future development, despite its benefits in many in solid achievements ­ for example rapid respects. The Government's Securing Afghanistan's economic growth, unprecedented primary school Future report argues that Afghanistan will need to enrollments including for girls, great expansion of achieve sustained economic growth on the order immunization, rehabilitation of major highways, a of 9% per year over the next decade or so to be new and stable currency, promulgation of a new able to phase out opium production while Constitution, Presidential and Parliamentary maintaining per-capita income growth at reason- elections, return of refugees, and demobilization of able levels. The key challenge therefore is to militias. Yet the challenges remain enormous. The transform recent rapid growth into robust, sustain- role of public finance in contributing to national able growth over the medium term, based on achievements and in meeting challenges in the private investment and increasingly competitive future is the main subject of this chapter. The production, with strong growth of exports. chapter starts by reviewing recent economic performance and the development strategy Macroeconomic stability. In contrast with the pursued by Afghanistan. It then discusses the con- hyperinflation Afghanistan suffered from in the tribution of public finance management to these 1990s and unlike experience in many post-conflict achievements and the role that it will need to play situations, inflation has been kept well under in the future. The chapter ends by briefly outlining control (Figure 1.1), and the exchange rate has some key public finance issues faced by the country been stable. Particularly noteworthy has been the in its efforts to achieve national objectives of successful introduction of a new currency to growth, state-building, and poverty reduction. replace the multiple, severely devalued currencies inherited from the 1990s. Prudent, conservative A.EconomicPerformanceand fiscal policy (embodied in the "no-overdraft rule") ChallengesandDevelopmentStrategy and sound monetary policy have contributed to price stability, and external financinghas covered Progress and Problems Afghanistan's large trade deficit and contributed to exchange rate stability. One concern is that the Economic growth. Afghanistan's economy has significant albeit controlled level of inflation (on rebounded since 2001, stimulated by the end of the order of 10% per year) combined with major conflict, good precipitation for agriculture, exchange rate stability are symptomatic of a the initiation of reconstruction activities, and "Dutch-disease" type of problem, whereby resource strong demand and financing from opium, remit- inflows due to opium, remittances, and aid drive tances, and reconstruction aid inflows. Economic up domestic prices and costs, making it difficult for growth has generally been at double-digit rates the Afghan economy to produce for export or (averaging 20% p.a. during 2001-2004), and is compete against imports, exacerbating the other expected to continue in the 10% per year range obstacles to private investment and activity. (Figure 1.1). However, recent growth has been Overall, however, the macroeconomic achieve- based largely on one-time, unsustainable, or ments compare favorably with other post-conflict undesirable (opium) factors and appears to have countries (World Bank, 2005a). 6 Afghanistan: Managing Public Finances for Development non-salary allocations); and the emergence of Figure 1.1:Economic Growth and Inflation multiple parallel mechanisms at subnational level, outside of Government leadership. Thus there are numerous challenges in the area of state building, and public finance will have to play a critical role in meeting them. Security. Security is widely considered as the number one short-run issue for Afghanistan's reconstruction. There have been undoubted improvements, including formation of the Afghan National Army (ANA), disarmament and demobi- lization of armed militias, initial progress in Source: IMF. interdiction against drug trafficking, etc. However, different types of insecurity remain endemic in Private sector development. Afghanistan's private many parts of the country, ranging in severity up to sector, predominantly informal as noted earlier, has outright conflict in some areas. Reforms in the been flexible and responsive and has contributed to police and especially in the judicial system have the economic recovery. However, there are serious lagged far behind the development of the ANA. weaknesses in the business environment (e.g. lack Another challenge is that the development of of access to electricity, land, and finance, problems security forces is proving to be costly, with serious with corruption as well as numerous illicit levies and questions about the fiscal sustainability of security "nuisance taxes" in the fiscal sphere, see Chapter 4 sector expenditures (see Chapter 3). and World Bank, 2006) and in private sector capacity, which need to be rectified if the private Infrastructure. Road investments, both rehabilitation sector is to become the "engine of growth" for of Afghanistan's main highways and building Afghanistan's economy. smaller and rural roads, have moved ahead, although implementation has been in some cases State building. In addition to implementation of the slower than desired for various reasons including Bonn process of political normalization including security, and costs of highway rehabilitation have promulgation of a new Constitution, significant tended to be high (see World Bank, 2005b, Volume progress also has been made in other aspects of IV, Chapter 5). Progress has been much slower in state building. This includes restoring at least a other sectors such as power and irrigation; minimal degree of Government functioning, paying financing of infrastructure is not on a sustainable civil servants on time, and initially bringing capacity basis; many state-owned enterprises are defunct; in from outside followed by efforts to build capacity and there are major regional differences and gaps. within Government on a selective basis. However, capacity in most of the Government is still grossly Human development. Primary school enrollments deficient, services are not being delivered, and have reached unprecedented high levels (54% in disproportionate staffing and resources are 2003) including for girls (40%), and basic health concentrated in Kabul. Subnational administration services are expanding while immunization for the most part is plagued by lack of capacity; campaigns have sharply increased coverage since extremely limited financial resources (particularly 2001. Progress has also been made in reviving Public Finance in Afghanistan's Development 7 tertiary education. Nevertheless, primary enroll- reviewing, updating, modifying, and refining its ments remain far below international norms in development vision and strategy, including particular for girls, with wide regional gaps espe- through widespread consultations within the cially by gender. Access to health is still problematic Government. The Interim Afghanistan National in many rural areas, especially for females. There Development Strategy (I-ANDS) has been are serious quality problems at all levels of approved by the Cabinet and discussed at the education, and differences in levels of service high-level London Conference on Afghanistan on provision are dramatic (see Chapter 5). January 31 ­ February 1, 2006. It is expected that the I-ANDS will be presented to Parliament Narcotics. The opium economy ­ linked with insecu- rity, anti-state interests, poverty, weak governance, Strategic foundation for public finance manage- and economic distortions ­ is an enormous problem ment. As will be discussed later in this report, it is and challenge for Afghanistan's development. essential that there be a close linkage between Modest progress has been made in interdiction development strategy and medium-term fiscal against drug trafficking, and opium cultivation has planning as well as annual budgeting. In this been greatly reduced in some areas, but it has grown regard, the Government intends that the I-ANDS rapidly elsewhere and is now found in all of the will form the strategic anchor for the 2006/07 country's 34 provinces. Large numbers of people ­ National Budget. It is also very important that the farmers, wage laborers, traders, militia forces, ANDS embody a medium-term fiscal framework commanders, government officials ­ are involved in (MTFF) to guide fiscal policy and reforms as well as the drug business. The nexus between drugs, insecu- public sector resource allocation. (The I-ANDS rity, warlords, and weak government is a profound includes the initial MTFF approved by the threat to state-building and reconstruction. Government in October 2005.) Development Strategy B.The Contribution of Public Finance Progress achieved. The Government articulated a Public finance has played and will continue to play compelling vision of the country's future in the a critical role in contributing to economic stability, National Development Framework promulgated in growth, and poverty reduction, and in enabling the 2002, and then with a more specific program in Government to perform effectively and deliver Securing Afghanistan's Future, presented at the Berlin public services to the Afghan people. Key linkages Conference in 2004. The Government's documenta- between public finances and the strategic tion for the 2005 Afghanistan Development Forum objectives of growth, state building, and poverty presented a comprehensive overview of develop- reduction are shown in Figure 1.2. ment issues and challenges, as well as Government plans. Progress has been slower in building owner- In order to promote sustained economic growth, ship for this vision across the Government, building an effective, accountable State, and consulting with civil society, and ensuring that reducing poverty, public finances must be: Government policies and decisions are in line with (i) affordable (dynamically growing revenues and national strategic objectives and priorities. expenditures under control); (ii) prioritized in terms of allocation across sectors in accordance with Preparation of the National Development national strategy, and over time so that investments Strategy. The Government has recently been made today can be effectively operated and 8 Afghanistan: Managing Public Finances for Development maintained in the future; (iii) efficient in the sense the budget. This has been the essential ingredient of value for money and service delivery; and of macroeconomic stability (see above). Domestic (iv) accountable and transparently reported to the revenues have increased substantially, growing at an Afghan public and other stakeholders. average annual rate of 60% per year from 2002/03 to 2004/05, rising from 3.2% of GDP to 4.5% in this On the negative side, weaknesses in public finance period. Revenue mobilization has been supported by can be very harmful for development. As discussed wholesale reform and rationalization of customs in Box 1.2, poor fiscal management can lead to duties as well as the income tax regime, and initiatives hyperinflation. It can also result in failure to prioritize are underway to strengthen the customs administra- spending among sectors and programs and reduced tion. Major efforts have been made to improve the development effectiveness. Problems in budget budget process, and it has come a long way since the execution (payments, procurement, accounting) can first post-Taliban budget of 2002/03 (see Chapter 6). lead to waste of resources and poor value for An initial Medium-Term Fiscal Framework (MTFF) has money. And lack of accountability and transparency been approved by the Cabinet. Budget execution also can generate corruption and loss of public support. has greatly improved in many respects ­ not least, most civil servants are now being paid, on time. PFM achievements. In a difficult post-conflict Finally, the Government has made a strong situation, Afghanistan has made remarkable progress commitment to financial transparency and accounta- on the fiscal front (see Table 1.1). Despite pressures, bility, which has been manifested in a number of ways fiscal discipline has been strictly enforced and and has resulted in adequate fiduciary performance maintained, including control over the Government albeit based on an injection of external capacity. wage bill. Although the fiscal deficit (before grants) These achievements have provided confidence to understandably has been very large in the context of donors resulting in mobilization of high levels of post-conflict reconstruction, expenditures have been external support for the national budget, mainly contained within the level of resources available from through the Afghanistan Reconstruction Trust Fund domestic revenues and external assistance, and there (ARTF) which finances most of the civilian recurrent has been no resort to domestic borrowing to finance budget (Box 6.2). Figure 1.2:Linkages between Public Finance and Strategic Objectives Public Finance in Afghanistan's Development 9 Box 1.2:Bad Public Finance Management is Bad for Development Afghanistan's history in the 1990s, as well as examples from many other countries, highlights that poor public finance management adversely affects national development in a number of ways: At the aggregate level, lack of a credible, realistic, policy-based (including a medium-term dimension), and reasonably comprehensive budget can result in high inflation and macroeconomic instability, and a crisis for the currency and for external relations. As inflation tends to hurt the poor most severely, poverty can be exacerbated. Reducing expenditures in such a crisis situation usually means cutting discretionary spending (investments, non-wage operating costs), and being excessively aggressive in striving to raise domestic revenues penalizes eco- nomic activities. Lack of affordability over the medium-term often is manifested in inability to operate and maintain public facilities and service delivery networks ­ deteriorating roads, inability to pay for fuel for power stations, hospitals unable to pay for running costs, health facilities without medicines, schools suffering from lack of maintenance and educational materials, etc. Such adverse outcomes disproportionately harm the poor, as they typically have few alternatives whereas better-off people are often able to arrange private alternatives to essential public services. At the sector level, a weak budget process can result in misallocations of resources and mismatches with national priorities, less value for money, and, in the end, inadequate service delivery. At the level of individual programs and activities, lack of a sound budget process can result in resources being wasted, roads built to inappropriate standards; power capacity constructed without finances for fuel and operations; hospitals opened without funding, medical staff, equipment, and medicines to run them; etc. Weaknesses in procurement, insufficient financial data given to line managers, and initial delays in making pay- ments outside Kabul have also been a constraint on the efficiency of public expenditures. If the procurement system is too complex, there is limited participation in particular from Afghan contractors, and contracts end up being more expensive. On the other hand, if the procurement system does not ensure adequate competition and sound technical review, there is a risk that opportunities for higher quality standards and lower prices stemming from competition are missed. Lack of fiduciary safeguards in procurement can result in outright corruption and poor value for money. Failure to generate information on development results, on contract awards, on financial accounts, or on audits contributes to suspicion and lack of trust between the Government and the people. A mismatch between the Government's capacity and its policy decisions can also weaken the legitimacy of the Government, and is likely to reduce the willingness of the international community to come forward with longer-term financial contributions. Source: PEFA (2005), especially Appendix 1. These achievements have been supported by institu- core Government capacity for key public finance tional improvements and capacity development, functions has only just started for the most part, and notably in MoF.So far, improvements have been to a there are also very serious weaknesses in public large extent dependent on external capacity brought in financial management capacity in the line ministries on an "emergency" basis to get things going. Examples (Chapter 9). include budget formulation, payments and reporting, procurement, audit, and support to central banking C.Key Public Finance Issues functions. However, some progress has also been made in building national capacity in the fiscal realm Despite the real progress made in many areas, on a more sustainable basis, for example in the fiscal challenges remain daunting. Among the key Treasury and certain other departments of MoF The of public finance issues for the coming years are shift from reliance on external capacity to sustainable the following. 10 Afghanistan: Managing Public Finances for Development Table 1.1:Fiscal Outcomes ($ million) 2002/03 2002/03 2003/04 2004/05 2005/06 Budget Est. Budget Est. Budget Est. a/ Budget Domestic Revenue 62 129 184 208 322 269 333 Donor Assistance Grants 283 208 322 206 313 314 345 (to operating budget) b/ Donor Assistance Grants - - - 93 772 173 714 (to core development budget) Total Expenditure (Core Budget) 345 342 505 614 1,706 874 1,887 Operating Expenditure 345 342 505 449 635 558 678 Wages and Salaries c/ ... ... 264 282 377 374 460 Purchase of goods and services ... ... 133 87 101 110 83 Debt service and Interest payments ... ... - 1 6 2 8 Other recurrent ... ... 20 18 43 30 22 Capital expenditure ... ... 34 61 37 41 47 Reserves and Contingencies ... ... 53 - 70 - 57 Core budget development spending d/ - - - 165 1,072 317 1,209 By Program 345 342 505 614 1,706 874 1,887 Human Capital Development ... ... 187 130 470 349 575 Physical Infrastructure ... ... 24 142 380 152 584 General Administration ... ... 48 106 129 81 258 Security ... ... 193 235 354 292 384 Reserves and Contingencies ... ... 53 - 374 - 86 Operating budget balance (283) (213) (322) (241) (313) (289) (345) (excluding grants) Operating budget balance - (5) 0 (35) 0 25 0 (including grants) Core budget balance (including grants) - (5) (0) (107) (300) n/a (494) Float and Adjustment - (14) 0 3 300 53 2 Financing - 19 - 104 - 66 492 External Loans (net) - - - 100 - 309 492 Domestic (net) - 19 - 4 - (243) 1 (In share of GDP) Revenues 1.5 3.2 4.0 4.5 5.4 4.5 4.7 Donor Grants 6.9 5.1 7.0 6.5 18.1 n/a 14.9 Total Expenditure (Core Budget) 8.5 8.4 11.0 13.4 28.6 14.6 26.5 Operating Expenditure 8.5 8.4 11.0 9.8 10.6 9.3 9.5 of which wages... ... 5.8 6.2 6.3 6.3 6.5 Development Expenditure - - - 3.6 17.9 5.3 17.0 Operating budget balance - (0.1) - (0.8) - 0.4 - (including grants) Core Budget Balance (including grants) - (0.1) (0.0) (2.3) (5.0) n/a (6.9) Memorandum item: External Budget (US$ million) - 503 1,955 2,182 3,448 2,503 3,180 Exchange Rate (AFA per USD) 45.3 45.3 49.0 49.0 47.8 47.7 48.5 GDP (US$ million) 4,084 4,084 4,585 4,585 5,975 5,975 7,130 a/ Preliminary annual statements. b/ Financing data based on IMF reports (ARTF for 2004/05 estimate and 2005/06 budget). c/ For 2002/03 to 2004/05, includes an estimate of in-kind food given to employees of the Ministry of Interior, Defense, and National Security (this amount is shown under "purchase of goods and services" in the Government's budget). d/ The 2004/05 budget includes US$304 million shown as "unallocated" in the original budget. Source: MoF documents, IMF. Public Finance in Afghanistan's Development 11 Extremely low domestic revenue. Afghanistan's In this regard, Box 1.3 highlights key issues related to revenue to GDP ratio (below 5%) is one of the aid effectiveness. lowest in the world (it would be even lower if the opium economy were included in GDP), well below The need to further improve the budget process. In half the level achieved by most poor countries. order to make the national budget the central instru- Only around 8% of total budgetary spending is ment of policy and reform it must become more covered by domestic revenue. This constitutes a strategic (with expenditures linked to the Afghanistan major constraint and liability for the country, neces- National Development Strategy), multi-year in its sitating substantial reliance on external assistance orientation (anchored in a Medium-Term Fiscal for the operating budget, which donors generally Framework), integrated (as between the recurrent are reluctant to provide in most country contexts. and development budgets), and with strong political Figure 1.3 highlights that domestic revenues are buy-in and ownership (Cabinet, Parliament, public). much smaller than external assistance, and that the gap between the two has increased sharply in Sustainability of expenditures. Massive expenditures are recent years due to the rapid growth of aid. Thus occurring in areas like security, counter-narcotics, and sustained rapid growth of revenue and a rising highway rehabilitation and road construction, mostly revenue-to-GDP ratio are imperative. through the External Budget. In addition, social services like education and health are being sharply expanded. A challenging expenditure structure. Strikingly, public These investments and programs are creating substan- expenditure in Afghanistan not only is very large tial expenditure liabilities for the future ­ roads will need (57% of GDP in 2004/05) but is dominated by to be maintained, teachers paid, and the sustaining external financing. Only a quarter is channeled costs of the Afghan National Army (ANA) and other through national Treasury and budgetary procedures security services covered. The same will be true of (the "Core Budget"): three quarters is executed by investment programs in sectors like electric power and donors through implementing agencies contracted irrigation. The challenge in this regard is two-fold: (i) directly by them (the "External Budget", see Figure public spending ­ both aggregate and at the sector 1.4). This constitutes a major challenge ­ for both level ­ needs to be increasingly based on a medium- Government and donors ­ in budget management. term vision of what the public sector can and will deliver, within a sustainable fiscal resource envelope, and (ii) a variety of funding sources for operation and Figure 1.3:Domestic Revenues and External maintenance (O&M) will need to be developed as Assistance,$ million appropriate in the sector and program context, getting away from relying primarily on budgetary funds. Problematic salary structure and weak public admin- istration. A key driver of spending is Government staffing and salaries. Afghanistan's civil service is not large by international standards, but it is not very effective, and many staff lack required skills and qualifications. Severely eroded by a decade of hyperinflation and sharply compressed by across- the-board cash allowances, the salary structure is Note: Original budget for 2005/06. Source: MoF, IMF. dysfunctional and inadequate to attract and retain 12 Afghanistan: Managing Public Finances for Development Figure 1.4:Expenditure Structure and Financing,2004/05 Estimates Source: MoF preliminary financial report; Staff estimates. qualified people for managerial and technical agement in line ministries is another area of weak- positions. The Priority Restructuring and Reform (PRR) ness where major improvements will be needed. program is intended to provide a short-run remedy by allowing some qualified staff to be paid more on Poor service delivery. While much has been done to a temporary basis. Key challenges include: (i) imple- improve public finances in Afghanistan, it will not menting an appropriate (and affordable) pay and mean anything if it does not translate into delivery of grading structure across the public sector; (ii) fully essential public services to the Afghan people, with implementing merit-based recruitment and promo- widespread access and adequate quality (Chapter tion practices; (iii) handling appropriately the many 8). There has been progress in some areas (e.g. civil servants whose skills and qualifications are inad- telecommunications, health, and education ­ based equate for a reformed public administration; and (iv) on very different models), but many public services restructuring organizations for greater effectiveness. remain grossly inadequate, giving rise to widespread public complaints. The challenge of improving Need to further strengthen fiduciary systems on a sus- service delivery is multi-fold and will require capacity tainable basis. While considerable progress has building (see below), good financing arrangements, been made in developing the legal framework and sound institutions, and appropriate incentives and in installing adequate fiduciary systems, these have accountability frameworks. Service delivery mecha- relied largely on external capacity provided by nisms need to vary in accordance with the charac- firms contracted by the Government. Although teristics of the service concerned; the market understandable, even essential as short-term meas- structure, ability to introduce competition, etc.; and ures, these mechanisms are not sustainable and will the appropriate role of the State. have to progressively give way to national fiduciary systems based on core Government capacity. Lack of sustainable Government core capacity. The Getting procurement right is of particular importance progress achieved in most aspects of public finance in view of the downside risks associated with weak management so far is fragile and excessively procurement practices (Chapter 7). Financial man- dependent on unsustainable external capacity. Public Finance in Afghanistan's Development 13 Thus building core Government capacity that will helps build sustainable Government capacity as outstay the current large aid inflows and associated opposed to substituting for or detracting from it. injection of external capacity will be essential (Chapter 9). Capacity development is at the heart Addressing these issues will be discussed in more of public administration reforms but also involves concrete detail in subsequent chapters, following related aspects like making the best possible use of an overview of the performance of Afghanistan's external technical assistance and ensuring that it PFM system in Chapter 2. Box 1.3:The Challenges of Increasing Aid Effectiveness Given its low revenue base (Chapter 4) and the enormous requirements for reconstruction (Chapter 5), Afghanistan very much needs external assistance (Chapter 3). With external assistance above 40-50% of GDP (Figure 6.1) and above 90% of public expenditures, the importance of increasing aid effectiveness cannot be overstated. In 2003, Afghanistan was among only seven countries in the world with an aid to GDP ratio above 30% (with Burundi, Congo, Eritrea, Guinea-Bissau, Sierra-Leone, and Timor-Leste). However, in other post-conflict countries aid has often declined after a few years even though such declines correspond with the period of time when absorptive capacity and aid effectiveness increase (World Bank, 2003a). This box reviews some of the critical challenges of aid effectiveness. First, at the macroeconomic level, these massive inflows of foreign exchange ­ compounded by very large flows resulting from opium exports ­ challenge the management of monetary and exchange rate policies. These inflows increase demand for goods and services. Whereas demand for tradables can be met by an increase in imports, increased demand for nontradables may encounter production bottlenecks, resulting in price increases and pushing up the real exchange rate. There is considerable uncertainly about this effect, known as "Dutch Disease", but the magnitude of foreign exchange inflows and capacity constraints in Afghanistan require that this risk be monitored and managed. Certainly, the impact on the skilled labor market in Afghanistan is marked (Chapter 9). Second, also at the macroeconomic level, is the issue of aid predictability. International experience indicates that aid can be more volatile than domestic revenues. This is challenging in terms of maintaining a stable macroeco- nomic environment. Uncertainty about available resources also makes budget preparation more complex. This requires donors to provide as much predictability as possible to the Government, as well as reducing the constraints attached to their support (notably in the form of project earmarking). On the Government's side, an adequate budget formulation process is required, as well as a cautious approach to programming pledges from donors (to make the budget realistic, some countries systematically discount pledges by as much as 30%). Chapter 6 explores these issues. The third, related issue is fiscal sustainability, including the risk of "aid dependency." Afghanistan's severe fiscal con- straint is of course eased by significant aid inflows ­ but these inflows are difficult to manage. First, for a number of decisions it has to make (e.g. pay and grading reform, investment decisions with downstream maintenance costs), the Government needs clarity from donors on their medium-term support. Second, there is a risk that incentives to raise more domestic revenues could be reduced by massive external assistance, also jeopardizing medium-term fiscal sustainability. This requires the Government to be up-front in preparing a Medium-Term Fiscal Framework (MTFF) and donors to establish a good dialogue around such a framework (Chapter 3). Fourth, massive aid inflows have implications for strategic sector allocations. Chapter 5 reviews these issues, stressing the role of a Government-led strategic plan to guide budget allocations. This is especially important for building the State, where the Government can demonstrate its stewardship of the reconstruction process. This issue is related to the previous one: aid not only could be ineffective if not well spent, it could make Government's budget ineffective if aid forces the Government to use its resources to operate and maintain low-priority or low-quality investments. 14 Afghanistan: Managing Public Finances for Development Box 1.3: The Challenges of Increasing Aid Effectiveness (Contd...) Fifth, making aid effective requires adequate delivery and management mechanisms. At the very minimum, donors should follow the Government's strategic leadership and report to the Government on expenditures. More system- atic use of Government systems can increase aid effectiveness, reducing the burden on the Government's limited capacity (e.g. to prepare dedicated reports, see Chapters 6 and 7) and clarifying accountability. However, the Government does not need to create the capacity to itself deliver a large development program. The modalities of aid delivery (including parallel mechanisms, Chapter 8, and technical assistance, Chapter 9) require attention. Finally, the implications of large amounts of external assistance for vulnerability to corruption need to be monitored (Chapter 7). 2 ASSESSING PERFORMANCE IN PUBLIC FINANCIAL MANAGEMENT The challenges outlined at the end of Chapter 1 Three levels of budgetary outcomes. The outcomes need to be addressed in a systematic way that of a country's PFM system can be assessed in terms transforms Afghanistan's public finance manage- of three levels, all of which have wider implications ment (PFM) system into a highly effective enabler of for national development (Figure 1.2): national development through its beneficial impact Budgetary aggregates and overall fiscal on fiscal and budgetary outcomes. Assessing the discipline (including fiscal sustainability current and future performance of the PFM system from a medium-term perspective). provides a basis for evaluating progress and Desirable outcomes include macro-fiscal identifying areas of weakness for priority actions. A balance and low inflation in the short run, PFM performance rating system recently has been and fiscal sustainability or (in the case of developed by the Public Expenditure and Financial Afghanistan) sustained progress toward Accountability (PEFA) multi-agency partnership fiscal sustainability over the medium term. program, which is intended to provide an objective, Strategic allocation of resources across internationally comparable framework for sectors and programs in accordance with assessing the performance of a country's PFM Government priorities to implement system (see PEFA, 2005). This framework is national objectives. Desirable outcomes outlined below, followed by a summary of the include allocation of public sector performance of Afghanistan's PFM system against resources across programs based on an the PEFA indicators. agreed development strategy, allocation of resources within programs based on sound A. Framework forAnalysis andAction sector strategies, and allocation of expen- ditures over time in line with appropriate The PFM system and the PEFA indicators do not prioritization (e.g. taking into account attempt to measure fiscal outcomes, the substantive recurrent cost implications of public appropriateness of public expenditure policies and investments and staffing decisions). decisions, or the actual impacts and value for Managing the use of budgetary resources money achieved through public expenditures. The in the interest of efficient service delivery PFM system instead should be seen as a crucial and value for money. Desirable outcomes enabler for achieving broader development goals include cost-effective service delivery, and substantive outcomes (including in the public avoidance of waste or corruption, proper finance sphere), which depend on sound accountability for use of resources, etc. Government strategies, policies, and institutions. Critical dimensions of PFM performance. Turning The discussion below starts from outcomes and from broad budgetary outcomes to the perform- moves to processes and the linkages between them. ance of the PFM system itself (as "enabler"), PEFA 18 Afghanistan: Managing Public Finances for Development has identified six critical dimensions of a well- critical importance as enabling factors for achieving functioning PFM system. Four of these comprise national development and fiscal objectives. important parts of the budget cycle (policy-based budgeting; predictability and control in budget Overall structure of the PFM performance measure- execution; accounting, recording, and reporting; ment framework. Assessment of the high-level PFM and external scrutiny and audit ­ see Figure 2.1). performance indicators provides an evaluation of Another relates to key cross-cutting features of the performance in terms of the six core dimensions of budget process, i.e. comprehensiveness and the PFM system, which in turn leads to an assess- transparency, and the last covers out-turns of the ment of the performance of the PFM system in PFM system, namely the credibility of the budget. achieving key desired outcomes (aggregate fiscal Figure 2.1 also signals that, given donors' impor- discipline, strategic allocation of resources, and tance in providing financial support to many devel- efficient service delivery). A model for a PFM oping countries, donor practices have a significant performance assessment is presented in PEFA impact on the performance of the PFM system. (2005) and applied to Afghanistan in World Bank (2005b, Volume II, Part 1). PFM indicator set. In order to operationalize the PFM performance assessment framework, 28 high- B. The Performance ofAfghanistan's level PFM performance indicators have been PFM System developed, each of them measuring performance in one of the six critical dimensions. Three additional The full list of indicators along with the ratings for indicators of donor performance have also been Afghanistan, which reflect an assessment of the developed. As indicated earlier, the PFM perform- PFM system's performance as of June 2005, is ance indicators measure how key parts of the shown in Table 2.1. The assessment is discussed in budget process are working, cross-cutting features detail, rating by rating, in World Bank (2005b, of the budget, and whether the budget is credible Volume II, Part I); it is summarized below under the (as demonstrated by its out-turn). These are of six critical dimensions of a PFM system. Figure 2.1:LinkagesAmong the Six Core Dimensions of PFM Performance Source: PEFA (2005, p. 4). Assessing Performance in Public Financial Management 19 Table 2.1:Public Finance Management Performance Indicators Indicators 1 2 3 4 A. PFM-OUT-TURNS:Credibility of the budget PI-1 Aggregate expenditure out-turn compared to original approved budget 2 PI-2 Composition of expenditure out-turn compared to original 2 approved budget PI-3 Aggregate revenue out-turn compared to original approved budget 4 PI-4 Stock and monitoring of expenditure payment arrears 2 B. KEY CROSS-CUTTING ISSUES: Comprehensiveness and Transparency PI-5 Classification of the budget 2+ PI-6 Comprehensiveness of information included in budget documentation 2 PI-7 Extent of unreported government operations 3 PI-8 Transparency of inter-governmental fiscal relations 1 PI-9 Oversight of aggregate fiscal risk from other public sector entities. 1 PI-10 Public access to key fiscal information 2 C. BUDGET CYCLE C(i) Policy-Based Budgeting PI-11 Orderliness and participation in the annual budget process 2 PI-12 Multi-year perspective in fiscal planning, expenditure policy 1+ and budgeting C(ii) Predictability and Control in Budget Execution PI-13 Transparency of taxpayer obligations and liabilities 1+ PI-14 Effectiveness of measures for taxpayer registration and tax assessment 1+ PI-15 Effectiveness in collection of tax payments 1+ PI-16 Predictability in the availability of funds for commitment of expenditures 1+ PI-17 Recording and management of cash balances, debt and guarantees 2+ PI-18 Effectiveness of payroll controls 2 PI-19 Competition, value for money and controls in procurement 2/3 PI-20 Effectiveness of internal controls for non-salary expenditure 2 PI-21 Effectiveness of internal audit 2 C(iii) Accounting, Recording and Reporting PI-22 Timeliness and regularity of accounts reconciliation 3 PI-23 Availability of information on resources received by service delivery units 1 PI-24 Quality and timeliness of in-year budget reports 2 PI-25 Quality and timeliness of annual financial statements 2 C(iv) External Scrutiny and Audit PI-26 Scope, nature and follow-up of external audit 2 PI-27 Legislative scrutiny of the annual budget law 1 PI-28 Legislative scrutiny of external audit reports 1 D. DONOR PRACTICES D-1 Predictability of Direct Budget Support 4 D-2 Financial information provided by donors for budgeting and 1+ reporting on project and program aid D-3 Proportion of aid that is managed by use of national procedures 1 Note: In the rating system 4 is the top performance rating, 1 the lowest. The ratings measure performance as of June 2005. Broadly speaking, most indicators would have been rated "1" in 2001 or early 2002. Source: Staff estimates based on PEFA framework (PEFA, 2005, Annex 1, and table on p. 9). 20 Afghanistan: Managing Public Finances for Development The situation in Afghanistan has some special AFMIS (the Afghanistan Financial Management features which need to be kept in mind when Information System). Comprehensive reports on interpreting the ratings. First, some ratings reflect budgetary aggregates are produced monthly temporary factors (for instance the absence ­ at the and are now available on MoF's website. This time of the assessment ­ of a Parliament). Second, information is generally reliable but is affected by some ratings are based on changes made recently, lags in recording provincial operations in AFMIS. and it is still uncertain whether these changes will Improvements are needed with respect to external be sustained. Third, the ratings assess the current audit reports. There are also uncertainties about the situation in which significant external support (both quality of information on the External Budget. In advisory and operational) is being provided to addition, fiscal risks which could arise from activities the Government; in several areas, this raises in state-owned enterprises and municipalities are sustainability issues as the external support will not effectively monitored because the financial decline over time, especially in relation to financial information is unverified and too limited for fiscal management operations. risk management in these areas. Credibility of the budget (Performance Indicators Policy-based budgeting (Performance Indicators 11- 1-4). Progress has been made toward a credible 12). Some progress has been made toward the budget, based on fiscal discipline and improve- Government's key objective of making the national ments in the budget process in recent years. budget the central instrument of policy and reform, However, the credibility of the budget is hampered but there are still important constraints. The full by optimistic budget projections, attributable to a implications of policy decisions, including for fiscal combination of lack of realism at the budget sustainability, are not taken into account due to lack formulation stage and limited capacity to imple- of capacity in Government to develop policy, agree ment the budget, and large deviations between on trade-offs between investments and recurrent budgeted amounts and actual out-turns. This is in costs, and match resources with policies. particular the case for the External Budget Multi-year planning is also constrained by the com- (accounting for as much as three-quarters of total plexity of aid coordination. Budgeting for recurrent public spending), which remains effectively outside and investment expenditures is carried out separately the Government's control, further reducing the in parallel, exacerbating fiscal sustainability risks credibility of the budget. from recurrent expenditure implications of investment operations. The budget process is orderly and well Comprehensiveness and transparency of informa- understood within the Government, but it needs to tion (Performance Indicators 5-10). The be linked more closely with the Government's Government is committed to share budgetary strategy; more widely owned politically including by information transparently. The annual budget for the the Cabinet and the Parliament; and more reflective national Government is impressive, with coverage of sector issues and with more engagement by sector of most public spending of the general Government agencies, provinces, and civil society. sector, whether implemented by the Government or directly by donors. It is a useful public document Predictability and control in budget execution relating the expenditures on specific projects to (Performance Indicators 13-21). Much progress has National Programs. Fiscal, revenue, and expendi- been made in improving the implementation of the ture records for the Core Budget are maintained budget (in particular with respect to the allotment through the budget implementation system based in process and cash management), but there is a Assessing Performance in Public Financial Management 21 need to enhance the predictability of funding for review by the ARTF Monitoring Agent (Box 6.2). The service delivery units. Line departments at the recent approval of a new Public Finance and provincial level often cannot predict with accuracy Expenditure Management (PFEM) Law will help in the funds that will be available to them because of further strengthening the control framework. delays in communicating with the Mustoufiats (provincial offices of MoF) and the complexity of Most procurement at present is carried out under the allotment process; this has led to cash rationing standards agreed with donors. The procurement at the discretion of the Treasury and the carried out under national rules has been subject to Mustoufiats. Many adjustments are made during an outdated regulatory framework which lacked the year, in particular through allotment transfers adequate institutional support for effective enforce- and the use of contingencies. No information is ment. There has been insufficient competition as available at the local level (e.g. primary schools) on the basis for contract awards and no guarantee of actual resources available. value for money. The Procurement Law recently approved provides the basis for modernization of A particular weakness in the budget execution cycle the procurement framework. is related to revenue collection. The system is not very effective, as demonstrated by the large gap Accounting, recording, and reporting (Performance between revenues that could be collected and actual Indicators 22-25). Considerable improvements collections. In addition, despite some progress with have been made in this area. The recording of taxpayer registration, the control framework on the expenditures and revenues has been strengthened revenue side remains weak. Nevertheless, clarifica- by implementation of a computerized system tion of the legislation and strengthening of financial (AFMIS) in MoF. Accountability of line ministries and management (including banking arrangements to MoF to the Cabinet is supported by frequent ensure a steady flow of collected revenues to the reporting on budget implementation, but more Treasury Single Account, TSA) have generated some reporting and accounting capacity in line ministries improvements in revenue performance. is required. Significant progress has been made toward consolidation of bank accounts under the Much progress has been made in implementing the TSA system. However, much remains to be done to control framework, as reflected by a significant improve standards of accounting, frequency of increase in the eligibility rate measured by ARTF. bank reconciliation, and the usefulness of reporting There is a division of duties between the line for line ministries' management. ministries, which approve expenditure, and MoF, which makes payments. The controls also include External scrutiny and audit (Performance Indicators effective cash management, allotment control on 26-28). Government accountability generally is budget uses, and reconciliations of records of the sought through the publication of audited financial Treasury and the line ministries. Significant weak- statements on the state budget and specific donor nesses remain, however, compounded by the lack funds. The Auditor General is working to interna- of internal audit to provide feedback on perform- tional auditing standards with operational support ance. Further improvements in the internal control from an audit advisor. However, the final audit of framework are therefore needed both for payroll the 2003/04 annual statements has not yet been and non-payroll expenditures and for revenues. released. In addition, the absence of a Parliament These arrangements are also fragile since they rely (until recently) has limited the extent of external on external operational support in Treasury and the scrutiny of the budget and its performance. 22 Afghanistan: Managing Public Finances for Development Donor practices (Donor Performance Indicators tive oversight (27-28) due to the absence of a 1-3). Donors have mobilized a considerable amount Parliament hitherto. Payroll control (18) and of support for Afghanistan's budget, mainly through predictability of budget support (D1) are areas of the ARTF. In particular, support to the Government's relative strength. recurrent budget through ARTF has been large and predictable. However, direct budget support still Using the ratings of this report as a baseline, future accounts for only a very small percentage of total progress in improving the performance of the PFM external assistance to Afghanistan, and the propor- system can be monitored. However, the nature of tion of aid that is managed by use of national the indicators and ratings means that measurable procedures remains low, with most aid executed by progress in terms of changes in ratings is more donors through their contractors. Financial informa- likely to occur over periods of a year or longer than tion provided by donors on donor-executed on a short-term basis. Moreover, since the ratings assistance activities, while reasonably comprehen- assess the system's performance with significant sive, is subject to delays, usually relates to disburse- external support (both advisory and operational), ments rather than actual expenditures, and may suffer questions arise about the sustainability of current from inaccuracies and inconsistencies. levels of PFM performance. This may mean that further improvements will be manifested in mainte- Concluding summary. Afghanistan's ratings against nance of current ratings based on sustainable the PFM performance indicators generally portray a national capacity and with declining levels of public sector where financial resources are, by and external support. large, being used for their intended purposes as authorized by a budget which is processed with The ratings against the PFM performance indicators transparency and has contributed to aggregate fiscal also provide an assessment for the donor commu- discipline. The expenditure and financial position of nity of the potential capacity of Government the resources under the authority of the Government systems (currently supported by external assistance) are reported reliably in an understandable format, to implement the operations which are now although there is some uncertainty with respect to occurring outside Government systems. revenue reporting. Performance regarding the allocative efficiency of spending across programs Chapters 3-7 of this report discuss in more detail and the efficiency of operations is not as good, how- key development and budgetary outcomes and ever. Given that performance most likely would have aspects of the PFM system, frequently referring been rated "1" on all dimensions in 2001 or early back to the PFM performance indicators. After 2002, this assessment highlights the significant Chapter 8 (on the organization of public service achievements of the last four years. In most dimen- delivery) and Chapter 9 (on institutional reforms sions, the ratings are now comparable to other and capacity development), Chapter 10 returns to low-income developing countries (for instance the PFM performance measurement framework African countries). Areas of relative weakness include and puts forward a roadmap for making improve- tax collections (indicators 13-15), as well as legisla- ments (see Table 10.1). 3 PROGRESSINGTOWARD OVERALL FISCAL SUSTAINABILITY A key outcome of a well-performing PFM system is fiscal traditionally low revenue mobilization), the long discipline: the Government spends only what it can period of conflict (e.g. civil service wages greatly afford. Affordability in the short run relates to the budget eroded by hyperinflation and severely compressed balance, i.e. keeping the fiscal deficit within available by fixed allowances), and current reconstruction normal financing. In the medium-term, fiscal sustain- activities (very high spending) and priorities ability is critical ­ spending decisions and the time-path (e.g. massive expenditures on security). More of expenditures need to be affordable from a multi-year specifically, as shown in Table 1.1 and in the perspective. Failing to keep public expenditures within Statistical Appendix: affordable limits has dire consequences (Box 1.1). Risks Public expenditures are extraordinarily high. are especially great in post-conflict situations like that Total budgetary expenditures in 2004/05 faced by Afghanistan. A large influx of aid, combined were equivalent to 57% of GDP (excluding with lack of domestic capacity and low domestic rev- the drug economy from the denominator). enues, can result in an unaffordable pattern of expen- This is accounted for by extremely high ditures if not well-managed. While international support development spending. Unlike in most gives Afghanistan an opportunity to temporarily soften countries, the development budget ($2.8 its national budget constraint, a visionary medium-term billion in 2004/05) dwarfs the operating framework is needed to ensure that the country moves budget ($0.6 billion). toward a sustainable fiscal position. This chapter first Operating expenditures are in line with reviews the structure of Afghanistan's budget and recent international patterns. At 9% of GDP in fiscal trends. It defines fiscal sustainability and puts for- 2004/05, the operating budget was split ward the concept of a Medium-Term Fiscal Framework roughly 70-30 between wage and non- (MTFF). The main expenditure drivers related to fiscal wage spending. sustainability are then analyzed ­ mobilizing domestic There are however large recurrent expendi- revenues is discussed in Chapter 4. The final sections tures in the development budget. These look at financing options and management of fiscal include health services, technical assis- risks, and present several illustrative medium-term fiscal tance, salary payments, and grants, among scenarios. others (Figure 6.2). There is underspending on non-wage A. Fiscal Structure andTrends operation and maintenance requirements. In education, for instance, there is almost Budget Structure and RecentTrends no spending at the school level other than teacher salaries (textbooks, chairs, etc. are Fiscal Structure. Afghanistan has an unusual provided in-kind, for the most part directly fiscal structure reflecting its historical legacy (e.g. by donors). 26 Afghanistan: Managing Public Finances for Development Most spending occurs outside Government This means that external financing of recur- channels. Around three-quarters of expen- rent expenditures has been one of the diture in 2004/05 was donor-executed, in fastest growing components of the budget the external budget, with very limited (Figure 1.3). Government oversight. The fiscal deficit (before grants) has The security sector is a major driver of increased sharply, reflecting large inflows overall spending. Security spending has of external assistance. Although aid been growing rapidly and accounts for predominantly has consisted of grants and 39% of total expenditure thus does not have direct implications for A disproportionate share of public spending debt sustainability, it will eventually decline occurs in Kabul. Most notably, only 30% of and shift more toward a mix of grants and non-wage O&M expenditures are made loans, with implications for the fiscal deficit outside Kabul (see Figure 7.1). and external debt. Domestic revenues are very low. They com- Actual development expenditures (in both Core and prise only about 4.5% of GDP (likely the lowest External Budgets) have fallen far short of budget ratio in the world for a sizable country) and pay targets, by margins of around half in recent years for only about 8% of total expenditures. (see Figure 3.1 for 2004/05). These shortfalls are The fiscal deficit (before grants) is extremely attributable to several factors, including the existence high and entirely aid-financed, mostly of unfunded projects in the development budget through grants. The non-resort to domestic (a practice now changed for the Core Budget), financing of the deficit is salutary and confusion sometimes between commitments and shows strong fiscal discipline, but this level disbursements, optimistic projections of disburse- of budget deficit and foreign financing ments, insufficient project screening during budget clearly are unsustainable. preparation, large contingencies in the budget, and Fiscal trends. Assessing fiscal trends based on only implementation constraints (security issues, lack of three years of data since major conflict ended in capacity to prepare sound budget proposals, exces- late 2001 is not easy, and there have been sive optimism about implementation delays, etc.). both significant volatility and step-changes in public expenditures. Nevertheless some important Implications developments have occurred: The first implication of the fiscal structure and Budgetary expenditures have increased trends outlined above is that there is a great and sharply during 2002/03 to 2004/05, with urgent need to mobilize more domestic revenue. operating expenditures almost doubling and Only an intensive effort to improve tax collection ­ development spending growing even faster with sound policy measures and administrative Revenues also have risen rapidly, more improvements leading to higher compliance ­ will than doubling during the same period. result in sustained rapid revenue growth and a Since revenues started out from a much sustainable fiscal balance over the medium term lower base, although their growth was (Chapter 4). Robust revenue growth will also give more rapid than that of recurrent expendi- donors greater confidence to continue providing tures in percentage terms, the absolute gap external assistance to finance the operating budget. between recurrent spending and revenues However, taxation efforts need to be non-distor- more than tripled. tionary and should not impose an excessive burden Progressing Toward Overall Fiscal Sustainability 27 on the private sector which would adversely affect during the year and can harm fiscal and economic growth. program management, undermining develop- ment effectiveness. Underspending, particularly A second implication is that all spending decisions what has been seen in relation to the civilian have to be considered in the light of their multi-year development budget in recent years, can under- implications. Even if substantial operating costs can mine public confidence and discourage donors be paid for by external assistance in the short run, from providing funding. The Government can they will become a claim on the Government's own aggressively hold donors to their pledges/ resources later. commitments of external financing, and "stretch" targets can be set for accelerated domestic A third implication is that significant external revenue mobilization (as has been the case in assistance will be required for Afghanistan's the IMF Staff Monitored Program for 2005/06), operating budget for some time, and for the but the Government should plan its budget on a development budget over the longer term. conservative basis. Projecting budgetary aggregates forward, taking into account likely growth of expenditures and Fifth, key drivers of public expenditures must be even with aggressive measures to promote rapid carefully planned and monitored. As discussed in growth of domestic revenues, there will continue Section C, these include notably the Government to be a gap between the Government wage bill wage bill, non-wage operating expenditures, public and total domestic revenues for a few years, and investments, recurrent costs in the development for some years longer a gap between total recur- budget, and security spending. rent expenditures and revenues. Finally, there is a need to increase expenditures A fourth implication is that the budget needs to outside Kabul. The Kabul-centric pattern of be realistic. Overspending leads to budget cuts spending and small non-salary budgets in the Figure 3.1: Budget Implementation (2004/05 actuals as % of budget) Source: MoF budget document, Staff estimates. 28 Afghanistan: Managing Public Finances for Development provinces and districts, as well as difficulties in hand, as seen earlier the fiscal deficit (before accessing and spending non-salary allotments, grants) is enormous as a ratio to GDP, and the negatively impact on service delivery (Chapter 8). levels of external grant assistance seen in recent years will eventually decline over time. Domestic B. A Framework forAchieving Fiscal revenue and its growth are far too low to support Sustainability fiscal sustainability as defined above in the absence of massive grant financing. Under these circum- Fiscal Sustainability in the Context of stances the size of the fiscal deficit in relation to Afghanistan GDP would be a better (negative) indicator of fiscal sustainability, but it also is highly imperfect for this What is meant by fiscal sustainability? The standard purpose and would vary greatly with the level of definition of fiscal sustainability is that a country's external grant financing. fiscal balance and underlying trends are such that, in a steady state, the ratio of total public debt and A practical definition of fiscal sustainability for debt servicing to macroeconomic aggregates like Afghanistan. This report analyzes a simpler and GDP is not increasing over time.1 Key parameters more practical fiscal sustainability objective for determining fiscal sustainability under this definition Afghanistan: whether and at what point in time the include the projected economic growth rate, the country will be able to cover its recurrent expendi- revenue growth rate and its elasticity with respect to tures from domestic revenues, with an intermediate GDP growth, expenditure growth, and the interest target of when domestic revenues will be able to rate at which the Government can borrow to cover the government wage bill, a primary compo- finance its fiscal deficit (because the cost of nent of recurrent spending. The logic is that the financing the deficit forms a component of budg- recurrent budget to a large extent represents the etary expenditures). Of particular interest is the core costs of maintaining government functionality level of primary deficit (i.e. the fiscal deficit and hence needs to be covered by reliable excluding interest payments) that is sustainable over domestic revenues. Issues related to the sustainable the medium term. A number of countries have level of borrowing and primary deficit will become adopted laws with specific rules related to fiscal more relevant over the longer term, after this sustainability (based for example on a targeted critically important objective is achieved. This debt level, overall deficit, or primary deficit). definition of fiscal sustainability does not imply dual budgeting as between operating and development Afghanistan does not fit neatly in this conceptual budgets.2 On the contrary, there is a strong argu- framework. The country is nowhere near a "steady ment for moving toward fully integrated budgeting state" in terms of fiscal aggregates. Financing costs of recurrent and development expenditures, recog- are negligible since the bulk of the fiscal deficit is nizing that, if the existing grant financing of the grant-financed, and the Government has adopted development program dries up, funding needs for a conservative stance that forbids overdrafts or this purpose would still remain, putting heavy pres- borrowing from the Central Bank. On the other sure on the budget. 1 See for instance Heller (2005). 2 For example, the UK has a policy rule of limiting capital expenditures to the level of borrowing, but this is a fiscal discipline tool and does not detract from unified budgeting which the UK practices (Sarraf, 2005, p. 4). Progressing Toward Overall Fiscal Sustainability 29 By this definition, Afghanistan falls far short of spending across sectors (see also Chapter 5), the being in a sustainable fiscal position. In 2004/05 technical demands of an MTEF are much greater domestic revenues were equivalent to only 48% of than those for an MTFF. Thus an MTEF is a more recurrent expenditures, and the budget for distant prospect than an MTFF which can be 2005/06 has a similar target (49%). The simple prepared fairly quickly. mathematics of growth from different bases means that domestic revenue will need to grow much While the technical analysis that underpins the more rapidly than total recurrent expenditures for a MTFF is important, political buy-in and a mean- number of years in order to "catch up". ingful linkage to the annual Budget are essential for an MTFF to be effective. The former is facilitated by Medium-Term Fiscal Framework: What It Cabinet review and approval of the MTFF, along Means, How ItWorks with presentation of the MTFF to Parliament, either in conjunction with the annual budget or as part of The concept of an MTFF is straightforward. An a national strategy document (e.g. the ANDS). MTFF sets forth a multi-year fiscal path that Chapter 6 reviews in more detail the budget reaches, or at least makes progress toward, a sus- formulation process. tainable fiscal position for the country. In addition to projections (typically over 3-5 years) of fiscal MoF has prepared an initial MTFF for aggregates including revenue, expenditure, deficit, Afghanistan which, together with the 2005/06 and key expenditure components (e.g. the wage mid-year budget review, was discussed and bill), the MTFF lays out the assumptions behind the approved by the Cabinet in October 2005. This projections, including the fiscal strategy and set of initial step represents a good start in developing policy actions envisaged to achieve the fiscal a medium-term fiscal vision. The MTFF has also objectives embodied in the MTFF targets. been included in the I-ANDS recently prepared. Projections in the absence of policies and actions to The key to success will be steadily improving the achieve the forecasts would be an empty exercise. MTFF over time and ensuring that it is closely Both the quantitative projections and the policy linked with both the national development package would be reviewed and updated annually. strategy and the annual budget process, which is Possible elements of an MTFF for Afghanistan are clearly the Government's intention. This will in outlined in Box 3.1. particular require a gradual improvement in the capacity to cost policies (Box 3.1). It should be noted that the MTFF is more rudimen- tary than other medium-term frameworks that are C. Managing Expenditures from a commonly talked about and sometimes applied. Medium-term Perspective A Medium-Term Budget Framework (MTBF) introduces a sectoral perspective to the multi-year In addition to domestic revenue (discussed in framework. At a more advanced stage, a Medium- Chapter 4), total expenditure and key expenditure Term Expenditure Framework (MTEF) would contain components comprise the core of an MTFF. The the same aggregate and sectoral projections but main expenditure drivers for Afghanistan include would also seek to fully cost sector strategies and the Government civilian wage bill, non-wage reconcile projected costs with sectoral resource operating costs, development expenditures, and envelopes. While this provides more detailed security spending (Figure 3.2). Medium-term issues guidance for the allocation of present and future around each of these expenditure categories are 30 Afghanistan: Managing Public Finances for Development Box 3.1: Possible Elements of a Medium-Term Fiscal Framework for Afghanistan An MTFF could have two main components: (i) a fiscal table with three- or five-year projections of domestic revenues, expenditures (both aggregate and key items like the wage bill), the fiscal deficit, and sources of financing, and (ii) a concise description of the policy actions which support the projections (i.e. which will contribute to achieving the fiscal targets). Within this broad structure, the MTFF for Afghanistan could seek to address questions like the following. Domestic revenues: What are the sources of expected increases in domestic revenues? These could include: (i) Expansion of the base on which domestic revenues are collected. Expansion of the tax base is mostly driven by (non-agricultural) economic growth, so the MTFF would need to specify assumptions regarding economic growth. (ii) An increase in revenue collection efficiency. Important measures that have been introduced to increase tax collection efficiency include the creation of the Large Taxpayer Office (LTO) and implementation of the Customs reform. What are the medium-term collection objectives from these measures? Does the Government intend to implement additional measures to increase revenue collection efficiency? If so, what measures? (iii) New measures to increase domestic revenues. Does the Government plan to introduce new measures to increase domestic revenues? Which ones? What are the expected impacts in terms of incremental revenue? Civilian wage bill: What policy actions explain the projected civilian wage bill? The civilian wage bill depends on: (i) The number of civil servants. What is the Government's strategy regarding the size of the civil service. What public services does the Government plan to deliver itself? For example, has the Government endorsed the purchaser-provider model in health? Has the Government decided that the overall size of the civil service should not be increased except for teachers? (ii) Wage structure. What salary structure does the Government plan to implement in the coming 3-5 years? Is it the salary scale which is going to be derived from the on-going Pay and Grading Review? What are the Government's intentions with respect to other salary increases (annual, ad-hoc, other)? (iii) Short-term programs. How many people are expected to be hired under programs created to attract skilled Afghans at higher rates on short-term contracts and the PRR and PRR superscale program? At what cost? Absorption of non-civilian expenditures into the Budget: Does the Government plan to absorb non-civilian expen- ditures (including on the new Afghan National Army) into the Budget? How will these expenditures be financed? What trends are expected in the security sector wage bill in particular, and its key components? Development expenditures: The Government has prepared its Interim Afghanistan National Development Strategy (I-ANDS). How does the Government plan to ensure that the ANDS is translated into annual national budgets? Fiscal Deficit: Domestic revenues are expected to fall short of total (ordinary and development) expenditures, leading to a fiscal deficit. How is the Government planning to finance fiscal deficits? How much financing does the Government expect from the recurrent and investment windows of the ARTF? How much from other sources? summarized below. Underlying these issues are key deliver through the private sector, and for which questions about the role of the State ­ which services both financing and delivery should be left services it should deliver and finance itself, which it to the private sector, with Government regulation should deliver but finance only partly (relying in as appropriate. These strategic issues are also part on cost recovery), which it should finance but discussed in Chapters 5 and 8. Progressing Toward Overall Fiscal Sustainability 31 The Government Non-Security Payroll ($187 transition toward more "normal" politics and the million in 2004/05)3 formation of Parliament. Another fiscal risk factor is pensions, whose cost to the budget is still relatively Managing and containing the growth of the low despite a recent increase, but which can be Government payroll, while ensuring that the salary expected to rise over time particularly with structure is adequate to attract and retain qualified increasing retirements. staff (Chapter 9), is a major challenge for Afghanistan. In many countries, the Government's With average salaries equivalent to 3-3.5 times wage bill tends to be a source of upward pressure average per-capita GDP (Table 3.1), current pay on expenditures in both the short run and over the levels in Afghanistan's civil service are not particularly medium-term, since there are often political pres- high compared to other countries. The challenge is sures to increase recruitment into the civil service as to decompress the salary structure to ensure that pay well as to raise pay (at least to keep up with infla- at higher levels is adequate to attract and retain tion). Afghanistan has maintained a remarkable qualified staff, while keeping the overall wage bill record of fiscal discipline during the past several affordable.4 Hyperinflation in Afghanistan during the years, with limited recruitment into the Government 1990s almost completely eroded the real value of except for teachers and security forces. However, base pay, which was offset (but only in part) by giving there have already been pressures for ad-hoc pay a cash allowance that was the same for everyone increases, and pressures for higher pay and recruit- and comprised the bulk of overall compensation. As ment can only be expected to increase with the a result, in 2001 Afghanistan inherited what was Figure 3.2: Key Drivers of Afghanistan's Public Expenditures, 2004/05 (% of total budget) Source: MoF reports; staff estimates for development budget classification into "recurrent" and "investment". 3 Excludes police, army, and justice. The total wage bill including security was $377 million in 2004/05 (Table 1.1). See World Bank (2005b, Volume III, Chapter 2). 4 There is a risk, seen in many countries, that political pressures (including from civil servants) result in a compressed pay struc- ture in the interest of "equity" across employees, while fiscal constraints keep average and top salary levels relatively low, leaving the Government unable to recruit and retain qualified staff in management and senior technical positions. 32 Afghanistan: Managing Public Finances for Development Table 3.1:Wage Bill in Afghanistan Region Size of the Civil Average salary (as Wage Bill Service (% population) multiple of per (% GDP capita GDP) Afghanistan 1.2 3.1-3.5 a/ 5.3 Africa 2.0 5.7 6.7 Asia Pacific 2.6 3.0 4.7 Central and Eastern Europe and the FSU 6.9 1.3 3.7 Latin America and the Caribbean 3.0 2.7 4.9 Middle East and North Africa 3.9 3.4 9.8 OECD 7.7 1.6 4.5 Note: for comparison purposes, this table refers to the civil service, including justice and police (but excluding the army). Source: Afghanistan: staff estimates for 2004 (a/ unweighted average pay scale for general civil service (3.1) or 2004/05 budgeted wage bill (3.5) divided by the non-drug GDP); other countries: Schiavo-Campo et al (1997) for various years in the 1990s. probably the most compressed civil service compen- some retrenchment ­ possibly limited to early retire- sation structure in the world, with total pay varying by ment or natural attrition ­ may be unavoidable in less than 20% between the top and bottom grades. the medium-term. In parallel, recruitment needs to A pay increase in 2003 somewhat decompressed be managed to focus on genuine needs for quali- the salary structure, increasing the variation to 55%, fied staff, e.g. teachers. Finally, there is excessive still much lower than in other countries. In addition, concentration of staff in Kabul, where a third of civil various interim reform schemes provide higher pay servants are located, and correspondingly relatively for selected positions (Figure 3.3), but these affect low staffing levels in the provinces and especially in only a small part of the civil service. rural areas. This pattern is problematic for service delivery, although it is gradually changing in Afghanistan's civil service size is not large by particular as more teachers are being recruited. international standards, as can be seen from Table 3.1, even taking into account that basic health Thus a modest increase in the size of the civil service services have been almost entirely contracted out may be expected in the future, as well as pay increases (Chapter 8). But its composition raises a number of at least in line with growth of per-capita GDP. As a challenges (Chapter 9). First, Afghanistan's civil result the ratio of the wage bill to GDP is likely to service has not been very effective, in running itself moderately increase in coming years. This trend will be or in delivering services to the Afghan people. Thus accentuated by the need for the operating budget to the developmental returns on the Government absorb substantial salary costs currently in the devel- wage bill may be relatively low. This means that opment budget (see pages 34-35).5 5 In addition to these recurrent costs, reforming public administration will have additional costs. The Government, in its Securing Afghanistan's Future report (2004), estimated these costs at about $200 million over 2004-2010, including a large amount for public buildings, systems, and equipment; a small component for retrenchment and retraining; and a component for tech- nical assistance (to restructure ministries, develop policies, etc.). Progressing Toward Overall Fiscal Sustainability 33 Figure 3.3: Pay Scales ($/month) Source:Lower and upper bounds of the scales. This includes base salary and an estimate of cash allowances See World Bank (2005b, Volume III, Chapter 2). These considerations underline the need for careful received when presented to the international management of the Government payroll. First, there community in April 2004, but there needs to be a needs to be a strategy for managing the payroll from clear statement of Government policy on the wage a medium-term perspective, as opposed to merely bill and updated projections. responding on an ad-hoc basis to pressures as they arise. Second, the Government will need to imple- Non-wageOperatingExpenditures($96million ment its strategy carefully. Even if the wage bill grows in 2004/05,excluding security) in a programmed manner as envisaged in the Securing Afghanistan's Future (SAF) projections, this In contrast to the Government payroll, non-salary must not be perceived to soften the hard fiscal expenditures tend to be unduly low in many coun- constraints within which the Government operates. tries, reflecting a variety of factors including a All sources of financing for the payroll ­ domestic political preference for investments and salaries revenues, ARTF contributions, other budget support and the Government's response to short-run fiscal ­ are scarce, precious resources for Afghanistan's constraints ­ non-wage O&M is much easier to cut reconstruction which have a high opportunity cost in in the short run than salaries. More fundamentally, terms of alternative uses. Third, maintaining strict underspending on non-wage O&M may reflect control over staffing levels will be critical, even as previous decisions with respect to public invest- disciplined recruitment of needed skills proceeds. ment, public sector service delivery institutions, and Fourth, transfer to the operating budget of salary staffing that turn out to be unaffordable. This results costs currently covered by donors in the External in chronic shortfalls in O&M spending, which Budget needs to be handled carefully, with transi- means that public assets are deteriorating due to tional mechanisms to avoid unmanageable fiscal lack of maintenance (e.g. roads); they cannot fully outcomes. And finally, the Government needs to function due to shortages of fuel or parts (e.g. provide full information to donors to secure their power stations); service delivery networks' ability to continued support. The SAF projections were well- deliver services is impaired due to lack of needed 34 Afghanistan: Managing Public Finances for Development inputs (e.g. teaching materials for schools, medi- currently being provided by a donor in-kind outside cines for basic health facilities); and Government the budget. employees lack the resources to do their jobs (e.g. fuel for vehicles). Although the examples cited above point to cost recovery as an essential way forward (Chapter 8, Also constraining non-salary recurrent spending at Section B), non-wage O&M will nevertheless be a the local level in Afghanistan is the low allocations rapidly growing claim on budgetary resources that for such expenditures provided to provinces and will need to be well-managed. Clearly, inade- districts, and the difficulties lower levels of adminis- quately funding O&M requirements is damaging to tration face in accessing and utilizing their service delivery outcomes and development objec- non-salary allocations (Figure 7.1). This appears to tives, but the root of the problem usually lies in reflect Ministries protecting non-salary expenditures public investment decisions made years earlier. This at the central level, as well as various constraints highlights the need for such decisions to take into affecting allotments and payments (Chapter 8). As account their future consequences for the budget the amounts involved are relatively small, such (Chapter 5). imbalances between Kabul and the provinces/ districts can and should be rectified relatively easily, The Development Program ($300 million with monitoring through the budget execution Core,$1,467 million External in 2004/05) process. Public investment. At some 30% of GDP, Turning to the future, fiscal challenges in meeting Afghanistan's non-security investment program is non-wage O&M requirements will be daunting. very large, reflecting massive requirements for Although there is substantial variation across reconstruction and availability of large amounts of sectors, a simple rule of thumb would suggest that external financing. These requirements had been every dollar of public investment leads to around reviewed by the Government in its SAF report, ten cents of additional recurrent costs on an annual presented to donors in Berlin in 2004. This report basis. This suggests that the public investment of projected total capital investment of some $26 2004/05 would generate more than $100 million billion between 2004 and 2010. As the develop- of additional O&M costs each year. The highway ment budget is fully funded by external assistance sector, with a current rehabilitation investment and most of it is donor executed (only about one- program of more than $1 billion, is an important sixth of civilian public investment spending flows example. Annual maintenance costs, not including through the Treasury), it is easy to make the mistake those of future highway investments envisaged by of thinking that it does not have fiscal conse- the Government, are expected to be in the range of quences for Afghanistan. However, the very large $40 million per year (as a first step, the 2005/06 O&M requirements for future years generated by budget includes $10 million for road mainte- current public investments (in both Core and nance). Another important example is electric External budgets) cannot be ignored (Chapter 5). power, where access to the grid is extremely low (estimated at only 10%) and large increases in Recurrent costs in the development program. As capacity will be required to support private sector noted earlier, Afghanistan's development program development and home consumption, yet even does not consist entirely or even predominantly of now the main thermal power plant in Kabul public investment ­ there is a large component of requires $40 million worth of fuel per year, recurrent costs estimated very roughly at 38% (and Progressing Toward Overall Fiscal Sustainability 35 more than 75% in the Core Development Budget, conditions in Afghanistan, let alone fiscal afford- see Figure 6.2). These include: ability considerations, would dictate. This aggra- vates further the fiscal risks involved and could Basic health services, which are contracted inflate costs more generally. out to NGOs and funded by both Core and External development budgets. The esti- mated cost in 2004/05 exceeded $100 There are no easy answers to the dilemmas posed million, which includes salaries and other by recurrent costs in the development budget, as recurrent costs (e.g. vaccines) as a large for the most part they are responding to urgent and component. high-priority reconstruction needs. At a minimum Technical assistance, which predominantly such recurrent costs need to be fully understood consists of recurrent costs (payments to and their fiscal implications taken into account by consultants etc.). This is truly large: OECD the Government and donors. This requires data estimate TA flows at $400 million in accurate reporting by donors and a dialogue with 2003, but only a fraction are on budget the Government on the levels of activities and costs (the 2004/05 budget identifies around involved, as well as the time horizon of the donors $200 million as stand-alone capacity- concerned in providing assistance. It is also quite building, technical assistance, or feasibility legitimate for the Government to raise concerns studies projects). about the unit costs and procurement methods Salary payments and top-ups paid by used, as keeping unit costs within reasonable limits donors through the External Budget in will help ensure fiscal sustainability of the activities several sectors. concerned (see for instance Chapter 8 on the cost Transfer schemes, such as the National of health services). Solidarity Program (NSP, $130 million in 2004/05) which provides block grants to Security Sector Spending ($1,328 million in communities; most of these are used for 2004/05,of which $292 million Core) small investments but likely include some recurrent costs as well. The security sector is a major driver of expenditures Teacher training, textbook printing, and with a large impact on Afghanistan's fiscal position other smaller items of recurrent costs. over the medium term. Therefore it needs to be fully incorporated in the MTFF and analysis of the Since the funding of these recurrent costs by donors national budget. In view of the critically important cannot be expected to be permanent, and in many and complex security problems that Afghanistan cases is committed by donors only on a yearly faces, it is not surprising that massive resources basis, such expenditures will sooner or later (including Afghanistan's own domestic revenues as become a charge on the Government's core fiscal well as donor funds) are being spent on security. resources. The magnitudes of some of these However, with the bulk of security sector expendi- recurrent costs are sufficient that they pose a large, tures occurring through the External Budget, even unmanageable fiscal risk over the medium decisions on funding and spending have occurred term. Moreover, as they are usually funded and in a fragmented way, often somewhat in isolation executed by donors on a fragmented basis with a from the requirements and strategy for the security focus on implementing the activities themselves sector as a whole as well as from medium-term and often without competitive procurement, there is fiscal affordability issues. The lack in the past of an a tendency for costs to be higher than underlying agreed national security strategy has made it more 36 Afghanistan: Managing Public Finances for Development difficult for the Government to provide oversight Some salient characteristics of Afghanistan's secu- and coherence across the various security subsec- rity sector are summarized in Box 3.2. The analysis tors and activities. There is also a risk that pay of security sector expenditures conducted as part of levels established in the security services will exert the PFM Review (discussed in detail in World Bank, upward pressure on general pay levels in the civil 2005b, Volume V) has identified the following key service (Figure 3.3). issues from a PFM and development perspective: Box 3.2: Salient Features of Afghanistan's Security Sector As discussed in detail in World Bank (2005b, Volume V), Afghanistan's security sector has some important charac- teristics with fiscal and development implications. First, the historical legacy of conflict was fragmentation into regional and local militias, capture of policing and military functions by non-legitimate actors, and erosion of both formal and traditional justice systems, also with capture by non-legitimate authorities. Building the State since 2001 therefore has entailed reconstituting and reforming the security forces under legitimate oversight by the civil authorities. Second, the immediate security threats faced by Afghanistan are variegated and disputed by different stakeholders. Some observers see the continuing insurgency in the south and east and conflict with Taliban/Al Qaeda forces as the most important security problem. Others are most concerned about criminality and lack of rule of law at the local level, with associated capture of policing and justice functions by warlords and commanders. Still others are concerned about the limited management capacity of civil authorities and inadequate oversight/accountability of security forces. The drug industry is widely seen as a major cause and consequence of insecurity. An agreed national security strategy, currently at an advanced stage of preparation, will facilitate reaching consensus on dif- ferent security threats and their relative priority. Third, the overall size of the security sector does not seem unreasonably high by international standards. This includes a planned size of the ANA of 70,000 (not all of them combat troops) and a planned size of the Afghan National Police (ANP) of 62,000. However, the appropriateness of the size and balance between different security forces can be questioned in the context of Afghanistan's particular situation and security needs. For example, the role of the ANA in meeting different external and internal threats would need to be clarified in order to assess the appropriateness of its size. Fourth, Afghanistan's security sector nevertheless is costly and may be unaffordable. The lack of short-run budget discipline (and lack of policies and programs to form the basis for sound budgeting), and the involvement of different "lead donors" and line ministries in decision-making on force levels and expenditures, have resulted in limited efforts to control costs. Over the medium term, it is extremely doubtful whether the sustaining costs of Afghanistan's security sector at planned force levels can be absorbed by Afghanistan's national budget (Figure 3.4). This implies that difficult trade-offs will need to be made in prioritizing expenditures, means of achieving efficien- cies in security-related expenditures will need to be identified, and the possibility of multi-year donor financing commitments for the security sector should be explored. Fifth, the progress in developing different parts of the security sector has been uneven. After a slow start initially, the formation and expansion of the ANA has moved forward rapidly. Progress in forming the new ANP has been much slower, and reforms and capacity building in the justice sector have lagged far behind, with adverse implications for legal reforms and for a pro-private sector business climate. Moreover, within sectors there has been a dispropor- tionate focus on building up security forces and less attention to strengthening the key management and oversight institutions, including the Ministry of Defense and especially the Ministry of Interior. Sixth, security and fiscal issues are closely interlinked. For example, low domestic revenue (discussed in Chapter 4) is both a consequence and a cause of insecurity. Reconstruction costs tend to be higher due to insecurity, while on the other hand security sector expenditures are a source of considerable fiscal pressure. Progressing Toward Overall Fiscal Sustainability 37 The need for an integrated security strategy nation functions, although the situation and policy framework, without which sound in this regard has improved markedly in decisions on programs ­ e.g. force sizes, 2004 and 2005. equipment ­ and expenditures cannot be Concerns about the growing security sector made. The national security strategy, wage bill and pressures for fiscally preparation of which is at an advanced unaffordable salary increases, as well as stage, will facilitate the necessary strategic the fiscal sustainability of security sector coordination and decisionmaking including staffing levels. The ANA salary structure, on public expenditures. determined apparently without reference to Very high donor-executed spending through fiscal constraints or pay elsewhere in the the External Budget (Figure 3.4), which civil service, has set a precedent which the renders achieving coherence of spending police and other sectors aspire to and across and within subsectors much more which will be fiscally costly (Figure 3.3). difficult, and also raises questions about There are also doubts about whether the fiscal sustainability of the security sector recruitment practices are being regulated in the medium term when donor funding by staffing establishment size limits. may decline. Slow implementation of priority public Difficulties in coordinating and priori- administration reforms and capacity tizing security sector expenditures and building in security sector management actions, reflecting the above problems and oversight institutions, which have and fragmentation of decision-making lagged behind the development of security across donors. These factors make it forces like the ANA. This imbalance, and more difficult for the National Security also the lack of progress in some security Council (NSC) to fully carry out its man- subsectors (e.g. justice), carry a variety of dated strategic, leadership, and coordi- risks for the future. Figure 3.4: Forecast Security Sector Spending Against Projected Revenues Source:Lower and upper bounds of the scales. This includes base salary and an estimate of cash allowances See World Bank (2005b, Volume III, Chapter 2). 38 Afghanistan: Managing Public Finances for Development The need to develop good governance and policy is needed to determine acceptable longer- sound and sustainable financial manage- term costs of security institutions and to appropri- ment practices in the security sector, fully in ately prioritize and sequence spending across and line with and integrated with national within subsectors (e.g. justice and police versus budget processes and fiduciary provisions. ANA). As in the case of the ANDS as a whole The most important message emerging from this (discussed below), the National Security Strategy is analysis of security sector expenditures is that the being developed by Afghan stakeholders, with full security sector needs to be appropriately integrated Government ownership (across the ministries and into all aspects of Afghanistan's PFM system: agencies involved), and will need to gain wide buy- medium-term fiscal programming (MTFF), annual in within and outside Government. This will require budget formulation, staffing and payroll manage- a meaningful and substantive consultation process. ment, procurement, financial management and controls, and external scrutiny, among others. Treat Security as an Integral Part of the National There is no justification for treating the security Development Strategy: The ANDS provides an sector as separate or sacrosanct, and not opportunity to ensure that security both is accorded subjecting it to budgetary and fiduciary processes. its due importance as a development issue for Specific recommendations include the following. Afghanistan and that the broader developmental and fiscal perspective is injected into the security Review the Fiscal Implications of Ongoing Security sector strategy. Security forms an integral part of the Sector Reforms: Quickly enhance the information I-ANDS recently prepared by the Government. base on security sector expenditures, and conduct an integrated security sector-wide fiscal review to Implement Priority Administrative Reforms and forecast fiscal implications of security sector Develop Security Sector Management and development and reforms over the medium- and Oversight Capacity: Support reforms enhancing longer-term. This would serve as a basis for human resource capabilities in the Ministries of revisiting security sector force levels and for discus- Defense, Interior, Justice, Counter Narcotics, and sions with donors on longer-term financing. It National Security Directorate. A particular priority is would also facilitate policy- and program-based developing solid financial management capacity budgeting of security sector expenditures with a and practices in these line ministries. Strengthening medium-term perspective. the control framework, notably with the develop- ment of an internal audit function, is a priority.6 Further Develop Policy Making Capacity in the NSC and Finalize the National Security Strategy: The Rigorously Enforce Staffing Size, and Set Salary NSC and National Security Advisor are tasked with Increases Based on Fiscal Absorption Capacity: It coordinating policy development and overseeing is vital that the agreed formal staffing establish- integrated strategic planning across all security ment sizes be enforced. Moreover salaries, like institutions. Adequate capacity is required for these non salary costs, must be subject to the normal purposes. An integrated security sector strategy and rigors of public expenditure management and 6 One option would be to focus the newly developing Internal Audit Department of MoF initially on the security sector. The voca- tion of this department, as per the new Public Finance and Expenditure Management Law, is to cover the whole of Government. Given that a mechanism (the ARTF Monitoring Agent) is temporarily in place for most of the civilian recurrent budget, this department could initially prioritize its work program toward the security sector. Progressing Toward Overall Fiscal Sustainability 39 fiscal discipline ­ the security sector wage bill must D. Financing Reconstruction and remain affordable. Managing Fiscal Risks Managing Budget Financing over the Medium Role of donors. Donors play an even greater role in Term Afghanistan's security sector than they do in other sectors. Specifically, donors can contribute to Afghanistan has been relying entirely on external improving public finance management in the assistance to finance its fiscal deficit, including a security sector by: (i) supporting development of large operating deficit as well as the entire devel- an agreed national security strategy and corre- opment budget. This approach has made a great sponding strategies and policies for the indi- deal of sense in a context where reconstruction vidual sectors (defense, police, justice, etc.); needs are enormous, revenues are extremely low, (ii) reassessing their views about force sizes and and large amounts of external assistance have cost requirements in the light of fiscal constraints; been available (mostly grants), including substan- (iii) helping enhance the capacity of oversight tial amounts for financing recurrent expenditures. actors (such as the Auditor General, legislature) The "no overdraft rule" has been an effective tool and economic managers (Ministry of Finance for inflation control and macroeconomic stability. Budget Office) to address issues relating to finan- While substantial external assistance can be cial management in the security sector; (iv) chan- expected to continue over the medium-term, it may neling more of their assistance to the security sector decline in magnitude, and in particular external through the Core Budget; (v) for resources not financing for the recurrent budget is expected to channeled through the Core Budget, ensuring that be phased out over time. Thus financing of the timely and accurate information is made available fiscal deficit will need to become more diversified, to the budget authorities, and maximizing use of probably including prudent levels of domestic internationally acceptable procedures e.g. for borrowing in the medium term. procurement; (v) helping key security ministries strengthen their budget formulation and budget Looking forward, risks to budget financing, external execution processes; and (vi) discussing medium- financing in particular, may be exacerbated by poor and longer-term availability of external resources performance in revenue mobilization or expenditure for the security sector. management. Future external assistance, particu- larly the part going through the Core Budget, is Implementing these recommendations and other likely to be positively correlated with domestic initiatives to improve security in Afghanistan, which revenue effort and improved expenditure manage- is a necessary condition for the country's develop- ment. This suggests that mutually-reinforcing trends ment, undoubtedly will take time. However, the may lead to a high scenario whereby good revenue need to get a handle on the fiscal sustainability performance and expenditure management issues in the security sector is urgent, as there is a (money gets well spent) encourage high inflows of risk that decisions on force levels, pay, non-salary external assistance, further enlarging the resource spending, equipment, construction, etc. that are envelope, or a lower scenario whereby poor rev- being made or implemented today will be enue performance and weak expenditure manage- unaffordable for Afghanistan in the future. ment (including inability to fully spend resources) Dialogue with donors, including on possible result in flagging external assistance, severely medium-term financial support to Afghanistan's constraining the resource envelope. Thus progress security sector, also is urgently needed. toward fiscal sustainability could occur under a 40 Afghanistan: Managing Public Finances for Development highly constrained situation or under a develop- concessional loans and ruling out com- mentally very positive scenario, enabled by rapid mercial or export credits for the foresee- revenue growth and more generous external assis- able future. tance. Achieving the positive scenario requires Strengthening Municipal Finances careful management and further underscores the need for strong revenue mobilization and effective Afghanistan's municipalities constitute the only semi- utilization of resources. autonomous level of government and should play a very important role in urban service delivery Within the supply of external assistance, Afghanistan (Chapter 8). They have their own budgets, but levels needs to carefully assess what level of external debt of municipal taxes and fees are determined by the it can prudently incur, to serve as the basis for a central Government, which also approves munic- sound debt management strategy. The International ipal budgets. Since municipalities are supposed Monetary Fund (IMF, 2005) has undertaken a debt to live within their means (i.e. expenditures are sustainability analysis for Afghanistan, although constrained by resources), they do not directly handicapped by lack of data and uncertainties contribute to fiscal deficits. However, there are about initial conditions (most notably about the important issues related to future municipal expen- disposition of Soviet-era Russian claims on the order diture liabilities associated with public investments of $10.8 billion ­ equivalent to about 190% of (which often are decided on and executed by 2004/05 GDP excluding the opium economy). The central ministries rather than by municipalities them- main findings of the analysis are as follows: selves). Similar potential issues arise with respect to staffing, although there is no indication that munic- Assuming forgiveness of all pre-existing bilateral claims (including Soviet-era debt), ipalities have gone on hiring sprees, probably due strong economic and revenue perform- to their relatively hard budget constraints. There are ance, and a very high degree of conces- serious weaknesses in the basics of public financial sionality in new debt (i.e. along the lines of management at the municipal level ­ budget IDA concessionality), Afghanistan can formulation, budget execution, accounting, and engage in modest new borrowing while auditing. And there are widespread perceptions of keeping its debt sustainability indicators corruption in municipalities. within safe limits. However, it is clear that the bulk of external Managing the fiscal risks associated with munici- assistance for some time to come will need palities will require: (i) much better information on to be in the form of grants. municipal revenues and expenditures; (ii) clear Any combination of weaker economic or delineation of their roles and responsibilities (in revenue performance, failure to secure full particular avoiding confusion and overlaps vis-à- forgiveness of all bilateral claims, a sub- vis central ministries); (iii) an assessment of the stantial share of loans in total external future municipal expenditure liabilities that are assistance, or a lower degree of conces- being created by public investments, including sionality of new borrowing could lead to a those by the Ministry of Urban Development and situation where Afghanistan's debt and debt other line ministries; (iv) pro-active revenue service burden become unsustainable. mobilization efforts by municipalities (focused on a Given the uncertainties, a very prudent small number of tax sources that have been widely external borrowing strategy is called for, demonstrated by international experience to relying only on modest amounts of highly be appropriate municipal revenue sources); Progressing Toward Overall Fiscal Sustainability 41 (v) strengthening municipalities' core PFM capacity; The SOE sector in Afghanistan does not appear to (vi) integrating their operating and development be very large, and many SOEs are defunct, with budgets; and (vii) improving governance. Progress their main asset being land. Information compiled in these areas will require significant capacity by the SOE Department of MoF indicates that development (see Chapter 9). there are about 70 SOEs, with total employment of 20,000. Although financial reporting by SOEs Kabul Municipality is much larger than all other and their supervisory line ministries is poor and cities in Afghanistan (accounting for something like incomplete, it appears that, particularly in 15% of the total national population) and currently 2004/05 when controls on SOE spending were has a special status (more-or-less akin to that of a tightened up, budgetary transfers to SOEs (subsi- ministry) in the overall structure of the dies and payments of salaries to SOE workers) Government. Thus it is particularly important that have been small. Transfers from SOEs to the budget data for Kabul Municipality be made avail- budget also appear to have been very small. able on a timely and transparent basis, and that However, a very rough estimate of public invest- the Municipality's PFM system ­ including the ments in SOEs through the (Core and External) budget process ­ is improved. development budget since late 2001 is in the range of $150 million, of which 70-80% has gone Managing National Assets including State- to the electricity and water utilities. Analysis by the Owned Enterprises7 SOE Department suggests that 10 SOEs would appropriately stay under Government ownership, Public investments create state assets, whose sound 20 could be liquidated, and 40-plus privatized. management is very important for the effectiveness of the PFM system. Often (though not always) The figures on SOEs are far from complete, however, public assets are managed by State-Owned leaving out some very important enterprises and their Enterprises (SOEs) involved in delivery of public assets. Certain joint venture enterprises are excluded services or other commercially-oriented activities. from the list even though their total Government Government departments also are custodians of ownership is well above 50% (e.g. Ariana Airlines, various types of public assets. While many SOEs in and some public sector banks). In other cases, activ- Afghanistan are defunct and were involved in activ- ities and associated assets are under Government ities that would be more appropriately handled by departments without formal creation of an SOE. the private sector, there are some activities (e.g. Moreover, both SOEs and their supervising line min- public utilities like electricity and water supply) that istries generally lack financial management capacity, are likely to remain primarily in the public sector for and as in the case of the budget in general, their the foreseeable future. SOEs and other commer- sources of financing tend to be fragmented, including cially-oriented activities carried out by the State investments sponsored by line ministries and also also entail fiscal risks which need to be managed. those channeled through the External Budget. In many countries the financial losses, wage costs, and other liabilities of SOEs constitute a serious risk It is very important to ensure that SOEs do not to fiscal and macroeconomic stability. become a significant fiscal risk factor for 7 This discussion on SOEs is based on World Bank (2005b, Volume III, Chapter 4, and also on Volume IV, Chapter 4 on the mining sector, which looks at SOEs in this sector). 42 Afghanistan: Managing Public Finances for Development Afghanistan and that those which are defunct or the same legislative provisions as other which are engaged in activities which should be companies. An inventory of state assets in the private sector are appropriately disposed should be compiled, including SOEs and of in a manner that encourages private sector other public sector activities. development, with reasonable provisions for the Regular reporting of key financial variables by affected SOE employees. Key priorities for moni- SOEs (including those with less than 100% toring and managing the fiscal risks associated Government ownership), and their compila- tion for use in monitoring and policy deci- with SOEs include: sions. This will require capacity development Improving the legal framework and infor- in SOEs, supervising line ministries, and MoF. mation base on SOEs and other state Careful policies on and monitoring of SOE assets. It is strongly recommended that the investments (including not establishing new existing legislative framework within which SOEs), which should include SOE investments SOEs operate be reviewed. It may be better occurring outside the Core Budget (Box 3.3 to repeal the SOE Law and corporatize all suggests practical guidelines for responding SOEs so that they can be governed under to funding proposals related to SOEs). Box 3.3: Recommended Guidelines for Responding to Budget Proposals for SOEs First, use of public funds (whether domestic resources or external assistance) should be limited to existing SOEs that will remain under public ownership for some time. MoF should first confirm whether the Government has full own- ership of the firm concerned, to avoid potential claims by private parties. MoF should then make use of the SOE Department's prioritized list, in which the SOEs that will remain under public ownership are identified. Specifically: Fresh investments in utilities could be considered, as utilities are likely to remain under public ownership for some time, so long as these investments are accompanied by necessary reforms and improvements in financial management in the public utilities concerned, including a sound business plan. No investment should be made in SOEs on the privatization list. Labor or financial restructuring could be considered, but other investments (e.g. in new equipment or technology) are not appropriate as international experience demonstrates that Governments usually do not recover such investments through a higher sale price. No investment should be made in SOEs that are to be liquidated. No investment should be made to create new SOEs because this would send an adverse signal to the pri- vate sector, and creation of new SOEs would generate fiscal risks and potential liabilities for the Government. Finally, some rehabilitation investments may be considered for SOEs that will stay in the public sector. Second, SOEs should have an acceptable minimum level of financial oversight. A certain level of administrative reform in the parent ministry of the SOE is required, so it has the capacity to supervise the SOE's operations. There also needs to be a minimum level of financial management capacity (accounting and reporting in particular) in the SOE itself. Being able to regularly assess the cash flow of the SOE is important, and ideally, audited accounts should be available. If these conditions are not met, major investments should be held back until improvements are made. Third, MoF in general should not respond positively to proposals for budget funding of SOEs' operating costs. In exceptional cases the budget may have to cover operating costs of certain SOEs in the short run, but such funding when required should be tied to improvements in cash flow, e.g. through increased cost recovery. Finally, in reviewing SOE funding proposals, MoF should consider the value for money within a limited resource envelope, and also the multi-year fiscal implications. The benefits and value of SOE proposals can be compared with other budget proposals, and the estimated economic rates of return should be adequate. Proposals with sub- stantial downstream fiscal implications need to be turned down until there are sustainable financial arrangements. Progressing Toward Overall Fiscal Sustainability 43 Ensuring transparent financial transfers on budget by 2010, O&M expenditures to operate between SOEs and the Government budget and maintain new investments, and close the (tax payments and subsidies). operating fiscal deficit before grants as defined in the A sound legal and policy framework for projections by 2012, revenue collection is expected to privatization/restructuring of SOEs. The increase by one-half percentage point of GDP per Cabinet has recently adopted a privatiza- year as a result of forceful implementation of the tion policy and has amended the SOE Law customs and tax administrative reform program and to facilitate divestment of SOEs. The priva- some expansion of the tax base through the imple- tization process will need to be clear and mentation of tax policy measures already decided. transparent; investments in SOEs to be Even though revenue would only rise to 8.3% of GDP divested as well as creation of new SOEs by 2012/13 (still very low by international standards), should be avoided. in absolute terms it would quintuple from less than $300 million in 2004/05 to more than $1,500 E. Medium-term Fiscal Scenarios million in 2012/13 (Chapter 4). The wage bill is In October 2005, the Government adopted its initial projected to remain largely stable as a proportion of Medium-Term Fiscal Framework (MTFF). An MTFF GDP. It is assumed that external assistance, primarily should be an evolving document, updated at the grants, could finance the gap between revenues and beginning of each budget cycle (Chapter 6). Most operating expenditures (more than $2.4 billion over important, the MTFF needs political buy-in, wide- seven years ­ compared to $0.7 billion during the first spread ownership in the Government, and strong three years of reconstruction). linkages to the development strategy and annual budget process. Three illustrative medium-term fiscal However, some recurrent expenditures currently scenarios are presented in this section, based on a included in the Core Development Budget ­ e.g. spreadsheet model, to show some of the trade-offs health services ­ and in the External Budget ­ e.g. involved in medium-term fiscal decision-making and costs of running elections ­ would still not be the implications of some of the key issues discussed financed by domestic revenues. Based on simple earlier in this chapter. For simplicity, the macroeco- assumptions, it is estimated that in 2004/05 nomic framework is the same in all three scenarios.8 revenues covered 48% of the Government's Core Recurrent Budget but only 28% of all recurrent In the base case, it is assumed that a combination of costs. With similar assumptions, in the base case prudent expenditure management, effective efforts to revenues would cover slightly less than three-quar- raise revenues, and sustained donor assistance allows ters of all recurrent costs by 2012/13.9 Afghanistan to achieve a number of its policy objec- tives in the next decade: implement a pay reform, Turning to the high-case scenario, with additional finance the wage bill by 2007, bring the ANA largely effort collection of domestic revenue could reach 8 The key assumptions are: (i) dynamic growth and stable inflation (based on IMF projections, with the exchange rate assumed constant); (ii) an increase in the wage bill driven by recruitment of teachers, pay reform, and inclusion of ANA salary costs on budget; (iii) an increase in O&M expenditures to operate new investments (based on data from the SAF report); (iv) an increase in investment expenditures, notably in the short run (based on data from the SAF report); and (v) a gradual move of develop- ment expenditures from the External to the Core Budget. More details are given in the Statistical Appendix (Table A.6). 9 Specifically with respect to the security sector, the projections assume that 20% of ANA non-salary expenditures remain outside the Core Budget over the medium term. Moreover, effectively reforming the Afghan National Police will require sizable addi- tional non-salary expenditures which are not incorporated in the Core Budget projections. 44 Afghanistan: Managing Public Finances for Development Figure 3.5:Three Illustrative Fiscal Scenarios (% of GDP) Source: MoF estimates; Staff projections. 11% of GDP toward the end of the projection would be in a position to cover Core Budget horizon (2011/12), i.e. at the lower end of the operating expenditures by 2010/11. The external range observed in other low-income countries financing required for operating expenditures (Figure 3.5b and Chapter 4). This would enable would be reduced to $1.3 billion over six years, the Government to speed up implementation of freeing additional external assistance to finance its civil service reform program, with a positive development programs. impact on budget implementation in the outer years. In this scenario, the Government could On the other hand, under a low-case scenario, if almost pay for its wage bill in 2006/07 and domestic revenues grow more slowly than in the base Progressing Toward Overall Fiscal Sustainability 45 1,593 2,637 1,624 909 440,1 31 2,225 2,637 1,624 909 214 (601) 1,303 2,470 1,458 892 761,1 155 7.5 5.0 48.5 2012/13 1,393 2,627 1,615 901 432,1 222 1,954 2,627 1,615 901 376 (339) 1,125 2,389 1,377 815 462,1 253 7.5 5.0 48.5 2011/12 1,220 2,415 1,574 861 591,1 354 1,618 2,446 1,605 891 828 (13) 970 2,156 1,315 755 581,1 345 7.5 5.0 48.5 2010/11 snoitcejorp 1,033 2,653 1,470 806 026,1 437 1,315 2,690 1,507 842 573,1 193 804 2,446 1,263 715 246,1 459 7.5 5.0 48.5 2009/10 853 2,437 1,254 700 485,1 401 1,046 2,475 1,292 736 924,1 246 651 2,288 1,105 645 736,1 454 9.7 5.0 48.5 2008/09 million) ($ 677 2,315 1,048 584 836,1 372 770 2,352 1,086 621 285,1 316 527 2,209 942 566 186,1 415 10.8 5.0 48.5 2007/08 Scenarios 532 2,067 843 504 535,1 312 569 2,067 843 504 794,1 274 443 1,997 774 487 455,1 331 11.2 8.0 48.5 2006/07 Fiscal e 379 1,226 678 460 748 299 393 1,226 678 460 338 285 353 1,226 678 460 478 325 13.6 10.0 48.5 2005/06 Illustrativ 269 874 558 374 606 289 269 874 558 374 606 289 269 874 558 374 606 289 8.0 ee 17.0 47.7 2004/05 Thr 3.2: slautca 208 614 449 282 604 241 208 614 449 282 604 241 208 614 449 282 604 241 15.7 6.4 49.0 2003/04 ableT 129 342 342 n/a 312 213 129 342 342 n/a 312 213 129 342 342 n/a 312 213 28.6 (22.2) 45.3 2002/03 stnar stnar stnar USD) projections. Expenditures G Expenditures G Expenditures G / evenuesR Operating wages ESA erofeBticife operating evenuesR Operating wages erofeBticife Expenditures operating evenuesR Core Operating wages erofeBticife terms) A staff (real (%) (AF operating rate estimates; Expenditures C which which ESAB Domestic Core of of DlacsiF ESA Expenditures growth deflator which C which which H of GI Domestic Core of of DlacsiF ESA which C which which which of W Domestic of of of DlacsiF MoF which o of GDP GDP Exchange H OL me M :ecruoS 46 Afghanistan: Managing Public Finances for Development case the Government is likely to delay the implemen- external funding for the ANA, and/or pressures to tation of pay reform and limit the increase in O&M reduce its size. spending (Figure 3.5c). This would have a negative impact on the Government's capacity and on the In sum, these projections highlight the importance of effectiveness of the investment program. Moreover, domestic revenue mobilization for Afghanistan to the Government would not be able to finance its achieve steady progress toward a sustainable fiscal wage bill before 2009/10 and would still run an position. They also indicate how more rapid revenue operating deficit in 2012/13. This scenario probably growth can create fiscal space for critical expendi- would prove unsustainable, as external assistance is tures in support of reforms and capacity building. unlikely to finance the considerably larger fiscal gap Conversely, lower revenue growth can be expected to ($2.7 billion over the next eight years). Consequently, have adverse development and macroeconomic the Government might seek to finance part of its impacts, which may be exacerbated if lower revenues budget deficit through domestic borrowing, with lead to loss of donor confidence and financing. This potential adverse implications for inflation and exercise also highlights the benefits of a simple MTFF macroeconomic stability. The Government might also ­ to outline the fiscal path that the Government has for example delay the necessary recruitment of embarked upon, manage the reform process, review teachers, slowing progress on education. There affordability issues, and engage the international would also be a risk of long-term dependency on community on issues of fiscal sustainability. 4 MOBILIZING DOMESTIC REVENUES As seen in Chapter 3, sustained rapid growth of compliance. This chapter first briefly outlines the domestic revenue is a central element of key features of Afghanistan's existing revenue base. Afghanistan's state-building and reconstruction It then reviews progress and summarizes key issues agenda. International experience suggests that the in improving revenue policy and strengthening larger the tax gap (the difference between the taxes tax administration. The last section presents some actually paid and what should be paid according to illustrative medium-term revenue projections. existing laws and statutes), the more radical are the changes needed. With a tax gap on the order of A. Revenue Structure 60%, Afghanistan needs to adopt a comprehensive strategy including revamping of the tax administra- While in industrialized countries the revenue to tion in order to obtain significant improvements in GDP ratio is typically around 45-55%, for the least Table 4.1:Central Government Revenues (% of GDP) Country/region GDP per capita (USD) 1/ Total revenue Total tax revenue Afghanistan (FY2004/05 est.) 253 4.5 3.4 Sub-Saharan Africa 765 19.7 15.9 Asia and Pacific 1,447 16.6 13.2 Low-income countries n/a 18.0 14.9 Low- middle income countries n/a 21.8 15.8 Non-OECD average n/a n/a 15.2 Selected countries average n/a 17.4 14.8 Pakistan 420 16.4 12.4 Iran 1,700 20.5 8.6 India 470 18.5 14.3 Kazakhstan 1,520 22.3 18.4 Kyrgyz Republic 290 19.1 15.0 Azerbaijan 710 20.5 19.4 Uganda 240 11.5 10.7 Rwanda n/a 10.4 n/a Sources: Government Finance Statistics (IMF); Keen (2004). Notes: Figures refer to country averages between 1997-2001, where available. For each revenue classification, only countries for which data are available are included. 1/ Country data refers to GNI per capita (World Bank) 50 Afghanistan: Managing Public Finances for Development developed countries it is closer to 20%. With directly, the need to consolidate Government revenue at 4.5% of GDP in 2004/05, Afghanistan control throughout the country, and heavy is an outlier even in this group (Table 4.1). Tax reliance on aid funds that are exempt from taxa- revenues (3.4% of GDP) are only one-fourth the tion. In addition, Afghanistan historically had very average for low-income countries. low domestic revenue mobilization ­ in the 1970s the tax to GDP ratio was around 7%, one of the Afghanistan's economy has many features lowest in the world. Afghanistan's medium-term commonly associated with a low tax base, revenue potential therefore is likely to be toward including: (i) extremely low level of development; the lower end of the 11-14% of GDP range. (ii) a large informal sector implying a narrow tax base; (iii) the dominance of agriculture which is Domestic revenue has grown significantly over the hard to tax; and (iv) capacity constraints hindering last two years, starting from an extremely low base. the ability of the Government to collect taxes and In 2002/03, revenue was $129 million, equivalent of taxpayers to comply with tax regulations. to 3.2% of GDP. In 2003/04, revenue reached Revenue mobilization is further complicated by the $208 million (4.5% of GDP), and in 2004/05 it large opium economy that cannot be taxed rose to an estimated $269 million, also 4.5% of Table 4.2:Domestic Revenue Collection 2002/03 2003/04 2004/05 2005/06 Est. Est. Est. Budget Domestic Revenue (percentage GDP) 3.2 4.5 4.5 4.7 Domestic Revenue (Afs) 5,864 10,168 12,812 16,150 Domestic Revenue ($) 129 208 269 333 Domestic Revenue (percentage shares) ­ 100 100 ­ Tax Revenues 62 75 Taxes on income, profits and capital gains 4 8 Domestic taxes on goods and services 3 9 Taxes on international trade and transactions 53 57 of which: Import duties 52 54 Non Tax Revenues 38 25 Admin. fees & charges, non-industrial sales 35 20 Central Ministries (percentage shares) ­ 29 21 ­ Provinces ­ 71 79 ­ of which (in percent of total revenue), Herat 41 34 Kandahar 7 11 Nangarhar 7 12 Kabul 5 5 Balkh 3 9 Sources: MOF, IMF staff estimates. Mobilizing Domestic Revenues 51 GDP (Table 4.2). The 2005/06 budget projected a services, Ministry of Commerce from commissions modest further increase in revenue to $333 million on imported goods, and Ministry of Interior from (4.7% of projected GDP), a target which was motor vehicle registrations. expected to be exceeded by a considerable margin. In addition, municipalities collect some revenues. Revenue is concentrated in a small number of taxes These include, for example in the case of Kabul, (Table 4.2). As in many less developed economies, taxes on real estate (a rental tax and a levy on import duties are the main source of revenue because property notionally intended to cover the cost of they are relatively easy to monitor and collect, sanitation services); various duties for business comprising over 50% of the total (Table A.5 in the licenses, contracts, property deeds, markets, etc.; Statistical Annex). Box 4.1 summarizes the major tax fees for services (e.g. cleaning of septic tanks of res- instruments currently being utilized in Afghanistan. idential properties); rents; and proceeds from sale of land etc. The revenue yields of these taxes and levies Over 93% of total revenue is collected either by are low, however: in the case of Kabul, total munic- Central Ministries (mainly in Kabul) or in just five of ipal revenues in 2004/05 are roughly estimated at Afghanistan's 34 provinces: Herat, Nangarhar, around $6 million ­ in a center of economic activity Kandahar, Balkh, and Kabul. Four ministries with a population of around three million. account for 88% of total revenue reported by cen- tral ministries: MoF, Ministry of Communications There are many small "nuisance" taxes. With around which derives revenue from the sale of telephone 90 active taxes ­ half of them generating less than Box 4.1:Summary of MajorTax Instruments inAfghanistan Customs duties constitute the largest source of revenue in Afghanistan, as in many developing countries, largely because they are relatively simple to administer. While domestic taxes tend to grow in importance as countries develop, these are more difficult to administer and will be a long-term objective for Afghanistan. In the interim, the average import tariff should be kept relatively low, with a limited dispersion of rates to reduce arbitrary and excessive effective rates of protection as well as to minimize opportunities and incentives for corruption. Export taxes should be avoided since they tend to cause an outflow of resources from the export sector to less efficient uses, compromising growth objectives. Recent tax reforms have lowered tax rates for exporters. Income Taxes. Income taxes ideally should be levied on a global basis and include all forms of income. The corporate and top personal tax rates have been aligned at 20%, relatively low by international standards. Accompanying this move, new administrative provisions were added to the law, including introduction of self-assess- ment principles; provision for tax rulings so that investors have greater certainty about tax rules; and strict secrecy rules to heighten the accountability of the tax administration in dealing with sensitive business information. The planned restoration of the wage withholding tax and the simplification of personal tax rates, with only two nonzero personal rates, should help improve compliance. The level of exemption has been set to effectively remove most civil servants from taxation (which should ensure a progressive system). Sales taxes. These taxes should be consolidated as a simple and broadly based tax on final consumption. However, Afghanistan currently has a complex and cascading system of Business Receipts Tax (BRT) based on turnover and numerous presumptive (fixed) taxes for smaller traders, which is far from ideal. While a single-rate Value Added Tax (VAT), with crediting provisions and zero-rating of exports, is one of the most efficient taxes, it would be adminis- tratively too complex to implement at this time. However, over the medium term Afghanistan should expand the BRT toward a more broad-based consumption tax that broadens the tax base and avoids cascading. Excise taxes. There are currently no excise taxes in Afghanistan. 52 Afghanistan: Managing Public Finances for Development Afs 1 million ($21,000) during 2004/05 ­ the GeneralApproach administrative costs of some taxes most likely outweigh the revenue gain. The income tax law The ideal tax system raises in a fair manner the provides for a variety of presumptive taxes on small required revenues while minimizing distortions. It businesses, usually referred to as fixed taxes, as well should (i) minimize interference with individual as the cascading turnover tax (BRT). The law also consumption, saving, and investment decisions; (ii) identifies 170 tax categories of business establish- be relatively simple, transparent, and rules-based ments. Removing many of these small "nuisance" to encourage compliance and discourage corrup- taxes and simplifying the tax collection system will be tion; and (iii) be stable and predictable to reduce cost-effective and helpful to the private sector. uncertainty. There are also illicit taxes and instances of double The Government's strategy should focus on taxation or ambiguities in tax laws. The business improving compliance for taxes and locations with community has noted numerous cases where the highest revenue yields. This also implies getting illicit taxes add to the cost of business. For rid of numerous low-yield "nuisance taxes" and example, additional "transport taxes" may be curbing illicit levies as well as avoiding double-tax- levied on the owner of the goods, and provincial ation and confusion. Some taxes may have good or municipal authorities may charge other potential over the longer run, but large revenue ill-defined taxes. Municipal taxes also need to be yields in the short ­ to medium-term should not be streamlined as noted above, and there are cases expected. Mineral exploitation has good potential of double taxation, for example on rental prop- and is likely to generate tax and other revenues erty income as the central government introduced once the recently approved Minerals Law is a new services tax on rental income in 2004 (in implemented. Similar potentials may also exist in most countries, property income is taxed at the hydrocarbons, for which a Hydrocarbons Law was local level). Businesses have also complained adopted in December 2005. However, these that the legal code is often unclear, for example potential revenue sources will take time to develop. with respect to tax-deductible expenses, with varying interpretations. This can lead to disputes Agricultural taxes have a long history as a religious and corruption. tax (zakat). Subsequently taken over by the State and collected at the local level, agricultural tax was B. Improving Revenue Policy andTax once a significant source of revenue. However, it Administration has fallen into disuse over a long period of time, and any attempt to reinstate it is likely to be severely MoF is responsible for revenue policy and revenue hampered by the security situation as well as collection, with functions divided between the widespread poverty in rural areas. Nonetheless, Afghanistan Customs Department (ACD) and the given the importance of agriculture to the economy General Presidency of Revenue (GPR). The ACD ­ and to avoid distortions that might result from historically has been a much more distinct entity, exempting an entire sector permanently from with functions including collection of customs taxation ­ it may be advisable to revitalize agricul- duties and management of a customs service. The tural and land taxes over time. GPR has traditionally been in charge of domestic taxation policy, with actual collection being Tax policy and tax administration reform will be handled by the Mustoufiats. closely linked. Afghanistan's strategy for revenue Mobilizing Domestic Revenues 53 mobilization needs to take into account the very CustomsAdministration Reform weak state of institutions and limited implementa- tion capacity. Tax policy needs to provide a modern Customs administration reform will continue to be framework within which the tax administration can critical for success. During 2004, the ACD be built. International experience suggests the implemented important measures to: (i) simplify the following guiding principles for tax administration tariff system (Box 4.2); (ii) introduce simplified reform: (i) reducing the complexity of the tax system customs clearance documentation and procedures; by reducing the number of taxes, harmonizing and (iii) establish an effective system of customs rates, reducing exemptions, and eliminating illicit brokers to facilitate a speedier transit process. charges and double taxation; (ii) encouraging Ongoing reforms are extending ACD's operations in taxpayers' voluntary compliance with simplified the provinces and include: (i) a modern customs self-assessment procedures and better taxpayer code; (ii) major improvements in the customs education; (iii) differentiating the treatment of tax- infrastructure throughout the country; (iii) gradual payers by their revenue potential, commonly introduction of a computerized recording and through the creation of a Large taxpayer Office and management system (ASYCUDA, a standard risk management strategies; and (iv) ensuring international program for customs, Box 7.2); (iv) re- effective management of tax reforms. organizing and re-building of human capacity in the central and regional customs offices; and (v) legisla- A major improvement was the establishment in tion to establish effective enforcement mechanisms, 2004 of the Treasury Single Account (TSA), which combined with an effort to reduce illegal charges and integrates Government accounts into an account or consolidate and rationalize the number of charges. set of linked accounts through which the Government collects revenues and transacts The Customs administration faces many chal- payments. The apex of the system is a single lenges, including the poor security environment, account held by the Ministry of Finance (Treasury) lack of experienced managers, poorly trained staff, at the Central Bank. The TSA is designed to ensure inadequate facilities and equipment, and outdated that all Government revenues, wherever collected, and cumbersome operating policies and are transferred to the central Government. procedures. Customs regulations reportedly are not being applied consistently throughout the country, Civil service reforms are required to develop a moti- and the lack of an automated system undoubtedly vated and skilled cadre of revenue staff (Chapter impacts negatively on revenue performance. 9). The customs and tax administrations face unique challenges in having to collect funds for the DomesticTaxAdministration Reform Government, which increases the risk of corruption. Therefore a key component of the customs and The domestic tax base is likely to remain relatively tax reform programs is the development of narrow for some time, and reforms being professional (dedicated) tax and customs services. implemented will focus on large taxpayers. The current This entails specialized training programs and insti- set of reforms includes: (i) the adoption of a tax reform tutions, a career development structure within the package in June 2004; (ii) the creation of a Large service, and as and when appropriate, a perform- Taxpayer Office (LTO) and restructuring of the head- ance-based remuneration system. These reforms quarters and provincial revenue organizations; (iii) the are currently being undertaken as part of MoF's nationwide roll-out of a new Taxpayer Identification Priority Restructuring and Reform (PRR) program Number (TIN); and (iv) the consolidation of tax 54 Afghanistan: Managing Public Finances for Development Box 4.2:Afghanistan'sTrade Regime Establishment of an open and transparent trade regime has been a consistent priority of the Government, which has made sweeping tariff and customs administration reforms, resulting in a significant improvement in transparency and simplicity, leaving Afghanistan as one of the most open economies in the region. Under the previous trade regime there were 25 tariff bands, with rates ranging from 7-150%, and with a simple average of about 43%. However, a highly-appre- ciated artificial exchange rate was used in calculating payments of customs duties (made in domestic currency), which meant that actual payments were on the order of only 5-10% of nominal tariff levels. An overhaul of the tariff system brought the number of rates down to six (2.5, 4, 5, 8, 10, and 16%), with relatively low dispersion of rates, and shifted to use of the market exchange rate in calculating duties payable. By virtue of this rationali- zation, the average tariff declined to 4% (weighted by the number of items in each rate category). Even with the addition of a range of "fees", the estimated average applied tariff is only 5.3% ­ the lowest in the region. Afghanistan maintains import bans on only a few prod- ucts (largely for religious purposes), and imposes no seasonal restrictions, quotas, or other non-tariff barriers. Furthermore, licensing requirements ­ reformed effective April 2004 ­ have been drastically simplified. The import license application process, which previously involved 42 steps, 58 signatures, and several weeks of processing, now involves only three steps, six signatures, and two days to process. As a result, Afghanistan's trade regime cur- rently rates as a "4" in terms of the IMF's Trade Restrictiveness Index, same as the EU and United States. legislation amendments to address the excessive use Reform of provincial tax offices will require long-term of tax holidays, exemptions, and "special agreements". capacity building efforts. Although the LTO in due course should collect a considerable proportion of A focus on large taxpayers can enhance revenues. In tax receipts, the provincial revenue offices, currently many countries a small number of taxpayers (perhaps based in the Mustoufiats, will continue to collect 5%) account for 75% or more of total tax collections. substantial amounts, which will be important to In Afghanistan, the need to focus on large taxpayers is ensure a relatively broad base of taxation. However, heightened by the low level of compliance and very the GPR has never been the headquarters of the tax limited administrative capacity. Afghanistan administration as the provincial Mustoufiats report established an LTO in 2004 within the Revenue to the Treasury. To develop a more professional Directorate of MoF. In order to become fully effective, service, the current PRR plan aims to build a new tax this newly-created organization needs to focus on administration headquarters and operational tax selecting and then developing an appropriate relation- offices in provinces reporting to it. ship with the largest taxpayers, and should not get diverted to collect revenue from smaller clients. MovingTowardaBroad-basedConsumptionTax Appropriate criteria for large taxpayers have been developed by the Government. Within about two The current indirect tax system has serious deficien- years, the LTO can be expected to be collecting at least cies, including: (i) a narrow tax base leading to low 60% of total (non-customs) domestic tax revenue. revenue yield; (ii) serious potential cascading (albeit Mobilizing Domestic Revenues 55 generally at a low rate); and (iii) disincentives to would not distort relative prices. This kind of sales export. These problems could be addressed by tax has been employed in many countries in the moving toward a broad-based manufacturers sales earlier stages of their tax development, and it can tax in 3-5 years, which can generate a significant be expanded further to wholesale and eventually amount of revenue and will be necessary to ensure retail commerce with a minimum of disruption. fiscal sustainability over the longer term. Value Added Tax (VAT) is the most common form of con- Taxation and Investment Incentives sumption tax imposed by central governments, used in more than 100 countries.9 However, introduction Overall, the tax regime in Afghanistan is rather of a VAT through to the retail level may represent a competitive, with one of the lowest corporate more radical reform of the tax system than the income tax rates in the region. In 2004, the Government is prepared to introduce, or is needed. corporate income tax was reduced to a flat rate of 20% of net taxable income. Cross-country A single-stage sales tax at manufacturing level may comparisons of tax rates are difficult, but in be the best option. Phased extension of the recently Pakistan corporate tax rates range from 35% to introduced taxes on selected services could pave 50%, Iran charges a flat rate of 25%, in China the the way for a broader-based consumption tax as rate is 30%, in India the rate is 36.75% for development of administrative capacity permits. A domestic companies with a more complex schedule manufacturing sales tax imposes the tax at the point for foreign companies, and in Uzbekistan the cor- where goods are first sold in the case of domesti- porate tax rate ranges from 20-35%. Figure 4.1 cally produced goods, and at the point of customs highlights Afghanistan's relative position by com- clearance for imported goods. A single tax rate for paring the total tax burden (excluding tax on labor) all goods would be simpler to administer and that would face a typical firm in several countries. Figure 4.1:TotalTax Payable (% of gross profits) Note: World Average covers 155 countries. Source: Doing Business Indicators, World Bank. 9 In a VAT system, all persons or businesses engaged in supply of taxable goods and services are required to register for VAT and charge VAT on all taxable sales. Their actual liability, however, is only the net of the VAT charged on their sales (output tax), reduced by the VAT paid or payable by them (input tax) for goods and services purchased for use in their taxable activities. 56 Afghanistan: Managing Public Finances for Development The first-best strategy for sustained investment by MoF put the revenue loss due to exemp- promotion consists of providing a secure, stable, tions and concessions granted prior to July and transparent legal and regulatory framework, as 2004 at $30 million. well as adequate supporting institutions, including Tax incentives could be of questionable a tax system in line with international norms. On value to a foreign investor because the the other hand, available evidence suggests that benefits may be offset when profits are providing tax incentives for investment promotion is repatriated through an increased tax not cost-effective and that the revenue cost is charge in the home country. potentially significant. As a general rule, indirect tax incentives should be avoided (as inefficient), and In 2004, tax holidays and exemptions were replaced discretion in granting incentives should be by two tax incentives: accelerated depreciation and minimized as this can encourage corruption. unlimited loss carry-forward. These have the least of the shortcomings associated with tax incentives. Since More specifically, tax holidays, which are merely accelerating depreciation of an asset does not widespread in developing countries, have increase the total allowable depreciation beyond its well-known shortcomings. They basically consist of original cost, little distortion in favor of short-lived applying a rate of corporate income tax lower than assets is generated. Neither is there much incentive the regular rate ­ often zero ­ to companies in a for an enterprise to engage in tax abuse. Accelerated certain sector or region for a pre-specified period. depreciation also does not have the other negative The main objective of tax holidays is to increase elements associated with tax credits. investment. They raise several issues: By exempting profits irrespective of their C. Medium-term Revenue Projections amount, tax holidays benefit an investor who expects a high rate of return and Underlying the fiscal scenarios outlined in Chapter 3 probably would have invested even without are illustrative revenue projections driven by: (1) the incentive. economic growth and inflation: (2) customs and tax policy reforms; (3) customs administration reforms; Tax holidays provide strong incentives for and (4) tax administration reforms. The macroeco- tax avoidance, as taxed enterprises could nomic assumptions are similar for each scenario, with enter into economic relationships with exempt ones to shift their profits to the latter real GDP growing at around 10% over the first four through transfer pricing. The duration of tax years and falling to around 7.5% thereafter. Inflation holidays also is prone to abuse. also falls from an initial rate of 10% per annum to 5%, while the nominal exchange rate remains stable. Time-bound tax holidays, if they have any Several alternative scenarios illustrate the implications impact at all, tend to attract short-run projects, which typically are less beneficial of different reform paths over a ten-year period: for the economy. In Afghanistan, over 40% Scenario 1 (baseline case) assumes of tax holidays granted before mid-2004 gradual but effective implementation of the were reportedly awarded to construction five-year customs and tax administration companies. reforms. These include the wage with- The revenue cost is seldom transparent, holding tax (raising a total of $120 million unless enterprises are required to file in the first three years); selected service proper tax returns and the aggregate fiscal taxes including roll-out to other urban "loss" is calculated. Conservative estimates centers ($36 million in the first five years); Mobilizing Domestic Revenues 57 and the airport tax ($2.7 million over three The revenue ratios for each scenario are shown as a years). Improvements in compliance are percentage of GDP in Figure 4.2 (see also Statistical 10-15% per annum during the first six Appendix Table A.6). These ratios may provide useful years before falling to 5% per annum benchmarks for assessing Afghanistan's revenue subsequently. path. As discussed in Chapter 3, in the low case Scenario 2 (high-case) assumes acceler- scenario Afghanistan would fail to meet a number of ated implementation of the five-year its policy objectives. customs and tax administration reforms combined with additional revenue While the high-case scenario would require consider- measures. Improvements in compliance able efforts and thorough reform implementation, rates are higher than in scenario 1, 20% experience in other post-conflict countries suggests p.a. in the first four years, then gradually that it could be achieved. Although the revenue to falling to 5% annually, assuming stronger GDP ratio rises by in excess of one percentage point performance by the Customs administra- per year in the first four years, some other post-con- tion and the LTO. There is also a gradual move toward a consumption tax which flict countries have achieved this level of revenue broadens the tax base, and eventually performance. For example, the creation of the royalties from the mineral sector gradu- revenue authority in Uganda helped to double the tax ally come on stream. revenue/GDP ratio from 6% to around 12% in the Scenario 3 (low case) assumes no further 1990s (Figure 4.3b). In Rwanda the tax revenue/GDP tax policy reforms. Based on reforms so far, ratio increased sharply from a low of 4% in 1994 to compliance rates improve by around 10% around 12% in late 2002 (Figure 4.3a). p.a. during the first six years before falling to 5% p.a. thereafter. No additional major However, Afghanistan's particular context and the policy reforms are implemented. inherent risks it faces should be kept in mind. The Figure 4.2:Medium-term Revenue Forecast (% of GDP) Source: Securing Afghanistan's Future (SAF) and IMF estimates. 58 Afghanistan: Managing Public Finances for Development Figure 4.3:Comparative Growth in Revenue Collection (% of GDP) a. Rwanda b. Uganda Source: IMF, Government Financial Statistics, and Staff reports. country's GDP, for example, depends to a large Nevertheless, fiscal sustainability considerations degree on agriculture, which is volatile. The (Chapter 3) imply that increasing domestic revenue exchange rate, relatively stable since the introduc- mobilization needs to be given very high priority. tion of the new Afghani (and assumed to remain so This will reduce aid dependence over time, create under all scenarios), may also be subject to bouts fiscal space for development, and send a very of instability in the face of shifts in demand, uneven strong signal of the Government's commitment to aid inflows, or actions against the opium economy. progressing toward fiscal sustainability ­ both to Furthermore, institutional capacity is still weak, and Afghanistan's own people and to the international the quality of policy-making (while strong thus far) community ­ thereby enhancing the latter's is uncertain over the medium term. These factors confidence to continue to provide financing for the suggest that there is a risk that revenues would turn country's operating budget until the gap between out to be considerably lower than projected here. recurrent expenditures and revenues is bridged. 5 PRIORITIZING EXPENDITURES A second key desired outcome of the PFM system is dominant sector, with a rough balance between the effective allocation of public sector resources to human capital and infrastructure pillars and much different sectors, programs, and activities. This less going into the fourth pillar, it is not possible to say should be within an affordable budget envelope (as much at this very aggregated level. However, the discussed in Chapter 3); in accordance with pattern of expenditures differs significantly as between Afghanistan's development strategy, sector strategies, the Core Budget and the External Budget. Human and national policies; and in a manner that achieves capital development is the largest pillar in the Core good development outcomes. With Afghanistan Budget, reflecting substantial spending in the recur- facing immense needs in most sectors, the issue rent budget on teachers' salaries and in the develop- clearly boils down to prioritization: What is the right ment budget on the National Solidarity Program balance across and within sectors? What is the right (NSP) and on basic health services (contracted out to sequencing between competing priorities? What are non-government providers ­ see Chapter 8). On the the most effective interventions? This chapter first other hand, security is considerably smaller than reviews the broad pattern of expenditures across human development in the Core Budget but twice as sectors and recent trends, and discusses why it is so large in the External Budget (reflecting in particular important to prioritize. The second section looks at massive spending on the Afghan National Army). prioritization of expenditures across sectors, the third Infrastructure comprises a much larger share of the section at prioritization within sectors. External Budget than of the Core Budget. A. Sectoral Expenditure Patterns: Within the broad pillars, spending can be divided Why It is Important to Prioritize among 16 national programs, of which the major ones include Education; Health; Livelihoods and The Allocation of Spending Across Sectors Social Protection; Transport; Energy, Mining, and and RecentTrends Telecommunications; Public Administration and Economic Management; National Police; and Afghan Afghanistan's budgetary expenditures can be classi- National Army (Table 5.1 and Table A.7 in the Statistical fied along programmatic lines, and divided into four Annex). The ANA was the largest single sector in terms broad pillars established by the Government in its of expenditures in 2004/05; the transport sector, mainly strategy documents (Figure 5.1): human capital consisting of roads, was second. development (25% of total spending in 2004/05), physical infrastructure (27%), general administration Why Prioritize? KeyTrade-Offs (9%, including trade and investment and public administration and economic management), and First, like any country Afghanistan faces major security (39%). Aside from the fact that security is the resource constraints over the medium term 62 Afghanistan: Managing Public Finances for Development Figure 5.1:2004/05 Expenditure Composition (% of total of each category) Source: MoF (preliminary annual statements for Core Budget and preliminary annual report for External Budget). (Chapter 3), and prioritization is essential to ensure Third, prioritization is a political process (Box 6.1), that the available resources are well used. which needs to be informed by and to interact with Substantial external assistance is available now but the national development strategy at the broader inevitably will decline over time, so making good level (and strategies for different pillars like use of these extra resources during the current security as well as sector strategies at the narrower window of opportunity is critical for success. level), and sound technical inputs and guidance are required for budget decision-making (by Second, with the bulk of public spending externally Cabinet, later by Parliament). While at one financed and most of it donor-executed, if the extreme there is no technical "magic formula" and Government does not prioritize, the allocation of it is unrealistic to expect a purely technical prioriti- expenditures will be determined in an ad hoc manner zation of expenditures to be feasible (or even by the fragmented priorities of others. The External desirable), at the other extreme political Budget has a very large influence in determining the decision-making in the absence of any sound ex post prioritization of expenditures. In 2004/05, for technical inputs can lead to disastrous outcomes. example, the relative ordering of total expenditure by pillars (security, infrastructure, human development, Fourth, Afghanistan faces especially severe issues general administration) was determined by the in terms of prioritizing expenditures over time, in External Budget, whereas expenditure was allocated particular related to the downstream O&M conse- quite differently in the Core Budget (Figure 5.1). quences of public investment decisions made today Moreover, the two top national programs in terms of (in both Core and External Budgets). The large funding (ANA and Transport) were determined by the amounts of recurrent expenditure in the External External Budget, as these were only fourth and fifth in (Development) Budget will generate enormous terms of spending in the Core Budget. pressures later (Chapter 3, Section C). Prioritizing Expenditures 63 Table 5.1:2004/05 National Budget Expenditures by Program ($ million) Core Budget External Total Budget Budget Operating Developt. Total Developt. Total % of total of which Exp. Exp. Exp. developt. Human Capital Development 192 157 349 494 843 25 651 1.1 Refugees and IDP return 2 - 2 73 75 2 73 1.2 Education 115 7 122 102 224 7 108 1.3 Health 25 39 63 91 154 5 130 1.4 Livelihood and Social Protection 37 111 148 192 340 10 303 1.5 Culture, Media, Sport 13 0 13 36 50 1 36 Physical Infrastructure 33 119 152 749 901 27 869 2.1 Transport 6 78 83 497 581 17 575 2.2 Energy, Mines, and Telecom 12 33 45 177 222 7 210 2.3 Natural Resources Management 14 2 15 30 45 1 31 2.4 Urban Management 1 7 8 45 53 2 52 General Administration 58 23 81 217 298 9 240 3.1 Trade and Investment 3 6 9 31 40 1 37 3.2 Public Administration and 55 17 72 186 258 8 203 Economic Management Security 275 17 292 1,036 1,328 39 1,053 3.3 Justice 21 0 21 24 45 1 24 3.4 National Police and Law 146 17 163 177 340 10 194 Enforcement 3.5 Afghan National Army 108 - 108 681 788 23 681 3.6 Mine Action - - - 96 96 3 96 3.7 DDR - - - 59 59 2 59 Unallocated - - - 8 8 0 8 Total 558 317 874 2,503 3,378 100 2,820 Sources: See Figure 5.1. B. How to Prioritize:Allocating better. Judgment is called for. And inevitably ExpendituresAcross Sectors political factors will be prominent. There are no easy answers on how to prioritize in A first critical point is that inter-sectoral allocation allocating public expenditures across broad pillars decisions need to be anchored in an encompassing and sectors. Sophisticated technical approaches national strategy for development. The national can require a great deal of resources and even so strategy document should provide general guidance are highly imperfect and can result in misleading and a framework for prioritization, as well as broad conclusions. Simpler rules of thumb may work strategic priorities. The Government's National 64 Afghanistan: Managing Public Finances for Development Development Framework (NDF ­ 2002) and subse- improved in 2004 and 22005; and (iv) fragmenta- quently Securing Afghanistan's Future (SAF ­ 2004), as tion across sectors possibly exacerbated by the "lead well as documents prepared for Afghanistan donor" approach (whereby a lead donor was Development Forum meetings, have provided a assigned for each sector within the Security Pillar). strategic vision and framework. In the SAF, a detailed medium-term investment program also was put More generally, identifying and mitigating gross forward. However, prioritization and sequencing were anomalies in inter-sectoral allocations of expendi- not concretely spelled out, and the discipline of a tures can be a powerful tool for prioritization, if resource constraint was not applied. The Government informed by strategy and mediated by the resource has recently prepared its Interim Afghanistan National envelope. Outliers can be identified in terms of their Development Strategy (I-ANDS). It is hoped that the relatively low (or very high) shares of total expendi- development of the full ANDS, and the consultative tures, or through comparing expenditure growth process around it, will provide guidance on broad rates for different sectors. Agriculture may be a prioritization of spending.10 Prioritization will also be good example of a critically important sector (in the facilitated by setting a medium-term fiscal resource natural resources management national program) envelope (Chapter 3), and progressively strengthening that has been underfunded.11 On the other hand, its sector content. the size and growth of expenditures on roads, while reflecting massive rehabilitation needs and the high Without overall strategic guidance, inter-sectoral priority assigned to this sector by the Government allocation decisions can be arbitrary and counter- and partners, do seem to have far outrun productive. A good example is security where, most investments in other major infrastructure sectors. strikingly, the justice sector has received only 3% of total security funding over the past three years It is very important to ascertain the reasons behind (Figure 5.2). Police reforms have progressed slowly gross anomalies in inter-sectoral expenditure compared with the rapid development of the ANA. patterns. Where major underspending in a sector is Based on the PFM Review's analysis, contributing related to limited capacity or poor performance of factors to these anomalies include (i) the earlier lack the concerned ministry, then additional funding of an agreed national security strategy (not surprising alone will not solve the problem and on the in the initial period following the end of major contrary could waste resources. Sometimes gross conflict in late 2001); (ii) the overwhelming anomalies may be in large part attributable to dominance of the External Budget in overall security donors' preferences, as they may gravitate toward spending; (iii) the above problems, and fragmenta- visible, popular, or well-performing sectors and tion of decisionmaking across donors, making it away from others. Thus rectifying underspending more difficult for the National Security Council to needs to be accompanied by measures to address fully carry out its mandated strategic, leadership, and the underlying problems that resulted in low coordination functions, although the situation has spending in the first place. 10 Such prioritization at a strategic level is challenging but possible, with success dependent on having a meaningful linkage to the budget process (medium-term framework and annual budgeting). For example, Armenia's draft Poverty Reduction Strategy Paper (PRSP) proposed interventions in over 100 areas, but intensive consultations supported by a software tool facilitated reaching consensus to concentrate on 12 priority areas linked closely to the MTEF and well-specified policy actions. 11 In 2003/04, less than $40 million was spent in the Development Budget on projects under the Ministry of Agriculture's over- sight, of which only $1 million was in the Core Budget. Prioritizing Expenditures 65 At the opposite extreme in terms of technical sophis- total spending is lower than in other countries (11% tication is use of cost-benefit analysis as a guide to against 18%). inter-sectoral prioritization. While superficially attractive, this approach carries heavy technical and An approach based on identifying bottlenecks and informational requirements, and even in the directing expenditures to alleviate them also may industrialized countries it is not used systematically be useful in the short run. One example is building except in the evaluation of new project proposals. an electricity transmission line from northern Moreover, there appear to be biases across sectors. Afghanistan to Kabul to deal with the power supply For example, power projects and roads tend to have bottleneck facing the city. Strengthening the high estimated economic rates of return, whereas judiciary and creating a solid statistical system those for large irrigation projects tend to be more appear to be important enabling factors for many marginal. Since such differences are common other sectors. Similarly, identifying successes can across projects and country situations, they most lead to scaling up or replicating them, for example probably reflect differences in the methods applied, in the case of the National Solidarity Program. data, etc. rather than mainly underlying differences in the development impact across sectors. Thus Another important lesson is the need for inter-sec- using cost-benefit analysis to prioritize across sectors toral prioritization to be comprehensive ­ no sector can be misleading and counterproductive. (e.g. defense) should be considered sacrosanct or immune from scrutiny. Information on international patterns of spending and outcomes across sectors may provide some In certain countries, the Government may allocate guidance, although it must be applied judiciously domestic resources so as to counterbalance donors' in line with the country context. An international allocations of donor-executed assistance, thereby comparison highlights the very large share of ensuring that the overall pattern of spending is in Afghanistan's public expenditures allocated to the line with national strategic priorities. In security sector (Statistical Appendix Table A4). It Afghanistan, however, the External Budget is so also suggests that, if the External Budget is taken large that it would be impossible to use the limited into account, the share of education and health in resources in the Core Budget to offset donors' priorities manifested in the External Budget. Hence Figure 5.2:Composition of Security Expenditures, there is no alternative to close cooperation with 2002/03-2004/05 donors to ensure that the overall allocation of resources in the External Budget corresponds with national priorities. But this is difficult, and the problems faced by the Government in managing the External Budget provide strong grounds for more external assistance to go through Core Budget channels (Chapter 6). From an incentive standpoint, it may make sense to have some linkage between sectoral allocations and performance. For example, ministries/sectors that do better in terms of spending the money they Source: World Bank (2005b, Volume V, Chapter 5). are allocated would get continuing or higher 66 Afghanistan: Managing Public Finances for Development allocations in the future, whereas those that are not reasons for public interventions are because of able to spend their allocations would get reduced public goods or externalities (i.e. goods and allocations. However, a strong linkage to perform- services that would not be adequately provided by ance can result over time in underperforming the private sector alone) and for redistribution. sectors systematically getting less resources than Even when there is a clear case for Government the importance of the sectors concerned in the intervention, the type of intervention can vary: national strategy would call for. Since donors in regulation, financing, or direct provision. Public their own allocation decisions respond to perceived expenditures should therefore be reviewed against good performance, they can exacerbate such these criteria (Box 5.1). imbalances. Thus while some short-term perform- ance linkage may be desirable, from a Geographical and gender disparities comprise an medium-term perspective it is essential to correct important dimension for prioritization within sectors. the reasons for underperformance and ensure that For instance, in education disparities in enrollments well-performing sectors do not become grossly between boys and girls, rural and urban areas, and overfunded in relation to their strategic importance, provinces suggest that adjustments in expenditure within overall resource constraints. allocations are necessary (Figure 5.3). A review of the education sector suggests that these issues can C. HowTo Prioritize:Allocating be addressed by an appropriate strategy, including ExpendituresWithin Sectors recruitment of teachers (notably female teachers), targeted programs to increase enrollment, and use As in the case of inter-sectoral allocation, prioriti- of local participatory mechanisms such as School zation of spending within sectors (e.g. health, Management Committees. power, highways, irrigation) needs to be anchored in sound sector strategies, which should provide Technical analysis can be used to evaluate indi- general guidance on priorities. Technically, prioriti- vidual project proposals and as general guidance zation within sectors is more manageable than for prioritization of expenditures within a sector. inter-sectoral prioritization because the alternatives Health is a good example of the latter approach, tend to be more comparable. Cost-benefit analysis, where the cost per life saved (cost per DALY saved) which cannot be used uncritically for broad of different types of interventions can be compared. inter-sectoral allocation decisions, is much more In general, basic health interventions are much useful for prioritizing projects or programs/activities more cost-effective than more expensive curative within a sector. Moreover, in sectors where benefits care including hospitals (Table 5.2). A general rule cannot be easily expressed in value terms or doing of thumb is that when the cost per DALY12 saved of so is controversial (e.g. health), cost-effectiveness a health intervention exceeds average GDP per analysis can be applied, whereas this could not be capita (around $250 in Afghanistan today), used for the most part across sectors. allocating public resources to that activity consti- tutes a relatively inefficient use of resources (partic- A very important consideration is the appropriate ularly if activities with lower cost per DALY saved role of Government for the activity. The two key are underfunded). Based on these considerations, 12 DALY is a disability adjusted life year, which provides a common measure for comparing the burden of disease taking into account both death and disability arising from illness. Prioritizing Expenditures 67 Table 5.2:Cost-Effectiveness of Different Health tion, and cost-benefit analysis can be very useful. Interventions The highway sector is a good example. Afghanistan already has a large highway rehabilitation program Intervention Cost per DALY Saved underway, with a total cost exceeding $1 billion. Particularly in view of the future O&M requirements, Vitamin A Supplementation $1-3 any major new highway project proposals must Treatment of Tuberculosis $1-3 therefore be treated with great caution and carefully Measles Immunization $20 prioritized. Benefits depend greatly on traffic Oral Rehydration Therapy $116 forecasts (both freight and passengers), and on available alternative routes. Costs per kilometer Point of use treatment of drinking water $124 may be fairly standard (depending on the type of Management of childhood pneumonia $133 road construction involved and the condition of the Treatment of depression $827 existing road), although there has been a great deal Hospital treatment of Leukemia $1,156 of cost variation in Afghanistan ­ depending in part Note: DALY is a disability adjusted life year. on mountains, the number of bridges, tunnels, etc. Source: World Bank (2005b, Volume IV, Chapter 1). (Box 7.3). High altitude and steep grades also affect the costs of users and reduce the net benefits to the Government has prioritized provision of an them. Another factor is extra security costs, esti- agreed Basic Package of Health Services, and has mated at 3-15% for highway rehabilitation projects. tried to resist pressures to make major new invest- ments in hospitals, particularly in Kabul. Some other considerations are very important for the intra-sectoral allocation of spending. One is In major infrastructure sectors where large projects complementarities between different projects. A are involved, decisions on individual projects form a good example is the power sector, where gross primary element of intra-sectoral resource alloca- imbalances between investments in generation, Figure 5.3:Net Enrollment Ratios,Grades 1-6 (2003) Source: World Bank (2005b, Volume IV, Chapter 2). 68 Afghanistan: Managing Public Finances for Development transmission, and distribution would sharply reduce ments become truly daunting, leading to questions returns. This highlights the need for a robust sector about what size of investment program is strategy, in this case an Energy Master Plan, which affordable over the longer run, and to the critical provides the rationale for prioritization, based on need and potential for cost recovery to partially or sequencing investments, taking into account lags in fully fund O&M requirements (Chapter 8). building large-scale infrastructure equipments, and adequately financing O&M. The hydrocarbon and mining sectors provide good examples of how important, and intricate, Prioritization of public investments within sectors sequencing issues can be. Managing these under- also must include the time dimension. Medium- ground resources is important for the Government, term targets for service delivery (whether for because of their potential impact on both domestic physical infrastructure or social services) need to revenues and private sector development (including inform investment decisions and O&M implications in downstream sectors). Capacity development is an ­ not investments driving O&M. In addition there urgent priority, as lack of capacity to shift to an are critical sequencing issues in terms of what effective regulatory approach, limited political comes first, what comes later. As public investment leadership to shift toward private development of accumulates over several years the O&M require- underground resources, lack of policy consistency, Box 5.1:PrioritizingWhen Everything is Critical Prioritization is technically and politically a daunting task in the Afghan context, with limited data and analytical capacity and enormous needs. However, prioritizing is important technically (not all projects will have the same economic and social impact and some projects require other projects to be completed first), fiscally (unrealistic budgets either produce large fiscal imbalances, or, not being implemented, make the budget an irrelevant tool), and politically (poorly prioritized budgets raise expectations, leading to disenchantment). The first filter for prioritization is that each project should contribute to the ANDS's objectives and be part of the sector's master plan. The contribution to objectives of the ANDS should be clearly specified. Beyond this filter, projects could be ranked based on four simple criteria: Rationale (Weight 15%): Should this be done by the public sector or can the private sector adequately under- take the activity? Does the project target the poor? Cost-effectiveness (Weight 15%): For the output of the project, has the least-cost alternative been identified? Are multi-year implications laid out, and is the project likely to be self-financing after completion? Benefit-cost (including identification of beneficiaries) (Weight 50%): Have benefits (e.g. social, financial) been quantified? Do benefits exceed costs? Risk and mitigation (Weight 20%): Is the project likely to be completed on time? Have allowances been made to address potential physical and financial contingencies? Are there institutional/managerial/technical constraints in carrying out the project? Are there any environmental risks? Based on this ranking, the top-priority projects can be included in the budget up to the sector resource envelope. It should be noted that a framework along the lines put forward above would need to be flexible in accordance with sector-specific circumstances. For example, some sectors like security are not expected to be self-financing, so the point in the second criterion about a project being self-financing after completion would not apply. Based on Swaroop (2004). Prioritizing Expenditures 69 and limited external assistance can combine to pre- approved projects and even those under imple- vent progress, whereas breakthroughs are required. mentation that have little hope of being completed. In Afghanistan some progress has been made in Finally, technical criteria including cost-benefit this regard: the 2004/05 development budget analysis can be used to clean out excessive "wish included 540 projects out of the 1,110 proposed lists" of proposed projects in the portfolios of by line ministries, of which only 210 were in the different ministries. A damaging practice that is Core Budget. But this most likely is still too many, sometimes found in other countries is to maintain and the slow pace of project implementation sug- much too large a portfolio of approved/ongoing gests that better project screening and budget projects, for which the likely funding available will realism is required (Figure 3.1). The preparation of be far from sufficient to complete all of the projects. the ANDS creates an opportunity to strengthen this This must be avoided through ruthless culling of process and create a lean, high-quality portfolio of new project proposals as well as dropping public investment projects (Box 5.1). 6 MAKINGTHE NATIONAL BUDGETTHE CENTRAL INSTRUMENT OF POLICYAND REFORM Previous chapters have looked at important June 2005, further specifies the processes and outcomes of the PFM system; the next two focus on responsibilities. The Government is responsible for the PFM system itself, starting with the central preparing the budget (and executing it, see Chapter process of national budget formulation. The first 7), with MoF leading the process. The budget is section of this chapter reviews the legal and institu- then to be presented for approval to the bicameral tional framework of the budget. The second legislature no later than 45 days before the start of analyzes progress and challenges in making the the fiscal year, and approval is required no later budget an effective policy tool. The third outlines than a month after the start of the fiscal year. In issues of ownership and political buy-in for the previous years, as the Parliament had not yet been budget. The last section looks at the implications of established, the Cabinet approved the national the large amounts of external aid for Afghanistan budget through a Presidential Decree (see also Box and discusses how donors can support the 6.1 on the political economy of the budget). Government's efforts to make the budget the central instrument of policy and reform. As reflected in PFM indicator 11, progress has been made toward an orderly annual budget process. In The issue of Afghanistan's weak institutional particular, it has moved from a pure bargaining capacity (Chapter 9) has to be taken into account. process to a more policy-oriented discussion. It would be futile to reform budgeting without Modernization of Soviet-inherited practices has improving the Government's overall management started. The mid-year review, established since framework. Ultimately, performance is a manage- 2004, has significantly improved the quality of ment issue, and there would be no demand for a budget management by allowing transparent performance-oriented budget without perform- adjustments during the year and creating a feed- ance-driven management. Moreover, effective back loop from one year's budget implementation budgeting is demanding in terms of information to the next year's budget preparation. Finally, and analysis. Thus appropriate sequencing is significant information is publicly available on the essential to bring about improvements that achieve Government's website, notably the budget guide- their objectives. lines, budget decrees, and fiscal reports (PFM indicator 10 and Box 7.2) A. Budget Preparation Process But much more remains to be done. A review of the The 2004 Constitution provides the legal authority seven steps of the budget formulation process for preparing, approving, and executing the (Table 6.1) reveals two key issues (in addition, some national budget. The Public Finance and features of the process weaken the policy content of Expenditure Management (PFEM) Law, approved in the budget, see next section). First, as in many 74 Afghanistan: Managing Public Finances for Development countries the schedule is very compressed, starting across sectors, reinforcing the budget's strategic after the mid-year review (late December 2004 for content. The absence of such ceilings weakens the the 2005/06 budget). Either the process ends on budget's policy content (Section B) and increases time (for the operating budget) but with limited political bargaining (Section C). Section D looks at opportunity for substantive analysis and discus- the role of external assistance in the process. sions, or it ends after the start of the fiscal year (for the development budget), constraining budget B. Policy Orientation of the Budget implementation. Timing is now even more critical since the Parliament will need sufficient time to Comprehensiveness and Classification review the budget. Second, the early stages of the process are weak, with no pre-determined budget There are two technical requirements for the envelope or sector ceilings. In many countries, the budget to be a useful policy tool (see PFM Cabinet reviews and agrees on the fiscal envelope indicators 5 to 9). First, the budget needs to give an (updating the MTFF, see Chapter 3) and on budget overall picture of public finances; if parts (e.g. ceilings by sector, which sets a clear direction for humanitarian or defense spending) are excluded, aggregate fiscal discipline and broad allocations the Government cannot assess the impact of the Table 6.1:Key Steps and Issues in Budget Preparation Steps Description Issues 1. Issue Budget Prepared by Budget Department and Schedule gives little time for analysis Guidelines issued to line ministries Development and operating budgets have been disconnected 2. Decide Budget Prepared by MoF ­ requires Cabinet dis- No review process (in particular by Envelope cussion and buy-in, and consultation with Cabinet) donors on external assistance Difficult to operationalize with large aid inflows 3. Prepare Expenditure Cabinet establishes "provisional operating Absence of sector ceilings Proposals budget" (envelope) for each ministry; line Limited capacity to prepare fully justified ministries and Budget Working Groups (in expenditure proposals and to learn from collaboration with donors) prepare their previous years (weak monitoring and proposals for both operating and develop- evaluation systems) ment budgets 4. Appraise Proposals Budget Committee (Cabinet subcom- Limited capacity to appraise proposals mittee) appraises proposals and holds and prioritize them hearings 5. Budget consolidation Ministries revise their proposals and MoF prepares a consolidated budget 6. Cabinet approval Cabinet discusses consolidated budget, revises it, and approves it 7. Enactment Currently through a Presidential Decree, To be approved by Parliament now that released transparently to public it has been established Source: "Budget Formulation in Post Conflict Afghanistan (2005/06)", background paper for the PFM review. Making the National Budget the Central Instrument of Policy and Reform 75 Figure 6.1:Comprehensiveness of Budget and ExternalAssistance (% GDP) Source: Government data based on MoF fiscal reports and financing indicated in 2005/06 budget (security expenditures in the External Budget are separated out); OECD data based on reports from donors to OECD / DAC (in principle excludes military support) ­ data available up to 2004. budget on the macro-economy or make The main classification problem has been the lack meaningful sector allocations. Second, the budget of integration between operating and development must follow a classification system that allows budgets. The dual budget structure has no policy meaningful analysis. basis, as the operating budget includes 7% of capital expenditures and the development budget Progress has been made toward a comprehensive includes almost 40% of recurrent expenditures budget. Thanks to strong aid coordination efforts, (based on simple estimates, Figure 6.2). Lack of the broader budget concept captures most external integration is very detrimental to the effectiveness of assistance (Figure 6.1). However, for the External public spending, as investments are made without Budget the Government relies on voluntary reporting planning (and financing) for maintaining them. by donors. The quality of data is poor (data are There is also a bias toward investments, crowding incomplete, based on somewhat different definitions, out operation and maintenance of completed classifications, and reporting periods), and actuals investments to actually deliver services, which can are often not available (see in Figure 6.1 the also lead to political difficulties (investments raise discrepancy between the Government's 2002/03 hopes that are disappointed afterward). Dual data and OECD data). Another issue is that the fiscal budgets also potentially open up the opportunity risks from public entities other than the national for double-allocations for the same purpose (e.g. Government are not monitored: there is very limited maintenance costs in a ministry's operating budget information on SOEs and on municipalities. and in a donor-financed project). Progress toward a meaningful classification system Achieving progress toward integrated budgeting also has been commendable. Since March 2005 requires three reforms. The first is to structure MoF's a chart of accounts, covering all Government Budget Department along sectoral lines, with no transactions, has been in place and should provide organizational separation between the operating information in line with internationally accepted budget and the development budget, and build up standards. its capacity, complemented by similar reforms in 76 Afghanistan: Managing Public Finances for Development Figure 6.2:Operating and Development Budgets ($ million) Source: Based on MoF reports for 2004/05; staff estimates for development budget (no official classification is available). line ministries. This is already being initiated. The level, annual budgets represent the year-wise second is alignment of classifications and the articulation of the path toward fiscal sustainability (see presentation in budget documentation, accounting, Chapter 3). To facilitate this linkage, the MTFF should and reporting systems, which has already started be updated every year with Cabinet approval. Within with the Chart of Accounts implemented in March sectors, budgets should anticipate the flow of 2005. Finally, donor practices need to support resources necessary to operate and maintain new budget integration (see Section D). investments, thus requiring integration of operating and development budgets as discussed above. A number of other accounting issues also need to be addressed in order to improve the quality of Second, across and within sectors, the budget budget presentation, notably full adoption of a should operationalize the Afghanistan National cash-based presentation instead of mixing cash Development Strategy (ANDS), whose interim ver- flows with commitments. The current presentation sion has been prepared. This means aligning with of the financing framework is weak and does not the main strategic trade-offs across sectors (see show properly the amount of cash that is carried Chapter 5); hence it is advisable for the Cabinet to over from one year to the next on the Government's agree on broad sector envelopes early in the accounts. These shortcomings contribute to weak- annual budget formulation process. For example, ening the realism of the budget and its usefulness while improvements in the justice sector are high on as a policy instrument. the development agenda, spending has not been in line with this priority (see Figure 5.2). The strategic From Policy to Budget linkage also implies careful prioritization of projects within each sector, as discussed in Chapter 5, and Building on these two important technical aspects, the adequate input from a monitoring and evaluation budget can actually become a policy instrument if the system, as discussed in Chapter 8. country's development strategy is translated into annual budgets. First, the budget should reflect the Finally, the budget should reflect cross-cutting Government's multi-year strategy. At the aggregate issues such as gender, environment, counter-nar- Making the National Budget the Central Instrument of Policy and Reform 77 cotics, and provincial allocations. The first entry should remain under control to avoid wasteful points are the sector strategies themselves (e.g. overlaps with sector programs. recruiting female teachers to reduce disparities in school enrollment between boys and girls). This C. Enhancing Ownership and Political strategy of "mainstreaming" is consistent with the Buy-In view that these issues cut across many sectors. In particular, the issue of gender needs to be reflected Political buy-in is of utmost importance for making the in budgeting, not only in sectors like Health and budget a credible policy tool ­ which reflects the Education but also in Agriculture, Public Government's strategy and is effectively implemented ­ Administration and Economic Management, etc. and an instrument of nation building. This requires the where women's contribution to the economy is involvement of many stakeholders at various stages of significant and growing (see World Bank, 2005c). the strategic and budget cycle, which is extremely chal- This approach can be complemented by expendi- lenging in Afghanistan, with a political transition, a ture analysis. For instance, some countries have fragmented Cabinet, the absence hitherto of a created virtual "poverty funds": expenditures that Parliament, a fragmented civil society, and extensive seek to reduce poverty (e.g. in health, education) foreign involvement. As outlined in Box 6.1, this means are tagged in the Government's accounting system that it is difficult to assess who decides on the budget to allow analysis. Such an approach may also be and therefore the extent of buy-in for the budget. useful in the counter-narcotics strategy. In some cases, targeted expenditure programs can be This section outlines two key directions to enhance created for these cross-cutting issues, but their size political buy-in: participation and transparency in Box 6.1:Who Decides on the Budget? The budget is one of the most important political tools, the one that provides financial means to implement policies. In Afghanistan the rules are straightforward; the Cabinet collectively prepares the budget, the Parliament approves it, the Government implements it, and the Parliament has final oversight with respect to the audited financial statements. The management of this political tool has been complex, however. First, in the absence of an elected Parliament, the budget has been approved by the Cabinet with the President signing Budget Decrees. There was limited external demand to release financial statements and audit findings. Second, during the transitional administration, budgets were based on imperfect information and thus reflected the outcome of a game among key political actors rather than a consistent strategic framework. Much progress has been made on this front, but political constraints have remained significant. Third, the President, both by his authority to sign decrees with financial implications (including decrees to increase establishment lists) and by his authority over large contingencies, retained significant power to reallocate budgets during the year. While contingencies have been significantly reduced in 2005, a more cohesive approach to budget management will require strengthening of the Cabinet Secretariat. Fourth, MoF is the counterpart for a number of donors, including the ARTF, in terms of resource allocation. In the absence of a strong Cabinet Secretariat and a comprehensive budget, projects have been proposed for financing without going through the due process of budget formulation. Fifth, both line ministries (by allotting funds to provincial departments) and MoF (by allocating cash to provinces) can influence the distribution of spending between Kabul and the provinces, with little external oversight. Finally, the international community retains considerable influence over the budget, mainly by directly financing ring-fenced projects but also through involvement in policy dialogue. 78 Afghanistan: Managing Public Finances for Development budget preparation. Implementation of the PFEM The election of Parliament in September 2005 also Law is a priority in this regard. provides a basis for more participation and transparency in decision-making. Although there Participation starts within the Government. At the are risks of the Parliament becoming fragmented technical level, ownership ­ as well as the quality of and paralyzed, the Parliament can also emerge as the budget, as argued in Chapter 8 ­ will be greatly a major element of peace-building, notably enhanced when provincial departments have a through its role in representation and reconcilia- substantive input into the national budget. This should tion. From the PFM perspective, the two major in particular correct the gross imbalances in resource roles of Parliament are to provide democratic allocation between Kabul and the provinces in sectors participation in the budget process (through its like education. At the political level, buy-in ­ as well budget approval function) and oversight of budget as strategic content, see the previous section ­ will be execution (by reviewing the Government's annual stronger if the Cabinet is engaged early in the budget financial statements and external audit reports). In formulation process through the establishment of a both cases, Parliament can generate demand for clear fiscal strategy and sector envelopes (preparation the Government's accountability ­ provided that its and approval of the ANDS also contributes to this internal rules allow for constructive politics and its objective).13 In many countries the budget process capacity (notably that of the dedicated Committees starts with a "strategy period", which gives the oppor- for Fiscal Affairs and Public Accounts) is built up. tunity for collective political buy-in on high-level The role of donors, including their role in owner- decisions such as the multi-year fiscal framework and ship and political buy-in, is the subject of the next sector ceilings for the budget. Progress in these areas section. will also require modernization of the processes and rules of the Cabinet (including strengthening of the D. Role of Donors in Improving the Cabinet Secretariat). Budget Process Participation of the Afghan people also should be As emphasized in several chapters, the interna- increased (directly and indirectly through media or tional community plays a significant role in PFM. civil society organizations). This is mainly relevant This is a major opportunity for Afghanistan, as at the policy-making stage (preparation of the donors bring significant financial resources as ANDS), while budget preparation itself can be well as technical advice based on worldwide expe- viewed as a more technical exercise requiring rience. But history suggests that this opportunity decisions under a tight deadline. Even without could be short-lived, as many post-conflict formal public participation, greater transparency in countries experience at best only a few years before the Government's budget preparation process (e.g. levels of assistance go down to more normal levels through improvements in publicly available budget (World Bank, 2003a). documentation, with translation into Dari and Pashtu) can help strengthen ownership. Chapter 8 With respect to PFM performance, the involvement of explores various mechanisms to give citizens a donors does give rise to challenges (Box 1.3). First, at voice in service delivery. the policy level, donors influence the agenda and 13 The disconnect between development programs and ministerial portfolios ­ partially addressed by the December 2004 Cabinet reshuffling ­ also contributes to fragmentation, lowers programs' coherence, and lessens political buy-in. Making the National Budget the Central Instrument of Policy and Reform 79 directions in a way that, when uncoordinated, flowing through the Government's accounts, reduces Government ownership and policy consis- donors should coordinate their interventions tency (e.g. in education, see Box 7.1). Even high-level through the Consultative Group process and report prioritization across broad pillars can be altered by financial data to the Government. Second, the donor funding (Figure 5.1), and the same is true of introduction of the Core Budget concept in 2004 prioritization across sectors and programs. Second, has formalized a Consolidated Fund under when the strategy is translated into budgets, donors Government control. In most cases, the can undermine budget choices by funding projects Government can decide on the allocation of that are not high priorities for the Government or that resources in the Core Budget (e.g. for IDA alloca- the Government cannot afford to operate and tions, the Government develops the work program maintain. Third, the sheer magnitude of external in consultation with the World Bank), funds flow assistance creates fiscal risks, since aid flows tend to through the Government's accounts, and be unpredictable over the medium term. As discussed accounting and reporting follow national proce- in Chapter 3, this is especially problematic in the dures. Often external audit is done independently, security sector. By negotiating projects directly with but this could be reformed since Afghanistan's line ministries, donors may also undermine the hard Auditor General already audits the whole of budget constraints that MoF seeks to enforce Government accounts, which include these funds. (including with respect to decisions on affordability of Similarly, donors often require the use of their own O&M). Finally, reflecting their own fiduciary interests, procurement guidelines, but this could change donors often promote fragmented, ring-fenced once the new, modern Procurement Law is projects that bypass Government systems and use implemented (Chapter 7). donors' own fiduciary processes, with lack of harmo- nization across donors (see PFM indicator D2). All of The ultimate step is direct budget support, for these issues arise not by design but because donors' example through IDA and ADB programmatic budget presence itself alters the incentives of various actors ­ support operations. In this case, procurement and to fragment projects, attract funding that bypasses external audit also follow national processes. These fiscal discipline, etc. operations provide some multi-year predictability, even though contingent on progress against a reform Should the Government go so far as refusing aid? program. ARTF provides a framework for such In extreme cases, this might well be appropriate. support and represents very good practice in For instance, donor-driven investments in public providing predictable funding for Government hospitals are sometimes referred to as "Trojan recurrent expenditures with fiduciary standards horses" because of their large operating costs providing confidence to donors (see Box 6.2). which crowd resources out of priority areas such as the basic package of health services. In most cases, These various positive factors, together with donors' however, the recommendation is not to refuse aid commitment to move toward aid harmonization as but to progressively integrate donor assistance in exemplified in the Paris agenda (see www.aidhar- the budget. monization.org), suggest a way forward. It is hoped that the ANDS will open up the possibility for multi- As suggested by Table 6.2, there are various donor support, as in many other countries that degrees of integration with national systems. First, have prepared Poverty Reduction Strategy Papers in 2002 the Government established the concept (PRSPs). The annual budget will be the vehicle to of an "External Budget": even if resources are not implement the ANDS and could be complemented 80 Afghanistan: Managing Public Finances for Development by an annual plan of policy actions. Such a comprise a "platform" from which the next set of package of prioritized short-run actions could thus actions would take off, with monitoring and feed- Table 6.2:Using National Budget Systems Areas Budget Formulation Budget Execution Amount a/ Multi-Year Allocation Procurement Banking Accounting/ Auditing Reporting Own Revenues 333 ARTF recurrent window 280 b/ c/ d/ Programmatic budget support 256 e/ " ARTF investment window 360 f/ c/ g/ d/ IDA project grants and loans 129 f/ c/ g/ d/ Other grants and loans to 446 h/ g/ d/ core budget External budget 1,629 h/ i/ Off-budget unknown Each indicates when the Government's system is used for: multi-year (predictability in the Government's MTFF), allocation (full discretion on alloca- tion of resources), procurement (national rules), banking (Government's bank accounts and payment processes), accounting and reporting (national accounting standards and reporting processes), and auditing (for external audit). Notes: a/ $ million (2005/06 Budget); b/ can be multi-year (e.g. DFID three-year commitment); c/ Government can only decide the allocation within the operating budget (ARTF recurrent window) or the development budget (ARTF investment window and IDA grants); d/Government's systems could be used since the Auditor General audits all Government accounts, which include ARTF and IDA; e/ multi-year predictability is subject to meeting policy benchmarks; f/ once funds are committed,, they are available for disbursements over the project's life; g/ donor procurement rules are used, but a Government agency (ARDS) processes contracts; h/ depends on donors; i/ most donors provide some reporting to the Government, but with quality issues (see main text). Box 6.2:The Critical Role of theAfghanistan ReconstructionTrust Fund The Afghanistan Reconstruction Trust Fund (ARTF) was set up in the spring of 2002 to provide coordinated external financial support to the Government budget. Up to the end of 2004/05, it has received contributions worth $847 million from 24 donors, disbursed $610 million, and committed an additional $98 million. The World Bank is the administrator of the ARTF, while the World Bank and three other multilateral institutions (ADB, IsDB, and UNDP) are members of the ARTF Management Committee. The main outcome achieved is that the ARTF has financed Afghanistan's civilian recurrent budget ($508 million, mainly focused on education and a few other civilian sectors, as police and military expenditures are not eligible), while a dozen investment projects are under implementation. In 2005, an external evaluation stressed the importance of the ARTF, in particular its recurrent cost window, in strengthening the Government's financial management systems. ARTF provides stability and predictability to Afghanistan's public finances and strengthens MoF and the budget process. Through the use of a Monitoring Agent ­ an external firm which reviews recurrent expenditures prior to reimbursement by the ARTF ­ it is also strengthening fiduciary standards and provides what is in effect an internal audit function to MoF. The evaluation also made recommendations to further strengthen the ARTF, notably the need to place ARTF support in a medium-term framework and to address the issue of capacity in public finance management. DFID's recent three-year commitment is a major step in the direction of multi-year predictability. Based on external evaluation of ARTF, March 2005. Making the National Budget the Central Instrument of Policy and Reform 81 back to guide the process at each stage. Moreover concepts such as expenditures, disbursements, and the package, rather than any single measure or commitments). mechanical target, would be what the Government takes responsibility for and could form the basis for The Government for its part cannot decree donor dialogue and agreements with the international harmonization, but progress in PFM performance will community. certainly contribute to substantial progress on this aspect. In particular, the Government's continuing Donors could also commit to: (i) increase the commitment to maintaining adequate fiduciary predictability of their financing (i.e. provide clear standards and taking actions to further improve indications of their commitments early in the budget fiduciary achievements, and demonstrated perform- process and, to the extent possible, multi-year ance in this regard, will be critical, as will be strong commitments); (ii) condition their project assistance performance in domestic revenue mobilization on the inclusion of the projects concerned in the (Chapter 4). Progress in budgeting, notably the recent national budget; and (iii) provide timely and harmo- adoption of an MTFF and strengthening of the MTFF nized reports to the Government (including an over time, will also help deepen the partnership with agreement on simple, harmonized definitions for the international community. 7 ENHANCINGTHE EFFECTIVENESS OF BUDGET EXECUTION If institutions and processes lead to a well- developed, and cash management has been conceived budget (Chapter 6), the quality of greatly facilitated by the ARTF (Box 6.2). Finally, expenditures depends on four conditions. Are despite remaining challenges the Central Bank, service delivery units receiving budgeted funds on which acts as the Government's banker, has made time? Are there adequate processes and controls great progress since 2002 in ensuring timely with respect to the use of these resources? Are payments throughout the country (see Box 8.3 and, procurement methods generating value for money? for the example of teachers' salaries, Box 7.1). And is the Government accountable for its management of public finances? This chapter dis- Much work remains to be done by MoF to ensure cusses these four conditions (PFM indicators 13- that service delivery units receive the cash and 28), and also looks at the very important issue of information necessary to perform their operations. corruption in this context. A first issue is that of quarterly allotments. Because their management is unclear and not tied to cash A.Getting Funds to Service Delivery availability, service delivery units sometimes receive Units conflicting information, and MoF may turn down their requests because of misunderstanding or lack To deliver services, units must receive the necessary of cash. A second issue is cash management, which funding in a predictable and timely way. Despite needs to be further strengthened to optimize much progress, there is evidence that this is not yet the use of resources and avoid unnecessarily the case. Substantial achievements have been constraining expenditures by service delivery units. made in reforming the payments system. However, In the medium term, these two instruments further improvements are needed at two main (allotments and cash planning) will have to be levels, MoF and line ministries. Indeed, timely flow complemented by recording and controlling of funds to ministries is mainly MoF's responsibility expenditures at the commitment stage, before it is in terms of managing cash assets and reviewing too late in terms of incurring a liability. budget implementation. But line ministries need to allocate these funds to their departments, including An effective mechanism to make progress on this in the provinces and districts. front would be to develop financial reporting. Such information is useful for all managers in the The development of mid-year reviews and basic Government. The Cabinet and the President should fiscal reporting (to line ministries and the Cabinet) get information to hold ministers accountable. The has been an early success (in part due to invest- Afghan public and Parliament should also get such ments in a computerized system, see Box 7.2). In data. Routinely, basic data on spending should be addition, some cash flow projections have been prepared from the Government accounting system. 86 Afghanistan: Managing Public Finances for Development Box 7.1:Tracking Public Expenditures in Education A small Public Expenditure Tracking Survey (PETS) was conducted in the education sector as part of the PFM Review. The study involved interviews with 217 teachers and 109 head teachers across 109 schools randomly chosen from 36 districts in nine provinces. The findings were as follows. First, schools as well as district and provincial education departments have little record of expenditures, which made analysis difficult. There are inconsistencies of records on financial allotments, notably for non-salary expenditures, because of miscommunication between Kabul and provinces and between the Ministries of Finance and Education. When available, records on expenditures were found to be largely consistent, however. Second, staffing controls through financial allotments were found to be effective. Three quarters of the teachers receive their salary every month, even though a third of them complain about delays. One third of them indicated that they had to pay a modest commission, usually to a bonded trustee, for the receipt of their salary every month (on average equivalent to about $1), a practice that was considered "normal" as a fee for travel expenditures. Third, it was confirmed that schools spent hardly anything on non-salary expenditures (books, maintenance, etc.). Kabul allots only 15% to non-salary expenditures; only 65% of this goes to provinces; provinces allot little if anything to lower levels; and Mustoufiats regularly reject requests from schools because of cash constraints. In fact, hardly half of schools made a request for non-salary allotments in the last quarter of 2004/05, and half of the requests were rejected. In sum, schools incur almost zero non-salary expenditures, and they mainly get books, desks, chairs, etc. in kind, usually from non-governmental organizations (although sometimes from the Ministry of Education itself). Given the uneven presence of these organizations around the country, significant disparities were found across schools. Fourth, schools and even district and provincial departments do not provide much input into budget formulation. in particular for the non-salary budget. However, they are often visited by the district or provincial department, sometimes even by the Ministry, to review performance or financial records. Finally, most schools report having a Parent-Teacher Association and a School Management Committee, usually to organize activities, sometimes to supervise teachers. Almost no school or teacher reported any payment from parents. Source: World Bank Education Expenditure Tracking Survey. In addition, the use of public expenditure tracking these resources, as their share of estimated actual surveys should be explored to focus on specific non-salary expenditures is higher than their share issues. The small-scale tracking survey on educa- of allotments. In addition, local units have little tion conducted as part of the PFM Review highlights influence over allotments, receive conflicting the wealth of analysis available from this instrument information on them, and are subject to unex- (Box 7.1). Another need is for gender disaggre- pected changes in allotments. Local departments, gated data to facilitate proper monitoring of social since they have more local information and are inclusiveness. themselves accountable to deliver services, should be given a role in the budget formulation process The role of the central line ministries also is (Chapter 6) and receive clearer information on problematic. Less than 20% of the non-salary budget allocations. In turn, central ministries allocation is given to provinces, whereas more should be held accountable for the constraints they than 50% of the salary allocation (and staff) are in impose on service delivery units, for instance provinces (Figure 7.1; see also Box 8.2). This through frequent monitoring by MoF and the situation is all the more problematic in that Cabinet on allocations made to provinces and the provinces tend to have better capacity to absorb frequency of changes in these allocations. Enhancing the Effectiveness of Budget Execution 87 Figure 7.1:Share of BudgetAllocated to Provinces (% ofTotal Expenditures) Source: MoF (AFMIS) and staff estimates. B. Controlling the Use of Public Funds notably with the implementation of a computerized A solid control framework should ensure that system in MoF (Box 7.2). Progress has also been Government organizations are working within their made on payroll control; a review by ARTF's legal and policy responsibilities and are achieving Monitoring Agent suggests that there is almost no the results set for them. This implies that basic problem of "ghost workers" in several central fiduciary standards must be observed, i.e. funds are ministries. Another significant improvement is the spent only when there is an approved budget, a introduction of a Treasury Single Account system secure process is followed to authorize expendi- (Chapter 4). Although still to be completed, this has tures, and the process is documented. At a more already made cash management easier, bank advanced level, this process will be simplified to account reconciliation simpler, and control of shift its focus toward performance, while the revenue collection more robust. systems themselves will be controlled continuously through audit. Treasury functions range from the However, as demonstrated by the PFM perform- commitment of expenditures to recording, ance indicators, much remains to be done to payment, and accounting. Internal audit provides a improve payroll controls, record-keeping, feedback loop that can foster improvements in accounting standards, frequency of reconciliation, expenditure management. The overall system and the usefulness of reporting for line ministries' needs to be complemented by effective enforce- management. Overall, the way forward requires ment mechanisms (Section D). improving business processes to reduce discretion, limiting the number of opportunities for corruption, Treasury Functions and developing the practice of reconciling accounts. Computerization is a possible tool to Basic fiduciary standards for civilian recurrent further pursue these objectives (Box 7.2). In expenditures have reached decent levels (Figure addition, individual and institutional capacity needs 7.2). Simple budget controls, accounting, to be developed to devolve responsibilities to the recording, and reporting have much improved, appropriate level (Chapter 9). 88 Afghanistan: Managing Public Finances for Development Figure 7.2:Share of Expenditures Reimbursed byARTF Source: The ratio is the amount approved for reimbursement by ARTF divided by the amount submitted by the Government, measured on a quarterly basis. The ratio of eligible expenditures over monitored (instead of submitted) expenditures is lower, notably because the Monitoring Agent uses a risk-based approach to monitoring. However, for accounting reasons, this ratio is difficult to track on a quarterly basis. Source: Monitoring Agent and ARTF Quarterly Reports. The Public Finance and Expenditure Management Government employees. More than 24,000 staff in (PFEM) Law, gazetted in June 2005, provides the legal 17 agencies in Kabul are paid directly (as opposed to basis for further progress. The new law empowers the the bonded trustee system), and 400 of them receive Government, through MoF, to regulate and control the their salaries directly in their bank account; 6,000- financing and expenditures of the State. All State plus employees in Kabul have received an individual revenue and expenditure, other than Special Funds, identification card; and 10 central ministries are using flow through a general budget fund, under the a payroll database to prepare the payroll. The Treasury, while uses are authorized by agencies from roll-out of these three components ­ automated the funds appropriated under the annual budget. MoF payroll, individual identification system, and transfer has responsibility for comprehensive reporting on to bank accounts ­ will move payroll management a budget execution, ex-post oversight through its internal long way becoming an effective, secure process. auditors (see below), and application of financial management laws and regulations. MoF intends to For non-salary expenditures, the most critical implement a fairly centralized system (although without improvements are related to procurement (see next the financial controllers that MoF traditionally posts in section). Other controls are well established in the line ministries in francophone systems). This is appro- central MoF with the computerized system but need priate in the short to medium term, given generally low to be rolled-out to provinces and line ministries, capacity and the need to ensure adequate controls, complemented by systematic commitment controls and does not preclude gradually decentralizing some in the medium-term. responsibilities closer to line management in the future, when capacity and systems will have been developed. A final control issue is related to asset manage- ment, including the assets generated through MoF is implementing a "Verified Payroll Plan" to donor-funded projects. The development of a ensure timely and accurate salary payments to simple asset registry is a priority for the Enhancing the Effectiveness of Budget Execution 89 Government if it wants to retain these assets and be departments, the Control and Audit Office, the able to account for them. Other asset management Attorney General's Office, and sometimes the issues, related to SOEs and underground Governor or the National Security Office. resources, are discussed in Chapter 3. Unfortunately, all of these activities review transac- tions only to assess compliance with rules and detect InternalAudit Functions errors, irrespective of their cause or impact on performance. The only effective feedback loop has Reports from central ministries and from provinces been an extraordinary arrangement whereby the suggest significant audit activities, by internal audit ARTF Monitoring Agent, after reviewing expenditures Box 7.2:Can E-Government Play a Role inAfghanistan? In 2001, Afghanistan had very limited telephone land lines and computer skills. However, the Government had a great need to communicate effectively with district and provincial offices and to promptly deliver services. Although e-Government seemed promising ­ to deliver services quickly, reach remote districts, and transparently publish information ­ it seemed impossible due to lack of skills and infrastructure. Four examples demonstrate that this pessimism was unwarranted. The success of cell phones demonstrates the ability of modern technology to be quickly implemented and that demand for it is large; the mobile footprint now covers 50-60% of Afghanistan's population, and mobile prices have declined by 70% during the last year and a half. In addition, a Government Communication Network has been set up in nine provinces and is expected to be expanded. A simple computerized general ledger was installed in record time in 2002. Initially set up to print checks, the system now records all expenditures and revenues as well as budgets. It has allowed breakthroughs in reporting and transparency. Basic financial controls (e.g. checking the availability of a budget) are now much easier. Annual financial statements were produced in the second year of the transitional administration whereas none had been produced in previous decades. Requests for reimbursements to ARTF were streamlined with this system, facilitating cash management. The system is now operational in the central MoF, two central ministries, and a pilot Mustoufiat. The Government has created a website (www.af) where a number of important documents are posted. In particular, all budget decrees and fiscal reports are available publicly. This website can also be used for communication campaigns, notably a tax information page (http://www.mof.gov.af/tax/index.htm). The ongoing implementation of the Automated System for Customs Data (ASYCUDA) will increase transparency (easy reporting, international classification, performance monitoring) and control (including through a reduction in interface between customs officers and traders), while facilitating trade (more standardized, predictable, transparent procedures). Transit is considered a priority: all goods entering into Afghanistan will be reported to the system and automatically discharged when they reach their destination. The first application is expected to be operational shortly; it will cover the transit corridor between the Torkham border point with Pakistan and Kabul and will be extended to the border with Uzbekistan. Some lessons emerge from experience in Afghanistan, as well as that of other countries. First, e-Government is not a panacea and needs to be well conceived. The "Systems Study" that has been initiated by MoF is welcome since it will define a master plan for financial management systems. Second, e-Government works when it is combined with improvements in business processes that seek to put the client (citizens, businesses, other parts of the Government) at the center. Third, e-Government requires strong leadership at the higher levels, as implementation is a long-term effort which disrupts habits, and widespread training at lower levels is needed. Fourth, some implementation issues ­ such as translation of English-based software or insufficient bandwidth for communication ­ have already emerged from early experience in Afghanistan and should be factored into any future proposal. 90 Afghanistan: Managing Public Finances for Development to assess eligibility for reimbursement, transmits C. Procuring Goods and Services performance reports to MoF, which has tabled them at Cabinet meetings and has included a provision in In 2004/05, the Government spent more than $500 the Budget Decrees to reduce budgets of agencies million on goods and services as part of the Core not performing against these eligibility criteria (Box Budget (of which $100 million was for capital invest- 6.2). Improvements shown in Figure 7.2 are a ments). Given the size of these expenditures, a 10% testimony to the impact of this innovative practice. increase in efficiency and value for money generated by procurement reforms would be equivalent to a 20% Sustainable arrangements for internal audit need to increase in domestic revenues. In addition to pro- be developed, however. The PFEM Law calls for a moting efficiency gains, a good public procurement centralized system, in which MoF's internal audit system should also adhere to key principles of non- department has authority to audit all Government discrimination, equal treatment, and transparency. operations. MoF has developed a plan to implement Although the rules in Afghanistan until recently fell this rule and expects to focus on compliance audit. short of these objectives, actual performance has been This seems appropriate in the short run given lack more encouraging thanks to temporary external of capacity. MoF's internal audit department will, support and ongoing legal reforms. Nevertheless, however, need to strike a balance by promoting there are numerous issues and difficulties, as illus- improvements in financial management practices trated by the experience with highways (Box 7.3). without paralyzing the system through excessive intru- sion in line ministries' management. Over the longer The existing regulatory framework has some essen- term, line ministries themselves would be expected to tial positive features, for instance basic financial play a more active role in internal audit, with MoF controls and an emphasis on competitive bidding, shifting to systems and performance reviews. but it is outdated. There has been excessive focus Box 7.3:Procurement for Highways A review of major road projects implemented in Afghanistan over the last three years reveals some key issues and constraints to obtaining value for money with adequate accountability and transparency. Major variances of unit costs, from $123,000 to $589,000 per km of road, were found. First, all projects incurred higher than expected security costs (3-15% of total project costs). While there were also other exogenous factors such as weather conditions, security remains a major constraint on project implementation and value for money (with further implications for delays, safety of personnel, etc.). Second, the price, availability, and quality of supply, often imported, raised unit costs. For example, unit costs for asphalt pavements were estimated to be 30-45% higher than in neighboring countries. Third, lack of participation by the Afghan private sector in bidding processes has somewhat reduced competition and increased costs. Constraints include lack of experience in managing large-scale projects and in following donors' financial management and procurement processes; lack of up-front capital (or financing) to mobilize equipment; and difficulties in mobilizing construction labor. Fourth, many of the projects were contracted with limited competition. Other factors also contribute to higher unit costs. For example, it was noted that implementation delays occurred because of red-tape on the Government's side, for instance to clear the importation of equipment. Source: World Bank (2005b, Volume IV, Chapter 5). Enhancing the Effectiveness of Budget Execution 91 on prices ­ at the expense of quality ­ and an with a total value of almost $400 million, mainly for absence of complaints and review mechanisms. projects financed by ARTF and IDA, but increasingly Similarly, the practice of public procurement has for projects financed by the Government itself. positive features ­ such as some familiarity with Performance under this arrangement has been modern basic processes, but also significant short- reasonably good, using competitive methods, with comings ­ such as absence of implementation adequate timing (to prepare and evaluate bids) and regulations and monitoring mechanisms. The line transparency (advertisement of bids and publication ministries lack capacity to define and communicate of awards). However, the overall performance of this effectively their desired technical specifications. mechanism is constrained by the limited capacity of In addition, the approval process seems unneces- line ministries to prepare all the necessary documents sarily cumbersome. These elements are of critical (see above), as well as sometimes delays in obtaining importance in contributing to delays in budget required approvals. Private sector participation has implementation (Figure 3.1). been limited ­ with typically less than five bids per offer. Similar extraordinary external support is also An additional deficiency relates to the Afghan available in a number of line ministries that have set private sector. Even though the review found a up Program Management Units (PMUs). The short- large number of contractors and suppliers, some- term benefits and potential longer-term shortcomings times offering up to 50 bids for small contracts, of these practices are discussed in Chapter 9. their participation is limited for several reasons that should be addressed (Table 7.1). Afghan women In addition to building capacity, further progress entrepreneurs face particular constraints that need requires improvements in the regulatory framework. to be alleviated (see World Bank, 2005c). The new Procurement Law that was recently approved by the Cabinet will establish a solid legal framework. Turning to external support, an international firm, the The accompanying regulations, including hand- Procurement Agent reporting to the Ministry of books, operational procedures, standard contracts, Economy, has processed more than 200 contracts etc., will be critical for operationalizing this Table 7.1:Constraints on Local Private Sector Participation in Public Procurement Constraint Possible Way Forward Mistrust in the way the public Simplify and disseminate rules (awareness campaign), increase transparency sector operates Cost of doing business with Simplify procurement rules and develop standard contracts; promote e-pro- Government (e.g. procurement curement; develop direct payments to vendor (ongoing in the Treasury); focus and payment delays) on simplification of procedures for small enterprises No quality standards Develop standards Poor capacity to prepare bids Prepare model contracts and detailed handbooks; train private sector Lack of financial capacity Create leasing businesses (e.g. through reforming tax rules); develop finan- cial sector (requires legal reforms) Lack of skilled labor Develop crash courses on selected topics; build up capacity of tertiary / vocational education system Preference given to SOEs Discontinue these preferences 92 Afghanistan: Managing Public Finances for Development framework. Progress is contingent on expanding audited annual financial statements by Parliament, Government ownership. The lack of a clear cham- this has not been possible so far without a pion in the Government, probably reflecting low Parliament. The President and Cabinet have had capacity and misunderstanding of the scope of the legislative powers, but with obvious limitations in procurement function (e.g. a belief that only major terms of separation of duties. Civil society ­ weak works or purchases are "procurement"), has been media, challenged NGOs, frequently unorganized detrimental to reforms. Creation of a Procurement communities ­ has been unable to perform its role Policy Unit in MoF would represent an important step either, in part due to lack of capacity to analyze PFM forward. This unit will be able to take the lead in issues. Donors have been active in promoting preparing detailed regulations, overseeing training, external scrutiny, but their unwillingness to use and monitoring procurement performance. Government systems for most aid has undermined the Government's efforts to improve PFM perform- D. Holding GovernmentAccountable ance. On the other hand, the ARTF has played an for the Use of Public Funds important role in enhancing external scrutiny of budgetary spending financed by ARTF (Box 6.2). External Scrutiny of the Budget FightingAgainst Corruption Development of the external audit function has been a key component of the Government's efforts There are widespread allegations of corruption, to enhance transparency. The PFEM Law mandates sometimes referring to unintended misuse of funds audit of annual financial statements by an (for example by error or lack of capacity to follow independent auditor. The Control and Audit Office the rules) or to traditional practices (for instance (CAO), which reports directly to the President, is payment of a commission to a bonded trustee who performing this function. With the support of an arranges salary payments, Box 7.1), sometimes international firm, it has made progress in referring to outright corruption. Box 7.4 reviews preparing audits, first for ARTF and then for the vulnerabilities to corruption. This issue is part of the Government's accounts. It has also audited a broader challenge of governance. As highlighted by number of departments and has reported its an international comparison largely based on polls findings to the Cabinet twice a year. and surveys (and hence subject to significant margins of uncertainty), Afghanistan ranks among Much remains to be done, however, to create the countries for which governance problems are the demand for control and accountability. The CAO's most severe (Figure 7.3). While significant progress capacity is weak and its focus is limited to basic has been made in some areas (voice, accountability, financial audits of annual accounts. Moreover, while and Government effectiveness), Afghanistan remains MoF has been preparing follow-up matrixes, there is among the bottom one-eighth of all countries in little evidence of actual follow-up on audit findings, terms of all six dimensions of governance measured, and reviews of departments are never followed up. and is among the worst-off in terms of rule of law, Part of the explanation probably is that audit reports regulatory quality, and control of corruption. are not publicly disseminated. This also relates to the absence, until recently, of a Parliament to hold Corruption is widely considered to be a symptom of the Executive accountable for addressing audit poor governance. This suggests that treating the findings. While the PFEM Law (and Constitution) symptom (corruption) directly most likely will be less mandate approval of the Budget and review of effective than addressing the underlying problems Enhancing the Effectiveness of Budget Execution 93 Figure 7.3:Six Dimensions of Governance Note: The three bars represent, for each dimension of governance, Afghanistan's percentile rank (0-100) for 2004, 2002, and 1996 (top-bottom order). The line represents the standard deviation of this measure (in other words the margin of uncertainty). Source: Kaufmann, Kray, and Mastruzzi (2005). that create or exacerbate vulnerabilities to corrup- Second, sound anti-corruption strategies need to tion, including problems in the PFM system. cover five pillars:15 (i) institutional restraints on International experience bears this out, although power (independent and effective judicial system experience also demonstrates the importance of and prosecution and enforcement, legislative setting a strong example at the top in terms of oversight); (ii) political accountability (political taking action against high-level corruption on the competition, credible political parties, transparency part of government leaders. in party financing, asset declaration, conflict of interest rules); (iii) civil society participation Tackling these issues requires a holistic approach, (freedom of information, public hearings on draft based on further analytical work and possibly laws, active role of media and NGOs); (iv) leading to adoption of an anti-corruption strategy competitive private sector (economic policy reform, by the Government. International experience offers competitive restructuring of monopolies, regulatory a number of lessons for the design of such a simplification for entry, transparency in corporate strategy. First, anti-corruption strategies work better governance, collective business associations); and through prevention than through investigation and (v) public sector management (meritocratic civil prosecution. service with monetized, adequate pay; budget 15 See the World Bank's website on anti-corruption strategy, http://www.worldbank.org/publicsector/anticorrupt/strategies.htm. 94 Afghanistan: Managing Public Finances for Development Box 7.4:Vulnerabilities to Corruption While specific evidence of corruption is difficult to find, concerns in a number of areas point to important vulnerabilities to corruption in Afghanistan. For example, significant "unofficial payments" reportedly are paid by Afghan firms (World Bank, 2006). Corruption is also one of the main concerns of many Afghans (HRRAC, 2004). First, there are widespread allegations of abuse of power, bribing, and other forms of corruption in the justice and police system (HRRAC, 2004). Land management is an important area of vulnerability to corruption. The recent Parliamentary elections also have generated rumors of corruption. Second, by all indications there is massive corruption associated with the drug industry, with many Government officials directly or indirectly benefiting from narcotics revenues. Other criminal activities also are likely to be associated with (lower levels of) corruption. Third, the State has traditionally been built on a patronage system. While recent civil service reforms are trying to reduce this factor (Chapter 9), the vulnerability to this form of abuse of power (power of hiring) remains. Fourth, vulnerability in the area of revenue collection has been reduced by a number of administrative reforms (Chapter 4). Nevertheless, the existence of numerous small "nuisance" taxes with obscure rules and the continuing collection of revenues by actors other than the MoF create a climate of uncertainty that is conducive to corruption. The lack of a clear privatization process could generate additional vulnerability to corruption if privatization occurs without this lacuna being corrected (Chapter 3). Fifth, concerns with regard to the misuse of public funds have been much less widespread. However, anecdotal evidence ­ such as striking differences in procurement delays in the power sector (unusually speedy process for one contract; unnecessarily protracted process for another) ­ suggests that vulnerabilities are real. Vulnerabilities seem more pronounced at the local level (notably in municipalities, but also in provinces and districts). In addition, even with strong PFM processes, PFM institutions could still be captured by private interests. Finally, these vulnerabilities are not yet well offset by opportunities for civil society to hold public officials accountable. While in the PFM area the Government has been transparent in reporting on budgets and expenditures, the capacity of the media and the people to hold Government accountable remains to be developed. management ­ coverage, treasury, procurement, sight. This report includes recommendations to audit; tax and customs; sectoral service delivery ­ simplify taxation rules and strengthen revenue e.g. health, education, energy; decentralization administration (Chapter 4); improve the coverage with accountability). While this report focuses on of the budget (Chapter 6); develop internal the last pillar, the other four pillars include a controls, procurement, reporting, audit, and number of areas where progress is needed. external scrutiny (this chapter); explore innovative Examples related to PFM include a strengthened accountability mechanisms (Chapter 8); and judicial system, rigorous processes of legislative strengthen the management of SOEs and munici- oversight, transparency to enhance civil society palities (Chapters 3 and 8). participation, simplification of regulations, and a merit-based civil service. Finally, while these recommendations should con- stitute the core of the anti-corruption strategy, an Third, improvements in PFM practices will help very additional question is whether an Anti-Corruption much in reducing vulnerabilities to corruption, by Commission would play a useful role, such as the limiting transactions that provide opportunities for Commission created in Afghanistan by the 2004 graft, reducing likely benefits from corruption, and Anti-Corruption Law, which reports to the President. enhancing information, transparency, and over- While there are some examples in other countries Enhancing the Effectiveness of Budget Execution 95 of such approaches having a positive impact, many ities to corruption ­ are a further increase in trans- experiences have been less positive, with some- parency (transparent allotments to service delivery times the commission losing all credibility in its fight units, release of annual financial statements and against corruption. A first issue in Afghanistan is external audit opinions, publication of bid that the 2004 Law does not distinguish between requests and contract awards); strengthening of corrupt practices and mistakes or negligence. A the audit function (both internal and external); second issue is the lack of capacity to prosecute and drafting of procurement regulations. The and try corruption cases. Additional issues include recent approval of the PFEM Law and the risks of politicization, predation, diversion of Procurement Law provides the legal foundation attention and resources from other necessary for pursuing these priorities. On this basis, areas, and bureaucratic duplication. capacity of line ministries (and of the private sector to participate in public procurement) will In summary, enhancing the effectiveness of need to be enhanced (Chapter 9) and PFM budget execution should be at the center of the responsibilities gradually devolved to line min- governance and anti-corruption strategy. Among istries; the role of the Parliament as a promoter of the key priorities ­ both to increase the effective- accountability can be developed; and, over time, ness of public spending and to reduce vulnerabil- more ambitious PFM reforms can be introduced. 8 DELIVERING SERVICESTO THEAFGHAN PEOPLE The ultimate objective of the PFM system is to deliver (see World Bank, 2003b). There are three main services to the Afghan people. Service delivery can actors: the people (as citizens and consumers/ take various forms, ranging from direct delivery by clients of services), the state (as political body and Government-paid civil servants, to delivery by non- policymaker), and the service providers. The governmental organizations financed from private or interactions by which these three actors foreign contributions, to private provision funded by influence and are accountable to each other form user fees. While the main message of this chapter is an "accountability triangle" (Figure 8.1a), and there unequivocal ­ people should be put at the center of are correspondingly financial flows among them the service delivery framework ­ the institutional (Figure 8.1b). The people can affect service implications are more diverse. The chapter reviews delivery by influencing policy makers (e.g. by voting the institutional framework for public service delivery, or through the advocacy role of civil society), who building on examples of particular sectors and in turn exert influence on the service provider (this drawing lessons from experience. It also looks at is the so-called "long route" of accountability). The PFM issues related to subnational administration people can also directly influence service providers from a service delivery perspective. (the "short route" of accountability) by selecting the provider (when there is competition), using their A. Six Models of Public Service Delivery voice (e.g. complaints), or making financial contributions (when there is cost recovery). Another A simple conceptual framework illustrates different important set of actors is the donor community, models of service delivery and their implications which exerts influence through its dialogue with Figure 8.1: Service Delivery Framework Source: Adapted from World Bank (2003b). 100 Afghanistan: Managing Public Finances for Development policymakers, its financing, and its direct contracts education system, for example, is highly centralized. with service providers. All important decisions, and even relatively less important decisions like appointments of teachers, Centralized Government Service Delivery are made by MoE in Kabul, often a very long dis- tance and at least three management layers away The "traditional" service delivery model in from the schools and the students they serve. Afghanistan is that the State itself provides services Schools have very little access to non-salary budget through its centralized bureaucracy (Figure 8.2). allocations, and many inputs are provided in-kind Ninety-seven percent of Afghan students are by donors and NGOs (Box 7.1) ­ leading to disad- enrolled in public schools operated by civil servants vantages associated with the "outside government" under the management of the Ministry of Education mode of service delivery discussed later. The distri- (MoE). This model directly links the Government bution of expenditures, especially non-salary expen- with the population and thereby may enhance the ditures, between Kabul and the provinces is skewed former's perceived legitimacy; it facilitates propa- against the providers, and there are major gaps in gation of nationwide service content (e.g. service delivery between urban and rural areas curriculum); and it may be able to exploit (which when combined with gender and regional economies of scale. Certainly Afghanistan has seen disparities become enormous).16 The needs of each an unprecedented expansion of elementary educa- school are not effectively responded to by distant tion since 2001, based on the application of this decision-makers. The efficiency of the centralized centralized model (Figure 8.3). Both girls' and boys' system is reduced by management difficulties, in enrollments have reached levels far higher than at particular how to hold teachers and principals any time in Afghanistan's history, including prior to accountable for their work from a distance. Another the conflict. issue is the role of donors, who may provide financing to the State for education (through ARTF Figure 8.2: Service Delivery by Central or project financing), but also may provide salary Government (Education) top-ups, direct payments, and in-kind contributions directly to schools. The result of all of these short- comings is poor quality of education and serious geographical as well as gender disparities (see Figure 5.3), reducing the returns to the large invest- ments being made in education. This centralized model, or variants of it, also exists in other sectors, a legacy of Afghanistan's history. Whereas in education (and in the pre-war health system), as well as in the military and national The centralized service delivery model has major police, the service provider is an arm of the central weaknesses, however. Management of the primary ministry, in other cases the provider may be a State- 16 In the health sector, similarly large disparities can be seen in Government-provided services like doctors and hospitals. For example, there is one doctor per thousand population in Kabul, one per 100,000 in Bamiyan Province. Operating expendi- tures of the Ministry of Public Health (MoPH) per capita of population are more than four times as high in Kabul as the national average, and there is great variation across provinces as well (see World Bank, 2005b, Volume II, Chapter 1, Figure 1.11). Delivering Services to the Afghan People 101 Figure 8.3: Enrollment Growth (Grades 1-12) Owned Enterprise (SOE) closely supervised by a de-concentration and delegation to improve budget parent ministry (e.g. power, water supply, major irri- allocation decisions and bring management closer gation schemes). In the case of electricity, the to the provider. In this context, ensuring that non- national power utility, Da Afghanistan Breshna salary budget allocations reach and can be utilized Moasessa (DABM), is supervised by the Ministry of by the service providers (e.g. schools) is a priority. Energy and Water (MoEW) and has neither an Greater management autonomy for service facilities appropriate governance structure nor financial can yield good dividends based on international resources to improve the country's electricity experience, including through flexibility in managing services. The result is very limited access to power and utilizing the budgetary resources made (only an estimated 10% of the population has available to them. Third, information sharing and access to grid power supply) and poor quality of greater transparency (both from the State and from supply (unreliable service, frequent interruptions, the service providers) can enhance the voice of the and high technical losses). Afghan people, and a free and capable press and other watchdogs can enhance oversight and There are several ways to improve service delivery accountability. Donors providing financing need to while staying within this basic model. First and fore- respect the Government's systems and work through most, mechanisms need to be created whereby the them rather than providing resources directly to people can use their voice directly with the service providers outside the Government's ambit (which providers and monitor them. Good examples in the undermines the accountability relationship between education sector include Parent-Teacher service provider and State). Associations / School Management Committees. Community monitoring, for example through the Short of privatization (the fourth model, see elected Community Development Councils (CDCs), below), better financial management of SOEs, is a promising approach for certain along with higher cost recovery as appropriate, sectors. Second, within the State, options include can improve service delivery. In the power 102 Afghanistan: Managing Public Finances for Development sector, required reforms include corporatization straightforward and visible for donors as well as of DABM, computerization of billing and service recipients. Moreover, by bypassing accounts, enhanced cost recovery, capacity Government procedures (and often normal inter- building in MoEW, and prioritization of national competitive procurement procedures), investment projects. Private sector participation this model enables a rapid response to humani- in power generation also can be pursued on a tarian crises and other urgent problems. limited basis. However, this approach does not support longer- Outside Government term national capacity building and does not exploit the opportunity for aid to help build up the This second model is common in conflict and post- State's legitimacy but on the contrary undermines conflict countries, with a failed State. Donors it. From a policy point of view, it also defeats the directly finance and contract or manage non-gov- purpose of policy coordination discussed in ernment providers (NGOs, private providers, Chapter 6. Finally, it can lead to higher unit costs sometimes international agencies e.g. UN agen- (for example in the case of building schools) and cies) to deliver services, often of a humanitarian weaker cost controls. Thus this model is not nature, with little or no direct involvement on the desirable beyond short-term emergency and part of the Government (Figure 8.4). This model is humanitarian interventions. still being used for a number of activities in Afghanistan, but much less than in the 1990s The overall thrust of Afghanistan's development when it was the primary mode of international strategy during the past several years has been to assistance. A variant consists of setting up a move away from humanitarian interventions narrow Project Implementation Unit (PIU), with isolated from the Government and toward longer- weak or no linkages to the Government, term development activities under Government specifically to oversee a donor-financed project. leadership. The way forward need not be through And even in sectors where the basic model is dif- direct Government provision, however, but rather ferent (e.g. centralized government service delivery through the Government taking policy leadership in education, see above), there may be elements and control of the contracting and funding of direct donor involvement through direct provi- process vis-à-vis non-government service sion of various inputs, financial top-ups, etc. The providers, thereby making the latter accountable appeal of this model is its simplicity and that it is to the State and supportive of the Government's efforts to build up its credibility and legitimacy. Figure 8.4: Service Delivery Outside Government This is the third model of service delivery, (Humanitarian) discussed below. There is in any case a great need for strengthening monitoring of service providers by the people and their communities. For PIUs, the best approach ­ strongly advocated by the Government ­ is that they be fully integrated in the concerned line Ministry and provide services (e.g. procurement, financial management) to its entire development program rather than only to a specific donor-funded project or program (Chapter 9). Delivering Services to the Afghan People 103 Government Outsourcing to NGOs/Private applied in the health sector, for delivery of Sector the Basic Package of Health Services (BPHS) through Performance-based Partnership In the third model, the Government is in charge Agreements (PPAs) in eight provinces. of (and accountable for) policy, financing, and monitoring, but non-government service There can be significant efficiency gains from this providers (NGOs, non-profit entities, or private model as compared with centralized Government firms) are put in charge of delivery on a provision of services (the first model). A review of competitive contractual basis by the global experience found that, in selected examples, Government (Figure 8.5). This model is being unit costs for contractual provision of health services were 11-50% lower than for government Figure 8.5: Service Delivery by Outsourcing to provision (Loevinsohn and Harding, 2004). In NGOs (part of Health services) Afghanistan, the per-capita cost of the BPHS covered by PPAs averages around $3.80, which is fully in line with patterns of health expenditure in other low-income countries. A competitive process overseen by the Government thus contains unit costs within reasonable limits. By contrast, the same BPHS package provided under donor-executed projects in the External Budget has more widely varying and often substantially higher unit costs (Table 8.1). Thus while it is too early to come to Table 8.1: Contracted Costs for Delivering BPHS ($ per capita of population served)1 7 Donor/Program Unweighted Average Lowest Highest Ministry of Public Health Strengthening Mechanism 4.1 n/a n/a (World Bank-supported) Performance-based Partnership Agreements 3.8 3.3 5.2 (World Bank-supported) Rural Expansion of Afghanistan's Community-based 6.7 0.3 46.5 Healthcare (USAID) Support to Health Service Delivery in Afghanistan 4.2 2.2 5.3 (European Commission) Asian Development Bank 4.8 n/a n/a Source: MOPH; Strong et al (2005); staff estimates. 17 It should be noted that these figures represent contracted levels; actual unit costs may differ and in the case of PPAs appear to be lower than contractual levels. Also, cost figures are not strictly comparable across donors/programs; for example the costs for the USAID-REACH program do not include the cost of drugs and most training (which are included in the PPAs), whereas the EC program includes some training and construction costs. Overhead costs of running different programs vary widely, ranging from $1.5 million during three years for the first two programs (run by MOPH) to $23 million for the USAID-REACH program, although the latter includes extra TA to MOPH (Strong et al, 2005). 104 Afghanistan: Managing Public Finances for Development very strong conclusions, it appears that open The requirements for maximizing the benefits of this competition for contracts to provide basic health model (which has preconditions as seen above and services holds down unit costs and reduces the may not be applicable, especially on a large-scale variance in costs. basis, in some sectors) include the following: Opening up scope for feedback and Moreover, as compared with the second model, monitoring by beneficiaries and their this approach provides for Government leader- communities.18 ship on policy, contracting, and financing, and Strong monitoring and evaluation by the thereby potentially also can enhance the State, which is critical for assessing results. legitimacy of the Government. In addition, this model can exploit existing capacity in the non- Ensuring managerial autonomy for providers government sector and harnesses it to meeting Ensuring adequate competition in contracting, national development priorities, as has occurred and monitoring costs. in the health sector. Consider diversifying financing to include partial cost recovery, as appropriate. This model requires adequate Government capacity to carry out policy/contracting/financing roles. In Regulation and/or Contracting of the Private the case of health, this capacity to a large extent Sector was brought in from the NGO sector, which had experienced managerial and technical personnel In the fourth model, the State focuses on its from its work in the 1990s. It also requires that non- regulatory role (which may or may not involve government capacity for service provision be explicit contracting), and services are delivered by available ­ whereas some non-government the private sector with users paying for them (Figure providers from outside the country may bid on and 8.6). The mobile telecommunication sector is a win contracts, it is important that there be a critical highly successful example of this model (Box 7.2). mass of experienced provider capacity in-country. The benefits of this approach include efficiency, This was the case in Afghanistan's health sector for bringing in private investment, competition holding historical reasons, but not necessarily in other sectors. Capacity limitations at the provider level Figure 8.6: Service Delivery by Private Sector (Telecommunications) may well limit the scale and in some sectors the applicability of this approach. There are challenges in terms of contract design depending on the nature of the service. And finally, while this model is fully consistent with state-building, the Government is less visible than in the first model where it is providing the service directly. Thus public communi- cations and other efforts may be needed to ensure that the people are fully aware that the service is being provided under Government auspices. 18 This includes the possibility of trying out various models for increasing gender targeting and inclusion, both in terms of staffing and beneficiaries, drawing on experiences from the NGO sector. This will lead to greater potential for inclusive strategies (vul- nerable groups, minorities etc.) Delivering Services to the Afghan People 105 down prices, and (often) enhanced revenue for the of telecommunications) also arise. Designing Government. appropriate regulatory frameworks can be a tech- nical and political challenge. Effective competition, While attractive in many respects, this model requires as has been achieved in the case of telecommunica- adequate regulatory capacity, which cannot be taken tions, is critically important. Where competition is for granted. Since the private providers are (quite impossible (in some network industries), the pressure rightly) profit-oriented, issues of equity and of access on the regulatory framework to ensure efficiency and (e.g. in remote parts of the country in the case reasonable pricing is all the greater.19 Regular Box 8.1: Forms of Private Sector Participation in Infrastructure/Utility Sectors There are numerous forms of public-private partnerships. The simplified figure below shows the main categories, where the extent of participation of the private sector grows from left to right: Works and services contract: A works or services contract is an arrangement in which the public utility contracts out specific works (e.g. rehabilitating and expanding a distribution system, construction of a new power plant, etc.) or services (e.g. technical assessments or project management for large works contracts) to the private sector. Operation and maintenance contract: An operation and maintenance contract is an arrangement by which a private company is entrusted with various types of tasks usually performed by the public authority, such as day-to-day operation and maintenance of existing electricity operations (e.g. a power plant). Concessions: A concession is an arrangement under which a public entity, owner of the asset concerned (e.g. power generation plant, transmission line, etc.), delegates to a private entity (the concessionaire) responsibility for providing and maintaining a specified level of service to users in exchange for the right to collect revenue from the users. Unlike the previous forms of public-private partnerships, a concession shifts some of the financial risk to the private sector. Concessions may take various forms: Under a Build Operate Transfer (BOT) concession, the responsibility of the concessionaire is not limited to oper- ation and maintenance of the infrastructure but also includes initial construction, upgrading, or a major rehabil- itation component. Large investment and consequent mobilization of private funding sources is therefore required from this company and is to be repaid from the revenue collected from users. BOT stresses the responsibility of the private entity during construction and operation of the asset and the handing over (transfer) of the assets to the public entity at the end of the concession period. The high initial investment required from the private sector and the consequent long concession period make the distribution of risk between the parties a key element of success in such schemes. Many variations of this type of contract have been implemented: BOO: Build, Own, and Operate type project financing BOOT: Build, Own, Operate, and Transfer type project financing BOT: Build, Own, and Transfer type project financing Source: World Bank (2005b, Volume IV, Chapter 3). 19 It may be possible to unpackage services so that competition can be introduced at least for some components (e.g. power gen- eration as opposed to transmission and local distribution). Moreover, in some cases introducing contestability (periodically re- opening service contracts or other arrangements for bidding on a competitive basis, so that a monopoly is not permanent) can reap benefits associated with competition. This approach does, however, raise important technical design issues. 106 Afghanistan: Managing Public Finances for Development monitoring and evaluation by the Government, enhancing the legitimacy and credibility of the including reliance on feedback from customers, can State. Moreover, there are built-in incentives for the play an important role in this regard. communities to contain costs. In addition to small- scale rural roads at the village level, NSP has For public utilities, there is actually a range of funded other small-scale infrastructure (for example options between service delivery by a Government irrigation, drinking water, sanitation, rural energy). enterprise or department and purely private service This approach also holds the biggest promise for delivery. In particular, various types of contractual involving women on a widespread basis across the arrangements involving different degrees of private country in local level decision-making and as active sector participation are possible (Box 8.1). participants in economic activities (Boesen, 2004). Community-based Although the NSP has achieved good initial results, there are significant issues: The fifth model involves community decision-making Continuity ­ What will be the roles and respon- and leadership (Figure 8.7). In the National sibilities of CDCs beyond their work with Solidarity Program (NSP), the most notable example respect to block grants? How will the commu- in Afghanistan, communities elect by secret ballot nity assets created under NSP be maintained? Community Development Councils (CDCs) which Capacity ­ How much and how quickly can prioritize community development needs with the CDCs, a very new and possibly fragile support from a facilitating partner. The communities institution, take on additional activities? are then provided block grants from the Government Coordination ­ How can it be ensured that which are used for the identified priority activities. community development activities mesh Implementation is overseen by the CDC itself. with development activities of other local actors, for example with respect to local Figure 8.7: Service Delivery by Communities road networks? (National Solidarity Program) Scale ­ Are there possibilities for communi- ties/CDCs to be involved in larger activities that encompass more than one commu- nity? How can this be managed? Linkages with local administration ­ What are and what should be the linkages between CDCs and district administration? There are both benefits and risks from such linkages.20 The way forward with respect to NSP would there- fore involve, first, a review of the implementation of This approach has turned out to be a powerful NSP so far, its accomplishments and shortcomings, instrument for building community social and including an honest assessment of the capacity and governance capital, empowering rural people, and potential of CDCs. An enhanced, structured role 20 Potential benefits include infusing a more participatory, accountable approach into local administration; potential risks include "bureaucratization" of CDCs if they come to be seen as de facto the lowest level of government administration, and increased possibility of "capture" by local powerbrokers. Delivering Services to the Afghan People 107 for CDCs in monitoring local service delivery by However, the municipalities of Afghanistan, other (State and non-government) organizations in exemplified by Kabul, face a host of problems and the village would appear to be a promising option. constraints, including most notably the following: On the other hand, expanding the role of CDCs Confused roles vis-à-vis central ministries, very widely into, for example, credit provision or especially the Ministry of Urban revenue collection would appear to be excessively Development, that are involved in planning burdensome and risky. and investments and sometimes supervising service delivery (e.g. water supply). Some of Municipal Services this confusion stems from lack of clarity in the legal framework. The sixth model (Figure 8.8) pertains to municipal Dysfunctional management arrangements authorities, which are the only level of government in with municipal service providers. For Afghanistan with a measure of de jure autonomy example, in Kabul Municipality the current (Chapter 3). They have their own revenues to fund institutional arrangements and existing municipal government costs and delivery of certain departments do not adequately address the municipal services (e.g. trash collection, recreation, full range of service delivery challenges. park services). However, their tax and fee rates are set Several key functions are not being per- by MoF, and they are under the supervision of the formed, such as environmental sanitation Ministry of Interior which approves their budgets (except and property management. Although solid for Kabul Municipality which has the status of a waste collection, maintenance of urban roads, cleaning of ditches and drains, and ministry). This model has some promising aspects, apparently some responsibilities with respect since the management of the service provider, and in to water supply and sewerage are handled by principle the political accountability, are located close a couple of departments in the Municipality, to where the service is delivered, potentially these departments are hamstrung by poor strengthening both the "long" and "short" routes of capacity, lack of funding for capital invest- accountability. Moreover, municipalities' autonomous ment projects, excessive bureaucracy (i.e. budgets and their fees and levies could provide some being subject to the full gamut of administra- linkage between funding and service delivery. tive procedures), and lack of incentives to effectively provide services.21 Service Figure 8.8: Service Delivery by Municipalities providers seem to have very little in the way of management autonomy, incentives, or accountability for service delivery, either to the Municipality or to beneficiaries. Lack of political accountability to the urban population. Although elections are the ultimate form of political accountability and elected Mayors and city councils are called for in Afghanistan's Constitution, Mayors of municipalities currently are appointed by the administration instead of being elected. 21 In fact, one of the municipal departments responsible for service delivery in Kabul was previously an SOE but was transformed into a department of the municipal government in 2004. 108 Afghanistan: Managing Public Finances for Development Weak governance, budgeting, and financial or in some cases by paying for the service and management. In Kabul, budgets are prepared thereby having a greater incentive to be concerned mechanically and never revised within the about quality. The need to strengthen the "short financial year; expenditures are constrained route" of accountability applies to most of the by cash availability; and the Mayor can different models outlined above, and to virtually all approve expenditures outside the budget. types of services ­ a striking example in the security Capacity is sorely lacking in the vast bulk of sector is the police. municipalities. As a result, municipalities are vulnerable to corruption (Box 7.4). Third, different models of service delivery have dif- The reform agenda for the municipalities is formi- ferent implications for state-building. Several dable, but an emphasis on service delivery will help dimensions are important in this regard: (i) the provide focus. Key priorities include (i) clarifying actual role played by the Government (e.g. policy, responsibilities (in particular between larger munic- financing, management, provision); (ii) the visibility ipalities like Kabul and the Ministry of Urban of the Government in relation to consumers/benefi- Development); (ii) improving the budget process ciaries; and (iii) the effectiveness of the services and execution controls; (iii) building human and (access, quality, inclusiveness with respect to women organizational capacity in core municipal functions and other vulnerable groups, etc.). Except for the (including PFM functions); (iv) reforming the second model (delivery completely outside govern- relationship between municipal governments and ment), the Government does play an important role municipal service providers, including considera- of one kind or another in all of the models, but in tion of contracting for private or community some of them (e.g. outsourcing to NGOs or private provision where appropriate; and (v) ensuring sector provision) there may be a need for measures effective outreach and response to community to enhance the Government's visibility. needs, especially those of vulnerable and marginal groups and women. Fourth, where possible competition (or at least con- testability) among providers can play a useful role. B. Lessons and Implications Mobile telecommunications is a notable example of competition resulting in major improvements in As demonstrated in the previous section, there are access, quality, and efficiency. In health, competi- a variety of different modes of service delivery, and tive contracting (even though there ends up being rich experience both in Afghanistan and interna- only a single service provider in each province) can tionally. The first lesson is precisely that "one size help control unit costs. does not fit all" ­ different approaches can and should be used depending on the characteristics of Fifth, although it seriously constrains service the service concerned and the specific context. delivery in the short run, the lack of capacity in tra- However, it is essential that the underlying account- ditional centralized service delivery systems pro- ability relationships support and encourage ade- vides an opportunity to rethink, modify, or move quate service provision. away from this model. In most sectors (whether social services or public infrastructure), Afghanistan A second lesson is that, in general, service has much more flexibility in choosing options than providers need to be made more accountable other countries with well-established service directly to consumers/beneficiaries, through delivery institutions and networks. Depending on enhanced channels for voice, choice of providers, the sector, this may involve de-concentration within Delivering Services to the Afghan People 109 the Government hierarchy, moving toward more Whether and to what extent it is appropriate to commercialized modes of provision by a utility, charge for any given service depends on the char- private sector participation, etc. acteristics of the service (whether people can be excluded from benefiting from the service or not ­ There are important lessons for donors as well, e.g. defense versus domestic piped water supply, including the need to work through Government whether charges can vary with usage), demand budget channels and not build up parallel (whether not charging will result in overuse, e.g. in structures; to avoid undermining service providers' the case of electricity), and consumers (whether relationship with the State by providing resources poor and non-poor consumers can be distin- (including salary top-ups) directly to providers; to guished, whether the poor are disproportionate ­ resist "flagging" of projects/activities that they or at least equal ­ users e.g. primary education, finance to the detriment of the Government's etc.).22 In many cases significant cost recovery may visibility; and to encourage rather than undermine be neither feasible nor desirable ­ Government- cost containment, for example by supporting provided primary education is one of the best competition in their own and Government procure- examples. Nevertheless, there are good technical ment procedures. While the need for quick impacts grounds for additional cost recovery for many and concerns about weak Government capacity public services. are valid, the various models outlined above highlight the importance of placing donor interven- In addition to its fiscal implications, cost recovery can tions under Government leadership and, when be a tool of accountability for improving service possible, using Government institutions (Chapter 6 delivery. People who pay for a service are more likely discusses the use of the Government's budget and to be concerned about whether and at what quality budgetary systems). level they are benefiting from the service, and to be more vigilant and selective, positively influencing the Financing of Service Delivery and the Role of behavior of providers. These beneficial effects Cost Recovery depend on whether there is competition among providers (and therefore the possibility of exercise of Financing and cost recovery deserve attention from choice by the consumer), on other factors that both fiscal and service delivery perspectives. The enable payment for services and exercise of voice to fiscal impact of downstream O&M requirements reinforce each other, and on receipts transparently associated with public investments and (re)building accruing to the service provider. of social service networks can be truly daunting (Chapter 3), and cost recovery where appropriate Turning to some examples, although willingness to can be an instrument for managing these pay for power is demonstrated throughout downstream costs and reducing associated fiscal Afghanistan (widespread use of expensive small risks. Cost recovery can also be an instrument for generators with full cost recovery), in Kabul (and demand containment (for example adequate power other largely hydel-based cities like Kandahar) the and water tariffs, and nominal charges for health effective grid tariff is only $0.021/kwh, far below facility use or higher education to discourage the actual cost of supply. Nationally, the effective unnecessary or excessive use). tariff is roughly estimated at $0.051/kwh, com- 22 See World Bank (2003b, Box 4.4, p. 71) for a schematic summary of these considerations (reproduced and discussed in the context of Afghanistan in World Bank, 2005a, p. 85). 110 Afghanistan: Managing Public Finances for Development pared to a cost of supply of $0.123/kwh, implying The natural gas sector also faces very serious an average cost recovery rate of 40% (Table 8.2). financing and cost recovery issues. As noted in Although donors are funding various power Box 8.2, private investment based on commercial investments as well as recurrent costs such as fuel pricing will be essential if this sector is to be (diesel fuel provided by USAID for the Kabul revived and developed. Currently natural gas Northwest Power Plant cost about $40 million in tariffs are far too low to fund rehabilitation, O&M, 2004/05), this pattern of financing is fragmented and necessary expansion of gas production and unsustainable. and infrastructure. Moreover, non-payment by end-users is common even at present low prices, Table 8.2: DABM: EffectiveTariffs and raising serious doubts about whether they will Costs by Region, 2004/05 be able to pay full cost-recovery prices. Thus Region Effective Costs Share of Power development of this sector will require a set of Tariff Billed as % complementary investments including in down- of System Total stream end-user industries, based on effective (US¢/kWh) Government regulation and economic pricing. Kabul 2.1 15.4 49% Higher education provides a good illustration from Kunduz 4.6 3.2 4% the social sectors of the need for cost recovery and Balkh 7.4 6.5 17% sustainable financing arrangements. Given its enor- Herat 2.5 5.2 7% mous needs and the high socio-economic returns to Nangarhar 7.3 1.3 6% investments in elementary education, this is being Kandahar 3.3 1.1 14% prioritized in terms of budgetary allocations (see Chapter 5). But delivering quality higher education NATIONAL AVERAGE 5.1 12.3 services leading to significant numbers of Note: Data apply to DABM. well-qualified graduates will be essential for Sources: World Bank (2005b, Volume IV, Chapter 3). state-building and capacity development in both public and private sectors. While charging fees for Thus there is an urgent need to raise power tariffs higher education is not popular in any country, the where they are very low. Moreover, it is important private returns to higher education are substantial not to exacerbate the problem of low cost enough that partial cost-recovery is well-justified, recovery. For example, MoEW recently purchased with scholarship or loan programs for those unable several diesel generating sets for use in Kabul. to afford fees. Moreover, an astonishing 40% of the Without higher user charges, it will be impossible recurrent budget of the Ministry of Higher Education to cover the estimated $10 million annual cost of is spent on running costs and food at university diesel fuel for these generators. In June 2005, dormitories. Since another 50% of the operating MoEW sharply reduced power tariffs (by on the budget of the Ministry goes for salaries, very little is order of 40%) in Herat, reflecting the lower cost of left for indispensable pedagogical inputs such as imported power from Iran. This will damage the internet access, textbooks, journals, lab materials, ability of the power system in Herat to finance etc. Even if charging fees for higher education is not expansion of its distribution network to improve possible in the short run, expecting students to cover coverage. These examples highlight the impor- part of living costs ­ at least food ­ would be tance of fully incorporating financing and cost reasonable and would free budgetary resources to recovery issues in decisions. improve the quality of higher education. Delivering Services to the Afghan People 111 Box 8.2: Natural Gas Pricing After years of neglect and underinvestment, many steps are needed to revive and develop Afghanistan's natural gas sector. Given the characteristics and investment requirements of the sector, large amounts of private investment will be essential. Two critical first steps for attracting private investment in natural gas are (i) pricing natural gas on commercial terms, and (ii) establishing a track record of full and timely payment for gas by end-users. Gas tariffs today are too low to cover costs of rehabilitation, O&M, and expansion of gas production and infrastructure. For incremental gas production, tariffs may be less than half of what they ought to be. Moreover, the Government collects no taxes or royalties from the natural gas sector, missing out on a potentially substantial source of revenue. Gas transmission and distribution tariffs tend to be regulated by the Government in all countries. Gas prices at the wellhead are generally determined by market forces, although some Governments such as Pakistan have established pricing formulas to attract investors. Determination of economic natural gas prices requires, among other technical work, separation of reasonable and prudent costs from unnecessary expenditures for cost recovery purposes. For the benefits of regulation to exceed its costs, regulation should be simple, workable, and cost-effective. The Government needs to strike a balance between abuse of market power (in the absence of competition and effective regulation) and over-regulation, in light of the available resources and its own capacity to regulate. A closely related question is the ability and willingness of consumers to pay prices that allow cost recovery. International experience demonstrates that creditworthy large-volume consumers form an important market base for the natural gas industry. In Afghanistan, non-payment by consumers has been a serious problem despite the current very low gas price. It is not clear whether current consumers, in particular the Kud Bergh fertilizer/power plant (the only large-volume consumer at present), can pay for gas at economic pricing levels. There is a need to identify potential creditworthy large-volume gas consumers to help develop the gas sector. A new power plant based on natural gas may be such a candidate. At the same time, what to do about current gas users who may not be in a position to pay for gas at cost-recovery levels needs to be carefully considered. Finally, the discussion above strongly suggests that development of the natural gas sector in Afghanistan will have to involve a set of complementary private investments in gas production, infrastructure, and major gas end-use activities, with effective Government policies and regulation. Monitoring and Evaluation mation is available on outputs and outcomes. Moreover, gender-disaggregated data is largely Information flows and monitoring and evaluation lacking. These deficiencies will need to be (M&E) are critically important for effective service corrected over time. delivery, as shown in the various models and examples discussed. Some progress has been Transparency and dissemination of information are made in improving statistics and information flows, extremely important as well. In addition to, and but there is a long way to go in further improving often more important than, vertical flows of these and exploiting them for effective M&E information to and within the administrative hier- leading to better service delivery. In particular, archy, information needs to flow to the public and there have been substantial improvements in flows civil society in a horizontal manner. of financial information on expenditures (Chapter 7). Good examples of progress in developing Better information flows are only part of the story, timely information flows include the Health however. Appropriate performance benchmarks Management Information System and Education need to be set and regularly monitored. For Management Information System. But little infor- example, performance benchmarks will help in 112 Afghanistan: Managing Public Finances for Development identifying where bottlenecks occur, e.g. in terms of are supposed to play a coordinating role and girls' retention rates in schools, women's access to are responsible for security, but they report to the maternal health services, causes of high maternal Ministry of Interior, and they have no supervisory mortality, etc. Setting the right benchmarks requires authority over line departments in provinces. a clear strategy and objectives. Indeed, setting Only municipalities have some degree of fiscal benchmarks and monitoring performance can be a autonomy (as discussed in Chapter 3 and earlier good device to clarify objectives and make them in this chapter). The de facto situation, however, truly operational. is that central control has been weak and non- state power bases at regional and local levels Finally, institutions need to take on the role of mon- strong. The structures of a unitary State, itoring and evaluation and treat it as a serious part provided for in Afghanistan's Constitution, are in of their work. This is clearly one of the important place in rudimentary form, but there are glaring roles of Parliament at the national level. The capacity weaknesses. With formation of the elected Provincial Councils can and should play a elected Parliament and Provincial Councils role in monitoring at the provincial level, and (and later District Councils), Afghanistan's similarly the elected District Councils (mandated administrative and political structure will be as under the Constitution but to be formed later) at the shown in Figure 8.9. district level. At the community level, as discussed above the CDCs could play a very important The need to improve service delivery and the chal- monitoring role vis-à-vis local delivery of services. lenge of building an effective, accountable State are closely linked; both are at the core of C.Sub-National Strategy Afghanistan's reconstruction agenda. An effective State delivers services to the people, and by Afghanistan is de jure a highly centralized State, ensuring that services are delivered with wide- with lower levels of administration serving as spread access by citizens (including women and arms of central ministries. Provincial Governors other vulnerable or marginal groups), the State Figure 8.9:Administrative and Political Structure of Afghanistan Delivering Services to the Afghan People 113 The experience in 2002/03 (until the can build its legitimacy. Subnational levels of creation of the Treasury Single Account) administration (provinces and districts) are very shows the risk that revenues will be spent important from both perspectives. A service by provinces and poorly accounted for delivery perspective provides some discipline in and that, even in resource-rich provinces, considering subnational strategy and focuses it on liabilities will be created. relevant outcomes. For example, there have been Issues related to ensuring reasonable equity improvements in financial management and other in funding (and ultimately service delivery) aspects of subnational administration (Box 8.3), across the country. but these may be only beginning to translate into improved service delivery. Design risks that could result in counterpro- ductive outcomes, for example inadequate accountability at lower levels of Government Decentralization is an important political choice administration. made by a country, which may have a variety of motivations. Although better service delivery is Nevertheless, Afghanistan's geographical character- often one of the avowed objectives of decentral- istics and regional and ethnic diversity would sug- ization, international experience has been gest that over the longer run, decentralized modes mixed. Moreover, there are examples where of governance may well be appropriate and could rushed and not carefully thought through be considered. From a service delivery perspective, decentralization initiatives turned out to be as seen earlier, there is very often a case (depending counterproductive. Among the risks of decentral- to some extent on sector-specific circumstances) for ization which may be particularly salient in management and oversight of service delivery to be Afghanistan are the following: close to the providers and consumers. However, the current situation and the legacy of conflict provide Possible "capture" of the decentralization ample grounds for exercising caution in this difficult process and structures by local elites ­ this risk is particularly great in Afghanistan given area in the short run, and in particular not under- the importance of non-state forces (often mining the state-building agenda. retaining some armed capabilities despite the DDR process). Capture of national Keeping within the present unitary state structure and revenues by Governors and other local taking a practical, results-oriented service delivery power-holders has sometimes occurred and focus, there are some promising options which include: is problematic for fiscal stability. Enhancing the functioning of the present Associated risk of inadvertently undermining subnational administration, including the effort to build up a credible unitary State. through measures to address the problems noted in Box 8.3. One concrete example Weakening of financial controls and would be increasing the share of non-wage fiscal discipline. Afghanistan's existing recurrent budgets going to lower levels of mechanisms and continuation of the administration. Government's strong "no-overdraft" policy will likely enable strong fiscal discipline to Making available information on budgetary be maintained. However, decentralization spending by provinces (and to the extent mechanisms such as block grants to lower possible districts). levels of Government administration, Providing greater management flexibility to without proper financial controls and provincial and district line departments in monitoring, could increase fiduciary risks. oversight of service delivery facilities 114 Afghanistan: Managing Public Finances for Development Box 8.3: Improvements and Challenges in Subnational Administration A recent update report on subnational administration, based on field visits to six provinces and interviews in Kabul, found that financial management at the provincial level has improved significantly over the past two years or so: In most cases civil servants at subnational level receive pay monthly, and on time. Access to cash balances for non-salary expenditures is much improved, particularly in very poor provinces. Financial reports are being submitted on time for the most part. The single expenditure and revenue accounts are working well. Audits are being conducted, although their impacts are not yet clear. However, there are still significant issues to be addressed: Low pay continues to be a major complaint. The takhsis (budget authorization) and tashkeel (administrative authorization for staff positions) arrive late in many cases, which can result in delays in pay and other expenditures; there can also be disconnects between the line ministries' takhsis and that reaching the Mustoufiats (provincial finance departments). The system of transferring positive balances into the provinces' single expenditure account, while effective in getting cash out to provinces, is still placing unnecessary constraints or delays on spending. Non-salary allotments are still low, and there continue to be inequities between provinces. There is still a lack of written manuals, and more training is needed. Management of the education budget is still a major issue. Moreover, little has changed in terms of recruitment and staff appointments. Although senior appointments are being channeled through the Independent Administrative Reform and Civil Service Commission (IARCSC), political and ethnic considerations appear to feature prominently in recruitment. Many (though not all) of these issues can be addressed relatively easily. However, there is confusion among a number of parallel and separate provincial coordination mechanisms supported by different external agencies (including for counter-narcotics), which detracts from the functionality and effectiveness of subnational administration (Lister, 2005). Source: Adapted from Evans and Osmani (2005, pp. 3-4); also see World Bank (2005b, Volume III, Chapter 3). (e.g. for provincial and district education "bottom-up" community-based efforts such as the departments in overseeing schools). This NSP. There is a risk of the two approaches clashing, can include an extended role for local user particularly in a highly politicized atmosphere, but groups (e.g. the Parent-Teacher Association this risk can be mitigated by maintaining a service for primary schools). delivery focus. As demonstrated by the initial Giving provincial line departments (and successes achieved by NSP, community-based through them districts) an explicit role organizations can play important developmental in the national budget formulation and governance-improving roles, building on the process, which could include proposals, traditional role of communities in decision-making consultations, etc. and on participatory mechanisms (including elec- Finally, "top-down" measures to strengthen subna- tions), and promote social inclusion (securing tional administration and enhance its capacity representation not only of local minorities but most to oversee service delivery can complement remarkably also of women). 9 INSTITUTIONAL REFORMSAND CAPACITY DEVELOPMENT While the previous chapter reviewed options for and/or regulator. This requires major enhancement organizing effective delivery of services, this chapter of Government capacity. focuses on building individual and organizational capacity to improve PFM performance. At the Three Strategic Components outset, the "sequencing" or "time horizon" dilemma must be emphasized ­ there is a dichotomy The Government has outlined its strategy as part of between the need to deliver services quickly to the the Public Administration Reform and Economic people (Chapter 8) and the need to develop Management (PAREM) program, one of the 12 NDF effective, sustainable national public institutions. programs. This strategy, revised in the ANDS, focuses The trade-off is complex, as both are necessary to on three key aspects. build a legitimate, well-functioning State. How to quickly deliver services while progressively devel- First, individuals (civil servants) must be well qualified oping capacity over time? The chapter opens with and motivated. Recruitment based on merit has been a discussion of the broader long-term agenda of found to be the most effective way to raise skills and capacity development. It then reviews the reform motivation, even though it can be politically sensitive process of MoF, the core of the PFM system. The in a fragmented society with a history of patronage. third section analyzes the challenges of building A diverse workforce ­ notably in terms of gender and PFM capacity beyond MoF ­ in line ministries, ethnic group ­ is necessary to build a legitimate provinces, and municipalities. State. Women are especially needed in the civil service for delivery and management of public serv- A. Developing the Government's ices for the female part of the population. However, Capacity the workforce composition needs first to be adequately understood and monitored before plans A quarter-century of wars and civil strife left can be designed to enhance diversity. A talented Afghanistan with a collapsed administration. While workforce also requires an adequate pay and there was some institutional memory of rules and grading structure, providing attractive wages and processes (notably with regard to financial manage- potential for promotion. Wages and promotion ment, see Evans et al, 2004b, and Box 8.3), service should also be linked to performance. A strong ethos delivery by the Government had largely ceased. ­ a sense of service and accountability ­ is very Skills have been depleted, due to both the weak important. While partly linked to issues of pay levels, education system and a major "brain drain" (Box this also requires leadership by management teams 9.1). The Government is committed to building an that model these values. In addition, capacity can be effective administration, with the Government not created from inside by training, not only formal delivering all services but often acting as a financier training but also on-the-job training or coaching 118 Afghanistan: Managing Public Finances for Development Box 9.1:HarnessingAfghan Expertise Severe capacity constraints in Afghanistan's civil service result from a number of factors. Millions of Afghans, including many with skills, were killed or fled the country during the conflict. Universities and schools were closed or operating at low capacity. This left the country deprived of expertise, knowledge, and experience in managing the development process. Women in particular suffered from lack of education opportunities. Many Afghans who left gained a better education and entered into skilled and professional employment in the region (especially in Pakistan and Iran) and also farther away (in countries such as the USA, UK, France, and Germany). In the early reconstruction phase, the Afghan civil service suffered further losses from among the (very few) skilled staff who had remained or returned immediately after the end of conflict, as NGOs and donor agencies offered much better salaries and working conditions than were available in the Government. It would be misleading, however, to con- clude that Afghanistan has no usable expertise; while external assistance is very much needed, tapping existing Afghan expertise is crucial. The first option has been to make use of the expertise and experience of Afghans working in NGOs and also some of the international agencies (these groups are generally referred to as the "second civil service"). Given the impor- tance (and, in some cases, size) of NGOs delivering services in the 1990s (Chapter 8), they have accumulated a wealth of management and technical expertise. In the early days of the transitional Government, several ministries tapped these human resources to quickly build very able management teams. The second option is to tap human resources from the Afghan diaspora. A number of talented Afghans returned from abroad, sometimes working as volunteers, and brought important skills and experience to the Government. In order to better tap both of these reservoirs of skills, the Government has created the Lateral Entry Program (LEP) and the Afghan Expatriate Program (AEP), both of which are being managed by the IARCSC. Under the LEP, the Government will inject up to 1,500 professional and skilled Afghans into senior and middle-level positions of the civil service, with enhanced pay that goes beyond PRR scales. The primary target of this program is the "second civil service" and Afghans in regional labor markets. Under the AEP, the Government will appoint up to 100 highly skilled Afghan expatriates to work in advisory posi- tions in priority areas, of which around 50 are already in place. This program's approach is based on a number of factors: (i) a dedicated Executive Committee; (ii) clear guidelines on recruitment and pay levels; and (iii) a review of both the capacity of the line ministry to use an expatriate Afghan effectively and of the expatriate to bring the required skills. from senior staff or external advisors (Box 9.2). issues and problems associated with specialized Finally, tapping skilled Afghan expatriates may be a anti-corruption agencies). Adequate management way to quickly bring talented Afghans into the civil processes (including sharing information, making service (Box 9.1). decisions, implementing decisions, and following up) need to be established, which often requires some Second, organizations (ministries and agencies) need disconnect between, and clear accountability of, to function well. In addition to recruiting the right the political level (working toward and making high- people, this requires institutional reforms to (i) specify level policy decisions) and the administrative level each organization's mission (in line with the ANDS); (providing information and analysis and imple- (ii) improve (simplify and standardize, with clear menting policy decisions). Some core functions need reporting lines) the organizational structure, and (iii) to be created or modernized, such as Human review and improve business processes. The solution Resources (HR), finance (see below), and communi- of creating new organizations to solve each problem cations units. Implementing these sweeping changes should be resisted (for instance, Chapter 7 highlights requires preparing a vision for the agency, translated Institutional Reforms and Capacity Development 119 into a medium-term strategy and annual business boring countries, Box 9.1, and funding for short-term plans with performance indicators, and implemented technical assistance and feasibility studies) is under with regular monitoring. It also requires physical implementation. However, there remain many issues, investments (buildings, IT, equipment). at the institutional level (weak enforcement capacity in the justice system, for instance), organizational level Third, the institutional environment needs to be (lack of in-depth organizational reviews and reforms), supportive of effective individuals and organizations. and individual level (uncoordinated training The PFM Review has highlighted a number of policies programs and slow recruitment). which are important in this regard. Policies should be matched to capacity, because a commitment to unen- Two Key Challenges forceable policies is economically costly (risk of red-tape and corruption ­ Chapter 7, poor service This uneven progress should be viewed in the context delivery ­ Chapter 8) and politically harmful (failure to of two important challenges that capacity develop- keep promises). In addition, decision-making should ment faces. First, international experience has amply be supported by adequate coordination mechanisms demonstrated that capacity development ­ recruiting throughout the Government. As indicated in Chapter and training people as well as reforming and 6, the Cabinet Secretariat will need to play an impor- strengthening institutions ­ is a long-term endeavor. tant role in coordinating policies and making sure that It involves technical assessments and preparation of Cabinet decisions are informed and implemented. detailed strategies, politically sensitive changes in The capacity of the justice system to enforce laws is practices, and learning by doing. Faced with the also critical for the Government's ability to deliver "time horizon dilemma", an asymmetric approach ­ services. Finally, the role and capacity of the in which reforms are implemented in selected agen- Parliament will be necessary for the Government to cies first and gradually rolled-out ­ may be the only operate under adequate oversight (Chapters 6 and 7). solution. But this is a risky strategy, which can be threatened by frustration at lack of more widespread Progress on these three dimensions has been uneven. results; social discontent arising from disparities At the institutional level, a number of policies have among pay levels; slow progress because unre- been adopted related to PFM that seek to simplify the formed departments weaken the performance of regulatory framework, and MoF envisages further reformed ones; and ineffectiveness due to uncertain- simplifying the tax code. Projects are underway to ties surrounding institutional reforms. These risks can reform the Cabinet Secretariat. At the organizational only be mitigated by high-level political leadership, a level, the Priority Reform and Restructuring (PRR) large and effective injection of technical assistance scheme (which allows departments to place qualified (Box 9.2), an adequate monitoring mechanism, and staff on an elevated pay scale in exchange for communication efforts. organizational restructuring) is being implemented for 15,000 positions. Finally, at the individual level, more The experience with the PRR highlights these difficul- than 100 senior appointments are now processed ties. Technically, implementing this scheme requires monthly by the Independent Appointment Board, significant assistance, as organizing ministries and following merit-based procedures. More than 100 grading jobs require specialized skills. appeals on recruitment, transfer, and termination of Implementation is also contingent on having employment have been evaluated. A short-term experienced management capacity. Politically as capacity building framework (including programs for well, the asymmetric approach requires solid Afghan expatriates and lateral entrants from neigh- high-level leadership and a good communication 120 Afghanistan: Managing Public Finances for Development Box 9.2:UsingTechnicalAssistance Effectively According to OECD/DAC data, more than $400 million of external assistance to Afghanistan was spent on Technical Assistance (TA) in 2003. Such a high level of TA may well be necessary given the low capacity in the Government and the need for a short-term injection of capacity (including for highly specialized skills). Nevertheless, various problems suggest that TA could be better managed. The following lessons can be learned from experience: TA should be based on explicit demand and leadership from a clearly identified Government counterpart, and should report to that counterpart (with quality control as needed from the donor); this should increase follow-up on TA recommendations. TA proposals should include clear and monitorable indicators and should be monitored, with outcomes evaluated; this would enable assessment of the quality of TA and better management of it. More specifically, there needs to be differentiation between (i) operating TA (directly carrying out certain Government functions ­ this should be on a strictly temporary basis until national capacity is built up); (ii) advisory TA (a small number of advisors on a long-term basis, with provision for short-term advisory support on specific issues and for identified analytical work); and (iii) capacity-building TA (intended to directly support sustainable capacity building). Ministries could also create dedicated processes to ensure adequate TA oversight and coordination; while a clear ministry strategic framework with specific milestones should help, more structural coordination may be required. To the extent possible, TA provision should be aligned with organizational structures to avoid unnecessary fragmentation, which would avoid in particular conflicting advice (some departments have up to six or more TA providers). This may, in some cases, lead to assigning one TA provider per department or agency, or pooling donor resources together (as is done, for instance, in Tanzania and Cambodia for PFM reforms). TA contracts should be subject to international procurement standards to seek maximum value for money. campaign to maintain support for ­ or at least that the Government, in need of similar skills, cannot acceptance of ­ this strategy, especially when its afford. In some cases, donors even directly pay civil impact is difficult to quantify and takes time to servants' salaries or "top-ups", which is not fiscally materialize. As indicated above, an asymmetric sustainable for the Government and can disrupt solution may well be the only option, but the risks accountability and loyalty relationships. Such have to be mitigated. relationships are also harmed when separate units dedicated only to supporting donor projects are Second, donors, while bringing financial and created (Section C). In some cases donors approve technical assistance, can distort incentives and the salary/wage levels that are well above prevailing labor market (impacts on the budget are discussed in rates for whole categories of employees ­ such as for Chapter 6). Given the shortage of skills (notably the ANA, National Security Directorate, and Counter management, language, and computer skills), Narcotics Police ­ but which are never costed or competition between local offices of the international assessed from a fiscal standpoint. Finally, external community and the rest of the market has led to technical assistance, while very much needed to "buy higher salaries, especially in Kabul, reaching levels capacity" in the short term, needs to be well Institutional Reforms and Capacity Development 121 managed to be effective (Box 9.2): otherwise it more revenues; and the planned creation of can result in a waste of resources that generates Revenue Offices in the provinces, with the resentment among less well-paid staff without having Mustoufiats becoming sub-Treasuries, would much positive impact. clarify accountabilities at the provincial level. Departmental reforms: With these organiza- B. Reforming the Ministry of Finance tional adjustments, the Ministry could submit a Ministry-wide PRR (as a further step to As emphasized throughout this report, MoF has a existing PRR programs in several depart- crucial stewardship role in public finance manage- ments); this should cover the strengthening ment. Its capacity to fulfill its role in PFM is therefore of the Budget Department (along sectoral critical for overall PFM performance as captured by lines, with no separation of operating and the PFM indicators (Chapter 2). Progress in mobi- development budgets), the Internal Audit lizing revenues also requires the development of Department (in line with the PFEM Law), and the Finance and Administration Department. a professional cadre in the tax and customs administration (Chapter 4). Progress has been Institutional strengthening: A number of substantial ­ under the leadership of a strong processes should be created or strengthened management team and with external assistance to improve the Ministry's effectiveness, supporting, sometimes operating, core systems such including the budget process for MoF's own budget; human resource strategy; internal as AFMIS. But the challenges remain very great. and external communications strategy; information sharing and decision-making In the first half of 2005, MoF therefore initiated a processes; and TA management (Box 9.2). strategic planning process. The first step was to put forward a vision for the Ministry, based on five goals: MoF may want to pursue a rigorous institutional (i) mobilizing revenue and managing Government reform process in order to develop its capacity as finances; (ii) supporting economic management and steward and custodian of Afghanistan's public promoting economic growth; (iii) managing public finances. The next step would consist of translating wealth; (iv) promoting good governance; and (v) MoF's vision into detailed and quantified performance being a best-practice leader within Afghanistan's targets to measure progress; specific and public sector. realistic annual business plans; and consistent strategic plans, performance targets, and annual busi- A review of the Ministry's capacity, from an individual ness plans at the department level. Implementation and organizational point of view (policy issues will require sustained efforts and regular monitoring. are discussed in Chapter 6 and 7), suggests the A possible vehicle for this purpose would be an following issues: institutional reform working group / monitoring cell within MoF, with support from MoF's top leadership. Organizational adjustments: The newly-cre- ated Fiscal Policy Unit in MoF should help strengthen analytical capacity; the Treasury C. Building PFM CapacityThroughout Department and the Accounting Department Government are being merged; a Procurement Policy Unit should be created as a clear champion of Beyond MoF, strengthening overall PFM perform- procurement in the Government (see ance calls for financial management reforms and Chapter 7); the creation of the Large capacity development in line ministries (including Taxpayer Office is intended to help mobilize those responsible for the security sector as well as 122 Afghanistan: Managing Public Finances for Development other sectors). Most of them have very weak extremely important to ensure that enclave/isolated capacity and operate based on outdated practices. PMUs/PIUs do not become the norm, and that those Most ministries continue to have two departments, already established are reformed. In particular, these sometimes reporting to two different deputy units should not cover only donor programs but ministers, separately working on their operating rather should be integrated in line ministries (OED, and development budgets. Many processes ­ 1998). The Grant and Contract Management Unit in including the expenditure process ­ involve dozens the Ministry of Public Health illustrates these issues: of signatures. This overabundance of ex-ante well integrated in the Ministry, its strong capacity not controls not only adds nothing to the effectiveness only facilitated implementation of donor-financed of internal controls but also leads to slow pro- projects but also contributed to the overall achieve- cessing and creates opportunities for corruption. ments of the Ministry. Nevertheless, tensions and resentments (including among donors) were not easy Financial management units or budget units in line to manage. ministries should therefore be reformed. MoF intends to pilot a "model office" in one ministry, before rolling At the subnational level, the PFM system works out reforms more widely in line ministries. This would through the Mustoufiat network. Analysis has shown need to be coordinated with the procurement that administrative and financial regulations are reform, according to which procurement authority is adhered to in provinces (Box 8.3). However, as the to be decentralized in line ministries. Over time, such Government seeks to implement the budget more reforms could allow a number of responsibilities to effectively outside Kabul, Mustoufiat reform is be devolved to line ministries, notably access to essential. At the individual level, this requires the AFMIS for reporting and, later, posting of expendi- implementation of pay reform and training. At the tures (Chapter 7). This process would need to be organizational level, it is recommended to separate subject to well-defined criteria, building on the Treasury functions from revenue functions, with a experience of Thailand, where under the so-called view both to specialize these units (with different skills "hurdle approach", PFM functions were devolved to and different clients) and ensure adequate separa- line ministries after they met performance standards. tion of duties. At the institutional level, strengthening Mustoufiats requires a commitment from the central The creation of Program Management Units or ministries (MoF in particular) to deliver funding in full Program Implementation Units (PMUs/PIUs) can and on time; to take into account local realities and support better PFM performance but also gives rise demands in the formulation of the budget; and to to risks. Donors often favor having such units to provide clear manuals, training, and other forms of manage their funds. These units have proven useful, support (e.g. implementation of AFMIS) to even indispensable, in cases where the civil service implement modernized PFM rules throughout the and the existing institutions have no capacity. country. Finally, devolving responsibilities to line However, autonomous PIUs can become "super- ministries (see above) would require developing PFM ministries", which require a long time and high capacity not only in the central ministries but also in spending to establish, absorb civil servants from their provincial line departments. ministries and generate resentment from others, expand their purview, and become over-stretched While municipalities have an institutional set-up that and entrenched. As a result, PMUs/PIUs easily can has potential to effectively deliver urban services become an obstacle to national institution building (Chapter 8), their PFM capacity is currently very weak. and sustainable capacity development. It is therefore A study of Kabul Municipality highlights the constraints: Institutional Reforms and Capacity Development 123 unclear institutional responsibilities between the munic- In summary, the capacity development agenda is ipality and line ministries (notably the Ministry of Urban far-reaching, as it covers the three dimensions Development and Housing); outdated functions outlined in Section A and cuts across the central including some (e.g. price control) inherited from the Government, its provincial and district depart- era of the Soviet occupation; an organizational ments, and municipalities (to which SOEs and the structure that has been adjusted but is still in need of private sector ­ for participation in public procure- further improvement; poor budgeting (e.g. separation ment ­ should be added, see Chapters 3 and 8). of operating and development budget functions), Further developing MoF's capacity ­ both in Kabul financial management, procurement, and record- and in the Mustoufiats ­ is the short-term priority keeping processes (for instance, if there is no line item as MoF is the core of the PFM system and the in the budget for a certain type of expenditure, the custodian of public funds. Building on this, expense is simply not entered in the ledger); and organizational reforms (budget, financial manage- opaque revenue collection mechanisms applied to ment, procurement departments) and training can numerous low-yielding local revenue sources. be rolled out to line ministries and municipalities Therefore, PFM processes and capacity need strength- while, in a sequenced way, authorities (e.g. for ening as a prerequisite for realizing municipalities' procurement) are de-concentrated to line ministries potential to deliver services in urban areas. based on performance. 10 KEY CHALLENGESANDA ROADMAP FOR PFM REFORM The previous chapters of this report have (notably in the security sector), and bringing these highlighted both the progress achieved and the expenditures progressively into national budget problems faced by Afghanistan's PFM system. channels. Building on the analysis presented earlier and looking to the future, this concluding chapter briefly Second, there is the challenge of sustained rapid summarizes the major challenges that need to be growth of domestic revenues, which will be the addressed and puts forward a roadmap for lynchpin of progress toward fiscal sustainability. strengthening and reform of the PFM system. Afghanistan's revenue-to-GDP ratio at around 5% is well below half the level even in other very poor A.Eight Main Challenges countries. Revenues have to grow much more rap- idly than expenditures on a sustained basis. At the Good public finance management is a key same time, a sound revenue system should be enabling factor for implementation of Afghanistan's conducive to development of the private sector. development strategy and for achieving central Key challenges in raising revenues include: (i) lack national objectives of state-building, sustained of capacity in the tax administration system as well rapid economic growth, and poverty reduction. The as among taxpayers to calculate and pay taxes; following broad challenges for Afghanistan's PFM (ii) existence of numerous, low-yielding "nuisance system have been identified and discussed in this taxes", illicit revenue collection by many local report. authorities, instances of double-taxation (mainly between municipal and national taxation), and First, and from a macroeconomic and growth ambiguities in the tax laws; (iii) the dominance of perspective of critical importance, there is the agriculture and the informal sector in the challenge of fiscal sustainability. Afghanistan needs economy, which are difficult to tax in any country; to make continuous and sustained progress toward and (iv) widely perceived corruption in the tax a fiscal position where domestic revenues cover all administration. operating expenditures. This will require, inter alia, (i) rapid growth of domestic revenues (see below); Third, there is the challenge of a policy-based, well- (ii) containment of overall expenditures in line with prioritized budget with strong political buy-in. This medium-term resource constraints; (iii) ensuring will require a close linkage with national and sector that downstream expenditure liabilities created by strategies that themselves will need to be oriented public investments and other spending decisions toward private sector-led growth and have are affordable; and (iv) incorporating recurrent widespread national ownership. Effective strategic expenditures funded directly by donors through the prioritization of budget allocations will be difficult External Budget in the fiscal sustainability equation (including politically) but essential. Key cross- 128 Afghanistan: Managing Public Finances for Development cutting issues such as gender will need to be Sixth, there is the challenge of service delivery, the mainstreamed in budgetary decision-making. ultimate outcome of a PFM system. With a few exceptions, public service delivery in most sectors Achieving this gives rise to a fourth challenge: the is poor, as demonstrated by available data on challenge of making the national budget the central outcome indicators, giving rise to frustrations and instrument for policy and reform. Key constraints weakening the credibility of the Government. include: (i) limited capacity; (ii) the dominant share of Accountability relationships and incentives for expenditures directly by donors outside Government service providers need to be gotten right, although systems; (iii) serious timing dilemmas and a institutional arrangements can and will vary compressed budget formulation schedule which by sector. Sustainable financing and, where weakens the quality of the budget; and (iv) lack of a appropriate, adequate levels of cost recovery will medium-term strategic and fiscal perspective to guide be essential. Donors will need to ensure that their annual budget formulation. The Government has interventions strengthen rather than undermine prepared an initial Medium-Term Fiscal Framework national service delivery mechanisms. (MTFF) which, integrally linked to annual budgeting, will be critical to further improve the budget process. Seventh, closely related, there is the challenge of Meaningful processes of political engagement sustainable national capacity development. Unless and approval (including by Parliament) and public com- this happens, Afghanistan will remain excessively munication will also be needed. Finally, there is an dependent on foreign expertise indefinitely, and urgent need for greater inputs and participation by highly vulnerable to reductions in aid flows and lower levels of the government administration (provinces external TA. Capacity development will require and districts) in the budget formulation process. public administration reforms (recruitment, pay, HR), organizational restructuring and improvements, and Fifth, there is the challenge of effective budget execu- training. Better management of the massive tion. While considerable progress has been made in amounts of external TA currently being injected into some areas, a great deal remains to be done. Relying Afghanistan will be needed to ensure that it supports on sound institutions and adequate capacity, longer-term national capacity development. strengthening financial controls, procurement, recording/reporting, and audit will be key elements of Finally, there is the challenge of coordination and com- better budget execution. Meaningful implementation munication within an overall national strategic and of the Public Finance and Expenditure Management budgetary framework. Coordination within the (PFEM) Law and the Procurement Law will Government needs to be improved (this can support effective budget execution. Strengthening be done around a widely-owned national accountability and reducing vulnerability to development strategy and a sound budget process), corruption will be critical. International experience and public communications and transparency will demonstrates that the latter is best achieved by be extremely important in fostering Government addressing the underlying governance problems (in accountability vis-à-vis citizens and their elected the PFM system and elsewhere), rather than mainly representatives. Coordination is a major challenge for through investigation and prosecution of individual donors as well, which also needs to occur around the corruption cases. Thus improvements in the PFM national development strategy and budget process ­ system, particularly in the area of budget execution, the low share of external assistance going through will need to be a key element of a holistic anti- national budget and treasury channels is a serious corruption strategy. constraint in this regard. Key Challenges and a Roadmap for PFM Reform 129 While the challenges outlined above are numerous B. A Five-Point ReformAgenda and daunting, Afghanistan can build on earlier progress, and prospects for success are better than The Government has fully recognized these it might superficially appear at first sight. In fact, the challenges and the centrality of the budget process major progress already achieved ­ for example and PFM performance for Afghanistan's future. It in Treasury functions, in currency reform and has prepared its interim Afghanistan National monetary policy, in expansion of education and Development Strategy (I-ANDS), in which the PFM delivery of basic health services ­ gives ground for agenda needs to be anchored. In this regard, this hope. The Ministry of Finance has developed a report concludes with a suggested five-point vision to guide it in identifying and implementing a agenda to concretely move forward. wide range of actions required for strengthening its current functions and capacities and moving for- First, the path toward fiscal sustainability needs to be ward from the emergency needs of the last two mapped out and steady progress in this direction years toward a modern and effective public achieved. Based on a sound MTFF (which can be financial management organization.23 Other rudimentary at the outset but improved over time), this supportive factors include positive developments in will require particular attention to increasing domestic the financial reporting system, solid institutional revenue mobilization (through administrative improve- reforms in a few line ministries, the establishment of ments leading to better compliance as well as sound basic processes to manage the budget, and the tax policies); maintaining control over aggregate positive collaboration with the international expenditures within the overall resource envelope; community, notably through the ARTF. setting and implementing clear policies with respect to key expenditure components notably the Government However, there are also many downside risks and wage bill; and ensuring that strategic and threats, ranging from insecurity to difficulties in public expenditure decisions are affordable over mobilizing domestic revenue, lack of core capacity the medium-term, including downstream O&M in Government, and fragmentation of much implications of public investments and service delivery international assistance in the External Budget. networks. Much will depend also on establishing the functionality and processes of Parliament as an Second, a number of policy decisions and actions essential element promoting accountability. Finally, are needed to improve service delivery. This will it must be recognized that improvements will not be require clarifying the roles of the State (operational, easy and will take time, not least because a stable financing, policy, and regulation) in service delivery political culture will take time to develop. Given the in different sectors; strengthening accountability; "time horizon dilemma" that was mentioned earlier ensuring sustainable financing arrangements related to achieving quick results versus including cost recovery where appropriate; and longer-term national capacity building, interim and determining the responsibilities of various levels of asymmetric mechanisms have been used and will Government administration (central ministries, continue to be required, but they need to be provinces, districts). As discussed in Chapter 8, a applied in a way that does not detract from variety of different models of service delivery are sustainable progress over the medium term. possible within Afghanistan's Constitutionally- 23 "Afghanistan Ministry of Finance ­ The Way Forward", background paper for the World Bank PFM Review. 130 Afghanistan: Managing Public Finances for Development mandated unitary state structure, and the choice the respective roles of MoF and the line ministries among them should depend on sector-specific (the Procurement Law clearly gives authority to line conditions. Although "one size does not fit all," the ministries). Progress along this roadmap could effectiveness of service delivery is largely dependent be measured by key fiscal outcomes and on the degree of ownership behind the approaches implementation and progressive improvement of and the coherence of the models in terms of the MTFF, and by the PFM performance indicators accountability, incentives, and financing. presented in this report. Monitoring of progress, along with a meaningful feedback loop into Third, the capacity of the key PFM institutions subsequent decision-making, will be as important should be developed. Without stronger capacity as the action plan itself. and institutional reforms, improvements in PFM performance as well as progress toward key Finally, continuing and further deepening collabo- national development objectives will be difficult to ration between the Government and the interna- achieve and impossible to sustain. Priority areas tional community will be critical for the success of include training, recruitment practices, pay the reform program. The Government's develop- structures, organizational reforms, detailed ment strategy ­ including plans for progressing business processes, specific IT systems, etc. While toward fiscal sustainability, more effective service these issues cut across all levels of Government, delivery, capacity development, and strengthened MoF's capacity is of particular importance. Since it PFM performance ­ should serve as the basis for a is chief custodian of the PFM system, its capacity to framework of mutual accountability. Donors would develop and implement policies is at the core of align their support to national strategic objectives PFM performance. Progress toward an MoF and the national budget and increasingly use the Strategic Plan ­ initiated in May 2005 ­ will be very Government's systems, while the Government important in developing MoF's capacity and would implement the decisions it has announced improving performance. PFM capacity develop- and further improve the performance of the PFM ment in line ministries also is very important but will system. In addition, the content, mode, and take time. capacity-building contribution of technical assistance will be very important and needs to be Fourth, and related to the previous recommenda- well-managed and well-coordinated in line with tions, the Government should adopt a clear action Government leadership and national budgetary plan to improve PFM performance, with time-bound and other capacity-building processes. milestones, quantified objectives, and clearly identified responsible agencies. Table 10.1 seeks to Way forward. Not surprisingly in view of the major provide a comprehensive, high-level roadmap of challenges that Afghanistan faces, this is a policy reforms required. It is comprehensive in the multi-faceted, demanding, and ambitious medium- sense that all areas of PFM are covered. It is term agenda. Each of the five elements includes high-level in the sense that some concrete next difficult sub-agendas and important actions steps are identified for the next 6-12 months, but required for success. This points to the need to many actions are less specific and will need to be prioritize and focus on a set of realistic yet converted into detailed action plans later by the meaningful short-term measures that will achieve responsible Government departments. Also, some significant improvements and step-changes, key accountabilities, left out of the PFEM Law, will thereby setting the stage for further progress. need to be fully specified, especially with regard to A package of prioritized short-run actions could Key Challenges and a Roadmap for PFM Reform 131 thus comprise a "platform" from which the next set implementation of this package (not necessarily all of actions would take off, with monitoring and of the measures but at least a critical mass of most feedback to guide the process at each stage.24 of them) would build the "platform" on which the Moreover the package, rather than any single following year's action plan could be based, measure or mechanical target, would be what the leading to further progress subsequently. This Government takes responsibility for and could form type of process would help in coordinating the the basis for dialogue and agreements with the expectations of all partners as to what the international community. Government realistically will be able to achieve every year and, with adequate monitoring, it would In this process, the Government first needs to help the Government to establish a strong track develop and reach agreement on its strategy. record of implementation. Adequate monitoring The recently completed I-ANDS marks a major and evaluation should also feed back into the next achievement in this regard and includes the year's annual plan and possible revisions to Government's MTFF. The I-ANDS and MTFF need the overall strategy ­ this requires significant to be supported by a PFM action plan that would development of statistical and analytical capacity. be adopted by the Government, as well as an MoF reform strategy. Clear sector strategies also This proposed way forward would fit appropriately are needed to guide prioritization and sector within the overall umbrella of the Government's expenditure programs. The ANDS and sector I-ANDS and its preparation of a full ANDS. It is strategies need to specify the roles of the State and also fully consistent with, and would support the put forward sound approaches to ensure effective implementation of, the Afghanistan Compact service delivery, differentiated by sector as agreed between the Government and donors at appropriate (see Chapter 8). The sector strategies the London Conference on Afghanistan (January will take varying amounts of time to develop and, 31 ­ February 1, 2006). like the interim ANDS, MTFF, and PFM action plan, will need to be improved over time and adjusted in In conclusion, the five-point reform agenda outlined the light of experience. It is critically important that above is ambitious, requiring sustained efforts over a these strategies have wide national ownership, both considerable period of time based on meaningful within and outside Government. steps each year. But as seen earlier, the challenges in building an effective, accountable, financially self- The strategy as it applies to public finance sufficient State that facilitates sustained economic management would then be translated each year growth, ensures adequate delivery of services to the into annual plans that would consist of three Afghan people, and reduces poverty are enormous building blocks: (i) an updated medium-term view and pressing ­ requiring a commensurate response. of the fiscal path (MTFF); (ii) an annual budget that The Government, with strong support from the is consistent with the MTFF and with the ANDS; and international community, has demonstrated its (iii) an "annual action plan" (a list of a small number willingness and commitment to embrace an ­ certainly less than 20 ­ of key actions to agenda along these lines and move forward with be accomplished during the year). Successful implementation in a determined yet realistic manner. 24 See Brooke (2003) for a discussion of the background, rationale, and modalities of how such a "platform" approach could work in the context of country situations involving external budget support. 132 Afghanistan: Managing Public Finances for Development .pseR evenueR Municip. evenueR Customs Municip. Budget, Budget, Ministries CSO, )shtno Customs MoF/ & MoF/ MoF/ MoF/ MoF/ MoF/ line MoF/ MoE M 21 .dnI 15 15 13, 13, ot 3, 14, 3, 14, 12 6 dnoyeB( to by for broad- policy (and plan Budget and frame- consider. plan sector evalua- mret- laws tax Business plan tax) National and of (e.g simple tax collection and muide snoitcA tax customs a sectors proposals needed) strategies medium-term policy convert expenditure into modernize implement Strategy 5-year 5-year as between revenue framework ormance M policy tax axT needed) and link sector and monitoring erfP taxes, consumption and selected preparation modernized as revise in municipalities out system PFM Develop modern excise eceiptsR based Enact eviewR for Implement revise Implement (and repareP modernize municipalities Deepen Development Develop medium-term work oll-R strategies expenditure Develop tion A4. A5. A6. A10. A11. A12. B5. B6. B7. B8. engthen Str to .pseR & with p MoF/ evenueR customs & MoF/ evenueR and Budget MoF/ evenueR Customs Ditto reasuryT MoF/ Budget, IARCSC MoF/ Budget )shtn Roadma o .dnI 13, 13, M 3, 14, 15 3, 14, 15 12 2 10.1: 1 ot tax per- rev- ableT 6txe tax budget its partic- in com- policy budget taxes) of B1) argeL and (in budget vs. N( mret-trohS snoitcA projections and revenue simplify of revenues, income part (see / new agreed underlying as for ANDS on (eliminating accounting medium-term bill, in budget revenue focus Office monitoring customs standard enforcement of the "nuisance" administration projections contributions) publish wage of clear cash. Implement decisions Consolidate measures small Develop and assumptions documentation Improve axpayerT formance Develop powers enue Strengthen mechanisms collection Strengthen fiscal ular donor light Use definitions (e.g mitments) A1. A2. A3. A7. A8. A9. B1. B2. Mobilization airF ormulationF saerA pro- and evenueR A. Sound evenueR olicies;P evenueR jections Effective evenueR Administration Budget.B Strategic, ealistic,R redictableP Multi-year rameworkF Key Challenges and a Roadmap for PFM Reform 133 .pseR min- and Budget, MoI,, line, MoLSA )shtno MoF Budget reasuryT MoF/ donors MoF municip. MoF istries MoF/ M 21 .dnI 11 ot 9, 5 9 6 dnoyeB( - in and, and as struc- present between costs policy based an results such assis- road revised to ued) mret- system a ordinary and fund below) a a along (program Owned- documen- classifications of and by budget sectors external (contin muide snoitcA toward linkages recurrent (see -term, reduction-related the municipalities State program budget budget under unify key and budget in classification on on budget health, M objectives in longer system fully develop with integrate budget the supported gradually -based definitions classification poverty data documentation data the Budget in and (requires and ormance functional erfP Move output over oriented Clarify development Core ture urtherF investments (starting education, development) urtherF tance Develop goals budget) budget Identify expenditures on Include budget Include enterprises tation B9. B12. B13. B14. B15. B16. B17. B18. PFM .pseR line engthen Str MoF/ Budget MoF Budget, ministries MoF reasuryT to shtno ) p .dnI 11 M 9, Roadma 21 ot to 10.1: 6txe all esti- review) for prioriti- link on for (as to implica- invest- ableT N( and mret-trohS snoitcA programs off-budget Budget based costs criteria program establish and ceilings mid-year efficiency by sizable clear requirement proposed and sectors orientation recurrent for integrate of ANDS budget Define investment zation the Set major policy allocative informed Enforce mate tions ments urtherF activities B3. B4. B10. B11. saerA Integrated Comprehensive, ullyF Budget 134 Afghanistan: Managing Public Finances for Development .pseR Budget Budget / reasuryT )shtno MoF/ MoF Committee MoF/ M 21 .dnI 12 19 ot 11, 11 27 17, 6 dnoyeB( , in in pro- min- prac- informed forecasts ued) mret- capacity line participa- the in budget process out flow for (contin muide snoitcA provinces investment PFM pensions review strengthen of on greater on carry budget cash SOE C26) M capacity and role to data articulate support the documentation to (see mid-year formulation of monthly D11) of including ormance erfP strengthen see Include budget Develop istries posals Continue tice ormalizeF budget (encouraging tion, programs) Develop arliamentP review efineR B19. B25. B26. B27. B29. C4. PFM engthen .pseR Str MoF/ Budget (and donors) Cabinet Secretariat MoF/ Budget MoF/ reasuryT to shtno ) p .dnI 16 M 11, 12 11 2, 27 17 Roadma 21 ot on for with for flows 10.1: 6txe cal- the trans- in envelop, olicyP sector expendi- publi- review transfers reliance allot- of Budget operating budgets ableT N( advance) of and formulation mret-trohS snoitcA forecast budget early sending in provinces and and approval, the budget provincial B4) new Budget and enhancing the a notion provincial from budget provincial reports budget both and (starting circular (see of Cabinet in frequency 2006/07 on in monthly of budgets with with. by input for role development contingencies flows Introduce endar year e.g Statement, budget Introduce ceilings eviewR tures cation Solicit 2006/07 their educeR across on repareP focus parliamentary a parency ments and Develop TSA B20. B21. B22. B23. B24. B28. C1. the Execution aerA Open,, rocessP of Budget Cash evisionsR Budget w Orderly articipatoryP Budget and Adequate egislativeL Scrutiny Annual La C. Effective Management Key Challenges and a Roadmap for PFM Reform 135 .pseR (with reasury;T )shtno B MoF/ DA Budget; reasuryT MoF/ reasuryT budget) MoF M 21 .dnI 4 ot 17 16 16, 6 dnoyeB( of and ("no out- line debt to (see cash instru- policy to systems) for enhancing informa- ued) mret- procedures consistent control policy with and debt system assignment for implement AFMIS (contin muide snoitcA TSA management management debt link study of system implement Mustoufiats architecture and out regulations; M cash debt and strategy scheduling requirements domestic appropriate and ministries allotment a management system and commitment internal as transparent D5) consolidate resources of roll- AFMIS ormance line guarantees systems and erfP Introduce payment for Mustoufiats ullyF eview Develop management with system overdraft") management ments on ensure scare financial tion come ministries D4 (processes; C5. C6. C9. C10.Implement C11.R C12.Develop C13.Develop C17.Improve C18.Develop C19.Initiate C20.Develop PFM engthen .pseR Str MoF/ reasuryT MoF/ reasuryT (with budget) to shtno ) p .dnI M 17, 19 17 16 4 9 Roadma 21 ot to all 10.1: 6txe TSA strategy incor- of each evenue/R banking existing expendi- develop for imple- ableT N( registry mret-trohS snoitcA of debt under under and received Flow Committee toward (including report budget) survey end- asset review year unit and an assets Cash consolidate external province simple at procedures operations MoE) by established Create Management reasury/Budget/(T AB/D urtherF arrangements Conclude debt Develop Capture tures appropriations development epeatR arrears Develop be budgetary related porating through .8 C2. C3. C7. C C14. C15. C16. aerA Debt Effective and Guarantees Management Smooth, redictableP Budget Implementation 136 Afghanistan: Managing Public Finances for Development .pseR reasuryT reasuryT reasuryT Admin; O )shtno MoF/ MoF/ and CA MoF/ MoF IA M 21 .dnI ot 23 9 20 21 6 dnoyeB( for MoF's moni- budg- PFEM min- and the reform munic- of to internal activities audit for ued) mret- for tracking line units provisions to of plan related Officers on-line audit audit (contin muide snoitcA of Mustoufiats basis registry PFEM for framework MoF editing internal adopt and D5) department the internal all the M form expenditure asset reforms standards inancialF and and AFMIS units and control implementation audit internal internal will arrears ministries from out units out administrative D4 ormance Chief out out annual erfP which toring surveys oll-R line oll- oll- etary control regulations istries' implement for recording budget (see municipalities internal and in activity ipalities C21.Develop C22. C25.Develop C26.Carry C27.R C28.Develop C33.R C34.Develop C35.Coordinate C36.Develop PFM engthen .pseR Office, the Str MoF MoF/ reasuryT MoF of residentP MoF/ reasuryT MoF IA to shtno ) p .dnI M 20 21 Roadma 21 ot and with staff pro- 10.1: 6txe - to certi- Audit) compli- reviews staff pre budgetary contracts account- MoF on standards MoF's and audit audit ableT N( mret-trohS snoitcA in for to regulation, the Agent in systems stop inancial Internal implementation department and typical control (F to expenditures streamline PRR of training internal outside up fiduciary key MoF ministries internal MoF awL and controls feedback audit of integrated or strengthening for Monitoring line with out manual, be speed mented Government Align PFEM Controllers approval to units eviewR internal to while ability Use provide and ance Implement internal Carry fication Develop audit grams C23. C24. C29. C30. C31. C32. aerA Audit Internal Controls Internal Key Challenges and a Roadmap for PFM Reform 137 .pseR MoE / reasuryT reasuryT reasuryT dpt Budget )shtno MoF reasuryT SOE MoF MoF/ MoF/ and MoF/ / M 21 .dnI 25 ot 18 19 22, 6 dnoyeB( to to other clas- stan- to and all centrally in review stan- line imple- and program ued) mret- to for means government responsi- transac- tendering of budget capacity resources in appeal standardization reports AFMIS role of complete (contin muide snoitcA and analysis an payroll accounting system pension implement ministries modern out for reporting human information transfer increase C18) national sector independent and aw)L M units clarify of monthly a of needs product procurement an line a and transparency (regulations public and roll- (see verified of for to private of and use PFEM in-year timely ormance personnel, ministries whole erfP management budgetary consolidate for needs to rogressively bility tions rain procedures repareP respect mechanism mechanism dards Develop dards ministries ment Enforce sification issue Complete line timely C38.Develop C39.Extend C42.P C43.T C44. C45.Establish C46.Develop D2. D3. D4. PFM .pseR MoE (with / engthen B Str MoF reasuryT MoF MoF/ reasury;T DA MoF/ Budget reasury)T to shtno ) p .dnI M 18 19 22, 25 22 5 Roadma 21 ot from bank of 10.1: 6txe pay by imple- devel- olicyP data, of to in ableT N( mret-trohS snoitcA (TSA) Salary rocurementP rules reasuryT payment accounting banking (including new clarify projects coverage budget) rocurementP reconciliation the and with regulations the Account list (and Expand Individualized aymentsP the transfer) Adopt ment awL regarding opment Establish Unit Automate government records particularly Single eportingR C37. C40. C41. D1. and , aerA ayrollP rocurementP Accounting.D Accounting In-year eportingR 138 Afghanistan: Managing Public Finances for Development .pseR MoF/; O O )shtno IARCSC MoF/ Line Ministries CA Budget CA M 21 .dnI 28 25 ot 6,7,8,9 9, 26, 6 dnoyeB( All to of of time posi- and All public and, annual owner- of and min- audits Audit pro- over projects regula- of ued) mret- AFMIS audited. waL capacity capacity covered line of financial review new be form be the audit audit (contin muide snoitcA structure, of external Audit out modernized and enterprises' objectives, employees. procedures for standards the gazette M roll- on should should of accounting accounting state results the collection, implemented and external external towards company governance (regardless for -up implement ormance donor erfP Undertake Mustoufiats Develop municipalities Develop SOEs Move accounting Disclose financial tion, ship, information information SOEs ownership) Establish requirements istries follow of inalizeF w La Develop tion, Develop curement D5. D6. D7. D8. D11. D12. E4. E5. E6. PFM .pseR with ; engthen O O Str MoF/ Budget reasuryT MoF/ reasuryT CA CA MoF/IA to shtno ) p .dnI M 25 26 Roadma 21 ot 10.1: 6txe cap- imple- and to process preparing period staff of ableT N( mret-trohS snoitcA accurately donor to quarterly Scrutiny work Accounts arliamentP means of of least and the report accounting Government projects commit accounting at certification audit ublicP processes out professional accounts and to of-- offs- Audit,, its all Develop ture expenditures mented MoF formal cut Carry auditing for Develop whole annual Create Committee and D9. D10. E1. .2E E3. Accountability aerA Accessible ransparentT and External inancialF eportingR External.E External Audit Key Challenges and a Roadmap for PFM Reform 139 .pseR )shtno MoF Donors M 21 .dnI ot D3 6 dnoyeB( plans ublicP civil budget of publish and scrutiny involved and the donor toward commu- ued) mret- reports by of assessment of established adjust for by reform ministries administration and (contin muide snoitcA move audit media execution) regularly reasuryT out line to scrutiny system of scrutiny and to external priorities roll- administrative in implement M further public the responses and alignment Committee role the ANDS to strategy and in performance for to through support the and and progress response ormance PFM erfP Develop and including ministries Accounts Develop society (formulation Government internal of Enhanced funding under Donors support budget Initiate budget departments Implement reforms Monitor nications E7. E8. F4. F5. F6. G7. G8. G9. G10.Continue PFM engthen .pseR Str MoF Donors to shtno ) p .dnI D1, M 1, D2 Roadma 21 ot infor- for and 10.1: 6txe to sup- B1) defini- year (see timely informa- public -wide to ableT N( mret-trohS snoitcA expenditures disburse- with fiscal implementa- reform process framework financial in -wide Plan medium-term respond provide actual provide applications Government's D9) start to donor on to planned early PRR Government taskforce(s) reform implementation can (see on and coordinate Action Develop expenditure which port Donors mation following tions Donors tion ments eviseR MoF tion; Government administration Adopt PFM Create oversee monitor F1. F2. F3. G1. G2. G3. acticesrP Management aerA undingF Donor.F eformR. Donor G 140 Afghanistan: Managing Public Finances for Development .pseR )shtno M 21 .dnI ot 6 dnoyeB( ued) mret- activities (contin muide snoitcA training M ormance erfP Continue G11. PFM engthen .pseR Str to shtno ) p .dnI M Roadma 21 ot 10.1: 6txe plan to PFM outside ableT N( mret-trohS snoitcA on reform training and approach an within detailed department initiate and MoF Develop communicating reforms government repareP by Plan activities G4. G5. G6. aerA STATISTICALAPPENDIX TABLEA.1:MACROECONOMIC INDICATORS 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 Estimates Projections A. Output GDP (US$ million, excluding opium production) 2,463 4,084 4,585 5,975 7,130 8,562 9,951 GDP (millions of new Afghani) 133,987 182,862 225,108 284,504 355,338 426,708 495,946 Real GDP growth rate ... 28.6 15.7 8.0 14 11 11 GDP per capita (in US dollars) 123 182 199 253 293 342 386 Opium production (metric tons) 185 3,400 3,600 4,200 4,100 ... ... Opium value (millions of US dollars) 56 1,300 2,300 2,200 ... ... ... B. Prices CPI (% year-on-year change) (43.4) 52.1 10.2 16.3 10 8 5 C. Exchange rates Afghani/US dollars (average during solar year) 54.4 44.8 49.0 47.7 ... ... ... Afghani/US dollars (end-solar year) 31.0 52.6 50.3 48.7 ... ... ... D. Monetary indicators Domestic currency in circulation (percentage change) ... 20.1 40.9 37.5 28 23 ... Gross foreign exchange reserves (US$ million) ... 426 816 1,261 1,691 2,036 ... Source: GoA, UNODC, IMF. 142 Afghanistan: Managing Public Finances for Development TABLEA.2:SOCIAL INDICATORS (2003) Indicator Rural Urban National Survival Infant mortality (number of deaths per 1,000 infants under 1 year) 121 97 115 Under five mortality (number of deaths per 1,000 children under 5 years) 183 142 172 Morbidity (%) Diarrhea (children under 5 reporting incidence in past 15 days) 30 30 30 Increased fluid and continued feeding given during diarrhea 54 51 53 Acute Respiratory Infection (children under 5 reporting incidence in past 15 days) 19 19 19 Advice or treatment sought from hospital/HC during ARI 27 32 28 Malnutrition (%) Children that have not received timely complimentary feeding (6-9 months) 73 66 71 Households consuming non-iodized salt 90 74 85 Pregnancy (%) Births not taking place in health facility 96 68 89 Married women (<49 years) who have not heard of a method to delay pregnancy 78 55 72 Married women (<49 years) not currently using a method to delay pregnancy 94 79 90 Disability and Orphanage (%) Children 1-4 years that are disabled 2 3 3 Children 7-17 years that are disabled 3 4 3 Children with both parents dead 6 6 6 Preventive Health (%) Children 12-23 months that have received DPT 3 immunization 23 48 30 Children 12-23 months that have received Polio 3+ immunization 43 71 51 Children 9-59 months that have received Measles immunization 73 84 76 Children under 5 that have received BCG immunization 55 73 60 Access to Sanitation and Water (%) Households with drinking water from pump/protected spring 31 61 40 Households having a flush or pit toilet 59 87 67 Households with water source and latrine within 15 meters 77 60 67 Education Illiteracy rate: Male (% of pop. aged 15 and over) 64 40 57 Illiteracy rate: Female (% of pop. aged 15 and over) 92 72 86 Primary school net enrolment rate (% of 7 to 13 year olds) Male 61 81 67 Primary school net enrolment rate (% of 7 to 13 year olds) Female 30 63 40 Source: NRVA (2003). Statistical Appendix 143 TABLEA.3:FISCAL SUMMARY (AFS MILLION) 2002/03 2002/03 2003/04 2003/04 2004/05 2004/05 2005/06 Budget Est. Budget Est. Budget Est. Budget (In millions of Afghanis) Domestic Revenue 2,822 5,864 9,000 10,168 15,380 12,812 16,150 Tax Revenues 6,262 9,546 Taxes on income, profits and capital gains 363 995 Taxes on international trade and transactions 5,369 7,247 Other taxes 531 1,304 Non Tax Revenues 3,906 3,266 Donor Assistance Grants (to operating budget) 12,828 9,430 15,750 10,074 14,952 14,984 16,733 ARTF 11,250 8,182 12,575 12,319 13,580 LOTFA and Army Trust Fund 4,500 1,892 2,377 2,583 3,153 Other grants - - - 82 - Donor Assistance Grants (to core development budget) - - - 4,569 36,882 8,250 34,648 Total Expenditures (Core Budget) 15,650 15,514 24,750 30,054 81,562 41,710 91,513 Operating Expenditure 15,650 15,514 24,750 21,972 30,332 26,605 32,883 Wages and Salaries 12,954 13,818 18,027 17,842 22,311 Purchase of goods and services 6,493 4,243 4,850 5,247 4,037 Debt service and Interest payments - 25 278 97 404 Other recurrent 1,002 881 (12,438) 1,440 (345) Capital expenditure 1,683 3,005 1,752 1,979 2,301 Reserves and Contingencies 2,618 - 17,863 - 4,175 Core budget development spending - - - 8,082 51,230 15,105 58,630 By Program 24,750 30,054 81,562 41,710 91,513 Human Capital Development 9,181 6,388 22,458 16,657 27,881 1.1 Refugees and IDP return 132 81 127 105 187 1.2 Education 6,002 3,938 7,513 5,824 9,179 1.3 Health 1,256 1,233 2,327 3,007 2,850 1.4 Livelihood and Social Protection 1,192 627 11,870 7,079 14,537 1.5 Culture, Media, Sport 600 509 621 642 1,128 Physical Infrastructure 1,159 6,941 18,160 7,253 28,312 2.1 Transport 188 1,381 9,100 3,975 12,537 2.2 Energy, Mines, and Telecom 363 3,224 5,840 2,163 9,577 2.3 Natural Resources Management 575 2,017 2,091 725 3,594 2.4 Urban Management 33 319 1,129 390 2,604 General Administration 2,358 5,203 6,155 3,876 12,521 3.1 Trade and Investment 99 231 1,298 421 1,489 3.2 Public Administration and Economic Management 2,259 4,972 4,857 3,455 11,032 Security 9,434 11,523 16,925 13,924 18,623 3.3 Justice 424 599 921 1,002 1,122 3.4 National Police and Law Enforcement 3,250 5,515 10,689 7,792 11,288 3.5 Afghan National Army 5,760 5,409 5,315 5,130 6,100 Reserves and Contingencies 2,618 - 17,863 - 4,175 Operating budget balance (excluding grants) (12,828) (9,650) (15,750) (11,804) (14,952) (13,794) (16,733) Operating budget balance (including grants) - (220) - (1,730) 0 1,190 0 Core budget balance (including grants) - - - (5,243) (14,348) (5,665) (23,982) Float and Adjustment (656) 0 140 14,348 2,507 97 Financing 876 - 5,103 - 3,158 23,885 External Loans (net) - - 4,886 - 14,754 23,853 Domestic (net) 876 - 217 - (11,596) 32 Memorandum item: External Budget 22,777 95,733 106,879 164,794 119,398 154,235 Source: MoF, IMF 144 Afghanistan: Managing Public Finances for Development Sri ankaL 7.62 5.5 4.9 5.7 4.2 5.4 1.1 20.2 6.52 1.5 4.5 1.1 2.5 1.6 3.3 4.3 6.8 Sen- egal 5.12 5.8 3.7 1.5 2.6 7.2 0.2 13.6 1.31 - 3.1 1.6 2.9 0.7 0.6 4.2 number Management om-R ania 4.61 3.7 1.8 4.0 4.6 1.6 14.8 (0.0) 4.61 0.8 1.3 1.8 2.5 0.4 1.7 0.2 2.9 4.8 small the Phili- ppines 7.91 5.5 4.5 4.3 3.4 1.8 0.1 17.7 6.91 Economic 1.0 1.0 1.4 3.7 0.4 0.9 0.2 3.3 7.7 given and -kaP istan 3.32 0.8 9.9 7.4 2.5 2.1 0.5 20.7 8.22 rograms.P 0.7 4.5 0.3 0.2 0.1 0.5 0.0 0.8 15.6 caution eformR Mol- dova 0.12 2.5 2.9 6.4 7.3 1.7 19.5 (0.2) 2.12 with 1.1 0.4 1.3 1.2 1.0 3.5 0.3 1.7 10.7 tration used Infrastructure yrgyzK -peR ublic 3.71 4.7 6.2 1.4 2.3 2.2 15.8 (0.7) 0.81 eb 2.7 1.7 1.1 3.5 2.0 2.7 0.5 2.1 1.6 Adminis Physical aza-K 4.41 g/ 1.1 3.3 1.3 6.8 1.1 0.6 12.6 7.31 should 0.9 0.6 1.3 0.5 0.3 5.6 0.2 1.5 2.8 ublicP khstan and 6.13 1.7 3.5 2.3 4.8 26.8 15.0 (0.0) 7.13 Statistics 2.0 6.0 2.9 5.0 3.3 5.7 0.5 2.4 3.7 rograms;P Jordan ARISONS India 2.81 1.7 2.1 4.7 6.9 1.3 1.5 15.4 7.61 Investment 1.1 2.6 0.4 0.3 0.8 2.3 9.2 available. and rotectionP COMP Bul- garia 5.91 2.6 7.0 3.9 4.1 3.0 17.7 (1.1) 6.02 data 2.2 2.3 1.9 1.5 1.4 0.9 0.6 2.9 6.9 of radeT Social set d/ 3.71 3.5 2.2 1.7 8.6 2.1 16.0 (0.8) 1.81 and 1.3 1.7 1.8 3.5 1.2 5.3 0.1 1.0 2.3 (2000) Bolivia service; 3.24 7.2 8.6 0.4 1.3 1.4 18.1 22.7 8.04 complete 8.8 2.2 5.5 3.8 1.4 0.3 0.4 a debt Livelihood 18.5 countries Bhutan EXPENDITURE and and 4.81 2.7 3.5 0.8 6.5 4.8 13.5 (0.0) 4.81 1.3 1.2 1.2 1.1 1.0 0.5 0.4 4.4 7.1 other Includes A.4: Belarus c/ return for 6.91 3.6 3.6 3.7 4.1 2.2 0.0 16.8 5.91 US$2,000 IDP 1.3 1.7 1.4 2.5 1.0 2.2 0.3 2.3 3.0 GFS ABLET / Median budget; and below a/ a/ a/ b/ a/ a/ c/ d/ e/ f/ IMF g/ issues. - 5 6 4 3 7 1 3 Afgha- nistan (total 75 28 n/a n/a n/a n/a 29 75 13 15 capita budget) efugeesR per f/ (2004), development classification Afgha- nistan (core budget) 6.41 - 6.3 2.8 0.0 1.6 3.9 10.8 6.41 - 1.4 1.8 3.1 2.0 1.1 2.5 0.2 2.5 GDP from with and rograms;P )gnidnelten Afghanistan data gnidulcni( Services )gnidnelten estimates oliceP for , Affairs countries and all available Includes Housing transfers eligiousR estimates b/ Justice and o/w( with includes e/ staff erutidnepxElatoT current repayments Goods Expenditures of aymentsP and Expenditures minus ages :seto Current W urchaseP Interest Subsidies Capital endingL serutidnepxElatoT Safety elfare, Services and and W, Cultural, table amenities countries Unknown; ublicP Services This of a/ rograms;P MoF Order Security Expenditures General Defense ublicP Education Health Social Community ecreational,R Economic Other N :ecruoS Statistical Appendix 145 0.1 1.5 0.5 1.1 1.7 1.1 0.3 0.7 0.3 0.6 0.5 0.1 2.7 1.2 0.0 1.1 0.6 0.2 1.3 0.0 0.0 0.4 1.4 0.7 1.6 0.3 0.8 ropertyP axesT axesT ... 0.0 0.3 ... ... 0.0 0.0 ... ... ... ... 0.0 ... 0.0 ... ... 0.0 0.4 ... 0.2 ... ... 1.4 ... ... 0.0 0.2 radeT Export duties which: of 2.8 0.7 1.4 2.4 1.0 0.7 1.3 ... 0.4 3.0 0.0 2.5 0.3 0.4 ... 0.5 0.5 2.5 1.0 1.1 1.6 1.3 1.0 1.2 0.7 1.7 1.3 Import duties International 2.9 0.8 1.5 2.0 1.0 0.7 1.3 1.5 0.5 3.0 0.0 2.6 0.3 0.6 0.7 0.5 0.5 2.9 1.4 1.4 1.6 1.3 2.5 1.2 0.7 1.7 1.4 otalT 1.0 1.8 1.5 2.4 2.9 1.9 3.2 2.2 1.0 4.4 3.6 3.2 1.5 0.5 2.1 3.9 3.5 2.2 4.0 2.8 2.0 2.8 2.1 2.9 2.7 3.6 2.5 Goods Excises which: on of or sales, axesT TAV 5.4 3.7 3.4 5.9 5.5 2.1 7.9 7.8 3.9 14.2 9.2 0.0 10.6 4.0 5.4 8.2 8.7 2.0 8.3 5.7 6.4 5.7 5.3 11.6 6.0 3.5 6.2 Services turnover General and Domestic otalT 6.9 5.6 8.2 18.6 10.3 12.6 11.2 10.8 9.0 18.8 12.9 8.1 12.6 6.2 11.1 12.6 12.4 6.2 14.4 11.0 8.4 9.2 10.7 14.8 9.3 8.4 10.8 ARISONS yrollaP ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... axesT 0.1 1.1 1.1 0.7 1.0 0.5 0.0 0.2 1.5 0.2 0.6 calculation. the ... ... ... COMP Social Security axesT 2.7 3.4 3.9 10.1 1.9 8.6 7.6 1.4 13.9 10.6 5.8 3.7 10.2 7.7 0.3 7.2 4.7 1.3 9.7 7.0 13.6 0.5 0.4 5.9 in 1.0 1.5 1.9 3.0 1.3 1.4 2.8 ... 0.5 1.4 1.7 1.5 3.4 1.7 1.1 2.2 0.9 6.0 1.1 3.0 2.0 2.9 2.0 1.2 4.0 2.6 2.1 included rofits,P Corporate (IMF). are REVENUE Gains which: of 0.2 3.0 1.5 3.2 0.3 0.3 4.1 ... 0.3 5.2 8.0 1.2 2.0 1.5 5.9 7.8 2.4 2.2 1.4 1.5 3.8 2.7 4.3 2.2 3.4 Income, 11.1 10.2 A.5: Statistics on Capital Individual available are ABLET axesT and otalT 1.2 4.6 5.0 7.8 1.7 4.5 8.1 4.0 1.8 7.2 9.7 2.8 15.4 5.4 3.2 8.1 8.8 8.4 4.2 5.8 3.5 6.8 7.6 7.6 14.4 5.0 6.2 inancialF data Other 4.0 2.3 1.2 3.4 4.8 8.2 8.3 4.2 1.2 4.6 4.3 4.3 7.1 3.9 4.1 5.8 1.9 7.9 5.4 8.5 3.6 4.1 5.7 2.8 3.3 2.4 4.5 which evenueR for International xaT and evenueR 13.7 20.9 19.4 41.7 18.1 29.4 29.2 19.3 12.6 43.8 33.7 14.3 37.5 18.4 15.0 32.5 30.0 19.4 28.6 23.8 14.5 28.2 30.3 39.5 27.3 15.9 25.3 countries (IMF) only otalT 17.7 23.2 20.5 45.1 22.8 37.6 37.5 23.5 13.8 48.4 37.9 18.5 44.6 22.3 19.1 38.3 31.9 27.3 34.0 32.2 18.1 32.3 35.9 42.3 30.6 18.3 29.8 evenueR Statistics Size Sample 1997 1997-98 1997-01 1997-99 1997-01 1997-01 1997-98 1997-01 1997-01 1997-99 1997-01 1997-01 1997-99 1997-01 1997-00 1997-00 1997-01 1997-01 1997-01 1997-01 1997-01 1997-01 1998-01 1997-01 1997-01 1997-01 inanceF classification, 1/ revenue average Government each epublicR Africa lbaniaA Argentina Azerbaijan Belarus Bolivia Brazil Bulgaria Chile China Croatia Estonia India Israel azakhstanK 1/ yrgyzK atviaL Lithuania Malaysia Moldova Mongolia eruP omaniaR ussiaR Slovenia South Thailand Unweighted :ecruoS orF 146 Afghanistan: Managing Public Finances for Development 31/2102 8.3 8.3 4.7 5.3 5.5 0.2 5.3 13.8 0.91 1,526 77,254 78,780 44,087 34,693 49,096 50,622 48,901 127,876 176,777 21/1102 8.2 9.3 5.3 6.0 7.3 1.3 5.9 15.5 4.12 67,570 78,348 43,691 34,657 49,060 59,839 10,778 48,901 127,408 176,309 11/0102 8.1 5.7 5.6 7.9 2.4 16.1 10.2 10.8 9.62 59,176 76,346 41,771 34,574 40,774 57,943 17,169 78,971 117,120 196,091 01/9002 7.8 6.1 8.9 3.3 19.9 10.7 12.2 17.1 0.73 50,095 71,290 39,090 32,200 57,368 78,563 21,196 128,658 110,237 238,895 90/8002 snoitcejorP 7.2 5.9 3.4 20.7 10.6 10.0 13.4 20.1 8.04 41,363 60,828 33,940 26,888 57,380 76,845 19,465 118,208 114,950 233,158 P 80/7002 D snoilli Gfo 6.6 5.7 3.6 22.6 10.7 12.4 16.0 25.9 5.84 32,821 50,848 28,346 22,502 61,433 79,460 18,026 112,281 128,567 240,848 6.0 5.7 3.5 23.5 10.1 13.9 17.4 31.8 3.55 SCENARIOS esa 70/6002 m sfA 25,789 40,909 24,467 16,442 59,318 74,438 15,120 egatnecrep 100,227 135,808 236,035 C sA AL FISC esaB.a6 60/5002 5.2 9.2 6.3 7.5 4.1 16.7 11.6 22.2 0.93 18,392 59,483 32,883 22,311 10,572 26,600 41,091 14,491 79,021 138,504 A.6: ABLET 50/4002 4.5 9.4 6.3 5.3 4.8 14.7 10.2 42.0 6.65 8,764 12,812 41,710 26,605 17,842 15,105 28,899 13,794 119,398 161,108 40/3002 slautcA 4.5 9.8 6.1 3.6 8.8 5.2 13.4 47.5 8.06 8,154 8,082 10,168 30,054 21,972 13,818 19,886 11,804 106,879 136,933 30/2002 - - n/a n/a 3.2 8.5 8.5 n/a 5.3 5.3 12.5 5,864 9,650 9.02 9,650 15,514 15,514 22,777 38,291 Expenditures Expenditures Expenditures Expenditures Grants Grants wage Expenditures wages non Before Expenditures Before operating evenuesR evenuesR Operating wages Development operating Operating Development Dvpt Dvpt Expenditures which which Deficit which Expenditures Expenditures which which which Deficit which which of of which of of of of of Domestic Core of of iscalF External otalT Domestic Core iscalF External serutidnepxElatoT Statistical Appendix 147 31/2102 8.3 5.0 5.3 1.9 4.8 11.6 13.6 (3.3) 4.81 76,882 45,986 30,896 49,096 18,073 44,620 107,905 125,978 (31,023) 170,598 21/1102 9.3 5.5 6.0 3.7 5.4 11.5 15.3 (2.2) 7.02 94,766 76,450 45,590 30,860 49,060 30,744 44,620 125,510 (18,317) 170,130 11/0102 6.2 5.6 5.2 10.8 16.0 10.4 (0.3) 10.2 3.62 78,457 75,949 45,127 30,823 40,774 38,266 (2,508) 74,690 116,723 191,413 01/9002 9.9 6.6 8.9 1.2 7,445 19.9 11.0 10.0 16.4 3.63 63,766 71,212 42,753 28,458 57,368 64,813 128,579 105,956 234,535 90/8002 snoitcejorP 8.9 6.7 2.1 20.9 10.9 10.0 12.1 19.3 3.04 50,729 62,479 38,073 24,406 57,380 69,130 11,750 119,860 110,515 230,375 P 80/7002 D snoilli Gfo 7.5 6.7 3.5 23.4 11.0 12.4 15.9 25.1 6.84 37,339 54,855 33,217 21,639 61,433 78,950 17,517 116,289 124,896 241,185 6.5 6.4 3.7 24.0 10.1 13.9 17.6 30.5 5.45 SCENARIOS esa 70/6002 m sfA 27,616 43,284 27,280 16,004 59,318 74,986 15,667 egatnecrep 102,602 130,050 232,652 C sA AL hgi FISC H.b6 60/5002 5.4 9.2 6.3 7.5 3.9 16.7 11.4 22.2 0.93 19,064 59,483 32,883 22,311 10,572 26,600 40,419 13,819 79,021 138,504 A.6: ABLET 50/4002 4.5 9.4 6.3 5.3 4.8 8,764 14.7 10.2 42.0 6.65 12,812 41,710 26,605 17,842 15,105 28,899 13,794 119,398 161,108 40/3002 slautcA 4.5 9.8 6.1 3.6 8.8 5.2 13.4 47.5 8.06 8,154 8,082 10,168 30,054 21,972 13,818 19,886 11,804 106,879 136,933 30/2002 - - n/a n/a 3.2 8.5 8.5 n/a 5.3 5.3 12.5 9.02 5,864 9,650 9,650 15,514 15,514 22,777 38,291 Expenditures Expenditures Expenditures Expenditures Grants wage Expenditures Expenditures Operating evenuesR wages non Development Before operating evenuesR Operating wages Development operating Dvpt Dvpt Expenditures which which which which Deficit which Expenditures Expenditures Deficit which which which which of of of of of of of of of Domestic Core iscalF External otalT Domestic Core iscalF External serutidnepxElatoT 148 Afghanistan: Managing Public Finances for Development 31/2102 6.8 7.6 4.7 5.3 6.1 0.8 5.3 7,520 12.9 2.81 63,172 70,692 43,274 27,418 49,096 56,616 48,901 119,788 168,689 21/1102 6.6 8.1 4.8 6.0 7.5 1.5 5.9 14.1 0.02 54,542 66,791 115,851 39,514 27,277 49,060 61,309 12,249 48,901 164,753 11/0102 6.5 8.7 5.0 5.6 7.9 2.3 14.3 10.8 2.52 47,069 63,784 36,619 27,165 40,774 57,489 16,715 78,971 104,558 183,529 01/9002 6.0 9.5 5.4 8.9 3.4 18.4 12.3 17.1 4.53 38,992 61,241 34,678 26,564 57,368 79,617 22,250 118,609 110,237 228,846 90/8002 snoitcejorP 5.5 9.4 5.5 3.9 19.4 10.0 13.9 20.1 5.93 31,571 53,605 31,298 22,306 57,380 79,414 22,034 110,985 114,950 225,935 P 80/7002 D snoilli Gfo 5.1 9.2 5.5 4.0 21.6 12.4 16.4 25.9 4.74 25,577 45,695 27,470 18,225 61,433 81,550 20,117 107,128 128,567 235,695 5.0 8.8 5.5 3.8 22.7 13.9 17.7 31.8 5.45 SCENARIOS esa 70/6002 m sfA 21,466 96,836 37,518 23,603 13,915 59,318 75,370 16,052 egatnecrep 135,808 232,644 sA C AL FISC 6: woL.c6 60/5002 4.8 9.2 6.3 7.5 4.4 16.7 11.9 22.2 0.93 17,115 59,483 32,883 22,311 10,572 26,600 42,368 15,768 79,021 138,504 A. ABLET 50/4002 4.5 9.4 6.3 5.3 4.8 14.7 10.2 42.0 6.65 8,764 12,812 41,710 26,605 17,842 15,105 28,899 13,794 119,398 161,108 40/3002 slautcA 4.5 9.8 6.1 3.6 8.8 5.2 8,154 8,082 13.4 47.5 8.06 10,168 30,054 21,972 13,818 19,886 11,804 106,879 136,933 30/2002 - - n/a n/a 3.2 8.5 8.5 n/a 5.3 5.3 5,864 9,650 9,650 12.5 9.02 15,514 15,514 22,777 38,291 Expenditures Expenditures Expenditures Expenditures Grants wage Before Expenditures Expenditures evenuesR Operating wages non Development operating evenuesR Operating wages Development operating Dvpt Dvpt Expenditures which which which which Deficit which Expenditures Expenditures which which which Deficit which of of of of of of of of of Domestic Core iscalF External otalT Domestic Core iscalF External serutidnepxElatoT Statistical Appendix 149 TABLEA.7:EXPENDITURES BY PROGRAM FROM 2003/04TO 2005/06 2003/04 2004/05 2005/06 2003/04 2004/05 2005/06 Est. Est. Budget Est. Est. Budget US$ million % of total budget Human Capital Development 688 843 1,549 25 25 31 1.1 Refugees and IDP return 33 75 66 1 2 1 1.2 Education 185 224 485 7 7 10 1.3 Health 168 154 259 6 5 5 1.4 Livelihood and Social Protection 273 340 668 10 10 13 1.5 Culture, Media, Sport 29 50 71 1 1 1 Physical Infrastructure 751 901 1,223 27 27 24 2.1 Transport 452 581 542 16 17 11 2.2 Energy, Mines, and Telecom 113 222 327 4 7 6 2.3 Natural Resources Management 97 45 207 3 1 4 2.4 Urban Management 88 53 147 3 2 3 General Administration 251 298 594 9 9 12 3.1 Trade and Investment 8 40 78 0 1 2 3.2 Public Administration and Economic Management 243 258 517 9 8 10 Security 1,105 1,328 1,615 40 39 32 3.3 Justice 16 45 63 1 1 1 3.4 National Police and Law Enforcement 209 340 597 7 10 12 3.5 Afghan National Army 797 788 830 28 23 16 3.6 Mine Action 63 96 77 2 3 2 3.7 DDR 21 59 48 1 2 1 Unallocated - 8 86 - 0 2 Total 2,796 3,378 5,067 100 100 100 Core - Operating 449 558 678 16 17 13 Core - Development 165 317 1,209 6 9 24 Total Core 614 874 1,887 22 26 37 External 2,182 2,503 3,180 78 74 63 Total Budget 2,796 3,378 5,067 100 100 100 Source: MoF (Preliminary annual statements for operating budget and 2005/06 Budget Decree estimates for development). LISTOFADDITIONALDOCUMENTSPREPARED ASPARTOFTHEPFMREVIEW In addition to the thematic chapters in Volumes II to V Additional background papers on institutional of World Bank (2005b), a number of background reforms: papers were prepared and shared with the Government during the process of the PFM review: Reforming the Treasury in Afghanistan, December 2004 Additional background papers on the budget and fiscal management: Afghanistan Ministry of Finance ­ The Way Forward, December 2004 / February 2005 Budget Formulation in Post Conflict Afghanistan (2005/06), December 2004 Institutions for Economic Policymaking: Key Considerations and Options, February 2005 Public Finance in Afghanistan: Trends and Prospects, February 2005 Ministry of Finance: Toward a Five-Year Strategic Plan, May/June 2005 State-Owned Enterprises and the National Budget, February 2005 Additional background papers on sectors: Operating Budget Allotment Control, February Public Expenditure Management in Livelihoods 2005 and Social Protection ­ summary of findings, February 2005 Overview of the 1384 Budget, March 2005 Public Expenditure Review of the Highway Reforming the Fiscal System and Achieving Systems in Afghanistan, February 2005 Fiscal Sustainability, March 2005 Public Expenditure Management in the Security Policy notes on PRR and pay reform, March Sector: Initial Findings and Conclusions, April ­ June 2005 2005 Strengthening ARTF and Enabling Budget Education Expenditure Tracking Survey ­ Support Through Selective Use of Benchmarks, report on key findings, June 2005 July 2005 REFERENCES Boesen, Inger W. 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