Report No. 36453-AL Albania Restructuring Public Expenditure to Sustain Growth A Public Expenditure and Institutional Review (In Two Volumes) Volume I: Overview and Policy Options December 2006 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank SSA Supreme State Audit VAT Value-Added Tax SST Social Security Tax WB World Bank UNDP United Nations Development Program WDI World DevelopmentIndicators us United States WHO World Health Organization Vice President: Shigeo Katsu, ECAVP Country Director: Orsalia Kalantzopoulos, ECCU4 Sector Director: Cheryl Gray, ECSPE Sector Manager: Bernard Funck, ECSPE Task Team Leaders: Alia Moubayed, ECSPE I CONTENTS ACKNOWLEDGMENTS EXECUTIVE SUMMARY ......................................................................................................................................... i A . INTRODUCTION ..................................................................................................................................................... 1 B. TRENDS IN GROWTH AND POVERTY REDUCTION .................................................................................................. 1 c . SIZE AND RESOURCING OF GOVERNMENT ............................................................................................................ 3 D. SUSTAINABILITY AND EFFICIENCY OF PUBLIC SPENDING ...................................................................................... 4 E. OVERARCHINGPUBLIC EXPENDITURE STRATEGY ................................................................................................ 7 F. REFORMING SECTORAL PROGRAMS .................................................................................................................... 11 F.l EDUCATION ....................................................................................................................................................... 12 F.2 HEALTH ............................................................................................................................................................ 14 F.3 SOCIAL PROTECTION......................................................................................................................................... 16 F.4 WATER .............................................................................................................................................................. 20 F.5 TRANSPORT ....................................................................................................................................................... 22 F.6 POWER .............................................................................................................................................................. 25 G. INSTITUTIONAL FRAMEWORK FOR PUBLIC SPENDING AND GOVERNANCE ......................................................... 27 G.l PUBLIC FINANCIAL MANAGEMENT .................................................................................................................. 28 G.2 MANAGING PUBLIC INVESTMENT ..................................................................................................................... 30 G.3 GOVERNMENT EMPLOYMENT ........................................................................................................................... 32 FIGURES FIGURE 1. DECOMPOSITION OF CHANGE I N POVERTY 2002-05 ...................................................................................... 2 FIGURE 2 . TAX REVENUE AND GDP PER CAPITA ........................................................................................................... 3 FIGURE3 . OVERALL AND PRIMARY FISCAL DEFICIT,1993-2005................................................................................... 4 FIGURE 4 . LORENZ CURVE OF PUBLIC SECTOR SPENDING ON HEALTH AND REGIONAL POVERTY INCIDENCE ............. 10 FIGURE 5 . ALBANIA WATER INVESTMENTS AND RUNNING WATER INSIDE THE DWELLING, 2002-05 ......................... 10 FIGURE6 . ALBANIA WATER INVESTMENTS AND ACCESS TO PIPED SANITATION, 2001 AND 200245 ......................... 10 FIGURE 7 . GROSS ENROLMENT RATE AND GDP PER CAPITA: ...................................................................................... 12 FIGURE 8 . ENROLMENT PROJECTION FOR GRADES1-8, 2004-15 ................................................................................. 12 FIGURE9. ENROLMENT PROJECTION FOR GRADES 9-12, 2004-15 .............................................................................. 12 FIGURE10. DISTRIBUTION OF SUBSIDIES AMONG RECIPIENTS ..................................................................................... 13 FIGURE 1. TOTAL (LEFT) AND PUBLIC (RIGHT) SPENDING ON HEALTH CARE AND PER CAPITA INCOME. 2005 ..........14 FIGURE 2 . RECURRENT EXPENDITURE ON HEALTH AND POVERTY HEADCOUNT BY REGION, 2004 ........................... 15 FIGURE 3 . PENSION CONTRIBUTIONS (% OFPA~ROLL) ................................................................................................ 17 FIGURE 4 . SYSTEM DEPENDENCY (%) ........................................................................................................................ 17 FIGURE 5 . ALBANIAN PENSIONS RELATIVE TO AVERAGE WAGE UNDER DIFFERENT INDEXATION SCENARIOS ......... 18 FIGURE 6 . RATIOS OF NON-REVENUE WATER (%) . . ..................................................................................................... 20 FIGURE17. STAFF NUMBERS PER 1. 000 CONNECTIONS ............................................................................................... 20 FIGURE18. FINANCING OPERATING COSTS THROUGH TARIFFS AND GOA SUBSIDY (LEKMILLION) ............................ 21 FIGURE19. STATUS OF ROAD CONDITIONS .................................................................................................................. 23 FIGURE 20 . W F I C DEATHS PER 10,000 VEHICLES, 2002 (UNLESSINDICATED OTHERWISE) ....................................... 23 FIGURE21. COLLECTION BY TYPE OF CONSUMERS (% OF BILLED)INCLUDING ARREARS ........................................... 26 FIGURE22 . ELECTRICITY:TOTAL LOSS % OF DOMESTIC SUPPLY ................................................................................ 26 TABLES TABLE1. SIZE AND DISTRIBUTION OF FISCALADJUSTMENT. 1993-2005 (CHANGEIN % GDP) ..................................... 4 TABLE2 . GENERAL GOVERNMENT SPENDING. ECONOMICCLASSIFICATION. AVERAGE 1995-2004 (% GDP) ..............5 TABLE3 . GENERALGOVERNMENT SPENDING. FUNCTIONAL CLASSIFICATION. 2004 (% GDP) ..................................... 8 TABLE4 . TOTAL UNIT COSTS B Y LEVEL OF EDUCATION.ALBANIA AND EU-15 AND EU-8 RELATIVE TO PRIMARY EDUCATION........................................................................................................................................................... 9 TABLE5 . POVERTY IMPACT AND ADEQUACY OF INDIVIDUAL SOCIAL PROTECTION PROGRAMS, 2005 ........................ 16 TABLE6 . NDIHME EKONOMIKE: DISTRIBUTION, COVERAGE, AND ADEQUACY (% OFHH) ......................................... 19 TABLE7 . POTENTIAL (ANNUAL) SAVINGS FROM ELIMINATING “HIDDEN COSTS” ....................................................... 21 TABLE8 . PROFIT AND LOSS ACCOUNTS HSH, 2000-05 (LEK 000) .............................................................................. 24 TABLE9. ALBANIA:SELECTED ECONOMIC INDICATORS .............................................................................................. 35 ACKNOWLEDGMENTS This report i s based on research and missions conducted by a World Bank team working in Albania during 2005 and the spring o f 2006 and covers developments prior to this period. The team wishes to thank the Albanian Government for the cooperation of i t s senior officials in the Prime Minister’s Office, Ministry o f Finance (MoF), Ministry o f Health (MoH), Ministry of Education and Science, Ministry of Labor and Social Affairs (MoLSA), Ministry o f Public Works, Transport and Telecommunications, Ministry o f Interior, Department o f Public Administration (DoPA), Health Insurance Institute, Social Insurance Institute, and KESH. Special thanks are reserved for Bernard Funck who provided continuous support, guidance and technical advice. The principal author o f the report i s Alia Moubayed (Task Team Leader), supported by Camille Nuamah, Sanjay Kathuria, Anna Gueorguieva and Nand Shani, drawing from background papers and contributions prepared by a team composed o f Monika Huppi and Dominic Haazen (Health), Anita Schwartz (Pensions), Loraine Blank (Social Assistance), Lorena Kostallari (Health and Social Protection), Keiko Miwa, Sue Berryman, Lindita Xhillari, and Yuli Cabiri (Education), Iftikhar Khalil and Richard Hamilton (Power), Richard Martin Humphreys (Transport), Michael John Webster, Arben Bakllamaja and Andreas Rohde with advice and guidance from Jonathan Halpern (Water), Artan Guxho (Infrastructure), Jana Orac, Jolanda Trebicka, Hugh Grant, and Gary Reid (Civil Service), Junghun Cho and Olav Christensen (Public Financial Management), Andrew Bird (Public Financial Management, Public Investment Management), Andrew Dabalen (Distributional Incidence Analysis), Juan Carlos Ginarte, Olga Vybornaia, (Macroeconomic Analysis) and Caroline Van Rijckeghem (Debt Sustainability Analysis). The team worked with the Country Fiduciary and Accountability Assessment Update (CFAU) team led by Devesh Chandra Mishra given the importance of public financial management issues for both tasks. Early findings o f the Public Financial Management and Public Investment Management Chapters were discussed with the Ministry of Finance. Early findings from the Water Chapter were also presented and discussed in a joint workshop with the Ministry of Public Works, Transport and Telecommunications, and relevant donors involved in the water sector. The team owes a special debt of gratitude to the Department for International Development for its encouragement and generous financial support. I t also benefited from close interaction with the DFID financed consultancy team at the MoF, the IMF, USAID, UNDP, the Urban Institute, and the Embassy o f the Netherlands, and with the members o f the donors’ thematic group for public financial management. It wishes to thank the EU-financed project team working on salary reform supporting DoPA. Useful comments were received from Professor Vito Tanzi (external peer reviewer), Bert Hofman (peer reviewer), Marianne Fay (Lead Economist, ECAVP), and the IMF Albania team led by Istvan Szekely. Comments from various governmental institutions in Albania were received in October 2006, based on which some aspects o f the reports were updated. Finally, the team wishes to thank Nadir Mohammed, Monika Huppi, Piet Van Heesewijk, Joao Oliveira and Gord Evans for their wise advice and guidance, and Erjon Luci for his support in finalizing the report. The team gratefully acknowledges the support o f Enkelejda Karaj who organized the team’s work in Albania as well as that o f Mismake Galatis, Ekaterina G. Stefanova, Armanda Carpani, and Denisa Bilali for their valuable assistance in processing the report. EXECUTIVE SUMMARY Albania has seen average annual growth o f seven percent over 1997-2005, the highest among transition economies. This growth rates has been accompanied by strong poverty reduction, including over the last three years, when the poverty ratio f e l l by seven percentage points. Successful macroeconomic management has been an important contributor to growth-the government deficit and debt have been reduced, and inflation has been kept low-while growth has been the critical factor in poverty reduction. Emerging concerns center on the need to sustain the momentum o f growth and poverty reduction. The productivity gains from resource reallocation typical o f the f i r s t phase of transition are slowing. Albania will need to create a better environment for private investment, further accelerate improvements in human capital, and stimulate new sources o f productivity growth, including in the public sector. Public expenditure policy i s at the heart o f this challenge to sustain growth. This report finds that Albania’s level of spending at 29 percent o f GDP i s broadly appropriate but that resource mobilization remains distortionary and spending i s inefficient. A narrow tax base and high labor taxes concentrate the burden on a small section of the economy and discourage the expansion o f formal sector employment. O f particular note i s the current socially unsustainable pension system, which i s characterized by low benefits and high contribution rates.’ Its reform will have to take place within a holistic strategy for social protection that rebalances the use o f assistance and insurance in line with Albania’s demographic and employment profiles. Despite a dramatic reduction since the financial crisis in 1997-98, debt levels remain relatively high at 55 percent of GDP and an over-reliance on short-term domestic debt escalates costs and creates significant rollover risk. Additional fiscal risks arise from burgeoning contingent liabilities and the widespread use of interagency arrears and cross-subsidies, which reduce financial discipline in the public sector. More importantly, Albania has a substantial opportunity to improve the productivity o f public spending, both as an independent source of growth and as a complement to increasing the productivity o f private capital. Cross-country analysis of expenditure efficiency shows that the country could achieve much greater outcomes with its current level o f spending. The levels o f public investment and public employment (wage bill) are broadly appropriate. Nevertheless, severe underfunding o f non-wage inputs handicap the accumulation o f human capital, leading to low levels of educational attainment and inadequate health care, and result in a relatively high level o f private spending on healthcare services. Meanwhile, over-emphasis on expansion versus operations and maintenance (O&M) has perpetuated the poor condition o f Albania’s infrastructure, especially the road network, water, and electricity transmission and distribution systems. Although allocation o f spending across economic and social sectors i s broadly in line with other high-growth countries, Albania should accelerate the transition to economic tariffs (in the water sector) and the establishment o f institutional frameworks for private investment (in the transport and energy sectors). These steps will enable the elimination of enterprise subsidies and provide fiscal space to increase spending in education and, when operational arrangements improve, in health. Government spending in Albania has become inequitable with stark variations in expenditures and outcomes at the local level. The authorities need to complete the reform of mechanisms for allocating resources to local governments and service providers so that the latter two respond to local needs; but also create the incentives for efficient use. These reforms are particularly crucial in the health, education, and water sectors. This report was prepared prior to July 2006, date at which the new Government reduced social security contribution rates by about nine percentage points. Analysis in this report and the forthcoming Social Insurance Review analyze in further depth the pension sustainability. Finally, improving the efficiency and equity o f public spending in Albania will not be possible without accelerating the institutional reforms aimed at restoring discipline and credibility in expenditure management. These reforms include rationalizing the pay system for public servants and strengthening the civil service management reforms to improve public sector performance and equity. I n the short to medium term, the government should focus on: 1. Further reducing overall levels of public debt by (a) a gradual reduction o f domestic borrowing through fiscal consolidation, (b) major efforts to strengthen debt management capacity, and (c) the formulation of a debt management strategy that focuses on increasing the average maturity o f public debt. 2. To respond to emerging demographic changes, beginning to adjust the functional and regional allocation of education spending toward secondary education based on careful projections o f the impact o f demographic changes on school age cohorts and their regional distribution. 3. Completing the review of the social insurance system and then embarking on a comprehensive reform of the pension system, securing a basic safety net for all, with additional benefits for those who actually contribute. 4. Channeling all public sector resources for health care through one agency (Health Insurance Institute), which will pool these funds, allocate them, and purchase health services on behalf o f the population. 5. Increasing the allocation of resources to recurrent road expenditures to address backlog maintenance and raise spending on normal maintenance; and strictly adhering to the agreed Albania National Transport Plan by subjecting all proposed transport projects to the full cycle o f the new public investment management guidelines. 6. Phasing out operational subsidies to water utilities in the medium-term and transferring the savings to investments and reallocating them based on sector priorities and utility performance. 7. Supporting the electricity utility’s (KESH) efforts to implement the annually updated Power Sector Action Plan, particularly with respect to reducing network losses and improving bill collections (including government own obligations); and deciding on options for restructuring KESH. 8. Deepening the reform in public expenditure management with a particular focus on strengthening the newly established Integrated Planning System for national and sectoral priority setting, focusing on annual budget preparation and execution (including curtailing use o f nontransparent virement, and implementing multiyear procurement for capital projects) and strengthening capacities in line ministries. 9. Designing and starting implementation of robust procedures to identify, select, and appraise public investment projects while ensuring full integration with the Medium Term Budget Plan (MTBP) process. 10. Reviewing existing options to harmonize the pay systems and assessing their fiscal impact in order to enhance performance and equity across the public sector. .. 11 OVERVIEW A. INTRODUCTION 1. Albania has made significant progress in maintaining macroeconomic stability and reducing poverty. Through its National Strategy for Social and Economic Development (NSSED 200 1- 06), the Government o f Albania articulated an inclusive long-term development strategy to bring Albania’s living standards and per capita income closer to the levels o f its neighboring European countries. Organized around two pillars-sustaining high economic growth and improving governance the NSSED emphasized education, health care, and infrastructure as priorities for addressing poverty and providing a sound basis for long-term growth and competitiveness. At the same time, to improve spending outcomes and strengthen the environment for private investment, it recognized the necessity for stronger public accountability and increased public participation in government decision making. 2. However, Albania i s facing new challenges in sustaining these growth rates and ensuring a more equitable distribution of welfare gains. The government recently launched the preparation of its new strategy, the National Strategy for Development and Integration (NSDI 2007-1 3). The government also expressed i t s commitment to sustain fiscal consolidation, keep government small, and increase its efficiency as the necessary elements o f its strategy to improve the competitiveness of the Albanian economy as it progresses toward integration with the European Union. Given ever-present resource constraints and trade-offs, a critical enhancement i s required to future resource allocations through a more thorough analysis and detailed prioritization and costing o f spending programs. 3. The Albania Public Expenditure and Institutional Review (PEIR) contributes to this debate by examining the role o f expenditure policy in enhancing future growth prospects while improving service delivery outcomes. Composed o f two volumes, this report assesses outcomes from public expenditures in Albania over the past 5-10 years; discusses the current and future challenges facing the government in improving the efficiency o f public spending and ensuring the sustainability o f the fiscal stance; and proposes an agenda for a public expenditure strategy to address them, at both the aggregate and sector levels. This Overview (Volume 1) synthesizes the detailed findings presented in Volume 11. B. TRENDS IN GROWTH AND POVERTY REDUCTION 4. Rebounding from the financial collapse of 1997, Albania did very well in sustaining high rates of economic growth. Economic activity recovered and, over 1999-2005, real Gross Domestic Product (GDP) growth rates accelerated to an average annual rate o f seven percent, enabling Albania’s per capita GDP to approach middle-income country levels. This growth record has been the highest among transition economies. Since transition, Albania’s growth has been driven primarily by the improvements in the allocation o f resources from low-productivity sectors, firms, and activities to those demonstratinghigher productivity. 5. Much o f this economic performance has been underpinned by sustained fiscal consolidation and macroeconomic stability. The government reduced the overall deficit from 13 percent o f GDP in 1997 to 3.4 percent in 2005, while the primary deficit declined from 7.3 to 0.3 percent o f GDP during the same period. Lower public sector borrowing requirements resulting from fiscal consolidation sustained the downward trend in interest rates, and kept year-on-year inflation within the Bank o f Albania’s target range o f 2 - 4 percent. 7. T u sustain its ~ ~ p r e s s ~ ~ e rates, growth Albania rvifI need to find and exploit new sources ctf productivity growth, while con evidence frmn slo n ~ f i c in ~ ~ ~ qe a reetnt ~ r nccumtlf at ian both labor and capital) has picked up on1j i ttCS to be kindieti by ~ t arid hrge r ~ ~ ~ ~flows n growth ~ athe c ~ in privatc credit. t I. Public e ~ ~ e ~ policy d ~ ~ is at u the ~ eheart o f these c ~ i a ~ j e n tu~ ~ s new ~ r o d ~ spur ~ t ~ ~ ~ j ~ ~ growth and reduce rty and inequalities in access tu services. I t has a fundan? establishing the broad macroeconomic framework for investment and job creation; (b) providing the public services that contribute to human capital accumulation or to private sector productivity growth; and (c) creating conducive institutional and regulatory frameworks for private investment. In particular, the size and resourcing of the state are critical elements in the macroeconomic framework for investment and job creation. In turn, the allocation and efficiency o f public spending will affect the delivery o f public services that support human capital accumulation and will influence public investments that augment the productivity o f private investment. 12. This report finds that Albania has a substantial opportunity to (a) improve the productivity o f its public spending, providing both a complement to raise the productivity o f private capital and as also an independent source o f economic growth; and (b) to deepen the impact o f this growth on poverty by improving the equity of public service delivery. 13. However, achieving a better allocation o f expenditures needed to support growth and job creation will not happen “by fiat.” It will require continued improvements in the institutional framework for translating expenditure policies into budget plans and ensuring effective budget execution. c. SIZE AND RESOURCING OF GOVERNMENT 14. The government’s current fiscal strategy o f keeping government small at approximately 30 percent should be maintained and consolidated. Cross-country analysis undertaken in this report for a group of high-growth countries of varying levels o f income suggests that the size of Albania’s government i s moderate by international standards. General government spending as a share o f GDP at an average 30.5 percent during 2000-04 places Albania within a group o f European countries with relatively small governments, such as Estonia, Latvia and Lithuania. In the broader perspective, however, the current level of spending i s actually larger than in some model high-growth countries, such as, Chile, Ireland, Korea, Malaysia, and Thailand. More detailed cross-country analysis on the relationship o f the level o f public spending and growth suggests that Albania’s level o f spending i s only approximately 3 percentage points o f GDP more than predicted by the model. 15. The overall level o f tax revenues at 22 percent of GDP i s also in line with Albania’s level o f development, but the structure of revenues has been distortionary (Figure 2). Except for extremely high labor taxes until July 2006, Albania’s tax rates are comparable with those 5 The decision o f the government to reduce social insurance contributions by 9 percentage point as o f July 2006 i s a positive step demonstrating government’s commitment to curb informal activities. 3 contributing to the growing informalization of the Albanian economy. More than three-quarters of the workforce i s employed informally, and unemployed workers are more likely to transit into informal rather than formal employment.6 16. The real issues however, are not ones o f levels o f spending; they have to do with the efficiency o f the spending and the underlying risks in the fiscal position. Extending recent work by Afonso, Schuknecht and Tanzi (2006),7 this report finds that the government could achieve current outcomes with fewer resources, or significantly improve outcomes with the same level of resources. This report also shows how the composition of spending, and the way spending i s planned and executed undermine its own efficiency. These findings are corroborated in individual sectoral analysis summarized in section F. D. SUSTAINABILITY AND EFFICIENCY OF PUBLIC SPENDING 17. Albania achieved a significant fiscal Figure 3. Overall and Primary Fiscal Deficit, adjustment over the last decade, with a 1993-2005 sustained reduction in the fiscal deficit over 00 1999-2005 that lowered public indebtedness. .2 0 Since 1993, the overall deficit has been reduced by 13 percentage points of GDP and the primary 4 0 deficit (excluding grants) by 14 percentage %O points. The largest and most sustained period of 4 0 adjustment occurred after the 1997 pyramid crisis and reduced the public debt level from 80 -100 percent in GDP in 1997 to 55 percent in 2005. I20 The latter i s still a relatively high level by .I40 international standards; thus, further debt reduction i s necessary. .I60 -+Pnmary Deficit (excluding granl) +Oicrall Deficit (mcludmg grans) Source: MoF. 18. The quality o f that adjustment undermined the efficiency of public spending Table 1. Size and Distribution o f Fiscal and increased rigidity in the budget. Most of Adjustment, 1993-2005 (change in % GDP) the adjustment resulted from cuts in capital and Total revenues 1.7 non-wage recurrent spending, including Total expenditures -8.5 operational subsidies (Table 1). In addition, Current expenditures -4.2 despite the gradual reduction in interest Personnel expenditures -0.8 payments and stable path of wages and Interest 1 .o transfers, Albania has experienced increasing Operations and maintenance -2.5 rigidity in the structure of spending, with Subsidies -1.3 Capital expenditures -4.2 nondiscretionary spending rising from 57 Domestically financed -0.7 percent of the budget in 2000 to 63 percent in Foreign financed -3.5 2005.’ Moving forward the challenge i s to Primary deficit (including grants) -1 1.2 adjust the input mix while providing enough Primary deficit (excluding grants) -14.0 flexibility for strategic resource reallocation to Total deficit (including grants) -10.2 meet Albania’s changing needs. Overall deficit (excluding grants) -13.0 Source: MoF. World Bank, “Albania, Labour Market Assessment” (2006). 7 A. Afonso, L. Schuknecht, and V. Tanzi, “Public Sector Efficiency: Evidence for New EU Member States and Emerging Markets” (European Central Bank, Frankfurt a m Main, ECB, January 2006). 8 Nondiscretionary spending includes debt service, wages and salaries, and transfers to social security. 4 19. Indeed, Albania has a significant opportunity to improve the productivity o f its public spending if it adjusts its input mix to support sustained growth. This conclusion emerges from a comparison of Albania’s economic allocation of i t s public resources with neighbors in the region and two groups of fast growing countries with small and large governments, respectively (Table 2).9 In particular, while government spending on capital investment as well as the wage bill i s appropriate for Albania’s growth path, i t s level of spending on goods and services i s critically low, and high interest payments continue to crowd out primary spending. 20. Public investment, although declining, remains comparable to other fast-growth countries. Although declining from 8.4 percent o f GDP in 1993 to 4.2 percent of GDP in 2005, public investment i s not low (Table 2). However, and despite Albania’s good progress in upgrading i t s dilapidated infrastructure, the poor condition and continued inefficiency of key utility sectors continue to pose a significant bottleneck to economic growth. Much of this bottleneck results from deferred maintenance of key networks and systems, the water and electricity sectors in particular, and unfinished reforms to improve operational efficiency in all sectors (transport, health, water). Although Albania does have significant investment needs in infrastructure to meet the demands of i t s growing economy, the efficiency o f these investments rests critically on ensuring adequate operations and maintenance (O&M) and improving operational and financial performance of utilities. The latter also will be instrumental in raising private and external financing. Table 2. General Government Spending, Economic Classification, Average 1995-2004 (YOGDP) Total Goods and services expenditure and net Primary lending” expenditure Wages Non-wage Transfers Subsidies Capital Interest Albania 31.6 26.7 7.0 3.8 9.0 0.7 6.1 4.9 High Growth (HG) 36.4 34.0 7.1 8.2 12.9 2.0 4.4 2.6 H G B i g Govt. 44.9 41.5 8.2 8.6 17.2 3.1 5.0 3.4 H G Small Govt. 28.8 27.2 6.1 7.4 7.9 1 .o 3.9 1.9 EU8 40.3 38.1 7.1 8.1 17.1 2.8 4.4 2.2 SEE^' 40.7 38.1 8.0 8.3 14.5 1.8 5.0 2.6 I’ 1995 or earliest year available, 2004 or the latest year available. 21 (excluding Turkey). Source: ECA Regional Public Finance Database. 21. Similarly, the size o f the wage bill relative to GDP is appropriate for Albania’s growth agenda. Personnel expenses have been relatively protected during the past fiscal adjustment, yielding a stable level of spending in relation to GDP. However, this stability reflects a substantial downsizing of public employment (by nearly 59 percent during 1993-2005) accompanied by a 3-fold increase in the average wage since 1996. Furthermore, the gains from rightsizing and improving staff remuneration need to be sustained. The persistent low quality of Albania’s bureaucracy, weak governance, high levels of administrative corruption, and state capture continue to reduce the effectiveness o f Albania’s public spending on personnel and call into question the underlying structure and incentives of the existing public employment pay system (section G.3). Moreover, given the broadly appropriate size o f the wage bill, any proposed adjustment of the wage structure as part of the ongoing civil service reform effort should be carefully analyzed for i t s fiscal implications. In this table, high-growth countries registered an average growth in per capita GDP over 1993-03 exceeding 2.5 percent. The High Growth Small Government (HG Small Govt.) countries include: Albania, Armenia, Chile, Estonia, Georgia, Ireland, Republic o f Korea, Latvia, Lithuania, Romania, and Thailand. High Growth Big Government (HG Big Govt.) countries include Bosnia and Herzegovina, Bulgaria, Croatia, Czech Republic, Greece, Hungary, Poland, Slovak Republic, and Slovenia. 5 22. Non-wage recurrent spending i s critically low and i s reducing the efficient use o f other inputs: personnel and capital. From 1993-2005, non-wage recurrent spending fell from 8 percent to 3 percent o f GDP and, at 11 percent o f general government spending, i s extremely low with respect to Albania’s high-growth peers and regional neighbors. As noted above, critical underspending on maintenance in the road and water sectors i s creating future direct liabilities for rehabilitation and reconstruction that are several times larger in present value terms than the foregone spending. In the road sector, spending on maintenance i s some 40 percent lower than required and already has created a backlog of nearly US$ 45 million (0.5 percent of GDP). Meanwhile, 67 percent o f the national road network i s in poor condition, compared with 22 percent o f the national networks in Bosnia and Herzegovina and Croatia (section F.5). 23. I n the education and health sectors, under-funding o f complementary inputs i s undermining the quality o f the services. In secondary education, only 3 percent o f current spending i s available for instructional materials and maintenance, and in primary health, fully staffed clinics face severe shortages of materials and poorly maintained equipment. These critical lacks have resulted in low quality of service delivery and an associated reduction in demand. Returns to general secondary education and enrollment rates are alarmingly low at a time at which the economy increasingly needs a more sophisticated labor force equipped with knowledge and workplace skills that cannot be developed through primary or basic education alone. In the health sector, poor service delivery in primary health has led to persons bypassing these facilities for polyclinics and hospital care, resulting in inefficient resource mobilization (sections F.1 and F.2). 24. Interest payments continue to crowd out primary spending, especially non-wage recurrent spending. Despite sustained reduction in interest rates and reduction in public sector borrowing requirements, interest payments o f approximately 13 percent of government spending continue to severely crowd out primary expenditures and exceed levels in other high-growth countries. This serious imbalance has constrained the government’s ability to allocate expenditure according to development and sectoral priorities. 25. Given these high interest costs, the government should articulate an active debt strategy, of which further debt reduction should be part. These high interest rates reflect the risk stemming from the current structure and management o f public debt. Domestic debt accounts for 70 percent o f Albania’s public debt and i s held in very short-term domestic instruments concentrated in the hands of a few domestic institutions. As a result, the rollover risk i s significant, and interest costs are relatively high. Under the IMF-supported PRGFBFF program, the government recently embarked on the development o f a strategy to improve its public debt management. These efforts should be given the utmost priority to manage and reduce the above risks, lengthen the average maturity o f public debt, and contain the government’s cost o f borrowing. 26. Further progress in reforming the state enterprise sector also will be needed to secure the hard-won reduction in subsidies, improve productivity both in the public and private sector, and reduce the risk o f emerging contingent liabilities. Albania has made good progress in reforming the state enterprise sector, thus reducing subsidies and improving operational and financial performance. Privatization o f SOEs, price and trade liberalization and enterprise reforms have reduced uneconomic subsidies. However, persistent operational inefficiencies and unfinished reforms, particularly in the water and railway sectors, and recent governance challenges in the power sector (par. 8Q may constrain the gains to be made in productivity improvements. 27. The water sector has increased its dependence on public subsidies over the past few years, as slow progress on tariff adjustments and efficiency improvements have been outstripped by increasing costs. The power sector critically needs external investment financing to meet rapidly rising 6 demand, but introducing private participation needs to be managed in orderly way to avoid future liabilities for the government. In addition, a quasi-fiscal deficit on the order o f 2.5 percent of GDP (arising from suboptimal tariffs and low collections) reflects perverse consumption incentives for residential consumers leading to excessive household demand for electricity. This deficit renders efforts to reduce theft, improve collections, and gradually raise household tariffs while mitigating the resulting impact on the poor even more critical. . 28. Finally, Albania faces additional fiscal risk from a potential build-up o f contingent liabilities, as has happened in several other transition countries. The nominal budgetary primary deficit o f 0.5 percent o f GDP in 2005 does not reflect the total public sector deficit, which should account for state enterprise deficits/quasi-fiscal deficits. Nor does it include the outstanding costs of compensation for land restitution, the web of intra-government cross-subsidies, transfers, and arrears that substantially weaken the hard budget constraint for beneficiary agencies and institutions. As mentioned, Albania’s pattern o f deferred maintenance in several infrastructure sectors i s creating future liabilities in reconstruction and rehabilitation costs that are several times larger in present value terms than the foregone spending. Moreover, as Albania seeks to increase the private financing for and participation in infrastructure, both the demand for new state guarantees as well as the risk o f government bailouts for nonguaranteed but publicly desired investments i s likely to increase the build up o f contingent liabilities. As such, the government needs to raise i t s capacity to appraise and evaluate such projects. E. OVERARCHING STRATEGY PUBLIC EXPENDITURE 29. The main thrust o f a public expenditure strategy oriented toward growth therefore would be to wrest greater outcomes from the existing levels o f spending and limit the risks involved in current fiscal operations. The report identifies several pillars of this strategy. First, there i s a need to alter the input mix, including through a reduction in debt levels (discussed at length above). Second, a review o f the current intersectoral and intrasectoral allocation i s warranted. Third, this review should be complemented by reforming the existing financing arrangements to reduce regional disparities in spending and by giving a greater role to the private sector in financing and providing certain services. Alter the input mix 30. I n keeping with the discussion in section D above, some o f the key features o f such a strategy would be to adjust the input mix to: Increase the share of spending on non-wage goods and services, notably O&M in the infrastructure sectors commensurate with the need for maintaining the capital stock in good condition and clearing backlog maintenance in the transport and water sectors. A l l o f this will demand a significant increase in O&M expenditures. Non-wage recurrent spending in the secondary education and primary health also must increase. Keep wages and salaries in check, and manage the cost o f the wage bill within a comprehensive approach to civil service reform and restructuringo f the state institutions. Maintain capital spending at current levels while subjecting it to the rigor o f investment management procedures, and ensure that appropriate O&M funding i s allocated for planned new investments. A l l new capital investments also should be subjected to the discipline o f the MTBP process, so that they are prioritized and O&M projections are built into the planning o f the investment (section G.2). Alleviate the burden o f interest payments on the budget by articulating an active debt strategy. I t should include reducing overall debt levels, increasing domestic maturities, and seeking long-term external (official and private) financing. 7 e) Gradually reduce remaining subsidies, notably in the water sector in the context o f an overall plan aimed at achieving cost recovery, and in the railway sector. Rebalance inter-sectoral allocations 31. Against a constrained resource envelope, every program in the budget also should be evaluated against the rationale for public intervention in a market economy. Selection o f each program should be made based on whether the public sector could deliver the goods and/or services in a sufficient and efficient manner, or whether this should be left to the private sector. 32. The above principle means that inter-sectoral allocation decisions should come under scrutiny. A comparison o f the functional composition o f Albania’s public spending with high-growth comparators reveals three important features: (a) relatively low spending on education; (b) higher than average spending on general public services; and (c) average level o f spending in the economic services including infrastructure, health, and social protection (Table 3). Table 3. General Government Spending, Functional Classification, 2004 (YOGDP) Defense Social General and security Total public public and Economic outlays sewices order Education Health werfare affairs Other Albania 29.1 3.6 2.9 3.1 2.5 7.5 3.6 5.8 High Growth (HG) 34.3 2.8 3.6 4.6 3.8 10.9 4.3 4.3 HG-Big Govt. 43.7 3.4 3.7 5.5 5.5 15.7 5.0 4.9 H G Small Govt. 28.1 2.4 3.6 3.9 2.7 7.7 3.8 3.9 EU8 41.7 3.3 3.3 5.9 5.0 13.8 4.8 5.5 SEE (excl. Turkey) 39.1 4.0 4.8 4.1 4.8 12.8 4.5 4.3 Note: The composition of countries and therefore the average for each group may differ from those in Table 2 because detailed hnctional classification of expenditure i s not available for all countries used in Table 2. Source: ECA Regional Public Finance Database. 33. Although investment needs are great in water and electricity, these sectors have the ability to finance a reasonable share of these expenses from own income or to garner private financing, provided tariffs move gradually to cost recovery levels and an appropriate institutional framework for private participation i s established. Given these, operating subsidies should decline over time, and publicly financed investment should be replaced by private investment (section F.4). Moreover, spending levels in general public services are larger, by approximately 1.0-1.2 percentage points o f GDP, than for comparator countries and often higher than those o f bigger governments including Bulgaria, Czech Republic, and Poland. Recent efforts to rationalize spending in this category should be strengthened and based on the ongoing functional review process underpinning the downsizing efforts o f government. These efforts should provide some fiscal space to increase spending in education, and (when financing and operational arrangements improve) in health. 34. Irrespective o f the differences in financing levels, expenditure outcomes in a l l sectors remain below potential for a given level o f spending and/or below Albania’s emerging needs. The three themes mentioned in paragraph 29 above are those that emerge from the analysis o f individual sector spending, and those that should be at the heart o f Albania’s expenditure strategy are discussed below. 8 Adjust intra-sectoral allocations 35. First, there i s a recurring need to adjust intrasectoral allocations in response to demographic changes o r technical exigencies: In education, an emerging decline in primary and secondary age cohorts combined with increasing secondary enrollment could yield a dramatic increase in demand for secondary education over the medium term. This need i s also driven by severe under funding o f general secondary education (Table 4). In response, Albania will need to reallocate additional spending in the sector in favor o f secondary education in the future. Concurrently, quality must improve to stem the f l o w o f poorly educated students who are ill-prepared for the labor market (section F.1). In the health sector, as the population ages, Albania i s beginning t o see an increasing incidence o f non-communicable diseases. However, the healthcare system i s ill prepared to face their increasing incidence and their associated long and costly treatment. The current situation argues for shifting spending from hospital sector, which i s relatively over financed, and reducing overspending on pharmaceuticals, t o preventive care and key public health functions that could significantly reduce not only the burden o f these diseases but also their related treatment costs (section F.2). During the past five years, social Table 4. Total Unit Costs by Level o f protection spending has shifted from Education, Albania and EU-15 and EU-8 social assistance to social insurance. At Relative to Primary Education the same time, the pension system, given Secondary Tertiary i t s broad coverage, has had a larger All Gen VET impact on poverty than Albania’s main Albania (2002-05) 1.27 0.94 3.07 2.44 social assistance program-Ndihme Ekonomike (NE)-which has decreased Albania (2005) 1.22 0.94 2.75 1.95 in real spending and real value o f Albania(2002) 1.59 0.89 2.29 2.71 benefits. However, the pension system i s EU 15 (2002) 1.29 1.79 characterized by l o w replacement rates EU-8(2002) ~ 1.21 2.32 and disconnect between benefits and Sources: MoF, OECD 2005. contributions. Therefore, given Albania’s demographic and employment profiles, it i s necessary t o fundamentally rethink the entire old-age security policy and the potential role o f social assistance and insurance programs and adjust expenditures accordingly (section F.3). Address regional disparities 36. The second major theme i s the need to address regional disparities and inequities in the delivery o f public services. Albania has a decentralized system o f service delivery that varies in structure from sector to sector. However, a common problem across all sectors i s the lack o f appropriate and (often) objective criteria for allocating resources to local governments, institutions, and service providers. Investment allocations to local government entities also often are based on a nontransparent mix of criteria and negotiations with little connection to poverty or growth needs. In many cases, the financing allocations for recurrent spending are based on input or traditional norms and unrelated to intended outcomes, local needs, or actual patterns o f resource utilization. They neither respond to local needs nor create the appropriate incentives for efficient use o f resources. Moreover, once resources are transferred, there i s little monitoring and oversight o f local government expenditure. 9 In the education sector, large variations in regional outcomes often can be traced to differences in per capita spending. For example, in general secondary education, the best funded region spends more than three times the amount per student o f the least funded region. The recent introduction o f formulas for determining regional allocations o f recurrent spending need t o be refined t o move gradually toward capitation financing for recurrent spending. Per capita public sector spending on health Figure 4. Lorenz Curve o f Public Sector Spending on Health varies markedly by and Regional Poverty Incidence district and region, largely due t o a skewed distribution o f facilities and staffing and an input-based financing system. The result i s that 0 0 2 0 4 0 6 0 8 1 the regional allocation o f cumulative K o f public health sector s p e n d l n g spending is quite regressive (Figure 4). Source: WB staff estimates. Although general practitioners are funded through Health Insurance Institute (HII) on a capitation basis, this payment i s not based on active enrollment nor does it include allowances for nonsalary operating costs (section F.2). 0 Decisions to allocate investments to water utilities and affiliated local governments also were not based on specific measurable objective criteria, but the variations in access and quality o f services are stark. Areas with higher levels o f access t o water and sanitation services generally receive higher per capita investment (Figures 5 and 6). The introduction o f a performance-based transfer system, currently under discussion, needs to be accelerated. In parallel, the central government needs to complete the transfer o f assets to local governments in line with their legally mandated responsibility for oversight and/or operation o f local water systems as a means to increase the effectiveness o f local management o f systems and improve equity in access and quality o f service. This performance-based transfer system should be implemented once the governance and financial arrangements are clarified. Figure 5. Albania Water Investments and Figure 6. Albania Water Investmentsand Running Water Inside the Dwelling, 2002-05 Access to Piped Sanitation, 2001 and 2002-05 0 1 Sources: WB staff estimates, INSTAT, MPWTT, MoF. 10 Rework the public-private financing mix 37. The third major theme i s the need to adjust the public-private financing mix to not only expand the overall envelope o f sector resources but also increase technical efficiency and improve outcomes. Given the reduction in concessional aid flows, Albania i s seeking to deepen private investment in infrastructure. Participation already has gained ground in civil aviation. However, establishing clearly defined institutional and regulatory frameworks for private sector participation (PPPs) in roads, ports, energy, water, and, ultimately, railways i s a necessity. A recent thorough assessment of Albania’s current Concession Law revealed several shortcomings that will need to be addressed along with other reforms to ensure an appropriate division o f risk between government and private sector, and to avoid the emergence of any contingent liabilities and other types of fiscal risks. It i s expected that the forthcoming law on concessions and private public partnership will address those issues. In both the social protection and health sectors, the use of contribution-based insurance systems to finance both pensions and health expenditures have run into serious problems, in part because of a disconnect between benefits and contribution rates that discourages participation and compliance. Both systems will require fundamental reform to address the perverse participation incentives but also to realign public spending with sector goals (sections F.2 and F.3). Finally, in tertiary education, increasing cost recovery i s an important policy option, given the large returns to tertiary education and the consumption profile o f the tertiary students (predominantly from the top two quintilesFso long as access o f students from poor families can be protected. Although tuition fees have increased from 2.2 percent o f university revenues in 2000 to 21.6 percent in 2005, current financial management arrangements for universities provide little incentive for further increasing such revenues. To date, there has been little use by universities o f the (limited) flexibility to move resources among the faculties since the current regulations do not make adequate provisions for strengthening accountability, such as through the establishment of university governing boards (section F.1). SECTORAL PROGRAMS F. REFORMING 38. The above strategy for expenditure restructuring derives from a bottom-up approach that builds on detailed sectoral analysis. The report examines public spending programs and issues in education, health, social protection, transport, water, and power. While the report proposes short- to medium-term recommendations in the areas discussed below, it does not pretend to provide a fully detailed, comprehensive reform blueprint. Instead, it seeks to illustrate the difficult issues that need to be confronted. In each sector, the discussion focuses on reform options that can help to reduce inefficiencies in public spending while improving i t s effectiveness in supporting the strategic goals o f growth, employment, and poverty reduction. The following paragraphs examine how this agenda could be pursued sector by sector. The main policy recommendations stemming from the analysis are presented in section F below. More detailed analysis o f each o f the six sectors i s provided in Volume 11. 39. Despite recent improvements in enrollments, the stock, flow, and quality of Albania’s human capital are insufficient to support the country’s transition to middle income country status. Albania i s close to reaching the objective o f universal primary education, a major achievement with expected long-term benefits in poverty reduction. The last three years also have seen signs o f improvement in secondary and tertiary enrollments. Yet, Albania’s secondary and tertiary net enrollment 11 at 55 percent and 18 percent, respectively, and average educational attainment at 9.6 years remain comparatively low (Figure 7). Inequality in enrollment i s relatively high and rising (between consumption quintiles and within urban areas), and the quality o f education i s inadequate to equip students with the required skills to meet labor market demands. F.l EDUCATION 40. Overall, the education system i s underfunded at 3.2 percent of GDP but relatively efficient in its use of inputs. Teacher-student ratios are reasonable, and there i s Figure 7. Gross Enrolment Rate and GDP Per Capita: extensive but declining use o f double shifts. Repetition and dropout rates are low. However, some efficiency measures may be critically impacting quality and, ultimately, demand. Observed lower returns to general rather than to vocational secondary confirm that the quality o f general secondary education i s not meeting market needs. 2 GEOO 41. With rapidly declining primary & TUN 0 age cohorts and high primary N- =J ALB ,THA completion rate, over the medium term, Albania could see a dramatic rise in demand for secondary education. Responding to these changes and the need to address serious under-funding of - general secondary education, will require a gradual reallocation o f spending between primary, secondary and tertiary education, and improved budgeting and financing practices. Emerging demographic changes may provide an opportunity for reallocating some expenditures to secondary education over the medium- term, while increasing cost recovery and private provision in tertiary can help generate additional, needed fiscal space (Figures 8 and 9). Figure 8. Enrolment Projection for Grades 1-8, Figure 9. Enrolment Projection for Grades 9- 2004-15 12,2004-15 Grades 1-6 Grades 9-12 600,000 500,000 I 400,000 300,000 200,000 100,000 2004 2005 2OW 2007 2008 2009 2010 2011 2012 2013 2014 2015 2004 2005 2008 2007 2006 2009 2010 2011 2012 2013 2014 2015 Source: WB staff estimates. Source: WB staff estimates. 12 42. While primary education has received over the past the largest share o f the sector’s resources, general secondary education is severely underfunded, both in per capita spending and funding for non-wage recurrent spending. The prospect o f gradually reallocating spending on teaching staff in the future from primary t o secondary education faces two challenges: there are not enough teachers with the basic qualifications for secondary instruction, and relatively l o w salaries (in relation t o per capita GDP) may need to be raised to accelerate recruitmentheplacement. At the same time, international and regional experience shows that small increases in class sizes may yield some savings in this area without affecting quality. A relatively large capital investment program that already has achieved some improvement in school infrastructure will need to be retargeted to accommodate projected enrollment and possible spatial consolidation o f schools. 43. T o respond effectively to existing regional disparities and emerging demographic changes, ~ Albania needs to continue reforming the //g7 financing formula and arrangements for -, education spending. Further refinement o f the financing formula, including potentially s m - /;///;/ capitation financing, are key to improve the allocative efficiency and equity. There i s ; o wi ? t - / also a need t o improve planning, f‘- // - /’ /- - coordination, and execution o f capital rn / investment across different levels o f , ,,~, ,/ /’ - //’ government. - 3 - = ”. --- - =-=- - - & - ‘ 0 2 4 6 8 1 Cumulative share of subsi&y recipients 44. Education subsidies, concentrated _ _ _ _ _ Secondary Academic VET in tertiary education, are highly --- Tediary -Equity line EDUCATION: SUMMARY OF RECOMMENDATIONS J Increase spending to the sector commensurately with level o f other high growth comparators. J Begin adjusting the functional and regional allocation o f spending to respond to demographic change, based on careful projections o f the impact on school-age cohorts and their regional distribution. J Strengthen across levels o f government the coordination o f capital investment and non-salary recurrent and salary spending in pre-university education to achieve necessary expansion o f secondary schools. J Prioritize the use o f any additional recurrent financing to (1) raise non-wage recurrent spending in general secondary education and (2) improve teacher skills and salaries. J Redistribute education subsidies toward poor, rural households. J Gradually introduce per-student or capitation financing formula for recurrent spending. J Increase cost recovery and private participation in tertiary education along with budget autonomy and accountability for public universities. I’See Chapter 6, Volume I1 for a full l i s t o f recommendations. 13 F.2 HEALTH 45. Albania's health outcomes are commensurate with its health expenditures, but its demographic and epidemiological profile is changing. In terms of l i f e expectancy and vaccination coverage, Albania compares favorably to other lower middle-income countries. At the same time, the incidence o f non-communicable diseases i s increasing substantially as the population ages. The health care system i s ill prepared to face the increase o f these diseases and the lengthy and costly treatment associated with them. I t continues to be heavily centered on secondary and hospital care, with insufficient emphasis on primary care, including preventive care and health promotion. 46. The share of public spending in total health spending i s relatively low, resulting in high out- of-pocket spending, reaching approximately 100 percent o f private health spending. Albania spends approximately 6 percent of GDP on healthcare, commensurate with its income level, but the share of public sector spending on health i s below that o f other countries with similar income levels. At 2.5 percent o f GDP in 2005, it remains below that o f most European and transition countries (Figure 11). The high share o f out-of-pocket spending at the point of service has serious equity and poverty implications. It also reduces the government's ability to drive the reforms needed to improve the quality o f service, sectoral efficiency, and, ultimately, health outcomes. 47. Sectoral funding remains fragmented and does not provide incentives for efficient resource use. Despite a mandatory contributory health insurance system, general revenues account for 93 percent of public sector funding. Moreover, approximately 70 percent o f the health insurance system resources come from public subsidies and contributions for public sector employees. Approximately only one-third of the active work force contributes to the Health Insurance Institute (HII). Incentives for contributing are weak because the scheme covers only primary care (outside polyclinics), reimbursement o f some prescription drugs, and certain high-end diagnostic procedures. In contrast, outpatient care in polyclinics and hospitals and inpatient care are financed by general revenues and, in principle, are free. igure 11. Total (left) and Public (right) Spending on Health Care and Per Capita Income, 2005 'I N 1000 1500 2000 2500 3000 1000 1500 2500 3000 ON per c a $ E UsD O N per capita in USD Sources: World Health Organization (WHO), World Development Indicators 48. The low utilization of primary care facilities and hospitals i s widespread. The low quality o f primary care has resulted in many persons' bypassing primary care facilities in favor o f care at polyclinics or hospital outpatient facilities, even for minor health conditions. Inefficient resource utilization also plagues the hospital sector, which has a large number of small hospitals with low occupancy rates. Over 60 percent o f Albania's hospitals are too small to exploit economies o f scale in the general acute care hospital setting. 14 49. This low utilization o f primary care facilities and hospitals i s explained partly by imbalances in the composition o f health spending as reflected in: a) High spending on hospital care: Hospital care absorbs approximately half o f total public sector spending compared with 38 percent in the EU8 countries. b) Soaring spending on HII-reimbursed prescription drugs: After doubling 2 years in a row, prescription drug spending reached 20 percent o f recurrent spending in 2005, largely as a result o f an imprudent expansion o f the positive list o f drugs and cancellation of co- payments for most beneficiaries. In early 2006, the government reintroduced a flat co- payment to help stem the rising expenditure. c) Underfunding o f primary care: Particularly for low non-wage spending and allocations for basic equipment. d) Low spending on preventive care: If increased, preventive care funding could significantly reduce both the burden of disease and related treatment costs. 50. Large marked variations in public health spending per capita across districts and regions also explains low utilization o f health care facilities. These variations do not appear to be driven by programs targeted at raising unusual regional health outcomes, by poverty targeted programs, nor by the location of facilities that provide services to a wider area. Instead, the variation i s largely due to the skewed distribution o f facilities and staffing and an input-based financing system; and results in a regional allocation o f spending that i s quite regressive (Figure 12). Health Expenditure by Region and Povetty Health Expenditures and Poverty By Region 30% g! 2G% g! 20% 0 2 10% 10% 0% ~ 2000 4000 m Eo00 10000 12000 Moo 3000 4ooo 5Mx) 6000 7000 8000 Recurrent Expenditurelcapita(incl. prescription Recurrent spending per capita (excl. prescription drugs) dNW) 5 1. Changing the input based-financing system will provide incentives for improving the quality and efficiency o f service provision. While general practitioners are funded through HI1 on a capitation basis, this payment i s not based on active enrollment nor does it include allowances for non- salary operating costs. Moreover, strong central control over hospitals and an input-based payment system leave hospital managers without incentives or authority to undertake changes to improve the efficiency and quality of their operations. The contemplated shift toward performance-based payments through a single payer system could substantially contribute toward improvements in the efficiency o f resource use, provided this shift i s introduced with the proper accountability mechanisms and information systems in place. 52. Moreover, the establishment and use o f a country wide hospital network plan i s critical to limit inefficient use of capital investments resources. The limited investment budget i s stretched too thinly and investment decisions often are not subject to rigorous cost-benefit analyses, particularly when external financing i s involved. Similarly, no framework has been established to make informed decisions about investments in high-end medical equipment, a key cost driver in the sector. 15 53. Finally, the current decentralized allocation of investments in primary care facilities has led to suboptimal use o f resources. Investment allocations are driven in part by arbitrary standards o f one health post per 1,000 population and one health center per 4,000 people, instead by regional primary health care development plans based on analyses of existing resource utilization. Moreover, there i s little evidence that local governments actually spend toward these objectives once resources are allocated. In the case o f the Tirana region, the development of such plans, if based on analysis o f the utilization o f the existing network and desired efficiency improvements could result in a substantially more consolidated and higher quality network than indiscriminate application o f relatively generous coverage coefficients. HEALTH: SUMMARY OF RECOMMENDATIONS J Channel substantially all public sector resources for health care through one financing - (HII), - agency - which will pool and allocate these funds and purchase health services on behalf o f the population. J Proceed towards the elimination o f the payroll tax-based health insurance contribution and replacing i t with general revenue funding while ensuring a predictable financing stream to HII. J Increase resources allocated to primary care and public health. J Authorize the use of co-payments for a wider range o f services to reduce informal payments and control out of pocket-spending, especially for the poor and vulnerable. J Revise the reimbursement policy for prescription drugs. J Develop a master plan for the hospital sector and regional primary health care plans as the basis for additional capital investments. I' See Chapter 7, Volume I1 for a full list o f recommendations. F.3 SOCIAL PROTECTION 54. Social protection programs in Albania have played an important role in providing social support to the population Table 5. Poverty Impact and Adequacy o f Individual Social and in alleviating poverty. In Protection Programs, 2005'' the absence o f all the social Poverty levels of recipients protection programs, the poverty rate in 2005 would (%) Value of transfer as % have been 20 percent higher Without of household for the recipients (Table 5)." transfers With transfers consumption The pension system has the All Programs 44 24 23.5 largest impact on poverty. The Ndihme Ekonomike 50 40 8.5 main social assistance Urban Old Age Pension 39 14 28.0 program, Ndihme Ekonomike, Rural Old Age Pension 39 23 14.4 although more appropriately Other Pensions 41 27 19.9 targeted to the extreme poor, Unemployment Benefits 30 25 15.5 has a more marginal impact in Maternity Benefits 33 23 11.3 coverage and adequacy o f benefits. Given the current Social Care 44 22 16.1 importance o f social insurance Source: LSMS 2005. in Albania's poverty profile and the general inadequacy of i t s social assistance programs, any reform of the former clearly must be formulated in conjunction with social assistance reforms. loThe analysis in Table 5 does not cover disabilityhnvalidity benefits because the LSMS questionnaire does not provide information about the receipt o f these benefits by respondents. " Assuming a 100 percent marginal propensity to consume the transfer. 16 55. Averaging 7.1 percent of GDP during 2000-05, Albania’s spending on social protection i s broadly appropriate. Total spending i s in line with regional comparators and countries with similar demographic profiles. However, the direction o f social protection spending has been shifting from social assistance to social insurance. During 2000-05, the latter increased from 4.4 percent to 5.4 percent o f GDP, while expenditures on social assistance declined in real terms and fell from 2.3 percent to 1.9 percent o f GDP. Pensions 56. With a third or more of its revenue coming from the State Budget, the pension system i s no longer a truly contributory system. More than half o f the contributors come from the rural system, for whom the government budget pays approximately 85 percent o f the contributions. Many urban contributors are government employees. The pension system i s thus heavily dependent on general revenues to cover the shortfall between contributions and benefits, which averaged 1.6 percent o f GDP for the last 5 years.12 The Social Security Tax (SST) s t i l l i s not performing well, despite the recent transfer o f collection to the General Tax Department. To finance i t s deficit, Social Insurance Institute (SII) relies on a web o f cross-subsidies from other branches o f social insurance and often has drawn down i t s reserve find. 57. Furthermore, compliance among private firms i s extremely low because of a disconnect between one of the highest contribution rates in the world and very low and compressed benefits. In addition, the indexation formula rapidly erodes the replacement rate, which i s felt more acutely as income rises but also i s subject to discretionary decisions by the Council o f Ministers. Given the perverse incentives and government interventions, the system’s 84 percent dependency ratio i s very high, while it has the one o f the lowest coverage rates in the ECA region (Figures 13 and 14). Figure 13. Pension Contributions (% ofpayroll) Figure 14. System Dependency (%) Pobnd Bugare KazaksBn Abana Lava Hungary Esbna Serb0 Macedona Crmb Sources: WB and OECD. Source: WB staff calculations. 58. I f the pension system stays its current course, both rural and urban pensions will become negligible in the long run, resulting in little o r no incentive to either participate or contribute. If the current inflation indexation and capping o f the benefits continue, projections show that the level o f pensions may fall from the current average o f 40 percent o f the average wage for all types o f pensions to 20 percent in the next 35 years (Figure 15). ’’ However, this deficit does not reflect accumulated arrears by state institutions and private sector entities, including farmers, which although gradually declining, remain approximately 1.5 percent o f GDP. In addition, estimated arrears l?om the State Budget for rural pension contributions amounted to 3.8 percent o f GDP. 17 59. Not only will pensions be low, but a large segment o f the Figure 15. Albanian Pensions Relative to Average Wage elderly population will find itself under Different Indexation Scenarios without access to any pension. Data weaknesses notwithstanding, the majority of the elderly population i s ............................................................. collecting pensions of some type.13 In .................................................... contrast, only 46 percent of those employed are making contribution^.'^ ................................ With 35 years o f contributions required ......................... to collect a full pension, a large ....................... number o f the future elderly will not be able to collect full pensions, and some will not collect any pensions. As a result, in future, there might be one- . E f P E . s49 Q @ 6 .& @ & & & #@&@@& 44% third fewer male pensioners as a YeS percentage o f the above-65 age group and 20 percent fewer female pensioners as a percentage o f the Source: Staff calculations. above-60 age - - If left with no - group. pension, this sizable proportion o f the population could reverse the current positive poverty trends that Albania i s experiencing. 60. There are three ways to approach fundamental structural pension reform in Albania. Each needs to be evaluated in terms o f its potential fiscal impact. This report suggests options for reforms that will be analyzed in further detail in the forthcoming World Bank Social Insurance Review: The first approach would be to fix the disincentives in the system as an attempt to induce individuals to contribute. Three actions are needed: to eliminate the limits on the maximum pension, convert the rural pension system to 'a social assistance program, and establish a basic minimum retirement income for all. This approach may not be preferable as many individuals will not have sufficient contribution history and will need some support as they become elderly. The second approach would be to recognize that attempts to shore up the contributory system may be either too costly or futile, and simply convert the system into a noncontributory old-age benefit for all individuals of a certain age, funded by a less distortionary tax than social security contributions. A final approach could be a combination o f the first two. The government could fund a basic level o f benefit to all citizens o f a certain age (as under the second approach) and establish a voluntary, contributory scheme for individuals who want a higher level of benefits and are willing to pay for them. However, the feasibility o f such a funded scheme would have to be evaluated before proceeding. The key point would be that the voluntary system should not be able to impose additional liabilities on the government. 13 As noted above, the data provided by the Social Insurance Institute show that well over 100 percent o f the population over the age o f 65 i s currently collecting a pension. l4 This number i s calculated by multiplying the number o f people employed in Albania by the share o f the population making contributions. 18 Social assistance 6 1. Resource allocation to Albania’s only specifically poverty targeted program, Ndime Ekonomike (NE) has been declining in real terms. Social assistance programs financed via general revenues amount to 1.2 percent of GDP, in line with other comparator countries. However, between 2000 and 2005, direct expenditures on NE declined by approximately 40 percent while the number of beneficiary households declined by only 20 percent-in line with a reduction in overall poverty levels and the introduction of a work requirement. 62. Yet, NE has substantially increased its coverage among the extreme poor, although further improvement i s needed through better targeting. NE coverage has increased from 25 percent to 33 percent-and among the extreme poor, from 3 1 percent to 5 1 percent-between 2002 and 2005, respectively. However, the extreme poor accounted for only 12 percent of the benefits in 2005 (Table 6). Moreover, non-poor households receive an increasing share of the benefits: 64 percent in 2005 as compared to 57 percent in 2002. This deterioration in coverage could be explained by beneficiary households moving out of poverty and the recertification process not doing a good job of screening them out and/or a problem at the application stage. Complex and non-transparent eligibility criteria also hinder access by the extreme poor and increase possibilities for manipulation at local levels. The report finds that if the richest three quintiles of the population are screened out of NE, and assuming no increasing in benefit levels, then nearly another 20 percent of the poor could be covered without increased program funding. Table 6. Ndihme Ekonomike: Distribution, Coverage, and Adequacy (% of HH) Ndihme Ekonomike Year Non-poor All poor Extreme poor Total Distribution 2002 55.4 44.6 10.1 100.0 (% o f benefits) 2005 __ ___ 61.9 -____II-___ 38.1 _________-_-I_ 1 11 11.7 _- -- 100.0 - - Coverage 2002 __ __-___ -7.8 24.6____ 31.2 __ __ - .- 11.0 - - -- (% o f poverty - group) . _ _ 2005 9.5 32.5 _.50.8 12.7 Adequacy 2002 -_--_ 7.5 - ___-I- 11.9 _ _ -_ ___- 17.1 _ .- -_ - 9.0 (benefit as % o f HH consumption) 2005 6.7 11.1 15.7 8.5 Source: LSMS 2002,2005. 63, Defining clear and transparent criteria for allocating resources to local authorities should be a top priority. Benefit levels across local governments vary substantially, and payments are unpredictable. Accordingly, additional increases in the size of the conditional grants allocated to local governments should occur only after objective criteria have been defined and possibly should be linked to poverty status. 64. I n parallel, a careful assessment o f the eligibility criteria, disability qualifications, and assessment system o f the disability benefits would be advisable. The real expenditures on the non- targeted disability benefit program almost doubled during 2000-05 with the real value of the benefit increasing by over 60 percent to more than twice the average NE benefit. As the program i s not targeted to the poor and eligibility criteria are broadly defined, a careful assessment i s advised. It should include a review of whether a separate disability benefits system, independent from an overall Ndihme Ekonomike poverty benefit, i s justified and affordable. 65. Finally, with the expected additional increases in electricity prices, a review of the electricity subsidy program design and implementation arrangements i s warranted. Established in 2003, the electricity subsidy program, supported NE households and other vulnerable consumers by mitigating the impact of higher electricity prices. So far, however, uptake has been less than 20 percent o f eligible households, likely due to reverse incentives. The remaining obligation of a N E household after the 19 subsidy would absorb approximately 55 percent o f its NE benefit, and KESH will not disconnect service to these households in the event of n~npayment.'~ Implementation challenges, including information flows among the Ministry of Labor and Social Affairs (MoLSA), local offices, and KESH, are also affecting the effectiveness of the subsidy. The report suggests exploring whether absorption o f the electricity subsidy by the NE program to consolidate social assistance transfers would be more efficient, provided appropriate measures are taken to improve compliance with the payment o f electricity bills. SOCIAL PROTECTION: SUMMARY OF RECOMMENDATIONS Complete the review o f the social insurance system and embark on a comprehensive reform o f the pension system, securing a basic safety net for all with a possible differential benefit for actual contributors as one option. J Reverse recent declines in real program spending and in the real value of the benefit for Ndihme Ekonomike; simplify eligibility criteria and link payments to the number of persons in the household but do not preclude an upper limit on benefits. J Define explicit and transparent criteria for the allocation o f conditional grants to local governments, including the link to poverty. J Review whether a separate disability benefits system independent from an overall Ndihme Ekonomike poverty benefit i s justified and affordable. J Undertake a review o f the scheme aimed at mitigating the impact o f electricity tariffs increases on the poor to improve i t s targeting and delivery mechanisms (including the possibility o f using the NE). I " See ChaDter 8. Volume I1 for a full l i s t o f recommendations. F.4 WATER 66. Despite important improvements over the past few years in access to water and sanitation and in the operating efficiency o f water utilities, Albania remains one o f the poorest performers in the Europe and Central Asia Region. Access to water supply has increased by 33 percent since 1990 (to 78 percent o f households), and utility revenues have more than doubled in the past 5 years. However, these improvements have proceeded at a relatively slow pace, and Albania remains one o f the poorest performers in the region in access, service quality, efficiency, and financial performance o f i t s water utilities. For example, consumers receive on average 6-13 hours o f water per day compared with an ECA regional average of 19 hours. Within country, disparities in access and service quality also are stark. Figure 16. Ratios o f Non-Revenue Water (%) Figure 17. Staff Numbers Per 1,000 Connections 100 90 80 70 60 50 40 30 20 10 0 Sources: WB staff calculations; MoPWTT (M&B Unit); Sources: Danilenko and Child 2005, Water Market database ECA infrastructure. Europe; (World Bank); MoPWTT. The electricity subsidy scheme was revised in August 2006 in a way to expand the targeted beneficiary group, and raise the subsidy from 0.4 lek per kWh to 500 lek for the first 200 kWh consumed (around 2.4 lek per KWh). 20 67. Moreover, the efficiency improvements have already been outpaced by increases in O & M costs. The majority o f utilities perform poorly with very high losses (non-revenue water ratios average 69 percent, the highest in the region),16 l o w revenues (tariffs do not cover O&M costs, and collection rates are l o w at 70 percent with only 20 percent o f consumers being metered), over-staffing, and other technical inefficiencies (Figures 18 and 19). Moreover, the current system for allocating subsidies from central government rewards encourages rather than deters these inefficiencies. In addition, the poor and deteriorating state o f the infrastructure i s creating huge future liabilities for maintenance and rehabilitation costs just to operate at the current l o w service levels. On the other hand, it i s important to note that Albanian utilities vary significantly in operational and financial performance, and that some utilities have achieved close t o international standards in both service delivery and efficiency. 68. Accordingly, the sector’s Figure 18. Financing Operating Costs Through dependency on central government Tariffs and GOA Subsidy (lek million) transfers has increased in recent years. I ... ........................................................ The operating deficit i s covered in part by ~ operating subsidies from the central 5,000 61000 ................... .. ....... .... ...... ~. m~../ 1 n government, in addition to transfers o f 4,000 approximately L e k 1.6 billion per year from the State budget to clear an accumulated stock o f arrears to other budgetary and non-budgetary institutions - (0.20 percent o f GDP). Some 34 percent o f these arrears are owed to the state-owned 2000 2001 2002 2003 2004 2005 electricity company, KESH; the remainder IRepayment of arrears i s owned to the Social Security Institute, GOA operating subsidy (less arrears) General Tax Directorate, and the National Collected Tariffs Oil Company (Figure 18). +Operating cost (incl. depc) Source: GDWSS 69. I n the medium term, Albania could save up to 0.8 percent of GDP per year i f reform measures are accelerated to finance its sector needs. Conservative estimates suggest that achieving the MDGs will require cumulative investments o f approximately 7.4 percent o f GDP, or 0.7 percent annually over the next 10 years. This represents more than doubling the recent (2000-05) average annual investment o f 0.3 percent o f GDP. By raising tariffs to economic levels, improving collection ratios, and reducing losses and overstaffing, the report estimates that savings could reach 0.8 percent o f GDP annually (Table 7). These reforms will require significant political consensus and strong political will to increase tariffs and collections, and reduce over-staffing. Table 7. Potential (annual) Savings from Eliminating “Hidden Costs” Sources o f potential savings (annual): lek millions 1. Collection failure (improve collection ratios to 95 percent) 835 2. Under-pricing (raise tariffs to cover O&M costs, including depreciation) 857 3. Excess losses (reduce NRW to efficient level o f 20%)” 5,042 Total savings 6,734 As share o f GDP PA) 0.8 ” 20% was used as the efficiency frontier for NRW in the Ebinger study; thus, the hidden costs in Albania can be compared with the other countries in the sample. Source: WB staff calculations. l6 “Non-revenue water” (NRW) i s a measure o f sector inefficiency. I t measures the percentage o f water produced that i s not sold (invoiced) and i s a combination o f technical losses (leaks) and commercial losses. 21 70. One approach to achieve these goals would be to maintain current levels o f government financing o f 0.6 percent of GDP but, over the medium term, gradually reallocate it from operating subsidies to investment financing. During that time, utilities would be expected to increase revenues to recover O&M costs and depreciation, which would necessitate their improving in service quality. In the long term, once the sector begins to cover some o f the capital costs as well to generate net income, the central government could start to withdraw from investment financing o f water supply and focus on investments in wastewater collection and treatment. 71. T o make tariff increases more acceptable, water utilities need to make a major effort to improve service standards. Affordability analyses confirm that there i s ample room for increases in residential water tariffs, while the experience o f these utilities on the efficiency frontier suggests that the operational goal i s achievable within the medium term. 72. I n parallel, accelerating institutional reforms is necessary to strengthen the incentives and capacity for improved performance by utilities and local governments. In particular, the governance and financial arrangements among the utility, the local government unit (LGU), and the central government need to be clarified to complete the transfer o f assets and utility management to local governments. The further corporatization o f utilities also needs to be accelerated. In addition, the central government budget allocation system will need to be reformed to respond to development priorities- expanding access-but also to improve incentives for better performance at the local level. 73. The government’s emerging plan for reform in the sector should be accelerated and gather the political support of stakeholders. The government’s strategy i s t o (a) phase out the operating subsidy; (b) allocate investment subsidy on both needs and system performance, that is, make incremental improvements in a range o f financial and technical indicators; and (c) introduce a safety net for poor consumers. Without an acceleration o f the reform effort with support from relevant stakeholders, the sector will increase rather than decrease i t s reliance on the public purse, and achievement o f the sector goals wi 11 be jeopardized. WATER: SUMMARY OF RECOMMENDATIONS J Phase out operational subsidies to utilities in the medium term and transfer these savings to investments. J Allocate investment subsidies based on sector priorities and utility performance in the short term. J Raise residential tariffs to cover at least the cost o f O&M and depreciation in the short term and the full cost o f supply in the long term, and establish a safety net for the poor. J Increase collection rates from 72 percent o f bills to at least 95 percent through the development of an electronic customer database (where possible), removal o f illegal connections, and universal metering. J Clarify governance and financing arrangements among utilities, local and central governments and then accelerate the asset transfer to local governments. J Rationalize utilities staffing from 11 to 6 staff/l,OOO connections. I’See Chapter 9, Volume I1 for a full l i s t o f recommendations. F.5 TRANSPORT 74. Albania spends a significant share o f public resources on the transport sector, a reflection o f the importance of the sector for economic development and poverty alleviation. During 2002-05, the sector’s share o f total public expenditures averaged approximately 8 percent or 2.4 percent o f GDP, and absorbed on average 37 percent, the largest portion, o f total budgetary public investment. O f this, the roads sub sector consumed the largest share (89 percent), followed by railways at 5 percent o f sector spending. 22 75. Despite considerable investment, the condition of the road network remains poor, and quality lags behind regional comparators. Both perceptions o f businesses operating in Albania as well as indicators of outcomes point t o deterioration or slow improvement in the quality o f infrastructure compared to other countries. A recent survey o f the national or main road network undertaken by the World Bank for this report revealed that 67 percent o f the network was in poor or very poor condition, compared to 22 percent in Bosnia and Herzegovina and Croatia (Figure 19). Albania’s figure represents limited improvement compared to 2002 and reflects primarily the inadequate or insufficient maintenance regime. Municipal roads are in particularly bad condition, especially in rural areas. The government estimates that some 80 percent of the rural regional roads and some 85 percent o f the local municipal roads are in poor condition. Moreover, Albania has one o f the worst road safety records in the region, with a rate that i s almost twice as bad as most neighboring countries (Figure 2O).I7 76. These outcomes reflect large inefficiencies in sector spending. In the main roads sector, there i s a significant imbalance between recurrent and capital spending, with expenditures on maintenance totaling some 40 percent lower than needed. This underfunding o f maintenance creates significant future liabilities in the form o f future rehabilitation and reconstruction costs. It also raises the costs o f transport to road users in terms o f increased time and cost for travel and vehicular wear and tear. The recent decision to address this imbalance i s a welcome step. Figure 19. Status o f Road Conditions Figure 20. Traffic Deaths Per 10,000 Vehicles, 2002 (unless indicated otherwise) IAltxriace Im o 50 BHO 0- Source: BEEPS 2005. Source: BEEPS 2005. 77. Significant cost savings may be realized from extending contracting to the private sector and better management of the procurement cycle. Despite an emerging private contracting industry, the government’s use o f private contractors rather than o w n force account to undertake the necessary routine and winter maintenance has been limited to the World Bank’s Road Maintenance Project. Under the latter, periodic and routine maintenance operations was undertaken on nearly 25 percent of the national road network. The maintenance contracted out to the private sector was on average 20 percent less expensive than equivalent operations on similar terrain undertaken by the General Road Directorate (GW. 78. The Albania National Transport Plan (ANTP), which was recently formally approved by the government and agreed with all the donors, confirmed the investment priorities for the road network as rehabilitation, upgrading, and limited network expansion. The overall financing needs consistent with such a strategy has been estimated at US$ 150 million per year over 2005-09: US$ 45 million per year t o clear the maintenance backlog, US$ 65 million per year for normal maintenance, and 17 Note that the definition o f a road accident fatality in Albania differs from the comparators, lowering the indicator considerably. 23 US$ 40 million’* to expand the road network. These plans were considered consistent with sound capital management and the fiscal position o f the country. 79. Any additional investments in the road sector beyond those planned in the ANTP need to be assessed very carefully. In particular, since the Durres-Kosovo road corridor i s already part o f the ANTP, additional planned investments in this corridor would need to be consistent with current and projected demand and national priorities at this time, or they will crowd out planned or necessary priority expenditures in both this and other priority sectors. Future proposed investments need to be part o f the ANTP and the MTBP process (so that the trade-off with expenditures in all sectors i s considered), be consistent with the fiscal situation and planned overall capital expenditures, and be consistent with the principles of competitive selection and transparency. 80. Existing weaknesses in the planning and budgetary processes in the road transport sector still undermine the efficiency o f roads expenditures. In particular, the government needs to develop the capacity to update the ANTP in the future and strengthen procedures and institutional arrangements for public investment management planning, execution, and monitoring (section. G.2). Asset management and prioritization o f maintenance needs to be improved by the establishment o f a robust information base on the condition and use of the network. Additional priority measures that are necessary to improve the efficiency of expenditures include (a) a review o f road classification to rationalize maintenance standards; (b) greater private sector involvement in maintenance and expansion o f the road network including through output-based contracting, and (c) improved procurement and contract administration to reduce unexplained variations in unit costs. 8 1, I n the railway sector, the declining traffic volume and the significant deterioration in the financial position o f Albanian Railways (HSH) call for radical measures. The railway network i s small, antiquated, and in a very poor condition. Financial losses are aggravated by serious depreciation o f assets due to lack o f resources for rehabilitation (Table 8). At the verv least. the maior Table 8. Profit and Loss Accounts HSH, 2000-05 (lek 000) loss-making lines and 2002 2003 2004 2005 services should be closed in Operating expenditures 1,033,65 1 1,500,529 1,212,350 1,328,401 the short run. The continued Operating revenues 443,183 605,683 386,935 305,184 provision of recurrent Totaloperating loss 191,477 647,716 633,940 863,426 HtH, expenditures to the railway eratin subsidies 556,773 609,238 638,234 608,633 sector should be assessed So:rce: against i t s opportunity cost, both within and outside the sector. ANTP estimates future investment needs of US$ 7-12 million through 2015. Even at such modest scale, these investments should be considered only in the context of a sound business plan for the sector that clearly indicates which lines and services should be closed. Eventual privatization, possibly supported by a public service contract for socially necessary services, remains an important reform option. 82. Recent developments in ports and aviation illustrate how the private sector could play an increasing role in meeting Albania’s transport infrastructure needs. Rinas Airport at Tirana was concessioned in 2005 to a consortium, Tirana Airport Partners, under a “Build, Own, Operate and Transfer” (BOOT) concession arrangement with a 20-year term under which some US$ 90 million i s expected to be spent on the development o f the airport. Reforms to facilitate private participation have started in the maritime sector but implementation has been restricted to Durres Port. While the demand 18 These figures do not include the costs o f recent embellishments to the Milot-Morine nor the costs o f the recently proposed central corridor. 24 for publicly subsidized investment in the port sector i s strong, the case for such outlays i s weakening. The new Port Authority Law o f 2003 sets the stage for moving to a landlord structure under which future investment needs should be met from internal revenues or from private sector participation. 83. Given current fiscal constraints, it i s urgent to improve the framework for private sector participation in financing and providing infrastructure services. An improved framework will entail higher levels o f competition in service provision, as well as better regulation, oversight, and contractual adherence. An enabling environment for public-private partnerships (PPPs) requires political stability, sound macroeconomic policy, the rule o f law, and a high degree of transparency within a clearly defined institutional framework. The forthcoming amendments to the Concessions Law are expected to upgrade Albania’s Concession legal framework to conform to best international practice. TRANSPORT: SUMMARY OF RECOMMENDATIONS Establish an Asset Management Information System for the national road network and, within a reformed GRD, revise the existing classification o f roads to facilitate the professional management of the network. Increase allocation o f total transport spending to recurrent expenditures on roads to address backlog maintenance and increase spending on normal maintenance. Adhere to the agreed ANTP by subjecting all transport projects to the full cycle of the new guidelines on public investment management and strengthen technical capacity in project identification and appraisal. Prepare a sound business plan for the railway sector and terminate major loss-making railway passenger and domestic freight services. Develop institutional framework for PPPs, strengthening primary and secondary legislation on concessions as well as MoF and MoPWTT’s capacity to evaluate proposals, and assess the potential implicit and explicit contingent liabilities. Move toward contracting out all routine and periodic maintenance works, including through output- based contracts, and strengthening procurement and contract administration processes and practices. ” See Chapter 10, Volume I1 for a full list of recommendations. F.6 POWER 84. Albania relies heavily on domestic hydropower production for its electricity supply and, since 1998, as demand has outstripped domestic production, on imports. This reliance leaves the sector and the economy vulnerable to hydrological conditions and import availability and price fluctuations. Both financing and transmission constraints have hindered Albania’s ability to ensure adequate electricity imports and since 2000 have led to frequent load shedding. To improve security and quality o f supply, Albania needs to expand generation, transmission, and distribution capacity both through new investments and further rehabilitation o f the network. During 2006-1 0, the projected investments amount to US$ 1.3 billion, and attracting private investments will be vitally important. 85. The Albanian power system achieved substantial improvements in efficiency and financial performance during 2001-04 and does not draw heavily on fiscal resources. However, since early 2005, the performance o f the electricity sector has deteriorated and presents significant risks to public finances and to macroeconomic stability. Albania’s power sector still has a substantial, although declining, quasi-fiscal deficit (QFD), estimated to have been 2.5 percent o f GDP in 2005 based on long- run marginal costs. Despite improvements in sector performance, revenues collected from household consumers are still a small proportion o f the true cost, which results in their uneconomic use o f electricity and deprives the power sector o f resources needed for rehabilitation and expansion. I t i s therefore critical that efforts to reduce theft, improve collections, and gradually raise household tariffs continue to be given high priority (Figures 2 1 and 22). 25 Figure 21. Collection by Type of Consumers (YO Figure 22. Electricity: Total Loss YOof of Billed) Including Arrears Domestic Supply 200 i I -- I II 100 IO 10 50 20 1 1 0 1 I 1 1 0 2000 j 2001 2002 2003 2004 2005 I Collections (YOof Billed) 1 Households rn Other private 0 Budgetary 0 Non-Budgetary Sources: KESH and World Bank. 86. The government's direct financing of the sector also has been reduced significantly. I t no longer provides a direct subsidy to the power sector due to improved sector performance, but has agreed to provide loans, if required, during subnormal hydrological conditions. However, there i s indirect government support: the government guarantees certain loans and credits to KESH. The government also mitigates the impact of electricity tariff increases for socially vulnerable consumers. 87. Sustaining the past achievements while limiting reliance on the public purse will require meeting several outstanding challenges. These include the urgent needs to (a) augment domestic generation capacity, primarily through private participation; (b) further reduce technical losses by strengthening the transmission and distribution systems; (c) streamline import processes and solidify arrangements for participating in the regional market; (d) curb growth in household demand for power by reducing implicit subsidies and theft of electricity; and (e) strengthen the sector safety net for vulnerable consumers. Continued implementation of the sector reform program and safeguarding the independence of sector regulators and operators from political interference also are necessary. Unfortunately, the deterioration in sector performance since early 2005 has reinforced the urgent need for improved governance to ensure the sustainability of improvements in sector performance. 88. I n this context, the role o f the government in the power market should be limited to (a) supporting KESHs efforts to implement the annually updated Power Sector Action Plan, particularly reducing network losses and improving bill collection, and to implement appropriate sector reforms; (b) establishing an appropriate market structure and related institutional framework to ensure the provision o f an adequate and reliable supply of electricity at a reasonable cost; (c) assuming an appropriate share o f the commercial risks aligned with public (versus private) benefits; (d) staying current on its own bills; and (e) ensuring the provision o f social safety net that mitigates the potential negative impact o f gradual tariff increases on socially vulnerable consumers. The government should respect the autonomy o f both KESH and the Electricity Regulatory Authority (ERE), and support KESH's efforts to improve i t s financial and technical performance and to prepare to participate in a competitive regional market. 26 POWER: SUMMARY OF RECOMMENDATIONS 1. Provide the conditions for improving KESH’s operational and financial performance by: J Supporting KESHs efforts to implement the annually updated Power Sector Action Plan, particularly reducing network losses and improving bill collection, and to implement appropriate sector reforms. J Adjusting the base for VAT payments by KESH for electricity sales from billed to collected revenues, and allowing KESH to write o f f bad debts to determine profit tax liability in accordance with internationalpractice. J Eliminatingall financial arrears of budgetary and non-budgetary entities to KESH and ensuring prompt payment o f all current bills. J Undertake a systematic review (including design and implementation arrangements) of the existing scheme aimed at mitigating the impact o f electricity tariffs increases on the poor in order to improve targeting and delivery mechanisms (including the possibility o f using the Ndime Ekonomike program). 2. Support sector reforms: J Decide on the recommendations o f the Power Sector Restructuring Study regarding the KESH holding structure and implement the option selected. J Allow KESH and ERE to operate as an independent commercial corporation and an independent regulator, respectively. J Continue the reforms to implement a competitive market and enable effective participation in the regional market. ” See Chapter 1 1, Volume I1for a full l i s t o f recommendations. FOR PUBLIC SPENDING AND GOVERNANCE G. INSTITUTIONAL FRAMEWORK 89. Achieving a better allocation o f expenditures needed for fiscal sustainability and high quality fiscal adjustment will not happen “by fiat.” How successful the government will be in maintaining sustaining its fiscal consolidation efforts, and in i t s broader efforts to improve the quality o f the fiscal adjustment and budgetary outcomes, will depend critically on progress in building the institutions for fiscal management and the capacities needed to design and manage reforms. There are a number o f important measures that government can and should take in the short term. However, most of the important measures for maximizing the growth impact of public spending through sustainably raising its efficiency, based on sound program reforms, will require a comprehensive review o f the overall expenditure program as outlined above. 90. This comprehensive review cannot and should not be done at once but should be a continuous process. This process should entail identifying reforms o f the main expenditure programs, prioritizing programs and projects, and undertaking a careful assessment and monitoring of their impact. This process will require, first, an improved public financial management (PFM) system that ensures aggregate fiscal discipline and allocative efficiency and i s both strategic in focus and performance oriented. Second, a robust system for selecting, appraising, and managing public investment i s critical to rationalize the use of Albania’s limited investment resources and improve their efficient use. Finally, an effective and meritocratic civil service will be required to design and implement the ambitious agenda outlined above. 27 G.1 PUBLICFINANCIAL MANAGEMENT 91. Since 2001, Albania has made significant progress in a series of measures to strengthen its PFM ~ystem.’~ These have included the (a) progressive deepening of the medium-term budget planning reforms initiated in 2000; (b) introduction o f a program classification to facilitate a more strategic approach to resource allocation within spending agencies; (c) initial steps in a number o f ministries to cost major policies under the NSSED; (d) modernization and computerization o f the Treasury system; and (e) design and introduction o f an Integrated Planning System (IPS). 92. However, Albania still has a long way to go to achieve two key objectives o f a well- functioning P F M system, namely, operational efficiency and value for money in the use o f i t s public resources. This report, undertaken in parallel to the Country Fiduciary Assessment Update (CFAU), analyzed in detail the various stages o f the PFM cycle and identified five priority action areas to complement the government’s ongoing ambitious reform plan. Establish a single strategicplanning framework linked to resource constraints 93. The government’s decision to develop and consolidate through the I P S a single strategic framework for national priority and sectoral policy setting that takes due account of public resource constraints i s a laudable step. It also has gathered support from Albania’s development partners. This reform should be part and parcel o f a broader institutional reform aiming at strengthening policy formulation and coordination across government. I t will facilitate the success o f reforms at the sector level by better linking policies to budget plans. Moving ahead with the development o f the National Strategy for Development and Integration (NSDI) as a single comprehensive strategy covering all sectors should be complemented by a strengthened and credible MTBP process. I t follows that the MTBP should constitute the only framework by which expenditure implications o f the NSDI are analyzed and within which resource allocation decisions are made. The preparation and evaluation of sectoral strategies and plans must be made against a realistic fiscal resource constraint. For this to take place, the integration and strengthening o f capacities for policy analysis, program development, and budget planning in the major sector ministries should top policymakers’ agendas. Consolidate the link between policy formulation and budgeting 94. The MTBP and budget planning processes do not yet provide an effective vehicle for linking resource allocations to strategic policy and program priorities. In updating the MTBP, line ministries and spending agencies significantly changed resource ceilings. These divergences can be explained by (a) inadequate analysis in setting the original ceilings; (b) insufficient consultation with line ministries in setting resource ceilings; and (c) the impact o f adjustments resulting from updating the macro-fiscal framework. The introduction o f a simple budget program classification has improved the policy orientation. However, program budgeting will successfully assist resource allocation only when program budgeting goals are well understood. Then, government operations can be assessed (or at least challenged) in terms o f their costs as well as their conformity with stated policies and objectives. Capacity limitations emphasize the need to take a realistic approach toward more fully fledged program budgeting. Fix budget executionfirst 95. In-year reallocations and under-execution o f the budget have undercut the government’s sustained efforts to establish a more predictable and policy-led budget process. Constrained cash releases, lack of proficiency in cash management, weak procurement planning, and restrictive 19 The preliminary analysis and findings were presented and discussed with the Ministry o f Finance and other development partners active in the PFM area in February 2005. 28 procurement procedures are seriously undermining the efficiency of spending, most notably capital investment. In fact: The absence o f commitment control means that the MoF does not have a full picture of its cash flow demands. In the absence o f active short-term borrowing to mitigate in-year revenue fluctuations, the MoF resorts to conservatively setting cash release allocations during the first part o f the fiscal year, often resulting in cash rationing and budget cut-backs. J The single-year procurement regulation requiring that all procurement tendering against budget funds must be completed by 31 July2' results in most of the expenditure against procurement contracts occurring during the second half of the year and leads to an overuse o f direct procurement. Overuse results in higher costs and contributes to a short-term planning outlook that undermines recent initiatives to plan expenditures and public investment within a medium-termcontext. The new Procurement Law i s expected to address this problem. J There has been only a limited increase in the use o f open tendering, from 3 1 percent of contracts in 2003 to 38 percent in 2005. The remaining procurement (approximately 60 percent of contracts) i s conducted through restricted tendering and requests for quotations. Strengthen the institutional frameworks and capacities for PFM 96. Until recently, slow progress in reforming institutional structures and in addressing persistent capacity constraints across the P F M system have seriously impeded the implementation of P F M reforms. Despite the government's best efforts to strengthen capacities with the support of the international community, the MoF continues to face critical shortages of professional staff, while line ministries have made only limited progress toward strengthening policy, planning, and budgeting functions. The last three are critical, given that ongoing revisions o f the Organic Budget Law (OBL) will entail further PFM reforms that will require further capacity strengthening at the level o f line ministries. 97. Improved P F M outcomes will depend on more urgent priority being given to addressing these institutional and capacity limitations. Reducing the disconnect among policy, planning, and budgeting functions in line ministries by involving staff in the design of key sector reform initiatives and the evaluation o f their implications for budget planning should be a top priority. Improving the linkages among functions will enable sectoral budgets to reflect planned changes in policy directions. The recent proposal under the I P S to establish a General Directorate for Strategic Planning and Budgeting in each line ministry i s a step in the right direction. The MoF should facilitate and support greater engagement of line ministries in strengthening their own PFM capacities and managing better across the PFM cycle. In this context, and when revising the OBL, it would be better if the government and the legislators could avoid setting out the MTBP and annual budget cycle in excessive detail. Rather, it i s advisable to specify the overall framework and key events in the budget calendar, leaving the more detailed timetable to subsidiary regulations and guidelines. Strengthen accountability 98. While external audit and parliamentary oversight arrangements are fairly sound in design, their effectiveness is severely limited by capacity constraints. The coverage and quality o f the annual audit o f the State Budget prepared by the Supreme State Audit (SSA) has shown gradual improvement, but the budgetary institutions continue to do insufficient follow-up on its findings and recommendations. Moreover, scrutiny o f the budget by Parliament remains limited mainly because Parliament lacks the technical competencies and time to assess the budget proposals submitted by the Executive. The challenge for the medium term will be to establish a more meaningful and strategic engagement of Parliament and civil society on PFM issues. 2o October 3 1 for funds approved under the Supplementary Budget. 29 PUBLIC FINANCIAL MANAGEMENT: SUMMARY OF RECOMMENDATIONS J Develop and consolidate through the IPS a single strategic framework for national priority and sectoral policy setting that takes due account o f public resource constraints. J Strengthen the focus on the outer year MTBP resource ceilings so that they can provide a realistic and credible basis for medium-term budget planning at sector and agency level. J Develop clear and transparent procedures for virement and revision of annual budgets that provide budget users with appropriate flexibility while maintaining the integrity of the process. J Implement full-value multiyear procurement, particularly for capital investment projects following the revision o f the Procurement Law. J Finalize and approve (a) the new OBL and (b) updated Treasury regulations. J Establish at MoF a stronger management framework of overall processes in the PFM. J As proposed under the IPS, strengthen policy, planning, and budgeting functions in line ministries. J Further develop the program-based budget classification to strengthen the explicit linkages between the sectoral policies and the budget, in parallel with strengthened capacities. J Allow additional time in Parliament to discuss the Budget by allowing for a timely processing o f the MTBP. J Strengthen the Budget Analysis Unit in the Parliamentary Secretariat. J Ensure timelier follow-up by all spending agencies on external audit report queries and recommendations. ” See Chapter 3, Volume I1 for a full list o f recommendations. PUBLIC G.2 MANAGING INVESTMENT 99. Against declining levels o f foreign assistance, Albania can no longer afford delaying upgrading its public investment management systems. The challenge will be to ensure that these systems help sustain the pace o f infrastructure improvement by increasing the efficiency of capital spending, notably domestic investment. 100. Resources made available for public investment, particularly domestically financed public investment, should be used more effectively and efficiently than in the past. In fact, domestic resources are currently spread, with l i t t l e strategic focus or prioritization, across a huge number o f small projects. There i s evidence that this broad but shallow distribution has contributed to both excessive costs and poor construction standards. Moreover, sectoral analysis discussed in section F confirmed that, in most sectors, particularly infrastructure, capital spending i s not used efficiently due to institutional weaknesses and inadequate allocation o f O&M. 101. I n this perspective, the government has taken initial steps to strengthen public investment management. The transfer o f responsibility for this function from the Ministry o f Economy to the Ministry o f Finance, in which a new Public Investment Management Department has been established in the General Directorate of Budget, i s a step in the right direction and reflects a comprehensive and integrated approach to overall budgeting and planning which for years has been lacking. This step needs to be backed by a series o f measures. Critical actions for the short term are discussed below. 102. Priority needs to be given to developing procedures for project identification, appraisal, and approval. Externally ’ financed projects are subject to more rigorous selection and appraisal than domestically financed projects. Introducing a common process for both domestically and externally financed investment projects would ensure that all public investment i s subject to a common appraisal requirement regardless o f the source o f financing. New measures should ensure that public investment planning and procedures are fully integrated within the MTBP procedures for program expenditure and investment planning. New draft procedures applied for the supplementary budget 2006 and 2007 go in that direction. 30 103. I n parallel, a rationalization o f domestically financed projects i s warranted, namely, by (a) consolidating the large number o f small investment allocations into fewer, larger projects and (b) eliminating projects that are not consistent with strategic priorities or are determined not to be economically viable. Otherwise, procedures risk becoming engulfed by the sheer number of projects requiring approval and there will be little opportunity to focus on improving the quality of project identification, preparation, and appraisal processes. An additional requirement i s to introduce total cost funding approval and accounting that covers the full implementation period o f the investment project but with annual funding allocations, which could be aggregated at the program level and sanctioned through the annual budget process. 104. A weak information base at MoF on ongoing public investment projects also has undermined realistic expenditure planning and execution. There i s no single register of approved investment projects in which annual allocations and expenditures are recorded against the total estimated cost o f each project. The MoF should take early steps to establish a register o f public investment projects integrated within the public expenditure planning system being developed under the MTBP. The register should be linked to the introduction of the project-level coding structure in the new Treasury system without which it would be impossible to systematically record expenditures against individual projects. 105. The problems o f financing adequate maintenance highlighted above emphasize the importance of further developing the MTBP analysis at the sector level so that it can provide a more integrated and balanced approach to budget planning. Specifically, the MTBP should consider the appropriate mix between capital and operations and maintenance spending and, in the infrastructure sectors, attach greater priority to ensuring more adequate maintenance provision. 106. Finally, the incomplete recording of externally financed public investment i s undermining budget transparency and the resource allocation processes of the MTBP. Incomplete recording i s a significant factor behind the recorded underspending on externally financed investment. I t also reduces public accountability, particularly on projects for which the government i s required to make a local financing contribution and provide coverage for import duty and VAT payments. Accurate budgeting and recording o f externally financed public investment are essential for the MoF to strengthen public investment management. It i s an area in which the MoF will need to seek the assistance and support o f the donor community. Externally funded projects should be required to pass through the same identification, appraisal, and approval procedures as domestically funded projects. MANAGEMENT OF PUBLIC INVESTMENTS: SUMMARY OF RECOMMENDATIONS J Rationalize the portfolio o f domestically financed projects by (i)consolidating the large number o f small investment allocations into fewer larger projects; and (ii) eliminating projects which are not consistent with strategic program. J Ensure that public investment planning and management are fully integrated within the MTBP procedures for program expenditure and investment planning. J Introduce formally new procedures for project identification appraisal and approval linked to the MTBP process to be applied to both domestically and externally financed projects. J Make cost-benefit and/or cost-effectiveness analysis an appraisal requirement for large investments. J Adopt a full-cost, multiyear funding approval for all public investment projects. J Give priority to more adequate funding the maintenance o f infrastructure networks. J Agree with donors on the measures and a timetable that will enable external funding to be channelled through the Treasury Single Account. ” See ChaDter 4. Volume I1 for a full list o f recommendations. 31 EMPLOYMENT G.3 GOVERNMENT 107. To carry out the challenging reform agenda, the government will need an effective, well managed civil service and public sector. The size and the cost of Albania’s wage bill are in line with regional and similar high-growth-country comparators. Nevertheless, Albania i s not reaping benefits commensurate with this spending, as evidenced by the perceptions o f corruption in the public administration, poor quality of the bureaucracy, and suboptimal public sector outcomes in various sectors (section F). This report suggests four areas in which broad critical reform challenges need to be met to improve the performance of the public sector. f past civil service reforms Strengthening and improving the achievements o 108. Between 1999 and 2005, Albania made impressive progress on several key dimensions of public administration reform. The new Civil Service Law (CSL) passed in 1999. The related secondary legislation subsequently developed set out clear principles to govern relevant processes such as recruitment and selection, performance evaluation, and avoidance o f conflict o f interest. Improvements in these processes are already evident. Key achievements o f the reform include: (a) the establishment of a largely depoliticized civil service; (b) establishment o f independent checks and balance mechanisms for civil service management actions; and (c) increased attractiveness o f the civil service. 109. This reform agenda needs to be protected, adjusted to address particular weaknesses in those reforms, and reinforced. First, the de-politicization achievements need to be protected. Progress in the rationalization o f the size and structure o f the public sector has been made at a macro level through the functional review process. In few ministries, however, the consultative process underpinning the proposed restructuring has not been very extensive and the implementation o f the new structures was hasty. Consequently, a capacity vacuum has been created mainly due to the reduction o f 615 public employees2’, being mainly concentrated in the civil service ranks. This outcome constitutes an important risk to the de-politicization and meritocratic civil service management objectives o f the reforms undertaken over the last six years. If these achievements are not protected, Albania’s public administration will face significantly greater difficulties attracting, retaining, and motivating the human capital it needs to run an effective and efficient public administration. 110. Second, the performance appraisal process applied to civil servants needs to be revisited and improved to ensure that the performance appraisal system reliably identifies and rewards good performers while identifying and helping to improve the performance o f the poorer performing civil servants. A high proportion o f staff (94 percent) i s currently rated in the top 2 performance categories.22 While, in the short run, the existing system has room for adjustments (results-based appraisal, the use of multiple feedback providers), in the longer term, a comprehensive approach to performance management linked to government’s objectives could be envisaged. A program o f training will need to accompany any changes to the existing system. 111. Third, the functional reviews need to be pursued to achieve an efficient and lean public sector. O f particular importance i s the need to build on the existing progress and follow-up reviews of subordinate institutions. 2’ As o f the end o f April 2006. 22There has been some improvement, During 2001-04, the percent o f staff rated in the highest category f e l l from 5 8 percent to 43 percent, but this decline was counterbalancedby an almost equivalent increase in the percentage rated in the second category from 36 percent to 5 1 percent. 32 Broadening the coverage of the civil service reforms 112. A number o f important aspects of the reforms that have been applied to the roughly 3.4 percent o f central government employees covered by the CSL need to be gradually rolled out to other sets o f personnel within Albania’s public administration. The government needs to take a cautious and measured approach to any such expansion for at least two reasons. First, as can be seen from the previous paragraph, the civil service reforms are still a work in progress. As such, lessons are being learned continuously, and it will be important to build those lessons into any expansion o f the coverage of the CSL. Second, since an important part o f any such expansion will be reform o f salary structures in the rest of the public administration, the fiscal costs o f such expansion need to be carefully assessed in advance o f any salary reforms, to ensure both that they will actually help to attract, retain and motivate qualified staff (for example, by providing competitive remuneration), as well a s that their costs will be fiscally sustainable. This i s discussed below. Reforming the pay system for improved performance 113. The current pay system i s nontransparent and complex to manage. At present, six different pay systems coexist across the public sector. The range and structure o f total pay vary considerably in different systems, leading to major inequalities in total income for the same level o f work. The pay levels applicable to health and education staff are below those applicable for civil servants at equivalent job levels. While the civil service pay system i s reasonably decompressed, others are not. Moreover, at a given job level, differences in pay levels are minimal, leaving no room for recognition of improved performance based on growing experience. 114. There i s a consensus on the need to rationalize and harmonize the pay system to improve transparency and provide incentives for improved performance and accountability. The government supports the principle o f equal pay for equal work across the public sector, and two appropriate options have been identified:23 a) Common system o f job grades and pay ranges that would apply in all public sector institutions. b) Harmonized pay system in which health, education, and other public sector employees could continue to have separate pay and grading structures as appropriate to their type of work but in which pay equity would be established by deciding agreed relationships among key job levels in the different systems based on proper job classification. 115. Both options are valid and should go hand in hand with a performance-oriented pay system that i s fiscally sustainable and concentrated on promotions and “job level” progression, under a disciplined process. More specifically, performance bonuses practices need to be curbed by (i) limiting overall fraction of pay coming through performance bonuses; (ii) imposing discipline on awarding of performance bonuses. The cost o f achieving pay equity with a revised bonus system under the second option exceeds the available fiscal envelope, which suggests that a phased approach to implementation would be desirable. 116. Future increases in salaries and wages should follow the reform of the pay system. Recent improvements in the macro-fiscal conditions could create space for wage increases as opposed to other priority expenditures. However, these increases could be counterproductive if key structural factors that distort incentives for better performance are not properly addressed. Improving the incentive structure would have budgetary implications, but they need not be excessive if they are well targeted and introduced gradually within a medium-term budgetary framework. Accordingly, increases in wages and salaries in the social sectors should be linked to the reform program in the respective sectors. 23 Based on the work done by DOPAand the EU-financed Ramboll Project. 33 117. Finally, however, management of the civil service to deliver required outputs to high quality standards within fiscal limits requires effective and efficient organizational structures and processes. In addition to the needs to improve merit-based processes to ensure that the best people are appointed to jobs and to have in place a good system for appraising their performance, financial control o f staffing costs i s critical. Staff planning and budgeting need to be upgraded and require the completion of the automated payroll management system, without which the data on which pay policy i s based will remain as inaccurate as it currently is. Rebalancing wage bill and other recurrent expenditures 118. To improve the efficiency of public sector human resources employees, adequate complementary inputs are required for effective program design and implementation. Analysis o f sectoral chapters reveals that the overall balance between the wage bill and other recurrent expenditures i s atypically heavily concentrated within the wage bill. This wage-heavy imbalance compromises the capacity o f staff and the entities within which they work to effectively design and implement policies and programs, such as education and health care delivery. Teachers need books, well maintained classrooms, and other teaching supplies to teach effectively. Health care practitioners need medicines, well maintained healthcare facilities, and other supplies to deliver effective healthcare services. Albania’s high wage bill expenditures relative to other recurrent costs almost certainly compromises service delivery capacity by limiting access to complementary inputs. This balance needs to be redressed. GOVERNMENT EMPLOYMENT: SUMMARY RECOMMENDATIONS J Ensure compliance with the Civil Service Law and gradual expansion o f coverage of certain CSL provisions dealing with (i) competitive recruitment and selection; (ii) due process protection; and (iii)redress mechanism. J Continue functional reviews in subordinate institutions and follow up on those reviews while avoiding disproportionateretrenchment o f civil service positions. J Proceed with the development and costing o f a performance-orientedand harmonized pay system. J Increase concentration of pay in the human capital element o f pay to improve internal equity and overall transparency. J Concentrate the performance related pay increases in promotions and “job level” progression, but under a di.sciplinedprocess. More specifically, performance bonuses practices need to be curbed by (i)limiting overall fraction o f pay coming through performance bonuses; (ii) imposing discipline on awarding o f performance bonuses. J Establish a job classification framework to provide a rationale for ranking jobs within sectors and to enable objective comparison o f jobs across sectors. J Review and improve the current system o f performance appraisal and provide extensive training to managers and employees to make the performance appraisal system more effective. J Monitor competitiveness o f salaries by (a) carrying out regular market pay research to monitor the competitiveness of public sector pay levels, and (b) regularly monitoring staff turnover and any recruitment difficulties. J Accelerate the establishment o f the computerized payroll management system and link it to the Treasurv. ” See Chapter 5, Volume I1 for a full list o f recommendations. 34 Table 9. Albania: Selected Economic Indicators 1996 1997 I998 1999 2000 2001 2002 2003 2004 2005 (% change unless indicated otherwise) Nominal GDP (billions o f Leks) 3 14.9 322.2 412.3 474.3 530.9 587.7 624.7 682.7 766.4 836.8 Real GDP growth 9.1 -10.2 12.7 10.1 7.3 7.0 2.9 5.7 5.9 5.5 CPI inflation (annual average) 12.7 32.1 20.9 0.4 0.0 3.1 5.2 2.4 2.9 2.4 Lending interest rate, nominal, e.o p.a 28.8 43.0 25.0 25.8 23.7 11.9 16.0 10.5 13.7 12.2 Deposit interest rate nominal, e.o.p.b 19.1 27.8 16.5 9.1 7.7 7.8 9.3 7.6 6.0 5.6 Unemployment rate, annual average 12.4 14.9 17.8 18.4 16.8 16.4 15.8 15.0 14.4 14.2 (% GDP) Foreign savings' 11.5 8.0 3.3 3.7 3.6 2.8 7.2 5.5 3.8 5.0 Gross domestic savings 4.0 8.8 12.9 16.2 21.1 24.8 17.4 17.9 20.0 18.6 Publicd -8.6 -8.8 -4.6 -1.6 -1.6 -0.6 0.0 -0.1 0.1 0.8 Private 12.6 17.6 17.4 17.8 22.6 25.4 17.4 18.0 19.9 17.8 Gross Investment 15.5 16.8 16.2 19.9 24.6 27.6 24.5 23.4 23.8 23.6 Public 4.5 4.3 5.8 7.8 6.6 7.3 6.7 4.6 5.0 4.6 Private 11.0 12.5 10.4 12.1 18.0 20.2 17.8 18.8 18.8 19.0 (% GDP) Total rev & grants 18.3 18.3 24.2 25.5 23.8 23.7 24.7 24.5 24.1 24.0 Total exp & net lending 30.4 31.4 34.5 34.9 31.9 31.6 31.4 29.0 29.2 27.4 Interest payment 3.1 5.8 8.8 7.5 5.8 4.3 4.0 4.4 3.7 3.1 Primary balance -9.0 -7.3 -1.6 -1.9 -2.4 -3.6 -2.7 -0.2 -1.4 -0.3 Overall fiscal bal -12.1 -13.1 -10.3 -9.4 -8.2 -7.9 -6.6 -4.5 -5.1 -3.4 Public & publicly guaranteed debt 84.6 75.9 72.7 72.8 67.6 65.0 61.8 56.5 54.5 Domestic 46.5 43.5 43.4 42.6 41.0 41.7 41.1 38.5 37.9 External 38.1 32.4 29.3 30.2 26.6 23.3 20.7 18.0 16.6 (% GDP unless otherwiseindicated) Export GNFS 11.6 11.1 10.3 17.3 19.0 20.4 20.5 20.8 21.5 21.7 Imports GNFS 36.0 37.3 35.8 41.9 40.6 42.9 46.3 45.9 43.2 44.3 Current account bal. -9.1 -11.1 -6.3 -7.6 -6.6 -5.8 -10.0 -8.1 -5.5 -6.5 FDl, net 3.4 2.1 1.5 1.1 3.9 5.0 3.0 3.2 4.6 2.9 Worker remittances 14.1 11.6 16.1 9.5 12.1 13.2 13.0 14.0 13.8 14.2 Official reserves [months o f imports] 3.1 4.5 3.7 3.8 4.1 4.6 4.4 3.9 4.1 4.2 (% GDP unless otherwise indicated) Broad money 49.1 61.6 58.1 61.7 61.8 67.1 65.3 65.0 65.7 68.5 Domestic credit 3.5 4.0 3.6 3.6 4.2 4.7 6.4 7.7 9.3 14.5 In local currency 2.3 1.7 1.4 0.8 1.5 1.6 2.0 3.6 In foreign currency 1.3 1.8 2.8 3.8 4.9 6.1 1.3 10.9 Private domestic credit growth 30.5 19.0 14.7 13.3 31.8 23.4 41.0 31.0 37.0 74.9 Exchange rate Lek/US$, e.0.p. 105.0 150.7 150.3 138.2 143.9 143.5 140.4 120.9 102.5 100.2 Exchange rate LekEuro, e.0.p. 147.5 133.5 130.6 138.5 142.6 132.5 124.0 a/ Refers t o interest rate o n 6-12 month loans in lek. bi Refers t o interest rate o n 12-month deposits in lek. ci Negative o f current account including official transfers. ' Revenue including grants less current expenditure and net lending. Sources: NSI, MoF, B O A , I N S T A T , W o r l d Bank, and IMF databases. 35