Document of The World Bank FOR OFFICIAL USE ONLY Report no. 87004-WG PROGRAM DOCUMENT FOR A PROPOSED GRANT (FROM THE TRUST FUND FOR GAZA AND WEST BANK) IN THE AMOUNT OF US$40 MILLION TO THE PALESTINE LIBERATION ORGANIZATION (FOR THE BENEFIT OF THE PALESTINIAN AUTHORITY) FOR A PALESTINIAN NATIONAL DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT VI April 23, 2014 Poverty Reduction and Economic Management Department West Bank and Gaza Country Department Middle East and North Africa Region This document is being made publicly available prior to Board consideration. This does not imply a presumed outcome. This document may be updated following Board consideration and the updated document will be made publicly available in accordance with the Bank’s policy on Access to Information. WEST BANK AND GAZA FISCAL YEAR January 1 – December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of April 23, 2014) Currency Unit New Israeli Shekel US$1.00 3.4685 NIS WEIGHTS AND MEASURES Metric System AHLC Ad Hoc Liaison Committee CTA Central Treasury Account CTP Cash Transfer Program DA Dedicated Account DAC Development Assistance Committee DPG Development Policy Grant DSA Debt Sustainability Analysis EU European Union GDP Gross Domestic Product GoI Government of Israel GPC General Personnel Council ICR Implementation Completion and Results Report IEC Israeli Electricity Company IEG Independent Evaluation Group IDF Institutional Development Fund IFMIS Integrated Financial Management Information System IMF International Monetary Fund INTOSAI The International Organization of Supreme Audit Institutions ISN Interim Strategy Note LDF Local Development Forum LDP Letter of Development Policy MoF Ministry of Finance MoLG Ministry of Local Government MoSA Ministry of Social Affairs NDP National Development Plan NIS New Israeli Shekels OECD Organization of Economic Cooperation and Development PA Palestinian Authority PEFA Public Expenditure and Financial Accountability PFM Public Financial Management PMA Palestinian Monetary Authority PRDP-TF Palestinian Reform and Development Plan Multi-Donor Trust Fund ROSC Report on the Observance of Standards and Codes SAACB State Audit and Administrative Control Bureau SG Strategy Groups SWG Sector Working Groups TAP Transition Assistance Program UN United Nations VAT Value-Added Tax WB World Bank Vice President: Inger Andersen Country Director: Steen L. Jorgensen Acting Sector Director: Bernard G. Funck Sector Manager: Bernard G. Funck Task Team Leader: Orhan Niksic WEST BANK AND GAZA PALESTINIAN NATIONAL DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT VI TABLE OF CONTENTS 1. INTRODUCTION AND COUNTRY CONTEXT (INCLUDING POVERTY DEVELOPMENTS) 1 2. MACROECONOMIC POLICY FRAMEWORK ..................................................................................3 RECENT ECONOMIC DEVELOPMENTS .............................................................................3 MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY .....................................8 IMF RELATIONS ...................................................................................................................10 3. GOVERNMENT’S PROGRAM ............................................................................................................11 4. PROPOSED OPERATION ....................................................................................................................11 LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION.....................11 PRIOR ACTIONS, RESULTS, AND ANALYTICAL UNDERPINNINGS ..........................13 LINK TO ISN AND OTHER BANK OPERATIONS .............................................................22 CONSULTATIONS AND COLLABORATION WITH DEVELOPMENT PARTNERS .....23 5. OTHER DESIGN AND APPRAISAL ISSUES ....................................................................................24 POVERTY AND SOCIAL IMPACT ......................................................................................24 ENVIRONMENTAL ASPECTS .............................................................................................25 PFM, DISBURSEMENT AND AUDITING ASPECTS .........................................................25 IMPLEMENTATION, MONITORING AND EVALUATION ..............................................28 6. SUMMARY OF RISKS ..........................................................................................................................28 ANNEXES Annex 1: Letter of Development Policy .....................................................................................................30 Annex 2: Policy and Results Matrix ...........................................................................................................36 Annex 3: Public Financial Management and Fiduciary Aspects .............................................................39 The PNDP Development Policy Grant VI was prepared by a core team consisting of Orhan Niksic, Team Leader; Nur Nasser Eddin, Economist; Pierre Prosper Messali, Senior Financial Management Specialist; Nikolai Soubbotin, Senior Counsel; Samira Hillis, Senior Operations Officer; Lina Tutunji, Procurement Specialist; Nadi Yosef Mashni, Financial Management Specialist; Riham Hussein, Financial Management Specialist; Basheer Ahmad Fahem Jaber, Procurement Specialist, Maha Muhammad Bali, Program Assistant. This Program Document is the result of a close cooperation between the World Bank staff and officials of the Ministry of Finance of the Palestinian Authority. GRANT AND PROGRAM SUMMARY WEST BANK AND GAZA PALESTINIAN NATIONAL DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT VI (DPG VI) Borrower Palestine Liberation Organization (PLO) (for the benefit of the Palestinian Authority) Implementing Agency Ministry of Finance (MoF) of the Palestinian Authority (PA) Financing Data Terms: Grant from the Trust Fund for Gaza and West Bank (TFGWB) Amount: USD 40 million Operation Type Standalone, single-tranche Pillars of the Operation The operation will focus on three specific policy areas. The and Program development objectives the operation seeks to achieve in each of these Development Objectives policy areas are as follows: (1) reducing the PA’s recurrent fiscal deficit; (2) improving effectiveness and transparency of public finances; (3) improving business climate. Result Indicators  Gross domestic tax revenues have increased in nominal NIS terms by 8 percent and by at least 0.1 percentage point of GDP between 2013 and 2014.  The 2014 central government nominal wage bill growth has not exceeded 4.9 percent (in NIS terms) and is at least 0.2 percentage points of GDP lower in 2014 compared with 2013.  (i) The use of National Standard Bidding Documents in public procurement has started; (ii) Posting of procurement plans, notices and award decisions by all procuring entities on a single portal procurement website has started.  PEFA scores on (i) cash flow planning and monitoring and (ii) access to reliable information on arrears have improved in 2014 as compared to “D” in 2013 PEFA.  Total real value of leasing contracts is higher at the end of 2014 compared to end 2013 (baseline: USD 7,674,000). Risk Rating High Operation ID P147687 i PROGRAM DOCUMENT FOR A PROPOSED SIXTH DEVELOPMENT POLICY GRANT TO THE PALESTINE LIBERATION ORGANIZATION (FOR THE BENEFIT OF THE PALESTINIAN AUTHORITY) 1. INTRODUCTION AND COUNTRY CONTEXT (INCLUDING POVERTY DEVELOPMENTS) 1. The proposed DPG VI is a standalone operation aimed at supporting the Palestinian Authority (PA) in managing public finances under difficult circumstances. Specifically, the DPG will support the PA’s efforts in reducing the fiscal deficit amid declining donor aid, and to reform and further strengthen public finance management and public financial management (PFM) systems. The DPG VI will provide support to the PA’s 2014 budget in the amount of US$40 million. While this is a standalone operation, it builds upon the reform progress supported by the previous DPGs. 2. As envisaged in the FY12-14 Interim Strategy Note, DPG VI remains a key instrument aimed at supporting the PA’s strategic priorities, advancing the policy dialogue, and also providing essential financing for the PA’s budget. Given the severity of the political situation, in particular the constraints to the PA’s authority in Gaza, it receives few revenues from Gaza. Public sector investment and growth are constrained by various restrictions imposed by the Government of Israel (GoI)1, while donor assistance continues to provide a life line to the PA’s budget. It is important to stress that the financial significance of this operation is not only in that it provides US$40 million in Bank financing, but that it directly leverages the support of other donors through the Palestinian Reform and Development Plan Multi-Donor Trust Fund (PRDP-TF) in the amount of roughly US$200 million per year. The operation also provides a positive signaling effect to other donors who provide assistance directly to the PA. 3. The preparation of this DPG is taking place against the backdrop of a recent government change and ongoing peace negotiations between Israelis and Palestinians. The new Cabinet of the Palestinian Authority was sworn in in June 2013, but the resignation of the Prime Minister in less than a month from his appointment and a subsequent reappointment in August have taken some momentum from the reform process in several key reform areas, such as energy and health sectors. However, it has also given rise to new reform initiatives. Furthermore, following an effort by the US Secretary of State John Kerry, the peace process between Israel and the Palestinians resumed on July 29, 2013. 4. The peace process is opening up a prospect of rapid economic growth, but comes at a time of a sharp growth slowdown. In parallel with the peace process an ambitious investment plan called the Palestinian Economic Initiative has been prepared by the Office of the Quartet (also known as the Kerry Plan), promising a 50 percent increase in the Palestinian GDP over the medium term that could accompany a possible peace agreement. The PA is also finalizing its own National Development Plan (NDP) 2014-2016 to replace the previous NDP as the reform roadmap. In the meantime, the PA has been coping with the consequences of a sharp slowdown in economic growth, which is clearly increasing fiscal pressures and rendering structural reforms that would negatively affect some segments of the Palestinian population more difficult to achieve. 5. The economic prospects are highly uncertain and depend very much on the outcome of the ongoing peace process. Thus, three distinct economic realities are plausible: first, a failed peace process could lead to further growth slowdown (if not a sharp deterioration in the overall political, security, and socioeconomic environment); second, a breakthrough in the peace process would 1 The Government of Israel states that these restrictions are necessary for security purposes. 1 undoubtedly breathe a new life into the Palestinian economy; and finally “muddle-through” scenario, with no major changes for the time being, is also plausible and that scenario is embedded in the macro-fiscal framework underpinning this operation. 6. Against this difficult background, progress on structural reforms has continued, though unevenly in some policy areas. Explicit and implicit energy subsidies have continued to grow in 2013 despite some ongoing reform efforts and, at roughly 4 percent of GDP, these represent a major drain on PA’s public finances.2 The problem is not expected to deescalate unless the reform effort is reinvigorated substantially. The same story applies to pension and health referral reforms. Reforms to boost domestic tax revenues are also overdue and it is encouraging that the PA is finalizing a new revenue strategy. Bold tax policy and enforcement measures are needed to broaden what is currently a very narrow tax base by international comparison. Finally, it ought to be noted that a relaxation of movement and access restrictions by the Government of Israel could give a significant impetus to private sector growth, which would render the political economy more conducive to conducting difficult fiscal reforms and could on its own significantly improve the sustainability of Palestinian public finances. 7. Civil servants in the West Bank have been on strikes to demand pay increases. The ongoing strikes are to protest against the failure of the PA to implement previously signed agreements that entail a rise in the Cost of Living Allowance in addition to an increase in compensation for danger and specialty for certain public professions. The PA has been delaying the implementation of these agreements due to fiscal stress. However, ongoing strikes and pressures by the public unions caused the PA to budget for some of these wage increases in 2014, to be followed by additional ones in 2015. This, however, has not fully satisfied the demands of the civil servants which continue to call for general strikes. 8. While extreme poverty remains low in Palestinian territories, broad poverty certainly is an important issue in particular in Gaza, and if the current trend of reduced growth persists, the problem could become worse. Almost 26 percent of Palestinians lived in poverty in 2011 according to the national poverty line.3 The percentage of extremely poor is small: even if the poverty line is raised from US$1.25 per day to US$2 per day, the Palestinian poverty rate is less than 5 percent. However, the overall figure at the national level masks a wide regional divergence. In Gaza, the poverty rate was 39 percent, which is more than twice as high as that in the West Bank at 18 percent. This regional contrast was driven by the severe economic shock that hit Gaza following the internal divide, which led to a dramatic poverty increase in 2007, leaving one in two Gazans living below the poverty line. Similar to other countries, larger households in the West Bank and Gaza tend to suffer from higher poverty levels. In 2011, the highest poverty rate of 50 percent was amongst individuals who are part of households comprising 10 or more members. Additionally, the incidence of poverty amongst households headed by civil servants was ten percentage points less than those headed by workers in the private sector. This is explained by the ongoing strain on private sector activity. Notably, social transfers have continued to play a key role in reducing extreme poverty levels, especially in Gaza. In 2011 and in the absence of all social programs, the official poverty headcount rate would have been 11 percentage points higher. 2 The PA subsidizes the cost of liquid fuels by providing tax rebates to the Palestinian Petroleum Authority, an entity within the Ministry of Finance, which is the sole importer of fuel in the West Bank and as of recently also the main source of Gaza fuel. Tax rebates amounted to about 2 percent of GDP in 2013. Electricity subsidies are indirect, expressed as “net lending,” and they are due to non -payments of Palestinian electricity distribution entities (Distribution companies and Municipalities) to the Israel Electricity Company (IEC), which are deducted by the Israeli Ministry of Finance from the clearance revenues collected on behalf of the Palestinian Authority. In 2013, electricity- related net lending amounted to 2 percent of GDP. Reform efforts to reduce net lending have been intensified as of very recently. 3 More recent poverty data is not available yet. 2 2. MACROECONOMIC POLICY FRAMEWORK RECENT ECONOMIC DEVELOPMENTS 9. GDP growth in 2013 hit its lowest point in six years, resulting in negative per capita growth. The Palestinian territories enjoyed a sustained period of growth between 2007-11, supported by large inflows of donor assistance accompanied by Palestinian reforms and some easing of movement restrictions. This fuelled a significant expansion in public and private consumption which pushed growth rates to an average of 8 percent during this period. In 2012, however, donor fatigue started to take effect as aid inflows had decreased by more than half in comparison to their peak in 2008. This, in addition to the ongoing restrictions, caused growth to decline to 5.9 percent by the end of 2012. The economic situation further deteriorated in 2013 and the latest estimates indicate that GDP growth sharply dropped to 1.5 percent. Given that population growth is estimated at around 3 percent, real per capita GDP has actually declined in 2013. 10. Economic activity weakened significantly in both the West Bank and Gaza. The economy of the West Bank contracted by 0.6 percent in early 2013 due to a significant increase in the level of uncertainty that was created by the PA’s fiscal difficulties. Particularly, delays by the GoI in the transfer of clearance revenues4 resulted in increased fiscal stress and the accumulation of wage arrears in Q1 2013, which negatively affected consumption patterns. Even though consumption had slightly picked up later in the year as the PA’s fiscal stress eased, it continued to be restrained by the uncertainty on the political front, and hence GDP growth amounted to a meager 0.4 percent. Growth in Gaza started out strongly in the beginning of 2013 at 12.2 percent due to large inflows of donor aid directed towards construction projects implemented to offset damages caused by the conflict in late 2012. However, growth has been interrupted as a result of political developments in Egypt and the related crackdown of the tunnel economy, which has also had a negative effect on consumption and real estate investment in Gaza. Consequently, growth in Gaza dropped to an estimated average of 4.6 percent in 2013. 11. Unemployment continues to be high mainly due to low private investment . Private investment has averaged around 15 percent of GDP over the past seven years, as compared with rates of over 25 percent in fast-growing middle income economies. Much of this investment has been directed towards non-tradable sectors that are not able to generate adequate growth and employment. Consequently, unemployment rates have remained very high in the Palestinian territories and reached 25 percent by the end of 2013: 18 percent in the West Bank and a staggering 39 percent in Gaza. Furthermore, almost 23 percent of the workforce is employed by the PA, an uncommonly high proportion that reflects the lack of dynamism in the private sector. 12. Israeli restrictions on trade, movement and access are a binding constraint to production and investment. These restrictions substantially increase the cost of trade and make it impossible to import many production inputs into the Palestinian territories.5 For Gaza, the restrictions on import and export are in particular severe. In addition to the restrictions on labor movement between the Palestinian territories, the restrictions on movement of labor within the West Bank have been shown to have a strong impact on employability, wages, and economic growth. Moreover, Israeli restrictions render much economic activity very difficult or impossible to conduct on about 61 percent of the West Bank territory called Area C. A recent report by the World Bank assessed the potential for growth associated with the removal of those restrictions to be equivalent to 35 percent of the Palestinian GDP. 4 Clearance revenues are import and VAT duties that the GoI collects on behalf of the PA and transfers on monthly basis. These revenues represent around two thirds of the PA’s total income. 5 These are goods on the so called “dual use lists,” which may have both civilian and military applications. Consequently, a n umber of chemicals, fertilizers and machinery for metal processing cannot be imported into Palestinian territories. 3 13. Inflation in the Palestinian territories is largely determined by Israeli inflation and remains contained. In June-July 2013 and after a one percentage point increase in the VAT rate in the Palestinian territories, Consumer Price Index (CPI) inflation increased to 2.6 percent. However, it has since continued to slow down to reach 1.7 percent by the end of 2013. In the West Bank, the yearly average inflation was 3 percent, while it was -0.8 percent in Gaza. Even though average yearly price developments in Gaza reflect a negative trend in 2013, CPI inflation has actually increased month on month during the majority of the second half of the year. Price increases occurred following the crackdown of the tunnel economy, as access to cheaper Egyptian fuel, construction materials and other commercial goods has significantly deteriorated6. Table 1: Selected Macroeconomic Indicators for the Palestinian territories, 2010-2018 Estimate Projections 2010 2011 2012 2013 2014 2015 2016 2017 2018 Output and prices (Annual percentage change) Real GDP (2004 market prices) 9.3 12.2 5.9 1.5 2.5 2.7 2.9 2.9 3.0 West Bank 8.4 10.4 5.6 0.4 1.9 2.3 2.5 2.5 2.6 Gaza 11.9 17.6 6.6 4.6 4.0 4.0 4.0 4.0 4.0 CPI inflation (period average) 2.8 2.7 1.7 2.7 2.2 2.5 2.6 2.6 2.6 CPI inflation (end of period) 3.7 2.9 2.8 1.7 2.2 2.7 2.8 2.8 2.8 Investment and saving Gross capital formation, of which: 18.5 17.3 13.7 12.6 11.6 11.6 11.1 10.7 10.5 Public 3.6 3.8 3.8 3.6 3.1 3.8 3.7 3.6 3.5 Private 14.9 13.5 9.9 8.9 8.5 7.9 7.4 7.1 7.0 Gross national savings, of which: 7.9 -6.4 -15.2 -5.8 -9.7 -10.2 -11.0 -11.9 -12.6 Public -0.5 -4.7 -6.6 -1.1 -2.2 -2.0 -1.1 -0.4 0.3 Private 8.4 -1.6 -8.6 -4.6 -7.5 -8.1 -9.9 -11.5 -12.9 Saving-investment balance -10.6 -23.6 -28.9 -18.4 -21.2 -21.8 -22.1 -22.6 -23.1 Monetary sector Credit to the private sector 31.1 23.8 14.2 9.8 10.8 11.1 11.3 11.3 11.3 Private sector deposits 9.9 4.1 6.9 11.0 10.9 10.8 10.7 10.6 10.5 External sector (In percent of GDP) Exports of goods and nonfactor services 13.8 15.4 16.3 18.4 18.2 18.2 18.2 18.1 18.0 Imports of goods and nonfactor services 55.5 59.1 63.1 58.9 59.8 58.7 58.1 57.8 57.5 Net factor income 7.2 7.3 7.0 7.1 7.1 7.1 7.0 6.9 6.8 Net current transfers 23.9 12.7 10.9 15.1 13.2 11.6 10.9 10.2 9.6 Private transfers 10.2 4.4 3.3 3.9 4.0 3.8 3.5 3.3 3.1 Official transfers 13.7 8.3 7.6 11.1 9.2 7.8 7.3 6.9 6.5 Current account balance (excluding official transfers) -24.3 -32.0 -36.4 -29.5 -30.4 -29.6 -29.4 -29.5 -29.6 Current account balance (including official transfers) -10.6 -23.6 -28.9 -18.4 -21.2 -21.8 -22.1 -22.6 -23.1 Memorandum items: Nominal GDP (in millions of US$) 8344 9775 10255 11282 12021 12814 13656 14542 15475 Per Capita nominal GDP (US$) 2061 2345 2389 2552 2642 2737 2835 2936 3037 Unemployment rate 24 21 23 23 24 25 26 27 28 Sources: MoF, IMF and World Bank staff calculations. 14. Although still large, the trade deficit is estimated to have declined in 2013 due to a drop in imports. Recent full year estimates indicate that nominal exports of goods and services grew by two percentage points in 2013 to reach 18 percent of GDP. The share of exports in the economy continues to be low due to the ongoing Israeli restrictions on trade. Imports of goods and services as a percentage of GDP decreased by 4 percentage points to reach 59 percent. This decline is mainly attributed to lower growth trajectories in both the West Bank and Gaza. Due to the persistently high trade deficit, the current account deficit (excluding official transfers) is estimated at 30 percent of GDP in 2013. In addition to official transfers which amounted to around 11 percent of GDP, the current account deficit was, according to estimates of the Palestinian Central Bureau of Statistics, mainly financed by drawdown in cash and foreign deposits. However, significant positive errors and 6 Reliability of inflation figures in Gaza, particularly changes in fuel prices, is questionable. Egyptian fuel and Israeli fuel are treated as two different commodities with different weights in the consumer basket. These weights, however, were not revised even though the share of Israeli fuel has significantly increased following the crackdown of the tunnel economy in August 2013 after which Egyptian fuel became no longer available. 4 omissions in the current account data are also likely, in particular related to unofficial exports and private transfers.7 15. The PA managed to significantly reduce its recurrent deficit as a percentage of GDP in 2013, despite a significant and unexpected drop in growth. Estimates show that the PA reduced the recurrent deficit from as much as 26 percent of GDP in 2007 to 14 percent in 2012. This trend was driven by solid reforms by the PA supported by strong growth. The PA’s tight control over spending and efforts to improve revenue performance successfully managed to further reduce the recurrent deficit by two percentage points to 12 percent of GDP in 2013, in spite of the sharp slowdown in economic growth. 16. The PA’s revenue performance was strong in 2013. Domestic tax revenues grew by about 17 percent (in nominal NIS terms) when compared to 2012. This growth was mainly driven by a significant increase in VAT collections as the PA focused efforts to collect VAT arrears and liabilities owed by delinquent tax payers. The PA also raised the VAT rate by one percentage point to 16 percent in June 2013. Clearance revenues, which are the PA’s main source of income, grew by 9 percent (in nominal NIS terms) in 2013. This is partly due to the rise in the VAT rate, but also due to higher collections from petroleum VAT and excise as a result of additional tax receipts from Gaza, which started importing fuel from Israel and Israel has in turn been remitting the associated VAT and excise revenues to the PA. The PA also signed an agreement with the GoI in late 2013 to share data on direct imports. These are goods that are directly imported to the Palestinian territories from outside of Israel and which are cleared by Israeli Customs.8 Following the agreement, Israeli Customs have been sending data on daily basis to the PA’s Customs regarding these imports. 9 This data has enabled the PA to go after merchants that undervalue their declarations, which has also contributed to increasing tax collections. The PA’s gross revenues as a percentage of GDP grew by 1.5 percentage points, but net revenues only grew by 0.3 percentage points in 2013, reaching 21 percent due to a significant increase in tax refunds.10 17. Despite increased spending on fuel subsidies, the PA successfully managed to reduce the share of government expenditure in the economy in 2013. Fuel subsidies paid by the PA grew by more than 50 percent in 2013 in an effort to reduce the cost of transportation for the Palestinian public following an increase in the rate of VAT by one percentage point amid the recent decline in real per capita GDP. Nonetheless, the PA managed to reduce its recurrent public expenditure by about two percentage points of GDP to an estimated 33 percent in 2013. This is due to a reduction in the share of net lending,11 goods and services, and wage expenditures in the economy. Net lending declined by 0.8 percentage points of GDP in 2013, but this improvement needs to be viewed with caution as it resulted from lower deductions by the GoI from clearance revenues (which led to debt accumulation to the Israeli Electricity Company) and not from a substantial decline in the incidence of nonpayment to the Israeli Electricity Company by Palestinian end consumers and service providers. Furthermore, the share of nonwage expenditures in the economy decreased by 0.6 percentage points in 2013 due to the PA’s efforts to rationalize spending, particularly on the use of goods and services and transfers. In addition, the PA adopted various measures to limit the growth of the wage bill in 2013, which is the largest spending item representing more than 50 percent of recurrent expenditure. Specifically, the PA implemented a zero net hiring policy and reduced the Cost of Living Allowance to 0.75 percent from 7 These exports may include purchases of goods and services by Israeli citizens in the West Bank. 8 The PA believes that these imports are widely undervalued as Israeli Customs rarely question declarations of West Bank and Gaza bound goods, which leads to fiscal leakages. 9 Information on direct imports is currently sent by the Israeli Customs to their Palestinian counterparts by the end of each day. Palestinians hope that a more comprehensive agreement is reached which entails sharing this information on real time basis through linking the Palestinian ASYCUDA (Automated SYstem for CUstoms DAta) system to the Israeli information system. 10 Tax refunds, mostly given to the Petroleum authority as a means of subsidizing fuel expenditures increased from US$ 113 million in 2012 to US$ 231 million in 2013. 11 Net lending represents utility bills paid by the PA to the GoI on behalf of municipalities and service providers in West Bank and Gaza. These payments are deducted directly by the GoI from the monthly clearance revenue transfers. 5 3.5 percent in previous years. These measures successfully limited the growth of the wage bill (in nominal NIS terms) to 1.7 percent in 2013 compared to around 7 percent in previous years. Nevertheless, the wage bill as a percentage of GDP remained very close to its 2012 level at around 17 percent as the nominal GDP in NIS terms increased by a mere 3 percent. Figure 1: The share of wage bill to GDP has Figure 2: Growing aid supported expenditure been declining in recent years. growth until 2008, but that trend had to be reversed following a drop in aid since 2008. 60 156000 2000 60 154000 50 1500 50 152000 1000 40 150000 40 US$ Million 500 148000 30 0 30 % 146000 % 20 144000 -500 20 142000 -1000 10 140000 10 -1500 0 138000 -2000 0 2008 2009 2010 2011 2012 2013 PA revenues in percentage of GDP PA employment PA expenditure in percentage of GDP Wage bill to total expenditure Budget deficit Wage expenditure to GDP Recurrent budget support 18. In spite of the reform efforts, the PA’s fiscal situation continues to be difficult for several reasons. First, donor aid for recurrent spending has declined from US$1.76 billion in 2008 to US$1.26 billion in 2013 and although there has been a very substantial fiscal adjustment in response, it has, understandably, not been commensurate with the reduction in aid flows. Second, revenue performance, despite some improvement in 2013, remains weak. Particularly problematic is the low amount of revenues raised from Gaza compared to expenditures there12, but the tax base in the West Bank also remains small due to inefficiencies in both enforcement and policy. These problems are also aggravated by the sharp slowdown in growth. 19. Thus, the PA continued to depend on arrears as a significant source of financing for the deficit in 2013. The PA accumulated about US$462 million in domestic arrears in 2013, more than what was needed to offset the shortage in aid. About US$155 million or 34 percent of these arrears is owed to the private sector, while the majority of the rest is owed to the pension system. Part of the excess financing that resulted from arrear accumulation -in excess of what was needed to cover the shortage in external aid- enabled the PA to reduce its net domestic bank financing by almost US$248 million, yielding a stock of debt to local banks of US$1.27 billion by the end of 2013.13 12 The PA reports that only 3 percent of its revenues are generated from Gaza while 43 percent of its expenditures are concentrated there. 13 The objective of this policy was apparently to reduce interest expenditures and other efforts have also been made with the same objective, such as the planned bond issuance. 6 Table 2: Central Government Fiscal Operations, 2010-2018 Estimate Projections 2010 2011 2012 2013 2014 2015 2016 2017 2018 Public finances (commitment basis) (In millions of US$) Total net revenues 1836 2045 2075 2312 2553 2815 3039 3270 3506 Gross domestic revenues 653 738 729 853 924 974 1038 1103 1165 Tax revenues 382 482 481 598 647 669 708 748 790 Nontax revenues 271 256 248 255 277 305 330 355 375 Clearance revenues 1259 1423 1459 1691 1818 1971 2104 2241 2387 Less tax refunds 76 116 113 231 189 130 102 74 46 VAT .. .. .. .. 22 .. .. .. .. Petroleum rebate .. .. .. .. 167 .. .. .. .. Recurrent expenditures and net lending 3077 3323 3531 3694 3910 4074 4193 4323 4454 Wage expenditure 1614 1782 1769 1919 2018 2107 2174 2240 2305 Non-wage expenditure 1227 1401 1483 1565 1681 1784 1863 1941 2020 Net lending 236 140 278 210 211 184 157 143 128 Recurrent balance -1241 -1278 -1456 -1382 -1357 -1259 -1154 -1053 -948 Development expenditures 299 370 243 187 194 307 328 349 371 Overall balance (before external support) -1540 -1648 -1699 -1568 -1551 -1567 -1482 -1402 -1320 Financing 1540 1648 1699 1568 1551 1567 1482 1402 1320 External budgetary support 1147 814 776 1255 1100 1000 1000 1000 1000 Development financing 131 169 156 106 96 206 220 234 249 Net domestic bank financing 84 93 127 -248 180 120 121 121 121 Domestic arrears 116 541 578 462 175* -100 -100 -100 -100 Other 0 29 109 4 0 340 241 147 49 Residual 62 1 -47 -11 0 0 0 0 0 Public finances (commitment basis) (In percent of GDP) Total net revenues** 22.0 20.9 20.2 20.5 21.2 22.0 22.3 22.5 22.7 Gross domestic and clearance revenues 22.9 22.1 21.3 22.5 22.8 23.0 23.0 23.0 23.0 Recurrent expenditures and net lending 36.9 34.0 34.4 32.7 32.5 31.8 30.7 29.7 28.8 Wage expenditure 19.3 18.2 17.3 17.0 16.8 16.4 15.9 15.4 14.9 Non-wage expenditure 14.7 14.3 14.5 13.9 14.0 13.9 13.6 13.3 13.1 Net lending 2.8 1.4 2.7 1.9 1.8 1.4 1.1 1.0 0.8 Recurrent balance (before external support) -14.9 -13.1 -14.2 -12.2 -11.3 -9.8 -8.5 -7.2 -6.1 Overall balance (before external support) -18.5 -16.9 -16.6 -13.9 -12.9 -12.2 -10.9 -9.6 -8.5 External budgetary support 13.7 8.3 7.6 11.1 9.2 7.8 7.3 6.9 6.5 Domestic arrears 1.4 5.5 5.6 4.1 1.5 -0.8 -0.7 -0.7 -0.6 Memorandum item: Nominal GDP (in millions of US$) 8344 9775 10255 11282 12021 12814 13656 14542 15475 Sources: MoF, IMF and World Bank staff calculations. *To the pension fund. **The main difference between net and gross revenues is fuel tax refunds (in effect fuel subsidies). 20. The Palestinian banking sector remains healthy. It is well regulated by the Palestinian Monetary Authority (PMA) which is steadily building the capabilities of a central bank. Banks in general are risk averse and profitable mainly due to high interest rate margins. The ratio of non- performing loans to gross loans continue to be low at 3 percent while about 60 percent of those are provisioned for. Credit to the private sector grew by about 10 percent in 2013, lower than in previous years.14 A Deposit Insurance scheme was introduced in mid-2013. It aims at compensating depositors against the loss of insured deposits up to US$ 10,000 placed with member institutions in the event of a member institution’s failure. This system will strengthen public confidence in banks, and hence their capacity to mobilize more savings and deposits. 21. Albeit reduced, the banking sector’s high credit exposure to the PA and its employees is a source of concern and the PMA has been carefully monitoring related risks. The PMA reports that by the end of 2013, credit to the public sector and PA employees combined, represented around 47 percent of the sector’s gross credit. This credit concentration creates risks that can threaten the 14 The decline is mainly attributable to the fact that since the restart of the peace negotiations in mid-2013, most individuals and companies have been keeping on hold investment and consumption plans until April 2014 - the date assigned for the end of the negotiations - hoping that economic and political prospects will be clearer then. Uncertainties over PA’s finances and the accumulation of arrears to the private sector, may have also contributed to the slowdown in credit growth. 7 viability of the overall sector. The PMA has been carrying out stress tests focused on monitoring these risks since March 2011. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 22. Growth is expected to pick up in 2014, but only slightly. This projection assumes no major changes in constraints on movement, access and trade. Foreign aid to the public sector is expected to be less than its 2013 level at around US$1.2 billion (for both recurrent and capital spending), which will not be enough to offset the impact of the restrictions on the private sector. That said, the increase in growth will be driven by higher consumption as consumer confidence is expected to grow given that the uncertainty that was created by the PA’s fiscal stress in 2013 has subdued. In addition, the PA’s decision to implement limited wage increases for its security personnel as well as public doctors, teachers and engineers in 2014 will also enhance economic activity, while keeping the wage bill to GDP ratio constant. These factors are expected to result in one percentage point increase in real GDP growth to approximately 2.5 percent in 2014. 23. Inflation is expected to remain roughly at the 2013 level of around 2-3 percent, but the West Bank and in particular Gaza remain vulnerable to increases in food and fuel prices. The projected inflation figure takes into account the expectation of Israeli inflation not exceeding 1.8 percent and relatively stable prices at international commodity markets. 24. The PA has prepared a revenue strategy that is expected to improve revenue performance, but the results will only begin to materialize in 2014. This strategy primarily focuses on widening the tax base as the PA plans to increase the number of registered taxpayers by 10 percent in 2014 to be followed by 15 percent in 2015. The PA is also working on revising penalties imposed on tax evaders and delinquent taxpayers as the current system has proven to be inefficient. A 10 percent dividends tax will also be imposed on dividends distributed by companies listed on the Palestinian stock exchange. Based on advice provided by the IMF, the Palestinian Cabinet has recently approved amendments to the Investment Promotion Law. The tax holidays previously provided under it were found to be too generous and ineffective in achieving the intended objectives. The revisions will reduce tax incentives for new investments, shorten their duration and also limit them to fewer sectors. The Large Taxpayer Unit (LTU) will be restructured to include income tax, VAT, customs and nontax administrations under the same unit. The number of taxpayers registered under the LTU will also be increased from 246 by the end of 2013 to 540 in 2016. The abovementioned measures are expected to significantly enhance revenue performance, but their results may take time to materialize. Hence, although data for the first quarter of 2014 is quite encouraging, revenues are projected to increase by a conservative 0.7 percentage points of GDP in 2014, to be followed by more growth in the coming years.15 25. The PA has announced a number of measures to control public spending. The resulting savings, however, are not expected to lead to an immediate decline in expenditures as a percentage of GDP in 2014 especially given the sluggish projected growth rates, but will start to take effect in the following years. A decision was adopted to reduce fuel subsidies. These subsidies have significantly grown in 2013 to reach about 5 percent of total recurrent spending by the end of the year. This placed pressure on the already tight budget and the PA has therefore taken a decision to reduce these subsidies in 2014 by more than 30 percent in nominal NIS terms. The PA has also decided to maintain the zero net hiring policy that it implemented in 2013 throughout 2014 as well. A decision was also made to discontinue paying supervision and transportation allowances for stay-at-home staff, most of who are based in Gaza. The wage bill as a percentage of GDP is expected to drop slightly from 17 15 Tax collection data for the first quarter of 2014 is very encouraging. Domestic taxes grew by 24 percent when compared to Q1 2013 and clearance revenues were about 31 percent higher than in Q1 2013. This can be explained by intensified enforcement activities, as well as increased shipments of fuel from Israel to Gaza and the fact that Israel is remitting applicable taxes on the sale of this fuel to the PA. 8 percent to 16.8 percent. In nominal NIS terms, it is expected to grow by 4.9 percent due to a 1.25 step increase that is mandatory by law, 2.5 percent Cost of Living Allowance, in addition to across the board wage increases to public security staff, teachers, doctors and engineers. These wage increases were introduced as a result of strong pressure to implement the agreements that the public unions had made with the Government in 2013, and whose implementation has been delayed due to fiscal difficulties.16 However, renewed pressures from the unions, ongoing strikes and declining per capita income prompted the PA to start implementing these wage increases in two stages, some in 2014 to be followed by others in 2015. As a result of these wage increases against the backdrop of sluggish growth rates projected for 2014, expenditures as a share of GDP are projected to stay at the 2013 level of 33 percent. However, the share of PA’s recurrent expenditures in the economy is expected to decline in the following years, as the PA continues with ongoing reform efforts, which should improve effectiveness and efficiency of public expenditures. 26. The recurrent fiscal deficit is expected to drop from 12 percent of GDP in 2013 to 11 percent of GDP in 2014. However, the financing need would remain large at US$1.36 billion, only to cover recurrent expenditures. A further US$194 million is needed to finance development projects, bringing the total financing need for the 2014 budget to US$1.55 billion. Aid to the public sector for recurrent and development spending in 2014 is expected to be less than in 2013 at about US$1.2 billion17, leading to a financing requirement after grants of around US$355 million. This, as in previous years, is expected to be financed through domestic sources mainly including arrears to the pension fund (de facto borrowing from the pension fund) and borrowing from commercial banks especially since the PA had managed to reduce its debt to the local banking sector in 2013, creating room for additional borrowing in 2014. 27. The PA’s budget for 2014 is tight and financing risks could arise during the year if for some reason donor pledges are not met. Therefore, it is highly important that the PA continues to further rationalize its expenditures and enhance revenue generation. The PA should also intensify efforts to mobilize additional donor financing in an attempt to raise pledges to the level of grants received last year. The private sector remains severely constrained and there is no immediate alternative to grant assistance and therefore donors should continue to support the PA through sustained and substantial financial support. Predictability of donor aid is also important, as unpredictable aid flows introduce an additional layer of uncertainty to decision making and prioritization of activities for the PA. 28. The deficit is projected to continue declining in the medium term as the PA carries on with fiscal consolidation efforts. Our projections indicate that the PA’s recurrent deficit as a percentage of GDP will continue to gradually drop to reach around 6 percent in 2018. This will mainly be driven by a reduction in the share of expenditures in the economy as the PA continues its reform efforts to rationalize spending and increase revenues. One of the main areas that the PA plans to focus on is reducing energy subsidies. For instance, the Palestinian Cabinet has recently passed a decision that obliges electricity providers in West Bank and Gaza to pay their bills in a timely manner to the Israel Electricity Company, as otherwise they will be heavily penalized. This decision, if properly implemented, will lead to a significant decline in net lending. In addition, the PA has recently established the Palestinian Electricity Transmission company (PETL) which will be in charge of establishing a modern transmission infrastructure and improving the existing network in order to reduce the volume of technical losses. PETL will also manage purchase agreements with electricity suppliers in an aim to reduce import prices. In addition, the PA has already taken a decision to gradually reduce its fuel subsidies in the coming years, starting in 2014. Measures are also underway to improve the efficiency of health expenditures, in particular through streamlining the referral costs. The medical referral process has already been strengthened through the establishment of three 16 The implementation of those agreements was made subject to availability of finances. 17 US$100 million out of the US$1.2 billion pledged for 2014 is earmarked for repayment of private sector arrears. 9 specialized referral committees whose members are in charge of auditing all referral cases to determine the ones that need to be treated outside the Palestinian health care system. In addition, the Ministry of Health with support from the USAID plans to introduce a health information management system that will allow it to have a centralized database for the overall referral process. This reform, once finalized, could lead to sizeable savings. The PA also plans to continue implementing measures to control the growth of the wage bill and move forward with civil service reform. The General Personnel Council (GPC) has been working on a general review of all posts in each line ministry or agency to update the currently used job descriptions and to produce job classifications. The ultimate objective is to rely on these job classifications as criteria to determine budget allocations for staff costs to various ministries. GPC also intends to carry out a series of functional reviews, looking at the overall machinery of government including major ministries and public institutions. These efforts combined are expected to lead to a 4 percentage points decline in government spending in the medium term which is projected at 29 percent of GDP in 2018. Furthermore, the share of revenues in the economy should grow and reach about 23 percent in 2018 as the results of the PA’s revenue strategy materialize with time (see paragraph 24 for details on the revenue strategy). 29. The external current account deficit is expected to remain high. Constrained by the restrictions system, export growth is expected to remain sluggish and the Palestinian territories will continue to heavily depend on imports to meet even some of the basic needs. Consequently, the current account deficit (excluding official transfers) will remain extremely high in 2014 at 30 percent of GDP, at least based on the official estimates. Absent significant improvements in the investment climate, the large deficit--even if overestimated--is bound to persist unless sharp downward adjustments are made to the fiscal deficit, which could have severe social and stability implications. In addition to official transfers, current account deficit financing will continue to depend on informal private capital transfers and possibly further drawdowns of foreign exchange in cash and savings. 30. Debt Sustainability Analysis (DSA) indicates that even though debt is sustainable in the medium term, it remains sensitive to shocks.18 The PA’s public debt consists of external debt, borrowing from the domestic banking sector and domestic arrears to the public sector and to the pension fund. It has increased from about US$2.3 billion in 2010 to about US$4.4 billion by the end of 2013. DSA indicates that public debt in a base line scenario is sustainable. However, this result is sensitive to shocks. Sensitivity analysis demonstrates that a shock equivalent to one standard deviation to the interest rate earned by domestic banks will raise the debt to 40 percent of GDP by 2018 - the limit prescribed by the Law on Public Debt. The shocks to growth, primary balance, or a combined shock will raise the debt level even more to 52, 48, and 47 percent of GDP by 2018, respectively. A one-time contingent liabilities shock equivalent to 10 percent of GDP (e.g., in the case of non- payments to utilities) will result in a commensurate increase of the debt level. A similar effect would occur with a fall in aid. 31. With continued reform efforts by the PA and sustained inflows of donor aid, the macroeconomic policy framework is adequate. While this macro-fiscal framework is subject to a number of risks, many of them beyond the PA’s control, there is probably no feasible alternative to a framework that relies on the one hand, on large amounts of donor aid, and on the other, on efforts to boost domestic revenues and curb public expenditure growth as much as feasible, but without causing politically and socially unbearable impacts on citizen welfare and social stability. IMF RELATIONS 32. West Bank and Gaza is not a member of the IMF. The IMF, however, has an office for West Bank and Gaza in Jerusalem and has had an active analytical and technical support program. The IMF has been providing technical assistance in the area of taxation, public finance management, statistics, 18 DSA was conducted by the IMF in preparation for the September 2013 AHLC meeting. 10 and financial sector reforms. It also conducts regular macro-fiscal monitoring and publishes two reports a year in advance of the Ad Hoc Liaison Committee (AHLC) meetings, as well as other ad hoc reports. 3. GOVERNMENT’S PROGRAM 33. The Government is currently preparing a new National Development Plan 2014-2016. The draft plan has three broad objectives: the first one is focused on growth, competitiveness, and job creation, the second one on improving governance and public institutions, and the third one on infrastructure development. Under the first objective, the PA’s aims are to improve the business environment, facilitate investments in areas that can lead to significant job creation, improve external competitiveness of Palestinian enterprises, as well as to facilitate entrepreneurship among women and youth. Under the area of governance, the focus is on efficiency, effectiveness and transparency in the public services, enhanced public service provision, enhanced capacity of local governments, enhancements in the security and justice systems, strengthening citizen participation in decision making, and improved functioning of Palestinian representation abroad. In the area of infrastructure, the focus is on improved efficiency and safety of transportation infrastructure, improving the provision of energy, water, and sewerage services, environmental protection, and the development of a housing sector that “supplies citizens’ needs more efficiently and effectively.” The strategy has been conceptualized with the aim of facilitating the implementation of the Palestinian Economic Initiative, which is being finalized by the Office of the Quartet Representative Tony Blair. 34. Sector and issue specific strategies are also being developed. Thus, for instance the Government is finalizing a revenue action plan, the aim of which is to significantly expand the tax base both through changes to tax policy and better enforcement. An action plan has also been designed for the energy sector, the main objective of which is to improve the sector’s financial viability and reduce net lending. 4. PROPOSED OPERATION LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION Box 1: Overview of Previous DPGs in West Bank and Gaza The Bank has already supported five budget support operations in the West Bank and Gaza between 2008 and 2013 (DPG I, II, III, IV and V). The previous programs all focused on two main policy areas: I) Strengthening the PA’s fiscal operations; and II) Increasing government transparency and accountability through improved public financial management. Main objectives targeted under policy area 1: I.1 Control public sector wage bill. I.2 Reduce net lending and improve targeting of social safety net. I.3 Improve domestic revenue collection. Main objectives targeted under policy area 2: II.1 Improve efficiency and transparency of the budget preparation process. II.2 Establish upgraded institutional and regulatory procedures to support PFM reforms. II.3 Strengthen PFM infrastructure and improve auditing functions. II.4 Increase financial accountability through improved and more transparent municipal accounts. Main results achieved: While work on meeting the above objectives under DPGs I-V still continues and progress is hampered by factors outside of the PA’s control, substantial results have already been achieved. 11  First, the recurrent fiscal deficit has been reduced drastically from 26 percent of GDP in 2008 to 12 percent in 2013. The size of the wage bill, although still large relative to comparators, has dropped from a peak of 26 percent of GDP in 2006 to below 17 percent in 2013.  Second, while net lending remains a problem, specific actions have been taken to bring it under control.  Third, the targeting of social assistance has been improved through the introduction and continuous improvements to the cash transfer program, which is considered among the best in MENA. Therefore, this area is no longer considered a top priority and no reforms are supported in this area under DPG VI.  Fourth, the efficiency and transparency of the budget preparation and execution process has also significantly improved. For instance, regular monthly fiscal reports are published on the MoF website and their quality and content has been continuously improved. A new computerized financial management system was introduced with a connection to all line ministries. The internal audit process has also been strengthened.  Fifth, despite some recent delays, which had to do with technical challenges and, perhaps, also the transition process related to the change in Government in 2013, a new modern legal framework for public procurement has been introduced and now final steps are being taken to enable the conduct of procurement under the new legal and institutional framework.  Finally, while wage bill control measures have resulted in a significant reduction in this spending item, recent progress has been very limited in reforming the civil service and the pension systems. Both of these reform areas are important for long term fiscal sustainability, but at the same time made difficult by social and political considerations in an environment of slower growth and severely constrained private sector, rise in unemployment, and internal political divisions. 35. This operation continues the efforts of the previous five in strengthening the PA’s fiscal position and public finance management, but it also ventures into private sector development as a new policy area. The first two policy areas are aligned with the priorities indicated in the governance and institution section of the PA’s draft NDP 2014-2016. Engagement in these areas is warranted by the fiscal conundrum the PA faces in light of recent decline in donor aid, its uncertain prospects, and the lack of progress in easing restrictions on private sector led growth, all of which have contributed to a significant slowdown in economic growth. Furthermore, provided that the reduction of poverty, improvement in prosperity for the bottom 40 percent of the Palestinian people, and sustainable public finances necessitate private sector led growth, this operation has been designed to also extend support to the PA’s recently intensified efforts to improve the business environment. This new area of engagement under DPG VI is aligned with MENA Region’s Framework for Engagement, specifically the objective of “creating Jobs, including for youth and women, by providing an enabling environment for opportunity, competition, innovation and entrepreneurship ,” and the crosscutting objective of supporting a “competitive private sector.”19 36. The most relevant lessons of the previous DPGs to this operation are that a strong government ownership of the reform process needs to be secured and that within the same 19 It is noteworthy; however, that the analytical work on the Palestinian economy, including the still unreleased Investment Climate Assessment, confirms that the political uncertainty and restrictions on access and movement are the binding constraint on economic growth. Consequently, PA’s efforts to improve the business climate can only have a substantial effect following the removal of the restrictions and the improvement in the political and security situation. 12 broad objectives the design of the program needs to be flexible due to rapidly changing circumstances in a fragile context. These lessons are important for success and have been taken into account during the preparations of this operation. This DPG follows the Government’s reform program closely to ensure full ownership in all areas of reform. Thus, for instance, while the dialogue continues with the authorities and technical assistance is being provided to reduce electricity-sector- related net lending and health referral costs, no related prior actions have been included in the DPG VI, as until very recently the PA was not prepared to take strong reform actions. Nevertheless, efforts are under way to intensify reforms in both of these areas and as the preparation of this operation was being finalized, the Government has taken some strong measures, which are expected to have a significant impact on reducing the size of net lending. PRIOR ACTIONS, RESULTS, AND ANALYTICAL UNDERPINNINGS Policy Area I: Reducing PA’s Recurrent Fiscal Deficit Domestic Revenue Performance Description of the Situation and Policy Challenge 37. After relatively weak performance in recent years, tax revenues increased significantly in 2013. Between 2003 and 2007, public revenues increased by about 5 percentage points of GDP. However, since 2008, revenue performance has deteriorated. Clearance revenues (70 percent of all revenues) dropped from 18 percent of GDP in 2008 to 14 percent in 2011 and remained at that level in 2012, but they increased in 2013 to just below 15 percent. The portion of tax revenues collected internally by the PA fluctuated between 4 and 5 percent of GDP over the same period, but increased by almost one percentage point in 2013.20 Increase in domestic tax revenues can be attributed to the PA’s heightened efforts to improve collection. 38. Given the current fiscal challenges the PA is facing, further enhancing domestic revenues is necessary. To a large degree, revenue performance is contingent upon the political situation. The effectiveness of clearance revenue collection largely depends on actions taken by the GoI and to a lesser extent those of the PA. However, even internally collected revenues have been low relative to GDP in comparison to other countries in the region. Thus, the main policy challenges are to boost internally collected revenues primarily by eliminating different loopholes in the system and strengthening tax enforcement, while at the same time continuing discussions with the GoI to strengthen clearance revenue collection. Government Actions to Date and Future Activities to Address the Challenge 39. The new Government, which came to power in July 2013, has already approved new Revenue Strategy and Action Plan. The new strategy builds upon the one prepared by the predecessor Government, but with greater emphasis on tax policy and enforcement measures. Given that a very narrow base is the main cause of low collection, the PA plans to reduce the Personal Income Tax (PIT) and Corporate Income Tax (CIT) rates to provide an incentive for tax payers to pay, while it implements policy and enforcement measures to broaden the tax base. However, rate reductions have been delayed until 2015, as the PA plans to first launch systematic efforts to broaden the base. Several laws and procedures are being revised and specific plans are being put in place to 20 Unsatisfactory revenue performance can be explained by two factors. After having dropped already in 2007, revenues from Gaza have remained stagnant in nominal terms and in 2012 they amounted to 4.4 percent of total clearance revenues (down from 17 percent in earlier years). Furthermore, tax revenue collection in the West Bank has also lagged GDP growth, dropping from 16 to 14 percent of GDP. This is explained by tax enforcement leakages. Enforcement weaknesses are, in particular, evident with PIT, where the collections amount to only 1.7 percent of GDP, which is very low even by regional comparison. 13 increase tax registration, as well as to detect and penalize non-payers. The PA has already reduced the size and scope of tax incentives provided in the Investment Promotion Law, as advised by the IMF. Assessments showed that these incentives have been ineffective instruments of encouraging new investments and have benefited few profitable companies at a significant cost in terms of lost tax revenues. Recent amendments to the Investment Promotion Law have narrowed the scope and duration of those tax incentives. In addition, the PA adopted amendments to the Income Tax Law to introduce a 10 percent tax on distributed dividends, which reduces opportunities for tax arbitrage and broadens the tax base. Neither of these two legal measures is expected to have significantly negative effects on job creation and business environment.21 40. Furthermore, regular discussions now take place between the Israeli and Palestinian ministries of finance where, inter alia, measures are being discussed to increase clearance revenue collections. An important action that has been agreed and is already being implemented by Israel is sharing information on daily basis on direct import declarations for goods destined to Palestinian territories. Yet, a lot more can be done to reduce an ostensibly large tax leakage on clearance revenues.22 Prior Actions Supported by the Operation  The Cabinet of Ministers has approved draft amendments to the Investment Promotion Law aimed at broadening the tax base by reducing the scope of tax incentives for new investments and limiting their duration.  The Cabinet of Ministers has approved draft amendments to the Income Tax Law introducing 10 percent tax on distributed dividends. Expected Results  Gross domestic tax revenues have increased in nominal NIS terms by 8 percent and by at least 0.1 percentage point of GDP between 2013 and 2014. Public Sector Wage Bill Description of the Situation and Policy Challenge 41. Despite successful efforts to reduce its size in recent years from 26 percent of GDP in 2006 to below 17 percent in 2013, the public sector wage bill in the West Bank and Gaza remains high by international standards. The main drivers behind the high wage bill are the relatively high public sector employment relative to the population, which is well above the regional average, approached only by some far wealthier Gulf States, as well as high cost of living in West Bank and Gaza relative to its GDP, which puts pressure on wages. Addressing the issue of a large and unsustainable wage bill, which the PA is currently struggling to fund, requires both short-term measures to contain the growth of wages and the number of staff on the PA’s payroll, but also wide ranging structural reforms. The precarious fiscal and political situation is most probably the reason why the PA has so far been addressing this issue through short-term measures. Government Actions to Date and Future Activities to Address the Challenge 21 On the contrary, one could argue that improving the PA’s fiscal position to enable it to eliminate the practice of arr ears accumulation to the private sector, should have a positive impact on private sector liquidity and consequently investor confidence. 22 According to the Palestinian MoF, the PA is losing around US$500 million per year as a result of (in)actions, which are within Israel’s power to address. 14 42. In 2014, the PA will continue implementing measures to control hiring and wage growth, which it had started back in late 2012, but will also allow some wage increases. Specifically, the PA introduced a hiring and promotions freeze for 2012 starting in August 2012, and adopted a zero net hiring policy for 2013. This policy has been quite successful in containing the wage bill growth and slightly reducing its size relative to GDP. The policy will continue into 2014 and it aims to limit new recruitments to ensure they do not exceed the number of retirement-related and other kinds of departures from the PA. This is expected to keep the number of staff on the PA’s payroll in 2014 at the December 2013 level. It is noteworthy that this policy is a sharp departure from earlier policies under which 3,000 net staff increase limit had been set. Given the annual population growth of about 3 percent, the zero net hiring policy is effectively reducing the size of public employment relative to the population. 43. Furthermore, the PA has recently reformed its policy on transportation allowance to ensure that staff who are temporarily not coming to work do not receive transportation allowance and that the allowance is based on staff current residences, regardless of where they resided when they joined civil service. This practice is most often observed in Gaza so it will have a larger impact there. However, the PA is also preparing a plan to verify actual residence of staff to serve as a basis for getting transportation allowance, which should affect a significant number of West Bank staff who have changed their residence since joining the PA. 44. Finally, the PA has been under tremendous pressure by trade unions to allow promotions in certain sectors, such as security, which have been frozen for a number of years and to allow salary increase for doctors, teachers, and engineers. The PA has agreed with the unions to implement those increases in line with available financing and it aims to implement the increases in such way that will prevent growth of the wage bill relative to GDP. Prior Actions Supported by the Operation  No increase in the number of civil and security personnel of the Palestinian Authority has been provided for in the 2014 Budget of the Palestinian Authority for the calendar year of 2014.  The Recipient has discontinued the practice of paying transportation and supervision allowances for stay-at-home staff of the Palestinian Authority. Expected Results  The 2014 central government nominal wage bill growth has not exceeded 4.9 percent (in NIS terms) and is at least 0.2 percentage points of GDP lower in 2014 compared with 2013. Policy Area II: Improving Effectiveness and Transparency of Public Finances Public Procurement Description of the Situation and Policy Challenge 45. Supported by the Bank, the PA has made good progress with the reform and modernization of its public procurement system. As part of these efforts, the PA had enacted in December 2011 a new Public Procurement Law (PPL), which represents a good balance between the current capacity to conduct procurement in Palestinian territories and internationally accepted practices. The new Law, which applies to all procurement activities by all entities using public funds (including municipalities), lays down an acceptable institutional and organizational set-up for public 15 procurement; provides comprehensive provisions on procedural matters; sets out provisions on transparency and accountability; establishes a complaint/dispute review mechanism; and provides for routine dissemination of information on public procurement through a single portal procurement website. It also provides for gradual adoption of online conduct of procurement. 46. As part of developing the supporting institutional infrastructure to implement the PPL, the Higher Council for Public Procurement Policies (the Council) was established in September 2012, with representation from public and private sectors. The creation of the Council is one of the most important building blocks in the construction of a modern, best-practice public procurement system that is an enabler of development. The Council is the entity mandated by the Law for oversight of all public procurement activity.23 With Bank support, the vision and mission statement, and the essential organizational structure, functions, and staffing of the Council were defined. Necessary budget to cover the cost of the Council’s key staff and other operating costs was allocated by the PA as part of the General Budget, and the recruitment of key staff is due to start shortly. The Council prepared, and is implementing, a two-year action plan for the development of the procurement system, as envisaged by the Law. The plan provides for sequenced implementation of essential activities for institution building and effective functioning of the system, e.g. the development and issuance of standard bidding documents (SBDs), the preparation and implementation of a capacity building strategy of the procurement workforce and other relevant stakeholders, the establishment and operation of a single portal procurement website, the establishment of a functioning dispute review unit, etc. 47. A key challenge for the PA has been to complete a clear working legal framework and a set of tools for public procurement that would ensure that the Law is understood and implemented properly and in a harmonized manner by all procurement practitioners and other participants and stakeholders. The enactment of recently prepared implementing regulations to the Law is now imminent. The issuance and mandatory use of SBDs, the preparation of standard process forms to be used by procuring entities for implementing various steps and procedures in the procurement process are also expected to be completed in 2014. As important for the modernization and effectiveness of the public procurement system is the development of the human resources that implement the procurement system to ensure that procurement is conducted in a competent and professional manner in order to achieve the objectives of the Law. Government Actions to Date and Future Activities to Address the Challenge 48. Implementing regulations providing, in a consolidated text, detailed rules and procedures for the implementation of the Law have been approved by the Cabinet. The Public Procurement Law was amended to fill some gaps and remove certain inconsistencies on the basis of inputs from various stakeholders. National SBDs for various types of public procurement, including goods, works and consultancy services and a procurement procedures manual (including standard process forms) are being prepared with the assistance of an international consultant.24 49. Following the promulgation of the Law and the implementing regulations, the Council will conduct a series of sensitization and awareness-raising events geared in particular to familiarize participants and other stakeholders in the procurement system broadly with the key aspects and innovations in the new legal, institutional and procedural framework that is being 23 In addition, the Council is responsible for the development of the procurement system, including policy setting, institution building, procurement documentation, guidelines and manuals, training and public awareness campaigns. 24 The issuance and mandatory use of the SBDs and manual present a number of advantages for the procurement system including helping to standardize and harmonize implementation of procurement proceedings; promoting transparency and predictability in public procurement proceedings, helping to mitigate the effects of low levels of procurement capacity in the public sector; facilitating participation by small businesses; facilitating oversight, control, and audit of procurement proceedings. 16 introduced. The series will be multifaceted, aimed at a broad audience, including procurement officials, financial control and audit authorities, senior managers and policy makers, private sector, professional associations and civil society. These will be followed by an initial, first round of training, providing participants with a basic introduction to the key steps and procedures in the procurement process, from planning through acquisition (bidding and contract award) until the completion of contract implementation and administration. Prior Action Supported by the Operation  The Public Procurement Law of the Recipient has been amended in order to refine, fill gaps, eliminate inconsistencies and further elaborate the provisions of the Law on institutional and procedural matters, and the Cabinet of Ministers has adopted the Regulations for the implementation of the amended Law. Expected Results  The use of National Standard Bidding Documents in public procurement has started.  Posting of procurement plans, notices and award decisions by all procuring entities on a single portal procurement website has started. Public Finance Management Description of the Situation 50. The PA has made good progress in developing modern PFM systems, despite the loss of capacity due to the separation from the MoF office in Gaza in 2007 . Progress has been particularly effective in setting up a performing IFMIS and the GFS budget classification. Together with the development of the unified treasury system (Treasury Single Account and zero-balance account) overseen by the Ministry of Finance in accordance with international practices, these reforms have allowed the MoF to commence devolving budget execution to line ministries. The flow of donors’ funds since 2007 has also enabled the PA to expand the scope and volume of public services. However, progress has been uneven across different PFM areas. Moreover, the temporary suspension of clearance revenue payments in 2011/2012 has, in a context of heavily donor-supported budget, significantly impacted the public financial management system of the PA. 51. Public Expenditure and Financial Accountability Report (PEFA) issued and published in July 2013 by a multi-donor team led by the World Bank provided a fresh overview of reform progress and challenges ahead. PEFA also reviewed and assessed the consequences of recent fiscal stresses on PFM systems. Budget execution and accounting/reporting procedures have been particularly affected due to the insufficient robustness of the mechanisms in place. The weak control of arrears’ accumulation and the weak comprehensiveness and accurateness of the accounting have also been flagged as primary systemic risks of the PFM system. 52. Significant reform challenges remain ahead, but as a priority, the PA will continue to improve the transparency and reliability of its expenditure to better inform budget planning and structural policies, as well as budget execution, control and accounting. For instance, to minimize the accumulation of payment arrears, which have been particularly problematic in recent years, improvements in arrears recording and reporting are needed, as well as better commitment control systems. The audit of the financial statements of the PA for 2010 has been issued with delays and approved by the State Audit and Control Administrative Bureau with some qualifications, some of 17 which have already been addressed in order to improve compliance with international standards for the next years. Government Actions to Date and Future Activities to Address the Challenge 53. Based on PEFA results, the Ministry of Finance has worked with the development partners to address the systemic risks that have been raised in the report: (i) the absence of cash planning mechanisms that could serve as a guide for budget execution to make the trend of expenditures more compatible with cash available; (ii) the weak procedures in place that do not allow to control expenditures at commitment level (i.e. at the incurrence stage) in addition to the current only payment stage; and (iii) the insufficient monitoring of arrears, including the current inability to provide reliable calculation and presentation automatically extracted from the IFMIS. Addressing these three risks should enable the PA to better plan budget execution and monitor more efficiently the arrears, which are generated partly as a result of aid reduction in recent years, but also as a consequence of insufficient budget discipline due to weak control mechanisms currently in place. 54. The PA has been implementing several reforms to improve the budget execution process and reduce the accumulation of arrears. With Bank support the PA has developed a significantly improved cash planning system, which it plans to implement along with a new commitment control mechanism (the latter to be implemented on a pilot basis). The cash forecasting and management process will be carried out by the Cash Committee. The Committee is headed by the Minister of Finance, and includes the Accountant General and the Budget Director; the Secretariat is held by the Cash and Debt Management Department. In addition, MoF has also been developing new IFMIS functionalities to improve arrears reporting. In addition, as a main component of its fiscal information and accountability, the PA plans to improve compliance of the financial statements with international accounting standards, both in quality and timeliness.25 Prior Actions Supported by the Operation  The practice of the adjustment and implementation of the Annual Cash Plan on a monthly basis has been established based on the template developed with the World Bank technical assistance.  The Ministry of Finance has issued an instruction to implement new functions of the Integrated Financial Management Information System to strengthen arrears management by introducing: (i) automatic carryover of arrears; (ii) age profile of all arrears; and (iii) reporting separately the total stock of arrears, arrears accumulation and arrears repayments in monthly budget execution reports. Expected Results  PEFA score on cash flow planning and monitoring has improved in 2014 as compared to 2013.  PEFA score on access to reliable information on arrears has improved in 2014 as compared to 2013. 25 In parallel, the PA also plans to improve the budget preparation procedure to suit more the overall fiscal constraint (top-down) and the National Development Plan (2014-2016) by moving towards a multi-year approach rather than the current annual only approach. The PA has benefited from technical assistance in conducting these reforms. 18 Policy Area III: Improving Business Climate Description of the Situation and Key Policy Challenges 55. Private sector growth, in particular its tradable side, has been severely constrained. Private investment has averaged around 15 percent of GDP over the past seven years, as compared with rates of over 25 percent in fast-growing middle income economies, and with Foreign Direct Investment (FDI) averaging a mere 1 percent of GDP, which is also very low in comparison to most fast growing economies. Much of this investment is channeled into internal trade and real estate development. Thus, with low level of investment and relatively sluggish growth, unemployment rates have remained very high in the Palestinian territories. While internal Palestinian political divisions have contributed to investor aversion to the Palestinian territories, Israeli restrictions on trade, movement and access are the binding constraints to investment: these restrictions substantially increase the cost of trade and make it impossible to import many production inputs into the Palestinian territories. For Gaza, the restrictions on import and export are in particular severe. In addition to the restrictions on labor movement between the Palestinian territories, the restrictions on movement of labor within the West Bank have been shown to have a strong impact on employability, wages, and economic growth. Israeli restrictions render much economic activity very difficult or impossible to conduct on about 61 percent of the West Bank territory called Area C. 56. In addition, the Doing Business Report reveals substantial room for improvement in some aspects of the Palestinian business environment that is under PA’s jurisdiction. Despite significant improvement in some areas over the past year, the 2014 Doing Business Report shows that several aspects of the Palestinian business environment do not compare favorably with other countries, even at a similar level of income. Although the aspects of the Palestinian business environment, which are assessed in the Doing Business report, may currently not be the binding constraint on investment, the removal of those constraints would prepare the Palestinian economy for sustainable growth once the other constraints—primarily movement and access restrictions and political risks—are removed or ameliorated. For some businesses, however, in particular for small and medium enterprises, ease of starting a business, getting credit, registering property and other aspects of the business environment amenable to improvement by government policy do affect investment decisions even now. Indeed, given heightened political uncertainty, security risks, and various restrictions which both increase the cost and risk of doing business in Palestinian territories, efforts ought to be made to render the Palestinian business environment as attractive as possible. 57. While it may not be a significant obstacle to large investors, high business registration costs and complicated procedures may deter new entrepreneurs. Business registration costs are probably not an obstacle to larger and wealthier investors, but they certainly might be an obstacle to young people with bright business ideas. Thus, efforts to further reduce the cost of business registration, the number of required procedures and time required to register a business should have a positive effect on entrepreneurial activity. 58. A dynamic private sector will be essential for West Bank and Gaza to achieve robust and sustainable economic growth, but an underdeveloped financial sector still remains a constraint to private sector development. Currently, the sector does not meet the financial needs of firms or individuals. In the most recent Doing Business (2014) rankings for “Getting a credit”, a measure of credit information sharing and legal rights of borrowers and lenders, West Bank and Gaza ranked 165th out of 185 countries, which is a slight deterioration compared to the previous year. Specifically, West Bank scored one out of 10 points on the strength of legal rights index which measures the effectiveness of regulations on non-possessory security interests in movable property. The growth of private credit remains constrained by the subdued economic activity. Banks cannot expand their lending portfolio (loan to deposit ratio remains very low hovering around 27-30 percent). Currently, collateralized lending in West Bank and Gaza is underdeveloped with immovable collateral (land and 19 real property) being rarely used to secure lending. This is due to the absence of a clear land titling system. On the other hand, businesses cannot utilize most of their movable assets, including equipment, inventory and accounts receivable, as collateral to obtain financing. This is primarily due to a weak legal framework relating to collateralized lending and the absence of a movable collateral registry that effectively supports proprietary rights of lenders. Completing an effective land titling reform will require significant effort and time, however, reform to increase lending against movables is easier to accomplish in the short run. 59. Secured lending reform can greatly increase private sector access to credit in West Bank and Gaza. The reform should include both legal enactments (Leasing Law, Law on Secured Transactions) and development of a movable collateral registry to publicize lenders’ security interests in movable assets and to establish their priority in the assets. These steps, taken together, would increase the availability of credit, reduce the cost of credit, improve financial system stability and expand the types of collateral lenders will accept as security. Thus, assisting West Bank and Gaza achieve these benefits has been the goal of IFC’s West Bank and Gaza Secured Lending Project. Government Actions to Date and Future Activities to Address the Challenge 60. With the help of donors, the PA has recently implemented some important reforms to improve the business environment. Specifically, the PA improved its ranking on “Starting a business” in the 2014 Doing Business report by 37 places by implementing reforms to reduce the cost and complexity of business registration. Perhaps, the most significant reform was the complete elimination of the capital requirement upon business registration from what was equivalent to 207 percent of per capita income.26 Furthermore, the number of procedures was reduced from 11 to 9 and the process was slightly shortened from 48 days to 45 days on average. 61. Furthermore, an important milestone was reached in January 2014 for the improvement of access to finance when the President promulgated the Leasing Law. This Law regulates the leasing activity and is expected to encourage new forms of business financing (i.e. leasing companies) in addition to banks and microfinance institutions, which are currently the main sources of business finance in Palestinian territories. Furthermore, an asset registry has been developed with the support of IFC, where leased assets can be formally registered and used for public notice. The asset registry will become particularly important once the Secured Transactions Law, which has been adopted by the Cabinet, is promulgated by the President. The Secured Transactions Law will formalize the use of different asset classes as collateral, including contractual future income streams and create a way to formally register pledges of assets used as collateral. Prior Action Supported by the Operation  The Law on Leasing has been enacted by the President. Expected Results  Total real value of leasing contracts is higher at the end of 2014 compared to end 2013. 26 The Government eliminated the capital requirement by suspending the implementation of the pertinent provision in the 1964 Companies Law in anticipation of this Law’s broader revisions. 20 Prior actions Analytical underpinnings Prior action 1: The Cabinet of Ministers IMF Technical Memoranda on Investment Tax has approved draft amendments to the Incentives Investment Promotion Law aimed at broadening the tax base by reducing the scope of tax incentives for new investments and limiting their duration. Prior action 2: The Cabinet of Ministers Assessments by several IMF technical missions, has approved draft amendments to the assessments by DFID and USAID technical Income Tax Law introducing 10 percent tax missions in addition to Bank staff assessment of on distributed dividends. Palestinian MoF revenue action plan Prior action 3: No increase in the number 2012 Bank report on civil service reform and of civil and security personnel of the continued assessment of wage bill sustainability Palestinian Authority has been provided for by the IMF and Bank staff in the 2014 Budget of the Palestinian Authority for the calendar year of 2014. Prior action 4: The Recipient has Bank and IMF staff analysis of current pay discontinued the practice of paying practices and PA’s own analysis, which transportation and supervision allowances for revealed that a significant number of staff on stay-at-home staff of the Palestinian PA’s payroll are not commuting to work, while Authority. receiving transportation allowances or are receiving transportation allowances based on previous residences that assume longer commuting distances Prior action 5: The Public Procurement Bank staff assessments of key weaknesses of the Law of the Recipient has been amended in Palestinian public procurement system as part of order to refine, fill gaps, eliminate preparation of the ongoing Bank-financed inconsistencies and further elaborate the project in support of public procurement reform provisions of the Law on institutional and procedural matters, and the Cabinet of Ministers has adopted the Regulations for the implementation of the amended Law. Prior action 6: The practice of the 2013 PEFA adjustment and implementation of the Annual Cash Plan on a monthly basis has been established based on the template developed with the World Bank technical assistance. Prior action 7: The Ministry of Finance has 2013 PEFA issued an instruction to implement new functions of the Integrated Financial Management Information System to strengthen arrears management by introducing: (i) automatic carryover of arrears; (ii) age profile of all arrears; and (iii) reporting separately the total stock of arrears, arrears accumulation and arrears repayments in monthly budget execution reports. Prior action 8: The Law on Leasing has Doing Business Reports and analytical work been enacted by the President. done as part of preparation for the ongoing IFC- financed West Bank and Gaza Secured Lending Project 21 LINK TO ISN AND OTHER BANK OPERATIONS 62. This operation is aligned with the World Bank Group’s strategic goals of ending extreme poverty and enhancing shared prosperity, as well as the MNA Region’s Framework for Engagement. With the West Bank and Gaza having achieved the elimination of extreme poverty, this operation will contribute to the efforts to boost shared prosperity by supporting reforms aimed at improving governance in the public sector by reducing tax avoidance and broadening the tax base, addressing issues that constrain efficient and effective use of public finances in providing essential citizen services. Fiscal sustainability, efficient and transparent management of public finances should also contribute, along with specific regulatory reforms to improve the business climate, to private sector growth and sustainable job creation. 63. This operation had been envisaged as one of the core operations under the World Bank Group’s FY12-14 Interim Strategy Note (ISN) for West Bank and Gaza discussed by the Board of Executive Directors on April 6, 2012. It has been designed to support both pillars of the ISN: (1) strengthening the institutions of a future state to efficiently manage public finances and ensure services to citizens, and (2) supporting the creation of an enabling environment for private sector-led growth. The ISN specifically notes that “ongoing series of development policy grants will maintain their focus on fiscal management and public financial management.” The operation will directly support the achievement of all three outcomes under the first pillar of the ISN: 1.1. Greater economic stability and transparent financial management; 1.2 Reinforced public administration; 1.3. Public services more responsive to users’ needs. Under outcome 1.1, DPG VI will cover each area of engagement proposed by the ISN: (i) Revenue and expenditure management; (ii) Public financial management; and (iii) Public procurement. In addition, this DPG ventures into the second pillar of the ISN, which supports the creation of an enabling environment for private sector led growth. The preparation of this operation has taken into account lessons from previous development policy grants (Box 2). 64. The operation is directly linked to several World Bank-financed projects and can indirectly benefit most of them. The operation, for instance, directly supports the Public Procurement Reform Support Project. It also supports the Government Services for Business Development and the IFC-supported West Bank and Gaza Secured Lending Project. However, the DPG is also used as an instrument to enhance policy dialogue that is relevant to the Second Land Administration Project and Utilities Management Project. 65. The Bank continues to manage the PRDP-TF, through which donors provide budget support based on the Bank’s monitoring of the PA’s progress in implementing the NDP reform program. The PRDP-TF provides a key mechanism for donor coordination in support of implementing the PA’s NDP. Collaboration with other donors, especially through the Trust Fund, helps focus the dialogue with the authorities on key issues considered critical for reform. This collaboration provides significant weight to common points in the reform agenda and therefore will be maintained and enhanced. 22 Box 2: Summary of Lessons from Previous DPGs Since the establishment of the Trust Fund for Gaza and West Bank (TFGWB) in 1993, a wide range of lessons have been learned, enabling largely successful Bank engagement in a fragile political and security environment. The Bank has been continuously active in the West Bank and Gaza since 1993 and this operation is the sixth DPG since 2008. The preparation of this operation benefited from the lessons identified in the ICRs for previous DPGs and the lessons from implementation experience drawn in the FY12-14 ISN. Several important lessons have been drawn from the ICR for DPG V and earlier DPG ICRs. Below is the summary of some of the main lessons:  Even in a high risk environment, DPGs can be successful if the design adequately takes the risks into account and builds on government ownership of the reform program. Client commitment to the program is a key for success under difficult circumstances. The previous DPGs were firmly embedded in the Government's own medium-term economic program, which is the main reason they were relatively successful in achieving intended development objectives, despite a truly difficult operating environment. Furthermore, these operations were designed with another important objective in mind: to provide indispensable financial assistance to ensure the provision of essential public services.  Even single tranche operations can and should be designed with a medium-term agenda in mind. While it would not be appropriate to design a programmatic DPG series given the high level of uncertainty in the West Bank and Gaza, the DPGs were designed with medium-term objectives in mind and were used as a platform to support dialogue on the medium-term program.  Political economy analysis of potentially controversial reforms should be carried out to minimize the likelihood of slippage.  Technical challenges of implementing specific reforms ought to be taken into account in operation design. CONSULTATIONS AND COLLABORATION WITH DEVELOPMENT PARTNERS 66. The Bank works closely with the IMF and other donors to support the PA’s implementation of the NDP. The IMF team was closely involved in the development of the policy matrices for the Bank’s previous DPGs, as well as for this one. 67. In addition to the IMF, the Bank has collaborated with all donors who provide financial support for the PA’s budget and will continue to do so. As they have done with the earlier DPGs, PRDP TF donors are expected to continue to rely on the DPG VI policy and results matrix as the sole criteria to evaluate the PA’s performance in implementing NDP for the purpose of quarterly disbursements under the PRDP TF. This has proven to be an efficient and effective way to leverage donor support around important structural reforms. Thus, the importance of the DPG program goes significantly above and beyond the operation itself. 68. More broadly, a more formal aid coordination mechanism in the West Bank and Gaza was set up following a decision made at the December 14, 2005 meeting in London of the AHLC. The aim behind this mechanism is to improve the effectiveness of aid coordination structures in providing coherent technical assistance and financial support based on national priorities to the 23 Palestinian people in line with the OECD-DAC Paris Declaration on Aid Effectiveness.27 At the local level, the donor coordination structure comprises the Local Development Forum (LDF), in addition to four strategy groups (SGs), each one supported by roughly five sector working groups. The LDF includes representation from the PA as well as all donor and aid agencies. The four SGs cover the clusters of economic policy, governance, infrastructure, and social development, and are intended to focus on overarching issues such as policy formulation and programmatic coordination. 69. The PA has held wide consultations during the preparation of its new NDP. The Government is consulting various stakeholders in the process of drafting the NDP. Formal consultations are an integral part of the NDP drafting process. Consultations were held with the private sector, civil society, and donors. 5. OTHER DESIGN AND APPRAISAL ISSUES POVERTY AND SOCIAL IMPACT 70. Government actions supported under this operation are not expected to have any negative impact on poor and vulnerable groups in the West Bank and Gaza. For instance, measures aimed at improving tax revenue collection will not increase tax rates (a decrease is being considered) or increase the tax liability of the poor and vulnerable groups. They are aimed at improving the collection efficiency and reducing tax evasion by private enterprises and wealthier individuals.28 Measures aimed at containing government expenditures and improving their efficiency will not cut any benefits to the poor. No negative effects are expected as a result of the measure to limit hiring, as it entails that all vacancies created as a result of retirement, or other eventualities will be filled through new recruitments. 71. Over the medium-term the reforms supported by this operation are expected to translate into augmented fiscal space for essential poverty-reducing programs and improved prospects for employment opportunities in the private sector, which is particularly important for women and youth. Measures aimed at increasing government revenues combined with measures to reduce inefficiencies in public expenditures will increase the fiscal space for essential poverty-reducing expenditure programs. Improved fiscal management is also an important requirement for economic growth and job creation. The measures supported by this operation to strengthen the public procurement process should reduce the procurement costs and thereby increase the fiscal space for essential public services; these reforms should also enhance business opportunities for more domestic companies and consequently support growth and employment of the private sector. This would have a positive poverty and social impact in particular on women and youth, whose participation in the labor market is currently low, but the PA is giving particular emphasis to the creation of employment opportunities for these two social groups in its 2014-2016 NDP. Other PFM reforms supported by this operation are aimed at strengthening public finance management practices, which usually strengthen accountability of public officials, increase efficiency and efficacy of public expenditures, all of which are important determinants of economic growth and development. The prior action in support of the business environment, along with other activities the Government has recently taken, is important for promoting entrepreneurship and sustainable economic growth with significant positive implications for poverty reduction. 27 The AHLC is chaired by Norway and brings together in a meeting on a semi-annual basis several donors as well as the PA and the Government of Israel. The Bank acts as Secretariat to the AHLC, submitting a report prior to every meeting that provides an update on recent economic and fiscal trends, as well as on broader economic and institutional developments in the West Bank and Gaza. The Bank’s report has often helped to set the agenda and frame the discussion at the AHLC meetings. 28 Individuals with gross taxable annual income of less than NIS 50,000, which is significantly above the household poverty line (NIS 27,516) are within the 5 percent tax bracket and with allowances pay a maximum of NIS 1,000 of tax. 24 ENVIRONMENTAL ASPECTS 72. DPG VI will not have significant effects on the country's environment, forests and other natural resources. None of the prior actions have environmental impacts or risks. PFM, DISBURSEMENT AND AUDITING ASPECTS Public Financial Management System 73. According to the 2013 PEFA indicators, the PFM system reveals a more positive picture compared to 2007 assessment. While the PA achieved significant progress during the past years, such as increased transparency and scrutiny, and improved accounting, significant weaknesses in other areas such as budget preparation and execution were also revealed. The DPG VI will be executed through the country’s PFM systems. The PFM system is deemed to be adequate insofar as the Bank’s criteria and standards for development policy operations are concerned. Recent improvements in the PFM system include the following:  A modern legal framework for public procurement has been put in place.  The recent establishment of the macro fiscal unit, which contributes to strengthening the budget process.  Development of an IFMIS which is used in all line ministries and agencies to ensure better integrity and accountability of the PFM system.  Development of broad procedures of control and the development of audit functions (both internal and external).  Introduction of the Chart of Accounts that is consistent with the IMF Government Finance Statistics 2001 manual. 76. The 2013 PEFA was issued in agreement with the PA and other donors. The PEFA provided an updated assessment over the broad spectrum of the PFM system including revenue administration and procurement. It highlighted progress mostly in terms of fiscal transparency, but some systemic issues related to budget preparation and execution were also revealed. 77. Final accounts for the FY 2010 were audited by the State Audit and Administrative Control Bureau (SAACB) though with notable delay. They were published on the SAACB website on March 18, 2013. The SAACB issued a qualified opinion on the financial statements that need to be addressed. Such qualifications included but are not limited to:  Non completion and inaccuracies in the bank reconciliations of the Petroleum Authority;  Closing balance 2009 not correctly rolled forward to 2010;  Absence of an accounting policy on how to present and calculate arrears;  Inaccuracies and weaknesses in disclosing public debt figures;  Non-compliance with International Public Sector Accounting Standards (IPSAS) for losses/gains from exchange rate variations;  Inconsistencies and changes in budget classification. 78. The Bank has helped the PA address these weaknesses by launching two technical assistance activities in 2013, including: 25 i) Assistance for improving the institutional and administrative framework within which the financial statements are to be prepared in compliance with IPSAS. ii) Assistance to improve the accounting and presentation of arrears as well as improving the IFMIS accordingly. 79. In addition, the Bank is planning, jointly with the UK Aid, to work with the Ministry of Finance on improving the accounting manual currently used for preparing the financial statements. 80. However, more improvements need to be adopted to further consolidate progress and address the challenges facing the PFM systems. As part of the NDP process, a PFM strategy was developed by the PA. Key elements of the strategy with respect to fiduciary control include:  Improvements in expenditure planning and control in budget execution.  Cash management improvements by strengthening cash forecasting and improving the link with the commitment control system as a means of reducing arrears.  Strengthening accounting and reporting by fully adopting IPSAS, and by increasing budget transparency.  Enhancing the legal framework of the SAACB that supports its audit responsibilities.  Building capacities for financial management at both the MoF and line ministries, given the objective of devolving more financial management responsibility from MoF to line ministries. 81. The fiduciary risk related to this operation is considered to be high. From June 2013 onwards, the monthly fiscal reports started showing a growing unexplained residual, which was then largely reversed in December. The sources of both the emergence and the reversal of this residual are not yet fully understood. Furthermore, the end-of-year budget execution/fiscal accounts involve a large discrepancy with the banking statistics compiled by the PMA. The PA has sought international expertise to clarify the situation, and has been working closely with the Bank and the IMF on this matter. The uncertainty regarding the causes of the residual and net domestic financing discrepancies, taken together with the significant delay in the production of audited annual accounts and a number of qualifications by the SAACB on the 2010 government financial statements, makes the fiduciary risk associated with general budget support disbursements high. The Bank will continue to monitor and work with the MOF on key measures to strengthen fiscal reporting and on a documented reconciliation of the discrepancies related to the 2013 accounts.29 Disbursement 82. Once the Grant becomes effective, the PA will submit to the Bank a withdrawal application to receive the funds in a single tranche. The Grant proceeds will be disbursed against satisfactory implementation of the development policy program. Upon effectiveness, the Grant proceeds will be disbursed in a single tranche to a US Dollar Dedicated Account (DA) that forms part of the PA’s official foreign exchange reserves. In the absence of a Palestinian central bank, the dedicated account will be held at the Bank of Palestine (Ramallah). 83. The PA will confirm to the Bank within 30 days of disbursement the receipt of the Grant funds and that the Grant proceeds have been credited to the Central Treasury Account to finance expenditures under the national budget management system, including the date and number of the 29 See Annex 3 for further details on the PFM environment. 26 Treasury Account into which the funds have been deposited as well as the exchange rate applied. If any portion of the credit is used to finance ineligible expenditures as defined in the Grant Agreement, the Bank shall require the PA to refund the ineligible amount. Flow of Funds Arrangements for DPG VI Grant proceeds to USD Expenditure on MoF Central Treasury Dedicated Account eligible budget Account activities Management of Foreign Exchange 84. Due to the fact that there is no Central Bank in the West Bank and Gaza, the foreign currency management is carried out through the MoF. DPG proceeds will be deposited into the Central Treasury Account held at the Bank of Palestine. The Bank of Palestine’s financial statements for the year ended December 31, 2012 were audited by Ernst and Young. The auditor expressed an unqualified opinion. The annual audit report and semi-annual reports for 2012 are published on the Bank of Palestine’s website. External Auditing of the Grant Dedicated Account 85. The PA will hire an independent external auditor acceptable to the Bank to perform an audit of the DPG VI dedicated account. The audit will be conducted in accordance with International Standards on Auditing, and with terms of reference acceptable to the Bank. The audit report will be approved and signed by the MoF before it is submitted to the Bank. The audit report will be submitted to the Bank within six months of the release of the single tranche. The external audit fees will not be financed from the Grant funds. 86. For DPG V, the MoF submitted an acceptable external audit report in a timely manner , and the external auditor expressed an unqualified “clean” opinion on the related dedicated account, and the management letter did not include significant weaknesses in the PA’s internal control system related to the banking controls over DPG disbursement. 87. In general, the auditor will be required to:  Validate the transfer and deposit transactions relating to the DPG VI.  Verify the extent to which the Bank’s requirements under the DPG VI agreement are being met, and whether the PA’s procedures are adequate to achieve this result.  Verify that no funds are kept in or paid into the Dedicated Account other than those disbursed by the Bank for this particular operation.  Ensure that the MoF follows adequate disbursement procedures as per PA and government standards, including accuracy of the exchange rate prevailing at the date of conversion from US Dollar to New Israeli Shekel and deposit to the Treasury Single Account within one week of the receipt of funds in the Dedicated Account. 27 IMPLEMENTATION, MONITORING AND EVALUATION 88. The design of the M&E arrangements built upon those developed under the earlier development policy grants. The results framework of the DPG was agreed with the authorities and developed in consultation with other development partners. As has been the practice, the results framework was developed not only to monitor progress under the DPG, but also to monitor the implementation of the Multi-Donor Trust Fund (a major source for donor funding to the budget) aligned with the NDP. Since both the DPG and the PRDP TF support the implementation of selected key objectives of the PA’s strategy and aim to provide stable and predictable financial support to the PA budget, a shared results framework has provided additional leverage to reform implementation. The indicators used were direct measures of project objectives, the data was collected by the statistics agency, MOF and line ministries, and enjoyed full ownership across the Government. 89. The monitoring arrangements have been institutionalized in the Palestinian Ministry of Finance. Based on the inputs from line ministries and other government agencies, the PA prepares quarterly reports on a regular basis to monitor the performance under both the DPG and the PRDP TF. The same arrangement is utilized to monitor progress against the PA’s medium term program. These reports are placed on the website of the Ministry of Finance. The monitoring arrangements developed in the context of DPGs and PRDP TF have not only been used for the purposes of those operations, but there is evidence that these arrangements have contributed to building stronger institutional arrangements for monitoring PA’s broader reform efforts. 6. SUMMARY OF RISKS 90. The implementation of the Government’s reform program under the NDP and likewise this operation which is designed to support it are exposed to multiple and significant risks. These risks are primarily related to the internal political situation in the West Bank and Gaza, as well as the actions of the GoI and the donor community. The overall risk is rated high. 91. The key risks are i. The political and security situation in the West Bank and Gaza is very fragile, as demonstrated by the very recent outbreak of conflict in Gaza, which remarkably increased the level of uncertainty pertaining to the economic and political situation. The recent social unrest and civil servants’ strikes also attest to the fragility of the political situation. The highly volatile political situation could deteriorate, with the consequence of stalled reforms. If the security situation relapses, private sector confidence and investment will decline, public revenues will fall and government reforms may stall. The PA will probably not be able to meet its medium term fiscal goals without substantial economic growth. However, under the recent political uncertainties, the relaxation of movement and access restrictions imposed by GoI in both Gaza and West Bank and restrictions on economic activity in Area C has slowed down. The international donor community is continuing to monitor the closure system and its economic impact. What is critical at this juncture is that the PA has continued to implement structural reforms despite the highly difficult economic environment and fiscal pressures and remains committed to continued reforms. ii. Possible reduction in the level and predictability of donor assistance poses significant risks to the PA’s fiscal position and growth. While the PA has chartered a course toward lesser dependence on external aid and is actively undertaking the relevant reforms, it will take many years for the PA to achieve fiscal sustainability and that will only be possible if there is a political settlement that allows for strong private sector-led growth. Thus, a further reduction in the overall level of donor assistance or its regularity is a significant source of risk to PA’s finances and the Palestinian economy as a whole. 28 iii. The fiduciary risks are also high, as discussed in Section 5 above. Risk Mitigation 92. The operation was designed to minimize the likelihood and the potential impact of some of the above-mentioned risks. However, it cannot fully mitigate them. This proposed sixth DPG sends a strong signal to donors that the World Bank places great importance on progress in implementing the NDP and a signal that donors should continue to support it. Most importantly, the operation leverages around US$200 million per year in additional resources through the PRDP Trust Fund, which the Bank administers. This will mitigate the risk of reduced donor assistance on PA’s finances. A simple design of this operation and strong PA ownership of the reform program supported by this operation, which contributes to fiscal consolidation and reduced reliance on donor assistance over the medium term, are also mitigating factors. On balance, the potential benefits of the operation justify the Bank’s engagement despite the significant risks identified above. 29 Annex 1: Letter of Development Policy Dr. Jim Yong Kim President International Development Association 1818 H street N.W Washington, D C. 20433 April l7 1h, 20 14 Subject: LETTER OF DEVELOPMENT POLICY Dear President Kim, As a result of robust economic grov.rth in previous years, coupled with significant improvement in the quality and functioning of Palestine Governmental institutions, the living conditions and the security situation have significantly improved in the Palestinian territories. Despite that, in 2013 the rate of grov.rth is estimated to have dropped substantially from roughly 6 percent in 2012 to 1.5 percent. This slowdown can be attributed to the uncertainty caused by the Palestinian Government fiscal hardship, the absence of any political horizon as well as the continuing Israeli restrictions on trade, access and movement. Despite the impressive growth attained in Palestine over the period (2008-20 II), recent indicators reveal that this grov.rth was unsustainable, since it was mainly driven by large fiscal deficits financed externally. Furthermore, external assistance for recurrent budgetary expenditures has significantly declined in recent years since its peak in 2008. The Palestinian Government has conducted impressive fi scal adjustment efforts in response to increase revenues and rationalize expenditures, but this has not been enough to offset the decline in aid which has led to a slowdown in economic growth. Indeed, the various reports that were submitted by the World Bank and the IMF in the last AHLC meeting held in New York in September 2013 suggest that the economic benefits from reforms alone have already reached their potential. Despite our fi scal 30 consolidation efforts, reaching fiscal sustainability is impossible as long as the Palestinian economy is constrained by Israeli measures and actions. We believe that sustainable economic growth that will help end the financial difficulties can only be achieved through boosting the Palestinian private sector, which requires removing Israeli restrictions on access and movement, especially access to land and natural resources. In addition, we affirm our right to access to so- called "Area C", which will enable us to benefit from its economic potential. Sustaining economic growth in Palestine also requires lifting the blockade on Gaza and allowing movement of goods between Gaza and the West Bank. It is also essential to restore full trade linkages between the West Bank and East Jerusalem and to also allow for the development of East Jerusalem institutions and businesses. Despite the ongoing difficulties, we have continued our efforts of institution building and maintained the pace of our reform agenda. We have continued working on achieving our development priorities for 20 13 as part of the National Development Plan 2011-2013. We have been working with the World Bank and the IMF to move forward the reform process in public finance, public financial management and the social safety net. When the economic environment and reform climate improve, we will resume parametric reforms in the pension system, as had been agreed with the World Bank. Public Finance 2013 The fiscal situation in 2013 was challenging despite strong expenditure controls and increased donor aid in comparison to 2012. Revenues were below their budget target due to slower than expected growth particularly in the WB where the majority of revenues are generated. However it is important to note that revenue performance was highly impressive in comparison to previous years. The recurrent budget deficit was 28 percent above the target, amounting to NIS4.99 billion. The Government also reported development expenditures of NIS674 million in 2013 and therefore, the overall deficit totaled NIS5.66 billion. Total external financing received amounted to NIS4. 92 billion and was NIS 746 million short of what was needed to cover the overall deficit. Therefore the Government resorted to accumulating arrears to finance the gap in 2013. This in addition to a large stock of arrears carried over from 2011 and 2012 further exacerbated the Government' s fiscal situation. - Revenue Collection: Gross revenues in 2013 amounted to NIS 9.18 billion, an increase of 9% over 2012, while Total net revenues reached NIS 8.35 billion in 2013 , a 4% increase over 2012. Domestic tax revenues reached NIS 2.16 billion in 2013, a 16% increase over the year 2012. Clearance revenues, which account for two thirds of the Government revenues, amounted to NIS 6.1 billion in 2013, an increase of 9% over the year 2012 . Revenue performance was highly impressive given thanhe estimation of the nominal growth rate in the West Bank in 2013 is 3.2%. This is mainly due to the efforts of 2 31 MoF to increase compliance and settling of some large files -Total expenditures and net lending: During the full year of2013, total expenditure and net lending reached NIS 13.34 billion, a 2% decline over the year 2012. This decline reflects the Government's efforts to limit the growth in the wage bill and rationalize public expenditure. There has been an effective freeze on net hiring in the Government, in addition to a limited increase in the wage bill by 2%. Use of goods and services amounted to NIS 1816.5 million in 2013, a 14% decline over the year 2012. Use of goods and services reached 95% of its budget target, falling short by NIS 89.5. Also, net lending declined in 2013 when compared to 2012, due to the non-recurring unilateral deductions of clearance revenue in 20 12 by Israel to repay outstanding debt to IEC Institutional and administrative reforms: -Wage bill We have been quite successful in reducing the size of the wage bill (as a share of GDP) in recent years. Furthermore, the Government placed a freeze on salary payments for all employees who reside abroad for non-work related reasons. The Government has also discontinued paying transportation and supervision allowances for stay at home staff. However, we realize that close to 17 percent of GDP, the wage bill is still quite high by international comparison and that further reduction is necessary to render it sustainable. This, however, cannot he accomplished quickly without having to incur undesirable social, poverty, and political impacts. As a result of the planned measures, we expect the wage bill to drop by another half a percentage point of GDP in 2014. Further substantial reductions will require a more conducive business environment that allows for growth and job creation in the tradable sector of the economy; this largely hinges on the removal of restrictions on economic activity by Israel. Waiting for these requisites to materialize, we are taking steps to prepare a comprehensive civil service reform- All government units were instructed to prepare job classifications in 2012. In the FY 2013 budget, job classifications were used as the basis for wage bill allocation to different units of government. The preparation of job classifications is also a necessary precondition to carry out effective functional reviews and conduct a pay and grading reform, which we plan to conduct as soon as the above conditions materialize. -Revenues As part of a long-term strategy for the modernization of revenue administration, in February 2013 the Government began to implement a three-year Revenue Action Plan (RAP). The RAP aims to expand the tax base and improve compliance by establishing a fully integrated revenue administration of income tax, VAT, customs, and other direct and indirect taxes. The RAP set nine priorities: (i) train staff; (ii) update laws and regulations; (iii) adopt a new computerized taxpayer system (Revenue Management 3 32 System, RMS); (iv) implement a taxpayer awareness program;(v) adopt integrated revenue administration and a matching functional organization; (vi) reform the Large Taxpayer Unit (LTU); (vii) initiate taxpayer identification and registration units; (viii) improve taxpayer services; and (ix) initiate a taxpayer investigations program. The efforts are moving on a broad front: Amendments to the investment promotion law have been adopted by the cabinet reducing tax incentives for new investments, limiting them to fewer sectors and limiting their duration. Also amendments to income tax law were adopted by the Cabinet introducing a 10 percent tax on distributed dividends .. For now, the focus is on running the RMS productively. Other areas will come online as resources and the timing dictate. These areas include awareness campaign for the staff, one-stop shop, taxpayer awareness, self-assessment, audits, and appeals processes. The RMS Phase I module went live in August 2013.In early 2014, the previously used Israeli Tax Authority information system was switched off as data was fully migrated to the new RMS. The Phase II modules (registration, collections, audits, appeals) continue to be constructed. A Tax Procedures Code has been drafted and is under review by the Finance Minister. - Net Lending Net lending, primarily the result of our municipalities and electricity distribution companies-not paying electricity bills fully to the Israeli electricity company has been a substantial source of fiscal pressure in recent years. In addition, Israel has been deducting their debt from clearance revenues which it collects on behalf of the Palestinian Treasury. We are taking a number of measures to address this problem. Financial and technical performance targets have been set by the Palestinian Electricity Regulation Committee (PERC) for West Bank electricity distribution companies. PERC continued its extensive consultation with several municipalities to join NEDCO. The MOF has started working with local goverrunent officials to increase the collection rate in the West Bank to 90%. To achieve this target, MoF has taken the following measures The Palestinian Cabinet has recently passed a decision that obliges electricity providers in WB&G to pay their bills in a timely manner to the Israel Electricity Company, as otherwise they will be heavily penalized. This decision will lead to a significant decline in net lending. In addition, the Govenunent has recently established the Palestinian Electricity Transmission company (PETL) which will be in charge of establishing a modern transmission infrastructure and improving the existing network in order to reduce the volume of technical losses. PETL will also manage purchase agreements with electricity suppliers in an aim to reduce import prices. -Public Financial Management MoF has achieved further progress in 2013 regarding the implementation ofthe financial accounting system and reporting. Transparency is being further enhanced by publishing 4 33 an additional table detailing expenditure on development projects and sources of financing on the MoF web site. Details of development expenditures are now published quarterly along with the fiscal tables. The MOF made available for the first time descriptions of the projects. Budget transparency was further enhanced in 2013, as a breakdown of transfer spending into major subcategories was also published. Furthermore, the Public Expenditure and Financial Assessment (PEFA) exercise that was conducted with the assistance of the World Bank in 2013 has enabled us to measure the success of recent public finance reforms, as well as to determine forward looking reform priorities. Moreover, to enhance our capability to manage an unprecedented shortage of liquidity, we have been working with the World Bank to develop an effective cash management system. In 2014, the MoF has started the practice of developing a monthly cash plan. Internal audit has been strengthened by the State audit and Administrative Control Bureau. Mof financial statements have been audited by the Bureau and we are moving to improve the timeliness of these completions to ensure that they are achjeved within six months of year end. The Budget process has been further refined by adopting the GFS classification and by gradually implementing program budgeting. - Social safety net The Government has promoted reforms in the social sphere by better targeting social assistance. This included a full updating of its database to support a more transparent and objective identification of beneficiaries. The Government has also initiated a process of merging the various ongoing cash assistance programs using the Ministry of Social Affairs (MOSA) poverty targeting database as the main mechanism for streamlining the cash assistance program across the various donor institutions (EU, and UN organizations). It has been graduating households, whose income exceeds the target threshold in both Gaza and the West Bank. Since the beginning of 2013, MOSA has started applying a proxy means test formula to determine the eligibility of vulnerable households to receive assistance - Public Procurement In 2013, our effort continued to achieve further reform in public procurement after the enactment of a Public Procurement Law in July 201\.The implementing regulations to the Public Procurement Law were finalized and submitted to the cabinet along with some modifications to the procurement law and the organization structure of the high Council for Public Procurement Policies to be adopted by the cabinet. With the assistance of the World Bank, A consultant has been hired to work on the Development of National Standard Bidding Documents (SBDs) for Goods and Works, RFP for Consultants' Services, Development of Procurement Operations Manual of Procedures Covering the Entire Procurement Cycle, Training of Stakeholders on SBDs and Procurement Operation Manual. · 5 34 Despite the difficult situation we are facing, the PNA is determined to move forward on the institutional reforms mentioned above. The World Bank has been assisting us both financially and though the provision of technical assistance. We are grateful for its continuing support and we are fully committed to maintaining this cooperation and achieving all the objectives we have prescribed in our reform efforts. We kindly request that the World Bank provides us with a sixth development Policy Grant of$ 40 million to assist the Government in progressing in this reform agenda. Sincerely, d.P . ;t. 1-1~ Rami Hamdallah Prime Minister 6 35 Annex 2: Policy and Results Matrix EXPECTED RESULTS PRIOR ACTIONS Baseline Target Indicator (2013) (2014) Objective I. Reducing PA’s Recurrent Fiscal Deficit  The Cabinet of Ministers has approved draft amendments to the Investment Promotion Law aimed at broadening the tax base by reducing the scope of tax incentives for new investments and limiting their Gross domestic tax duration. Domestic tax revenue from NIS 2,196 million, or 5 revenues have increased in VAT, customs and income taxes percent of GDP nominal NIS terms by 8 in nominal terms and as a percent and by at least 0.1 percentage of GDP percentage point of GDP  The Cabinet of Ministers has between 2013 and 2014. approved draft amendments to the Income Tax Law introducing 10 percent tax on distributed dividends. The central government wage NIS 6,927 million in 2013, The 2014 central  No increase in the number of civil bill in nominal terms and as or 16.7 percent of GDP government nominal wage and security personnel of the percentage of GDP bill growth has not Palestinian Authority has been exceeded 4.9 percent (in provided for in the 2014 Budget of NIS terms) and is at least the Palestinian Authority for the 0.2 percentage points of 36 calendar year of 2014. GDP lower in 2014 compared with 2013.  The Recipient has discontinued the practice of paying transportation and supervision allowances for stay- at-home staff of the Palestinian Authority. Objective II. Improving Effectiveness and Transparency of Public Finances  The Public Procurement Law of the Use of standard bidding Standard bidding (i) The use of National Recipient has been amended in documents and publication of documents in line with the Standard Bidding order to refine, fill gaps, eliminate procurement-related information new PPL have not been Documents in public inconsistencies and further on a single portal website for adopted. Access to procurement has started. elaborate the provisions of the Law public procurement procurement information is (ii) Posting of procurement on institutional and procedural limited. plans, notices and award matters, and the Cabinet of decisions by all procuring Ministers has adopted the entities on a single portal Regulations for the implementation procurement website has of the amended Law. started.  The practice of the adjustment and PEFA indicator 16(i) on cash Current Score (2013 PEFA) Improved PEFA Score on implementation of the Annual Cash flow planning and monitoring is D (very poor quality, cash flow planning and Plan on a monthly basis has been cash flow planning and monitoring established based on the template monitoring are not developed with the World Bank undertaken) technical assistance.  The Ministry of Finance has issued PEFA indicator 4(ii) on access to Current Score (2013 PEFA) Improved PEFA Score on an instruction to implement new reliable information on arrears is D access to reliable functions of the Integrated information on arrears Financial Management Information System to strengthen arrears 37 management by introducing: (i) automatic carryover of arrears; (ii) age profile of all arrears; and (iii) reporting separately the total stock of arrears, arrears accumulation and arrears repayments in monthly budget execution reports. Objective III. Improving Business Climate  The Law on Leasing has been Value of leasing contracts in USD USD 7,674,000 at the end Total real value of leasing enacted by the President. of 2013 (in 198 contracts) contracts is higher at the end of 2014 compared to end 2013. 38 Annex 3: Public Financial Management and Fiduciary Aspects The proposed DPG will be executed through the PA’s public financial management (PFM) systems. In order to assess the fiduciary risks with respect to the proceeds of this operation, this annex summarizes the current state of certain aspects of these systems as well as ongoing reform efforts for further enhancement. The Palestinian PFM system is considered to be reasonably adequate as far as the Bank’s criteria and standards for development policy operations are concerned. The following description of ongoing reform activities provides a more detailed assessment of certain aspects of PFM reforms in the West Bank and Gaza. State Audit and Administrative Control Bureau The State Audit and Administrative Control Bureau (SAACB) is the Palestinian supreme audit institution responsible for independent oversight and external audit over public sector bodies in accordance with provisions of PA law. The organization in its current form was established in 2004. The SAACB has issued its opinion on the financial statements of the Palestinian Authority (PA) since 2008, the latest covering the year ended December 31, 2010. According to the 2013 PEFA report with regard to the “scope, nature and follow up of external audit”, namely, high -level indicator PI-26, the three dimensions of the indicator are rated at B or C levels (on an A-D scale basis). The audit of the FY 2011 financial statements has not commenced yet. According to the law, Ministry of Finance should produce Consolidated Financial Statements within a year of the end of the fiscal year. However, Ministry of Finance and the SAACB are striving to finalize the audit of the financial statements in a period of six months after the end of each fiscal year. SAACB has completed the audit of the FY 2010 financial statements and issued a qualified audit opinion on the PA financial statements as well as on PA compliance with applicable laws and regulations for the year ended December 31, 2010. The SAACB identified significant issues in the PFM system that should be further addressed by the PA. Going forward, there are several issues affecting the SAACB operating environment that need to be addressed, such as:  Independence: Although SAACB is legally independent, it is beholden to the MoF for funding in a challenging fiscal environment. A Legal Drafting Working Group was established in July 2011 to develop a draft law in accordance with INTOSAI Standards and Palestinian legislative/drafting norms. A compliant law was produced in June 2012. A number of issues raised by the SAACB Legal directorates led to changes in the draft law not consistent with INTOSAI. Such issues were resolved during 2013 and the new draft law is expected to be submitted to the PA President for endorsement in the nearest future.  Staffing and administrative issues: SAACB has approximately 150 staff. SAACB staff is part of the civil service and thus their salaries are paid centrally from the MoF. SAACB is working on hiring and enhancing its staff capacity, as well as conducting the required audit to meet its mandate. Also, in Gaza there are 50 auditors who cannot perform their duties due to political reasons30. These human resources and administrative issues are being addressed through a review of the civil service law and work on position structures for all PA institutions.  Mandate and scope of work: The SAACB has a broad mandate under the law; it is mandated to carry out ex-post audits for all the PA organizations. SAACB’s mandate includes conducting external audit assignments of institutions at the levels of central government, local government, 30 This information was confirmed by the SAACB President during the PEFA mission in May 2013. 39 and non-governmental organizations. Also, it is mandated to monitor financial and administrative performance and to identify financial and administrative irregularities, including fraud and corruption. Financial Controllers A key component in the MoF internal control framework is the function of the financial controller. This is the traditional ex-ante model (pre-audit) used by governments. The current MoF financial controller mandate requires each financial controller at the respective line ministry to review and clear all transactions, including those relating to Bank-financed projects, before they are processed for payment. Financial controllers are appointed by the Accountant General and are decentralized and housed in line ministries. The financial control function is not driven by a risk-based approach and lacks adequate guidelines and procedures. Currently, there is no clear step in IFMIS to enter and record budget commitments. There is a step called ‘budget credit reservation” but it is not ma ndatory and is not controlled by the financial controller. As a result, the system can generate arrears if there is no cash available to process the disbursement at the time the expenditure is made. Internal Audit The Internal Audit Department (IAD) was created in 2004 within the MoF with the dual mandate of performing the central internal audit, and decentralizing the internal audit function from the MoF to line ministries. The scope of the Internal Audit Function across the Palestinian National Authority (PNA) is governed by regulation No. 11/2011 (the Charter) issued in August 2011, which clarifies roles and responsibilities of the IAD as well as reporting requirements. A Central Harmonization Unit (CHU) was also established within the MoF. According to the law, the CHU is responsible for setting and updating the internal audit methodology as well as providing advice to the internal audit units in line ministries. The CHU also supervises the decentralization transition process and reports to the Internal Audit Committee. The IAD adopted the International Internal Auditing Standards (published by the Institute of Internal Auditors) that were customized to meet the country context. In practice, the internal audit and the CHU are not yet fully operational and decentralized due to capacity and financing constraints. The Bank is discussing with MoF ways to develop the status of the internal audit function, the links to the Bank-supported portfolio, and opportunities for involvement and cooperation. Accounting and Reporting The fiscal year of the PA is January 1st to December 31st. The financial statements of the PA are prepared in accordance with cash basis IPSAS standards. However, IPSAS have not been completely applied, as noted by the SAACB in its 2010 qualified opinion. The financial statements do not adhere to several standards detailed in the cash basis IPSAS and lack certain information and/or explanations. Since the IFMIS is the only source of information for financial reporting, financial information produced in the reports is considered to be largely accurate. Monthly bank reconciliations are performed at the level of line ministries and are submitted to the MoF in a timely manner. Each line ministry has a zero balance account opened by the MoF as part of the Single Treasury Account. Reconciliations on revenues are performed at the MoF. 40 Implementation of Integrated Financial Management System The IFMIS has been rolled out to all line ministries and is considered the official country system to account for public financial resources. Transactions are entered by the line ministries with approval for the transaction by Financial Controllers who are decentralized to all line ministries. IFMIS modalities have been updated which has led to improvements in terms of consolidation of the financial statements, quality of financial reports and the orderly exchanges between line ministries and the MoF. The IFMIS has controls for payments against cash ceilings but it is not used to prevent arrears from being accumulated. The IFMIS also has a commitment module but this module is generally not used. Single Treasury System and Bank Funded Projects The PA budget preparation and execution process has been supported by IFMIS since 2009. All tax revenue is paid directly into the treasury account, and most operational payments and transfer expenditures are executed by line ministries in a devolved Treasury model. Reconciliation between the Treasury subaccount and payment is made on a daily basis. There are three main Treasury Accounts: (i) Clearance Revenue Account; (ii) a Donor Fund Account; and (iii) an account catering to domestic revenues and expenditures. Each TA has subaccounts which are consolidated each day to ensure zero balances in the subaccounts. All accounts are managed online and a daily cash report is produced. Currently, World Bank funds as well as all donor funds are not channeled through the Treasury Account but rather through separate designated accounts held at the Bank of Palestine (Ramallah) for funds receipts and disbursements. Anti-Corruption Overview A 2011 World Bank study summarizes the progress made and challenges ahead in this area as follows: First, the PA has made significant strides to improve economic governance over the past decade. Second, reform efforts have achieved varying degrees of success and the PA needs to prioritize and address the ongoing challenges. Finally, the PA should take a more proactive approach to investigating and prosecuting corruption, as well as communicating its anti-corruption activities to build public confidence in government accountability.31 The report indicates some positive actions that have been implemented recently. There is now an anti- corruption law and a fairly new Anti-Corruption agency. These two developments will need some time to have an impact on the corruption perception. Another positive note is that civil society organizations and media play a very important role. This is critical in addressing corruption issues. Conclusion In recent years, the PA has made significant progress in reforming PFM. Significant work has been done towards implementing international good practices, and there is broad agreement between the PA and the international development community to continue to pursue these efforts. This progress includes, but is not limited to:  A modern legal framework for public procurement has been put in place.  The recent establishment of the macro fiscal unit, which contributes to strengthening the budget process. 31 Improving Governance and Reducing Corruption in West Bank and Gaza, the World Bank, May 2011. 41  Development of an IFMIS which is used in all line ministries and agencies to ensure better integrity and accountability of the PFM system.  Development of broad procedures of control and the development of audit functions (both internal and external).  Introduction of the Chart of Accounts that is consistent with the IMF Government Finance Statistics 2001 manual. A strategic PFM reform approach could build on the strengths of the current PFM system by using improved IFMIS functionalities, existing control/audit capacities and learning from the experience accumulated from the ongoing reforms. 42