Report No. 16094-LA Lao PDR Public Expenditure Review Improving Efficiency and Equity in Spending Priorities February 28, 1997 Country Operations Division Country Department I East Asia and Pacific Regional Office Document of the World Bank CLUI'ENCY EQUIVALENTS 'Dro-ot [996) C-enct UL - kip(C) <.9 .i5O . SSO. 55 Lss:.'0 - K9¶4 LIST OF ABBREVIATIONS ADB - Aaian Decelop-nenlt Bar AFTA - ASEAN Free Tnde A-es AIT - Ajio lno-i-re s)Tecnc-o-cgy (i Thailnd) APB - Agrcstrn. 3 P-omor:on Sans AF i - Acute Rnsostor-y 'n-c-n ASEŽN - A-oocia.cncf S-ss E.s, Asian Naior, A-A-DM Auslniai Agency for loleoasonal Oevelopreoe BoL - BSk of ' P0KR COMEA - Ouncil foe Mutual Scaonorc Assistance CPC Co.ine fot Plarming ad Coordinacon (eoo SPC) CI - tosciumer .Rrse loden CPPR C-ou-y P-nrolio Pen'--ntoce Revie- DArFSO D- Cnict Agicalfi-rn and Fo-tts S-raice Office DARCS - Ceparor.enof?ro.ic Adm-r=tsdocand oe CMii Serice DLVS Depanr_ic of Loennoci id Veeargxy Ser-ices DPIP - Dnpecenert of Pbfic Ln-emeer P!an EaL - l-e;con du Laos EGAT E!ecr-icity Generation Audhntry of Th`iload ENAG - Natonal School AdMniasnaso and Mang,emeet EPTL Poet & Teoonooicshons ESAF - Enhanced Stc,,rnl Adjannenor: Fc:liry FACO Foreign Cu-eny Affair DepIDrent FAMC - Foreig. Aid Mmagnc-ent Corren FDI - Fo-eigp Direct Locesonent P040C Foreigr locecaminir .Maoogencecc Contouien FTC - Federsoco of Trsce Unions CDP G Cicee D-oeuoc Prdu. GFS - CoaernneoeFim-nr Ssmecii H5RD - Ratan Resounona Depa-r-nt BF D - lnieinonal Send foe Recotsudon ad D-oelormeo- ICSOD - c atdonaui Cene for Snerecet of Locecpmcet Diapotan LDSA - lotemaustnal Ceceopteent Associanono [OF Insliuiaonal DnnnloyreceFmcc IFC . Iniennacceal Finance Corpotrion LLCO le-le .u.onal Labh-n Cgrgtnrotiur LIP - In:rational Monetary Fuoc [RMR - Inant Moraliry Ran InD - l ,teaed Rural Ceonlop-eec IRRI - loteeuirneal Rice Raennch Sinstitute IICA oarern-e Inier--rional Canpe-nuon Age.cy LECS - La .opeoditoce and C-roniption Survey LFBSS - Lao F-ein!iy sd Birn Spaning Survey LFS - Laa Sat-e FPel Coapnyy LSFP . L-o - S-edish Foeesy- Pente: L5IS - Lao Sociai lodi-tor S-rvey MAF - Ministy rfAdniccin and For-cay MOM - stciertiM- and Calod A1-nar MC7FC - Mi-isy of Co=r-nan:ccon. Tmipoen Post and Consrurtion MICA - Ntiltibt,ac l [n-n-eni CGu-nete Agency MLSW - Msisroc of La,or ,ad Social Weif-e MiO - M nissy of Defens MoF - M--sry of Flnie MoM - Minry of anon MRPH - Min-sy of ublsic Heacdh MCL - Me-cor=ndan sf Ucderoodisg NC3 - Nauion-! Coperioce Stdu=g NEM - Ne- Econseij Meoliasisin NMO - N-Cor-nroemer rganOioid NRRP - Naional Rct- R-e n Pr,gai NIM r N- Theun 2 (hydropower pmj) ODA - Otficial De-elopent Assistance OdM - Operq-eoca ond Mamnlresce OPEC - Orgooiauisn of Pe,onlnr ESpoetg Coun-ie, P.40FSO . rovinaial Agrciclice sd Foretty Service Office PAYG - Pay As Yna Go (financial rsyse-) PDG - PFojea Dece!op-eet Croe PDR . Popin's De-ocaiuL Repsblic PER - Poblic ESpendir-e R-iie- PFP - PoLcy F--ktork Paper PHRD - Policy and HuatDa RPssioure Develop-sit FPsd P'MS * ?Puli loceostent Montortmg System PIp - Pus-icn lccs--n ltPa./i Ptrgam PERR Peocreroecm I Rplemchg Sides and Regilato.s PfLU P roject ULpernenroonlsts PMR5 -1 P,-caonottan and VMantrosa-t of Road S.ectr L unestises PPA - Project Peromnance Audit RAD . Road Admiiupasoe Di-i-SE RMSM . Re-iced Mmimum Standard Modei SIDA . Scedis- h Loterscoed Deseop-oot Autannity SIP - Sectosl Innesrena ePogram SOCB - Sane-Owned C-ome-rcid BSank SOE . Siote-On-d Eteenri SPC - Stale Pl anog Comtmnsee (fomerly CFC) TA - leculAo-sisie TVET - Tec-roical ann Vootisnal Eduindon UDMR l D.tter RFiefe Yar MortlityRain UNCOF Drie- Nali-se Catitni Dceinpr,ert FPnd NDRP - Doiten Noarona Dscelspmrnt Pnnpsnmme UNESCO . Dnited Nolinen EdSairio-l. Scientifc and Culiral Orgecmrahsa UNICEF - U-Loed Nations Chiidren' F-nd WOK Wcid De-.opm-nt Report WHO . W1-itr Hosts, Organ-cicon 'VUG - Waler Lint Csap Vice President: letotliane. buevros OieJtct la-d i-ltltL.dnh-Shirani Dicie so Cb ' e5anoger: ns- Chi r(, ng) Stff -Inron- Sb-sco K-nerle - v - TABLE OF CONTENTS MAIN REPORT EXECUTIVE SUMMARY .............................................................. XI INTRODUCTION ................................................................1 PART I. RECENT ECONOMIC DEVELOPMENTS AND RESOURCE MOBILIZATION 1. MACROECONOMIC FRAMEWORKAND THE RESOURCE ENVELOPE ......................3 A. THE DEVELOPMENT AGENDA AND PUBLIC EXPENDITURE ..............................................3 B. TRENDS IN PUBLIC FINANCE ...............................................................5 C. GOVERNMENT MEDIUM-TERM BUDGET FINANCING STRATEGY .....................................8 D. PROJECTED RESOURCE ENVELOPE AND FISCAL SUSTAINABILITY ................................. 12 E. REVENUE MOBILIZATION MEASURES ............................................................... 14 F. CONCLUSIONS .............................................................. 16 PART II. PUBLIC EXPENDITURE ANALYSIS 2. STRUCTURE OF PUBLIC SPENDING: TRENDS AND TRADE-OFFS .......................... 17 A. PUBLIC EXPENDITURE POLICY IN THE TRANSITION TO A MARKET ECONOMY ............... 1 7 B. ECONOMIC COMPOSITION OF PUBLIC SPENDING . .......................................................... 18 C. FUNCTIONAL COMPOSITION OF PUBLIC SPENDING ........................................................ 25 D. FUTURE TRENDS IN PUBLIC EXPENDITURE .............................................................. 29 3. SECTOR STRATEGIES AND EXPENDITURE PRIORITIES ........................................... 33 CRITERIA FOR EXPENDITURE PRIORITIZATION ...................................................... 33 TRANSPORT .......................................................... 34 A. SECTOR OVERVIEW .......................................................... 34 B. GOVERNMENT POLICIES FOR TRANSPORT ........................................................... 35 C. FUNDING MECHANISMS ........................................................... 36 D. EXPENDITURE TRENDS ........................................................... 36 E. EFFICIENCY OF PUBLIC SPENDING FOR TRANSPORT ..................................................... 37 F. SCOPE FOR PRIVATE SECTOR PARTICIPATION .......................................................... 37 G. PROPOSED MEDIUM-TERM EXPENDITURE PROGRAM .................................................... 39 - vi - AGRICULTURE .................................. 41 A. SECTOR OVERVIEW ................................. 41 B. GOVERNMENT POLICIES FOR AGRICULTURE ................................. 42 C. FUNDING MECHANISMS ................. 44 D. EXPENDITURE TRENDS ................. 45 E. EFFICIENCY OF PUBLIC SPENDING FOR AGRICULTURE .................................................. 46 F. SCOPE FOR PRIVATE SECTOR PARTICIPATION ................................................... 47 G. PROPOSED MEDIUM-TERM EXPENDITURE PROGRAM ................................................... 48 HEALTH ................................................... . 49 A. SECTOR OVERVIEW ................................................... 49 B. GOVERNMENT POLICIES FOR HEALTH ................................................... 50 C. FUNDING MECHANISMS ................................................... 51 D. EXPENDITURE TRENDS ................................................... 52 E. EFFICIENCY OF PUBLIC SPENDING FOR HEALTH ................................................... 53 F. SCOPE FOR PRIVATE SECTOR PARTICIPATION ................................................... 54 G. PROPOSED MEDIUM-TERM EXPENDITURE PROGRAM ................................................... 54 EDUCATION ................................................... 56 A. SECTOR OVERVIEW ................................................... 56 B. GOVERNMENT POLICIES FOR EDUCATION ................................................... 57 C. FUNDING MECHANISMS .................................................... 57 D. EXPENDITURE TRENDS ................................................... 58 E. EFFICIENCY OF PUBLIC SPENDING FOR EDUCATION ................................................... 59 F. SCOPE FOR PRIVATE SECTOR PARTICIPATION ................................................... 61 G. PROPOSED MEDIUM-TERM EXPENDITURE PROGRAM .................................................... 62 CONCLUSIONS ....................................................64 SECTORAL RECOMMENDATIONS ................................................... 65 TRANSPORT ............................................... 65 AGRICULTURE AND FORESTRY ............................................... 66 HEALTH ............................................... 67 EDUCATION ............................................... 68 PART III. BUDGETARY INSTITUTIONS 4. PUBLIC RESOURCE MA NAGEMENT ........................................................ 69 A. ANALYZING THE EFFECTIVENESS OF LAO BUDGETARY INSTITUTIONS .......................... 69 B. STRENGTHS AND WEAKNESSES IN BUDGETARY INSTITUTIONS AND ARRANGEMENTS ....................................................... 71 C. CONCLUSIONS ....................................................... 89 STATISTICAL APPENDIX ......................................................... 91 - vii - TEXT TABLES TABLE 1.1: SUMMARY OF BUDGETARY OPERATIONS, 1991/92-1995/96 .............................6 TABLE 1.2: GRANTS VERSUS DOMESTIC REVENUE, 1991/92-1995/96 .................................7 TABLE 1.3: ESTIMATES OF RESOURCE ENVELOPE, 1996/97-1999/00 ................................ 13 TABLE 2.1: ECONOMIC COMPOSITION OF PUBLIC EXPENDITURE: INTERNATIONAL COMPARISON ........................................ 18 TABLE 2.2: LAO PDR: EXTERNAL DEBT OUTSTANDING .21 TABLE 2.3: INTERNATIONAL COMPARISON: SECTORAL EXPENDITURE SHARES .26 TABLE 2.4: GOVERNMENT EXPENDITURE BY FUNCTIONAL CLASSIFICATION 1995/96-1999/2000 .29 TABLE 2.5: COMPARISON BETWEEN 1991-1994/95 AND 1995/96-2000 PIPS .30 TABLE 3.1: TRANSPORT PIP AND SUGGESTED ALTERNATIVE PIP, 1995/96-1999/2000 .40 TABLE 3.2: ALLOCATION OF INVESTMENT FOR AGRICULTURE AND FORESTRY 1990/91-1994/95 .46 TABLE 3.3: SUGGESTED INVESTMENT PROGRAM FOR AGRICULTURE AND FORESTRY, 1996-2000 .49 TABLE 3.4: ECONOMIC COMPOSITION OF PUBLIC HEALTH EXPENDITURES .52 TABLE 3.5: PUBLIC INVESTMENT PLAN FOR HEALTH, 1995/96-1999/2000 .56 TABLE 3.6: EDUCATION BUDGET AND OVERALL BUDGET, 1990-1996 .58 TABLE 3.7: EDUCATION BUDGET PROJECTIONS, 1995/96-1999/00 .59 TABLE 3.8: AVERAGE UNIT RECURRENT COST ESTIMATES FOR EDUCATION, 1994/95 .60 TABLE 3.9: ENROLLMENT IN PRIVATE EDUCATION, 1989-95 .62 TABLE 3.10 :PUBLIC INVESTMENT PLAN FOR EDUCATION, 1995/96-1999/2000 .. 63 TEXT FIGURES FIGURE 1.1: MAJOR REVENUE CATEGORIES, 1988-1995/96 .6 FIGURE 1.2: GOVERNMENT BUDGET REVENUE PROJECTIONS .9 FIGURE 2.1: MAJOR GOVERNMENT EXPENDITURE CATEGORIES .19 FIGURE 2.2: COMPOSITION OF PIP, 1985 AND 1994/95 .27 FIGURE 2.3: SOURCES OF PIP FINANCING, 1995/96 .28 FIGURE 2.4: PIP COMPARISON, 1991-95 AND 1996-2000 .30 FIGURE 2.5: COMPOSITION OF PROJECTED PIP, 1995/96-1999/00 .................................... 31 - viii - TEXT BOXES Box 1.1: POWER DEVELOPMENT AND PUBLIC EXPENDITURE ............................................ 11 Box 2.1: SOCIAL SECURITY PROVISIONS IN LAO PDR .................................................... 22 Box 2.2: DIVESTING STATE-OWNED ENTERPRISES - PROGRESS AND ISSUES ..................... 24 Box 4.1: LAO PDR's BUDGET PROCESS .................................................... 70 Box 4.2: METHODOLOGICAL WEAKNESSES OF LAO PDR's PUBLIC INVESTMENT PLAN (PIP) .................................................... 76 Box 4.3: How Do FORWARD ESTIMATES OF BUDGET OUTLAYS WORK? ......................... 78 Box 4.4: IMPROVING AID COORDINATION .................................................... 79 Box 4.5: STATE-OWNED ENTERPRISE MANAGEMENT AND THE BUDGET .......................... 82 Box 4.6: CIVIL SERVICE REFORM ..................................................... 83 Box 4.7: PROJECT IMPLEMENTATION IN LAO PDR .................................................... 84 Box 4.8: PRE-AUDIT VERSUS POST-AUDIT .................................................... 86 Box 4.9: INTERNAL AUDITORS .................................................... 88 Box 4.10: THE EXTERNAL AUDITOR'S ROLE .................................................... 88 - ix - This report is based on missions to Lao PDR in March and July 1996. The team consisted of Stefan Koeberle (task manager), Vinaya Swaroop (lead adviser), Ed Campos (civil service), Pam Prangkham (project implementation), Loup Brefort (SOEs), Geoff Dixon (budget institutions), Jan Johnson and Dieter Havlicek (transport), Malcolm Mayfield (agriculture), Sue Szabo (health), Ruth Kagia, Chris Thomas (education), Vilay Soulatha, Ky Tran (statistics), and Malathi Jayawickrama (donor coordination). Marc Quintyn (IMF) contributed the analysis of the resource envelope. The mission was supported by Linda Schneider (liaison officer) and cooperated closely with the IMF Resident Representative, Paul Wade. Bonita Brindley and Emily Evershed provided editorial advice. David S. Peterson Jr. and Amy Mendez were responsible for document processing. The report benefited greatly from the comments of the peer reviewers, Martha De Melo and Malcolm Holmes. Valuable comments were also received from Anil Bhandari, Enrique Crousillat, Maurice Le Blanc, John Irving, Shilpa Patel, Jo Martins, Susan Shen, Denis Robitaille, Peter Long, Frank Byamugisha, Marie Khoury, Bill Smith, and Mohammed Farhandi. This report was written under the guidance of Pamela Cox (former Division Chief, EA I CO) and Bill McCleary (Lead Economist, EA1DR). The Director was Javad Khalilzadeh-Shirazi. The task team is grateful for the Government's cooperation in analyzing public expenditure issues and collecting data and would like to thank, in particular, the Budget Director, Mr. Sunthorn Manodharm; the Director of the National Statistics Centre, Mr. Bounthavy Sisouphanton; and the PIP Director, Mr. Chantavong Saignasith, for the time they devoted to this report. LAO PDR: PUBLIC EXPENDITURE REVIEW EXECUTIVE SUMMARY Objectives of the Review 1. This report is the first comprehensive review of public expenditures in Lao PDR, where economic transition has changed the role of government and has led to a gradual shift in the composition of public spending. The emergence of a booming private sector is placing heavy demands on the Government to provide quality infrastructure and macroeconomic stability, and to improve education and health services for the Lao people. The country's Socio-Economic Plan and the five-year rolling Public Investment Program (PIP) for 1995/96-1999/2000 spell out the large number of commitments across different sectors that need to be addressed with limited public resources to end of the decade. Yet public expenditure planning in Lao PDR has to date neglected a number of key questions that are critical to systematically evaluating public expenditure allocations: Where will the revenues for future spending commitments come from? What is the rationale for government intervention in each sector? Are there clear criteria for deciding where to allocate scarce public funds? How can institutional arrangements ensure effective budgeting, planning, and project implementation? 2. This Public Expenditure Review (PER) highlights the risks and opportunities of these changes by discussing past and future trends in public finance, analyzing the efficiency and equity of government spending, and identifying bottlenecks in expenditure management. By looking at public expenditure priorities up to the year 2000, the PER aims to assist the Government of Lao PDR to: (i) determine a realistic aggregate level of public spending within the available resource envelope; (ii) prioritize the allocation of scarce public resources across and within sectors; and (iii) strengthen the institutional effectiveness of the budgeting and planning process. I. THE DEVELOPMENT AGENDA AND RESOURCE MOBILIZATION Economic Trends and the Development Agenda 3. Lao PDR is in the process of making broad systemic reforms which have created the basic foundations of a market-oriented economic system: a market-based price system; a dynamic private sector; a two-tier banking system; and a largely open foreign trade regime are all in place. During 1992-96, output growth was sustained at a robust rate of over 7% per annum, although in 1995 temporary price and exchange rate pressures required corrective action. 4. Lao PDR 's development agenda is to alleviate poverty while maintaining macroeconomic stability. Despite extensive reforms, rapid population growth continues to erode gains in economic growth, and poverty is pervasive. Mobilizing resources to finance substantial public expenditures, especially toward the fulfillment of basic needs, will be critical in improving the future living conditions of the poor and thereby reaping the full benefits of economic reforms. - xii - 5. Several key structural and institutional characteristics of the Lao economy, such as weak government institutions, limited human capacity and infrastructure, and critical needs in health and education, constrain the potential aggregate level and composition of public spending. In the transition from a command to a market economy, the legal, administrative, and institutional structures have lagged behind the growth of the private sector, while rural-urban disparities have widened. Domestic savings have remained low, and large segments of the subsistence economy are still barely monetized. Although the country receives substantial foreign assistance, donor activity is neither well coordinated nor adequately accounted for toward future government expenditures. Potential export revenue, over the medium term, is based on the sustainable development of natural resources -- forests and hydroelectric power. Resource Mobilization 6. The Government has made good progress toward fiscal consolidation in recent years. Nevertheless, the position of public finance remains fragile, necessitating further reforms. Current revenues are inadequate, and future revenues are uncertain. Despite tax reforms since the end of the 1980s, medium-term fiscal sustainability is not yet assured in Lao PDR. The ratio of tax revenue to GDP is still low, tax administration is weak and the tax system continues to rely heavily on taxes from international trade and natural resources (timber). Government budgets are also highly dependent on hydropower revenue and on foreign assistance. To achieve its expenditure goals in a context of fiscal sustainability, the Government must therefore further enhance the tax system and tax administration to mobilize additional domestic resources. 7. The Government's preliminary projections through 1999/2000 would bring revenue close to 14.9% of GDP, with planned expenditures set at 24.2% of GDP. Judging from the present medium-term outlook for the Lao economy, this would lead to deficits that are likely to be unsustainable in the medium term; deficits would in fact increase somewhat from -8.8% at present to -9.3% by 1999/2000. However, a revenue target of about 15.5% of GDP revenues should be realistically within reach over the next five years, given that the buoyancy of the tax regime will be increased as the new tax law takes effect. Together with a decision to limit public expenditures to 21.5% of GDP, this alternative scenario would reduce the overall deficit before grants from 8.8% to 6.0% of GDP (and the deficit after grants from -5.3% to -3.5% of GDP) by the year 2000, and would compensate for uncertain revenues from foreign aid and hydropower. 8. Fiscal prudence suggests that the proposed Government expenditure program should stay within the likely resource envelope. While it is not completely beyond reach, the Government's proposed capital expenditure program stretches a little too far and should be trimmed from 1,500 billion kip to about 1,266 billion kip (equivalent to 11.6% of GDP) over the five-year period 1996-2000. This, together with an additional revenue effort, would avoid inflationary pressures or potentially costly actions, such as reducing current expenditures or suspending or slowing projects in midstream to ensure fiscal sustainability. 9. Of equal concern is that the Government's medium-term financing strategy until the end of the decade relies increasingly on revenues from hydropower production and trade taxes. Import tax revenue is probably overestimated in light of the further regional integration of the Lao economy in the context of the ASEAN. While hydropower is potentially a major source of revenue, the amounts and timing of the revenues are not yet clear; much will not materialize until 8-10 years or more have elapsed. Therefore, it would be advisable to begin diversifying the tax base now, and to rely more strongly on traditional domestic tax sources (i.e., income and commodity taxes). - xiii - 10. The ability of the Government to stay within its resource envelope is crucial for fiscal stability and depends as much on adhering to the targeted budget deficit as on strengthening the institutional capacity for macroeconomic management and revenue forecasting. Greater efforts to enhance domestic resource mobilization are needed to reduce the risks inherent in the Government's expenditure strategy, since the size and timing of future revenues from power exports, timber, import duties, and aid are uncertain. In the short run, this will require additional tax reform measures to increase the share of domestic direct and indirect taxes and reduce reliance on trade taxes and royalties, by increasing the tumover tax, broadening the income tax base, increasing excise duties, and increasing the land tax for residential land. In the medium term, administrative improvements should focus on organization, better control, and collection. Revenues from Power Exports 11. The energy sector accounts for over 15% of public investment. Its true dimension is even larger, since it is dominated by the development of large hydropower projects which are not included in the PIP. Apart from some investment in domestic rural electrification, the bulk of investment in the energy sector is designed to mobilize revenues from electricity exports. Hydropower development is likely to generate substantial future revenues, but it also entails significant uncertainties for the public expenditure program. To create a permanent source of foreign exchange (by exporting over 90% of electricity produced) and satisfy domestic demand, the Government has thus far signed at least 23 Memoranda of Understanding (MOUs) with foreign developers to augment its hydropower potential. It is difficult to say how many of the proposed projects will ever be implemented and what the financing arrangements will be. Hence, projections of fiscal revenues are highly uncertain. To justify large-scale hydropower development, an important question is also whether the Government will be able to direct the bulk of incremental fiscal revenues into developmental and poverty alleviation expenditures. 12. The Government needs to set out a consistent hydropower development strategy that would clearly establish (i) which of the proposed hydropower schemes are economically and financially justified; (ii) what future revenues in the form of royalties, dividends, and taxes would accrue to the budget; (iii) what financing arrangements would ensure a fair share of the revenues for the Lao Government; (iv) how the potential adverse social, economic, and environmental consequences of different realistic alternatives could be mitigated; and (v) what financing needs would arise from project-related financial obligations (such as resettlement, reforestation, or maintenance). II. PUBLIC EXPENDITURE ANALYSIS Trends and Trade-offs in Expenditure Composition across Sectors 13. Recent trends in the economic composition of expenditures across sectors reveal problems such as a bias toward new capital investment, the underfunding of non-wage operations and maintenance, and an overstaffed but poorly paid civil service. There is concern that: (i) new capital investments are being undertaken at the expense of maintaining existing infrastructure; and (ii) administrative expenses include substantial non-wage benefits. The functional allocation of spending across sectors shows that: (i) transport (roads) has accounted for a large share of public spending; (ii) government spending in industry has been declining owing to wide privatization; and (iii) the social sectors have received comparatively little funding, but the Government has recently increased allocations for health and education. - xIv - 14. While the functional pattern of expenditures has been moving in the right direction, further adjustments in sectoral expenditure priorities are called for, and the Government would be well advised to continue shifting expenditures away from economic sectors (industry, energy, and transport) and further increasing expenditures on the social sectors (health and education). At the same time, it is necessary to evaluate intrasectoral allocations for effectiveness by asking whether the balance among different sectoral programs within the key sectors is adequate and by assessing the extent to which expenditures deliver concrete results. 15. To be selective, this report focuses on four key sectors: Transport, Agriculture, Health, and Education, which together represent over two-thirds of the country's investment budget and also attract most of donor funding. The bulk of the Government's planned investment until the year 2000 will still accrue to the transport and communications sector, although its average share of investment would decline over the next five years (to 30%, compared with 51% during 1991- 95). The share of agriculture in investment will be reduced to around 11.4% of investment (down from 15%). The Government's increased emphasis on the social sectors is reflected in increased investments. Education will receive an average of 10% of public investment until the year 2000 (compared with 7% in the previous five years). Health will increase its share in investment from an average of 4% in the last five-year PIP to 8% during the rest of the decade; health is also the only sector in which current expenditures are projected to increase substantially as a share of total expenditures. 16. The Government's expenditure plans are broadly adequate in allocating resources to the sectors where they are needed. There are no obvious costly and inefficient expenditure programs ("white elephants") that need to be cut. Since all sectors seem to be of high priority in the country's development program, difficult choices must be made within the tight resource constraint. The recommendations of this report are consistent with tailoring the size and composition of government expenditures to the resources available up to the year 2000, the need for which was spelled out in paras. 7-8 above. A moderate reduction in transport investment, of around 8.7% of overall proposed investment by 129.6 billion kip over the next five years, is suggested; this would help ensure the fiscal sustainability of the public investment program, would focus transport expenditures on a feasible core program, and would make way for high priority allocations for other sectors. This Report makes recommendations for reallocations within the other major sectors in the public investment program (listed in para. 15) but no recommendations for reallocation between these sectors. Key Criteria for Expenditure Prioritization within Sectors 17. Public expenditures are constrained by the available resource envelope and should be concentrated on high priority programs. Before decisions are taken on spending scarce public resources for a particular project, be it a road or a hospital, the following questions should be examined: * The role of the Government and the public-private mix. Does the Government have a legitimate role in the project or should the project be left to the private sector? * The cost-benefit of project inputs and outcomes. Is this project justified in terms of its rate of return? * The complementarity of public investment. Does public investment encourage private investment? Can the sector absorb additional funds and is there adequate implementation capacity? - xv - * Operations and maintenance (O&M). Is new construction taking place at the expense of maintaining and repairing existing facilities? Are resources likely to be adequate to finance the recurrent expenditures for O&M generated by the project? * Cost recovery policies. Should part or all of the project costs be recovered from the actual users and beneficiaries through user charges? * Impact on the poor. Will project or program benefits accrue to the poor? Transport 18. Roads have been the Government's top expenditure priority, and the road system has also attracted the largest share of donor funding. This has reflected the need to upgrade the extremely rudimentary road network in this sparsely populated country, to help link dispersed domestic markets and create trade links to neighboring countries. In the future, the pressing need to upgrade the country's dilapidated road network will still make transport the priority sector for public investment, but its relative share will shrink to make way for increased efforts in the social sectors. Within the transport sector, the emphasis should shift from the construction of national highways toward rural roads, to enable subsistence farmers to market their surplus products. 19. The effectiveness of this substantial funding is much reduced by a number of key problems which need to be addressed. (i) The size and scope of the proposed transport expenditure program lacks coherence and exceeds macroeconomic and funding constraints and the Ministry's absorptive capacity. The Government should thusfocus transport expenditure on a "maintainable" core road network within a resource envelope of about 3.5% to 4% of GDP. (ii) Maintenance is inefficient because of weak institutions, conflicting roles and mandates concerning central and provincial entities, and problems with maintenance funding. An important recommendation is to concentrate on systematic maintenance of the core network. (iii) Planning and prioritization are inadequate, management and budgeting procedures are weak, and technical and managerial capabilities at the central and provincial levels are insufficient. All this makes it necessary to improve organizational effectiveness by simplifying and streamlining the decision-making process in the Ministry of Transport and Communications, improving financial and reporting systems, professionalizing relationships with contractors, and clearly defining the responsibilities and funding of the authorities in charge of road construction and maintenance in the center and the provinces. (iv) Road user charges contribute substantial revenues, and they need not be increased at this time and should not be earmarked to fund systematic road maintenance. Instead, the authorities should improve collection efficiency and eliminate distortions in the structure of user charges (e.g., charges on heavy trucks need to be increased). (v) The Government should devote increased attention to promoting private sector participation as contractors in construction and maintenance, while exercising caution toward certain privately funded projects which include extensive logging concessions. Agriculture 20. Although agriculture's contribution to GDP has been falling, the sector remains the primary source of income for about 85% of the working population. Close to 90% of Lao PDR's poor live in rural areas. The composition of agriculture expenditures has been concentrated on large capital-intensive irrigation schemes for rice cultivation, along with forestry and area development. The Government has been correct in starting to refocus its policy on agricultural - xvi - investments, which have been shifting toward less capital-intensive farmer-managed irrigation schemes. Despite progress, agricultural performance remains constrained by some key weaknesses in public expenditure allocations, (i) In the future, the Government should increase funding for areas with high expected rates of return, such as research and extension, and livestock/veterinary services. (ii) Poor, small farmers face limited opportunities to borrow for agricultural investments, owing to the exclusive reliance on the Agricultural Promotion Bank (APB) to provide agricultural credit. The Government would achieve a greater poverty focus by emphasizing small-scale savings/credit institutions and establishing market-based interest rates. (iii) Payoffs to expanding major irrigation schemes are low. Since planned investment still includes some new, capital-intensive irrigation projects, focus should shift toward rehabilitating and maintaining existing irrigation schemes. (iv) Transparency and accountability in logging are insufficient, while spending on reforestation and conservation exceeds the capacity to use funds efficiently. Public investment in forestry should be concentrated on the sustainable management of forestry resources. (v) Livestock development is underfunded and the Department of Livestock and Veterinary Services is particularly weak. This should be addressed by a national livestock and forage improvement program, a larger budget, and training. (vi) The poor quality of agricultural data continues to obstruct effective planning for agricultural development and needs to be improved. Health 21. Lao health indicators, which rank among the lowest in the world, reflect several problems: (i) the share of public spending for health has been very low; (ii) the composition of health expenditures has neglected preventive care in rural areas and has led to an inequitable distribution of resources among provinces; (iii) the health system is fragmented at the central level, which places a heavy burden on the government health budget; (iv) donor assistance is not well coordinated and focuses on vertical health programs instead of encouraging local programs aimed at improving the integration of preventive health measures; and (v) lower level services are underutilized, which indicates serious inefficiencies and low public confidence. 22. The Government recently adopted several action plans (National Drug Policy, National Malaria Control Program, and HIV-AIDS Control) and began using a six-program budgeting scheme. Its commitment to improving health conditions is reflected in an increase in the share of health in the next five-year PIP, from 3.5% to 8.1%. Given the weak institutional capacity of the Ministry of Health, the challenge will be to effectively implement these initiatives and integrate them into a coherent strategy for delivering health services, to identify priority areas for future policy development, and to guide donor support. Over the next five years, the Government should rationalize the composition of health expenditures, by increasing total resources for health to ensure a basic package of services of about US$12.15 per capita in real terms by the year 2000, and by budgeting for future operations and maintenance of facilities and equipment. Funding should target preventive care and basic clinical services, and should shift from central hospitals to villages. Institutional reforms should emphasize strengthening the budgeting process and prioritizing the health system. In the longer term, the Government will need to rebuild the referral system by increasing investment expenditures at the provincial level and by delivering quality services to the rural poor. - xvii - Education 23. Poverty alleviation in Lao PDR requires broadening access to high quality basic education. Educational attainment is currently too low to enable the poor to take advantage of economic opportunities, and significant allocations of resources are needed to improve the quality, quantity, and equity of all levels of education. Opportunities to increase efficiency and equity in education are numerous. For example, a disproportionately high amount is spent on post-secondary education, which benefits mainly upper income groups; the majority of schools are of small size; the non-teaching staff represents an inordinate proportion of the total education staff; and secondary teachers are underutilized. Moreover, too little is spent on improvements in the quality of education which might reduce repetition and dropout rates and enhance learning. In addition, the planned rapid expansion of relatively costly post-secondary education may place undue stress on future education budgets. 24. The challenge for policymakers will therefore be to economize, prioritize, and protect. First, the government should economize on education resources by (i) financing post-secondary education more equitably (e.g., through cost recovery); (ii) merging small schools to form more economical units; (iii) decreasing the proportion of non-teaching staff, particularly at the higher levels of education; and (iv) decreasing the unit costs of education (e.g., by job and curriculum restructuring). Second, it will be necessary to prioritize education expenditures by (i) developing a coherent, prioritized national investment policy in education; and (ii) planning and budgeting for the recurrent cost implications of investments. Third, public expenditures must protect a core education program and the rural poor by (i) ensuring an adequate budget for textbooks, materials, teacher training, and school maintenance, especially in poor communities with limited capacity for resource generation; (ii) monitoring the growth of higher education; and (iii) increasing resources for primary and lower secondary education. Broad Sectoral Priorities 25. Although public expenditure priorities lead to different specific recommendations for each sector, some broad key observations run across all sectors. * Weak implementation capacity, particularly in the public sector, is a major constraint to public expenditure performance. In line with absorptive capacity, sectoral expenditure strategies should focus on an affordable core program which can be implemented while quality and efficiency are being improved. Measures to address the weak human capacity and institutional bottlenecks should include more effective use of technical assistance, improved donor coordination, more selective expenditure allocations for high priority programs, and greater reliance on the private sector. Over the medium term, strengthening implementation performance across the sectors would require focused training, improved budgetary planning, greater decentralization and accountability of implementing units, and acceleration of public sector reforms. * Poverty reduction requires better performance in the rural sector. This in turn will require greater efficiency in the use of available resources and greater equity in public expenditure allocations to reach out to the rural poor. * Private sector participation should be encouraged across the sectors, particularly where there is no clear rationale for public sector involvement (e.g., road construction, fertilizer imports, language training). This would allow the state to focus on providing - xviii - macroeconomic stability, strengthening physical infrastructure and human capital to support private sector growth, and assisting poor Laotians who are excluded from the benefits of economic growth. * Operations and maintenance (O&M) have generally been neglected across the sectors in favor of new investments, which has led to an unacceptable waste of scarce resources. The investment agenda has been driven by foreign donors, and it is questionable whether this has always been in line with sectoral priorities. Ensuring adequate provisions for O&M while keeping recurrent expenditures under control requires forward-looking budgeting that takes account of the recurrent cost requirements over the medium term. Sectoral Investment Programs should be explored as budgetary instruments to improve aid coordination. These operations would be agreed upon among donors, the Government, and local stakeholders, and would clearly set out sector strategies in a sector-wide program approach covering all sector expenditures, both current and capital. III. PUBLIC RESOURCE MANAGEMENT AND EXPENDITURE STRATEGY Budget and Planning Institutions 26. Without the right institutional framework, resources will not be allocated in accordance with priorities and translated into results on the ground. The effectiveness of institutional arrangements for managing the budget process can be assessed by three key dimensions of public sector performance. How can Lao PDR's public institutions be improved to provide: (i) aggregatefiscal discipline (i.e., sound demand and supply management at the macroeconomic level); (ii) prioritization (i.e., appropriate expenditure composition); and (iii) technical effciency (i.e., cost-effective use of budgeted resources)? (i) FiscalDiscipline 27. Overall, Lao PDR's budgetary institutions provide a reasonable degree of fiscal discipline, since there has been sustained macroeconomic growth with only moderate inflation and balance of payments deficits. However, the current approach to medium-term macroeconomic management is rather unsophisticated. It is not clear whether the ambitious annual growth target of 8% set out in the PIP for 1995/96-1999/2000 is achievable on average, since it is higher than any in the past. The Government appears to depend too much on growth rather than tax improvements to achieve its revenue targets. To enhance fiscal discipline, the Government needs to (i) develop a consistent medium-term revenue framework as an alternative to the extrapolations of revenue undertaken at present; and (ii) monitor and review the consistency of the expenditure plans, particularly the PIP, within an integrated macroeconomic framework (covering the national accounts, budget, and balance of payments), under the responsibility of an interministerial macroeconomic committee. - xix - (i) Expenditure Prioritization 28. Lao PDR's budgeting institutions and processes are fairly effective in prioritizing the distribution of budget outlays, although improvements in transparency would be desirable. There is no consistent realistic medium-term expenditure framework encompassing all expenditures which focuses on programs and their total ongoing costs. Resource allocations tend to be driven by available donor funding instead of by policy priorities in an integrated program approach. Instead, planning, policymaking, and budgeting decisions are separated, with the PIP simply listing possible investment projects with little regard for the available resource envelope or forward expenditure estimates. First, the Government still needs to rectify methodological defects in the PIP process and improve the analysis and documentation of project proposals. Second, the PIP should be developed as a full set of forward estimates for all components of public outlays (including recurrent spending requirements) over a multiple-year horizon. Third, there is an urgent need to improve aid coordination to align foreign assistance with development priorities, avoid overlaps, and increase the consistency of sectoral policies. (iii) Technical Efficiency 29. Substantial progress has been achieved in the capacity of the Lao public sector to effectively deliver results on the ground, mainly through reforms of state-owned enterprises and the civil service. The Lao budgetary process works fairly effectively at the practical level: there is acceptable documentation, good reporting at the regional level, and feedback on annual achievements. However, (i) project implementation is frequently delayed owing to insufficient delegation of responsibility and slow release of counterpart funding; (ii) there is no effective project monitoring; and (iii) revenue collection is weak. The Government should therefore (i) delegate increased authority to program managers, which should go hand in hand with the need to increase the skill level and competence of public sector employees; (ii) build an effective Public Investment Monitoring System for disbursement, physical implementation, and economic targets, which feeds back into the rolling annual investment plan; (iii) establish the Office of the Auditor General as an independent auditing authority to evaluate public spending decisions; and (iv) further strengthen the technical capacity for tax collection by improving enforcement and reducing evasion. 30. Project Implementation. The best expenditure allocation is meaningless unless projects can be implemented effectively. Institutional constraints that frequently hinder implementation in Lao PDR include: (i) unclear formulation of sector strategies; (ii) weak institutional capacity because of the shortage of qualified staff, high turnover, and insufficient training; (iii) insufficient and delayed release of counterpart funds; (iv) inefficient administrative review procedures; and (v) inadequate procurement and disbursement systems. Improving project performance is a long-term process which places heavy demands on the Government to (i) improve the country dialogue between donors and implementing agencies; (ii) increase the skill levels of public sector staff; (iii) reduce the multi-layer review and approval process; (iv) involve provinces and local stakeholders in the project design; and (v) adjust public procurement practices and improve disbursement systems. 31. Donor Coordination. The public investment agenda in Lao PDR is donor-driven, but the effectiveness of donor coordination varies from sector to sector. To ensure that the donors' priorities correspond to the country's development priorities and to avoid conflicting policy advice and overlap of technical assistance, the Government and donors should make a concerted - xx- effort to: (i) involve donors at an earlier stage of the PIP process; (ii) improve the institutional framework for the coordination and management of aid; and (iii) consolidate administrative procedures among donors. To carry out these objectives, to improve project implementation, and to provide for a more comprehensive, forward looking medium-term expenditure program, the Government should explore Sectoral Investment Programs as an operational instrument for a broad sector approach to investment lending. Center-Provincial Relationships 32. There are large differences in income levels, incidence of poverty, and capacity for revenue generation among the different provinces. Contrary to trends in other countries, Lao PDR's budget system has become more centralized. Nonetheless, provinces help formulate the PIP and there is a system of fiscal sharing between richer and poorer provinces. More recently, some provincial governors have been granted somewhat more autonomy through small discretionary funds for (emergency) spending. Lao PDR's recentralization has created a system of fiscal sharing which appears to be performing reasonably well. As the economy grows and policymaking becomes more complex, it would be advisable to consider ways to create a stronger mechanism for leveling regional income disparities, based on an automatic revenue sharing formula rather than on political negotiations. At present, all revenues collected by the provinces in principle accrue to the national Treasury, but if provinces exceed their set annual revenue target they are "rewarded" with about 30% of the surplus. Provinces could be given an even stronger incentive for revenue collection if they were allowed to retain a larger share. Similarly, additional spending authority could be devolved to the provincial level to strengthen ownership in project planning and implementation. This would also make it necessary to clarify administrative responsibility and strengthen the capacity of provincial authorities to prepare realistic project proposals. State-Owned Enterprises 33. Privatization. The Government's privatization program has dramatically reduced the number of state-owned enterprises (SOEs), from about 600 in the late 1980s to about 90 at present. SOEs are no longer subsidized and have to compete with private enterprises. After the recent Sixth Party Congress, however, a certain disappointment over the performance of privatized SOEs has led to pressures to slow down the scheduled privatization of 58 remaining SOEs and increase protection from competing imports. However, such a policy reversal toward reasserting state control over key industries would stifle private sector growth. It would be an inefficient use of resources to use subsidies or preferential credits from state commercial banks to prop up failing former SOEs that would otherwise not be viable in a competitive market environment. New start-up private enterprises generally performed much better than privatized SOEs. The relatively poor performance of privatized SOEs can be attributed to the method of divestiture: most were privatized through leases rather than outright sales, which discourages long-tern investment. The Government's strategy therefore should be (i) not to reverse privatization by artificially resuscitating non-viable enterprises; and (ii) to replace leases by outright sales of SOEs to the highest bidder in a fully competitive process. 34. SOE Management. Thirty-two SOEs are currently excluded from the privatization process and will remain under state control for "strategic" reasons. These SOEs do not receive subsidies but are contributing significantly to government revenue. However, they include a number of clearly commercial activities. Ministries are not adequately equipped to manage and - xxi - supervise these SOEs. In addition, there is a risk that scarce public resources will be channeled to finance costly future investment programs. The Government should therefore maintain sufficient managerial autonomy for the SOEs but should carefully monitor their financial performance. Over the medium term the Government should consider divesting its remaining commercial activities to the private sector. In the short term the priorities are to (i) appoint the members of the Board of Directors for all SOEs, and (ii) strengthen the capacity of the Ministry of Finance to move to responsible monitoring of SOE performance while safeguarding managerial autonomy of SOEs. Civil Service Reform 35. Administrative reforms have followed economic reforms closely in Lao PDR. The main thrust has been to downsize the civil service, but administrative structures have barely been changed. The Government's challenge will be to reconstitute the civil service to meet the demands of the emerging market-based economy, by changing its skills mix and increasing its effectiveness rather than by merely reducing its size. This will make it necessary to (i) replace redundant civil servants with individuals whose skills match current and future requirements; (ii) enhance competence and accountability; and (iii) narrow salary differentials between public service and private enterprise to attract competent personnel to the civil service. Social Security 36. Provisions for social security essentially cover only civil servants and are relatively generous. However, the Government should strengthen the administration of social security and restructure the current public sector pension scheme to address several flaws. (i) There is no specific matching contribution from the Government as employer and the resulting deficit is a growing fiscal liability. (ii) The benefit levels and coverage are not clearly defined. Instead, pension financing should be separated from other benefits (war veterans, health care). (iii) It should be made clear as to whether former SOE employees still maintain their pension rights. (iv) The burden of pension payments is likely to increase unless the Government stops fully indexing benefits to civil service salary increases This inhibits civil servant salary reform because increases in compensation translate into additional pension costs. 37. Social protection for the private sector labor force, including compensation for injury and retirement benefits, is provided for in the Labor Law but has never been implemented, and benefits and necessary contribution levels are not clear. They may become a growing fiscal liability if they are not properly designed. The Government should prepare an implementing regulation for the 1994 Labor Law which is coherent, consistent, and affordable. To avoid a growing fiscal burden in the future, the Government should carefully study alternative social security schemes for the private sector. Thus, a cautious approach should be taken regarding the provision of pension arrangements for private sector workers. At this stage, only a very modest scheme to provide for employment injury, sickness, maternity, and death should be allowed. IV. CONCLUSIONS 38. This report analyzes the adequacy and effectiveness of public expenditures in Lao PDR, where the Government's role is gradually shifting from direct production to the provision of social infrastructure and a stable macroeconomic environment for private sector growth. The - xxii - report assesses the available resource envelope, and examines trends in the allocation of expenditures across and within the key sectors and the efficiency of budget institutions, reaching four broad conclusions. First, macroeconomic stability has been achieved, but enhanced resource mobilization and diversification of the revenue base will be vital to achieving the Government's development goals and decreasing the risks of relying too much on donor aid and hydropower in its long-term expenditure strategy. To stay within a likely resource envelope given by a realistic revenue target of 15.5% of GDP, the Government's proposed capital expenditure program stretches rather far and should be trimmed. Second, heavy emphasis has been placed on infrastructure investment, particularly on building up the country's rudimentary road network, but intersectoral expenditure allocations should continue to shift toward the social sectors -- health and education -- to focus more on human resource development. Third, although expenditure priorities differ within each sector, all sectoral expenditure strategies need to focus on an affordable core program which emphasizes quality and efficiency in delivering concrete results and reaches out to the rural poor. Across the sectors, this will also require encouraging private sector participation and keeping recurrent expenditures under control while ensuring adequate provisions for operations and maintenance. Fourth, the Lao budgetary arrangements work fairly effectively at the practical level, but key bottlenecks such as weak institutional capacity, methodological deficiencies in investment planning, and insufficient aid coordination need to be effectively addressed to improve macroeconomic consistency, expenditure prioritization, and project implementation. INTRODUCTION 1. Background Lao PDR has made remarkable progress in its transition from a poor economy based on subsistence agriculture to a market-oriented economy. The emergence of a booming private sector has been accompanied by vigorous growth, reduced macroeconomic imbalances, and lowered distortions in the incentive system. The ongoing transformation of the production base is placing heavy demands on the Government to provide the necessary quality infrastructure and macroeconomic stability for private sector productivity and growth, and to improve education and health services for the Lao people. The country's strategic plan up to the year 20001 and the five-year rolling Public Investment Program (PIP)2 spell out the large number of commitments across different sectors that need to be addressed with limited public resources. Yet public expenditure planning in Lao PDR has to date neglected a number of key questions that are critical to systematically evaluating public expenditure allocations: Where will the revenues for future spending commitments come from? What is the rationale for government intervention in each sector? Are there clear criteria for deciding where to allocate scarce public funds? How can institutional arrangements ensure effective budgeting, planning, and project implementation? 2. Objectives of the Review. This Public Expenditure Review (PER) undertakes, for the first time, a comprehensive review of the adequacy and effectiveness of public expenditures in Lao PDR. Its recommendations complement the Government's annual PIP, which provides a broad outline for public expenditures consistent with development objectives. As part of the World Bank's Third Structural Adjustment Credit (SAC III) and the IMF's ESAF program, the Government has agreed to incorporate the recommendations of this PER in the formulation of the 1996/97 budget and the accompanying report to the National Assembly. The PER therefore focuses on providing useful and practical advice on a few key areas in a timely manner. Because of the inadequacy of the data, the review is selective in its coverage. This first PER aims to assist the Lao Government in: * Realistically assessing the available resource envelope within a consistent macroeconomic framework to determine how much the Government can afford to spend, while taking into account the sustainability of domestic resource mobilization and foreign assistance * Defining an appropriate role for the state * Adequately prioritizing the allocation of scarce public resources across sectors, by (i) rationalizing aid coordination to align donor-driven investment objectives to Governrment priorities; and (ii) channeling public resources into activities deemed For details, see "Report on the Implementation of the Socio-Economic Development Plan for 1993-94, 1994-95 and 1995-96." 2 The outline of the PIP for 1995/96 - 1999/2000 was presented by the Public Investment Programming Department in the SPC in November 1995; it was subsequently revised but had not been finalized by the end of 1996. - 2 - necessary for public sector involvement while leaving the provision of other services to the private sector * Allocating public resources within sectors on the basis of systematic intra-sectoral analysis, which requires linking inputs (e.g., public spending on primary education) and their outcomes (e.g., school enrollment at the primary level) with particular emphasis on improving the welfare of the poor * Reserving adequate funds for non-wage operations and maintenance, and providing sufficient domestic counterpart funds to complement donor-financed projects while improving project implementation performance * Strengthening the existing institutional setup of the budgeting and planning process to enable effective planning, budgeting, monitoring, and ex post evaluation to take place after project completion. 3. Scope of the Review. The main audience for this report is the Lao Government and the international donor community, who are invited to continue the dialogue on the policy recommendations contained in this PER. During the consultation process for the preparation of this report, workshops on public expenditure analysis were held with Government representatives from budget, planning, and line agencies, with positive participation. It is hoped that this PER will demonstrate for policymakers the usefulness of a thorough analysis, which would then become a regular exercise allowing for periodic reviews of all sectors. A Government team from the key agencies acted as counterpart for the PER mission. Dissemination of the report and the background papers took place through workshops in Vientiane, which included donors and NGO representatives. The PER will also be presented during the Round-Table Meeting of international donors in 1997. 4. The PER is structured as follows:3 - Part I outlines key structural characteristics of the Lao economy and discusses the availability of external and internal financial resources for public expenditure, within a stable macroeconomic framework * Part II presents a functional and economic analysis of Lao PDR's past and future expenditure program, summarizing expenditure recommendations for the principal sectors -- transport, agriculture, health, and education * Part III describes Lao PDR's institutional arrangements for budgeting and expenditure planning, and reviews their effectiveness in providing fiscal discipline, expenditure prioritization, and technical efficiency. 3 A set of background papers for the PER is contained in a separate volume available upon request from the World Bank. These are organized around four themes: (i) criteria for expenditure prioritization and in-depth sectoral analysis of agriculture, transport, health, and education; (ii) budgetary institutions (PIP, budget process, center- province fiscal relationships, donor coordination, and project implementation); (iii) sources for revenue mobilization (tax reform, hydropower, and timber); and (iv) issues in public expenditure management (SOEs, civil service reform, and social security). -3 - PART I. RECENT ECONOMIC DEVELOPMENTS AND RESOURCE MOBILIZATION 1. MACROECONOMIC FRAMEWORK AND THE RESOURCE ENVELOPE 1.1 The Govemment of Lao PDR has embarked on a broad effort to consolidate public finances in order to establish fiscal sustainability. This chapter describes the key structural characteristics of the Lao economy which determine the agenda for decisions on public expenditure allocations and define the appropriate role of the state. A brief overview of past trends in public finance highlights the key weaknesses of the Lao system of revenue collection. The outlook for revenue generating capacity is then analyzed to determine which aggregate level of government spending and budget deficit is macroeconomically sustainable. This leads to targets for revenue generation from intemal and extemal resources for the rest of the decade, which would allow Lao PDR to maintain the current pace of growth with external and internal stability. Together with estimates of sustainable levels of government borrowing, this analysis provides the aggregate "resource envelope" and guidelines for prudent levels of public investment expressed as a share of GDP. A. THE DEVELOPMENT AGENDA AND PUBLIC EXPENDITURE 1.2 Lao PDR is in the middle of large-scale systemic change. The country has successfully embarked on the path of deep economic reforms, which has led to accelerated economic growth and a remarkable degree of macroeconomic stability. Considerable progress has been achieved in structural transformation and macroeconomic management, creating the basic foundations of a market-oriented system. Strengthened public and private investment and improved economic incentives contributed to the growth of real GDP at the robust rate of 6.3% per annum over 1990-94, and to per capita income rising at a 3.2% rate over the same period. Growth accelerated to 8.1% in 1994 and continued at 7.1% in 1995 and an estimated 7.5% in 1996, led by the strong recovery of agricultural production and a continued boom in manufacturing, construction, and services. Macroeconomic stability was threatened in 1995, when lax monetary management pushed annual inflation up to over 20% and made a devaluation necessary. However, the Govemment took the necessary corrective measures by adopting a floating exchange rate regime, curbing excess liquidity through monetary measures, and consolidating the fiscal situation. 1.3 Structural Features. The objectives and requirements of policymaking in Lao PDR are narrowly circumscribed by main structural and institutional features of the economy that have a direct bearing on the level and structure of public expenditures: * Lao PDR is a small, landlocked, poor economy with weak governmental institutions and a very limited number of trained, skilled staff, as well as inadequate infrastructure and a critical need for improvements in health and education. * The country has come quite far in shifting from a command to a market economy, but its legal, administrative, and institutional structures have not kept pace with the growth of the private sector. The respective roles of the public and private sectors need to be -4 - redefined, as the traditional controlling dominance of the state hampers the private provision of services. * Political and social demands suggest that care must be taken to prevent a sharpening of income and regional disparities. Poverty is widespread and chronic, and the vast majority of the poor live in rural areas and are engaged in subsistence agriculture production. The distribution of per capita income in Lao PDR is still relatively equal, but 46% of the population lives below the poverty line -- 53% in rural areas compared with 24% in urban areas. * While the country is still sparsely populated, population growth is high by Southeast Asian standards (2.4%), thus eroding gains from economic growth and creating substantial future expenditure needs. * Domestic savings levels have been very low and large segments of the subsistence economy are still barely monetized. * The country receives substantial foreign assistance, but donor activity is not well coordinated and absorptive capacity is limited. Moreover, the implications of aid programs for future government expenditures are not adequately taken into account. * The country's greatest export potential in the medium term is based on the sustainable development of natural resources (forests, mining, and hydroelectric potential) which are at present being exploited without coherent planning, and with potentially severe environmental consequences. 1.4 Development Agenda and Government Objectives. How do these development needs and constraints translate into public expenditure priorities? The development agenda is substantial and involves overcoming bottlenecks in public administration, strengthening human capital, building physical infrastructure, and helping the poor. Lao PDR is therefore in urgent need of obtaining the financial resources to improve the living conditions of its poor population while maintaining macroeconomic stability. The Government has officially proclaimed eight overall priority development programs: (i)food production (securing food self-sufficiency); (ii) material production (moving from subsistence to commercialization); (iii) stabilization of slash-and-burn shifting cultivation; (iv) integrated rural development; (v) infrastructure development; (vi) economic relations with foreign countries (foreign investment); (vii) human resource development; and (viii) development of services. These programs were subsumed under the three overarching objectives adopted by the Sixth Party Congress in March 1996: (i) poverty reduction (particularly in the rural and multi-ethnic areas, with emphasis on rural development, including the elimination of slash-and- burn cultivation); (ii) infrastructure development; and (iii) human resources development. Public expenditure decisions are supposed to follow these rather broad categories, although they partially overlap and do not prioritize among a wide range of development programs. Specific Government priorities in the different sectors are also not always very clearly articulated, nor is it entirely clear how they are reflected in public expenditure allocations across and within the main sectors. 1.5 The key question is how public expenditure can be allocated in economically and socially efficient ways to address Lao PDR's development constraints. Clear choices have to be made in addressing the large development agenda, since the available finances will be limited by the resources which can be mobilized domestically and externally. To maintain macroeconomic stability, -5- it is crucial to be realistic in keeping expenditures over the medium term in line with the likely available resources. To determine expenditure priorities, the Government also needs a clear rationale for public sector involvement, which should make increased private investment possible rather than crowding it out. Expenditures should thus be well screened, cost effective, targeted toward the poor, and likely to lead to private or public sector productivity gains. Before these issues are taken up in more detail in the next chapters of this report, this chapter will examine how the country's development has been financed in the past and the extent of resources available until the year 2000. B. TRENDS IN PUBLIC FINANCE 1.6 Fiscal Adjustment. Fiscal performance in Lao PDR has improved dramatically since 1989. Continued improvements in the tax system, in tax administration, and in the budgetary process, combined with a tight fiscal policy since 1988, have put Lao PDR on the path to fiscal consolidation and sustainability (Table 2, Statistical Appendix). Total revenue recovered from around 8% of GDP in 1989 to reach more than 13% in 1995/96. Imposing a hard budget constraint on SOEs strengthened fiscal discipline and improved the transparency of fiscal accounts. Taken together, better revenue mobilization and improved control over expenditures (through a paring down of nonessential expenditures) have generated a current surplus since 1992/93 (Table 1.1). The current account thus turned from a deficit of almost 2% of GDP in 1991 to a surplus of 3.2% of GDP in 1995/96. The overall deficit (before grants) declined markedly from its peak of almost 20% of GDP in 1988 to 9.7% in 1994/95 and 8.8% in 1995/96. 1.7 System of Revenue Collection. Tax reforms have transformed the revenue collection system from an "extraction system"--common to centrally planned economies--to a genuine "taxation system" which relies on tax categories typical for most market economies. The tax system now contains all the representative major taxes that compose a modem tax system. The structure of taxes is simple, and the major taxes have a reasonably broad base with limited distortionary effects. As a result, the budgetary process can respond better to the growing needs of a market economy. Nonetheless, a number of weaknesses remain: * Lack of Revenue Diversiflcation. A major change in the composition of tax revenue took place in the first reform years as profit taxes from SOEs dropped with privatization, and timber royalties became an important source of revenue (Figure 1.1). However, since 1992/93 the relative shares of major tax categories have not changed drastically. The 1995/96 budget still relies for 22% on trade taxes and for more than 15% on timber royalties, sources that tend to be inelastic in the long run. On the other hand, the share of domestic direct and indirect taxes (profit, income, turnover taxes and excise duties) has not been growing significantly. In short, continued revenue diversification remains desirable. See the Background Papers, Chapter 11, for details on reforms of the tax system and tax administration. - 6 - TABLE 1.1: SUMMARY OF BUDGETARY OPERATIONS, 1991/92-1995/96 (PERCENT OF GDP) 1988 1989 1990 1991 1992wa 92/93 93/94 94/95 95/96 Total Revenue 12.1 8.3 10.0 10.3 10.7 12.0 12.7 12.5 13.3 Tax 9.2 6.4 6.1 7.5 7.5 9.1 10.0 10.2 10.8 Nontax 3.0 1.9 3.8 2.8 3.2 2.9 2.7 2.3 2.5 Total Expenditure 31.9 24.9 23.4 20.9 20.6 18.1 24.2 22.2 22.2 Current 11.9 9.4 11.4 11.4 10.9 11.1 11.9 10.8 10.1 Without wages 4.8 4.6 5.8 6.3 6.5 6.5 6.6 5.6 5.3 Capital 20.0 15.6 12.0 9.6 9.7 7.0 12.3 11.4 12.1 Current Balance 0.2 -1.0 -1.5 -1.0 -0.2 0.9 0.8 1.7 3.2 Overall Balance (cash basis) -19.8 -16.6 -13.4 -11.3 -9.9 -7.7 -11.5 -9.7 -8.8 Grants 5.4 4.0 3.8 4.5 4.7 3.3 6.3 5.5 5.5 Overall Balance -14.4 -12.6 -9.7 -6.8 -5.2 -4.4 -5.2 -4.2 -3.3 (cash basis, after grants) Foreign Financing 13.9 15.5 10.6 4.1 4.6 2.9 4.7 4.6 5.0 Domestic Financing 0.6 -2.8 -0.8 2.7 0.6 1.5 0.5 -0.4 -1.6 a/ The fiscal year was changed from a calendar year basis to October-September in 1992. Sources: Lao Government authorities and World Bank staffestimates. FIGURE 1.1: MAJOR REVENUE CATEGORIES, 1988 - 1995/96 (PERCENT OF TOTAL REVENUE) 43 8.6 83 11.7 12*2 f S::0 Other Taxes aWNontax El Timber Royalty 10.1 O Profit Tax 30 Income Tax 212.11~~~~~~~~2. 0 Trade Tax M Tumnover Tax 1988 1992/93 1993/94 1994/95 1995/96 * Weak Tax Administration. The revenue collection process has improved with an overhaul in 1992 of the budget implementation process, which is now smoother and more transparent, and ensures better control. Substantial shortfalls in the collection of timber - 7 - royalties were a problem in the past but have not recurred in recent budgets. Over time, actual revenue collection has improved significantly compared with the original plan (from 96% in 1992/93 to 105% in 1995/96). Despite these improvements, the capacity to administer the increasingly sophisticated tax system remains limited, mainly owing to a shortage of skilled staff and lack of computerization. High Reliance on Foreign Aid Foreign aid in the form of grant disbursement and concessional borrowing finances around 80% of the country's Public Investment Program. Until recently, the budget depended heavily on grants, which amounted to almost half of domestic revenue from taxes and non-taxes (Table 1.2). However, this dependence appears to have started to decline in 1994/95. This high reliance on foreign aid and the outlook of decreasing foreign grants pose new challenges to the Government's budget. TABLE 1.2: GRANTS VERSUS DOMESTIC REVENUE, 1991/92 - 1995/96 (MILLION KIP) 1991/92 1992/93 1993/94 1994/95 1995/96 Domestic Revenue 85,648 113,256 135,818 165,502 217,362 Grants 33,971 31,270 67,283 72,710 57,700 Grants/Domestic Revenue (%) 39.7 27.6 49.5 43.9 26.5 Source: Staff calculations. 1.8 Outlook. The challenge for the future will be to address the above-mentioned weaknesses and trends, so as to stay on the path to fiscal sustainability. A sound foundation has been laid by a tight fiscal policy which has helped achieve macroeconomic stability during the first half of the 1990s. Indeed, the overall budget deficit, though still large, has been shrinking. The debt ratio is low and most of this debt is contracted at concessional terms. If these broad macroeconomic policy strategies are followed and the reform momentum is maintained, longer-term fiscal sustainability should be within reach. However, the above listed weaknesses indicate that the present fiscal position is stillfragile, requiring further decisive reform and policy action. This fragility is in part due to the fact that most of the reforms are recent and need time to take root, and in part to the fact that new challenges are looming. Hence, additional efforts will be required to contain the overall budgetary deficit. 2 For a detailed discussion of timber and timber royalties, see Chapter 13 of the Background Papers. -8- C. GOVERNMENT MEDIUM-TERM BUDGET FINANCING STRATEGY 1.9 Government Assumptions. According to preliminary projections prepared by the Lao Government, total revenue is projected to grow rather slowly to nearly 14.9% of GDP in fiscal year 1999/2000 (from 13.3% of GDP in 1995/96). Over the five-year period 1995/96-1999/2000, total revenue is estimated at 13.9% of GDP and total expenditure is set to stabilize at 24% of GDP (Table 4, Statistical Appendix). The projections of the Lao authorities are based on assumptions of real GDP growth of 7.8-8% per annum and inflation that declines slowly from 12% to 6% over the period to 2000. Both of these projections exceed levels in the Policy Framework Paper agreed with the IMF and 3 the World Bank. 1.10 Projected Deficit. These preliminary projections would bring Government savings from 3.2% of GDP in 1995/96 to 4.6% by 1999/2000. In this scenario, the total deficit (before grants) would increase to 9.3% of GDP by 1999/2000 (from 8.8% in 1995/96). 1.11 Projected Composition of Revenues. Given the country's expenditure needs, the projected tax revenue/GDP ratio is low. In the Government's medium-term scenario, the major domestic tax categories --profit tax and turnover tax -- are projected to grow at the same pace as nominal GDP, 4 implying an overall buoyancy ratio of only 1.2. The average revenue buoyancy during 1988-94/95 was at 1.1 -- only slightly less than in the Government's medium-term projections (Table 2, Statistical Appendix). Of the major tax categories, only import taxes are projected to grow more rapidly than GDP. Growth in nontax revenue is projected to come almost exclusively from hydropower export revenue. Revenue from timber royalties, on the other hand, is set to stagnate at its current nominal level. Accordingly, the share of taxes in total revenue would decrease. Compared with the 1995/96 budget, the share of major tax categories in total revenue, such as profit, income, and turnover tax, would gradually decline. The share of timber royalties (together with some other, minor, categories) would shrink and be replaced by revenue from hydropower, which, together with some other non-tax categories, would account for more than 30% of Government revenue by 1999/2000 (Figure 1.2). 3 All GDP estimates in this report are based on the PFP projections of 7% real growth and a decline in inflation to 4.5% after 1998 (para. 1.13). The detailed revenue projections prepared by the Ministry of Finance are presented in Table 3 of the Statistical Appendix to the Background Papers. Although they contain no projections of foreign grants, the PIP for 1995/96-1999/2000 prepared by the SPC assumes the availability of foreign financing for 71% of proposed capital investments. 4 The buoyancy ratio of a tax category with respect to GDP is defined as the ratio of the annual growth rate of revenue from that tax category over the annual nominal growth rate of GDP. -9 - FIGURE 1.2: GOVERNMENT BUDGET REVENUE PROJECTIONS (PERCENT OF TOTAL REVENUE) 1996/97 1997/98 Profit tax Profit tax Hydro power, comf tx Hlydro poAer, Prt imtax odier nontax 5% other nontax 5% p 0/0 ~~~~~~~~~~~240% Timber Tumover tax royalties Turnover tax14/ 15% Timber 14% 12% ~~~~~~~~~~~~~~~~~~~royalties 1ne&Interest& 30a 1lease Oter taxes Trade tax . Otherte Tra2de/o tax 1998/99 1 1999/00 Profit tax Profittax hydro po%er, %I, Income tax M3O/ Income tax other nontax 5% Hydro poAer, 5% other nontax~ ~ ~ ~~~~~~~~~ohe ona 270% othr onax 2Ph. / _ ~~~~~ ~~ ~~30% /- Tumover tax Turnover tax 14%/ 14%/ Timber Timber royalties royalties ineesl nterest& ta lease Trade tax 200ro 3% Other taxes 2 /o lease Other taxes 11/ N. 1 1.12 The Government's projections do not fully reflect the concerns regarding fiscal sustainability and the needfor further adjustment. There are several problems with these projections: (i) a high level of domestic finance (without much Government savings) means there will be borrowing from domestic sources, which is likely to be inflationary; (ii) the Government is relying too heavily on high levels of real growth, which have never been sustained in Lao PDR before, to generate revenues, which is risky; (iii) the composition of revenues is not broad-based; (iv) the Government's tax effort is too modest; and (v) the projections continue to rely too heavily on aid. The following should be borne in mind: * The overall deficit may not be contained or may even widen under the Government's projections and thus undermine macroeconomic stability in the medium term. With expenditures set at 24% of GDP and revenue at 13.9%, overall deficits (before grants) will be only slightly lower than in the past two years (as indicated in para. 1.10). Should economic growth be lower than Government projections without compensating cutbacks in Government expenditures, deficits would be likely to increase. The outcome of this scenario may be the risk of accelerating inflation. - 10- * The Government's medium-term strategy for financing public expenditures, as depicted in Figure 1.2, depends increasingly on revenue from two primary sources: import taxes and hydropower. Over the medium term, this strategy seems risky since domestic direct and indirect taxes are not planned to contribute sufficiently to the diversification of the tax base. First, as the Lao PDR economy continues to integrate into the regional (jASEAN) and world economies, import taxes are likely to decline as a source of revenue. Second, projected revenues from hydropower exports over the medium and long terms are far from clear because there is still a risk that some of the major hydropower projects will not 6 materialize (Box 1.1). The prospect of growing revenue from electricity exports is uncertain, but may serve to delay the necessary broader-based diversification in fiscal revenue. * Maintaining timber revenues at current nominal levels may not be sustainable. The current levels of cutting -- over 600,000 cubic meters for 1995/96 -- are based on strip- logging of areas to be developed for hydropower projects (especially Nam Theun 2). 7 Once these projects have advanced, the logging potential is likely to decline sharply. In addition, logging should be reduced in line with the official environmental and reforestation guidelines adopted by Lao PDR. * The Government's projections are probably conservative in underestimating potential revenue from tax reform. Many of the tax reform measures taken during the past few years and the effects of the 1995 tax law are only now starting to generate domestic revenue effects. Overall, several measures in the tax law are likely to have a lasting 8 positive effect on revenue. This justifies a higher elasticity with respect to GDP than the unitary elasticity used by the authorities for major tax categories. 5 Negotiations with ASEAN on the terms of Lao PDR membership are still ongoing. The country is expected to join in 1997. Even if full compliance with the level of ASEAN import tariffs is still some years off, it is expected that gradual reductions will be made, starting in the near future. Hence a downward impact of revenue from import tariffs should be reflected in forecasts. 6 Only two hydropower projects currently under construction (Houay Ho and Theun Himboun) are likely to generate certain revenues before the year 2000, while a larger venture such as Nam Theun 2 is still under discussion and would only generate substantial budget revenues over the medium term. See Chapter 12 of the Background Papers for a detailed discussion. 7 For a discussion of timber royalties, see Chapter 13 of the Background Papers. The buoyancy of the system with respect to GDP will be increased by ad valorem excise duties which replace specific rates; higher turnover tax rates and the widening of the base for this tax category; the introduction of a land tax; the use of the market exchange rate for valuation of imports for duty and tax purposes; and the phasing out of the "forfeit" system for assessing profit and turnover taxes and replacing it by a "pro rata" system. For a further discussion, see Chapter 11 of the Background Papers. - I1 - BOX 1.1: POWER DEVELOPMENT AND PUBLIC EXPENDITURE Lao PDR's hydropower potential is one of the main resources of the country. Although electricity production currently contributes a relatively small share (1.4%) of GDP, the country's hydropower resources are being developed, principally for export. The country has an estimated potential of some 18,000 MW from over 60 possible project sites on the Mekong tributaries, of which less than 2% have been developed. At present, the largest hydropower plants are Nam Ngum I with an installed capacity of 150 MW, and Xeset, with an installed capacity of 45 MW. At present, EdL exports about 655 of its output of about 900 GWh of energy to Thailand. This accounted for about US$24.8 million in revenues, or about 8% of all Lao exports. Electricity is an important source of tax revenues; in 1994, EdL accounted for nearly US$9 million in total taxes and duties. Ex,panding Power Exports. Demand from neighboring countries for power exports has been secured with a protocol concluded with Thailand to purchase up to 3,000 MW from Lao PDR by the year 2000. In addition, agreements for power sales have been signed with Cambodia and Vietnam. To create a permanent source of foreign exchange (by exporting over 90% of electricity produced) and satisfy domestic demand -- which is estimated to grow at about 8% per annum, taking into account rural electrification-- the Government has thus far signed at least 23 Memoranda of Understanding with foreign developers to augment its hydropower potential, proposing an additional installed capacity of 7,000 MW. Projects with scheduled completion dates include Theun Himboun (by 1998), Houay Ho (by 1999), Nam Leuk (by 1999), Nam Ngum extension (by 2000), and Nam Theun 2 (by 2002). Financing Strategies. For small projects, the Government will continue to obtain official financing from multilateral and bilateral donors. However, the development of larger projects will be undertaken by private sector initiative, perhaps as a joint venture with the Government, or as a build-own-transfer (BOT) scheme. Since 1992, Lao PDR has encouraged developers to seek concessions for private development of hydropower projects to export energy to Thailand. Gains and Risks of Hydropower. Large hydropower projects are likely to bring significant future revenues but also entail significant uncertainties in the form of (i) technical risks; (ii) possible adverse environment and social impacts; and (iii) the financing (and taxation) arrangements which determine how the gains will be shared between the developers and the Government. Thus, before deciding on any power undertaking, it will be critical to determine that there are likely to be significant gains for Lao PDR and that the technical, environmental, and social risks can be appropriately mitigated. In justifying a large hydropower project, an additional critical issue is also whether the Government will be able to direct the bulk of incremental revenues into developmental and poverty alleviation expenditures. It is difficult to say how many of the two dozen proposed projects will ever be implemented. In the longer term, power exports could be a major source of revenues, but their timing and magnitude are highly uncertain. Hence, there are no reliable projections of the likely revenues actually accruing to the national budget. Power Development Strategy. The Government still has not set out a medium-term hydropower development strategy which would clearly establish which of the proposed schemes are economically and financially justified; what future revenues in the form of royalties, dividends, and taxes would accrue to the budget; what financing arrangements would ensure a fair share of the revenues for the Government; how the potential adverse social, economic, and environmental consequences of different realistic alternatives could be mitigated; and what financing needs would arise from project-related financial obligations. Such a strategy for hydropower development should focus on; (i) securing fnancing arrangements which ensure appropriate budget revenues; (ii) identifying the optimal hydro development for the local and export power markets; and (lii) introducing competition in the selection of developers and projects to obtain better conditions. The Government's projections do not reflect the likely reduction in the flow of foreign grants and other sources offoreign finance. However, current trends in donor countries to limit grants, and the current discussions over the replenishment of IDA, clearly signal -12- that it would be wise to anticipate a decline in grant flows over the medium term. Grant flows to Lao PDR may still be substantial as long as new donors (such as the European Union and South Korea) provide assistance, but should be expected to subside as the country's economy grows. D. PROJECTED RESOURCE ENVELOPE AND FISCAL SUSTAINABILITY 1.13 Alternative Projections. The key to strengthening fiscal sustainability lies with the need to continue the present macroeconomic policies. The Government's scenario depends too much on uncertain sources of finance (hydropower, timber, import duties, and foreign grants) and does not involve a large enough domestic effort to diversify sources of revenue and to finance a growing proportion of development expenditures. To ensure internal and external sustainability, estimates of the likely resource envelope in this PER are based on a somewhat more cautious macroeconomic scenario, derived from the Policy Framework Paper (PFP) 1996-98 and the consistency framework of the World Bank's RMSM model for Lao PDR (Table 1, Statistical Appendix). As agreed in the PFP, the main macroeconomic objectives will be to: (i) achieve an annual average output growth rate of about 7%; (ii) reduce consumer price inflation (end-year to end-year) to 7.5% in 1996 and 1997 and further to about 4.5% in 1998, broadly in line with inflation in major trading partners; and (iii) reduce the external 9 current account deficit (excluding official transfers) to 12% in 1998. 1.14 Resource Envelope. In the fiscal area, the projections show that a further reduction of the overall deficit after grants from its current level of -5.3% of GDP in 1995/96 to no more than -3.5% by 1999/2000 would be consistent with this policy line (Table 1.3). Once the impact of the 1995 tax reforms takes full effect, the average buoyancy ratio of the tax system is likely to increase to about 1.3, compared to a ratio of 1.1 over the period 1988-1994/95 (see paras. 1.20-1.24). Applied to total revenue up to 1999/2000, this ratio would yield about 424.4 billion kip in total revenue, or 15.5% of GDP. Increased revenues through increased efforts at domestic resource mobilization to at least 15.5% of GDP by 1999/2000 (as compared with 13.3% in 1995/96) would suffice to meet the objective of containing the budget deficit. 1.15 This realistic buoyancy ratio of 1.3 is based on an above-average buoyancy in those tax categories that are most affected by the new tax law, while the ratio for non-tax revenues is projected to stagnate at about 1.1. For some of the main tax categories (profit, income and turnover tax, and excise duties), a buoyancy ratio of about 1.4 over the period until 1999/2000 would be achievable through increased domestic resource mobilization. This alone would yield approximately 352.7 billion kip in 1999/2000 from tax revenue alone. In line with the suggested shift toward domestic tax sources, this estimate would represent about 83% of total revenue. 9 Regarding external balance, the PFP also sets the objective to increase and maintain the import coverage of gross official reserves to about three months of imports by end-1996 to provide a cushion against the economy's increased vulnerability to external shocks following the liberalization of the trade and payments system (Table 1, Statistical Appendix). In this scenario, the external current account deficit (11.2% of GDP in 1995 and 17.9% in 1996) will remain high until 1998, reflecting increased import demand, largely due to increased hydropower investment Thereafter, however, the deficit would start to decline as hydropower exports expand. To sustain external viability, export earnings will need to provide an increasing share of import financing, although foreign lending and assistance will continue to finance a large share of capital goods imports. - 13 - TABLE 1.3: ESTIMATES OF RESOURCE ENVELOPE, 1996/97-1999/00 1995/1996 1/ 1996/1997 1997/1998 1998/1999 1999/2000 Total Bn. kip % GDP Bn. kip % GDP Bn. kip % GDP Bn. kip % GDP Bn. kip % GDP Bn. kip % GDP Domestic Revenue 217.4 13.3 250.8 13.2 317.1 14.5 366.8 15.0 424.4 15.5 1,576.4 14.5 Tax 176.0 10.8 205.1 10.8 264.6 12.1 303.2 12.4 352.7 12.9 1,301.5 11.9 Nontax 41.4 2.5 45.8 2.4 52.5 2.4 61.1 2.5 71.1 2.6 271.9 2.5 Grants 57.7 3.5 74.0 3.9 75.0 3.4 75.0 3.1 70.0 2.6 351.7 3.2 Foreign Finance 112.0 6.9 103.0 5.4 115.9 5.3 129.6 5.3 117.6 4.3 578.1 5.3 Expenditure 361.6 22.2 409.5 21.5 471.0 21.5 526.7 21.5 588.9 21.5 2,357.7 21.6 Current 164.8 10.1 190.1 10.0 218.7 10.0 244.5 10.0 273.4 10.0 1,091.5 10.0 Capital 196.8 12.1 219.4 11.5 252.3 11.5 282.2 11.5 315.5 11.5 1,266.2 11.6 Current balance 52.6 3.2 60.6 3.2 98.4 4.5 122.3 5.0 151.1 5.5 484.9 4.5 Overall balance before grants -144.2 -8.8 -158.7 -8.3 -153.9 -7.0 -159.9 -6.5 -164.4 -6.0 -781.3 -7.2 Overall balance after grants -86.5 -5.3 -84.7 -4.5 -78.9 -3.6 -84.9 -3.5 -94.4 -3.5 -429.6 -3.9 1/ Figures for 1995/96 are actual estimates. Source: World Bank staff estimates. 1.16 A revenue target of 15.5% of GDP should therefore be realistically within reach over the next five years if adequate revenue mobilization efforts are undertaken. With this revenue stream, total expenditures could be kept more or less constant relative to GDP, at about 21.5%, which would seem a reasonable overall public spending level for the remainder of the decade. Provided the Government undertakes a systematic effort to ensure that sufficient resources are collected to meet its expenditure priorities, this likely resource envelope provides a realistic upper boundary for current and capital expenditures. On this basis, Government savings would rise from 3.2% to 5.5% of GDP and the overall deficit (before grants) would decline from 8.8% to 6.0% of GDP between 1995/96 and 1999/2000 (compared to a rise in the deficit to 9.3% in the Govemment's projections, para. 1.10). This increased domestic effort would compensate for the declining contribution of foreign grants and loans from 12.4% to 7.1% of GDP. In sum, a fiscally more sustainable financing plan could thus be achieved over the medium term through a somewhat higher revenue target (15.5% rather than 14.9% of GDP) and a moderately reduced expenditure target (21.5% rather than 24.2% of GDP) by 1999/2000. This reduction in proposed expenditures relative to GDP over the medium term should be achieved by trimming projected capital expenditures to a realistic level, given that several public investment projects have not been clearly identified. Current expenditures could thus remain at a roughly constant share of GDP and should only be increased for recurrent cost requirements in high priority sectors, such as education, if public revenue targets are exceeded. 1.17 Projected Current and Capital Expenditures. From the projected resource envelope over the next five years (Table 1.3), limiting current expenditures at around 10% of GDP and maintaining capital expenditures (including maintenance for major projects) at 11.5% is likely to be fiscally sustainable. Government current expenditure in Lao PDR is at a level comparable to other Asian countries (Table 2.1). It seems realistic to contain average current expenditures at roughly 10% of GDP as long as civil service reform holds the public wage bill in check with higher wages being compensated in part by reductions in the number of persons on the payroll (see Chapter 15, Background Papers). Foreign interest payments will not be a substantial burden, since most debt is on concessionary - 14- terms or has been rescheduled (Table 2.2). A constant ratio of current expenditures to GDP is also consistent with the argument for better social infrastructure (which should be brought about by efficiency gains) and higher provisions for operations and maintenance (since this is mostly included in the PIP). 1.18 Capital expenditures in Lao PDR consist of the Public Investment Program (PIP) excluding project-related technical assistance. The PIP could be considered as somewhat similar to a "Development Budget": it comprises recurrent spending on maintenance above 10 million kip (mostly for donor-financed projects), but does not include public participation in large hydropower projects which is largely donor financed in most cases. Privatizations have sharply reduced the share of capital expenditures and stopped transfers for operating expenses going to public enterprises, but the PIP still includes (mostly donor financed) capital investment programs for the utilities (water, 10 electricity, and telecommunications). It also includes investment programs in key sectors such as transportation, agriculture, and the social sectors. 1.19 A realistic resource envelope implies that the Government's proposed capital expenditure budget of 1,484 billion kip over the five-year period 1996-2000 (equivalent to 13.6% of GDP), while 11 not completely beyond reach, stretches a bit too far. To avoid inflationary pressures or potentially costly actions, such as reducing current expenditures or leaving projects in midstream, it would be better if the Government were to scale down its public investment program to around 11.5% of GDP (a total of 1,266.2 billion kip over the five-year period 1996-2000), as suggested in Table 1.3. A suggested prioritization of capital expenditures, consistent with this lower estimate, is provided in the next chapter. E. REVENUE MOBILIZATION MEASURES 1.20 The following changes in the tax system, brought about by the 1995 tax law, are expected to improve buoyancy: ad valorem excise duties which replace specific rates; higher turnover tax rates and the widening of the base for this tax category; the introduction of a land tax; the use of the market exchange rate for valuations of imports for duty and tax purposes; and the introduction of a pro rata 12 system for assessing profit and turnover taxes. 1.21 However, additional reform measures will be needed to achieve or exceed the 15.5% domestic revenue target and reduce the risks inherent in the Government's expenditure strategy. Without such measures the Government would not be able to reap all the benefits of tax system reform and would be unable to offset the uncertainties regarding foreign aid and revenues from hydropower and timber. Tax system consolidation in Lao PDR requires some additional revenue-enhancing measures which can take three forms: new taxes; modifications to existing taxes; and improvements in tax collection and administration. Since the most important taxes are already in place, short-term efforts should focus mainly on reviewing the tax system and, over the medium term, improving the tax administration. 10 For a detailed discussion of the PIP, see Chapter 7, Background Papers. II Projected capital expenditures are based on the proposed PIP of 1,500 billion kip over 1996-2000, adjusted for actual figures in 1995/96. 12 For details on the 1995 tax law, see Section D, Chapter I1, Background Papers. - 15 - 1.22 Tax reform should aim at diversifying the tax base by increasing reliance on domestic direct and indirect taxes, away from trade taxes and royalties. Domestic direct and indirect taxes are the traditional forms of taxation in most countries. Taxes on incomes, profits, and consumption should become as broadly based and as non-discriminatory as possible. The focus should be on those tax categories that typically demonstrate the highest elasticity with respect to GDP growth (i.e., turnover, profit, income, and land taxes, and excise duties). Most other categories--in particular non-tax categories -- are typically less elastic. Administrative improvements should focus on organization, better control, and collection. Taken together, the measures listed below would contribute to increasing the average buoyancy ratio of the tax system to about 1.3, which would bring revenue up to 15.5% of GDP by 1999/2000. 1.23 Short-run Measures. To safeguard adequate resources for public expenditure, the Govemment should implement the following revenue mobilization measures, which a recent IMF tax review suggested could generate additional revenues of as much as 20 billion kip (around 1.4% of .13 GDP) => Increase the turnover tax. An increase in the "base" rate from its current level of 5% to 7% could generate roughly 12 billion kip annually in additional revenue (calculated on the basis of the 1994/95 revenue yield). Gradually, the retail level should also be included in the tax system. When this is done, a transition to a full-fledged value-added tax system should be considered. => Broaden the income tax base. It necessary to unify the different progressive rate structures applicable to incomes from employment and other forms of income. Incomplete data on income make it difficult to compute the impact on revenue of this measure. = Increase excise duties, in particular on petroleum products. The increase implemented in May 1996 is a first step and is likely to yield roughly 5 billion kip on an annual basis. => Increase the land tax for residential land. Although revenue from this category remains a minor source, there still appears to be room for a further increase. 1.24 Medium-Term Measures. Administrative reforms should be continued to maximize the benefits from adopting a modem and broad-based tax system. There is no tradition of voluntary compliance among taxpayers in Lao PDR. A change in mentality will take time and will require even more effort from the tax administration. In addition to enforcing compliance with tax payments (including timber royalties), tax authorities should: (i) gradually transfer large taxpayers' accounts from the Tax Headquarters in Vientiane to the Vientiane Prefecture (with appropriate staffing, training, and equipment in the provincial office, this would give Headquarters more time to focus on broad oversight and managerial work); (ii) give Tax Headquarters an adequate budget, equipment, and space accommodations to enable it to carry out its mandate; (iii) carefully evaluate the costs and effectiveness of tax incentives given to foreign investors and enforce payments due; (iv) train and equip staff throughout the country with hardware and software, particularly auditors for taxes and customs; and (v) strengthen custons administration by enforcing compliance with regulations, clamping down on smuggling, and establishing more formal checkpoints. 13 For a full review of the Lao tax system, see Gandhi et al. (1995) "Lao PDR: Scope for Tax Reform," IMF. - 16- F. CONCLUSIONS 1.25 Despite the far-reaching reforms undertaken since the end of the 1980s, medium-term fiscal sustainability is not yet assured in Lao PDR, mainly because of the uncertainty of continued foreign aid inflows and fiscal revenues from hydropower exports. To achieve its expenditure goals in a context of fiscal sustainability, the Government must therefore further enhance the tax system and administration to mobilize additional domestic resources. 1.26 The Government's preliminary projections through 1999/2000 would bring revenue close to 14.9% of GDP. Together with planned expenditures at 24.2% of GDP, this would lead to deficits which are likely to be unsustainable in the medium term. Fiscal prudence suggests that the proposed PIP should be trimmed to stay within the likely resource envelope given by a feasible revenue target of 15.5% of GDP to ensure fiscal sustainability. Of equal concern is that the Government's medium term financing strategy is relying increasingly on revenues from hydropower production and trade taxes. Import tax revenue is probably overestimated in light of the further regional integration of the Lao economy. High dependence on uncertain hydropower exports as a main source of revenue does not reflect sound revenue policy and should be avoided. Even if these uncertainties only fully emerge over the longer term, it would seem advisable to start the process of diversifying the tax base now, and to rely more strongly on traditional domestic tax sources (i.e., income and commodity taxes). 1.27 The revenue mobilization measures listed in this chapter address these concerns and should enable the Lao PDR Government to increase revenue to around 15.5% of GDP or higher by the end of the century. The resulting resource envelope would put the Government in a more comfortable position to meet its exp_nditure goals while maintaining fiscal sustainability. -17 - PART II. PUBLIC EXPENDITURE ANALYSIS 2. STRUCTURE OF PUBLIC SPENDING: TRENDS AND TRADE-OFFS A. PUBLIC EXPENDITURE POLICY IN TIRE TRANSITION TO A MARKET ECONOMY 2.1 The level and composition of public expenditures have been changing gradually during Lao PDR's transition from a command to a market economy. At the heart of this transition are the growth of the private sector and the withdrawal of government from direct production. Increasingly, a large part of distribution, pricing, credit, and other economic decisions is left for markets to determine. 2.2 Effective public expenditure policy aims to influence three dimensions of expenditures: (i) the level and growth rate of expenditure and the overall fiscal balance as instruments of macroeconomic policy; (ii) the composition of expenditure to efficiently allocate public resources among government programs according to national economic priorities; and (iii) the design and implementation of individual expenditure programs to maximize their quality and cost-efficiency. As the economy moves toward a market-based system, the private sector undertakes much of the investmnent required for economic growth, rising productivity, and increased living standards. An appropriate public expenditure strategy supports the required changes in public expenditures associated with this transition. This section briefly examines the broad nature of these changes and what they imply for the strategic directions of expenditure policy in Lao PDR. 2.3 In Lao PDR, public expenditure patterns must increasingly reflect the demands of a market economy, where the Government typically fulfills three main functions: v Ensuring the provision of public goods and services that markets fail to provide completely or efficiently, such as defense, law and order, or environmental protection. Economies of scale and positive externalities also provide an argument for public investment in some infrastructure and some social services (for example, roads or water supply systems, health, education) that competitive private markets tend to undersupply or not provide efficiently. * Facilitating the effective functioning of markets by establishing a legal, institutional, and policy environment conducive to private sector development. This includes maintaining macroeconomic stability by balancing the expenditures with expected revenues to avoid substantial budget deficits and to contain inflation. * Alleviating poverty and pursuing broader social equity through income transfers, other measures of wealth redistribution, and expenditures that raise the poor's productivity (such as education, health, and rural roads). Some of the major changes in public expenditure policy in transition economies are also discussed in Ke-Yong, Chu and Robert Hohmann, "Public Expenditure: Policy Aspects," in: Vito Tanzi (ed.), Fiscal Policies in Economies in Transition, International Monetary Fund, Washington D.C., 1992. - 18 - B. ECONOMIC COMPOSITION OF PUBLIC SPENDING 2.4 Total Expenditure. Similar to other transition economies, the role of the state in Lao PDR has declined in relative terms since the beginning of substantial reforms. Public spending as a share of GDP has declined from 32% in 1988 to around 22% currently (Table 2, Statistical Appendix). This share of public expenditure is roughly comparable to the average levels in other developing countries generally (Table 2.1) and can be considered roughly appropriate given Lao PDR's stage of development. Increased public expenditures (e.g., 1994/95) were generally concentrated in investment rather than current expenditures. 2.5 Overall Trends. Expenditure policies have shifted markedly to reduce budget deficits and to reorient priorities over the last few years. Lao PDR's move toward a market economy has been accompanied in a changing economic composition of expenditures, including (i) large fluctuations in capital investments and (ii) relatively stable overall current expenditures, with a rising share of wages and salaries, reduced administrative expenses, and low shares of interest payments and subsidies (Figure 2.1). Although these changes indicate the capacity of public expenditure management in Lao PDR to respond to changes, the following overview shows that the typical problems of bias toward new capital investment, underfunding of non-wage operations and maintenance (O&A , and overstaffing of a poorly paid civil service remain policy issues. There is also concern that (i) new capital investments are undertaken at the expense of maintaining existing 2 infrastructure, and (ii) administrative expenses cover substantial non-wage benefits. TABLE 2.1: ECONOMIC COMPOSITION OF PUBLIC EXPENDITURE: INTERNATIONAL COMPARISON Lao PDR Vietnam Thailand Indonesia Philippines LDCs (Avg. 91-95) (Avg. 90-95) (1994) (1994) (1994) o~~J 0 .~~~~~~~~~~~F 0 e ;0 0c 0 O , 0 0c . 0 0 Total Expenditure 100.0 21.6 100.0 26.2 100.0 16.5 100.0 18.5 100.0 21.2 24.4 CurrentExpenditure 52.2 11.3 48.2 12.6 66.9 11.1 57.7 10.7 80.2 17.0 19.6 Consumption, o/w: 41.4 8.9 39.6 10.4 56.1 9.3 45.2 8.4 36.3 7.7 16.3 Goods and Services 18.8 4.0 14.6 3.8 30.8 5.1 14.0 2.6 na na 9.2 Wage 22.7 4.9 25.0 6.6 25.2 4.2 31.2 5.8 na na 7.1 Interest Payment 3.4 0.7 4.6 1.2 3.7 0.6 12.0 2.2 30.2 6.4 4.9 Subsidies and Transfers 7.3 1.6 4.0 1.0 7.2 1.2 0.5 0.1 13.7 2.9 3.8 Capital Expenditure 47.8 10.3 51.8 13.6 33.1 5.5 42.3 7.9 16.5 3.5 4.2 Sources: Lao PDR: Government authorities; Other countries: Unified Survey data base; LDCs; Pradhan (1995). 2 There are apparently no extrabudgetary funds, although data limitations make it difficult to verify this. - 19- FIGURE 2.1: MAJOR GOVERNMENT EXPENDITURE CATEGORIES (PERCENT OF TOTAL EXPENDITURE) 1988 1 1992/93 Materials & Materials & Supplies Supplies 20.9%232 Traosfers Capital - i s3 Expenditure Salaries Severance Capiital 15.2% Paymnents Expenditure eI .terest 12% Wages& Payents Salaries 4.0% 25.8% 1994/95 1995/96 Materials & Materials & Supplies Supplies 14.5% Transfers 14.3% Transfers 6.3% 6.5% .............. ASeverance Severance ........... Payments Payments Capital 0.8% 0.5% Expenditure Interest Capital Interest 51.4% Payments Expenditure Payments 3.7% 54.4% 2.6% Wgs&Salaries 21.7% 23.3% 2.6 Capital Expenditures. More than half of public expenditures are allocated for capital investment, reflecting the country's vast infrastructure needs and the dominance of donor-driven investment programs. By contrast, public expenditures in many developing countries are dominated by current expenditures (Table 2.1). The Government has tended to use adjustments in capital expenditures as an instrument to respond to revenue shortfalls and inflation control. Overall expenditures were compressed from 32% of GDP in 1988 to 18% of GDP by 1992/93 (Table 2, Statistical Appendix) by reducing capital outlays, in response to a sharp drop in revenues due to faltering SOE performance, tax reform, and the drying up of Soviet assistance. Large-scale privatization also led to a transfer of public investment activities to the private sector (Box 2.2). As a result, capital expenditures were cut from 64% of total government expenditure to 39% between 1988 and the 1992/93 fiscal year (Figure 2.1). Since 1992/93, however, the Government has been boosting public investment to around 12% of GDP, more than half of total expenditure (Table 3, Statistical Appendix). - 20 - 2.7 The resulting bias in favor of public investment raises several questions: Are the existing investments in the different sectors efficiently operated and maintained? Are the recurrent cost implications of new investments adequately taken into account? These issues of intrasectoral allocations are discussed for key sectors in Chapter 3 of this report. At the same time, resources will not be allocated in accordance with priorities or translated into concrete results without the right institutional framework. Chapter 4 thus discusses how existing institutional arrangements bias expenditure choices and what might be done about this, and also addresses another question: To what extent do budgetary arrangements ensure that existing investments are consistent with policy and program priorities? 2.8 Current Expenditures. Current government expenditures have remained remarkably stable as a share of GDP over the years but their composition has changed noticeably since the late 1980s (Figure 2.1). * The bulk of current expenditure shifted markedly in favor of employee compensation. The wage bill rose sharply from 15% of total public expenditure in 1988 to almost 26% in 1992/93 owing to salary increases and an expansion of the civil service. Since then, civil service reform has lowered the wage bill to 22% in 1995/96. * As retrenchment has slowed down, severance payments have also been reduced. Similarly, transfers (mainly pensions) have been declining slightly since 1992/93. * Administrative expenditures (materials and supplies) have dropped substantially, to less than 15% of total expenditures, after reaching a peak of 23% in 1992/93. * Government debt service has decreased slowly, and remains below 1% of GDP and less than 3% of total expenditure. 2.9 Wages and Salaries. Lao PDR occupies a middle ground in terms of the size of its wage bill compared to its regional neighbors. Low public sector salaries make it difficult to recruit and retain qualified staff, despite sizable non-wage benefits (para. 2.10). Since pension entitlements are at present fully indexed to civil service grades, the Government needs to be cautious in considering further public salary increases to avoid unmanageable costs in the future (Box 2.1). At the same time, there is a danger that low public sector salaries will restrict recruitment to those who cannot gain employment in the private sector, contributing to a second class bureaucracy. This would conflict with the argument of this review for the need to improve the efficiency of public administration--including devolving the responsibility for decision-making (see Chapter 4). 2.10 Administrative Expenses (materials and supplies). This highly aggregated budget item includes the Government's operating budget (for water, electricity, fuel, telephone, etc.), and covers 4 purchases for office supplies and equipment (photocopiers, computers, fax machines, cars, etc.). A more detailed breakdown will be available only when the new budget nomenclature is implemented 3 This is also reflected in an increased monetization of previously hidden food subsidies and a declining share of materials and supplies (Figure 2.1). For a detailed discussion of civil service reform, see Chapter 15, Background Papers. 4 About 50% is accounted for by operational costs which can reach 60-70% for ministries with large staffs such as Health and Education. The remainder is for equipment and O&M. It includes repair and renovation of ministries and both official and non-official maintenance of equipment which covers non-wage benefits such as the repair or renovation of housing and cars allocated to officials. - 21 - 5 for the 1996/97 budget. The picture emerging from more disaggregated data at the ministry level cannot entirely alleviate the concern that this part of administrative expenses hides substantial non- wage personal benefits for civil servants, primarily in the forn of education benefits for dependents, repairs of private homes, cars for private use, plus fuel and vehicle maintenance. At the same time, allocations for official (non-personal) maintenance cannot be clearly identified; most O&M for capital expenditures is supposed to be covered by the PIP. As discussed in Chapter 4, this tends to lead to inadequate provision for general maintenance and a bias toward new investment. 2.11 Interest Payments and Debt Service. Government debt service is almost evenly split between 6 foreign debt service and debt service on Treasury bills, which were introduced in March 1994. Lao PDR's external convertible currency debt amounts to US$0.7 billion, which mainly consists of soft loans from multilateral donors. Lao PDR is classified as a highly indebted country, but this is due to the outstanding debt incurred through the non-convertible CMEA area (Table 2.2). Valued at the official exchange rate declared by the Central Bank of Russia (transfer ruble 0.56 per US$1), this 7 represents US$1.4 billion; but at the ruble market rate, its value would be considerably lower. Total external debt is equivalent to about 52% of GDP in net present value terms. TABLE 2.2: LAO PDR: EXTERNAL DEBT OUTSTANDING (US$ MILLION) 1990 1991 1992 1993 1994 Convertible area 338 412 492 579 687 Bilateral creditors 32 30 31 34 41 Multilateral creditors 306 381 461 546 646 Nonconvertible area 1,419 1,410 1,401 1,391 1,382 2.12 Subsidies and Transfers. Social welfare provisions are very limited in Lao PDR (Box 2.1). Transfers account for less than 7% of total expenditures, and cover social welfare payments which are roughly equally divided among social security expenditures, purchase of pharmaceuticals, and 8 emergency relief Despite a similar historical legacy, this is in sharp contrast to the substantial 5 The new budget nomenclature was adopted by the Ministry of Finance in 1995 and will be introduced for the 1996/97 budget. It follows the French budget classification and presents budget and Treasury data in a more disaggregated and transparent form. 6 In 1992/93 the Govemment had issued costly Treasury bills to the public and six-month bonds through the BoL to commercial banks and state enterprises to finance a budget shortfall. These bills were retired rather suddenly in 1994, creating inflationary pressures. 7 The CMEA debt is mostly held by Russia and can be classified into three types: some very small amounts of debt on which a repayment schedule in kind has been agreed; debt, nearly amounting to 90% of the total, for which a moratorium has been agreed until 2005; and debt for which no repayment terms have yet been worked out. Pending an eventual bilateral or Paris Club settlement of the ruble debt, both the implicit value of in-kind transfers (mainly coffee) and the market rate of the ruble indicate a significant discount of Lao convertible debt from its official value. s About one-fifth of the amount is for the Ministry of Labor and Social Welfare to reimburse civil servants for drugs bought (transfer of the Pension Fund and Social Security Funds to the MLSW). About four-fifths are for the Ministry of Health to pay for: (i) drugs bought by hospitals at the central and provincial levels; (ii) prevention (vaccination campaigns when already planned); and (iii) epidemics (forecast). If epidemics and calamities needs exceed the forecasts in the "purchase of drugs" line, the "emergency" item would be used. - 22 - Box 2.1: SOCIAL SECURITY PROVISIONS IN LAO PDR Provisions for social security essentially cover only civil servants. While the vast majority of the rural population has to rely on informal social safety nets and provisions for private sector employees are still under discussion, the current scheme for civil servants is relatively comprehensive and generous. The present system of financing civil service benefits reveals several flaws (see also Chapter 16, Background Papers): > There is no specific matching contribution from the government as employer and the resulting deficit is a growing fiscal liability. ' The benefits coverage is not clearly defined. > It is not clear whether former SOE employees still maintain their pension rights. => The burden of pension payments is likely to increase unless the Government stops fully indexing earnings to the civil service grade and scale at the time of retirement. This inhibits civil servant salary reform, because increases in compensation translate into additional pension costs. Social protection for the private sector labor force is limited. The 1994 Labor Law provides for a program for protection of workers, including assistance to victims of occupational injury or disease. While some private sector employers are complying with the Law, others are not. It is desirable to ensure consistent and fair payments and compensation for these situations. However, implementing regulations have not yet been completed, so that benefits and necessary contribution levels are not clear. Article 48 of the Labor Law also contains provisions establishing a social security fund (or funds) and the right of workers in the private sector to retirement benefits. Regulations to establish and operate the fund(s) and to define contributions and benefits have not yet been formulated, but they may become a fiscal burden in the future if not properly designed. Recommendations for Social Security Reform: > Restructure the public sector pension scheme in accordance with following principles: (i) establish a self- financed pension fund based on contributions from employer(s) and workers; (ii) separate pension financing from other benefits (war veterans, health care); (iii) revise the pension forrnula with a link to the CPI and lower replacement rates; (iv) revise the system for determining insurable earnings; (v) provide for survivors and equal retirement age for women; and (vi) ensure adequate coverage of SOE employees. = Strengthen the administration of social security. Increase the capacity of the Ministry of Labor and Social Welfare (MLSW) to monitor the financing and administration of the Social Security Fund by: (i) establishing a data base for all pensioners; (ii) revising procedures for collection of pension information; (iii) introducing computerization for management of the data base; and (iv) reviewing and integrating the functions of the Departments of Social Security and Pensions. => De-link pension adjustments. Pension adjustments are currently indexed fully with increases in civil service salaries but should be linked to the CPI to be made more manageable. > Prepare an implementing regulation to article 48 of the 1994 Labor Law which is coherent, consistent and affordable. The Government should carefully study social security alternatives for the private sector to be aware of alternative schemes and their costs. Thus, a very cautious approach should be taken to the provision of pension arrangements for private sector workers. At this stage, the government should only allow for a very modest scheme to provide for employment injury, sickness, maternity, and death. - 23 - support for war veterans in Vietnam, where a large proportion of social spending is on pensions and welfare (over 13% of the entire budget in 1994). 2.13 How is the financial viability of the consolidated public sector affected by subsidies and transfers to and from public institutions outside the Central Government? As a result of large-scale privatizations, non-tax revenues from dividends and lease payments of non-financial public enterprises have lost their importance as a source of budget revenues, only accounting for about 9 2.7% of total revenues in 1995/96 (Box. 2.2). A remarkable feature of public expenditure management in Lao PDR is the hard budget constraint imposed on SOEs which do not receive direct 10 operating transfers from the state budget. However, the PIP still partially finances the investment program of state-owned utilities, mostly through donor funding. Moreover, the remaining "strategic" SOEs still rely on credit lines from state commercial banks and their management presents a major task for public sector efficiency (Box 4.5). 2.14 As far as financial public entities are concerned, available budget data do not suggest a direct fiscal link between the budget and state commercial banks (through subsidization) or the central bank (through profit transfer). However, there are at least two connections between the state-owned part of the financial sector and the state budget. First, the Government budget subsidized the establishment of the Agricultural Promotion Bank (APB) through a one-off payment, but apparently does not finance the APB's operating costs (which are partially covered by the profits of other state commercial banks). Second, the loan portfolio of state-owned commercial banks may contain bad 12 loans. To prevent them from becoming a fiscal liability, financial accounts of state commercial banks need to be audited according to international standards, and loan loss provisions will have to be phased in gradually. 9 For a discussion of the SOE sector and privatizations, see Chapter 14, Background Papers. 10 By contrast, most transition economies still pay significant transfers to their ailing SOE sector even when the budget relies heavily on surpluses extracted from SOEs. For instance, neighboring Vietnam still pays subsidies to SOEs equivalent to around 5% of total SOE transfers to the budget (World Bank Report on Industrialization and Industrial Policy in Viet Nam, 1995). it On the Agricultural Promotion Bank, see Box 1, Chapter 3, Background Papers. 12 A recent audit report commissioned by the ADB (TA No. 2316-LAO) warns that collectively the SOCBs need to set aside additional loan loss provisions in the order of 11,834 million kip (US$12.86 million). However, methodological issues will require a more thorough study based on a larger sample. - 24 - Box 2.2: DIVESTING STATE-OWNED ENTERPRISES - PROGRESS AND ISSUES Lao PDR has gone further than most other ex-socialist countries in divesting most SOEs and reducing their drain on the budget. In 1988, the total number of SOEs was estimated at around 600, of which approximately 260 were in the industrial and small-scale manufacturing sectors, accounting for about 10% of GDP at that time. Seventy percent were under the control of provincial governments, and 30%, mainly the larger ones, pertained to the Central Government ministries. Most of these SOEs were small, with fewer than 30 employees. By 1995, most of the small and medium-size SOEs, and a large percentage of the larger ones, had been privatized. About 90 SOEs remain under state ownership, of which 58 SOEs (27 in the central Government portfolio and 31 provincial under provincial control) are targeted for privatization in 1996/97. The private sector, including a rapidly growing body of new start-ups, now dominates the insurance, manufacturing, transport, and distribution sectors, and is strongly represented in banking and construction where it now competes with SOEs. Despite this promising emergence of private sector activity, there is disappointment over the Number of SOEs performance of privatized SOEs. Pressure emerged 500 after the recent Sixth Party Congress to slow down lp the privatization process and to reintroduce trade 400 protection measures and soft lending from the state 300 commercial banks to prop up failing enterprises. 200 - However, this shift in policy fails to take account of two observations: 100 i~ 0 * The comparative performance of new private 1990 1995 Expected start-ups and privatized enterprises indicates that 1997 Lao PDR is experiencing a necessary process of economic restructuring. Former SOEs that could not survive in a competitive and non-subsidized environment are being eliminated. This process is essential for better use of scarce resources. * The disappointing performance can be linked to the main method of privatization -- leases usually granted through a non-competitive process rather than outright sales -- which encourages investors to opt for short- term gain. In the future, the Government should transfer full ownership of assets in order to give incentives to new owners to manage the privatized firms for long-term benefits. Recommendations for Privatization =, Do not backtrack on privatization progress. Lao PDR cannot afford to divert scarce economic resources to artificially provide a life-support system for non-viable enterprises. The Government should instead focus its efforts and resources on improving the conditions for sustainable growth of private activities. =. Replace leases by outright sales. The Government should eliminate leasing. SOEs should be privatized through outright sales to the highest bidder in a fully competitive process. Experience suggests that private operators that have invested their own financial resources to become owners of productive ventures are far more likely to take an active interest in the long-term success of their property than operators, such as lessees or management contractors, that simply use the assets of others at no financial risk to themselves. - 25 - C. FUNCTIONAL COMPOSITION OF PUBLIC SPENDING 2.15 Sectoral expenditure priorities have resulted in several key trends in the functional allocation 13 of spending across key sectors (Table 3, Statistical Appendix). * Public investment has been mainly concentrated in the economic sectors. In particular, the transport sector (especially roads) has accounted for a very large share of public spending compared to other countries (see Table 2.3). This reflects the extremely poor '4 road network in this sparsely populated country. As Chapter 3 shows for transport, substantial funding for roads also reflects the costly rehabilitation of existing roads, which were insufficiently maintained. * The share of Government spending in "industry" has been declining with progress in privatization. Allocations toward SOEs under the category "industry" have been replaced by public investment in energy, especially hydropower. * Social sectors (especially education and health) have not received adequate attention. Social spending as a percent of GDP has been very low by international standards (Table 2.3), although the share of education and health increased from 11% to 19% of government expenditure between 1990 and 1995/96. - There has been a marked sectoral difference in the balance between capital and current spending: expenditures in social sectors have gone mainly to wages, while expenditures in economic sectors (agriculture, energy, and transport) have been heavily concentrated 16 on infrastructure, with few resources devoted to recurrent spending. 13 Intersectoral analysis is somewhat limited in that a sector constitutes too aggregate an expenditure category, consisting of expenditures with very different rationales for government intervention, economic rates of return, and impacts on the poor (for a discussion of these criteria, see Chapter I of the Background Papers). A program as a set of expenditures within a sector constitutes a more useful unit of analysis, and this is the approach taken in the sectoral discussion in Chapter 3 of this report. 14 In a landlocked economy, roads link dispersed domestic markets and open profitable trade routes to economically strong regional neighbors -- China, Thailand, and Vietnam. Moving away from a rural subsistence economy requires that farmers have access to markets to sell their produce. Feeder roads help reduce poverty and increase economic growth. See WDR (1990). 15 The energy sector is classified under "Industry" since it falls under the authority of the Ministry of Industry and Handicraft. On hydropower, see Chapter 12, Background Papers. 16 Current expenditures on wages have been particularly high in the education sector, where a large number of former revolutionaries are on the payroll as teachers (see Chapter 15, Background Papers). Salaries also seem to make up the bulk of funding within the highly aggregated expenditure category "Other," although data limitations prevent a detailed discussion. - 26 - TABLE 2.3: INTERNATIONAL COMPARISON: SECTORAL EXPENDITURE SHARES (PERCENT OF TOTAL EXPENDITURE) Lao Vietnam* East South Southern Latin All LDCs PDR** Asia Asia Africa America Social Sectors 15.4 33.2 33.5 26.5 26.2 31.3 28.2 Health 4.4 5.5 7.0 4.2 5.5 7.2 Education 11.0 10.4 20.5 8.9 14.0 14.9 Social security and welfare * 12.2 3.1 5.7 2.3 5.5 Economic Sectors 41.7 23.7 25.2 30.6 22.2 18.6 22.5 Industry 6.2*** 3.3 1.9 2.9 2.2 7.6 Energy 7.5 1.3 2.2 1.3 1.3 Agriculture 9.9 1.4 8.1 11.2 7.4 4.1 Transport and communications 25.6 7.5 1.9 9.7 6.2 7.6 Other Sectors 42.9 43.0 47.0 42.9 51.6 50.1 49.0 Total Expenditure 100 100 100 100 100 100 100 Share of Total Expenditure to GDP 25.4 26.2 22.5 21.3 23.2 17.3 24.4 * Average, 1992-95, Vietnam PER. * Average, 1992/93-1994/95. t Includes energy. Source: IMF, Government Finance Statistics. 2.16 Public Investment Program, (PIP). Changes in the composition of public investnent have played a central role in adjusting the role of state involvement to the demands of an evolving market- based economy. In fact, the PIP took on an increasingly important function as the country's development program. Reflecting available donor funding, public expenditures became heavily concentrated on infrastructure investment, in line with the Government's stated development priorities. The breakdown of investment by ministerial responsibility in Figure 2.2 highlights the shift in the last five-year PIP (1991-94/95) from direct government involvement in productive sectors toward infrastructure investment. * Transport and communications increased to 47% of total investment in 1994/95 compared with 37% in 1985, at the expense of other sectors (down from 30% to 7%). The main focus of investment was on the construction of national roads (Roads No. 8, 9, 13, 20); interprovincial roads and the (Australian grant financed) Friendship Bridge across the Mekong. It also included water supply systems and provincial airports. Investment in telecommunications focused on microwave installations and telephone communications. Public investment under the responsibility of the Ministry of Industry and Handicraft dropped when SOEs were divested or cut off from subsidies, but then increased again due to energy investments, from 15% in 1985 to 20% in 1994/95. This industry/energy category now covers the domestic Government investment in power transmission and generation, but largely excludes Government participation in large power projects designed to export power. It also includes some support for the development of the industrial and handicraft sector in the form of credit for private industrial firms and - 27 - FIGURE 2.2: COMPOSITION OF PIP, 1985 AND 1994/95 198 1994/95 Others Agriculture Health 70/o Agriculture Others 15% 5% 13% Education 8%/ Industry & Industry & Energy Energy 150/o 20% Education Transport& Tansport & 3% _,/ Telecom Telecom geological surveys. In recent years investment focused on electricity transmission and generation with the construction of the Xeset Dam and the Nam Song Dam. * The share of public investment in agriculture declined somewhat from 15% in 1985 to 13% in 1994/95 since subsidies to farmers were abolished. Investments focused on irrigation, but also supported rural development and forestry management as well as establishing the APB. v The relatively small share of social sector investments has been an important corollary of this infrastructure-based development. However, as the Government's development objectives focused on the need to strengthen human resources, it increased investment in education in the PIP (8% in 1994/95 compared to 3% in 1985) and health (5% in 1994/95 compared to 0.4% in 1989). After some delays, investment in education focused on the National Polytechnic and the National University and on teacher training and the expansion of the provincial education network. Investments in the public health sector were also delayed and were mostly devoted to disease prevention. Investment in social welfare assisted the return of Lao refugees, and the construction of retirement homes, orphanages, and rehabilitation centers for the disabled and war veterans. * About 2% of investment was allocated to the Ministry of Information and Culture, mostly for television broadcasting, the preservation of national culture and the rehabilitation of historical and cultural sites. 2.17 External Financing. Public investment has broadly followed the Govemment's development priorities, but it has been clearly driven by available foreign assistance. Foreign donors funded approximately 75.6% of Lao PDR's PIP in 1995/96. The degree of foreign financing varied considerably from sector to sector (Figure 2.3). Among the main sectors, the highest shares of foreign financing were in energy, social welfare, health, and transport, while most of the funds for public building and information and culture came from domestic sources. To date, donors have thus tended to support the Govemment's emphasis on infrastructure development. This substantial share - 28 - of donor financing may be justified in view of the country's low level of development but should be a source of concern if it creates long-term dependency by substituting for efforts at domestic resource mobilization. Moreover, effective aid coordination should aim to minimize conflicts, overlaps, and waste and to ensure that foreign assistance supports the country's development needs 17 rather than particular donor agendas. FIGURE 2.3: SOURCES OF PIP FINANCING, 1995/96 (PERCENT) 70.6 77.2~~~~~~~0. 2.18 Conclusions on Past Trends. In sum, public expenditure in the past has been dominated by donor-financed investment, reflecting the country's pressing infrastructure need. However, economic andfunctional expenditure shifts did not go far enough in addressing the human capacity constraint by investing in people 's health and education. Past trends in expenditure allocation broadly reflected the Government's overall development objectives and supported the changing role of the state. The heavy emphasis on infrastructure, particularly roads, allowed remote provinces to share in the benefits of growth and improved living conditions in rural areas. Public sector involvement in the economy was beginning to be redefined with the abolishment of subsidies for SOEs and farmers and the encouragement of private sector participation. A trade-off in emphasizing infrastructure has been the relative neglect of social goals such as human capacity building, rural development, and poverty alleviation, although the state has begun to put more emphasis on social programs. The shortcomings of social sector investment also underlined the country's limited implementation capacity and delays due to insufficient counterpart funds for donor-financed projects. 17 On donor coordination, see Chapter 10, Background Papers. - 29 - D. FUTURE TRENDS IN PUBLIC EXPENDITURE 2.19 Budget Outlook and Planned PIP, 1996-2000. The Government's budget projections for 1996-2000 -- which exceed the estimated resource envelope in Table 1.3 -- reveal that some important shifts in the Govemment's development priorities have taken place, compared with the I8 trends of the last five-year PIP (1991-1995) (Table 2.4). Most important, policymakers have recognized the significance of social sectors as a key development constraint. Budget allocations to health and education are proposed to rise from 19.3% of total expenditures (or 4.3% of GDP) to 25% (5.3% of GDP) by the year 2000. Most of this increase will be achieved by a very substantial reallocation in proposed capital spending, which would almost double the share of education and health in the new five-year PIP (1996-2000) to 19% of public investment, compared to an average 19 around 10% in the last five-year PIP (1991-95) (Figure 2.4 and Table 2.5). In fact, the high real growth rate of proposed health expenditures raises serious concems of absorptive capacity in the health sector (para. 3.74). Economic sectors would still make up for the bulk of public expenditures, but their share is projected to decline from 43% of total expenditures (9.6% of GDP) to 34% (7.9% of GDP). Again, most of the reallocation of public spending would be brought about by a shift in capital rather than current spending and would fall on the transport sector. Although expenditures will be higher in absolute terms than in the previous five-year period, the relative share of transport would drop from around 51% to 35% of public investment in the 1996-2000 PIP (Figure 2.4 and Table 2.5). TABLE 2.4: GOVERNMENT EXPENDITURE BY FUNCTIONAL CLASSIFICATION, 1995/96-1999/2000 1995/96 1996/97 1997/98 1998/99 1999/00 Real Growth % of % of % of % of %of %of %of % of % of %of '95/96-99/00 Total GDP Total GDP Total GDP Total GDP Total GDP (%) Agriculture 7.8 1.7 7.5 1.8 7.7 1.8 7.7 1.8 8.3 1.9 10.2 Industry/Energy 8.5 1.9 8.0 1.9 8.2 1.9 8.5 2.0 8.8 2.0 9.5 Transport/Comm. 23.7 5.3 22.0 5.2 20.9 4.9 19.0 4.4 17.5 3.9 0.6 Education 12.5 2.8 12.4 2.9 12.7 3.0 13.0 3.0 13.5 3.0 10.8 Health 6.9 1.5 7.4 1.7 8.1 1.9 9.1 2.1 10.4 2.3 20.2 Other Sectors 40.6 9.0 42.8 10.1 42.3 9.9 42.6 9.8 41.5 9.3 9.2 TOTAL 100.0 22.2 100.0 23.7 100.0 23.5 100.0 23.0 100.0 22.3 8.5 Sources: Minisuy of Finance and World Bank staff estimates. IS The detailed breakdowns of proposed government expenditure up to the year 2000, given in Tables 4-6 of the Statistical Appendix, are based on Ministry of Finance Budget Department's projections for current expenditures and the projections of the SPC draft PIP 1996-2000 for capital expenditures. 19 Projected capital expenditures are approximate. The Government's proposed figures are set to equal the five-year PIP 1996-2000, which is summarized in Table 6 of the Statistical Appendix to this report and presented in more detail in Table 4 of the Statistical Appendix to the Background Papers. The PIP figures also include technical assistance, which is not separately identified. This outline of the PIP is still being revised to address data inconsistencies, incorporate new Party recommendations, and identify projects more clearly. Some of the data problems are still severe: a detailed breakdown by sectoral programs is only available in U.S. dollars and is not consistent with aggregate figures; the aggregate of identified projects amounts to far less than the projected total public investment over the five-year horizon; and actual capital expenditures have not been fully incorporated. - 30 - FIGURE 2.4: PIP COMPARISON, 1991-95 AND 1996-2000 60.0% 50.0% 40.0% - ____ 30.0%- - 20.0% ~ ~ ~ ~ ~~ 1~01996-2000 20.0%- 10.0% _fi L __fi__ _ 0.0% >. E o ,, E Z 21 ~~0 co _ '~~~~~~~4 la 0 TABLE 2.5: COMPARISON BETWEEN 1991-1994/95 AND 1995/96-1999/2000 PIPs 1991-1995 1996-2000 Actual PIP Gov't PIP* PER Suggested PIP Billion kip %of total Billion kip % of total Billion kp r% of total Agriculture 82.3 15.4 168.9 11.4 168.9 13.3 Industry 92.9 17.4 217.7 14.7 217.7 17.2 Transport/Communication 273.5 51.2 513.5 34.6 383.5 30.3 Education 35.4 6.6 145.4 9.8 145.4 11.5 Health 18.8 3.5 120.9 8.1 120.9 9.5 Information 9.4 1.8 30.4 2.0 30.4 2.4 Social Welfare 2.3 0.4 96.5 6.5 96.5 7.6 Public Building 13.5 2.5 47.1 3.2 47.1 3.7 Rural Development 6.4 1.2 143.8 9.7 55.9 4.4 Total 534.4 100.0 1,484.0 100.0 1,266.2 100.0 Total as percent of GDP 13.6 11.6 * The new Government-proposed PIP during 1995/96-1999-2000 amounts to 1,500 billion kip. The figure in this table is lower because it reflects actual 1995/96 capital expenditure which is lower than proposed. Sources: Government authorities and World Bank staffestimates. 2.20 Development Objectives and Public Investment. Under the PIP for 1996-2000, all of the Government's traditional priority programs mentioned in Chapter I of this report receive attention, although the order of priorities differs in terms of actual budget allocations (Figure 2.5). Food production is still the number one policy objective, but in terms of funding it continues to trail far behind public investment in infrastructure. In fact, planned allocations show a continuing emphasis on bricks and mortar, or more correctly, asphalt. Human resource development is the last in the order of priorities but will be given a tremendous boost over the coming years. - 31 - 2.21 Agriculture-based objectives (rural development, together with goods production and the reduction of slash-and burn cultivation) will receive higher importance than in the past. Following the resolutions of the Sixth Party Congress in March 1996 for an increased emphasis on the rural sector, the draft PIP for 1996-2000 was revised by substantially increasing the allocation for rural development from 55.9 to 143.8 billion kip over the next five years. Since the allocations for other sectors were not cut correspondingly, the overall PIP was simply increased without regard to fiscal sustainability or to ensuring adequate funding. It was assumed that donor funding would be forthcoming, but no projects or programs have been developed to give real meaning to this line item. This example of ad hoc public expenditure allocation makes the case for moving toward a more 20 systematic forward-looking medium-term expenditure framework advocated in Chapter 4. FIGURE 2.5: COMPOSITION OF PROJECTED PIP, 1995/96-1999/00 100% 80% 60% 40% 20% 0% 9 199912000 1995/96 1996/97 1997/98 1998/99 1999/2000 *Blnfrastructure 0Human resources *Abolishment of slash & bum *Food production *Goods production & seNrices 3Rural Development 2.22 Future Agenda. The Government's proposed medium-term expenditure projections are still tentative because revenue forecasts are unclear and the five-year PIP 1996-2000 is being revised in the light of methodological weaknesses and Party guidelines. Nonetheless, it is clear that the focus of public spending is broadly moving in the right direction: although simply increasing funding is not a panacea, the Government will have to substantially reallocate expenditures toward the social sectors to overcome human resource constraints. Infrastructure will remain a priority, but much progress has been made during the last decade in addressing critical bottlenecks. Increasing private sector participation in the provision of energy and transport will gradually allow the government to 21 confine its attention to a traditional role in a market economy. 20 The draft PIP allocation of 155.9 billion kip has been adjusted downward for actual expenditure in 1995/96. On the methodological problems of the PIP, see Chapter 7 of the Background Papers. 21 The shifting role of the Government is discussed in more detail in Chapter I of the Background Papers. - 32 - 2.23 The most important task for the Government will be to evaluate intrasectoral allocations for effectiveness by asking whether the balance among different sectoral programs within sectors is adequate, and assessing the extent to which expenditures deliver concrete results. In this context, the detailed discussion of key sectors (transport, agriculture, health, and education) in Chapter 3 makes recommendations to ensure that sectoral priorities are adequately reflected in expenditure allocations. The second challenge will be to avoid delays in implementation, or ad hoc cuts, by underpinning public expenditure priorities with realistic revenue projections. Chapter 4 addresses the changes in Lao PDR's institutional arrangements which will be necessary to allocate resources, within the medium-term resource envelope, in accordance with priorities, on a sustainable basis. 2.24 Proposed Core Program. As discussed in Chapter 1, the Government's proposed five-year PIP (1996-2000) would somewhat overstretch fiscally sustainable expenditure projections. To ensure broad consistency with the likely resource envelope established in Chapter 1, the Government should consider moderately scaling down public investment to around 11.6% of GDP (instead of 13.6%). This core program would trim the five-year PIP from 1,484.0 billion kip to 1,266.2 billion over 1996-2000, as suggested in Table 2.5. This would make it possible to maintain the share of current expenditures and prevent ad hoc cuts in case of revenue shortfalls. 2.25 Since there are no obvious "white elephants," it is not immediately evident where public investment should be cut. Most development programs appear to merit high priority in a poor country with huge needs for physical and human infrastructure. However, realistic choices need to be made in light of revenue constraints. Therefore, public expenditure management should focus on greater efficiency in resource use, improve revenue mobilization, and introduce a core list of high priority projects for which funding is assured (see Chapter 4). 2.26 To attain fiscal sustainability, this report suggests trimming proposed investments until the year 2000 by a total of 217.8 billion kip in two areas. First, the allocation for rural development should be reversed to the originally planned 55.9 billion kip (instead of 143.8 billion kip), since no additional donor funding or project ideas have been identified. Second, the sectoral analysis in Chapter 3 recommends that this focus on a core PIP be achieved by reducing planned public investment in the transport sector by 130.0 billion kip (from a total of 513.5 billion kip). Despite the continuing need for road development, public investment in the last five-year PIP has made a good start in tackling the enormous backlog of investments made necessary by the previous underinvestment in new roads and the neglect of maintenance. A lower share for transport -- to levels that can be effectively absorbed and implemented -- is needed to make way for urgent priorities in other sectors. 2.27 However, there may be clearer candidates for trimming -- such as military or political expenditures -- which could not be examined because of the lack of available data. Any necessary adjustment in investment should begin with cost savings through higher efficiency within the sectors. Public sector reform in Lao PDR may not require a further substantial downsizing of the civil service, but should focus on replacing unskilled public sector employees. If the Government exceeds the medium-term revenue target through increased mobilization of domestic or foreign resources, additional funds could be allocated to fund current expenditure requirements in the education sector or to fund other high-priority projects in the social sectors drawn from a PIP reserve list. - 33 - 3. SECTOR AND EXPENDITURE PRIORITIES 3.1 How should scarce resources be allocated within sectors? This chapter highlights key sectoral spending priorities, summarizing the in-depth background analysis for the following sectors: Transport, Agriculture and Forestry, Health, and Education (these sectors are presented in detail in the Background Papers to this report). This chapter analyzes past expenditure trends, evaluates the efficiency of intrasectoral outlays in meeting sectoral objectives, points out the scope for private sector participation, and, when appropriate, suggests reallocations of expenditure priorities and improvements to institutional and organizational structures. Sectoral recommendations and key observations across sectors are summarized at the end of the chapter. CRITERIA FOR EXPENDITURE PRIORITIZATION 3.2 Public expenditures are constrained by the available resource envelope and should be concentrated on high-priority programs. Before decisions are taken on whether scarce public resources should be devoted to a particular project, be it a road or a hospital, the following questions need to be asked:' * The role of Government and the private-public mix. Does the Government have a legitimate role in the project or should the project be left to the private sector? Public investment should make increased private investment possible rather than crowding it out. For Lao PDR, the key issue will be to carefully maintain an appropriate balance to maximize the complementarities between public and private investment in each sector. On the one hand, Lao PDR will want to enhance its core government functions -- of providing public goods and general administration. On the other hand, the state has largely withdrawn from providing goods and services which can now be left to the emerging private sector (such as manufacturing, commerce, and tourism). In particular, the state should grow into a role of encouraging private sector activity by creating a market-enhancing legal, institutional, and macroeconomic policy environment. * The cost-benefit of project inputs and outcomes. Is a particular project or program justified in terms of its rate of return? The quality of public expenditures, not only the overall amount, is of crucial importance for the sustainability of economic growth. Individually approved capital expenditures should thus be well screened, cost effective, and likely to lead to private or public sector productivity gains. Before projects are included in the annual capital budget, a cost-benefit analysis should be carried out, at least for major projects, to compute financial and economic rates of return, comparing the rate of return on the marginal project with the marginal costs of funds. * Absorptive capacity. Can the sector effectively absorb additional funds and is there adequate implementation capacity? On economic efficiency grounds, expenditure These key prioritization criteria to guide public expenditure allocations are discussed in Chapter I of the Background Papers. - 34 - decisions should take account of institutional constraints by limiting expenditures in areas where project implementation capacity is limited. * Operations and maintenance. Is new construction taking place at the expense of maintaining and repairing existing facilities? Building new projects is almost always more appealing than fixing up old ones. However, rehabilitation is usually more cost effective than new construction and should thus be given priority. This is particularly true in an aid-dependent country like Lao PDR, where substantial aid flows are directed to building new structures while domestic resources have not been made available to maintain and repair existing facilities. * Cost recovery policies. Should part or all of the project costs be recovered from the actual users and beneficiaries through user charges? Cost recovery could help reduce dependence on tax revenues, and it encourages a more efficient allocation of resources. Whether cost recovery policies are useful depends to a large extent on the nature of the public good that is being provided and the government's objective in providing it. In general, cost recovery policies need to take into account consumers' ability to pay. Where current expenditure is provided on equity grounds, or where the beneficiaries are difficult to identify, financing expenditures from tax revenues is likely to be more efficient. - Impact on the poor. Will project or program benefits accrue to the poor? Poverty concerns are usually not part of individual project evaluations. However, it may be feasible to evaluate the benefits incidence of broad expenditure to ensure that expenditures meet the objective of poverty alleviation. 3.3 The key sectors reviewed in this chapter are Transport, Agriculture, Health, and Education, which together represent over two-thirds of the country's investment budget (Table 5, Statistical Appendix). Energy is another key sector which accounts for over 15% of public investment. Its true dimension is even larger, since it is dominated by the development of large hydropower projects (Box 1.1) which are not included in the PIP. Apart from some investment in domestic rural electrification, the bulk of investment in the energy sector is designed to mobilize revenues and is therefore discussed separately in the Background Papers (Chapter 12). TRANSPORT A. SECTOR OVERVIEW 3.4 Lao PDR's transport system is rudimentary, dilapidated and unreliable except for some recently restored sections. This has made internal and border crossing transport extremely difficult and costly. The Government realizes that the present lamentable state of the transport system is a key impediment to economic growth, with particularly negative and disruptive effects on the economic and social opportunities for the widely dispersed rural population. 3.5 The country has no natural transport arteries and relies almost exclusively on road transport, except for about 1,190 km of sections of the Mekong River which are navigable, depending on the season and other factors. Roads serve about 90% of all freight and passenger traffic and the Laotian - 35 - economy therefore depends crucially on the road system's performance.2 Official records indicate that the road network comprises about 14,800 km and is classified into about 4,100 km of national roads, 5,800 km of provincial roads and 4,900 km of district roads. However, only about 1,000 km of national roads are usable year-round, and another 2,000 km of roads can be used part of the year. The remainder can only be used by specially equipped vehicles. Some roads included in the system are only in the planning stage. 3.6 Substantial resources have been allocated to the sector (see Chapter 2, Background Papers), but they need to be better focused toward programs and projects with the highest economic returns; and systematic maintenance of restored assets needs to become an institutional feature. Better outcomes will also depend on substantial progress in improved planning, programming, and budgeting procedures; streamlined decision-making within the Ministry of Communication, Transport, Post and Construction (MCTPC); clarification of the roles and relationship between central government and provincial transport entities; and strengthened program implementation, including a better integration of donor-supported projects into the overall strategy. B. GOVERNMENT POLICIES FOR TRANSPORT 3.7 Past Priorities. The 1991/95 PIP focused on the development of physical infrastructure, particularly roads, and on measures aimed at strengthening the country's transition to a market-based economy. In this context, the highest priority was accorded to the physical restoration of the country's transport system, which absorbed about 51% of total PIP expenditure. During this period important policy measures were also initiated by the Government, such as the simplification of the regulatory framework for goods transport; the commercialization and privatization of state enterprises; and the promotion of private sector participation in the investment process. In addition, administrative and institutional reforms were started in order to improve the efficiency of government entities in the management of the transport sector. However, progress in implementing these measures has been slower than anticipated and regulations for domestic and international traffic remain cumbersome. 3.8 The Government's Future Agenda. The Government's transport development objectives for the period 1996 - 2000 seek to continue the previous efforts of network development and to deepen institutional and regulatory improvements. They support the Government's broader policy goals of completing the transition to a market-based economy, achieving regional balance and integration into the international economy, and developing the human resource base. The targets for institutional improvement in transport are: (i) administrative and process reforms, which includes reforming road classification, devolving responsibility for certain road classes to local authorities, establishing design standards, improving the supervision of local contractors and consultants, and strengthening the formulation and implementation of construction projects and road maintenance; (ii) regulatory reforms, including facilitating cross border movements and vehicle control; and (iii) the acceleration of economic reforms relating to transport, including privatization and the tightening of financial discipline and accountability. 2 Therefore, the primary focus of this review is on the road sector, although it includes other modes where warranted. There are also a small gasoline supply line from Vietnam, one international airport, and some 16 small airports and airfields. The country has no railway. - 36 - 3.9 The Government's targets for physical infrastructure development include: (i) continuing the construction/rehabilitation of the trunk road system; (ii) investing in international transit corridors to diversify access to seaports and promote the country's potential role as a land bridge, including investing in roads to facilitate the trade of border provinces with neighboring countries; (iii) constructing/reconstructing inter- and intra-provincial roads to improve access to rural and remote regions; and (iv) maintaining and preserving the transport network. 3.10 Although the program seems very ambitious, the scope and balance of the institutional improvements appear reasonable, especially in view of the fact that a number of different government units are likely to formulate and/or implement these improvements (assuming they are supported by the decision makers). However, what is still needed is an implementation strategy. There is reason to doubt that the existing institutional, human resource, project management, and local funding weaknesses can be overcome rapidly enough to deliver the desired physical outcomes. In view of the transport sector's institutional constraints to absorbing the Government's planned medium-term investment, this report would suggest trimming funding and focusing on a sustainable core program (Section G). C. FUNDING MECHANISMS 3.11 The majority of transport capital and current expenditure is at present funded through a combination of official development assistance (ODA) from bilateral and multilateral donors and domestic resources raised from taxes.3 Foreign assistance for transport alone has amounted to about US$500 million between 1983 and 1995/96. ODA has funded on average between 65% and 80% of capital expenditure and, since 1989, over 50% of spot improvement and emergency repairs, included under maintenance expenditure. By contrast, coinciding with increased donor interest, localfunding has declined from an average of 30 - 35% during the early to mid- 1980s to a current average of 20%. This pattern of funding is not unusual for a low-income country such as Lao PDR, given the pressure on the budget from other priority sectors of the economy. The question is whether this pattern of aid dependence is sustainable. As discussed in Chapter 1, donors may one day reduce their assistance or redirect it into other programs. Such a shortfall of foreign aid could probably not be compensated for by local funding. D. EXPENDITURE TRENDS 3.12 The transport sector has been the Government 'sfirst priority in the 1991/95 PIP. Lao PDR is a landlocked country with a very low population density, which explains why the share of transport investments in total government expenditure increased from 4.1% of GDP in 1991 to 6.1% in 1994/95. This is high when compared with other countries in Asia (e.g., Indonesia, Korea, Vietnam) at a similar stage of development, where spending on road infrastructure has varied between 2.2% and 3.3% of GDP per year. Transport programs absorbed more than half of the Government's capital expenditure over the 1991-95 period (534 billion kip in current prices including donor assistance). This also reflected the need to catch up with the huge backlog of road investments brought about by the severe underfinancing of maintenance for about two decades, from 1970 to 3 In addition, there are contributions in kind from the local population, especially in rural areas. However, the monetary value of these contributions is not known. -37 - 1990. In the future, spending levels of about 3.5 - 4% of GDP could be justified for another decade in view of the urgent need to provide the country with a core transportation system covering basic transport needs. E. EFFICIENCY OF PUBLIC SPENDING FOR TRANSPORT 3.13 Most of the targets set for transport in the 1991-95 five-year investment program have been met. Important physical achievements during this period were the completion of the bridge between Lao PDR and Thailand, crossing the Mekong near Vientiane; the reconstruction and rehabilitation of about 25% of national roads (1,000 km); and improvements to a number of river installations and airports. Another 25% of national roads is currently under construction. The majority of these projects are donor financed and managed by expatriate technical assistance. However, underlying problems of weak domestic preparation and implementation capacity and erratic local funding (caused by delays and/or cuts in allocated funds) have hampered project execution. 3.14 As regards maintenance, routine and periodic repairs of a defined road network that can regularly be maintained appear to be the exception. The bulk of current efforts seems to consist of emergency repairs, such as removal of landslides and spot improvements. Inadequate routine and periodic maintenance has led to the deterioration and downgrading to fair condition of half the roads completed since 1980. Moreover, since 1989 more than half of the expenditure recorded as maintenance has been donor funded, and even donor supported programs have been poorly executed. Donors are helping to address the problem through a capacity building program designed to establish a more efficient road maintenance organization and to introduce systematic road maintenance. However, adequate O&M funding is not just a matter of addressing the Ministry of Transport's traditional preference for reconstruction over rehabilitation of roads. If systematic road maintenance is to become an institutional feature, a number of other problems, such as a weak contractor base, inefficient supervision and quality control, payment delays, and unrealistic government fixing of unit costs also need to be tackled. F. SCOPE FOR PRIVATE SECTOR PARTICIPATION 3.15 Private Sector. A recent development has been the invitation to private investors to finance roads and bridges in exchange for toll and concession revenues. Private sector participation in the funding of transport infrastructure can be beneficial, provided the economic benefits to society exceed the financial and economic costs (including the exploitation of natural resources and the costs of environmental degradation) of private provision of transport infrastructure. It is doubtful whether the projects now being planned and agreements being reached in Lao PDR can be included in this category, since all are likely to be low volume roads. Moreover, it appears that construction and performance standards have not been defined. Therefore, the Govemment would be well advised to exercise caution regarding such agreements and to carefully examine the real costs and benefits of each proposed project. First, restricting access to underutilized roads would be a waste of scarce resources if roads are tolled. Second, the potential toll income is unlikely to cover development and operating costs of the roads. In order to attract private investors, the Government therefore has to provide substantial additional incentives, such as timber and/or mineral concessions and other subsidies with potentially substantial (environmental) costs. Third, the Government might incur contingent liabilities in the event of the default of the concessionaire on contractual obligations or - 38 - might have to shoulder unplanned expenditure for the maintenance and operation of a road after termination of the concession agreement. 3.16 Of more promise seem to be efforts to involve the private sector increasingly in maintenance and construction. The Government's strategy in this respect is two-pronged: namely, to allow both state enterprises slated for privatization and private sector companies to bid for public contracts. However, the implementation of the strategy is proving difficult because of the Government's lack of experience in contract management and supervision; the uncompleted transition of state companies to the private sector (which tends to distort fair competition); the lack of competition in remote parts of the country; company cash flow problems because of late payments; unrealistic unit prices set by the state; and, on the side of the companies, a lack of management, financial, and administration skills, poor equipment, and undercapitalization. 3.17 Cost Recovery. Revenue from road users is raised from (i) taxes on fuel used on roads, (ii) import taxes on vehicles, and (iii) annual vehicle license fees. The total revenue collected from road users has been estimated to yield between US$15-19 million per year. A more difficult question is whether this amount constitutes a fair contribution from road users to compensate for the damage they inflict on the roads. Economic theory suggests that optimal road use (and thus resources use) is assured if road users pay for the incremental road damage they cause.4 This means that they should pay at least for the variable cost of road maintenance and, under certain conditions, make a contribution to the fixed cost of road maintenance as well. Cost estimates for road maintenance, as defined, amount to about US$5.8 million per year.5 Comparing this with the total yield from road user specific charges of US$15-19 million per year, it is evident that from the point of view of economic policy there is no need to increase user charges at this time. By contrast, the accumulated backlog of reconstruction/rehabilitation, exceeding US$I billion by some estimates, should, however, be funded through long-term borrowing and general revenue (including any surplus from economically appropriately determined road user charges). 3.18 The crux of the problem seems to be that the Ministry of Transport is reluctant to regularly fund systematic road maintenance. Earmarking of levies collected from road users for maintenance purposes is not efficient since it restricts budgetary flexibility and the likely revenues would be insufficient to cover maintenance requirements. The Ministry of Finance should thus continue to retain the revenue from road users for general budget purposes. In addition, there appear to be distortions in the structure of road user charges which should be eliminated. For example, heavy vehicles (such as trucks carrying timber) do not appear to pay charges commensurate with the damage they inflict on roads. Another issue is that fuel prices in Lao PDR have tended be lower than those of Thailand, resulting in smuggling. Thus, there is wide room to increase the yield, promote a more equitable user charge system, and improve the structure of user charges without necessarily increasing overall rates. In particular, the efficiency of collection should be enhanced through: 4 See, for example, A. A. Walters: "The Economics of Road User Charges," World Bank Staff Occasional Papers, No. 5, Baltimore, 1970. 5 For that part of the network that should receive systematic maintenance and, additionally, spot repairs of critical road segments. 6 For a discussion of cost recovery and earmarking, see Chapter 1, Background Papers. - 39 - * Additional trained staff and comprehensive data collection/monitoring systems and tools for the Customs and Taxation Departments to better control imports through all gateways * Rationalization of the vehicle tax/fee regime to reduce exemptions, evasion, and avoidance with charges more closely reflecting relative road damage responsibility and ability to pay * Establishment of a national vehicle registration data base and adoption of an annual fee system for active vehicles showing paid status with a decal of a clearly visible sticker. G. PROPOSED MEDIUM-TERM EXPENDITURE PROGRAM 3.19 The transport investment program for the period 1996-2000 proposed in the PIP (Table 3.1) adopts a strategy of incremental and selective system improvements.7 It emphasizes the completion of the north-south trunk road and seeks to improve access to northern, eastern, and southern districts with poor linkages between isolated and developed areas. Further, the construction of international transit links and border crossings has been started. In addition, there is a rural road program included in agricultural projects. 3.20 Evaluation and Issues. The proposed PIP for the transport sector reflects the weaknesses in planning, programming, and budgeting already highlighted as systemic problems of the previous Plan. There is no indication of ranking and screening of projects in accordance with a coherent set of project selection criteria and likely budget constraints, showing trade-offs and relative returns among projects, which would allow a more rational approach to project choice. In particular, there are several key issues: * Size of the Transport PIP. The allocation to transport of 387.6 billion kip in the PIP 1995/96-1999/2000 somewhat exceeds an adequate benchmark of 3.5-4% of GDP. The MCTPC proposes an even larger investment plan, which would crowd out priorities in other sectors, especially if revenue projections are unrealistic (see Chapter 1). * Composition of Planned Expenditure. It is not clear whether the multitude of proposed transit corridors and border crossings can be justified economically and it should be clarified to what extent the Government expects private finance or participation in these roads. In addition, the allocation for maintenance in the PIP seems inadequate. It is not clear how the proposed funding will reverse the present pattern, where the majority of the road network has fallen into such disrepair that it has become unmaintainable and needs to be reconstructed instead. The US$1 billion reconstruction and rehabilitation backlog needs to be urgently addressed through higher O&M funding and a systematic road maintenance program. 7 By contrast, a program proposed by the MCTPC is based on the goal to develop during the five-year plan an all- season road network between the center and the provinces and linkages between districts, while at the same time constructing transit corridors and border crossings to facilitate international trade. See Chapter 2, Background Papers, for a discussion. A summarized version of the PIP 1996-2000 for all sectors is presented in the Statistical Annex to the Background Papers. - 40 - * Funding Constraints. Transport proposals do not focus sufficiently on a coherent, high priority program of capital and recurrent expenditure in view of the likely funding constraints. A tendency observed in the past has been the wasteful practice of starting projects without fully secured financing. To date, the lion's share of total transport expenditure has been funded by donors and the share of local funding has tended to decrease since the mid-1980s. * Costs. The transport PIP contains substantial "hidden" expenditures in the sense of underestimated costs. In many cases, cost estimates for future projects appear low in view of recent unit cost experience, particularly for the work to be carried out and the nature of the terrain. This seems to imply either a lower design standard or underestimation of costs to induce commitment to particular projects. * Absorptive Capacity. It is unlikely that the existing institutional constraints at the levels of the implementing agencies and the local contractors can be overcome in a short period of time. TABLE 3.1: TRANSPORT PIP AND SUGGESTED ALTERNATIVE PIP, 1995/96-1999/2000 (BILLION KIP) Gov't. PIP PER Proposed Change Comments Bn kip % Bn kip % Bn kip China-Cambodia 77 1 19.9 93 0 36.1 16.0 Costs underestimated, stretch implementation National Rural Roads 58.3 15.0 33.9 13.1 -24.4 Stretch implementation Route No. 1 26.3 6.8 - - -26.3 Consider later Intl. Transit Links 31.2 8.1 8.9 3.4 -22.4 Only high econ. priority; seek privatefunds Prov. Border Crossing 31.9 8.2 32.2 12.5 0.3 Interprovincial Roads 28.7 7.4 9.7 3.8 -19.0 Stretch Implementation Intraprovincial Roads 63.7 16.4 - -63.7 Consider later Maintenance 22.0 5.7 31.4 12.2 9.4 Adaptedfrom Road Maintenance Study Routine 15.3 5.9 15.3 Periodic 4.8 1.9 4.8 Bridges 4.0 1.6 4.0 Spot Improvement 7.3 2.8 7.3 River Transport 6.6 1.7 6.6 2.6 0.0 Aviation 41.9 10.8 41.9 16.2 0.0 Total Transport PIP 387.6 100.0 257.6 100.0 -130.0 PER proposed -130 billion kips less Telecom. & others 125.9 125.9 0.0 Incl. telecom. and other infrastructures Total TranslTelecom. 513.5 383.5 -130.0 - = ._ . , Sources: Government authorities and Bank staff. 3.21 Government Focus. The Government needs to focus on a few priorities within the extensive project list that can realistically be implemented within the stated time frame. Therefore, it is recommended to define a coherent "economic" core network (commensurate with the existing funding and absorption capabilities) of a total of 2,000 - 3,000 km around which an effective road maintenance and reconstruction effort could be organized. Such a program is estimated to require - 41 - investments of about 257.6 billion kip, which would shave 130.0 billion kip from the Government's proposed allocation for transport from 1995/96 to 1999/2000. Together with the proposed cut in funding for rural development, this adjustment of transport sector funding would trim the PIP from 1,484.0 to 1,266.2 billion kip over the period 1996 - 2000. This would allow consistency with the likely resource envelope established in Chapter 1, while leaving the funding for other sectors unchanged. A suggested program of capital and recurrent expenditure based on this concept is presented in Table 3.1. The core network could be expanded, if it were economically justified and if increased funding and implementation capacities were available. Where appropriate, public funding could be supplemented by private sector finance. It would be important to include the donor community in this approach as well. 3.22 As is the case with capital expenditure, recurrent expenditure for routine and periodic maintenance should also be limited to a core maintainable network and should be funded as the highest priority in order to keep the core network operable at all times at the designed standards. The advantage of this approach is that it would increase the credibility of requests for maintenance funding and stay within the limits of the sector's absorptive capacity. In addition, some funding should be provided for spot improvement, emergency repairs, and the like, where a minimum level of network connectivity and accessibility has to be provided. AGRICULTURE A. SECTOR OVERVIEW 3.23 Most Laotians are farmers. Although agriculture's contribution to GDP has been falling -- from 63% in 1987/88 to 54.3% in 1995 -- the sector remains the primary source of income for about 85% of the working population. Close to 90% of Lao PDR's poor live in rural areas and 99% of the rural poor live in farm households. Major improvements are needed in both the allocation of government spending within the sector and the performance of government agencies responsible for implementing policies and achieving national goals for agriculture. 3.24 From the Lao Government's perspective, markedly slower growth in the agricultural sector compared with other sectors is a major problem, implying a widening gap between rural and urban incomes, increased food security problems in the countryside, and, if the trend continues, a long-term threat to social stability. As the basic staple food in Lao PDR, particular emphasis is attached to rice production. Slow average annual growth rates for total rice output are thus a cause for concern. 3.25 Relative to its major regional trading partners (Thailand, China, Vietnam), Lao PDR has abundant arable land per capita. It need not, and perhaps should not, become dependent on food imports. Instead, Lao PDR has the potential to become a substantial net exporter of food. To accomplish this, the country must transform the prevailing subsistence-oriented, low productivity, low input farming systems. This depends greatly on addressing key constraints to agricultural growth. Developing rural infrastructure is a key priority, in particular investments in rural roads to provide access to markets. Because of the poor transport infrastructure, no rice is marketed in half of the villages, although it is the main crop in nearly all villages and accounts for about 80% of total cropped area in Lao PDR. Agricultural productivity has also been held back by underdeveloped - 42 - markets systems, declining fertility in the uplands, lack of skilled manpower, lack of a national system of research and extension, and undeveloped rural savings and credit systems.8 3.26 Livestock problems have not received the attention they deserve. Although livestock contributes about 40% of agricultural GDP and could become a major export potential, diseases, parasites, and poor nutrition keep both productivity and exports well below potential. Foreign donors in particular showed little interest in livestock development prior to 1995. 3.27 Between 250,000 and 300,000 families (40 - 50% of farm households) practice some form of shifting, slash-and-burn agriculture in upland areas, either exclusively or to supplement lowland paddy production. These farmers--primarily ethnic minorities--face the consequences of shortened fallow cycles owing to population growth, including greatly increased weeding requirements and lower yields. 3.28 Deforestation caused by both logging and shifting cultivation is a serious concern shared by the Government and donors. Deforestation in Lao PDR is leading to increased erosion and threatens the country's natural biodiversity and watershed catchment areas. Logging activities are very difficult to monitor or plan rationally, owing to significant unrecorded logging. Although the Government has rationalized the industry by granting logging oversight to three state-owned logging enterprises, planning for sustainable use of timber resources is haphazard and ineffective. 3.29 Other important problems characterizing agriculture in Lao PDR include the vulnerability of agricultural communities to droughts and floods; lack of an effective national extension system; reliance on an underdeveloped and biased system for collecting basic agricultural data; and low rates of lending, particularly to poor farmers, and of investment in the sector. Moreover, formal credit is rationed and does not reach poorer farmers. Private foreign investment has been insignificant except in the forest sector. B. GOVERNMENT POLICIES FOR AGRICULTURE 3.30 Since 1986, when the Government initiated its New Economic Mechanism (NEM), there has been a host of policy changes affecting revenues and expenditures and the composition and focus of Government programs in agriculture and forestry. The overall responsibility for carrying out Government policies and programs in agriculture nominally rests with the Ministry of Agriculture and Forestry (MAF).'° The Agricultural Promotion Bank (APB) controls agricultural lending, and with increasing frequency is the institution that decides whether local level projects go forward. 3.31 Development Programs. Of the Government's eight development programs for the nation, four concern agriculture explicitly: (i) increasing food production; (ii) stabilizing/reducing slash- and-burn cultivation; (iii) promoting the production of commodities (commercial crops and a See World Bank (1995), "Lao PDR-Agricultural Sector Memorandum," Report No. 13675-LA. 9 In March 1994, the Government passed the Resolution on Rural Development, which emphasized livestock. 10 Since spending proposals are initiated and implemented within the MAF at the provincial level or below, the Provincial and District Agriculture and Forestry Service Offices (PAFSOs and DAFSOs), together with the Rural Development Committees, also play important roles in translating policies into spending allocations. - 43 - livestock); and (iv) integrating rural development. The first three programs, together with research and extension, irrigation/watershed management, and human resource development, form the core of the "priority programs" pursued by the MAF. 3.32 For the food production program, the primary focus is on boosting rice production on the larger plains, with emphasis on the Vientiane Plain, to ensure adequate supplies of rice for the capital city. Irrigation policy underwent a crucial shift in 1991 when the Government decided to relinquish direct responsibility for operating and maintaining irrigation schemes. Financial and administrative responsibility for operations and maintenance was transferred to local Water User Groups (WUGs) formed among beneficiaries." In the past, the Government's irrigation policy reflected its emphasis on rice self-sufficiency: farmers in Government-sponsored irrigation schemes were often required to grow rice, which typically shows low economic returns relative to alternative crops. Now, farmers are encouraged to use irrigation water for higher-value crops. 3.33 Since 1991, there has been a gradual shift toward low-cost farmer-managed irrigation schemes as well as donor-supported programs to rehabilitate the old capital-intensive schemes and to hand them over to farmers to manage. This shift in policy underpins planned Government investment. Although for small schemes local management is feasible and often successful, management of medium and large irrigation schemes is beyond the existing technical and organizational capacity of village-level authorities. Moreover, funds have not been provided to provincial authorities (or the Department of Irrigation) to adequately maintain irrigation assets. As a result, most of the larger irrigation schemes have been poorly maintained or grossly underutilized or are simply non-functional. 3.34 Reducing shifting cultivation is one of the Government's eight priority programs. It seeks to introduce sustainable farming practices, including agroforestry, to promote alternative income- generating activities for upland villages, and to resettle part of the upland farming population in lowland areas. These efforts are focused on watersheds, reserve forests, and perennial forests near major towns and roads. The national policy on upland agriculture is to stabilize and reduce slash- and-burn cultivation. Nonetheless, the Government recognized the impracticality of eliminating all upland rice production. In areas where there is little available land suitable for lowland (i.e., flooded) rice, improved, sustainable methods of growing upland rice are being developed using crop rotation and fertilizers. In addition, the traditional rights of families to use plots of land in the uplands are to be recognized to encourage them to invest in environmentally sustainable land use, including planting tree crops. 3.35 In the forestry subsector, the Government's goal is the sustainable management of resources, through reducing illegal log exports, encouraging replanting with fast-growing species, and promoting the domestic wood processing industry to increase value added before products are exported. 3.36 Commercial crops and livestock, the so-called "commodity production" program, seeks to boost farmers' incomes and diversify away from subsistence rice production by promoting commercial crop (e.g., coffee) and livestock production, largely through improvements in market Farmers participating in WUGs provide land (e.g., for canals), labor, material, and cash for purchased inputs. Complete recovery of project costs is required by regulation only for small-scale projects. For all projects, O&M costs are supposed to be covered by water user fees (cash or in kind) by the WUG after each harvest. - 44 - access (mainly road construction and repair). This raises the question of to what extent the public sector should be involved in directly supporting private sector commercial activities. 3.37 Agricultural Credit. The Government has made a clear policy choice to subsidize agricultural lending to alleviate rural poverty. Credit is channeled through the APB at below-market interest rates and financed by the Bank of Lao PDR with assistance from the donor community.12 However, the vast majority of Lao farm households in need of credit are too poor or lack the right connections to gain access to APB loans, which are not targeted toward the poor. Under current policies, the APB's rate structure and lending policies are not geared toward maximizing the mobilization of resources for agricultural lending, and subsidization occurs at the expense of coverage (at only 5%). As a result, the benefits of subsidized agricultural credit are effectively rationed toward a minority of wealthier farmers. C. FUNDING MECHANISMS 3.38 Domestic Resources. The most fundamental change in the allocation of public resources to the agricultural sector since the beginning of the NEM was the "centralization" of the line ministries in the early 1990s, which began with the MAF. Since then, agricultural programs and projects managed by the provincial governments--and funded from revenues retained by the provinces--have come under central government control. In practice, the more powerful provincial govemors have exercised considerable discretion over the use of funds."3 3.39 Foreign Assistance. Agricultural spending is somewhat less dependent on foreign donors than other sectors in Lao PDR.'4 However, there remains a strong tendency to allocate Govemment funds to areas in which donor interest is the greatest, while neglecting other areas. In the irrigation subsector, for example, the Govemment focused much of its own resources on large, capital- intensive schemes when extemal funds were forthcoming. This policy of maximizing foreign funding of irrigation tumed out to be rather wasteful. As donors have begun to pull out of supporting large schemes, the Govemment has also signaled that its emphasis in the 1996-2000 development plan will be on developing small-scale irrigation works. These low-cost, farmer-managed systems continue to be supported by NGOs and other donors. IS 12 As of November 1995, the APB was charging 10%, 8%/o, and 7%, respectively, for short, medium, and long term loans, compared to a range of 17.6% to 26.5% charged by commercial banks for kip loans. See Box 3.1, Chapter 3, Background Papers. 13 See also Chapter 8 of the Background Papers, on the role of provinces and provincial governors in the budget process. 14 Looking at proposed 1996-2000 public investment in four sectors--agriculture, health, education, and transport and communications--the share from foreign sources ranges from 66.6% in agriculture to 75.8% in the health sector. The relatively high domestically financed share in agriculture suggests that the Lao Government gives an even greater priority to agricultural and rural development than do foreign donors. I On a per irrigated hectare basis, some small-scale irrigation schemes have proved very costly, according to project documents. Unlike larger schemes, however, most can at least be managed and maintained by local WUGs. - 45 - D. EXPENDITURE TRENDS 3.40 Agriculture's share of total public spending has fluctuated significantly since the late 1980s. Expenditures for agriculture (including forestry) under the MAF and the provinces fell from 12% of total government spending in 1988 to 6.3% in 1989, then recovered to 7.1% in 1991. In 1994/95, current and capital spending on agriculture was 9.7% of the total budget and fell to 7.8% in 1995/96 (Table 3, Statistical Appendix). Current expenditures have been very low, between 1.7% and 2.5% of total government current expenditures. Spending on wages and salaries in the sector has also remained very low, averaging about 3% of the total government ware bill, and is low compared to reported capital expenditures, averaging under one-tenth of the latter.6 3.41 Although past total O&M spending cannot be determined accurately owing to data problems, it is widely acknowledged to have been grossly inadequate. This is reflected in a utilization rate for existing irrigation systems of just 30% of designed capacity during the dry season. About 20% of "investment" during 1991-95 was allocated toward spending for O&M. However, such funds accounted for only 12% of public investment in the sector over 1993-95, while the bulk of investment was funded by foreign donors who usually do not pay for the recurring costs of development projects. 3.42 A large part of the Government's agricultural budget is spent directly in the provinces rather than in the central Ministry. The share of current expenditures going to the provinces increased from 50% prior to 1992 to 71% in 1995; provinces received 5.1 billion out of 7.4 billion kip in planned 1995/96 agricultural capital expenditure. Two provinces (Champasack and Savannakhet) and the Special Region received 40% of total provincial-level spending in 1995/96, but per capita spending is generally greatest in the poorer provinces. 3.43 Among departmental programs within the MAF, public investment, excluding foreign sources, is concentrated increasingly on irrigation. The Irrigation Department's share of investment grew from 35% in 1991/92 to 64% in 1994/95, of which only 3.7% was allocated for O&M (Table 3.2). In contrast, areas with high expected rates of return were clearly underfunded, including research and extension and livestock/veterinary services. The MAF's investment plan for 1996-2000 has irrigation absorbing up to two-thirds of local funds while comparatively minor amounts are allocated to other areas with a stronger poverty focus. 16 It should be noted, however, that past reporting practices included O&M spending as capital investment if it was funded by foreign donors, as a result of which current expenditure figures were underreported. - 46 - TABLE 3.2: ALLOCATION OF INVESTMENT FOR AGRICULTURE AND FORESTRY, 1990/91-1994/95 (LOCAL RESOURCE COMPONENT) 1990/91 1991/92 1992/93 1993/94 1994/95 Department mlu. % mil. % mil. % mil. r mil. % kip j kip kip I kip [ kip I Cabinet Office (incl. buildings) 87 5.2 22 0.9 20 0.7 57 1.5 126 2.4 Agriculture & Extension 116 7.0 168 7.2 151 5.2 157 4.2 381 7.4 Livestock & Veterinary 70 4.2 119 5.1 122 4.2 138 3.7 169 3.3 Irrigation 743 44.4 817 34.7 1,799 62.4 2,213 59.7 3,302 63.8 Meteorology/Hydrology 35 2.1 86 3.6 78 2.7 118 3.2 146 2.8 Forestry 71 4.2 249 10.6 173 6.0 235 6.3 294 5.7 Rural Development 208 12.4 533 22.7 248 8.6 436 11.8 517 10.0 Personnel & Tech. Schools 342 20.4 359 15.3 290 10.1 354 9.5 239 4.6 TOTAL 1,673 100.0 2,354 100.0 2,880 100.0 3,709 100.0 5,173 100.0 Source: Ministry ofAgriculture and Forestry. 3.44 Data on public investment from foreign sources are sparse for earlier years, but project spending was also concentrated on irrigation. In 1993 ongoing irrigation projects totaled US$44.8 million out of a total of US$100 million. However, the MAF's public investment plan for 1995/96 shows a drastic reduction in irrigation investments in favor of the forestry subsector -- with just 15% for irrigation compared to 46% for forestry. Investment expenditures on forestry had fallen from 28% of total in 1988 to 9% in 1992. The second largest share (19%) of total planned agricultural investment in 1995/96 is for "rural development" projects that do not fit into the more narrowly targeted departmental categories, such as integrated rural development projects. Overall public investment in agriculture is currently planned to grow more rapidly than anticipated inflation, rising slightly from 11.5% of total public investment in 1996 to 12.5% in 2000. E. EFFICIENCY OF PUBLIC SPENDING FOR AGRICULTURE 3.45 Outcome Indicators. Between 1979/80 and 1992/93, production per capita decreased and the use of modern inputs (e.g., fertilizer) declined. Several factors contributed to this poor performance, including an inadequate transport network, poorly maintained irrigation facilities, poor animal vaccine coverage, and the absence of proven locally adapted technical packages for rice and other crops. There are signs that these constraints are diminishing; large investments are under way in transport, including rural feeder roads, and the national rice research system is beginning to generate promising results, including area-specific fertilizer recommendations. In the medium term, inadequate extension services could increasingly become a major bottleneck as other constraints to increasing agriculturalproductivity are being addressed. - 47 - 3.46 A precise evaluation of the effectiveness of public spending on agriculture is not yet possible in Lao PDR, owing to a lack of data on unit costs of government-provided goods and services. Nevertheless, it is clear that the overall record is poor. The performance of capital-intensive irrigation projects, some of which have cost over US$4,000 per irrigated hectare, has been dismal. In addition, public investment has been hampered by severely limited human capital resources for planning and administration. The problem is compounded by the proliferation of donor projects and the lack of mechanisms, in most sub-sectors, to coordinate them and share information and experiences. With over 100 agriculture and forestry projects in operation, staff at the central level are forced to devote much time and effort to dealing with the complex reporting requirements of donors, which leaves little time for planning and monitoring functions. Moreover, there has been a tendency to transfer projects to local users that did not participate in the design and thus do not have a high degree of ownership. 17 3.47 Agricultural policy has been underfunded and has not shown a clear poverty focus. Areas in which agricultural spending has failed to produce satisfactory results include livestock (all aspects), agricultural data services, and extension. In the livestock sub-sector, national vaccination coverage ranges from 0 to 30%, and veterinary services have consequently been ineffective in controlling diseases. The agricultural data system, meanwhile, yields production figures that have limited credibility. Extension workers lack the skills and incentives to contribute to the dissemination of useful technologies. The main cause of failure in these areas can be traced back to the lack of budget resources provided. F. SCOPE FOR PRIVATE SECTOR PARTICIPATION 3.48 Agriculture in Lao PDR essentially consists of private sector farming. At the same time, the Government concentrates on key public goods in the sector -- research, collection and dissemination of information, market integration, control of epidemic diseases in livestock, and so forth. Greater private participation is feasible in construction and repair of irrigation structures, seed multiplication, agricultural lending, and veterinary services. 3.49 Private irrigation construction firms exist, but they are small and lack adequate equipment. Also, since they have experienced long and unpredictable delays in receiving payment for work done for the Govemment, they prefer either to subcontract through the remaining irrigation SOEs or to deal directly with donors. 3.50 Seed multiplication is now carried out by state seed multiplication centers with the participation of one Thai company in Vientiane. Since farmers must have confidence in purchased seed quality, a government seed certification program would help create and expand private sector seed multiplication. Fertilizer imports are subsidized via Japanese "KR2" project funds. The Government effectively rations fertilizer at its "state" price, which is only half the going market price. A preferable approach would be to sell most of the donated fertilizer in open auctions to private traders and use the proceeds to fund additional research on soils and soil fertility management. 17 See Chapter 9, Background Papers, for a discussion of project implementation difficulties. -48 - 3.51 Agricultural credit is another area in which greater private sector participation ought to be encouraged. The APB has a de facto monopoly on agricultural lending which hurts farmers by limiting opportunities to borrow for agricultural investments."8 The low coverage and lack of targeting of present agricultural credit policies impose an unnecessary constraint on the pace of private investmnent in agriculture that can only hurt the majority of poorer farmers. There is thus a clear need for private rural credit institutions tailored to small holders. 3.52 By including non-governmental, non-profit membership organizations (for example, the coffee producers' association) important extension functions can be "privatized" for commercial crops and livestock/poultry. It is difficult to overestimate the contributions of voluntary associations of farmners, traders, and processors to the progress of agriculture in market economies. Private associations in Lao PDR could provide their members with information on market opportunities, new varieties of crops or breeds of livestock, or new production techniques. 3.53 Overall, the record of commercial investment in agriculture has been poor, in particular foreign investment. The traditional lack of formal land tenure security has been a key obstacle which is being addressing by a Land Titling Project. However, other constraints need to be tackled to make agriculture attractive to investors, such as facilitating foreign investment licensing procedures, adjusting the structure of tax exemptions to fit the requirements of agricultural projects, and reducing excessive government intervention in the operation of markets. G. PROPOSED MEDIUM-TERM EXPENDITURE PROGRAM 3.54 The Government's proposed expenditure program over the next five years goes some way toward addressing the constraints of the agricultural sector. However, the balance among the different programs could be improved by following the recommendations of this review. This is reflected in an alternative PIP proposal for the period 1995/96-1999/2000 (Table 3.3), which maintains the same projected aggregate spending levels used by the SPC to be consistent with the likely resource envelope (Chapter 1). It proposes a reallocation in relative spending priorities among sectoral programs: spending more on livestock and research and extension; slowing down growth in spending on forestry and area development; and stabilizing spending on irrigation. These proposed changes do not indicate a radical departure from the Government's proposed investment plans, but rather indicate a broad shift in emphasis toward higher priority areas. The reallocations would contribute to greater effectiveness in raising agricultural productivity and could be implemented without posing an additional burden on the absorptive capacity of the sector and the Ministry. See Box 3.1, Chapter 3, Background Papers, on agricultural credit. - 49 - TABLE 3.3: SUGGESTED INVESTMENT PROGRAM FOR AGRICULTURE AND FORESTRY, 1996 - 2000 Gov't. PIP PER Proposed Change Comments Bn kip % Bn kip % Bn kip Research and Extension 17.2 10.2 37.0 21.9 +19.8 Continue data collection projects; conduct an agricultural census. Irrigation 48.3 28.6 33.0 19.5 -15.3 Focus on rehabilitating and improving operations of existing schemes; conduct national inventory/evaluation. Forestry 50.4 29.8 43.0 25.5 -7.4 Emphasize conservation; moderate growth in spending. Livestock 4.9 2.9 18.0 10.7 +13.1 Create national livestock and forage improvement programn modeled on the National Rice Research Program. Area Development 43.1 25.5 33.0 19.5 -10.1 Moderate growth in spending. Narcotic Reduction-related 4.9 2.9 4.9 2.9 0 TOTAL Investment 168.9 100.0 168.9 100.0 0 Sources: State Planning Committee and World Bank staff estimates. HEALTH A. SECTOR OVERVIEW 3.55 The health conditions of the Lao people are among the poorest in the world; the health sector is underutilized and underfinanced, and offers low quality care. Annual population growth is estimated at 2.4%, which strains health services, social services, employment creation, and food availability. Government allocations to the health sector have been inadequate; this situation is compounded by inequitable distribution, fragmented organization, and a high dependence on external aid. Improvements in health will be important to underpin future productivity and economic growth, and to reduce the gap between urban and rural areas and between rich and poor. 3.56 Health Status. The overall morbidity and mortality profile in Lao PDR is characterized by diseases that could be substantially reduced by better preventive care, education, and improved access to good quality basic health care. Malaria is the most serious public health problem in Lao PDR, yet until recently prevention has been seriously underfunded. - 50 - 3.57 Life expectancy at birth is only about 50 years. The infant mortality rate (IMR) and Health Indicators under-five-year mortality rate (U5MR) have IMP U5MR declined only slowly during the last 15 years. (per '000) (per'000) The IMR is currently still at around 113-125 Residence: urban 52 76 per 1,000 live births, compared with an rural 136 200 Economic Status: well-off 82 108 average of 71 for low-income economies. poor 148 250 Maternal mortality is estimated at 660 deaths Ethnicity: lowlanders 115 161 per 100,000 live births. Health indicators show mid/highlanders 147 230 enormous variation between rural and urban Source: LSIS (1992/3). areas and between different socioeconomic groups. While the Asia region as a whole exceeded all other regions in improving female life expectancy and infant mortality over the 1965-80 period, Lao PDR has remained far behind its neighbors. 3.58 Health-seeking Behavior. Only one person out Pattern of Health Provider Use of ten visits public health facilities. Field surveys Type Bottom 20% Top 20% Avg.% indicate that the reluctance to use public services stems No care 18 4 13 from factors which generally reflect the poor quality of Traditional 25 10 17 care available, difficulty of access, or cost. Women Phannacy 49 63 58 rarely use modem facilities for childbirth; this Modem 8 22 12 contributes to high maternal mortality. Overall, only Source: LECS/LSIS, 1994. 7% report attending a hospital or clinic, while almost 40% -- most of them in living in poor rural areas -- deliver in their own home without assistance. B. GOVERNMENT POLICIES FOR HEALTH 3.59 The framework for public health policy is the Government's Socio-Economic Development Plan 1993-2000. The Ministry of Health (MoH) has recently adopted some policies and action plans pertaining to the health sector, including the National Drug Policy (1993); the National Malaria Control Program Plan (1994-2000); and HIV/AIDS Control. The challenge for the MoH will be to integrate these initiatives into a coherent health services delivery strategy, to identify priority areas for future policy development, and to make associated requests for donor support. 3.60 Translation of Objectives into Resource Allocation. Some major donors have been implementing health management development projects with the MoH. In the 1995/96 fiscal year, the MoH began using a six-program budgeting scheme: health protection and promotion, therapy and rehabilitation (curative care), consumer protection, human resource development, medical science research, and administration and management (including all personnel costs). The new budgeting system should lead to a clearer picture of the relationship between health priorities and spending patterns, and it represents an important improvement over the previous incremental, line- item system. Nevertheless, the new system will need to address a number of issues: => Clarifying the geographic allocation of resources among provinces, and the disparities between rural and urban areas. For the next budget (fiscal year 1996/97) the MoH is working with districts to examine how to divide the budget between hospitals and other programs. - 51 - > Reducing the discrepancy between budgeted and actual spending. Provinces have to bear a disproportionate burden of spending shortfalls. => Reducing the fragmentation of the health system into vertical programs. This separation into parallel, rather than integrated, health departments reflects donor preferences, but does not encourage efficiency in health care provision, coordination among sector programs, and an adequate rural-urban balance. > Setting aside funds for recurrent costs, because capital spending is projected to increase. => Strengthening health systems by devolving decision-making to provincial health officials, who must be trained in financial planning and management. C. FUNDING MECHANISMS 3.61 Domestic Sources. Of the total expenditures on health, household spending is estimated to be more than Health Expenditures, by Source, 1994/95 half. Government expenditures represent about one-third (millions) of total spending,"9 with the remaining funding from Gov't 11,700 31.6 2,554 donors. National revenues fund four levels of care in the Aid 6,152 16.6 1,343 Lao health system: central, provincial, district, and sub- Household 19,118 51.7 4,173 district (such as "health posts" and "health centers"). The Total 36,970 100.0 8,070 army and the police have separate health care systems. Provincial offices receive resources from the MoH. 3.62 Foreign Assistance. The statistics on external Sources of Aid (million kip) resources for health have been patchy, although this 1989 1992 fiscal year, for the first time, the MoH is compiling more Bilateral 330 12% 744 12% comprehensive data, including registering the Multilat. 1,811 64% 3,141 50% approximately 54 NGOs active in health. Many NGO NTota 686 24% 2,352 38% projects are implemented at the provincial level, with Source: IDS, 1995. activities focused on districts and villages. Much of the support is allocated to primary health care and to maternal and child care, and NGOs, together with UN agencies, are also increasingly active in HIV/AIDS prevention. Few data are available to show the functional composition of external support. An estimate from the MoH for 1992/93 suggests that total donor support is about equally divided among four categories: (i) technical assistance (mainly advice from foreign experts), (ii) construction and vehicles, (iii) medical equipment and pharmaceuticals, and (iv) fellowships and study tours. Aid resources are expected to finance the bulk of investment in the health sector in the future, (see Section G, below). 19 This increases slightly when both recurrent and investment budgets are considered. Public health resources in the PIP are about an additional 10-15% of what is in the recurrent budget (for recent years and estimates for the 1996-2000 PIP). - 52- D. EXPENDITURE TRENDS 3.63 Overall Health Expenditures. Government health expenditures declined dramatically in the 1989-91 period, both as a percentage of total govemment expenditure and as a percentage of GDP. Even after recovering in the 1992/93 fiscal year, government health spending reached only 0.7% of GDP in 1992, then dropped to 0.5% in 1992/93. This proportion has increased to over 1.0% of GDP over the past three years (See Table 3, Statistical Appendix). Even considering Lao PDR's level of development, this is very low compared to an average of 1.8% (in 1990) for Asia (excluding India and China). As a proportion of total government expenditures, health received about 4% over the 1991-1994/95 period; this is projected to increase to 7% in the 1995/96 budget. 3.64 Pattern of Expenditures. The previous budget structure makes it difficult to distinguish between recurrent and capital costs in the past, but Table 3.4 groups line items in order to approximate such a breakdown. Salaries and allowances clearly account for a major part of the MoH budget. Regarding proposed expenditure by type of service, about 40% of MoH spending is budgeted for curative services, mainly hospitals. Government allocations to preventive care are expected to increase from 14% of the total budget in 1995 to approximately 20% in 2000. Administration accounts for over 40% in 1995/96, but is supposed to be trimmed to 31% by 2000. TABLE 3.4: ECONOMIC COMPOSITION OF PUBLIC HEALTH EXPENDITURES (MILLIONS OF CURRENT KIP) 1992/93 1993/94 actual 1994/95 actual 1995/96 approved m.kip % total m.kip m r.kip % total m.kip % total Salaries and allowances 2,214 51 3669 56 6,684 66 7,171 64 Drugs 900 21 800 12 1,105 11 1,555 14 of which: central* 371 (34) 655 (42) provincial 734 (66) 900 (58) Repair+newpurchase ** ** 758 12 769 8 781 7 Other recurrent*** 1,267 29 1,350 21 1,538 15 1,677 15 Total recurrent 4,381 100 6,577 100 10,096 100 11,185 100 Recurrent 4,381 72 6,577 85 10,096 86 11,185 81 Capital 1,727 28 1,155 15 1,605 14 2,636 19 * Note that some proportion of central allocations may be spent in the provinces by the Department of Hygiene. ** "Repair + new purchase" not given as separate line item. *** "Other recurrent" includes administration (including electricity, water, etc.), training, and food subsidies. Capital costs are primarily construction. Sources: Datafor 1992/93from IDS (1995). Otheryearsfrom MoH data. 3.65 Center-Province Distribution and Administrative Structure. About 35-40% of the government health budget is distributed to the central level, and 55-60% directly to the provinces. Central spending consists primarily of budgets for hospitals, training centers, and research institutes. The bulk of resources and administrative efforts at the center is diluted among nine institutes and centers (e.g., Mother and Child Care, Malaria, and Sanitation Sections), while the provincial level lacks support for relevant preventive services. 3.66 Distribution by Provinces. Data show that not only are there wide differences in per capita expenditures among provinces, but the dispersion appears to be growing. If both provincial and - 53 - central expenditures were examined, it is clear that there would be a large, and possibly growing, bias toward Vientiane. Health expenditure allocations therefore need to be refocused toward poorer rural areas. 3.67 The disease profile in Lao PDR argues for better public resource allocation to rural areas. Yet the allocative pattern indicates inequities in the system, given that it is mainly directed toward urban hospitals, particularly those in the Vientiane area. The current administrative structure for preventive medicine at the central level must be rationalized In view of the high morbidity rates in the country, district hospitals are most sophisticated facilities required to deliver the minimum elements of the essential clinical package (WDR, 1993). Providing services in lower-level facilities allows costs to be contained at more modest levels for minimal versions of the essential clinical package. E. EFFICIENCY OF PUBLIC SPENDING FOR HEALTH 3.68 Internal Efficiency. Quantitative indicators of Lao health care provision do not show a true picture of access to the Lao health system. There is clearly a serious underutilization of the health system outside of the Vientiane area, indicating inefficient use of scarce resources. Particularly with the decrease in real health expenditures at the end of the 1980s, occupancy rates in central hospitals fell to about 50%, in provincial hospitals to about 40%, and in district hospitals to about 10%. Utilization of health posts is also very low, and many, perhaps the majority, of the posts provide little or no service. 3.69 The reduction in the number of health personnel Health Personnel, Total in the 1990s probably reduced the efficiency of the Level 1987 1992 health system. Over the 1988-92 period, lower-level Higher 901 8% 1,246 13% staff (nurses, pharmacy technicians) were more likely to Middle 2,977 25% 2,758 29% have left, and staff at the central level had actually Lower 7,883 67% 5,417 57% increased. The result is that a significant proportion of Total 11,761 100% 9,421 100% the most highly qualified staff reside in the Vientiane area, while the key health problems lie in the rural areas; this tendency has been growing in recent years. The MoH is presently planning to pilot the use of staff supplements in isolated areas, to try to increase motivation among health staff to remain. Low quality or non-existent care at lower levels also leads patients to bypass these facilities, resulting in greater costs at higher-level facilities. The poor and rural population are least able to afford to travel to higher-level facilities. 3.70 External Efficiency. As is mentioned above, health outcomes in Lao PDR are poor. While the overall resource effort is important, Lao PDR will need to achieve better results per health dollar spent if it is to make any significant progress in the health status of its population. If current patterns are maintained, Lao PDR will still be far from the recommended type of government expenditures comprising the US$12 per capita recommended as a minimum public health package and covering essential clinical services (WDR, 1993). In tenns of equity, the better-off benefit more than the poor from public health spending. - 54 - F. SCOPE FOR PRIVATE SECTOR PARTICIPATION 3.71 Private Sector. The private sector is already very much in evidence in Lao PDR, mainly in the retailing of drugs, but also in some medical services. The number of private clinics is increasing, though the majority are located in Vientiane. To safeguard a secure supply of basic drugs to poor rural areas, two state factories produce pharmaceuticals, but they are completely self-financing and have no budgetary implications for the MoH.20 The commercial import of drugs is a growing business, and the number of private import-export companies dealing in drugs grew from 12 to 29 between 1990 and 1992 (IDS, 1995). There is also a sizable, but unquantifiable, unofficial import of drugs. Private pharmacies are widespread. In 1994 there were about 1,700 registered pharmacies, but it is also known that there are a substantial number of unregistered outlets. They raise both public safety (quality of drugs, poor quality of prescribing and treatment) and equity issues. 3.72 Cost Recovery. Household spending on health mainly consists of drug purchases from the private sector, much of this without prior prescriptions. There are significant differences in the total spending of poor and well-off households, although the differences between urban and rural households are not as marked. Even better-off and urban households, however, spend little on treatment. While some data indicate that cost recovery in the larger hospitals might be substantial,21 this would be true of Vientiane but atypical in the provinces. Because of the high incidence of poverty, user fees could have substantial negative equity implications. Moreover, the MoH currently does not have the capacity to target the remaining government subsidies to the neediest, which would be a necessary complement to a user fee strategy. 3.73 Revolving drug funds are also appearing, financed either by government or donor resources. However, a recent Prime Ministerial Decree (No. 52/PM) requires the transfer of 20% of collected moneys to the Treasury. If it is used to apply to revolving drug funds in the public sector, it could have a negative equity impact on the poor by raising the costs of drugs. G. PROPOSED MEDIUM-TERM EXPENDITURE PROGRAM 3.74 The Government's commitment to improving health conditions can be seen in the increases in the allocations of the PIP to health (Table 3.5) and the projected doubling of the share of current health expenditures (from 2.6% of total government expenditures in 1995/96 to 5.7% in 1999/2000). Overall, health expenditures are supposed to increase from 1.5% of GDP in 1995/96 to 2.5% of GDP by the year 2000 (Table 4, Statistical Appendix). The 1991-95 PIP allocated 18.7 billion kip (3.5% of the PIP) to public health. The 1996-2000 PIP plans to raise investment to 120.9 billion kip, or 8.1% of total investment, over five years. However, this still leaves the health sector relatively underfunded. Any additional revenue that the Government manages to mobilize should therefore be primarily allocated to health expenditures on priority programs, provided the Government ensures that this is a realistic plan. 20 On state-owned enterprises, see Chapter 14, Background Papers. 21 Since 1988, hospitals in Lao PDR have been allowed to charge for some consumable items. In 1992, the MoH introduced a more formal cost recovery policy in the public health sector, and while a variety of schemes exist, charges are made mainly for drugs. - 55 - * The projected PIP increase over the 1996- Health PIP: Plan vs. Actual (billion kip) 2000 period is very ambitious. The weak 10 implementation capacity in the health sector 8 raises some concerns about the level of 6 activity implied by the resource projection in 4 the PIP. 2 * The PIP also envisages a significant increase 0 1 1 1 in domestic resources devoted to health investment. However, past data show that, -Plan -a-- Actual compared to other sectors, the social sectors, and health in particular, have significantly underspent in relation to PIP targets. Domestic health underspending appears to result from relative Government priorities and delays in project implementation. * Over three-quarters of health investment, totaling about US$100 million over the five- year period, is expected to come from donor resources, representing increasing dependency on donors. In order to ensure that minimum preventive and basic health care needs are met, the MoH should be prepared to allocate Government health resources to these areas even in the absence of donor financing. * Another concern is the level of construction expenditures planned in both the PIP and the annual Government budget, and whether the associated recurrent maintenance costs will be sustainable in terms of future calls on the budget. 3.75 The key challenges for the Government will therefore be to ensure that this ambitious program will actually be implemented. If the envisaged increase in health sector investment is adequately funded, even in the absence of donor funding, and if it meets minimum preventive and basic health needs, the proposed composition among the broad program categories in Table 3.5 may not need to be changed. Within the proposed programs, however, this will require both increased efficiency and equity in the health services delivery system. To improve efficiency, the Govemment's priority should be to strengthen health system management and institutional capacity, particularly at the provincial level. The Government will also need to ensure sufficient and better targeted funding for O&M requirements, preventive care, and basic services. To improve equity in the proposed allocation, in particular to reach the rural poor, the Government should aim for a more equitable budget allocation among the center and the provinces. - 56- TABLE 3.5: PUBLIC INVESTMENT PLAN FOR HEALTH, 1995/96 - 1999/2000 (BILLION KIP) 1995/96 1996/97 1997/98 1998/99 1999/00 Toal'95/96 Ongoing & committed 8.0 1.9 0.9 1.0 1.0 12.8 Health & nutrition program 3.4 - - - - 3.4 Basic health services Savannakhet, Sekong 0.7 0.6 0.7 0.7 0.8 3.5 Other projects 3.9 1.3 0.2 0.2 0.3 5.9 New programs 7.4 17.2 22.4 27.7 33.5 108.1 Malaria control (IDA) 3.4 5.4 7.8 8.4 7.7 32.8 Vaccination - 1.1 1.7 1.2 1.3 5.2 Drinking water programs - 1.1 1.7 2.4 3.9 9.0 Sanitation - 1.1 1.7 2.4 3.9 9.0 Nutrition 0.6 1.1 1.1 1.2 1.3 5.3 Birth spacing & maternal & child health 0.6 1.1 1.1 1.2 1.3 5.3 Hospital & curative services - 1.1 1.1 3.6 6.4 12.2 New rural upland programs 2.9 5.4 6.2 7.2 7.7 29.3 Total Health PIP, of which 15.4 19.1 23.3 28.6 34.5 120.9 Domestic Finance (O/O) 17.4 19.4 23.2 26.6 28.7 23.1 Foreign Finance (%) 82.6 80.6 76.8 73.4 71.3 76.9 Current Expenditure on Health 10.1 15.0 20.0 26.0 34.0 105.1 Total Health Expenditure 25.5 34.1 43.3 54.6 68.5 226.0 TotalHealthExpenditureas%ofGDP 1.6 1.8 2.0 2.2 2.5 2.1 Sources: Government authorities and World Bank staff estimates. EDUCATION A. SECTOR OVERVIEW 3.76 Poverty alleviation in Lao PDR requires broadening access to good quality basic education. Educational attainment is currently too low to enable the poor to take advantage of economic opportunities: the net enrollment rate in primary school is 73% and the cohort survival rate is about 30%; gross enrollment is 12% in upper secondary school, and is 2% in technical and vocational education (TVET) and 1% in higher education. At each of these levels, achievement needs to increase substantially, and regional and gender disparities must be reduced. 3.77 The basic issue facing education policymakers is how to orient the education and training policy framework to: (i) improve access to high quality basic education in order to produce a flexible work force with strong general skills; and (ii) improve the ability of post-secondary education institutions to flexibly respond to emerging labor market trends and new skill demands. The resource requirements for successfully pursuing this two-pronged strategy are likely to overwhelm the public sector unless a coordinated and sustainable investmnent program is developed. The contribution of the private sector is sporadic and is confined to narrow subsectors (e.g., language training, computer schools). - 57- B. GOVERNMENT POLICIES FOR EDUCATION 3.78 Recognizing the large returns to education, the Government has placed a high priority on increasing the stock of human capital through education and training and has set ambitious goals for the sector to the year 2000. Targets include: (i) expanding enrollment in primary education from 63% in 1990 to 80% in 2000; (ii) increasing the retention rate from 27% to 63%; (iii) increasing literacy rates for the 15-40 age group from 60% to 80%; (iv) improving the quality of teachers; (v) providing the legal and regulatory frameworkfor encouraging private education; and (vi) expanding and rationalizing higher education. These goals are unlikely to be attainable given the financial and human constraints outlined above. Also, the targets lack the qualitative increases needed to catalyze social and economic outcomes. C. FUNDING MECHANISMS 3.79 Domestic Sources. Funding for education comes mainly from government and international donors. Communities also make significant contributions for school construction and operation and for student support. In principle, domestic resources (including government and community contributions) support the entire recurrent budget for education. The average level of recurrent spending on education during the past seven years was 13.3% of total government recurrent spending, or roughly 1.5% of GDP (see Table 3.6). This is somewhat lower than the average for other countries at comparable income levels (see Chapter 2). Domestic resources supported only about 25% of the investment budget between 1992-93 and 1995-96. 3.80 Foreign Assistance. The sharp increase in investment spending since 1992 has largely been financed from international sources. While external support has been readily available, it is fragmented and not integrated into a national framework. Nearly 75% of 1995/96 capital expenditures are provided by external sources, without clear criteria for prioritizing investments or assessing their overall recurrent cost implications. - 58 - TABLE 3.6: EDUCATION BUDGET AND OVERALL BUDGET, 1990 - 96 (BILLION KIP) 1990 1991 1992 1992/93 1993/94 1994/95 1995/96 Education Budget 11.8 11.3 14.9 17.9 25.5 36.3 45.0 Recurrent 11.3 9.0 10.1 11.9 15.4 23.0 25.6 Capital 0.5 2.3 4.8 6.0 10.2 13.3 19.4 GDP at Current Price 615 722 848 942 1,069 1,323 1,630 Government Expenditure 143 151 175 171 259 294 362 Recurrent 70 82 92 105 127 143 165 Capital 74 69 82 66 132 151 197 Education as Percentage of GDP Education Total/GDP 1.93 1.57 1.76 1.90 2.39 2.74 2.76 Edu. Recurrent/GDP 1.84 1.25 1.19 1.26 1.44 1.74 1.57 Edu. Capital/GDP 0.09 0.32 0.57 0.63 0.95 1.01 1.19 Education as Percentage of Government Budget Edu. Total/Total Govt. Expd. 8.3 7.5 8.5 10.5 9.9 12.4 12.4 Edu.Recurrent/Govt.Recurrent 16.2 11.0 11.0 11.4 12.1 16.1 15.6 Edu. Capital/Govt. Capital 0.7 3.3 5.8 9.1 7.7 8.8 9.9 Notes: - The 1992 budget is a nine-month budget to allow for a change in the budget year calendar. - Budget does not include community contributions. Community contributions come from several sources, including families, enterprises, and community-based groups such as Parent Associations or School Support Organizations. Contributions are an important supplement to both the inxestment and the current budgets of schools and, most important, a critical source of support for individual students. However, there appears little scope for increasing community contribution in the near term. Sources: Government authorities and World Bank staff estimates. D. EXPENDITURE TRENDS 3.81 There has been tremendous growth in the education budget during the previous six years, with expenditures nearly fourfold between 1990 and 1995/96. Most of the increase occurred in the investment budget, which grew from 0.5 million kip in 1990 to 19.4 million in 1995-96. The recurrent budget, in contrast, grew only more than two times during the same period--from 11.3 million kip to 25.6 million (see Table 3.6).22 3.82 Projections for growth in the Government budget show that the education budget would increase in real terms from 45 billion kip in 1995/96 to 72.9 billion in the year 2000 (see Table 3.7). A danger exists that, given current resource allocation and utilization patterns, the recurrent budget n In real terms (constant 1990 kip) the recurrent budget rose from 11,310 million kip in 1990 to 15,328 million in 1995- 96. The investment budget rose from 543 million kip to 10,394 million in the same period. - 59 - will not be sufficient to provide proper support for investments and that serious compromises in quantity or quality will have to be made.23 Generating savings within the sector will thus be the main tool education managers have at hand to mobilize resources to sustain investments. This entails careful examination of education expenditures to (i) ensure that resources are allocated to priority areas; (ii) identify areas of inefficiency; and (iii) explore the potential for cost saving and cost sharing. TABLE 3.7: EDUCATION BUDGET PROJECTIONS, 1995/96 - 1999/00 (BILLION KIP) 1995/96 1996/97 1997/98 1998/99 1999/00 (Current prices) Total 45.0 57.6 67.7 78.3 89.4 Recurrent 25.6 34.0 39.0 44.0 50.0 Investment 19.4 23.6 28.7 34.3 39.4 (1995/96 price) Total 45.0 53.6 60.2 66.7 72.9 Recurrent 25.6 31.6 34.7 37.5 40.8 Investment 19.4 22.0 25.5 29.3 32.1 Investment/recurrent (%) 76% 69% 74% 78% 79% Sources: Ministry of Finance and World Bank staff estimates. E. EFFICIENCY OF PUBLIC SPENDING FOR EDUCATION 3.83 Resource Distribution between Sub-sectors. Analysis of costs per student -- or unit costs -- paints an unbalanced picture of education expenditure. Unit costs typically increase with the level of schooling. However, the costs of TVET, teacher training, and higher education are very high in relation to lower levels of education, since they are 16 to 18 times more expensive on a per student basis than primary education (Table 3.8). 23 While it is not known what the exact impact of the recent surge in donor-financed investment will be on the future recurrent budget, it will probably generate significant demands in areas of building maintenance, supplies, student stipends, and teacher salaries. Experience from other countries shows that each dollar invested in the education sector leads to as much as USS5-6 in recurrent costs. Continued high levels of investment will therefore produce even more pressure on the recurrent budget. Moreover, investment as a proportion of the recurrent budget is projected to increase from 50% to 70°/O. Disregarding classification problems between investment and recurrent costs, such high levels of investment would appear to be unsustainable. - 60 - TABLE 3.8: AVERAGE UNIT RECURRENT COST ESTIMATES FOR EDUCATION, 1994/95 Level Kip Per capita GDP Relative to primary Pre-school 31,335 0.120 1.76 Primary 17,841 0.068 1.00 Lower secondary 39,625 0.152 2.22 Upper secondary 43,319 0.166 2.43 TVET 286,872 1.101 16.08 Teacher training 311,546 1.196 17.46 Higher education 332,273 1.275 18.62 Source: Lao PDR authorities. 3.84 There are substantial differences across sub-sectors in terms of the relative importance of the components of unit costs. Particularly striking is the high proportion of resources devoted to scholarships in post-secondary education. This ranges from 36% of the budget for teacher training to nearly half of the budget for TVET and higher education. The justification for such costly items needs to be reconsidered, especially in light of the planned establishment of a National University. Also at issue are the relatively high costs of salaries in post-secondary education, brought about largely because of very low pupil-teacher and pupil-non-teaching staff ratios. 3.85 Resource Distribution across Categories of Expenditure. The scope for savings through improving educational flows is enormous, with repeaters currently taking up 21% of the primary school places. In order to generate resources over the longer term, Lao PDR needs to embark on a sustained program of quality improvement. This should begin with a program to identify those inputs which would have a clear impact on learning and promotion and should be followed by programs of targeted managerial and expenditure support.24 3.86 Lao PDR currently allocates little to investments in quality of education. Eighty-four percent of the recurrent budget goes for salaries and administration. Of the remaining 16%, 7% is for operations and maintenance and 9% for fellowships. Allocations for pedagogical materials are buried in the budget for operations and maintenance, and textbooks (along with other printed materials) are placed rather unconventionally under the heading "Fellowships and Subventions." Complete data are not available, but the best estimate for actual spending on textbooks and materials in 1994-95 is 429 million kip, or roughly 1.6% of the total education recurrent budget. 3.87 Resource Distribution across Schools. The first observation regarding the distribution of resources across schools is that there are a large number of very small schools. Clearly, the geographic and demographic conditions of Lao PDR explain the existence of many small schools and much of this is probably unavoidable. However, the issue of amalgamating a certain number of these schools should probably be contemplated in areas where amalgamation would continue to ensure easy access for students. This would enhance the ability of managers to rationally and economically distribute managerial, personnel, and material resources. 3.88 The second observation regarding resource distribution across schools is that there is wide variation in pupil-teacher ratios, even among schools of the same size. This is true at the primary, lower secondary, and upper secondary levels. Variation tends to be greater in small schools. For 24 In most developing countries investments in improved curricula, textbooks, and effective teaching, and efforts to improve children's learning capacity (e.g., through improved health and nutrition), have had positive impacts on learning achievement. - 61 - example, primary schools of about 80 students have pupil-teacher ratios ranging from 12:1 to 84:1. Ratios in lower secondary schools of the same size range from 6:1 to 30:1. The variation could be caused by real need, by problematic deployment policies, or by a legacy of uneven funding across provinces. Ideally, one would want to re-deploy teachers from schools that are "over-staffed" to schools that are "understaffed." One could also consider releasing teachers from over-staffed schools once opportunities for re-deploymnent are exhausted. Such decisions should be made on the basis of a school-by-school analysis. 3.89 Teacher Utilization. Teacher utilization at the secondary level is a major resource allocation issue. Lower secondary teachers are estimated to teach only 13 hours per week on average, instead of the statutory 20 hours. Upper secondary teachers teach on average only 12.1 hours per week instead of 18 hours. These rates are very low and should be a matter of concern for educational policy. For example, if the teacher utilization rate is related to the teacher salary bill for secondary education, it appears that the Ministry of Education (MoE) is in effect paying 1,835 million kip (6.7% of the total MoE recurrent budget) for teaching services which it does not receive. 3.90 Incidence of Public Expenditure on Education. Public spending in Lao PDR is biased toward the better-off The most recent data available on education spending by income group is presented in the "Lao PDR Social Development Assessment and Strategy" (World Bank, 1995). This report highlights an important public financing issue for education managers, namely, that public education spending per capita is nearly three times higher for those in the highest income quintile than for those in the lowest income quintile. 3.91 What could the Govemment do to address these inequities? First, the Government must assess its higher education admissions policies to ensure that they do not inadvertently discriminate against rural and poor students. Over the longer term, the Government needs to improve the quality of education at the primary and secondary levels in poor areas to ensure that all students are equally well prepared to compete for positions in upper secondary school and higher education. Second, the Government may wish to raise additional income by applying a fee schedule on upper secondary and higher education, so that better-off students receive less in subsidies and the poorest can be provided with assistance. Fees could also be used to finance lower secondary school construction and operation in areas where access is lowest. F. SCOPE FOR PRIVATE SECTOR PARTICIPATION 3.92 There is a small, but rapidly growing, private education system in Lao PDR. Presently, private schools only operate at the basic education level. Less than 3% of all students at the pre- school through lower secondary level are currently enrolled in private schools (Table 3.9). Private schools are concentrated in a few major urban areas, where the demand for education is relatively high and where there is a critical mass of higher income families. 3.93 At present, the scope for expanding private education outside of existing urban areas is probably quite limited, owing to the high rates of poverty and the limited profit margin. Generally, the private sector flourishes where there is substantial excess demand for education -- a condition which does not yet exist in Lao PDR except in selected areas of specialized training, such as secretarial and language skills. - 62 - TABLE 3.9: ENROLLMENT IN PRIVATE EDUCATION, 1989-95 1989/90 1990/91 1991/92 1992/93 1993/94 1994/95 % of total students 1994/95 Pre-school (700) (1,000) 1,655 2,324 3,242 (4,500) 13.4% Primary (2,000) (4,000) 6,886 10,415 14,409 (18,000) 2.5% Lower secondary (0) (0) 165 713 996 (1,300) 1.1% Note: Figures in parentheses are estimates. Source: Lao PDR authorities. G. PROPOSED MEDIUM-TERM EXPENDITURE PROGRAM 3.94 The proposed balance of capital expenditures among the broad, highly aggregated program categories in the education sector appears broadly reasonable for the next five years, and no alternative expenditure suggestion is therefore indicated (Table 3.10). However, there are strong indications that reallocations within the categories are desirable. In particular, there is a danger that rapid growth of post-secondary education (through investment in the National University) -- where expenses are very high in relation to basic education -- will place undue stress on future education budgets. In fact, a recent World Bank study on Education Finance and Management concludes that the gap between budgeted and required current expenditures is likely to exceed 16,000 million kip by the year 2000. The MoE should therefore look for ways to reduce the unit costs of education generally, with a particular emphasis on secondary education, to bridge the gap between the required and available resources. To close this gap, the Government has a choice of (i) shifting resources from the capital expenditure program to current expenditure requirements; (ii) increasing allocations to current education expenditures (and therefore cutting expenditures in other sectors to stay within the available resource envelope); (iii) compromising on its goals for expanding education; or (iv) preferably, increasing the efficiency of available resource use by looking for ways to reduce the unit costs of post-secondary education in order to finance its growth. As long as resources remain constrained and no additional funding can be mobilized from internal or external sources, adequate recurrent cost financing will have to rely on greater efficiency gains. The Government must therefore ensure that new investments in post-secondary education are made according to a well- reasoned set of priorities which balance concerns for quality, growth, and equity. 3.95 There appears to be a considerable need to increase expenditure on inputs that would improve the quality of the learning environment, including textbooks, teaching materials, in-service teacher training, principal training, and school maintenance. These categories of expenditure are not normally financed by donors and will therefore require re-examination of the current budget. The education system could certainly benefit from increased allocation for quality improvement programs, provided the capacity to manage such resources well could also be developed. - 63 - TABLE 3.10: PUBLIC INVESTMENT PLAN FOR EDUCATION, 1995/96 - 1999/2000 (BILLION KIP) 1995/96 1996/97 1997/98 1998/99 1999/00 '99 90500 Ongoing & committed 18.1 13.4 12.2 7.3 6.0 56.9 Prinaty & secondary education 8.8 7.1 7.4 5.8 6.0 35.1 Technical & vocational training 4.1 3.1 2.4 1.5 - 11.0 National polytechnic 3.1 - 3.1 Dong Dok tertiary institution 1.8 3.1 2.4 - - 7.2 Non-formal education 0.3 0.2 - - - 0.5 New programs 1.3 10.2 16.5 27.0 33.5 88.6 Primary & secondary education - 6.1 9.4 14.6 17.9 48.0 Technical & vocational training - - 1.8 4.4 7.4 13.6 Non-formal education - 1.0 1.8 2.9 3.0 8.7 Rural primary & vocational programs 1.3 3.1 3.5 5.1 5.2 18.3 Total Education PIP 19.4 23.6 28.7 34.3 39.4 145.5 Current Expenditure 27.3 34.0 39.0 44.0 50.0 194.3 Total Education Expendiure 46.6 57.6 67.7 78.3 89.4 339.7 Total Education Expenditure as % of GDP 2.9 3.0 3.1 3.2 3.3 3.1 Sources: Government authorities and World Bank staff estimates. 3.96 The challenge for Lao PDR 's education finance managers will be to economize, prioritize, and protect key expenditure items. First, they must ensure that available government and non- government resources are mobilized and used most effectively and efficiently. Second, they must ensure that new investments in the sector follow priorities that balance the aforementioned concerns for quality, growth, and equity. In this regard, particular attention should be given to developing a coherent national education investment policy which would lay the groundwork for improved donor coordination. Third, these managers must develop planning and budgeting procedures to protect key categories of expenditures and vulnerable groups, such as basic education, provision of teaching and learning materials, and support for educational services in disadvantaged areas. 3.97 The most promising avenue for mobilizing resources in the education sector will therefore be to achieve cost savings within the education sector itself Savings in the current budget could be obtained from (i) taking steps to lower the unit costs of post-primary education; (ii) investing in key quality inputs which would eventually improve efficiency; (iii) more efficiently and effectively distributing resources across schools; (iv) improving teacher utilization; and, (v) developing more equitable cost-sharing arrangements for higher education. - 64 - CONCLUSIONS 3.98 Public expenditure priorities are different within each sector, and the specific sectoral recommendations drawn from the sectoral surveys are summarized below. However, certain broad key observations run across the sectors: * Weak implementation capacity, particularly in the public sector, is a major constraint to public expenditure performance. All sectoral expenditure strategies need to focus on an affordable core program which takes account of absorptive capacity constraints and emphasizes quality and efficiency in delivering concrete results. Short-term measures to address weak human capacity and institutional bottlenecks include more effective use of technical assistance, improved donor coordination, selective expenditure allocations for high priority programs, and greater reliance on the private sector. Over the medium term, strengthening implementation performance across the sectors requires focused training, improved budgetary planning, greater decentralization and accountability of implementing units, and acceleration of public sector reforms (see Chapter 4). * Poverty reduction requires better performance in the rural sector. This in turn will require greater efficiency in the use of available resources and greater equity in public expenditure allocations to reach out to the rural poor. • Private sector participation should be encouraged across the sectors, particularly where there is no clear rationale for public sector involvement. Together with a greater use of cost recovery, this would help reduce dependence on tax revenues and would encourage a more efficient allocation of resources. It would allow the state to focus on providing macroeconomic stability, strengthening physical infrastructure and human capital to support private sector growth, and assisting poor Laotians who are excluded from the benefits of economic growth. * Operations and maintenance have generally been neglected across the sectors at the expense of new investments, leading to an unacceptable waste of scarce resources. The investment agenda has been driven by foreign donors, and it is questionable whether this has always been in line with sectoral priorities. Ensuring adequate provisions for O&M, while keeping recurrent expenditures under control, requires the discipline of forward- looking budgeting which takes account of the recurrent cost requirements over the medium term. Sectoral Investment Programs are proposed in Chapter 4 as budgetary instruments to improve aid coordination. These operations would be agreed upon among donors, the Government, and local stakeholders, and would clearly set out sector strategies in a sector-wide program approach covering all sector expenditures, both current and capital. - 65 - SECTORAL RECOMMENDATIONS TRANSPORT Issues Problems | Recommended Actions Formulation of Size and scope of =' Focus recurrent and capital transport expenditure on a appropriate proposed transport core program of about US$387 million. transport expenditure programs expenditure lack coherence and = In the long term, aim at overall level of transport program, justification; expenditure of about 3.5 - 4% of GDP (in real terms). 1996-2000 they exceed macroeconomic and funding constraints as well as absorptive capacity. Inadequate road Inefficient delivery of => Direct available financial and human resources to routine maintenance systematic and periodic maintenance as the first priority. maintenance due to weak institutions, =' Focus spot improvements and emergency repairs on conflicting roles of provision of a minimum level of network connectivity central and provincial and accessibility. entities and problems with maintenance => Implement a system of forward budgeting linked to a funding. rolling maintenance work plan. Organizational Inadequate planning =' Streamline and simplify the decision-making process effectiveness and prioritization of within MCTPC. transport programs and projects; weak > Define clearly the relationship between center and management and provinces and define each level's rights and obligations. budgeting procedures; => Improve financial reporting and payment systems. insufficient technical and managerial > Develop arm's length relationship with contractors, capabilities. update the unit price system, and ensure contractor mobility among provinces. Cost recovery Claims that revenue => Improve the efficiency of tax collection and eliminate from road user distortions in the structure of road user charges. (There is charges is insufficient no need to increase user charges to fund road to fund systematic maintenance.) road maintenance. Private sector Lack of coherent => Promote private sector participation selectively. Private participation policy concerning sector funding of transport infrastructure should only be private sector considered if the economic benefits to society exceed the participation in financial and economic costs of private provision. transport investment; uncertain prospects => Involve the private sector as contractor and eliminate for Government remaining obstacles to create a level playing field and to attempts to establish strengthen private contractors. a domestic _=____________ Scontracting industry. - 66 - AGRICULTURE AND FORESTRY Issues Problems Recommended Actions Composition of Inefficient allocation of > Decrease planned spending on irrigation and agriculture public spending among forestry, increase funding for research and expenditures sub-sectors. extension, livestock health services, and information services (statistics/ surveys/ publications). Agricultural data Quality of agricultural > Extend initiatives begun by FAO to improve the data is too low for quality of basic agricultural data. Provide effective planning. sufficient funds for an agricultural census. Rural credit Rural credit is => Develop small-scale savings/credit institutions insufficient. targeted at poorer farmers Poor farmers are not => Move toward market-based positive real interest reached by APB. rates for agricultural credits. Irrigation Insufficient attention is => Cease further investments in new irrigation given to rehabilitating works. If new schemes are considered at all, they and maintaining existing should be small enough so that local water users' irrigation schemes. groups can manage and maintain them (in most Improving the quality cases, schemes serving less than 100 hectares). information for planning and monitoring irrigation => Train irrigation staff and enable them to development is also determine the demand for irrigation water through needed. surveys and simple analysis. > Conduct a national irrigation inventory and evaluation in two to three years to prioritize irrigation spending. Forestry Unrecorded logging => Limit the expansion of public investment in operations make forestry over the next four years. Concentrate following a coherent public involvement on forest conservation and strategy to manage forest management. resources difficult. Greater transparency and =' Improve transparency and accountability of accountability are logging operations for sustainable forest planning essential. Projected and management, and adequate revenue forestry spending collection. exceeds the Government's capacity = Increase budgeted funds for operational expenses to use funds efficiently. of long-duration forestry projects. Animal health There is a need to => Strengthen capacity of the DLVS through training improve animal health and increasing staff. conditions. Capacity of Department of Livestock => Develop a national livestock and forage program and Veterinary Services on the model of the National Rice Research (DLVS) is weak. Program. Vaccine coverage is low. => Increase the budget for vaccine procurement and reduce cost recovery; increase village-level training. - 67 - HEALTH Issues Problems Recommended Actions Increase Improve utilization of => Increase resources to reach a minimum recommended level of efficiency public health services, US$12 per capita for a basic package of services, by the year of health and increase public 2000. services confidence in the health delivery system. => Ensure that sufficient funds are budgeted for future operations system and maintenance of facilities and equipment. Redirect resources to => Ensure sufficient and better targeted funding for preventive meet key health care (particularly immunizations, birth spacing and maternal concerns. care, and malaria), and basic services (particularly for common childhood diseases). => Reduce heavy demands on Government health budget at the central level, and increase support to provincial level preventive services. Expand access to safe => Encourage expansion of revolving drug funds, including pharmaceuticals. through their exemption from remittances to the Treasury. Improve health system = Improve (a) categorization, by budgeting program, of public priority setting, and external resources, and (b) integration of policy management and statements and resource allocation by program, in order to coordination. strengthen coordination and prioritization of health sector expenditures. =: Strengthen capacity at the provincial level and at lower levels, to improve resource management and provide the requisite financial and management training. Improve Ensure more equitable => Allocate a greater proportion of resources to service delivery equity in division of budget: below the central level, including an increased proportion of health between "center" and public investment expenditures transferred directly to services "provinces," among provinces. delivery provinces, and between rural and urban => Strengthen monitoring and analysis of new program areas. budgeting system, particularly to indicate inequities in resource allocation among provinces and the impact of expenditures on services to rural areas. => Increase coordination and collaboration between MoH and provincial health offices, to ensure adequate health coverage of rural population. - 68 - EDUCATION Issues Problems Recommended Actions Economize Disproportionately high spending for post- > Introduce more equitable financing of education secondary education benefits upper income post-secondary education by better resources groups. targeting fellowships and other subsidies. The majority of schools are very small. The > Explore options for merging very small percentage of schools with fewer than 100 schools to formn more economical units, students is 72% at the primary level, 45% at taking into account geographic and the lower secondary level, and 30% at the demographic constraints. upper secondary level. Non-teaching staff represent about 18% of => Continue to decrease the proportion of the total education staff. non-teaching staff, particularly at higher levels of education. Secondary teachers are underutilized, => Experiment with training, curriculum teaching only 13 hours per week in lower restructuring, or job restructuring, to secondary school and 12.1 hours per week in increase utilization of teachers. upper secondary school. Prioritize Current levels of investment appear = Develop a coherent, prioritized national education unsustainable. investment policy in education and use expenditures this as a framework for donor coordination. => Build analysis of recurrent cost implications of investments into the planning and budgeting processes. Protect core Spending is low on inputs which enhance the > Provide budget for textbooks, materials, education quality of teaching and learning. in-service teacher training, and school program maintenance, especially in poor communities. There is a danger that rapid expansion of = Monitor higher education growth. Use post-secondary education -- where expenses savings from efficiency gains in higher are very high in relation to basic education -- education as the principal source of will cause undue stress on future education growth for higher education. Maintain budgets. or increase the share of resources for primary and lower secondary education. - 69 - PART III. BUDGETARY INSTITUTIONS 4. PUBLIC RESOURCE MANAGEMENT A. ANALYZING THE EFFECTIVENESS OF BUDGETARY INSTITUTIONS 4.1 The institutional processes of budgetary arrangements set the rules for allocating public spending among key decision makers. Without the right institutional framework, resources will not be allocated in accordance with priorities and translated into results on the ground. The effectiveness of these underlying budgetary institutions and incentives is a key factor in improving expenditure allocations and outcomes on a sustained basis. As is discussed in Chapter 2, Lao PDR's economy is undergoing a profound systemic shift and the role of the state is changing. The Public Investment Plan (PIP) envisages a shift in the composition of expenditure toward the social sectors, as well as an ambitious annual GDP growth rate of 8% over the next five years. The country remains highly dependent on external assistance for financing the government budget, with future revenues expected from hydropower. For the Government to successfully manage change and meet its growth targets while maintaining macroeconomic stability, it is critical to have well-functioning budgetary institutions that can ensure efficiency and equity in the composition of spending and the cost effectiveness of budgeted resources. This chapter identifies the strengths and weaknesses of the budgetary institutions in Lao PDR in meeting these objectives. 4.2 To identify these institutional arrangements, budgeting can be essentially considered a bargaining process for expenditure allocations between and among: (i) line ministries and the Ministry of Finance; (ii) the central and provincial agencies in the bureaucracy; (iii) the Party and its representatives on different committees, the National Assembly, and the ministries; (iv) interest groups; and (v) donors. This creates two types of tensions, primarily driven by differences in incentives. First, there is the interest of various parties in increasing expenditures for their constituencies and projects, as well as the concern of the Government, the central ministries, and key donors about the aggregate level of spending and the interests of society. The manner in which this tension is resolved will depend on the institutional arrangements that govern the budget process (i.e., Who has strategic dominance over what aspects of the budget process? Are there credible mechanisms by which the Government commits itself to fiscal targets?) These rules basically determine expenditure outcomes pertaining to the aggregate level and composition of spending.' The second type of tension results from the fact that politicians, central agencies, local beneficiaries, and donors must rely on line agencies for implementing the budgeted programs, while holding them accountable for achieving the intended objectives. This tension arises from incentive incompatibilities and information asymmetries. The way in which this is resolved will depend on the implicit/explicit contractual relationship among the politicians, central agencies, and donors and the relative autonomy and accountability of line agencies. Do they have incentives to use resources cost effectively to achieve stated objectives? 4.3 Therefore, budget institutions and processes in Lao PDR should be assessed against a broader range of criteria than the traditional criterion of the compliance of spending agencies with budget rules and appropriations. The degree to which Lao budget institutions can reconcile the often See Pradhan, "Evaluating Broad Allocations of Public Spending," World Bank, 1995 (mimeo). - 70 - conflicting requirements of traditional budgetary control and effective change management will determine the extent to which the Government's ambitious targets for overall growth and change in sectoral balance can be met. Criteria for Assessing the Performance of Budget Institutions 4.4 The budget process in Lao PDR is described briefly in Box 4.1 *2 The institutional arrangements that influence each stage of this process -- formulation, approval, and implementation-- can be assessed by three key dimensions of public sector perfornance which determine the design, selection and implementation of programs and projects.3 Box 4.1: LAO PDR's BUDGET PROCESS The main stages in budget preparation and execution involve identifying and prioritizing spending proposals, ensuring consistency of proposals with funding constraints, and arranging financing for measures approved in the budget. Starting in May of each year, line ministries submit investment proposals to the State Planning Committee (SPC) for consideration in the next financial year's budget (which begins October 1). Proposals are also developed by the provincial offices of the line ministries and coordinated by the provincial governor, in consultation with Rural Development Committees, villages, districts, and mass organizations (such as the Lao Women's Union). In an iterative process among the Ministry of Finance, the SPC, and the provinces, all these proposals are prioritized on the basis of political criteria (e.g., recent Party guidelines) and economic criteria (the expected availability of funds for capital purposes, the requirements of projects already under way, and counterpart payments associated with the new projects). These decisions are made against the background of overall development priorities set out in the Socio-Economic Development Plan. The investment component of the budget proposed by the SPC is then forwarded to the Ministry of Finance (MoF) for reconciliation with revenue projections for the budget year. Following several consultations, the MoF consolidates the line ministry spending proposals into a detailed draft of the State Budget, which is presented to the Government for review and endorsement and eventual adoption by the National Assembly in September. During budget execution, short-term adjustments in public expenditures can be made in case of revenue shortfalls when mid-term reviews of budget implementation are undertaken every six months by the Standing Committee for Planning, Economic and Financial Matters of the National Assembly. 4.5 (1) Do budget institutions provide aggregate fiscal discipline? What institutional arrangements (formal and informal) influence aggregate fiscal discipline (i.e., incentives to control deficits and spending)? Consistency with the available resource envelope ensures stability in domestic prices, in the balance of payments, and in the level of international indebtedness, together with an environment favorable to private sector growth. In practice, this requires that the financing consequences of the development plan be achievable under current and projected revenue collection, domestic and external borrowing, and access to foreign aid. Otherwise, either the plan or the 2 A detailed description of the budget process and the financing of budget outlays is given in Chapter 6 of the Background Papers. 3 These three criteria correspond to the framework adopted by Pradhan and Campos, "The Impact of Budgetary Institutions on Expenditure Outcomes" (World Bank, 1996, mimeo), to study the links between budget institutions and budget outcomes. The responses to a corresponding questionnaire on budget processes provide quantitative evidence underpinning the points made in this chapter and are summarized in the Appendix to Chapter 6 of the Background Papers. - 71 - financing arrangements must be altered to preserve macroeconomic stability. As is discussed in Chapter 1, this is particularly important because of Lao PDR's ambitious development objectives against the background of uncertain revenues from aid, timber, and hydropower. The high growth objective carries the risk of instability if the institutional arrangements linking plan and budget fail to ensure that the public sector operates within the available resource envelope. 4.6 (2) Is there an adequate prioritization in the composition of spending? What arrangements affect the allocation of expenditures across sectors and programs? How well do budget institutions reflect development priorities in the composition of yearly public investment? This becomes particularly important when priorities are changing; the increased emphasis on social priorities over the next five years requires flexibility in public sector planning. 4.7 (3) Do budget processes lead to efficient results? What arrangements encourage (or discourage) efficient delivery of outputs (i.e., services) by line agencies? Does the budget system support and require efficiency in program delivery? Once the spending limits have been set and the priorities in the composition of expenditure established, budgetary institutions need to deliver results on the ground. This requires coordination and the minimization of delays in disbursements and staffing of agencies, as well as the avoiding of duplication among different levels of government. Other traditional concerns are that there is probity and transparency in the disbursement of public funds, and that tax revenues are raised with minimal administrative costs. B. STRENGTHS AND WEAKNESSES IN BUDGETARY INSTITUTIONS AND ARRANGEMENTS (1) Fiscal Discipline and the Macroeconomic Framework 4.8 The permissible aggregate level of spending depends largely on the level of the sustainable budget deficit and the composition of that deficit, as discussed in Chapter 1. The risk of substantial losses in national income growth and welfare resulting from macroeconomic instability underlines the importance of strengthening the first dimension of budgetary arrangements, namely, the Government's capacity for macroeconomic management. Poor macroeconomic management will not only require fiscal consolidation (with lower budget outlays) in order to return to balance, but may also reduce both private sector growth (causing further welfare losses) and tax revenues (causing further pressure on limited budgetary resources). Repairing an episode of internal or external macroeconomic instability is likely to result in low growth for several years, which reduces the "economic pie" that would otherwise have been available for the Government to disburse. The welfare costs of the diminished pie may greatly outweigh the losses resulting from poor slicing of the pie (the second dimension) or from wasting part of each slice (the third dimension). 4.9 Lao PDR's recent track record of overall economic stability and sustained growth indicates that budgeting and planning arrangements are relatively effective in reconciling the Government's ambitious growth targets with price and balance of payments stability. The current process for developing the annual budget and the Public Investment Program (PIP) provides some institutional underpinning for fiscal discipline: During budget execution, the Ministry of Finance (MoF) generally keeps tight control of budgeted expenditures by closely supervising and authorizing the expenditures of line agencies and imposing hard budget constraints on state-owned enterprises. In the past, unforeseen revenue shortfalls have resulted in delaying transfers to line ministries and - 72 - postponing capital expenditures, often in an ad hoc manner. The budget is centralized and the provinces have no autonomous authority for raising revenue, spending, or incurring debt. * Coordination of public investment and access to foreign aid was improved by the creation of the Committee for Planning and Cooperation (CPC) in 1993, which was in charge of both the PIP and the selection of foreign aid projects--responsibilities previously divided between two ministries. This arrangement made it easier for foreign aid to be channeled to the Government's highest investment priorities. However, following the Sixth Party Congress, the CPC was restructured in July 1996 as the State Planning Committee (SPC), while foreign aid management (together with foreign investment management) was assigned to the Prime Minister's Office. Although this arrangement may increase direct control over the country's public and private investment, it risks returning the previous ineffective compartmentalization and making effective aid coordination even more difficult. * A central function of the SPC is to ensure that medium-term investments in the PIP match the resources available from domestic taxes, charges, and foreign aid. Since foreign aid requires counterpart funding commitments, and capital investments have recurrent cost implications, a key issue for macroeconomic balance is whether projects included in the PIP are sustainable, given the constraints of fiscal revenue mobilization over the medium term. Macroeconomic Management: Areas for Change 4.10 The Lao budget and planning institutions lack the capacity to ensure that the investment assumptions built into the PIP are consistent with the Government's medium-term resource envelope. Two principal ways to improve the relationship between the planning processes and the medium-term macroeconomic framework are: (i) to develop a realistic medium-term framework for assessing future government revenue; and (ii) to ensure the consistency and realism of the macroeconomic variables underlying the PIP. 4.11 (i) Developing a Medium-Term Revenue Framework. At present, macroeconomic targets are set as political guidelines rather than realistic scenarios of what can be achieved. The Government's 1996-2000 development plan assumes a high growth of real GDP of around 8%, maintained over the five-year period. However, this projection of high growth is not underpinned by a realistic assessment of fiscal revenues and by an estimate of the resource envelope that seems feasible (see Chapter 1). At present, medium-term revenue assumptions are either sketchy or tend to simply rely on broad extrapolations of past trends in revenue growth. Growth, revenue, and inflation targets, as well as balance of payments projections and investment-output ratios underlying the PIP, are often not internally consistent and diverge from estimates by the MoF. To back up economic targets, the feasibility of these assumptions should be regularly examined within a consistent medium-term revenue scenario which clearly specifies sources of revenue growth and measures to mobilize them. - 73 - 4.12 The importance of projecting a realistic resource envelope is exemplified by 1991-95 Public Investment Program the actual outcome of the 1991-95 PIP, which Domnestic Fund only was not fully achieved owing to inadequate (Actual vs Plan) capacity to raise sufficient funds for 50 , counterpart payments.4 Revenue was planned 40 at 15% of GDP, but actual revenue reached only 13% of GDP. Such revenue shortfalls lead to unplanned deficits in the State Budget, _ 20 with adverse effects on inflation and the 10 balance of payments -- unless there is a 41 corresponding reduction in scheduled public 1991 1992 1993 1994 1995 expenditures or a mobilization of additional *PIan Actual domestic or external resources. Both adjustments appear to have occurred in the 1991-95 PIP, rather than major inflationary and balance of payment distortions. Some aid projects were delayed owing to lack of counterpart funds, a number of domestically funded capital projects were postponed, and government suppliers were paid late.5 Grant aid from donors was used to cover domestic financing shortfalls. 4.13 The medium-term revenue framework must take into account external events affecting resource availability in the medium term. As was discussed in Chapter 1, these external factors include: (i) the possibility that foreign aid may be less freely available in the medium term as a "gap filler" for shortfalls in domestic revenue; (ii) the likelihood that future growth of government revenues from imports and exports may be reduced by Lao PDR's impending membership in ASEAN; and (iii) the risk that hydropower may not provide the expected substantial revenues in the short and medium terms. Therefore, the forecasting and mobilization of revenues must be managed proactively, parallel with investment planning. 4.14 (ii) Ensuring the Macroeconomic Consistency of the Medium-Term Public Expenditure Plans. The development aspirations built into the Government's current and capital expenditure plans, and their overall claim on the budget, must be met within realistic boundaries set by domestic and foreign resources available to the Lao economy over the medium term.6 To maintain macroeconomic stability, it is crucial for aggregate public investment and government consumption to be consistent with sustainability in public finances and the balance of payments. Underlying assumptions on growth, inflation, and the capital-output ratio must be based on a sound judgment of economic structures rather than on political imperatives. This need for macroeconomic consistency and realism can be partially addressed by a framework of national account identities (such as the RMSM model), but formulating a model is only part of the solution. The key issue is to ensure consistency and close cooperation between the PIP Department in the SPC and the Budget Department in the MoF. In other countries, issues relating to the macroeconomic consistency of the 4 See Chapter 9 of the Background Papers for details on project implementation. On methodological weaknesses in the PIP, see Chapter 7, Background Papers. 5 Delays in govemment payments to suppliers are reflected in deposits of enterprises at the Treasury. Treasury holdings include unspent funds transferred by the central govemment to the provincial offices and cash revenues obtained by the provinces and not yet transferred to the central govemment. 6 Foreign aid is not a perfect substitute for domestic savings, since it normally involves conditions relating to counterpart funding which must be met from domestic savings. As indicated above, the ability to meet counterpart payments has been a problem in the past owing to shortfalls in the growth of public sector revenue. - 74 - budget and plan are typically handled by a committee of technical officers reporting to senior civil servants, who then set the overall framework for the budget and the medium-term plan. 4.15 This type of arrangement could be used in the preparation of the Lao PIP to institutionalize the present practice of ad hoc discussions of concerned officials from different Government agencies. This would involve formally establishing an interministerial Macroeconomic Committee, which would have an official mandate to review the medium-term macroeconomic framework and the implications of alternative future revenue scenarios on public investment. The Macroeconomic Committee should meet regularly as part of the rollover process for the PIP and should incorporate technical analysis based on' updated projections derived from a macroeconomic consistency framework such as the RMSM model. On this basis, consensus should be achieved on medium-term projections for key macroeconomic variables (such as inflation, growth, ICOR, exchange rates, balance of payments) which could then be used consistently across all Government agencies. It would be crucial for this Committee to be of a technical rather than a political nature. It could be chaired by a high-ranking official from the MoF and should be composed of core representatives from the PIP Department (SPC), Budget Department (MoF), National Statistics Center (SPC), Research Department (BoL), and Planning Department (SPC). 4.16 An urgent priority for the committee would be to interface the macroeconomic planning for the PIP with the medium-term revenue framework discussed in Chapter 1. Where medium-term domestic funding appears insufficient to support the level of investment proposed for the PIP, this information should be fed back to the medium-term revenue framework, triggering a search for options to increase domestic revenues. Alternatively, the investment targets themselves should be modified. RECOMMENDATIONS FOR MACROECONOMIC MANAGEMENT => Create a consistent medium-term revenue framework to underpin macroeconomic growth and expenditure targets. = Establish an interministerial, non-political Macroeconomic Committee to monitor and review the consistency of the PIP within an integrated macroeconomic framework. (2) The Prioritization of Public Expenditure 4.17 Although Lao PDR's budgeting institutions and processes are somewhat opaque and unsophisticated, they are fairly effective in prioritizing the distribution of budget outlays across sectors. One of the strengths of the current budgeting process is the method of selecting investment projects for inclusion in the annual budget through the merging of top down and bottom up priorities (Box 4.1). Proposals for investment projects are developed within provinces and coordinated by provincial officials of line ministries under the guidance of the provincial governor. Provincial proposals are then submitted to line ministries and the SPC, which select projects in line with sectoral and national priorities, including political guidelines set by the Party Congress. In an iterative process, this consensus-oriented selection process effectively sorts the priorities set at the central level with the preferences identified by line ministries and provinces, and should help to -75 - ensure that scarce public resources are allocated where they are really needed.7 This is a substantial improvement over budgetary arrangements in other countries, where investment priorities are imposed centrally. Compositional Efficiency of Budget Processes: Areas for Change 4.18 Nonetheless, the efficiency of Lao budget institutions in determining the composition of budget spending could be improved by: (i) enhancing the technical procedures for developing the PIP; (ii) improving the balance of spending on new projects and the operations and maintenance (O&M) of existing infrastructure; and (iii) improving aid coordination. 4.19 (i) Enhancing the Technical Aspects of the PIP. A well-structured process for developing a medium-term expenditure program is essential to ensure that scarce public resources are directed to those sectoral programs and projects which achieve, with the greatest cost effectiveness, the priorities in the development plan. At present, the rolling five-year PIP has a central role to play as the only forward-looking source of data, but its usefulness is undermined by a number of methodological weaknesses (Box 4.2). Since policy, planning, and budgeting are separated, the PIP continues on an expansionary trajectory with little regard for available budget resources. The PIP in its present form does not provide an integrated approach to policymaking and budgeting of total expenditures which would spell out the total ongoing costs of policies and programs. 4.20 In particular, there is no information on the future recurrent expenditures implied by investments included in the PIP. Project monitoring information about ongoing investments is limited. The PIP does not distinguish between a Core PIP (defined as a program of approved priority projects with assured funding for capital and current expenses) and a Reserve List (stand-by projects to be implemented when resources become available). Projects in the five-year PIP portfolio are often not clearly identified (some exist in name only) and data are frequently inconsistent. 4.21 Furthermore, the documentation for investment proposals being considered for inclusion in the PIP is incomplete. In principle, the information presented to the SPC by line agencies and provinces in support of their project proposals should include both an economic and a financial appraisal of the proposed project, a clear statement of benefits relative to the Government's social and economic objectives, and an analysis of the likely outcomes under different values of the key assumptions. Experience suggests that this goal is rarely met, which makes it difficult to evaluate sectoral expenditure and investment programs. Even in developed economies, budget decision makers typically make do with patchy information, often of a qualitative nature, on some aspects of project proposals. It is recommended that project proposals submitted to the SPC by line agencies and provinces should, at a minimum, clearly state the outcomes expected from the investment proposal compared to the "no project" situation, and how these relate to national and regional development priorities. Unless the returns from different projects are assessed at least in some broad terms, it is unlikely that the PIP will maximize the benefits from the limited quantum of resources available for investment. It is more likely that the composition of expenditure will be driven by donor preferences rather than by national priorities, as is argued in the sectoral discussion in Chapter 3. Weak coordination of foreign assistance is reflected in fragmented sectoral policies, unclear priorities, and wasted resources (see Box 4.4, below). See Chapter 6, Background Papers, for a discussion of the budget process. The problems of the PIP are discussed in detail in Chapter 7, Background Papers. - 76 - Box 4.2: METHODOLOGICAL WEAKNESSES OF LAO PDR's PUBLIC INVESTMENT PLAN (PIP) Weaknesses in the technical aspect reduce the usefulness of the PIP as key instrument for expenditure planning: Lack of Comprehensiveness. Planning, policymaking, and budgeting decisions are separated, with the PIP simply listing possible investment projects with little regard to the available resource envelope, forward expenditure estimates, and projected future recurrent expenditures implied by capital investments. Project monitoring and evaluation of investment progress and project completion are inadequate. => Unsystematiw Project Selection and Prioritization. Projects are notprioritized to take account of possible cuts in planned public investment. Expenditure allocations and project selection are not based on systematic criteria such as economic (cost-benefit) analysis, do not examine the rationale for government intervention, and disregard the link between inputs (e.g., public spending on primary education) and outcomes (e.g., school enrollment at the primary level). Incomplete Project identification. Projects are often not clearly identified and data are incomplete. The PIP excludes all major hydropower projects, despite their large potential recurrent cost implications, but covers some capital investment programs of state-owned utilities. => Inconsistent Data. Many individual project line items fail consistency checks. Different exchange rates are used to compute dollar and kip values. = Incoherent Presentation. The data base on PIP investments is spread across many independent spreadsheets and contains numerous small projects and sub-categories that detract from important government priorities. It is not possible to trace the amounts reflected in summary schedules to detailed sectoral project listings. Recommendations. Further work is needed to strengthen the PIP in the following areas: Comprehensiveness. Shift to a more integrated program and policy approach where policy priorities drive resource allocations. Decision making, resource allocation, and aid management should be supported by forward expenditure estimates and sector investment programs (see Chapter 10, Background Papers). Clearly identify and budget for longer-term recurrent costs implied by capital investments. Install a functioning system to monitor and evaluate public investment during budget execution and after project completion. Project Prioritization. Distinguish high priority projects in a Core PIP from stand-by projects on a Reserve List that can be postponed in case of funding shortfalls. Use a coherent methodology for project selection (of at least the major projects) based on economic analysis, and provide a rationale for public sector involvement (see Chapter I of the Background Papers). z> Project Identykication. Fully identify projects, complete project information, and clarify programs beyond the concept stage. Include all hydropower schemes with public sector participation. = Data Management. Create orderly management of equipment and records at DPIP. Train staff in methods of proper collection, entry, organization, and protection of data. See that actual and projected numbers agree with their respective sources at line ministries, the MoF, and with foreign donors; prepare reconciliations. Presentation. Consolidate the hundreds of small projects into single line items on a sectoral and provincial level; write abstracts for major projects. 4.22 (ii) Improving Budgeting for Recurrent Operations and Maintenance Costs. Public expenditure in Lao PDR is strongly biased toward new investment. Current budgeting arrangements - 77 - are not very effective in managing the balance between capital expenditure on new projects and current expenditure on O&M of completed projects. Underinvestment in O&M is worsened by Lao PDR's present budgetary arrangements and its dependence on foreign aid. First, capital expenditure planning through the SPC allocates capital resources over a five-year period, while the budget in the MoF sets aside recurrent outlays such as repairs and maintenance only for a single year.9 This separation has failed to allow for the recurrent costs of O&M for established infrastructure. Second, the lack of maintenance is exacerbated when line ministries choose to allocate available funds for new capital investment rather than to rehabilitate existing infrastructure. For example, the Ministry of Transport deliberately underfunded the program to maintain existing roads to the point where they had deteriorated sufficiently to require (donor-funded) capital commitments for road reconstruction. Third, donor-financed projects have long-term recurrent cost implications, which are not always taken into account in project financing (Box 4.4). 4.23 Provided the initial investment was justified and was well prepared, how could systematic underfunding of maintenance expenditures be addressed? Key strategies to rectify this are through provisions in the budget (earmarking or forward estimates), as well as through a stronger institutionalfocus on O&M and improved aid coordination. * Earmarking. The asymmetry between the time profiles of plan and budget suggests that funds could be earrnarked to provide a more stable multi-year environment for key recurrent outlays on O&M. A frequently advanced example is road funds financed from road user charges. However, earnarking is difficult to reconcile with the fundamental principle of sound budgeting--that the best uses of revenue for the year in question should be decided by completely reviewing all spending options without exception.'0 * Forward Estimates. An altemative approach to finance O&M is to develop forward budget estimates for recurrent items as part of the annual budgeting process, in a systematic way. This would involve extending the PIP into a medium-termn budgeting framework which includes both capital outlays and forward estimates of recurrent outlays that are currently included in the annual budget. Forward estimates of key budget outlays have been pioneered successfully in Australia (see Box 4.3). * Institutional Focus on O&M. The Govemment should consider assigning the primary responsibility for overseeing O&M expenditure needs and programs to a single agency. The Budget Department in the MoF could be given the necessary official mandate (and technical expertise) to establish a consistent forward-looking multi-year O&M strategy to guide public investment decisions, carefully balancing clearly identified expenditure requirements with realistic revenue projections. Under the auspices of the State Property Department, spending ministries and agencies, in conjunction with the relevant provincial authorities, should compile sectoral data bases on public assets and their maintenance requirements and then define sectoral O&M objectives, programs, costs, and other requirements and establish ongoing monitoring and evaluation of O&M expenditure programs. This would also involve incorporating line items that identify actual O&M expenditures within the Government budget accounting system. 9 About 15% of PIP outlays are budgeted for spending on O&M. The Ministry of Communications, Transport, Post and Construction is the only line ministry which currently prepares (with the help of foreign consultants) three-year projections for O&M outlays. 0 See Chapter 1, Background Papers, for a discussion of earmarking and suggestions for improved provisions for O&M. - 78 - Box 4.3: How Do FoRWARD EsTimATES oF BUDGET OUTLAYS WORK? Forward estimates of budget outlays are useful where spending decisions in one budget affect the options available in later budgets. For example, an investment project, once approved, may require funding (including counterpart payments) in subsequent budgets and spending on O&M upon completion. Advantages of forward estimates: => Such estimates enable the government to see how far future budgets are already locked in by previous decisions, and how much room there is for new spending commitments; this encourages a medium-term approach to budget strategy and the adoption of medium-term macroeconomic targets. =' Forward estimates ensure that funding is available in future budgets for investnent projects which have already been started, avoiding the wastes of postponement or cancellation of work already in progress due to previous overcommitment. = Such estimates improve the quality of budget decisions; since ministers do not need to scrutinize every line item in each budget where they have previously approved the forward estimates for the item, they have more time to review in depth the pros and cons of new policy proposals, which results in clearer decisions and instructions to program agencies. This in turn facilitates greater devolution of decision making (see Box 4.8, below). The PIP is a set of forward estimates for the capital side of the Lao budget (together with some O&M) over a rolling five-year period. It is a "soft" set of forward estimates, since including a project in the PIP does not guarantee that it will be funded in future budgets without further consideration. 'Hard' forward estimates, such as those used in Australia, mean that once the Cabinet has approved a project, funding is automatically provided in future years' budgets without the need for reconfirmation in subsequent budget processes (adjustments for movements in prices, exchange rates, etc., are made automatically). Funding can only be altered at some later stage via a new policy proposal in a future budget. Lao PDR could gradually introduce hard forward estimates at least for major projects. The challenge of this concept is that the initial project decision must be of high quality, requiring a high standard of presentation of the proposal. Improved Aid Coordination. Donor-financed projects may seem like an almost free good, but they also entail the need for counterpart funds and O&M expenditures." This has not always been recognized in Lao PDR public expenditure planning, as is shown by the frequent shortage of counterpart funds and the general lack of provisions for O&M requirements once the foreign funding for a project runs out. In some instances, bilateral donors tend to work directly with line ministries, with the result that the SPC loses oversight. An effective Foreign Aid Management Committee (FAMC) which coordinates different donor projects and the PIP Department, is thus a prerequisite for ensuring adequate O&M funding (Box 4.4). See Box 4.4 in this chapter and Chapter 10, Background Papers, for more detailed discussions of aid coordination. - 79 - Box 4.4: IMPROVING AID COORDINATION The bulk of external assistance to Lao PDR during the past few years has been directed toward (i) industry, energy, transport, and communications; (ii) economic management; and (iii) agriculture, forestry and fisheries. IDA and ADB accounted for the largest share of multilateral funds disbursed during 1992-94, while Japan was the largest bilateral donor. The principle institutions that identify the Government's development objectives, coordinate external assistance, and guide donors are: (i) the 1995-2000 Socio-Economic Development Plan, which outlines the country's development objectives, and the PIP, which sets out the Government's expenditure planning and identifies the areas where assistance is needed; (ii) a Donors' Round Table Conference, which is held biennially under the auspices of UNDP, in an effort to collectively structure the assistance program; and (iii) the Foreign Aid Management Committee (FAMC), which coordinates external assistance operations and ensures that donor projects reflect the development objectives in the Development Plan. The key agency for aid coordination is the Cooperation Department under the Prime Minister's Office which acts as the FAMC's secretariat. Several key issues call for improved aid coordination and management: (i) Unclear Government Priorities - Official development priorities are not very clearly defined, nor are they well articulated in terms of how they translate into actual programs. Moreover, donor-driven priorities are not always consistent with the Government's strategic priorities, or may delay Government programs at the sectoral level. (ii) Weak Coordination Capacity - The use of sector coordination groups is limited. The linkages between the aid management units in the ministries, the SPC, FAMC, and the donors--especially bilateral and NGOs--are weak, as some of these units operate independently. Bilateral donors and NGOs often bypass the SPC and deal directly with line agencies for individual projects. Moreover, multiple bureaucratic requirements from different donors tend to overload administrative capacities that are already overstretched. (iii) Fragmented Sectoral Policies - Aid coordination works well in some sectors, but seems to be fragmented in others. Lack of effective coordination leads to overlaps and conflicts. Recommended changes to improve aid coordination are: = Involve donors at an earlier stage of the PIP process. The Government must take the lead in providing guidance on investment needs, and ensuring that donor activities do not operate at cross-purposes. > Improve the institutional framework for the coordination and management of aid. As the primary source of information on all commitments/disbursements of loans and grants, the Foreign Currency Affairs Department in the MoF should establish computerized links (or a compatible information system) among the line ministries, the FAMC, and PIP departments in the SPC. =, Establish inter-ministerial working groups or donor-government working groups. These should, ideally, include representatives of the MoF, the SPC, and the relevant provincial administration and line ministries. Two other proposals are to establish: (i) one technical coordinating committee (UNDP, major donors) dealing with administrative aspects on a regular basis; and (ii) sectoral working groups and sectoral conferences (as already started for energy, forestry, transport, and health). . Consolidate administrative procedures among donors. A beginning has been made by a coordinated approach between the World Bank and ADB in assisting the Government to incorporate international procurement practices in the Procurement Decree. => Explore Sectoral Investment Programs (SIPs) as an operational instrument for implementing a broader sector approach to investment lending. The Government would be in a better position to influence the allocation of external resources within a sector if the Government and donors would agree on an SIP for key sectors, based on a coherent, operational sectoral strategy. - 80 - 4.24 Forward estimates would be an important step toward a more integrated medium-term expenditure framework in which policy priorities drive resource allocation decisions within realistic resource constraints. A broadening of the role of forward estimates in the budget process is consistent with the recent move by the Government to include post-project O&M expenditures greater than 10 million kip in the PIP. This is a first step toward presenting the PIP as a full set of forward estimates of all budget outlays--both capital and recurrent--over the planning period."2 This full-fledged set of forward estimates of budget outlays would ensure that O&M outlays for the growing infrastructure base will not be subordinated to the capital requirements of the PIP.'3 4.25 Sectoral Investment Programs (SIPs) should be explored as budgetary tools to complement a forward-looking PIP. SIPs support a policy and program approach to decision making, resource allocation, and aid management in line with sectoral priorities. '4 These operations are useful in addressing typical problems with the implementation of development programs: insufficient local ownership and commitment; the lack of a noticeable "trickle-down" effect from some individual projects; projects that are not maintained after initial implementation; confusion and dissipation of effort caused by different approaches pushed by different donors; excessive numbers of expatriate technical assistance personnel; the weakening of government capacity by the creation of donor- financed project units; and, finally, inefficient allocation of public expenditures. These implementation issues can be addressed by the essential features of SIPs: (i) an SIP is sector-wide in scope and it must cover all sector expenditures, both current and capital; (ii) an SIP has to be based on a clear sector strategy and policy framework; (iii) local stakeholders, meaning Government, beneficiaries, and the private sector, must be fully in charge; (iv) all main donors must sign on to the approach and participate in its financing; (v) implementation arrangements should to the extent possible be common to all financiers; and (vi) local capacity, rather than long-term technical assistance, should be relied on for the project. The present conditions for exploring this type of broad sector coordination are favorable, given the macroeconomic and political stability in Lao PDR. 12 At present, however, the Government still has to approach donors to provide ad hoc funding for former projects (e.g., Australia is still financing repairs of the Friendship Bridge over the Mekong because no provisions were made for its maintenance). 13 It might also provide for higher levels of civil service wages and an urgently needed improvement in skill levels available in the public sector, as discussed in further detail in Chapter 15, Background Papers. 14 See Chapter 10, Background Papers, for a discussion of Sectoral Investment Programs. For details, see P. Harrold and Associates (1995), "The Broad Sector Approach to Investment Lending," World Bank Discussion Paper 302. - 81 - RECOMMENDATIONS FOR EXPENDITURE PRIORITIZATION =, Rectify the methodological defects in the PIP and improve the analysis and documentation of project proposals to be considered in the PIP process. => Progressively develop the PIP as a full set of forward estimates for all components of public outlays over time. = Improve aid coordination to align foreign assistance with development priorities, avoid overlaps, and increase the consistency of sectoral policies (Box 4.4). Sectoral Investment Programs and a stronger institutional focus on O&M should be explored to provide a systematic approach to medium-term expenditure requirements. (3) The Technical Efficiency of Public Expenditure 4.26 The best public spending prioritization is meaningless unless expenditure decisions can be effectively implemented. To what extent do public sector agencies operate efficiently and divert minimum resources from the private sector? Where do public sector decision-making processes result in unintended delays in implementing investment projects? Substantial progress has been achieved in the capacity of the Lao public sector to effectively deliver results on the ground, mainly through reforms of state-owned enterprises (SOEs) and the civil service. The Lao PDR budgetary process works reasonably well at the practical level: the MoF keeps close control over expenditures and revenues at the provincial level; efforts have been made to improve documentation and feedback on annual achievements. The transparency of the system should be further improved with the implementation of a newly adopted budget nomenclature for the 1996/97 budget, which replaces the old Soviet-style classification. Despite these promising beginnings, further reform efforts will be needed in all these areas to create an effective and modern public sector capable of managing the changing demands of a market economy, 4.27 State-owned Enterprise (SOE) Reform. Privatization of the majority of SOEs promoted competition, allowed unviable enterprises to close down, and released resources for more productive uses. Enterprises remaining in the state sector are to operate without subsidy and are subject to private sector tax provisions. As summarized in Box 4.5, the foundation exists for efficient production and effective corporate governance within the public sector.'5 4.28 Civil Service Reform The civil service personnel management system has also been substantially reformed (see Box 4.6). From 1989 to 1992 the work force was reduced by an estimated 22%. The pace of retrenchment has slowed since then, and upgrading skill levels has become a high priority."6 I5 However, given the present tendency for borrowing to finance capital investments, significant increases in the profitability of the remaining SOEs will be required to meet future debt-servicing burdens. SOE reform and privatizations are discussed in further detail in Chapter 14, Background Papers. 16 The progress and challenges of civil service reform are discussed in detail in Chapter 15, Background Papers. - 82 - Box 4.5: STATE-OWNED ENTERPRISE MANAGEMENT AND THE BUDGET The 32 SOEs which, for the time being, will not be privatized have significantly improved their financial performance following their exposure to hard budget constraints. These SOEs contribute to budget revenue through taxes and interest payments on the bilateral and multilateral grants and credits which are received by the Government and on-lent to finance the SOEs' capital investment. Total Credit to the Enterprise Sector 100% 80%I. 60% 40% 20% 0% I 1991 1992 1993 1994 1995 ID Credit to SOEs 1 Other Credit Following the elimination of direct operating subsidization from the budget in the early 1990s, the Government implemented a comprehensive reform of the banking sector, which terminated soft lending practices by state-owned banks. Credit to SOEs is now a small percentage of the total credit extended to the enterprise sector. Short-term loan conditions are identical for private borrowers and SOEs. Loans extended to SOEs actually have fewer arrears (4% on average) than those to private borrowers (8 %). Although the present financial situation looks good, there are reasons for concern in the future. Most SOEs are only marginally profitable and cannot generate the resources required to replace, let alone modernize, their equipment. Larger utilities rely almost exclusively on external donors to finance their investment programs, and their debt service is increasing rapidly. Their profitability must increase through much stricter cost control and adequate tariff adjustment. However politically difficult, these measures will be essential to ensure that these enterprises do not become a liability to the budget and the state banking sector. Recommendations for SOE Management. The Government should maintain sufficient managerial autonomy for the SOEs but should carefully monitor their financial perfomance to intervene in a timely manner if necessary. For this reason, the Government should quickly introduce mechanisms and incentives to exercise governance in the SOEs. Over the medium term it should consider divesting its remaining commercial activities and devolving them to the private sector. In the short term, the priorities are to: =:> Appoint a fully functional Board of Directors for the enterprises targeted for commercialization to represent the state as shareholder => Strengthen the capacity of the MoF to move to active portfolio management from its present focus on control over the contribution of SOEs to the state budget, and should introduce technical and financial targets against which SOE performance and management will be measured. - 83 - Box 4.6: CIVIL SERVICE REFORM Administrative reforms have followed economic reforms closely in Lao PDR. These administrative reforms have dealt with: (i) organizational change; (ii) reforms of the personnel management system governing the civil service; (iii) compensation; and (iv) retrenchment. The Government has made organizational changes and has introduced new laws pertaining to the civil service, but the main thrust of reform efforts to date has been to downsize the civil service. The administrative structure has barely been replaced, and much more needs to be done. The reform process should reconstitute the civil service to meet the demands of the emerging market- based economy. That is, change the skills mix and increase the effectiveness of the civil service as opposed to merely reducing size. Further progress in civil service reform must focus on a range of measures: =: Replace Redundant Civil Servants. To alter the skills mix of the civil service, individuals whose skills do not match current and future requirements must be replaced. These people are likely to fall into two categories: those who participated in the revolutionary war (1954-75) and those who were civil servants under the "Ancient" regime (pre- 1975). => Enhance Competence and Accountability. Client surveys should be undertaken as a first step toward long- term civil service reform, which requires that (i) personnel are competent, (ii) line agencies have flexibility to decide how to allocate resources across programs within their mandate and within programs to achieve least cost provision, and (iii) line agencies be held accountable for the results that they are expected to produce. => Establish Job Descriptions. Recruitment and compensation are directly linked to a transparent system of job descriptions and classifications. => Narrow Salary Differentials between Public Service and Private Enterprise. Attracting competent personnel to the civil service requires compensation comparable to the private sector. = Standardize Recruitment. A process of identifying qualified applicants with the requisite skills will need to be established (e.g., through competitive entrance exams). Technical Efficiency of Budget Processes: Areas for Change 4.29 Despite the impressive progress in SOE reform and civil service reform, further reforms are required to: (i) avert project implementation delays caused by bottlenecks in public administration processes. (ii) enhance the capacity for monitoring public investment projects; and (iii) improve revenue collection by granting more resources to the Taxation Department. 4.30 (i) Project Implementation. Investment projects contained in the PIP (and for which funding has been approved in the annual budget) have experienced frequent implementation difficulties. One key reason is the shortage of technical and management skills at the provincial level (Box 4.7).' Implementation difficulties also reflect shortcomings in the delegation of authority and responsibility between line ministries and their regional counterparts, and delays in the release of counterpartfunding. "7 Difficulties in project implementation are discussed in detail in Chapter 9, Background Papers. - 84 - 4.31 Problems in allocating responsibility among the line ministry, its provincial arm, and the provincial government are exemplified by the sectoral discussion in Chapter 3. Line ministry officials are often reluctant to give project and program managers autonomy to manage project operations. Most spending decisions are still passed to the level of vice minister or above, which delays progress. Sometimes the provincial office of the line ministry has closer links with the provincial authorities, which results in mismatches of budget allocations and planning targets. This also curtails progress reports to the central ministry on the project, which contributes to poor program execution monitoring on the part of the ministry. Box 4.7: PROJECT IMPLEMENTATION IN LAO PDR Institutional constraints that frequently hinder project performance in Lao PDR are: (i) weak institutional capacity owing to the shortage of qualified staff, high turnover of staff, insufficient training and knowledge transfer, and weak local ownership of projects; (ii) insufficient and delayed release of counterpart funds; (iii) inefficient administrative review procedures; and (iv) inadequate procurement and disbursement systems. Given the high dependence on external assistance in achieving investment targets, and the possibility of cutbacks in future support, it is crucial that Lao PDR uses funds more effectively and improves the overall performance of its project portfolio. Although the Government has made good progress in recent years to streamline its administrative procedures (by adopting a Procurement Decree, for instance), further efforts are required to build on progress achieved to date: = Increase the skill levels of public sector staff by: (i) providing opportunities and rewards for increasing short-term and long-term training, establishing a wage policy and incentive structure that will permit the civil service to attract and retain qualified staff, improving the recruitment system, replacing redundant personnel, and reassigning staff between central and provincial offices to agencies facing skill and personnel shortages; (ii) improving information technology by linking project information among SPC, MOF, and line ministries; (iii) providing training in procurement and disbursement. =: Improve country dialogue among donors, recipients, and implementing agencies, make aid coordination more effective and relevant to clarify policy objectives, and ensure local ownership by exploring Sectoral Investment Programs (SIPs) (Box 4.4). => Involve provinces and local stakeholders at an early stage in the project design to increase local ownership. > Reduce the multi-layer review and approval process by: (i) using post-reviews instead of pre-reviews through the MoF, which would simplify the procedures for releasing funds from special accounts in a timely manner; and (ii) strengthening accounting capacity by using ongoing and planned technical assistance. =: To improve procurement, (i) amend the Procurement Decree and adopt clear implementation guidelines to take into account standard international procurement practices of major multilateral donors; and (ii) implement national competitive bidding (NCB) for civil works on all new projects. => To improve disbursement, (i) develop financial management systems capable of monitoring the flow of funds at Project Implementation Units (PlUs) in the line ministries; and (ii) increase the autonomy of PIUs by delegating the authority for loan withdrawal applications and fund replenishment to the PIUs. 4.32 Highly centralized authorization arrangements for financial commitments on behalf of the Government ensure that outlays do not exceed appropriations and that procurement is sufficiently rigorous. However, project implementation can be delayed by administrative bottlenecks when approvals and procurements must be cleared at the center. Funding delays result because program managers need centralized approval before they can draw down credits authorized in the budget. For - 85 - example, payment delays to road maintenance enterprises average four months and may be as long as eight months. 4.33 This tension between probity and central control, decentralized flexibility and quick response is probably found to some degree in all budget systems. Nonetheless, it is particularly relevant at the current stage of Lao development to design budget processes which allow for greater decentralization of spending approval without losing centralized accounting controls. In some budgeting systems, more decentralized types of checks and controls have been introduced which reduce the need for central clearance of spending decisions "up the line." These checks and controls have generally included two components. The first is the requirement that decentralized spending decisions be made within prescribedframeworks that ensure transparency; the second is that they be subject to routine ex post audit processes. 4.34 A practical example of this type of reform is the devolution of purchasing authority (up to a specified limit) to operational personnel of a government agency provided that: * The decision is made within a centrally prescribed framework, involving requests for competitive tenders and peer review of the process for selecting the successful contractor (a development currently incorporated into Lao procurement regulations). * There is also a system of selective expost review of procurement activity, which requires some explanation that helps to ensure that the purchasing officers pursue best value for money and eschew malpractice. Box 4.8 outlines an example of this type of devolved purchasing framework, presently operating in Australia. 4.35 Replacing centralized clearance procedures with flexible delegations to program managers is a fundamental shift in public administration processes which is likely to occur only when senior and operational staff are confident that: * Audit and evaluation capabilities can identify ex post poor performance by program managers . Program managers recognize that poor performance constitutes intrinsically risky behavior on their part. Senior management could then relax ex ante clearing of operational activity and increase its focus on selective ex post review of this activity. 4.36 Public administration in Lao PDR has probably not yet reached this point. Audit and evaluation functions are not well developed. Audits appear to take place on an ad hoc basis rather than as a standard function of the decision-making process. Perhaps centralized clearance of operational decisions reduces the need for ex post audits designed to identify irregularities. However, ex ante clearance does create administrative bottlenecks, particularly for project implementation units (PIUs). There is a case for gradually reducing centralized approval, creating a standard framework for decentralized decision-making, and strengthening ex post audit and evaluation of these decentralized decisions. A first step could be taken by relinquishing central approval practices for well-established PIUs, where a reasonable degree of trust in their adherence to proper civil service procedures exists. 4.37 Improving the technical efficiency of the public sector also depends crucially on the availability of qualified staff. Upgrading the skills and competence levels of civil servants is clearly - 86 - a prerequisite for more flexible and decentralized administrative structures. Effective public expenditure management requires a reasonable degree of analytical and computing ability among middle level civil servants, which could become a binding bottleneck unless resources are made available for skills development. Some progress has been made, but further civil service reform must remain a high priority (Box 4.6).'" Box 4.8: PRE-AUDIT VERSUS POST-AUDIT Hierarchical control slows development and reduces flexibility. Effective control can be achieved at the expense of effective project implementation. The challenge for public administration is to achieve the benefits of control while minimizing the detrimental effect of the control process. Alternative approaches to achieving the benefits of control with fewer of the costs typically involve decentralizing, and delegating much more authority to the program manager, but retaining control over program outcomes by: => Establishing a framework for devolved decisions which explicitly states the government's objectives and provides for transparency and accountability of the decision process > Establishing an "after the event" audit mechanism which provides for disciplinary action if the rules are not followed and encourages decision makers to maximize the outcomes of spending decisions = Ensuring a greater degree of participation in project preparation of technical personnel at the local level who will later be in charge of implementing the project. The devolved approach has a number of advantages: = Control is maintained but with a freer, more flexible, and more motivating environment for program management => The performance of program managers is judged not only by whether they have disbursed funds according to the rules (the traditional criterion of good public sector management) but also by the effectiveness with which they deliver the outcomes sought by the government => Program managers are empowered to manage their programs and senior officials can release their grip on detail and devote their time to overall strategy. The devolved model also carries risks: > There are risks in introducing such a model in isolation from other preconditions of public sector reform Threshold standards of competency are required of program managers before the devolved model will work, implying adequate levels of training together with wage levels which are reasonably competitive with the private sector = Reasonable levels of documentation of project proposals are required in the budget process so that program managers understand what ministers have agreed to and what is expected of them in regard to outcomes > Adequate information systems for tracking progress on projects are necessary in order for outcomes to be identified and program managers to be held accountable for their management performance. 4.38 (ii) Expenditure Monitoring. Controlling and monitoring expenditures is critical to improving public finance management. There is poor accountability in budget execution because institutional systems for accountability and control of expenditures are deficient. Although the MoF provides a strong control and audit function, the capacity to monitor project implementation and finances remains weak in several respects. See Chapter 15, Background Papers, for details. - 87- * Unclear Budget Execution. The decision-making process for disbursements remains unclear, and budget priorities are frequently redesigned when revenue uncertainty is faced during the budget execution. The danger is that these distortions in the budget execution process may result in chronic overspending and underspending in some categories (e.g., travel and salaries), lack of control over any extrabudgetary funds, ad hoc spending, or misappropriations. Lack of a Public Investment Monitoring System. No monitoring systems are in place for disbursement, physical implementation, and economic targets. At present, Lao policymakers cannot make decisions on the basis of a monitoring system that could show what percentage of the PIP has actually been carried out or how much of a particular donor project has been disbursed. Substantial sums have been spent on technical assistance to create a Public Investment Monitoring System, but there is still an urgent need for an effective system that would: (i) feed back the results of monitoring into the rolling annual investment plan; (ii) provide updated information from the line ministries and the Treasury to the Budget Department; (iii) coordinate monitoring functions among line ministries, the SPC, and PIUs; and (iv) show an up-to-date picture of actual project implementation and aid disbursements.9 * Lack of an Independent Audit. There is no independent auditing authority to evaluate public spending decisions and detect fraud or misappropriations. At present, internal auditing functions are mainly exercised by the Inspectorate under the MoF.20 This office is poorly staffed and has little experience and skills. Although it is in charge of controlling all ministries, the Inspectorate does not have enough staff to assign them to any of the provinces. Its lack of independence is illustrated by its obligation to report directly to the Minister of Finance, who decides whether to act on confidential reports. Moreover, the Inspector only carries the rank of Director and is thus faced with the task of investigating his peers at the Director level. This weak auditing function falls short of the prerequisite for an effective internal auditor (Box 4.9). It also contrasts strongly with the largely positive experience in other countries, where an independent Auditor General -- usually a highly respected authority not eligible for public appointment after the end of his or her duty -- reports directly to Parliament (Box 4.10). 4.39 (iii) Revenue-raising Capacity. Revenue raising capacity that is below potential is another key weakness undermining the efficiency of public sector management in Lao PDR. Revenue limitations are a constraint on public sector investment when counterpart payments cannot be met. Shortfalls occurred during the last PIP, and the revenue assumptions for the current PIP are ambitious. As was discussed in Chapter 1, defects in tax collection may inhibit the achievement of these ambitious growth targets. 9 On the PIP and PIMS, see Chapter 7, Background Papers, for details. 20 In addition, there is a unit under the Prime Minister's Office in charge of investigating serious cases of corruption. - 88 - BOX 4.9: INTERNAL AUDITORS The task of an internal auditor is quite distinct from that of the external auditor (in some countries, the Auditor-General). The latter is a statutory office holder, reporting to the legislature on the propriety of expenditures, on the accuracy of the government accounts, and, in a growing number of countries, on whether value-for-money in government programs has been achieved. The internal auditor, by contrast, is wholly an officer of the executive branch of government. Typically, an internal auditor is an accountant well versed in government procedures. In many countries internal auditors are part of the government accountancy cadre, seconded by the head of that service to serve in a line ministry. The internal auditor's principal duty is to advise the ministry's senior management on whether financial control systems are adequate and whether they are being followed. He or she must be answerable only to his/her senior management, and will report directly to either the controlling (accounting) office or to his/her) chief financial deputy. Direct access is important--the internal auditor may have to tell the Finance Minister that controls in the Ministry's accounting unit are inadequate or are being sidestepped. To be credible, an internal auditor must be a seasoned government accountant--it is not a job for newly trained staff. An internal auditor must be knowledgeable about all aspects of govermment financial procedures, and about the systems that must work for effective financial management. The internal auditor will check that financial procedures are being followed and that financial management and control systems are operating. The auditor will review whether departmental procedures are being followed in such areas as: use of transport, collection of revenues, payment of wages, maintenance of commitment registers and cash books, and bank reconciliation. The auditor may conduct special investigations at the behest of the controlling officer. Although cooperating with the staff of the Auditor-General and supplying them with all the material they need to carry out the external audit, the auditor will not routinely copy reports to them. A by-product of the internal auditor's task is protecting the controlling officer from an unfavorable external audit report by ensuring that financial systems in the Ministry are in good order. In recent years, most governments have had to operate within tighter budgets while facing demands for better services. This has increased the profile of the internal auditor and the contribution made to financial management by the internal audit function. Box 4.10: THE EXTERNAL AUDITOR'S ROLE External auditors are concerned with value-for-money and compliance reporting. They face the choice of whether to emphasize deficiencies (deficiency reporting) or management responsibilities (accountability- based reporting). These approaches are not alternatives, but their objectives are different. The objective of deficiency reporting is to report only instances of failure on the part of public administration to meet important performance criteria. The executive branch has a crucial evaluation function in this compliance reporting, where the government acts on a management-by-exception basis. The objective of accountability-based reporting is broader: to report whether public administration has met the most important performance criteria. If significant deficiencies are found, these are reported to the government at an audit level of rigor. Reports issued by a general auditor state the most important responsibilities of the public administration subject to audit and the performance criteria applied. - 89 - 4.40 Revenue could be increased in both the short and the medium term through better enforcement of existing tax provisions. Lack of resources within the Taxation Department, including computer-based systems, limits the ability to check returns actually received against schedules of taxpayers.2' Improved taxpayer data bases would also facilitate more frequent and productive field audits by identifying the characteristics of likely tax evaders and sorting for taxpayers exhibiting those characteristics. With additional resources, the Tax Department could broaden enforcement to the general population of taxpayers. This would depend critically on improving the skills of the Tax Department personnel, particularly in audit procedures. The first step is to teach the trainers themselves. RECOMMENDATIONS FOR TECHNICAL EFFICIENCY Explore ways of delegating increased authority to program managers within (i) a clearly defined set of decision rules (including transparency provisions) and (ii) strengthened arrangements for selective audit after disbursement. = Build an effective Public Investment Monitoring System. => Establish the Office of the Auditor General and strengthen the internal audit function. = Strengthen technical capacity for tax collection to improve enforcement and reduce evasion. C. CONCLUSIONS 4.41 The Government of Lao PDR is effectively in command of the growth process. The complex task of managing an economy in which the private sector is growing rapidly and foreign aid ensures large-scale access to external savings has required a national, centralized approach to budgeting rather than the former combination of provincial and national budgets. It has also made it necessary to prioritize investment projects to match the Government's development objectives and the medium-term resource envelope. Establishing a national budgeting system and locating investment planning within the SPC are actions that have addressed these issues. 4.42 Lao budgetary and investment planning processes are capable of a high standard of change management against the three criteria set at the beginning of this chapter -- macroeconomic, compositional, and technical. However, significant challenges remain in all three areas. It is difficult to overemphasize the importance of strengthening the first dimension of budgetary arrangements, namely, the Government's capacity for macroeconomic management, particularly in the medium term. Achieving high levels of real growth consistent with stability in prices and the balance of payments requires improved macroeconomic medium-term planning that is consistent with a realistic resource envelope set by likely public sector revenues. A medium-term expenditure framework must be integrated with the annual budget, developing forward estimates of full capital and recurrent costs of programs for inclusion in the PIP. 21 This checking process currently has to be undertaken manually, as resources permit, and is confined to larger taxpayers. - 90 - 4.43 Public expenditures must be flexible and responsive to the environment while retaining overall control and coordination in the prioritization of expenditure decisions. The Lao budget arrangements seem successful at matching project selection to national objectives and at regional identification of options.22 But project implementation and the disbursement of available funds could be improved. At the implementation level, there is the danger that the momentum of change could overstretch the administrative capacities of the Government and create bottlenecks in public administration, which would delay investment and prevent the full use of available resources. The central government should devolve delegations to program managers, within clearly defined guidelines and a well-established system of ex post review, to avoid unplanned public sector restraints on the pace of economic growth. As a broad sectoral approach to aid management and forward estimates, Sectoral Investment Programs provide a mechanism for addressing many of the challenges identified in this review -- the need for medium-term planning, greater efficiency, and better implementation on the ground -- in other words, for having policy and program priorities drive investment decisions, and not the other way round. See Chapter 6, Background Papers, for an analytical framework for international comparisons of budgetary arrangements. - 91 - STATISTICAL APPENDIX TABLE 1: LAO PDR: KEY ECONOMIC INDICATORS, 1991-1999/2000 1992 1/ 92/93 93/94 94/95 95/96 96/97 97/98 98/99 99/00 Actual Population (mid-year, thousand) 4,326 4,419 4,512 4,605 4,711 4,820 4,930 5,044 5,160 Nominal GDPFY(billionkip) 848 942 1,069 1,323 1,630 1,901 2,187 2,445 2,734 GDP (billion kip, 1990 price) 682 722 781 836 894 960 1,026 1,097 1,173 Real GDP Growth (real) (%) 7.0 5.9 8.1 7.1 7.0 7.0 7.0 7.0 7.0 Inflation Rate Growth (year-end) 9.9 6.2 6.8 19.5 25.7 7.5 4.5 4.5 4.5 Exchange Rate (IMF rf) 716 716 719 862 925 954 975 975 975 Per Capita GNP (US$, straight conversion) 274 298 330 333 374 413 455 497 543 Per Capita Foreign Assistance (US$) 39 49 50 Balance of Payments (million US$) Exports (fo.b.) 133 232 300 348 315 325 349 436 495 Imports (c.i.f.) 266 411 564 589 678 708 762 801 819 Services (net) 21 40 33 21 12 16 17 45 69 Private transfers 9 10 10 22 43 47 49 51 54 Current account (before official transfers) -104 -129 -221 -198 -308 -320 -347 -269 -201 Official transfers 63 104 125 109 75 81 87 88 83 Current account (after official transfers) -41 -26 -97 -89 -234 -239 -260 -181 -118 Net private foreign direct investment 9 60 60 95 160 98 88 102 89 Medium and long-term loans 63 49 65 83 142 151 150 136 68 Other capital (incl. DMB & errors-omissions) 2/ -26 -69 -39 -74 16 -10 -26 -33 -27 Overall balance 5 14 -11 15 84 0 -48 24 12 Change in reserves (incl. use of IMF funds) -5 -14 11 -15 -84 0 48 -24 -12 Extemal assistance inflow (mil. US$) 175 228 239 263 298 305 302 298 276 Current account balance (% of GDP) Before official transfers -8.8 -9.4 -14.4 -11.2 -17.0 -16.0 -15.0 -11.0 -7.0 After official transfers -3.5 -1.9 -6.3 -5.0 -13.0 -12.0 -11.0 -7.0 -4.0 Money Supply (end-year, billion Kip) 77 126 166 193 232 269 318 372 435 Money Supply Growth (% change) 49.1 64.4 32.0 16.4 20.2 15.9 18.3 16.8 16.9 Total DOD (mil. US$)3/ 1,875 1,917 1,986 2,057 2,173 2,315 2,457 2,567 2,610 Netdisbursements 115 55 61 71 87 75 85 89 67 Total debt service 9 10 29 23 25 37 55 67 72 1 / In 1992 the fiscal year changed from a calendar year basis to October I to September 30. 2/ DMB = deposit money banks. 3/ DOD stands for debt outstanding and disbursed. Sources: Government authorities and World Bank staff estimates. - 92 - TABLE 2: GENERAL GOVERNMENT BUDGET, 1988-1995/96 1988 1989 1990 1991 19921/ 92/93 93/94 94/95 95/96 Buoyancy w.r.t. GDP (Billion kip) Total Revenue 29 36 61 75 90 113 136 166 217 1.04 Tax 22 27 38 54 64 86 107 135 176 1.08 Nontax 7 8 23 20 27 27 29 31 41 0.89 Total Expenditure 75 106 143 151 175 171 259 294 362 Current 28 40 70 82 92 105 127 143 165 Without wages 11 20 36 45 55 61 71 74 86 Capital 47 67 74 69 82 66 132 151 197 Current Balance 1 -4 -9 -7 -2 8 9 23 53 Overall Balance (cash basis) -47 -71 -82 -81 -84 -73 -123 -128 -144 Grants 13 17 23 33 40 31 67 73 58 Overall Balance (incl. grants) -34 -54 -59 -49 -44 -42 -56 -55 -87 Foreign Financing 33 66 65 30 39 27 51 60 82 Domestic Financing 1 -12 -5 19 5 15 5 -5 -28 (Percent of GDP) Total Revenue 12.1 8.3 10.0 10.3 10.7 12.0 12.7 12.5 13.3 Tax 9.2 6.4 6.1 7.5 7.5 9.1 10.0 10.2 10.8 Nontax 3.0 1.9 3.8 2.8 3.2 2.9 2.7 2.3 2.5 Total Expenditure 31.9 24.9 23.4 20.9 20.6 18.1 24.2 22.2 22.2 Current 11.9 9.4 11.4 11.4 10.9 11.1 11.9 10.8 10.1 Without wages 4.8 4.6 5.8 6.3 6.5 6.5 6.6 5.6 5.3 Capital 20.0 15.6 12.0 9.6 9.7 7.0 12.3 11.4 12.1 Current Balance 0.2 -1.0 -1.5 -1.0 -0.2 0.9 0.8 1.7 3.2 Overall Balance (cash basis) -19.8 -16.6 -13.4 -11.3 -9.9 -7.7 -11.5 -9.7 -8.8 Grants 5.4 4.0 3.8 4.5 4.7 3.3 6.3 5.5 3.5 Overall Balance (incl. grants) -14.4 -12.6 -9.7 -6.8 -5.2 -4.4 -5.2 -4.2 -5.3 Foreign Financing 13.9 15.5 10.6 4.1 4.6 2.9 4.7 4.6 5.0 Domestic Financing 0.6 -2.8 -0.8 2.7 0.6 1.5 0.5 -0.4 -1.7 1/ The fiscal year changed from a calendar year basis to October I to September 30 in 1992, thus 1992 is a nine-month year. Sources: Government authorities and World Bank staff estimates. - 93 - TABLE 3: GOVERNMENT EXPENDITURE BY FUNCTIONAL CLASSIFICATION, 1991-1995/96 1991 1992 1/ 1992/93 1993/94 1994/95 1995/96 %of %of %of %of %of %of %of %of %of %of %of %of Total GDP Total GDP Total GDP Total GDP Total GDP Total GDP ECONOMIC SECTORS 38.7 8.1 39.3 8.1 33.6 6.1 43.5 10.5 41.0 9.1 40.1 8.9 Current 1.6 0.3 1.5 0.3 1.6 0.3 1.7 0.4 2.2 0.5 2.1 0.5 Capital 37.1 7.8 37.8 7.8 32.0 5.8 41.8 10.1 38.8 8.6 37.9 8.4 Agriculture 7.1 1.5 9.1 1.9 9.2 1.7 9.4 2.3 9.7 2.2 7.8 1.7 Current 1.1 0.2 1.0 0.2 1.0 0.2 1.1 0.3 1.5 0.3 1.4 0.3 Capital 6.1 1.3 8.1 1.7 8.2 1.5 8.3 2.0 8.2 1.8 6.5 1.4 Industry/Energy 11.6 2.4 8.3 1.7 4.9 0.9 4.2 1.0 7.5 1.7 8.5 1.9 Current 0.1 0.0 0.1 0.0 0.1 0.0 0.1 0.0 0.2 0.0 0.2 0.0 Capital 11.5 2.4 8.3 1.7 4.9 0.9 4.1 1.0 7.3 1.6 8.4 1.9 Transport/Comm. 19.9 4.2 21.8 4.5 19.4 3.5 29.9 7.2 23.8 5.3 23.7 5.3 Current 0.5 0.1 0.4 0.1 0.5 0.1 0.5 0.1 0.6 0.1 0.6 0.1 Capital 19.5 4.1 21.4 4.4 18.9 3.4 29.4 7.1 23.3 5.2 23.1 5.1 SOCIAL SECTORS 11.0 2.3 11.5 2.4 12.9 2.3 14.4 3.5 18.0 4.0 19.3 4.3 Current 7.9 1.7 7.5 1.5 9.0 1.6 8.9 2.2 11.3 2.5 9.7 2.2 Capital 3.0 0.6 4.0 0.8 3.9 0.7 5.5 1.3 6.7 1.5 9.6 2.1 Education 7.5 1.6 8.5 1.8 10.5 1.9 9.9 2.4 12.4 2.7 12.4 2.8 Current 6.0 1.2 5.8 1.2 7.0 1.3 5.9 1.4 7.8 1.7 7.1 1.6 Capital 1.5 0.3 2.7 0.6 3.5 0.6 3.9 1.0 4.5 1.0 5.4 1.2 Health 3.5 0.7 2.9 0.6 2.4 0.4 4.5 1.1 5.6 1.2 6.9 1.5 Current 2.0 0.4 1.7 0.3 2.0 0.4 3.0 0.7 3.4 0.8 2.6 0.6 Capital 1.5 0.3 1.2 0.3 0.4 0.1 1.5 0.4 2.2 0.5 4.3 0.9 OTHERS 50.4 10.5 49.3 10.1 53.5 9.7 42.1 10.2 41.0 9.1 40.6 9.0 Current 44.7 9.4 44.0 9.1 51.0 9.2 38.5 9.3 35.1 7.8 33.7 7.5 Capital 5.6 1.2 5.3 1.1 2.6 0.5 3.6 0.9 5.9 1.3 6.9 1.5 TOTAL 100.0 20.9 100.0 20.6 100.0 18.1 100.0 24.2 100.0 22.2 100.0 22.2 Current 54.2 11.4 52.9 10.9 61.5 11.1 49.1 11.9 48.6 10.8 45.6 10.1 Capital 45.8 9.6 47.1 9.7 38.5 7.0 50.9 12.3 51.4 11.4 54.4 12.1 Memorandum Items Total Expenditure (bnkip) 151.1 174.6 170.5 258.9 293.6 361.6 Nominal GDP FY (bn kip) 722.0 848.2 942.0 1,069.0 1,323.0 1,630.0 1/ January I to September 30, 1992, only. Sources: Ministry of Finance and World Bank staff estimates. - 94 - TABLE 4: PROPOSED GOVERNMENT EXPENDITURE BY FUNCTIONAL CLASSIFICATION, 1995/96-1999/2000 1995/96 1996/97 1997/9a 1998/99 1999/00 Total Total Avg. Growth % of % of % of % of % of % of % of % of % of % of '95/96-99/00 '95/96-99/00 '95/96-99/00 Total GDP Total GDP Total GDP Total GDP Total GDP (Bn kip) (% GDP) (%) ECONOMIC SECTORS 40.1 S9 37.5 9.1 36.9 9.0 35.2 8.7 34.6 84 956 8.8 9.1 Current 2.1 0.5 2.0 0.5 2.0 0.5 2.0 0.5 2.4 0.6 56 0.5 16.5 Capital 37.9 8.4 35.4 8.6 34.9 8.5 33.2 8.2 32.3 7.8 900 8.3 8.6 Agriculture 7.8 1.7 7.5 1.8 7.7 1.9 7.7 1.9 8.3 2.0 206 1.9 10.6 Current 1.4 0.3 1.3 0.3 1.3 0.3 1.3 0.3 1.7 0.4 37 0.3 18.0 Capital 6.5 1.4 6.2 1.5 6.4 1.6 6.4 1.6 6.7 1.6 169 1.5 9.2 Industry/Energy 8.5 1.9 8.0 1.9 8.2 2.0 8.5 2.1 8.8 2.1 222 2.0 16.3 Current 0.2 0.0 0.2 0.0 0.1 0.0 0.1 0.0 0.2 0.0 4 0.0 15.0 Capital 8.4 1.9 7,8 1.9 8.1 2.0 8.4 2.1 8,7 2.1 218 2.0 16.4 Transport/Comm. 23.7 5.3 22.0 5.4 20.9 5.1 19.0 4.7 17.5 4.2 528 4.8 5.9 Current 0.6 0.1 0.6 0.1 0.6 0.1 0.5 0.1 0.5 0.1 15 0.1 13.3 Capital 23.1 5.1 21.4 5.2 20,4 5.0 18.4 4.5 16.9 4.1 514 4.7 5.8 SOCIAL SECTORS 19.3 4.3 19.8 4.8 20.9 5.1 22.1 5.4 23.9 5.8 563 5.2 20.6 Current 9.7 2.2 10.6 2.6 11.1 2.7 11,6 2.9 12.7 3.1 297 2.7 18.4 Capital 9.6 2.1 9.2 2.2 9.8 2.4 10.5 2.6 11.2 2.7 266 2.4 24.7 Education 12.4 2.8 12.4 3.0 12.7 3.1 13.0 3.2 13.5 3.3 338 3.1 16.1 Cunrent 7.1 1.6 7.3 1.8 7.3 1.8 7.3 1.8 7.6 1.8 193 1.8 14.3 Capital 5.4 1.2 5.1 1.2 5.4 1.3 5.7 1.4 6.0 1.4 145 1.3 18.8 Health 6.9 1.5 7.4 1.8 8.1 2.0 9.1 2.2 10.4 2.5 225 2.1 28.6 Current 2.6 0.6 3.2 0.8 3,8 0.9 4.3 1.1 5.1 1.2 104 1.0 27.0 Capital 4.3 0.9 4.1 1.0 4.4 1.1 4.8 1.2 5.2 1.3 121 1.1 36.2 OTHER 40.6 9.0 42.8 10.4 42.3 10.3 42.6 10.5 41.5 10.0 1,101 10.1 15.0 Current 33.7 7.5 31,6 7.7 29.8 7.2 29.3 7.2 27.3 6.6 783 7.2 9.1 Capital 6.9 1.5 11.2 2.7 12.5 3.0 13.4 3.3 14.2 3.4 318 2.9 37.9 TOTAL 100.0 22.2 100,0 24.4 100.1 24.3 100.0 24.6 100.0 24.2 2,620 24.0 13.8 Currnt 45.6 10.1 44.2 10.8 42.9 10.4 42.9 10.6 42.3 10.2 1,136 10.4 11.7 Capital 54.4 12.1 55,8 13.6 57.1 13.9 57.1 14.0 57.6 13.9 1,484 13.6 15.4 Mmormandm Itms TomI1Expeaditaoc(bnkip) 362 464 532 601 661 2,620 Nominal tGDP (bn kip) Il/ 1,630 ,901 2,117 2,445 2,734 11.197 1/ PER's GDP projection. Sowrces: Ministry ofFinance and World Bank s,r&ffernimales. - 95 - TABLE 5: GENERAL GOVERNMENT EXPENDITURE BY FUNCTIONAL CLASSIFICATION, 1991-1999/2000 (BILLION KIP) 1991 1992 1/ 92/93 93/94 94/95 95/96 96/97 97/98 98/99 99/00 Actual Projected ECONOMIC SECTORS 58.4 68.6 57.2 112.7 120.4 144.8 173.9 196.2 211.8 229.0 Current 2.4 2.6 2.7 4.5 6.5 7.7 9.5 10.7 12.0 15.7 Capital 56.0 66.0 54.6 108.2 113.9 137.1 164.4 185.5 199.8 213.3 Agriculture 10.8 16.0 15.7 24.3 28.5 28.3 35.0 41.1 46.5 55.0 Current 1.6 1.8 1.7 2.8 4.3 4.9 6.1 7.0 8.0 11.0 Capital 9.2 14.1 14.0 21.5 24.1 23.4 28.9 34.1 38.5 44.0 Industry/Energy 17.5 14.6 8.4 11.0 22.0 30.9 37.0 43.9 51.4 58.5 Current 0 1 0.1 0.1 0.3 0.5 0.6 0.7 0.7 0.8 1.1 Capital 17.4 14.5 8.3 10.7 21.5 30.3 36.3 43.2 50.6 57.4 Transport/Communication 30.1 38.0 33.1 77.4 70.0 85.7 101.9 111.2 113.9 115.5 Current 0.7 0.6 0.8 1.4 1.7 2.3 2.7 3.0 3.2 3.6 Capital 29.4 37.4 32.2 76.0 68.3 83.4 99.2 108.3 ]10.8 111.9 SOCIAL SECTORS 16.6 20.0 22.0 37.2 52.8 69.9 91.7 111.0 133.0 157.9 Current 12.0 13.1 15.4 23.1 33.1 35.1 49.0 59.0 70.0 84.0 Capital 4.6 7.0 6.6 14.2 19.7 34.8 42.7 52.0 63.0 73.9 Education 11.3 14.9 17.9 25.5 36.3 45.0 57.6 67.7 78.3 89.4 Current 9.0 10.1 11.9 15.4 23.0 25.6 34.0 39.0 44.0 50.0 Capital 2.3 4.8 6.0 10.2 13.3 19.4 23.6 28.7 34.3 39.4 Health 5.3 5.1 4.1 11.7 16.5 24.9 34.1 43.3 54.6 68.5 Current 3.0 2.9 3.5 7.7 10.1 9.5 15.0 20.0 26.0 34.0 Capital 2.3 2.2 0.7 4.0 6.4 15.4 19.1 23.3 28.6 34.5 OTHERS 76.1 86.1 91.3 109.0 120.4 146.8 198.4 224.9 256.3 274.4 Current 67.6 76.8 86.9 99.6 103.1 121.9 146.5 158.3 176.0 180.3 Capital 8.5 9.2 4.4 9.4 17.3 24.9 51.9 66.6 80.3 94.1 TOTAL 151.1 174.6 170.5 258.9 293.6 361.6 464.0 532.4 601.0 661.2 Current 82.0 92.4 104.9 127.1 142.7 164.8 205.0 228.4 258.0 280.0 Capital 69.1 82.2 65.6 131.8 150.9 196.8 259.0 304.0 343.0 381.2 l/ January I to September 30. 1992, Only. Sources: Ministry of Finance and World Bank staff estimates. - 96 - TABLE 6: COMPOSITION OF PUBLIC INVESTMENT PLAN, 1995/96-1999/2000 95/96 1/ 96/97 97/98 98/99 99/00 Total '95/96- '99/2000 (Billion kip) ECONOMIC SECTORS 137.2 164.4 185.5 199.7 213.3 900.1 Agriculture & Forestry 23.4 28.9 34.1 38.5 44.0 168.9 Industry (excl. electricity) 9.3 13.2 16.3 18.5 20.0 77.3 Electricity 21.0 23.1 26.9 32.1 37.4 140.4 Transportation 63.4 75.5 83.0 83.6 82.1 387.6 Telecommunications 8.4 11.6 12.4 13.9 14.7 61.1 Other Infrastructure 11.6 12.1 12.8 13.1 15.1 64.8 SOCIAL SECTORS 52.8 86.6 109.2 132.5 156.0 536.9 Education 19.4 23.6 28.7 34.3 39.4 145.4 Health 15.4 19.1 23.3 28.6 34.5 120.9 Social Welfare 8.6 17.2 20.5 23.5 26.8 96.5 Rural Development 5.6 21.8 30.8 38.7 46.9 143.8 Culture 3.8 4.9 6.0 7.3 8.5 30.4 OTHER 6.9 8.1 9.4 10.8 12.0 47.1 TOTAL 196.8 259.0 304.0 343.0 381.2 1,484.0 Of which: Domestic funds 48.0 61.3 78.4 95.4 114.8 397.8 Foreign funds 148.8 197.8 225.6 247.6 266.5 1,086.2 (Percent of total PIP) ECONOMIC SECTORS 69.7 63.5 61.0 58.2 56.0 60.6 Agriculture & Forestry 11.9 11.2 11.2 11.2 11.5 11.4 Industry (excl. electricity) 4.7 5.1 5.4 5.4 5.2 5.2 Electricity 10.7 8.9 8.8 9.3 9.8 9.5 Transportation 32.2 29.1 27.3 24.4 21.5 26.1 Telecommunications 4.3 4.5 4.1 4.1 3.9 4.1 Other Infrastructure 5.9 4.7 4.2 3.8 4.0 4.4 SOCIAL SECTORS 26.8 33.4 35.9 38.6 40.9 36.2 Education 9.9 9.1 9.4 10.0 10.3 9.8 Health 7.8 7.4 7.7 8.3 9.1 8.1 Social Welfare 4.4 6.6 6.7 6.9 7.0 6.5 Rural Development 2.8 8.4 10.1 11.3 12.3 9.7 Culture 1.9 1.9 2.0 2.1 2.2 2.0 OTHER 3.5 3.1 3.1 3.2 3.1 3.2 TOTAL 100.0 100.0 100.0 100.0 100.0 100.0 Of which: Domestic funds 24.4 23.6 25.8 27.8 30.1 26.8 Foreign funds 75.6 76.4 74.2 72.2 69.9 73.2 I / Actual figures. Actual expenditure for 1995/96 is lower than the proposed figure in the 1996-2000 PIP because of an SPC proposed increase in the allocation for rural development. Sources. Government authorities and World Bank staff estimates.