Laos: Evaluation of the Impact of Budget Norms on Budget Equalization Needs (2009)

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Laos: Evaluation of the Impact of Budget Norms on Budget Equalization Needs (2009)

  1. 1. Public Finance Management Strengthening ProgrammeEVALUATION OF THE MACRO-FISCAL IMPACT OF BUDGET NORMS AND EQUALIZATION NEEDS ON THE GENERAL BUDGET March 2009 Jean-Marc Lepain Public Finance Specialist Intergovermental Fiscal Advisor 1
  2. 2. EVALUATION OF MACRO-FISCAL IMPACT OF BUDGET NORMS AND EQUALIZATION NEEDS ON THE GENERAL BUDGETEXECUTIVE SOMMARYThe introduction of a budget norm system integrated with the intergovernmental fund transfersystem is an important component of the public finance reform launched through the Public FinanceManagement Strengthening programme. The introduction of budget norms over a period of time ofthree years, with six year transition period, will have an important impact on the budget structureand will bring more fiscal equality between provinces.The present survey is based on the development of a macro-fiscal model that analysis disparities inthe allocation of funds between provinces and measure the fiscal gap likely to appear as a result ofthe introduction of budget norms. Data generated by the model strongly support commendationmade in the “Budget Norm Policy Framework” which in the final phase of its development wasdrafted in parallel with this report.Disparities in funds allocation per capita are extremely high in Lao PDR and can easily reach 300% insome sectors. As shown by the analysis, these disparities are not linked to any objective criteria suchas population structure, human poverty index, life expectancy, etc. Excessive pro-poor policies havein some cases aggravated the imbalance when low population density provinces are compared withhigh density provinces because these policies have not been applied uniformly across the country.One vital question that we have tried to answer is the affordability of budget norms, considering theequalization effect that they are likely to generate. The survey concludes that based on FY 2007/08the fiscal gap required for equalization will be equal to 4.78% of that year budget. As the introductionof budget norm will be progressive, the cost of closing the fiscal gap resulting from equalization willbe less than 1% of the budget per year. The conclusion is that the country will have no difficulty inabsorbing the equalization cost resulting from budget norms.However the task remains complex and will require careful monitoring. Based on the Work Planpresented in November 2008, designing budget norm formula for each sector and testing them on aMedium Term Expenditure Framework and Macro-fiscal Model is a task requiring around 290 days ofwork. The implementation phase will be complex as well and will require dedicated human resourcesin the Fiscal Policy Department as well as in the Budget Department. For that reason we recommendan implementation in three phases: year one for Education and Health; year two for Agriculture,CTPC and general administration (line-ministries not delivering direct services to the population) andyear three for provincial administration. The implementation of budget norms, as already envisaged 2
  3. 3. in the World Bank’s Aide Memoire of September 2007 should go hand in hand with a reform ofbudget formulation at the provincial level and a better linkage between planning and budgeting.An important finding of the survey is that provincial administration is the sector that will require themost important fiscal effort with a total cost representing 38% of the fiscal envelope required forbudget norm implementation. The reason is that level of spending for local administration in theprovinces does not seem to be directly linked to population, service delivery or poverty. Introducingbudget norms in that sector will require a complete review of budget allocation by province to thedistrict and municipal level.The main constrain on the implementation of budget norms is not the lack of fiscal resources at thecentral level but the absorption capacities of the provinces. Equalization needs representing 30% of asectoral provincial budget are frequent but some provinces should see a doubling of their budget.This raises two problems. The first problem is that some provinces have low sectoral budget notbecause of a lack of resource but because of poor management. The new system should avoidcompensating provinces which have diverted resources from education and health to other sectors.The second problem is that the capacity of absorption must be created before the budget isincreased. For example, for justifying an increase of the recurrent budget of education and health,schools and clinics must be built and teachers and doctors trained and recruited. Then only thebudget for goods and services can be increased. Obviously this will require careful planning. Ourrecommendation is that each of the three phases of the budget norm implementation plan must gothrough a four years transition period. During that period increase in sectoral budget allocation willbe conditional and based on a local implementation plan approved by all relevant authorities at theprovincial and central level.Tables which are appended to that reports gives all the details on the overall equalization cost, theequalization model chosen, and the most likely scenario for a three phases implementation of fouryears each, resulting in a total implementation plan of six years. Although than implementationperiod might seem long, we expect that most of the benefits will appear during the third year and bythat time 80% of equalization needs will have been covered, as the cost of equalization is likely to bereduced by inflation from one year to the other.Last but not least, we would like to stress the fact that accounting data entered in GFIS do not reflectthe reality of provincial expenditures, making the introduction of budget norms very difficult. Thisdue to several factors: (a) some investments recorded centrally are in fact local investments andshould be recognized are part of provincial budgets; (b) a lot of small investments recorded at thelocal level are in fact maintenance expenditures, (c) according to data from MPI, most of theprovinces have built important arrears which do not appear as such in accounting but are disguisedas ongoing projects. MPI is trying to keep the payment of arrears under 35% of the investmentbudget, but it can reach 70% in some cases. (d) Governors might make fund transfers from onesector to another sector which are not recorded in accounting. These facts highlight the need for thereform budget formulation procedures to go hand in hand with a reform of budget executionprocedure and stricter implementation of accounting rules. 3
  4. 4. 4
  5. 5. 1. IntroductionThe introduction of a budget norm system integrated with the intergovernmental fund transfersystem is an important component of the public finance reform launched through the Public FinanceManagement Strengthening programme. The introduction of budget norms over a period of time ofthree years, with six year transition period, will have an important impact on the budget structureand will bring more fiscal equality between provinces.The success of this reform will depend on seven factors: (1) The implementation of a new fiscal strategy required for absorbing the impact of budget norms over a period of time of six years (2) The successful integration of the budget norm system with the Intergovernmental Fund Transfer System based on a number of grants; (3) The successful integration of budget norms in new the multi-year planning and budgeting process under development with the Assistance of ADB; (4) The completion of the treasury centralization reform and the implementation of the Single Treasury Account that will ensure that provincial budget are correctly implemented and that no fund move from one sector to another or from one project to another; (5) The deepening of other reforms such as the introduction of programme budgeting and a better integration of the investment budget and the recurrent budget, (6) The modernization of the budget formulation process at the Ministry of Finance, and (7) A complete reformulation of the planning and budgeting process at the provincial level with sufficient capacity building. This reformulation process should clarify various levels of responsibilities between the central government and the provinces for planning and budgeting as well asOverall, the introduction of budget norm should lead to a number of very positive outcomes:  A better equalization of expenditures between provinces and better predictability of provincial budget;  A better balance between centralization and decentralization in budget formulation;  A better linkage between provincial budgeting and the National Growth and Poverty Reduction Strategy objectives;  A strengthening of macro-fiscal planning and a better integration between planning and budgeting at the national level  A better alignment of provincial budgets with national objectives and increase efficiency in provincial spending  Improved service delivery at the provincial and district level 5
  6. 6. I. METHODOLOGY AND GENERAL OUTCOME OF THE SURVEY 1. Objectives of this reportAs indicated in the Work Plan prepared in November 2008, the calculation of the budget norm fiscalenvelop is the first step toward the design of the budget norm and intergovernmental transfersystem. The sizing of the fiscal envelop requires two things: (a) An evaluation of the budget gap when current budget is compared to a prospective budget calculated with an equalization formula reproducing the likely impact of the introduction of budget norms. (b) A fiscal strategy that will determine the ways and means of absorbing the equalization cost, presumably by assigning part of the future revenue increase to various fiscal envelopes. This report is primarily concerned with the first point: the evaluation of the budget gap and the costof equalization induced by the introduction of budget norms. The fiscal strategy required forabsorbing that cost will only be broached in the last section of that report with the objective toidentify the different options in terms of definition of the different fiscal envelops in competition,and of the time frame required for absorbing the cost.As a consequence of the methodological requirements, the objectives of the present survey havebeen identified as follows:  to ensure that the introduction of a budget norm system with its equalization function is affordable;  to make a first assessment of the fiscal enveloped required for the system implementation along with the outline of a fiscal implementation strategy;  to define more precisely the sectors to which the budget norm system will apply;  to define fiscal target zones, or pre-norms, that will help defining budget norms by sector; for example minimum spending per capita for sectoral recurrent budget, arithmetic relation between the minimum investment budget and the recurrent budget, non-wage expenditures as a percentage of salary, maintenance cost as percentage of investment. In the tables that have been appended to this report, these fiscal target zone for budget norms appear as “equalization norm”. However, it should be noted that those equalization norms will not become part of the budget norm system. They only indicate a level of spending with which budget norm must be compatible.  to determine the outline of a fiscal strategy for absorbing the cost of budget norm and for determining a comprehensive approach of the evaluation of budget needs as part of an interim strategy until the new Medium Term Fiscal Framework linked Medium Term Expenditure Framework under development is put in place.  to prepare the way for sectoral expenditure need assessment by defining each sector equalization needs and making a first assessment of the balance required between recurring expenditures and investment. 6
  7. 7. 2. Outline of the Budget Policy FrameworkThe draft of the Budget Norm Policy Framework is now completed and awaiting approval by MoF’smanagement. Although the possibility exist that the document might be amended changes areunlikely to affect to general principles on which the document is based.  The policy framework envisaged is a two tiers system with two types of budget norms: -Budget norms defining the size of the intergovernmental transfer to the provinces; -Sector budget norms to allocate funds between economic categories at the local level.  Budget norms for intergovernmental transfers will be based on equalization principles  Salaries will remain unaffected by sector budget norms at the local level but will be nevertheless included in the formula for intergovernmental transfer.  What will be available for non-wage spending will be calculated after deduction of salaries  Provinces with expenditure above the equalization norms will 3. New definition of sectorsA few changes have been made in the definition of sectors compared to what was presented in theNovember 27th version of the Budget Norms’ Policy Framework and have been consolidated in thefinal version of the document.  Education, Health and Agriculture remain as the core sectors of the budget norm system  Transport and Telecommunication has been added to the list of core sector because (a) the ministry is responsible for district roads, (b) investment for the lay-off of landlines and other telecommunication infrastructures will play a role in the country development strategy.  A sector called “General Administration” has been created to cover at the provincial level the ministries of Industry & Commerce, Information & Culture, Justice, Finance, and Planning  Provincial Administration has been added as an independent sector  Energy and Mining so far remains outside of the scope of the budget norm system  Labour has not been integrated in “General Administration” due the importance of social transfers for that ministry. The expenditure need assessment for General Administration will determine if the Ministry of Labour should be integrated in that sector or not. 7
  8. 8.  “Other organizations” thar covers the Ministry of Foreign Affairs, Police, Defence, etc., remain out of the scope of the budget norm system.The question of access to clean water will be probably treated under provincial administration withthe possibility of having specific budget norms for sanitation. 4. MethodologyIn the absence of figure for FY2008-09 budget, we have used figures of FY2007-08 budget for themacro-fiscal model. The assumption is that the budget structure is relatively stable and the costexpressed in relative terms (percentage) should not be very different, as horizontal imbalance insector spending across provinces is structural.The survey covers only funds administrated by the provinces. Cost of the possible introduction ofbudget norms at the central government level should be very limited because there will be very fewbudget norms and no need to integrate them in a fund transfer formula. The cost for recurrentexpenditures should no exceed 0.5% of the general budget. The 0.5% will mostly apply tomaintenance costs.Assumptions for equalization have been formulated for each sector. The level of equalization hasbeen determine in a way that minimize cost without leaving more than 5 to 6 provinces above theequalization line set by budget norms. It is assumed that provinces above the equalization thresholdwill beneficiate from ad hoc grants during a transition period necessary for integrating all provincesin the system.For the recurrent budget, the main criteria for determining the optimum level of equalization havebeen the number of provinces above the equalization line combined with affordability. The objectivehas been to have no more than 6 provinces above the equalization line, with an average of 5 (seetable below).A total equalization of investment spending across provinces is neither possible nor desirable as largeinvestments in infrastructure are always exceptional in nature. The equalization line for investmenthas been defined as a minimum envelope for investment either based on population or on apercentage of the recurrent budget. As a consequence, the number of provinces above theinvestment equalization line fluctuates between 4 and 12, depending on sectors. Equalization ofinvestment is easy for Agriculture, Provincial Administration and General Administration, becausethose sectors are not dependent on large infrastructure investments. Equalization is nearlyimpossible for Health and CTPT, and problematic for Education. Our first recommendation is tointroduce a distinction between small and large investments and to exclude large investments fromthe budget norm system. This raises several issues that MoF will need to address. Some sectoralinvestment budgets are so small that they can hardly qualify as investment at all, especially if weconsider that the budget must be spit between several line-items. This is the case of the investmentbudget of Justice which is 20 millions kips in Atapeu, 50 millions kips in Phongsaly and 60 millions 8
  9. 9. Bolikhansay. Some investment budget can be as small as 10 or 20 millions kips. The AccountingDepartment should determine a minimum threshold for expenditure to be recorded as investmentwith depreciation rules set accordingly.There are three good reasons to include at least partially investment norm in the budget normsystem:  Any significant increase of any local budget will require some new investments (It is impossible to increase significantly the number of teachers without increasing the number of school).  Any investment has an impact on the recurring budget because it raises the maintenance cost of fix assets and therefore impacts directly the provision of goods and services.  Funds for investment should be included in the intergovernmental fund transfer system either as unconditional grant or as ad hoc grant.However we agree that budget norm cannot cover large investments. Budget classification needs todistinguish between “national investment”, “provincial investment” and “district investment”. In adistant future, when local planning will improve, the MTEF will be made by province, defining fiscalenvelopes for local investments. NUMBER OF PROVINCES ABOVE THE EQUALIZATION LINE Recurrent Investment Budget Budget Education 5 8 Health 6 12 Agriculture 4 5 CTPT 5 8 Provincial Administration 6 5 General Administration 6 4 9
  10. 10. 5. Integration with the medium term fiscal policyUsually the introduction or the modification of budget norms is done within the context of thegeneral fiscal policy of the country and required to be integrated with the Medium TermExpenditure Framework (MTEF), itself the reflect of macro-economic and macro-fiscal policiesdecided at the highest level of the self.ADB / Maxwell Stamp team in charge of the development of the MTEF has come to the conclusionthat due to important methodological issues and capacity limitation the development of a full-fledgeMTEF would be impractical. The first methodological issue is that the MTEF must be based on aMedium Framework Macro-Economic Framework (MTMF) and a Medium Term Fiscal Framework.ADB / Maxwell Stamp team has suggested replacing the MTEF by a Medium Term Budget Framework(MTBM) that would combine the MTMF, the MTFF and the MTEF in one simplified document.Because of this issue, a close cooperation between the Intergovernmental Fiscal Adviser and the ADB/ Maxwell Stamp team has been put in place with almost daily short meetings and frequentdiscussion of the macro-fiscal model. The ADB project inception report has been prepared in closeconsultation with consultant; even minor areas of disagreement might subsist. The new team leaderis also promoting cooperation with the two projects.Although, most of the data for the MTMF are already collected by the Fiscal Policy Department andused for revenue forecasting, it does not appear that there is a multi-year formal MTMF. The mainconsequence is that assessing the impact of the current economic crisis on revenue collectionbecomes very difficult. However determining this impact is critical for assessing the timeframerequired for the absorption of the budget norm cost and absorbing new budgetary needs.Usual budget norm methodology requires the use of an MTEFF to ensure consistence betweensectoral fiscal envelopes, programmes and projects. In the absence of the MTEF, there is no othersolution that conducting an Expenditure Need Assessment as described in the work plan. Like theMTMF, the MTFF faces methodological issues, one being the lack of integration between therecurrent budget and the expenditure budget, the other being the absence of programme budgetingresulting in lack of accounting data for programmes. The Expenditure Need Assessment and planningprocess for budget norms will face the same issues. Additionally the Expenditure Need Assessmentwill be confronted to the lack of data on programme and project by province.The Sectoral Expenditure Need Assessment can be an important step in the development of theMTBF and the MTEF. It has been already been decided that ADB / Maxwell Stamp team will beassociated to this project phase. However it is not yet clear if the MTBF will general additionalrequirements for the expenditure survey. Requirement for budget norms will be clearly identified inthe Project Strategy. The ADB / Maxwell Stamp team will need to identify its own requirements andsynergies, because the Budget Norm timeframe does not allow any delay that might be required forextending the expenditure survey requirements. 10
  11. 11. 6. Other policy and regulatory issuesThe introduction of budget norms for investment is always difficult when there is no completebudgeting autonomy at the provincial level. On the other hand, having no norm for investmentwould cause even more serious problems as we need a mechanism that link the growth of therecurrent budget to improvement of service delivery impossible without a additional investments.The result could be that the increase in spending on the recurrent side would be waisted due to thelack of proper level of investment or that the level of investment would be too high, resulting ininfrastructures that cannot be maintained. As complete budgetary autonomy is not desirable, it hasbeen proposed to define budget norms for investment as a minimum level of investment. In theorythis could mean that the province will be authorised to spend freely that fiscal envelope withpossible contraction with the with the investment plan developed at the central level. The use ofinvestment fund will require additional clarification that should reflected in regulation issued by MoFand the Ministry of Planning. A reinforcement of cooperation between the MoF and the Ministry ofPlanning would be necessary. That level cooperation could be achieved through a joined Macro-Economic Planning Committee as already recommended by ADB / Maxwell Stamp team. 7. Introduction of budget norms at the level of the Central GovernmentThe introduction of budget norms at the level of the Central Government is an issue that has beentackled only superficially in the Policy Framework but that is not expected to cause major problems.This section will address partially the problem through the angle of the potential cost of the differentsystems under consideration.The allocation of funds to line-ministries can be based on different budget norm systems: a) A resource sharing formula that will split resources between the Central Government and the provinces b) Budget norm that define fiscal envelopes by sector c) Budget norms that defined the relation between the recurrent budget and the investment budget d) Budget norms that allocate fund between different economic categories of the budgetIt should be remarked that the transfer of funds to the Central Government’s agencies does not havethe same constrains that the transfer of fund to provinces that require an equalization formula. As aconsequence there is no need to integrate budget norms for the central government to any fundtransfer system. This gives the Government a lot of freedom in the way that funds are assigned andour view is that the Government should keep as much flexibility as possible by limiting the number ofbudget norms. A. Expenditure Assignment FormulaAs we will see in the next section, in fiscal year 2007/08 the spit between central government andprovincial expenditures was 51.62% / 48.38%. This resource assignment seems to have been fairly 11
  12. 12. stable along the years and that raise the possibility to have an Expenditure Assignment Formula thatwill assign for example 52% of all resources to the Central Government and 48% to the provinces andthat possibility has been suggested by some members of the Budget Norm Committee.However Expenditure Assignment Formulae do not work as well as Revenue Sharing Formulaebecause the total budget ceiling of the state does not depend only on revenue collection but also onborrowing and borrowing decisions takes many factors in consideration such as debt service, macro-economic stability and ad hoc financing of large investment.The second thing that we need to take into consideration is that the expenditure split of 51.62% /48.38% that we see in accounting does not represent reality. In practice a number of investment andmaintenance contracts are signed in the capital by line ministries but benefit the provinces. This iscertainly the case of health and telecommunication infrastructures, national roads, airports, powergeneration and distribution, and mining. Our accounting coding system for the past years did notallow the clear identification of provincial expenditure and although progress have been made by theintroduction of the new accounting system the problem has not been solved completely.Another issue is the rigidity that such system will introduce. According to a 2006 survey 87% of civilservants works in the Provinces against 13% in the central government. With the recentralization ofthe state, capacity of the central Government will need to be strengthened and probably more staffrecruited. It would be dangerous to freeze expenditure assignment between the centre and theprovinces when the Central Government is such a need of expanding its outreach, strengthening itplanning and monitoring capacity and developing new services and function. B. Sectoral Budget NormIn a few countries we can find systems that allocate resources to sectors using budget norms. Thosenorms are either expressed as a percentage of budgets or more frequently as a percentage of GDP.However most governments prefer using non mandatory objectives that are expressed in fiscal policyterms and can become binding if endorsed by a Parliament.The main objections which have been raised against expenditures assignment systems can also beused against sectoral budget norms.Such an approach appears impracticable in Lao PDR due to low revenue collection and past distortionin sectoral fund allocation. Education is likely to keep absorbing a large portion of revenue growth.Investments in roads and transports will probably slow down and more efforts must be made inproving health services. Such a situation requires year by year fine tuning. Sectoral Budget Normwould create a straight jacket that would put counter productive constrains on Government’s policy. 12
  13. 13. C. Relation between the recurrent budget and the investmentAs already said, the question of the relationship between the recurrent budget and the investmentbudget is made more difficult by the fact that line-ministries may sign contracts that areimplemented in the provinces. There is not a strong stance for implementing budget norms in thatareas but something can be done to avoid under investment and, even more important, overinvestment.There is a strong tendency in the Lao DPR to inflate the investment budget in the hope of boostingGDP growth. Investments are often in competition with improvement of Government’s servicedelivery. Maintaining the right balance between the investment budget and the recurrent budget iscritical for sound public finance. The size of the fiscal envelop available for investment should bedetermined in function of a number of factors such as the maintenance cost of existing investments,the cost of expending or improving Government’s service delivery D. Budget norms for economic categoriesThe new chart of account is based on three economic categories  Salaries  Goods and Services  Capital ExpendituresCapital Expenditures have already been discussed in the previous section.Regarding salaries, their structure and the level of compensation is determined by the Civil ServiceCommission and the number of civil servants is approved by the Prime Minister Office. TheExpenditure Need Assessment will have to check if the same horizontal imbalance that we see infinancial resource allocation does not exist for human resource allocation. Equalization of financialresources should go hand in hand with the equalization of human resources. The Expenditure NeedAssessment will have to determine the strategy to reach that objective.Goods and Services is the economic category on which budget norms are expected to have thegreatest impact. Each sector will have different norms to ensure that (a) operating expenditures arecovered, (b) there is enough budget for fix asset maintenance. 8. Main Outcomes of this SurveyThe six sectors under consideration (Education, Health, Agriculture, CTPC, General Administration,and Provincial Administration) represent 48.38 % of the general budget. The two main constrains ofthe budget norm system will be (a) its affordability and (b) the absorption capacity of the provinces. 13
  14. 14. a) Preliminary results from the macro-fiscal model show that the impact of the budget norm system on the budget will be minimum; therefore affordability does not appear to be an issue. The total fiscal envelope required is estimated to be around 4.36% of the budget over six years for provinces. The cost will be minimum during the first year (0.39%) and will pick during the third year (1.31%) before starting to decline after. Additionally, the cost of budget norm at the central level of government might generate an additional increase of 0.5% of the general model. This is only a guestimate, as the macro-fiscal model, in the absence of a budget for FY2008/09 based on the new chart of account and budget classification cannot tell us much about that. The old chart of accounts does not allow a clear distinction between salaries and social transfers and between investments and maintenance costs.b) Absorption capacity, define as the capacity of the poorest provinces to bring there expenditure average national level set by budget norms appear to be a more crucial problem. According to initial projections, that need to be discussed with the Ministry of Education, it will take four years for the less advance provinces to reach the national average.c) Budget adjustments must be incremental. Some provinces have under-invested in sector like education, health and agriculture. Having large year to year increase of their sectoral budget will not help them because there will be bottleneck to raise rapidly their level of spending. Bolikhamxay spent half of the nation average per capita (41,000 kips against 81,000 kips) on education. Raising suddenly the level pending of Bolikhamxay to the national level would not produce any result, because schools need to be built and teachers need to be recruited and trained before the province can spend the money. The Expenditure Need Assessment that will be undertaken during the second phase of the design of the Budget Norm Systemd) One of the major finding of the survey is that provincial administration is the sector that will require the most important fiscal effort with a total cost representing 38% of the fiscal envelope required for budget norm implementation. The reason is that level of spending for local administration in the provinces does not seem to be directly linked to population, service delivery or poverty. Because tacking the issue of provincial administration might be difficult, we have isolated sector as a distinct phase of budget norm implementation that will not start before the third year of the implementation plan. It does not mean that the problem should be ignored. On the contrary we think that the two first years of the implementation must be used for preparing a comprehensive plan that will address the major issues of the delivery of government services at the provincial level, the strengthening of provincial planning and budgeting, and the rationalization of provincial administration. It is clear that without an important effort to make provincial administration more efficient, efforts made by line-ministries for improving their service delivery in the provinces might fail.9. Budget Norms Fiscal Envelope The Work Plan prepared in November 2008 was based on the assumption that the introduction of budget norm could be completed in three years and that most of the cost could be absorbed during the first year The present studies shows that budget norms will 14
  15. 15. need far more time than initially anticipated, not so much because of budgetary restrictionbut because of the limited absorption capacity of the provinces. However the fiscal enveloperequired is very affordable. Contrary to what was thought in November 2008, there will beno need to earmark funds for sectoral budget norm implementation. Over the next threeyears we can expect that inflation will remain around the present level of 8-10% and thateconomic growth will remain substantial. As a consequence the nominal budget will grow ata minimum rate of 15% to 20%. The 1% required for budget norm will be easily absorbed byinflation. As for provinces above the equalization line, if their allocation grows at half the rateof other provinces, that should be enough to solve the problem of horizontal imbalance. 15
  16. 16. II. SECTOR ANALYSIS 1. Education SectorThe national education budget represents 12.8% of the general budget, a very low rate compare toother ASEAN countries or to countries with a similar level of development.The provincial budget of 546,214 M kips represents only 47.9% of the total education budget.However that figure might be misleading because some investments are finance centrally. EXPENDITURE BY ECONOMIC CATEGORIES: EDUCATION Budget Economic Categories Amount % % Total Provincial Budget 546 214,62 100,00% Investment Budget 90 102,76 16,50% Recurrent Budget 456 111,86 83,50% 100 Salaries 379 075,71 69,40% 83,11% Com. & Allowances 56 438,76 10,33% 12,37% Salaries + Com. & Allow. 435 514,47 79,73% 95,48% Goods & Services 20 597,39 3,77% 4,52%Out of a provincial budget of for FY2007/08, 83.5% goes to the recurrent budget and 16.5% to theinvestment budget. The level of investment is low compared to the need and experience in othercountries with similar level of development. By it has been impossible precisely how much of thecentral investment budget is allocated to provincial projects.Out of the recurrent budget 95.48% goes to salaries and compensation and allowance, leaving only4.52% for good and services. However there are important fluctuations of that ratio across provinces.This ratio suggest no only that there is not enough funding for books and teaching material which arepaid by the families, but that no money is left for basic building maintenance, casting a doubt on theviability of the present investment policy. Only investments made in FY2007/08 would require amaintenance budget representing 1% of that year recurrent budget. As a consequence we can 16
  17. 17. estimate the real maintenance need between 15% and 20% of the present recurrent budget; a levelconsistent with international experience.The national average spending per capita on education is 79k kip, with important variations acrossprovinces. There is no linkage between education expenditure per capita and the poverty level.Houaphan, the poorest province with a Human Poverty Index (HPI) of 1.52, spend 89 k kips percapita, reasonably above the national average, but well below Xekong (91k kip per capita with a HPIof 1.51) while Saravanh with HPI of 1.54 spent only 54k kips. The highest level of spending (129k kipsper capita) is found in Vientiane province which has one of the lowest level of poverty (HPI = 1.19),but paradoxically, that level of spending fall to 65k kips in Vientiane Capital (HPI = 1.17). The lowestlevel of spending is found in Bolikhamxay (HPI = 1.29).More disparities are found in the investment budget. The ratio Investment/recurrent expenditurefluctuates between 5.81% (Louang Prabang) and 65.32% (Houaphan). Despite a low level of recurrentspending, Vientiane Capital has a high level of investment. Houaphan with 5% of the country totalpopulation has an investment budget representing 140% of Savannakhet with 14.7% of totalpopulation.For the purpose of macro-economic simulation of expenditure equalization, we have selected a levelof equalization of 85 m kip per capita for recurrent expenditure. This level of equalization leaves sixprovinces above the equalization line. Eleven provinces will require an increase of their budgetrepresenting 5.6% of the total education budget and 0.77% of the general budget.Regarding the investment budget, it has been decided that the equalization approach was notpossible as the central government must keep the control of large investment programmes. Insteadwe have defined a minimum investment envelope representing 7% of the corrected recurrentbudget. This minimum investment envelope leaves ten provinces above the line but require onlyminor budget adjustments for four provinces representing only 0.5% of the sector budget and 0.06%of the general budget. During the expenditure need assessment and after consultation with theMinistry of Education and the Ministry of Planning we will see if it is a valid approach for budgetnorm. In that case we will introduce a budget norm for small investments, and large investments willbe financed by ad hoc grants.Education is the sector which, after provincial administration, will require the more adjustment forequalization of expenditure, mostly in the recurrent budget. However the present approach is purelymacro-fiscal and is not based on an expenditure need assessment. It does not take into considerationefforts that must be made independently from the introduction of budget norms if the Lao PDRwants to meet it millennium development goals. The Expenditure Need Assessment, due to startshortly, will tell us more of the real needs of the sector. However we can already see a contradictionemerging between the need for increasing the recurrent budget for financing maintenance cost andteaching materials, and the need for investing more in construction of teaching facilities. 17
  18. 18. 2. Health SectorThe total health budget represents 3.85% of the national budget. The provincial budget of 546,317 Mkips represents 47% of the national budget, but like education some investments might be financedcentrally. EXPENDITURE BY ECONOMIC CATEGORIES: HEALTH Budget Economic Categories Amount % % Total Provincial Budget 160 845,56 100% Investment Budget 54 677,92 34% Recurrent Budget 106 167,64 66% 100 Salaries 62 224,32 39% 58,61% Com. & Allowances 28 188,56 18% 26,55% Salaries + Com. & Allow. 90 412,88 56% 85,16% Goods & Services 15 754,76 10% 14,84%The provincial budget represents 47% of the national budget. Investments at the consolidate level(central + local) represent 56% of the national budget and only 34% of the provincial budget,suggesting that some major investments made in the provinces might be financed centrally. In anycase, the level of investment appears too high in relation to the recurrent budget.34% of the central budget is earmarked for goods and services, against only 14.8% of the provincialbudget. Here again the possibility exists that some goods and services (such as vaccine) arepurchased centrally, but for the purpose of transparent information it appears important to correctthe accounting. In any case, the 14.8% recorded at the provincial level appear too low for a properfunctioning of medical facilities. A well equipped hospital in a developing country can have anoperating budget representing 50% to 100% of the initial investment, depending on the technologylevel of the equipments.Expenditure per capita fluctuate from 11k kips in Vientiane Capital to 36k kips in Xekong, but thatprovince appears to be an exception. In general, recurrent expenditures per capita tend to be low inmost populated provinces such as Vientiane Capital, Savannakhet and Champassak. The nationalaverage is 18k kips per capita, but raise to 19.5k kips if we exclude Vientiane Capital.With a average spending per capita of 18 m kips for the recurrent budget, we have put theequalization line at 21k kips per capita. That level of equalization still leaves eight provinces abovethe line. Xiengkuang and Bokeo spent 22 k kips, and there is of course the possibility to consider 22 m 18
  19. 19. piks a better level of adjustment. However we have taken a conservative approach. Only discussionwith the Ministry of Health will tell us what the correct level of equalization is.With 17 provinces, the Lao PDR cannot expect delivering all medical services in all provinces.Regional centres covering certain medical specialities and serving several provinces will have to becreated. Within that context, it is impossible to equalize investment across provinces. Like education,we have only defined a minimum level of investment which temporarily has been put at 12% of therecurrent budget. It leaves 11 provinces above the equalization line, but as already said largeinvestments in the health cannot be based on equalization or budget norms. What is important is todefine a minimum level of investment that will allow the renewal of medical equipments. 3. Agriculture SectorThe agriculture budget represents only 4.4% of the national budget. A very low amount for a sectorthat represents nearly 50% of the GDP, employs 80% of the work force and has been growing at 5%per year during the last decade.The main characteristic on the agriculture budget is that investments take the lion share with 81,3%of all funding. 55.8% of the investment budget is executed centrally and 44.2% locally.Local budgets represent 49% of the sector budget. Recurrent spending in provinces fluctuatebetween 4k kips per capita (Houaphan, against 6k kips in Vientiane Capital where agriculture is not apriority) and 23k kip in Xekong. At the national level, the average level per capita is 9k kips but shouldnot be considered as significant considering that the State deliver few direct services to theagriculture sector.The agriculture recurrent budget is the easiest budget to equalize. We have put the equalization lineat 11 kips per capita, representing only an increase of 0.38% of the national budget.The situation is very different for investments. On average, the State spent 25k kips per capita onagricultural investments, with fluctuations going from 4k kips in Louang Prabang and 112k kips inAttapeu. Paradoxically, Xekong which has one of highest recurrent budget has also one of the lowestinvestment budgets. We have put the equalization line at 23k kip per capita and we have excludedVientiane Capital from the budget norm system as we do not expect any need for major investmentthere. It leaves only five provinces above the equalization line.Budget norms for agriculture will need to distinguish geographic areas by the type of dominantagriculture, such as irrigated land and non irrigated land, plain agriculture and mountain agriculture,etc. Mountain agriculture has a strong link with poverty. 4. CTPCThe Ministry of Construction, Transport, Post and Communication has very disparate activities that,for the most part, should not enter in the budget norm system. Part of the activities of the 19
  20. 20. telecommunication branch should be excluded from the budget norm system and most probably thepostal activity. That will leave only provincial and district roads. However, only the Expenditure NeedAssessment will allow defining more precisely the perimeter of budget norms in that sector.Because the budget data that we have received do not allow distinguishing between the differentactivities of the ministry we have made only a rough estimate of the impact of budget norm on thesystem.The CTPC Budget is the largest economic sector budget. Representing 14.16% of the national budgetit is larger than the education budget. The sector is mostly driven by investment financed by foreigncapital. The investment budget represents 97.2% of the sector budget. 79.6% of the investmentbudget is financed by foreign capital. That level of investment is probably unsustainable in the longterm and raises the question if budget norm can apply to that sector.The recurrent budget represents 2.84% of the sector budget, with 55.2% of the recurrent budgetgoing to the provision of goods and service. Considering the very high level of investment in thesector, those figures appear impossible. Even if infrastructures are poorly maintained, theirmaintenance should represent a minimum of 10% of the value of existing investments. Theconclusion is that most maintenance costs are probably entered in the accounting system as newinvestments.In that context only the Sector Survey and the Expenditure Need Assessment will allow us to cost themaintenance needs and the cost of equalization can be only a guess. We have put the equalizationcost at 0.72% of FY2007/08 budget with 0.07% going to the recurrent budget and 0.66% going tothe investment budget. As there might either no investment norm for that sector, or a norm that willapply only to the transport budget, we expect the 0.66% to go mostly to maintenance of existinginvestments. 5. General AdministrationAs explained earlier, we have decided to aggregate the local budgets of the ministries of Industry &Commerce, Information & Culture, Justice, Planning and Finance in one sector that we have name“General Administration” and that comprise mostly the representative offices of those line ministriesin the provinces, with the exception of Justice that has a more extensive presence.The budget of that sector remains very small in comparison with other sectors with only 2.12% of thenational budget. 70% of that budget goes to recurrent expenditures and 30% to investment.However, when we look more in details to the investment budget of the provincial offices of theministries, a large number of line items are so small that they do not qualify as investment per se butshould be rather considered as the provision of goods and services.The national average spending per capita for the recurrent budget is 22k kips, against 9k kips foragriculture, and 18k kips for health. However we should keep in mind that the sectoral budget mustbe split between five ministries. However, putting most of the general administration under one roof 20
  21. 21. would certainly generate important saving and facilitate the introduction of a single window for mostgovernment services.The introduction of budget norms in that sector should be relatively easy and could be based mostlyon population. We have put the equalization line for the recurrent budget at 11 m kip with only fourprovinces above the line.Regarding investments, we have put the minimum budget at 6 m kip per capita that leaves only fiveprovinces above the equalization line. The cost of equalization represent only 0.40% of the general budget, with 0.28% going to therecurrent budget and 0.12% going to the investment budget. 6. Provincial AdministrationProvincial Administration is the sector where the introduction of budget norms will be the moredifficult but also the more needed. Local budgets for provincial administration show wide disparitiesbetween provinces and there is no obvious link between spending and population, service delivery orpoverty. For these reason we have isolated the introduction of budget norms for provincialadministration as a separate project phase taking effect on the third year on the implementationplan. However, we consider that preparation of the reform should start much earlier, probably in thelast quarter of 2009 or in early 2010.The introduction of budget norms for provincial administration should be linked to the reform oflocal budget formulation which is also part of the Intergovernmental Fiscal Advisor’s Terms ofReference, but also to the reform of civil service, the introduction of Operational Expenditure BlockGrants and the creation of District Development Funds (DDF), although DDF block grants might havemore impact on key ministries’ local budget.On average, the Lao PDR Government spend 163 k kip per capita for provincial administration,compared to 80 k kips for education, 18 k kips for health or 9 k kips for agriculture. Recurrentexpenditures for provincial administration represent 33.35% of all provincial expenditures andinvestment budget 5%. The weight of provincial administration in provincial administration explainsthe impact that equalization will have.However there are considerable disparities in spending between provinces. The lowest level ofspending is found in Savanaketh with 100k kips per capita and the highest level of spending is inAttapeu with 420k kips per capita. In general, the most populated provinces have a level far belowthe national average. This can suggest two things: either in densely populated provinces theprovincial administration is under represented or important economies of scale are made in thoseprovinces. The truth is probably a combination of the two explanations. It does not appear that thereis any correlation between poverty and the cost of provincial administration and we do not think thatany one should be made. 21
  22. 22. Several factors should be taken into consideration for the introduction of budget norms. One is theshare of provincial services in the local budget. Part of the activity of provincial administrations isdirected at managing the province relations with the central government and that activity is notdirectly affected by land area or poverty and is directly proportional to the size of the population.Delivery of provincial services is affected by factors other than poverty such urbanization rate andpopulation density. The more the population is scattered the more the delivery government servicesis difficult.Following this analysis we have decided to divide provinces in three categorises 1. Provinces with population less than 270.000 inhabitants 2. Provinces with population from 270.000 to 500.000 inhabitants 3. Provinces with population more than inhabitants We have taken a very conservative approach keeping the equalization norm as close as possible to the category average. Equalization norms and target zone for budget norms have been defined as follow: Recurrent Expenditures Capital Expenditures Average Equalization Average Equalization Spending Norm Spending Norm Up to 270.000 inhabitants 0,255 0,250 0,037 0,040 From 270.000 to 500.000 inhabitants 0,171 0,170 0,032 0,032 Above 500.000 inhabitants 0,114 0,134 0,010 0,010For the three most populated provinces, the equalization norm is equivalent to raising VientianeCapital and Savanakhet to the same level of spending as Champasak. The expenditure needassessment will tell us if it is justified.Despite the fact that the equalization norm is very close to the category average except for thesmallest provinces which are also the poorest, the impact on the national budget is important. Theequalization need is estimated at 1.77% of FY 2007/08 budget,1.24% going to the recurrent budgetand 0.53% going to the investment budget. 22
  23. 23. 7. Equalization ModelThe Equalization model defines the “equalization line” which is the level of spending that equalizesthe level of spending per capita for the majority of provinces. Budgets of provinces under theequalization line need to have their budget increased. Budget of Provinces above the equalizationline will increase more slowly than other provinces. However complete equalization of spending percapita for all sectors is neither possible nor desirable.The Equalization Model gives us indicative equalization norms that represents target zones forbudget norms. For example the Equalization Model tells us that all budget norms for the educationsector should result in a level of expenditure per capita “around” 85,000 kip. That number will beadjusted to take into account the poverty level of each province and other factors such as populationdensity, urban zones and rural zone, etc., and specific local conditions such as teachers receivingspecial compensation for teaching several grades in poor provinces.Education SectorRecurrent Budget : 85,000 kips per capitaInvestment Budget: 7% of recurrent Budget as minimum investment envelopeMaintenance cost: 5% of investmentHealth SectorRecurrent Budget: 21,000 kips per capitaInvestment Budget: 12% of recurrent Budget as minimum investment envelopeMaintenance cost: 10% of investmentAgriculture & Forestry SectorRecurrent Budget: 11,000 kips per capitaInvestment Budget: 26,000 kips per capitaMaintenance cost: 8% of investmentCTPC SectorRecurrent Budget: 4,000 kips per capita 23
  24. 24. Investment Budget: 35, 000 kips per capitaMaintenance cost: 10% of investmentGeneral Administration SectorRecurrent Budget: 25,000 kips per capitaInvestment Budget: 6,000 kips per capitaMaintenance cost: 5% of investmentProvincial AdministrationRecurrent BudgetFor provinces with population less than 270,000 inhabitants: 255,000 kips per capitaFor provinces with population between 270,000 and 500,000 inhabitants: 171,000 kips per capitaFor provinces with population more than inhabitants: 134,000 kips per capitaInvestment BudgetFor provinces with population less than 270,000 inhabitants: 40,000 kips per capitaFor provinces with population between 270,000 and 500,000 inhabitants 32,000 kips per capitaFor provinces with population more than inhabitants: 10,000 kips per capitaMaintenance cost: 5% of Investment 24
  25. 25. III. FINANCE AND IMPLEMENTATION STRATEGY 1. A three phase approachFor practical and financial reasons the budget norm system cannot be implemented at once. Afteranalysis of the financial and technical constrains, we recommend implementing the budget normsystem in three phases:Phase 1: Health + EducationPhase 2: Agriculture + CTPC + General AdministrationPhase 3: Provincial AdministrationPhase 1 will start with the preparation of FY 2010/11 budget. Il will last four years for the recurrentbudget and three years for the investment budget.Phase 2 will start with the preparation of FY 2011/12 budget and will last four years.Phase 3 will start with the preparation of FY 2012/13 budget and will last four years.Although all phases have an implementation duration of four years, the majority of provinces areexpected to make the transition in two years, except for provincial administration which is facingdeep structural problems. 2. Fiscal impactThe total fiscal enveloped required for budget norms has been estimated at 4.78% of FY 2007/08budget. Assuming that the budget structure is relatively stable that means that the introduction ofbudget norms at the national level, based on equalization needs will require an increase in resourcesrepresenting 4.78% of any year budget but spread over a period of six years.The three phases and four years implementation strategy will minimize the impact of the budgetnorm system on the budget structure. The total impact will represent an amount equivalent at 0.39%of FY2008/09 budget for year 1; 0.82% of FY2008/09 budget for year 2; and 1.31% of FY2008/09budget for year 3 and will decline sharply after.With an inflation rate between 8 to 10% during that period, the total impact of the system could beabsorbed by inflation. If this strategy is adopted, it means that the implementation of the budgetnorm will not require additional resources as it was feared before and that the economic crisis and 25
  26. 26. the expected decline in revenue collection should not be an obstacle to the introduction of thebudget norm system.In a context of a decline in revenue collection there is a risk that competition between provinces forlimited resources might exacerbate political tensions. The budget norm system will offer alternativeby promoting clear and transparent rules for expenditure assignment. It will strengthen budgetdisciple at the provincial levelThe full fiscal implementation strategy is presented in table 1 of this report under the title “BudgetNorm Consolidated Strategy. This table is reproduced below. BUDGET NORMS CONSOLIDATED FISCAL STRATEGY(expressed in percentage of FY2007/08 budget) YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 YEAR 6 TotalPHASE 1Recurrent Budget 0,33% 0,26% 0,21% 0,20% 1,00%Investment Budget 0,05% 0,02% 0,01% 0,08%PHASE 2Recurrent Budget 0,00% 0,20% 0,18% 0,17% 0,07% 0,63%Investment Budget 0,00% 0,35% 0,34% 0,32% 0,25% 1,26%PHASE 3Recurrent Budget 0,00% 0,00% 0,41% 0,34% 0,33% 0,19% 1,28%Investment Budget 0,00% 0,00% 0,17% 0,14% 0,12% 0,11% 0,53%TOTAL 0,39% 0,82% 1,31% 1,18% 0,77% 0,30% 4,78%The same numbers are presented in table 2 for all sectors (see annexes), but those numbers do notinclude the impact of new investments on the recurrent budget. The cost of maintenance of newinvestment has been estimated at 0.20% of the budget.Tables 3, 4 and 5 show the breakdown of budget adjustments required for equalization by province(see annexes). Those numbers include the impact of new investment on the recurrent budget. 3. Linkage with fiscal policyAlthough the introduction of budget norms will be painless fiscally-wise, it does not mean that it willbe effortless. High fiscal discipline will be required at the central and provincial level. During the firstyear of implementation, budget norms will put more strains on the recurrent budget. It means thatthe level of investment should integrate this new constrains.Generally speaking, budget norms will make more funds available for maintenance of buildings andfor other operating expenditures such as books for education or small equipments for hospital. Thiswill require an investment level compatible with the size of the recurrent budget. This objective can 26
  27. 27. only be achieved through the implementation of a Medium Term Expenditure Framework (MTEF)that is under development and should be ready when implementation of budget norms starts. 4. Way forward Attention must be given to the following tasks:  Conclusions of this survey have already been integrated in the Budget Norm Policy Framework that needs to be approved by the Minister to meet PRSO5 requirements.  Budget Execution issues have not been considered in the Policy Framework and must be addressed before the implementation of phase 1 starts.  Budget norms will affect the way budget is prepared at all level (provinces, line-ministries and MoF) attention must be paid to capacity building.  Both MoF and line-ministries have insufficient data on budget executions to be able to pilote the project effectively. The Budget Norm System will require the full implementation of the new budget classification and chart of account. At the moment there is no matching between concept used for budget formulation and concept used for accounting.  Managing the system of intergovernmental transfers based on equalization grants, budget norms and ad hoc grants will require dedicated human resources in the Fiscal Policy Department and in the Budget Department.It should be remembered that what has been presented in this report is only a macro-fiscal approachof the impact of budget norms based on equalization need. It is a bottom up approach that integrateexisting fiscal constrains at the macro level and therefore does not say if the current level of spendingin the sector is compatible with the Government’s objectives for public service delivery. Beforebudget norm formula for each of the six sectors can be tested two main tasks must be completed:  The expenditure needs assessment that will tell us if expenditure need exceed equalization need and what are the main objective indicators of needs.  The cost driver analysis that will us what are the main factors that affect service delivery in the provinces. The approach that we are taking will start for a notional minimum spending per service users adjusted for needs and cost. If: STr. = Sectoral Transfer 27
  28. 28. NEN= Notional Expenditure Norm (example: 28.000 kips per capita)N = Need IndicatorC = Cost IndicatorSTr.= (NEN x N) + (NEN *C) 28

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