PRDP-TF: Quarterly Review April – June 2016 The Palestinian Authority’s Fiscal Performance 1. Despite strong revenues, a significant drop in donor aid in the first half of 2016 resulted in extremely tight financing conditions and resulted in further arrears accumulation. Expenditure growth was high in the first half of 2016, but it was offset by strong revenues resulting in a 32 percent year-on-year decline in the Palestinian Authority’s (PA) total deficit. At the same time, aid to the PA’s budget dropped by a third compared to its 2015 level, forcing the PA to accumulate additional arrears. 2. The PA’s revenues performed strongly in the first half of 2016 growing by 24 percent mainly due to frontloaded domestic tax receipts and one-off revenue transfers by the Government of Israel (GoI). Domestic taxes grew by 8 percent, compared to the first half of 2015, mainly due to frontloaded VAT payments as more large taxpayers opted to benefit from the early payment discount offered by the Ministry of Finance and Planning (MoFP). Growth in tax receipts was also driven by increased domestic customs collected on cars following a rate hike in early 2016. The PA has continued with its efforts to widen the tax base and about 5 thousand payers have so far been registered in 2016. Nonetheless, income tax collection declined in the first half of 2016 due to amendments to the income tax law altering tax brackets, introduced in the second quarter of 2015. One-off revenue transfers by the GoI following the Israeli-Palestinian ministerial level discussions have significantly contributed to the strong revenue performance in the first half of 2016. In fact, non-tax revenues grew by 36 percent, year-on-year, mainly driven by the transfer of US$15.6 million by the GoI on account of Allenby Bridge exit fees. Other one-off transfers by the GoI totaled US$115 million to cover some VAT receipts collected on imports to Gaza in addition to a refund on fees charged by the GoI to handle Palestinian imports. This boosted clearance revenues 1 by 20 percent in the first half of 2016, year-on-year. 3. Public expenditure growth was high in the first half of 2016, exceeding the prorated budget target by 5 percent. This was mainly due to a 4 percent year-on-year rise in the wage bill – despite a successful zero net hiring policy in 2016. 2 Also, the 2016 cost of living allowance has so far not been disbursed, but wage bill growth was driven by unbudgeted increases for teachers, vets and engineers. 3 Spending on goods and services grew by 8 percent due to an increase in the cost of referrals to local hospitals while the cost of referrals to Israeli hospitals has been declining. Expenditure growth was also driven by a 13 percent rise in transfers following an increase in social spending in Gaza. Net lending4 increased by 4 percent in the first half of 2016 as Palestinian utility distributers continue to accrue dues to the Israeli suppliers, particularly for water and sewage. 4. Strong revenues offset the increase in spending and pushed the total deficit down by 32 percent compared to the first half of 2015, but a significant drop in donor support led to a sharp decline 1 Clearance revenues are VAT, import duties and other income collected by the GoI on behalf of the PA and transferred to the latter on a monthly basis. 2 According to the PA’s employment numbers, the net increase in the number of PA employees amounted to 45 during the first six months of 2016. 734 employees were hired in the West Bank while 696 departed from the labor force in Gaza. The number of employees abroad increased by 7. Net employment in the health and education sectors increased by 144 and 20, respectively, while it was reduced by 107 in the security sector. 3 Engineers and vets received a 30 percent increase while teachers’ increase amounted to 5 percent. 4 Net lending represents deductions by the GoI from clearance revenues it collects on behalf of the PA for unpaid utility bills by Palestinian public utilities and local governments. 1 in resources available to finance the deficit, in turn causing an accumulation of further arrears by the PA. The PA’s total deficit amounted to US$480 million in the first half of 2016. Aid received was US$316 million: US$266 million in budget support and US$50 million in development financing. Aid received was 32 percent lower than in 2015, and 38 percent below budget. As a result, a financing gap of US$164 million ensued in the first half of 2016. The majority of the gap was financed by one off transfers and other small clearance revenue adjustments made by the GoI, all totaling US$138 million. The remainder of the gap was financed through domestic arears to the private sector and the pension fund, while debt to domestic banks remained unchanged at US$1.5 billion. 5. Fiscal pressures are expected to intensify throughout the rest of the year with a projected financing gap of about US$600 million. Revenue growth is projected to slow down in the second half of 2016 given that domestic taxes were frontloaded and additional clearance revenue transfers by the GoI to offset fiscal leakages are not certain. In parallel, expenditure growth is expected to remain strong throughout the remainder of the year driven by salary increases, the growing cost of medical referrals to local hospitals and net lending, particularly for water and sewage services. The PA’s total deficit is expected to reach US$1.3 billion in 2016 or about 10 percent of GDP. Given the recent trends in aid, full year donor support is not projected to exceed US$700 million, leading to a financing gap in excess of US$600 million. Given that the PA’s borrowing from domestic banks is fast approaching the limit set by the Palestine Monetary Authority (PMA), the PA may resort to domestic arrears to the pension fund and private suppliers to fill the gap. The stock of arrears to the pension fund is estimated at US$1.6 billion – and it threatens the viability of the overall pension system. Also, arrears to the private sector currently stand at about US$598 million, which heavily weighs on the private sector’s ability to operate normally and is damaging for the economy and tax collection efforts. Reform Progress 6. The PA has been prioritizing revenue reform but the impact has been limited. As mentioned above, the PA’s revenue reform efforts have so far focused on widening the tax base. However, most of the additional taxpayers are low earners and their contribution to the tax system has been very small. A more effective reform would cover large taxpayers and high earning professionals. Also, the PA should accelerate efforts to strengthen legislation to penalize nonpayers such as the proposed amendments to the income tax law that were supported by the Bank’s previous Development Policy Grant and that are still pending approval by the President. 7. The PA has succeeded in reducing the cost of medical referrals to Israeli hospitals, and additional efforts are needed to reform the overall referral system. Given that the highest unit cost for referral cases is charged by Israeli hospitals, recent efforts by the Ministry of Health (MoH) have focused on reducing the cost of referrals to Israel 5. Such efforts have already yielded good results with the annual cost of referrals to Israel declining by about 30 percent. However, the overall cost of referrals continues to increase due to increased spending on referrals to local facilities. It is therefore, recommended that the MoH extends measures applied to Israeli hospitals to cover local facilities as well. Furthermore, reducing the cost of referrals requires reforming the extremely generous Government Health Insurance (GHI) scheme as it remains the main source of the growing expenditures. In its current status, the Health Insurance System allows individuals to gain access to health services through paying a minimal yearly registration fee that grants them immediate access to the referral system. This creates a large imbalance between the system’s revenues compared to its expenditures. 5 Even though referrals to Israel represent 11 percent of the total number of referred cases, the associated cost is about 47 percent of the total referral cost. 2 8. Some measures have been implemented to reduce electricity net lending, but more needs to be done to cover water and sewage services as well. The Palestinian Energy Authority signed Memoranda of Understanding (MoU) with four electricity distribution companies and two municipalities wherein they commit themselves to paying 90 percent of what they collect from customers to electricity suppliers, while 10 percent is kept for operational costs. These efforts have helped set up some controls for electricity net lending. However, the first half of 2016 witnessed a strong increase in net lending for water and sewage services. Therefore, there is a need for a more comprehensive reform by the PA that covers all aspects of the net lending issue. Encouragingly, the PA and the GoI are close to reaching an agreement on the settlement of the electricity debt owed to the Israeli Electric Corporation which stands at about NIS1.9 billion, according to the GoI. 6 The Bank team has not seen details of the agreement and it is therefore not clear whether it fully addresses other outstanding issues between the parties in the electricity sector. 9. There has been good progress in some areas of Public Financial Management (PFM) but more needs to be done. Reporting of arrears has significantly improved since a line on repayment from previous years was added to the monthly reports published on the MoFP website. These reports now also include the total stock of arrears and the amount owed to private sector suppliers. A commitment system that ensures a budget allocation is secured for any expense prior to its contracting is now in place in seven ministries. Also, the audit of the 2011 financial statements was completed in May 2016. However, the audit identified a range of weaknesses in the accounting practices of the PA. While some of these weaknesses may have been addressed in the interim period, work is needed to ensure that all problems are resolved. The PA, therefore, needs to focus on strengthening accounting procedures and give immediate priority to clearing the backlog of outstanding financial statements for 2012-2015. 10. Efforts to finalize the procurement reform are progressing well. The new procurement law entered into effect as of July 1, 2016. It applies to all public procurement activity including local government units. The Higher Council for Public Procurement Policy (HCPPP) is not yet operational, but budget was allocated to it and staff recruitment is in progress. With the Bank's support, an introductory training program was delivered to staff of the various ministries and authorities. National Standard Bidding Documents were drafted and are nearing completion. The single procurement portal is also under development and will be launched in the coming months. 6 The PA disputes this amount and it states that about NIS1.3 billion of the debt is owed by the Jerusalem District Electricity Company (JDECO) which is 75 percent privately owned, and hence, the PA should not be accountable for it. 3