Report No. 34582-AF Afghanistan Managing Public Finances for Development (In Five Volumes) Volume III: Improving Public Financial Management: Key Cross-cutting Issues December 22, 2005 Poverty Reduction and Economic Management Sector Unit South Asia Region Document of the World Bank Table of Contents ACKNOWLEDGEMENTS ....................................................................................................................... V CHAPTER1 DOMESTICREVENUES: STRUCTURE, POLICIES.ADMINISTRATION' AND . PROSPECTS ............................................................................................................................................... 1 EXECUTIVE SUMMARY .............................................................................................................................................. 1 .......................................................................................................................................... 2 ..................................................................................... ................................................ 3 c.REVENUEPOLICY AND ADMINISTRATION ........................................................ ................................................ 7 Movingto a broad-basedconsumptiontax ......................................................................................... 13 Taxation andinvestment incentives.................................................................................................... 14 Tax treatment ofthe petroleumandminingsectors ............................................................................ 17 Landtaxes ........................................................................................................................................... 18 D.MEDIUM-TERM . ................................... 18 E.SUMMARYRECOMMENDATIONS......... REVENUE FORECAST .............................................................. 22 ANNEXES .............. ............................................................................... ..................................... 31 CHAPTER2 THE GOVERNMENT OF AFGHANISTAN'S PAYROLL . ........................................ 38 EXECUTIVE SUMMARY ............................................................................................................................................ 38 A.SIZEOFTHE CIVIL SERVICE ....................................................................... ................................... 40 c.PAY SCALES ..................................................................... ............................. 42 D.THEWAGEBILL............................................................... ............................. 46 E.PAYROLLPROCESSING ..................................................... ............................. 48 E.PENSIONS............................................................................................................................................................. 50 ANNEXES ................................................................................................................................................................. 53 CHAPTER3 UPDATEONAFGHANISTAN'S SUBNATIONALADMINISTRATION . .............58 EXECUTIVE SUMMARY .................................................................... .............................................. 58 A.INTRODUCTION ................................................................................................................................................... 59 FindingsandRecommendationsfromthe OriginalStudy .................................................................. 59 The Government's Response............................................................................................................... 60 Summary of MainFindings................................................................................................................. 61 B.OVERALLSUPPORTFORPROVINCES ................................................................................................................... c.PROVINCIALALLOTMENTS 61 AND BUDGET EXECUTION........................................................................................ 63 The Single RevenueandExpenditureAccounts ................................................................................. 63 Timeliness ofReceipt ofTakhsis (Allotment).................................................................................... 66 Adequacy of Positive Balancesinthe Single ExpenditureAccount ................................................... 67 GreaterFlexibilityto ManageExpenditures....................................................................................... 69 TimelyReportingto the Center........................................................................................................... 70 D.EXECUTING PAYROLL.................................................................................................................................. THE 70 Timeliness ofReceipt ofTashkeel (StaffingEstablishment).............................................................. 71 Managingthe Payroll for Teachers..................................................................................................... 72 ReportingonNumbers ofPaidEmployees......................................................................................... 73 Adequacy ofAllotments...................................................................................................................... 74 Procurement ........................................................................................................................................ 76 Merit-BasedAppointments................................................................................................................. 81 I.MUNICIPALITIES PRR..................................................................................................................................................... 82 ................................................................................................................................................... 82 i CHAPTER 4 . STATE OWNED ENTERPRISES ................................................................................ 87 EXECUTIVE SUMMARY ............................................................................................................................................ 87 A.INTRODUCTION ................................................................................................................................................... 89 B.OVERVIEW OF STATEOWNEDENTERPRISES ....................................................................................................... 89 Overview o f SOEs............................................................................................................................... 89 c.Legal Framework ................................................................................................................................ 91 REGULATIONOF FINANCIALAFFAIRSOF STATE OWNEDENTERPRISES ............................................................. 92 Role ofthe Ministry o f Finance .......................................................................................................... 92 Fiscal Plans and financial reporting .................................................................................................... 92 Actual reporting................................................................................................................................... 93 D.FISCALAND BUDGETISSUES ............................................................................................................................... 94 Official subsidies through the Ordinary Budget.................................................................................. 94 Other transfers to SOEs through the Ordinary Budget........................................................................ 94 SOEs and the Development Budget .................................................................................................... 96 Dealing with SOEs inthe National Budget......................................................................................... 98 Revenue from SOEs ............................................................................................................................ 99 E.ECONOMIC RESTRUCTURINGPOLICY AND PROCESS.......................................................................................... 100 Policy statements............................................................................................................................... 100 Recommendations on restructuring. privatization. and liquidation................................................... 100 Economic restructuringprocess ........................................................................................................ 102 Implementationo fthe economic restructuringstrategy .................................................................... 102 ANNEX ................................................................................................................................................................ 105 CHAPTER 5 MUNICIPAL FINANCES AND MANAGEMENTINKABUL . ................................ 106 EXECUTIVE SUMMARY .......................................................................................................................................... 106 A.INTRODUCTION ................................................................................................................................................. 107 B.LEGAL FRAMEWORK- PASTAND PRESENT ....................................................................................................... 107 C.THEFUNCTIONS KABULM~ICIPALITY OF ........................................................................................................ 110 D.ADMINISTRATION ANDFINANCE KABULMUNICIPALITY IN .............................................................................. 112 The Organization o f Kabul Municipality .......................................................................................... 112 Revenue Generation inKabul Municipality...................................................................................... 113 Financial Planning and Budgeting inKabul Municipality ................................................................ 115 Expenditures and Accounting ........................................................................................................... 116 E.MANAGING. PLANNING. AND DEVELOPING CITY THE ....................................................................................... 117 F.DELIVERING SERVICES INKABUL ...................................................................................................................... 120 G.SUMMARYOFRECOMMENDATIONS .................................................................................................................. 121 ANNEX ................................................................................................................................................................ 128 Annex 5. 1: Responsibilities and Authorities o fMunicipalities and District Offices ....................... 128 REFERENCES ........................................................................................................................................ 130 BOXES Chapter 1 Box 1. 1: Summary o f Major Tax Instruments inAfghanistan..................................................................... 7 Box 1.2: Desirable Properties of Revenue Instruments............................................................................... 8 Box 1.3: Afghanistan -Trade Regime....................................................................................................... 11 Box 1.4: Selecting the Largest Taxpayers.................................................................................................. 13 Box 1.5: International Experience Tax Incentives..................................................................................... 16 Chapter 2 Box 2. 1: Staffing inthe Security Sector ..................................................................................................... 42 11 Chapter 3 Box 3. 1:ManagingBamyan's Education Payroll...................................................................................... 73 Box 3.2: Two National Initiatives Focused on Subnational Development ................................................ 80 Box 3.3: Bamyan's `Fair Futures' Council ................................................................................................ 80 Box 3.4: Examples o f Provincial Expenditures Fundedby Municipal Revenues...................................... 83 FIGURES Chapter 1 Figure 1. 1:Revenue Collection 2003/04 and 2004/05 ................................................................................. 5 Figure 1.2: Medium-term Revenue Forecast.............................................................................................. 21 21 Figure 1. 4: Uganda. Revenue as a Percent o f GDP.................................................................................... Figure 1. 3 Rwanda. Revenue as a Percent o f GDP................................................................................... 22 Chapter 2 Figure 2. 1: Current Structure o fthe Civil Service ..................................................................................... Figure 2.2: Average Salary (Afs/month) .................................................................................................... 40 43 Figure 2. 3: Pay scales ($/month) as o f May 2005 ...................................................................................... 43 Figure 2.4: Average Salary / Per Capita GDP (SAF projections) .............................................................. 45 Figure 2. 5: Headcount inProvinces -Example o f Kandahar .................................................................... 49 Figure2. 6: Sample age distribution o fthe civil servants ........................................................................... 52 Chapter 3 Figure 3. 1:Non-Uniformed, Civilian Government Staff for Whom Salaries Have Been Paid .................62 Figure 3.2: Non-Uniformed, Civilian Government Staff for Whom Salaries Have Been Paid .................62 Figure 3.3: Non-Salary Expenditures as a Share o f Total ExpenditurebyProvince ................................. 63 Figure 3.4: Budget Spending as a Percent o f Allotment by Province, 2002/03 to 2004/05....................... 65 Figure 3. 5: Positive Balances at MonthEndas a Ratio o f Average Monthly Spending............................ 68 Figure 3. 6: Share o f Ordinary Budget Allocated to Provinces................................................................... 76 Figure 5. 1: Organizationo f Kabul Municipality, April 2005................................................................... Chapter 5 Figure 5.2: Organization o f Gozars (Districts) ......................................................................................... 124 124 Figure 5. 3: Organization o fKabul Municipality, March2002................................................................. 125 TABLES Chapter 1: Table 1. 1. Total Tax Collection Performance-Regional Comparison......................................................... 3 Table 1.2: Domestic Revenue Collection.................................................................................................... 4 Table 1.3: Central Government Revenues by Group ................................................................................... 6 Table 1.4: Concentration o f Domestic Tax Collections inSelected Countries .......................................... 12 Table 1.5: Summary Recommendations ................................................................................................... 23 Chapter 2: Table 2. 1: Size o f the Civil Service............................................................................................................ 41 Table 2.2: Average Salary (as multiple o f per capita GDP)....................................................................... 44 Table 2. 3: Wage Bill (% GDP) .................................................................................................................. 47 Table 2.5: Pension after increase (Afdmonth) ........................................................................................... Table 2. 4: Steps for Monthly Payroll Processing....................................................................................... 49 50 Chapter 3: Table 3. 1: Non-Salary Expenditures, 2002/03 -2004/05 .......................................................................... 63 Table 3.2: Total Provincial Expenditure Shares by Category, 1st 9 Months o f 2004105........................... Table 3.3: ProvincialBudget Spending as a Percent o f Allotment by Expenditure Category, 2003/04 ....64 65 ... 111 Table 3.4: Provincial Budget Spending as a Percent of Allotment by Expenditure Category. 1st 9 Months of2004/05 ........................................................................................................................................... 65 Table 3. 5: Provincial Budget Spending as a Percent of Allotment by Ministry, 1st 9 Months of 2004/0566 Table 3. 6: Addressing the Delays inProcessing the Payroll...................................................................... Table 3. 7: Share of 2004104 3Q Salary and Non-Salary Allotment Providedto Provinces, by Ministry..71 75 Table 3. 8: Process for Executing Non-Salary Payments............................................................................ 77 Table 3.9: Provincial Municipalities: Revenues and Expenditures, 2003/04............................................. 83 Table 3. 11: Summary of Recommendations .............................................................................................. Table 3. 10: Provincial Municipalities Staffing Structure for 2004/05 ....................................................... 83 85 Chapter 4: Table 4. 1:Classification o f SOEs .............................................................................................................. 90 Table 4.2: Summary Statement of Revenue and Expenditure from SOEs by LineMinistry.................... 93 Table 4. 3: Subsidies to State Owned Enterprises (2002/03-2004/05, Afs) ................................................ 95 Table 4. 4: Salary Transfers to SOEs through the Ordinary Budget ........................................................... 95 Table 4. 5: Planned and Actual Investments inSOEs Based on Selection o f Projects inDevelopment Budget ($m) ........................................................................................................................................ 97 Table 4. 6: Summary o f Recommendations .............................................................................................. 104 Chapter 5: Table 5. 1:Kabul Municipal Revenues, 2002/03 to 2004/05 .................................................................... Table 5.2: Examples of Number o f Plots Allocated by Municipality on Already-Owned Land.............114 119 Table 5. 3: Findingson Allocation of Functions from the Review of Selected Country Constitutions and Laws ................................................................................................................................................. 126 Table 5.4: Local Functions Across Countries'.......................................................................................... 127 iv ACKNOWLEDGEMENTS As part of the overall Public Finance Management Review (see Acknowledgements for Volume I), this volume was preparedby the following team: Chapter 1(Revenue): The0 Thomas (IMF) Chapter 2 (Payroll): StCphane Guimbert (SASPR) Chapter 3 (Subnational Administration): Anne Evans and Yasin Osmani (Consultants, AREU) Chapter 4 (State-Owned Enterprises): Habib Rab (DFID) Chapter 5 (Municipal Finances o f Kabul): Soraya Goga (SASEI) The role o f the IMF in preparing Chapter 1, the role o f DFIDwhich prepared Chapter 4, and the role o f the Afghanistan Research and Evaluation Unit (AREU), whose consultants prepared Chapter 3, are gratefully acknowledged. This volume was processedby Juliet Teodosio (SASPR). The process o f carrying out the PFMReview involved extensive interactions with the Ministry o f Finance and other Government agencies, whose valuable cooperation and support was indispensable for completingthe review and also greatly benefitedthis report. V CHAPTER 1. DOMESTICREVENUES: STRUCTURE, POLICIES,ADMINISTRATION, AND PROSPECTS "In developing countries, taxpolicy is often the art of thepossible rather than thepursuit of the optimal"' Executive Summary 1. With a revenue to GDP ratio o f 4.5% in 2004/05, Afghanistan has one o f the lowest revenue effort levels in the world. With many features common to countries with a low tax base (e.g. a large informal and agriculture-based economy, sectors which are difficult to tax), the revenue potential o f Afghanistan inthe medium-tern nevertheless i s substantia1,probably toward the lower end o f the 11-14% range observed inother developing countries. ii. Thecurrentrevenuebaseisveryconcentrated. EvenAfghanistanhasoneofthemostliberal trade regimes in the region, as in other low-income countries customs duties account for more than half the total revenues. And 93% o f total revenue i s collected by central ministries inKabul or injust five o f Afghanistan's 34 provinces. There are in addition a number o f "nuisance" taxes (taxes generating small revenues, expensive to administer, and economically not effective), as well as illegal taxes. ... 111. From a policy point o f view, the main priority i s to implement a number o f changes introduced in the income tax and customs codes. New investment tax incentives have been introduced; by replacing tax holidays with accelerated depreciation and unlimited loss carry-forward, Afghanistan has managed to provide incentives for new investment with much less shortcomings (revenue loss and economic distortions) than tax holidays. Inthe medium term, Afghanistan will have to expand its tax base through the introduction o f a broad-based consumption tax. In addition, mineral taxation could provide a substantial source o frevenue. iv. More importantly in the coming years, Afghanistan needs to increase compliance with existing taxes. Some progress has already been made, notably by the creation o f a Large Taxpayer Office and the introduction o f a system o f Treasury Single Account. Forceful implementation o f the five-year strategic plans in Customs and in Tax Administration require in particular: (i)substantial civil service and administrative reforms to build a professional cadre o f customs and tax officials; (ii)continued implementation o f equipment and systems improvements inthe customs area (including computerization of the recording and management system); and (iii) a strong focus on the Large Taxpayer Office. v. A baseline scenario is outlined inthis chapter, under which the revenue to GDP ratio reaches 8% in2010. This assumes gradual implementation of the five-year customs and tax administrationreforms and the implementation of existing tax measures. Ina high-case scenario, assuming stronger increases in compliance (resulting from faster progress in administrative reforms) and introduction o f a broad-based consumptiontax, this ratio rises to above 11.5%. On the other hand, under a low-case scenario o f weaker reformimplementation, this ratio remainsbelow 7% inthe medium term. Tanzi andZee, (2001). 1 A. Introduction 1.1 Mobilizing domestic revenues in Afghanistan is complicated by the limited tax base and the fragmented economy. Many studies have noted the strong relation between revenue, as a proportion o f GDP, and the level o f GDP. While in industrialized countries the revenue to GDP ratio is typically inthe 45-55% range, for the least developed countries the ratio i s closer to 20%.* Afghanistan's economy shares many o f the features associated with a low tax base, including: (i) a large informal sector (often proxied by a low degree o f monetization) that tends to imply a narrow tax base; (ii)the dominance o f the agriculture sector, which i s hard to tax for both administrative and political reasons; and (iii) capacity constraints that hinder the ability o f the Government to collect taxes and o f the business community and individuals to comply with the reg~lations.~Revenue mobilization i s further complicated by the large opium economy that cannot be taxed directly, the need to further consolidate the central government's control throughout the country, and the heavy reliance on donor and NGO funds that may qualify for tax exemptions. 1.2 Afghanistan's revenue potential may be toward the lower end of the 11-14% of GDP range. One of the most common statistical methods o f assessing the appropriate aggregate tax level i s to compare the tax level in a specific country with the average tax burden in a representative group o f countries (see Tables 1.1 and 1.3 for selected regional and developing country comparison^).^ Recent studies have suggested that "for low income countries, raising the tax share to at least 15% o f GDP should be seen as a minimum objective. International experience suggests that some increases beyond this are certainly reasonable and de~irable".~Inaddition, Afghanistanhas historically had extremely low levels o f domestic revenue mobilization-in the 1970s the domestic revenue to GDP ratio was around 7%, one o f the lowest inthe world.6 This method does not attempt to determine the "optimal" level or composition o f revenues, and while it may provide a perspective on the need for increased revenue effort it does not provide grounds for setting a specific revenue target. Nonetheless, given the low level o f development in Afghanistan and limitednatural resources, the current tax potential i s likely to be toward the lower end o f the range o frevenue to GDPratiosinother low-income developingcountries. 1.3 The signiflcant tax gap suggests that Afghanistan needs to drastically improve its tax administration. The tax gap i s the difference between the taxes actually paid and the taxes which should be paid according to existing laws and statutes. InAfghanistan, the tax gap i s extremely large (as there are few enforcement mechanisms function compliance i s largely voluntary and the compliance rates are therefore likely to be extremely low). International experience suggests that the larger the tax gap, the more radical are the changes that are needed.' With a tax gap o f more than 40% Afghanistan should adopt a strategy that i s "quite comprehensive with a complete revamping o f the tax administration" to obtain significant improvements in compliance. Developing countries with large natural resource sectors, such as oil, tend to have higher tax/GDP ratios. Keen et a1(2004). Although this statistically based approach has no basis intheory, and choosing the relevant countries is necessarily subjective, it i s a commonly used approach in countries like Afghanistan where the statistical base i s extremely limited. Heller (2005) See World Bank (1978). See Baer and Silvani's (1997) review of tax administration reforms. 2 Country 1999 2000 2001 2002 2003 Afghanistan 3.2 4.5 Average 11 12.8 12.7 12.9 14.1 14.4 Pakistan 13.1 12.9 13.0 13.5 13.7 India 14.2 14.7 13.8 14.9 15.1 Iran 21 5.6 5.8 6.3 5.5 5.7 Kyrgyzstan 12.2 1 11.7 I 12.4 I 13.8 I Tajikistan 11.8 I 11.5 I 12.3 1 B. Revenue Structure 1.4 Revenue mobilization is critical achieving fiscal consolidation. Domestic revenues have significantly increased over the last two years from an extremely low base. In2002/03, they reached $131 million, equivalent to 3.2% o f GDP. The Government has progressively reestablished basic control over domestic revenues, particularly in the provinces where there was reportedly considerable leakage through avoidance and illicit charges. In2003/04, revenue collection reached $208 million, equivalent to 4.5ercent of GDP. In 2004/05, revenue reached $269 million, equivalent to around 4.5% GDP (Table 1.2 and Figure 1.1). The 2005106 budget projects a modest increase in domestic revenue to $333 million, equivalent to around 4.7% o f GDP. 1.5 The increase in revenue in 2004105, compared to the previous year, has been attributed to improvements in the coverageand compliance ratesfor the main tax categories. Major revenue reforms in2004/05 included arrangements to ensure that provincial revenue is regularly swept into the Treasury Single Account (TSA) and other administrative reforms - such as the simplification o f customs procedures, the introduction of a market-based exchange rate for valuing imports, the gradual introduction of customs brokers and the harmonization o f corporate tax rates. There has also been a significant improvement inthe collection o f fees and taxes on goods and services. 1.6 The domestic revenue base is concentratedin a relatively small number of taxes (see Tables 1.2 and 1.3). Box 1.1 summarizes the major tax instruments currently being used inAfghanistan. As inmany less developed economies, import duties are the main source o f revenue because they are relatively easy to monitor and collect, comprising over 50% of the total (see also Table 1.3). The pattern i s not significantly different from that of the mid-l970s, when around 78% o f tax revenue was derived from trade taxes.' * See WorldBank(1978). 3 Table 1.2: Domestic Revenue Collection Source: MoF. Fundstaff estimates. 1.7 More than 93% of total revenue is collectedby Central Ministries (mainly in Kabul) andjust in five of Afghanistan's 34 provinces: Herat, Nangarhar, Kandahar, Balkh, and Kabul.g Four ministries account for 88% o f the total revenue reportedby central ministries. These include the Ministry o f Finance (MoF), the majority of revenue for which i s customs duty collected in Kabul and one-off payments such as over-flight charges ($16 million in 2003/04). The Ministry o f Communications derives significant revenue from the sale of telephone services, while the Ministry o f Commerce derives revenue from commissions on imported goods and the Ministryo f Interior from the registrationo f motor vehicles. With the exception o f the revenues collected by the Ministry o f Commerce, whose revenue base should be rationalizedinfavor o f the customs department, most o f these revenues are generated inKabul. 1.8 The remaining provinces and ministries either have much lower revenue capacity or suffer from poorer collection rates. Many ministries and provinces collect a minimal amount o f revenue. With around 90 different active taxes - half o f which generated less than Afs 1million, equivalent to less than $21,000, during FY2004/05 - it i s highly likely that the administrative costs o f some taxes outweigh the revenue gain. Afghanistan i s a centralized fiscal system and the provincial government refers to a de-concentrated level o f central government, rather than to a subnational level. Municipal governments are relatively more autonomous but comprise only a small part o f the overall fiscal picture. 4 Figure 1.1: Revenue Collection2003/04 and 2004/05 (US$ million per month) 1 2 3+4Fy2003/04 5 6 7 8 9 1 0 1 1 1 2 -D- EyT001/05 Mordh Source: MoF and IMFstaff estimates 1.9 There is considerable scope for rationalizing the number of taxes collected to remove "nuisance"' taxes. The income tax law provides for a variety o f taxes, usually referred to as fixed taxes, which comprise presumptive taxes on small businesses (sometimes expressed as fixed amounts, but also as percentages o f presumed turnover), as well as a cascading turnover tax known as the business receipts tax (BRT). The law also identifies 170 tax categories o f business establishments. Removing many o f these small "nuisance" taxes and simplifyingthe tax collection system i s likely to be cost-effective from the perspective of the revenue authority, and it should also help to promote the private sector. Indeed, it may increase revenues ifcompliance improves as a result." M o F undertakes a revision o f the classifications andrates every three years, and a process o f consolidationand simplification i s underway. 1.10 Illicit taxes and instances of double taxation or ambiguities in the tax laws should also be eliminated. The business community has noted numerous instances where illicit taxes have been charged for both customs and domestic taxes, adding to the cost o f business." For example, additional "transport taxes" may be levied on the owner of the goods rather than on the transport, and provincial or municipal authorities may charge other ill-defined taxes. The tax authority o f the Municipalities (see Chapter 5 o f this volume) is also unclear, and there maybe instances o f double taxation - for example the central government introduced a new rent withholding tax in 2004, but Municipalities may also collect property taxes. Business organizations have also complained that the legal code is often unclear; for example tax- deductible expenses are often not clearly specified (the tax code specifies "all normal and necessary business expenses") and the interpretation may vary over time and between mustoufiats. This lack o f transparency and accountability can lead to disputes over the interpretation o f the law and i s a potential source o f administrative corruption. loThe removal o f such nuisance taxes was a one of the main recommendations o f a joint conference o f the Afghan American Chamber o f Commerce (AACC) and the Afghan International Chamber o f Commerce (AICC) in January 2005. "Various AICCreportshavedocumented instancesof illicittaxes, doubletaxation andareaswhere thelawmaybeinterpreted inconsistently or is ambiguities. 5 I 3 0 2 2 x 3 0 2 z I Box 1.1: Summary of M a j o r Tax Instruments in Afghanistan Annex 1.1 details the current structure o f taxation, which can be summarized as follows. Customs duties constitute the largest source o f 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, with consumption-based taxes eventually taking o n the primary revenue raising role, 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 o f rates to reduce arbitrary and excessive effective rates o f protection as well as to minimize incentives for corruption. The recent reforms to Afghanistan's tariff schedule should achieve many o f these aims. Export taxes should generally be avoided, since they tend to cause an outflow o f resources from the export sector toward less efficient uses, compromising growth objectives. The recent tax reforms have significantly lowered the tax rates for exporters. Following the introduction o f the new tariff regime, the Business Receipts Tax (BRT) rate for importers and exporters who are also subject to fixed taxes was set at 0%. Inaddition, the fixed tax on importers and exporters was lowered to 0.5% for 2004105. Income Taxes. Income taxes should ideally be levied on a global basis, and include all forms of income. The corporate and top personal tax rates have been aligned at 20%, which is relatively low by international standards. N e w collection enforcement powers and penalty provisions are pending. The planned restoration o f the wage withholding tax and the simplification o f personal tax rates, with only two non-zero personal rates, should help to improve compliance. The level o f exemptionhas been set to effectively remove most civil servants from taxation (and which should ensure a progressive system). The tax brackets need to be regularly reviewed, particularly when inflation i s high, to maintain the desired llnk to relative incomes. Sales taxes. These taxes should be consolidated as a simple to administer andbroadly basedtax on final domestic consumption. However, Afghanistan currently has a complex and cascading system o f BRTs based on turnover and numerous presumptive (fixed) taxes for smaller traders, which is far from ideal Whde a single rate Value Added Tax (VAT), with creditingprovisions and zero-rating o f exports, is one of the most efficient taxes, it would be administratively too complex to implement at this time. Over the medium-tern Afghanistan should expand the BRT toward a more broad-based consumption tax thai I Excise broadens the tax base and avoids cascading. taxes. There are currently no excise taxes inAfghanistan. 1.11 The Government's strategy should focus on improving compliance for those taxes and locations where the revenueyield appears highest. Without undertalung a detailed analysis o f economic activity in each province and for each type o f tax, which would provide an indication o f the underlying revenue potential but i s extremely complicated to do in Afghanistan, it i s not possible to determine whether the current geographic distribution o f revenue collection reflects differences in the underlying revenue potential of each province or varying effectiveness o f revenue collection practices. However, improvements that can be made in the effectiveness and efficiency o f revenue administration and collection targeted at the current high-yield taxes and in high-yield locations are likely to yield more significant revenue than anywhere else. C.RevenuePolicy andAdministration 1.12 The ideal tax system is designed to raise revenues required to achieve a sustainable flscal position while minimizing distortions and is generally perceived as being fair (see Box 1.2). The tax system should: (i) minimize interference with individual consumption, saving, and investment decisions; 7 (ii)erelativelysimple, transparent, andrules-basedtoencouragecompliancewiththelimitedcapacity b available and discourage corruption; and (iii) b e stable and predictable to reduce the economic costs of uncertainty. B o x 1.2: Desirable Properties o f Revenue Instruments A central objective of the tax system is to raise revenue tofinance government spending, without resort to injlationaryfinancing. The tax system should generate revenue increases (at least inline with the growth in nominal income), without frequent changes in tax rates or introduction o f new taxes. Reliance o n specific (quantity-based) taxes in times o f inflation, or on tax bases that are shrinking in relation to the rest o f the economy, should be avoided because they contribute to low tax elasticity (i.e. l o w responsiveness of revenue growth to economic growth. Efficiency. Taxes influence relative prices in the economy and, therefore have an impact on the pattern o f production, consumption, and income. The objective should be to gradually establish a tax system that minimizes distortions. Inpractice, efficiency is achieved by levying simple taxes on as broad a tax base as possible and at fairly low and uniform rates. This also implies keeping tax exemptions to a minimum. Equity. Taxes should be levied in a fair and equitable manner. Vertical equity refers to differentiation of the tax burden according to ability to pay (as measured by income, wealth, or consumption), while horizontal equity refers to equal treatment o f those in similar economic circumstances. However, expenditure policy is likely to be a more efficient instrument than taxation for influencing income distribution, through transfers, social services, and targeted social assistance. Transparency.Tax codes should be clearly drafted, well defined, and easily understood by the tax- paying community. For private investment, it i s especially important to have tax rates that are both stable and predictable. Once tax laws are established that can generate buoyant revenue growth, it i s preferable to minimize the frequency o f discretionary modifications to these laws. If changes are planned over a reformperiod, taxpayers ideally should know inadvance the tax implications o f their production and consumption decisions. A simple, transparent tax system is also relatively easy to administer andpromotes compliance. Reasonable tax burden. There are constraints on how much a government can raise in taxes. Too high a tax burden will undermine the system's effectiveness by encouraging tax evasion and distorting the structure o f relative prices in the economy. An "acceptable" level will be determined to some extent bypublic choices concerning the level of government expenditure. Source: DFID Economists Handbook 1.13 Tax policy reform and tax administration reform will be closely linked. In designing Afgh istan's strategy for revenue mobilization, consideration needs to b e given to the very weak state of the institutions and the extremely limited capacity o f the administration to implement policies after the end of the conflict - as reflected in the large tax gap. T a x policy needs to provide a suitably m o d e m framework within w h i c h the tax administration can b e built. International experience suggests the following guidingprinciples for administrative reform: 0 Reducing the complexity of the tax system, by streamlining the system through reducing the number of taxes, harmonizing rates, reducing exemptions, and eliminating illicit charges and double taxation; 0 Encouraging taxpayers' voluntary compliance with new, simplified self-assessment procedures andbetter taxpayer education; IFromBaer and Sifvani (1997). 8 0 Differentiating the treatment o f taxpayers by their revenue potential, commonly through the creation o f a Large taxpayer Office and risk management strategies; and 0 Ensuringeffective management o fthe reform. 1.14 Customsand tax authorities have both adopted comprehensivefive-year reform plans, through 2007 and 2008 respectively. The revenue raising function is located in MoF, and responsibilities are divided between the Afghanistan Custom Department (ACD) and the General Presidency o f Revenue (GPR), which bothreport to a Deputy Minister. The ACD i s historically a muchmore distinct entity, with functions that include collection and the management o f a customs service. The GPR has traditionally been in charge o f domestic taxation policy, with collection being handled by the provincial Treasury office (Mustoufiats). The A C D and GPR are currently implementing comprehensive reform plans that have been designed with, and implementation i s being supported by, considerable external technical assistance. The short-term focus i s to extend the coverage o f customs operations in the provinces, to reform the tax collection system, and to enhance overall compliance. In order to maximize effectiveness, implementation o f these reform plans needs to be closely monitored, regularly evaluated, and revised as required. However, M o F currently does not have a steering committee to make strategic decisions and oversee the reform programs, and there appears to have been little monitoring and evaluation o f implementation o f the plans. 1.15 A major complementary reform was the establishmentof the Treasury Single Account (TSA) in 2004. A TSA is the integrationo f Government accounts into an account or set o f linked accounts through which the Government collects revenues and transacts all its payments. The apex o f the system i s a single account held by the Ministry o f Finance (Treasury) at the Central Bank. The TSA i s designed to ensure that all Government revenues, wherever they are collected, are transferred to the central government (once funds have been deposited in provincial revenue accounts they are transferred directly to the Treasury).' 1.16 Civil service reforms are also required to develop a motivated and skilled cadre of revenue staff. The customs and tax administrations face unique challenges in having to collect government monies, which increases the needto address the potential for corruption (corruption can take many forms, from the levying o f additional charges to the arbitrary waiving o f taxes). A key component o f the customs and tax reform programs i s the development of professional (dedicated) tax and customs services within the Afghanistan Custom Department (ACD) and the General Presidency o f Revenue (GPR). This entails specialized training programs and institutions, a career development structure within the service and, as and when appropriate, a performance-based remunerationsystem unique to revenue administration needs and conditions o f work. These reforms are currently being undertaken as part o f the Government-wide Priority Reform and Restructuring (PRR) program that allows the progressive restructuring o f the MoF, starting with reorganization o f the central policy and management h n ~ t i o n s . ~ 1.17 TheACD and GPR are both in theprocess of implementing major reform programs that will require further organizational consolidation and will absorb considerable energy and resources. T o address some o f the human resource issues, some countries have adopted a semi-autonomous "revenue agency" model, to enable staff to be recruited, trained, and paid outside o f the civil service structure. This 'The deposit of all revenue into the TSA i s a separate issue from the question o f earmarking. Even if an agency deposits revenues into the TSA, the Government can still earmark these revenues to the agency's budget. Such earmarking i s expected to be a strong incentive for the agency to mobilize resources. However, earmarking breaks the key public finance principle according to which trade-offs should be made between all expenditures: in other words, it distorts expenditure allocations toward potentially non-priority areas. See also "Afghanistan Ministry o f Finance - The Way Forward", background paper for the World Bank Public Finance Management Review. 9 approach may have benefits in terms o f freeing the agency from some o f the normal budget constraints, weak management, and poor terms and conditions that affect government departments. However, while it i s important to provide the right incentives for staff, these benefits can probably be better achieved within the current governance structure and the PRR given the established priorities - like re-creating the headquarters function, consolidating control over provincial revenue collection and improving the reconciliation with Treasury. A change in status might be an additional complication and a diversion o f effort inthe present situation. 1.18 Customs administration reform will continue to dominate the revenue mobilization effort over the medium-term. During2004 the A C D implementedmeasures to: (i) simplify the tariff system (see Box 1.3), including use of market exchange rates for import valuation and transfer o f responsibility for customs valuations from the Ministry of Commerce to the Ministry of Finance; (ii) introduce simplified customs clearance documentation and procedures, including a monitoring system for duty-exempt imports, notably aid-related; and (iii) establish an effective system o f customs brokers to facilitate a speedier and more robust transit process (the brokerage system i s designed to expedite the clearance process but needs to be carefully supervised by the ACD to ensure that it does not create additional administrative bamers). 1.19 Ongoing reforms in the customs area include: (i) recently adopted customs code should be the implemented; (ii) a major program to improve customs infrastructure throughout the country i s being supported by USAID, the World Bank, and the EC; (iii)a computerized recording and management system i s being gradually introduced (this i s a standard international program for customs, know as ASYCUDA); (iv) the re-organizingand re-building o fhuman capacity inthe central and regional customs offices i s being supported by an extensive DFID and World Bank funded training program; and (v) legislation i s beingprepared to establish effective enforcement mechanisms, combined with an effort to reduce illegal charges and to consolidate and rationalize the number o f charges being applied, 10 Box 1.3: Afghanistan-Trade Regime Establishment o f an open and transparent trade regime has been a consistent priority o f the Government - moving in tandem with sweeping reforms the tariff regime and customs administration. The result has been a significant improvement in transparency and simplicity, leaving Afghanistan as one o f the most open economies inthe region. Under the trade regime inherited by the transitional government, there were 25 tariff bands, with rates ranging from seven to 150% - with a simple average o f about 43%. An overhaul o f the tariff system brought the number o f rates to six (2.5, 4, 5, 8, 10, and 16%), with a relatively low level o f dispersion. By virtue of this rationalization, the average tariff also declined to 4% (weighted by the number o f items in each rate category). Even with the addition o f a range o f "fees" (both legitimate and illegitimate), the estimated average applied tariff i s only 5.3% - the lowest in the region. Afghanistan maintains bans o n only a few products (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 o fprocessing, now involves only three steps, six signatures, and two days to process. As a result, Afghanistan's trade regime currently rates as a "4" on the Fund's Trade RestrictivenessIndex, the same as inthe EUand the United States (see Figure below). South and Central Asia -- Trade Restrictiveness m ! AfghanEita. C& P&lW Tlrrbm!istw h hdia Uzbekktw Notwithstanding these improvements, numerous problems remain. Local administrations in a few provinces reportedly prohibit the use o f foreign-owned trucks in their regions, and trucking cartels also increase transit costs. There are also other ad hoc fees imposed by local governments, warlords, and commanders, but these appear to be evenly applied to all transport, and notjust levied o n imported goods. Customs clearance in some areas (for example, in some o f the more problematic areas on the border with Pakistan) can also be cumbersome. From a government policy perspective, however, substantial progress is being made to simplify customs administration - including computerization and the introduction o f a customs single administrative document. With regard to international trade policy, the emphasis thus far has beenregional-reflecting the potential for immediate gains from facilitating transit trade with such countries as India, Pakistan, and Iran. This process i s expected to continue, with the Government o f Afghanistan seeking to codify relationships with other neighboring economies. On the multilateral level, Afghanistan has recently initiated the WTO accessionprocess. Source: International Monetay Fund, Article I V Consultation, Janualy 2005. 11 1.20 The Customs administrationfaces many challengesin its efforts to meet the expectations of the Government for much needed revenue. In this regard, its efforts are hampered by the poor security environment, which reduces access to many parts o f the country, in addition to a lack o f experienced managers, poorly trained staff, inadequate facilities and equipment and outdated and cumbersome operating policies and procedures. Customs regulations reportedly are not applied consistently throughout the country, and the lack o f an automated system undoubtedly impacts negatively on revenue performance. 1.21 Tax administration reform (GPR). The tax base i s likely to remain relatively narrow for some time,, and reforms being implemented will focus on large taxpayers. The current set o f reforms includes: (i)theadoptionofataxreformpackageinJune2004;4 (ii)creationofaLargeTaxpayer Office(LTO) and restructuring of the headquarters and provincial tax organizations; (iii) nationwide roll-out of a the new Taxpayer Identification Number (TIN) to the major provincial centers; and (iv) consolidation o f tax legislation amendments to address the excessive use o f tax holidays, exemptions and "special agreements" that were in danger o f eroding the tax base. Full implementation o f the tax reform package and consolidation o f tax legislation were severely delayed, partly because o f delays in the legislative process. 1.22 Afocus on large taxpayerscan significantly enhance revenues.Many countries have found that a small number o f taxpayers (perhaps 5%) may account for 75% or more o f total tax collection (Table 1.4). T h i s approach has been adopted in many post-conflict countries (e.g. Albania, Kosovo, Liberia, Serbia and Montenegro, Timor-Leste, and West Bank and Gaza). InAfghanistan, the case for establishing a dedicated LTO to monitor, audit, and enforce collection for large taxpayers i s further strengthened by the low level o fcompliance and extremely scarce administrativecapacity. Table 1.4: ConcentrationofDomesticTax Collections in SelectedCountries Sources: Dos Santos (1994), IMF 2002 andIMF staff estimates. Iran establishedan LTO in2001. 1.23 The LTO can also contribute to the longer-term developmentof tax administration by piloting new systems andprocedures, but it may take timefor the LTO to becomefully functional. Afghanistan established an L T O in 2004 within the GPR. However, a fully functional L T O requires a high degree of This includedthe reintroductionof a wage withholding tax, introduction of a BRT tax on selected "high-value'' services, a reductioninthe corporatetax rateto 20% for all businesses,anda newrent withholding tax. SeeAnnex 1.1 for details.. 12 preparation and training to build staff capacity and to establish more efficient procedures. Staff need to develop a sound understanding o f the tax laws, regulations, and taxpayer service activities, such as regular visits to client business premises to support improvements in compliance (through both support and enforcement mechanisms). Inorder to become fully effective, it i s important that the newly created LTO focuses on selecting and then developing appropriate relationships with the largest taxpayers. An appropriate selection criteria has been developed by the Government (see Box 1.4). Box 1.4: Selectingthe LargestTaxpayers It is important to carehlly determine the LTO's clients in order to ensure that scarce resources are effectively targeted toward those taxpayers that will yield the highest revenue. InAfghanistan, criteria have been developed and approved to select the largest taxpayers, estimated at around 100(inorder): Foreign-owned entities with capital investments in Afghanistan exceeding US$lO million; Foreign-owned entities (not included above) operating in oil and gas, banking and finance, and international air transport; State-owned enterprises operating inoil and gas, banking, and air transport; and Other entities ranked by annual sales/ turnover (over Afs 50 million or $1million). 1.24 Within about two years, the LTO can be expected to be collecting at least 60% of total domestic tax revenue. Within this period the LTO should become fully functional, and operated by officials who have a good knowledge o f all LTO large taxpayer clients and the sectors inwhich they operate. Collection enforcement procedures should be operating effectively, and audit operations based on risk-management principles should have commenced. A higher proportion o f total collections can be achieved as the LTO expands its client base, but plans to do so should wait until the office i s fully functional. It i s also important that the newly created LTO focuses on its main clients and i s not diverted to collect revenues from smaller clients. 1.25 Reform of theprovincial tax offices will require a long-term capacity building effort. Although the LTO should in due course start to collect a considerable proportion o f total tax receipts, the provincial offices, currently based in the Mustoufiats, will continue to collect a substantial share, which will be important to ensure that taxes are derived from a relatively broad a base. Incontrast to the ACD, the GPR has never been the headquarters o f the tax administration, as the provincial Mustoufiats report to the Treasury. The GPR was originally conceived as a tax policy body with a revenue analysis and statistics function. However, in order to develop a more professional service the aim o f the current Priority Restructuring and Reform (PRR) program for GPR i s to build a new tax administration headquarters and operational tax offices in the provinces that report to it. Given the degree to which the physical infrastructure and human capacity have deteriorated inrecent years, a sustained effort over many years to buildcapacity is required. MOVING ABROAD-BASEDCONSUMPTIONTAX TO 1.26 The current indirect taw system contains serious deficiencies: (i)a narrow tax base leading to low revenue yield; (ii) serious potential cascading (albeit generally at a low rate);5 and (iii) disincentives to export. These features could be addressed in the medium term by moving toward a broad-based manufacturers sales tax in3 - 5years, as an intermediate step inmovingtoward a value-added tax (VAT). Tax cascading occurs when the tax at one stage of production or distribution is included in the price on which further tax i s imposed at later stages of productionor distribution. This i s sometimesreferred to as tax-on-tax. 13 1.27 A broad-based sales tax, which can generate a signifcant amount of revenue, is likely to be necessary to ensure budget sustainability in the longer term. VAT i s the most common form o f consumption tax imposed by central governments. It i s in use in more than 100 countries around the world. The basic characteristics o f a VAT are that all persons or businesses, throughout the production and marketing chain that are engaged in the supply o f taxable goods and services, are required to register for the VAT and charge VAT on all taxable sales. Their actual liability, however, i s only the net o f the VAT charged on their sales (output tax), reducedby the VAT paid or payable by them inrespect to goods and services purchased for use in their taxable activities (input tax). However, introduction o f a VAT through to the retail level represents a radical reform o f the tax system and i s constrained by the generally low level o f record keeping and accounting, so most probably VAT would be a realistic prospect only in the medium-to longer-term. 1.28 A single-stage sales tax at the manufacturing level may be a simpler option and could be operatedin conjunction with taxes on selected services. The phased extension of the recently introduced taxes on selected services could pave the way for development o f a broader-based consumption tax as administrative capacity permits. A manufacturing sales tax imposes the tax at the point where goods are first sold in the case o f domestically produced goods, and at the point o f customs clearance inthe case o f imported goods. A single tax rate applicable to all goods would be simpler to administer and would not distort relative prices. A single-stage manufacturers sales tax has been employed in many countries, particularly inthe earlier stages o f their tax development, and can be expanded to further trade levels with a minimumo f disruption. TAXATIONAND INVESTMENTINCENTIVES 1.29 Granting tax incentives to encourage investment is a common practice in many countries, despite the available evidence suggests that their effectiveness inattracting incremental investment (above and beyond that which would have occurred intheir absence) i s often questionable, and their revenue cost potentially high. For foreign investors, the primary target o f most tax incentives - the decision to enter a country - normally depends on a host of factors, such as security, infrastructure, a stable and predictable political legislative/regulatory and macroeconomic environment, and an open trade regime. If these factors are favorable, and the country's tax system i s in line with internationalnorms, then tax incentives are likely to play a marginal role at best ininfluencing an investor's decision.6 1.30 I n 2002, the Government introduced a new investment incentive taw, the Law on Domestic and Foreign Private Investment, containing a number of tax provisions. The law allowed for tax holidays (both income tax and business receipts tax) for qualified investments by both domestic and foreign investors, for periods ranging from four to eight years from the date o f licensing, or three to seven years from the start o f production, whichever comes first. Almost 6,000 licenses were granted by the Ministry o f Commerce (MoC), without much scrutiny, before approvals were centralized in Kabul under a new organization, the Afghanistan Investment Support Agency (AISA), a corporation under the leadership of MoC. countries despite their well known shortcomings.ifThey basically consist o f applying a rate o f corporate 1.31 Tax holidays are one particular type o tax incentive that are widespread in developing income tax lower than the regular rate - often zero - to companies in a certain sector or region for some pre-specified period. A s with other forms o f tax incentives, the main objective o f tax holidays i s to ~ For a comprehensive review o f tax incentives indeveloping countries, see Shah (1995). Furthermore, the practice of granting tax holidays also appears to have grown during the 199Os, particularly among the lowest- income countries (see Keen, 2004, for a limited survey). 14 increase the overall level o f investment, including investment by foreigners. They raise a number o f issues: 0 By exempting profits irrespective of their amount, tax holidays tend to benefit an investor who expects a high rate o f return and hence probably would have invested even if there had been no incentive. 0 Tax holidays provide strong incentives for tax avoidance, as taxed enterprises could enter into economic relationships with exempt ones to shift their profits to the latter through transfer pricing. The duration o f tax holidays also i s prone to abuse. 0 Time-bound tax holidays tend to attract (if they have any impact at all) short-run projects, which are typically less beneficial to the economy and could even be a disincentive to long- term investment in the absence o f loss-cany forward provisions. Inthe case o f Afghanistan, over 40% o f tax holidays granted before mid-2004 were reportedly awarded to construction companies, which should not be considered as "investors" for the purpose o f such incentives. 0 The revenue cost to the budget i s seldom transparent, unless enterprises are required to file proper tax returns and the aggregate fiscal "loss" i s calculated. Conservative estimates published by MoF put the revenue loss o f the exemptions and concessions granted prior to July 2004 at $14.6 million in 2005106, with a total of $30.2 million between 2003/04 and 2005106. Tax incentives could be o f questionable value to a foreign investor because the benefits may be undone when profits are repatriated, through an increased tax charge in the country o f residence. The true beneficiary may end up being the Treasury in the investor's home country. 1.32 I n 2004/05, the system of tax holidays and exemptions was replaced. Considerable concerns had been raised that the previous system was eroding the tax base without encouraging sufficient additional investments. It was also acknowledged that revenue measures are best consolidated within the appropriate tax laws. A new Law on Private Investment was developed that did not contain any tax measures. The Income Tax Law was amended to provide two types o f tax incentives: accelerated depreciation and unlimited loss carry-forward. 1.33 Providing tax incentives in the form o f accelerated depreciation (and unlimited loss cany- forward) has the least o f the shortcomings associated with tax incentives. Since merely accelerating the depreciation o f an asset does not increase the total allowable nominal depreciation beyond its original cost, little distortion in favor o f short-lived assets i s generated. Neither i s there much incentive for an enterprise to engage in the lund o f tax abuse noted above with respect to tax holidays. Accelerated depreciation also does not share the negative elements associated with tax credits: a bias toward short- lived capital since further allowances or credits become available each time an asset i s replaced; and attempts to abuse the system by qualified enterprises selling and purchasing the same asset to claim multipleallowances or credits. 15 Box 1.5: International Experience Tax Incentives The main messagefrom the research on tax incentives in developing countries is that they may influence investment, but they are rarely cost effective? The research suggests that tax incentives may stimulate investment, but that a country's overall economic characteristics - such as a secure, stable macroeconomic and business environment - are more important for the success or failure o f industries than any package o f tax incentives. A summary o f selected country studies includes the following observations: A s inthe case o f developed countries, even iftax incentives stimulate investment, they are generally not cost-effective. For instance, for a range o f developing countries Shah (1995) found that tax incentives significantly eroded the tax revenue base without substantive effects on investment. Malaysia (Boadway, Chua, and Flatters, 1995): tax holidays failed to promote investment in desirable activities or assist infant industries and disadvantaged economic and social groups. Instead, broadly based taxes, levied at low marginal rates, were identified as one o f the most effective forms o f investment incentives. A similar conclusion was reached fox Thailand (Halvorsen, 1995), where corporate tax holidays were found to be ineffective as an investment incentive. The various incentives granted in several projects were unjustified, since their rate of return was so high that the investments would have taker place in any event, regardless o f the incentives. Transition Economies (OECD 1995): this study found that, on balance, tax incentives are unlikely to affect significantly the decision o f investors to engage in FDI. Also, foi Central Europe (Mintz and Tsiopoulos, 1995), tax allowances and credits were found tc be probably more cost effective than tax holidays inattracting FDI, without undue revenuz losses. Foreign investment decisions a survey o f 75 Fortune 500 companies (Wunder, 2001 found that non-tax factors were the main determinants o f their location decisions. On11 four o f the 75 companies surveyed identified tax factors as being the most important variable. Brazil (Estache and Gaspar, 1995): tax incentives, rather than being a decisive factor in the decision to invest, are in fact more efficient at reducing revenue than at stimulating investment, and have significantly distorted the tax system. Mexico, Pakistan and Turkey (Bernstein and Shah, 1995): discriminatory tax incentives, such as investment tax credits, investment allowances, and accelerated depreciation, are more cost effective in promoting investment than more general tax incentives, such as corporate income tax rate reductions. Afghanistan currently has one of the lowest corporate income tax rates in the region. The reforms in 2004 reduced the corporate income tax rate to a flat tax o f 20% o f net taxable income. Cross- country comparisons o f tax rates are difficult because o f the complexity o f tax rules found in many countries (particularly regarding deductions and exemptions) and the need to present similar "effective" tax rates. However, a sample o fregional tax rates include the following: inPakistan, the rates range from 35% to 50%; Iran charges a flat rate o f 25%; in China, the rate i s 30%; in India the rate i s 36.75% for domestic companies with a more complex schedule for foreign companies; and in Uzbelustan, the corporate tax rate ranges from 20% to 35%. Furthermore, a roundtable organized by the Afghan American Chamber o f Commerce (AACC) in conjunction with the Afghan International Chamber o f Commerce (AICC) in Washington, DC inJanuary 2005 didnot conclude that a reduction inthe corporate * Forareview ofthe empirical literature on the effectivenessof tax incentives inencouraginginvestment, see Zee et al, (2002). 16 income tax rate was a highpriority. Instead, the meeting highlighted the need to continue to simplify the tax regime and to remove the plethora o f 'nuisance' taxes and illicit charges as key priorities for the tax authority. Other issues to consider are summarized below: 0 The first-best strategy for sustained investment promotion invariably consists o f providing a secure, stable and transparent legal and regulatoly framework as well as adequate supporting institutions, including a tax system in line with international norms. The latter strongly suggests avoiding use o f tax exemptions or concessions, except those contained in revenue legislation (as this greatly simplifiestax administration). 0 Available evidence suggests that the cost-effectiveness o f providing tax incentives for investment promotion in attracting incremental investments (over and above the level that would have occurred without the incentives) i s questionable and that the revenue cost is potentially significant. The problem o f revenue loss i s particularly acute in Afghanistan where tax compliance rates are extremely low and the current revenue base, at around 5% o f GDP, i s one o fthe lowest inthe world. 0 The provision o f tax incentives inthe form o f accelerated depreciation and loss-cany forward has the most comparative merits. Tax holidays, reduced tax rates, and investment subsidies are among the least meritorious. 0 As a general rule, indirect tax incentives should be avoided (as inefficient), and discretion in granting incentives should be minimized as this can encourage corruption. TAX TREATMENTOFTHE PETROLEUMAND MININGSECTORS 1.35 Afghanistan i s reasonably well endowed with exploitable natural resources. There i s potential to increase the production o f minerals such as coal, quarries, sand, copper, and gemstones, in addition to prospects for natural gas products. The international mining companies are expected to show some interest inthese sectors, which could lead to a degree o f energy independence, foreign exchange earnings, and employment. 1.36 Moreover, mineral exploitation i s likely to generate some tax and other revenue for the government. A World Bank study suggests that the gross annual market value o f solid minerals produced could increase from an estimated $60 million currently to $253 million per annum within a 4-5 year time horizon. At that stage the sector could generate value added o f $108 million and yearly royalties and other taxes o f around $18 million." For this to materialize, significant reform measures are required, such as the establishment o f a sound legal and regulatory environment, in addition to significant public and private sector investment. 1.37 The basis for the legal and regulatory framework, in the form o f a modem Minerals Law, was being prepared with international assistance and approved in July 2005. If the legal and regulatory environment are properly structured, with economic pricing principles established, the hydrocarbonsector could also become a source o f Government revenue over time. However, inboth miningand oil and gas, the Government will not see income tax for a significant period o f time after the initial investment i s made because it will take firms a long time to accumulate taxable income. Royalties will be the first revenue stream. Considerableacademic literaturehas focusedonthe cost-effectivenesso f such tax investmentincentives,for example see: Shah (1995). loFor a detailed review of the mining sector see: World Bank (2004). Given the provisions for depreciationand loss-carry forward, which would provide adequate incentives for investment, the tax regime that applies to mineral companies would be consistentwith the standardprovisionsset out inthe recentlyamended revenuelegislation. 17 1.38 A pipeline through Afghanistan is a potential route for carrying natural gas from Eastern Turkmenistan (Daulatabad gas field) to Palastan and beyond. This pipeline, which would cost several billion dollars to construct, could earn significant revenue and generate employment. International oil and gas companies explored the feasibility o f the Turkmenistan-Palustan route in the 1990s, but interest subsequently waned with the discovery o f new gas reserves in Palustan and due to security concerns in Afghanistan. However, as conditions in Afghanistan continue to stabilize, interest in constructing the pipeline has been renewed. As a transit country, the fiscal side o f a pipeline agreement might include (i) payment o f a transit fee (estimated at anywhere between $100 million and $300 million annually), (ii) taxation o f the profits from the pipeline, and (iii) possible benefits in lund. However, completion o f this project i s highly uncertain and even in the best circumstances i s likely to be some years away in the future; hence it would be unlikely to generate revenues over the medium-term. LAND TAXES 1.39 Agncultural taxes were traditionally collected at the district and local levels and were reportedly a major source o f revenue. However, they have been suspended in most provinces for several years, and any attempt to reinstate them i s likely to be severely hampered by the ongoing security situation and the widespread prevalence of opium cultivation. Moreover, the prolonged drought that has affected significant parts o f the country, combined with the aftermath o f the conflict, has resulted in widespread poverty. It would be difficult to implement land and agriculture taxes inthis situation. 1.40 Nonetheless, given the importance o f agnculture to the economy, it may be important to revitalize agncultural and land taxes. Planning for this should begin now, in order to prevent agriculture from evolving into a privileged sector o f the economy, which will be hard to reverse. To prepare for the possible re-introduction of redesigned agricultural taxation, it will be necessary first to collate current regulations, decrees, laws and rulings on all aspects o f taxation o f land, including land registration and transfer, and prepare a consolidated law. This exercise could be considered as an element o f a medium- term reform strategy. D.Medium-termRevenueForecast 1.41 Thepriority for the Government is tofund the growing operating budget. Inorder to maintain aggregate fiscal discipline, the Government has committed not to use Central Bank financing for the budget, i.e. the no-overdraft rule, and not to b d recurrent costs with loan resources." Operating expenditures are therefore constrained by the availability o f domestic revenues and external (grant) resources. Given the large weight o f salaries and wages in total operating expenditures, medium-term fundingrequirements are likely to be largely driven by an ambitious public administration reform-under these reforms the wage bill i s expected to grow faster than the projected increases in GDP over the next few years, and to remain significant over the mediumterm.'* 1.42 The Government has targeted domestic revenues to be able tofinance the wage bill by 2008/09 and total recurrent spending around 2012/11. In the interim, the Government would be highly dependent on donor funding but anticipates that the operating budget's financing needs will be fully met though donor grants. Over the next seven years, development spending would be entirely funded by external assistance. There is currently also no domestic debt market, which adds another condition effectively constraining fiscal expenditures, The medium-term fiscal strategy is elaborated inAfghanistan Government (2004). 18 1.43 Projecting domestic revenues is associated with a high degree of uncertainty, particularly in such a rapidly changing environment. The weak statistical base underlying key macroeconomic variables such as GDP, and the lack of reliable information regardingthe structure o f dutiable imports or domestic taxpayers, are a matter of concern given that revenue projections rely on such figures. Moreover, the large structural shifts that are emerging as Afghanistan moves ahead with macroeconomic stabilization and restructuring - such as security, control over provincial transfers, the impact o f opium production and eradication, and significant tax policy reforms - obscure the outlook and raise questions regarding the precision o f any revenue forecast. 1.44 To ensure that Afghanistan moves toward a more sustainablefiscal position over the longer- term, analysis of thepossiblepath of revenues is both timely and warranted. However, the constraints and limitations noted above call for considerable caution ininterpretingthe results. The Government also needs to remain vigilant to ensure that the reform program remains on-track. 1.45 Reaching the Government's ambitious medium-term revenue targets will require robust economic growth and continuing strong implementation of a number of policy and administrative reforms. The projections presented below follow broadly the same methodology as used by the MoF and are drivenby four elements: Economic growth and inflation. The tax base i s expected to grow in line with nominal GDP growth, or for import duties in line with the growth in dutiable imports. These variables are particularly susceptible to the effects o f exogenous factors, such as the prolonged drought, and also could be negatively affected in the short term by an opium eradication campaign. Non-tax revenues are assumed to grow only with inflation: with the potential exception o f over-flight fees,13 there i s hence little growth to be expected from these administration fees. Customs and tax policy reforms. The Government enacted a sweeping reform o f trade taxes toward the end o f 2003/04 and has at least partially implemented a wide range o f tax reforms aimed at mobilizing revenue (see above). Customs administration reforms. Measures to improve customs administration have been discussed earlier and will focus on improving enforcement and compliance, including rebuilding o f physical and human capacity, new international standards for classification o f goods, progressive recovery of customs functions from other agencies (e.g. valuation o f goods), and replacement o f multiple customs declaration forms with a single form for all types o f imported goods. 0 Tax administration reform. Measures to improve tax administration (also discussed above) will focus on enforcement and compliance. Important developments include the establishment of a Large Taxpayer Office (LTO) and restructuring o f headquarters and provincial tax organizations. 1.46 Several alternative scenarios are used to illustrate the implications o f different reform paths over a ten-year period. The underlying macroeconomic assumptions are similar for each scenario, with real GDP growing at around 10% per year over the first four years, falling to around 7.5% p.a. thereafter. Inflation also falls from an initial rate of 10% per annum to stabilize at 5%, while the nominal exchange rate remains stable. The alternative scenarios include the following changes to key variables: Scenario I (the baseline case) assumes the implementation of theJive-year customs and tax administration reforms. Under this scenario, there i s gradual implementation o f the proposed l3Afghanistan currently receives around $16 million per year as overflight fees. With some additional investment inthe sector andmore air traffic, these fees could increase. 19 tax policy reform measures, including the wage withholding tax (raising a total o f $120 million over the first three years); selected service taxes, including roll-out to other urban centers (raising a total o f $36 million over the first five years); and the airport tax ($2.7 million over three years). The improvements in compliance rates are substantial, assuming that the Customs administration and the LTO's performance is good, improving by 10-15% per annum over the first six years before falling to 5% per year for the remainder o f the projection period. e Scenario 2 (high-case) assumes slightly accelerated implementation of theJive-year customs and tax administration reforms combined with some additional revenue measures.Under this scenario the improvements in compliance rates are slightly higher than the base case, assuming stronger performance from the Customs administration and the LTO, with compliance improving by 20% per annum over the first four years before gradually falling to 5% annually for the remainder o f the projection period. In addition to the policy reforms elaborated in scenario 2, there i s a gradual move toward a consumption tax, which broadens the tax base, and toward the end o f the projection period royalties from the mineral sector and the gas pipeline gradually come on stream. e Scenario 3 (low case) assumes no further taxpolicy reforms. Under this scenario, based on the reforms so far, compliance rates improve by around 10% per annum over the first six years before falling to 5% per annum for the remainder o f the projection period. No additional major policy reforms are implemented, such as the wage withholding tax or an extension o f the current service taxes. 1.47 The revenue ratios for each scenario are shown as a percentage of GDP inFigure 1.2, along with the expenditure assumptions outlined in the government's Securing Afghanistan s Future report. These ratios may provide useful benchmarks for assessing Afghanistan's revenue path, depending on the progress made with the customs and tax reform programs (see Volume I, Chapter 3). 1.48 While the high-case scenario would require considerable efforts and thorough reform implementation, experience in other post-conflict countries suggests that it can be achieved. Although the revenue increases projected under the high-case scenario could be considered ambitious, with the revenue share o f GDP rising by in excess o f 1 percentage point per year for the first four years, this might be considered an obtainable goal if compared to the experience o f some other post-conflict countries. For example, the creation o f the revenue authority in Uganda helped to double the tax revenue/GDP ratio from around 6% inthe base case, at the start o f the 1990s to around 12% inthe late 1990s, before a period of relative stagnation (Figure 1.4). Similarly, in Rwanda the tax revenue/GDP ratio increased sharply from a low of 3.6% in 1994to around 12% inthe late 2002 (Figure 1.3). 20 Figure 1.2: Medium-term Revenue Forecast (as a percent of GDP) 12 SAF revenue projections - _ - - _ - _-- _ - _-- _--· 10 8 6 Low-case revenue 4 2 2004/05 2005/06 2006/07 2007/08 2008/09 2009/10 2010/11 2011/12 2012/13 Sources: Afghanistan Government (2004) and IMF estimates. Figure 1.3 Rwanda, Revenue as a Percent of GDP l4 1 12 - 10 - S - 6 - 4 - 2 1 I , I , I I , I , , , , I 1990 1991 1992 1993 1994 1995 19% 1997 1998 1999 2wO 2001 2002 Source: IMF, Government Financial Statistics and Staff reports. 21 Figure 1.4: Uganda,Revenueas a Percent of GDP 12 - 11- 10- 9 - 8 - 7 - 6 - 5 - 4 1 I I , , , I , I , , , , , , 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Source: IMF, Government Financial Statistics and Staff reports 1.49 However, Afghanistan's particular context and the inherent risks it faces should be kept in mind. The country's GDP, for example, depends to a large degree on agncultural output, which has demonstrated a high degree o f volatility. The exchange rate, while relatively stable since the introduction o f the new Afghani (and assumed to remain so under all scenarios), may also be subject to bouts o f instability in the face o f underlying shifts in demand, uneven donor flows, or attempts at eradication o f the opium economy. Even prior to the conflict dating back to 1978, Afghanistan had relatively low tax revenue collection rates, below 10% o f GDP. This was attributed to a narrow tax base, low compliance, and a weak administration. Furthermore, institutional capacity i s still weak, and the quality o f policy- malung (while strong thus far) i s uncertain over the medium term. These factors suggest that the revenue ratios, and consequently the margin o f safety, mightbe considerably lower than shown here. Nevertheless given the very low level o f government revenues - especially compared to expenditure needs - fiscal sustainability i s a critical concern over the longer-term. E. SummaryRecommendations 1.50 The recommendations summarized below are broadly consistent with the five year reform plans adopted by the Afghanistan Customs Department (ACD) 2003-2007 and the General Presidency of Revenue (GPR) 2004-2008. The recommendations also draw from various technical assistance reports from the IMF and donors. Short-term recommendations are those that should be enacted within the next six to twelve months, while medium-term actions are those that could be enactedin 12-30 months. 22 * G E A rA m hl q -3E :a, .3 z v, N I T h a n e Y 53 .3 m 0 m Annexes Annex 1.1: Description of Afghanistan's Tax System .Taxes Tax Nature of Tax IExemptionsand Deductions 1 Rates .ndcapital gains ~~ on income, profit .I Individualincometax [ncome tax imposed on hemptions: Foreign Taxable annual Marginal individuals earning salaries or ;overnments, international income Tax rates .aw o f Income Tax wages, persons havingnet irgs and their non-resident (inAfs) (percent) Law introduced in 1965 income from self- ,rnployees in accordance with 0 to 150,000 0 iuthasbeen significantly zmployment, and other ,xisting treaties and contracts 150,001 to 10 nodified) individuals. The tax is vith the State of Afghanistan. 1,200,000 imposed on net income, Art. 10) 1,200,000 and 20 .ast modification: March defined as the difference above !005 between gross income and ipproved applicants for deductions permitted by law. :xemption beingorgs legally wganized under Afghan law Residents (natural persons md organized and operated and legal persons such as :xclusively for educational, companies etc.) are taxed on xltural, literary, scientific or income from all sources :haritable purposes. (Art. 11) (including from abroad). Non-residents are taxed on 9gencies and departments of income from Afghanistan he State andmunicipalities. sources. ,Art. 12) Wage withholding tax will be \Jon-residents provided that restored inFY2004105 .herespective foreign country (Article 64), with the pants a similar exemption to withholding being a final tax Pesidentso f Afghanistan. inthe case of employees with :Art.7) no other sources o f income. A wage eamer who has a single Foreign airlines ifreciprocal employer i s not required to exemption for Afghan airlines file a tax declaration. An inthe respective foreign employee with two or more jurisdiction. (Art.9 (3)) employers or with other sources of income will be Deductions:-Most expenses requiredto file an annual incurred to derive gross declaration. Annual lodgment income are deductible when and payment within 4 months computing taxable income o f year end. (Article 19). The calculation o f tax withholding spread the Dividendsand other income rates applicable to distributions o f profit are wage income over each pay taxed at the individual level period (Article 65). inAfghanistan. Dividend withholding (Art. 51) non- final (i.e. credit against annual income tax liability). 1.2 Corporate incometax A flat rate income tax Exemptions: As for 1.1 Taxable annual Marginal imposed on legal persons- above. income Tax rates Law o f Income Tax corporations, limited liability (inAfs) (percent) companies, and some types oj Deductions: Expenses Afsl and above 20 Last modification: March partnerships. The tax is incurredto derive gross 2005 imposed on taxable (net) income are deductible when profits, defined as the computing taxable income 31 Tax Nature of Tax Exemptions and Deductions Rates difference betweengross (Article 19). The Incometax incomeand deductions law containsprovisionsfor permittedby law. depreciation, of buildingsand other capitalassets, and loss New administrative carryover (Article 53). For procedureswere introduced qualifyng businesses, inFY2004/05,includingthe accelerateddepreciation and introducingof atax rulings lossescarriedforward system andnew penalty indefinitely apply. provisions. 1.3 Taxation of Capital For corporationsor limited Exemptions: Immovable Corporatetax rate-20% Gains liabilitycompanies, the sale propertythat is: pricefrom disposal of 1. inherited,or propertyless the cost not 2. atrade or business, Individuals-gain taxable infull depreciatedandother including goodwill, or at marginalincometax rates. If expenses. Capitallossesare 3. a factory including the propertyis held 18 months or deductible. equipment, machinery, more,the gain is averagedover buildings andland, or any the periodheld andtaxed at the For individuals,the saleprice part of such assets, or averagerate applicablefor that o f atrade or business, a 4. shares of stock in part ofthe gain inthe year of factory or shares in corporations or limited disposal. corporationswill betaxable liability companies. Gain onthe sale of immovable A fixed tax appliesto the sale For items 2-4, the annual property- 1YOofthe market o f immovableandmovable income provisionsregarding value propertyownedby an capitalgains applybut with individual. This is afinal tax certain modifications.(Art. 34 Gain on the sale of movable inlieuofincometax. and 27) property-2% ofmarketvalue 2. Taxes on goods and sell :es 2.la Business receipts tax A cascadingturnover tax, Exemptions: BRT applies 2% rate inprinciple on sales of (BRT) leviedon limited liability only to legalpersonsandnot all goods and services.* companies, corporations and individuals.Agencies and Law o f Income Tax partnershipson gross departmentsof State andof Receiptsof commissions, fees, (Article 73) receipts (before deductions) municipalitiesare exempt, interest, dividends,rent, from the provisionof goods except incomederivedfrom royalties, and similar incomes Lastmodification: March and services whether or not a commercialactivities.(Article are taxed at 5%. 2005 profit or loss is madeduring 12). New businessapproved the year (Art 75). underForeignInvestment Law. Paidannuallywithin six months of endof year either Deductions:No deductions beforeor at same time as are allowed. incometax (Art. 74) BRT is deductiblewhen calculatingthe taxable income ofalegalperson for annual incometax. (Art.77) 2.Ib BRT on selected This measureimposesaBRT Exemptions: Incomefrom Businesseswith atotal sales services on the gross receipts of services other than designated value (turnover)per month on service providersin services is not includedin the designatedservicesat the Last modification: March telecommunications, calculationwhen considering following rates: 2005 internationalairlines, ifataxpayerhasmetor restaurants, cafes andbars exceeded the threshold. Ifthe andhotelsandguest houses taxpayer is alegalpersonand Afs 1- 50,000 2% where the thresholdof50,000 derives less than the Afs over Afs 50,000 10% Afs per monthhas beenmet. 50,000 thresholdinamonth 32 Tax Nature of Tax Exemptions and Deductions Rates ?omprovidingdesignated R e tax commenced inKabul iervices, the existing2% BRT n2004 andwill be vi11applyto that person.If xogressivelyintroducedin hetaxpayer is an individual itherprovinces as the mdderives less than Afs idministrativecapacity j0,OOO in a monthfrom mproves. xoviding designated, no BRT s payableon the receipts f i e tax i s to be paidquarterly ?omthose services. ]ut calculatedon a monthly >asis. Deductions:-As above, BRT s deductible when calculating hetaxable incomeof alegal 3erson for annual income tax. :Art. 77) ?.2Rent Withholding Tau Withholdingtax payableon Exemptions: Rent incomenot !O% of gross payments for rental :he gross rent from rental :axedunder thisprovision, ;erviceswhere those rental Last modification: March services providedby a secause it falls belowthe ;ervices exceedAfs 15,000 per 2005 landlordfor the use of land monthlythreshold of Afs nonth. andor buildingswhere the 15,000, remainstaxable under payment for the service the income tax law. ExceedsAfs 15,000 per Example; A landlordreceives month. The tax is imposed Deductions:No deductions 4fs 40,000 per monthfor rental on the landlordwho is services. Additionally, the tenant entitledto receivepayment As anon-final withholding, ias made Afsl0,OOO inrepairs for the rentalservicesbut the the landlordi s requiredto file md improvementsto the tenant withholds the tax from an annualincometax return property during the month. The therent or leasepaymentand declaringgrossrentalincome, rent withholding tax is calculated paysit on behalfofthe may claim deductions and as follows: landlordto the credit for the amounts government. ** withheld. Monthlyrental 40,000 income Rental servicesfor the Plus: provisionof landand Repairs 10,000 buildingsincludes,but is not and limitedto, rentalor lease improve paymentsmadefor the rental ment or lease o f land, houses, guest houses, office buildings, Amount subject 50,000 office-cum-living space, to tax shops, shops-cum-houses, warehouse andindustrial Rent Afsl0,OOO space. The renting,leasingor withholding tax subleasingof any ofthese 20%x propertieswill give rise to a Afs50,OOO rent withholding obligation. 2.4 Fixedtaxes Articles 78 - 95 o f the Exemptions: None Fixedtaxes are levied on incometax providefor a importers and exporterswithout Law of Income Tax variety o ftaxes, usually All individuals sellinggoods abusinesslicense (or those with (articles 78-95) referredto as fixed taxes. and servicesfrom established an interim business license that They comprisepresumptive placesofbusinessare subject do not provide a business Last modification: March taxes on small business to taxes specifiedinthe declarationformto the MoF) as 2005 (sometimesexpressed as schedule of tax categoriesof apercent of the value ofthe fixed amounts, but also as businesses.These taxes are transactioninclusive of customs percentages ofpresumed inlieu of incometaxes from duties. Onthe former, the rate is turnover); atax on the value the sale of such goods and 3% and on the later. the ratei s o f importsand exports for all services. The tax due from an 2% (Articles SO and 81). As a I 33 Tax Nature of Tax Exemptionsand Deductions Rates traders without a business ndividualowner (or owners) ransition measureassociated license (which i s in addition ) f a fixed place o f businessi s vith the tariffreforms, therate to the BRT on international he amount specified for the In bothimportersand exporters trade for legalpersons); anda elatedcategoryand grade of vas loweredto 0.5% in 2004105. sales tax in lieu of income tax iuchestablishment. for individualswho supply 'resumptive taxes inlieuofthe goods andservices to the ncometax include: government. 1. Tax on shops andtraders A fixed tax is imposedon with no fixed business premises businessestablishments (Articles 88, 92 and 94): The which do nothave complete rules for imposingfixed tax on accountingdocuments.There shops are very complicated, are identifiedinthe current basedonthe classificationo f a law 170tax categoriesof businessby reference to alist of businessestablishments.The morethat 170categoriesof fixed tax ofbusiness taxpayers. The amountof tax establishmentsis set by a leviedon each category of shops committee is to be approved i s determinedusingarange of by the Minister of Finance factors including the type of every three years. A process goods soldand the size and of consolidationand locationofbusinesses. A simplification is underway. committeecomprising representativesfromthe provincial Mustoufiat, the Ministry of Commerce, and municipalitiesdecidesuponthe level o fpresumptiontax to be levied on each categoryof shops. Fixedtax applicable to traders with no fixed place of business i s levied accordingto the type and size ofthe business. 2. Tax onturnover (Article 85, 86): This tax i s appliedto specific businesses (e.g., cinemas) at arate of 10%on turnover. 3. Lump sumtax (Articles 83. 86,87 and90 ofthe incometax law and90.1 of the incometax manual): It is appliedon selectedbusinesses (e.g., transportationbusinesses, kilns, m i l l s andmedicalpractitioners) at very low to moderate amounts. 4. Tax on contracts(Article 84): When the government purchases goodsor servicesfrom an unincorporatedcontractor or individualswho provide constructionservices, at 7% of the purchaseprice is withheld as a creditablewithholding tax (there i s afinal settlingup at the end of the year). 2.4a Fixed taxesfor As with shopkeepers, there is Exemptions: None The highestlevel i s Afs 93,320 money changers ascheduleof fixed taxes for per day and above payingan 34 Tax Nature of Tax Exemptionsand Deductions Rates moneychangers (Article 94) annual fixed tax o f Afs 700,000. ,ast modification: A new fixed tax on money 'residential Decree o f changers, with 10 Iecember 2003 classifications, was passed in June 2004 to simplify rhis measure i s yet to be compliance with the law. idly implemented. ?.5Sales tax on Manufacturing organizations Exemptions: Bread, flour, Consumable goods tax collected :onsumable goods of are required to pay an ad- stationew. forms. books. as an ad valorem tax on the sales ,I iomestic manufacturing valorem tax on income they notebooks, ink, chalk, pencils, price o f various manufactured wganizations receive from the sale o f their movies, newspaper, goods according to a schedule. products inside Afghanistan. magazines, coal, medications, The tax rates range from 1%to 'ublished in the Official medical items and chemical 10% o f the sales price. 3azette in 1980 and All,organizations including fertilizer are exempted from mended in 1982 corporations, general payment o f the consumable partnerships, limited liability goods tax companies and state owned rhis tax does not appear enterprises that manufactures, LObe beingapplied at processes, assembles or the currenttime undertakes miningactivities are subject to the provisions o f this Law. Organizations approved and established under the Foreign and Domestic Private Investment Law are required to pay tax. 3. Taxes on internationalt idetransactions 3.1 Customsduties Underthe trade regime inherited import duty. based on treaty, international by the transitional government, Customs Law (1984) has law, law, regulation etc shall there were 25 tariff bands, with been updatedwith a new The Customs Tariff i s a be implemented through an rates ranging from 7 to 150% - Customs Code document enacted in amendment or annex to the with a simple average o f about promulgated in2005. accordance with this law tariff. The following import 43%. which determines the import goods shall be exempted from Last modification: March and export duty o f goods paying customs duty: An overhaul o fthe tariff system 2005 based on their classification. 1- Goods imported by officials reduced and simplified the The Customs Tariff i s o f the State during official number o f ad-valorem and approved by the Minister o f travels not inexcess o f Afs. regionally specific customs duty Finance, upon the 100,000 as providedby the 'ates to the following six: recommendation o f the Customs tariff.. Rate Type of product General Director o f Customs. Office materials and (YO) equipments o f political 2.5 essential food and non- FromJanuary 2005, the representatives and food products customs valuation service International Agencies, 4 Capital goods, was relocated from the materials intended to be used Machinery Ministry o f Commerce to the inresidency o frepresentatives 5 raw materials and capital good Ministry o f Finance under o f foreign countries in 8 Petroleum, diesel, General Director o f Customs. Afghanistan, after aviation fuel confirmation o f competent 10 semi-manufactured Pursuant to Presidential authorities. products Decree o f July 14,2003, only 2- Items intended for personal 16 non-priorityproducts, Customs Brokers licensed by use by foreigners working in luxury products, arms the Ministryo f Finance will Afghanistan according to the and ammunition be authorized to clear terms and conditions o f their importedor exported goods contract. The tariff uses the single national through Customs in 3- Allowed books, gazettes, official exchange rate published Afghanistan. This magazines and newspapers. byDa Afghanistan Bank for the requirement was initially 4- Goods provided for purpose of valuation o f goods. enforced inKabul, and then government projects funded 35 Tax Nature of Tax Exemptionsand Deductions Rates infour other major provincial iy loans or imported to the l e General Directorate o f jurisdictions in a staged :ountry by or for public and :ustoms is responsible for processthroughout 2004. xivate foreign and arrying out the tariff [nternationalrelief and :lassification o f goods kvelopment agencies. :oncerning description and i-Personaleffectsusedby :oding in accordance with the 4fghan delegations or Afghan larmonized System o f the international workers and their World Customs Organization family members abroad. md for assessing any i-Travelers'personalgoodsin :orresponding duty under the accordance with the Customs h t o m s Tariff. Inorder to Tariff. :ombat false valuation o f certain 7- Commercial samples and ;oods with suspicious values, advertising gifts. heirminimumvalue shall be $- Post parcels valued at Afs ietermined by General 5000 or less. >- 3irectorate o f Customs -with honorary decorations or henew systemisbased on awards; nternationalnorms. LO- samples sent to organizations protecting copyrights or industrial or commercial patent rights; 11- Used movable property belongingto natural persons, who transfers their normal place ofresidence from another country to the State, as provided inthe Customs Tariff; 12- a consignment o f less than Afs 1000value; 13- Pure-bred breeding animals and insects and laboratory animals, biological or chemical substances needed for scientific researches; 14- therapeutic substances of human origin and blood grouping and tissue typing reagents,; 15- substances for the quality control o f medicinal products; 16- Fuels, lubricants and equipments carried with and necessary for the normal functioning o f transport vehicles in accordance with the relevant procedure. Other goods may be exempted upon recommendation o f MinisterofFinance and approval o f Council o f Ministers. 4. Other taxes Airport Departure Tax A flat rate tax charged levied ExemptionsiAir crew on the Proposal:-$12 for international on passengersat the airport departing aircraft, members o f passengers is envisaged. prior to departure. This the defense force o fthe measure i s to be enacted United states and o f the 36 Tax Nature of Tax Exemptionsand Deductions Rates through the Departmentof peacekeepingforces o f Civil Aviation. NATO, personsbeing extraditedfrom Afghanistan anddomesticpassengers. Extractive Industries Details are beingprepared Detailsbeingpreparedwith TBD Tuxes- special provisions with the assistance ofthe the assistanceofthe World for Royaltiesand World Bank. Bank and IMF. deductions (coveredby sector-specific legislation). Acres Afsiacre Land Taxes Landassessedaccordingto Exemptions: Landof less 2 to 10 45 grade and size. Cultivated thanhalfan acre, land 11 to20 60 landdividedinto 3 categories uncultivatedor ruinedby 21 to 50 85 and 7 grades. unexpectedcircumstances, 5 1 to 100 120 landownedby agricultural 101to 200 175 Becauseof the drought co-operatives, or government, 201 to 500 400 conditionsandcompliance or used for religious, problems,this tax has yielded educational,or research A co-efficientof 1is used for zero for the past 10years. activities. Landused as a primeland. The co-efficientis Governmentplansto extend cemetery reduceddependingon the exemptionsbecauseo fthe categoryand grade ofthe land. continuingdrought. Deductions - none Toll tax Reportstogetherwith a TBD decisionmatrix havebeen receivedfroma consultant engagedby ADB. This proposalhas progressedto a stage where discussionsneed to occur with other Ministries on the various options. Historically, there were 48 roadtoll stations set up across the country.Currentlythere are only two that couldbe set upfor operationaluse along the Kabul-Kandaharroad. * Following the introduction01 ie new tariff regime, the BRTrate 'importers and exporters who are a subject to fixed taxes was set at 0%. Inadditionrthe fixed tax onimorters and exuorters was lowered to 0.5%for FY2004105 ** ~~~ ~~~ A tenant i s a legal person, or naturalperson who uses the rentedproperty in the course of business. "Legal person" i s defined to include corporations, foundations, limited liability companies, partnerships, unincorporatedassociations, clubs or organizations, non-profit institutions, charities, Afghanistan and foreign government and their agencies, international organizations. 37 CHAPTER 2. THE GOVERNMENT OFAFGHANISTAN'S PAYROLL Executive Summary i. ThischaptercoversarangeofissuesrelatedtothepayrolloftheGovernment ofAfghanistan. Salient points include: Small and stable public employment. By international standards, public employment in Afghanistan i s relatively small. Civilian employment has been stable over the last two years, except for teacher recruitment. The Government has articulated its strategy to maintain a lean public service, while only recruiting teachers: this relatively small size i s important given the Government's strategy to increase salaries to build capacity. Gradual increase in average salary. The average salary has been increasing as a result o f the pay increase in 2003. Much-needed gradual increases will continue to be phased in as the Priority Reform and Restructuring (PRR) scheme i s implemented. Subsequently, the pay and grading review may result in further pay increases which have to be coordinated and sequenced with the overall public administrationreform program, including measures to deal with those civil servants who lack the necessary qualifications for their jobs. Together, these reforms should increase Government's capacity to implement policies that will lead to growth. Increase in the wage bill. The wage bill increased from $281 million in 2003/04 to $374 million in 2004/05. The increase reflected recruitment o f teachers, full-year impact o f the 2003 pay increase, and implementation o f the PRR. These various ongoing payroll reform efforts, including implementation over time o f the pay and grading review, together with additional teacher recruitment, will result in continuing increases in the wage bill. The Government's Securing Afghanistan 's Future (SAF) report roughly projected that the annual wage bill would reach $900 million in six years. Even if actual growth o f the wage bill i s lower, there will continue to be a large operating budget deficit inthe short to medium term, which will require significant external financing. Given strong economic growth and domestic resource mobilization, this shouldbe sustainable. There are undoubtedlyJisca1 risks. Limited Government capacity, schemes to attract talented professionals, and the relatively high salary level and programmed rapid growth o f the Afghan National Army, as well as a proposed large pay increase for the Afghan National Police, generate significant pressures for increases in salary levels. However, sizable sector- specific or generalized salary and pensions increases that are not part o f the public administration reform program, or loss o f recruitment discipline, would have severe adverse fiscal consequences, as would failure o f domestic revenues to increase rapidly. Improvements in payroll processing. The re-decentralization o f payroll processing in March 2004 has expedited the process. The Individualized Salary Payment program has improved effectiveness in Kabul. Issues remain, however, with respect to further facilitating payroll processing and improving controls, especially in provinces, and in particular for security sector Ministries where bothheadcount and payroll reporting remain weak. Uncertain pension policy. Pensions for civil servants have been increasedin2004 butremain low; important policy and administrative reforms are needed but their fiscal implications need to be assessed. 38 ii. Insummary,theGovernmentneedsto: Implement pay reform strategy carefully: Although the strategy set out in the SAF report implies that the wage bill will grow in a programmed manner despite a large operating deficit, this must not be interpreted as a softening o f the hard constraints within which the Government operates. The Government will need to monitor the wage bill and revenues closely, and make trade-offs between its sector policies as part o f its Medium-Term Fiscal Framework (MTFF). It should use the annual budget as an instrument to state its policies with regard to the wage bill. Maintaining strict discipline over staffing levels in the Government will be critical. Providefull information to donors to secure their continued support: The Government wage bill will be a key driver o f Afghanistan's fiscal aggregates and balance. Followingthe SAF projections in2004, the MTFFrecently prepared and approved provides a welcome statement o f the Government's medium-term fiscal stance. Ina situation characterized by a continuing large operating budget deficit financed by external assistance, the Government will need to provide full information to donors and take them into confidence about its fiscal policy including wage policy. While adjustments may be required in the light o f subsequent developments, it would not be advisable to allow the gap between core budget operating expenditures and revenues to widen significantly in an unprogrammed manner. The Government should alert donors to any departures from its fiscal policy stance if it i s to maintainthe support that donors have so far provided to the operating budget. 39 A. Size of the Civil Service 2.1 This chapter describes and analyzes a range o f issues related to the payroll o f the Afghan Government. It first in this section, reviews recent trends in the size o f the civil service, highlightingits overall stability. Despite issues with data quality, this suggests that the Government i s retaining control over the total size o f the civil service. Second, the chapter describes the pay increases decided in 2003/04' Third, it reviews the Government wage bill, concluding that it is increasing, as predicted, mainly as a result o f pay increases rather than recruitment. The fiscal sustainability o f the current trajectory i s explored. Fourth, the chapter reviews the improvements inpayroll processingthat have been made. Finally, it considers the situation regarding pensions - concluding that pensions for civil servants have been increased in 2004 but remain low and that important policy and administrative reforms are needed. 2.2 Totalpublic employment is around 380,000 (Figure 2.1).' In theory, SOE staff (estimated at 19,000) and from the Central Bank (estimated at 3,000) are excluded from general government employment, although the distinction i s inpractice less clear.3 General government employment includes the army and other uniformed staff (on the order o f 70,000 employees, see below) and municipal employees (a tentative estimate o f 3,000). The rest, civilian central Government, includes central ministries and provinces: of the 284,000 employees, two thirds are inprovinces. Figure 2.1: Current Structure of the Civil Service Population(2004 est) 23 4 millioi TOTAL WBUC EMPLOYMENI Civilian Central Govt as % of Population 129. Education 0 49. T A T E OWNED EhTERPRISES GENERALGOYERAMEM 22,000 1 360,437 1 ARMED FORCES C M W N CENTRALWVERNMEM [ MUNICIPAL A~~loTMTloN 7 283I737 rBad,yrlr Based Inthe PROVINCES 191,363 1 of which: I I total education 19,908 90,101 health 8,136 7,543 15,679 health police 15,479 37,880 Source: Payand employmentmodel; staffestimates(January2005). 2.3 Thesize of the civil service is relatively low by international standards (Table 2.1). It comprises around 1% o f the total population, compared to the regional average o f about 2.6%. This i s an important advantage for the Government given its strategy to increase the average salary (see Table 2.1). The 1382Afghan fiscal year startedon March21,2003 and ended on March 20,2004. The estimatehas beendevelopedfor the AfghanistanPayandEmploymentModel (APEM), preparedby the World Bank, based on a detailedanalysis oftrends fromthe headcountdatabase(first developedby Adam Smith Instituteandnow maintainedby the ARTF's Monitoring Agent). The databaserelies on M16 forms (summary of payroll) receivedby the Treasury and provides the number of employees for each department (each ministry in each province) every month. More recent data suggests that this number couldhaveincreaseddue to recruitment of teachers (see below). Apparently,the Departmentof Oil and Gas inthe Ministryof Mines and Industry has staff on the Government's payroll, while part of it (e.g. Oil and Gas Exploration Developmentand Afghanistan State Gas Enterprise) should be considered as separate entities; arecent analysisby the ARTF's Monitoring Agent indicatesthat there could be other such examples (Chapter 4). 40 Table 2.1: Size of the Civil Service (% totalpopulation) Region Total Civil Service Teachers Health staff Afghanistan 1.2 0.3 0.001 Africa 2.0 0.6 0.2 Asia Pacific 2.6 0.8 0.2 Central and Eastern 6.9 3.0 2.1 Europe and the FSU Latin America and the I 3.0I 0.8 I 0.3 Caribbean Middle East and North 3.9 1.2 0.4 Africa OECD 7.7 2.1 1.4 2.4 Overall, the size of the civil service remains largely stable although the volatility from one month to another requires careful interpretation of the data. This conclusion i s based on the observation o f actual payments (inAnnex 2.1). A detailed analysis suggests: A move from Kabul to provincial employment, largely concentrated in education: during 2003104 and 2004105,4some 42,000 persons have been recruitedinthe provinces while 5,000 fewer people were on the payroll in Kabul. This mainly reflects recruitment in education, while other provincial and district departments have kept employment levels at a similar, even sometimes lower, level. Overall stability in numbers but an increase in teachers: over the same period, while the number of employees inthe Ministry o f Education was increasing by 50,000, the number o f other employees was decliningby 13,000. Uncertainty about police: over the same period, the number of uniformed staff paid by the Ministryo f Interior has increased by 4,000. Although headcount volatility suggests that the quality of data i s problematic (see below), this increase might indicate a trend as an increase inthe number ofpositions (23,000) was agreed throughPresidentialDecree during2003/04. 2.5 Discipline in recruitment has largely been achieved through the tashkeel system. Decisions on the establishment are size validated by the Office o f Administrative Affairs o f the President's Office (see Evans et al, 2004). This department maintains the tashkeels (detailed lists o f authorized positions). Changes in the tashkeels are usually decided annually, in advance o f the budget. To process payroll, departments also need to receive their takhsis (an allotment for payroll payments), sent on a quarterly basis by the Ministry o f Finance. Tashkeels and takhsis are sometimes inconsistent, but have been improvements as the Office o f Administrative Affairs now participates in the budget hearings. Some discrepancies remain however, such as the significant increase inthe tashkeel for the Ministry of Interior approved two months after budget approval during 2003104. 2.6 Discipline in recruitment has enabled the Government to implement its policy of a lean civil service. There i s a planned increase in education staff, but this i s bringing Afghanistan in line with regional average (see Afghanistan Government, 2004). There remains uncertainty concerning security sector employment totals, however. These trends compare the first three months of 2005106 to the corresponding period o f 2003/04. 41 0 Teacher?. Based on projected number o f pupils, the number o f teachers would need to increase from around 110,000 to above 194,000 by 2010/11. The cost i s about $50 million (withno change inaverage salary, see below). 0 Other Civil Servants. The rest o f the civil service would stay the same size.6 0 Police. A recent exercise in the Ministry o f Interior indicated that there were 53,400 uniformed staff, o f which 37,000 were provincial police and 7,000 were border police? However, the tashkeel for uniformed staff inthe M o I i s almost 82,000 staff. The size o f the police force i s expected to increase, as will the counter-narcotics sector (which could add a few thousandpolicemen, see Box 2.2 ). 0 Army. Currently the Afghanistan National Army (ANA) stands at around 26,000 and i s projected to grow to 70,000 by 2009/10. The Afghan Militia Force have been phased out through the DDRprocess (Box 2.1). Box 2.1: Staffingin the Security Sector Headcounts. Current estimates put security staffing (mainly including the army, police, andjustice sector) at 175,000, but this is likely to increase to over 200,000 during 2005106 once recruitment following Presidential decrees has been implemented. Wage Bill. Currently, a substantial proportion of the wage bill for the security sector is funded outside of the core operating budget. ANA operating costs for 2005106 are believed to be in the order of $140-170 million. Food allowancesof $2.7 per ANA soldier per day show food costs for ANA of $34 million for 2005/06 alone. Intotal, a wage bill of approximately $74 million is paid off-budget. MoIis considering adoption of anew pay and grading structure for the ANP, which will increase salaries to match (and for a few of the higher grades exceed) the current pay structure for the ANA. MoI also pays $33 monthly for food to eachmember of staff. Financial Management. While there has been good progress inreporting both wage and non-wage recurrent costs and staffing numbers for security institutions, significant information gaps continue to undermine the integrity of the overall analysis. These largely result from the rather fluid nature of staffing and the restructuring of security institutions. For example, the Afghan Militia Force, estimated by MODat around 100,000 have been demobilized, but their number turned out to be only 63,000. On the other side, significant numbers of new ANA soldiers are being recruited every month, and a force size of around 26,000 has been built up. Furthermore, analysis indicates some disparity in actual staffing numbersfor MoI and MoJ. MoI i s currently inthe process of approving an increasedstaffing size for the ANP from 53,400 up to 62,000 for 2005106, although this has yet to be agreed. MoJ currently reports staffing "actuals" of 10,502, but only 4,701 are shown on the payroll. The Attorney General's Office has an agreed staffing establishmentof 4,923, but reports actuals almost 50% higher. The staffing of the National Defense Secretariatis assumed at 10,000, but no actualpayroll figures are available. Volume V reviews public finance management inthe security sector. C.Pay Scales 2.7 Over time, the averagepaid salary has increased, from around Afs 1,80O/month ($36) in early 2003/04 to above Afs 3,00O/month (almost $60) in the most recent months (Figure 2.2, based on actual payments). A detailed analysis indicates different trends as between the center and the provinces. The A census of all school facilities and teachers has been conducted in2004. A total of 105,000 teachers were recorded and, given the numberof schools not recorded, the total could be around 110-120,000. There will, however, be an increase with the formation of Parliament. The staffing for Parliament could include around 300 parliamentarians,a secretariat of probably 500 staff, and 500 additional support staff. 'This i s based on LOTFA accounts. However, headcounts recorded in the MoF database varied between 37,000 and 50,000 policemen in2004105. 42 gap appears to be increasing over time, possibly reflecting implementation o f the Priority Reform and Restructuring (PRR) scheme (see below).8 2.8 Pay policy decisions are made by the Cabinet. The Cabinet has decided that pay scales would be proposed by the Independent Administrative Reform and Civil Service Commission ( M C S C ) , after review by the Ministryo f Finance (MoF). This has provided an effective mechanism for the Government to implement a consistent approach to pay policy. There is currently no pay policy unit. Figure 2.2: Average Salary (Afdmonth) 6,000 ~ _ _ _ _ 1,000 - Provinces+Average - -Center 1 1382 I 1383 1 1384 1382= 2003104; 1383 = 2004105; 1384=2005106 Note: Total wage bill dividedby headcount for non-uniformed staff. The unusuallevel in Jawza 2004/05 is due to ahigh paymentin the Ministry of Interior. Source: Headcount database (updated inNovember 2005). 2.9 There are severalpay scales (Figure 2.3). Most civil servants are on the "general pay scale". Teachers have their separate pay scale. There are also specific scales inthe security sector. Figure 2.3: Pay scales ($/month) as of M a y 2005 1,ooo 4 888 / 600 I I 400 I I 350 300 250 200 150 100 I I t I I t 1 I 50 t 1 70 I 4 7 .,1 , .,I , ~ 47 ~ 44 ~ 8 I Civilian PRR Education Ph?ce Roposed A& ANA GOVCmmCnl ANP I Lower and upper bounds of the scales. This includes the base salary and an estimate of cash allowances 2.10 Thegeneralpay scalefor civil servants, despite apay increase in 2003, is low and compressed. Before the 2003 pay increase, the average salary was on the order o f $38 per month, with the ratio of the * While the PRR allowances recorded in the Government's information system are low, it i s possible that they are misrecorded. The increase at the central level could then in part be explained by the fact that, at mid-year in 2004/05 ,around 3,000 employees (4% of Kabul-basedcivil service) was inthe PRR scheme, and they received on average amonthly allowance of Afs 5,000. 43 highestto lowest grades (compression ratio) only 1.09:1. This was largely driven by the payment o f large and flat allowances that amounted to 95% o f the salary. InNovember 2003 base pay was multiplied by seven, bringingthe average salary level to $48 per month and increasing the compression ratio to 1.6:1, a substantial de-compression. These ratios intheory include all allowances, which are now paid incash. In practice, some in-lund benefits are in addition granted to civil servants (most notably but also transport). InNovember 2005, a modest pay increase was granted to civil servants: as it was equal for all of them, the compression ration slightly worsened to 1.5. 2.11 Teachers have their ownpay scale. In2003 a new allowance was created for teachers (based on qualification instead o f grade), which increased teachers' salaries from about $30 to $50 per month. For university teachers (estimated to number about 1,700), options to give them a one-time cash or in-kind transfer (e.g. research grant or IT equipment) were reviewedin2004 and could cost $2 to 3 million. 2.12 There are severalpay scalesfor the army and thepolice. The police has its own salary scale, and police wages were increased in 2003. A new pay scale was created for the new Afghan National Army, much higher than what had previously been in effect for the Afghan Militia Forces. For both the police and the army, employees also receive in-kindbenefits (food). Differences between these scales have created significant pressures for further pay increases in the security sector, i.e. for the Afghan National Police (ANP)and the National Directorate o f Security. As a result o f such pressure, M o I has proposed adoption o f a new police pay scale similar to the ANA scale. Placingpolicemen on the proposed scale would cost a total o f close to $180 million per year. There has also been discussion in MODabout increasing the current ANA scale. 2.13 The average salary probably needs to continue to increase over time. Currently, the average salary i s similar to that o f other countries interms o f GDP per capita (Table 2.2). However, income per capita in Afghanistan i s very low and i s expected to increase significantly inthe next decade. Inaddition, the lack o f capacity inthe current civil service and competition inthe labor market (mainly from donors and NGOs currently, but potentially later from the private sector) mean that the Government has to rely on expertise paid by donors (either through the provision o f technical assistance or, for line positions, by provision o f top-ups)." Inthe Securing Afghanistan's Future (SAF) report, the Government's has stated its strategy to increase the average salary faster than per capita GDP over the next few years (Figure 2.4). Region Salary Afghanistan 3.1-3.5 Asia Pacific 3.0 Central andEasternEuropeandthe FSU 1.3 Latin America andthe Caribbean 2.7 Middle East andNorth Africa 3.4 Accordingto the Government's accounts,more than$50 million were paid for food in2003104. Itwould appear that a large part of it is not for employees (for students, patientsinhospitals, conscripts, andprisonersinjails) andthat most employees receivinglunchespay for it (even thoughwith a subsidy). lo This is particularly true in the health sector. A top-up decree was approved by the President to ban top-ups. It i s not yet implementedandthe Government's plans are to phasethemout, usingthe capacity-buildingframework. 44 Figure 2.4: Average Salary / Per Capita GDP (SAF projections) 5.0 2.5 2.0 1.5 1.o 0.5 0.0I 1382 1383 1384 1385 1386 1387 1388 1389 1390 1391 1392 1393 1394 Source: Government of Afghanistan (SAF report). 2.14 The Government's policy has been to grant pay increases only through its capacity-building framework in the short term and, inparallel, to review the structure of the compensationsystem. There are however strong pressures, both for general increases and for increases targeted to specific slulls (i.e. in the health sector). Such pressures resulted in an across-the-board increase inthe cash allowance for civil servants o f Afs 350 per month in mid-2005/06. Giving in to these pressures would quickly erode the Government's ability to engage incomprehensive coherent reform o f the pay structure. 2.15 InJuly 2004, the Ministerial Advisory Committee (MAC) approved aframework for capacity building, which introduces a number o f other programs to allow higher pay rate either for specific positions inthe civil service or for external consultants temporarily hired (Annex 2.2) Priority Reform and Restructuring program. Individual departments reform their structure and are allowed to pay higher salaries to qualified staff (see scales in Figure 2.3, with the higher rate at almost $300 for the PRR scale compared to $65 for the regular scale). The 2003 pay increase (for the general scale) has somewhat reduced the premium to staff placed under PRR. For 2004/05, the objective was to bring 15,000 employees under the program: as o f November 2004, however, only 8,000 positions were covered. Inthe 2004/05 budget, $35 million was set aside in the Civil Service Reform Fund for the PRR allowances. Only $1.5 million has been spent, reflecting slow implementation." There has been little implementation so far at the provincial level to date (Chapter 3). PRR superscale. For a limited number o f officials in PRR agencies, a 2-3 year contract is envisaged to place them at a higher level than the existing PRR scale. Budgeted for 500 positions at an average o f $600 per month (up to $2,000), this could cost $4 million annually. The MAC has already approved several such positions. It can be assumed that it will be difficult to return these positions to the existing PRR scale later, and therefore that this cost i s likely to be lasting. e Lateral Entry Program. For agencies where there are no immediate prospects for the PRR process, lateral entrants could be brought into help launch the reform process. Budgeted for 1,500 entrants, at an average o f $1,000 per month, this could cost $18 millionper year. The program is designed with explicitly non renewable, fixed term contracts. But it i s possible that it could have some longer term fiscal implications. Slow implementation reflects: backlog in reviewing PRR applications; delays in recruitment; and lack o f capacity and leadership to implement programs, especially when they imply moving staff. 45 0 Other programs. These include the Technical Assistance and Feasibility Study Unit (TAFSU), providing short-term consulting services, and the ARTF Expatriate Window, providing one or two year contracts for expatriates. The cost o f these programs i s assumed to be borne by external assistance without long-term impact on the civil service wage bill. 2.16 Inparallel, IARCSC has initiated a pay and grading review for all civilian employees. The first phase seeks to evaluate the current system, prepare job descriptions, and develop a consistent grading structure. The second phase will consist o f developing a pay structure to be attached to the new grading structure, based on local labor market conditions for the skills and qualifications required. Anecdotal evidence suggests that pay scales at the lower end o f the civil service are already about in line with market rates, but the upper end will have to increase in order to attract and retain staff with appropriate qualifications. However, it is important that staff laclung necessary skills and qualifications are not paid higher salaries that may be called for by the pay and grading review. In addition, all PRR position holders will be required to re-apply for the permanent positions when the pay and grading review i s implemented (PRR contracts have beenissued for 12 months, and renewals are supposed to be based on a satisfactory performancereview). Close coordination betweenthe IARCSC and the M o F will be required inthis matter. 2.17 Although ongoing PRR and related reforms are notfiscally costly, implementing thepay and grading review would carry significant costs. The implementation o fthe pay and grading review will be very costly if it leads to a salary structure close to PRR scale levels. Bringingall civil servants (120,000 employees, excluding teachers and policemen) to the PRR salary level would cost more than $100 million (the cost i s about $9 million per 10,000 employees). Another $160 million would be required for teachers (assuming 194,000 teachers). The temporary schemes (i.e. PRR superscale and lateral entry program) require careful management to avoid creating additionalpressures on the general salary scale. Finally, the creation o f the ANA scale has generated pressure at least on the entire security sector. D.TheWage Bill 2.18 The wage bill accountsfor 67% of the operating budget or 6.3% of GDP (2004105 actuals).'2 This is somewhat higherthan the international average. 2.19 The wage bill in 2003/04 was close to budget, at $282 million against $264 inthe budget (Table 2.4). This reflected two partly offsetting factors. First, the civil service wage bill was lower than budgeted. Indeed, headcounts were below the budgeted ceilings both because information in the tashkeels was weak and because some recruitment targets were too ambitious (e.g. in education). However, the average salary was above the budgeted amount due to salary increases granted during the fiscal year (the general increase was decided at mid-year, after the mid-year review had identified potential savings). Second, the wage bill for the security sector was higher than expected, with in particular spending inthe Ministryo f Interior 30% above the plan. 2.20 I n 2004/05, the wage bill was also close to budget, at $374 million against $377 million budgeted. The $92 million increase over 2003/04 resulted from two factors: l2To compare with other countries, in-kind food given in the police and the army is includedin this number. By contrast, the Government's budget document does not include these benefits- and is thereforelower - while IMF tables include in the wage bill all food paidby the Government, including food for students, patients, andprisoners- and the wage bill is thus estimatedat a higherlevel. 46 The increase in headcount largely reflected the recruitment of teachers. For the civilian Government, the headcount ceiling in the budget was set at almost 370,000, above the level estimated inthe Government's 2003/04 mid-year review (30 1,000). The average salaly is now budgeted at $61per month, upfrom the previous year's budget and actuals. This reflects the full-year impact o f the pay increases decided in 2003 (see above) as well as implementationo fthe PRRprogram. Source: For Afghanistan: civil service only (includesjustice andpolice,but excludesthe army). For Regions: Schiavo- Campo et al. (1997). 2.21 I n 2005/06, the wage bill is budgeted at $460 million. This reflects some minor recruitment, some pay increases (security sector, university teachers, and PRR implementation for the civilian side), and the transfer o fpart o f the Afghan National Army's costs to the budget. 2.22 The Government articulated in the SAF report its strategy to increase salaries in a responsible manner, while maintaining a lean civil service. The Government also indicated in the SAF report its intention to cover its civilian wage bill by 2008/09. The scenario outlined would raise the wage bill to 8% GDP by 2010/11. At the same time, conservative projections suggest that without new tax policy measures and other major improvements, revenues would barely reach 7% of GDP in 2010/11 (compared to 11%inthe SAF report).I3 2.23 Monitor wage bill and revenues. Although the strategy set out inthe S A F report implies that the wage bill will increase over time despite a sizable deficit in the operating budget, this must not be interpreted as a softening o f the hard constraints within which the Government must operate. The Government will need to monitor the wage bill and revenues closely, and make trade-offs betweenpolicy options as part o f its medium-term fiscal framework (MTFF). The upcoming preparation o f the 2006/07 budget, along with its multi-year framework, provides an opportunity for the Government to specify its policy direction and restate its commitment to public administration reform combined with fiscal responsibility. This requires careful attention to the three main risks that mightaffect the wage bill side (a fourth risk i s related to the capacity o f the Government to mobilize domestic resources): 0 The required changes in skills mix might necessitate a temporary small increase in staff (recruitment o f new slulls, without being able to retrench obsolete skills other than by retirement), but given the strategy to increase salaries to build capacity, the Government cannot afford to lose the advantage of a relatively small civil service; however, undisciplined recruitment and significant increases inestablishment size mustbe avoided. The PRR scale, PRR superscale, and LEP cannot be allowed to exert significant pressures on the rest o f the pay and grading scale; pressures for generalized wage increases will have to be resisted inorder to avoid serious adverse fiscal consequences. l3Volume I,Chapter 3 outlines fiscal scenarios (including a projectionofthe wage bill). 47 0 Wage increases inthe security sector could have major adverse fiscal consequences, reducing the space to create a civil service with adequate capacity. 2.24 Providefull information to donors to secure their continued support. The Government wage bill will be a key driver o f Afghanistan's fiscal aggregates and fiscal balance. Following the SAF projections in 2004, the MTFF recently prepared and approved provides a welcome statement of the Government's medium-tern fiscal stance. In a situation characterized by a continuing large operating budget deficit financed by external assistance, the Government will need to provide full information to donors and take them into confidence about its fiscal policy including wage policy. While adjustments may be required in the light o f subsequent developments, it would not be advisable to allow the gap between Core Budget operating expenditures and revenues to widen significantly in an unprogrammed manner. The Government should alert donors to any departures from its fiscal policy stance if it i s to maintain the support that donors have so far providedto the operating budget. E.PayrollProcessing 2.25 There are shortcomings in the existing arrangementsfor payroll (failures to pay government employees on time, in full amount, and with clear identification o f receiving individuals), which undermine the integnty o f the process and the motivation o f civil servants. These include: (i) delays in confirming employment and authorizing quarterly budget allotments by line ministries to provinces and districts and in preparing lists o f established positions (tushkeels), (ii) errors and existence of "ghost" employees due to manual calculation o f payroll and lack of supervision over salary distribution, and (iii) delays and payment o f less than 100% o f salary associated with the use o f bonded trustees contracted by the budget institutions for collection o f cash from the Central Bank and for disbursement o f salaries in cash to individuals. The ARTF conducts spot checks on payroll distribution, but the Government's financial controls and audit are inadequate to rectify such problems. 2.26 The Government has already madeprogress in addressing these issues. The two key reforms have been: (i) re-decentralization o f payroll and (ii) Individualized Salary Payments (ISP) inKabul. First, the salary payment process has been re-decentralized to provinces (after having been centralized between 2002 and March 2004). This has reduced delays (before, all the paperwork was sent to Kabul).14 The impact on compliance remains unknown however. Second, the ISP was piloted in Kabul in 13 agencies and ministries in December 2004. The program involves giving a list o f employees to the partner bank (DAB, MillieBank, and PashtanyTejaraty Bank) andrequesting the employees to come personallyto the bank to receive their salary. This requires three supervisors to be physically present (one from the department, one from the Treasury, one from the bank), and as they need to reach each employee, this solution might be difficult to roll out to the provinces, and in particular to districts. As part o f the ISP project, a stand-alone database i s being piloted to computerize the ~ a y r 0 l l . I ~ 2.27 Monthly payroll processing now consists offve main steps (Table 2.4 and Table 2.8).16 First, every month each unit (at the local level) prepares a payroll form (M41) with the list o f all employees, their attendance, and their pay: this form, together with the summary form (M16), i s sent to the Treasury (either inKabul or to the Mustoufiat in provinces). At about the same time, the Treasury gives the order to transfer cash to provinces based on allotments, and DAB physically transfers this cash to provinces. The local or central Treasury then processes the payroll, checking that sufficient allotments are available. l4Data collected in Kabul reflect limited change (Box 2.3), but these data do not capture a consistent part o f the process over time (payments were made after data was collected in Kabul before the decentralization, while they are now made inprovinces, before the'datai s collected inKabul). l5Inaddition, MoI is developing its own payroll and personnel database. l6See Evans et al. (2004), which also includes the other steps o fpayroll processing (e.g. employment confirmation, Table 2.9). 48 Payments are then made to individuals, often through the bonded trustees (who cash the payroll at the bank and then distribute it to individuals) or through ISP. Finally, for provincial payrolls, Mustoufiats send a summary o f salary payments (M23) to the central Treasury, which enters it inAFMIS (and update the Headcount database). Deadline Responsible unit Action 1 15" Sub-budget Prepare M41 (payroll form) organizations 2a 20* Treasury Transfer cash to all provinces department based o n allotment 2b 25" DAB Transfer physical cashto all provinces based on the above cash transfer advice from the Treasury Department 3 26" Treasury (local Process provincial salary or central) payments 4 7* (next Treasury (local Salary payments to individual month) or central) employees 5 10" Treasury (local) Send monthly Payment Reports - M23 for provincial salary payments and non-salary payments - and payroll summary reports to Treasury 2.28 The re-decentralizedpayroll process is considered a significant improvement by provinces; the most significant remaining obstacles are the receipt of takhsis, and the timing and adequacy of the Treasury order to transfer cash. The provinces visited during the updating work on subnational administration consistently reported major improvements in the timing o f pay, and most staff are paid on a monthly basis, before the end o f the current month. The Mustoufies reported that the main reason for delays in pay were delays in receipt o f takhsis, which can be received as late as the third month in the quarter. When this happens, the affected staff cannot be paid. The second significant reason for provincial delays in pay i s the delay in the Treasury's order to transfer cash, or an amount that i s inadequate to cover the payroll and other non-salary expenditures. Provinces reported that the Treasury order could come as late as the 28* o f the month, too late to process the pay in the current month. Provinces will not process M16s (required in order to issue checks) until enough cash to cover the checks i s available. Finally, the delay inreceiving the tashkeel (as much as six months) i s also a problem, but it has not materially affected processing the payroll as provinces have used the 2003/04 tashkeel as authorization. Figure2.5: Headcount inProvinces-Example of Ka dahar 11,000 10,000 +I382 4,000 3,000 2,000 1,000 I 1382 = 2003/04; 1383 = 2004105; Source: Headcount database (January 2005). 49 2.29 The Government has developed a plan tofurther improve thepayroll process (Annex 2.2). The plan relies on computerized systems (integrated between human resource management, budget, and financial management) and individual identification systems (picture ID). In the next few years (March 2006 for Kabul and main provincial centers, March 2008 for the rest o f the country), the Government intends to make direct deposits to its employees' bank accounts. E.~ensionsl' 2.30 Pensionsfor civil servants are low, despite a recent increase (Table 2.5). The current pension i s a definedbenefit pension (retirement benefits based on the employee's final pay - including only the base pay, not allowances - and length o f service). The scheme covers civil servants, workers on contracts, military, police, and SOE employees. Untilrecently, civil service pensions were so low that most people entitled to receive them did not pick them up. But a substantial increase took effect in March 2004, following the general pay increase passed a few months before (see above). The pension adjustment i s said to be an interimmeasure, which does not apply to those retiringafter the beginning o f 2004/05. 2.3 1 Most recently,from around 69,000 accounted eligible beneficiaries in Kabul and theprovinces (including civil servants, military, and survivors) close to 30,000 werepaid." Accounting o f the flow and stock o f active retirees as well as assessment o f the short and longer-tern financing needs, however, are complicated by the fact that pensions are reportedly paid on an annual basis and can be collected retroactively for several years. Therefore any current increases in expenditure may partially be reflective o f the process o f clearing the backlog o f outstanding liabilities. Lack o f sound record-keeping arrangements and any automation makes the task o f financial analysis and planning extremely difficult. (A separate scheme managedby the Central Bank covers over 4,500 insuredemployees o f various public banks and pays benefits to over 1,500 pensioners.) 2.32 Administrative capacity to implement any policy changes at present is very limited. Operations of the pension scheme clearly require modernization. Urgent measures should include investment inbasic infrastructure and record-keeping systems, comprehensive inventory o f the current records, assessment o f operations and procedures, staff training, and survey o f beneficiaries o f the system. A longer-tern objective should be automation o f the processes, full connectivity o f the local branches, and implementation o f the sustainable and transparent record-keeping mechanisms. l7This section i s based on "Afghanistan's Pension System: Policy Issues and Options for Reform", July 2, 2004, World Bank; andreport of the pensionmission to Kabul inOctober 2005. The PensionOffice, Ministry of Labor and SocialAffairs. 50 2.33 Pension financing is a pay-as-you-go system. Each covered organization" i s supposed to contribute 8% o f each employee's,pay, and each employee i s supposed to contribute 3% (plus 25% o f hisher salary in the first month o f employment and 50% o f the incremented portion on every salary increase). The employer contribution i s currently not collected, while the employee contribution i s unevenly collected. The gap i s financed by the budget. The original 2005/06 allocation o f $15 million was supplemented by another $4 million inthe mid-year budget review. The cost o f the recent increase i s actually carried by the budget: this i s supposed to be a short-term mechanism, while the Government prepares a plan to make the regime sustainable. The system used to work as a partially funded system. In principle, the pension fund has assets (mainly land and buildings)to generate income that would finance pensions; however, inpractice the fund faces difficulties inregaining control o f these assets, which were taken out o f its control under the Communist regime. 2.34 Variouspublic sector reform initiatives create urgencyfor coordination of with theprogram of thepension reform. Public sector reformproposals basically include: 0 Changes in'thescale and composition of pay. With increased overall pay inthe civil service, pensions would have increased as well, leadingboth to rise incurrent financing needs and to a very considerable increase inpension liabilities to individuals who retire after that measure gets implemented (given that it currently excludes various allowances). Analysis o f options and provisions ensuring fiscal sustainability and cross-generational equity i s clearly needed. 0 Demographics of the civil service. The demographics o f the civil service (Figure 2.6) will lead to retirement o f many civil servants in the coming years. In addition, various compensation packages may stimulate rapid resignations o f some employees who are close to the retirement age, leading to increased pressure on the budget to provide and sustain both regular and various lump sumpensionpayments. 0 Hires of new employees (e.g. in the education sector). When new employees start joining the reformed civil service, it i s essential that they start contributing to and accumulating stakes in the new andreformed pension system. 0 SOE restructuring, privatization, and liquidation. Given that coverage o f the pension system includes various SOEs and other state-operated entities, reforms aimed at their structural transformation will have implications for finances o f the national pension scheme. 2.35 Comprehensiveanalysis of various reform measures directed topensions or other public sector provisions requiresfull-scale financial projections. At present, analysis o f both short- and longer-term implications for liabilities o f the pension system appears to be laclung. Availability o f quality data i s essential for this task. IARCSC recently launched the process o f capturing the data on active civil servants and retirees to be used inpensionprojections. 2.36 Preliminary analysis of demographic data for civil servants reveals that even without active downsizingmeasures,fiscal pressures topay pensions may significantly grow in the short- to medium term. The most recent sample with over 12,000 records provided by IARCSC indicates that the cohort o f males aged between 50 and 59 represents close to one-third o f all the employed in civil service; those aged 60 and over represent another 10% o f total employment. Some o f these individuals will start retiring fairly soon (Figure 2.6). Furthermore, inthe same sample, over 80% o f both men and women have likely completed the minimum required 10 years o f service qualifying them for some regular pension benefit at some point o f time in future. Close to 40% o f men and around 10% o f women have completed a service that could qualify them for the benefit equivalent to 80% or more o f their last drawn wage. Actually, large private sector organizations are currently, in principle, required to participate inthis pension program. 51 Figure 2.6: Sample age distribution of the civil servants I 500 500 400 300 200 100 0 0 100 200 300 400 500 600 Numberofemployees Number of employees Source: Staff estimatesbasedon the data providedby IARCSC. Notes: Basedon 12,000 electronic recordscoveringKabul province. 52 Annexes Annex 2. 1: Size of the Civil Service A/ Overall Civil Service 220,000 200,000 180,000 &-- 160,000 140,000 ' $ 1 80,000 1 1382 I 1383 -Central -Prownces AI Teachers b/ B/Health c/ 120,000 60,000 105,000 50,000 90,000 75,000 ' \I 40,000 60,000 30,000 45,000 30,000 20,000 15,000 10,000 .. 1 1382 I 1383 I 1382 I 1383 - -Central -Prownces -Centra -Prowinces C/ Policed/ D/Other CivilService 70,000 60,000 4 60,000 50,000 50,000 40,000 40,000 ' I 30,000 30,000 20,000 20,000 10,000 10,000 I 1382 I 1383 I '384 I I 1382 I 1383 I 1384 I -Central -Prodnces -Central -Prounces 1382 = 2003104; 1383 = 2004105; 1384 = 2005/06. Note: Data reflect the number of persons to whom payments were made, not the number of positions. The decrease at the end of each fiscal year and at the end of the reporting period reflects lack o f reports, not a real decrease in headcount. a/ Herat has not reported payroll in 2003104 (the headcount was around 21,000 in 2002/03 and 18,000 in the first months of 2004105). b/ Teachers = 80% of Ministry of Education and Higher Education (assumption that 80% o f employees are in classrooms), c/ Health= Ministryof Public Health, d/ Police =uniformed staff of Ministry of Interior. Source: Headcountdatabase/ MA (updatedNovember, 2005), Staff estimates. 53 I3 + E 3 W Y 0 e, -r a x c .- 2m D -e + u 6 I----I-- CHAPTER 3. UPDATE ONAFGHANISTAN'S SUBNATIONAL ADMINISTRATION Executive Summary 1. A detailed analysis o f Afghanistan's subnational administration was conducted by the World Bank and AEWJ in2003104. This chapter provides an update o f this study. One o f the main conclusions of this update i s that financial management at the provincial level has improved significantly since the original study was done: Inmostcasespayisnowreceivedmonthly, andontime. Access to cash balances for non-salary expenditure i s much improved, particularly in the very poor provinces. Financial reports are being submitted on time (mostly). The single expenditure and revenue accounts are working well. Audits are being done -although it was unclear what effect these audits were having. 2. Butthere are still significant issues to be addressed: L o w pay continues to be a major complaint The takhsis and tashkeel arrive late in many cases, and in the case of the takhsis it causes delays in pay; there are also disconnect between the line ministry's version o f the takhsis and the Mustoufiat's version. The system o f transfemng positive balances into the provincial single expenditure account, while effective in getting cash out to provinces, i s still placing unnecessary constraints or delays on spending. Non-salary allotments are still low, and there continue to be inequitiesbetweenprovinces. There i s a still a lack o f written manuals, and more training i s needed. Management o f the educationbudget i s still a major issue. 3. Interms o frecruitmentand staff appointments, however, little has changed. Senior appointments are going through the civil service commission, but still, political and ethnic considerations appear to feature prominently in recruitment. There has also been some small movement towards introducing the Priority Reform and Restructuring (PRR) scheme at the provincial level, but so far it i s only seen as a means to increase pay, and those left out are resentful. 4. As an overarching recommendation, this chapter concludes that the package o f reforms in the areas o f financial management and staffing administration should continue, and efforts shouldbe focused on ensuring effective implementation. While the improvements that have been seen at the subnational level are encouraging, there is still a risk that the gains will be effectively lost if growing reliance on mechanisms outside the provincial administration's budget and planning processes begins to marginalize these structures. 58 A. Introduction FINDINGS RECOMMENDATIONSFROMTHE ORIGINAL STUDY AND 3.1 In2003, the Afghanistan Research and Evaluation Unit (AREU) and the World Bankjointly undertook a study of subnational administration in Afghanistan. A central part o f this study included missions to six provinces - Badakhshan, Bamyan, Faryab, Herat, Kandahar and Wardak. The study results were published in Evans et al. (2004a and b). 3.2 The overarching conclusion o fthe study was that, despite the many political challenges, there was a basic bureaucratic structure at the subnational level that could be made to function. But this opportunity was time limited; if no action were taken soon, the skills, experience and commitment to public service would have completely drained from the system. Key issues addressed by the recommendations include: Inadequate salaries -too low and too late Delays in staff appointments Outdated tashkeel Lack o f training and knowledge o f procedures Low-levels o fnon-salary cash flow Lack o f central government presence inthe provinces & districts Lack o f adequate office facilities Central policy decisions bypassing existing structures Changing district and provincial boundaries Need for `new blood' inthe civil service 3.3 The report proposed a two-pronged strategy. One strand called for the center to commit itself to delivering some basic support for provinces, districts, and provincial municipalities in their hnctional role as service provider or commissioner, and in their political role as local representative o f the unitary state. The second strand o f the strategy was comprised o f tailored incentives for subnational administrations that reflect their institutional and historical roots. Effective incentives at the subnational level would entail providing valued resources that are triggered by simple measures o f administrative effort, and tailoring the incentives to suit the different circumstances faced by provinces, districts, and provincial municipalities. 3.4 Specifically, the report proposed commitments from the national government inKabul to: Complete the pay and pensionreform. Build confidence in the central agencies by demonstrating progress in the Independent Administrative Reform and Civil Service Commission (IARCSC) and by increasing Treasury authority over payroll, by providing procedural guidance from the Ministry o f Finance (MoF), and by enhancing oversight o fthe ordinary and development budgets. Build loyalty to Kabul by removing delays in processing the payroll and in staff appointments, by updating the tashkeel, increasing the levels o f non-salary cash flow, by improving Kabul presence in the field and re-orienting Kabul ministries, and by stabilizing districtjurisdictions. Restore provincial dignity and capacity by physical reconstruction and priority support for provincial health and education departments. Revive districts by physicalreconstruction and support for a return to written procedures. 59 3.5 The study proposed matching these commitments with conditional incentives for subnational administration, based on a combination o f grants, modest delegation, and technical assistance, with triggers based on simple measures o f administrative effort. The underlyingapproach proposed was one o f modest and selective deconcentration to give the center more practical control over local operations. THEGOVERNMENT'S RESPONSE 3.6 Since the original subnational study was conducted, the Government has taken a number o f actions that address issues inthe report. For example: 0 It has launched the Afghanistan Stabilization Program, which will provide funding for priority provincial projects through the Provincial Stabilization fund, provide buildings for district administrations, and support capacity buildingat the provincial and district levels 0 It approved the Priority Reform and Restructuring (PRR) Decree, which provides a packaged approach to restructuring government units and providing improved pay levels for key leadership positions. 0 Ithas introducedanumber o freforms inthe MoF, such as: .... re-decentralization o f the payroll improved cash management clarified budget procedures and revenue collection reforms 0 It has established the IARCSC to oversee the administrative reform agenda, and manage merit-based recruitment for staff at grade 2 and above. 3.7 Inaddition, theMoFisreviewingtheMustoufiat's structure, rolesandresponsibilities. Although some elements are still undecided, such as the reporting structure for the revenue and treasury functions, it appears one o f the innovations being considered will be to establish a budget coordination unit, that would support provincial departments in preparing budget requests, and more generally would help with coordinatingprovincial planning. 3.8 While these actions are important, positive steps, inother areas issues raised inthe original report persist. Inparticular, there are several ongoing initiatives at the provincial and district levels, that operate outside the subnational administrative structures o f government. For example,' there are Provincial Reconstruction Team (PRT)-related processes at the provincial level, including Provincial Reconstruction Offices in some provinces, and proposed Provincial Development Committees developed with the Ministry ofFinance to coordinate National Priority Programs. There are now also provincial and district planning/coordination mechanisms being set up as part o f the counter-narcotics effort. Although there i s some coordination between these various structures and subnational administration, in many cases the linkages are very weak. 3.9 Issues related to district and provincial boundaries also remain. InFaryab in particular, the four districts along the border continue to operate largely through the province o f Jawzjan. The tashkeel for these districts i s sent to Faryab province, but their takhsis i s sent through Jawszan, the payroll and non- salary expenditures are processed through Jawzjan, and the revenues are also collected through Jawzjan. Since the original report was published, the government has also createdtwo new provinces. 'Fora fuller discussion see Lister (2005). 60 SUMMARY OF MAINFINDINGS 3.10 One o f the main conclusions o f this update i s that financial management at the provincial level has improved significantly since the original study was done: 0 Inmost casespay isnowreceivedmonthly, and ontime. 0 Access to cash balances for non-salary expenditure i s much improved, particularly inthe very . poor provinces. 0 Financial reports are being submitted on time (mostly). 0 The single expenditure and revenue accounts are working well. 0 Audits are beingdone -although it was unclear what effect these audits were having. 3.11 Butthere are still significant issues to be addressed: 0 L o w pay continues to be a major complaint 0 The takhsis and tashkeel arrive late in many cases, and in the case o f the takhsis it causes delays in pay; there are also disconnect between the line ministry's version o f the takhsis and the Mustoufiat's version. 0 The system o f transferring positive balances into the provincial single expenditure account, while effective in getting cash out to provinces, i s still placing unnecessary constraints or delays on spending. 0 Non-salary allotments are still low, and there continue to be inequitiesbetween provinces. 0 There i s a still a lack o f written manuals, and more training i s needed. 0 Management o f the education budget i s still a major issue. 3.12 Interms o frecruitment and staff appointments, however, little has changed. Senior appointments are going through the IARCSC, but still, political and ethnic considerations appear to feature prominently inrecruitment. There has also been some small movement towards introducing PRR at the provincial level, but so far it i s only seen as a means to increase pay, and those left out are resentful. 3.13 There i s some coordination going on at the provincial level, but it i s unclear how effective it is. Andthe NSPappears to be successful, especially inbuildingcommunity identity. 3.14 Many o f the issues identified inthis chapter can be addressed relatively easily. A summary o f the study's recommendations is contained inthe concluding section o fthis chapter. B. OverallSupportfor Provinces 3.15 As noted above, the original study was critical o fthe central government interms o fits support to subnational administration, and by extension, to mechanisms supporting service delivery. A starting point for assessing the extent to which the central government has improved its overall support for the subnational administration i s to look at trends instaffing and inthe provision o fnon-salary expenditures. 3.16 Figure 3.1 shows that, after discounting for end o f year anomalies and lags in reporting at the provincial level, the general trend in staff numbers seems to be a reduction of staff based inKabul, and an increase in staff at the provincial level. However, as Figure 3.2 shows, the increase in staff numbers at the provincial level i s in fact only happening in Education, and for other departments the trend i s flat or slightly downwards. This conclusionwas supported ininterviews conducted inthe case study provinces. And, once Educationfigures are taken out, there continues to be more staff employed at the center than in all the provinces combined. While there i s no doubt that education i s an important priority for the 61 government, there i s clearly still scope to shift the balance o f staff numbers in other ministries closer to the points of service delivery. s Have BeenPaid 180000 - - 160 000 - -A I 140000 -. 120 000 - \ : 100000 - *oooo- .- - - - - - - - ____..____ I 60 000 -. 40,000 - I 20,000 - , 511312 I 511313 [ - - Central Govt -Provinces excl. Herat 1 I Note: Herat data was not available for 2003/04, and so i s excluded from the 200' 35 data Source: Headcount database, ARTF MonitoringAgent 3.17 A major issue identified in the original sub-national study was the lack o f access to non-salary expenditures, particularly in provinces without access to revenues, and in districts generally. The adequacy of allotments was discussed, and evidence suggested that a disproportionate share of non-salary expenditures was kept at the center. Still, the overriding issue was the lack of physical cash; provinces without access to revenues were not able to spend even the low level o f allotment they were given, because the limited amount of physical cash that was transferred was only received at the very end o f the year. Figure 3.2: Non-Uniformed, Civilian Government Staff for Whom Salaries Have BeenPaid -ExcludingEducation - - S Y O ~ Z I SI1383 Cenlrsl Govl excl Edu -Pmvin6esexcI Edu --Told Education Note: Herat datawas not available for 2003/04, and so is excluded 'om the 2004/05 data Source: Headcount database, ARTF Monitoring Agent 3.18 The issue of availability o f physical cash has largely been resolved. There are still issues with respect to access to positive balances in the province's single expenditure account, which are discussed later in the paper. But still, non-salary spending has improved significantly since 2002103, for the "revenue-poor'' provinces. Table 3.1 summarizes the reported spending on non-salary expenditures 2002103 and 2003104, along with allotments for 2004105, and Figure 3.3 shows the change in non-salary spending as a share of total expenditure in each o f the six case study provinces. 62 Table 3.1: Non-Salary Expenditures, 2002/03 -2004/05 * In Herat. in 2003/04. a large uavment was made in the Ministrv o f - . , Reconstruction before the implementation of the Treasury Single Account Source: Ministry o f Finance Ministries' B10 forms and AFMIS database 3.19 Inother respects, support fromthe center to subnational administration has improved, particularly inthe area of financial and fiscal management. Through the issuance of budget and treasury circulars, Finance i s providing clearer instructions to the Mustoufiats. Training seminars are taking place, particularly where new or changes procedures are being introduced. And a Bearingpoint consultant has been placed in each Mustoufiat to facilitate the introduction o f new procedures and computerized technologies. While there i s certainly room for improvement in the quality o f these support mechanisms, they havebeen beneficial. Figure 3.3: Non-Salary Expenditures as a Share of Total Expenditure by Province 2004105 compared to 2002103 I 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20 0% 10.0% 0.0% Badakhshan Bamyan Faryab Herat Kandahar Wardak 1 W1381 01383, 1st9 months Note: 1381= 2002103; 1383 = 2004/05. Source: Evans et a1(2004); Ministry of FinanceAFMIS database, as of December 15,2004 C. ProvincialAllotmentsandBudgetExecution THESINGLE REVENUEANDEXPENDITURE ACCOUNTS 3.20 Inthe original subnational study, one ofthe mainfindingswas that the pattern o f expenditures at the provincial level varied dramatically depending on whether a particular province had access to revenues. An analysis of 2002/03 data from that report showed that for those provinces that were largely 63 or completely dependent on Kabul for cash, most expenditure went to salaries; inthe case of Bamyan, the ratio was as high as 95.1%. Only those provinces that had access to customs duties incurred substantial non-salary expenditures, and signzjkantly overspent their allocation. 3.21 However, inthe summer o f 2002/03, the Government introduced single revenue and expenditure accounts.' With this system, all revenues formally collected in a particular province are now deposited into a single revenue account. This revenue account i s controlledby the M o F inKabul, and the provincial administration has no authority to access these funds. Provinces can only draw funds from the expenditure account, and the balance in this account i s controlledby the Treasury presidency inthe MoF. The result o f this reform has been to cut provinces off from any access to the officially collected revenues, and their spending i s limited by the allotment and cash management controls o f the MoF. 3.22 While this i s a significant step forward, it does not mean that these provinces no longer have any access to `unofficial' revenues. But the general view i s that these reforms have made it much more difficult to access additional sources o f revenues. Still, these activities do go on, with examples found duringfieldwork. 3.23 On the expenditure side, the overall impact of introducing the single revenue and expenditure accounts has been to reduce dramatically the inequities in spending that were documented in the original study. Table 3.2 shows the actual expenditures for each o f the six provinces inthe study for the first nine months o f 2004/05. Source:Ministry of FinanceAFMIS database, as of December 15,2004. 3.24 Similarly, the pattern for budget execution has also improved. Table 3. 3 and Table 3. 4 show budget execution (actual expenditures as a percentage of the allotment) by category for the six provinces for 2003104 and 2004105, respectively. While in 2003/04 there continued to be significant overspending in the `revenue-rich' provinces o f Kandahar and Herat, for the first nine months of 2004105 all six provinces show a more comparable rate o f expenditure. Figure 3.4 compares total budget execution to 2002/03, as reported inthe original study. Table 3. 5 shows budget execution for the first nine months o f 2004/05 for the six provinces, broken down by ministry. * The provinces ~ do have other accounts, but these must be approvedby the Ministry of Finance. Typically, there will be separate accountsfor pensionpayments(throughthe Ministries of Labor and SocialAffairs, and Martyred and Disabled), and an account to hold deposits of merchants involved in the procurement process. Although the DAB holds other accounts such as NSP or other development budgetfunds, the mustoufiatis not involved. 64 Table 3.3: Provincial Budget Spendingas a Percent of Allotment by ExpenditureCategory, 2003104 Total, non-salary expenditures 96.1% 96.8% 69.2% 663.1% 235.5% 101.5% GrandTotal 80.0% II 92.8% I1 85.0% II 232.0% II 134.5% 1I 85.1% Source: Ministry of Finance AFMIS database Table 3.4: Provincial Budget Spending as a Percent of Allotment by ExpenditureCategory, 1st 9 Months of 2004105 I Badakhshan Bamyan Faryab I I I Herat I Kandahar Wardak1 Source: Ministry of FinanceAFMIS database, as of December 15,2004. Figure 3 :BudgetSpendingas aPercentofAllotmentbyProvince,2002103to 2004105 _ _ _ _ _ _ ~ ___________-_ \ 1000.0% 800.0% 600.0% 400.0% 200.0% 0.0% Badakhshan Bamyan Faryab Herat Kandahar Wardak 1 Dl381 El1382 01383, Ist 9months 1 Note: 1381= 2002103; 1382 = 2003104; and 1383 = 2004105. Source: Ministry of Finance AFMIS database, as of December 15,2004; Evanset a1 (2004). 3.25 While this analysis points to a significant improvement in budget execution over the last two years, there are still major issues that continue to constrain or delay budget execution at the provincial level. Specific issues related to payroll are discussed in a separate section. The balance of this section deals with the timeliness of the receipt of the provincial allotment, and the adequacy of transfers into the single expenditure account. In addition, the impact of providing provinces with more flexibility to manage their allotments is discussed, as well as improvements inprovincial reportingpractices. 65 Table 3.5: ProvincialBudgetSpendingas a Percentof Allotmentby Ministry, 1st 9 Monthsof 2004/05 Source: Ministry of Finance AFMIS database, as of December 15,2004. TIMELINESSOFRECEIPTOFTAKHSIS(ALLOTMENT) 3.26 As documented in the original study, provinces cannot execute any expenditure until they have received their quarterly allotment (takhsis) from the center. Past practice had been for each ministry to send the quarterly allotment to each o f their provincial departments on form B20. At the same time, the line ministrywould send a copy o fthe form B20 to the provincial mustoufiat. The Mustoufiat would only authorize payments once ithad a copy o f this form. While the timing o f the receipt o f the takhsis was not identified as an overriding problem in the original study given other issues at the time, delays in communicating the takhsis was a constraining factor. 3.27 One o f the improvements implemented for 2004/05 i s that the M o F is now responsible for sending the form B20 directly to the Mustoufiats, whereas in the past, this was the responsibility o f the line ministries. However, ministries continue to be slow in submittingthe B20 form to Finance. Based on interviews with provincial officials, very few ministries manage to submit forms before the start o f the quarter, as required. Some provincial departments receive their allotments during the first month o f the quarter; a significant number are sent the allotments during the second month, and a few even receive them only in the last month o f the quarter. This i s further complicatedby the fact that allotments for the 2nd, 31d and 4thquarters are issued in two parts. As a result, M o F must send monthly updates to the allotment to the Mustoufiat. Officials from the mustoufiats consistently cited the delays inreceipt of the takhsis as the most commonreason for delays inprocessing both the payroll and non-salary expenditures. 66 3.28 Once the allotments are sent to provincial departments, provinces reported that the allotment data received by the department (from the line ministry) differed from the details in the form B20 receivedby the mustoufiat (from the MoF). It i s not clear why this has been occurring, but it may be due to the timingo fwhen various forms are sent. However, the form B20 that the mustoufiatreceives is the official record o f the allotment, and the Mustoufie enforces this amount. (However, it was reported in one instance that the Mustoufie usedwhichever figure was lower.) 3.29 The practice of sending the takhsis through the MoF to the Mustoufie is a significant improvement over past practice, but to be truly effective it i s essential that all ministries comply with the deadlines, and ideally, the takhsis should be communicated to provinces in advance o f the quarter. The background paper on "Operating Budget Allotment Control" (see Volume I,p. 99) makes specific recommendations on allotments that would address this issue. For 2005/06, it proposes that the MoF create an annual financial plan for each secondary budget unit (includes provinces) based on ministry input, and then using this plan, issue the quarterly allotments directly to mustoufiats at the start o f each quarter. Ministries could make adjustments duringthe year, but these would not delay the issuingo f each quarterly allotment. Implementingthis process would effectively eliminate the issue o f late allotments to provinces. ADEQUACYOF POSITIVEBALANCES INTHE SINGLE EXPENDITURE ACCOUNT 3.30 Once the mustoufiats have received the quarterly allotments for the provincial departments, the mustoufiats can proceed to process payroll and non-salary expenditures. However, before checks can be issuedagainst the allotment, mustoufiats must also confirm that there i s an adequate balance inthe single expenditure account to cover the amount o f the check. 3.31 The Treasury in the M o F i s responsible for transferring positive balances into the single expenditure ac~ount.~According to Finance Circular No. 8/2004/05, the Treasury i s to transfer positive balances based on the allotment to the province's single expenditure account no later than the 2 0 o~f each month. Based on this transfer advice, the DAB i s to ensure that physical cash i s available no later than the 25* o f the month. Inorder to ensure provincial compliance with reporting requirements, the timing o f transfer o f positive balances i s also dependent on mustoufiats submitting monthly expenditure and revenue reports on time. 3.32 Infact, the set of procedures put inplace by the Treasury to regularize the flow of funds and support budget execution at the provincial level i s a very significant improvement compared to 2002/03 and early 2003/04. As part of implementing these new procedures, the Treasury has developed a monitoring system which tracks provincial payments based on monthly expenditure reports (form M23), the dates these forms are received, and accumulated positive balances inprovincial expenditure accounts. The Treasury uses this data to adjust the amount transferred to the expenditure account to also take into account actual spendingpatterns. 3.33 The intent underlying this monitoring system - to ensure adequate positive balances while minimizingthe accumulation of excess balances - i s clearly a sound one. However, duringthe provincial missions, it quickly became apparent that the implementationo f this system was causing serious problems for some o fthe provinces. Their complaint was that insome months the transfer o f positive balances was too little to cover all expenditures for the month, or the transfer happened so late in the month that all payments for the month could not be processed. In analyzing the flow of payments, it became clear that Provincial officials referred to this transfer of positive balances as darai or "spending authorization."'It does not refer to physical cash. 67 the problem with Treasury's monitoring system was that it did not take into account current expenditures. Because the system relies on the monthly reporting form (M23) to record expenditures, which comes in after the end o f the month, there i s always a delay in reported expenditures, while the information on positive balances is current. So the monitoring system will always be reporting more cash balances than the reality. When this fact i s coupled with substantive swings in month to month spending levels, it becomes a very poor predictor o f cash flow needs in the provinces. To document this problem, data on monthly expenditure reports and transfers o f positive balances to provincial single expenditure accounts were collected from the case study province^.^ From this data, it was possible to calculate the actual positive balances at the end o f each month (Figure 3.5). This shows that for the five provinces for which data was collected, seven times out o f 10, the positive balance at the end o f the month was lower than the average monthly spending. On average, the transfer o f positive balances was received on the 18" o f the month, but inmany cases it was only received within the last five days o fthe month. 3.34 Some o f the Mustoufies felt that transfers o f positive balances to the expenditure accounts equal to the quarterly allotment should occur at the beginning o f the quarter. While this solution would make it difficult for the Treasury to manage account balances effectively, even transferring amounts equal to the monthly allotment would ease the problem considerably. 3.35 The World Bank's draft paper on allotments (referred to earlier) acknowledges this problem, and also proposes that the M o F move towards fully-funded allotments. Ifissuing fully-funded allotments on a quarterly basis i s likely to cause cash flow problems, allotments could be issued for shorter periods, but this wouldbe apreferredsolutionto withhold fundingo f approved allotments. Figure 3.5: Positive Balancesat Month End as a Ratio of Average Monthly Spending 6.00 .. ....... .... --. - ... -- __ .. -. ..... ... ... . .... - ..... .... I -- - - - - 5.00 4.00 3.00 I 2.00 I '. -+* - ,\/ - T - 1- -6adakhshan -Bamyan Faryab-- .Herat- - -Wardakl 3.36 The remaining problem, which i s a very important concern for the Treasury, i s the significant degree o f fluctuation in spendinglevels from one month to the next. This fluctuation can be explained to some extent by delays in receipt o f takhsis and constraints caused by low expenditure account balances, but not entirely by these factors. For all of the five provinces for which data are available, for example, there was no or virtually no spending reported for the first month o f the fiscal year. Lack o f takhsis cannot explain all o f this. An analysis o f monthly spending patterns by provinces i s necessary, but such an analysis will be more informative once these two major influences are taken out o fthe equation. Dataare not available for Kandahar. 68 GREATERFLEXIBILITYTOMANAGE EXPENDITURES 3.37 One o f the significant changes that affected provinces this year' has been the decision to give provinces greater flexibility to shift expenditure allotments between minor codes. 3.38 Historically, allotments to provinces have been broken down into major codes (babs) and minor codes (fasils). These allocations are determined by the parent ministry in Kabul, with no input from the provincial department or mustoufiat. If provinces wanted any changes to these allotments during the year, they had to request permission through their ministry, and ultimately, the M o F in Kabul. This approval procedure could cause significant delays and other problems for provincial officials and could even lead to disruptions in service delivery. And given the number o f requests for adjustments that come through eachyear, this process placed a considerable administrative burdenon the MoF. There i s also the beliefthat controls o fthis sort provide opportunities to elicit rents or bribes. 3.39 To address this issue, the MoF is now issuingallotments at the major code level only. It i s then up to provincial departments to decide how these funds are to be allocated to the minor spending codes. Reporting on actual expenditures, however, i s still required at the fasil (or minor code) level. 3.40 To facilitate the introduction o f this change, training seminars were given for all affected staff in the provinces. Despite this, implementation has varied considerably across provinces and ministries. Kandahar, for example, requires its departments to submit to the Mustoufie their allocation at the fasil level at the start o f the quarter, and then enforces this allocation during the quarter. Other provinces generally leave this up to the departments. InBamyan, the Mustoufie requires departments to submit and `register' their allocation o f allotment to fasils with the Mustoufiat, and to submit requests for changes, but the Mustoufie does not reject any requested changes. Ina few cases, ministries continue to provide their allotment at the fasil level. InFaryab, for instance, it was noted that the Ministries o f Education and Interior continue to issue allotments at the fasil level, so the Mustoufiat does enforce these allocations. In Badakhshan, MRRD and Education were cited as ministries providing allotments at the fasil level. In these cases, the Mustoufiat enforces the allocation, and any changes to the allocation between fasils must be approved by the respective ministry. 3.41 The provincial perspective on this change was very mixed. While some officials liked the change, most often those inline departments, the officials inthe Mustoufiat generally viewed this change negatively, as it was believed to lead to abuse. For example, a head o f department could allocate extra funds to his or her office at the expense o f more pressing needs. Within bab 10000 (Salaries and Allowances), there i s potential to switch funds from basic salaries to bonuses and overtime. While provincial departments have not normally had funds to pay staff overtime or bonuses, duringthe missions we found that in at least two provinces, the same provincial department was paying both overtime and salary bonuses to staff. During the course o f the provincial missions, some alternatives were suggested, where the allocationat the fasil level could be controlled at the provincial level, by the Mustoufie or even the governor, but still concern was raisedthat the decision-makers could be influenced by the opportunity for personal gain. 3.42 Nevertheless, this move to less central control over line items i s in place, and will soon be extended further by consolidating the non-salary, non-capital babs into a single classification. This practice i s consistent with international standards, i s also consistent with the principle that local managers know better what their mix o f expenditures needs are. Inaddition, it eliminates the transaction costs of This change was formally introducedfor the 2003/04 budget year; however, provinces did not report any change in practice until2004105. It is possible that ministries, who were still responsiblein 2003104 for transmittingthe B20 forms to provinces, continuedto provideallotmentsinfasils. 6 9 getting approval from Kabul for every small adjustment. However, delegating control over the distribution o f expenditures to different fasils i s challenging in a context where there i s a lack o f alternative accountability mechanisms and good management practices at the provincial level. Equipping managers with the skills needed to take on this type o f delegated authority should be an important focus for future training programs. Inaddition, mechanisms for buildingaccountability are needed; init will be important to monitor spending patterns across ministries and provinces to ensure that no gross abuse i s happening. TIMELYREPORTINGTOTHE CENTER 3.43 Another finding from the original study was that provinces were doing a poor job o f reporting on revenues and expenditures in a timely and accurate way. This was viewed in Kabul as a very serious problem, especially given the lack o f other controls and information sources at the provincial level. 3.44 This situation has improved dramatically. The Treasury has issued clear instructions on reporting procedures, including a requirement that reports be submitted by the 10" of the following month. Inthe absence o f receiving these reports, transfer o f positive balances to the single expenditure account i s withheld. As a result, inmost cases provinces are submitting reports on time. This was confirmed both byprovincial officials and officials inthe Treasury. In some cases, delays insubmittingreports continue to result from the lack o f modem communications facilities, but in most cases provinces are able to send reports in with someone who i s traveling to Kabul anyway, often the Mustoufie himself or the Bearingpoint consultant who has been assigned to each Mustoufiat. Still, this i s not a sustainable solution, and efforts are needed to modernize communications arrangements. D.ExecutingThe Payroll 3.45 One o f the most compelling issues reported in the original study was the delay in processing the payroll, particularly at provincial and district levels (see also Chapter 2 o f this Volume). That report identified seven main reasons for payroll delays. Many o f these reasons for delays have been addressed by re-decentralizing the payroll (provinces are no longer required to submit payroll documents to the Ministry o f Finance for approval before receiving authorization to process the payroll), and to a large extent reinstitutingprocedures that hadbeen inplace for many years. 3.46 As a result, the current procedures for processing the payroll are well understood and work smoothly. As long as the takhsis has been issued, and there are adequate balances in the expenditure account, staff are paid each month, usually before the end o f the month. Even in districts, once the physical cash i s received fi-om the Mustoufiat, it takes at most 4-6 days for staff inremote areas to receive their pay. Inthe six case study provinces, there were only a few exceptions. InBamyan, all district staff have agreed to be paid quarterly, due inpart to logistical constraints, but also because o f equity concerns when some departments have their takhsis and others do not. In Badakhshan, monthly pay is still not feasible in the very remote districts o f Darwaz, Wakhan and Keranmunjan. And in winter, conditions may pose some additional delays. But in all six provinces, including Bamyan, it was consistently reported that staff are happy with the current payroll arrangements. 3.47 Inre-decentralizing the payroll, it could be argued that the controls on payroll processing have been weakened, despite the fact that the added controls imposedby a centralized process were inpractice ineffective. But by ensuring that regular audits o f the payroll are conducted as part o f the Auditor General's normal audit agenda serve to address this risk. 70 3.48 Table 3.6 summarizes the actions that have been taken to address the seven main reasons for payroll delays, as identified in the original study. The reasons for delays in processing the payroll now center on the delays in issuingthe takhsis, and the lack o f adequate balances in the expenditure account; these issues have already been discussed inthe preceding section. 3.49 While the improvements to date in processing the payroll comprise a very positive development, more needs to be done to ensure that government employees receive their full salary entitlement. In Kabul, the Individualized Salary Payment (ISP) program i s being phased in, where staff can receive their pay directly from the DAB. While there i s optimism in some quarters that the ISP program can be extended to provinces and even districts, on-the-ground circumstances dictate that such a roll-out is a long way off, with the possible exception o f a few o f the larger provincial centers. It may be more realistic in the short to medium term to build up the bonded trustee model by formalizing the relationship and strengthening the rules, so that the risk o f abuse i s reduced. Table 3.6: Addressingthe Delays in Processingthe Payroll Reasonfor Delays fromthe OriginalStudy What Has BeenDone 1. Some provincial staff, who are not confirmed in J While no specific action has been taken their position by their parent Kabul ministry, are to address this, it i s no longer viewed as rejected from the payroll - a significant issue 2. The tashkeels (staffing establishment) are J x Departments can use 2003104 tashkeels issued late to authorize payroll if the 2004105 - tashkeel i s not available 3. The line ministries issue takhsis that are J X In 2004105, the inconsistency has been inconsistent with the tashkeels, at least at the minimized, but a serious problem still provincial level exists within Education 4. Provinces and districts are under the impression J With very few exceptions, payrolls are that they should only be preparing the M41s now processed monthly, facilitated by (payroll) every quarter - the re-decentralization o f the payroll 5. The mustoufie must make what is often a J The re-decentralization o f the payroll laborious and time-consuming journey to take has eliminated this issue the payrolls to Kabul - 6. Provinces report that many forms are repeatedly J The re-decentralization o f the payroll rejected by the Treasury Presidency for very has eliminated this issue minor reasons 7. There are extensive delays in the DAB moving J Improved systems in the DAB have the cash to the provincial branches. virtually eliminated this issue TIMELINESS OFRECEIPT OF TASHKEEL (STAFFING ESTABLISHMENT) 3.50 The formal rules for approving the tashkeel for a ministry require that all ministries submit their proposed tashkeel to the Tashkeelat Office6 three months prior to the start o f the fiscal year. The Tashkeelat Office i s then to approve all tashkeels before the start o f the fiscal year. The tashkeel includes organizational structures, number o f posts and job descriptions for each position. The review o f the tashkeel i s coordinated with the budget process. The head o f the Tashkeelat sits in on budget discussions, and part o f his responsibility i s to check that the total tashkeel and the total takhsis for a ministry are consistent. Based on reports from the case study provinces, the tashkeel and takhsis do in fact match in most cases. The major exception to this i s the Ministry o f Education, which will be discussed below. Once the tashkeel has been approved, it i s the responsibility o f each ministryto communicate the tashkeel to each provincial department. The departments then give a copy o f the tashkeel to the mustoufiat, which checks the payroll against the tashkeel as part o f its pre-audit process. The Tashkeelat Office i s part o f the Office of Administrative Affairs, reporting directly to the President. 71 3.51 However, despite the requirement to meet the deadlines noted above, many ministries are very late in issuing their tashkeel. According to the Head o f the Tashkeelat, as o f December 2004, some ministries, including the ministries of Borders, Interior, Education, and Labor and Social Affairs had still not submitted their proposed tashkeel for 2004/05 to the Tashkeelat Office. The provinces also reported that in many cases the tashkeels were received very late. The tashkeel for the Mustoufiat only arrived in the sixthmonth o f 2004/05 insome provinces. 3.52 This delay in issuing the 2004/05 tashkeel has not affected the processing o f the provincial payroll. Budget Circular No. 7/2004/05, issued on May 10, directed provinces to process the payroll based on the 2003/04 tashkeel untilthe 2004/05 tashkeel i s received (thiswas repeated at the beginningo f 2005106). This process was reasonable given that provincial departments have no control over the issuance o f the tashkeel. But it did pose some risk ifthe new tashkeel resulted in a reduction o f staff. In practice, however, in cases where there was a reduction inposts, it was possible to reassign staff to vacant posts. 3.53 Nevertheless, the delays in issuing the tashkeel are a problem that needs to be addressed. While the impact this year may have been minimal, when more extensive restructuring starts to take place the impacts could be significant. The requirement for ministries to submit their tashkeel on time needs to be enforced; given its relation to the budget process, it could be a requiredpart o f the overall ministrybudget submission, and once received by Finance, the proposals could be redirected to the Tashkeelat Office for review. Inaddition, a copy o f the approved tashkeel could be sent to the mustoufiats from the MoF, as i s currently done with the B20 forms (allotment). A proposal would be that the Office of the Tashkeelat should be moved to the MoF. On its own, this move does not guarantee that the tashkeel process will move any faster, but it would reinforce efforts to integrate the process into the budget cycle, and dramatically increase compliance by ministries. 3.54 Over the longer term it will be desirable to reform the tashkeel process more generally, but it plays such a fundamental role inadministrative practices that for now the better course is to make it work as effectively as possible. Inthe future, delegating some o f the more detailed aspects o f the tashkeel (that do not affect the number o f staff) to ministries and even provincial departments couldbe considered. MANAGING PAYROLLFORTEACHERS THE 3.55 In the case study provinces, the review team encountered significant payroll problems per teachers. One problem was a general lack o f qualified teachers, which means there are large number o f unqualified teachers being put on contract, instead o f filling permanent posts. More significantly, from a financial point o f view, the number o f teachers inmany cases greatly exceeded the provision for salaries inthe allotment. The reason for this was that there was excess demand for teachers inthese provinces, and the departments felt they had no choice but to hire. The Ministry o f Education's position on this i s not clear, but based on interviews in the provinces, it appears that the Ministry is sympathetic at a minimum,and has done little to discourage this hiring. 3.56 The manifestation of this issue varied in each province. In Faryab, for example, the excess number o f teachers was offset by vacancies in administrative and agir posts in the Education department, so that overall the salary allotment for Education was adequate, even if the specific number o f teaching posts were not approved. 3.57 InHerat, the excess teacher issue was more significant. According to figures provided by the local education department, there are 10,629 teachers and administrative staff in the department. But the salary allotment i s based on a tashkeel o f only 7,970. They have temporarily managed the situation by 72 not paying distnct teachers for as many as three months. However, all city teachers and HQstaff have been paid to date. The estimate we received was that there was an outstanding payroll liability o f around 95 million Afs as of the date o fthe mission. 3.58 InBamyan, itwasreportedthat Educationhadofficially giventhematashkeel of2,250 (teachers and administration) which matches current employment, but the salary allotment only covers a staffing level of around 1,823. All 2,250 staff have been paid to date, but they have done so by "borrowing" from the next quarter's allotment (see Box 3. 1). The Mustoufiat staff were fully aware o f this, and agreed there i s no obvious solution to this short of getting more allotment from the Ministry o f Education. In Badakhshan the situation was similar to Bamyan, where the excess teachers were paid by `borrowing' from the next quarter's allotment. However, by the time the Badakhshan visit took place, they had received an additional allotment o f 50 million Afs, sufficient to pay for the excess teachers. Box 3.1: Managing Bamyan's Education Payroll For the 1st quarter of 2004105, according to Bamyan's Education Department, they had an approved tashkeel o f 1,823 staff, including teachers, administration and agirs. The actual number o f staff was the same. The HQ staff and city teachers were paid for three months inthe 3`d month, because they did not receive their takhsis till then, District staff and teachers were paid for 3 months inthe 4" month. Inthe 2"d quarter, they reported that they received a revised tashkeel o f 2,25 1from the Ministry o f Education, and quickly hired new teachers (presumably on contract) up to that level. But, the salary allotment was not increased to match the new tashkeel. Still, the HQstaff and city teachers were paid each month, and the district staff and teachers were paid for three months inthe 6" month. But with the increase number o f teachers, it was necessary to `borrow' from the 31dquarter allotment. As o f the 8" month, the HQand city teachers had been paid up to date. The Department was planning to process the M41s for three months' pay for the district staff and teachers, but there i s not enough salary allotment, so did not know what the Mustoufie would do. 3.59 While this issue o f hiringmore teachers than provided for through the allotments was consistent across the six provinces, varying only in degree, overall the Ministry o f Education has been unable to spend its budget, and infact the budget for Educationwas cut at the Mid-Year Review. Clearly, there i s a need for better planning on the part o f Education at the provincial level, and making a more realistic assessment during future budget deliberations o f the provincial distribution o f salaries and staff. In addition, there i s a need for implementing better monitoring and enforcement mechanisms to ensure that only an affordable number of teachers are hired. REPORTING ON NUMBERS PAID EMPLOYEES OF 3.60 With the re-decentralization o f the payroll, the MoF instituted a new reporting requirement dealing with summary payroll data, to be submitted as an attachment to the monthly expenditure report (form M23). This reporting requirement covers numbers o f staff who have been paid each month, by department. Previously, this information had been submitted to Kabul as part of the payroll data required for payment authorization. Among other uses, this data i s used to create a headcount database managed by the Afghanistan Reconstruction Trust Fund (ARTF) Monitoring Agent. This database provides valuable informationthat can usefully informplanning and budgeting processes. 3.61 However, during the provincial missions, numerous problems were encountered when trying to reconcile information on staffing levels provided by provincial officials with figures produced by the headcount database. Although there was not sufficient time to resolve these issues, it was possible to 73 conclude that the monthly fluctuations in the headcount database are not due to changing staff levels. In most cases, staff levels do not change significantly from one month to another. In Education's case, additionalteachers may be hired, but they do not experience significant drops from one month to the next. The most likely explanation for these fluctuations in the data i s that provinces are having considerable difficulty filling out the new form and are creating errors, particularly when dealing with situations where pay i s delayed, and therefore individuals are beingpaid for two or more months at once. It i s strongly recommended that this form be reviewed so that it more clearly deals with situations where staff are paid for two or more months at once. In addition, it would be beneficial to provide clear written instructions on how to fill out this form. E.Non-salaryExpenditures ADEQUACY OFALLOTMENTS 3.62 With the exception o f only one department, where staff acknowledged that their allotments were sufficient, provincial officials in the case study provinces reported that the non-salary allotment to provinces and districts i s still very low. While there has been some improvement in some areas, this i s still a big issue. And for Herat and Kandahar, lack o f access to revenues collected within the province has had a dramatically negative impact by forcing them to keep spending levels within their allotment. The lack o f non-salary expenditures i s especially problematic for those ministries that have little assistance through the development budget (core or external) to, for instance, refurbishtheir offices. 3.63 The availability o f non-salary expenditures in districts varied somewhat in the case study provinces, but generally they continue to receive little or no allotment. District officials recounted many examples o f lack o f firewood, and lack o f vehicles and/or fuel for transportation. What they do receive i s either in kmd, or they might get some cash for a particular purchase. Inthese cases, they do not submit monthly expenditure reports (except for payroll), but instead provide documentation for each purchase as it occurs. 3.64 As was the case inthe original study, it i s very difficult to assess from the data available whether the current provincial allotments for non-salary expenditures is infact adequate. For this, a more detailed review at the ministry level i s necessary. However, an examination o f the share o f non-salary expenditures that is allocated to provinces, compared to the share o f salary expenditures allocated to provinces, did strongly point to a disproportional distribution. In the original study, the only data available were the allotments for the first quarter o f 2003/04; these data indicated that provinces received only 14% o f non-salary expenditures, compared to 41% o f salaries. 3.65 Figure 3. 6 provides more current comparisons. This chart indicates that the provincial share o f non-salary expenditures has increased, but it also suggests that there i s still room to improve. As noted already, the only way to truly assess the appropriate level o f non-salary expenditures at the provincial level i s to do a detailed review in each ministry, which i s well beyond the scope o fthis paper. 3.66 One o f the innovations o f the 2004/05 budget preparation process was to present to the government an analysis showing the distribution o f the then proposed budget to provinces, by ministry. Although the decision on how much provinces receive remains with the respective ministries, this increase in transparency may be motivating ministries to better justify their decisions on provincial allocations. For the 2005/06 budget, this practice o f examining the provincial impacts o f ministrybudget decisions should continue. 74 Table 3.7: Share of 2004/04 3Q Salary and Non-Salary Allotment Provided to Provinces, by Ministry 15,2004. Note that only ministrieswitha provincial presenceare listed. 3.67 The government should also be strongly encouraged to publish the annual allocations and expenditures by province as well as by ministry. An implicit requirement in the new Public Finance and Expenditure Management Law. The need to be more transparent about spending patterns on a provincial and even district level will only grow, especially once parliament and local councils are established. 75 Figure 3.6: Share of Ordinary Budget Allocated to Provinces 50 0% 40 0% 30 0% 20 0% 10 0% 0 0% 1382Allotment 1382 1383 FY 1383 3Qs 1383 3Qs Expenditure Allocation Allotment Expenditure 1 Provincial Share of Salaries , 0Provincial Share of Non-salary Exenditures I database (for 34 allotmentsand expenditures,used YTD figures as of December15,2004). PROCUREMENT 3.68 The procurement procedures are detailed in regulation, and have not changed in the last two years, except to amend the limits relating to the types o f purchases. The current procurement procedures are outlined inTable 3. 8. 3.69 These procedures have been inplace with little change for many years, as a result, provincial and district officials are well versed in these rules, and generally adhere to them. Nevertheless, some o f the rules are regularly `bent.' For instance, it i s common practice to obtain three quotes from the same merchant, under different names. 3.70 While the bulk of the procurement activity occurs at the provincial level, districts do undertake some smaller purchases. They do not inpractice receive their own allotments as such, but ifa purchase i s required, and the province feels it makes more sense to make the purchase locally, the districts will be given funds for the purchase. Inthese cases, the districts will go through the procurement procedures, and will send inthe documentation for the completed purchase to the mustoufiat. 76 Table 3.8: Process for Executing Non-Salary Payments Stages ProvincialDepartment DistrictOffice Establishing Provincial departments receive their quarterly allotments listricts receive their quarterly allotments !heallotment (usually after the start of the quarter). usually aper the start of the quarter). (See iote.) An adequate positive balance is transferred into the single :ash for the district quarterly allotment is expenditure account, and the physical cash is received in ,ent to the district finance oflce and held by the Drovincial branchof the DAB. he treasurer in a safe. (See note.) Liuthorizing The provincial department prepares a proposal and submits f i e district office prepares a proposal and thepurchase it to the governor. iubmits it to the uluswal. For `retail' purchases, a purchasing mission o f up to five listricts follow the same procedures as people is appointed, one appointed by the department head, irovinces, ifthey make purchases at all. one by the Mustoufie, and three by the governor. 1. If the price o f a commodity or the cost o f a required service is up to Afs 10,000, the purchase can be done by a single member o f the purchasing mission. 2. Ifthe price or the cost is from Afs 10,000 to 50,000, the purchase can be done by two members o f the purchase mission. 3. If the price or the cost is from Afs 50,000 to 200,000, purchase can be done by three members o f the purchasing mission. 4. If the price or the cost i s from Afs 200,000 to 1,000,000, purchase can be done by all five members o f the purchasingmission. For `bulk' purchases, the Governor appoints a commission to oversee an open biddingprocess The governor authorizes the proposed purchase. The uluswal approves the proposed purchase and appoints a representative from the uluswal's office to participate in the purchase. The proposal also goes to the mustoufiat, where the audit The proposal also goes to the finance office, department does a preaudit of the purchase proposal. The where the audit department does a preaudit mustoufie authorizes the proposal. of the purchase proposal. The finance office authorizes the proposal and appoints a representative to participate inthe purchase. Executing Usually, the mustoufie issues a check to the department in Usually, the treasurer gives cash to the thepurchase advance o f the retail purchase so that the purchase can be department in advance so that the purchase made in cash. Sometimes, purchases are made before the can be made incash. cash has been received in the province; in this situation, the mustoufiat might issue a check for the purchase, but the seller must wait for the cash to arrive in the bank before check will be honored. Alternatively, a purchase contract might be signed with a merchant, but no payment made untilthe cash arrives. In the case of retail purchases, the mission goes to the In the case of retail purchases, the mission market and gets three quotes for the purchase. See earlier goes to the market and gets three quotes for notes about the limits. the purchase. If the purchase is under Afs 10,000, only one quote i s needed. Based on the lowest quote, the purchase i s made. Based on the lowest quote, the purchase is Sometimes the purchase i s done in the form o f a contract to supply goods or services over a period o f time. These contracts may be reviewed and approved by the administrative council o f the province. 77 Table 3.8: Process for Executing Non-Salary Payments Stages Provincial Department District Office For `bulk' purchases over 1,000,000 Afs, an open bidding process is conducted by a commission appointed by the governor. As part of the bidding ceremony, participants have to deposit 3% of the whole estimated price of the purchase in a specific account on a temporary basis. The winner is announcedon the radio,and anyone can choose to make a lower bid. After this second round, the bidding mission will sign the contract with the winner, and is finalized with the approval of the authorized authority (as definedintheDrocurementreeulationl Settling the The receipts are taken to the mustoufiat, and the account is The receipts are taken to the finance office, accounts settled (if the purchaseprice was less than the advance, the and the account is settled (if the purchase difference is returned, if it is more, the difference is price was less than the advance, the reimbursed). difference is returned, if it is more, the differenceis reimbursed). Note: The receipt of district quarterly allotments and cash is traditional practice, and does not happen currently Source: Updated from Evans et al(2004). F.Audit Practices 3.71 There are a number of audit activities happening in the provinces. First, there i s a pre-audit function inthe Mustoufiat that checks every salary and non-salary transaction before it i s executed. This pre-audit unit i s separate fi-om the drafting unit, which keeps the tashkeel and takhsis documentation, reconciles the M 4 1 forms (detailed payroll prepared by line departments) with the tashkeel and prepares the M16 form (summary payroll). The pre-audit process rechecks the accuracy o f all forms, including whether the expenditure i s allowed within the specific bab (major code) within the takhsis, and inthe case o f payroll, whether it i s consistent with a department's tashkeel. 3.72 Inaddition, anumber o fministries have conductedinternalaudits o ftheir provincial departments inthe last year, including the Ministries of Finance, MRRDand Education. Presumablyother ministries have done the same. 3.73 The Auditor General's office has sent out audit teams to the provinces. These teams have been trained with the assistance o f PKF Consulting. Their audit methodology has been simplified, and they use a check-list form that focuses on specific standards o f performance and other points o f compliance. While in a province, the team will audit procedures o f 11-12 departments at a time. The results o f the audit are later sent back to the departments, and during follow-up visits the team will check to see if deficiencies have been corrected. 3.74 However, there was no clear evidence that any o f these audit processes were resulting in improved practices. Inthe case o f Bamyan municipality, for example, where improper expenditures were knowinglybeing paid (see Box 3.4), the results o f an audit by the Auditor General's office carried out six months before the mission had still notbeen communicated. 3.75 Inaddition, itisworth notingthat the governor ofFaryab has authorizedthe provincialprosecutor to conduct audits o f any department in the province, although this function is not formally within the prosecutor's area o fresponsibility. 78 G.Budgetingand CoordinationMechanisms 3.76 There continues to be very little involvement by the subnational administration inbudgetingand planning activities. Inthe case o f the ordinary budget, departments have been asked to propose tashkeels, but their view is that this information has been ignored - their recommendations are not accepted, and they receive no response or explanation. However, both Education and Health departments reported that they have already prepared and submitted a budgetrequest for the 2005/06 budgetyear, at the request o f their ministries. This i s an improvement, the budget preparation instructions have directed ministries to do this, but there is no enforcement mechanism. 3.77 The development budget process also does not involve the provincial authorities, not only in terms o fbudget preparation, but also interms o f execution, which continues to be predominantly donor- managed or coordinated. The Provincial Stabilization Fund o f the ASP was intended to give some development hnds to the Governor to be spent on local priorities, but even here final approval of the projects rests with the Cabinet. Beyond this, programs have been launched that use parallel administrative structures not necessarily coordinated with the provincial administration; most prominent among these i s the National Solidarity Program(NSP) (see Box 3.2). 3.78 In addition to these various budgeting and program processes - and arguably to provide some linkages between them - there are a number o f coordinating mechanisms at the subnational level. There continues to be an administrative council o f all heads o f department ineachprovince, ledby the governor. It meets weekly or every two weeks to deal with administrative issues cutting across provincial departments. Beyond this, some provinces have a sectoral coordination committee, comprised of the main NGOs and international organizations, the main department heads, and the governor. This group deals with various planning and coordination issues; in some cases, ASP projects have been discussed. There are also Provincial Reconstruction Team (PRT) processes in place or proposed, various shura structures and ad hoc initiatives. Box 3. 3 describes one such example from Bamyan. But these coordination mechanisms often have their own agendas, and are generally not focused on strengthening the role o f subnational administration. 3.79 The negative impact o f these various disconnected mechanisms to date has probably not been profound, as reforms efforts within subnational administration have been focused on reestablishing normal procedures, centering on the ordinary budget. Going forward, however, efforts at the center to integrate the ordinary and development budgets will demand parallel actions at the provincial level. To prepare subnational administration, and particularly the Mustoufiat, efforts should be made to channel program funds that fall outside the ordinary budget through provincial channels. That was the original intent o f the ASP; but there was no indication during the provincial missions that this was to happen. In fact, most Mustoufies had very little knowledge o f the ASP program details. 3.80 While the intent of the ASP and various other coordinating mechanisms i s to give governors and other local leaders some say in provincial priorities, these mechanisms are outside the main decision process for the development budget. Rather than giving governors a say over a separate budget, it would be more effective in the longer term to engage the governors in discussions on the whole development budget, as it pertains to their province. And with the establishment o f the Parliament, as well as local councils, the pressure for this broader engagement will only grow. 79 Box 3.2: Two National Initiatives Focused o n Subnational Development Afghan istan Stabilization Program Generally, the f i s t pillar o f the Afghanistan Stabilization Program (ASP) - the Provincial Stabilization Fund- is underway in all provinces visited. Under the fund, each province i s to receive $1 million for large development projects that fit certain criteria, with no one project to exceed $250,000. The original concept was to give governors some discretionary funding to address localpriorities, to be identified through a consultative process involving local leaders. Although the practice has varied somewhat across provinces, generally there has been a coordination committee in place to review the projects, and a consultant from the Ministry o f Interior assigned full-time to the program. The coordination committee typically involved representatives from international organizations and NGOs, as well as the key ministries involved inthe program. As o f the dates o f the provincial missions, the status was that provinces had identified projects for funding, but they were still waiting to hear which projects had been approved by Kabul, and infact it was understood that Cabinet would make the final approvals. The second pillar i s the District Infrastructure Development (DID)program, which will provide funding and support for the construction o f district government offices. Across the country, 78 districts had been assessed at the time of the missions, and construction was either being planned or underway. Under the third pillar, capacity building, some preliminary activity has begun, with forms being distributed to staff in departments and districts. Based on this information, trainingprograms will be developed. The fourth pillar, dealing with PRR, is still some time off. National Solidarity Program The National Solidarity Program (NSP) provides funding for small infrastructure projects in local communities. T o obtain funding, communities must form Community Development Committees (CDCs), and the CDCs propose projects and manage implementation. NSP was active in all provinces visited. Reaction was generally very positive, particularly in terms o f the community involvement aspect o f the program. However, concerns about implementation were also voiced. The program i s managed through the provincial MRRD office. NGOs, usually with experience in the particular region, are employed as facilitating partners and assist indeveloping Community Development Committees (CDCs) that identifyprojects and manage their implementation. Projects that are proposedby the CDCs are reviewed by the supervising NGO, and then forwarded to the provincial MRRD office. They must then go to Kabul for final approval, which can normally take a couple of months. (In Badakhshan, MRRD had not received approval o f their projects until the ninth month o f the year, too late to begin work until the spring.) Apart from MRRD, there is no provincial or district involvement in the program. However, if projects are being considered that have some connection to other government departments, there should be some consultation. But for most projects, such as wells, ditches, bathrooms, etc, the ongoing upkeep would be minimal and could be done by the local community without additional financial support, so consultation was not necessary. For each project that i s approved, an account i s set up inthe DAB, and the representative o f the CDC can withdraw funds. Box 3.3: Bamyan's `Fair Futures' Council InBamyan, there is abroad, community-based councilthat meets once a year, called `Fair Futures.' Itis comprised o f senior provincial and district officials, and community leaders from the villages. They discuss priorities for the province, and at some time following the meeting a delegation will take their conclusions from the meeting to Kabul and meet with President Karzai. What i s not clear is how various planning decisions around such programs as ASP fit with this group, as the ASP projects had already been agreed to at the provincial level at the time of the mission to Bamyan, while this council was scheduled to meet a few weeks later. 3.81 As it now stands, consideration is being given to increase funds flowing to the subnational level through the ASP, a consolidation of NSP, andor through new counter narcotics efforts. If n o action i s taken to integrate these processes into the existing financial mechanisms within the mustoufiat, 80 subnational administration will become increasingly less relevant as a national government presence at the local level. 3.82 The Ministry o f Finance i s currently reviewing the structure, role and responsibilities o f the provincial Mustoufiat offices. One o f the innovations being considered i s the establishment o f a budget unit within the Mustoufiat, which would provide support to provincial departments inpreparing budget requests, and more generally would help with coordinating provincial planning. This reform could provide the vehicle for incorporating these separate programs into the single expenditure account, and should be actively supported. H.StaffingAdministration 3.83 The original subnational study identified a number o f issues inthe area o f staffing administration. Inparticular, the selection andappointment process was viewed as cumbersome and centralized, subject to nepotism and staffed with many unqualified personnel. Some responses to these issues are under development, such as the capacity building component o f the ASP, but generally, very little has changed in this area. The rules regarding appointments of staff remain unchanged; all karmand appointments at grade 6 and above, and agir appointments at grade 2 and above, must still be sent to Kabul, and all others must be approved by the governor. The delays in getting approval from Kabul vary significantly, but probably the average i s about one to two months, and some take up to five or six months. However, there were not as many complaints about this issue as before, with many interviewees saying that they realize the process does take time. However, there was support for implementing the recommendation in the original study that a two month time limit be placed on approving appointments. 3.84 The staffing reforms being implemented at the center, regarding merit based appointments managed by the IARCSC and PRR program, are just beginning to move out to the provinces, but very slowly. MERIT-BASEDAPPOINTMENTS 3.85 Inmostoftheprovinces visited, staffhadsome awareness that senior appointments (grades 2 and up) are to be done on the merit basis, and supervised by the IARCSC; but inmany cases, there had been no recent appointments at this level. In some provinces, a representative fkom the IARCSC had visited, and explained the new recruitment procedures. (Reportedly, in a few provinces a local representative o f IARCSC had established an office, but only recently, and apparently to review the structure o f the governor's office, not to deal with recruitment.) 3.86 The study team did interview some newly appointed heads o f department who had gone through the new process. InBamyan, for instance, the head o f the Education department hadbeen appointedthree months earlier. His appointment was first proposed by the governor, and this proposal was sent to the Ministry of Education, and then to the IARCSC. Apparently, the Commission did an analysis and checked the incumbent's background and qualifications. They also interviewed him. Finally, his appointment was approved by President Karzai. InFaryab, the Uluswal in the district o f Pashtun Cote said he was recruited through the IARCSC. 3.87 But the general view was that most appointments are still based on factors other than merit, such as ethnic or regionalconnections. 81 3.88 The level of awareness about the PRR program was mixed; some senior officials had no knowledge at all about the program. This is not entirely surprising, as the PRR process has barely started inthe provinces. It is clear based on discussions inprovinces and inKabul that rolling-out PRR inthe provinces will require strengthening the IARCSC's presence in provinces to review / support PRR applications and make appointments. Moreover, it remains unclear whether a fully demand driven scheme like PRR i s appropriate in the subnational context or whether an approach where the governor's office and the Mustoufiat are first reformedwould be preferable. 3.89 Based on discussions with the IARCSC staff inKabul, there i s a view that more work needs to be done on how PRR i s applied in provinces. Efforts have begun to look at restructuring the governor's office, by developing a model that can be applied across provinces in a more coordinated fashion. This would certainly be an improvement over the apparent ad hoc approach experienced to date. Looking forward, applying PRR inprovinces must recognize the close connections across the various departments that exist at the provincial level. I.Municipalities 3.90 The functioning o fmunicipalities has not changed since the last round o fprovincial visits. Inthe provinces where the district municipalities were subservient to the provincial municipality (Herat and Kandahar) this practice continues, and in those provinces where the district municipalities were operating independently, that too has not changed. 3.91 According to the Ministry o f Interior, the current legislation stipulates that all municipalities are independent units, and are responsible for the execution o f their budgets, including both revenue collection and expenditures. Ministry officials were not aware o f the situation in Herat and Kandahar, where those provincial municipalities collect the revenues from the district municipalities, approve their budgets and process their payrolls. They told the study team that they would immediately send a directive to these two provinces to comply with the law, but it i s not known what the impact has been. 3.92 There has also been some question about whether the wording in the new Constitution, which says that "every kind of tax, duty and income collected shall be delivered to the State account," changes the financial independence o fmunicipalities. The view o fthe Ministry o f Interior was that municipalities will continue to have access to their revenues, and that any new legislationwill confirm the assignment o f municipal revenues to municipalities. However, the new Public Finance and Expenditure Management (PFEM) Law appears to be silent on this issue. The Law does say that municipalities can impose taxes and fees, and that their expenditures must not exceed the total o f taxes and fees collected, and the budget issuedby the central government, but it does not say that municipalities can keep any revenue that they do not spend, and how these excess revenues are to be spent. This shouldbe clarified. 3.93 Duringthe provincial visits, comments were frequently made that municipalrevenues were being used by the governor or others in the province for their own purposes. And as provinces find it increasingly more difficult to access provincially collected revenues, the municipal revenues become increasingly attractive. Box 3. 4 gives examples o f the sorts o f expenditure that municipalities are being required to pay. To help avoid this occurring, clear instruction should be given to governors and mustoufiats on rules regarding municipal revenues, and regular audits should be conducted. 82 Box 3.4: Examples of Provincial ExpendituresFunded by Municipal Revenues An eight-person foreign mission visited aprovince; the governor gave eachperson arug worth $120, and sent the bill to the municipality Meals for guests o f the governor or deputy governor are routinely paid by the municipality The hotel costs ($1,380) o f a mission from the Ministry o f Interior was paid by the municipality, by order o f the governor Costs o f the inauguration o f a provincial university were paid by the municipality 3.94 Table 3. 9 provides a summary o f revenues and expenditures for the six provincial municipalities, for 2003/04. It should be noted that based on the data provided by Herat and Kandahar municipalities, they both show deficits for 2003/04. The mission team was not able to confirm why this occurred, but it i s likely that both were able to draw on surpluses from previous years. Table 3. 10 provides a summary o f staffing in each provincial municipality. Because the size o f municipalities varies significantly, and consequently the available revenues, the types o f activities that municipalities are able to perform also varies considerably. But there appear to be a number o f core functions across all municipalities, even if the extent o f the activity may differ. These core functions include: cleaning the city, construction and repair o f municipal buildings and infrastructure, provision o f water, municipal planning, supervision o f transport services, and tax collection. Table 3. 9: Provincial Municipalities: Revenues and Expenditures, 2003/04 I Faizabad I BamyanCity 1 Maimana I Heratcity 1KandaharCity IMaidanShahr (Badakhshan)* (Bamyan)*- (Faryab) (Herat)** (Kandahar)*** (Wardak) Revenues 3,780,337 1,856,000 na 30,169,244 74,33 8,836 737,295 Expenditures 2,552,862 1,856,000 3,501,093 33,261,931 78,157,644 484,010 Surplus/(deficit) 1,227,475 0 na -3,092,687 -3,818,808 253,285 I Table 3.10: Provincial Municipalities Staffing Structure for 2004/05 1 - Positions Filled Tashkeel Faizabad(Badakhshan) 34 40 Bamyan City (Bamyan) 22 na Maimana (Faryab) na 66 Herat City (Herat) 567 567 KandaharCity (Kandahar)* 537 635 Maidan Shahr (Wardak) 59 59 J. ConclusionsandRecommendations 3.95 As stated at the beginning of this paper, the main conclusions o f this review are that financial management at the provincial level has improved significantly since the original study was done, but there are still important issues to be addressed. Some o f these issues, such as the management o f positive 83 balances in the single expenditure account, have only arisen now that the system has been implemented, and can be fixed relatively easily. 3.96 Interms ofrecruitment and staff appointments, however, little has changed. Senior appointments are going through the IARCSC, but still, political and ethnic considerations continue to feature prominently in recruitment. There has also been some small movement towards introducing PRR at the provincial level, but so far it i s only been seen as a means to increase pay, and those left out are resentful. 3.97 As an overarching recommendation, the conclusion o f this study i s that the package o f reforms in the areas o f financial management and staffing administration should continue, and efforts should be focused on ensuring effective implementation. While the improvements that have been seen at the subnational level are encouraging, there is still a risk that the gains will be effectively lost if growing reliance on mechanisms outside the provincial administration's budget and planning processes begins to marginalize these structures. Specific recommendations contained inthis report are summarized inTable 3.11. 84 T cu 0 CHAPTER4. STATEOWNEDENTERPRISES Executive Summary 1. Overview of SOEs: The Government has made good progress inmapping the status o f SOEs in Afghanistan. A total o f 71 SOEs have been identified(with two additional ones identified under the Ministry o f Transportation) under 12 line ministries. There is now a good basis on which to further expand and improve the information available on SOEs, particularly on the finances o f those recommended for privatization and on employment figures to prepare a comprehensive social safety response. I t is strongly recommended, however, that the existing legislative framework within which SOEs operate be reviewed. It may be better to repeal the SOE Law and corporatize all SOEs so that they can be governed under the same legislative provisions as other companies. SOEs would still, however, have to report to the Government on financial and operational affairs. I n addition, more attention should be paid to the oversight of public enterprises that are currently not classfled as SOEs (often becauseState ownership is below 100%). ii. Financial regulation of SOEs:The MinistryofFinance (MoF) took important steps in 2004105 to restore financial reporting by SOEs, their fiscal obligations, and eligible transfers through the Budget. However, there is little consolidated information on SOE finances, the quality o f information is poor, and reporting and auditing are not systematically carried out or enforced. With the economic restructuringprocess underway, the SOE Department of MoF should carefully consider its evolving role. Emphasis o f activities will shift kom financial regulation to economic restructuring. But it is essential that MoF retains oversight of SOEfinances andfinancial management in order to protect public finance and public assets. Part o f the SOE Department's responsibility includes monitoring capital investments. Currently, however, neither line ministries nor SOEs are reporting these to the SOE Department. iii. Fiscal and budgetissues: Measures takenbythe Government in2004105 seem to have brought fiscal transfers to SOEs under control. Freezing o f SOE bank accounts has meant that transfers would only be made on the basis o f financial reports from SOEs. As a result, official subsidies through the Operating Budget have gone down andtransfers to meet operating expenditures do not seem to be o f major fiscal significance. Investments in SOEs have been roughly estimated at around $150 million since 2002103, with the majority going to the utilities sector. The SOE Department needs to monitor these aspart of its regulation of capital expenditures on SOEs, but also to ensure that investments are consistent with its recommendations on individual SOEs. iv. In general, there needs to be a stronger link between the SOE Department and the Budget Department o f MoF. SOEs are not budgetary units, however. In responding to budget proposals relating to SOEs,MoF could take thefollowing approach: (i) use o f public funds should be limited to existing SOEs that will remain for some time under public ownership; (ii) budget proposals should be accepted only for SOEs that have an acceptable minimum level o f financial oversight (iii) o F in M general should not respond positively to proposals for budget hnding o f SOEs' operating costs; and (iv) MoF should consider the multi-year fiscal implications o f SOE proposals, and the value for money (compared with other budget proposals) within a limited fiscal resource envelope. v. Economic restructuring policy and process: The Cabinet has recently adopted a privatization policy. It has also approved a Decree setting out amendments to the SOE Law, which grants MoF the authority, in consultation with the relevant ministry, and under oversight of an SOEs Evaluation Commission (Ministers of Finance, Commerce, Economy, and the Senior Economic Advisor to the President), to make recommendations and implement transfer o f control andor ownership o f SOEs to the private sector. The revised SOE Law also has provisions for publication o f Government decisions on SOEs in the media. The process in terms of soliciting private sector 87 interest, preparing documentsfor sale, valuation methods, negotiation, proposal, and approval by the Government needs to be clear and transparent. Unrealistic expectations should not be attached to the privatization potential o f some SOEs. Considerable time and effort could be spent soliciting investor interest in enterprises that have little businessviability. The Government should also avoid malung new investments in SOEs, particularly on the basis o f vague or tentative investor interest, and should not establish any new SOEs. 88 A. Introduction 4.1 There are currently 71 State Owned Enterprises (SOEs) in Afghanistan.' This does not include SOEs in the financial services sector (e.g. state-owned banks) or joint stock companies (e.g. Ariana Airlines). Most have been operating at a fraction o f capacity or not at all for a number o f years, and many had significant assets destroyed due to conflict. As a result few SOEs, if any, have been able to function within the legislative framework that governs their operations. There have also been inconsistencies in the way financial affairs o f SOEs are treated across different line ministries. For most SOEs there is a lack of: (i) accurate and up-to-date financial information; (ii) accounting standards and capacity to implement them; and (iii) State oversight o f their financial affairs. 4.2 M o F started to address these issues recently by undertakinga review o f all SOEs, including updating o f employment and financial information. The Ministry has also taken steps in the 1383 (2004/05) Financial Year to try to bring SOEs into line on financial reporting, fiscal obligations, and eligibility for transfers through the Budget. The prime responsibility for this falls under the Presidency o f the State Owned Enterprise Department o f M o F (SOE Department), which i s also responsible for SOE reform and privatization (Economic Restructuring Office, ERO, of the SOE Department). This chapter reviews recent developments and future plans with regard to SOEs, with particular emphasis on fiscal and budgetary issues. It makes recommendations on how SOEs could be treated and regulated within the Government's fiscal and budget frameworks, and reviews the proposed process for sale o f SOEs to the private sector. B. Overview of State OwnedEnterprises OVERVIEWOF SOES 4.3 The SOE Department has undertaken a review o f the operational and financial status o f all SOEs. Through actual site visits, this exercise rationalized an earlier attempt by Adam Smith Institute, which had estimated that there are more than 140 SOES.~It provides narrated information on current activities, finances, assets, and employment o f SOEs. Although the information i s not very comprehensive, it is the most up-to-date and complete available. A separate exercise was also carried out on employment levels and workforce composition. Based on this initiative, the total employment figure for SOEs has come to around 18,500. 4.4 The following table classifies line ministries in terms o f the number o f utilities, large non- utility SOEs, and small and medium non-utility SOEs they have under their control. Large non- utilities are SOEs with more than 500 employees. This i s not an official method o f classification and ideally should have used financial information. Nonetheless, given lack o f business activity and massive depreciation in the value o f working assets, employment provides a good criterion for categorizing SOEs by size. Moreover, the implications o f SOE reform, liquidation, or privatization are likely to be greatest interms o f impact on employment. ' Two additional SOEs have been identified under the Ministry of Transportation: (i)Millie Bus 2; and (ii) Gas Liquid TransportationEnterprise,bringing the total to 73 SOEs. Governmenti s also investingin cement and coal mine projects, but these are treated as budgetaryunits andnot classifiedas SOEs. * Adam Smith Institute, "Consolidated Planfor State Owned Enterprise ReforminAfghanistan," A ConsultationDocument (April 2003) 89 Table 4. 1: Classificationof SOEs Classification No. of Approx SOEs with no Operations SOEs emp dataonemp Full Semi Non Unknown Utility Ministry of UrbanDvpt andHousing 1 434 1 - - Ministry of MinesandIndustry 1 1,029 1 - - Mmistrv o f Enerw and Water 1 5,432 1 - - Sub-totalfor utilities 3 6,895 3 Large non-utility Ministryo fCommerce 2 1,494 1 1 - Ministryo fUrbanDvptandHousing 1 560 - 1 - MinistrvofMines andIndustry 4 4,847 2 2 - Sub-totalfor large non-utilities 7 6,901 3 4 SmalVMediumnon-utility Ministry of Transportation 10 620 1 1 9 1 Ministry of Public Health 1 234 0 - 1 - Ministry of Commerce 5 355 1 1 2 2 1 Ministry of Education 1 210 0 - 1 - Ministry of UrbanDvpt andHousing 3 783 0 2 1 Ministry of Justice 1 - - -- 1 Ministry of Minesand Industry 12 1,926 4 3 9 4 Ministry of Defence 2 193 0 2 - - Ministry of Culture and Information 3 655 1 2 - 1 1 Ministry of Energyand Water 4 584 0 - 2 - 2 Ministry of Finance 1 - _ _ 1 Ministry of Agriculture 9 1,069 1 4 2 1 3 Municipality 1 - - - 1 Sub-totalfor srnall/rnediurn non-utility 50 6,629 15 27 5 14 Total 60 20,425 11 21 31 5 14 &!!E: Department(ReviewofSOEoperationalandfinancialstatus+Employmentfigures) SOE 4.5 At the time of writing, employment data was available for 60 out of the 71 SOEs, andnot all o f these had yet been verified, which is why the figure inthe table (20,425 employees) is higher than the estimate o f actual employment (18,500). The employment figures include permanent employees and workers hired on contract. SOE Department data show that nearly two thirds o f workers are on contract, but in discussions it was noted that this is likely to be a gross over-estimate. A more accurate breakdown will be available when employment figures have been verified in detail. Over 90% o f the SOE workforce is claimed to be skilled (engineering, mechanical, or other), just over 60% have at least primary education, and on average employees have over 23 years o f work experience with SOEs across the board. 4.6 Of all the SOEs visited by the SOE Department, around eight claimed to be in arrears on salary payments, but no detail was obtained on the level and structure o f pay. It is unlikely that any SOEs are following set procedures on recruitment, promotion, termination o f employment, and remuneration. In addition to the 71 SOEs, the Government owns enterprises inthe financial services sector (e.g. Millie Bank, Afghanistan National Insurance Company - ANIC), and has joint stock ownership o f the national Airline, Ariana. There are also some disputed cases ofjoint ventures and joint stock companies (e.g. Torghandy Enterprise claiming it is a subsidiary o f another SOE and the Afghan Textile Enterprise claiming it has more than 4,000 investors). 4.7 The Ministryof Mines and Industries has the largest number o f enterprises, with 21 SOEs. It inherited 11 SOEs when the Ministry o f Light Industry and Food was disbanded in December 2004. Eight other enterprises (food related) under the Ministry o f Light Industryand Food were transferred 90 to the Ministry o f Agriculture, which along with the Ministry o f Transportation has the second largest number of enterprises with 10 SOEs. Based on available data, nearly 50% o f all SOEs are only semi- operational, just under 30% o f them are fully operational, and the rest are not operating. LEGAL FRAMEWORK 4.8 The operation and management o f SOEs are governed by the State Owned Enterprise Law (Tassady Law, 1991), which i s administered by M o F and defines SOEs as legal entities with independent balances operating with 100% capital o f the state. For most SOEs, control rests with line ministries, but proceeds from any sale revert to MoF. The SOE Law has provisions on: (i) establishment o f an SOE; (ii)use o f SOE financial resources; (iii) financial management including reporting and fiscal obligations to the State; (v) auditing arrangements; (vi) governance, including management andbusiness decisions; and (vii) liquidation. 4.9 Although SOEs are classified as independent entities, the SOE Law gives line ministries and M o F significant control over SOE operations and finances. Some provisions are quite prescriptive, for example on the duties and authorities o f the "Conducting Delegation". This is defined as the functional organ of an SOE and acts as the management board o f the SOE. The primary legislation could perhaps have been more general, with more detailed regulations applying to specific sectors. The Law as it currently stands may be quite onerous and create inflexibilities in particular sectors, weakening productive and allocative efficiency. 4.10 The Government may wish to review the relevance o f the SOE Law and consider whether it may not be better to repeal it and corporatize both SOEs that will remain under Government ownership and those that will be sold to the private sector. For enterprises that remain under State ownership, there were provisions on financial management andreporting to MoF inan earlier draft o f the Public Finance and Expenditure Management (PFEM) Law, but these were omitted in the final text. There are provisions inthe Income Tax Law on the tax obligations o f SOEs to the Government 4.11 The SOE Law has specific provisions on financial management (chapters I1and 111), which state that SOEs can use their capital for recurrent costs ("upgrading production standard and paying rights o f employees") but capital investments ("expansion o f basic possessions") require M o F approval. M o F also sets minimum profit targets on the basis o f annual fiscal plans, which are discussed in more detail in paragraphs 4.19 and 4.20 below. The SOE Law states that auditing o f SOEs will be carried out by MoF, and that SOEs will be required to submit productive, financial, and annual balance reports to their line ministries, MoF, and the Central Statistical Department - every four months for the functional report, and by June o f the new fiscal year for the annual balance report. Ifthe SOE Law were to be repealed and SOEs corporatized, financial reportingwould have to be in accordance with the Commercial Law, but some provision would need to be made for SOEs reporting on financial activities to MoF. 4.12 Under the Income Tax Law, SOEs are liable to pay income tax like any corporation or limited liability company. The SOE Law has its own provisions on transfers to the State. Under the Income Tax Law, SOEs must withhold taxes on income andpay to the Government business receipts tax, rent tax, contract tax, and income tax, among others. All SOEs will be classified as large taxpayers. They will be responsible for filing their returns with the Large Taxpayer Office (LTO). The LTO is inthe process o fregistering all SOEs, but currently it has only 10 SOEs on its books. Only one enterprise to date has submitted a tax return (Millie Bank). 4.13 The Commercial andInsurance Laws also apply to other Government-owned enterprises (i.e. not the 71 SOEs registered under the SOE Law). ANIC and Ariana Airlines, for example, are registered under the Commercial Law o f 1955 (The Code), which governs their formation, management, and dissolution. This creates some difficulty for companies such as ANIC because they are 100% Government owned and therefore also governed by the SOE Law. Inthe case o f Ariana, its Articles o f Incorporation state that "Dissolution and liquidation o f the Company shall be achieved in 91 accordance with the Commercial Law o f Afghanistan." Inthe case o f ANIC, the Insurance Act states that dissolution will be inaccordance with both the Commercial Law and directives o f MoF. 4.14 IfSOEs are corporatized, they will be governed by the provisions of the Commercial Law, like other companies in Afghanistan. This will mean less management control over SOEs by the Government, even though SOEs would still be obliged to report regularly on financial and operational affairs. This would be a positive outcome, although an earlier report by the Adam Smith Institute recommended "a wholesale revision o f the present Code (Commercial Law) with the aim of creating a legal andbusiness environment which is more responsive to the present needs o f Afghanistan."(Adam Smith Institute, 2003, p. 12). I t would be preferable to corporatize after any revisions are made, although this should not delay corporatization o f SOEs. 4.15 The Labour Code (1987) also applies to SOEs and other Government owned enterprises, covering provisions on: (i) financial assistance on retirement; (ii) assistance to workers when they are not capable o f working; (iii)maternal leave; (iv) assistance to family o f deceased for burial arrangements; and (v) retirement pension. In case workers are involuntarily separated from their SOEs, the Ministry o f Labour and Social Affairs has an obligation to find them work in the Government within six months. The SOE Department is seeking to propose an amendment so that retrenchment packages currently being developed can be accommodated within the existing legislative framework. C. Regulationof FinancialAffairs of State OwnedEnterprises ROLEOFTHE MINISTRY OFFINANCE 4.16 The SOE Department in M o F has an extensive role under law to analyze, monitor, and agree on financial operations o f SOEs. Ths includes responsibility for auditing, reviewing capital investments, and monitoring debt accumulation by SOEs. Line ministries' responsibilities cover mainly operational oversight and presiding over the main governance body o f an SOE (the High Council, which sits over the Conducting Delegation). 4.17 There are currently 38 staff and 14 contractors in the SOE Department, who are divided broadly between three sub-departments covering the sectors withm w h c h enterprises operate: (i) Commercial and Services; (ii) Construction and Transportation; and (iii) Industrial. For each sub- department there are meant to be two sector specialists and two finance specialists. 4.18 There is also the Economic Restructuring Office (ERO) under the SOE Department, which has recently applied for Pnority Reform and Restructuring (PRR). The ERO has taken over the responsibilities o f the Evaluation Commission for SOEs established soon after the end o f the conflict, which was disbanded inMay 2004. FISCAL PLANSAND FINANCIAL REPORTING 4.19 Enterprises, through their line ministries, are meant to agree annual fiscal plans with the SOE Department. This is based on an overall revenue target for the SOE Department (Le. net income to the SOE Department from taxes and fees collected from SOEs), set by revenue authorities in MoF. The net income to the SOE Department from individual SOEs is agreed on the basis o f the latter's operational plans. 4.20 Implementation o f fiscal plans i s monitored by the SOE Department through quarterly reports submitted by the enterprises to line ministries. This may be quite onerous for line ministries, particularly if they consider this as the core o f their activity or because SOEs have limited capacity to provide reliable reports. This may detract line ministries from their core functions, particularly those 92 that have significant SOE activities under them. MoF has the responsibility o f auditing SOEs, but this has not been carried out systematically (or at all) for several years. The SOE Department, claims that audits are carried out "when the need arises." ACTUALREPORTING 4.21 SOEs were asked to fill out a general financial questionnaire on balance sheet and income statement items. The SOE Department has broken down assets between short-term (worlung capital related) and fixed assets and liabilities along the same principles. They found that SOEs have very limited long-term liabilities outside o f some possible loans to the line ministries or to MoF. But the information i s not very reliable or consistent, so the SOE Department does not plan to use it further. The SOE Department indicated that there are agreed fiscal plans with the majority o f SOEs and that most are submitting quarterly income statements. Table 4.2: Summary Statementof Revenue and Expenditurefrom SOEs by Line Ministry I Reports 1 Revenue 1I Expenditure Salaries Other I1 Source: SOEDepartment 4.22 Table 4.2 was compiled using income statements (although inreality the statement only had aggregate information on revenue and expenditure) o f SOEs for the first two quarters o f 2004105. The data are presented according to ministries, before the Cabinet reorganization in December 2004 because it shows actual reporting. The data are poor and not very reliable (e.g. data was presented using different formats, there were basic arithmetical mistakes), probably reflecting lack o f accounting standards in SOEs but perhaps also lack o f capacity in the SOE Department. Revenue figures are reported in gross terms, based on achievement o f operational targets. The concept o f net income is not clearly understood by the SOEs or by the line Ministries. 4.23 Based on Table 4.2, twenty-two SOEs reported financial information in the first two quarters o f 2004/05, which includes three large non-utilities (Millie Bus, Housing ConstructionEnterprise, and Fuel and Liquid Gas Enterprise) but does not include the utilities. Reporting may be a result o f the MoF having frozen the bank accounts o f most SOEs since April 2004 inorder to regain oversight over their financial affairs. Although data are available on SOE revenues and expenditure up to 2002/03 onthe Central Statistics Office website, the SOE Department was not aware o f this. 4.24 With the freezing of the bank accounts o f SOEs, the SOE Department now has to approve disbursements after requests have been verified against fiscal plans. Any expenditure above Afs 100,000 has to be approved by the Deputy Minister o f Finance for Administration, and anything above A f s 1 million has to be approved by the Minister o f Finance. This micro-management creates major inefficiencies for SOEs by impinging on their financial independence. However, given that they are not operating under normal circumstances, the benefits (e.g. enabling M o F to re-establish SOEs' fiscal obligations and financial oversight over them, preventing poor investment decisions) may outweigh the costs inthe short term. 93 4.25 There needs to be a clearer idea about the quality and compliance o f financial reporting to the SOE Department, and it is recommended that the SOE Department consolidate this information. Information for 2003104 and previous years is apparently archived, and given the reporting format and likely small volume o f information, it should not be a time consuming exercise to prepare this electronically for 2003104 and the first two quarters o f 2004105. The data provided already helps to identify line ministries and SOEs operating in accordance with the system but also those that are detached andhow they are treated inthe public finance system. Inthe longer term, better information can help make improvements inthe financial relationship with the SOE Department and inaccounting standards particularly for enterprises that will, at least temporarily, remain under Government ownershp. 4.26 It is important that MoF retains oversight of SOE finances and financial management standards in order to protect public finance and public assets. Currently this is not talung place systematically. Part o f the SOE Department's responsibility includes monitoring and analyzing capital investments. At present, however, neither line ministries nor SOEs are reporting these to the SOE Department. The information also is not readily extractable from the Development Budget. Projects are classified according to National Programs, with details on lead ministries which are also often the implementing agency. Project Summary Sheets need to specify whether or not the investment concerned is intended for an SOE. D.Fiscal andBudget Issues OFFICIAL SUBSIDIESTHROUGH THE ORDINARY BUDGET 4.27 Due to patchy financial reporting and inconsistent treatment o f SOEs across line ministries, M o F has little consolidated information on the transfer o f public finances to SOEs. The 2002103, 2003104 and 2004105 Budgets, however, did have a provision for line ministries to report specifically on subsidies to SOEs (sub-code 7020 inTreasury Reports covering "'Subsidies to SOEs"). 4.28 The Ministries shaded in grey are those that actually have SOEs under them (before reorganization). Out o f 15 of them, 11 ministries officially reported subsidies to SOEs. The largest recipient by far was the Ministry of Light Industry and Food. But official subsidies in 2004105 have been insignificant. This isprobably a result o f Government's policy o f controlling transfers to SOEs. OTHER TRANSFgRSTO SOES THROUGH THE ORDINARY BUDGET 4.29 There may be "hidden subsidies", a potentially significant one being salaries because some SOE staff may be counted as part o f the Ministrypayroll. However, the six Ministries that have the largest number o f SOE employees were interviewed, and only in two cases were there found to be salary transfers to SOEs through the Ordinary Budget: (i) Ministryo f Mines and Industryis paying 1,800 people in Jawzjan province (in addition to the 353 staff approved for the Ministry there), and (ii)Ministry o f Light Industry and Food is paying 125 staff in Herat and 190 staff in Kapisa (in addition to the 320 staff approved for the Ministry). But inboth cases M o F agreed that the Ordinary Budget would meet staffcosts o fprojects and commercial enterprises for one year pending re vie^.^ TransitionalIslamic StateofAfghanistan, Ministryof Finance:AfghanistanOperatingBudget, An Overview(p. 5) 94 other operational costs are partly and irregularly paid.'A Provincial branches o f CAWSS function outside the Operating Budget. They have opened their own bank accounts and cover part o f their operational costs (primarily wages) through revenues. 4.32 CAWSS is undergoing a restructuring process, to be implemented in two phases. The two- year short-term program envisages $3 million worth o f financial support to meet operation and maintenance costs o f CAWSS including salaries inheadquarters and 13 branches; enable recruitment of new staff for expanded operations; and provide incentive bonuses to motivate staff. The subsidy will be phased out as revenues become sufficient to cover operational costs. 4.33 The electricity utility company (Da Afghanistan Brishna Mussessa, DABM) i s also undergoing a restructuring and commercialization process. As in the case o f CAWSS, it i s in poor financial condition and depends heavily on Government support for operational and investment funds. Until2003/04, salaries of staff were paidthrough the OrdinaryBudget of the Ministryof Water and Power (see Volume IV, Chapter 3). SOESAND THEDEVELOPMENT BUDGET 4.34 There have been planned (and some realized) investments in SOEs through the Development Budget, particularly inthe Electricity sector. The latter has also benefited from `inlund' subsidies in the form o f fuel supplies through USAID ($40 million per year according to latest information). Table 4.5 is based on a selection of projects in the Core and External Development Budgets that were targeted to SOEs. 4.35 The majority o f commitments, and the highest level o f disbursements to SOEs in the Development Budget, are for DABM. There are other investments through the Development Budget as well, for example a $1Omloan available from the Asian Development Bank to rehabilitate public sector construction industries - these probably include Banaye Construction Enterprise, Afghan Construction Enterprise, and Housing Construction Enterprise inthe Ministry o f Urban Development and Housing. This loan has not yet been budgeted or committed, but the Government should ensure that any investment plans inpublic sector construction enterprises (or other SOEs) are consistent with the privatization list, because Banaye Construction Enterprise has been recommended for privatization and the latter two have been recommended for liquidation. The expenditure review o f the Ministryo f Mines and Industry also identified a number o f additional projects worth $26.7 million (see Volume IV, Chapter 4). This data was obtained directly from the Ministry (shaded grey inTable 4.9, but the Development Aid Database shows that although some o f these projects are in the pipeline, they have not yet been budgeted for or committed. 4.36 CAWSS has also received significant investments through the Development Budget (not in Table 4.5) for feasibility studies and short-term rehabilitation o f water supply systems. Around $35 million has been contributed by the World Bank and KfW (German Reconstruction Bank) since 2002 for the Urban Water Supply and Sanitation Program. A further investment o f nearly $100 million is envisaged for the Water Supply and Sanitation Sector over the coming three years through the Afghanistan Reconstruction Trust Fund ($36m for CAWSS only), USAID ($30 million) and KfW (around $45 million). The majority of this will most likely be for restructuring and expanding CAWSS. These investments will bridge the gap untilthe start o f a medium-term investment program, which will be inexcess o f $200 million. 4.37 Taking into account investments made in CAWSS, a very rough estimate o f actual investments on SOEs through the Development Budget since the end o f conflict would stand at around $150 million. Roughly in the range o f 70-80% o f thls has been channeled to the water and electricity utilities. Certain line ministries, including Mines and Industry, have shown interest in Proposal for hnding to the Afghanistan Reconstruction Trust Fund, "Short-term Support to the Urban Water Supply and SanitationSector," 10 December 2004 (Annex 1E). 96 . . . Ma/,PowerandFelliliser Enterprise I O (itiori C c m t Enterprise 0.I JabaiSenj Cemcnt Enterprise 2 Ja~i@IakFactoiyE~tl~vnse 0.5 NorthCoal MiticsEritcrprise I O iferatZ;tbsak Coal Mine Projtrt 4 iterat Cenicnt Project 0.1 DEALING WITH SOESINTHE NATIONAL BUDGET 4.39 SOEs are not budgetary units; therefore any transfers o f public resources to SOEs should be recorded as subsidies in the Budget. Budget submissions from line ministries must clearly separate expenditures on SOEs (if any) from other line items, and this should come out o f fiscal plans agreed with the SOE Department. Currently there is no link between the Budget Department and the SOE Department, but a strong relationship needs to be established between the two. Budgetary appropriations should only be allowed as subsidies if there is a genuine need, which the SOE Department i s meant to oversee. The SOE Department should feed into the budget formulation and review processes to inform any subsidy appropriation on the basis o f financial statements from SOEs. These links are also essential to ensure consistency betweenrecommendations of the SOE Department on privatization and liquidation and line ministries' plans with regard to SOEs. Out o f the SOEs listed in Table 4.5 for which there are planned investments, the Housing Construction Enterprise and Jangalak Enterprise have been recommended for liquidation. Even in other cases, the Government mustbe cautious about investingpublic funds inSOEs inthe hope that this will improve prospects for privatization. 4.40 The following steps are recommended for responding to budget proposals from SOEs: 0 First, the use o f public funds (whether domestic resources or external assistance in the form o f grants or loans) should be limited to existing SOEs that will remain for some time under public ownership. M o F should first confirm whether the Government has full ownership o f the fm,to avoid potential claims by private parties. The Ministry should then use the SOE Department's prioritized list, inwhich the SOEs that will remain under public ownership are identified as well as those recommended for privatization or liquidation. This requires close cooperation between the Budget Department and the SOE . Department. Based on this list, M o F could consider the following approach: Fresh investment inutilities could be considered, as utilities are likely to remain under public ownership for some time, as 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. The Government could consider some labor or financial restructuring, but other investments (e.g. new equipment or technology) are not appropriate as international experience shows that Governments usually do not recover these investments in terms of a higher sale price . for the privatized firms. No investment shouldbe made in SOEs that are to be liquidated. No investment should be made to create new SOEs because, first, this would send an adverse signal to the private sector and, second, the creation o f new SOEs would generate additional fiscal risks and potential liabilities for the Government; Finally, some investments o f a rehabilitation nature could be considered for SOEs that will stay for some time inthe Government's portfolio. 0 Second, budget proposals should be considered only for SOEs that have an acceptable minimum level o f financial oversight. A first requirement is a certain level o f administrative reform in the parent ministry o f the SOE concerned, so that it has the capacity to supervise its SOEs' operations. A second requirement is a minimum level o f financial management capacity (accounting and reporting inparticular) inthe SOE itself. In particular, being able to assess regularly the cash flow of the SOE is important. Ideally, there should be audited accounts available. If these conditions are not met, budget proposals should be directed at such improvements and major investments held back. 98 0 Third, MoF in general should not respond positively to proposals for budget funding o f SOEs' operating costs, as opposed to investment proposals. In exceptional cases, the budget may have to finance operational costs o f certain SOEs (e.g. wages or non-wage operating costs) in the short run, but M o F should tie such funding to improvements in cash flow - for instance an increase in cost-recovery. This i s necessary for MoF to have some confidence that the multi-year fiscal implications o f such budget proposals will be manageable, Le. that the costs will be contained and declining over time. An important principle should be that any budget funding o f SOEs' operating costs should be in the form o f explicit subsidies rather than hiddensubsidies in other budget lines. 0 Finally, in reviewing SOE proposals, M o F should consider the value for money within a limited resource envelope and the multi-year fiscal implications. First, M o F should seek to compare the benefits and value o f SOE proposals with other budget proposals. It i s critical that the projects technically meet a critical level o f economic rate o f return, since allocating resources to SOEs diverts scarce fimds from other growth-enhancing spending. Second, M o F should take into account the multi-year fiscal implications o f the proposals. These proposals will have direct (e.g. need for sustained investment or subsidies infuture years) and indirect (e.g. creation o f contingent liabilities if the project fails) fiscal impacts; they will also raise expectations about public investment, further increasing fiscal risks. REVENUEFROMSOES 4.41 The SOE Law has provisions on transfers from SOEs to the State, namely up to 37.5% of net profits (after deducting 25% for special expenditures and 37.5% for workmg capital and other). The SOE Department, however, also referred to a 2% levy on gross revenue and 20% tax on gross profits (which i s the corporate income tax). The SOE Department indicated that all revenues are remitted to SOE accounts, and liabilities to the state are calculated by the SOE Department and then transferred into the Treasury Single Account (TSA). SOEs would ordinarily be liable for paying taxes directly to the revenue authorities, and the SOE Department's role would be limited to monitoring compliance. The current arrangement was probably put in place as part o f the Government's efforts to impose stricter financial controls over SOEs. 4.42 Information on the amounts that the SOE Department has transferred to the TSA in 2004/05 was not immediately available. The General Presidency o f Revenue (GPR) was not aware o f any transfers from the SOE Department. The SOE Department gave a presentation to the GPR on this issue, but this did not provide any further clarity on how SOE obligations to the State are being treated. 4.43 The Large Taxpayer Office will be providing training on accounting to both the SOE Department and some SOEs, using a basic bookkeeping program and looking at basic budgeting, revenue forecasting, and submission o f income statements. The GPR is also following up on 11 enterprises that claim to be current on tax payments, based on information from the SOE Department's review). From a quick review, GPR found evidence o f only one enterprise having submitted a tax return o f 300,000 A F S directly into state accounts (Millie Bank- which i s not on the SOE Department's list o f enterprises). Existingtax records do not show that SOEs are either current or compliant with tax payments. 4.44 It is doubtful that the SOE Department is calculating SOE liabilities to the State according to the formula in the SOE Law (paragraph 4.41), largely because o f lack o f reliable financial information. The revenue formula is another aspect o f the SOE Law that makes it quite restrictive. The formula will, however, probably no longer be applicable once the Income Tax L a w comes into effect - SOEs will be liable for income taxes like any other corporation or limited stock company. 99 The GPR is already making efforts to bring SOEs under the new system by having all o f them registered under the LTO. 4.45 I t would be useful to consolidate the information on revenue transfers from SOEs to state accounts. In the short run it may be difficult to ensure that SOEs comply with the new tax administration system, although the training planned by the LTO should help. The SOE Department could therefore carry on its short-term functions, but on the basis o f the new tax policy measures (i.e. tax measures contained inthe draft income tax law includingbusiness receipts tax, rental tax, etc.). E.Economic RestructuringPolicy and Process POLICY STATEMENTS 4.46 Pillar 3 o f the National Development Framework (promulgated in April 2002) indicated that the privatization process is a medium-term objective and not a short-term pri~rity.~ The stated goal was to reduce state presence in the economy by privatizing "appropriate state assets including: state hotels, state cement factories and other state owned enterprises." The privatization process falls broadly under Sub-Program 3.1.1 "Trade, Investment and Private Sector Development Policies" and Sub Program 3.1.2 "Administrative Reformand Restructuring." 4.47 In"Securing Afghanistan's Future" there is no explicit mention o fprivatization, but the poor state o f SOEs i s highlighted as a key issue to address in strengthening infrastructure and service delivery (Afghanistan Government, 2004, Chapter 3). There are large public investment programs envisaged for (i) the transport sector (including in state-owned bus companies); (ii) energy sector the (including investment inDABM, rehabilitation o f gas production and transmission, investment in oil storage tanks); (iii) the mining sector (including investments geared toward regularizing existing production o f quarry materials and gemstones, rehabilitation o f some coalmines, and investment in coal and copper production and exploration); and (iv) the urban developmenb`management sector. But the state will act as facilitator andregulator rather than service provider. 4.48 More recently, in November 2005 the Cabinet adopted a privatization policy, which states that "the Government is committed to expanding the private sector through the efficient and rapid transfer o f State-Owned Enterprises."6 The responsibility for preparing proposals on economic restructuring and divestiture will rest with M o F and will be based on the review of SOEs completed in December 2004. The policy statement is an important step to help promote Government-wide coordination intaking forward the privatization process. But M o F will need to work closely with line ministries indeveloping proposals to ensure buy-infor, among other issues, recommendations on type o f divestiture, post-privatization responsibilities, anduse o fprivatization proceeds. RECOMMENDATIONS ON RESTRUCTURING,PRIVATIZATION, AND LIQUIDATION 4.49 Based on their review o f SOEs, the SOE Department recommended inNovember 2004 that: (i)10enterprisesshouldremainunderGovernmentownership(withpossibleprivatizationatalater date); (ii) 41 enterprises should be privatized as going concerns; and (iii) enterprises should be 20 liquidated. They then revisitedtheir assessment and recommended that out o f the 41 to be privatized, seven are likely to attract interest from foreign investors. These include: (i)Mazar Power and Fertiliser Enterprise; (ii)Jabalseraj Cement; (iii)Ghuri Cement Enterprise; (iv) Afghan Gas Enterprise; (v) Kabul Silo; (vi) Mazar-e-Sharif Silo; (vii) Brishna Organisation Enterprise. The SOE Department suggested that these seven SOEs be privatized through international tenders. See Afghanistan Government (2003, Annex 3, Pillar 3). http://privatization.mof.gov.af 100 4.50 The SOE Department's recommendations are based on: (i) operational activity; (ii) o f state the equipment and degree o f economic obsolescence; (iii) capability o f senior management; and (iv) formulation and quality o f a business plan. The SOE Department recognizes the weaknesses in the available information and will help potential investors to obtain as much financial information as possible. But the Government must undertake comprehensive valuations itself, particularly for some o f the larger enterprises recommended for privatization, in order to ensure a sound basis for negotiation. 4.51 With the new privatization policy, the Government has decided to classify SOEs under two rather than three categories, which are: 0 Enterprises currently recommended to remain in State ownership, which are mainly SOEs inthe utilities sector or those that mustremaininGovernment ownership bylaw; and 0 Enterprises recommended for divestiture, with method o f transfer to the private sector (e.g. transfer o f assets, sale o f shares, long-term leases, or management contracts) to be determined on a case by case basis. 4.52 Privatizationand other reforms and restructuring o f SOEs can lead to important gains interms o f growth and therefore revenues, as well as lower public expenditures. In addition to the net gain from higher tax revenues and lower fiscal transfers, the Govemment can also benefit at the time o f sale from improved performance o f privatized concerns. Fiscal gains will be reduced, however, if sales are not transparent and SOEs are undervalued, or excessively favorable terms are granted to investors (e.g. inthe form o f tax concessions). Inaddition to the direct fiscal cost, these may also lead to indirect costs to the Govemment (and society) in the form o f reduced incentives for efficient and profitable operation. The privatization policy states that "transfers shall take place in an open, fair, and transparent manner with the objectives o f maximizing sales revenues balanced against employment preservation and creation and encouragement o f investments and technological development." 4.53 A number o f enterprises recommended for privatization as going concerns from the November 2004 list may also need hrther investigation. In particular, these may include the Mazar Fertiliser and Power Enterprise, for which a study by Hill Enterprise has shown limited economic viability, and Afghan Gas Enterprise, for which it may be better to go through a restructuring exercise first beforeprivatization. 4.54 The Government should exercise caution in offering too many enterprises for privatization and may instead begin with a few enterprises where enough information exists to indicate that these are strong candidates for privatization. Qualified transactions advisors should help the Government to identify potential buyers and negotiate deals. It is important that the Government does not invest considerable sums o f money in SOEs in the hope o f makingthem attractive privatization candidates. The classification o f SOEs should be considered tentative, and there should be processes inplace to move enterprises from the "privatizable" category to the "to be liquidated" category if additional information establishes that these are not genuinely sellable as going concerns. 4.55 For the SOEs that remain under the Government's control, performance and transparency can be improved in a number o f ways. A first tool is to enforce hard budget constraints. This requires sound financial management and transparency. This means that SOEs should have no access to hidden subsidies (e.g. loans from Government, privileges to bid on Government contracts, requirements from Government agencies to buy SOE outputs, rent-free access to Government land or buildings), and no preferential access to credit. Any explicit subsidies should be limited and tied to improvements inthe finances o f the SOE concerned over time (e.g. through enhanced cost recovery). A secondtool is to reform the institutional relationship betweenSOEs and the Government to change the incentive structure. Some countries have instituted various forms o f corporatization, contracting between SOEs and the Govemment, introduction o f signed management contracts (which may or may not be performance-based), new oversight bodies, and increased managerial autonomy. A third tool is 101 to increase competition, by opening up markets to trade, easing restrictions against entry, and unbundling large enterprises. A fourth tool i s to move toward privatization through various options such as subcontracting (the SOE subcontracts execution to a private party), leasing (of the entire SOE, or its equipment or assets, sometimes in the form o f lease-and-operate contracts in infrastructure sectors), or concessions (as well as build, operate, and transfer, BOT, contracts, often used for the privatization of infrastructure sectors with monopolistic characteristics-see Volume IV, Chapter 3). ECONOMICRESTRUCTURINGPROCESS 4.56 The SOE Department under Presidential Decree 4514 (12 April 2004) has the sole responsibility to assess the economic viability o f SOEs and to recommend and execute the necessary economic restructuring o f enterprises. This responsibility was previously with the Evaluation Commission o f State-Owned Enterprises (ECSOE), established in June 2002. The ECSOE was dissolved inM a y 2004. 4.57 InNovember 2005 the Cabinet approved a Decree setting out amendments to the SOE Law, which grants the Ministry o f Finance the authority, in consultation with the relevant ministry, and under the oversight o f an SOEs Evaluation Commission (Ministers of Finance, Commerce, Economy, and the Senior Economic Advisor to the President), to make recommendations and implement transfer o f control and/or ownership o f SOEs to the private sector. The revised SOE Law provides for different forms of transfer (e.g. change o f legal form, reorganization, restructuring, liquidation and dissolution, transfer o f ownership through sales o f shares or assets, management contracts, lease contracts). There are also legal requirements for publication o f any decisions in the media, w h c h is key in ensuringtransparency and accountability. 4.58 A balance needs to be struck between ensuring an efficient privatization and liquidation process, and ensuring transparency and accountability for decisions taken on SOEs. A proposal on promulgation o f a Privatization Act was turned down earlier - the preference was to proceed with privatization on the basis o f the existing legislative framework. The SOE L a w previously had provisions on liquidation but not on privatization as a going concern or other private sector participation such as management contracts. For sale o f shares, an SOE would have to be corporatized first. IMPLEMENTATION OF THE ECONOMIC RESTRUCTURINGSTRATEGY 4.59 Key components o f the Government's strategy include (USAID, 2004): Designing a social safety net for employees that may be retrenched as a result o f privatization or rationalisation o f staffing levels. Designing a public awareness campaign on the economic restructuring process. Strengthening o f the information base on SOEs by building on the initial due diligence and refining where neededthe list for SOEs to be retained, privatized, or liquidated. Developing a detailed strategy and implementation procedures for disposition o f each class o f SOE. Establishing essential institutional infrastructure, including necessary legislation, accounting standards, training in corporate governance, development o f capital markets, andinformationtechnology. Designing o f an enterprise support program for privatized and corporatized firms; Providing technical assistance to local counterparts for specific transactions, including preparing necessary documentation, undertaking the tendering process, and providing post-privatization support. 4.60 A draft work program has been prepared for the first year, during which one of the major tasks will to develop and establish essential institutional and legal frameworks for restructuring. 102 4.61 A second major task will be to design and pilot a social safety net program for employees affected by the economic restructuring program. A Social Safety Net package has now also been approved by the Cabinet. This has two components: (i) the first includes monetary benefits such as severance payments; and (ii)the second includes non-monetary benefits such as retraining and redeployment services. Details o f the package or its costs have not yet beenpublished. But MoF, with the help o f the Ministryof Labour and Social Affairs, is inthe process o f reviewingthe status o f SOE workers and finalizing the total registry (with detailed breakdown by each SOE) to appropriately target severance and training packages. Severance packages may have important fiscal implications, particularly when factoring inpayment of accrued pensions. The SOE Department is working closely with the Civil Service Commission (IARCSC) to ensure that severance packages are not inconsistent with what would be offered elsewhere in the civil service. They have very roughly estimated that around 6,000-7,000 workers may be dislodged inthe economic restructuring process. 4.62 The recommendations o f this chapter are summarized inTable 4.6 below. 103 Table 4.6: Summary of Recomn- idations Issues Recommendations ConcreteNext Steps Legislative Implementthe new legislative Set out obligationsof SOEs and framework for SOE framework for SOEs andprivatization other companies, and ensurethat operationsinflexible recentlyapproved. these are consistent across all and onerousfor line SOEs shouldcontinueto report on legislation. ministries finances andoperationsto the MoF. Review institutionalresponsibility and capacity within line ministriesto reporton operation and finances of SOEs. Structure and The role ofthe SOE Departmentneeds Adopt andimplementPRR planfor capacity of theSOE to bereviewedinline with progress on SOE department. Department may not the economic restructuringprocess and be in line with its clarifiedto line ministries. And an evolving role administrative reformplan(covering boththe "economic restructuring"and the "monitoring / reporting" functions shouldbe adopted The SOE Department's accountingand sector capacity needto be strengthened inlinewith SOEsthat will remainin Governmentownership. Lack of consolidated All financial informationsubmittedby Retrieveand consolidate financial inform ation on SOEs over the past two years should information. financial reports betaken out of archives,reviewed, Feedinformationinto EROanalysis submittedby SOEs to consolidated, andtransferredinto and use it to review financial the SOE Department electronic files. reportingcapacity in SOEs recommendedto remainunder Government ownership and those to beprivatizedas goingconcerns. Review financial reportingformats andrecommendchangesto meet agreed standards. Lack of SOE Investmentprojectsfor SOEs should IntroducerequirementinBudget Department bemarkedas such inthe Development formulation guidelinesand agree oversightfor SOE Budget and shouldbereportedto the with relevant departmentsinline investments through SOE Departmentas part oftheir ministries. the Development monitoringrole. Budget Lack of linkage The SOE Department shouldfeed into Budget and RevenueDepartments between the SOE the Budget formulation andreview and SOE Departmentto discuss how Department and the processesto inform any subsidy the latter's input can beregularly Budget and Revenue appropriationonthe basis of financial integratedinto Budget formulation Departments statements SOEs. andreviewprocesses. Inconsistenciesin Tax returnsof SOEs shouldbe Review SOE and IncomeTax Laws provisions on calculatedon basis o ftax policy set out and introducenew tax policy transfers to the State inthe IncomeTax Law. measuresinregulationwork of SOE between the SOE The SOE Departmentmay want to Department. Law and theIncome administerthis inthe short-term, but TaxLaw responsibilityto comply should eventually restwith SOEs directly. 104 i zz5 L c, 8 0 c, d, 3iQ .. rl i 4c a2 x CHAPTER 5. MUNICIPALFINANCES AND MANAGEMENTIN KABUL Executive Summary 1. InAfghanistan's highly centralized institutional context, municipalities have a unique degree of autonomy, especially Kabul. There are several institutional mechanisms available to municipalities to allow for close co-ordination with citizens. This makes them potentially a very effective tool to deliver services to the people. The unique history and current position o f Kabul Municipality, including its resources (land and potential financial resources), the presence o f administrative systems (albeit with room for improvement), and an existing legal framework that accepts a measure o f its independence, provide an opportunity for the Government o f Afghanistan to implement systems for the delivery o f services at the city level. There are a number o f challenges to realize this potential however. ii. First,the existingmunicipal lawsrequirereview andrevision. Two aspects are o f notable importance: the particular position and regulations for Kabul (as opposed to other municipalities) and the issue o f functions devolvedto municipalities (as opposed to line ministries o fthe central Government). ... 111. Capacity will needto be developed for municipal functions. This will require adequate financial and human resources. Capacity development will require public administration reforms as well as training and other efforts to build up human capacity. Further administrative reorganization o f Kabul Municipality should occur on the basis o f the functions that it i s required to undertake. Kabul Municipality i s fortunate in that it has independence in hiring its own staff, below a certain level. This system i s useful in that it allows for the municipality to determine its own staffing requirement based on need. However, the capacity constraints o f the municipality are enormous. Addressing these constraints will take a number o fyears. iv. Moving to financial aspects, a priority i s to clarify taxes available to the municipalities (in coordination with the national Government), update tax rates, and review and reform the tax administration systems. In addition, financial management must be enhanced, by strengthening the existing manual accounting system first, before moving to a more complicated computer based system. Improvements in the budget process will be required. Improvements in the development budget process need to be linked to the development o f a plan for Kabul. Such a plan should identify key service deficiencies for the city and key growth areas. This should be followed by identification o f projects and their prioritization. The process o f deriving this plan should take into account new methodologies o f planning and its links to the budget process. v. Interms of delivering services, a clear priority is to address the issue o f land development. In addition, Kabul Municipality needs to turn its attention to the way in which i s it servicing the city, particularly in solid waste management and operations and maintenance. While this will be a long-term effort, it i s critical to think through the specific services that should be delivered by or under the oversight o f Kabul Municipality, and what institutional and financial arrangements will be needed to maximize effectiveness. 106 A. Introduction 5. 1 In Afghanistan's highly centralized institutional context, municipalities have a unique degree o f autonomy, especially Kabul. There are several institutional mechanisms available to municipalities to allow for close co-ordination with citizens. This makes them potentially a very effective tool to deliver services to the people. However, the current set o f municipal laws, the 2004 Constitution, and some central Government policy decisions appear to be inconsistent, reflecting lack o f consensus about what municipalities should focus on and how they should operate. If municipal laws are to be changed, the Government will have to decide on the functions and accountability relationships o f municipalities in general, and also as to whether it wishes to allocate different functions and accountability relationships based on size o f municipality and other factors. Significant organizational changes and efforts to r e f o m and develop capacity will be required. This chapter first looks at the legal basis and issues relating to Afghanistan's municipalities, in particular Kabul. It then discusses the functions o f Kabul Municipality and its relationship with other levels o f Government. The core o f the chapter i s devoted to administration and finance in Kabul Municipality, broader municipal planning and development in Kabul (especially relatedto land), and service delivery. The chapter closes with some recommendations for improvements. B. LegalFramework-Past and Present' 5.2 TheLegal Standing of Municipalities. Afghanistan's various earlier Constitutions (1964, 1976, 1987 and 1990) only briefly mention municipalities. All stipulate that municipalities shall be ruled by law. The most distinctive features o f the various Constitutions are in the 1987 Constitution which calls for local elected councils (Chapter 11) and the 1990 Constitution where Kabul City i s given equal status as provinces inthe Loya Jirga (Article 131). 5. 3 Although the Bonn Conference adopted the 1964 Constitution, the municipalities have been regulated in accordance with the 1990 Constitution, through the Municipal L a w o f 1369 (1990), amended in 1379 (2000), hereafter referredto as the Municipal Law.* The law provides an overall framework for municipal status, authority and functions including General Orders (Chapter l), Organization (Chapter 2), Financial Affairs (Chapter 3), Responsibility and Authorities (Chapter 4), and Final Orders (Chapter 5). Ten other laws, all passed or amended in 2000, also regulate the municipalities. These include the (i) Municipal Law, (ii) Service Tax Law, (iii) Acquisition Law, (iv) Hoarding PreventionLaw, (v) City Land Greenery and Sanitation Rules, (vi) Safai Tax Law, (vii) Provincial Vehicle Parlung Tax Rule, (viii) Rental Fixing Rule of Municipal Property, (ix) City Projects Settlement Rule (25th Year Plan), (x) Implementation Rule o f Master Plan, and (xi) Rule o f Distribution and Selling o f Residential, Commercial and HighRise BuildingLands inKabul City. 5.4 According to the Municipal Law, provincial municipalities3 are accountable to the local (provincial) administration in that the Governor assumes responsibility for their structure, approval of staff, and budget but under the overall control o f the Ministry o f Interior (MoI). The exception i s Kabul. See Pathak (2004). Islamic Emarate (Government) o f Afghanistan, Ministry o f Justice, Decree No. 29 on Municipal Law, 1369 (2000). Afghanistan's municipalities are graded into provincial municipalities and rural municipalities. Distinctions include (i)M o I and provincial municipalities having some level o f intervention in the organizational structure o f the rural municipality, whereas the Governor and the M o I approves structure o f provincial municipalities; (ii) formal budgetary allocation other than salaries are no made, and development budget expenditures are agreed on an ad-hoc basis for rural municipalities. The ordinary budget and development budgets o f provincial municipalities are approved by MoI. 107 5. 5 Thespecial status of Kabul. The Municipal Law interpreted Article 130 o f the 1990 Constitution as giving Kabul Municipality a great degree o f independence in its functioning. Article 6 o f the Municipal Law designates Kabul Municipality as a part o f the national Government. Consequently, Kabul Municipality's legal standing and its operations are more autonomous since authority for decision malung, operations, finance, and management rests with it. However, this has not been accompanied by a clear and legally recognizedjurisdiction over which Kabul Municipality exercises its authority, within which it performs public functions, and to whose constituents it i s accountable. Kabul Municipality's apparent status as a Ministry-level entity has a number o f implications: 0 The Mayor and top managers are appointed by the President. The rest o f the staff are appointed by the Municipality (unlike other Municipalities where staff are appointed by MoI). 0 The salary scales used are the same as the national scale. 0 Unlike other municipalities, Kabul Municipality's budget i s approved by the Ministry o f Finance (MoF), not MoI. 0 The municipality also has a separate budget head (approximately $10 million) inthe 2005/06 national budget. 0 However, like other municipalities Kabul has independence inrevenue generation, budgeting and planning, and expenditure control and procurement. 0 Ithas various systems inplace for administration o fthe urbanarea. 5. 6 There i s an argument for a special status for Kabul, based on its size, its level o f economic activity, its history, and the fact that it i s the capital city. Several countries have used size and economic activity to differentiate cities. For example, South A h c a divides its municipalities into categories A, B, and C. Category A municipalities are designated based on (i)conurbations which include high population density, intense movement o f goods and people, extensive development, multiple economic centers, diverse economy; (ii) a single area where integrated planning i s desirable; and (iii)strong economic and social linkages within the area. Such an area has exclusive municipal executive and legislative authority in its area. All other municipalities are classified as Category B, which shares municipal executive and legislative authority with a Category A municipality within whose area it falls, and Category C, which has municipal executive and legislative authority in an area that includes more than one municipality. 5. 7 Afghanistan's cities can be distinguished in a similar manner. Kabul's population currently stands at approximately three million people or 15% o f total Afghan population (Bertaud, 2005). The population o f Kabul far exceeds that o f the second largest city, Herat, which has an estimated population o f about 700,000 (Afghanistan Government, 2004). The cities o f Herat, Kandahar, Jalalabad, Mazar and Kunduz form a second category with populations ranging from 300,000 to 700,000. The rest o f Afghanistan's urban centers are smaller, and form a possible third category. 5. 8 There i s also an argument for continuing special treatment o f Kabul because it i s the capital city. This is the case for several capital cities including Washington DC, Islamabad, and Berlin. The territorial administration o f capital cities varies across countries, with at least three possible types o f arrangements: (i)separate,specialadministrativedistrict(e.g. IslamabadandWashington); (ii) statusascityand a dual province or federal state (e.g. Berlin); and (iii)incorporated into the federal or national political geography like other cities inthe nation (e.g. Pretoria and Bonn). 5. 9 The internal political structure o f the nation (including the level o f centralization) certainly plays a major role in determining administrative relationships. But a capital city's territorial-administrative arrangement, like the location o f the capital city itself, i s also the product o f chance, historical legacy, the 108 relative political and economic power o f the capital city, and the relative strength o f regional and national political forces. The evidence strongly suggests that no one arrangement i s inherently better than the other two. Consequently, Kabul's historical and administrative past may be used as a strong argument for continuing special status o f some sort. 5. 10 The 2004 Constitution and the Municipal Law: some contradictions. The 2004 Constitution, although consistent with the 1964 Constitution regarding the status o f municipalities, does remove some o f the powers that municipalities had under the 1990 Constitution, which the current municipal law i s based on. In particular, the 2004 Constitution does not appear to entirely support the current administrative arrangement whereby the Kabul Municipality has the status o fa line ministry. 5. 11 Article 136 of the 2004 Constitution defines the administration o f Afghanistan as being based on central and local administrative units in accordance with the law. Provinces are defined as the local administrative units (Article 138). The President appoints ministers (Article 64, 11) and high-level officials (Art 64, 13). Ministers are defined in the Constitution as heads o f administrative units and o f government. Kabul Municipality would arguably not be includedineach o f these definitions. 5. 12 Municipalities are mentioned inArticle 141: "Municipalities shall be set up inorder to administer city affairs. The Mayor and members o f the City Council are elected by free, general, secret and direct elections. The affairs related to municipalities are regulated by law." 5. 13 The apparent contradictions between the current law governing municipalities - particularly Kabul Municipality - and the 2004 Constitution require clarification. The unclear legal framework i s currently the source o f tensions between Kabul Municipality, the Infrastructure Ministries (especially MUDH and Ministry of Public Works), and the Ministry of Finance MoF). Kabul Municipality has interpreted its current legal standing and its independence strictly. It argues that it i s accountable directly to the President. It refuses to accept a degree o f accountability and coordination between it and the line ministries. It has accepted that its budget should be approved by MoF, but it does not use the M o F budget template, follow budgetary regulations, or meet deadlines for budget approval. Kabul Municipality's strict interpretation o f its independence has also brought it into conflict with the central government on the Procurement Law and the Public Expenditure and Financial Management (PFEM) L a w - both o f which have attempted to address the role o f the municipality in these two substantive areas. Consequently, there are contradictory practices in financial administration, especially budgeting and procurement, as between nationalregulations and those o fKabulMunicipality. 5. 14 The PFEMLaw (Articles 23 -26) clarifies some o f the accountability and reporting relationships for municipalities, and curtails their independence in certain ways. First, it allows transfers to municipalities fi-om the national budget. Consequently, it appears that municipalities are n o longer constrained by their ability (or inability) to collect taxes to cover their operations and maintenance budgets. Second, it states that the amount and the manner for collecting the revenues o f municipalities shall be determined and specified by law. Third, it also gives permission for municipalities to borrow, albeit only fi-om the State. Finally, it insists that municipalities shall provide budget execution reports at least every six months to M o F through the appropriate Mustoufiat. However, it i s not yet clear whether Kabul Municipality will recognize that the PFEM Law supersedes the provisions o f the Municipal L a w that stipulate its independence. There i s also a degree o f confusion on taxation. For example, the national government has implementeda rental tax that i s also collectedby the municipalities. 5. 15 Quite apart from the constitutional discrepancy, the need for a new municipal law also arises because the old laws are not quite clear in their description o f functions to be undertaken by municipalities and inthe accountability relationships for Kabul Municipality. Currently,municipalities in Afghanistan are in an unusual position regarding their financing and accountability relationships. They 109 have some level o f fiscal autonomy vis-a-vis the national government and limited service delivery functions, but are creatures o f MoI. The system therefore may be characterized as "delegation", whereby a central government transfers responsibilities for decision-making and administration o f public functions to local governments or semi-autonomous organizations that are not wholly controlled by the central government but are accountable to it, i.e. a principal-agent relationship (Litvak, Ahmad, and Bird, 1998). 5. 16 The lack o f clarity and differentiation o f functions has led to confusion in service delivery in Kabul in several sectors, including planning, roads, and water. Clarification also i s needed, particularly given the current perceived independence o f Kabul, as to whether or not municipal functions, funding, and accountability relationships should differ depending on the size (or any other relevant characteristics) o f a municipality. As discussed earlier, there i s a case for continuation o f the special treatment o f Kabul and for its autonomy, but this would need to be agreed across Government and clarified. 5. 17 In sum, a Municipal Law needs to clarify the functions of municipalities, their funding sources, and their accountability relationships in delivering services and in reporting. A Municipal Law should also address the need for differentiation in municipal administration for different types o f municipalities. However, given their lack o f capacity, Municipalities should stay focused on a limitednumber o f services that they can deliver well. Delineation o f the financing mechanisms for municipal services should follow the definition o f these tasks. C. The Functionsof KabulMunicipality 5. 18 The basis o f designating functions to local government, and consequently, the functions themselves, differ across countries. Generally, however, they adhere to the following principles (see also Table 5.3): 0 Federal states are characterized by having functions assigned between the federal and formative unit (state, province, Lander) in the constitution; unitary states rarely specify the functions o f lower levels o f administrationinthe constitution. 0 Federal nations generally leave the matter o f local government (i.e. levels o f government below the formative unit) to their formative units, explicitly or by residual power. 0 While unitary countries rarely assign local government functions in the constitution, principles or safeguards relating to local government are commonly found in unitary constitutions. 0 However Italy, and even more so South Africa -both unitary states -have principles as well as lists o f functions for subnational levels o f government enshrined in the constitution itself (Italy just for the regions). 0 Older federal constitutions have rather shorter lists o f functions than newer constitutions (for the federal and formative unit levels). Formative units in federal states can have their own constitution, and if so, local government principles and sometimes functions are addressed in these constitutions (see Ferrazi, 2002). 5. 19 Typically, infrastructure functions such as water, waste water, solid waste, local roads, and local regulatory functions for public health are most often allocated to local governments. Public (e.g. police) and social (e.g. health) services are also sometimes local functions4 (see Table 5.4). A useful general concept inthe allocation of functions i s that o f subsidiarity - the idea that functions should be handled by See Goga(2002). 110 the lowest appropriate competent authority. This would mean that the central authority should perform only those tasks which cannot be performed effectively at a lower or local level. The converse i s that the municipality should be competent to deliver the services assigned to it. Consequently, Kabul Municipality for example should focus on a limitednumber o f services that it can deliver well. 5. 20 Kabul Municipality has functions similar to other municipalities internationally. Consequently, the current recommendations o f the PRR program for the Municipality are for it to retain its existing functions but to review these to ensure better service delivery. Chapter 4, Article16 o fthe Municipal Law presents a list o f 44 wide-ranging responsibilities and authorities o f municipalities (See Annex 5.1). These include infrastructure development and service delivery, public health, environmental protection, land and buildings, management and tax collection, involving people in city services, complaints and redressal, setting and controlling prices, prevention o f illegal construction, licensing, data collection, strengthening society building,providing legal support, and assisting inmaintaininglaw and order. 5.21 Relationship with other levels of Government. In spite o f the long list responsibilities assigned to it by law, there i s immense confusion about the relationship between Kabul Municipality and other levels o f government in terms o f delivery o f services and actual functions to be carried out by Kabul Municipality. The Municipal Law states that in cooperation with Government line ministries, the municipality is indirectly involved in the construction o f the city sewerage system, water supply, construction o f prefabricated apartments, city power, communications, public health, education, and sport. However, the lack of clarity in the accountability and reporting relationships has meant that coordination i s minimal.5 5. 22 There are also several issues that require further attention in the list o f municipal functions as presented inthe law: 0 The list o f functions confuses the substantive functions o f the municipality (e.g. provision o f water, sanitation, etc.) with its administrative functions (e.g. leadership o f relevant subordinate departments, inviting and convening meetings on service delivery). 0 The municipality does not have the capacity to perform several o f its mandated functions. For example, regulation o f underground water is a municipal function that i s currently not being performed by Kabul Municipality. However, the definition o f "regulation" i s unspecified. Theoretically it could include public health regulation, education, permits for borehole drilling, monitoring the level o f the aquifer, etc. 0 Several functions are obsolete - harking back to the era o f the Soviet occupation. The most obvious o f these are "setting prices o f houses, based on regulation, supervision and control o f prices, distribution o fprice list based on law, strict implementationo fprice list." 0 Several key functions are unclear or are not fully covered. Environmental sanitation i s generally an important local government responsibility. In Article 16 passing references are made to the "cleanliness o f the areas" inFunction No.3 and to construction o fpublic toilets in Function No.4. Construction, repair, and cleaning o f public drains and ditches in the city i s also included (No.30). No specific mention i s made o f household sanitation or solid waste management. 0 Land and property management i s a crucial responsibility, which can generate significant revenues for municipalities. But the Municipal Law provisions are limited only to For example: KfW has been integrally involved inassisting the CentralAuthority for Water Supply and Sanitationinrepairing and expanding the current water network in Kabul. The engineeringdesigns thus rest with CAWSS. KfW has come across a number of examples where KabulMunicipality has plantedtrees directly on top of water mains-resultingindamageto pipes. 111 distribution o fplots and land acquisition (Nos. 9 and 10). The legal authority should be given to municipalities to do much more to obtain optimum benefits from this valuable asset.6 Several other crucial functions are absent. The range o f urban challenges facing Afghanistan includes rampant urban growth and the growth o f informal settlements, massive service delivery backlogs, land tenure confusion, and poor urban management. These give rise to several policy concerns including (i) housing; (ii) settlements and informal settlements; new (iii)service deliveryincludingstandards andoptions (particularly for informalareas); (iv) options for planning and land use; (v) urban land tenure and management; (vi) finance and revenue generation; and (vii) local public administration and civil service reform. Several o f these functions are not beinghandledby the municipality. D.Administration andFinanceinKabulMunicipality THEORGANIZATIONOFKABULMUNICIPALITY 5.23 Kabul Municipality has been restructured several times during the past two years. The most recent restructuring was in Aprilmay 2004 (see Figure 5.1). The municipality i s also undertaking a Priority Restructuring and Reform Process (PRR). However, the structure has, as yet, not been finalized under this process. The April 2004 structure embodies some improvements over the previous structure (represented in Figure 5.3). Although the basic structure o f the municipality - its organization into two essential components of the Head Office and the 18 Nahiya (District Offices) - remains, there has been some restructuring at the Head Office level. Nevertheless, further improvements are needed such as further refiningthe institutional structure and ensuring adequate staff, systems, and capacity and financing for service delivery. 5.24 The Head Office. The 2004 restructuring streamlined the municipality, consolidating the four Vice Mayor Positions into one. The single Vice Mayor now effectively acts as a CEO. There also appears to have been a logical effort to separate the administrative functions o f the municipality fi-om its service delivery functions through the creation o f two General Directorates, i.e. City Services and Technical Work and Construction. However, the separation o f the administrative from the service delivery functions i s not always clear. For example, the Technical and Construction Department i s under the "Technical Division" although it does undertake construction. The Property Department i s under the City Services Division, although it does not deliver traditional services. 5. 25 The creation of a City Services Directorate nevertheless represents a move to turn the municipality into a more service-oriented entity. This Directorate now has a sewerage section and a water supply section which are bothnew to the organizational structure. Staff are currently being recruited for both o f these sections, and the objectives and tasks o f these sections are being formulated. Unfortunately, however, the establishment of these two sections overlaps with the h c t i o n s and responsibilities o f the Central Authority for Water Supply and Sanitation and the newly formed Kabul Authority for Water Supply and Sanitation. These overlapping responsibilities require resolution. 5. 26 The Municipality has also formed a Policy and Coordination Department. This is a laudable attempt to manage the development o f the city more strate'gically. Currently, however, the mandate o f this department i s unclear. Pathak (2004) describes some of these: (i) land information system; (ii)land regularization and titling program; (iii)street names and numbering; and (iv) landdevelopment regulations. 112 5. 27 Kabul Municipality needs to also turn its attention to updating the functional descriptions o f divisions, departments, and sections. The existing operational and organizational manuals pertain to the previous organization o f the Municipality during the Taliban period. The updates that exist often lack consistency in the framework o f the overall organization. The organizational processes and procedures also are not formalized and documented. Finally, there are no job descriptions or specifications (see GauffEngineering, 2005). 5. 28 The DistrictsAVahiya. Structurally, the district'nahiya offices appear to be de-concentrated administrative units o f the Municipality. At the local level, each district has a president and vice president, below whom are five offices: Planning, Cost Control, Administration (under which sanitation falls), Direct Income, Markets, and Technical Services, which are branches o f the head office h c t i o n s (see Figure 5.2). 5. 29 Operationally, however, it appears that the district president has somewhat greater power than this would imply. While this can have a positive effect on infrastructure provision and service delivery - as emphasized by several international studies on decentralization - this i s not occurring in Kabul. Several aid agencies working in Kabul have reported that they are unable to undertake infrastructure works without explicit permission from the nahiya administrator/president. Furthermore, it also appears that, unfortunately, the Municipality (at Head Office or centrally) i s not aware o f what infrastructure i s currently under construction by donor agencies indifferent parts o f the city and where it i s located. This makes coordination and operations and maintenance extremely difficult. 5. 30 Below the district level, residential areas or neighborhoods are currently organized administratively by the municipal government in all cities into gozars (neighborhoods) with distinct physical boundaries, each with a wakil-e-gozar (neighborhood level representative). Typically, about 15- 20 gozars form a single district. There i s a strong relationship between the wakil i gozar and the district administrator. This level o f de-concentration can provide some impetus for responding to community needs, particularly in the provision o f local urban infrastructure. Such improvements have not occurred, however. REVENUEGENERATION INKABULMUNICIPALITY 5. 31 The key departments for revenue generation in Kabul Municipality are the Revenue Division (under the Policy Co-ordination Department), and the Property Department. Both o f these units face serious capacity constraints, compounded by the numerous small taxes and levies they attempt to collect, many o fthemwith very low revenue yields - actual and potential. 5. 32 Kabul Municipality has access to several sources o f revenues, which it collects in accordance with a reasonably clear system o f administration. There are several improvements required, however. First, municipal revenue sources need to be reviewed to ensure a consistent framework between municipal and national levels. Second, tax rates require review. Third, tax administration i s onerous, in particular due to collection o f a number o f taxes with low returns. Fourth, Kabul Municipality has no right to engage in enforcement actions against non-payment. Finally, the reporting classification system requires updating. 5. 33 Sourcesof Revenue. Sources o frevenue for Kabul Municipality include rental tax (one month o f rentper year), safiyi tax (a service charge and a property tax), market rental, business permits, a levy on imports, 1% tax on profits o f traders and business establishments, sale o f municipal property, fines, documents, the Kabul Zoo, income from cinemas and public bathrooms, and NGO Tax. Overall, roughly 25% o f revenues come from taxes, 25% from land sales, 25% from rents, and 13% from construction revenues. 113 5. 34 The sources o frevenue o fKabul Municipality requirereview: 0 Several taxes are not levied intheir most efficient form e.g. the safiyi tax acts as a proxy for a property tax and yet i s a cleaning tax. 0 The tax onprofits o ftraders -which appears to be a sales tax -normally is not an appropriate revenue source for local government. 0 The most serious concern, however, relates to the current rental tax. This has historically been a tax levied by Kabul Municipality. A similar tax has recently been added to the list o f national taxes by MoF; thus the same base i s taxed twice, once by the Municipality and again by the national government. International experience strongly suggests that real estate taxes are more appropriately kept as local government revenue sources, rather than accruing to the national government. 0 Currently, there i s no significant cost recovery inthe Municipality. 5. 35 Inreviewingmunicipaltaxes, the Government shouldkeepinmindwhat are the "best -practice" (i.e. most appropriate) municipal government taxes. These include fees and user charges, real estate property tax, betterment and improvement levies, vehicle and transportation taxes, and possibly a piggyback flat-rate personal income tax 5. 36 Revenue Collection. Kabul Municipality has undertaken a major drive to increase revenue collection, and revenues have more than tripled since 2002/03 (see Table 5.1). However, current collection i s far below potential. For example, the estimated potential revenue collection for the safiyi tax i s Afs 450 million, compared with Afs 22 million collected in 2004/05 and Afs 50 million budgeted for 2005106. Table 5.1: KabulMunicipal Revenues, 2002/03 to 2004/05 Sell of land, duties on animal markets, etc. 12,123,000 10.29 19,300,000 7.44 104,100,000 26.46 Construction Revenue - 50,000,000 19.26 50,000,000 12.71 Other revenues 57,476,800 56,129,789 TOTAL 117,799,920 100 259,551,789 100 393,430,000 100 5. 37 The Safiyi Tax i s paid by renters and owners in both formal and informal areas. The tax i s recorded in a book (the Safiyi) which also records the property and the name o f the head o fhouseholdand the payment amount which i s based on a property valuation. The safayi tax i s a sanitation tax that i s supposed to guarantee service delivery for those who pay. However, informal settlers also pay the tax in the hope that it will provide some form o f security o f tenure with the Municipality - although the document specifically states that it i s not a legal document o f land ownership. 114 5. 38 The tax i s based on a buildingvaluation, not a land valuation, and vacant land i s not taxed. The tax in residential areas is calculated at 0.3% o f the total building value, in commercial areas at 0.75% o f total value. The property valuation i s based on a formula which includes location, size o f land, and services. However, tax rate has not changed in the last five years (at least), and the building valuation was last undertaken in 1978. Furthermore, it has beennotedthat properties owned by the Government are not paying taxes. 5. 39 The payment of the Safiyi Tax i s relatively simple. The home ownedrenter visits the Central Bank and pays the Safiyi Tax into the Bank Account o f the Municipality, and receives a certified stamp/letter. This i s taken to the District Office, which then provides a stamp o f payment in the Safiyi Book. Tax collection does occur. The Municipality does not, however, have any means o f enforcement against non-payment of the Safiyi. Instead a list o f "offenders" i s sent to M o I which is responsible for law enforcement. It i s unclear whether any follow-up occurs on that side. 5. 40 The reporting and classification system currently used for municipal revenue also makes it extremely difficult to collect detailed income information. It i s difficult, for example, to disaggregate among items such as land sales, rents, and engineering fees. FINANCIALPLANNINGAND BUDGETINGINKABULMUNICIPALITY 5.41 Financial planning in the municipal government i s minimal. The former "Planning Department" -renamed"Policy andCoordinationDepartment" -supervises theBudgetSub-Department (inpractice totally independent and reporting directly to the Mayor) and the Investment Department. 5.42 The budget formulation process i s simple - each department submits its staff estimates (tashkeel) and its budget estimates to the Policy and Coordination Department in the eighth month o f the financial year (this budget estimate does not include new projects). The estimate i s usually based on last year's budget plus an increment. A form outlining increases from the year before does exist. A covering letter from the Head o f Department to the Head o f Finance and Planning explains the needs for the increase. The budget i s submitted to an administrative meeting o f the municipality, which endorses it before it i s sent on to the President's Office for approval. The President's Office submits the budget to M o F for coding and approvals about 10 days before the end o f the year. M o F then sends the budget back to the President's Office for final approval. The implication i s that the budget o f the municipality i s not part o f the unifiednational budget. 5.43 The approved budget has two components; cash (nakdi) and payroll. There are two budget lines under the cash component: the ordinary budget (for O&M and including any ordinary repairs and maintenance) and the development budget (for new constructions/projects as sanctioned by MoF). O&M includes general expenses, fuel, and vehicle costs. This i s prepared for the entire municipality - not by department. However, the Municipality also has a departmental breakdown based on what was submitted by the Department. 5. 44 There are several problems inthis process. 0 Departmental budget plans are usually based on last year's budget plus an increment. Consequently, the municipal budget risks being merely a compilation o f documents prepared by the different departments on the basis o f the previous year's budget, with little policy content or evaluation o fpast expenditures. 115 0 The budget i s never revised during the financial year. Revenues are usually overestimated, so money cannot be allocated on the basis o f the budget. 0 Expenditures are made on the basis o f cash available at the bank after the Mayor's approval. 0 The Mayor can stipulate expenditures that are not in the budget. In 2004105 the Mayor approved asphalting o f roads and beautifying the city for the President's inauguration, without reference to the budget. 5.45 New projects and new allocations are not included in the regular budgeting process o f Kabul Municipality. Instead, new projects are - intheory -formulated through a consultative process between the Municipality, the Ministry o f Urban Development and Housing, and the Ministry o f Economy. Once all three institutions are in agreement, this i s sent to M o F for approval and allocation o f resources. In practice, this has not occurred with the projects submitted by the Municipality. In2003 the Municipality submitted a list o f 421 neededprojects to M o F for approval. None o fthese projects were approved. 5.46 The planning process i s very much top-down, with limited assessment o f development needs and strategic planning. The only investment plan that exists i s several years old and consists o f a list o f 25 roads that need to be built on the basis o f the old Master Plan. That list has never been revised, and the financial evaluation i s simply based on a notional cost. The District Officers also have an evaluation o f District needs, based on weekly meetings between the Wukils, Shurus, and district officers, and sent to the Planning Department every year. However, engineering designs and consequent costings o f these needs do not exist. EXPENDITURES ACCOUNTING AND 5.47 The key departments in Kabul Municipality for financial management are the Administration Department, the Income Department, the Control Office, and the Accounting office. The Cash budget and the payroll budget are controlled by the Accounting Unit, which i s located at Kabul Municipality's main office. 5.48 Bookkeeping and accounting systems are in place but require strengthening. The Municipality's accounting system i s a budget execution control system based on a very simple form o f book-keeping. There i s no double-entry accounting. Each department has a budget line, and the accounting department deducts expenditures from each budget line, only to ensure that the department does not go over budget. When the budget does not have a line item for a certain type o f expenditure (like computer maintenance), the bill i s paid but not written inthe ledger. The system o f expenditure management i s paper-based. 5. 49 Salary expenditures are controlled by the Salary Unit, which receives attendance sheets from all departments and from the districts betweenthe 15* and 20* o f the month. The Salary Unit confirms these against the tashkeel. After the 20*, it prepares the payroll, which i s then submitted to the disbursement unit (under the Income Department). Based on approved payroll, a Payment request (M16) is prepared. The relevant department will then visit the Bank to get the checks issued. The checks are signed by the Head of Disbursement and the Head o f Income. Each department head (including each District Head) gets one check. A "Trustee" then cashes the check, accompanied by two others. These three then distribute the money to employees. Each employee's payroll has hisher name, grade, serial number, basic salary, special allowances (for technical staff), and food allowance. 5. 50 O&M expenditures undergo a similar process. Once the budget and its codes are approved by MoF, these are givento the Disbursement Unit. When a department head requires an expenditure, he/she prepares a list which i s submitted to the Mayor, Deputy Mayor, or a delegated person for approval. On 116 approval, the list i s sent to the purchasing department and i s then submitted to the Procurement Committee. 5. 51 The Procurement Committee receives three quotes for each purchase. In the case o f high-value purchases, advertisements are placed in the newspapers. The winning bid i s evaluated through a comparative analysis normally based on the lowest bidder. Once these are obtained, a Purchase Order (M3) i s prepared. The winning bid i s sent to the Purchase Department, and then to the Accounts Department. The Accounts Department reviews the items and checks with the original budget as to whether or not there i s an allocation for that item. An M 1 6 i s prepared and submittedto the Disbursement Unit. A check is .prepared for an authorized person. The Purchase Department keeps a record of expenditures. A system o fregistered vendors does exist. E.Managing,Planning,andDevelopingthe City 5. 52 Kabul faces several major development challenges. The city, with its population o f three million people, has grown at an exceptionally fast pace over the last 10 years, with a rate o f population growth o f around 17% p.a. over several years. About 80% o f the city now lives in unplanned settlements. Constructionininformal settlements represents a private investment in fixed capital o f around $1.3 billion (not including land value). There are reported to be only about 4,000 homeless families in the city (Bertaud, 2005). 5.53 Consequently, Kabul's major development problem i s not housing but rather the provision o f infrastructure and access to legally subdivided land. Kabul Municipality i s not responsible for the provision o f all types o f required infrastructure. However, it does have a role in planning and coordination o f development, and, more importantly, it controls large tracts o f land. Thus the Municipality controls access to land and its sub-division. 5. 54 Currently, development planning i s not an activity o f Kabul Municipality. The municipality does have a Master Plan which was first issued in 1964, updated in 1970, and finally adopted in 1978. Since the adoption o fthe 1978 Plan, the city has seen23 years o fwar, population growth from 700,000 to three million, and six changes in government. The Master Plan does not take into account the vastly different circumstances and key development issues that have arisen since 1978. The plan requires updating, including extensive consultation with communities. This will be possible through the existing Nuhiyu, Wakil e gozar, and other community development forums that have been establishedthroughout the city. 5. 55 An additional source o f confusion is that, according to a PresidentialDecree, it is the Ministryo f Urban Development and Housing which i s responsible for formulation o f the city plan, with the Municipality responsible for its implementation. This i s in contradiction to the current best-practice recommendation that urban planning i s best done at the local level. It i s the City Planning Department that i s responsible for implementation o f the Master Plan, and also for the design o fbuildings. 5. 56 Consequently, this department should be responsible for the formulation o f a development plan for the city. However, skills inthe City Planning Departmentrequire updating. For example: 0 The "Master Plan" that is referred to is the "map", not documentation that supports the reasoningbehind the map. 0 Re1ate.dto the outdated framework, planners in MUDH and the Municipality view planning as a "graphic design" and not as a strategy. For these planners, the "picture" i s the end 117 product, not the reality on the ground. Reading and drawing plans are not based on realistic analysis o furban development and service delivery issues. 0 This notion o f the "plan as design" i s entrenchedbecause most o f the planners inMUDHand Kabul Municipality are structural/civil engineers and not urban planners. The concept o f the plan needs to shift from "graphic design" to strategy. 5. 57 The City Planning Department will remain relevant if it can adapt to new circumstances and improve its functioning. More specifically, several relevant issues for Kabul's spatial development need to be addressed. These include: 0 Secure tenure. Many settlements fall outside the Master Plan o f Kabul or are not identified as residential according to the Master Plan. Most often, these areas house poor residents, internally displaced persons, and refugees who have returned. Residents inthese areas do not have formal security o f tenure. One o f the barriers to granting tenure in these areas i s that they lie inareas not legally recognized as residential by the Master Plan. 0 Provision of services. The lack o f recognition o f these informal settlement areas i s also a barrier to the provision o f services by the municipality. 0 Identification ofvacant land. The plan will also need to identify suitable vacant land for housing development. This i s crucial to accommodate further development for the substantial numbers of IDPs and returningrefugees. 0 Environmental sensitivities and waterproblems. Kabul i s growing at an extremely rapidrate. There i s a daily influx o f more people into the city. However, some o f the land in Kabul i s environmentally sensitive. Furthermore, water resources inthe city are scarce. Development in these areas will be detrimental to settlers and to the environment o f Kabul. The right to land should therefore be balanced against environmental issues. 0 ' Ad-hoc andpiecemeal development. Currently inKabul, there are several piecemeal and ad- hoc developments - many supported by donor agencies. A proper urban development plan will help identify where these initiatives are, what they are, and what other initiatives are required inwhich locations. 5. 58 Land and land development are an especially critical issue in Kabul. The Municipality has substantial power and resources with respect to land development. Its power stems from two sources. First, in accordance with the Municipal Law, one o f its functions is to acquire private property (at open market rates) and reallocate this to persons able to construct their own houses. Second, a significant amount o f real estate within the City (original Master Plan limits) i s owned by the Government and has been made available to the Municipality to plan and allocate. Estimates o f 1,000 ha are given, with several thousand additionalhectares o f State land outside the original KabulMaster Plan area. 5. 59 Kabul Municipality, at least untilMarch 2004 when Mayor Noorzad was appointed, continued to allocate plots o f land to individuals.' Although not technically illegal, the allocation o f these plots contains the seeds o f urban conflict. Municipal officials estimate that a minimum o f 26,000 plots have been paid for and allocated on land which the Municipality i s yet to purchase or develop (see Table 5.2); one official intimated that the true number could be double this figure. 'Historically, theprice ofthese plotshasbeendeliberatelykeptbelow the openmarket rate, to enablepoorerpersonsto acquire building landandto ensurethat construction falls within formally plannedareas (projects). Currently, aminimumof Afs 25,000 -35,000($500-$700)ispayabletoacquireaplotnumber(fora100sqmeterplot),andafeeof$1,050forprovisionofservices (roads, water, drainage, electricity etc). 118 Table 5.2: Exa Owned Land Source: World Bank.(2005). 5. 60 Often the land on which the plot numbers are indicated is already privately-owned land. Sometimes houses already exist on the land and are occupied by their owners. Since March 2004, the current Mayor has resolved about 5,000 o f what are estimated to be around 14,000 disputed plots. This was achieved through purchase o f other land and reallocation. 5. 61 The ways by which plots were formally acquired were heavily tainted with what current officials now say was outright corruption. Many plots were sold for which there was simply no real plot. Others were indicated on land already occupied and owned. In addition to the fees lost by applicants, bribes often had to be paid, doubling or tripling costs to them.' 5. 62 In the past, the Municipality has at times been party to unjustified cancellation o f buildingplot allocations. Legally, the failure to build upon a plot within one year can result in loss o f the plot allocation. Most cancellations occurred during the 1992-2001 period, but they also continued up until March 2004. Some cases o f alleged wrongful cancellation have been submitted to the Property Department since March 2004. 5. 63 Kabul Municipality also plays a role in controlling development through land ownership. A significant amount o f real estate within the City (original Master Plan limits) i s owned by the Government, and variously made available to the Municipality to plan and allocate. Estimates o f 1,000 ha are given, with several thousand additional hectares o f State land (or Government Land) falling outside the original Master Plan area. It is inthese areas that most unauthorized informal housing construction has occurred, including on steep hillsides. Most o f this construction has been entirely illegal, but the fact that this landis ownedby the state, andnot the private sector, provides an easy opportunity to deliver security o f tenure to the unplanned settlements. However, there i s not yet any commitment from the Government that this will occur. 5. 64 The vast ownership o f state land also creates an opportunity for the Municipality to put in place the frameworks to facilitate the development o f such land and consequently create income. But on the contrary, officially the Municipality has attempted to tightly control land. This has left scope for illegal *Note however that outside the official project-bound plot planning and allocation o f land which is not in the power of the Municipality to allocate are allegedly a host of other cases where plots have been acquired, and legal letters o f allocation and court entitlement issued, for plots which fall well beyond planned areas. Kabul residents cite a common practice until at least March 2004, in which an influential individual secured an allocation o f State land plots directly from the leadership, or simply through force (commanders). Such persons used their military power to construct houses and offices on such properties, and coerced or colluded with others to secure court documents demonstrating title. Municipal officials have by no means always colluded in these developments; on the contrary, some key officials have received violent beatings from commanders when attempting to challenge building activity on such sites. 119 construction o f houses - with collusion o f senior officials. In these instances, beneficiaries have not always been the urban poor. 5.65 The most common o f these illegal practices has been where a commander has appropriated a land area and proceeded to sell one beswa plots, at ever-inflating prices. Once the house i s constructed, owners frequently resell the house, and for significant sums. The Sai Sang Wakil-e-Gozar reports that the price doubles with each sale. A chain o f evidentiary documentation o f purchase i s set up, removing the original land developer from detection without determined pursuit o f the case. No trustworthy Wakil-e- Gozar will witness such transactions, although neighbors in similar situations readily do so. While disputes at the time o f transaction or post-transaction may arise in such cases (for example where a brother with a claim to a family home has not been party to the sale), these disputes do not enter the formal arena (courts or even the Wakil-e-Gozar). This i s because even the most recent buyer o f the house i s perfectly aware that his occupancy i s illegal given the status o f the land as belonging to Government. However, the fact that prices nonetheless soar suggests that there i s widespread confidence that occupancy will in due course be regularized. Should this not be the case, then literally thousands o f cases will result, inthis instance launchedby the Government seelng restitution o f its properties. The fact that by no means all house owners are poor, or without choice, gives rise to concern. There are significant numbers o f owners who build speculatively (for sale) and/or build to rent out, not to provide themselves and their families with desperately needed shelter. These are, however, numerically inthe minority. F.DeliveringServices inKabul 5.66 The newly formed City Services Department focuses on the actual delivery o f services (sanitation, greenery, parks, etc.) but also contains the Operations and Maintenance (O&M) Department which currently acts as the main construction implementation arm o f Kabul Municipality. The O&M Department consists o f the following units: (i) buildingconstruction; (ii) construction (construction road of roads and streets, bridges and culverts, repair and overlay o f roads); (iii)drainage systems (for construction o f drains along the sides o f roads); (iv) city transport (tahng care of the machinery and equipment o f the department); (v) water supply (newly established); (vi) sewerage (newly established); (vii) workshop and networks (repair o f Municipal equipment and vehicles, extension o f electrical networks inthe city); and (viii) healthclinic. 5. 67 According to the approved structure for the O&M Department, it has a total o f 1,078 staff/posts. Of these 226 are permanent staff positions (188 staff are present, out o f which 31 persons are technical and the remaining 157 administrative, financial, and other staff). There are also 852 posts for fixed-term staff, o f which 329 are employed. These include project staff like mechanics, drivers, masons, carpenters, bar benders, etc. Inaddition, the O&M Department hires an average o f 15 day laborers per day. 5.68 This Department has substantially changed under the new structure, taking on new functions. In addition to its traditional road construction role, water supply and sanitation and sewerage have been added to its mandate. The water supply and sewerage sections are still not fully operational, however. These operations will have to be closely coordinated with CAWSS. 5.69 The O&M Department has also apparently lost its independence. Until 2004, it was a State OwnedEnterprise (SOE), whereas it i s now a budget unit o f Kabul Municipality, based on a Presidential Decree. However, it i s still on the SOE list recently prepared by the MoF. It needs to be ascertained whether this change instatus has resulted inany deteriorationinthe functioning of the Department. 120 5. 70 Irrespective o f its formal organizational structure, the O&M Department reports directly to the Mayor o f Kabul. Currently, its main task i s to act as an implementation agency for the Municipality. Consequently, its main responsibilities include road construction; asphalt overlay and repair o f the existing roads; construction o f public and residential buildings inurban areas (such as mosques, cinemas, public halls, residential apartments, markets, etc.); and construction o f drainage systems, bridges and culverts, pathways, retaining walls, and maintaining the existingbuildingso f the Municipality. 5.71 The Department o f Sanitation (DoS) i s under the City Services Division. It is responsible for solid waste collection and disposal as well as some basic wastewater services such as cleaning roadside ditches and open drains, removing sludge from culverts, and evacuating septic tanks ofprivate houses and buildings. Ithas over 60 employees and about 1,300 workers, equivalent to about 4.5 employees/workers per 10,000 population. DoS owns a small fleet o f solid waste collection vehicles, in addition to some water trucks and earth moving equipment. With the exception o f 24 waste collection trucks recently donated by the Government o f India, most o f the fleet i s Russian, worn out, and obsolete. 5. 72 DoS collects 300 tons o f solid waste from the streets o f Kabul every day. This i s well below the average rate o f waste generation in Kabul (about 1,280 tons per day). Moreover, waste collection by Kabul Municipality i s ad-hoc. There i s no specific routing plan assigned to each o f the 40 vehicles and crew belonging to the Municipality. Furthermore, the existing collection vehicles are small in size (3-5 cubic meter capacity), and drivers currently conduct only two trips per day. In the most accessible and visible parts o f Kabul, waste i s collected once per week. In other parts o f the city, where streets are narrow and generally unpaved, the frequency o f collection drops to as low as once per month. 5. 73 Since the establishment o f the new dumping site at Gazak, the costs recorded for solid waste removal have increased to almost $20,500 per year (from $15,000), principally due to increased fuel consumption. This sum does not reflect total expenditures such as salaries, insurance, depreciation o f collection vehicles, etc. DOS's only billable service i s the provision o f septic tank cleaning services to clients. The total average tariff per trip to a client's premises i s around $12, whereas the tariff applied by private companies i s about $18-24. 5. 74 There are several different options for delivery of solid waste management services in Kabul, which require further study and subsequent decisions. These include: 0 Formation o f an independent municipal corporation, either separately from the water supply and sewerage function or merged with either the sewerage function or the water supply and sewerage function. 0 Outsourcing/privatization o f selected sanitation functions regardless o f which legal status is chosen. 0 Full privatization either as a Sanitation Company or as a Water Supply and Sanitation Company G. Summaryof Recommendations 5. 75 The unique history and current position o f Kabul Municipality, including its resources (land and potential financial resources), the presence of administrative systems (albeit with room for improvement), and an existing legal framework that accepts a measure o f independence, provide an opportunity for the Government o f Afghanistan to implement systems for the delivery o f services at the city level. However, in order to ensure success, a number of legal financial, administrative and service delivery changes are required. Recommendations for improvements are summarizedbelow: 121 5. 76 Improve the Legal Foundation. The existing municipal laws require review and subsequent revision. Two aspects are particular importance: 0 First,the anomalousposition o fKabulMunicipality interms of its reporting processes and its accountability requires serious consideration. The key problem that should be addressed at this point is not necessarily to force Kabul Municipality to report to another line Ministry. Indeed, as this chapter has shown, there i s precedent for capital cities to have a special status. What i s needed i s to introduce a measure o f fiscal responsibility for Kabul Municipality so that it i s at the very least accountable for its finances to MoF. This issue should be considered within a broader debate that addressesthe role o f municipalities inAfghanistan. 0 Second, the functions o f the municipalities as they currently stand require further review to address the key concerns raised in this chapter. To recapitulate, these include the confusion o f substantive and procedural functions; the presence o f functions which are no longer relevant; and the absence o f functions which are required for improved service delivery in Kabul. 5. 77 Further reorganizationof Kabul Municipality should then occur on the basis o f the functions that it is requiredto undertake. 5.78 Develop core capacity on a sustainable basis. For any municipality or government body, successful fulfilment of functions and delivery o f services must be based on adequate resources. These include financial resources (discussed later) and human resources i.e. capacity. Capacity development will require public administration reforms (initially through the PRR) as well as training and other efforts to buildup human capacity. Kabul Municipality i s fortunate inthat i s has independence inhiringits own staff, below a certain level. This system i s useful in that it allows the Municipality to determine its own staffing requirement based on need. However, the capacity constraints o f the municipality are enormous. Addressing these constraints would take a number o f years. 5. 79 Clarify taxes, update tax rates, and review and reform tax administration systems. Currently, Kabul Municipality appears to have a potentially strong fiscal base. However, clarifications and further actions are required on the following issues related to revenue generation and collection: 0 Most important, the national government should clarify the taxes that should be available to the municipalities as opposed to those available to the national government. These should be based on the lessons from internationalexperience. 0 Kabul Municipality should review and update its existing rates and valuations to ensure that they reflect current pricerealities. 0 The Municipality should review its tax administration and tax collection systems to ensure that it i s collecting the maximum out o f its existing base; this may require review of the current registry o fproperties and land ownership inKabul. 5. 80 Strengthen the existing manual accounting system, before moving to a more complicated computer-based system. Kabul Municipality has a logical paper-based system o f accounting. The systems do work, although they have a number o f loopholes. The recommendation for the short run i s to strengthen the existing manual system o f accounting, and to focus on the generation of a series o f reports on the state of the Municipality's finances to improve their transparency. The current capacity o f staff in the Municipality precludes immediate implementation o f a computer-based system. The latter could, 122 however be implemented in the medium term, after strengthening the existing manual system and development o f the capacity of municipal staff inaccounting.' 5. 81 Formulate a developmentplan for Kabul, linked to the developmentbudget. Improvements in the development budget process need to be linked to the development o f a plan for Kabul. Such a plan should identify key service deficiencies in the city and key growth areas. This should be followed by identification o f projects and their prioritization. The process o f deriving this plan should take into account new methodologies o f planning and its linksto the budget process. 5. 82 Addressing Land Development. There are several actions that should be undertaken in addressing land development inKabul, including: 0 Determination o f a process/procedures/criteriato legalize unplanned settlements. 0 Determination o f a process/procedures/criteria to deal with the 26,000 families on the land allocation list o f the municipality. 0 Develop a framework for alienation and development o f existing lands held by Kabul Municipality. This will alleviate land invasions, help control the rising process o f land, and help address burgeoningland conflicts. 5. 83 Improve service delivery. Kabul Municipality needs to turn its attention to the way in which i s it servicing the city,particularly in solid wastemanagement and operations and maintenance. While this will be a long-termeffort, it is critical to think through the specific services that shouldbe deliveredby or under the oversight o f Kabul Municipality, and what institutional and financial arrangements will be needed to maximize effectiveness. 5. 84 With respect to solid waste management, the Government needs to take an informed decision on institutional arrangements. There are currently several different options for solid waste management in Kabul, including: 0 Formation o f an independent municipal corporation, either separately from the water supply and sewerage function or merged with either the sewerage function or the water supply and sewerage function. 0 Outsourcing/privatization o f selected sanitation functions regardless o f which legal status i s chosen. 0 Full privatization either as a Sanitation Company or as a Water Supply and Sanitation Company. 5. 85 In addition to clarification o f functions and accountability relations, enhancing the ability o f Kabul Municipality to manage its finances, deliver services, and administer the City will be essential for successful service delivery. Currently, this i s seriously constrained by lack o f capacity, an institutional and administrative structure not responsive to current development needs, and a financial and taxation system that does not meet the development needs. 5. 86 Finally, Afghanistan would benefit from a sector-wide approach to municipalities which would review the existing laws, suggest policy changes, and then use incentives o f development grants to encourage municipalities to institutereforms for improved service deliver. The Kabul Urban Reconstruction Project will take this approach. 123 Figure 5.1: Organizationof Kabul Municipality, April 2005 I Secretariat Deputy Mayor 18D i s t r i c t s Figure 5.2: Organization of Gozars(Districts) 124 c1 0 0 c1 E, ; L i. c) j; I .I Q a .I a c j - 0 5: 0 .I c) Q 9P .I N Q 0.. m vi a2 L % n 2 s s L P I I I - 1 x ANNEX ANNEX5.1:RESPONSIBILITIES AND AUTHORITIES OFMUNICIPALITIESDISTRICT AND OFFICES (Chapter 4, Article 16, Municipal Law) 1. Taking measures for provision o f living facilities for the residence within their area. 2. Takmg measures on construction and maintaining o f wells, underground water ways (kurizes), ponds and drinkingwater reservoirs throughrelevant offices. 3. Taking measures for protection, development and preservation o f green areas, maintenance o f cleanliness and sanitation, and conservation o f environment within city and districts. 4. Takmg measures to construct streets, playgrounds, public toilets, public bath (Humam), markets and civil and cultural centers throughprivate investments inplanned areas. 5. Setting prices o f houses based on regulation. 6. Fixingthe rent o fthe municipalproperties based onregulation. 7. Taking measures to monitor cleanness o f public baths, restaurants, hotels, guesthouses, teahouses, swimming pools, saloons and other food stuff sellers in collaboration with relevant departments. 8. Taking measures to maintain collaboration with health institutions to prevent the outbreak o f diseases andprotection o f environment. 9. Taking measures for distribution o f land for construction o f houses and commercial areas based on relevant regulation. 10. Land acquisitionbased on land acquisition law. 11. Taking measures towards participation in construction o f residential areas, and maintenance o f roads, streets and residential areas. 12. Takmg measures for improvement o f city transportation through relevant departments. 13. Takmg measures to assist food stuff distribution and improve livelihood services. 14. Supervision and control o fprices and tools o f measurement, managing and universalizing the metric system intheir areas. 15. Takmg measure to promote sports and physical education based on Islamic tradition. 16. Seeking voluntary assistance o f people for taking part in sanitation, greenery and other useful urban services. 17. Takmg measures to assist preservation and maintenance o f historical and cultural monuments with the cooperation o f concerned departments. 18. Taking measures to assist incollection o f statistics and demographic data. 19. Collecting taxes for city services according to the law. 20. Taking measures for effective cooperation in the fight against illiteracy, improving the general education and culture level, vocational training, development o f social services networks, schools for general and vocational education and libraries in their areas throughrelevant departments based on Islamic criteria. 21. Approval o fbills according to this law. 22. Leadership o frelevant subordinate departments and sections. 23. Inviting and conveningmeeting on delivery o f city services. 24. Managing implementation o f annual budgetary revenue and expenditures plans and takmg measures for excess expenditure control. 25. Supervision and control o f implementation o f decisions o f the Administrative Council. 26. Making suggestions inregards to constructions o f traffic infrastructureinthe city. 27. Establishment o f slaughterhouses and better regulation o f butcheries from sanitary point o fview. 128 28. Distribution o f price list based on Islamic law. 29. Assessment of bids, agreements, obligations, contracts for lease o f municipality properties. 30. Construction, repairingand cleaning o fpublic drains and ditches inthe city. 31. Arrangement for receiving people and resolving their complaints in timely and just manner and taking supervision decisions within their authority. 32. Cooperation in eliminating primary and emergency socio-economic needs in the area in collaboration with relevant departments. 33. Demarcationo f graveyard sites. 34. Taking decision for burial o f unknown and heirless dead body free o f charge in collaboration with Red Cross. 35. Taking measures on demolition o f dilapidated buildings based on the report o f the technical committee. 36. Acceptance o f assistance, funds and donations on behalf o f municipality and its proper documentation. 37. Prevention o f constriction o f unauthorized buildings in collaboration with security forces inthe region. 38. Givingbusinesslicenses. 39. Issuingwork permits to workers o f foreign organizations. 40. Collection and registration o f reliable statements o f marriage, birth, death and change o f residence incollaboration with relevant offices departments. 41. Strict implementation o f the price list. 42. Assist inlaw enforcement, strengthening o f security, civil order and safety o f society. 43. Assist indefending the legal rights o fresidents inthe area. 44. Fullcooperation inconstruction o f society and strengthening o fIslamic rule. 129 REFERENCES Afghan American Chamber o f Commerce (AACC) and the Afghan International Chamber o f Commerce (AICC) (2005). 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