Cambodia - Public expenditure review enhancing the effectiveness of public expenditures (Vol. 1 of 2) : Summary

Report No. 18791-KH Cambodia Public Expenditure Review Enhancing the Effectiveness of Public Expenditures (In Two Volumes) Volume I Summary January 8, 1999 Poverty Reduction and Economic Management Sector Unit East Asia and Pacific Region Document of the World Bank CURRENCY EVALUATIONS Currency Unit = Cambodian Riel AVERAGE VALUE OF US$1.00 IN 1995 1996 1997 December 1998 2451 2,624 2,946 3,700 WEIGHTS AND MEASURES Metric System GOVERNMENTS FISCAL YEAR January I - December 31 ABBREVIATIONS AND ACRONYMS ADB - Asian Development Bank ADD - Accelerated District Development Program BIS - Bank for International Settlements ASEAN - Association of South-East Asian Nations CCC - Cooperation Committee for Cambodia CDC Council for the Development of Cambodia CIF - Cost, Insurance and Freight CG - Consultative Group CR - Cambodian Riel CRDB - Cambodia Reconstruction and Development Board CSES - Cambodia Socioeconomic Survey CVAP - Cambodia Veterans Assistance Program DHC - District Health Center DFW - Department of Forestry and Wildlife EPI - Expanded Program of Immunization FAO - Food and Agriculture Organization of the United Nations FDI - Foreign Direct Investment GDP - Gross Domestic Product GSP - General System of Preferences MEF - Ministry of Economy and Finance MFN - Most Favored Nation MOEYS - Ministry of Education, Youth, and Sports MOH - Ministry of Health MOP - Ministry of Planning MTEF - Medium-Term Expenditure Framework NBC - National Bank of Cambodia NGO - Non-Governmental Organization O & M - Operations and Maintenance ODA - Official Development Assistance PER - Public Expenditure Review PIMS - Public Investment Management System PIP - Public Investment Program PSI - Pre-shipment Inspections RCAF - Royal Cambodian Armed Forces SEDP - Socioeconomic Development Plan SWAP - Sector-Wide Approach UNTAC - United Nations Transitional Authority in Cambodia TA - Technical Assistance TVET - Technical and Vocational Education and Training UNDP - United Nations Development Programme UNESCO - United Nations Educational, Scientific and Cultural Organization UNICEF - United Nations Children's Fund USAID - United States Agency for International Development VAT - Value Added Tax WHO - World Health Organization WTO - World Trade Organization Vice President: Jean-Michel Severino, EAP Chief Economist: Masahiro Kawai, EAP Country Director: Ngozi Okonjo-Iweala, EACSM Acting Sector Manager: Kyle Peters, EASPR Task Manager: Su-Yong Song, EASPR TABLE OF CONTENTS Page No. A. INTRODUCTION .................................................................. i B. RECENT ECONOMIC DEVELOPMENTS AND STRUCTURAL REFORMS .........................II C. PROSPECTS FOR DOMESTIC REVENUE MOBILIZATION ............111....................... D. ANALYSIS OF THE LEVEL AND COMPOSITION OF PUBLIC EXPENDITURES ................... vii E. ASSESSMENT OF PUBLIC EXPENDITURE MANAGEMENT: INSTITITUTIONAL DIMENSION.........x F. MACROECONOMIC FRAMEWORK, RESOURCE ENVELOPE, AND PUBLIC EXPENDITURES............. XiV G. CONCLUSION .................................................................. xvi SUMMARY OF RECOMMENDATIONS ..................XVII....... .....................xvii ACKNOWLEDGEMENTS This report was prepared on the basis of an economic mission that visited Cambodia in March 1998. The report was prepared by a team led by Su-Yong Song (task manager), and composed of Bill McCleary (advisor), Tom Hart (revenue mobilization), Govinda Rao (public expenditure analysis), Geoff Dixon (public expenditure management), Wijaya Wickrema (accounting and audit), Marc Quintyn (macroeconomic framework, IMF), Bill Magrath (forestry issues), Markus Kostner (military demobilization), Anil Deolalikar (health and education), Vin McNamara (education), and Ky Tran (statistics and projections). Contributions were also made by Rama Lakshminarayanan, Peter Moock, and Christopher Thomas. The peer reviewers were Vinaya Swaroop, Malcolm Holmes, Jeffrey Hammer, Pascale Kervyn De Lettenhove. It was prepared under the guidance of Masahiro Kawai (Chief Economist, East Asia and Pacific Region), Ngozi Okonjo-Iweala (Country Director, EACSM), Kyle Peters (Acting Sector Manager, EASPR), and Richard Newfarmer (Lead Specialist, EASPR). The manuscript was edited by Emily Evershed and typed and formatted by Lily Tsang. The team would like to express its gratitude to various ministries and agencies of the Government of Cambodia throughout the preparation of this report, in particular the Ministry of Economy and Finance, the Council for the Development of Cambodia, the Ministry of Health, and the Ministry of Education, Youth, and Sports. The team would also like to express its gratitude to various donor and NGO agencies, especially WHO, UNESCO, UNICEF, and MEDICAM. The report was discussed with the Government of Cambodia in December 1998 and revised on the basis of these discussions. A. Introduction 1. After two decades of conflict, Cambodia remains one of the poorest countries in Asia--with a per capita income of less than US$300, widespread poverty, and weak social indicators. 36 percent of the total population is below the poverty line. Poverty is concentrated in the rural areas, with 40 percent estimated as poor, four times higher than the II percent poverty incidence in Phnom Penh. To reduce poverty significantly and enhance economic and social well-being, Cambodia has to implement a coherent economic program that will produce rapid and broad-based economic growth over the long term. 2. As the centerpiece of such a program, the government must tackle its underlying governance problems. In particular, the government must take decisive actions in the areas of economic management, including weak domestic revenue mobilization, inadequate and inefficient public expenditure management, and environmentally unsustainable forestry management. 3. To be sure, since 1993 Cambodia has made remarkable initial progress in stabilizing the economy, in restoring economic growth, and in undertaking policy reforms to transform the economy into a market-oriented one. In particular, inflation which averaged 140 percent per annum during 1990-92 was reduced to single digits during 1995-97. Since 1996, however, despite the government's piecemeal efforts the progress in implementing key fiscal and structural reforms stalled due partly to the political developments. The medium-term prospects remain bleak unless the government swiftly takes determined actions in addressing the interrelated fundamental fiscal and governance problems. The Prime Minister's speech on October 22, 1998 and the subsequent Royal Government of Cambodia's Platform on Second Term, 1998-2003 demonstrate an awareness of this need and reaffirm the new government's commitment to implementing the necessary fiscal and structural reforms. While it is encouraging that they are broadly consistent with the recommendations made in this report, the challenge for the government is to fully follow through with its renewed commitments. 4. Weak physical infrastructure and, more important, the inadequate capacity of human resources severely constrain Cambodia's medium-term development potential. The majority of people lack access to potable water and the schools and health clinics are yet to be rebuilt. Rural areas lack serviceable roads, irrigation systems, and agricultural extension facilities. Industry and trade are hampered by high transport costs, the low quality and unstable supply of electric power, and poor telecommunications facilities. The effects of conflict have been even more devastating on human resources. Almost 35 percent of the total population is illiterate and only about 10 percent is engaged in skilled occupations. About a third of the population aged five years and above has had no education, only 20 percent have had schooling beyond the primary level, and only 4 percent have completed lower secondary education. The infant mortality rate, at 90 per 1,000 live births, is one of the highest among the countries in the region and about 50 percent of children suffer from malnutrition. Moreover, the lack of adequate physical and social infrastructure limits access to public services by the poor households. Most poor households, particularly in rural areas, have lower access than more affluent households to important economic and social services. All of these factors place severe limitations on labor productivity. 5. Public expenditure policy plays an essential role in reconstructing physical infrastructure, developing human resources, and improving the accessibility of public services to the poor. First, the level of public expenditures and the methods employed to finance them are important from the viewpoint of macroeconomic stability. Second, spending on social and economic services directly contributes to poverty alleviation and broad-based economic growth. Third, the allocation of public expenditures among various activities determines their efficiency and the ability of the economy to deliver social and -11- economic services. Fourth, the assignment of fiscal responsibilities among different levels of government determines the responsiveness and incentives in the provision of public services according to the diversified needs in different regions. The regional distribution of public expenditures determines the accessibility of public services to the poor. Fifth, the institutional mechanisms for formulating and implementing expenditure policy contribute to accountability and incentives, and also determines the efficiency with which expenditures are translated into public services. 6. This Public Expenditure Review (PER) undertakes, for the first time, a systematic review of the adequacy and effectiveness of public expenditures in Cambodia. Rather than narrowly focussing on expenditure issues, the PER takes a broader approach--it closely links public expenditure issues to revenue mobilization and governance problems as reforms to enhance the effectiveness of public expenditures need to be implemented in a comprehensive context. While the PER analyzes sector- specific issues for various sectors within the overall framework, it provides a more in-depth analysis of the health and education sectors because of their direct relevance to poverty reduction strategy through human resource development. The PER aims to help the government strengthen its capacity to manage public expenditures. The PER is composed of two volumes. This volume summarizes the findings of the main report. A summary of recommendations is presented in the matrix in this volume. 7. Throughout the preparation, the PER greatly benefited from close collaboration of the various ministries and agencies of the Royal Government. In particular, the PER benefited from the extensive discussions with the Ministry of Economy and Finance (MEF) and the numerous reports issued by the MEF on the occasions of the preparation of budget and the reporting of its implementation which have made a broad analysis of the fiscal situation focusing on the lack of discipline in fiscal management and the failure in implementing proper management procedures. The PER also benefited from the consultations with various donor and NGO agencies, especially on the health and education sectors. B. Recent Economic Developments and Structural Reforms 8. The Royal Government, a coalition government formed in 1993, performed well during its initial years and made remarkable economic progress. Continued Khmer Rouge insurgencies, however, led to pressures on defense expenditures. Since 1996, tensions between the two main coalition partners over power sharing escalated and culminated in the July 1997 events. Partly reflecting this, the government's reform efforts weakened considerably, which adversely affected economic performance. While macroeconomic stability has largely been maintained, little progress has been made in implementing the measures to address the interrelated fundamental fiscal and governance problems, namely weak domestic revenue mobilization, inadequate and inefficient public expenditure management, and the lack of governance in economic management (forestry management in particular). More recently, the political and security situation improved significantly with the formation of the new coalition government resulting from the national elections held on July 26, 1998 and the marked weakening of the Khmer Rouge elements. 9. Since mid-1997, the economy has suffered two shocks. One was the political events of early July 1997 and the ensuing suspension of a substantial part of donor assistance. The other was the regional financial crisis. Although it is difficult to separate the respective impact of the two shocks, the impact of the political events appears to have been initially more severe than that of the regional financial crisis. While the July 1997 events and the ensuing political uncertainty substantially affected growth, particularly through undermining investors' confidence, the impact of the regional financial crisis to date has been mitigated by the highly dollarized nature of the economy. The adverse impact of the regional financial crisis has been manifested mainly in the cancellation/delay of committed investment projects and in the drop in tourism. -111- 10. The macroeconomic outcome for 1997 was somewhat better than had been expected immediately after the onset of the two shocks, thanks to the government's fiscal discipline. After registering an average rate of 6 percent during the previous five years, GDP growth decelerated to 1 percent in 1997. Tourism and construction were the hardest hit. Stagnation deepened in 1998. GDP growth in 1998 is estimated at zero percent due to the draught and continued regional financial crisis and political uncertainty. Fiscal performance in 1997-98 largely repeated the fragile pattern of the past few years: civilian non-wage operating expenditures were compressed significantly to sustain macroeconomic stability in response to a revenue shortfall and an overrun in defense and security outlays. Budgetary developments in 1998 were particularly worrisome. The government has borrowed CR 82 billion (or 0.8 percent of GDP) from the National Bank of Cambodia (NBC)--for paying salary arrears, integrating Khmer Rouge defectors, and also financing a part of the election costs--after having avoided bank financing of the budget deficit since 1994. The most significant monetary development during 1997-98 was a sizable withdrawal of foreign currency deposits as a combined result of the political developments and regional financial crisis, which led to significant deceleration in monetary growth. Substantial declines in dollar-denominated prices of imports from neighboring countries that were undergoing financial crises mitigated inflation in 1997, and thus it was contained at 9 percent. In 1998, inflation accelerated to 12 percent owing mainly to the rice price increase resulting from a rice harvest shortfall and also from the hoarding of some commodities ahead of the July election. The exchange rate remained largely stable during the first half of 1997, but depreciated by 20 percent during the second half. In 1998, the exchange rate has stabilized after a rapid rise during May-July owing to the uncertainty in the runup to the July election. Although the rate of depreciation of the riel has been substantially lower than that of the currencies of other countries in the region, this has as yet had little significant effect on exports as Cambodia has no quota on garment exports whereas most regional competitors have already filled their quotas. I1. Whereas some progress has been made in the areas of banking supervision and the privatization of state-owned enterprises, progress in implementing key structural reforms was not satisfactory and in some cases took a backward step. While the adoption of the Law on Taxation was a major step toward revenue enhancement, the measures under the Law on Taxation have not been fully implemented; the initial introduction of Value-added Tax (VAT) for about 800 large taxpayers, which was to be effective from 1998, has been postponed until January 1, 1999; the granting of ad hoc tax and customs exemptions has continued; the exemption from pre-shipment inspections has been extended; and the Implementing Regulations for the Law on Investment have allowed granting tax holidays for virtually every sector in the economy. Moreover, despite the government's piecemeal initiatives, no significant improvement in addressing the fundamental problems in forestry has been made (see paras 19-20). C. Prospects for Domestic Revenue Mobilization 12. Current Situation. Domestic revenue as a share of GDP doubled between 1991 and 1994. Since then, however, it has been flat at about 9 percent during 1995-97 and worsened further to 8 percent in 1998. This level of domestic revenue in Cambodia is about half of the average for low income countries. The main reasons for poor revenue performance are: (i) inadequate implementation of the Law on Taxation and delay in introducing a VAT; (ii) generous tax exemptions granted under the Law on Investment; (iii) ad hoc tax and customs duty exemptions, often associated with unwarranted political interference; (iv) weak capture of forestry revenue; and (iv) limited capacity in tax and customs administration. 13. The current low revenue effort is extremely detrimental to achieving sustainable development over the medium term. Nevertheless, there exists substantial revenue enhancing potential. Foregone revenues in 1996 and 1997 estimated by the PER based on known information were large, amounting to -iv- 5-6 percent of GDP each year (equivalent to two-thirds of actual budget revenue). In addition, owing to the delay in implementing a VAT, another 1.7 percent of GDP was foregone during 1998. To realize the existing revenue potential, the government needs to decisively implement the following recommendations, the core of which lies with improving governance. 14. Implementing the Law on Taxation and the VAT. In terms of revenue generation, about 80 percent of the new tax measures under the Law on Taxation are currently being implemented. These measures--the tax on turnover charged on the first sale after import, the excise tax on automobiles, the base expansion of the tax on salary, the fringe benefits tax, the new tax accounting rules for the tax on profits, and the introduction of withholding taxes under the tax on profits--need to be fully implemented. 15. The government has decided to implement the VAT initially for about 800 large taxpayers beginning January 1, 1999. The preparation for the implementation--training tax officials, drafting sub- decrees and supporting regulations, publicity campaign, taxpayer registration, education, and advisory visit--has been largely on track. After some delay since the elections in July 1998, the preparation for the VAT implementation accelerated during the last few months. For the effective implementation, the government needs to swiftly issue necessary sub-decrees and regulations, and continue and intensify the training at the Tax Department, education of taxpayers, and publicity campaign. The whole year implementation of the VAT would add 1.7 percent of GDP to revenue collection, because a significant portion of turnover tax (which is transformed into the VAT at a single rate of 10 percent) was collected at the border in the form of a consumption tax at a standard rate of 4 percent. As it would take some time before becoming fully operational, the expected revenue enhancement from the VAT implementation in 1999 would be somewhat lower than the full effect. 16. Limiting Tax and Duty Exemptions. The Law on Investment is one of the most critical impediments to improved revenue mobilization. The Law provides too generous incentives: tax holidays of up to eight years; a permanent 9 percent corporate tax rate after the end of the holiday period; duty free importation of capital goods and other fixed and movable assets; duty free importation of raw materials for export enterprises; and restrictions on the taxation of remissions abroad. There is little justification for the tax incentives provided under the Law on Investment. The corporate tax rate (20 percent) is 10-15 percentage points lower than those of other ASEAN countries. In addition, the tax on profits provides other incentives which include rapid depreciation and a five-year operating loss carry forward. The combination of these two provisions would eliminate the need to grant tax holidays. Moreover, the experience of other countries indicates that tax incentives rank low on the list of the major determinants of investment flows as compared with political and economic stability, a sound legal environment, and an adequate quality of physical infrastructure. Furthermore, the exemption of certain earnings, dividends, and interest, paid abroad, is hard to justify on the grounds that they in fact represent a subsidy to foreign governments, as most of the payments exempted in Cambodia are taxable in the home country of the investor. 17. In addition to the exemptions granted under the Law on Investment, various ad hoc tax exemptions, such as on rubber exports, play a significant role in undermining the revenue potential of the tax system. Even more serious, the government has granted a quasi-legal character to the exemptions, as in the case of logging and cement production. This has been accomplished through the Implementing Regulations which now extend the scope for exemptions to virtually every sector, in particular to natural resource exploitation, beyond the initial intent to limit them only to manufacturing activity. 18. The combination of the Law and the Regulations has eliminated any room for the business income tax to be a policy instrument in the revenue mobilization effort. With the Law on Investment in its present form, tax revenues would be limited to domestic taxes on goods and services and trade taxes. -V- Once Cambodia becomes a member of ASEAN shortly, revenue from trade taxes will be limited, and therefore, the only real revenue potential will be constrained to domestic consumption taxes. Thus, the government is urged to revise the Law on Investment and the Implementing Regulations by: * Removing all the incentives currently granted to resource and resource processing firms from the Implementing Regulations. * Removing the production of consumption goods from the preferred sectors in the Implementing Regulations. (However, the revision of the Implementing Regulations to this effect should not be retroactive.) * Repealing the 9 percent tax rate, the tax holiday period, and the profits reinvestment rule in the Law on Investment, with grandfathering up to three years. While the implementation of some of the above recommendations (except for the first and the second one which can be undertaken quickly) could be carried out over the medium term, the legislative preparation needs to be carried out in next few months. 19. Proper Capture of Forestry Revenue. Forests are Cambodia's most developmentally important natural resource and could bring in significant revenues. The current forestry situation, however, poses serious governance problems and shows evidence of pervasive corruption. Conditions in the forestry sector have continued to decline and illegal logging and log smuggling have reached alarming levels. It was estimated that illegal logging in 1997 totaled between 3 and 4 million cubic meters. This is three-eight times levels that are sustainable. If the current anarchic situation continues, the commercial potential of Cambodia's forest resource would disappear in less than five years. 20. The revenue loss arising from illegal logging to the government in 1997 is estimated as well in excess of US$60 million, or 2 percent of GDP (as compared with the actual collection of one-fifth of that amount in the budget). It was reported that private and unofficial rent amounted to US$14 per cubic meter, in addition to the official royalties and the unofficial charges associated with the original felling operation. Thus, in the short term, much of the potential for increasing government revenue would come from re-channeling private and unofficial rent capture. Toward this end, the government must take the following "emergency measures" immediately to arrest the deteriorating situation:(i) stop granting new concessions; (ii) freeze approving all new investments in wood processing; (iii) establish mechanisms to monitor and prevent illegal log felling and exports; (iv) enforce cancellation of all permits for "collection" of logs and stop issuing new permits; and (v) strengthen the Forestry Department. 21. Furthermore, over the medium term the government must implement the recommendations of the four studies it has conducted with the aid of Bank Technical Assistance--which are essentially completed and embody the framework suggested by the Bank/UNDP/FAO and also by the government's own forest policy consultants--with a view to establishing an environmentally sustainable, economically sound, and market-oriented forestry management: * Log Control and Monitoring. The current forest law enforcement crisis justifies a special effort to control illegal logging, increase revenue collection, and facilitate movement toward a more efficient log trade regime. A set of protocols for assessing the scope, spatial distribution, and character of illegal logging has been tested and needs to be developed for transfer to the government. * Legal Study. Concession contracts are badly biased against the government, but they do specify performance obligations which are likely to form the basis for a structured and legally defensible challenge to individual contracts on a case-by-case basis. A draft model -vi- contract has been prepared, comments on the draft forest law have been submitted, and a training program has been conducted. Forest legislation needs to be resubmitted to the National Assembly, following revision. An earlier draft did not provide an effective platform for forest exploitation, risks perpetuating the current system of arbitrary allocation of forest resources, and does not resolve key institutional issues. * Forest Concession Management. Concessions can provide the basis for sustainable sectoral development provided a satisfactory policy framework is put in place, regulations are strengthened, and security and technical guidelines are enforced. A framework of planning, harvesting, and revenue systems will be provided and, following review and consultation, will need to be formalized through appropriate legislation or regulation and implemented through pilot projects. * Forest Policy. Elements of the government's forest policy are at odds. Pressures for immediate revenues are now swamping the concerns about sustainability; strong measures and commitments will be needed to redirect privately appropriated rent to the public treasury; land allocation is chaotic and arbitrary; community involvement in forest development is severely limited; and public statements are inconsistent. 22. The government recognizes the importance of decisively implementing the recommended actions of the four studies, and has indicated its willingness to embark on these challenging tasks. To achieve these medium term objectives, the government must take the following actions for the next few months: prepare a proposal for illegal logging control; prepare the illegal logging monitoring program; undertake a performance review of concessions; and prepare the Cambodia Code of Forest Practice (CCPF) which is essentially an operational manual that lays out the rules for concession operations. In the subsequent few months, these actions should be followed by: the preparation of the revised forest law; decisions on the termination or renegotiation of concession contracts; the preparation of a sub-decree establishing the operational manual for concession management; the strengthening of the implementation capacity of forestry management; and the strengthening of law enforcement capacity regarding illegal logging. 23. Strengthening Tax Administration/Governance. While strengthening tax administration, especially in the audit capacity and in VAT implementation, would be important, more fundamental improvements must be made in governance, particularly in the elimination of the unwarranted intervention that undermines the rule of law and the authority of tax administration. The Law on Taxation was the first serious attempt to consolidate tax legislation into a code. Legislation passed prior to the Law, however, remains outside the Law. In addition, there are several draft laws in circulation that also contain tax provisions. All issues relating to taxation should be included in the Law on Taxation with the MEF responsible for legislative drafts, implementation, and administration. As part of the administrative protest procedure under the Law on Taxation, the final step in the process involves the Committee of Arbitration. Constraints must be placed on this Committee so that it does not legitimize the process of appealing to the Prime Minister's Office or the Council of Ministers for special relief or ad hoc exemptions. The authorities need to amend the Law to require that any other exemptions not specified in the Law should be void. Regarding customs administration, the government extended the exemption from pre-shipment inspections (PSI) to imports for the projects approved under the Law on Investment, garments, and cigarettes which together amount to about three-fifths of total customs imports. To protect the import tax revenue base and to generate the revenues that should be collected at import, the government must place more reliance on the PSI. The PSI should be required on all shipments over some minimal c.i.f. value. The government should require that the official PSI valuation be used as the customs value for duty and domestic tax purposes. Finally, rents and fees collected by some of the line ministries should be fully transferred to the Treasury, as they are often collected and used in a non- transparent manner. -Vi- D. Analysis of the Level and Composition of Public Expenditures 24. Scope of Public Expenditures. It is difficult to obtain a reliable picture of the total expenditure of a public nature because a significant portion of aid-financed expenditures are not captured in the government's official budget. Thus, with a view to presenting a more complete picture, in collaboration with the government, the PER constructed a consolidated database covering the period from 1994 to 1997, combining the budget data at the MEF and the donor aid database at the Council for the Development of Cambodia (CDC) in a consistent manner by function, by economic classification, and by region. This resulted in evaluation of three different concepts of spending on public services: (i) public expenditures financed from domestic revenues raised by the government; (ii) expenditures included in the government's official budget; and (iii) total spending on public services financed from the government, donors, and NGOs. 25. Level of Spending on Public Services. In 1996, expenditures financed from the government's own revenues amounted to only 8.4 percent of GDP. Expenditure estimates included in the official budget were 17.2 percent of GDP. On the other hand, aggregate expenditures on public services from all sources constituted 24.8 percent of GDP. Total spending on public services from all sources as a share of GDP was more or less constant at about one-quarter during 1994-96 (while it dropped to 22 percent in 1997 owing mainly to the partial suspension of external assistance). This means that expenditures financed from the government's own revenues contributed about one-third of total spending on public services. It also implies that about one-third of total spending on public services would be lost if the analysis is limited to the official government budget. The budgetary expenditure level in Cambodia was much lower than the average expenditure levels prevailing in East Asian economies--for example, Vietnam (24.7 percent) and Lao PDR (22.1 percent)--and most of the regional averages. 26. Role of Government and AidAgencies. From the viewpoint of expenditure maneuverability, the sources of financing expenditures are important. Financing from the government's own revenue sources formed only about 42 percent in 1994 and steadily declined to 34 percent in 1996. Thus, a major proportion of financing for public services was from external donor and NGO assistance, especially in social and economic services. In 1996, for example, government financing of social services was about 34 percent, and for economic services it was a mere 12 percent. In 1997, donors suspended their assistance mainly in the economic sectors in the aftermath of the July 1997 events, but continued and even strengthened their assistance in the humanitarian/social sectors. 27. The predominance of donor financing of public services limits the ability of the government to determine expenditure allocations according to its own priorities. The issue of sources of financing, however, is immaterial if resources are fungible. While there exist some empirical evidence in other countries that aid may be partially fungible, it is difficult to assess the extent of fungibility in Cambodia. 28. Functional Composition of Public Spending. The most conspicuous feature of the functional composition of expenditures incurred from the government's own revenue efforts is that outlays on defense and security have crowded out resources for spending on development activities. In 1996, for example, the preemption of almost a half of government revenues for defense and security left the government with only about one-third for spending on the reconstruction of physical and social infrastructure. (It should be noted, however, that these expenditures included some spending of social and economic nature such as allocations for the families of defected Khmer Rouge soldiers and infrastructure rehabilitation for them.) -viii- 29. Defense expenditure during the period 1994-97 varied from 3.3 percent to 5 percent of GDP, owing mainly to continued Khmer Rouge insurgencies. This level of spending compares unfavorably with the average of 2 percent in 1990 for the East Asian countries and 2.3 percent for the developing countries taken together. To make expenditure reorientation toward development spending possible, it is critical to significantly reduce and rationalize military expenditures. In this regard, decisive implementation of the Cambodia Veterans Assistance Program (CVAP)--which has been put on hold owing mainly to the political events--will be essential. With the effective implementation of the demobilization program (demobilizing 43,000 soldiers over the next three years, for example), the share of defense expenditure in GDP could be reduced from 3.3 percent in 1997 to 1.9 percent by the year 2002 ("peace dividend'). Toward this end, the government needs to take the following preparatory steps for the next few months: (i) the updating of the CVAP (especially in view of Khmer Rouge defectors); (ii) the identification and registration of special target groups; and (iii) the pilot demobilization of special target groups. 30. In Cambodia, as elsewhere, the poor do not have adequate access to land or capital, and investment in human resources is a critical policy component of the development strategy to accelerate growth and reduce poverty. The development experiences of successful countries in the region underline the importance of investment in education and health in improving labor productivity and increasing the shared basis of economic growth. However, the outlay for human resource development from the government's own resources has been extremely low. In 1996, for example, expenditures on education and health from the government's resources constituted only about 1 percent and 0.5 percent of GDP, respectively. Even when total expenditures on public services (i.e., financed from government, donors, and NGOs) are considered, the education and health sectors together secured only 5 percent of GDP, which is inadequate in view of the massive human resource development needs. Similarly, the total expenditure available for physical infrastructure was limited to less than 4 percent of GDP. In particular, in a country where 85 percent of the population and 88 percent of the poor are concentrated in rural areas, the agriculture and rural development sectors received only 22 percent of the total expenditure allocation. It is of critical importance to allocate adequate expenditures to irrigation, rural roads, and agricultural extension service to help extend a market economy to rural areas and enhance income earning opportunities for the poor. 31. In addition to increasing the level of spending on economic and social services, the efficiency and equity of public expenditure within the sectors needs to be enhanced. In the health sector, Cambodian households are paying far more than they can afford for health care (US$33 per capita per annum) and government-financed health spending is woefully inadequate (US$7 per capita per annum). Thus, there is a need to increase government spending on health significantly, particularly through greater cost recovery. The Ministry of Health (MoH) is piloting programs of cost recovery on a trial basis. One of the highest priorities for the MoH should be to see how the large informal fees that are already being paid by individuals to public health providers can be formalized and internalized. It is important that the user fee collection process be transparent and the collected revenues be kept at the facility level to improve the quality of services. Equally important, government health facilities need to increasingly target their services to the poor individuals and underserved provinces since the private sector caters disproportionately to the more affluent groups. To the extent that secondary and tertiary based facilities are disproportionately used by the better-off while primary care facilities such as health centers are used mostly by the poor, government health policy needs to shift its focus from secondary and tertiary care to primary care. 32. In the education sector, there is substantial scope for increased cost recovery through charging official school fees. The Ministry of Education, Youth, and Sports (MoEYS) has yet to establish a cost recovery policy to benefit from regularizing or formalizing the currently widespread unofficial fees and -ix- contributions. The MoEYS needs to consider introducing user fees especially in higher education institutions, with transparent collection mechanism at the facility level. Tertiary and technical education (including language, technical, and management training) takes up a disproportionately large share of the total public spending (i.e., including donor aid) on education. While tertiary and technical students account for merely 0.5 percent of all students in Cambodia, public spending on tertiary and technical education took up 30 percent of total public spending on education in 1996. At this stage of development, the government needs to focus spending more resources on the provision of basic education and lower secondary education. At the same time, it needs to put in place policies which encourage private sector involvement in upper secondary, tertiary, and technical education. Such policies need to include a regulatory and quality control framework, public information systems, and policies which ensure access for the poor. 33. Economic Composition of Public Spending. Owing to substantial over-employment, salary expenditures in 1996 constituted about 43 percent of current expenditures despite the low salary levels of government employees. Low salary levels tend to reduce productivity levels in the public sector. Low salary levels also encourage a high degree of absenteeism on the one hand and rent seeking on the other. In this regard, effective implementation of public sector reform including civil service reform, which has been stalled owing to lack of consensus and political uncertainty, will be critical. While there may not be much scope for expenditure reduction, the scope for rationalizing expenditures to make them effective, efficient, and productive is immense. In order to achieve this medium term objective, the following actions need to be taken over the next several months: (i) strictly limit new hiring and reduce the number of civil servants through eliminating ghost workers and also through normal attrition; (ii) carry out a civil service census to provide a record of numbers and grades, education attainments, experience, and skills which will facilitate personnel planning; and (iii) prepare options for the appropriate role of government, the appropriate structures for that role, the needed skills mix for the reformed government, and the pay, training, and recruitment policies to support that mix. 34. Expenditures for civilian non-wage operations and maintenance have been squeezed to the bare minimum in the course of budget implementation (an average of 23 percent shortfall as compared with the budgeted allocation during 1994-97) because of revenue shortfalls and overruns in defense non-wage O&M. This has resulted in underuse, or inefficient use, of capital investment and ineffective service delivery. It is of the utmost priority to secure an adequate amount of non-wage O&M to ensure the efficiency of capital investment and the quality of service delivery. 35. A very low level of local funding of investments has affected the government's ability to influence investment in public services so as to implement its development strategy, and insignificant counterpart financing has adversely affected the technical efficiency of developmental projects. The minimal level of counterpart funds has led to ineffective implementation of externally financed investment. Although some progress has been made to link the Five-Year Socio-economic Development Plan (SEDP) with the investment allocations included in the annual budget more closely through the Public Investment Program (PIP) process, the linkage between the medium term plan and the annual budget remains weak. In particular, public expenditure financed from government revenues during 1996- 97 (which is essential for the effectiveness of public investment by providing O&M support) allocated only 5 percent to agriculture and rural development, which raises concerns as to how the target of allocating 65 percent of public expenditure benefits can be channeled into rural areas where 88 percent of the poor live. 36. Regional Composition of Public Spending. Cambodia has a highly centralized system of public finances. The provincial share of expenditures financed from the government's own revenues in 1996 was only about 22 percent. Almost 97 percent of provincial budget expenditures were of current -X- spending. Thus, the provinces have scarcely any role in building physical infrastructure. As they lack the powers to raise revenues or vary the level and composition of expenditures, the provinces have neither the incentives nor the accountability to provide public services efficiently to match the preferences and requirements of different regions. (However, the government recently approved the Provincial Budget Management Law, which devolves certain limited revenue and expenditure powers to provinces.) 37. The spending by the aid agencies is concentrated in the better off regions, particularly Phnom Penh. In 1996, for example, Phnom Penh, which has only 7.5 percent of the total population, received a predominant share of 51 percent of the total donor assistance (excluding nationwide programs). This could be explained by the fact that the bilateral and multilateral donors tend to dispense funds in areas which are more accessible, have facilities, and can be monitored more effectively. Although more balanced than the donor-financed expenditures, the regional distribution of the government's budgetary expenditure also seems to favor the relatively better off provinces. The consequence of these two factors has been the concentration of expenditures in Phnom Penh: total expenditure on public services per capita in Phnom Penh was ten times higher than that in the other provinces together in 1996. Since poverty is heavily concentrated in rural areas, this pattern does not serve the equity objectives of the government well. E. Assessment of Public Expenditure Management: Institutional Dimension 38. Overview. The effective translation of government expenditures into expenditure outcomes depends critically on institutional arrangements through affecting incentives that govern the size, allocation, and use of budgetary resources. Institutional arrangements influence the quality of the outcomes on three levels: (i) aggregate fiscal discipline; (ii) resource allocation and use based on strategic priorities (allocative efficiency); and (iii) the efficiency and effectiveness of programs and service delivery (technical or operational efficiency). Institutional arrangements alone, however, may not necessarily have any effect. For such arrangements to be binding, the mechanisms that make adherence to these rules transparent and that hold the government and its ministries accountable for bad performance are necessary. 39. To better assess the budgetary process in Cambodia, it is essential to understand the current fiscal system, adopted with the Organic Budget Law in December 1993. Under the previous system, although tax and expenditure policies were determined by the central government, the provinces were empowered to collect revenues and the center depended on the transfers from the provinces to meet its expenditure requirements. The unification of the budget in 1994 swung the pendulum completely in the opposite direction, from a rather anarchic to a highly centralized system of public finances. Under the current system, local governments do not have revenue-expenditure decision making authority. They merely act as agents or implementing bodies of the central government. The recently approved Provincial Budget Management Law, however, recognizes provinces as independent budgeting entities and devolves some limited revenue and expenditure powers. 40. Budget institutions and processes in Cambodia have made a remarkable contribution to macroeconomic control. In the late 1980s, unsustainable large budget deficits funded by new money creation contributed to galloping inflation. This peaked at 150 percent in 1991 and continued at high levels until 1994, before decreasing markedly to single digits, with the adoption of the Organic Budget Law and the subsequent reforms aimed at improving budget management. Budget institutions and processes in Cambodia, however, have been very detrimental to allocative and technical efficiency. The fundamental problem is that the Cambodian budgetary process has sacrificed too much in terms of allocative and technical efficiency to maintain aggregate fiscal discipline. Thus, the challenge is to -Xl- enhance the allocative and technical efficiency of the budget process without compromising the high level of aggregate expenditure control which is being achieved by highly centralized budgeting practices. This involves improving the current unnecessarily large trade-off between aggregate fiscal discipline on the one hand and allocative and technical efficiency on the other. In fact, in the longer run there is evidence that improving allocation and operational performance can support improved fiscal discipline. 41. Linking Planning, Policy, and Budgeting. Closely linking planning, policy, and budgeting is one of the most important factors contributing to desirable budgetary outcomes. The Five-Year SEDP (1996-2000) sets out the developmental objectives and strategies for the medium term and makes an indicative allocation of the investment pattern. This has to be translated into concrete expenditure programs in the annual budgets. Over the last four years, some important progress has been made to link the Plan with the annual budget through three-year rolling PIPs; nevertheless, the linkage between the medium term plan and the annual budget remains weak. A critical institutional weakness is the absence of a proper system of monitoring. There is no system in place to monitor whether the actual disbursement of assistance to these sectors and sub-sectors has, in fact, occurred. The government has recognized this problem and a system for monitoring of the PIP is to be established under the Public Investment Management System (PIMS). 42. Budget Preparation. Budget preparation takes place in several elaborate stages. Despite this elaborate system, although some progress has been made in involving other ministries and agencies in the process, in practice the MEF largely dominates the entire budget preparation process. The involvement of strategic agencies such as the CDC, the Ministry of Planning, and the NBC is limited. Although every line ministry has to prepare its budget allocation on the basis of the expenditure ceiling provided, the financial controllers--officials of the MEF--attached to line ministries play the lead role. The involvement of the provinces is even less. The preparation of the budget by different departments of the provinces is carried out under the guidance of the financial officials deputized to the province by the MEF. While this is due largely to the weak capacity of other agencies as well as the need to exercise strict fiscal discipline, it brings up problems of incentives and accountability. 43. Budget Execution. Budget execution is very highly centralized, with the MEF approving the individual spending decisions of line ministries to an extent which has few parallels. Expenditure approval processes in the provinces are even more complex. A single expenditure action can involve approvals from the responsible line ministry, the Department of Financial Affairs at the MEF, the provincial governor, and the provincial treasury. Expenditures are subject to complex central controls intended to tightly control the evolution of the budget deficit through the course of the year. The very highly centralized approach to budget execution ensures a high level of expenditure discipline. However, these controls render the proactive management of programs by line agencies extremely difficult and also significantly reduce the allocative and operational efficiency of the budget process. 44. Owing to the uncertainty of government receipts from month to month and the ad hoc (and often unwarranted) injection of new spending priorities (in particular in defense and security) into the budget process, budget execution is dominated by a monthly cash allocation process at the MEF. This prioritizes the access each line ministry will have to the cash expected to be available during the month. However, the process of authorization is a long and complex one. Financial controllers employed by the MEF and assigned to line ministries, provinces, and municipalities play a central role in this process. Financial controllers undertake a pre-audit of each expenditure proposal by line ministries. Payment orders issued by the financial controllers in response to a purchasing activity which they approve are cleared through the MEF. Notification of MEF approval is then given to the national or provincial treasury, authorizing the treasury to make a direct payment to the external supplier. -xll- 45. The monthly cash allocation process does take account, to some extent, of the claims of the competing ministries, and involves a form of ad hoc reprioritizing in the face of unforeseen cash flow constraints. However, the reprioritizing is undertaken without the same transparency and review mechanisms that characterize the budget preparation phase, thus reducing the allocative efficiencyof the budget process. More serious is the effect on the technical efficiency. The technical inefficiency created by the highly centralized system of cash allocation to line ministries relates particularly to the tendency for cash release to be irregular and unpredictable during the budget year. Operational units of line ministries are uncertain about how long each allocation will last, distorting the manner in which they determine their own spending priorities. Lack of resources to finance the projects on a continuous basis can also result in time and cost overruns. For example, while the Ministry of Public Works and Transport would like to spend on road repairs when the road conditions are bad after the monsoon, they cannot undertake these repairs until the end of the year. In addition, there exists a practice of informally borrowing from local moneylenders at exorbitant rates of interest to meet immediate expenditure obligations and repaying the money when the liquidity position improves. The monthly allocation practices during budget execution, often resulting from unwarranted political intervention, raise questions about the value of the elaborate processes associated with budget preparation and also point to the importance of developing the capacity for reliable and honest revenue projection. 46. A further reason why ministerial and provincial departments effectively fail to receive their budgeted allocation is associated with the informal diversion of funds released to individual agencies for uses unrelated to the agency program ("leakages" of funds). These leakages fall into two categories: the diverted funds are used for other programs, compromising the allocative efficiency of the budget; and the diverted funds supplement the personal income of those processing the payments (outright corruption), resulting in technical inefficiency owing to the higher than necessary budget cost of achieving given program deliverables. 47. Budget Monitoring and Reporting. Although the government has taken several steps to improve financial management and public accountability, efforts to increase transparency and accountability in the public sector have yet to bring the expected outcomes because of weaknesses in implementation and lack of a proper accounting and auditing system and sound financial management at line agencies. Thus, budget monitoring and reporting remains very weak. The severe limitations of the accounting and auditing systems are detrimental to technical efficiency because they create an environment that is more conducive to widespread leakages. There is an urgent need to establish a standard accounting system for line agencies which offers greater transparency of transactions and helps to curb leakages. Linked with this is the need to establish an audit capability, both internal and external, for line agencies. A draft Audit Law is under consideration to establish an independent Auditor General's Office reporting to the National Assembly. When the Audit Law and the relevant decrees under discussion are approved in current form, the laws would establish the basis for a modem auditing function. 48. Recommendations. Given the history of fiscal and macroeconomic instability, it is clearly undesirable to introduce changes to budget processes which might weaken the current effective management of the budget deficit. However, considerable scope exists for improved allocative and technical efficiency in the budget process consistent with the present high levels of fiscal discipline. This relates particularly to the institutions and processes involved in budget execution. Because of the weak technical capacity at the central and provincial levels, the government should focus on the pragmatic removal of impediments to effective budget operation. The six key directions for reform are: * Ensuring political commitment to an authoritative budget process * Establishing responsibility for performance at the level of spending units * Rationalizing the roles of the central and provincial administrations -xiii- * Developing financial participation schemes (user charging) * Improving the allocative and technical efficiency of donor funding * Strengthening the Public Investment Management System. 49. The top priority is for the government to respect the budgetary process, because if the government does not abide by its own budget rules and procedures (which has often been the case in Cambodia), there is little point in making efforts in designing budget reforms. In this regard, reducing unwarranted political interference in the budgetary process should be considered as the prerequisite for any budget reforms. Another prerequisite is to improve the managerial and accounting and reporting capacities at the spending units. This is especially so if responsibility for performance at the level of spending units is to be established--which is the key to improving the trade-off between fiscal discipline and allocative and operational efficiency--without unacceptable loss of financial control. 50. Toward this end, the government needs to take the following concrete steps: * Ad hoc spending decisions taken outside the budget preparation context should be minimized. Where new spending measures are proposed during the course of the budget year, they should not exceed the reserve budgeted for this purpose. * The foremost medium-term direction for change is to increase responsibility for effective program performance at the program agency level. The government needs to gradually extend the scope for lump sum program allocations rather than detailed line allocations. The government introduced the Accelerated District Development System (ADD) which provides more efficient and flexible funding for hospitals and health centers in a small number of districts as a pilot approach toward program-based budget allocation. An evaluation of the effectiveness of the ADD needs to be undertaken and a trial of a similar program-based scheme needs to be planned in other agencies. * Before introducing more devolved budgeting, good financial management skills within line agencies need to be established. The MEF needs to establish a financial management improvement team to help agencies introduce ministry-wide accounting systems for reporting, analyzing, and benchmarking resource use by each of their functional units. * If financial decision making is to be devolved, the responsibility for program performance needs to be clearly assigned to the program units. To this end, the MEF needs to prepare a timetable for introducing activity-based budget bids by line agencies over a five-year period. * A priority should be given to separating the roles of the line ministries and provincial governors in the disbursement of budget funds. In parallel, the financial management skills of the regional units of line ministries should be upgraded within each line ministry. * The existence of financial participation (user charging) schemes should be acknowledged as a significant budget tool, and the incidence and terms of such arrangements should be progressively documented over time. A set of guidelines should be developed by the MEF on the circumstances in which user charging is appropriate, the appropriate basis for determining charges, and the handling of associated equity issues. * To improve the efficiency of donor funding, aid coordination needs to be strengthened, in addition to strengthening the capacity to identify, design, and implement projects. A promising way to move toward better aid coordination would involve the adoption of the Sector Wide Approach (SWAP), under which responsibility for sector development is shared collectively between donors and the government. Preparation for a SWAP needs to be initiated in the health sector, as the MoH has established a better capacity for this and coordination between the MoH and donors is relatively close. Even at the MoH, however, a number of system-wide issues, such as managerial decentralization, reforms in accounting -Xiv- and budgeting systems, and changes in staffing incentives, should be addressed for a SWAP to be adopted effectively. * The line ministry's capacity for monitoring the implementation of the PIP needs to be strengthened. The development of PIMS needs to be extended beyond a broad framework for linking capital budgeting institutions, to become a vehicle for developing concrete strategies aimed at overcoming the current weak links in the operation of the capital budget cycle. 51. Donors' Role. To effectively complement the government's efforts, donors need to play a significant role in two areas: well-coordinated capacity building and better aid coordination. The current situation is such that much donor assistance bypasses the budget and involves direct funding of project contractors. This reflects a lack of donor confidence in line ministry capacity to identify, design, and implement projects. Magnifying the problem is the weak coordination at the sectoral level. This has resulted in a fractionalized public sector effort with little central organization and control and with a number of adverse side effects such as: (i) the absence of strong government ownership of many projects; (ii) piecemeal efforts by aid agencies toward sectoral issues and institution building; (iii) weak coordination among donor programs; (iv) a proliferation of different procurement, disbursement, auditing, and progress monitoring activities among agencies; and (v) the creation of special project units, staffed by expatriates or by nationals with "topped up" salaries, with adverse impacts on institution building. 52. Thus, the donors' first role is to provide well-coordinated technical assistance and training to strengthen the line ministry's capacity in a more systematic and programmed manner. Ad hoc approaches to capacity building would make the proposed budget reforms more difficult to implement. The donors' second role is to move toward better aid coordination, such as through a SWAP. The effective subordination of donor activities to mutually negotiated sector-wide strategies would be not be easy and there would be problems of agreement among individual donors regarding responsibility for specific inputs or outcomes. However, this approach would link donor funded capital spending more closely with the priorities identified in the SEDP. Furthermore, a sector-wide approach would move toward common management arrangements and could lead to more coordinated and explicit donor involvement in sector development to help strengthen the institutional capacity in line ministries. F. Macroeconomic Framework, Resource Envelope, and Public Expenditures 53. Whether the government would implement the recommendations of the PER--in terms of revenue enhancement, improvement in governance, expenditure rationalization, and improved budgetary management--would have significant implications for medium-term sustainability. With a view to highlighting the importance of decisively implementing the policy recommendations, two alternative scenarios are presented: the full reform scenario and the status quo scenario. 54. The Full Reform Scenario. This scenario assumes that the government will take decisive actions to reinforce macroeconomic stability, mainly through prudent fiscal policies, and, more important, to implement structural reforms at an accelerated pace. Under this scenario, it is expected that domestic investment would pick up and foreign investment would accelerate. As the government would decisively pursue the reforms, the international donor community would be willing to continue its financial support. As a result, economic growth would start to accelerate from 2000 and would reach 6-7 percent by 2002. Inflation would gradually decrease to 5 percent by 2002. 55. Revenue would increase from the current 8-9 percent of GDP to 13-14 percent by 2002. It should be noted that revenue enhancement would be gradual after a one shot jump in 1999 with the initial -xv- introduction of the VAT as this scenario assumes the step-by-step implementation of policy recommendations, in forestry management in particular, over the medium term. In addition to benefiting from growing tax and non-tax revenue, the government's full implementation of structural reform would engender higher foreign inflows which would be needed for the successful transition toward sustainable development. This would require commitments of official assistance of about US$405 million (excluding IMF assistance which is for international reserve accumulation) per year during 1999-2001, of which about US$50 million would be budget/balance of payments support to cover some recurrent expenditures--especially for civil service reform and military demobilization. 56. The growing resource envelope would allow the government to increase spending and to bring about the required reorientation in spending. Current expenditure would reach around 11-12 percent as compared with the current 8-9 percent, which would allow for some long-awaited wage increases for civil servants--which should go hand in hand with the civil service reform--and for increases in non-wage operations and maintenance. Capital expenditure could be increased to 7-8 percent from the current 3-4 percent. Expenditure reorientation would also be facilitated by the peace dividend of military demobilization. Benefiting from the peace dividend and increased revenue, expenditure for the non-defense sectors could be doubled in GDP terms by 2002. In particular, spending for health and education financed by the government's own revenues, taken together, could grow from the current 1.5 percent of GDP to nearly 5 percent by 2002. 57. In sum, this scenario underlines the critical need for enhanced revenue performance, improved governance, and expenditure reorientation as the core of the government's macroeconomic stabilization and structural reform policies. Credible policies, aimed at stabilizing the economy and providing the framework for durable economic growth and at increasing government revenue through consistent tax policies, would also increase foreign aid inflows and enable the government to pursue its expenditure plans. Given Cambodia's current level of economic development, this is the only possible way to reduce poverty and rebuild the country. 58. The Status Quo Scenario. This scenario assumes that the government would not demonstrate the decisive political will to implement a package of far-reaching structural measures and to reinforce macroeconomic stability. This would be reflected in minimal increases in budgetary revenue and only a slight improvement in defense and security expenditures. Moreover, the lack of credible reforms would reflect on the business climate, leading to a lack of growth in domestic, and in particular foreign, investment. As a result, output growth would be 2-2.5 percent and inflationary pressures would intensify and keep inflation in the 16-20 percent range. Under these circumstances, revenue would still be about 9 percent of GDP by 2002. Without major improvements in the country's economic situation, several donors would reduce their grants and loans, so that foreign finance would decrease in GDP terms. 59. This insignificant revenue growth would prevent the government from improving expenditure patterns. Moreover, the government would not be able to finance the overall deficit entirely with foreign inflows, so that it would become necessary to resort to domestic bank financing, which would threaten fiscal sustainability. Under this scenario, no improvements could be expected in sectoral allocation. Outlays for defense and security would remain high without the effective implementation of military demobilization. This, in conjunction with low revenue, would limit spending on key sectors such as health and education. 60. Between the two extreme scenarios, a host of intermediate cases and outcomes are possible, depending on the extent of the efforts made to address the issues discussed in the PER. One probable scenario is that the government would only implement reform measures minimally affecting powerful entrenched interests. Any effort to raise revenues above the path envisaged in the status quo scenario, as -xvi- well as any effort to reduce military expenditure, would open up the possibility of increasing and/or reorienting some civilian expenditure categories. Such a policy might lead some bilateral donors to lend more funds or give more grants, taking away some pressures for domestic financing of the budget deficit. A likely outcome would be higher GDP growth and lower inflation compared with the status quo scenario. 61. Downside Risk. One distinct downside risk is afurther deepening of the regionalfinancial crisis. This would threaten macroeconomic stability and limit the scope for growth over the medium term. Under the full reform scenario, the effects of such a risk could be reduced with prudent macroeconomic policies. In addition, the high degree of dollarization and the fact that the country is still largely agrarian would also help mitigate some of the effects of the regional crisis. Nevertheless, it is likely that foreign direct investment inflows from the region would slow down, which would have a negative impact on growth and employment. A slowdown in tourism would also have a negative impact. Withdrawals of foreign currency deposits could further weaken the already fragile financial system, and a further depreciation of currencies in neighboring countries would erode Cambodia's export competitiveness. In addition, a further slowdown in the economy would have a negative impact on government revenue, which would slow down the reorientation of government expenditure. It is obvious that the impact of the above effects would be all the more dramatic under the status quo scenario, and a prolonged regional crisis under this scenario is likely to render the economic situation deeply unsustainable over the medium term. G. Conclusion 62. The current economic situation poses a serious threat to medium-term sustainability. To make a transition toward sustainable development with significant poverty reduction and broad-based economic growth, Cambodia must substantially upgrade the current weak physical infrastructure and the poor quality of human resources. Toward this end, the government must decisively implement the recommendations made in the PER--as summarized in the attached matrix--to resolve the interrelated fundamental fiscal and governance problems. As the political and security situations improved significantly, the new government is now in a position to demonstrate clearly strong political will in renewing its efforts to reinforce macroeconomic stability and implement structural reforms. SUMMARY OF RECOMMENDATIONS Issues Recommendations Time Frame Immediate: < 3 months Short-tem: < I year Medium-term: > I vear 1. Increasing Domestic Revenue Mobilization The current low revenue effort is extremely detrimental to achieving sustainable development. The effectiveness of public expenditure policy as an instrument for accelerating growth and reducing poverty is severely constrained by weak revenue effort. The authorities must address weak governance which is the core of the current low revenue performance. 1. The new measures of the Law on Fully implement the measures of the Law on Taxation. = Immediate Taxation are partially implemented. 2. The implementation of the VAT Effectively implement the VAT initially for 800 largest taxpayers beginning January 1, 1999: = Immediate has been delayed. * Swiftly issue the sub-decree on the VAT and supporting MEF regulations. = Immediate * Continue and intensify the training at the Tax Department, education of taxpayers, and => Immediate publicity campaign. 3. The Law on Investment and the => Remove all the incentives currently granted to resource and resource processing firms from the Immediate Implementing Regulations are too Implementing Regulations. generous, posing one of the most Remove the production of consumption goods from the preferred sectors in the Implementing = Immediate critical impediments to improved Regulations (but not retroactive). revenue mobilization. Repeal the 9 percent tax rate, the tax holiday period, and the profits reinvestment rule in the Law Medium-term on Investment, with grandfathering up to three years. 4. Despite its significant revenue Immediately take "emergency measures" to arrest the deteriorating situation: stop granting new potential, forestry continues to concessions; freeze approving all new investments in wood processing; establish mechanisms to Immediate make a very limited contribution, monitor and prevent illegal log fellings and exports; enforce cancellation of all permits for as the severity of illegal logging "collection" of logs and stop issuing new permits; and strengthen the Forestry Department. has worsened. => Implement the recommendations of the four studies assisted by the Bank TA (i.e., legal review, forest concessions management, forest policy, and log control and monitoring) with a view to establishing an environmentally sustainable, economically sound, market-oriented forestry management over the medium term: * For next three months: prepare a proposal for illegal logging control; prepare the illegal logging monitoring program, undertake a performance review of concessions, and Immediate prepare the Cambodia Code of Forest Practice (CCPF). * In the subsequent few months: decide on the termination or renegotiation of concession contracts; prepare a sub-decree establishing the CCPF; strengthen the implementation Issues Recommendations Time Frame Immediate: c 3 months Short-tem: < I year Medium-term: > I year capacity of forestry management; and strengthen law enforcement capacity on illegal = Short-term logging. 5. Tax administration and > Ensure that all issues relating to taxation are included in the Law on Taxation with the Ministry of Immediate governance in tax collection are Economy and Finance (MEF) responsible for legislative drafts, implementation, and weak. administration. = Eliminate the exemption from pre-shipment inspections for import for the projects approved Short-term under the Law on Investment, garments, and cigarettes. a Fully transfer non-tax revenues collected by line ministries to the Treasury. Amend the Law on Taxation to require that any other exemptions not specified in the Law on Taxation should be void. Short-term a Strengthen the audit capacity of tax administrators. Medium-term II. Improving the Efficiency and Equity of Public Expenditures through Expenditure Rationalization Despite its critical role in the development strategy through reconstructing physical infrastructure, developing human resources, and improving the accessibility of public services to the poor, the effectiveness of public expenditures is constrained not only by weak revenue efforts but also by low efficiency and equity associated with the allocation of public expenditures. 1. Defense expenditure crowds out z Decisively implement military demobilization as envisaged under the Cambodia Veterans = Medium-term resources for spending on Assistance Program (CVAP): development activities. * Update CVAP. Immediate * For the following few months: identify and register special target groups; and implement Short-term pilot demobilization of special target groups. 2. Despite the urgent need for => Substantially increase outlays for social sectors financed from revenue enhancement and also = Medium-term human resource development savings from military demobilization. which is critical to poverty reduction and economic growth, outlays on social sectors from government's own resources are very low. 3. The efficiency and equity of a Increasingly target services of government health facilities toward poorer individuals and - Medium-term public expenditure within the underserved provinces and also from tertiary to primary facilities since the private sector caters social sectors needs to be disproportionately to the more affluent. enhanced. = Implement pilot programs for cost recovery in the hospitals, including user charges, community- Issues Recommendations Time Frame Immediate: < 3 months Short-tem:< I year Medium-term: > 1 year based prepaid insurance schemes, and contracting out of specific services in public facilities to = Medium-term the private sector. => Focus spending more on the provision of basic education and lower secondary education, with putting policies which encourage private sector involvement in upper secondary and tertiary _> Medium-term education. = Regularize the current informal cost recovery program especially in higher education, with transparent user fee collection process and the collected revenues kept at the facility level. - Medium-term 4. Owing to substantial over- => Decisively implement civil service reform: => Medium-term employment, the wage bill is high * Strictly limit new hiring and reduce the number of civil servants through eliminating = Immediate despite the low salary level. The ghost workers and also through normal attrition. combined result of over- 0 Carry out a civil service census to provide a record of numbers and grades, education Short-term employment and low salary level attainments, experience, and skills which will facilitate personnel planning. leads to low operational * Prepare options for the appropriate role of government, the appropriate structures for that efficiency of public service role, the needed skills mix for the reformed government and the pay, training, and delivery. recruitmentpoiistsuprthtmx 5. The squeeze in civilian non-wage Substantially increase outlays for civilian non-wage O&M and counterpart fund from revenue => Medium-term O&M and counterpart fund for enhancement and also savings from military demobilization. externally financed investment results in the underuse, or inefficient use of capital investment, and in ineffective service delivery._________________________________________________ 6. Public expenditures are * Reorient expenditures to rural areas as envisaged in the SEDP. n Medium-term concentrated in Phnom Penh, which is not desirable as poverty is heavily concentrated in rural areas. Ill. Enhancing the Effectiveness of Public Expenditure Management While highly centralized institutions and processes make a remarkable contribution to macroeconomic control, they are very detrimental to allocative and technical efficiency. The fundamental problem is that the Cambodian budgetary process has sacrificed too much in terms of allocative and technical efficiency to maintain aggregate fiscal discipline. Thus, the challenge is to improve the current unnecessarily large trade-off between the aggregate fiscal discipline on the one hand and the allocative and technical efficiency on the other. The top priority is for the government to respect the budgetary rules and processes. In this regard, reducing political interference in the budgetary process is a prerequisite for other reforms. Issues Recommendations Time Frame Immediate: < 3 months Short-tern: < I year Medium-term: > I ear I. Ensuring political commitment to Minimize ad hoc spending decisions taken outside the budget preparation context. => Immediate an authoritative budget process. Ensure that new spending measures do not exceed the reserve budgeted for this purpose, where - Immediate they are proposed during the course of the budget year. 2. Establishing responsibility for Undertake an evaluation of the effectiveness of the Accelerated District Development (ADD) => Medium-term performance at the level of System of the Ministry of Health (MoH) and plan a trial of a similar program-based scheme for spending units in parallel with the other agencies (with Ministry of Education, Youth, and Sports as a priority). strengthening of technical, Establish a financial management improvement team at the MEF to help agencies introduce = Medium-term financial managerial capacities. ministry-wide accounting systems for reporting, analyzing, and benchmarking resource use by each of their functional units. Prepare a timetable for introducing activity-based budget bids by line agencies over a five-year . period. Medium-term 3. Rationalizing the roles of the = Give a priority to separating the roles of the line ministries and provincial governors in the Medium-term central and provincial disbursement of budget funds. administration. => In parallel, upgrade the financial management skills of the regional units of line ministries within ? Medium-term X each line ministry. 4. Developing financial participation : Acknowledge the existence of financial participation schemes as a significant budget tool and => Medium-term schemes (i.e., user charging). progressively document the incidence and terms of such arrangements. => Develop a set of guidelines on the circumstances in which user charging is appropriate, the = Medium-term appropriate basis for determining charges, and the handling of associated equity issues. 5. Improving the allocative and Initiate a Sector-Wide Approach (SWAP) in the health sector as the MoH has a better capacity > Medium-term technical efficiency of donor and coordination between the MoH and donors is relatively close. funding. - Address a number of system-wide issues-such as managerial decentralization, reforms in Medium-term accounting and budgeting systems, and changes in staffing incentives--in the health sector for a SWAP to be adopted effectively. 6. Strengthening the Public r Strengthen the line ministry's capacity in monitoring the implementation of the PIP. Medium-term Investment Management System = Extend the development of the PIMS beyond a broad framework for linking capital budgeting (PIMS). institutions, to become a vehicle for developing concrete strategies aimed at overcoming the Medium-term current weak link in the operation of the capital budget cycle. 7. Donors need to play a significant - Provide well-coordinated technical assistance and training to strengthen the line ministry's = Medium-term role to effectively complement capacity in a more systematic and programmed manner, the government's efforts. r Move toward better aid coordination, such as through a SWAP. = Medium-term