Working Paper 2 for Afghanistan Public Expenditure Review 2010 Second Generation of Public Expenditure Reforms Public Expenditure Trends and Fiscal Sustainability CrA DFID teoteotalv n Co-produced with the UK Department for International Development ÿþI Public Expenditure Trends and Fiscal Sustainability' Key Findings * The role of public expenditure significantly increased in the past several years as core national budget expenditures rose from 9 percent of GDP in 2002/03 to 20 percent in 2009/10. * The domestic revenue-to-GDP ratio increased to 9.4 percent in 2009/10. Afghanistan's ratio remains lower than other low income countries. Income tax revenues increased considerably, mainly due to the operationalization of Large Taxpayers Office (LTO), while those of customs duties stagnated. Transfers of administration fees from line ministries to the Treasury Single Account could potentially increase domestic revenues. The introduction of two percent BRT on imposts with the enactment of the amended income tax law and revenues from state fuel company contributed to the increase in 2009/10. * Key policy recommendations are, (i) smooth implementation of new tax measures; (ii) adequate resource allocation for the revenue and customs departments; (iii) operationalization of LTOs and Medium Taxpayers Offices (MTOs) in provinces; (iv) improvement of the domestic revenue policy formulation framework, and (v) introduction/operationalization of the Standard Integration of Government Tax Administration System (SIGTAS). * Afghanistan's expenditure structure is dominated by the external budget (off-budget) that accounts for about three quarters of total expenditures. Security consumes about 60 percent of the national expenditures followed by infrastructure in the past several years. The security and education sectors account for more than 80 percent of government employees and are the largest sources of core operating expenditures. The low execution rate of core development expenditures has negatively affected development. On average, the undisbursed core development budget amounts to 9 percent of GDP. In terms of equity of core expenditures, imbalances measured by per capita income were observed in both operating and development expenditures across provinces. Improving the quantity/quality of data on external budget expenditures should be a priority. * Low core budget deficits (after grants) have contributed to macroeconomic stability. However, the increase in the core budget deficit in 2008/09 is of great concern, and MoF will need to manage cash flow more carefully. * Progress towards fiscal sustainability (i.e. domestic revenues fully covering operating expenditures) has fallen far behind earlier expectations, though it improved in 2009/10. The indicator deteriorated from 66 percent in 2007/08 to 60 percent in 2008/09 due to the combination of lower revenues and higher operating expenditures, then it improved to 72 percent in 2010. Furthermore, prospects for achieving fiscal sustainability have further deteriorated. The March 2008 Medium Term Fiscal Framework (MTFF) projected fiscal sustainability would be achieved in 2012/13, but the July 2009 MTFF projects a fiscal sustainability rate at 73 percent in 2012/13. Significant upward revision of security expenditures (mainly due to Afghan National Army (ANA) and Afghan National Police (ANP) salary increases) is the main cause for the deterioration. Key risks affecting future fiscal sustainability are, (i) domestic revenues; (ii) further increase in security sector expenditures, and (iii) implementation of Pay and Grading (P&G) reforms. Accelerated implementation of P&G would raise P&G costs by more than 60 percent in both 2009/10 and 2010/11. It is critical that the Ministry of Finance (MoF) and the Independent Administrative Reform and Civil Service Commission (IARCSC) intensify coordination and actively manage fiscal liabilities stemming from P&G. This working paper was produced by Yoichiro Ishihara (World Bank, SASEP) for Afghanistan Public Expenditure Review based on information available as of March 31, 2010. 2 A. Structural Change and Size of Public Expenditure 1. The structure of the national budget has changed significantly in the past six years. Total government expenditures in nominal terms increased by more than seven times from Af 15.5 billion (US$0.3 billion) to Af 135.6 billion (US$2.6 billion) between 2002/03 and 2009/10. Concurrently, domestic revenues (excluding grants from donors) increased by almost 1,000 percent. The expansion of both domestic revenues and expenditures has been outpacing that of GDP. In terms of shares in GDP, domestic revenues increased from 3.3 percent to 9.4 percent, and total core budget expenditures increased from 8.6 percent to 20.2 percent (Table 1). Core budget expenditures consist of operating and development expenditures. In 2002/03, the first full year of post-Taliban Afghanistan, there were no development expenditures and even in 2003/04 core development expenditures accounted for 27 percent of total expenditures. The share of core development expenditures increased to 35 percent in 2009/1000, reflecting the county's reconstruction needs and improvements in spending capacity. Table 1 Structural Change in the National Budget (Af billion, Percent of GDP) 2002/03 2005/06 2009/10 1/ %GDP Af %GDP Af %GDP Af %GDP Recent Trend Domestic Revenues 5.9 3.3% 28.8 7.5% 63.3 9.4% Core Budget Expenditures 15.5 8.6% 54.2 16.8% 135.6 20.2% Operating Expenditures 15.5 8.6% 32.0 9.9% 88.0 13.1% Development Spendling 0.0 0.0% 22.2 6.9% 47.6 7.1% Operating Budget Balance I ! 3 -9.7 I -5.4% -11.3 I -3.5% -24.6 I -3.7% (excl. grants) Core Budget Balance -22.0 I 2.4 : 1.3% -2.9 : -0.9% -3.7% (incl. grants) (08/09) a External Budget 65 208.7 52.2 29.1% 209.7 65.1% (08/9) 35.0% 1/Very preliminary data Source: Ministry of Finance, World Bank 2. Public expenditure per capita is Table 2 Size of Public Expenditure 1/ equivalent to other low-income Pe countries. Due to the significant % GDP capita increase in public expenditures, public Afghanistan expenditure as a share of GDP in Core expenditures 21 75 Afghanistan is larger than low-income Core expenditures (exc. security) 14 51 and South Asia countries (Table 2). Public expenditures 2/ 36 133 However, the level of public Public expenditures (exc. Security) 29 106 expenditure remains a key issue as a Low-income countries 16 76 higher share in GDP reflects the low South Asian countries 15 105 GDP level, and security sector's share 1/Afghanistan data is in 2007/08; others are 2005 2/ Including both core and external budget expenditures of expenditures is large. Per capita Source: World Bank, WDI public expenditure (excluding 3 security) is equivalent to other South Asian countries, though higher than average low-income .2 countrieS Given the importance of public expenditure in achieving national objectives including the reconstruction of infrastructure and improvements in public service delivery, the level of public expenditure seems insufficient. Increasing fiscal space through domestic resource mobilization, absorbing available resources by increasing core development budget execution rates and improving the efficiency of public expenditure prioritization are equally essential. B. Domestic Revenues 3. Afghanistan's domestic revenue-to-GDP ratio remains among the lowest in the world , despite significant improvements earlier in this decade, and it would be even lower if the drug economy were included in GDP. The average domestic revenue-to-GDP ratio of low-income countries and South Asia was about 13 percent in 20064. Although the challenges Afghanistan face are different from those of other countries, domestic revenues equivalent to between 12 percent and 13 percent of GDP can be a medium-term target. Currently, domestic revenues have been sufficient to cover only 45 percent of total core expenditures. The operating budget deficits and core development expenditures are all covered by donors. Afghanistan's immediate target is therefore to cover the core expenditures with domestic revenues (See Section E on fiscal sustainability). 4. Revenue composition significantly changed. (Figure 1). The change in revenue composition demonstrates good progress on income tax reform, but improving the collection of customs duties remains a significant challenges. Between 2003/04 and 2008/09, total domestic revenues increased by more than 300 percent, though growth rates by major categories are uneven. While income tax increased by 22 times, customs duties only doubled. Income tax collection accelerated, especially in 2006/07 as LTOs became fully operational. By contrast, customs duties and non-tax revenue collection (including administration fees and sales of goods and services) shows room for improvement. Figure 1 Changes in Revenue Composition between 2003/04 and 2008/09 2003/04 2008/09 (Af.10.2 billion, US$203 million) (Af.41.6 billion, US$816 million) Others, 4.7 Income tax, ,11% Others, 0.1 0.7,7% Income tax, , 1% 15.6,38% Non-Tax Revenues, 8.0, 20% Non-Tax Revenues, Customs 3.8, 38% Duties, 5.6, Customs 54% Duties, 12.6,31% Source: Ministry of Finance, World Bank 2 Annex 5 (Education) also argues the international comparison of public expenditure. 3 Tax revenue-to-GDP ratio is low not only in other fragile states such as Cambodia (8.2 percent in 2006) and Democratic Republic of Congo (6.3 percent in 2002). 4 World Development Indicator 2008. 4 5. The establishment of the LTO in February 2004 and its operationalization in December 2005 has contributed to the growth of domestic revenues. The LTO is intended to improve tax collection in Kabul by providing timely and transparent tax services to large businessess that were handled by Kabul Mustofiats (provincial office of MoF) in the past. LTOs collected one- third of total national income tax in 2007/08 and further increased in 2008/096. In light of its success, MoF established MTOs in 2008 and opened LTOs to Herat (covering 13 large taxpayers), Jalalabad (19 large taxpayers) and Mazar-e-Sharif (14 large taxpayers). 6. Customs duties need to be increased in a sustained manner. The growth of customs Figure 2 Relationship between Customs duties is almost in line with that of dutiable Duties and Dutiable Imports Dutiable Imports Custom Duties imports (Figure 2), though the ratio of the 3,400 280 two deteriorated from 8.2 percent in 3,300 CustomDuties(RHS,US$million) ,. 260 2007/08 to 7.5 percent in 2008/09. There 3,200 240 were no major tariff changes except for 3,100 ' 220 tariffs on wheat, during this period, 3,000 / 200 suggesting weak enforcement and 2,900 - 180 2,800 - 160 insufficient resources (e.g. number of staff). 1Dutiablelmports(LHS,US$million) 2,700 140 Inadequate import evaluations also affect 2,600 120 revenues from customs duties. Starting in 2,500 - -100 March 2009, customs department staff 2004/5 2005/6 2006/7 2007/8 2008/9 began accessing FLGE (state fuel company) Source: World Bankstaffcalculation to check the volume/value of imported fuel to Hayraton in Balkh province. An adequate evaluation should result in additional customs duties. 7. Transfers from line ministries. Administration fees and sales of goods and services accounted for 20 percent of total revenues in 2008/09. Despite the Public Finance and Expenditure Management (PFEM) law7, not all administration fees collected by line ministries have been transferred to the Treasury Single Account. MoF has started to explore with line ministries such as with the Ministry of Interior (Mol), Ministry of Transportation (MoT) and Ministry of Agriculture, Irrigation and Livelihood (MAIL), the possibility of transferring more non-tax revenues. As few efforts have been made in this area, non-tax revenues have the potential to increase. 8. Income tax law was amended in March 2009. It is essential that the legal framework that allows revenue mobilization to broaden the tax base be strengthened. The government submitted the amendment to parliament in March 2007. The lengthy discussion process has prevented MoF from implementing its tax reforms. Together with a recent decision to increase resources available to MoF , the amendment is expected to achieve the following changes. s The selections of business under LTO are basically based on (i) capital (minimum US$1 million) and (ii) turnover (US$10 million). Regardless of the criteria, telecommunication, airlines, state owned enterprises (SOEs), foreign owned oil- and gas companies and banks are handled by LTO. 6 In 2008/09 and 2009/10 (very preliminary), the share of LTO in total tax collections was 36 percent and 27 percent, respectively. For example, Article 9 says fees imposed and collected by state administrations in accordance with the provisions of the law are public assets upon receipt, and Article 16 says "Receipts derived from fees, fines, compensation of damages and charges related to decisions and proceedings of courts shall not to be treated as special funds". SThe 2009/10 state budget agreed to increase Tashkeel (manpower ceiling) by 680. Most additional staff are allocated to the Revenue and Customs Departments. 5 * Impose a two percent Business Receipt Tax (BRT) on imports. * Simplify income tax for small businesses and eliminate most fixed taxes for specific activities. * Move the BRT towards a broad-based goods and services tax (and future Value Added Tax). * Remove a number of nuisance taxes (notably Sukook taxes) and simplify the tax structure in this area. * Introduce a new income tax bracket at two percent (Af 5,000-12,500 per month) to instill a tax culture among Afghans. The rate is low but will generate revenues. 9. Corruption and Taxation9. Vulnerabilities to Corruption Assessments (VCAs) of the Revenue Department of MoF'0 identified five key areas with the combination of high corruption risk and high potential revenue losses. These are: * Returns processing, review, and analysis by Mustofiats. * Internal audit of MoF. * Selection of taxpayers for audit investigation. * Corporate audit investigations. * Issuing Public/Private rulings, handling objections and appeals, and the litigation process. For each one of these areas the VCAs made recommendations relating to, (i) process, (ii) vulnerabilities and potential scale of revenue loss, and (iii) mitigation measures. The Revenue Department of MoF has incorporated mitigation measures into its strategy. Box 2.1 shows an example of "returns processing, review and analysis by Mustofiats". Box 1 Returns processing, review, and analysis by Mustofiats Process: Except for large taxpayers, Mustofiats retain responsibility for the assessment and collection of a wide range of taxes and sukooks (administrative levies), including Business Receipts Tax of Limited Liability Companies and Corporations, and Tax on Income of Importers/Exporters. Financial management and record keeping practices vary between Mustofiats. There is a high degree of discretionary authority during the process of reviewing returns, where taxpayers are required to present different forms of business and financial information. Vulnerabilities and Potential Scale of Revenue Loss: Returns processing, like all other tax assessment and collection process in the Mustofiats, is inherently prone to a high degree of corruption risk at petty and major administrative levels. Bribery occurs to both accelerate processing and to enable taxpayers to avoid their tax obligations. Survey evidence consistently confirms "speed money" is the norm at all levels of the Mustofiats, as is a "bribery tariff" to remove or reduce tax liabilities based on payment of 5-10 percent of the assessed liability. Mitigation Measures: The reform of the seven priority provinces supported by 982 appointments under the Priority Reform and Restructuring (PRR) program is significant for corruption prevention. Interim mitigation measures, that also serve to send positive anti-corruption signals to the Mustofiats include, (i) increasing the level of internal audits; (ii) risk-based MoF audit of selected taxpayers; (iii) staff rotation policy and practices, and (iv) introduction of taxpayer report cards, secure post boxes and telephone hotlines supported by a complaints investigation procedure and disciplinary framework under Article 111 of the Income Tax Law. Action Implemented: While the process of reforming Mustofiats has benefited from building capacity in accounting and legal knowledge, fundamental aspects of the reform process, like the establishment of Provincial Revenue Offices directly responsible to the Director General of Revenue, have been held up due to political factors. The capacity development of LTO/MTOs and roll-out of the Standard Integration of Government Tax Administration System (SIGTAS) in five priority provinces - Herat, Balkh, Nangarhar, Kunduz and Kandahar - represent key components of Phase II of the Revenue Reform Project, however the strengthening of Mustofiats' capacity and integrity remains a challenge and imperative. 9VCA on the Custom Department is being conducted by the World Bank. 10 World Bank (2009) "Fighting Corruption in Afghanistan: Summaries of Vulnerabilities to Corruption Assessments" provides more details including process 6 10. Policy formulation process based on analyses should be established. A steering committee was created to oversee tax reform and customs modernization. Policy decisions in these areas must be based on sound analysis because of the affect they will have on domestic revenues and other macroeconomic variables. The reduction of soft drink tariffs from 40 percent to 20 percent in 2007 is an example of a key policy decision made in the absence of concrete .11 analysis". C. Expenditures 11. Data limitation. Analysis of expenditures in Afghanistan is severely constrained by the lack of timely, reliable and comprehensive data. A consistent classification of expenditure data covering both the core budget and external budget is currently not available. All of the external budget expenditures are loosely labeled as "development spending". There are also major reporting problems that create serious data gaps. In particular, external budget data are not reported in a timely manner, creating serious problems for data comparability. While these deficiencies detract from drawing robust conclusions on public expenditure trends, it is still possible to draw some broad conclusions on expenditure composition and trends, key drivers of change and their implications for public resource management. National Budget 12. Afghanistan's expenditure structure is dominated by the external budget (donor-executed, off-budget), as opposed to the core budget (on-budget). Between 2002/03 and 2008/09, total national expenditures amounted to US$35.1 billion. The core budget reached US$8.8 billion (25 percent), while external budget accounted for US$26.3 billion (75 percent). Nevertheless, the share of the security sector in external budget expenditures during the period was 65 percent. 13. Sectoral composition has also changed significantly. The increase in the size of public expenditures was accompanied by an equally notable change in sectoral composition. The security sector's share of total national expenditures (sum of the core and external budgets) increased from 34 percent in 2003/04 to 47 percent in 2008/09 (Figure 3 A and B). By contrast, shares in the education, infrastructure and social protection sectors fell by three, four and eight percent, respectively. In terms of core expenditures, part of the 14 percentage point decline in the security budget was allocated to agriculture and rural development (5 percentage points) and infrastructure (5 percentage points) (Figure 3 C and D). The increase in the agriculture and rural development budget is mainly due to the creation of the National Solidarity Program (NSP). Turning to external budget expenditures (Figure 3 E and F), security's share rose from 34 percent to 57 percentl2 Yoichiro Ishihara (2007) "Note on Recent Tariff Changes" discussed more on this issue. 12 External budget security expenditures fluctuate significantly (Statistical Appendix 8). Also, quality of data is of concern. 7 Figure 3 Changes in Expenditure Composition between 2003/04 and 2008/09 (% of total of each category) A. National Expenditure (2003/04) B. National Expenditure (2008/09) Social Private sector Others Social Private sector Others protection 5%1% Agrcuture& Potection 0% Agriculture& Rural Dev Health 5% 4% Health dcto 4%du!o Good Good governance governance 9% 9% C. Core Budget Expenditure (2003/04) D. Core Budget Expenditure (2008/09) Social Private Social Private Agriculture protectionprotecti & Rural p c r Dev Agriculture 7%& Rural Health Dev Healthh 4%% Goodd geaernance Good Go governance 5% E. External Budget Expenditures (2003/04) F. External Budget Expenditures (2008/09) social Private sector Others Agriculture & Social Privatesector Others protection 5% 1% Rural Dev Protection 3% 1% 12% 7% Health 4 S4% AgricultureA Rural De& Education HHealth 4%5 1%Rualev3% 1 4q V od Good governance governance 9% 10% Source: World Bank Core Budget Expenditures Figure 4 Core Expenditures 14. Increasing share in GDP. Total core (% of GDP) expenditures increased from Af 15.5 billion 25% Development Expenditures (US$0.3 billion) in 2002/03 to Af 135.6 20% Operating Expenditures billion (US$2.6 billion) in 2009/10. As .17 expenditures grew significantly faster than 15% - A 10.0 0 GDP, their share of GDP increased from 8.6 10% 70 percent to 20.2 percent. Development expenditures have accounted for the largest 1.10 1.4, *. 1.20 .e increase during a period (Figure 4), while operational expenditures remained constant. 2002/3 203/4 2o4r5 20516 2999/7 2087(8 2908/9 20991 Pr.limnary Source: Ministry of Finonce, World Bonk 8 15. Expenditure composition by economic Figure 5: Expenditures by Economic classification (Figure 5)13 . The share of Classification (% of total expenditures) capital expenditure in total core 2004/5: Inner circle; 2008/9: outer circle expenditures has steadily increased, from 15 percent in 2004/05 to 27 percent in e 2008/09. Concurrently, the share of goods and services has been reduced by 16 pit 15% percentage points. The increase in capital investment reflects the country's need for reconstruction. However, under the current expenditure structure, there is no clear link between capital investment (including both core- and external budgets) and future operating and maintenance costs under Source: Ministry of Finance, World Bonk goods and services expenditures. Operating Expenditures Figure 6 Government employees by sectors (2009/10 budget) 16. Wages and salaries are the biggest 1 0,808- - ,Security operating expenditures. Between 2003/04 1 -1,5 and 2008/09, wages and salaries accounted 14,000- 8,012 governance for 66 percent of operating expenditures E Infrastructure followed by operations and maintenance E Education (24 percent), capital (5 percent) and others IIHealth (4 percent)'4. Over 500,000 people work for 2 Agriculture & the government (including ANA and ANP). ESocial The education (228,000) and security protection (228,000) sectors account for more than 80 14,804 41,262 de percent of total government employees Source: Ministry of Finance, World Bank (Figure 6). Wage and salary issues in Figure 7 Average Annual Wage across Sectors these two sectors are especially (Af thousands, data for 2009/10 draft budget) I/ important and discussed further in Annex 4 (Security) and Annex 5 2.1 Good governance and the rule ef law 104 (Education). Aerage 12 200/5 Pinesetr crclope; 2089utrcrl 17. Average wage and salary levels of Bank government staff vary across sectors. 3.Agricultureand rural velrnment ec Annual average wages and salaries in3.Helhg th 0 9/ 0 b d et ae A 1 22 5 3.1 Infrastructure and natural resources 79 the 2009/1 budget9ar0Afb102,22 (about US$2,040), though they differ 3.5u I Social protectiun h 3.2 Educative, Cutre, Media and Spvrts V 63 across sectors (Figure 7). Security sector salaries reach Af 145,282, more than a so 80 gov 2e0 those in the education 1/OCalculated total wage and salaries divided by total sctie A m ) a Tashkeel Source: Ministry of Finance, World Bank 13 Expenditures can be roughly divided into three items: (i) wages and salaries (Code 21); (ii) goods and services (Code 22); and (iii) capital investments (Code 25). In theory, operating expenditures include (i) and (ii), while development expenditures include (iii). However, this is not really the case. For example, in 2008/09, the sum of wage and salaries, and goods and services accounted for a third of total development expenditures. In other words, only two-thirds of development expenditures were capital expenditures. On the other hand, operating expenditures in 2007/08 included about 3 percent of capital expenditures. Expenditures by economic classification can better inform the composition of expenditures. 14 Others include, for example, fuel subsidy. 9 salaries in the security sector are partly due to the US$20 per month salary increase for ANA and ANP introduced in the second half of 2008/09. Differences in average salaries in non- uniformed sectors are related to differences in the composition of the civil service and ministries, resulting in service delivery personnel like those in the Ministry of Education (MoE) receiving lower average salaries. 18. Pay and Grading reforms. A new Civil Servants Law in July 2008 includes provisions for a new P&G structure that 400 Cumulative Number of Civil Servants 354 has eight grades and monthly salaries 350 ranging of US$100 to US$650. This . 300 replaces the previous personnel grades 250 with position-based grades that reflect - 200 Teachers(incl.new& the civil servants responsibilities. Plans 1 contract teachers) Non Teaching Civil call for all non-uniformed civil servants 88 to shift to the new grade structure 5 within four years (Figure 8). 31 47 Implementation has been slower than 2009/10 2010111 2011112 2012J13 expected, but momentum is growing. As of November 2009, 62,000 posts were Source: Ministry of Finance, World Bank created, 23,000 civil servants were appointed and 19,000 civil servants received salaries based on P&G reforms. MoF has allocated US$32.8 million to P&G implementation which will cover the roughly 80,000 civil servants (including teachers) who will migrate to the new structure during 2009/10. It is critical that MoF and IARCSC actively manage these pressures to ensure implementation stays within the parameters set in the MTFF, and is adjusted should the overall fiscal framework change. 19. Security is by far the largest source of Figure 9 Operating Expenditures by Sectors in operating expenditures (Figure 9). In 2008/09 2008/09, the security sector accounted for Agriculture& Soil Pvaescr 46 percent of total expenditures. Mol and deveop~n %rtdo dv~, 350 the Ministry of Defense (MoD), which are 229 responsible for the ANP and ANA N i respectively, account for nearly 90 percent Ed~o Security governanceervctor of those costs. The education sector 22% accounts for about 20 percent of operating expenditures, followed by the good (including parliament,e MoJ etc). As wages and salaries account 11% for between 60 percent and 70 percent of Source: Ministry of Finance, World Bank total operating expenditures, the number of government employees is a key determinant (Figure 6). Core Budget Development Expenditures 20. Classification issue. Economic classification shows that core development expenditures include large amounts of spending on operations and maintenance. Between 2004/05 and 2008/09, 43 percent of total actual development expenditures were for operations and maintenance, and 56 percent were for capital expenditures. This is not due to classification problems but rather because of the large amount of recurrent spending in the external 10 assistance that supports core development expenditures, particularly in the health sectoris Currently, external assistance accounts for more than 90 percent of the core development budget, which is largely formulated on a project basis. As such, economic composition is heavily weighted by external assistance to the core development budget. Nevertheless, the share of capital expenditures in core development expenditures has increased from 26 percent in 2004/05 to 65 percent in 2008/09. 21. Low execution rates are key constraints to Figure 10 Core Development Expenditures development. Persistent low execution (absolute values ($ million) and disbursement rates of core development expenditures rates 1/) hinder the achievement of development 10 Eco 54% 60% objectives. These low rates generally 1,400 50% reflect, (i) low absorption capacity of 1,0 4 967 40% implementing agencies; (ii) weak budget 1000 Absoutevaues(HS 891 914 formulation process by both MoF and 30% implementing agencies, and (iii) poor 600 project formulation capacity of donors. The execution rates, defined as the ratio 10% between actual disbursements and the mid- year budget, improved from 41 percent in 2005/6 2006/7 2007/8 2008/9 2009/10 2005/06 to 54 percent in 2006/07-2007/08. In 2008/09 and 2009/10, execution rates 1/reated o id-Ye W deteriorated to 43 percent and 40 percent, respectively (Figure 10). The fall in execution rates in 2008/09 can be attributed to confusion about program budgeting that had led to almost no disbursement in the first month, and the lack of resources for bridge financing by MoF. Although donors are partly responsible for low execution rates, questions must also be raised about the absorption capacity of line ministries that prevents donor assistance from shifting from the external budget to the core development budget. 22. Estimates of the impact of low core 16 Table 3 Impacts of Low Core Development development budget execution In Expenditures Afghanistan, almost 100 percent of the core Yea r Gap % Nominal development budget is externally financed (US$ million) GDP so the gap between budgeted and actual 2005/06 596 9.3 core development expenditures can be 2006/07 609 7.9 considered a proxy for GDP loss. On 2007/08 833 8.7 average, between 2005/06 and 2008/09 an 2008/09 1,174 9.7 amount equivalent to nine percent of GDP 2009/10 1,368 10.6 (nominal) was not executed (Table 3). Source: MoF, World Bank calculation 1For example, the MoPH's Basic Package of Health Service (BPHS), which is a part of core development budget programs, includes sizable operations and maintenance components. 16 Overestimates of the core development budget are part of the reason for low execution rates. This estimate to some extent overstates the impacts. Also, this paragraph does not take multiplier effect into account. e I 23. xectio rats b 10largst ine Table 4 Core Development Expenditures in 2008/09 by 23. Execution rates by 10 largest line Mnsre ministries in 2008/09 (Table 4). Actual ris The 10 largest line ministries (ual mi)re C b accounted for more than 90 MRRD 216 41% 27% percent of total core development Public Works 115 32% 21% expenditures. MRRD accounted for Education 60 38% 8% 27 percent of the overall low Energy and execution rate, followed by the Water 178 63% 8% Ministry of Public Works (MoPW) Finance 69 64% 3% Agriculture 21 38% 3% (21 percent), MoE (eight percent) Urban and the Ministry of Energy and Development Water (MoEW) (eight percent). Of and Housing 19 36% 3% particular note, MRRD's execution Transportation 22 43% 3% rates fell significantly from 66 Communication 45 81% 1% percent to 41 percent between Public Health 63 112% -1% 2007/08 and 2008/09. Total 807 76% 1/ Calculated based on the gap between budgeted and actual disbursements in each ministry relative to total gap Eq Uty17Source: MoF, World Bank calculation 24. Core budget expenditures by provinces. Equity of expenditures across provinces (horizontal fiscal balance) is achieved if financial resources are provided in a manner that balances resource-availability with needs in the provinces. In other words, equity is achieved when fiscal resources are distributed 'fairly' across provinces. In both core operating and development budgets, imbalances measured by per capita expenditures were observed in 2006/07. 25. Operating expenditure allocation across provinces. On average, per capita operating expenditures (wages, operations and maintenance) are Af 1,000 (US$20). However, the gap between the best-off and worst-off provinces is about 10 times. Kabul Figure 11 Operating Expenditure Distributions across receives the least (Af 200), while Provinces in 2006/07 (Af per capita) Nuristan province receives the 2000 1,903 most (Af 1,900) (Figure 11). An 308 analysis by sector and by category 1600 shows significant differences 13200 between sectors measured by 1,000 coefficient of variation (Table 5). in 800 total, payroll (0.38) has less 700 variation compared to operations he 20 and maintenance (0.64). The r e t variations, while public works has high variations in operations and Source: World Bank maintenance. 17 Adapted from World Bank (2008) "Intergovernmental Fiscal Relations and Subnational Expenditures in Afghanistan". The distribution across provinces is based on 'expenditure metric' in order to capture actual expenditures. 12 26. Development expenditure Table 5 Per Capita Operating Budget Expenditure Variation allocation across provinces. It among Sectors is not unusual for the variations (Coefficient of variation) in allocations of core Payroll Operation & Total development expenditure Maintenance Operating across provinces to be less equal Education 0.42 0.61 0.40 ta coe oeaig Public Health 1.28 1.23 1.02 than core operating expenditures in a specific year Agriculture 0.72 0.59 0.65 because capital expenditure Interior 0.67 0.67 0.64 prjcstn ob oe Public Works 0.77 2.24 1.99 projects tend to be more discrete in nature and more 2.0 2.24 2.10 geographically concentrated. Urban Anaayi n20/7sos Energy & Water 0.93 0.82 0.72 An analysis in 2006/07 shows Total 0.38 0.64 0.41 this to be the case. The gap Source: World Bank (2008) between the best-off province Figure 12 Development Expenditure Distributions (Ba nyam, Af 1,100) and the worst- across Provinces in 2006/07 (Af per capita) 1/ off province (Dikondy, Af 1.0) is 1400 1,000 times (Figure 12). Among 1200 sectors, the highest variation 1000 measured by coefficient of variation) is observed in the urban development sectors followed byO the education sector (Table 6). 400 200- Due to a technical reason, Kabul is not included Source: World Bank Table 6 Variation of Per Capita Development Expenditures for Selected Ministries in 2006/07 Education Health Agriculture Urban other 1/ Total Rural Dev. Development Average 13.6 17.2 51.6 1.2 212.8 296.5 Standard Deviation 29.3 26.8 81.0 3.5 323.8 334.2 Coefficient of Variation 2.1 1.6 1.6 3.0 1.5 1.1 Minimum 0.0 0.0 0.0 0.0 0.0 1.2 Maximum 133.6 90.0 411.9 17.7 1,083.6 1,144.0 1/including provincial development spending by the Ministries of Interior, Public Works, and Energy and Water. Source: World Bank (2008) External Budget Expenditures 27. Potential alignment problem with national objectives. The external budget is donor assistance that does not go through the government's treasury account. Even though most donors consult with the government on projects, the government has difficulty aligning the external budget to achieve national objectives because: i Information is not properly shared with the government. " Projects are formulated based on donors' interests rather than national objectives. " Operation and maintenance costs are not well reflected in the core budget (especially in the case of investment projects). 13 28. Progress on data collection. Although information sharing needs to be further improved, 2008 saw significant progress in the collection of data related to the external budget. The Aid Management Unit (AMU) of MoF initiated the Donor Financial Review (DFR) in mid-2008 to improve the quality/quantity of donor assistance data with particular attention paid to the external budget. There are several areas for further improvement. Although by far the largest sector, by its nature information sharing on the security sector is extremely difficult. Key donors (USA, World Bank, EU and IMF) and ministries (MoF, MoD and Mol) have created an informal technical working group to improve security sector information sharing. 29. While there has been a contraction in the Figure 13 Security vs. Non-Security External security sector's external expenditures, the Budget non-security external budget has been (in millions US$) constant over the past five years. The annual external budget ranged from US$1.6 9,000 Non-Security billion to US$9.2 billion between 2003/04 and 8,000 2008/09 (Figure 13). While non-security 7,000 6,000Seuiy - external expenditures have been stable since 5000 2003/04, security expenditures significantly 4,000 fluctuated. Security sector external budget 3,000 expenditure fluctuations were mainly due to ,0 - investments in ANP/ANA equipment and infrastructure. 1 2003/4 2004/5 2005/6 2006/7 2007/8 2008/9 30. External budget expenditure execution rates Source: Ministry of Finance, World Bank were higher than core development expenditures. Execution rates of Table 7 Disbursement Rates Comparison between external budget expenditures were External and Core development budget in 2005/06- higher in all eight sectors (Table 7). 2008/09 Higher execution rates for external Core Dev External budget expenditures may be Budget Budget attributed to the following factors. Security 47 100 " ihrcmoet foeaig Good Governance 27 38 * igercopoens f peatng Infrastructure 50 104 expenditure items. The external Education 35 56 budget includes both investment Health 64 61 and operating items (e.g. salaries, Agriculture & Rural 56 73 operations and maintenance) so Social Protection 54 81 a direct comparison between theS external and core development Total488 budgets may not be relevant. Source: Ministry of Finance, World Bank " Availability of budget data. Availability of the budget data may have been limited and consequently it affects the denominator of the rate. " Less absorption capacity issues compared with the core development budget. As the external budget does not go through implementing agencies, it does not necessarily face the problems of absorption capacity within the implementing agencies. 14 D. Core Budget Balance and Financing Figure 14 Core Budget Balance I/ 31. Low core budget deficits and the (% of GDP) 2% Operating Budget Balance (After Grants) central bank's no-overdraft rule have 1.3% 1.2% 1.3% contributed to macroeconomic ;!% stability. '8 Core operating budget 0% -0.2% 0 deficits remained below 4 percent of 1% GDP between 2005/06 and 2007/08, but deteriorated to 4.6 percent in 2008/09 (Figure 14). Operating budget deficits are financed by foreign 1 Core Budget Balance .5% -3.6% (After Grants) 37 grants such as the Afghanistan Ori Bgaa % Reconstruction Trust Fund (ARTF) and - 54% 54% (BeforeGrants) the Law and Order Trust Fund 2002/3 2003/4 2004/5 2005/6 2006/7 2007/8 2008/9 Afghanistan (LOTFA) 19. Operating 1/Grants amounts in 2008/09 are not yet available budget surpluses are used as Source: Ministry of Finance, World Bank discretionary funding to fund core development expenditures. The Figure 15 Core Budget Financing deterioration of the core budget balance in 2002/03-2007/08 (% of GDP) in 2008/09 can be attributed to the Loans and Domestic combination of lower domestic revenues other. to core Rvne development2. and higher operating expenditures. A badget32 further deterioration would negatively13 affect macroeconomic stability.deloen 32. Make grant financing a short-term Grants to priority, and aim for fiscal sustainability budget 1.3149.% 13 in the medium term. Core budget 27% G6 rants to deficits are funded by external finances budget -3% -2.7 such as (i) grants to operating budget; (ii) 2 -4. grants to development budget, and (iii) Source: Ministry of Finance, World Bank loans to core development budget. Between 2002/03 and 2007/08, total financing (including domestic revenues) Figure 16 Discretionary Cash Balance in 2008/09 was US$7.1 billion (Figure 15). Grants (months of operating expenditures) accounted for more than 50 percent of 30 total financing. As grants do not require future repayments, securing grants 2.5 would contribute to fiscal sustainability 2.0 in the future. 33. The importance of cash flow management should be emphasized. ii) The management of discretionary cash 0.5 balances in the central bank's treasury 0.0 account is important for two reasons: 1 2 3 4 6 7 8 9 to 11 12 the MoF needs to have a certain Source: Ministry of Finance, World Bank minimum level of discretionary cash for 18 Forbids borrowing from the central bank to finance budget deficits. LOTFA is explained in greater detail in Annex 4. 15 essential payments (e.g. salaries Table 8 Government Cash Position and wages), and the discretionary (US$ million) cash balance can be used to Item 07/08 08/09 09/10 implement donor-financed core Actual Actual Budget development budget projects2. In 1. Operating Budget 2008/09, discretionary cash Opening Balance 123 148 150 balance measured by months of Financing 1,140 1,506 1,611 operating expenditures sometimesRevenues 673 832 972 fell below one month (Figure 16). ank copperamine B 81 5 Poor budgeting, unexpected Use 1,015 1,425 1,807 expenditures and weak revenue Operating Expenditures 1,015 1,425 1,807 performance were to blame, but Operating Budget Balance 125 80 -196 given the extent of grant financing Transfers to Dev. Budget 100 79 n/a for the operating budget, the level Surplus/Deficit aftertransfer 25 1 -196 of discretionary cash balance Discretionary fund balance 148 150 -46 seems to be very low. Projections (stock) for the state budget suggest the Transfeome. Budget situation may worsen in 2009/10 Source Mom Orld Bonket estimates (Table 8). Careful managementas s (ensuring timely trust fund flows; better expenditure projections etc) is required. E. Fiscal Sustainability and the MTFF 34. The definition of "fiscal sustainability" in the context of Afghanistan. Against the standard definition of fiscal sustainability (the ratio of total public debt and debt servicing to macroeconomic aggregates such as GDP is not increasing over time), in Afghanistan a simpler and more practical fiscal sustainability indicator refers to "where and at what point in time the country will be able to cover its recurrent expenditures from domestic revenues". This is because Afghanistan is still nowhere near a "steady state" in terms of fiscal aggregate, and 21 financing costs are negligible since the bulk of the fiscal deficits are grant-financed 35. Progress towards fiscal sustainability has fallen far behind earlier Figure 17 Fiscal Sustainability Indicator expectations. The indicator of fiscal (the ratio between domestic revenues and sustainability improved significantly 100% operating expenditures, percent) 9 from 38 percent in 2002/03 to 67 percent in 2006/07 and remained at 66 0% Projectionas of Oct 2005 85, percent in 2007/08. However, progress 80%- to date is very much behind the 70% schedule set out in the IMF's Poverty 60%-67 6% 60 Reduction and Growth Facility (PRGF) 50% 46% and the original MVTFF. In October 2005 40%-38 when the MTFF was produced, the 3%Preliminary government planned to achieve fiscal DActual Actual 20% sustainability by 2009/10. However, 200213 200384 200485 200546 20067 200718 2008/9 2009/10 actual rate was 72 percent in 2009/10 Source: Ministry of Finance, World Bank (Figure 17). The comparison between the 2005 MTFF and actual shows that while domestic revenues fell behind target by four This is called "bridge-financing". Projects committed by donors can be commenced with bridge-financing even before funds become available from donors. 21 World Bank (2005, pp.17-18) "Afghanistan: Managing Public Finances for Development Volume 1: Main Report). 16 percent in 2008/09, operating Table 9 Fiscal Sustainability Comparison in 2008/09 expenditures were 39 percent (Af billions) higher (Table 9). Domestic revenues 05-Oct Gap almost reached the original target in MTFF Actual (%) absolute terms despite the Domestic Revenues 43.3 41.6 -4% stagnation of the revenue-to-GDP Operating exp. 50.6 70.2 39% ratio over the past several years. Fiscal sustainability Indicator 85% 59% -26% Source: MoF, World Bonk 36. Prospects for achieving fiscal sustainability have further deteriorated. The July 2009 MTFF has further downgraded the prospects for fiscal sustainability compared to the March 2008 MTFF (Table 10). The March 2008 MTFF projected that the ratio would exceed 100 percent in 2012/13, while the July 2009 MTFF projects that the ratio will be 69 percent, little changed from the 2007/08 actual. Table 10 Fiscal Sustainability Indicator Comparison between Mar 2008 MTFF and Feb 2009 MTFF 2007/8 2008/9 2009/10 2010/11 -2011/12 -2012/13 2013/14 T(Actual) (Proj) (Proj) (Proj) (Proj) (Proj) (Proj) Mar 2008 66% 68% 70% 79% 90% 101% - July 2009 s a66% 60% 5% 59% 66% 73% 83% -Gap - 1 -8% -16% -20% -24% -27% - Source: Ministry of Finance, MoF The difference in projections suggests that the deterioration of fiscal sustainability indicators is attributed to both domestic revenues and Table 11 Factors behind Fiscal Sustainability Indicator Change in operating expenditures 2012/13 (Af billions, percent) (Table 11). Domestic March Ju ly 2009 Difference revenue projections 2008 MTFF MTFF % Value were lowered by 9.2 Domestic Revenues 96.3 87.4 -9.2 -8.9 percent, while Operating Expenditures 94.3 119.6 26.8 25.3 operating expenditure o/w Security 38.9 44.2 13.6 5.3 projection increased by MoD 19.2 13.4 -30.2 -5.8 26.8 percent. Among Ml 14.0 25.1 79.3 11.1 operating expenditures, o/w Non-Security 55.4 7.4 36.1 20.0 security sector P&G 9.8 30.0 206.1 20.2 operating expenditures Fuel subsidy 0.0 0.5 - 0.5 were increased by 13.6 Fiscal Sustainability 101% 73% percent. The size of Indicator A N A is p ro je c te d to ris e o / wc e c 3 8 .9 4 4 .2 1 .5 3 from 86,000 in 2008/09 to 134,000 in 2010/11. The size of ANA was assumed at the lower figure in the March 2008 MTFF. By contrast, the projected increases in Mol's budget are mainly due to goods and 22 services as the size of ANP is projected to stay at 82,000 in the medium-term Future size of ANA and ANP is being discussed. Please see more discussion in Annex 4. 17 37. Both the security and non-security Figure 18 Fiscal Sustainability Indicators sectors negatively affect prospects (Overall vs. non-security expenditures) for fiscal sustainability. Both the size of the security sector operating 160% 152% expenditures and the decision- '126% 10 11%14% 114% making process (please see Annex 4 1 105% on the Security Sector) inhibit fiscal sustainability. MoF has little 80% 03% 60% 66- % authority over security sector 5% 66% operating expenditures. In light of 4 Total this, non-security sector fiscal sustainability indicators are 0%, compared with the overall 0. #. .v . e sustainability indicator (Figure 18) Source: Ministry of Finance. World Bank based on the July 2009 MaiTFF. The comparison shows that domestic revenues will not be enough to cover non-security expenditures between 2008/09 and 2011/12. According to the projections, coverage should reach nearly 100 percent by 2011/12 and increase further in subsequent years. This underlines the fact that in addition to the shortfall in revenue mobilization, the security sector is a primary factor in preventing further progress toward fiscal sustainability. This in turn implies that predictable medium-term external financing for Afghanistan's security sector will be essential and requires pro-active consultations between the government and donors. 38. Risks to fiscal sustainability. While prospects for fiscal sustainability have already deteriorated, other risks present themselves: * Low domestic revenues. The July 2009 MTFF assumes that domestic revenue-to-GDP ratio will improve by between 0.4 percent and 0.6 percent annually after 2010/11. This level of improvement requires significant progress in tax administration. Also, if GDP growth rates turn out to be lower than the assumed 7.5 percent per annum, it will lead to lower domestic revenues. Box 2 Sensitivity Analysis of P&G Reforms The February 2009 MTFF projects that additional operating expenditures from P&G will be about US$820 million (including new recruitments and promotions) between 2009/10 and 2013/14, or roughly seven percent of total projected operating expenditures. These cost estimates are sensitive to underlying assumptions such as grade escalation and acceleration of rollout. The top half of the table below examines the impact of higher-grade distribution (10 percent of staff has one grade up). The analysis shows that grade escalation has only marginal impacts on P&G costs. Additional P&G costs would be 2.3-2.6 percent. By contrast, accelerated P&G implementation will have much bigger impacts. The bottom half of the table shows that additional cost will be 65 percent in 2009/10, 63 percent in 2010/11, and 29 percent in 2011/12 if 20,000 (half teachers/half non-teachers) more civil servants are in P&G in 2009/10 and 2010/11 each and 10,000 in 20211/12. Table Sensitivity Analysis (% increase from the estimates of the Feb 2009 MTFF) Assumption 2009/10 I2010/11 2011/12 I2012/13 Grade escalation: 10% of staff have one grade up 2.6 2.6 2.5 2.3 Accelerated P&G implementation 1/ 64.5 63.1 28.6 0.0 1/2009/10- 20,000 (o1w 10,000 teachers); 2010/111- 20,000 (o1w 10,000 teachers) and 2011/12- 10,000; Source: Sebastian Eckardt (March 2009) Policy Note "Assessing Wage Bill Pressure in Afghanistan" 18 * Higher operating expenditures from security sector: While ANA's ceiling increased to 134,000, ANP's ceiling remains at 82,000 . If the security situation continues to deteriorate, future strengthening of ANA/ANP will lead to additional operating 24 expenditures * P&G. P&G expenditures are the largest non-security-related contributors to the fading prospects of fiscal sustainability (Table 13), so affordable P&G reforms are critical. The MTFF cost estimates of P&G reforms are sensitive to underlying assumptions (Box 2). It is critical for MoF and IARCSC to intensify coordination for P&G implementation. 39. Medium-term fiscal scenarios (Figure 19). Three illustrative medium-term fiscal scenarios based on a spreadsheet model show how macroeconomic and fiscal risks affect fiscal sustainability. * The security operating budget is adjusted from the July 2009 MTFF based on the size of ANA and ANP2 , and this is used as the base case. It assumes that real GDP growth rates and inflation rates are 7-9 percent and 1-4 percent per annum respectively in each of the next five years. Domestic revenues as a share of GDP are projected to increase at a rate of roughly 0.5 percent annually from 9.4 percent in 2009/10 (very preliminary) to 11.9 percent in 2014/15. Due to the implementation of P&G reforms and additional pressure on the security sector expenditures, core operating expenditures as a share of GDP are projected to increase from 13.1 percent in 2009/10 to 17.6 percent in 2012/13 before leveling off to 16.3 percent in 2014/15 due to the security sector. In the base case scenario, the fiscal sustainability indicator will gradually increase from 60 percent in 2011/12 to 73 percent in 2014/15. External financing need of the operating budget is US$6 billion over five years. * In the high case scenario, additional domestic revenue collections and higher real GDP growth produce a fiscal sustainability indicator of 85 percent towards the end of the projection horizon (2014/15). Domestic revenues reach 13.4 percent in 2014/15, the average of the low-income country average. A more favorable macroeconomic environment (annual GDP growth rate of 10-12 percent over five years) will also help domestic revenue generation. Although the pace of domestic revenue increase (0.8 percent of GDP per year) is slower than actual between 2002 and 2006 (1.1 percent of GDP a year), achieving the target requires not only the additional revenue collection efforts stated in Section B of this Annex, but also favorable overall macroeconomic environments including improvement in the security situation. In this high case scenario, foreign financing will amount to US$5 billion over five years. * In the low case scenario, domestic revenues as a share of GDP are almost unchanged over five years. Additional pressures on operating budget expenditures include additional security expenditures (ANA and ANP size reaches 500,000 in 2013/14 instead of 400,000 on the base case). Operating budget expenditures as a share of GDP will reach 21 percent in 2013/14, and the fiscal sustainability indicator will stay around 40 percent throughout the projection period. This scenario requires US$10 billion in external financing for the operating budget over five years. 23 ANP size was increased to 97,000 in late 2009. 24 Annex 5 on the Security Sector includes fiscal sustainability analysis. 25 Size of ANA and ANP reaches 400,000 in 2013/14. 19 Figure 19 Three Illustrative Medium-Term Fiscal Scenarios A. Base Case US$ billion Fiscal Sustainability %GDP 8/9 9/10 10/11 11/12 12/13 13/14 14/15 14% Actual Pre. Act <------------ Projections--------------> Domestic Revenues (RHS) 12% Domestic Revenues 0.8 1.2 1.5 1.8 2.2 2.6 3.0 170% Operating Expenditures 1.4 1.7 2.5 3.0 3.5 3.9 4.1 150% 10% of security 0.6 0.8 1.2 1.6 1.9 2.3 2.4 130% - of which non-security 0.8 0.9 1.4 1.5 1.6 1.6 1.7 110% Fiscaluwainablity(Non-Security)(LHS) Operating Budget Balance -0.5 -0.5 -1.0 -1.2 -1.3 -1.4 -1.1 90% Memo: Real GDP Growth 3.4% 9.0% 7.0% 8.1% 8.8% 9.2% 7.0% 90% Fiscal Sustainability (Total) (LHS) 4% Size of ANA and ANP 148,000 174,980 224,500 294,000 340,000 400,000 400,000 70% 50% Pre. 2% Act Act <---------- Projection -----------> 30% 0% 2008/9 9/10 10/11 11/12 12/13 13/14 14/15 B. High Case US$ billion Fiscal Sustainability %GDP 8/9 9/10 10/11 11/12 12/13 13/14 14/15 190% 16% Actual Pre. Act Projections------- 170% Domestic Revenues (RHS) 14% Domestic Revenues 0.8 1.2 1.6 2.0 2.4 2.9 3.4 150% 12% Operating Expenditures 1.4 1.7 2.6 3.1 3.8 4.5 4.7 130% 10% of security 0.6 0.8 1.3 1.6 2.2 2.9 3.0 11%t % o hc o-euiy0.8 0.9 1.4 1.5 1.6 1.6 1.7 110% Fiscal Sustainability (Non-Security) (LHS) 8%ofwihn-scrt 90 isa Ssanairiy(NnScuiy)(HS % Operating Budget Balance -0.5 -0.5 -1.0 -1.1 -1.4 -1.6 -1.2 9%Fiscal Sustainability (Total) (LHS) 6% Memo: Real GDP Growth 3.4% 9.0% 10.0% 11.1% 11.8% 12.2% 10.0% 70% 4%Size of ANA and ANP 148,000 174,980 224,500 294,000 340,000 400,000 400,000 50% 2% 30% 0% 2008/9 9/10 10/11 11/12 12/13 13/14 14/15 C. Low Case US$ billion Fiscal Sustainability % GDP 8/9 9/10 10/11 11/12 12/13 13/14 14/15 190% 14% Actual Pre. Act <------ Projections --------- 170% - - 12% Domestic Revenues 0.8 1.2 1.2 1.4 1.5 1.7 2.0 150% - Domestic Revenues (RHS) 10% Operating Expenditures 1.4 1.7 2.6 3.1 3.8 4.5 4.7 of security 0.6 0.8 1.3 1.6 2.2 2.9 3.0 110% of which non-security 0.8 0.9 1.4 1.5 1.6 1.6 1.7 110% 6% Operating Budget Balance -0.5 90% - Fi altamnability(Non-Security)(LHS) 4% Memo: Real GDP Growth 3.4% 9.0% 5.0% 5.0% 5.0% 5.0% 5.0% 70% 2% Size of ANA and ANP 148,000 174,980 250,000 300,000 400,000 500,000 500,000 30% 0% 2008/9 9/10 10/11 11/12 12/13 13/14 14/15 Source: World Bank staff projection 20 F. Policy Recommendations Domestic Revenues * Smooth implementation of the income tax law amendment. New tax policies such as the BRT tax on imports have raised domestic revenues. Implementation measures, including the preparation and publication of a revised income tax law manual should be accelerated. * Ensure adequate resourcing of the revenue and customs departments. In the 2009/10 budget, MoF was allocated an additional 700 Tashkeel, mainly for the revenue and customs department. Hiring capable staff and providing training is important. * Improve the domestic revenue formulation process. Domestic revenue policy (including tax, customs duties and line ministry revenues) affects not only revenue performance itself but also macroeconomic management. Responsibility for domestic revenue policy formulation remains opaque so a clear/transparent policy formulation process should be created. * Introduction and operationalization of SIGTAS. SIGTAS is expected to efficiently follow-up on non-compliant taxpayers and to better manage information (e.g. performance of revenues), leading to increased domestic revenues. SIGTAS should be operationalized at the earliest opportunity. * Further follow-up anti-corruption measures in the revenue department. The revenue department should continue to actively following-up on the successfully integrated key VCA policy measures. Expenditures * Wages and salaries in the security and education sectors. These two sectors account for more than 80 percent of government employees and roughly 70 percent of total operating expenditures. The transparency and accountability of sectoral wages and salaries should be improved (discussed further in Annex Four on Security and Annex Five on Education). * The execution rates of core development expenditures should be increased. As low disbursement rates negatively affect growth and development, MoF should create concrete measures to improve the rates (discussed in Annex Three on Expenditure Framework). Particular attention should be paid to ministries like MRRD and MoPW that contributed heavily to the current low execution rate. * Equity. Operating and development expenditure inequities were observed across provinces. On-going pilot provincial budgeting (Annex Three) should be used to formulate policy and allocate resources to address these inequities. * Core budget balance and financing. Cash must be managed with greater care to address the deteriorating core budget balance and lower discretionary cash balance. Measures include the timely receipt of grants financing from donors by satisfying eligibilities criteria, and better expenditure forecasting. * Active management of the P&G process for fiscal sustainability. I addition to its impacts on public administration reform, the quality of P&G implementation will affect fiscal sustainability indicators. MoF and IARCSC should actively manage the implementation of P&G reforms. 21