Report No. 28123-KG Kyrgyz Republic Public Expenditure Review Fiscal Policies for Growth and Poverty Reduction (In Two Volumes) Volume I: Main Report March 22, 2004 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank CURRENCY AND EQUIVALENT UNITS (as of March 22,2004) CurrencyUnit = Som US%l=42.80 Som WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank NGOs Non-Governmental Organization CDF Comprehensive Development Framework NPV Net Present Value CG Categorical grants NSPR National Strategy for Poverty Reduction CFAA Country Financial Accountability O&M Operations and maintenance Assessment CPAR Country Procurement Assessment Review OECD Organization for Economic Cooperation and Development EBRD European Bank for Reconstruction and PC Paris Club Development EDF Economic Development State Fund PEM Public Expenditure Management EIRR Economic Internal Rate of Return PIP Public Investment Program EU European Union PPI Producer Price Index FGPs Family Group Practices PPP Purchasing Power Parity FSU Former Soviet Union PSOS Public Service Obligations GDP Gross domestic product PTUs Professional Technical Schools GSAC Governance Structural Adjustment Credit RADS Rural Advisory Development Service GTAC Governance Technical Assistance Credit RCLAR Republican Center for Land and Agrarian Reform I&D Irrigation and Drainage SCI State Customs Inspectorate IDUs Intravenous Drug Users SCPFI State Committee for Property and Foreign Investments IGIAs Intergovernmental Irrigation Agreements SES Sanitary Epidemiological Services IMF International Monetary Fund SMEs Small and Medium Enterprises IMR Infant Mortality Rate SMESP Small and Medium Enterprise Support Fund KAJ Kyrgyz national airline SMRF State Material Reserve Fund KR Kyrgyz Republic SOEs State-OwnedEnterprises MAWR Ministry of Agriculture and Water SPF State Property Fund Resources MEC Ministry of Education and Culture STI State Tax Inspectorate MHIF Mandatory Health Insurance Fund TB Tuberculosis MMR Maternal Mortality Rate TDMHIFs Territorial Departments of the MHIF MoF Ministry of Finance UMB Unified Monthly Benefits MOH Ministry of Health UNDP United Nations Development Programme MOLSP Ministry of Labor and Social Protection VAT Value Added Tax MOTC Ministry of Transport and Communications WUA Water Users Association Vice President: ShigeoKatsu (ECAVP) Country Director: Dennis de Tray (ECCUS) SectorDirector: Cheryl W. Grey (ECSPE) Sector Manager: Samuel Otoo (ECSPE) Task Team Leader Pedro L. Rodriguez (ECSPE) ACKNOWLEDGMENTS This report was prepared by a group of the World Bank staff and consultants led by Pedro L.Rodriguez and composed of Azamat Abdymomunov, Natalia Pisareva, Luis Alvaro Sanchez, Ekaterine T. Vashakmadze, (Fiscal and Economic Framework, overall report); Alexander Morozov (Public Investments); Sarbani Chakraborty, Joseph Kutzin,' Jan Bultman, and Dinara Djoldosheva (Health), Jacques Yenny, Richard Podolsky (Transport); Jana Orac (State Employment and Compensation), Rashid Faroque (Agriculture and Irrigation), Michael Mertaugh (Education), Verdon Staines (Pensions), Dana Frey2(Revenue Administration) and Dan Mullings (Intergovernmental Finance). Valuable comments and guidance were received from Jit Gill, and Alma Kanani (Governance Structural Adjustment Credit), Sebnem Akkaya (Executive Summary) and Joop Stoutjesdijk and Gotz Schreiber (Agriculture). Peer reviewers were Richard Allen andVinaya Swaroop. The Kyrgyz authorities assisted inthe preparation of this report during the course of a mission in March 2002. The team i s particularly grateful to MessrsMmes.: Kanimetov, Komarover (Economic Policy Department, President's Administration); Abildaev, Toromorozaev, Aaliev, Mambetjanov, Azykov, Mukambetov, Ibraimova, Baigonchokov, Rysalieva, Sabirova, Temirbekov (Ministry of Finance), Shadiev, Kasymaliev (Revenue Committee), Jumaliev, Imanaliev, Borunbaeva, Miyarov, Moldobaev, Svirodova (Ministry of Transport and Communications), Omurkulov (Railway Department, Ministry of Transport and Communications), Mwatov, Abakirov (Civil Aviation Department, Ministryof Transport and Communications); Meimanaliev, Mukeeva, Madybaev, Karakulov (Ministry of Health Care); Abdullaeva, Kaibaliev, Kobesheva (Ministry of Labor and Social Protection); Ilyasova, Matanov, Abduganiev, Shamkeev (Ministry o f Agriculture, Water Resources and Processing Industry), Jeenbekov, Makarov, Bakirov (State Committee for State Property and Direct Investments) and Boldjurova, Djumagulova, Djunusova (Ministry of Education and Culture). The World Bank team also receivedvaluable support from staff inthe National Bank of the Kyrgyz Republic, the National Statistical Committee, and the Ministry of Agriculture. The report builds on the following background papers: (i)Socium Consult: Kyrgyz Republic Review of Public Funding of Health Sector, July 2002; (ii)WHO Working Papers on Health Issues in Kyrgyzstan, Various by Joseph Kutzin (WHO Sr. ResidentAdvisor for the Manas Health Policy Analysis, Fundedby DFIDLJK);(iii) Dan Mullings, IntergovermentalFinances and Reform in the Kyrgyz Republic, June 25, 2002; and (iv) World Bank, Kyrgyz Pension Policy Note, July 2002. Thefindings of this PER Joseph Kutzin was the WHO Sr. Resident Advisor for the Manas Health Policy Analysis, funded by DFIDAJK. Dana Frey was the Senior fiscal resident advisor under a USAID sponsored project. The views reflected hereare those o fMr. Frey and the World Bank and do notnecessarilycorrespondto those o fUSAID. are complemented by a recently produced Country Procurement Assessment Review, and Country Financial AccountabilityAssessment. An earlier versionof the Executive Summary of this report was discussed during the Consultative Group MeetingheldinBishkek, October 9-11, 2002. The PERhas been discussedwith the President Administration in July 2003, as well as with the Revenue Committee. The chapters on health and education were discussed with government authorities as well as with keyParliamentarians. TABLE OF CONTENTS EXECUTIVESUMMARY AND RECOMMENDATIONS i PART I:STRATEGIC CONTEXT ............................................................. ..................... 1 1 GROWTHAND POVERTYREDUCTION . ........................................ 2 .................................................................................... 2 B. DETERMINANTS A. DETERMINANTS OF GROWTH ................................................................................... 4 C. CONCLUSION............................................................................................................ OF POVERTY 7 2. FISCALPOLICY INTHE 1990's ........................................................ 8 A. THECHANGINGROLEOF THE STATE 8 B. ........................................................................ ADEQUACYOF PASTFISCAL ADJUSTMENT ............................................................. 12 C. CONCLUSIONS ........................................................................................................ 14 3. QUASI-FISCALDEFICITS ............................................................... 16 A. 16 B. BROADER QUASI-FISCAL ACTIVITIES INTHE POWERSECTOR................................................. 22 C. CONCLUSION .......................................................................................................... ISSUES OFSOEs................................................. IN THE MANAGEMENT 23 4. MEDIUMTERM FISCAL FRAMEWORK .................................... 24 A. MACROECONOMIC FRAMEWORK ............................................................................ 24 B. .............................................................................................. 27 C. CONCLUSIONS........................................................................................................ FISCAL FRAMEWORK 33 PART TWO: CHALLENGES .................................................................. 34 5. OVERVIEW OF SPENDING POLICIES ........................................ 35 A. ECONOMICALLOCATIONOF BUDGET RESOURCES B. ................................................. 35 FUNCTIONAL ALLOCATIONOF BUDGET RESOURCES .............................................. 37 C. CONCLUSION.......................................................................................................... 38 6. SYNTHESIS OFKEY SECTORAL ISSUES ................................... 40 A. HEALTH 40 B C. . .................................................................................................................. EDUCATION............................................................................................................ 43 SOCIAL D. PROTECTION.............................................................................................. 48 TRANSPORT ............................................................................................................ 56 E. IRRIGATION AND AGRICULTURE ............................................................................. 59 7. SELECTED INSTITUTIONAL CONSTRAINTS ........................... 61 A. 61 B. CONSTRAINTSTO RESOURCEMANAGEMENT ........................................................... ............................................................ 67 C. RATIONALIZING STATE EMPLOYMENT COMPENSATION AND INTERGOVERNMENTAL FINANCES................................................ SO .. 11 ANNEXES ................................................................................................... 96 ANNEX 1: INTERNATIONAL COMPARISONS................................................................. 97 ANNEX 2: PUBLIC INVESTMENT PROGRAM................................................................. 98 MAP ........................................................................................................... 106 Index of Tables Table 1.1: Evolution of GDP by Expenditure Components........................................................................... Table 1.2: Absolute Poverty inKyrgyz Republic, 2001.................................................................................. 2 6 Table 2.1: Kyrgyz Republic: KeyEconomic and Fiscal Indicators, 1990-96................................................ Table 2.2: Kyrgyz Republic: Key Economic and Fiscal Indicators, 1997-2001.......................................... 9 Table 2.3: Kyrgyz Republic: Debt Indicators, 1993-2001........................................................................... 10 Table 3.1: Kyrgyz Republic: Selected Indicators for the Electricity Supply Industry, 2000-2002 Table 4.1: Key Macroeconomic Parameters, 2001-2010 ............................................................................. ..............12 19 Table 4.2: Kyrgyz Republic: Sources ofFinancing, 2002-07 ...................................................................... 24 Table 4.3: Kyrgyz Republic, External Sustainability Indicators, 2001-10................................................... 25 Table 4.5: Kyrgyz Republic: Medium-term Fiscal Framework, Revenue Projections,2001-07 .................28 Table: 4.4 Kyrgyz Republic: Medium Term Fiscal Framework, Main Results,2001-07............................ 26 29 Table 5.1: Kyrgyz Republic: Key Expendituresby Economic Classification, 1999-2002.......................... Table 4.6: Kyrgyz Republic: Medium-term FiscalFramework, Public Expenditure, 2001-07..................... 32 Table 5.2: World Expendituresby Functional Categories, 1990s................................................................ 35 Table 6.1: Public Spendingon Health inRelation to GDP .......................................................................... 38 Table 6.2: Public Expendituresfor Education as a Share of Total Public Expenditures, 1990-2001 ...........41 Table 6.3: Sources o f Financing for Primary School Expenditures............................................................. 44 Table 6.4: Average Monthly Earnings in2001 by Sector ............................................................................ 45 46 Table 6.5: Teaching-Hour RequirementsinPrimary Education, Kyrgyz Republic and SelectedComparator Countries.............................................................................................................................................. Table 6.6 Kyrgyz Republic: Social Expenditure of Consolidated General Government, 1995-2001 .........47 Table 6.7: Impact of Pensionson Poverty Risk Among the Overall Population.......................................... 49 Table 7.7.1: Expenditure Allocation by Level of Government and ExtrabudgetaryFunds, 2001 ...............52 63 Table 7.3: Budget-funded Civilian Government Employees, 2001.............................................................. Table 7.7.2: Revenueand Expenditure from Special Means, 1999-2001.................................................... 66 Table 7.4: Monthly Earnings for SelectedMinistry Posts............................................................................ 68 74 Index of Figures Figure 1.1:Kyrgyz Republic: Exports. Investments. and Savings. 1993-2001.............................................. Figure 1.2:Consumption, GDP, and Social Spending, 1996-2001................................................................. 3 Figure 2.1: Kyrgyz Republic: Trends inReal Wages................................................................................... 5 11 Figure 2.2: The Relationship of Public Spendingand Per Capita Income in Selected Europeanand Central Figure 2.3: Adjustment in Public Spending inSelectedCIS Countries duringthe 1990s............................. Asian Countries, 2000 ......................................................................................................................... 13 14 Figure 3.1:Kyrgyz Republic: Evolution of Electricity Tariffs and Electricity Consumption for Residential Figure 3.2: Kyrgyz Republic: EstimatedElectricity Subsidies and Losses as a Share of GDP ...................30 Households, 1994-2002....................................................................................................................... 17 Figure 4.1: Relationship of Tax Revenueand Income inSelectedECA Countries ..................................... 18 Figure 6.1: Health Capacity Reduction in Chui and Issyk-KulOblasts, 2001 ............................................. 42 ... 111 Figure6.2: Kyrgyz Republic:EvolutionofDirectSocial Spendingand Implicit Social Subsidies. 1995- 2001..................................................................................................................................................... 49 Figure 6.3: Risk of PovertyandAmount o fPoverty Gap Coveredby PensionBenefit(by IncreasingLevel Figure 7.1: Implementationof Spendinginthe StateBudgetandthe PIP, by function, 2000...................... ofPension)........................................................................................................................................... 53 62 Figure 7.3: LocalGovernmentEmploymentby Sector, 2001...................................................................... Figure7.2: Employmentbythe RepublicandLocal Governments,2001.................................................... 69 Figure 7.4: MinistryEmployment, 2001...................................................................................................... 69 Figure 7.5: Base Salaryas PercentofTotal Earnings.................................................................................. 70 73 Index of Boxes Box 2.1: DebtDevelopmentsand Strategy................................................................................................... 12 Box 3.1: AttractingInvestmentCapital to the Kyrgyz's PowerSector......................................................... 20 Box 4.1: A DiagnosticFrameworkfor RevenueAdministration.......................... :...................................... 31 Box 7.1: KyrgyzRepublic, An Example ofOff-budget Grants, 2001......................................................... Box 7.2: IntergovernmentalElementsRequiring Attentioninthe KyrgyzRepublic................................... 65 83 Box 7.3: Componentso f a RestructuredIntergovernmentalTransfer System.............................................. 90 EXECUTIVESUMMARY AND RECOMMENDATIONS3 STRATEGIC CONTEXT 1. Like many o f the republics o f the former Soviet Union (FSU), the Kyrgyz Republic suffered a number o f severe shocks duringthe early years o f independence. It lost its traditional markets in the other FSU republics, as well as substantial transfers and subsidies from the Soviet Union. Its GDP fell by over 50 percent duringthe first five years o f transition. 2. These difficult circumstances prompted the Kyrgyz Republic to adopt a wide range o f reforms aimed at accelerating the transition to a market economy. Early emphasis was given to price and trade liberalization and the shift o f ownership o f state assets to the private sector, including land and most state-owned enterprises (SOEs). In parallel, directed credits were phased out, domestic financing o f the budget deficit was sharply curtailed, and large loss-making state banks were closed. A framework for rural credit was established, and reforms and investments were made to support critical telecommunications, energy, and irrigation infrastructure. Pension and health reforms were initiated, and improvements to budgetary procedures were made (including the introduction o f mechanisms for financial control, transparent procurement, and a basic framework for intergovernmental finance). Core economic legislation appropriate to a market-based economy was developed. These reform efforts were supported with substantial assistance from the international community in the form o f loans, grants, and technical advice. 3. Since the mid-l990s, the economy has shown steady signs o f recovery. Real GDP growth averaged over 5 percent per annum in 1996-2001, despite the disruptions o f the regional financial crisis o f 1998. The agriculture, gold mining, and trade sectors have witnessed strong growth. Other sectors o f the economy, notably manufacturing, have remained stagnant or have declined continuously. On the demand side, consumption (including imports) and public investment led the recovery, fueled by ample external financing. More recently, investments by (public and private) enterprises and net exports have beenprominent. 4. These favorable developments notwithstanding, the Kyrgyz Republic remains the second poorest o f the FSU republics and one o f the poorest countries in the world. In 2001, per capita income was barely US$300. Absolute poverty affected about half o f the population in spite o f the progress made in 2001. Though poverty is highest in rural areas, there are large regional disparities. Transient poverty is high as a result o f high consumption volatility. Access to public services such as running water, public sewerage, reliable electricity, district heating, and telephone service is very low. Overall, rural households have much less access to these services than do urban households. Moreover, access to these services is lower for poorer households in both rural and urban areas. Most o f the population is vulnerable to poverty because o f the low savings levels and the absence o f financial instruments to allow for consumption smoothing. 3 This report was printed in 2004 for information purposes, without any major update on data, analysis or recommendations. It should be mentioned that many of the recommendations made (e.g., in revenue administration) have been adopted by the authorities and are under implementation. The original policy matrix was replaced by a piece which integrates recommendations made by the three key pieces of economic and sector work in the area of public finance (e.g., this PER, the Country Procurement Assessment, and the Country Financial Accountability Assessment), and the support provided by the Bank's GovernanceStructural Adjustment Credit. 11 .. 5. While a number of reforms and initiativeshave been initiatedduringthe last years, many have not been followed up or completed, and thus the populationhas not fully benefited.The inability to complete reforms is linkedto a dispersion of efforts on many different fronts, in turn associated with weak institutions. Policy reforms, in particular, have not been matched by progress in the areas of institutionalreformand governance. The level of corruptionis very high and is a major impediment to enhancingpublic service deliveryand the investment climate. The administrativecapacity o f the various levels of government is very weak and severely limits the capacity to prioritizeand implement policies.The presenceof donors with uncoordinatedagendas has also contributedto the dispersionof governmentattention and capacity. 6. Fiscal management has been a particular challenge. Early in the 1990s, subsidies and transfers were sharply curtailed. However, public expenditures overall fell much less as a percentage of GDP than did revenues, as the government made major investments in infrastructureto complement the market policyreforms. As aresult, the fiscal deficit remainedat relatively high levels, averaging about 9 percent in 1996-97. The large real depreciationo f the currency duringthe regionalfinancialcrisis in 1998 substantially increasedthe burdenof growing energy sector losses and external debt service requirements and pointed up the need for more rapidfiscal adjustments. Inresponse, the authorities cut budget expenditures from 34 percent of GDP in 1998to 26 percent in2001, reducingthe deficitto 5 percent of GDP (see Table 1). Table 1: Kyrgyz Republic: Key Fiscaland Economic Indicators, 1992-2001 (%GDP) 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Revenueand grants, of which 20.5 24.6 25.8 21.9 20.6 20.4 22.2 20.4 18.5 20.3 Tax revenue 14.5 14.5 13.6 15.0 12.7 12.5 14.2 12.2 11.7 12.4 Social securitycontributions 4.0 4.3 5.0 5.1 4.6 4.2 4.2 3.6 3.3 3.3 Nontax and capital revenue 2.0 1.5 4.7 1.4 2.4 2.6 2.9 3.6 2.5 3.7 Grants 0.0 8.6 2.5 0.3 0.9 0.6 0.6 0.6 0.9 0.8 Expenditure(economic classification) 38.4 39.0 37.6 38.6 29.9 29.3 33.5 32.0 28.1 26.1 Current(other than interest) 23.7 29.3 27.8 30.0 24.4 25.6 27.4 22.9 20.7 21.9 Interest payments 0.5 0.7 0.2 0.4 1.2 1.7 2.1 3.0 2.2 1.7 Capital 2.4 0.2 4.9 4.8 3.8 3.8 6.6 9.5 7.8 5.3 Net lending 7.8 8.8 4.7 3.4 0.4 -0.1 -0.5 -0.4 -0.5 -1.1 Expenditure(selected functions) 38.4 39.0 37.6 38.6 29.9 29.3 33.5 32.0 28.1 26.1 Education 5.0 4.2 6.1 5.7 4.4 4.2 4.2 3.4 3.3 3.5 Health care 2.9 2.6 3.5 3.4 3.0 3.3 2.9 2.7 2.0 1.8 Social security and social insurance 8.6 8.6 8.1 12.5 10.5 9.2 8.6 7.5 6.1 6.3 Agriculture, forestw, fishing and hunting 3.3 2.2 0.7 0.9 0.7 0.8 1.4 1.5 1.7 1.8 Transport and communications 0.6 0.6 0.5 0.6 1.6 2.0 3.3 5.4 4.5 2.5 Other economic affairs 1.6 1.3 0.4 0.2 0.6 1.1 0.9 0.4 0.2 0.3 Fiscal balance Cash deficit -17.9 -14.4 -11.8 -16.8 -9.3 -9.1 -9.5 -11.0 -8.8 -5.0 Deficit w/o interest and PIP -17.4 -13.7 -7.7 -12.6 -4.9 -4.4 -1.7 0.4 -0.2 1.1 Memorandum items: GDP real growth (%) -14.1 -15.5 -20.1 -5.4 7.1 9.9 2.1 3.7 5.4 5.3 Inflation ( % end o fperiod, CPI) 2,033 929.9 62.1 32.1 34.8 13.0 16.8 39.9 9.6 3.7 Per capita dollar GDP (Bavg rate) 503 234 244 325 392 374 340 255 279 308 Note: Fiscal indicators consolidate the state budget (in turn a consolidation of republican and local budgets), the Social Fund, and the foreign finance public investmentprogram (PIP). Sources: Ministry of Finance, Social Fund, World Bank, and International Monetary Fund. ... 111 7. Issues remain regardingthe quality and sustainability of fiscal adjustment efforts to date. Adjustment in recent years has beenachieved largely on the basis of across-the-boardexpenditure cuts that are unsustainable and that have often failed to reflect strategic priorities. Civil servants are poorly paid and often seek alternative sources of income, which reduces the quality of public services and promotes rent-seeking behavior and corruption. Reduced maintenance of infrastructurehas affected such critical areas as irrigation networks, transportation, educationand health facilities. Pensions are low on average. Public expenditureson socialprotection other than pensions have been severely constrained. Finally, the government is incurring substantialquasi- fiscal expenditures by pricing public utility services below their economic costs. These implicit subsidies, which are not targeted, have been reduced substantially in the past three years. However, in 2001 they still amountedto over 4 percent of GDP (and are close to 10 percent of GDP if losses are included). 8. Despitethe fiscal adjustment, the country is saddledwith a heavy burdenof externaldebt. While the country started at independence with virtually no external debt, by end-2001 the net present value of the public debt was 477 percent of government revenues. The country's level of external debt, at 206 percent of exports in 2001, is also unsustainable. There are a number of reasons for the large build-up of externaldebt, including lax policies toward enterprise borrowing early in the transition, andthe large overall fiscal deficits runfor most of the decade. 9. To stabilize debt ratios, it is imperative that the overall fiscal deficit be further reduced and, most importantly, that quasi-fiscal deficits be eliminated. Our simulations indicate that reducing fiscal and quasi-fiscal deficits to around 3 percent of GDP over the next four years, and maintaining a per capita growth of 3 percent, would be consistent with a reductionof the external debt burden to sustainable levels-assuming that the ongoing efforts to secure a concessional debt stock reduction are successful. Broadly speaking, this is to be achieved primarily by increasing the level of tax and non-tax collection and by eliminating quasi-fiscal expenditures. Securing support from the international community, largely in the form of grants at highly concessional terms, will also be necessary. Expenditures, at around 26 percent of GDP, appear appropriate in a regional context, but if revenue efforts prove insufficient or if donor support is not forthcoming, further cuts in budget spendingwill also be required. The current composition of expenditure, however, must be changed, reflecting a carefully drafted reform of key spending policies. 10. In view of the country's low income and high poverty levels, enhanced growth is the most fundamental requirement for progress in poverty reduction consistent with fiscal and external sustainability. Reforms inthe public sector will play a significant role by facilitating and encouragingthe developmentof the private sector, while ensuring that available public resources are efficiently targeted to the most vulnerable groups in the population. The government recognizes the importance of timely and resolute action to strengthen the fiscal adjustment process and to accelerate public sector reforms. This is reflected in the National Strategy for Poverty Reduction (NSPR), recently presentedto stakeholders and donors. However, the overall agenda for policy and institutional reform emerging from the NSPR is very broad, and implementation needs to be carefully prioritized given the government's capacity constraints. Consequently, the objective of this PER is to assist the government by providing an explicit linkage between its priorities for poverty reduction and the challenges it faces for fiscal adjustmentand public expenditurereform. iv ELEMENTSA STRATEGYFORFISCAL OF ADJUSTMENT PUBLICEXPENDITURE AND REFORM 11. Inthe areas of fiscal adjustment and expenditure management,the KyrgyzRepublic faces the followingkey challenges: Consolidating fiscal adjustment and ensuring external financial sustainability, while protecting the most vulnerablegroups to the extent possible. The success of the adjustment would hinge on the ability to improve revenue administration,eliminate quasi-fiscaldeficits, andsecure financialassistance. Aligning sectoral policies rigorously with the priorities emergingfrom the NSPR in the context of a consistent medium-term fiscal framework. The role of the state needs to be brought in line with the available resources and capacity. Health and education reform programs should be supported, and social expenditures should be more targeted. Greater emphasis should be given to recurrent expenditure to maintain the highest priority public infrastructure. Enhancing the systems and capacities of the public administration and the government to improve overall efficiency, service delivery, and financial accountability and to reduce corruption. The first task is to reformpublic sector compensationand employment, focusing on the civil service, education, and health. The secondtask is to further improvepublic sector resource management to put in place a system that allows for the comprehensive overview andmanagementof all public resources. I:CONSOLIDATINGFISCAL ADJUSTMENT 12. Consistent efforts to reduce the overall fiscal deficit, currently at around 5 percent of GDP, have beenmade since 2000. These efforts are clear from the trendofthe domestic primary deficit (i.e without interestpayments andthe foreign-financedpublic investment program), which by now is in surplus. Similarly, efforts have been made to reduce quasi-fiscaldeficits since 2000 by steadily increasingpower sector tariffs above inflationandtaking complementary measuresin the sector (Figure 1). 13. However, at about 10 percent of GDP, the quasi-fiscal deficit in the power sector is unaffordable.And power is not the only source of quasi-fiscal deficits; mis-pricing and price discounts are widespread in district heating, gas, transport operations, and irrigation. From the public policy perspective, this spending is untargeted and highly inefficient. From the sectoral perspective, it underminesthe investment and growth potentialof sectors that arguably can, and should, contribute to the development of the Kyrgyz economy. Thus, quasi-fiscal activities contradictthe NSPRprincipleson various grounds. 14. We argue for strong effortsto bring fiscal deficits to 3 percent of GDP over the next four to five years, and to eliminate all quasi-fiscal deficits in the energy sector. To achieve this objective, efforts must be made to: (i)increase revenue collection; (ii)bring tariffs to cost reflective levels for at least the power and gas sectors inparallelwith reducinglosses, increasing efficiency inthese industries, and attractingforeign know-how; and (iii)secure continuedsupport from the international community to reduce debt service obligations. In the process, efforts should be made to protect the most vulnerable groups of the population, which requires strengtheningthe (budgetary) safety nets in light ofthe needto curtail quasi-fiscalactivities. V Figure 1: Kyrgyz Republic: Fiscal and Quasi-fiscalAdjustment,1994-2002 (Deficit=+,Surplus=-) 1% _" ...... . . . . . . . . . . . . . . - . . . . . . . . . . . . ."..I . . . . . . . . . . . . . . . . . . . . . . . 16 - ., . I , . 14 - 12 - 8 10 - 0 / \ ................... ;8 ir * 1 f - I \ a 6 - 1, L c 4 - 2 - \,\ 0 - ----*--- -2 - . . . . . . - . . . . . . . . . . . . . . . . - . . . . . - . . . . . . . . . . . . . . 1. Improving the RevenueInstitutions 15. Revenues, includingsocial security contributions, have remained roughly stagnant since 1996. Since tax and contribution rates have been reduced somewhat, this suggests that few collection and compliance gains have been realized. Tax exemptions (a number of which still exist) do not appear to explain the stagnation in revenue performance. Overall tax rates and contributions are also at levels comparable with (or higher than) international practice. In contrast, the administrative agenda is broad, and indications are that a comprehensivereform of the revenue institutions would yield positive revenue results over the medium term and could contributesignificantlyto improvingthe business environment. 16. Thus, the government is advised to follow a two-pronged strategy to improve revenue performance. First, it should seek a revision of the tax legislation to eliminate some of the existing exemptions and to strengthen excises, VAT, and other indirect taxation. It should also reducethe number of nuisancetaxes andmake further progress inreducingpayrolltaxes. Second, the government should undertake a comprehensive modernizationof the revenue system. A key pillar of such a strategy should be a greater integrationamong the four bodies that now enforce revenue obligations. This strategy must address the critical problems that impair enforcement, such as the use o f revenue targets as an administrativetool, weak auditing, smuggling, and low remuneration and distorted incentives for personnel. In addition, the strategy should seek to facilitate taxpayer compliance and provide expeditious and effective appeals mechanisms. An important by-product of these reforms would be a significant improvement in the business environment. 17. The revenue gains from these reforms would have to be sufficient to: (i)reducethe fiscal deficit over the medium term; (ii)make it possible to eventually reduce certain taxes and V i contributions(especially payrolltaxes); (iii)allow timely paymentsof VAT refunds; and (iv) end relianceon tax advances. The bulk of revenue effects are likely to materializewith certain lags, and thus significant public sector deficit reductions may not be possible in the short term. The scenario here assumes an average increase in revenueperformance o f around 0.5 percent of GDP per annum, which shouldcertainlybe feasible. 2. Eliminating Quasi-fiscal Deficits 18. Buildingconsensusfor the tight wage policy and the stringent adjustment inentitlements duringthe mid and late 1990srequiredthe authoritiesto relax adjustment on other fronts, mainly on pricing for most key services, such as power, district heating, gas, public transport, and water and irrigationfees. 19. Electricity, which is a relativelyabundant source of energy inthe Kyrgyz Republic, was perhaps the key vehicle for compensating households-followed by gas and district heating, which provide subsidies to those areas of the country that are less afflicted by poverty. This compensation took the form of price discounts that apply to up to one-third of the population, and, most important,of low overallpricing. 20. Cheap power ledto an upsurge in demand. This, and a concurrent reduction in revenues available for maintenance, erodedthe industryassets, particularly inthe distributionnetwork, and precipitated large losses. Lack o f maintenance and basic investment led to a deterioration of service that started first in remote rural areas, and stemmed from the companies' practice of raising funds from users, in addition to tariffs, to undertake basic repairs. This, in turn, has created frustration among households and incentives for theft (Le., commercial losses). The system as a whole, however, has been maintained, mainly because of the large installed hydropowercapacity, which is cheapto generate. Butthese are, nonetheless,worrisome trends. 21. Mis-pricingandthe resultingcommercialand technical losses cost the economy about 17 percent of GDP in 1999alone. These losses were reducedto less than 10percentof GDP in2001 through tariff adjustments and complementary reforms aimed at increasing efficiency and accountability in the use of the sector's resources (e.g., industry unbundling). While the reform has reducedthe quasi-fiscaldeficit somewhat, and has ledto greater understandingof the sector's problems, consumers have seen little or no improvements in service. The sustainability of these reforms requires that the sector's companies improve service provision as much as financial performance. Despite the difficulties in the external and internal environments, the Kyrgyz Government has no option but to seek private sector participationto: (i)mobilize the resources that are neededto bringabout operational enhancements; and (ii) bringthe necessary commercial andmanagerialexpertisethat is neededfor a steady enhancement of operations. 22. Losses have been financed through the erosion of assets, as well as by cross- subsidizationfrom exports. The Kyrgyz Republic provides power and water release services to neighboring countries through Intergovernmental Irrigation Agreements (IGIAs), but has to devote the entire revenue from these activities(mainly paid inthe form o f gas and coal) to cover the losses the system incurs in the domestic market. In years in which neighboringcountries do not require water release services (such as in 1998 and this year), the finances of the sector are weakened. In 2002, for instance, exports totaling US$46 million were expected, of which only US$16million hasbeenrealized. 23. Quasi-fiscaldeficits in the power sector must be eliminated over the next three to four years-parallel to greater efforts beingmade to protectthe most vulnerable groups to the extent vii possible, as outlined in the sections below.Introducingtransparency into quasi-fiscaloperations, evenbeforethat time is necessary, occurs by ensuringthat subsidiesto the population(or to some of the weakest distribution companies) are given through the budget rather than intra-industry pricing or other arrangements. In addition to increasing the efficiency of public resource management, greater transparency should contribute to create consensus for the eliminationof these deficits.Key stakeholders(includingParliament)needto gaina greater understandingofthe magnitude of resource misallocation. In this context, it is important that the annual budget includes explicit subsidies to the power and district heating sectors financed by revenues from IGIAs. 24. Once key stakeholdershave gaineda greater understandingofthe opportunitycost of low pricing in electricity, it is likely that the government's role in providing price subsidies will be reassessed, which will facilitate the elimination of quasi-fiscaldeficits. Eventually, the revenues from IGIAs couldbe usedfor general public purposes (includingfor strengthening safety nets), a matter that can be determinedas part of the budget discussions.Issues of mis-pricingintransport operations and irrigationare discussedinthe sections below. 3. Securing Debt Relief and Highly ConcessionalFinancialAssistance 25. Strong adjustment efforts, whether fiscal or quasi-fiscal, are likely to result only in a stabilization of the overall stock of public debt. Bringing debt ratios to sustainable levels, therefore, would require securing debt relief. The 2001 Paris Club Agreement did not change the stock of external debt, nor was it providedat the highly concessional terms that a reduction in debt indicators would have required. However, the agreement includes a goodwill clause that allows for a potential stock reduction operation in the future, this time at concessional terms. Securingsuchrelief is necessaryto improvethe fiscal outlook. 26. Balance of payments support grants would also ease the difficulties of the needed adjustment. They would create headroomfor spendingand, as a by-product,cash grants havethe positiveeffect of helpingwith the monetizationof a budget that is currently riddled with offsets and other non-cash practices (see the third point, below). The government must continue to enforce its stance of borrowingonly at highly concessionalterms. 11:ALIGNING SECTORALPOLICIESRIGOROUSLY WITH THE PRIORITIESEMERGING FROMTHE NSPR 27. Although public expenditures in relationto GDP are expectedto remain at their present levelnet of the quasi-fiscalcomponent, sectoral policies needto reflect the new priorities of the NSPR. This should result in a different composition of expenditures across and within sectors. For instance, as investments in infrastructure are completed, a greater emphasis will need to be givento the recurrent spending of several sectors. 28. Current policies inthe Kyrgyz Republicprovide more entitlements (e.g., universalhealth care, pensions, and basic and highereducation) thanthe country can afford. The public sector has also attemptedto fill many of the country's needs (e.g., from airports to airlines in the transport sector) without concerted efforts to attract the private sector when appropriate, and without due consideration of its own financialand capacity constraints. As a result, the public sector outstrips the resource and implementationcapacity o f the government. Thus, a suitable mid-termstrategy shouldcombine a streamliningof expenditure responsibilitiesand sectoral objectives with efforts to improve the efficacy and transparency o f the public sector. These objectives imply: (i) completingcriticalreform initiativesand investments that have already commenced; (ii) reducing viii promises and focusing sectoral policies mainly on the poor, particularly in the human development and social protection areas; and (iii)further concentrating the role of the government to avoid the recurrence of broad but incomplete agendas and the initiation of large projects with public resources (such as those under discussion in railways, coal, and hydropower). These measures would not only release economic resources but would also create direct room for private sector growth. This PER examines these issues with particular attentionto building human capital, minimizing social risks, and enhancing economic productivity through more modest transport and agricultural policies. 1. BuildingHumanCapital 29. Public expenditures inhealthand educationhave suffered most from the fiscal adjustment after 1998, and private contributions have gained in importance as a source of finance. The poor regions have been negatively affected, and there is a wide divergence in the quality of these services throughout the country. The large rural population makes matters more difficult. Fortunately, a series of reform initiatives, mainly in health but also in education, has been implemented successfully in small oblasts and now can be extended to the larger ones. Since health and education represent the bulk of resources managed by the lower levels of government, there is a need to tighten coordination between social sector reforms and adjustments to the intergovernmentalfinance framework. 30. Health. Deterioration in key health indicators began before independence and continued until around 1995-96, when health outcomes began a gradual recuperation. Tuberculosis (TB) and AIDS, however, have been on the rise. In 2001, public financing of sector expenditures (around 2 percent of GDP) was complemented with similar levels of private contributions (around2 percent of GDP). 31. The Kyrgyz health sector is at a crossroads. On the one hand, progresshas beenmade in developing a comprehensive health care financing reform that has shown potential gains to improved public resources management for health care inthe four smallest oblasts.However, the nationwide expansion and sustainability of these reforms currently faces two threats. First, public funding has been on the decline. This is associated with: (1) wage compression-to which the health grants for the republican budget are currently tied; (2) the claw back of resources by local government when efforts to formalize the co-payments system were made (and the reported diversion of republican funds earmarked for healthto other activities); and (3) the capture of part of the sector's small but catalytic funds by the PensionFund. Second, funding remains focused on hospitalsrather than on primary care, which is mainly driven by the city of Bishkek where the reforms have not yet been introduced.As a result, the city's largeand highly specializedhospitals do not yet face incentives to downsize and become more cost effective. Together, these two factors have had a negative impact on the ability of the poor and rural populations to access good quality care closeto where they live. 32. The most significant initiative in the health sector was the introduction in 1997 of the Single Payer system in two oblasts in 2001 and in two more in 2002 (Issyk-Kul and Chui, and Talas and Naryn, respectively). Currently, the Mandatory Health Insurance Fund (MHIF) and its Territorial Departments channel all local budget resources for health in the four small oblasts. . The MHIF finances only a small percentage of the resources inthe sector, but it is empoweredto administer all the health sector funds in the four oblasts, allowing it to initiate changes to the financial incentives for providers. The effect of these changes in the initial two oblasts has ledto clear gains in efficiency (e.g., a 30 percent reduction in the number of beds and buildings and a 30 percentreduction in the number of staff) (Figure 2). By channelingfunds mainly as a payment ix for services, the MIHFreversed those incentives inthe existing budget allocation process that had contributedto excess capacity and high fixed costs. Figure 2: HealthCapacity Reductionin Chui and Issyk-KulOblasts,2001 I I c number of beds number of buildings physicians nurses I 19Chui Issyk-Kul I Source: Socium Consult (2002) -Dra!? Reporton HealthSectorReforms. I 33. There is, therefore, a potentially large payoffto be derived from including Bishkek inthe Single Payer system, where the bulk ofhospital rationalization needs to take place, as well as Osh and Jalal-Abad. There is also a large payoff for the republicanbudget in relying increasingly on the MHIF as a manager of its funding (i.e. the categorical grants that it provides to local governments). For this purpose, significant changes will have to be made inthe manner inwhich these grants currently work. Clearly, one key step is to sever the link betweencategorical grants and wages and instead to link them to basic services under the Single Payer system. As the experience in Single Payer oblasts suggests, it would also be important to allow reforming health care providers that will not be completely closed to keep part of the returns that stem from their greater efficiency (i.e., some of the savings that are generated through reductions in staff or facilities). This incentive, and greater autonomy in the management of their resources (i.e setting wages, determining employment levels, and handling funds outside of the Treasury in the same manner as other government contractors), will result in better service delivery. However, efforts must be made to define the manner in which the hospitals will be setting wages and controlling other costs. 34. The government should also allow the health sector to keep part of the returns coming from greater efficiency in service delivery and, in particular, care should be exertedto ensure the stability o f funding for the sector. Public funds should not be reduced as the process to convert informal payments made by patients for health care into formal co-payments progresses. Formal co-payments shouldbe regardedas a complementto, ratherthan a substitute for, public funds. To the extent that public funding is reduced (and this includes the lack of transfers from the Social Fund to the MIHF), the mix of funding sources becomes more regressive. Direct payments at the time of service use are most burdensome for the poor and also pose the greatest financial barrier to access. 35. There is also an emerging public health threat posed by TB and HIV infection. These diseases demand concerted action in the short run to prevent major economic and social consequences inthe mediumterm. X 36. Education. One of the particular challenges of education delivery is the high proportion of rural population. Inthe aggregate, 65 percentof the Kyrgyz Republic's population lives in rural areas, mostly in mountainous areas. In Naryn and Chui Oblasts, more than 80 percent of the population is rural. This situation presents a challenge in terms o f both delivery of education and demand for education. The situation o f rural schools complicates delivery and raises education costs because the greater dispersion o f population in rural areas leads to smaller class sizes, to smaller school sizes, and often to lower teacher utilization rates. At the same time, the situation of rural schools is often a deterrentto both school attendance and school performance-to school attendance because lower household incomes in rural areas make it more difficult for families to afford textbook rental and other educational necessities that students are expected to provide, and to school performance because schools are poorly equipped, teachers are often relatively inexperienced and not fully trained, parents are relatively uneducated themselves, and the rural environment provides few educational stimuliand little educational reinforcement. 37. Although there are no time series data to track changing education quality, there is a consensus on the part o f teachers, students, and parents that the quality o f education has deteriorated seriously over the past decade in all but a few well-endowed urban schools. Declining quality results mainly from cumulative budgetary neglect, resultingin depleted stocks of textbooks and other educational materials, in an underpaid and demoralized teaching force, and in the physical deterioration of schools. The increasing reliance on formal and informal parental contributions to meet essential school needs also results in a more unequal distribution of education quality. Large differences have emerged in teaching conditions and educational outcomes among oblasts and between urban and rural schools. In a recent national assessment of fifth grade students, results innumeracy skills varied markedly by oblast and urbadrural location- this of course is only an example an a more detailed assessment o f overall achievements is needed. 38. The share o f the consolidated public budget allocated to the education sector was essentially the same (20 percent) in 2000 as in 1990, and increased to 23 percent in the 2001 budget year. But in spite of this increased level of commitment, the share of GDP devoted to education fell by exactly half duringthe 1990s-from 7.4 percent in 1990 to 3.7 percent in2000. This is a lower share ofGDP spendingon education than inother countries inthe region with the exception o f Russia and Tajikistan, and is considerably below the average for the OECD. The effects of this budgetary contraction in education programs included widespread deprivation o f the basic educational materials needed for effective teaching and learning and for the modernizationo f education programs. The recent National Survey of Primary Education Quality found, for example, that 80 percent o f primary schools lacked a complete supply of textbooks for students, 70 percent lacked teachers' guides, 20 percent lacked desks and chairs for students, 70 percent needed repairs to school furniture, 23 percent lacked a water supply, and 39 percent lacked telephones. 39. The budgetary collapse also led to a decline in teachers' salaries, which has eroded teacher morale and motivation, has induced many teachers to take additional jobs, and has exacerbated the problems of corruption in education. An added complication is the endemic problem of arrears in teachers' salaries. There is also increased inequality in the quality of education and in access to education, as the shrinkage o f central budget support has led to increasing reliance on financing sources other than the republican budget-including unevenly available local financing, parental contributions, private tutoring charges, and supplementary income through the rental o f premises and other non-educational activities. On average, 35 percent o f the expenditures o f primary schools in urban areas and 25 percent o f expenditures of rural schools come from non-budget sources. The increasing reliance on these non-budgetary xi sources is not only a source o f increased inequality but also threatens to displace the core teaching function o f primary and secondary schools. 40. The cessation o f new school construction has led to excessively intensive use o f existing school facilities. Only 10 percent o f primary schools operate on a single shift. Fully 81 percent o f rural schools and 71 percent o f urban schools operate on double shifts. Nine percent o f rural schools and 19 percent o f urban schools operate on triple shifts. Finally, parental contributions have become an important source o f financing school maintenance, fuel, and other necessities in urban schools. Parental contributions to urban schools often exceed US$lOO per year per student. Parents also contribute to schools in rural areas, but widespread poverty means that income from this source is very limited. The reliance on parental contributions is a major source o f inequity in the quality o f education. 41. Although class sizes in urban schools are relatively large by OECD standards, there are opportunities in some cases to release resources that might help finance increased teacher salaries. A more widely applicable approach to mobilize savings to help finance teacher salaries is to raise required teaching hours, which are very low by international standards. It would be easier to implement a plan to improve teacher salaries in exchange for more intensive use o f teachers if it is undertaken on a voluntary basis by individual rayons or oblasts. Also, the goal o f increasing teacher salaries would be more feasible if some o f the cost were to come from efficiency improvements within the sector. There is considerable room for seeking more intensive use o f teachers inexchange for higher salaries inview o f the low level o f requiredteaching hours. 42. To address these issues and to support the development of the Kyrgyz Republic's most important economic resources-its human resources-it is proposed that the Education Reform Program be made more comprehensive to adequately address issues affecting sectoral performance and efficiency, including unequal capacity for local financing, depressed teacher salaries, lack o f efficiency incentives, school rehabilitation needs, and transparency in access to higher education. Once developed, this reform can be supported by gradual increases in budget allocations, which could reach 6 percent o f GDP in 2005-07. But these dynamics would need to be worked out indetail, and the agreed reform program would needto be followed strictly. 43. One issue to be tackled in this context is that o f teacher remuneration, which is low relative to the minimumconsumption level for individuals, and relative to compensation in other parts o f the public sector. Unlike other sectors (e.g., copayments in health) teachers do not have opportunities to supplement their income (although some activities, such as mentoring new teachers, or providing community education or remedial education, might be compensated through supplementary income). Moreover, whereas co-payments are desirable in some government services (e.g., health or irrigation), they are not desirable in the education sector at the compulsory level, where fuller use o f education is to be encouraged, rather than discouraged. 2. Minimizing Social Risks 44. Social Assistance. The second part o f the 1990s was characterized mainly by a strong shift away from explicit safety nets (in the state or Social Fund budgets) and toward assistance provided by mispricing key public services. This was the result o f a needed compression o f fiscal spending, particularly on wages and pensions and other entitlements, which required some relaxation on other fronts-in this case lax pricing policies for controlled commodities, such as power, district heating, gas, public transport, and water and irrigation fees. As mentioned before, electricity was perhaps the key vehicle for compensating households-followed by gas and xii district heating, which provided subsidies to those areas of the country that are less afflicted by poverty. As illustrated in Figure 3, while per capita spending in the social and human development sectors was cut from about US$67 in 1995 to US$30 in 2000, quasi-fiscalper capita subsidies in the power sector were increased-albeit from an already high level. In the process, interventionso f the consolidatedgovernment (i.e. SOEs and the state budget) becameuntargeted, inefficient,andcostly. Figure 3: Kyrgyz Republic: Evolutionof Direct Social Spending and Implicit Social Subsidies, 1995-2001 75 1 T 44.0 - 25 15 96 97 98 99 00 :::: ~ 95 01 CumulativeExplicit Social Spending -Cumulative Quasi-fiscalsubsidies 1 Note: Budgetary social spending includes health, education, social protection, and pensions. Quasi- fiscal expenditure is measured as the cost o f two elements: (i)transmission and commercial losses above what would be acceptable by international standards, to the extent that these mainly reflect lax disconnection policies; and (ii)the difference between the statutory tariff and an estimated long- runmarginal cost for the sector (US$2.3 centslkwh). Sources: Data provided by the authorities; authors' calculations. 45. The challenge is, therefore, to revert to budgetary funding for social polices and, as elaboratedearlier, phase out quasi-fiscalactivities.Indoingso, care shouldbe exertedto improve existing safety nets and to ensure that subsidies are given to enterprises in regions where the population's ability to pay does not allow the introductiono f full cost recovery policies. In this respect, the country has a solid base, as it has developeda subset of programs throughthe budget, includingthe following: 0 A Unified Monthly Benefits (UMB) system (a means-tested cash benefit for the poorest families) and the State Social Benefits (categorical cash benefits paid to orphans, certain groups o f individualsand elderly people ineligible for pensions), which mainly support food consumption. The UMB has been developed by the government and has been broadly recognizedas the mosttargeted social assistance instrument inthe KyrgyzRepublic. 0 Energy price discounts for electricity consumption (up to a fixed upper limit) to privileged energy consumers, with the budget payingthe price differenceto the distributioncompanies. About one-thirdof the Kyrgyzpopulationis eligible for these privileges.InNarynOblast, the entire populationreceives such discounts. In BatkenOblast, discounts are providedto about 60 percent of households.These discounts are additionalto the generallow pricingo f energy. ... Xlll 0 A means-testedprogramof housingsubsidies for multi-dweller buildings inBishkek. 0 A new set of "socially protected energy prices" (for gas, hot water, and district heating) for all parts of the country excludingBishkekCity. 46. The government has allocated about 1.3 percent of GDP or about 3 percent of public expenditure for the financing of the above programs in the 2002 budget, after a significant increase aimed at mitigating the impact of the electricity price increase in March 15, 2002. In addition, the government aims to overhaul the system of price discounts (second bullet above) as the means of providing social protection, and has submitted a draft Law on State Benefits with that in mind. The current draft law has been the result of consultations by the Ministry of Labor and Social Protection with numerous stakeholders, including Parliament and the affected beneficiaries. Itwould not only reduce the number of untargetedprivileged categories, but would also introducemoretransparentrules for determiningthese benefits. Any remaining entitlement is expectedto be paid incash ratherthan as a price discount. 47. At the same time, the authorities have been making substantial efforts to improve the UMBprogram. The mostrecent efforts includean increase inthe budget, a commitmentto make most payments in cash, and the launching of a monitoring effort in the form of an "audit" of beneficiaries that will be carried out by an independent local institution. Previous assessments suggested that the system has been relatively well targeted in the use of resources-a result mainly driven by the fact that the targetingformula is dominatedby the number of children inthe family, which correlates strongly with poverty. However the authorities have found that a substantialportion ofthe poorest households are not reachedby the UMB. 48. On social assistance, the government must continue its ongoing efforts to de-link any provision o f benefits through distortionary means, such as price discounts-except perhaps for a regional discount to remote areas funded from the budget. Securingthe support of the Parliament for the current draft Law on State Benefits is essential in this respect. Furthermore, efforts to improve the targeting and delivery of social protection.must continue, particularly to further strengthen the UMB program. Finally, efforts should be made to further develop safety nets for vulnerable groups, such as the disabled, children without parents, and the pockets o f poverty in Bishkek. The Naryn region has been found to be the poorest by far in various poverty assessments made by the National Statistical Committee as well as those made by the World Bank. It thereforeposes a specialchallengeto the socialprotection system. 49. Pensions. Pensions for the elderly are the main direct social expenditure of the government (4.7 percent of GDP). They present a mixed picture and raise hard policy choices. Reforms in 1997, which restructured the inheritedsystem, sought to redefine benefits so that past entitlements would not endanger financial sustainability, and new entitlements would reflect expected long-term revenues. Pensions were reduced in real terms after the 1998 crisis. After increases above inflation in 2001 and 2002, average pensions should reach81 percentof their real 1998 level in 2003. Increasedretirement ages and fewer early retirementprivileges have further improved the system's fiscal health. Accordingly, pension spending fell by 1.8 percent of GDP between 1998 and 2001. Its lowest level was in2000 at 4 percent of GDP. However, currently, with a low taxable wage bill, the pension system is severely strained financially. Budget support was needed in recent years (except for 2001) and health insurance revenueswere also divertedto help finance pensions. Even so, the system can afford only small pension benefits. Pensions average just over US$10 per month and will not match the poverty line before 2009, even with strong economic growth. As the system is designed to maintain benefits constant in real terms, the "catch up" o f the poverty line by the benefit is due mainly because new entrants will get xiv higher pensions than the current retirees. Frequently, pensions are paid late and partly in kind. Currently, political pressure to increase benefits is strong, but contribution rates are already so highthat they discourage formalization o f the economy and thus enlargement o f the contributory base. The sense o f crisis permeating the current debate about pensions policy has arisen because policymakers now want the system to provide larger pensions more quickly, at least for poorer pensioners, than the pension system adopted in 1997 was designed to provide. 50. This PER argues that policymakers must clarify social priorities and streamline expenditures accordingly. For pensions, a crucial policy issue is to clarify priorities among the multiple and partly conflicting objectives o f pension sy~tems.~These objectives now include: replacing pre-retirement earnings so as to smooth income across a worker's lifetime; assuring adequate income to alleviate poverty; and usingfinancing arrangements that minimize distortions in labor supply and in participation in the formal economy. It should be noted, however, that all transition countries in the first years o f independence could have responded quite differently when faced with collapsing economic activity and incomes, widespread distress, fiscal austerity, and the prospect o f very slow recovery in livingstandards. They could have opted for an austere, limited social safety net-for example, one confined to flat rate, means-tested benefits for those inthe most vulnerable groups who lacked family support and were not expected to work. Under such a policy, earnings-related pension benefits for retirees would have been deferred until better economic times returned. The available resources would then have been focused on the poorest retirees, facilitating larger benefits than otherwise for those eligible. The 1997 Kyrgyz reforms opted instead for a system that stressed earnings replacement over income adequacy objectives. The pension benefit formula incorporated a low basic benefit plus components reflecting pre- 1996 earnings and post-1996 contributions. Yet there are complaints that benefits are too small to prevent poverty and are too low to replace pre-retirement incomes adequately. Policymakers must consider whether clarifying social priorities should mean giving a higher priority to the improvement o f benefit levels for the poorest pensioners and, conversely, giving a lower priority to the proportion o f pre-retirement earnings that pensions replace. 5 1. Ifpolicymakerswant to streamline pension expenditures by emphasizing the objective of adequate incomes, two options are potentially available (singly or incombination). One is to give top priority to increasing pension levels for those pensioners who are poorest or who have the smallest pensions-for example, by using revenues available for pension increases to "top up" pensions, starting with the smallest pensions. The other is to augment Pension Fundresources by seeking to free up existing taxable capacity or to achieve savings within state budget expenditures so that additional resources could be directed to the pension system on a sustainable basis. (These approaches would have costs in terms o f letting the purchasing power o f larger pensions decline or grow more slowly, or reducing the incentive for workers with higher incomes to participate in the pension system.) 52. Another major issue for policymakers is whether (and, if so, how) to pursue a transition to a "funded" or "accumulative" basis for the pension system-one in which pensions are financed from individual accounts for each worker that have accumulated from savings over the worker's lifetime and from the interest income derived from wise investment o f these savings. (The National Poverty Reduction Strategy includes such a commitment.) Within the current system, the component o f the benefits formula based on post-1996 contributions, which was expected to eventually predominate, is linked to a notional account that measures cumulative contributions. Higher cumulative contributions result in larger pension benefits, thus encouraging lifetime participation and contributions. But the account is only notional. As in other unfunded See World Bank, "Kyrgyz PensionsPolicy Update," Draft of July 2002. xv or "pay-as-you-go" pension systems, all contributions to the pension system have been immediately paid out to existing pensioners as pension benefits. Advocates of switching to a funded system would like to replace notional accounts with accounts that really accumulate investedfunds. Numerous prerequisites are neededfor such a system to be viable. Nonetheless,, eventhough many of these prerequisitesare highly desirable,they would also take years to put in place. There are also potentially major costs for individuals, the budget, and the economy as a whole in attemptingsuch a transition. Detailedfeasibility analysis should, therefore, precede any irrevocable commitment to this path inthe nextfew years. 53. Regardless of the choices made on these issues, the govemment needs to improve collection enforcement by tacklingthe critical problem of arrears and by expanding the revenue base. These actions would have to be part of the modernizationstrategy for the revenue system. Specifically, a greater integrationof social security contributions and the collection of personal income, land, and patent taxes is very much needed. Finally, it is necessary to enforce a strict separationof the account for the contributionsto the MHIF, andto preventthe diversiono f health resources to finance pensionpayments. 3. Ensuring Infrastructure Support Growth 54. The bulk of public spending in transport and irrigationhas been carriedout throughthe PIP, and mainly for the rehabilitationof a mainroad, major irrigation channels, and the Bishkek Airport. However, maintenance has received limited resources in this early phase, and this has contributedto the continued deteriorationof the broader networks. Key recurrent spending other than maintenance (e.g., extension services) is severely underfunded. This will eventuallyhave a negative impact on economic activity includingagriculture.As major rehabilitationworks are by now well advanced, the country is in a unique opportunity to optimize the use of resources (including donor resources) in support of infrastructure,particularly in the appropriate blend of investmentsand recurrent.A key step inthis is for budgetinginstitutionsinlineministriesandthe Ministry of Finance (MoF) to be responsible for a single recurrent and PIP budget process. In addition, policy departments in line ministries(particularly Transport and Agriculture) will need to prepare Maintenance Programs, with a view to reaching consensus within various branches of the government on a realistic and affordable maintenance plan for roads and irrigation. As rehabilitationworks are completed, spending should shift toward recurrent spending (including maintenance). Donors should support these efforts, as they provide the entire funding for the agriculturalsector, other than wages, anda substantialpartofthe transport budget. i. Transport 55. Road Transport.Road is the predominant mode, with rail and air playinga much smaller role. In recent years, only minimum routine maintenance has been performed on the network under the Ministry of Transport and Communications (MOTC), and periodic maintenance has been undertaken on only 250-300 km annually. There has been no maintenance on local roads under MOTC, except for emergency repairs. There is no maintenanceon the 15,000 km of farm roads, previously built by state and collective farms. Clearly, the priority is to complete the Bishkek-Oshroad as soon as possible, to overcome the "hump" in investments, and to free up resources for maintenance. Considerationshould be given to increasing the counterpart funding over the next two years, to speed up completionpresently planned for 2005. This would hasten the time when better maintenancecouldbe initiatedfor the restofthe network. 56. While finalization o f the Bishkek-Osh road proceeds, the MOTC should develop and submitto the government maintenancescenarios indicatingwhat size networkcan be maintained, xvi at what standards, and for what level o f resources. Such a prioritization exercise is needed because the resources available will not be sufficient to maintain the entire network-even if funding increased to international standards over the medium term (Le. about 1percent o f GDP). This planning should be worked out over the next 18 months to two years, with a view to reaching a broad agreement and understanding within various branches o f government on a realistic and affordable maintenance plan for the road network. 57. Greater user financing should be sought to (indirectly) support the maintenance program, which means that taxation o f road users should increase. However, the current funds nominally earmarked for road maintenance, namely, one-third o f the turnover tax, do not come directly from road users and should be allocated for general budget purposes. The MOTC must compete with other sectors for scarce resources during the budget process, which makes it most important for the MOTC to produce the O&M scenarios suggested above. The current Road Fund, which works currently only as a recording system, should be dismantled. 58. Transport Operations.The government has made substantial progress inreducing its role as a transport operator. Although many former state-owned companies are still joint-stock companies owned by the government, they nonetheless operate on commercial principles and have not been receiving contributions from the budget. Since transport demand has fallen drastically over the last decade, most joint-stock companies are still overstaffed, despite substantial retrenchment. Equipment is grossly over-aged and costly to operate and maintain. For these two reasons, operating costs are higher than they could be under fully commercial operation. Consolidation can be expected among the joint-stock companies and failures among the private companies-and, in all cases, spillovers to the budget, other than indirectly through reduced collection, must be prevented. 59. The government should sell its remaining shares in all intercity freight and passenger transport companies. In the case o f urban transport, the main problem is in the capital city, Bishkek. Except for this and the Trolleybus Company in Osh, all other urban services are run by the private sector. Despite substantial allocations from the city budget in Bishkek, the bus and trolleybus companies have high operating losses and no resources from which to renew their deteriorating fleets. Bus services should be fully privatized and operations should be competitively tendered which would leave only the trolley bus companies under direct state control. As part o f the privatization process, the government should review the public service obligations (PSOs) that it imposes on passenger transport, both intercity and urban. Not only does the Anti-Monopoly Committee fix the tariffs at levels well below total costs, but there are many classes of passengers who are either fully or partially exempt from payment o f fares. The resulting losses o f the companies are only partially compensated by the government. On one hand, transport enterprises need to improve their efficiency, and on the other, government should compensate the enterprises for the PSOs it imposes on them. 60. CivilAviation. On May 15, 2001, the Kyrgyz civil aviation sector was reorganized into three independent entities: the national airline, the airports, and air navigation. The first two are joint-stock companies under the State Property Fundand the third is a department o f the MOTC. 61. Air transport consists o f the national airline (KAJ) and 16 companies that have registered to operate as private airlines, o f which 5 or 6 have started operations. There are no explicit subsidies from the state to either the national or the private airlines at the moment. However, since K A J is losing money on domestic services, which they are forced to operate for social reasons at fares fixed by the Anti-monopoly Committee, they receive a 50 percent discount on air navigation services and airport fees. K A J also loses money on international flights, at least under xvii international accounting standards. In addition to operating old and inefficient aircraft, and having to bear the cost imposed by the authorities through discounts, the company still has over 1,200 employees. The government will have to carefully weigh the value of keeping a national airline against its cost. 62. The Airport Company includes the three main airports of the country, Manas (Bishkek), Osh, and Karakol. Other small airports and landing strips have virtually been abandoned. Only Manas Airport is presently financially self-sufficient; the other two airports are losing money. They have been attached to the company, so that the surpluses expected at Manas would cover the losses at the two smaller airports. This subsidization scheme may need to be shown clearly in the books ofthe Manas Airport. ii. Irrigation andAgriculture 63. Irrigation. The operations and maintenance of the irrigation infrastructure (about 1.1 million ha with about 800,000 supplied with water by the MAWR in total) broadly consists o f two kinds o f expenditure-the maintenance of head works and the (off-farm) main canal system, and the maintenance of the on-farm infrastructure. A good part of the infrastructure has fallen into disrepair, though the essentialpieces are beingrehabilitatedwith donor support. 64. A draft strategy-still to be further developed and adopted by the government-suggests a two-track approach. The first track is that the bulk of O&M financing should be borne by users (farmers in Kyrgyzstan as well as neighbouring countries) over the medium to long term. For domestic farmers, the government is expected to finance over the next few years the bulk o f rehabilitation and O&M spending, but over time (the exact turning point is still to be defined) it will focus on a reduced area, perhaps one-fourth o f what intheory it should cover today, leaving the rest to farmers. At that time, the area for government focus is to be selected on the basis of social needs. The role o f Water Users' Associations (WUAs) in delivering O&M it is expected to increase overtime. A key next step is to develop a comprehensive rehabilitation and maintenance plan. By some accounts, ongoing projects only address a minimum amount of potential rehabilitation needs. On the other hand, the irrigation projects are large relative to the financial capacity of the country. Hence, planning and prioritization o f works is essential. 65. In this strategy, the government (and perhaps also the oblast governments) would play mainly a regulatory role in laying out the rules for the WUAs and the communities, and also in monitoring the use o f water resources. Water use would be regulated through licensing abstraction and return flows (based on an assessment of the overall demands for, and availability of, the water resources) and through maintaining and enforcing environmental protection standards. The government would also be expected to provide assistance o f last resort, mainly to communities in need, and to negotiate all water issues with neighbouringcountries. 66. Part o f the overall strategy-that related to the creation o f WUAs-is already under implementation but will take several years to mature. In contrast, progress has not been made in the area of introducing a sound regulatory framework for irrigation fees, as well as in resource mobilization. Irrigation fees remain low at about US$0.6 per 1,000 m3 (som 30) against a cost- reflective fee estimated to be above US$15 per 1,000 m3. Clearly, donor support will have to continue to enable the Kyrgyz Republic to save the irrigation infrastructure. However, greater progress on the policy front must be made. A key step is to finalize the Water Code and obtain endorsement from the Parliament. On the institutional side, developing a set o f strategic xviii simulations o f costs and sources of financing, so as to pin down the future turning point in which budget fundingcould beginto be phasedout, is important. 67. Agriculture. Parallel with putting irrigationfunding requirements on a more predictable and sustainable basis, attention could be directed to other important public functions, notably research, extension, regulation, and the creation o f marketable individualland ownership rights. At the moment, the pattern o f government activities in agriculture is distorted, with excessive intervention in some areas and underfundingin others. The government (through off-budget means) plays an overextended role in agricultural inputs and machinery, and has allowed input market interventionsto seep into decisions in other areas, notably in the allocation of land to public seed institutions. Output market interventions are relatively restrained by comparison, although the public wheat reserve is rather large. Research, extension, and land reform appear to be underfunded. This is justified only in the case of research, where reforms have only recently started. Efforts must therefore be made to restructureagriculturalexpenditures away from inputs and into landreformandextension. 111:ENHANCING SYSTEMS AND CAPACITIES OF PUBLICADMINISTRATION AND GOVERNMENT 68. The effectiveness of fiscal policy must improve if the authorities are to achieve development goals and poverty reduction policies. We focus on three tasks that are critical to these objectives. 69. The first task is to reformpublic sector compensation and employment, focusingon the civil service, education, and health. Today, although the overall public sector wage bill seems reasonable, public sector employment comprises the bulk of formal employment. Hence, a considerable percentage o f qualifiedhuman resources are working for low wages, which creates two problems: low motivationand the search for alternative sources o f income-including rent- seeking. Emphasis should be given to the need to raise salaries, streamline employment, train those who remainandthose who leave, andreducethe discretionarycomponento fremuneration. 70. The secondtask is to further improvepublic sector resource managementwhere progress hasbeen made in the past, but efficiency is still compromisedby: (1) the widespread use of barter and non-cashtransactions; (2) the growingimportance of specialmeans inthe financingo f public institutions; (3) the presence of a small but still damaging number o f extra-budgetary funds; (4) the separation of current and capital budgets preparation and execution processes; and (5) the extreme reliance on protectedexpenditures as a budget execution tool-which avoids massive wage and debt servicing arrears, but which precludes needed reallocation of expenditures overtime. Ifthese weaknesses are addressed, the KyrgyzRepublicwould be a good candidate for a modernizationof its treasury. As for prioritization,the Medium-termExpenditureFramework should becomethe backboneo fthe NationalStrategy for Poverty Reduction. 71. The third task is that o f improving IntergovernmentalFinance (IGF) arrangements, of whichthe PERhighlightsthe needfor particularattention. 72. As suggested in the 2003 NSPR, the authorities are well aware of these needs. In fact, in collaboration with donors, work is ongoing to develop a broader framework for public administration and Public Expenditure Management (PEM) reform^.^ Clearly, sequencing The World Bank and other donors intend to support such a program with a possible Governance Structural Adjustment Credit, currently under preparation. The UNDP and the EUhave been providing critical assistance inthese and broader public administration reform areas. xix reformsinthese areas is important, to ensure that issueswith largest immediatepayoffare tackled first. In any case, institutional reforms require a long-term commitment before results on the ground are noticeable, butthese resultsare essential. i. IntroducingTransparentEmploymentand CompensationPolicies 73. The size ofthe KyrgyzRepublic'swage bill was estimated at 5.8 percentof GDP in 2001 and the level of public employment was about 309,000, of which approximately 25,000 employees were estimated to be civil servants. The size of the wage bill is not excessive when comparedwith that in other countries. However, public employment is too highfor a low-income economy and represents the bulk of formal (non-agricultural)employment, even though public employmentrelativeto populationfalls withina broadrange for transitionalandOECD countries. More important, the public and government leaders are not satisfied with the administration's ability to fulfill the fundamental responsibilitiesfor service deliveryand regulatoryenforcement. 74. As for compensation, a large number of regulations govern a fractured wage system in the civil service alone. This poses an implementationand monitoring challenge and makes it difficult to evaluate the fiscal impact of policy options. Moreover, basic pay is low, and special allowances and bonuses couldaccount for 60 percentofthe total remunerationof civil servants- a much higher percentage than that in countries with a greater institutionalcapacity to evaluate performance. The civil service wage scale (and the resultingaverage wage after allowances) is significantly higher than that o f the social sectors-where the compensation frameworks also need to be worked out further. Nevertheless, civil service pay levels remain modest and somewhat compressed. 75. As the experience of other countries shows, civil and public administrationreformtakes time. Priorityshould be givento raisingthe levelof pay and simplifyingthe systemof allowances and bonuses. However, the design of a new remuneration system is a major challenge and simulationsmust be carriedout to assure that key criteriaare met, including: (i) affordability; (ii) adequacy o f wage levels; and (iii) management, includingthe need for flexibility to adjust risk wage levels down inthe event of a downturninthe economy. 76. The design of a new remuneration system for the civil service should take account o f its likely effects on the rest of the public sector. Hence the needto undertake pay and employment reforms inthe healthand education sectors, the mainemployers outside ofthe civil service. Here, however, pay and employment reforms should be an integral part of the implementationof the respective sector strategies. As part of the overall public employment reform, the government should develop a comprehensiveretrenchment strategy for helpingworkers make the transitionto viable new jobs, including providing assistance to displaced workers. Finally, the government needs to strengthen the system for monitoring whether wage bill funds-one o f the larger monetaryflows ina country where in-kindtransfers are widespread-are well spent. 77. Reforms inemployment and compensationneedto go hand inhandwith other reformsin personnelmanagement. These includecreatinga professional, politically neutral and stable civil service; implementing transparent rules and practices relating to recruitment, promotion, performance appraisal, training and discipline; and strengthening the human resource management capacity of the government. They also need to be followed by administrative reforms aiming to eliminate overlapping functions as well as redundant or excessively intrusive activities. Such reforms will take time, and thus they should be carefully sequenced so as to reformfirst those institutionsthat impose larger costs on the privatesector. xx ii. Improvingthe ResourceManagementFramework 78. The KyrgyzRepublichastaken importantinitial steps towardestablishinginstitutionsfor public resource management. A basic legalframework for budget preparationand execution was established in the mid-1990s. In 1996, the Treasury system became operational, making the KyrgyzRepublicthe first CIS countryto have a functioningmanualTreasury. A revenue sharing arrangementwas designedto providemorestable budgetaryfinancingto the localgovernments. 79. Currently, the state budget comprises recurrent republican(central) government and local government expenditures, andthe domestic counterpart for foreign-financedprojects. The bulk of capital expenditures are under a separate program-the Public Investment Program (PIP). Although lacking a formal budget formatiodexecutionprocess, the program is currently part of the budget documentation submitted to the authorities and is certainly an integral part of their macroeconomic framework. There is also an extrabudgetary arrangement for managing social insurance revenue and expenditures, the Social Fund, which is regulated by the Law on State Social Insurance and the Law on State Pensions. The fiscal operations of the Social Fund are reportedto Parliament. Unfortunately, a number of factors still compromises efficiency in the managemento fpublic resources. 80. Comprehensivenessin the use of public resources.Effortsnotwithstanding,the annual budget does not yet provide a comprehensive picture of the coverage o f all the fiscal activities, nor does it allow for optimizingresourcesacross a limitedset ofpractices.To illustrate the degree of segmentationof public resources, a Chapter in the PERattemptedto qualify the full size ofthe state. Quasi-fiscaloperations in the power sector alone accounted for about 7 percent of GDP. This, and the public funds handled through extra-budgetary funds and off-budget operations, bringsthe size ofthe state budget in2001to about 42 percentof GDP (comparedto a reported26 percent after manual integrationof the Social Fund and the Public Investment Program into the state budget). 81. Three issues are to be re-assessedinthis regard: First, the real needto maintainsome of the existingextra-budgetary fund arrangements. There are eight extrabudgetary funds in the Kyrgyz Republic that handle at least 15 percent of total public resources according to available accounts. Such a high level of earmarkingreducesthe resourcesavailable for fiscal policy.Moreover,the multiplicity of extrabudgetary funds undermines oversight and accountability in the management of public resources, since some of the activities are not subject to the regular procurement and reporting requirements that apply to budgetary institutions. A direction for reform could consider: (i)closing the Economic Development State Fund; (ii)increasingthe transparency and rightsizing the State Material Reserve Fund; (iii)corporatizing or closing the Small and Medium Enterprise Support Fund; and (iv) considering the integrationof the Social Insurance Fund(although reducedinscope), the Unemployment Fund, andthe StateProperty Fundintothe budget. Second, the frameworkfor handlinggrants from donors, particularlythose inthe form of commodities (e.g., tractors, seeds, fuel, or fertilizers) that are not recorded with the Treasury. These generate financial flows for the recipient line ministries, provide direct or indirect finance to the state, or providesupport to public or private enterprises. Efforts should be made to include in-kind grants in the budget, which requires that these be auctioned off for cash at the entry port (rather than lent through the Economic Development State Fund). xxi . Third, the integration of budget processes for recurrent and capital spending. The PIP represents the bulk of the capital investment and is already part of the macroeconomic framework of the budget. Inmany other respects, it is also well integratedinto the budget &e., it is includedas an attachment to the Budget Law, and its management is now the responsibility of the Ministry of Finance). However, decisions on annual PIP implementation do not follow any of the established principles of the budget, nor its calendar. The foreign part of the PIP is also implementedoutside of the Treasury. Taking the few missing steps to fully integratethe PIP with the preparationand execution of the domestic budget is important to strike an appropriate balance between capital and recurrent spending. First, consideration should be given to merging the Goskominvest Commission within the Budget Commission to ensure that only one executive body decides on recurrent and capital interventions. More importantly, the PIP program must be agreed on within the budget preparation cycle (rather than during the year of execution) and be approved by the Parliament. The PIP should also be executed on the basis of semi-annual or quarterly allocations to avoid interfering with contracting and supervision. The PIP unit in the MoF should develop a system for strict conciliation of bank statements; this should be developedto ensure that transactions are recorded in the Treasury so that monitoring of financial flows becomes automatic inthe near future. 82. Segmentation of the State Budget. Several de facto `mini' budgets, independent from each other, are run outside the State budget. These account for about 18 percent of GDP (e.g., the foreign financing public investments as well as social fund transactions). About one-third of the State budget is tied inthe form of special resources, barter, or offsets andthus cannot be allocated to the priority areas specified in the approved budget. Another one-third of the budget corresponds to protected items which cannot be reallocated either. In short, in a year such as 2001, only 5 percent o f GDP out of a total of 18 percent of GDP can be effectively decidedupon in the event of a crisis. Barter, offsets and protected items explain the significant variation betweenthe plannedand executedbudget. 83. As the experience of other countries shows, budgetary reform takes time. The recommendations here give priority to imposing hard budget constraints by: (i) ensuring that all transactions between the state, the enterprise and the household sectors are made through monetary or financial means ratherthan inthe form of barter or offsets; (ii) reducingthe scope for specialmeans; and (iii)gradually shifting budget preparation and executionprocess away from a protected-items approach and into a protected-program approach (i.e., priority programs being financed by the budget will not be cut inthe eventof a revenueshortfall): Barter. Although the government sets a limit to barter collection at a maximum of 4-5 percent of total collection in 2001, this policy has been bypassed because the root problem (a budgetary imbalance) has not been fully addressed. Barter is a common practice for paying taxes and penalties to the revenue collection agencies (the State Tax Inspectorate, the State Customs Inspectorate, and the Social Fund), and debt service obligations (collected by the Economic Development State Fund). Such collections are generally encouraged by the government-in an effort to show an improved tax or debt collection performance.A sufficiently largenumber of institutions complain about barter, which suggests that it has become a common practice, despite the official reports on its reduction. In2002, for instance, roadmaintenancedepartmentsreceived food products as part of their budget allocation, and the Social Fund is to pay old debts to the Health Insurance Fund in kind. Unfortunately, reliable estimates of the extent of barter are not available to key policymakers. Clearly, a policy of hard budget constraint must be xxii instituted properly by ensuring that all revenue collection agencies and the Economic Development Fund stop receiving goods as tax or debt service payments. This can be achieved by virtue o f closing any department handling goods and by selling any assets it may have to handle collections in kind (trucks, warehouses, etc.). The state Material Reserve Fund should also be precluded from providing these services to any agency in the government; all transactions between the SMRF and budgetary institutions must be accounted clearly in the budget and the books o f the SMRT and locked with financial statements that can be audited. Penalties must be imposed if budget allocations are to be .executed inbarter. Offsets. More recently, the authorities have been using cash-to-cash transactions, which are offsets between one or various taxpayers and the budget, in which cash is provided at the final stage to ensure that they are recorded in Treasury. Cash-to-cash operations, which are most common as a way to effect the transactions between the budget and the power, gas and district heating companies, are not documented but can be estimated to account for around 20 percent of state budget operations. The implicit offset blurs the relationship between tariffs and tax obligations since it ensures that accounts payable and receivable match exactly. One way to reduce cash-in-cash operations in the energy sector .is to allow the sector to enforce the due dates on the government's bills. Prepayments can also be requiredfrom one party or the other (i.e. the M o F or the companies). Special Means. A large number o f budget-financed agencies (e.g., State Tax Department, State Customs Department, Ministry o f Justice, Ministry o f Transportation, Ministry o f Education, Ministry o f Agriculture, Procurement Agency, Chamber o f Accounts) collect and spend own fees, fines, and other direct revenues. Although these revenues are reported in the official budget, the framework for levying and retaining them needs to be sharply improved. First, the right o f collecting fees-as opposed to being fully financed from the budget-should be curtailed for a number o f agencies, to remove perverse incentives and conflicts o f interest (e.g., the State Procurement Agency). Second, while it may be legitimate for some institutions to collect fees or impose fines, only the agencies that provide fee for service activities should be entitled to keep proceeds (e.g., higher education institutions, health care providers, and the Departmento f Water in the Ministry o f Agriculture). Third, independent sources o f financing (fees or taxes) must be introduced for a small subset o f agencies (e.g., National Bank of the Kyrgyz Republic, State Energy Agency, the Chamber o f Accounts). A reform o f special means must be implemented in conjunction with a revision (and harmonization) o f the government's compensation policies, given that the fees currently represent a significant top-up to the base salary funded from the general budget. Protected Items. The priority given to protected items (wages, social security contributions, food purchases, and foreign interest payments) during the budget formulation and execution process has allowed the government to avoid arrears in these critical items. However, this strategy is counterproductive over the long run because it makes it difficult to reallocate resources in line with national priorities. Ideally, budget execution rules would ensure that key programs be run, regardless o f whether the key inputs to these programs are labor, goods or services. However, the phasing out o f protected items requires a number o f prerequisites. First, it demands further reforms in the health and education sector, as outlined earlier, and in particular it involves shifting the nature o f categorical grants by tying them to specific standards o f services (currently these transfers are made on the basis o f labor inputs). Second, the budget management agenda must be furthered, including the modernization of the Treasury and the xxiii improvements in the financialaccountabilityo f spendingunits. Efforts should, therefore, be made to develop a plan for gradually phasing out the protected item approach to budgeting. 84. Planning, prioritization, and costing. The Ministry of Financehas taken the initial step o f producing its first Medium-TermExpenditure Framework (MTEF) earlier in 2003. While still in embryonic state (the MTEF focused mainly on the macro parameters and covered only the State budget), it highlights an important effort to identify broad priorities. The MTEF should evolve intwo important directions. First, sector policies (inkey areas) should be developed, to determine specific policy directionsand, most important, to understandthe true cost of delivering priority services (Le. primary health or education). This PER provides an initial assessment of policies in health, education, social protection, pensions, transport and agriculture, as well as in wage and employment issues, which are expected to be part of the next MTEF. Second, the MTEF should become the backbone of the National Strategy for Poverty Reduction. Due to differences in the calendar o f the NSPR and the MTEF, these two importantefforts couldnot be integratedthis time. iii. FurtherDevelopingtheFrameworkforIntergovernmentalFinance 85, Effective governance requires coordinated and specialized execution of public responsibilities by governmental and administrative units through the range of geographic, functional and hierarchical divisions. In the Kyrgyz Republic there are tremendous regional variations in economic structure and revenue potential that creates pronounced disparities in service needs and localcapacities to satisfy these needs. 86. Previous elements of Kyrgyz intergovernmental finance reforms intended to, inter alia, rationalizeand fixed expenditureresponsibility; and to introducea revenue assignmentconsistent with expenditure responsibilitiesand a system of transparent, specific ("categorical") grants to support specific service provisionat the regional and sub-regionallevel via central government resources. In addition, a formula-based equalizationgrant was designedto provide a transparent and non-negotiatedmechanism for augmenting revenue availability in a manner inversely related to local resource capacity and directly related to expenditure needs. Together, these would provide a framework for generating a fiscal system consistent with the vertical distribution of expenditure responsibility, and would deal with horizontalimbalances in revenue capacity while simultaneously providingproper economic incentives for both sub-nationalrevenue mobilization and the efficient delivery o f services consistent with the needs o f local populations and the prioritiesofthe nationalgovernment. 87. While progresshas been made in sortingout expenditure responsibilitythrough the Law on the Principlesof the Budget (1997), as well as in establishingrevenue assignments (including a tax sharing system and local revenue options), and in codifying the framework for intergovernmental transfers between the national government and the oblast level, implementation has been erratic and problematic. Service delivery responsibility between different levels o f governments varies considerably across and within oblasts. Enhancedstability between Central and regional governments has not been mirrored sub-regionally. Rayons routinelyshift controlledexpenditureresponsibilitydown to village levels to correspondwith any additionalrevenue capacity a village may have achieved, thereby eliminatingincentives for both revenue generation and any meaningful level of local discretion in a manner consistent with sector reformstrategies. xxiv 88. The equalization structure has not been formalized and is far from stable. Revenue transfers (up and down) between villages, rayons, oblasts and the Central Government remain ad hoc and negotiated. "Excess" revenue is routinely siphoned away from Bishkek and Chui on an ad hoc basis to provide "gap-filling" transfers to other oblasts. While, due to their relative fiscal strength, these two regionalunitswill be the major source o f nettransfers, the structure by which these transfers are made undermines incentive for revenue mobilization. 89. Fixed sharing rates are meaningless when categorical, equalization and ad hoc transfers are manipulated. Transparent, non-negotiated, formula-based equalization grants, which transfer resources in inverse proportion to local revenue capacity (based on a predetermined pool o f available resources), have yet to be implemented. Those that exist muddle equalization with the categorical grants and mid-year (unbudgeted) transfers from the republican budget. Categorical grants have been used for covering predetermined wages and social contribution requirements in the sub-national health and education sectors, rather than as instruments for allocating resources based on established national minimum service standards. Beyond this, the coverage o f these grants is incomplete and varies considerably between oblasts, and the fmal allocations are made through non-transparent ad hoc arrangements. 90. The Agenda o f IGF is, therefore, large. The PER highlights the following areas for particular attention: (i)refinement and stabilization o f expenditure and revenue assignment, (ii) continued development o f local revenue sources, (iii)refinement o f the character o f the categorical grants, specifically moving away from their use as a vehicle for covering predetermined wages and social contribution requirements in the sub-national health and education sectors to instruments allocated based on an established national standard o f minimum service requirement, (iv) establishment o f a transparent, non-negotiated, formula-based equalization grant which transfers resources inverse to local revenue capacity, while maintaining incentives for local revenue mobilization, and (v) defining a consistent pool o f resources committed by the national government to these transfer programs. A key next step is to simulate alternatives IGF arrangements, to ensure that any new IGF system takes appropriate resources from the richest regions (i.e. Bishkek) so as to avoid ad hoc claw back o f resources mid into budget execution. CONCLUSION 91. This PER has sought to provide a strategic framework for fiscal adjustment and public expenditure reform in the Kyrgyz Republic consistent with the government's objectives for accelerated growth and poverty reduction. The broad contours o f the strategy are: 0 To stabilize the government's finances through stronger revenue and expenditure management instruments and institutions, as well as through debt relief. 0 To re-align sector policies with the most essential country priorities, with a general thrust toward the improved targeting and efficiency o f resource use in both social and public infrastructure sectors. 0 To revamp the public administration to improve policy implementation and service delivery, and to reduce corruption. 0 To secure a stable and predictable flow o f future external financial support, notably grants and investment. xxv 92. In light of the fragile external debt situation and the extent of poverty, priority has to be given to fiscal adjustment and to the expenditure reform agenda.By makingthe government less intrusive, and by securing greater efficiency in the delivery o f the most essential public services, fiscal policies would also serve the overarching requirement o f fostering private investment and growth. Since the agenda in these areas is comprehensive, a matrix summary o f short term and longterm issues is attached. 93. Finally, to enhance the credibility of the above reform efforts and promote a timely supply response from the private sector and foreign investors, there is a need to encourage transparency and accountabilitythroughstrengthenedpublic oversight. Government performance needs to be monitored, particularly at the grass roots levels, includingthrough systematic and publicized diagnoses of institutional problems, and through the development o f quantitative performance indicators to track progress and competition in public service delivery where possible. An initial effort has been made in this direction with the preparation of "Governance and Service Delivery in the Kyrgyz Republic: Results of Diagnostic Surveys," that has been reviewedby the government and is already availableto the public. xxvi PUBLIC FINANCEMANAGEMENT:INTEGRATEDPOLICY RECOMMENDATIONSOF THE RECENT WORLD BANK ECONOMIC SECTOR WORK INTHE AREA OF PUBLIC FINANCE The following pagessummarizes recommendationsprovidedinthis PublicExpenditure Review(PER), and integrate themwith those inthe Country FinancialAccountability Assessment (CFAA), Country ProcurementAssessment Report(CPAR), projectdocuments for the Government Structural Adjustment Credit(GSAC) and its TechnicalAssistance component (GTAC), andthe Reporton Governanceand Service Delivery inthe Kyrgyz Republic.Basedon thoserecommendations, followingmajorpolicyand institutional capacity buildingreformoptions are identifiedfor medium-termreformsinpublic finance management: I. Policyframework: Fiscalconsolidationto determinethe real size, composition, andthe scope ofthe public sector operationinthe KyrgyzRepublic. Betterprioritization,basedon a consolidatedframework, of expenditure policies throughredefiningthe role of state in service provision-a particularchallenge is to refocusthe budgetresourceallocationbetweencurrent andcapitalspendingand within the capitalspendingbetweenamounts goingto "human infrastructure"or the maintenanceofessentialphysicalinvestments andthose devotedto expenditures that do not serve to enhanceproductivecapacity, like consumptionsubsidies and subsidies ofpublic enterprises. Soundrevenuepoliciesto supportthe expenditurepolicy framework-like inmany other developingcountries taxationinKyrgyzRepublic is presently regardedas a meanto maximizeandsecure revenuerather than provide incentivesto efficient resource allocation. Tax burden is biasedtowards producers o fexports, import- intensiveactivities, large-scaleenterprisesand public sector, which inter alia, discourages investment inthese sectors. The challenge is therefore to linkthe expenditureandrevenuepolicies,remove existingdisincentives, while at the same time broadenthe tax baseto includethe untraditionalsectors liketrade, services and to some extent agriculture. II.Institutionaucapacitybuildingframework: Proper policies would not guarantee desired outcomes in Kyrgyz Republic unless complemented efficiently by strong budget management institutions and capable public sector officials, subject to checks andbalancesby financial accountabilitymechanisms.This calls for a followingthree-prongreformapproach in the periodahead: 0 Improvefinancial managementto strengthenbudgetplanningandbudgetexecution. 0 Streamline public financialaccountabilityto insuretransparency inpublic resource allocation. 0 Strategicallyplanand implement capacity buildingto ensure efficientpublic service delivery inthe mediumand longterm. xxvii I. PublicPolicyFormulation 1. Introduce a Conceptof ConsolidatedPublic Sector to Determine the Real Size, Compositionand Scope of the Public Sector Operations 9 Includethe extrabudgetary Funds(Social Insurance, Unemployment, StateProperty, Economic Development State Fund, Small and Medium Enterprise Support Fundand State Material Reserve Fund) inthe Budget definition to reflect comprehensively the intended social and other state obligations and spending (partially addressedunder GSACcore action?. 9 Develop amechanismfor calculating the costofimplicitbudgetsubsidies inenergy, irrigation, transport and other services and appropriately reflect it as well as explicit financing sources (e.g. the revenue from IGIAs7)inthe Budget. This mechanism should include at least three components: 0 Costs related to low-tariffs and fees 0 Financial implications o f non-payments and losses 0 Cost of the public service obligations imposed on State Owned enterprises (enterprises in Utilities and Public Transport sector) through exemptions from payment of fares and rigid labor regulations imposed on the companies8. 9 Fullyreflect inthe MediumTerm BudgetFrameworkthe future recurrent costs associated with the on-going and planned capital projects (e.g. maintenance cost for existing and new roads, maintenance and utility costs for existing and new facilities). 9 Integratethe off-budget in-kindgrants receivedbypublic entities alongwithother Budget spending. 9 Provideadequate provisionfor the contingences, includingprovisionsfor the guarantees. 2. Improve Public ServiceDelivery by Focusing on the Essential Areasfor Public Sector Intervention. Enhance Public-Private Partnership and Private Sector Participation in Other Areas. Education 9 Address the issueofinequality inservice delivery amongtheregionsgthrough: 0 Developing and implementing a capitation-based formula for calculating categorical grants for Education(GSAC core actions). 0 Developing and implementing a plan to modify the textbook rental scheme to ensure that low household income does not prevent students from receiving textbooks (GSAC broader reform objectives). GSAC core actions implies working out and implementing an action plan for transferring all extra- budgetaryaccounts, with the exception of the Social Fund, into TreasuryGeneralLedger. Inparallel the effort shouldbe madeto monetizethe IGIAs with neighbouring countries. Measures might require liberalization of the Labor Code. Presentlyeducationspending favors urban andrelatively resource-richregions. xxviii 9 Address the issue oferodingqualityofeducation, through: 0 Definingthe methodologyfor developingminimumservice standards inthe educationsector andrefiningthose inthe healthsector (GSAC broaderreform objectives). 0 Increasingdepressedteacher salaries through development and implementationofa teacher, retrenchment, remunerationandhiringframework (includingcost saving measuresto finance wage increases). 0 Providingadequate financingfor complementary inputs (e.g. learningmaterials, text books, etc). 0 Providingadequate financingfor the school rehabilitationneeds especially inthe ruralandresource-poor areas. 9 Increasetransparency inthemanagementofschoolfees, by providinggreaterautonomy to parentsto set their levels anddecide ontheir allocation. 9 Promotetransparencyinaccessto highereducation. 9 Developprogramsthat enhanceeducationperformance(e.g., nutritionalinitiativesfor children, energy conservation). 9 Promotesingle payer systemthrough: 0 Enactinga Law onthe single-payer reforms inthe Healthsector (GSAC core actions). 0 Issuingan appropriate legal instrumentto revisethe budgetmanagement arrangementsfor the healthsector consistent with the Lawson Single Payer System, Basic BudgetPrinciplesand Treasury (GSAC core actions). 0 Graduallyrollingout singlepayer systemto all regionsstartingfromBishkek, Osh andJalal-Abad. 9 Ensurefinancialsustainabilityofsingle payer systemthrough: 0 Aligning the State GuaranteedBenefitsPackagewith the legalfinancing provisions.IO 0 Developingand implementinga capitation-basedformulafor calculatingcategorical grants for Healthsector (GSAC core actions). 0 Replacinginformalpaymentswith transparentco-payments. 0 Reassessingthe needfor tying healthinsuranceco-paymentsto payrolltax (rather thanpricethis `insurance' on a cost per service basis). 0 Allowing the sector (and individualhealthfacilities) to keep savings generatedfrom efficiency gains (i.e., precludefrom automaticallyreducingbudget allocations as facilitiesare rationalized)as neededfor stabilityof budgetfinancing. 0 Developinga basic framework for increasedautonomy of reforminghealthcare providers(hirindwage andother managementdecisions), andstrengtheningthe frameworkfor privateprovisiono fhealthcare. lo Inthis context,the current levelof30 somper capitawill needto beupgraded. xxix Directly paying the 2 percentpayroll tax to the MHIFaccount. e Amending current legislationto establish responsibility of the Republicanbudget for the financing o f allocations for healthcareinsurance of pensioners and unemployed. e IncreasingRepublicanbudget's reliance on the MHIF as amanager o f its funding to local government(i.e., categoricalgrants). 9 Createenablingconditionsfor the personnelretrenchmentandfacility rationalization. 9 Strengthenthe HIV/TBpreventionpracticeswith thedonor support. 9 Developanenergy conservationprogramfor healthcare providersandconsidera matchinggrant scheme for vanguard rayonsofhealthcare providers. SocialAssistance 9 Graduallyphaseoutbroadlyuntargetedsocialassistanceprogramsrunthroughutilities and transportationwith subsidies provided only to the poorestregions(e.g. Naryn and Talas) and incases of obvious market failure (e.g. urbantransport) and reflected explicitly inthe budget. Adopt and implementthe draft Law on State Benefits (incash or coupons, but not through offset, or barter). Continue strengtheningoftargeted social assistance programs(e.g. UnifiedMonthly Benefit program). Harmonizetransfer systemto the disabled(from pensionandthe Law on State benefits) and secure funding for aminimumamount of healthand rehabilitation programs. Pensions 9 Define objectivesofthe pensionsystem with attentionto bothfinancial sustainability andequity objectives: e Ifthe future pensionpolicy is basedonreplacingpre-retirementearningsso asto smooth incomeacross a worker's lifetime; implementan across the boardCPI based indexation. Ifthe hture pensionpolicy is to assureadequate incometo alleviatepoverty give top priority to increasingpension levels for those pensioners who are poorestor who have the smallest pensions-for example, by usingrevenues available for pensionincreases to "top up" pensions, startingwith the smallest pensions. 9 Developastrategy for financingthe non-contributory pensions, includingthe option of financing them through direct budget subsidy separately from the Social Fund. 9 Developan actionprogramandtimetablefor creatingthepolicies, institutions and proceduresnecessary to introduce a fully funded element into the basic structure ofthe Kyrgyzpensionsystem (GTAC core actions). xxx Enerw Sector 9 ContinuetheMediumTermTariffFrameworkimplementationinPowerandGas Sector till the tariffs reachthe cost-recoverylevels (CSAC core actions). 9 Phaseout graduallyimplicitsubsidies inpower(financedthroughtheIGIAs)andkeep the IGIAs revenue, freed-up inthe process, for generalbudgetpurposes." 9 Monitoronacontinuingbasisprogresstowardeliminationofnon-paymentsandlosses inpower sector (currentlyat around40%) through appropriatemeasures. 9 Launchacredibleinvestmentprogramindistributionsupportedby PrivateSector participation(PSP) for Severokelectro (CSAC core actions). 9 Attract PSPinotherdistributioncompanies(includinginthe form ofmanagement contracts), and inthe gas transmissionanddistributionbusinesses (CSAC core actions). Transport 9(i)Roadsinitiatingany majorpublicprojectinroads,railways,airways tillexistingmajor Avoid investments are completedandnew major investmentsbecomeaffordable. 9 FocusonOperationandMaintenance(O&M) ofacoreset ofthe roadinfrastructureby consideringthe maintenance scenariosfor the core network. 9 Completethe Bishkek-Oshroadto overcomethe "hump" ininvestments, andto free up resourcesfor maintenance. (ii)Urbantransport 9 Formallytender public serviceobligationsthat arenotphasedoutto public andprivate providers. 9 FormallysignPSOagreementsandallocate the appropriate fundinginthebudget. 9 Monitorenterprise performanceunderPSOs. 9 CompletebusservicesprivatizationinBishkek, exceptthetrolley buscompaniesin Bishkekand in Oshwhichcouldbe kept under "direct" state controlbudneedto be supportedby adequate direct financingto provideservices to the most vulnerable. 9 Further developregulationsandtraffic controlfor urbantransport. 9(iii)Air transport Financethe air routesthat must bekeptfor strategic reasonsdirectlyfrom the budget. 9 Furtherstrengthenair-traffic regulations. 9 Launchaninvestmentprogramwithprivatesectorparticipationto initiatea restructuringofKAJ(KyrgyzNational Airline) with aview to downsize staffand facilities, sell unneededassets, andmake it ready to competewith other emerging domestic airlines for all lines ofbusinesses. Irrigation 9 Developanirrigationstrategyframeworkandadopt itby GovernmentResolutionto phaseinthe cost recovery o f O&M for headworks through following actions: "Thedomesticmarketshouldallowfinancingofthesystemwithoutresortingto export(IGIA) revenues, xxxi 0 Departmento fWater Resourcesshouldbegina programo fconsistent long- term planningo fexpenditureneedsfor the irrigationsystem. 0 The Water Code shouldbe approved, onthe basis o fa coherent longterm planto align irrigationfees with cost in a decentralizedmanner (i.e. with authorities fixing only part o fthe fees andWater Users' Associations fixing andmanagingthe rest). 0 Improveexistingfinancialframework for further promotingsustainabilityin O&M for irrigation. 0 Encouragethe developmentof Water Users' Associations. 3. Formulate Modern Revenue Policy Compatible with theMarket Economy Principles and Improve RevenueAdministration RevenuePolicv 9 Forequity purposes,focustaxpolicyon indirectandpropertytax enhancement measuresthrough:(the proposedmeasures,together with better administration,are estimatedto increasenettax revenueby about 0.5 percento fGDPperyear over the medium-termperiod): 0 IntroducingVAT on power and gas consumptionby the population. 0 Increasingtax collectionsfrom luxuryproductsthroughbetter implementation of excise tax. 0 Rollingouttax on immovableproperty. 0 Increasingtaxes on roadusers and smokers. 0 Phasingout remainingtax exemptions(includingthose for FreeEconomic Zones sellingindomestic markets). 9 ReduceTax BurdenontheLaborCostthrough: 0 Developinga planfor phasing-infurtherpayrolltax reductionalongwith improving the compliance andexpandingthe contributionsof contributoryand con- contributorybeneficiaries. 0 Introducingthe ceilingon the payrollcontributions. 9 Simplifytaxpolicyandeliminateexistingdistortionsto promoteefficiencyandgain taxpayers' confidencethrough: 0 Eliminating`nuisance' taxes. Eliminatingtrade restrictions(seasonaltax on importedwheat) andnormalizetrade relationswith the neighboringcountries. 0 Ensuringproper administrationandtimely payments o fVAT refunds. 0 Gradually phasingout turnover taxes. 9 Formulatenon-taxrevenuepolicyinlinewiththe market-economyandcost- effectiveness principlesthrough(the proposedmeasuresare estimatedto increasenet non-taxrevenuesby about 1 percento fGDP over the medium-term): 0 Magnetizingthe revenuesfrom intergovernmentalirrigationagreements(IGIAs). 0 Increasingnon-taxrevenuesby implementingthe cost recovery policiesin irrigation. xxxii 0 Improving the regulatory framework for SOEs, which should result in higher taxes and dividends. 0 Ensuringthat fees, from issue o f licenses, permits, certificates and other similar requirements placed on economic activities, and fines resultingfrom inspections are directed only to the State budget and not credited to the Special Means Accounts o f regulatory agencies (with the exception o f State EnergyAgency andNational Communications Agency) and that regulatory agencies are provided compensatory funding, as necessary through the State budget (GSAC core actions). RevenueAdministration 9 Developacomprehensive programofTax Administration Reform, includinggreater integration o f the revenue collecting agencies (and rationalizing o f premises and staff) modifying compensation framework, and further develop key functions (e.g., inspection and auditing). 9 Improvecollection ofexcises, payroll, income andprofit taxes and endreliance ontax advance to meet collection targets. 9 Overhaulrevenuetarget methodologyandendreliance ontax advance to meet collection targets. 11. InstitutionalBuilding 1. StrengtheningPublic Administration PersonnelManapement 9 Introducereforms inpersonnelmanagementto create aprofessional andstable civil service that is clearly differentiatedfrom political appointees and to introduce transparent rules o f recruitment, promotion and performance appraisal (GSAC core actions). 9 Ensurethat allpersons appointed to "Main" and"Lead" positions arerecruitedand promoted, inaccordance with the Civil Service Law. 9 Establishthe Civil Service Management Agency (CSMA) andensure that it is fully operational, by appointing management and staff, providing adequate budgetary resources, and developing rules and regulations for the functioning o f the agency. (GSAC core actions). 9 Developawell-coasted planto reformpublic sector compensation andemployment policies, focusing on the civil service, education and health, with a view to: 0 Raise the salaries. 0 Streamline employment. 0 Train those who remain and those who leave. 0 Reduce the discretionary component o f remuneration (inclose coordination with the reform o f special resources) (GTAC core actions). Organizationaland Regulatorv Reforms 9 Launchinstitutionalreformsthat impose largecosts to private sector development with a view to substantially downsize the scope o f their activity and make them service xxxiii oriented. Kyrgyzstandardand Sanitary EpidemiologicalService andPharmControl Laboratoryare candidatesfor priority implementation(GTAC core actions). 9 Consider further strengtheningthejudiciary system, andbasicmechanismto safeguard propertyrightsfor SMEs (notaries, legalprofession, etc.). 9 Enactamendmentsto theLawonNormativeLegalActs requiringalldraftnormative legalacts regulatingor otherwiserestrictingeconomic entitiesto be published, openly discussed, harmonizedandstudied for their economic, social andbudgetary impact, beforebeingenacted. (GSAC core actions). 9 ConductRegulatoryImpactAssessments(RIA) of3 new lawsand3 newregulations,to be agreedwith IDA, inaccordance withthe Law onNormativeLegalActs (GTAC core action). 9 Undertakethe functionalreviewsofthe MinistryofHealth, MinistryofEducation, Ministry o f Laborand Social ProtectionandMinistryo fJustice and implementthe recommendations initially for the oblast andrayonlevels is a step towards streamlining the public administration(GSACcore actions). 2. ImprovingBudgetExecutionSystems Modernizationof the TreasurvSystem (GTAC core actions) 9 Implementthe Treasury ManagementInformationSystemandrestructuretheTreasury GeneralLeger (GTAC core actions.) 9 Strengthenthe treasury cashmanagementfunctionto assurepredictabilityofbudget funds (GTAC broader reform objective).l2 9 Computerizetheemployeepayroll,whichconstitutesasignificantportionofbudget expenditures, by creatinga centralized and secure employeedatabasethat would strengthenthe internalcontrolsinpayrollprocessing(GTAC core actions). 9 Aimingat eliminatingbarterandnon-cashtransactionsthrough: 0 Identifyingthe facilitiesthat revenueadministrationuse for handlingin-kindand offsettransaction. 0 Introducingsevere penalties to non-cashcollections. 0 Graduallyphasing-outandfinally discontinuingnon-cashand offsettransactions (GTAC broaderreformobjectives). BudgetEvaluation,Prioritizationand Costin?and FinancialManapement 9 Introduceabudgetevaluationfunctionfor proper evaluationofbudgetoutcomes,thus enablingthe resultsto be factored inthe budgetingprocessand increasingthe accountabilityof projectmanagers. 9 Reviewoptions for replacingthe protecteditemsapproachto budgetwith minimum standards of service deliveryinpriority areas (e.g., healthandeducationas notedunder healthand educationreforms in SectionI) core actions). (GTAC 9 Insureappropriateinputmixandadequatelevelofcomplementaryinputsfor the selectedpublic programs. 9 Integratetheplanningprocessfor recurrentandcapitalexpenditures, through, inter alia, integratingthe PublicInvestmentProgram(PIP) infunctionalandeconomic l2 Specific measures will include a daily reconciliationo f the treasury payment requests with the NBKR reimbursementsandthe revenuetransferswith the taxpayer paymentforms. xxxiv classificationof the Budget (presently the foreign financed PIP is included as a separate attachment to the Budget Law) (GSAC core actions). 9 Developclear-cut criteriafor selection ofcapitalprojects, includingtechnical, > economic, financial, environment, and social criteria. Introducetraining programs for the line ministry accounting staff for introducingthe concepts o f financial management. 9 Providetrainingto departmental managersinunderstandingandinterpretingfinancial management reports. 3. EnhancingAccountingSystem 9 Buildcapacity intheAccountingDepartment oftheMoFto prepareconsolidated modified accrual-basedfinancial statements for the Government.l3 9 Consider adopting InternationalPublic SectorAccounting Standards. 9 Introduceuniformand integrated accounting andreportingsoftware inbudget institutions that use the same database as the treasury and adher to the one transaction - one data entry -one record principle. 9 Expandthe use oftheIMF's GFSclassificationfromthe current budgetexecution for inputmonitoringto preparation and approvalofthe budget for improvingmonitoring capacity. 9 Introducetrainingprogramsfor the line ministryaccounting stafffor developingbetter understanding ofthe accounting regulations. 4. StrengtheningAuditingRequirements InternalAudit14 9 Enactthe LawonPublic SectorInternalAudit andbuildinternalaudit capacity (GSAC core actions.) 9 Establisheffectiveinternalaudit methodology andstructures inthe lineministries (GSAC core actions). 9 Strengthenthe internalauditcapacity withinthe SocialFundbyadoptinginternationally acceptable internal audit standards and by providing training to the internal audit staff. 9 Require internalauditors to carry out detailed COS0(Committee ofSponsoring Organizations) -based assessments o f internal controls to analyze their effectiveness. 9 Provideextensive trainingto the internalauditstaff. ExternalAudit 9 Improve legalframework for ExternalAuditFunctionthrough, interaliaamendmentsto the Law onthe Chamber of Accounts, through: 0 Empoweringthe Chamber of Accounts (CA) to determine its own structure, staffing and employee salaries within parameters agreedwith the Government and the BudgetCommittee of the Parliament; l3The Accounting Department has issued detailed guidelines for accounting and reporting by the line ministries, which has facilitatedstandardization in terms o f accounting and consistency inreportingby line ministries. l4The internal financial,inspectoratewas abolished in 2000 and currently there is no systematic internal audit function except in four ministries, which have small internal audit units (focusing more on control work). xxxv 0 Authorizing the BudgetCommittee ofthe Parliament, insteadofthe Ministry of Finance, to review the draft budget proposalsofthe CA; 0 Eliminating the provision entitling the CA to receive 10percent of the amount recoveredto the budgetas a result of irregularitiesdetected by it; and 0 Requiring the CA to adopt INTOSAIaudit standards (GSAC core actions). 9 Grantauthoritytothe CAto perform interimpostaudits. 9 Requireacertification role for the CA inrespectoftheyear-endfinancial statementsof the government both cash-basedandmodified accrual-based. 9 Makethe processofappointmentofthe Chairmanofthe CAtransparent. 9 Strengthenthe capacityofthe CA-enter intotwinning -arrangements with awell- establishedSAI. 9 Clearlydefinethe accountabilityofthe SOEs. 9 Conductan operationalandfinancial auditof SocialFundby an-internationalaudit firm at least once in five years. 5. EnablingOversight over BudgetExecution 9 Submittheannualauditedfiscal accounts ofthe governmentto the Parliamentfor revision and approval (GSAC core actions).l5 9 StrengthentheparliamentarycommitteesonBudgetandEconomicPolicy to provide effective oversight over the executive by buildingresearchand analytical capacity and by providing exposure to internationalbest practices inthe legislative scrutiny. 6. Promoting PublicAwareness 9 Publishannualfinancial statements, bothcash-basedandaccrual-based, including postingthem on the website. 9 Publishcompleteannualauditreportofthe ChamberofAccountsonthe executionof the State budget (GSAC core actions). 9 Publishannualauditedfinancial statementsandauditreportsofalljoint stock companies with State share of 51percent or more (GSAC core actions). 7. EnhancingProcurementProcedures Lepaland RegulatorvFramework (GSAC and GTAC core actions) 9 Prepareaset ofdetailedregulationsonthe implementationofthe PublicProcurement Law (PPL) and amend the PPL to reflect the recommendationsofthe CPAR through: 0 Supplementingthe PPL through the inclusion of appropriateproceduresfor selection of consultants. 0 Extendingthe scope ofthe PPL to all enterprises with at least 50 percent state ownership. 0 Encouragingthe use of arbitration for contractualdisputes. Budget execution reports (cash-based) are prepared and submitted to the Parliament, but there is no system o f consolidated financial statements. xxxvi 0 Introducinga comprehensive set of regulationsto replacethe multiple subsidiary instrumentsthat are presently inplace. Clarifying the issue of "bulk procurement" regulatedby the Government Resolution486. Procedures and Practices > Procuring entities to comply with State Commissionon Public Procurementand Material Reservesprescribedprocurementplan after budget approval and to update it > regularly. Procuring entities to launchtenders only uponMOF confirmation of availability of > funds for timely contractualpayments. Extendbid submission/opening deadline formally inwriting and only sufficiently in > advance ofthe deadline. Expandbid evaluationcriteria to includecommercial, legaland technicalfactors in addition to price. Eliminate voting as a criteria for bid evaluation. Limit SCPPMR's review ofprocurementdocuments only to the cases necessary to > fulfill its monitoring and evaluationrole. > Reinstatethe publication of the Public ProcurementBulletin. Carry out a procurementaudit of selected, high value items thaf affect service quality in the Healthand Educationsectors (e.g. selected pharmaceuticalsonthe List of Essential Drugs, text books etc.) (GTAC core actions). Organization and Resources > Amend the law (Article 14, sub-clause 5) to discontinue the practice of 1percent financing of SCPPMRfrom savings through tenders with necessary compensation > funding to be provided from the RepublicanBudget (GSAC core actions). Within the SCPPMRseparate the procurementfunction from State Material Reserve > Fund (GSAC core actions). Restructure and strengthen SCPPMRfor reorganizingprocurementfunction at the level > of procuring entities (GSAC core actions). SCPPMRto coordinatewith the President's administration inthe designand > introduction of e-procurement. > Establisha computerizedprocurementdata collection andmaintenancesystem. Develop and implementtraining strategy and preparetraining plans andprograms including seminars for contractors and suppliers; strengthen the training center; and >>eventually introduceaprocurementprofessionalcertification program. Train staff ofprocuring entities in preparingclear technical specifications. Providetraining to Chamber ofAccounts staff inprocurementto facilitate their task of auditing procurements. PARTI:STRATEGICCONTEXT 2 1. GROWTHAND POVERTYREDUCTION A. DETERMINANTS GROWTHOF 1. TheKyrgyz economy has achievedsome stabilization over 2000-2001. Real GDP grew at about 5 percent and inflation was below 7 percent. On the supply side, growth has beenledby the agriculture, gold mining, power, and trade sectors, while other sectors o f the economy have shown continuous decline. On the demand side, it i s encouraging that the relatively recent external and fiscal adjustments have resulted in a more sustainable stance (Table 1.1). Whereas consumption (including imports) and public investment led growth during 1998 and 1999, most o f which was supported through unsustainable levels of external borrowing, investments by (both public and private) enterprises and the external balance have playeda key role thereafter. Table 1.1: Evolutionof GDP by Expenditure Components 2. In this regard, ~~ the fiscal adjustment 1996-2001 1998-99 2000-01 that took place during GDP, Annual growth % 5.6 2.9 5.4 the 1999-01 period, Dec-to-DecInflation,% 21.2 28.4 6.7 when the overall deficit GDP at current prices, 'YOtotal 100 100 100 o f the government was 1. Resourcebalance -10 -18 -3 reduced from 11 to 5 - Exportsof G&S 38 39 39 percent o f GDP, does - Imports of G&S 48 58 42 not appear to have been 2. Consumption 91 101 85 - Consumptionpublic 18 18 19 contractionary. Early - Consumptionprivate 73 83 66 arguments pointed out 3. Investments 19 17 18 at the risk that --- Enterprises Public administration 7 9 7 adjustment in spending, 9 6 10 and in particular the Change in stocks 3 2 2 slow down in public Memo: Gross Domestic Savings 9 -1 15 in a loss of growth Sources:Natstatcom and World Bank staffcalculations. momentum. This observation may still be valid over the medium term, if key projects continue to be unnecessarily delayed, butthe immediate impact has not beenfelt. 3. Equally important was the progress in adjusting large quasi-fiscal deficit from 16 to 7 percent o f GDP over the same period by means o f increasing energy tariffs. This adjustment does not appear to have slowed down the economy either, although in early 2000 it was argued that performance in energy intensive industries would be affected by higher relative prices. 4. I n short, there are enough reasons to believe that the strongfiscal, quasi-fiscal and external adjustment efforts since 1999, together with structural measures in areas, such as energy and banking, boosted domestic investor's confidence and overall economic performance. Indeed, the uncertain economic conditions prevalent in the aftermath of the regional financial crisis in mid-1998 required a strong signal to the economy that the authorities were willing to reign on fiscal imbalances. 5 . However, there is still progress to be made before the country is on a sustainable growth path. Sustaining growth i s expected to be much harder over the coming few years, as the conditions that stimulated the 1996-2001 growth-public investment and consumption (including imports) -cannot be afforded over the medium term. It i s particularly worrisome that export performance has been extremely weak and private investments (coming from private rather than public enterprises) have been insignificant. Also, although national savings have improved, financial intermediation is weak. While growth inthe 2000-01 period was more balancedthan inthe earlier years, it still lacked exports andprivate investment dynamism (see Figure 1.1). Figure 1.1: Kyrgyz Republic: Exports, Investments, and Savings, 1993-2001 i 750 I Total Exports, and Exports without Power and Gold (US mln) 650 550 450 350 250 150 j 1993 1994 1995 1996 1997 1998 1999 2000 2001 Investments a n d National Savings (% o f GDP) 30 25 28 20 15 10 $ 5 0 -5 -10 1995 1996 1997 1998 1999 2000 200 1 I -Investments 0 0 . w . Public Investments -National Savings 1 6. Unless sufficient preconditions for exports and private investments are laid out, economic activity over the medium-termwill be largely determinedby global or regional conditions, and random internal events, rather than by the force of a health productive sector. More importantly, a negative trend in exports is already envisaged as the gold reserves in the Kumtor gold mine are expected to be substantially reduced by 2008-10, reducing overall exports sharply. Clearly, the reforms in the agricultural sector, if continued and strengthenedto induce productivity gains, are likely to serve as the basis of 4 a positive trend inGDP and export growth, but this trendwill be relatively small and may not even compensate for the envisaged reduction in gold exports. Similar consideration can be made regarding efforts to improve the investment climate for SMEs, which i s essential for employment and steady growth. In addition to these efforts, the authorities should focus on attracting investments inlarge scale industries, such as hydro-generation as well as mining-sectors where the economic potential o f Kyrgyzstan i s significant. 7. The year 2002 provides a good example of how the Kyrgyz economy swings with unexpected events: GDP sharply slowed down (and even stagnant inthe aggregate) due to a landslide that paralyzed gold extraction, and to positive climatic conditions that resulted in lower demand for power (Le water services) by neighboring countries. Indications that industrial activities (other than those related to gold and power) have shown some recovery this year for the first time in a decade, are encouraging, but far from providing comfort when the two larger activities are affectedby external shocks. 8. Fiscal policies contribute to strong economic growth based on exports and private investments Based on the experience over the past 5-6 years in the Kyrgyz Republic, this PER argues that unsustainable fiscal and quasi-fiscal policies deter growth and, thus, contribute to a worsening in poverty ratios. As will be discussed elsewhere, deficits must be kept within reasonable limits, taxation compliance should be eased, nuisance taxes abolished, and a few basic public services must be well provided. This poses the challenge to replace public investments and other direct interventions as the main fiscal instruments to promote growth, in favor o f prudent economic management, and the introduction o f taxation policies that facilitate private sector development. B. DETERMINANTSPOVERTYOF 9. Highpoverty levels inthe Kyrgyz Republic (about half of the population lives in absolute poverty) also pose a special challenge to public spendingpolicies inthe Kyrgyz Republic. Growth in and of itself can do much to alleviatepoverty, particularly if it is based on reasonablemacroeconomicpolicies (including an appropriate real exchange rate and sustainable deficits), as has been pointed out in a recent analytical report prepared by the National Statistical Committee and the World Bank.16 Figure 1.2 below illustrates the strength o f these findings. Average real consumption for the poorest 40 percent o f the population was increasing with GDP even as social spending was falling. This i s not to say that social spending (in this case defined to include health, education, social protection and pension spending) did not have a role in poverty alleviation, but rather it highlights that only sustainable improvements in overall income and production levels can be expected to make a dent on poverty (i.e to reduce it rather than alleviate it). l6Kyrgyz Republic, Enhancing Pro-poor Growth, ReportNo. 24638-KG, August 23,2002 5 Figure 1.2: Consumption, GDP, and Social Spending, 1996-2001 (Per capita in 1996 constant prices) 850 750 650 1996 1997 1998 1999 2000 2001 Source: Staff calculations base on Ministryof Finance, Social Fund and Kyrgvz Republic, Enhancing Pro- poor Growth, Report No. 24638-KG. Social spending includes health, education, pensions and safety nets. 10. There is an important role for social spendingto alleviate poverty and to prevent the risk of households falling into poverty. But this can only be achieved with a strong focus on basic safety nets and primary health and education. 11, An appropriate poverty alleviation spending package will first focus onpreventing that sickness or lack of education `decapitalize' the poor, further reducing their probability of getting out o f poverty. Depending on the available fiscal resources, spendingpolicies could then focus on helpingthe poor to secure a basic minimumcaloric intake, assisting them to secure sufficient heating in the winter, providing capital grants to bring water and sewerage to the poorest households or top up basic health and educationprograms with nutrition or vaccination campaigns. 12. The remainder of this Chapter focuses on the general characteristics o f poverty that policy makers should take into account when designing the umbrella o f social policy interventions. The discussion o f how education, health, social protection and pension spendingcan alleviate poverty or reduce the risk to falling into poverty is left for Chapter 6 and for the relevant chapters inVolume 11. 6 Table 1.2: Absolute Povertyin Kyrgyz Republic,2001 Measure of werfare PovertyLine, soms HeadcountIndex PovertyGap Extreme Absolute Extreme Absolute Extreme Absolute Expenditureper capita 4510 7491 13.5 47.6 2.7 13.9 Consumptionper capita 4648 6975 24.7 56.4 5.3 17.2 Consumptionper adult 4648 6975 14.6 45.0 2.7 11.7 equivalent Source: Kyrgyz Republic, Enhancing Pro-poor Growth,ReportNo. 24638-KG, August 23,2002 13. The most recent poverty analysis suggests that, inbroadterms, poverty alleviation efforts should: (i) have a strong regional dimension; (ii) on children; (5)show an focus ability to adopt to rapid changes in circumstances; and (iv) ensure access to basic services. Social policy and spending should have a strong regional dimension. The capital city of Bishkek and nearby Chui Oblast are substantially less poor than the rest of the country, while Naryn Oblast i s the poorest oblast, and seems to be lagging behindthe other oblasts. A household inNaryn Oblast is three times as likely to be poor as a household in Bishkek City or Chui Oblast. These differences clearly justify a regional focus on the poverty reduction strategy. The findings presented in Chapter 6 (Health and Education) and Chapter 7 (Intergovernmental Finance) suggest that there is a long way before social spending reflects thisprinciple. Socialpolicy and spending shouldfocus on children and the disabled. Poverty increases with household size, with the presence of young pre-school children, andthe presence of a disabled individual inthe family (after controlling for region and other key determinants). It should be noted that the Kyrgyz Republic is demographically a young country (about 37 percent of the population consists of children), although 10 percent of its population is beyond retirement age. The Jindingspresented in Chapter 6, suggest that the bulk of social spending is on the . elderly and on untargeted, quasi-fiscal, subsidies; and that health spending is heavily biased towards large hospitals. Socialpolicy must adapt to high consumption volatility. Households have high exposure to shocks and lack the ability to smooth consumption. The high consumption volatility makes households, even inthe richest quintile, experience transient poverty at times. Indeed, about 11percent of households inthe richest . quintile in 1998 experienced serious shocks and had stepped down two quintiles or more by 2001. Mechanisms to improve housing conditionsfor the poor are to be found. The poor live in poor health and sanitary conditions, have limited access to running water, public sewer, internal plumbing, and lack sources for reliable electricity, 7 and heating. Large quasijkcal dejkits (Chapter 3) waste scarce resources, which could be used to provide subsidies for service in the poorest (generally rural) areas of the country. 14. As will be illustrated inforthcoming chapters (and ingreater detail inVolume II), the authorities face a substantial challenge in restructuring key social policies (health, education, social protection, and pensions) first and foremost to ensure these sectors develop a dynamic overall supply structure (Le., restructure and become efficient), but also to fulfill basic poverty alleviation objectives. C. CONCLUSION 15. Experience over the past 3 years suggests that fiscal and quasi-fiscal adjustment have contributed to reinvigorating growth rather than becoming its deterrent as was argued earlier. There is, therefore, a case for a well-planned shift inthe fiscal instruments to promote growth: away from large public investments and thinly spread interventions, and into facilitating tax compliance, and efficiently delivering a few basic public services. There is also a case for ensuring that social spending alleviates poverty (even if it does not reduce it), and for minimizingthe risk o f families falling into poverty. 16. Such a shift needs to take place together with a needed reallocation in public spending. As active economic interventions are phased outs, resources should be freed-up first o f all for private initiatives, but also for more meaningful efforts to maintain basic infrastructure, to prevent the erosion o f key assets (education or access to electricity levels) and to efficiently provide a few basic social programs. 17. Indesigning social interventions, the most recent poverty analysis suggests that policy makers should ensure: (i) a strong regional dimension (e.g., focus on the poorest regions); (ii) strong focus on children; (iii) ability to adopt social policy to rapid the changes incircumstances; and (iv) access to basic services. 8 2. FISCALPOLICY INTHE 1990's A. THECHANGINGROLEOFTHE STATE 1. Breakingwith the Legacyof CentralPlanning: 1991-1996 18. During the first years of independence, the Kyrgyz Republic struggled with a substantial loss o f transfers, an adjustment in oil prices, and a sharp reduction in tax collections. The loss o f transfers alone reduced revenues by half between 1991 and 1992. An institutional collapse, however, was avoided in 1992, as spending was financed initially through domestic credit &e., inflation) but shifted quickly to external financing through a concerted effort to attract donors assistance. 19. Efforts to delineate the role of the state along the lines of market economies began almost immediately and led to a considerable restructuring of spending. First, between 1992 and 1994 the authorities eliminated the bulk o f subsidies and reduced net lending from the budget to enterprises and farms. By end-1996, net lending from the budget was minimal-other than selective support to infrastructure enterprises and private farms through the public investment program. Second, there were several attempts at cutting the wage bill-initially through massive layoffs from the state, then through reductions in wages, which resulted in an overall decline in the wage bill o f about 2 percentage points o f GDP between 1991 and 1996 (Table 2.1). 20. By functions, the above described efforts resulted inan appropriate contraction o f spendinginagriculture (6 percentage points of GDP between 1990 and 1996), as well as inother economic affairs (8 percentage points o fGDP over the same period). Health and education reflect the overall fluctuations in the wage bill, with increases in 1994 but an overall reduction o f about 2 percentage points between 1991 and 1996. Spending on social protection and pensions declined slightly through 1994 and increased thereafter. The increase after 1994 partially reflectedthe introduction of a new framework for social protection (i.e the UnifiedMonthly Benefit), but mainly the use o f the pension system to mitigate the impact o f enterprise and government restructuring through early retirements, Overall spending remained at around 38 percent o f GDP during the 1991-95 period, as cuts were offset by a growing public investment program (Table 1.1). 21. The fruits of expenditure cuts and reforms (and the more broad economic reforms) began to show in the 1996fiscal accounts. Total spending fell by a full 8.6 percentage points o f GDP-to 30 percent o f GDP-in 1996, aided by a resumption o f growth and the stabilization o f the overall macroeconomic situation. The cuts brought the overall fiscal deficit to single-digit levels, although it was still highat about 9 percent o f GDP. Tax revenues,including payroll taxes, stabilized at about 17percent o f GDP. 9 Table 2.1: Kyrgyz Republic: Key Economic and FiscalIndicators, 1990-96 1990 1991 1992 1993 1994 1995 1996 State budget (share o f GDP) Revenueandgrants, ofwhich ... 39.7 20.5 24.0 25.8 21.9 20.6 Tax revenue ... 17.5 14.5 13.9 13.6 15.0 12.7 Social security contributions ... 4.1 4.0 0.0 5.0 5.1 4.6 ' Nontax and capital revenue ... 18.1 2.0 1.3 4.2 1.1 1.1 Grants ... 0.0 0.0 8.6 2.5 0.3 0.9 Expenditwe (economic classification), ofwhich . . 35.2 38.4 38.4 37.6 38.3 29.8 Current (other than interest) ... 29.8 23.7 28.4 27.8 29.7 24.3 Wages andsalaries ... ... ... 5.2 8.1 7.8 5.7 Interestpayments ... 0.0 0.5 0.7 0.2 0.4 1.2 Capital 1.3 2.4 0.5 4.9 4.8 3.8 Domestic capital investment (exept PIP) ... ... ... 0.5 1.o 1.0 0.7 Domesticaly financed PIP ... ,.. ... 0.0 0.0 0.0 0.0 Foreign financed PIP ... ... ... 0.0 3.9 3.8 3.2 Net lending ... ... 7.8 8.8 4.7 3.4 0.4 Expenditure (selectedfunctions) ... 35.2 38.4 38.4 37.6 38.3 29.8 Education 7.6 6.0 5.0 4.2 6.1 5.7 4.4 Health care 3.7 3.1 2.9 2.6 3.5 3.4 3.0 Socail security and social insurance ... 10.8 8.6 8.6 8.1 12.5 10.5 Agriculture, foreshy, fishing andhunting 6.6 2.9 3.3 2.2 0.7 0.9 0.7 Transport and communications 0.8 0.7 0.6 0.6 0.5 0.6 1.6 Other economic affairs 8.4 3.8 1.6 1.3 0.4 0.2 0.6 Fiscal balance Cash deficit ... 4.5 -17.9 -14.4 -11.8 -16.8 -9.3 Primary domestic deficit (wio interest and PIP) ... 4.5 -17.4 -13.8 -7.5 -13.1 -4.9 Memorandum items: GDP real growth (%) ... -8.2 -14.1 -15.5 -20.1 -5.4 7.1 Inflation ( % Dec-to-end of period, CPI) ... ... 2,032.7 929.9 62.1 32.1 34.8 Per capita dollarGDP (at averageexchange rates) ... .., 503.0 234.0 244.0 325.0 392.0 Note: The state budget consolidates central and local budgets and includes foreign-financed public investment programs and operations ofthe Social Fund,which became an extrabudgetaryfundin 1991. . . Sources: Kyrgyz authorities; WB staff calculations. 2. Regionaland Domestic Crisis and Policy Response: 1998-2001 22. Theperiod of relative economic andfiscal stability lasted only two years (1996 through early 1998). The external account, which improved substantially after the Kumtor gold mine came on stream in 1997, worsened inearly 1998 owing to an upsurge in consumption and other imports. It further deteriorated with the fall inthe two largest exports (gold and electricity/water release services). The regional crisis inAugust further deterioratedthe trade balance, and precipitated a large realexchange rate adjustment. 23. External shocks affected various sectors, particularly energy and banking. Losses inthe power sector increasedas itrelies onexport revenuesto cover its domestic market costs. The state gas company, which was riddled with policy and managerial inefficiencies (and still is), was unable to pay for imports and went bankrupt late in 1998-bringing down the two largest commercial banks inthe country. Inshort, external and internal difficulties in 1998 severely eroded the authorities' fiscal stance as shown in Table 2.2. 10 Table 2.2: KyrgyzRepublic: Key Economicand Fiscal Indicators, 1997-2001 1997 1998 1999 2000 2001 prel. State budget (share of GDP) Revenue and grants, o f which 20.4 22.2 20.4 18.5 20.4 Tax revenue 12.5 14.2 12.2 11.7 12.4 Social security contributions 4.2 4.2 3.6 3.3 3.3 Nontax and capital revenue 2.6 2.9 3.6 2.5 3.7 Grants 0.6 0.6 0.6 0.9 0.8 Expenditure(economic classification), of which 29.3 33.5 32.0 28.1 26.2 Current (other than interest) 23.9 25.3 19.9 18.6 20.4 Wages and salaries 5.3 6.2 4.6 4.4 4.9 Interest payments 1.7 2.1 3.O 2.2 1.7 Capital 3.8 6.6 9.5 7.8 5.3 Domestic capital investment (exept PIP) 0.7 0.9 1.1 0.9 0.3 Domesticaly financed PIP 0.0 0.0 0.0 0.4 0.6 Foreign financed PIP 3.1 5.7 8.4 6.5 4.4 Net lending -0.1 -0.5 -0.4 -0.5 -1.1 Expenditure (selected functions) 29.3 33.5 32.0 28.1 26.2 Education 4.2 4.2 3.4 3.3 3.5 Healthcare 3.3 2.9 2.7 2.0 1.8 Socail security and social insurance 9.2 8.6 7.5 6.1 6.3 Agriculture, forestry, fishing and hunting 0.8 1.4 1.5 1.7 1.8 Transport and communications 2.0 3.3 5.4 4.5 2.5 Other economic affairs 1.1 0.9 0.4 0.2 0.3 Fiscal balance Cash deficit -9.1 -9.5 -11.0 -8.8 -5.0 Primary domestic deficit (w/o interest and PIP) -4.3 -1.7 0.4 -0.1 1.0 Memorandum items: GDP real growth (YO) 9.9 2.1 3.7 5.4 5.3 Inflation ( YODec-to-end o f period, CPI) 13.0 16.8 39.9 9.6 3.7 Per capita dollar GDP (at averageexchange rates) 374.0 340.0 255.0 279.0 308.0 Sources: Kyrgyz authorities; WB staff calculations. 24. More significantly, the real depreciation of the currency substantially affected the country's debt carrying capacity. As in the previous years, the overall deficit was financed mainly from external sources (e.g., grants, arrears with foreign creditors, and new borrowing). Although external borrowing by the government has been almost exclusively at highly concessional terms since 1997, large fiscal deficits over the 1990s coupled with the reduction in dollar GDP and exports following the 1998 shocks translated into a considerable external debt burden inthe late 1990s. 25. Faced with a substantial debt overhang, fiscal policy was especially austere during the three years that followed the regional financial crisis. The brunt o f the adjustment was borne by current spending, which was sharply cut in 1999 and further reduced in 2000. Unlike early in the 1 9 9 0 ~inappropriate or highly inefficient spending ~ items were difficult to find. As a result, cuts were mainly driven by an across the board compression of wages and pensions. The reduction in the wage bill was particularly damaging as it was not accompanied by staff reductions-except for those in the civil service which accounts for less than 10 percent o f government employment. Wage bill 11 reductions, therefore, affected remuneration in the health and education sectors most harshly, as these sectors not only account for the bulk of government employees, but were significantly unpreparedto adjustlrationalize staffing and facilities. Between 1998 and 2001, education spending as a share of GDP was reducedby 16 percent and health spending by almost half. 26. The pension reform was more comprehensive, includingmeasures to increasethe retirement age by three years over a nine-year period that is still under implementation. Avenues for early retirement were also closured, and pension levels frozen during the peak inflation year o f 1998. Unfortunately, cuts in pension spending came along with a revision of the pension formula which reduced its poverty alleviation component. This meant that the higher pension levels recovered faster once indexation restrictions were lifted in 1999 (Figure 1.1). Wage, pension, and other arrears, which flourished in 1998, were common almost untilmid2002. Figure 2.1: Kyrgyz Republic: Trends in Real Wages and Pensions, 1993-2002 00 o\ 2 550 cc 0 .-& v1500 0 450 6E 5 4 350 0 0 ~ c _-- J \ .d 300 c--. - 250 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 /-Real public sector wages --Real average pensions/ Sources: Ministry o f Finance; World Bankstaff calculations. 27. Capital spending was also compressed in 2001, which together with earlier adjustment efforts drove the fiscal deficit to below 5 percent of GDP by end 2001. While efforts to prioritize the cuts were made-parallel to a strong embracing of the principles of the Comprehensive Development Framework (CDF)-these efforts only singled out a few project proposals that were considered inappropriate and would have accounted for minimum disbursements. Thus, the bulk of the PIP adjustment had to be implemented by compressing disbursements in all projects. This, and administrative disruptions coming from the need to transfer the management o f the PIP from Goskominvest to the Ministryo f Finance (MoF) resultedina severe disruption inproject implementation, unnecessarily delaying the payoff for most projects inthe government's portfolio. As shown in Box 2.1 below, the debt strategy was not limited to fiscal adjustment (and PIP compression), but was also based on an improved debt management capacity (with the support of the IMF and the Swiss Authorities). 12 Box 2.1: Debt Developments and Strategy By end-2000, it was clear that the face value of the public sector debt and its net present value (NPV) had reached unsustainable levels. The NPV o f the debt was equivalent to 506 percent o f revenues, which was well above the empirical sustainable threshold o f 280 percent. The debt service burden o f the public sector before rescheduling was large, at an estimated 31 percent o f revenues (Table 2.3). Table 2.3: Kyrgyz Republic:Debt Indicators,1993-2001 Public external debt, stock InUS$million (incl. IMF) 317.0 435.0 617.5 750.3 926.2 1,115.0 1,326.4 1,403.1 As share of GDP 29.8 39.3 41.4 41.1 52.4 67.7 106.2 102.4 Total public debt service In US$million (incl. IMF) 4.5 18.6 95.8 75.9 43.4 55.8 53.4 77.6 Percentof central budget revenues 2.7 9.2 39.2 27.6 15.8 19.5 26.4 31.1 Source: International Monetary Fund. The Kyrgyz authoritiesformally enacted a debt reduction strategy in 2001 that received supportfrom bilateral creditors. The debt reduction strategy builds on three main premises: (i) continued fiscal adjustment through 2005; (ii)strong drive to restructure the current debt service a profile; (iii) efforts to privatize large infrastructure companies (including telecommunications and energy distribution companies). These efforts were supported by the Paris Club (PC) in early 2001 and early 2002, through a flow of relief at non-concessional (Houston) terms. This agreement relieved the country o f about US$95 million in debt service due over the course o f 2002 through 2004 (the debt service due was reduced from US$101 million to US$5.6 million)." The PC debt restructuringagreement did not change the stock o f external debt. Therefore, the fiscal burden o f the external debt remains unsustainable and calls for continued fiscal adjustment. However, the PC agreement included a goodwill clause which allows for a potential stock operation inthe future at concessional terms. 3. ADEQUACY PASTFISCAL OF ADJUSTMENT 28. Thesize and scope of the Kyrgyz government has changed considerably over the past decade. Consolidated government spending as a share of GDP, a conventional measure of government size, declined in the Kyrgyz Republic from about 39 percent of GDP in 1992-93 to 28 percent in 2000.'8 This adjustment, if sustained, has increasedthe consistency betweenthe levels o f spending inthe Kyrgyz Republicand its overall income per capita" by positioning the size ofthe Kyrgyz government closer to the regressionline "ThereremainsaboutUS$42millionofbilateraldebtservicetonon-ParisClubmembers,halfofwhichis owed to one commercial creditor, for which the country is seekingequal treatment. '* Spending is defined to include the state and local budgets as well as the Social Fund (the largest extra- budgetary fund). The data exclude quasi-fiscal operations and other extrabudgetary funds for which data are not available. We use dollar GDP as a proxy for income. IfGDP inPurchasingPower Parity (PPP) U.S. dollars is used instead, the Kyrgyz Republic would already be on the regression line (Le its level of spending and income would be consistent with other countries in the region). However, the PPP GDP for the Kyrgyz Republic does not yet capture the sharp real exchange depreciation during the 1999-2000 period and thus overstates the Kyrgyz economy's true spendingcapacity (see Annex 1). 13 o f 16 countries in Europe and Central Asia (ECA) (Figure 2.2). Indeed, by the end of 2002 the Kyrgyz Republic is expectedto be well into the curve owing mainly to progress inincreasing income levels. .. Figure 2.2: The Relationshipof Public Spendingand Per Capita Incomein Selected Europeanand CentralAsian Countries,2000 ""I Bosnia . 42 Belarus Bulgaria v KR 95 Armenia + Azerbaijan A 1 Georgia Kazakhstan Tajikistan 5.0 5.5 6.0 6.5 7.0 7.5 8.0 Log of GNI per capita Athlas method (current USS) Sources: IMF; World DevelopmentIndicators, World Bank staffcalculations. 29. Nonetheless, deficits inthe Kyrgyz Republic are higher than inother countries of the region-and at 5.3 percent of GDP in 2002, still unsustainable from the debt point of view. There i s therefore a need to further adjust spending as a share of GDP, increase revenue collection levels, or a combination of these two. The options for adjustment are discussed inthe medium-termframework describedinChapter 4 below. 30. Progress towards aligning spending levels with those in other countries in the regions speaks well of the past adjustment process. As illustrated in Figure 2.3 below, the adjustment in the Kyrgyz Republic appears moderate when measured as a share of GDP. The 10 percent adjustment in the size of the Kyrgyz government over the 1990s was not extraordinary in the CIS context, where the average cut was about 23.1 percent of GDPa2' The largest reductions in expenditure as a share of GDP took place in Tajikistan, Georgia, Azerbaijan, Kazakhstan, and Armenia.21 31. Nevertheless, the adjustment of spending levels in the Kyrgyz Republic was remarkable if measured in U.S. dollar terms (as a proxy for the real level of spending) with a reduction of over 90 percent between 1991 and 2000. Dollar adjustment in the Kyrgyz Republic was slightly higher than inGeorgia and was similar to that inMoldova. It was far larger than in Armenia, Kazakhstan, and Azerbaijan, where an early recovery 2oSee Asad Alam and Mark Sundberg, A Decade of Fiscal Transition, World Bank, May 2002. The initial level of expenditure is approximated at 45 percent of GDP, as the data for the selected set of countries are not quite comparable. See Sanjeev Gupta, Luc Leruth, Luiz de Mello, and Shamit Chakavarti, Transition Economies: How Appropriate Is the Size and Scope of Government?, IMF Working Paper, 2001. 14 was likely to make the adjustment less painful as a percent o f GDP and less pronounced inU.S.dollars. InAzerbaijan, spending(measured inU.S.dollars) has increased steadily since 1995, while in Kazakhstan it increased from 1995 to 1998 and again in 2000. In contrast, the Kyrgyz Republic has been reducing per capita dollar spending every year since 1995. No country matched the dollar adjustment experienced in Tajikistan, where dollar spending collapsed driven by conflicts and civil unrest. The adjustment in the Kyrgyz Republic, however, has weak points-such as the emergence o f quasi-fiscal deficits, as outlined inChapter 3 below. Figure 2.3: Adjustment in Public Spending in SelectedCIS Countries during the 1990s 0 I O 20 30 40 50 60 70 80 90 100 El Share ofGDP USdollars Note: The change in the spending to GDP ratio is measured as the difference between the 2000 and 1991 levels (see footnote 4). The change in dollar spending i s measured as the ratio of 2000 and 1991 spending in U.S.dollars. Sources: Recent Economic Developments, IMF; World Development Indicators, and World Bank staff calculations. C. CONCLUSIONS 32. The Kyrgyz Republic has substantially adjusted its level and composition of spending over the past decade. The country's current level of expenditure appears consistent with that of a sample o f CIS countries with similar characteristics, but could be further consolidated through further recovery in the country's GDP. In this regard, the country's adjustment efforts could benefit greatly from greater progress in reactivating economic activity (and GDP levels), efforts to formalize business activities, and efforts to monetize payments and business transactions (Le., phase out barter and offsets). Such benefits could accrue in the form o f higher revenue collection ratios that could avoid the need of further overall spending cuts. These benefits will also reduce the ratio o f total spendingto GDP, as some spendingitems are boundto grow less than the economy. 33. The country's fiscal stance, however, i s not yet on a sustainable path and, as the 1997-1998 experience shows, spendinglevels could easily grow uncontrolled inthe event of an external shock. A key threat (described in the next chapter) is the extent o f quasi- fiscal operation and the potential spillover into the budget of losses by state-owned 15 enterprises. Additional risks come from the fragility o f the growth process itself, and from the possibility that efforts to facilitate the formalization o f economic activity andthe monetization o f most transactions be derailed or not pursued vigorously. There are also pressures for higher spending or for a public undertaking o f large infrastructure projects as inthe early 1990s. These pressures mustbe faced with strong budget constraints. 16 3. QUASI-FISCALDEFICITS 34. Over the past decade, the authorities have almost entirely cut out funding to SOEs from the domestic budget (i.e., budgetary loans and subsidies). Furthermore, efforts have been made to ensure the transparency o f public choices inthe social sphere. For example, for the last three to four years, the Ministry o f Labor and Social Protectionhas received a budget allocation that is intended to compensate SOEs for the cost o f price discounts given to privileged categories, although the allocation is insignificant relative to the true cost o f providing price discounts to about one-third o f the population-in addition to overall low pricing. There is, therefore, substantial room for increasing the consistency between promises and policy stands and the actual ability o f the Republic to finance programs. 35. Moreover, the policy framework in which a number o f SOEs carry out its activities i s significantly distorted and, together with under investmentand inefficiencies, they pose a serious risk to the budget. In various cases, government policies impose significant social obligations to SOEs, generally by maintaining low pricing policies, but direct compensation i s not provided. This chapter argues for phasing out quasi-fiscal operations in the energy sector, and advises improving the monitoring o f all SOEs financial results and addressing the endemic factors that make them loss making. For profitable SOEs, greater financial oversight would be important to ensure their profitability and efficiency increases (and thus the dividends, and taxes paid to the budget). A. QUASI-FISCAL ACTIVITIES INTHE POWER SECTOR 36. Insufficient consensus was built for the adjustment inthe mid 1990s. Instead, the authorities cushioned the adjustment by relaxing pricing policies o f key public services, such as district heating, gas, public transport, water, irrigation, and power. Taking into account these quasi-fiscal activities, social policies as a whole became substantially untargeted and unaffordable. This was particularly important during the 1995-97 period when some reform fatigue was registered. 37. Electricity, which i s a relatively abundant source o f energy in the Kyrgyz Republic, was perhaps the key vehicle for compensating households-followed by gas and district heating, which i s a subsidy mainly for Bishkek and Osh. In addition to price subsidies, this compensation took the form of price discounts that applied to one-third o f the population by the end o f 2001. 17 38. Both of these, and a deliberategovernmentpolicy to encourage a switch from gas topower, resulted in a very high level of consumption (Figure 3.1), which in turn required greater amounts of O&M and rehabilitation that an undercapitalized sector could not afford. Paradoxically, while costs for the industry were increasing (due to the upsurge in demand) actual spending was falling. The need to balance accounts under falling revenues resulted ina squeeze on all spending, including the wage bill and O&M. This, andthe breaking up o fthe integrity and efficiency o f billing and collection imposed by the widespread use o f tariff discounts, resulted in an enormous increase in technical and commercial losses. Only when the sector was unbundled in late 2001 did it become clear that losses were well above 30 percent o f generation. Figure 3.1: Kyrgyz Republic: Evolutionof Electricity Tariffs and Electricity Consumptionfor ResidentialHouseholds, 1994-2002 1 0.3 7.5 ~ ~ 94 95 96 97 98 99 00 01 02 Years 1 +Billed tariff+Consumption Sources: State Energy Agency; World Bank staff calculations. 39. The resulting deterioration o f the energy sector's assets eroded the sector's financial position. As a result, the power sector i s a contingent liability for the budget: eventual bailouts will be needed, as was the case in 1998 for the gas and air transportation sectors. Such an event i s more likely during years o f good rain, when the demand for water release services by neighboring Uzbekistan and Kazakhstan means that the sector will need to pay for the fuel it consumes during the peak demand in winter. This year is one in which such an event materialised. Figure 3.1 illustrates the cost o f quasi-fiscal activities, which i s proxied as the sum o f low pricing and technical and commercial losses (the Graph in the executive summary only includes the cost of low pricing). 40. Thegross costs of quasi-fiscal activities increased to up to 17percent of GDP in 1999, but were reduced to about 10percent of GDP by 2002 through a series of price adjustments. Structural changes have also been promoted, including the unbundling o f the power sector to introduce financial and technical transparency, make management more accountable, and ensure that investment decisions are much more targeted to the needs of the industry. 18 Figure 3.2: Kyrgyz Republic: EstimatedElectricity Subsidies and Losses as a Share of GDP 1994-2002 18 16 14 ij l2 1% $ 4 2 0 94 95 96 97 98 99 00 01 02proj. i ILowtariffs 0 Technical & CommercialLosses Sources: State Energy Agency; World Bank staff calculations. 41. However, unbundling i s only a "mid-course" policy rather than a structural change. As such, it cannot be expected to improve the situation of an inherently undercapitalized industry, and indeed it has not as suggested by Table 3.1. The lack of short-term progress (and the worsening of some indicators), however, is due to at least two sets of factors. 9 External Factors. Over the past 9 months, the industry lost about US$26 million inexport revenue(or anequivalent value inthe form ofcriticalinputs, such as gas and coal). That loss was somewhat offset by a US$5 million increase indomestic revenues over the same period due to higher tariffs. Unfortunately, no further domestic revenue gains were achieved through a tangible reduction of losses. Collection rates did not improve either, and thus did not contribute to domestic revenue gains. On the contrary, collection rates fell, but such a fall was well anticipated by the industry and the regulator, given that payment levels of government, industry, and commercial consumers in 2001 were unsustainably high (well above 100 percent o f the billed amounts). Collection rates for residential consumers have deteriorated, but only slightly. 9 Internalfactors. The external factors behindthis crisis have been exacerbatedby: (1) high levels of in-kindcollections and offsets; (2) somewhat by the confusion created by the new institutional setup, which requires the new companies and the government to go through a steep "learning curve;"22 and (3) by severe 22 Itis, however, important to recognize, first, that even before, the unbundling the industry did not generate enough cash to cover the consolidatedwage bill. Secondly, that large arrears accumulatedby Kyrgyzenergo were transferred on the opening balance sheet of the newly created companies almost automatically creating non-payments problems. Thirdly, that intra-industry arrears were build almost automatically due 19 deficiencies in the tax system applicable to the sector, such as the difficulty to write off irrecoverable accounts receivables, and the lack o f VAT on households which translates into an additional tax burdenon the industry. 42. Clearly, the industry is experiencing a financial crisis similar to that experienced in 1998, i.e deeply rooted in the sharp reduction in external demand. Unlike 1998, the industry has lost the `bargaining' power that a company the size of Kyrgyzenergo had vis a vis the Government which, at that time, helped it by facilitating access to credit for winter fuel purchases, as it i s now conformed by smaller and independentcompanies. Table 3.1: Kyrgyz Republic: Selected Indicatorsfor the ElectricitySupply Industry, 2000-2002 2000 2001 2001 2002 Year Year 9 months 9 months Domestic consumption(kWh) 7782 6524 4838 4771 Export (kWh) 3153 2208 2208 895 DomesticRevenue,mlnUSD 43 51 41 46 Export Revenue, mlnUSD 80 45 45 19 Billedaverage tariffs($UScent/kWh) 0.6 0.9 0.8 1.1 Collection(% of billed) 86% 93% 99% 87% Losses (% of generation), o f which 26% 37% 31% 38% QuarterlyIndicators 2001 2002 2001 2002 2001 2002 Quarter 1 Quarter 2 Quarter 3 Losses (% of generation) 45% 38% 25% 30% 15% 20% New arrears of Discoswith TranscoIGenco,mln som n.a. 394 n.a. 155 n.a. -8 CollectionRate 71% 64% 129% 104% 117% 117% Source: State EnergyAgency and WorldBank staffcalculations. 43. A key outcome o f this crisis is that the industry faces major cash flow problems, due to dramatically reduced export volumes inthe summer o f 2002 and the need to buy winter fuel. Ifthe enterprises inthe sector were solvent, a commercial bank could perhaps bridge such revenue shortfall. However, audit reports since 1997 provide enough evidence o f the lack of solvency in this industry and o f the inflated nature o f the real revenue and profits reported by the industry. The inflation i s partly due to existing accounting standards which strictly limit provisions for bad debts, and partly due to the implicit subsidization that the industry (Genco) must provide to district heating. It i s also important to bear in mindthat export revenue does not generate cash for the industry but barter goods in the form o f fuel used by Bishkek TES whose value i s used to cross- subsidize domestic tariffs. The revenue shortfalls of the sector have so far been accommodated through a buildup o f arrears on wages, debt service, tax, and dividends. Recent agreements with Kazakhstan on old liabilities may contribute to alleviating the current situation, but only marginally. to, among other factors, inflated intra-industryprices relative to consumertariffs which is an issue that the SEA has now beencorrecting. 20 44. The need for fundamental change. To address in a fundamental way the industry structural problems, the authorities must continue to address: (i)high dependence on export revenuesto subsidize domestic consumption; (ii) widespreadbarter and offsets practices, including on the part of Government to pay its own large energy consumption bills; (iii)severe under-investments in distribution; (iv) likely corruption among company employees involved in commercial operations (meter reading, collection, barter transaction, etc.); and (v) the lack of an appropriate framework of taxation for what is one of the most important industriesinthe country, with very specific revenue characteristics. 45. The previous and current management of the industry have not been able to improve service to the population. At the moment, the authorities have little choice but to move boldly to attract both investment and commercially and financially experienced managers in the industry through a concession arrangement, with management contracts as a fallback position(Box 3.1). 46. The subsidization of domestic consumption through export revenues. In a normal `export year', the losses imposed on the sector are financed by the revenue generated by the Intergovernmental Irrigation Agreements (IGIAs). Under these agreements, neighbouring countries negotiate a timely release o f water for their crops in summer inexchange for gas andcoal. This fuel is thenusedfor thermo-power generation during winter times. Since electricity is generated every time water is released, the exchange is often regarded as a gadcoal for power deal, even though, arguably, part of the export revenue (i.e., the gadcoal) is provided strictly in exchange for the service of storing and releasing water at the right time for downstream countries. Box 3.1: Attracting Investment Capital to the Kyrgyz's Power Sector There has been a significant deterioration of the global environment for investments in the power sector, and this is compounded by the relatively small size and remoteness of the Kyrgyz market, as well as by investors' perception of Kyrgyz country risk. However, given fiscal and external debt constraints, the government does not have the ability to directly raise the funding needed by the industry, nor to channel it through its Public Investment Program. Accordingly, the authorities will still need to make a concerted effort to attract private sector participation in the electricity distribution sector. Indeed, fresh capital and expertise is neededto sustainthe government's efforts to address high level of losses, to improve quality of service and to tap on the richpotential that the power sector offers to the people ofthe Kyrgyz Republic. Under current conditions, a framework of public-private partnership is needed to successfully attract private sector participation in the power industry, which rests on four pillars: (i)a model of privatization that abandons the idea of outright sale of assets (together with upfront privatization revenues) and instead focuses on a concessionapproach, with a fallback of a managementcontract; (ii)a policy framework that recognizespotential policy constraints (i.e the inability to increase substantially tariffs, as well as the need for basic social protection), but cost them and create explicit compensationmechanisms for the industry; (iii)agreaterroleandresponsibilityforthegovernmentinpreparingandcatalyzingprivatesectorfunding for necessary investments, and filling in any financing gap; and (iv) carefully crafted contractual arrangements that would bind operators and government performance and establish arbitration mechanisms.The World Bank has successfully structured privatization arrangementsalong these lines in the region(see Pamir Private Power Project for the Republic of Tajikistan). 21 47. Assuming that out of the total price of exports equivalent to US 2.3 cents/kWh about U S 0.8 cents/kWh could represent the true value of electricity exports23then in a year such as 2001, out o f the total value o f the gas and coal received as a payment for export o f electricity (US$46 million), US$30 million could be considered state revenues rather than company revenues. Since the former Kyrgyzenergo conglomerate (and the successive Generation company, which inheritedthe right to export) kept all revenues, it often shows profits even though its domestic market operations are carried out at substantial loss. 48. The State Energy Agency has made a major effort to increase the transparency o f this cross-subsidization from exports (of electricity and water services) to domestic consumption. In effect, this i s clearly specified in the Medium-TermTariff Framework that was approved in 2000. The subsidies, however, are not carefully registered in the books o f the companies or inthe fiscal accounts and therefore appear only inpaper. 49. The regulator would need not only to determine the two parts o f the export tariff (that for water services and that for electricity), but also to promote an appropriate institutional setup to handle the irrigation revenues and provide them to the parts o f the industry that needs the most subsidies, i.e remote areas and district heating. At the moment, the allocation o f these resources i s made by applying differential tariffs for power generation (lower for the most remote areas, highest for Bishkek) and the generation company subsidizes the district heating company with gas and coal earned in watedelectricity exports. 50. A more transparent way to handle these subsidies would be to include them as revenues and expenditures in the budget. While the bulk o f these will need to be eliminated over the next 2-3 years, some may remain such as those to the district heating company and distribution companies inremote areas (i.e areas where the population does not have the ability to pay for its full consumption o f electricity for the access to it). However, as discussed el~ewhere?~substantial work will be needed to create the institutions that would make this possible. It should be noted that the gas and coal received inthe intergovernmental agreements would needto be monetizedupfront for the subsidization through the budget to work well, Monetization o f this barter i s therefore desirable (Le. the government i s to sell its gadcoal inthe domestic market for cash upon boarding crossing) for this reason, as well as to put pressure on the generation company and the gas company to collect bills (from distribution companies and large industries) in cash. 51. Over the medium term, once the key stakeholders have gained a greater understandingof the opportunity cost o f low pricing in electricity, it is likely that the ~~ ~ 23The figure of 0.8 centsIkWh is to be further developed as it is defined from an internationallybased estimation of the marginal cost of generating hydro and high voltage transmission, plus an ample profit margin. 24See, for example,the Aide-Memoirefor the CSAC Mission of November2001, and the backgroundnote preparedat the same time on "Measures to Improvethe FinancialViability of the Electricity Sector in the KyrgyzRepublic." 22 government's role in providing price subsidies may be reassessed, leading to better pricing policies in power. Eventually, the IGIAs' funds must be used for general public purposes other than only for price subsidization (to be determined in the context o f budget preparation). IGIAs, therefore, could play an important role in the overall adjustment o f the fiscal accounts-assuming that a decision i s made to phase out the price subsidies (e.g., soft budgetconstraints), evenifonly gradually. B. BROADER ISSUES INTHE MANAGEMENT OF SOES 52. The public sector includes not only republican, oblast, rayon and Ailokmotu governments, but also state enterprises. If SOEs inthe Kyrgyz Republic were to behave inall respects like the private sector, thenquasi-fiscal activities (such as those described above) could not be run through them without full and stable compensation. Other activities that tendto be imposed on SOEs inthe Republic include providing employment inexcess o f their labor requirement (nearly a universal case inall o f the large SOEs). In other countries, the SOEs' assets (cars, liquidity) are also often utilized for political purposes, but this has not beendocumented yet for the Kyrgyz Republic. 53. The SOEs inthe Kyrgyz Republic are significant innumber and magnitude. Itis common for SOEs to draw substantial resources (directly or indirectly) from the government budget, especially given the fact that the government also imposes obligations on them. Infact, over the past decade the bulk o f SOE investments have been supported directly or indirectly by the budget. As a result, the SOEs account for a significant portion o f the current stock in the Kyrgyz Republic o f external public debt (about 37 percent in2000) and for the bulk o f the state's domestic debt. 54. The lower the operational savings are inthe SOE sector, the higher i s the risk that contingent liabilities will derail fiscal adjustment efforts.25Unfortunately, the government does not have a full picture o f the consolidated losses and the direct and contingent liabilities accumulated by the SOEs. 55. The monitoring o f the financial performance o f SOEs at the government level is weak and segmented. Some SOEs inthe commercial sectors report to the State Property Fund (SPF) and others report to sectoral ministries. The books of most SOEs are not audited regularly. In the end, a consolidated view o f the financial workings o f SOEs i s available neither to the MoFnor to the Parliament. This information is important not only for an understanding o f the risks coming from loss-making SOEs, but also for the accountability o f non-loss-making SOEs. Although the SOEs are either fully or partially owned by the government, their annual budgets or financial statements are not subject to the same stringent scrutiny by the Parliament as is the annual budget o f the government. This results in an important portion o f the public sector resources being left out o f the 25 Given that the recently enacted Debt Law precludes the government from issuing guarantees to enterprises, the bulk of the outstanding guarantees are now "implicit" or "contingent." For instance, a pending case against Kyrgyz Telecom in an international tribunal is likely to affect the budget directly (through some payments,as inthe 1998 default of the airline), but will substantially reducethe operational profits(and profittaxes) as well as the privatizationvalue ofthe company. 23 purview o f the Parliament, thereby missing the public scrutiny essential for all public resource usage. 56. The MoF, with support from the SPF or the sectoral ministries, should establish the practice of preparing the overall "deficit" or "surplus" (i.e., the consolidated operational savings) of the SOEs and SOBSto gauge the risk the sector i s imposing on the budget. To increase accountability, an annual report on SOE and SOB activities and their "deficit" or "surplus" should be submittedto the Parliament. C. CONCLUSION 57. The operational balances o f key SOEs (particularly in the energy sector) are closely linked to government social policies and should be closely monitored by the fiscal authorities as well as parliament. More importantly, however, i s to break the linkages that make enterprises less accountable for their performance. This will requireputtinginplace a framework which, at a minimum includes: 1 Tariffs move towards cost recovery levels steadily overtime, and during the transition period the losses o f the industry due to low pricing are costed and compensated 1 The number and scope o f price discounts to the population are sharply reduced (and any residual one i s monetized or paid in the form o f a voucher, except perhaps inNaryn) 1 Specific social policies are developed to protect very poor regions, such as Naryn, against tariff increases (e.g., a regional discount may be more appropriate than a voucher program inplaces where the bulk o f the populationcannot afford tariffs). Transactions betweenthe industry and the government are made fully incash, and no arrears are built on the consumption o f government institutions Rulesonhow revenues from the IGIA are managed are developed 58. The above conditions are to be complementedwith strong efforts to attract private sector participation inthe power sector to raise the capital and expertise that the industry needs to improve operations and to tap the rich potential that this sector offers to the people o f the Kyrgyz Republic. Given fiscal and external debt constraints, the government does not have the ability to directly raise the funding neededby the industry, nor to channel it through its Public Investment Program. The public sector, however, will need to play a catalytic role for private sector participation, given the deteriorated global conditions for energy and the small size of the Kyrgyz market. Such a role may include, in addition to firmly guaranteeing that the obligations enumerated above are fulfilled, filling-in any financing planina carefully drafted loss reduction and investment plan on the basis o f which a concession or management contract i s structured. 24 4. MEDIUM TERM FISCAL FRAMEWORK^^ A. MACROECONOMIC FRAMEWORK 59. A fundamental building block of the fiscal framework is the rate at which the economy will produce additional resources-some o f which are to be taxed to run fiscal policies. Inthe case o f the Kyrgyz Republic, there are potential gains to be made above the simple economic growth coming from efforts to facilitate business operations (Le., formalize SMEs activities), and monetize barter transactions. A second element i s the rate at which the government can attract fresh financing (domestic or local) to finance a deficit-without exacerbating an already critical debt situation. 1. Growth 60. The medium-term fiscal framework constructed in Table 4.1 assumes 4 percent growth over the medium term (i.e., 3 percent in per capita terms). This assumption has two components: (i) past reform efforts (ifdeepened and strengthenedover the medium term) would provide a basic rate o f growth o f about 1.5 percent (equivalent to 4 percent annual growth in agriculture); and (ii) efforts to attract private sector participation (and secure higher investment rates) in the energy sector, and improve the overall business environment-underpinned by strong governance and banking reforms-should result in an additional 2.5 percent growth. If reforms are successful, the investment ratio will increase over time, with public investments playing a lesser role as they become more selective, and enterprise investments (from private enterprises) playing a leading role. There i s very little headroom for hesitation: lack o f progress in reforming the energy sector or in improving the overall business climate will result in almost zero per capita growth-with higher or lower pace o f growth than that, as will be determined by random regional or global developments. Table 4.1: Key MacroeconomicParameters, 2001-2010 2001 2002 2003 2004 2005 2006 2007 RealGDP growth 5.3 1.5 4.0 4.0 4.0 4.0 4.0 NominalGDP (million $) 1,527 1,680 1,754 1,821 1,897 1,983 2,062 GDP per capita($) 308 336 348 358 371 384 396 CPI (average) 6.9 2.9 4.2 4.5 4.1 4 4.5 Deflator GDP (%) 7.4 5.3 4.6 4.3 4.3 4.5 4.5 ExpodGDP ratio 36.7 34.8 33.9 33.7 35.2 36.3 37.6 InvestmentiGDPratio 16.4 16.7 16.9 17.2 17.1 17.2 17.3 Enterprises (SOE and private) 11.1 11.5 11.5 11.5 12 4 12.7 13.0 Public 5.3 5.2 5.4 5.7 4.7 4.5 4.3 Sources: Ministryof Finance, National Statistical Committee, andNational Bank; World Bank staff calculations. 26All calculations are provided for illustrative purposes as the base for projections changed (e.g., 2002) and consequently other indicators as well. The Country Assistance Strategy considered by the Board o f Executive Directors in mid-2003 includes a more updated fiscal framework. 25 61. Realizing a 4 per cent growth over the next four years would be a significant achievementfor the Kyrgyz Republic. Under such growth scenario, the economy would experience an average growth o f 4.5 percent during the 1996-2006 period: an achievement not seen inmany countries around the world. 62. While it is appropriate that strong objectives drive the policy reform agenda, the risks o f lower growth are highsince even ifall reforms inthe energy and business climate are carried out, the supply structure inthe Kyrgyz Republic cannot yet be expected to be able to withstand a negative downturn inglobal and regional conditions over the next five years. This calls for careful interpretation o f the resulting fiscal policies discussed below-and provides a reason for tighteningthe fiscal framework over the medium-term beyondthe basic requirements called for by the debt and fiscal sustainability. 2. External Financing 63. It is critical that the medium term framework be built on the need to make progress towards fiscal sustainability, Le., reducing overall budget deficit. This i s to be carried out by reducing fiscal and quasi-fiscal deficits that would require the overall economy in general, and the public sector inparticular, to save more and borrow less. In this context, foreign assistance will continue to play a critical, albeit declining, role in deficit financing, with funding for investment projects constituting an important element o f donor financing, but not the exclusive one. 64. Foreign financed public investmenti s projected to remain at about 4.5 percent of GDP over the period 2002-04 to ensure the completion o f the largest investment projects (i.e the Bishkek-Oshroad). As shown in Annex 1, these projections are in line with the realistic pace o f implementation o f the foreign-financed projects that are already in the pipeline. New investment commitments are nonetheless expected to be signed in the amount of US$20 million in 2003 and 2004, and between US$50 and US$70 million during the 2005-10 period. Even under these assumptions for new projects, the PIP financing i s expected to decline sharply after 2004. 65. Debt relief will continue to play a critical role in the financing of the deficit. In addition to amortizations, Table 4.2 includes an estimate o f actual and possible debt restructuring, but this i s provided for illustrative purpose only. Table 4.2: Kyrgyz Republic: Sourcesof Financing,2002-07 2001 2002 2003 2004 2005 2006 2007 Total financing (including PIP) 5.0 5.6 4.6 4.4 4.3 3.2 3.0 External financing (including PIP) 5.7 4.7 6.5 6.3 5.2 4.4 3.7 LoanfinancedPIP 4.4 4.4 4.5 4.6 3.3 3.3 3.1 BOP support (already committed) 2.7 0.4 1.3 0.9 1.3 0.8 0.5 BOP support (to be committed) 0.0 0.0 0.3 0.0 1.3 0.8 0.5 Total amortization (before restructuring) -2.5 -1.1 -1.8 -2.0 -2.1 -2.3 -2.3 Debt service rescheduling 1/ 1.1 1.o 2.5 2.8 2.7 2.6 2.4 Domestic financing -0.7 0.8 -2.0 -1.8 -1.0 -1.1 -0.7 Memorandum items: Net donor support (as share of GDP) 2/ 5.5 4.6 5.9 5.3 3.6 2.8 2.2 Net donor support (in$US million) 83.6 77.4 102.9 96.5 68.0 56.5 45.9 Source: MinistryofFinance; World Bank staff calculations. 1/ Including ParisClub reschedulingfor the 2001-04 period. An scenario is also presented for after 2004 for illustrative purposes only. Includes bothprincipal and interest. 21Equivalent to grants, all disbursements,anddebt restructuring minus debt service. 26 66. Finally, balance of payments financing will not only assist with the continuation of the important structural reform agenda but will facilitate budget implementation through: (i) financing the overall deficit; (ii) providing liquidity to smooth out the strong seasonalities in tax collections; and (iii) facilitating monetization of spending (including payments incash to the power sector). 67. Balance of payments funding will come essentially from the support that the Asian Development Bank and the World Bank are providing for the reforms inthe areas of governance @ublic as well as private), customs, and energy. The flow of this support will clearly depend on the pace at which reforms can be implemented. As currently planned, however, various disbursementscould come in2003 and 2004, which, giventhe deficit objectives, would lead to some accumulation of government deposits inthe central bank (i,e., to a negative domestic financing). Avoiding such "bunching" of support will be an important element of the fiscal framework preparation. However, it shouldbe noted that a slower pace of implementation of the PIP program would create headroom for higher amounts of budget support-assuming that deficit targets do not change. In this context, the authorities would be increasing recurrent spending-and reducing capital spending-parallel to a shift from project related to BOP support. It is therefore important for the authorities to determine whether recurrent or investment spending is more likely to support the implementation o ftheir poverty reduction strategy. 3. Debt SustainabilityImplications 68. Debt management is a key element of the overall framework. The total external debt of the Kyrgyz Republic was estimatedat US$1.77 billionby the end of 2001 (115.7 percent of GDP) of which US$1.4 billion was government and government-guaranteed debt. The net present value (NPV) of the total debt stock, estimated at about US$1.2 billion (equivalent to 90 percent of GDP or 223 percent of goods and services in 2001), reflecting a high share of almost exclusively highly concessional borrowing since 1997 (see Table 4.3). In2001, the high debt-to-export ratio (224 percent) and the high debt-to- government revenue ratio 480 percent) demonstrate the unsustainable debt service burden of the Kyrgyz Republic. Table 4.3: Kyrgyz Republic, External Sustainability Indicators, 2001-10 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 TotalExtendDebt 1,767.1 1,720.1 1,730.5 1,644.0 1,686.0 1,751.1 1,840.0 1,957.5 2,069.3 2,220.1 Netpresentvalue 1,238.4 1,202.0 1,194.8 1,074.5 1,080.9 1,107.6 1,151.8 1,211.1 1,266.0 1,341.6 %of expotti ofgoods andservices 223.7 205.6 197.7 170.8 168.3 168.7 170.2 175.2 179.0 185.3 %of govemnt revenue 11 479.7 418.6 356.2 283.9 259.0 239.5 223.8 212.9 200.7 191.6 %GDP 90.5 78.7 71.8 54.8 53.5 46.3 444 42.9 41.0 39.7 TotalDebtService 165.5 180.9 130.1 99.8 111.1 96.7 84.9 83.0 88.8 90.0 %of Ewportsofgoods andservices 29.5 29.2 20.6 15.7 16.8 14.4 12.2 11.8 12.3 12.1 %of G o v e m trevenue 1/ 27.1 26.0 16.6 14.0 15.9 14.5 13.0 12.6 12.3 11.2 Memorandumitem: Expitof goodsandservices(threeyearavenge) 553.7 584.7 604.4 629.1 642.4 656.4 676.6 691.4 707.2 724.0 State govemnt revenues(excludinggmnts) 246.1 281.1 330.7 375.3 415.2 462.4 514.6 569.0 630.8 700.2 Sources: Ministryo fFinance;InternationalMonetaryFund. 27 69. Inmid-2001,the Kyrgyz authorities approved a debtreductionstrategy built upon a strong fiscal adjustment and received support from the Paris Club (Box 2.1). The Paris Club debt restructuring agreement did not change the stock o f external debt, andthe debt sustainability, therefore, remains an outstanding issue for the Kyrgyz Republic over the medium term. 70. Under the deficit and external financing framework, the projected NPV debt-to- export ratio will remainunsustainable (above 170 percent inthe mediumterm). However, greater adjustment will have strong negative implications on growth and poverty reduction efforts, which in turn make it more difficult to achieve a sustainable external stance. This vicious circle calls for strong and continued debt restructuring efforts. 71. The authorities will, therefore, need to secure a stock reduction operation from the Paris Club creditors in late 2004 if this indicator i s to be brought to sustainable levels. Such a deal would not only create the needed headroom inthe budget, but it would also effectively control inflationary expectations and assure stability, which i s presently at risk owing to the extremely vulnerable external environment. To this end, building a track record on appropriate implementation o f economic and structural reforms i s essential. B. FISCAL FRAMEWORK 1. Overall Results 72. Two events make the exercise o f consolidating a budget for the next three years difficult: (i)the significant hump in public investments (particularly the Bishkek-Osh road); and (ii) the needto secure progress inreducing the overall deficit. For the humpof public investments to be accommodated, and still make progress in reducing the overall deficit (i.e. slowing the rate at which the country i s borrowing), either the revenue effort has to improve significantly or recurrent ex enditures have to be cut beyond the headroom already created by the Paris Club?'The PER argues for a strong revenue collection effort in light o f the difficulties in cutting the wage bill without first designing clear health, education and civil service policies, and the need to start buildingoperation and maintenance (O&M) programs in roads and irrigation-which would normally be classified as recurrent rather than investment spending. In addition, there may be transitional costs from wage and compensation reforms or from pensions that may need to be accommodated once reforms in these areas are costed. A fiscal framework built on this premise is illustratedinTable 4.4 below. 73. The overall deficit o f the general government (cash deficit adjusted by wage and other selected arrears) i s projected to decline from its 2001 level o f about 6 percent o f GDP to about 3.0 percent of GDP by 2007. Programming a sharp adjustment i s important given the likelihood that external shocks destabilize growth (and, thus, fiscal policy). Such shocks could not be accommodated through larger deficits as this will certainly move the country away from the course of debt sustainability. 27 The Paris Club has already provided headroom in recurrent spending by postponing the payments of interestthat were to be due between2002 and 2004. 28 Table 4.4: Kyrgyz Republic: Medium Term FiscalFramework, Main Results, 2001-07 2001 2002 2003 2004 2005 2006 2007 Total revenueand grants 20.4 21.2 23.5 23.5 23.7 23.9 23.9 Total revenue 19.6 20.1 22.7 22.9 23.2 23.4 23.5 Currentrevenue 19.5 20.0 22.6 22.9 23.2 23.4 23.5 Tax revenue 15.8 16.4 17.4 17.7 18.0 18.4 18.6 Payroll tax 3.3 3.5 3.4 3.3 3.1 3.0 2.9 Nontaxrevenue 3.7 3.5 5.3 5.3 5.1 5.0 4.8 Revenues from IGIA'sexport 0.0 0.0 1.9 1.8 1.7 1.7 1.6 Capital revenue 0.1 0.1 0.0 0.0 0.0 0.0 0.0 Grants 0.8 1.1 0.8 0.6 0.5 0.5 0.4 Total expenditure(including PIP) 26.2 26.5 28.0 28.0 27.9 27.1 26.9 Currentexpenditure 22.0 22.0 23.6 23.2 24.1 23.5 23.0 Wagesand Salaries 4.9 4.9 4.9 4.9 5.0 5.1 5.1 Capitalinvestment withPIP 5.3 5.2 5.4 '5.7 4.7 4.5 4.3 Accrual surplus(+) /deficit (-)(including PIP) -5.8 -5.3 -4.6 -4.4 -4.3 -3.2 -3.0 Cashsurplus(+) / deficit(-) (including PIP) -5.0 -5.6 -4.6 -4.4 -4.3 -3.2 -3.0 Source: Ministry ofFinance,World Bankstaff calculations 74. The bulk o f this adjustment is to be achieved through significant gains in revenues, which should be sufficient to compensate for a reduction in the tax burden, especially on labor and turnover (plus nuisance taxes). Non-tax revenue should also increase by almost one percentage point o f GDP (mainly by bringing the revenues from IGIAs into the budget), which combined with tax revenue increases is expected to offset a decline ingrants. 75. Overall spending i s projected to increase initially to 28 percent o f GDP, but converge back to its present level o f about 26 percent o f GDP over the medium term, which is consistent with the international comparison made earlier in this volume. The increase in 2003 o f about 1.5 percent i s due to the assumption that quasi-fiscal activities will beginto be shown inthe budget (inparticular, the subsidizationo f energy companies duringthe period in which tariffs remain below cost recovery levels). Spending falls, as these (now fiscal) activities are eliminated. The composition o f expenditure i s expected to change substantially inresponse to structural measures, as elaborated inSection 3, below. 2. RevenueMobilization 76. Challenges. As suggested earlier, fiscal sustainability in the Kyrgyz Republic relies mainly on revenue gains if further sharp reductions in spending are to be avoided. These gains are to come from both tax and non-tax revenues as illustrated in Table 4.5 below. Tax collections need to be raised by about 3 percentage points o f GDP by the year 2007 (about 0.5 percent a year), on the basis o f both administrative and tax policy measures. Inview o f the overestimation of revenues and the government's dissatisfaction with some o f the high tax rates, a strong package o f revenue administration and policy reform i s needed that will raise sufficient resources to compensate for correcting the overestimation of revenues, compensate for the reductions in rates, end reliance o f tax advances, and still achieve net gains incollections. 29 Table 4.5: Kyrgyz Republic: Medium-term FiscalFramework, RevenueProjections,2001-07 2001 2002 2003 2004 2005 2006 2007 Total revenueand grants 20.4 21.2 23.5 23.5 23.7 23.9 23.9 Total revenue 19.6 20.1 22.7 22.9 23.2 23.4 23.5 Current revenue 19.5 20.0 22.6 22.9 23.2 23.4 23.5 Tax revenue 15.8 16.4 17.4 17.7 18.0 18.4 18.6 Income and profit taxes 2.7 2.6 2.7 3.0 3.2 3.4 3.5 VAT 5.7 5.9 6.4 6.5 6.5 6.6 6.8 Excises 1.5 1.6 1.7 1.7 1.8 1.9 2.0 Customs 0.4 0.4 0.5 0.5 0.5 0.6 0.7 Landtax 0.3 0.3 0.4 0.5 0.6 0.7 0.8 Roadand EmergencyFund 1.3 1.4 1.5 1.3 1.3 1.1 0.8 Other 0.5 0.7 0.8 0.9 1.o 1.1 1.1 Payroll tax 3.3 3.5 3.4 ' 3.3 3.1 3.0 2.9 Nontax revenue 3.7 3.5 5.3 5.3 5.1 5.0 4.8 Profit ofNBKR 0.4 0.4 0.4 0.4 0.4 0.4 0.4 Didivends from stock companies 0.5 0.5 0.2 0.3 0.3 0.3 0.2 Consessionpayment from "Kumtor" 0.3 0.2 0.4 0.3 0.2 0.2 0.1 Payments for services 1.9 2.0 I.8 1.9 2.0 2.0 2.0 state fees 0.2 0.2 0.2 0.3 0.4 0.4 0.4 special means 1.7 1.8 1.6 1.6 1.6 1.6 1.6 Other non-tax proceeds 0.5 0.5 0.5 0.5 0.5 0.5 0.5 Other non-tax proceeds (SF) 0.1 0.1 0.1 0.1 0.1 0.1 0.1 Electricity export revenues 0.0 0.0 1.9 1.8 1.7 1.7 1.6 Capital revenue 0.1 0.1 0.0 0.0 0.0 0.0 0.0 Grants 0.8 1.1 0.8 0.6 0.5 0.5 0.4 Source: World Bank estimates basedon data from the MoF, the Social Fund, and the State Energy Agency 77. Non-tax revenues are to increase mainly by incorporating into the budget the revenue from intergovernmental irrigation agreements (IGIAs). These arrangements are, however, deficit neutral initially, since the power and district heating sectors that currently use these revenues will need them up to the point at which prices reach cost- recovery levels (which i s expected to take another two to three years for power and much longer for district heating). Fees are expected to be overhauled and this may well result in their overall reduction. However, fees that are closely related to cost-recovery for O&M in irrigation and other public service are expected to partially compensate for this reduction. Finally, dividends from SOEs are expected to improve as the price and other elements o f their regulatory framework are corrected over time. 78. Increasing revenues in Kyrgyzstan i s a challenge and would require a concerted effort from the govemment, with donor support. Infact, revenues inthe Kyrgyz Republic (at about 16 percent o f GDP after social security contributions) are already consistent with the country's low income level, its output structure (about 40 percent o fvalue added comes from incipient agriculture), and its limitedadministrative capacity (Figure 4. 1).28 '*IfGDP in purchasingpower parity (PPP) U.S. dollars were utilizedas a measure of income, the Kyrgyz Republic would be below the regression line, Le., its level of tax revenue would be much lower than requiredbythe incomelevel(see Annex 1). 30 Figure 4.1: Relationshipof Tax Revenue and Incomein Selected ECA Countries 8E 46 Belarus 0 41 - A 0 BosniaeT .=I 2 36 - v2 31 - t 26 Uzbekistan 'UkrAr Rus- Macedonia 1 - ig Romania 5.O 5.5 6.0 6.5 7.0 7.5 8.0 Log of GNI per capita Athlas method (current US%) Sources: Recent Economic Developments, IMF; World DevelopmentIndicators, WB staff calculations. 79. Strategy. The PER advocates a two-pronged strategy for raising revenue (see Volume 11). First, better means should be provided to the revenue authorities by the launching of a program for the rationalization and modernization of the revenue collection institutions. Such a program must be comprehensive, encompassing investments in human capital (training, compensation, and a stringent hiring policy) as well as in the necessary minimum hardware that would reduce to the maximum extent decisions made on the basis o f individual judgments and client-tax officer contacts. The program should also substantially rationalize the existing infrastructure for revenue collection, beginning at the level o f institutions but also reaching branches and possibly staff, and should revamp budget procedures for revenue collection agencies. Based on international experience, a revenue collection modernization program would probably need to allocate about US$15 million for these purposes over the next 4-6 years. This priority program should be a primary candidate for inclusion into the Public Investment Program. Exact costing inthe case o f the Kyrgyzstan should be developed inthe context o f preparing a comprehensive assessment-with donor assistance-along the lines described in Box 4.1 below, specifically identifyingboth the scope and the costs o f the modernization. 80. Second, a series of simplifications of tax policy, base expansions, and assignment of taxesto local governmentsshould be launched that would be designed to inducegreater compliance.Followingthe government's objectives, these simplifications would include: phasing out turnover and other "nuisance" taxes and further reducing payroll taxes; compensating for lost revenue by expanding the tax base through such measures as extending the VAT to products that are currently exempted; and reconsidering special exemptions for certain categories o f imports and entities. In addition, incentives for compliance would increase through the assignment o f revenues to local governments, along with the responsibility for their collection and accountability to their local taxpayers, beginning with a tax on immovable property and continuing 31 through a restructuring o f all local taxes. On the taxpayer side, the 2001 reductions inthe rate o f corporate, income, and payroll taxes should facilitate compliance. This must follow a better-developed allocation o f functional responsibilities and expenditure assignments, combined with an alignment o f incentives to maximize the collection o f revenues. Box 4.1: A Diagnostic Framework for Revenue Administration ~~ ~ Traditionally, the approach to the modernization of tax and customs administration has focused on tax policy and tax laws; the streamlining of basic technical processes, such as taxpayer registration, processingof returns and payments, tax audit and border operations; computerization; the reorganization of tax departments on functional lines; the creation of Large Taxpayers Units; and technical training. This approach, as comprehensive as it sounds, may fail to fully uncover the underlyingcauses of institutionaland organizational dysfunction, leadingto partialsolutionsandsub-optimaloutcomes. More recently, various countries, includingJamaica, Colombia, and others, have developed an approach based on a comprehensivediagnostic analysis of revenue administration that wouldtake into account, in an integratedmanner, boththe traditionalareas of focus as well as non-traditionalareas such as the array of environmental factors that impinge on the RevenueAdministration(RA); the effect of the history of the RA on its current and future functioning; organizationalstrategy; organization and management functions; and informal culture, For a description of the integratedapproachto tax administration, see Jit B. S. Gill, World Bank TechnicalPaperNo472, June 2000. 81. These investments and policy efforts would bring results, as there i s ample room for improving the efficiency o f revenue collection. This should result in higher revenue, either by reducing leaks in the system (ie., the difference between amounts paid and amounts collected) or by expanding the tax base as the various measures facilitate business development. Reforms o f the revenue collection system should also be directed to facilitate business compliance. Such improvements, when effectively obtained, could be basic to promoting small and medium enterprise de~elopment.~' 82. The revenue gains from the modernization would have to be sufficient to reduce the fiscal deficit over the medium term, to eventually allow a reduction in certain taxes and contributions, to pay timely VAT reforms, and to put an end to reliance on tax advances. The sequencing is, therefore, important: to launch the modernization program first and to reduce rates only as the program shows improvements incollections. 3. ExpenditureReforms 83. A number o f spending policies are expected to change over the next three to four years including those in transport, energy, social sectors, and public administration. *'Thecosts and impedimentsthat revenue collection agencies impose on business development have by now been well studied. See, for example, World Bank, "Governance and Service Delivery in the Kyrgyz Republic," 2002; and USAID ARDIChecchi, Regulatory and Business Environment Survey, December 2000. 32 Those policies have been simulated in Table 4.6 below. The underpinning analysis for these assumptions i s presented inChapter 7 and in Volume 11. Table 4.6: Kyrgyz Republic: Medium-term Fiscal Framework, Public Expenditure, 2001-07 2001 2002 2003 2004 2005 2006 2007 Total expenditure(including PIP) 26.2 26.5 28.0 28.0 27.9 27.1 26.9 Current expenditure 22.0 22.0 23.6 23.2 24.1 23.5 23.0 Wages and Salaries 4.9 4.9 4.9 4.9 5.0 5.1 5.1 Capital Repairs 0.5 0.6 0.6 0.9 1.4 1.9 2.5 Transport and Communications 0.3 0.4 0.4 0.4 0.5 0.6 0.7 Irrigation 0.1 0.1 0.1 0.2 0.4 0.5 0.6 Health and education 0.1 0.I 0.1 0.2 0.4 0.6 0.8 Others 0.1 0.0 0.0 0.0 0.2 0.3 0.4 Transfersand subsidies 8.2 8.6 10.5 9.9 9.4 8.5 7.6 Power sector 0.0 0.0 1.9 1.3 0.9 0.4 0.0 Social fund, O.W. 5.2 5.6 5.6 5.4 5.2 5.1 4.9 Pensions 4.7 4.9 5.0 4.8 4.6 4.5 4.3 Social insurance 0.2 0.2 0.2 0.2 0.2 0.2 0.2 Employment fund 0.2 0.2 0.2 0.2 0.2 0.2 0.2 Health insurance fund 0.2 0.3 0.2 0.2 0.2 0.2 0.2 Stipends 0.1 0.1 0.1 0.1 0.1 0.1 0.1 Social Protection programs, O.W. 1.2 1.4 1.5 1.6 1.6 1.6 1.5 UMB 0.5 0.6 0.8 0.8 0.9 1.o 0.9 Social benefits 0.2 0.2 0.2 0.3 0.3 0.3 0.3 Social privileges (new Law from 2003) 0.5 0.5 0.4 0.4 0.4 0.3 0.3 Interest due 1.7 1.8 2.1 2.0 2.6 2.5 2.3 Foreign interest 1.1 1.2 1.5 1.6 2.1 2.0 1.9 Domestic interest 0.4 0.6 0.6 0.5 0.5 0.5 0.5 NetLending -1.1 -0 7 -0.9 -0.9 -0.8 -0.8 -0.5 Capital investmentwith PIP 5.3 5.2 5.4 5.7 4.7 4.5 4.3 Domestic capital investment(exept PIP) 0.3 0.2 0.2 0.3 0.8 0.8 0.8 Domesticaly financed PIP 0.6 0.6 0.7 0.8 0.6 0.3 0.5 Foreign financedPIP 4.4 4.4 4.5 4.6 3.3 3.3 3.1 Source: Ministry of Finance, Social Fund, State Energy Egency, World Bank staff calculations 84. Overall spending will transitorily increase if the quasi-fiscal activities in the energy sector are budgeted, although the increase in spending i s likely to be deficit neutral (and certainly revenue enhancingover the medium-term).Another key element of the framework is the rolling out of O&M strategies, particularly, in the infrastructure sector (e.g., roads and irrigation), but also inthe social sphere (i.e. health and education). Room for these is expected to be created by the completion of large infrastructure projects under the public investment program. Consequently, capital repair spending should increase five-fold over the next five years-although from a low base. At the same time, capital spending i s projected to decline as a share of GDP. Foreign financed investments will fall from 4.6 percent to 3.2 percent of GDP between 2002 and 2007 even as new resourcesare committedtotaling US$230 million. 85. Insocial protection, the phasing out of price subsidies inthe energy sector will require strengthening other (budgetary safety nets). In this regard, social protection spending i s expected to increase up to 2005. These increases are moderate as an underlying strong growth will begin to reduce poverty. On pension, the current framework takes into account the likely evolution of the stock of pensioners, and assumes 33 that the margin for pension increases i s targeted towards poorest pensioners for the next 3-4 years through 2007. The margin for increases results from increasing total spending by the expected inflation. 86. The fiscal framework described above does not simulate wage and compensation reforms for the civil service as well as health and education sectors. However, it i s likely that wage bill, severance payments, and wage decompression will result in an increase in total spendingafter 2005 (perhaps even larger than i s envisaged inthe above Table). 87. It should be noted that an effort was made to integrate, in the above fiscal framework, all public sector resources, including key extra-budgetary funds (i.e., those under the social fund). The budget planning process inthe Kyrygz Republic should also be comprehensive-which requires a number o f institutional reforms that are elaborated inPartI1below. C. CONCLUSIONS 88. The Paris Club flow agreement provided the Kyrgyz authorities needed headroom to undertake substantial spending reforms and to increase revenue collection efforts. More importantly, it has allowed the country to runa less contractionary fiscal policy. If this headroom is usedappropriately, the Kyrgyz would have made major strides towards achieving a more sustainable external debt position, but efforts would fall short of bringingabout sustainability. 89. Economic management, and fiscal policies in particular, will nonetheless prove challenging over the next few years. On the one hand, a selected set o f projects in the pipeline o f the Public Investment Program must be accommodated if their benefits are ever to be realized. On the other hand, the country's revenue collection infrastructure i s still underdeveloped and i s in need of consistent investments (mainly o f institutional character) . 90. Perhaps more important i s the need to conceptualize strategies o f key sectors, such as infrastructure, health, education and social protection and to formulate them in the context o f a rolling 3-year medium-termbudget strategy every year.30 It is expected that the Ministryo f Finance will eventually institutionalize the formulation o f three-year rolling medium-term strategies as part o f the budget preparation process, and that this becomes the backbone o f future National Strategies for Poverty Reduction. The World Bank (and DFID) are making available technical assistance support to this end under the Governance Structural Adjustment Credit. 30The medium-term framework presentedhere was made on the basis ofthe economic classificationof the budget, rather than on the basis o f functions. This way, it can be viewed as complementary to Government's efforts to prepare a medium-termframework on a functional basis, which in many ways is consistent with the one presentedhere. 34 PARTTWO: CHALLENGES 35 5. OVERVIEW OF SPENDINGPOLICIES 91. Although public expenditures in relation to GDP are expected to remain at their present level (but quasi-fiscal expenditures are to be phased out) sectoral policies need to reflect the new priorities o fthe National Strategy for Poverty Reduction. Inthis respect, it i s important to understand the current composition o f expenditures across and within sectors. In what follows, a brief analysis i s made o f the economic and functional allocation o f resources. This analysis builds on the historical assessment o f spending made inChapter 2. A. ECONOMIC ALLOCATIONOFBUDGETRESOURCES 92. Today, the Kyrgyz budget consists mainly o$ (i) wages; (ii) transfers; and (iii) Cforeign-financed) investments. Together, these items account for over 70 percent o f total spending, crowding out operations and maintenance for basic infrastructure (e.g., irrigation and roads other than those rehabilitated under the investment program) and key facilities (schools, hospitals, orphanages, boarding houses, andjails). These expenditures also limit the room for purchasing basic equipment and materials, e.g., medicines, bandages, textbooks, and learning materials (see Table 5.1). Table 5.1: Kyrgyz Republic: Key Expendituresby Economic Classification, 1999-2002 1999 *Ool prelim. budg. 2002 1999 2000 2001 budg. prelim' (% ofGDP) (%of total) Total 32.0 28.1 26.1 26.0 100.0 100.0 ioo.0 100.0 1. Current, non interest, of which 22.9 20.7 21.9 21.3 71.6 73.9 84.1 82.0 a. Transfers & subsidies 7.8 7.5 8.2 8.6 24.4 26.8 31.5 33.2 -state enterprises 0.7 0.7 0.8 0.8 2.1 2.4 3.0 3.0 -state enterprises - insuranceiunemployment 5.7 5.0 5.2 5.6 17.7 17.9 20.1 21.5 0.5 0.4 0.4 0.4 1.5 1.5 1.5 1.5 -social protection programs 0.9 0.9 1.2 1.4 2.7 3.1 4.5 5,4 b. wages & salaries 4.6 4.4 4.9 4.9 14.3 15.7 18.9 18.8 2. Interest payments 3.0 2.2 1.7 1.5 9.4 7.8 6.4 5.8 3. Food 0.9 0.8 0.7 0.7 2.8 3.0 2.8 2.9 4. Purchaseso f other goods and senice 7.5 6.7 7.1 6.3 23.6 23.1 27.3 24.3 a. Operation and maintenance 0.6 0.5 0.5 0.6 2.0 1.8 1.9 2.3 b. Equipment, tools and materials 0.3 0.3 0.2 0.2 0.9 1.2 0.7 0.7 c. Medicaments and bandages 0.3 0.2 0.2 0.2 0.9 0.7 0.7 0.7 d. Utilities 1.3 1.8 1.8 1.9 4.2 6.3 6.8 7.2 e. Special resources 1.8 1.4 1.6 1.6 5.6 4.9 6.0 6.2 5, Capital 9.5 7.8 5.3 5.4 29.6 27.8 20.3 20.8 a. Domestic investments 1.1 0.9 0.3 0.2 3.4 3.2 1.3 0.8 b. Foreighfinanced PIP 8.4 6.5 4.4 4.6 26.2 23.0 16.8 17.6 c. Counterpart funds 0.0 0.4 0.6 0.6 0.0 1.6 2.2 2.4 6. Net lending -0.4 -0.5 -1.1 -0.7 -1.2 -1.7 -4.4 -2.8 Notes: Includes the state budget (central and local budgets), the foreign-financed public investment program, and the operations ofthe Social Fund. Sources: Ministryof Finance, SocialFund; IMF and World Bank staff calculations. 36 93. Such concentration o f resources intransfers, underminesthe development o f basic expenditure management institutions such as procurement, since less than 20 percent o f the budget is potentially subject to procurement (about 19 and 14 percent in 2000 and 2001,respectively), andpart o f that is not procuredbutrather bartered.31 94. Lack of funding for complementary inputs, in combination with poor remuneration of public employees, has resulted in ineffective delivery of almost all public services, such as health, education, andjustice. Stakeholders, including public servants, are frustrated with the current system inwhich the budget provides only partial funding for their activities (as captured by arecent service delivery survey).32 1. Wages 95. The casefor an employment and compensationreform program is strong. There are considerable structural problems with the wage bill, which maintains a large number o f employees without properly compensating any o f them. More importantly, payment o f wages has beenerratic (with persistent arrears since 1998) and indexations are ad hoc. As a coping strategy for dealing with low and unpredictable wages, most government agencies have created special fees to top up salaries, which has resulted in a highly discretionary wage regime and segmented the budget into funding coming from the Republic and own revenue raising efforts. The discretionary reliance on special means, inter alia, has exacerbated regional disparities inpublic service delivery, as the capacity to generate special resources varies from region to region and depends mainly on the income level o f the population. The reporting o f "ghost" workers has also proliferated, to increase funding from the budget. 2. CapitalExpenditure 96. Domestically driven investments have been reduced to less than 1percent of total spending by 2002, whereas foreign-driven investments and their counterpart funds account for about 18 percent o f the total spending. While donor-sponsored investments are subject to a more rigorous oversight interms of preparation and implementation, such a level o f reliance on donor projects undermines efforts to build domestic capacity, particularly in priority setting, project preparation, and project implementation. Also, since the foreign finance investment program i s only partially part o f the regular budgetary process, it has contributed to making the domestic budget essentially an exercise in allocating wage bill amounts to various spending agencies, rather than providing a comprehensive focus on the overall set of activities that these agencies are supposed to undertake in favor o f households and the private sector (see Annex 2). 97. Nonetheless, theforeign-financed PIP has been successful in various respects. First, some infrastructure has been improved, including parts of the Bishkek-Osh road (though the benefits o f this project are uncertain until the full road i s completed), a 31The KyrgyzRepublic CountryProcurementAssessment Report, Draft, October22,2002. 32World Bank, "Governance and ServiceDeliveryinthe KyrgyzRepublic: Results of Diagnostic Surveys," 2002. 37 transmission line to the Kumtor gold mine (the largest foreign investment), irrigation channels and dams (which isolated the Kyrgyz Republic from floods in 2001), the Bishkek Airport (now in use by the antiterrorist forces led by the United States), and some digital telephone lines. And second, interventions in agriculture other than irrigation (e.g., extension services, land titling, and rural credit) have also been successful even though some were more difficult to design than others (e.g., sheep and wool development) and most have not yet been completed. These interventions and a strong reform effort in agricultural policies have represented a comprehensive approach to reform inthis key sector. 98. Less successful have been the interventions intended to support public and private enterprises. Support to investments of SOEs in the energy sector (e.g., non- Kumtor-related transmission, and the district heating) lacked a well laid out sectoral strategy, and therefore policy changes that would have been needed for successful investmentsbeganto take place only in2000-after substantial disbursements. Lines of credit for private enterprises have been disastrous, in that most of them are now in the government's books due to failure in many of the supported projects. This is mainly because the capacity of the financial sector to intermediate resources was overestimated but also due to lack of collateral legislation anda workingjudiciary system. Finally, one- time types of interventions (such as the procurement of a specific price of equipment for a hospital, school, enterprise, or government agency) have also failed inthe absence of a more systematic approach. Although efforts have beenmade to limit the PIP to activities undertaken by either a government agency or a utility, there are still one or two projects that could have beenleft entirelyto the private sector. 99. Success or lack of it notwithstanding, the largest opportunity cost of capital expenditureshas beenthe crowding out effect they have had on the rest ofthe budget and on the processesof prioritizationandplanning. Securing the sustainability of some of the infrastructure-including that inirrigation, transport, and energy-is the key issue for the coming forth years. B. FUNCTIONAL ALLOCATIONOFBUDGETRESOURCES 100. Table 5.2 provides an international comparison of the functional composition of expenditures (average for the 1990s) and compares it with spending in the Kyrgyz Republic in2001. This year is considered"standard" relative to the previous years, which were characterizedby considerable adjustments inrecurrent spending, or "humps," inthe foreign-financed PIP or both. 101, The Table points out that education and health are areas inwhich the KR spends muchless than Africa and Latin America as a percent of total spending. Incontrast, the KR spends substantially muchmore than most other countries includingthose inthe CIS inareas, such as economic affairs such as transport and agriculture. These international comparisons captures the most obvious deviations in the financing of key public 38 functions, but that in itself may well have a logical e~planation.~~this regard, these In comparisons need to imply that spending in health and education must increase and spending in transport must fall. Instead, they point out at the need to carry out more detailed assessment o f the spendingpolicies that are behindthe level o f spending inthese sectors, which i s what we undertake inChapter 6. Table 5.2: World Expendituresby Functional Categories, 1990s (%of GDP and% ofTotal) 1/ World ECA CIS OECD LAC Africa EA&P SouthAsia MENA KR2001 Social security and welfare 7.6 10.1 8.1 15.6 5.5 1.5 0.7 1.6 3.6 6.3 Economic affairs 4.6 3.8 4.2 3.5 2.1 4.1 6.4 7.1 5.6 5.8 Education 4.4 4.7 4.5 5.3 3.3 3.2 3.4 3.9 4.6 3.5 Interest 3.3 2.7 1.7 5.0 3.1 2.9 1.3 3.1 0.4 1.4 Health 3.1 4.0 2.5 5.6 2.3 1.6 1.0 2.1 1.6 1.8 GPS 2.9 2.5 1.9 2.7 2.2 2.4 1.7 5.2 3.3 2.6 Defense 2.6 1.9 1.8 1.9 1.5 2.5 2.4 3.2 5.1 1.3 Public order 1.5 2.3 1.4 1.3 1.3 1.2 0.9 1.1 2.2 1.0 Housing affairs 1.4 1.8 1.3 1.7 0.9 0.8 1.1 2.0 1.1 1.2 Recreation and culture 0.6 0.9 0 7 0.9 0.2 0.2 0.2 0.1 0.8 0.4 Total I/ 32.0 34.7 29.7 43.5 23.6 20.5 19.2 29.3 28.4 26.5 (as share of total) Social security and welfare 23.9 29.0 27.3 35.9 23.9 7.4 3.7 5.3 12.8 23.8 Economic affairs 14.4 11.0 14.3 8.0 11.5 20.1 33.5 24.3 19.6 22.0 Education 13.6 13.6 15.2 12.3 14.3 15.6 17.6 13.3 16.1 13.3 Interest 10.4 7.9 5.8 11.6 13.5 14.1 7.0 10.6 1.5 5.3 Health 9.6 11.5 8.5 12.9 10.0 7.9 5.4 7.1 5.6 6.8 GPS 9.2 7.3 6.5 6.1 9.8 11.6 9.0 17.6 11.7 9.8 Defense 8.2 5.6 5.9 4.4 6.7 12.4 12.5 10.9 18.1 4.9 Public order 4.7 6.5 4.9 2.9 5.6 5.7 4.4 3.7 7.8 3.8 Housingaffairs 4.3 5.2 4.5 3.9 3.9 3.9 6.0 7.0 3.8 4.5 Recreation and culture 1.8 2.5 2.2 2.0 0.7 1.1 0.9 0.3 2.9 1.4 Total I/ 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 "Excludes net lending. Sources:IMF GFS; For KR, Treasury Departmentofthe MoF. C. CONCLUSION 102. In 2001, the Kyrgyz Republic spent much less in health than the CIS countries, the South East Asian countries, and the Latin American Region (the latter two having systems in which the Government only plays a residual role). Health spending only barely surpassedthe level o f health expenditure inAfrican countries. As a percent o f total spending, a measure which captures better the importance o f certain activities among competing priorities, the share o f health in the Kyrgyz Republic is higher than only two comparable set o f countries (those inEast Asia and the Pacific, and the Middle East and North Africa Region). Similar, though less sharp observations, can be made inregard to education spending. These findings are determined by the importance given to economic spendinginthe Kyrgyz Republic, a feature which is not unique to 2001, Budgetary social 33 It should be mentioned that not all countries pursue the same principles (e.g., universal provision of health care and social security), and in that regard choosing the appropriate "peer" group is important. More important, any outlier behavior must be thoroughly examined for an understandingof the policies and institutions underlying this behavior (including general policy stands as well as transitory factors that may account for a behaviorthat is out of line with other countries). 39 spending appears normal relative to most comparison groups, as well as spending in general public services. This facts points to the needto analyze the policies ineducation, health, transport and agriculture, which this PERcarries out inChapter 7 and Volume 2. 103. By economic classification, the analysis inthis chapter points at the needto assess wage and compensation policies, and explore capital investments. However, economic and functional classifications are not independento f each other. In fact, the reduction o f wage bill spending can be traced one to one to the reduction o f health and education spending-suggesting the importance o f understanding remuneration policies beyond the civil service. The economic classification also pointed out the lack o f resources for complementary inputs (in health, education, and any other public service) as the bulk o f resources are currently spend intransfers, wages and investments. 40 6. SYNTHESIS OFKEY SECTORAL ISSUES34 A. HEALTH 104. Despite the major economic challenges it faces, the Kyrgyz Republic has developed a strategy for reforming its health care system that, if implemented steadily over the next decade, will represent a model for the Europeanand Central Asian region as a whole. This strategy involves ongoing changes inthe organization o f health care and in the way care is financed and providers are paid. These changes have begun to show better health outcomes and more effective use o f the limited resources available for health in the regions where they have been rolled out. The financing reforms have the potential to improve the effectiveness o f the health care system and to reduce costs by altering the incentives facing institutional and individual providers, as well as consumers. Although significant progress has beenmade in implementingthis strategy, key reforms are now stalled or under threat. 105. At independence, the Kyrgyz Republic inherited a health system that largely focused on specialized hospital care. Preventive and primary health care services were weak, and there was an excess supply o f health facilities and personnel, especially in Bishkek. Health services were provided free o f charge, and there was a generous system o f social transfers and services. Resource allocation was based on the recurrent input needs o f existing health facilities, rather than on actual health needs. This allocation process resulted in health facilities and health personnel in urban centers receiving the bulk o f public resources. In the years following independence, the withdrawal of subsidies from Moscow compounded the sharp fall in GDP and the shrinking size o f public revenues in relation to GDP. The contraction in public spending particularly affected the health sector. But despite the collapse o f public resources for health care, there was no downward adjustment in the numbers o f health facilities, beds, and health personnel to reflect the new budget reality. Health infrastructure deteriorated; salaries o f health staff declined inreal terms and were often paid late; informal payments by patients proliferated as the only means o f financing drugs and other vital recurrent inputs; and there was growing concern over the increased prevalence o f communicable diseases such as tuberculosis (TB). 106. It was clear to health policymakers that major reforms were neededinthe health sector to enable the country to provide health care services in a more efficient and equitable manner. In 1996, the government formally adopted the Manas HealthProgram, which was a comprehensive approach toward restructuring the health sector to improve the way in which public and private sector resources are utilized. The reform program 34For acomplete discussion of sectoral issues see the relevant chapters in Volume 11. 41 envisioned moving the health system away from historical budgeting processesdriven by input norms and toward incentive-based purchasing arrangements based on outputs and population needs. It aimed at introducing hard budget constraints for providers and encouraging providers to be efficient. It defined a new health care financing system that would consolidate public resources in the health sector, thereby reducing fragmentation among the different sources of revenue and improving the efficiency with which public sector resources are used. Finally, the reforms aimed at improvingthe cost-effectiveness o f the health sector by supporting preventive and primary care and improving the resource allocation formula so that population dynamics and health needs would guide allocation. 107. These restructuring reforms have been successfully launched in some parts of the country. For example, primary health care services have been strengthened throughout the country with the establishment of family group practices. A financing mechanism (the Single Payer system) operational in four oblasts (Issyk-Kul, Chui, Talas, and Naryn) has allowed local health care resources (oblast and rayon) to be combined for more effective use. This system i s allowing cross-subsidies to flow within the entire oblast rather than only within rayon boundaries. It has also reduced the administrative costs of managing health care by giving the responsibility to a single organization that already has established and well-defined rules for contracting with health providers. These reforms are moving the health system away from historical budgeting processes driven by input norms toward incentive-based purchasing arrangements based on outputs. In the four oblasts in which the Single Payer system is operational, health facility managers face hard budget constraints which motivate them to rationalize health infrastructure and staffing. 108. The nationwide expansion and sustainability of these reforms currently faces two threats. First, public funding has been on the decline (Table 6.1). Second, funding remains focused on hospitals rather than on primary care; this i s mainly drivenby the city of Bishkek, where large and highly specialized hospitals do not yet face incentives to reform. Together, these two factors have had a negative impact on the ability of the poor and the ruralpopulation to access good quality care close to where they live. Table 6.1: Public Spendingon Health in Relationto GDP 1995 1996 1997 1998 1999 2000 2001 Total, of which 4.0% 3.1yo 2.8% 2.8% 2.4% 2.0% 1.9% State budget 4.0% 3.1% 2.7% 2.7% 2.2% 1.9% 1.8% MHIF* 0.0% 0.1% 0.2% 0.2% 0.2% MHIF=Medical Health Insurance Fund Source: Treasury data for state budget health spending, MHIF for MHIF expenditures from revenues received from the Social Fund, and National Statistical Committee for GDP data. Budget health spending data exclude the PIP. 42 109. The reduction in funding is associated with: (i) compression-to wage which the health grants for the republican budget are currently tied; (ii) clawback o f resources the by local government when efforts to formalize the co-payments system were made (and the reported diversion o f republican funds earmarked for health to other activities); and (iii)thecaptureofpartofthesector's smallbutcatalyticfundsbythePensionFund.At the end of 2001, the proportion of public funds going to health in the Kyrgyz Republic was among the lowest in the world. Surprisingly, the country spends amounts on health that are similar to those spent by African and Latin American countries, which do not claim to provide universal health care coverage intheir constitutions. 110. Figure 6.1 illustrates some o f the restructuringachieved intwo o f the Single Payer oblasts. It shows that there i s a potentially large payoff to be derived from including Bishkek in the Single Payer system, where the bulk o f hospital rationalization needs to take place, as well as Osh and Jalal-Abad. By channeling funds mainly as a payment for services, the MIHF has reversed the incentives in the existing budget allocation process that had contributed to excess capacity and highfixed costs-at least infour oblasts. Figure6.1: Health CapacityReductionin Chui and Issyk-KulOblasts,2001 -> Q E 0 30 c 0 *= 20 ->me! Q .-t;0 S I O '0 a se! o number of beds number of buildings physicians nurses j i Chui Issyk-Kul 1 surce: Socium Consult (2002). 111. There is also a large payoff for the republican budget to be derived from relying increasingly on the MHIF as a manager o f its funding in all regions (Le., the categorical grants that it provides to local governments). For this purpose, significant changes will have to be made in the manner in which these grants currently work. Clearly, one key step i s to sever the link between categorical grants and wages and instead to link them to basic services under the Single Payer system or directly to the family group practices. As the experience in Single Payer oblasts suggests, it would also be important to allow reforming health care providers, that are not identified for complete closure, to keep part of the returns to their greater efficiency (i.e., some of the savings that are generated through reductions in staff or facilities). This incentive, and greater autonomy in the management o f their resources (ie., setting wages, determining employment levels, and 43 handling funds outside o f the Treasury in the same manner as other government contractors), will result in better service delivery. However, efforts must be made to define the manner in which the hospitals will be setting wages and controlling other costs. The autonomy o f hospitals must be increased by making them fully non-budgetary institutions-but how to do this requires further analysis. 112. The government should also allow the health sector to keep part of the returns coming from greater efficiency in service delivery and, in particular, care should be exerted to ensure the stability o f funding for the sector. Public funds should not be reduced as the process to convert informal paymentsmade by patients for health care into formal co-payments progresses. Formal co-payments should be regarded as a complement to, rather than a substitute for, public funds. To the extent that public funding is reduced (and this includes the lack of transfers from the Social Fundto the MIHF),the mix offundingsourcesbecomes more regressive. Directpayments at the time o f service use are most burdensome for the poor and also pose the greatest financial barrier to access. The emerging public health threat posed by TB and HIV infection should also be addressed. These diseases demand concerted action from central and local governments in the short run to prevent major economic and social consequences in the medium term. B. EDUCATION 113. Overview. The Kyrgyz education system comprises pre-school education for children between 1 and 6 years o f age, primary education (grades 1 through 4), lower secondary education ( rades 5 through 9), upper secondary education (grades 10 and 1l), and higher education. % In addition to the formal sector, there are numerous out-of- school institutions and organizations to meet the education and training needs o f the population. Specialized schools withinthe public education system provide instruction in each o f the major minority languages. Kyrgyzstan entered the transition with relatively highlevels of educational participation. 114. One o f the particular challenges o f education delivery i s the high proportion o f rural population. Inthe aggregate, 65 percent o f the Kyrgyz Republic's population lives inrural areas-mostly inmountainous areas. InNaryn and Chui Oblasts, more than 80 percent o f the population i s rural. This situation presents a challenge in terms o f both delivery o f education and demand for education. It complicates delivery and raises education costs because the greater dispersion o f population in rural areas leads to smaller class sizes, to smaller school sizes, and often to lower teacher utilization rates. 115. Although there are no time series data to track changing education quality, there i s a consensus on the part o f teachers, students, and parents that the quality o f educationhas deteriorated seriously over the past decade in all but a few well-endowed urban schools. 35The initial years o f formal education in the Kyrgyz Republic are referred to as "secondary education." Initial schools offer grades 1through 4. Basic schools or "incomplete secondary schools" offer grades 1to 9. "Complete secondary schools" offer grades 1 through 11. For clarity, we use the more conventional terminology o f primary education to refer to the compulsory initial 9 years o f formal education, and secondary to refer to grades 10 and 11, including general and vocational/technical education. 44 Declining quality results mainly from the budgetary neglect which i s described below, resulting indepletedstocks o f textbooks and other educational materials, inan underpaid and demoralized teaching force, and in the physical deterioration o f schools. The increasing reliance on formal and informal parental contributions to meet essential school needs also results in a more unequal distribution o f educational quality. Large differences have emerged in teaching conditions and educational outcomes among oblasts and betweenurban and rural schools. Ina recent national assessment o f fifth grade students, results innumeracy skills varied markedly by oblast and urbadrural location. 116. Finance. There are distinct issues in education finance which relate to: (i) the overall level o f public support for education; (ii) teachers' salaries; and (iii) level, the central or local, at which education services are financed. The issues and recommendations for these topics and others are summarized inthe discussion below but are covered indetail inVolume 11. 117. Level of Public Support. As shown in Table 6.2, the share o f consolidated public budget allocated to the education sector was essentially the same (20 percent) in2000 as in 1990, and increased to 23 percent in the 2001 budget year. But in spite of this increased level o f commitment, the share o f GDP devoted to education fell by exactly half during the 1990s-from 7.4 percent in 1990 to 3.7 percent in 2000. This decline reflects the smaller size o f the public sector under the market economy. This i s a lower share o f GDP spending on education than in other countries in the region with the exception o fRussia and Tajikistan, and i s considerably below the average for the OECD. Table 6.2: Public Expendituresfor Education as a Share of TotalPublic Expenditures, 1990-2001 Education Education TotalPublic Educationas GDP Education Expenditures Expenditures Expenditures % of Total (in as YOof (in millionso f (in millionso f (in millionsof Public millions GDP current som) 1995 som) current som) Expenditures of current som) 1990 3.2 2,381.0 15.9 20.1 Yo 43 7.4 Yo 1991 5.6 1,775.5 24.4 23.0 % 93 6.0 % 1992 37.3 1,271.4 231.1 16.1 % 741 5.0 % 1993 227.2 906.3 1,225.8 18.5 % 5,355 4.2 Yo 1994 730.8 1,038.0 2,812.8 26.0 % 12,019 6.1 Yo 1995 1,064.9 1,064.9 4,610.5 23.1 % 16,145 6.6 Yo 1996 1,222.8 903.5 5,202.4 23.5 % 23,399 5.2 % 1997 1 314.0 937.6 6,695.7 22.6 % 30,686 4.9 % 1998 1,68 1.6 954.7 7,298.3 23.0 % 34,181 4.9 % 1999 1,892.3 780.9 9,042.2 20.9 % 48,744 3.9 % 2000 2,289.9 740.17 11,284.5 20.3 Yo 62,203 3.7 % 2001 2,849.3 854.3 121257.0 23.2 Yo 731890 3.9 % Sources:NationalStatistical CommitteeandWorld Bank database. 118. The effect o f this budgetary contraction on education programs includes widespread deprivation o f the basic educational materials needed for effective teaching and learning and for the modernization of education programs. The recent National Survey of Primary Education Quality found, for example, that 80 percent o f primary schools lacked a complete supply o f textbooks for students, 70 percent lacked teachers' 45 guides, 20 percent lacked desks and chairs for students, 70 percent needed repairs to school fumiture, 23 percent lacked a water supply, and 39 percent lacked telephone^.^^ 119. The serious decline in teachers' salaries, which has eroded teacher morale and motivation, has induced many teachers to take additional jobs, and has exacerbated the problems o f corruption. An added complication is the endemic arrears in teachers' salaries. The Ministryo f Educationand Culture reports that payment o fteachers' salaries i s in arrears in the amount o f 43 million som (about US$930,000) as o f September 2 0 0 2 . ~ ~ 120. More important, there i s an increased inequality inthe quality o f education and in access to education, as the shrinkage o f central budget support has led to increasing reliance on unevenly available local financing, parental contributions, tutoring, supplementary financing through the rental o f premises, and non-educational activities. On average, 35 percent o f the expenditures o f primary schools in urban areas and 25 percent of the expenditures o f rural schools come from non-budgetary sources. The increasing reliance on these non-budgetary sources i s not only a source o f increased inequality but also threatens to displace the core teaching function o f primary and secondary schools. 121. The cessation o f new school construction has led to excessively intensive use o f existing school facilities. Only 10 percent o f primary schools operate on a single shift. Fully 81 percent o f rural schools and 71 percent o f urban schools operate on double shifts. Nine percent o f rural schools and 19 percent of urban schools operate on triple shifts. 122. Finally, parental contributions have become an important source o f financing for school maintenance, fuel, and other necessities in urban schools. Parental contributions to urban schools often exceed US$lOO per year per student. Parents also contribute to schools inrural areas, but widespreadpoverty means that income from this source i s very limited. The reliance onparentalcontributions is a major source of inequity inthe quality o f education (see Table 6.3). Table 6.3: Sources of Financingfor Primary School Expenditures Urban schools Rural schools Total 100% 100% Government budget (Republican + local) 65 Yo 15 % Tutoring 19% Parents' fees 13 % 27 % % NGOcontributions 2 % 8 % Private sponsors 1 Yo 6 Yo Income-earning activities 0 Yo 2 % Source: Monitoring Learning Achievement, Bishkek, 2001. 36 MonitoringLearningAchievement, Bishkek, 2001, 37 Kyrgyz News, September 2,2002. 46 123. To address these issues and to support the development o f the Kyrgyz Republic's most important economic resources-its human resources-it i s proposed that a Comprehensive Education Reform be developed, encompassing issues such as low wages, central or local finance, rehabilitation needs, pensions and curricula, and the optimal decentralization balance for management. Once developed, this reform can be supported by gradual increases in budget allocations-which could reach 6 percent o f GDP in2005-7, but these dynamics mustbe worked out indetaiL3* 124. Low Teacher Salaries. Teacher salaries, on average 857 som per month in 2001, are low in both absolute and relative terms. In absolute terms, they are only half the minimum consumption level for individuals, not to mention households. As a result, teachers lack motivation, and are compelled to work at other jobs in order to support themselves and their families. Inhigher education, low faculty salaries have contributed to a serious problem o f corruption, with students often paying for admission and grades. This has led to a severe deterioration in the quality of education. More significantly, it has led to cynicism on the part o f employers and the public regarding the significance o f higher education diplomas, except for the few institutions that have been able to prevent or control corruption. 125. Teacher salaries are also low in a relative sense, as shown in Table 6.4. Average monthly earnings inthe education sector arejust 857 som, versus the considerably higher average earnings in all other sectors except forestry and health. It is notable, in particular, that average teacher salaries are less than 40 percent o f average earnings in public administration. Table 6.4: Average Monthly Earnings in 2001 by Sector (incurrent som) Sector Average Monthly Earnings Health 710 Education 857 Industry 2,466 Transport 1,684 Communication 3,030 Construction 1,894 Trade 936 Finance 4,650 Public administration 2,159 Forestry 556 Source: National Statistical Committee. 126. Under the reforms being piloted in the health sector, the introduction of copayments and health insurance payments, accompanied by a sharp reduction in staffing, have led to major efficiency gains and significantly higher earnings for physicians and other health staff.39 They have also sharply reduced corruption as under- 38In an address to the Annual Conference of Schoolteachers in Bishkek on August 27, 2002, President Akaev announced the government's plan to allocate 6 percent o f GDP to the education sector by 2005. 39These improvements have been undermined during the 2002 budget year because the MoF has reduced central financing by the amount o f the efficiency savings, thereby removing the incentive for health sector staffto maintain the reforms. 47 the-table payments for health services have been replaced by the more transparent system o f copayments. Teachers do not have equivalent opportunities to supplement their income (although some activities, such as mentoring new teachers, or providing community education or remedial education, might be compensated through supplementary income). Moreover, whereas copayments are desirable inthe health sector to discourage excessive use o f health services, they are not desirable in the education sector at the compulsory education level, where fuller use o f education i s to be encouraged, not discouraged. Although class sizes in urban schools are relatively large by OECD standards, there are opportunities insome cases to release resources that might help finance increased teacher salaries. A more widely applicable approach to mobilize savings to help finance improved teacher salaries i s to raise required teaching hours, which are very low by international standards. It would be easier to implement a plan to improve teacher salaries in exchange for more intensive use o f teachers if it i s undertaken on a voluntary basis by individual rayons or oblasts. 127. The goal o f increasingteacher salaries would be more feasible ifsome ofthe costs o f this measure were to come from efficiency improvements within the sector. There is considerable room for seeking more intensive use o f teachers in exchange for higher salaries. The required teaching hours in the Kyrgyz Republic are low by Western standards. Teachers inprimary and secondary schools are requiredto teach 18 50-minute class periods per week (Table 6.5). This has been reduced from the 22 to 24 hours per week that were required duringthe Soviet period. The requirednumber o fteaching hours defines a standard teaching load, or "norm." Teachers are paid for teaching hours above the norm, upto 2 norms per teacher. Teaching more than the minimumteaching load is a widespread practice. Table 6.5: Teaching-Hour Requirementsin Primary Education Kyrgyz Republic and Selected Comparator Countries RequiredTeachingPeriods Country Per Week France 27 Portugal 25 Belgium 23.3 Turkey 20 Kyrgyz Republic 18 NewZealand 25 UnitedStates 33 Source:Education at a Glance,2001, OECD. The figure for France includesnon-teachingtime for consultation, 128. To address the issue o f inadequate teacher salaries, it i s recommended that the government develop and subsequently implementthe necessary legislation and decrees to encourage rayons to achieve savings in teacher deployment through higher required teaching hours and reduced numbers o f teachers and, where possible, increased average class sizes in conformity with international standards. To increase the incentive for local governments and teachers to pursue such efficiency gains, local governments should be allowed to keep the savings from these measures for other educational improvements, and should be permitted to use part o f the savings to increase teacher salaries inexchange for higher minimum teaching hours. 48 129. Central or Local Financing. Economic theory predicts that reliance on local financing for services that provide widespread benefits (or "externalities") will lead to lower levels o f financing and provision than reliance on central financing. Education expenditures are widely recognized as generating widespread indirect benefits for society, beyond the direct benefits that accrue to the individuals who are educated. This i s particularly true o f initial education. Relying on local governments to finance primary and secondary education in any setting risks underspendingon education, or providing a lower level o f educationthan the economically efficient allocation. This i s a predictable outcome o f decentralizing financing responsibility for pre-university education, and it is, broadly, what happened in the Kyrgyz Republic after decentralization. Improving this situation will require changes in the financing formula, as outlined in Chapter 6 in Volume 11. Inbroad terms, the funds that the central government makes available to local governments (i.e., the categorical grants) should flow as a differentiated capitation system o f financing, which pays providers for education on the basis o f the number o f students enrolled in each type o f program. Developing such a formula will require a careful examination o f the sources and magnitudes o f intrinsic cost differences prior to the implementation o f the formula, as well as a consideration o f the cost of training, and a provision for heating and other utilities, which account for an unusually large share of recurrent costs. In the short term, it i s recommended that primary and secondary education textbooks and utilities, as well as teacher salaries, be financed under the republicanbudget inorder to provide more equal learning opportunities to all children. C. SOCIAL PROTECTION 130. The second part of the 1990s was characterized mainly by a strong shift away from explicit safety nets (in the state or Social Fund budgets) toward quasi-fiscal subsidies. This was the result o f a needed compression o f fiscal spending, particularly on wages and pensions and other entitlements, which required some relaxation on other fronts, mainly on pricing for most key services such as power, district heating, gas, public transport, and water and irrigation fees. Electricity, which i s a relatively abundant source o f energy in the Kyrgyz Republic, was perhaps the key vehicle for compensating households-followed by gas and district heating, which provide subsidies to those areas o f the country that are less afflicted by poverty. As illustrated in Figure 6.2, while per capita spendinginthe social and human development sectors was cut from about US$67 in 1995 to US$30 in 2000, quasi-fiscal per capita subsidies in the power sector were increased-albeit from an already highlevel. 49 Figure 6.2: Kyrgyz Republic: Evolution of Direct Social Spending and Implicit Social Subsidies, 1995-2001 I 751 T44.0 43.0 42.0 41.0 40.0 :::: 39.0 25 15 99 00 01 ~~ 95 96 97 98 1- CumulativeExplicit Social Spending -Cumulative Quasi-fiscalsubsidies 1 Note: Budgetary social spending includes health, education, social protection, and pensions. Quasi-fiscal expenditure is measured as the cost of two elements: (i) transmission and commercial losses above what would be acceptable by international standards, to the extent that these mainly reflect lax disconnection policies; and (ii)the difference between the statutory tariff and an estimated long-run marginal cost for the sector (US$2.3 cents/kWh). Sources: Dataprovidedby the authorities;authors' calculations. 131. The overall result was that spending on social safety nets, broadly defined to include price subsidies, became highly untargeted. The system as a whole also became unaffordable. The aggregated level o f social expenditures (both on budget and off budget) was estimated at about 12.2 percent o f GDP in2001, but as Table 6.6 illustrates less than half o f that was budgetary. Table 6.6 Kyrgyz Republic: Social Expenditure of Consolidated General Government, 1995-2001 (as share of GDP) 1995 1996 1997 1998 1999 2000 2001 Total Social Security,Welfare and offbudget social protection,O.W. 19.2 14.3 13.9 14.0 16.6 14.6 12.2 (a) Social insurance,O.W. 8.1 7.6 7.2 6.9 5.6 4.9 5.1 Pensions 7.2 6.9 6.5 6.3 5.1 4.4 4.7 Social insurance 0.7 0.5 0.4 0.4 0.3 0.2 0.2 Employmentfund 0.2 0.3 0.3 0.2 0.2 0.2 0.2 (b) Welfare programs, O.W. 4.0 2.0 1.1 0.7 0.9 0.8 1.2 Allowancesto poor families 31 4.0 1.8 1.0 0.7 0.7 0.3 0.6 Social allowances ... 0.2 0.1 0.1 0.1 0.1 Child allowances .., ... ..... ... 0.0 0.0 Privileges4/51 ... ... ... ... ... 0.4 0.5 (c) Estimatedlevel of quasi-fiscalsubsidies(due to the low prices) 7.2 4.8 5.5 6.4 10.1 8.9 5.9 I/Includestherepublicanandlocalbudgetsandtheextrabudgetaryfunds.Expenditureisprovidedonacashbasis. 2/ Grantedto certain categories o f individuals. 3/ SpendingunderUnified Monthly Benefit (i.e the only means-testedprogram). Before 2000 was not reported as separate line itemin the budget. Sources:MOF of KR, National Statistics Department; WB staff calculations. 50 132. Today, therefore, social protection is provided through: (i)social security programs based on insurance principles, including pension provision, sickness and maturity benefits, and unemployment benefits (about 5 percent of GDP in 2001); (ii) welfare programs (about 1.2 percent of GDP in 2001); and (iii) quasi-fiscal subsidies (about 6 percent of GDP in2001). This sectionbriefly discussedthe first two. 1. Pensions 133. Pensions for the elderly are the main social expenditure (4.7 percent of GDP). With a low taxable wage bill, the pension system is strained financially and can afford only small average pensions-often paid inkind and almost always late. Budget support was needed for the past few years, with the exception of 2001. Pensions fell inreal terms after the 1998 crisis. As a result, expenditures dropped by 1.8 percent of GDP between 1998 and 2001. Increases (above inflation) in2001, and early 2003 are expected to bring the averagepension levels to 81percent of the 1998 levels by end-2003. Currently, there i s considerable pressure to increase benefits, some of which are genuine as the system cannotprevent some pensioners from falling into poverty. 134. However, the current level of collection do not afford increases above inflation- on average-and the contribution ratesare already too high, preventing the formalization of the economy and the enlargement of the contributory base, and thus should be reduced rather than increased. Since total spending cannot increase, as a share of GDP, the government has beenincreasing pensions selectively. 135. The 1997 pension reforms redefined current and future pension entitlements to reflect the expected long-term revenues of the Pension Fund. The rising retirement age andthe elimination of many early retirementprivileges are expected to raise the average number of contributors per pensioner, improvingthe system's fiscal health. Accordingly, if policy makers choose to adopt a conservative approach to pension policy, long-term projections indicate the possibility of expenditures converging to about 3.5 percent of GDP-which would allow a reduction in the payroll contribution rate, as a deliberate policy choice as the economy expands. 136. So far, the 1997 reforms have generally been delivering broadly what they promised (including a spread of pension benefits around the mean of US$10 dollars) and they seem likely to continue to do so if policy makers make consistently disciplined choices. Pension expenditures reached their lowest share o f GDP in 2000, when they represented 4.0 percent o f GDP. The system was approaching a balance in 2001, although this was achieved partly by co-opting social insurance raised for health and other purposes. Since 2000, the increase inpension expenditures on current benefits, as a share of GDP, has been due primarily to a faster increase in pensions than in prices, rather than to a particularly high burden of new benefits (number of pensioners). Accordingly, expenditures on pensions from social insurance are expected to reach 4.4 percent of GDP in 2002, after including the recent increase in May. This estimate excludes expenditures on: (i)pensions for military personnel and policemen; and (ii) administrative costs, which together amount to about 0.5 percent of GDP. The financing 51 gap in 2001, which was covered by planned State Budget transfers, was about 0.5 percent o f GDP. It i s expected to be about 0.7 percent o f GDP in2002. 137. Nevertheless, there remains unfinished business from the 1997 reform agenda. The failure to legislate an intendedmechanism for indexingpreviously awarded pensions in a sustainable way has made the system's financial health dependent on continued prudence and restraint by policy makers. Steps to eliminate in-kind collections and payments must be completed successfully. Institutional developments are also needed: (i)improvecollectionperformance; (ii) createamuchstrongerinformationbaseon to to differences between and within pensioner subgroups inpatterns o f household income and in economic and social characteristics including energy use; (iii) establish more to transparent accounting systems that meet international standards; and (iv) to improve record-keeping, auditing, and other technical requirements for efficient administration. Moreover, the timing during the year o f State budget transfers and the collection o f revenues must be matched better with the pattern o f disbursements required to pay pensions on time so that arrears inpension payment during the winter and spring periods (as in 2001) can be avoided. In 2001, this situation implied not only arrears but also some "predatory borrowing" from revenues collected for the Employment and Health Funds. 138. There are other short-term, medium-term, and long-term policy concerns: First, the system is under current and medium-term fiscal pressure. Striking evidence comes in the way that pension spending continues to crowd out important health expenditures by diverting revenue collected for the health and employment social insurance programs. Moreover, although budget transfers are programmed to finance benefits outside the insurance framework, additional transfers will be required in 2003 to offset the cut o f 3 percentage points in the rate o f pension insurance contributions that took effect in2002. Further increases inpensions above prices before 2005 would leadto arrears unless they are offset by additional budgetarytransfers. Another medium-term problem i s that, even with relatively strong economic growth, it will be at least 2009 before averagepensions reach the poverty line or base pensionsreach the extremepoverty line. w Finally, the stock o f pensioners (excluding military personnel and police) i s expected to continue to decrease until2007 and will then increase, However, the ratio o f contributors to pensioners will remain relatively high because the current population is young, the proportion o f working-age adults i s increasing, and future pension entitlements will be limited to those contributors who have been insured. A key long-term problem is that coverage of the current contribution-based pension system isprojected tofall gradually to 70 percent in year 2040 ifcurrent patterns o f contribution (and non-contribution) to social insurance persist. The proportion o f new retirees, disabled people, and survivors who qualify to receive 52 pensionswould also fall. This is because only 60 -70 percent of the current labor force i s insured for pensions and so will have satisfied the new requirement for years o f contributory employment. Hence, the number of beneficiaries will slowly converge to the number of insured. Furthermore, a key reason for the low participation rates is that contribution rates are already so high that they discourage formalization of the economy andthus enlargement o fthe contributory base. 139. More importantly, policy makers would like the system to provide larger pensions more quickly than the pension system adopted in 1997 was designed to deliver. This desire results from the recognition that the purchasing power of pension benefits remains inadequate for many, if not most, pensioners. For example, the average pension i s only two-thirds of the general poverty line; and the base pension is about two-thirds of the extreme poverty line-which inturncovers only the food budget incorporated within the general poverty line. 140. These concerns about poverty among pensioners are certainly appropriate. Pension benefits play an important role in alleviating poverty among Kyrgyz pensioners. For example, analysis shows that pensions reducedpoverty among pensionersin 1998 by 12 percentage points (Table 6.7). Ifpensions had not been paid but everything else had remained the same, the poverty rate for all pensioners in 1998 would have been 67 percent instead of 55 percent. Moreover, this estimated effect i s statistically robust. The most important impact o f pensions on poverty is among aged pensioners above the standard retirement age. Had pensions not been paid, poverty among this group would have been higher by 14 percentage points. Similarly, in the absence of pensions, the average rate of extreme poverty among aged pensioners would have been 30 percent insteadof 18 percent. Risk of Poverty Risk of Poverty ifpensionswere not paid Type of population average 95% confidence average 95% confidence interval interval Total Population 0.64 0.60 0.67 0.65 0.62 0.69 Total Pensioners 0.55 0.50 0.60 0.67 0.63 0.71 Old-age pensioners 0.53 1 0.48 1110.58 1 0.67 1 0.62 11I 0.71 141. Figure 6.3 compares two relationships to show how the impact o f pensions varies by pension level. The solid line and the left axis show the risk of poverty among pensioners by increasing level of pension. The broken line and the right axis show, by increasing level of pension, the average proportion of the poverty gap that the pension benefit covered. (The poverty gap for a family is the difference betweenits poverty line and the sum of its members' expenditures if no pensions had been paid to them). The figure shows that, regardless of the level o f pensions, some pensioners are poor. It also shows that pension benefit helpedcover just under 30 percent of the poverty gap o f those pensioners receiving the lowest pensions. Poor pensioners and their families remain poor 53 or very poor after receiving pensions. However, even the very small pensions these families receive make a difference in their poverty outcomes. As one moves from the pensioner groups with the lowest pensions to those with the highest, their risk o f poverty generally decreases, while the proportion o f the poverty gap that their pensions cover generally increases. Figure6.3: Riskof Povertyand Amount of PovertyGap Coveredby Pension Benefit (by IncreasingLevel of Pension) 80% 70% 60% 60% 50% 40% 40% 30% 20% 20% 10% 0% ,, , , , I I , I I I ,, I 0% 1 - 2 3 4 5 6 7 8 9 10 Risk of Poverty (left axis) Percent of Family Poverty gap covered by Pension Benefit Source: Kyrgyz Pensions Policy Update, 2002. 142. In moving forward, the authorities must decide among the various pension objectives and act accordingly, including: Maintain the 1997 Strategy. Continue to balance the multiple objectives o f income adequacy, earnings replacement, fiscal balance and sustainability, and gradual decreases in the contribution rate for pension insurance. Index pensions, once awarded, to changes in a consumer price index. Recognize that more adequate pension levels will flow only to new pensioners, once economic growth raises real wages. Emphasize Adequacy of Incomes Over Earnings Replacement. Define the objective operationally as eliminating pensions that are less than the extreme poverty line. Next, freeze payments under the current pension system at their current nominal levels. They add a fourth component, supplementary assistance, to the payments due under the current system. Channel all future funds available for pension increases into this component. Use it to top up the lowest pensions first. Gradually increase supplementary pensions until, for those with no entitlement to pension from the earnings replacement components, it reaches a ceiling level equal to the extreme poverty line minus the base pension. This could be done either with current funding only, or with current funding plus any additional budgetary transfers available. Recognize that this would let the purchasing power o f larger pensions decline or grow more slowly and that it would also reduce the incentive for workers with higher incomes to participate in the pensionsystem andto contribute to it.Once the operationalobjective has been 54 met, start to unwindthe revised system. First, increase supplementary assistance payments in line with the indexed value o f the extreme poverty line. Second, use remaining revenues for pension increases to raise pensions with earnings-related components progressively to the levels they would have had inthe absence o f the freeze. This process would, once again, top up pensions "from the bottom up" as funds permitted. Combine Previous Option with Slower Reduction in Contribution Rates. Delay gradual reductions in the contribution rate. Redirect those resources within the pension system to improving the adequacy o f benefits, enabling the objective o f Option 2 to be achieved faster. Recognize that the total tax rate on earnings would remain very high and, as a consequence, there would remain very substantial disincentives that would discourage: participation in social insurance arrangements; growth in formal employment; efficient use o f labor (and, indirectly o f capital); and new development within the private sector.40 143. Inaddition, the government is advisedto identifythe prerequisites for introducing a Funded Pension Pillar. The National Poverty Reduction Strategy includes a commitment to pursue a transition to a "funded" or "accumulative" basis for the pension system. This approach seeks to replace notional individual accounts with accounts that really accumulate invested funds. Such a system has numerous prerequisites. Accordingly, initiate analyses to identify the prerequisites for introducing a funded pension pillar, to determine the actions required to meet those prerequisites, the time neededto complete these actions, and the proper sequencing o f these activities. Identify the costs for individuals, the budget, and the economy as a whole in attempting such a transition. Complete these feasibility analyses before taking any irrevocable steps towards implementing this approach. 144. Finally, revenue collection must be improved. To this end, the authorities are to develop a modernization system for the revenue system that addresses arrears in payment, evasion o f contribution obligations, and the high rate o f participation in the informal economy. Increase integrationo f social security contributions and the collection o f personal income, land, and patent taxes. Enforce a strict separation of the account for contributions to the MHIF, and to prevent the diversion o f health resources to finance pension payments. Adjust contribution rates to eliminate current indirect flows of revenues to the MHIF fund via the pension and employment funds. 40Present expectations are that the reductions would gradually lower the overall contribution rate from 29 percentofthe gross wage to 21percent, and the portionofthese contributions that would be recordedinthe individual accounts from 23 percentage points to 15 percentage points. Under this option, those reductions would be scaled back in whole or part or slowed down. 55 2. Social Safety Net 145. The budgetfinances the following programs: 0 A Unified Monthly Benefits (UMB) system (a means-tested cash benefit for the poorest families) and the State Social Benefits (categorical cash benefits paid to orphans, certain groups o f individuals and elderly people ineligible for pensions), which mainly support food consumption. The UMB has been developed by the government and has been broadly recognized as the most targeted social assistance instrument inthe Kyrgyz Republic. Energy price discounts for electricity consumption (up to a fixed upper limit) to privileged energy consumers, with the budget paying the price difference to the distribution companies. About one-third o f the Kyrgyz population i s eligible for these privileges.InNaryn Oblast, the entire population receives such discounts. InBatken Oblast, discounts are provided to about 60 percent o f households. These discounts are different from the general low pricing o f energy. 0 A means-tested program o f housing subsidies for multi-dweller buildings in the capital. 0 A new set o f "socially protected energy prices" (for gas, hot water, and district heating) for all parts o f the country excluding Bishkek City. 146. The government has allocated about 1.3 percent o f GDP or about 3 percent o f public expenditure for the financing of the above programs in the 2002 budget, after a significant increase aimed at mitigating the impact o f the March 15 2002 increase inthe price o f electricity. In addition, the government aims to overhaul the system o f price discounts (second bullet above) as the means o f providing social protection, and has submitted a draft Law on State Benefits with that inmind. The current draft law has been the result o f consultations by the Ministryo f Labor and Social Protection with numerous stakeholders, including Parliament and the affected beneficiaries. It would not only reduce the number o f untargeted privileged categories, but would also introduce more transparent rules for determining these benefits. Any remaining entitlement i s expected to bepaid incash rather than as a price discount. 147. At the same time, the authorities have beenmaking substantial efforts to improve the UMB program. The most recent efforts include an increase in the budget, a commitment to make most payments in cash, and the launching o f a monitoring effort in the form o f an "audit" of beneficiaries that will be carried out by an independent local institution. Previous assessments suggested that the system has been relatively well targeted in the use o f resources-a result mainly driven by the fact that the targeting formula i s dominated by the number o f children in the family, which correlates strongly with poverty. However, the authorities have found that a substantial portion o f the poorest households are not reached by the UMB. 56 148. On social assistance, the government must continue its ongoing efforts to de-link any provision o f benefits through distortionary means, such as price discounts-except perhaps for a regional discount to remote areas funded from the budget. Securing the support o f the Parliament for the current draft Law on State Benefits i s essential in this respect. Furthermore, efforts to improve the targeting and delivery o f social protection must continue, particularly to further strengthen the UMB program. Finally, efforts should be made to further develop safety nets for vulnerable groups, such as the disabled, children without parents, and the pockets o f poverty in Bishkek. The Naryn region has beenfound to be the poorest by far invarious poverty assessmentsmade by the National Statistical Committee as well as those made by the World Bank. It poses a special challenge to the social protection system. 149. The authorities also run assistance to the unemployed (both passive and active) through the Social Fund. The amounts spent, however, are minimal, creating severe rationing o f resources among a substantial number o f unemployed-even if only those who registered are counted. In general, the real potential for creating jobs lies with the private sector-and their work cannot be facilitated through social policies. Inthis regard, most international reviews have found little evidence that active labor market programs represent an effective use o f resources. The Bank's 1999 Review o f Kyrgyz Social Expenditures also questioned the effectiveness o f unemployment insurance. In this regard, efforts should be made to curtail interventions for the unemployed-and rather to focus Ministryo f Labor and Social Protectioncapacity and financing on programs for the poor. A first step in this direction would be to transfer these programs-and their financing-from the Social Fundinto the budget. 150. On social assistance, the government must continue its ongoing efforts to de-link any provision o f benefits through distortionary means, such as price discounts. Securing the support o f Parliament for the current draft Law on State Benefits i s essential in this respect. Furthermore, efforts to improve the targeting and delivery o f social protection mustcontinue, particularly to further strengthen the UnifiedMonthly Benefit program. D. TRANSPORT 151. Roads. Road transport is the predominant mode, with rail and air transport playing a much smaller role. Inrecent years, only minimal routine maintenance has been performed on the network under MOTC and periodic maintenance has been undertaken on only 250-300 km annually. There has been no maintenance on local roads under MOTC, except for emergencyrepairs. 152. There has also been no maintenance on the 15,000 km o f farm roads, previously built by state and collective farms. Clearly, the priority is to complete the Bishkek-Osh road as soon as possible, to overcome the "hump" ininvestments and to free up resources for maintenance. Consideration should be given to increasing the counterpart funding over the next two years, to speed the completionpresently planned for 2005. This would hasten the time whenbetter maintenance could be started for the rest o f the network. 57 153. While the finalization o f the Bishkek-Osh road proceeds, the MOTC should develop and submit maintenance scenarios to the government, indicating what size network can be maintained, to what standard, and for what level o f resources. Such a prioritization exercise i s needed because the available resources will not be sufficient to maintain the entire network-even if funding increased to international standards over the medium term (Le., to about 1percent o f GDP). This planning should be worked out over the next 18 months to two years, with a view to reaching a broad agreement and understanding within various branches o f the government on a realistic and affordable maintenance plan for the road network. 154. Greater user financing should be sought to (indirectly) support the maintenance program, which would mean that taxation o f road users should increase. As discussed in the taxation strategy, this would mean that the effective taxation o f cars and fuel should increase. The current funds nominally earmarked for road maintenance, namely, one- thirdo fthe turnover tax, do not come directly from roadusers and shouldbe allocated for overall budgetary purposes. Limited public resources suggest that earmarking these or any sources o f funding for road maintenance i s a luxury that the Kyrgyz Republic cannot afford at the moment. The MOTC must compete with other sectors for scarce resources duringthe budget process, which makes it most important for the MOTC to produce the scenarios o f O&M suggested above. The current Road Fund, which works only as a recording system, should be dismantled. 155. Transport Operations. The government has made good progress in reducing its role as a transport operator. Although many former state-owned companies are still joint- stock companies owned by the government, they operate on commercial principles and have not beenreceiving contributions from the budget. Since transport demandhas fallen off drastically over the last decade, most joint-stock companies are still overstaffed, in spite o f substantial retrenchment. Equipment i s grossly over-aged and costly to operate and maintain. For these two reasons, operating costs are higher than they could be under a fully commercial operation. Consolidation can be expected among the joint-stock companies and failures among the private companies. 156. The government should sell its remaining shares in all intercity freight and passenger transport companies. Inthe case o f urban transport, the main problem i s inthe capital city, Bishkek. Except for the Trolleybus Company in Osh, all other urban services are runby the private sector. Despite substantial allocations from the city budget inBishkek,the busandtrolleybus companies have highoperating losses andnoresources to renewtheir deteriorating fleets. Bus services should be fully privatized and operations should be competitively tendered. As part o f the privatization process, the government should review the public service obligations (PSOs) that it imposes on passenger transport-both intercity and urban. Not only are the tariffs fixed by the Anti-Monopoly Committee, but there are many classes o f passengers that are either fully or partially exempt from payment o f fares. The resulting losses to the companies are only partially compensated by the government. On one hand, transport enterprises need to improve their efficiency, and on the other, the government should compensate the enterprises for the PSOs it imposes on them. 58 157. Rail. Rail traffic has fallen off drastically since 1990. Freight traffic is now only 13 percent o f its 1990 level and is still falling. Passenger traffic is about 25 percent of its 1990 level. After running operating deficits until 1998, the railways now operate with a small but increasing operating surplus. This was obtained by reducing staff by almost 20 percent and reducing the number of passenger trains. However, the railway i s still overstaffed for its traffic level. Productivity is about 82,000 traffic units (tkm +pkm) per employee, which is about half of that in the Albanian railways in 1990, and about one- tenth that of a more efficient railway, such as that of Korea. While freight services are profitable, passenger services are losing money, since fares are regulated by the Anti- Monopoly Commission. There are no public funds going to the railways at this time. 158. Studies continue for a rail link from the Chinese border (Torugart Pass) to either the FerganaValley, where it would connectwith the Uzbek railway or to Balikchi, where it would connect, through Bishkek, with the Kazakhrailway. This is ongoing despite the fact that previous feasibility studies have clearly shown that there was no economic justification for the Kyrgyz Republic to spend US$1.5 to 2.5 billion on such a line. Previous consultants recommended the development of a "Multi-Modal South Kyrgyzstan Transport Corridor," which would require a detailed feasibility study of the minimumroadimprovements neededprior to any investment commitment. 159. Civil Aviation. On May 15, 2001, the Kyrgyz civil aviation sector was reorganized into three independent entities: the national airline, the airports, and air navigation. The first two are joint-stock companies under the State Property Fund and the third i s a departmentof the Ministry of Transport and Communications (MOTC). 160. Air transport consists of the national airline (KAJ) and 16 companies that have registered to operate as private airlines, of which 5 or 6 have started operations. There are no explicit subsidies from the state to either the national or the private airlines at the moment. However, since they are losing money on domestic services, which they are forced to operate for social reasons at fares fixed by the Anti-Monopoly Commission, they receive a 50 percent discount on air navigation services and airport fees. The company is used also for government services for which it does not always receive payments. These arrangements fit the definition used by this PER of quasi-fiscal activities, andthus the same recommendations apply: they must be made transparent. The company also loses money on international flights, at least under international accounting standards. Inaddition to operating old and inefficient aircraft, and having to bear the cost imposed by the authorities through discounts, the company still has over 1,200 employees. The government should carefully weigh the benefits of keeping a national airline inthe light of its cost. 161. The Airport Company includes the three .main airports in the country, Manas (Bishkek), Osh, and Karakol. Other small airports and landing strips have virtually been abandoned. Only Manas Airport i s presently financially self-sufficient; the other two airports are losing money. They have been attached to the company, so that the surpluses expected at Manas would cover losses at the two smaller airports. For the sake of 59 transparency, it would be better to subsidize the two smaller airports directly from the (state or local) budget. E. IRRIGATIONAND AGRICULTURE 162. Agriculture is the dominant component of the Kyrgyz economy, accounting for 47 percent of GDP in 2001. Its impact is even greater if services and manufacturing activities that are closely related to agriculture (e.g., the food industry) are taken into account. Owing largely to strong reform efforts, agriculture has made a relatively better recovery than the rest of the economy, particularly primary production. 163. higalion. The operations and maintenance of the irrigation infrastructure (about 900,000 ha in total) broadly consist of two kinds of expenditure-maintenance of head works and the (off-farm) main canal system, and maintenance of the on-farm infrastructure. A good part of the infrastructure has fallen into disrepair, though the essential pieces are being rehabilitated with donor support. A draft strategy-still to be further developedandadoptedbythe government-suggests atwo-track approach. 164. First, the financing of the bulk of O&M should be borne by farmers over the mediumto long term. Over the next few years, however, the government will still play a key role in O&M spending but over time it will focus only on a reduced area, perhaps 200,000 ha, which i s to be selected on the basis of social need (i.e for the poorest regions). 165. Second, the role of government indelivering actual O&M is to be delegatedto the Water Users' Associations (WUAs). The central government (and perhaps also the oblast level governments) would play a mainly regulatory role in laying out the rules for the WUAs and the communities, and also in monitoring the use of water resources. Water use would be regulated through licensing abstraction and return flows (based on an assessment of the overall demands for and availability of the water resources) and through maintaining and enforcing environmental protection standards. 166. Inthis overall strategy, the government would be expected to play a regulatory role, as well as a role in terms of providing assistance of last resort, mainly to communities inneed. The government would negotiate all water issues with neighboring countries. Part of the overall strategy, that related to the creation of WUAs, is already under implementation. Up to now, there are 55 legally registered WUAs and around 153 informal ones. Much more progress i s needed in forming WUAs and in having them assume more maintenance responsibilities. 167. Progress inregulatory issues, including transferring the right from the Parliament to the government for the setting of pricing strategy, i s lagging, however. To illustrate the magnitude of the challenge o f resource mobilization, it can be mentioned that total proceeds remain limited because the fee remains low (som 15 per 1,000m3 until 1999, when it was increased by the Parliament to som 30 per 1,000m3, or US$60 cents). Estimates of the average cost of maintenance vary. Even if a cost of US$lO per 1,000m3 i s assumed-the lowest of all the sources consulted-the total cost comes to about US$9 60 million (som 450 million) which i s more than twice the Department o f Water Resources (DWR) budget in2001, And this would be more than 10times the irrigation fees ifall the fees were collected. 168. Overall, calculations show very clearly that the DWR will not have sufficient funds under the present system of financing the O&M costs of head works and primary/secondary canals. Thus, donor support will have to continue, or even increase, to enable the irrigation infrastructure to be saved. Inany case, greater emphasis on policy i s required. 169. The key next step i s for the authorities to further develop this irrigation strategy. This would meanthat the DWR should begina program o fconsistent long-term planning o f expenditure needs, in connection with the irrigation system, to ensure that there i s an explicit framework for formulating a path for managing and containing the costs. There are also equity considerations that justify donor support to the sector, but greater emphasis i s needed on policy. 170. Agriculture. Parallel to putting irrigation funding requirements on a more predictable and sustainable basis, attention could be directed to other important public functions, notably research, extension, regulation, and the creation o f marketable individual land ownership rights. At the moment, the pattern o f government activities in agriculture i s distorting, with excessive intervention in some areas, and underfundingin others. The government (through off-budget means) has an overextended role in agricultural inputs and machinery, and has allowed input market interventions to seep into decisions in other areas, notably in the allocation o f land to public seed institutions. Output market interventions are relatively restrained by comparison, although the public wheat reserve i s rather large. 171, Research, extension, and land reform appear to be underfunded. This appears to be justified only in the case o f research, where reforms have only recently started. The government has rightly begun consolidating the functions o f several different research institutes previously scattered across several ministries into the Ministry o f Agriculture and Water Resources, but muchmore progress i s needed. 61 7. SELECTED INSTITUTIONALCONSTRAINTS A. CONSTRAINTSTO RESOURCE MANAGEMENT 172. The Kyrgyz Republic has taken important initial steps toward establishing public expenditure management (PEM) institutions.A basic legal framework for budget preparation and execution was established in the mid-1990s. In 1996, the Treasury system became operational, making the Kyrgyz Republic the first CIS country to have a functioning manual Treasury. A revenue sharing arrangement was designed to provide more stable budgetary financing to the local governments. 173. Currently the state budget comprises recurrent republican (central) and local government expenditures, and the domestic counterpart for foreign-financed projects. The bulk of capital expenditures are under a separate program-the Public Investment Program (PIP), which still lacks a formal budget formatiodexecution process. There is also an extrabudgetary arrangement for managing social insurance revenues and expenditures-the Social Fund, which is regulated by the Law on State Social Insurance and the Law on State Pensions. The fiscal operations of the Social Fund are reported to the Parliament. 174. Efforts notwithstanding, the annual budget does not yet provide a comprehensivepicture of the coverage of all thefiscal activities. Key steps have not beentaken in various areas, such as the integration of the recurrent and capital budgets, and there are various off-budget activities that make it difficult for the authorities to prioritize the use of resources. Moreover, the state budget i s fragmented by a widespread use of non-cashtransactions and special means. Finally, a number of social activities are runthrough state-ownedenterprises (SOEs) inthe form ofhighly subsidizedprices. 175. This section focuses on: (i) extrabudgetary funds; (ii) off-budget transactions; and (iii)factorsthatfragment thebudget.41These'three sets ofissuesimposetremendous impedimentson the ability ofthe authorities to react to shocks or to change the course of fiscal policy. Certain activities are run as entitlements outside the budget, which i s inappropriate given the need for the authorities to adjust fiscal policies. Non-cash transactions, special means, and to some extent protected items in the budget, predetermine budget outcomes to a large extent. As a result, there is generally a wide difference between the budgets and the actual outcomes in spending by function, as Figure 7.1 shows for the year 2000, which combines the state budget with the initial implementation plans regardingthe PIP. 41The chapter does not give extensive coverage to the full PEM agenda, which the authorities are developing in close collaboration with the World Bank (through a Governance Structural Adjustment Operation, and the Financial Accountability Assessment), the IMF, and other donors. 62 Figure 7.1: Implementationof Spendingin the State Budget and the PIP, by function, 2000 Other Interest Agriculture total SocialSecunty & Welfare Other economc affaus Education total Health total Transport and communic Mmmg & Manufact Fueland energy Houslng total GPS Defense Public Order Recreation & culture Total expenditure 0 20 40 60 80 100 120 140 176. Table 7.1 attempts to quantify quasi-fiscal activities that were discussed earlier in Chapter 3, together with the extrabudgetary and off-budget activities. It is based on a limited set of information available. Quasi-fiscal operations in the power sector, measured as low tariffs only (i.e., without accounting for large levels of losses), accounted for about 6 percent of GDP (line A inTable 7.1). This, and at least 14 percent of GDP of public funds handled through extra-budgetary funds and off-budget operations (line B inTable 7.1), brings the size of the state in2001 to about 42 percent of GDP on a gross basis. Out of this total spending, Parliament approves only 18 percent of GDP when it reviews the state budget (line C in Table 7.1) and an additional 5.4 percent of GDP when it considers the budget of the Social Fund in a separate session (line B.1.iin Table 7.1). Parliament also receives an attachment on the PIP (4.4 percent of GDP as shown inline B.2.ii inTable 7.1), but does not approve it.42 177. Table 7.1 also attempts to illustrate the degree o f flexibility inthe state budget. O f about 18 percent of GDP (line C), about one-third cannot be changed as it is tied as special resources or offsets (lines C.l and C.2). Ifprotected items are included, then only 5 percent of GDP can be effectively decided upon. Strong short-term action in these areas i s a prerequisite for greater selectivity and prioritization in the use o f budget resources. It is also essential for reininginthe country's fiscal stance. 42 The analysis in Chapters 2 and 4 is based on the consolidation o f these three items made by IMF and World Bank staff. 63 Table 7.7.1: ExpenditureAllocationby Levelof Government andExtrabudgetaryFunds, 2001 2001 % GDP % intotal Broadlydefinedtotalexpenditure 39.2 100.0 A. QuasifiscalOperationsand Managementof SOEs na na. 1. Price Subsidiesa/ 5.9 15.0 2. Operational savings (-)or losses of SOEs b/ na na. B. Extrabudgetaryfunds and Off-budgettransactions 12.4 31.6 1. ExtrabudgetaryFunds na na i Socialfund, ---- Health O.W. 5.4 13.9 Social InsuranceFund 0.2 0.5 EmploymentFund 0.2 0.5 PensionFund 4.8 12.3 & MedicalInsuranceFund 0.2 0.5 ii.SmallandMediumEnterprisesupportfundcl 0.01 0.02 iii.Privatizationfundd/ 0.1 0.1 iv. Economic developmentstate fund na na v. State MaterialReservefund el 1.o 2.5 2. Off-budget Operations 5.0 12.7 i.Grantsoutsidethebudgetf/ 0.6 1.5 ii.ForeignfinancedPublicInvestmentProgram 4.4 11.2 C. State BudgetExpendituresg/ 18.5 47.2 1. Spendingthrough special means 1.6 4.0 2. Non-cashsettlementh/ 4.9 12.6 3. Protecteditems i/ 6.9 17.5 a/ Pricesubsidies(excluding losses of electricity) for electricity. Other price subsidies were not calculated. b/ Not regularlycompiledby the fiscal authoritiesor the State PropertyFund. This is the only part of the fiscal activitiesthat is approvedby Parliament, althoughParliamentalso approvesthe SocialFundbudget in aseparate session. c/ Financedfrom 3 percentshare of privatizationproceeds. d/ Financedfrom 7 percent share of privatizationproceeds. e/ Total resourcesspent by this fund are classifiedas confidential.Amounts included are estimatesbasedon the realizationof in-kind assistance. f/ Includesan in-kind grant worth Yen 800 million in2001 as well as about 4,600 tons of diesel fuel purchasedthroughthe proceeds ofthe second Japanese Grant (KW). g/ Amount approvedby Parliament, excludesSocialFundandthe foreign-financedPIP. h/Includespaymentsofutilities, subsidiesto SOEs, paymentsfor privilegesto SOEs, VAT refundfor gas, halfofUMB, halfof capitalrepairs, andcollections from the EconomicDevelopmentFund.Non-cash settlement couldalso be estimatedas tax collectionsfrom the energycompanies, plusthe relatively smaller amounts reportedby the Treasury as collectionsin-kind andoffsets. i/ Wages, socialsecurity contributions,and foreign interest payments. Source: World Bank staffcalculationsbasedon informationfrom the MoF andother agencies. 64 1. ExtrabudgetaryFunds: SocialFund,Economic DevelopmentFund, State MaterialReserveFund,PrivatizationFund, and StatePropertyFund 178. The eight extrabudgetary funds (The Social Fund comprises four extrabudgetary Funds) in the Kyrgyz Republic handle at least 15 percent of total public resources according to available accounts. Such a high level of earmarking reduces the resources available for fiscal policy. It also makes it difficult to take stock of the public interventions-a key objective in the formulation of the Medium-Term Expenditure Framework and the National Strategy for Poverty Reduction. Moreover, the multiplicity of extrabudgetary funds undermines oversight and accountability in the management of public resources, since some of the activities are not subject to the regular procurement and reporting requirements that apply to budgetary institutions. This PER recommends: (i) theEconomicDevelopmentStateFund;(ii) closing increasing the transparency of the the State Material Reserve Fund; (iii) corporatizing or closing the Small and Medium Enterprise Support Fund; and (iv) considering the inclusion of the Social InsuranceFund (although reducedin scope), the Unemployment Fund, and the State Property Fundinthe budget. 2. Off-BudgetTransactions: Grants and the PIP 179. There are two important types of off-budget transactions: off-budget grant financing and the foreign-financed public investment program (PIP). Off-budget grants are those grants not recorded with the Treasury, particularly those that generate financial flows for the recipient line ministries, provide direct or indirect finance to the state, or provide support to public enterprises (Box 7.1). This PER recommends ensuring that in- kind grants are auctioned off shortly after they are received-without government financing-and includingthe proceedsinthe budget. 180. The PIP represents the bulk of the capital investment and is already part of the macroeconomic framework of the budget. It is also included as an attachment to the Budget Law. However, decisions on PIP implementation do not follow any of the principles of the budget, nor its calendar. Rather, the pace of implementation is negotiated throughout the year. For example, some projects had not yet received budget approval on foreign disbursementsfrom the Goskominvest Commission or the MoF as of mid-2002, and this generated substantial uncertainty. The foreign part o f the PIP i s also implementedoutside of the Treasury. The PER recommends that the authorities take the few missing steps to fully integrate the PIP with the preparation and execution of the domestic budget so that the appropriate balance can be struck between capital and recurrent spending. Thus, the PIP program must be agreed on within the budget preparation cycle and approved by the Parliament. Furthermore, expectations of foreign disbursements for projects under a given spending unit must be part of their budget proposal. The PIP should also be executed on the basis of quarterly or semi-annual allocations ("warrants") to avoid interfering with contracting and supervision. A system for strict conciliation of bank statements should be developed to ensure that transactions are recorded in the Treasury. Finally, consideration should be given to merging the Goskominvest within the Budget Commission. 65 Box 7.1: Kyrgyz Republic,An Exampleof Off-budget Grants, 2001 Part of one donor fund (i.e US$5 million) receivedby the Kyrgyzgovernment in 2001 was usedto purchase4,600 tons of dieselfuel from Kazakhstanfor springworks, but bythe time the fuel was deliveredthe works hadbeencompletedandthe government decidedto sell the fiel, procure cotton from Kyrgyz farmers, and send it to Belarus in exchange for tractors. Fromthe proceedsof the sale ofthe diesel, about 800 tons o fcotton were procuredand sent to Belarus in exchange for 96 tractors, part of which shipment has not yet been received. The price ofthe tractors procuredunder this arrangementwas estimatedat US$12,000. The tractors were supposed to be distributedto the farmers under the loan agreement with the Economic DevelopmentFundo fthe MoF. Interest-freeloans were denominatedinKGS, at the exchange rate as of the date of the Grant Agreement. A three-year maturity was proposedstarting from the Grant Agreement date and translating into an actual maturityof two years for the farmerstaking intoaccountthe procurementdelays. There was no demand for the tractors from the farmers' side and the authorities have decidedto transfer the tractors to the state-ownedKyrgyzAiyl Tech Service. Source:PERMissionmeetings. 3. Fragmentation of the Budget: Special Means, Non-Cash Transactions, and Protected Items 181. Prioritization and strategic resource allocation in the Kyrgyz Republic are also limited because key components o f the state budget operate independently. The PER focuses on: (i) special means; (ii) non-cash settlements; and (iii) protected items. 182. Special Means. A large number o f budget-financed agencies (e.g., State Tax Department, State Customs Department, Ministry o f Justice, Ministry of Transportation, MinistryofEducation, Ministry ofAgriculture) collect andspendtheir own revenues (see Table 7.2). Although these revenues are reported inthe official budget, the framework for levying and retaining them needs to be tightened. This should include formulating clear objectives o f the rationale behind the imposition o f fees (Le., whether it follows the provision o f a service, i s part o f a cost recovery policy, or i s aimed at guaranteeing autonomy to the agency). Clear-cut criteria for the setting o f fees in each agency should also be developed and formally approved for each institution authorized to levy fees. Efforts should be made to reduce the number o f entities authorized to levy special fees, and to concentrate on the basic cases in which cost recovery must be pursued strongly (e.g., Department of Water in the Ministry o f Agriculture). Equally important is minimizing the number o f agencies that will be allowed to keep any portion o f the fee collected. Here, again, the most stringent criteria should be used, such as the need to maintain some independence or the fact that the institution i s not necessarily a spending unitbutis rather a service provider (e.g., higher educationinstitutions, researchinstitutes, and hospitals). Such a reform must be implemented in conjunction with a revision (and harmonization) o f the government's compensation policies, given that the fees currently represent a significant top-up to the base salary fundedfrom the general budget. 66 Table 7.7.2: Revenue and Expenditure from Special Means, 1999-2001 1999 2000 2001 Percent o f GDP Revenues: Payments for services 2.5 1.8 1.9 state fees 0.4 0.3 0.2 special means 2.1 1.5 1.7 Expenditures: Special resources, o.w.: 1.8 1.4 1.6 state services 0.6 0.4 0.4 education 0.6 0.6 0.8 other 0.5 0.4 0.4 183. Non-cashSettlements.Although the government set a limit to barter collection at a maximum o f 4-5 percent o f total collection in 2000, this policy has been bypassed because the root problem (a budgetary imbalance) has not beenfully addressed. Barter i s a common practice for paying taxes, penalties, and debt service obligations. In2000, the government encouraged barter payments as a way to reduce the stock o f arrears by setting "procurement" prices well above market prices. Since then, barter has become a common practice-last year, road maintenance departments received food products as part o f their budget allocation. More recently, the authorities have also been using cash-to-cash transactions, which are offsets between one or various taxpayers and the budget inwhich cash i s provided at the final stage to ensure that they are recorded in the Treasury. Cash- to-cash operations are not documented but can be estimated to account for around 20 percent o f state budget operations. The implicit offset blurs the relationship between tariffs and tax obligations since it ensures that accounts payable and receivable match exactly. 184. Both barter and offsets limit budget flexibility and arrest transparency. Non-cash settlements, whether barter or offsets, must be phased out by introducing hard budget constraints for taxpayers. One way to reduce cash-in-cash operations inthe energy sector i s to allow the sector to enforce the due dates on the government's bills. Prepayments can also be required from one party or the other (Le., the MoF or the companies). All revenue collection agencies and the Economic Development Fund must also be prevented from receiving goods as tax or debt service payments. This can be achieved by virtue o f closing any department handling goods and by selling any assets it may have to handle collections in kind (e.g., trucks, warehouses, etc.). The state Material Reserve Fund should also be precluded from providing these services. 185. Protected Items. The priority given to protected items (wages, social security contributions, food purchases, and foreign interest payments) during the budget formulation and execution process has allowed the government to avoid arrears inthese critical items. This strategy i s counterproductive over the long run because it makes it difficult to reallocate resources in line with national priorities. The PER recommends that, as part o f the preparation o f a full Public Expenditure Management (PEM) strategy 67 and the modernization o f the Treasury, the authorities develop a plan for gradually phasing out the protected item approach to budgeting. As debt and wage management systems develop, such an approach can be replaced by a simple version o f commitment accounting. B. STATEEMPLOYMENT COMPENSATIONAND 186. An effective public administration should deliver good quality services, should provide an appropriate regulatory function, and, inthe case o f ministries, should take the lead in the development o f sound sectoral policies. In the Kyrgyz Republic, the consensus i s that the administration i s not presently able to fulfil these responsibilities to a satisfactory degree. The government's own repeated calls for improved administrative performance and its quest for effective reform strategies recognize this fact, as do opinion surveys that reveal widespread discontent with, and distrust of, public institutions on the part o f citizens and enterpri~es.4~Many public officials themselves express frustration with a working environment that largely emphasizes rote tasks over substance, and does not provide the fulfilling, appropriately paid careers that they seek. 187. This section examines issues related to the government's workforce, starting with overviews o f the status o f government employment and pay, and analyses o f key systemic issues. Effective government operation goes far beyond questions o f employment numbers and salary levels, however. The latter part o f this section highlights issues o f management and administrative culture that have been the subject o f detailed analyses elsewhere.44 Since the civil service i s the administrative elite o f a country, it should be the backbone o f an effective public administration. Therefore, the chapter pays particular attention to that small, yet crucial, sub-group o f the government workforce. 1. Excessive PublicEmployment 188. According to official data, total budget-financed civilian government empl~yment~~-includingthe republic level and local governments-was 308,597 in 2001. Of this number, approximately 24,000 to 25,000 are estimated to be civil servants (covered by the current civil service law). Table 7.3 shows the distribution o f budget- financed civilian government employees by financing source, branch o f government, and sector, Since a number o f entities finance staff through so-called special resources (the proceeds o f user fees or other undertakings) there are most likely additional individuals who, although working within the government structure, are technically not financed from the budget and thus are excluded from this figure. 43 See Governance and Service Delivery in the Kyrgyz Republic, World Bank, 2002, which presents the findings of surveys of citizens, enterprises, and government employees. For example, of 27 services coveredinthe surveys, only 8 were ratedsatisfactory by 50 percentor more of householdrespondents,and 7 percent by enterprises. At the bottom of the list for both enterprisesand householdswere police services, with only 18 percentofrespondentssatisfied. 44For example, in Civil Service Reform in the Kyrgyz Republic, UNDP, 1999, and papersby the European Union's TACIS program. 45This excludes employment in the Ministriesof Interior and Defense and in security services, for which dataare not available. 68 Table 7.3: Budget-funded Civilian Government Employees, 2001 White Blue Total Percent collar collar ur, service) Republican budget President's& PrimeMinister's 1,048 1,168 2,216 2.9% administrations, affiliatedbodies (SupremeAuthority) Legislativebranch 407 51 458 0.6% Judicial branch 2,065 723 2,788 3.6% Executivebranch 46,482 20,148 66,630 86.9% Of which Justice & related 391 79 470 0.6% Foreign Affairs 237 43 280 0.4% Environment & Emergency 5,027 971 5,998 7.8% Finance, Tax, Customs 4,514 1,159 5,673 7.4% Education & Culture 5,449 13,816 19,265 25.1% Health 10,852 2,071 12,923 16.8% Labor & Social Protection 5,590 1,019 6,609 8.6% Agriculture 8,753 521 9,274 12.1% Industry & Trade 205 205 0.3% Transport 341 341 0.4% Variouscommittees, agencies 5,123 469 5,592 7.3% Other 4,471 676 5,147 6.7% Total, Republican budget 53,451 23,266 76,716 100.0% Local budgets Public service delivery 7,013 1,658 8,671 3.7% Science 245 50 295 0.1% Education 94,048 45,722 139,771 60.3% Culture 5,597 1,111 6,708 2.9% Health 62,439 11,508 73,947 31.9% Social protection 2,196 129 2,325 1.O% Agriculture 157 10 166 0.1% Total,Local budgets 171,693 60,187 231,881 100.0% Total budget-financed 225,144 83,453 308,597 189. At about 6.3 percent of the population, civilian government employment falls withina broadrange for a number of other transitional and OECDcountries. However, if the level o f income and the economic structure o f the Kyrgyz Republic are taken into account, the country's public sector i s far too large. For instance, public employment accounts for about two-thirds o f non-agricultural employment (i-e., the formal sector). This share would increase if public enterprises-most o f which are overstaffed-were included. The bulk o f civilian staff (231,881 or 75.1 percent) is employed by local governments, largely in the education and health sectors, which accounts for 92 percent o f local government employment (see Figures 7.2 and 7.3). 69 Figure 7.2: Employment by the Republicand Local Governments, 2001 1 250,000 I 1 200,000 150,000 100,000 50,000 I I Republic Local Gov't White collar HJr. service Figure 7.3: Local Government Employment by Sector, 2001 1 150,000 139.771 I I 120,000 90,000 60,000 30,000 190. At the republic level, most employees work for the executive branch, which had a staff of 66,630 in2001. Of this number, only 1,108 (of which 166 are blue-collar "junior service" staff), or less than 2 percent, worked in the ministry headquarters offices themselves (Figure 7.4).46Indeed, after several rounds of "restructuring" over the years, staffing of headquartersis so low as to raise concerns regarding the ministries' ability to fulfil what should be (and is not yet) a key function: formulating and coordinating sectoral policy. Inpractice, Kyrgyz ministries are overwhelmed by rote tasks and by the fulfilling of numerous commands from above; they are also likely to lack the professional skills for such an agenda at present. One of the few clear conclusions that emerge from 46All data exclude the Ministries of Defense and Interior,whose employment levels are confidential. The vast majorityof executive branchemployeesworked in deconcentratedoffices (at sub-nationallevels) or in subsidiary entities, as well as in state committees, commissions, and agencies andtheir deconcentratedor subsidiary units. In 2001, civil service employment in ministry headquarters was: Foreign Trade, 93, Health, 45, Education, 75, Agriculture, 75, Transport, 69, Labor, 51, Environment and Emergency, 58, Finance,275. Datafor other ministrieswere not available. 70 this brief quantitative overview is that, inthe future, meaningful administrative reforms should address the need for appropriate roles and suitably-skilled staff (and staffing levels) inministries. Figure 7.4: Ministry Employment,2001 1 10,000 , I 8,000 6,000 Non-headqtrs 4,000 Headquarters 2,000 0 191. The problem i s not limited to ministries, however. Indeed, there i s a general need to attain a more appropriate skill composition o f the workforce. As in other transitional countries, the Kyrgyz Republic has staffing imbalances not only in the area o f skills but also according to geographic area or setting. So, for example, the health sector may face an overall excess supply o f nursing skills, but a shortage inremote areas and inBishkek, where nurses seek better paying jobs outside o f their profession. Achieving an appropriate skill mix will take time and turnover rather than mere enforcement o f a particular aggregate employment level. 192. The size o f the civil service is estimated at around 24,000 to 25,000 based on available data. About 4 percent o f civil servants work inministry headquarters, 4 percent inthe deconcentrated offices of ministries, 66 percent inthe headquarters of subsidiary entities o f ministries, and 26 percent in the deconcentrated offices of such subsidiary entities. Since the size and distribution o f the civil service has direct implications for the nature and cost o f reforms (particularly salary reforms), it would be advisable to establish a detailed accounting o f the number and distribution o f civil servants (by entity, geographic location, andposition), to make accurate analysis possible. 2. Multiple Wage Systems 193. The Kyrgyz Republic has several separate wage systems for various groups of employees including the civil service, the social sectors, the central bank, and uniformed personnel. Annex 3 lists the various types of employees and the principal regulations that govern their wages. In practice, a large number o f regulations (and their amendments) govern each wage system, posing a challenge not only to those charged with implementing current legislation but also, at the republic level, to anyone who seeks to 71 oversee the implementation o f regulations, to develop policy options, or to analyze their fiscal impact. In fact, for reasons that include difficulties with information flow and constraints on technical skills and staff capaciy, little systematic in-depthanalysis o f this nature appears to have been made to datea4 As described later in this chapter, the Ministry o f Finance in spring 2002 launched a laudable effort to collect detailed entity- level data that have the potential to substantially increase analytical capabilities. 194. Social Sectors. Inthe social sectors, jobs are slotted into a 23-level tariff net (the Unified Scale of Rates) that calculates monthly base salaries by applying a series of coefficients to a cornerstone amount.48 On April 1, 2002, the cornerstone was raised from 120 to 140 som, yielding a monthly salary ranging from 196 som (US$4) at the bottom, to 1120 som (US$23) at the top.49An individual's total earnings, however, take into account additional factors such as workload and particular tasks performed. For example, teachers are paid according to the numbero f hours taught relative to norms, and receive payments for such tasks as marking student assignment books. Work norms apply to blue collar as well as professional jobs and, in some cases, have not been updated since the Soviet era. Inthe course o f interviews, more than one official pointed out that mechanistic norms (e.g., mandating one cleaner per 400 square meters o f office space, or one electrician for a particular number o f electrical outlets) effectively result in a system that pays far less than a living wage while restricting worker output, rather than allowing managers to hire a smaller number of productive staff at more acceptable salaries. 195. Inthe case of professional staff such as medical doctors, the restrictive nature of the tariff net and lack o f managerial authority over and accountability for budget expenditures have grave implications for service delivery. Skilled doctors, unable to live on salaries on the order o f 1,000 som (US$21) per month leave the profession, take on additional employment, or resort to unofficial payments to supplement their income.50 The health sector is currently implementing a noteworthy pilot project that includes giving hospitals in selected regions greater autonomy in managing their budgets as well as in setting salary scales and employment levels. Salaries o f medical staff in these selected hospitals have risen to as much as 3,000 som (US$62) per month, a level that, while still modest, represents a significant improvement. This undertaking is likely to yield important lessons for future reforms inthe social sectors and beyond. 47Many records are still kept on paper, rather than in electronic form. To date, central oversight of employment levels has largely been limitedto compiling an annual record(in paper form) that lists a total employment figure for eachentitywithout greater detail. 48Coefficientsrangefrom 1.4to 8.0. 49As an example, a newly graduated teacher might earn 500 som (US$lO). Nationwide, the average monthly salary for doctors was 985 som (US$20), of which 780 som was budget-financed and the remainder came from insurance payments. Mid-level medical personnel earned 705 som (US$l5), of which 562 som was budget-financed. The exchangerate usedthroughout this chapter is US$1= 48.4 som. Unofficial paymentsare rampantinthe healthsector, as in other activities inwhich citizens or enterprises come into contact with the government. According to Governance and Service Delively in the Kyrgyz Republic, 39 percent of households reported makingunofficial payments when visiting the hospital. Fifty- six percentofhouseholdshadmade such paymentsto elementaryschoolstaff. 72 196. Compounding the low earnings levels, wage arrears can also be a problem- reportedly more so at the local government level, for example, inthe case o f teachers. In recent surveys, nearly half o f public officials hadreceived their salary late at least once in the preceding 12months, with payments delayed by a mediano f 30 days.5' 197. Civil Service Earnings.The civil service is paid accordingto its own wage scale, established by presidential decree and last updated inDecree 196 o f August 1, 2000.52In addition to a base salary, civil servants are eligible for a wide array o f allowances and bonuses that account for a significant proportion-generally 50 to 70 percent-of an employee's total earnings. Payment o f certain allowances i s mandatory, while others may be reduced in amount, depending on the entity's wage bill a l l ~ c a t i o nJob-related. ~ ~ non-monetary (in-kind) benefits do not appear to be a significant issue, at least for regular, non-uniformed staff. 198. The system of allowances and bonuses raises numerous concerns. The sheer number o f bonuses and allowances (at least 11)54and the fact that each has its own criteria make administering the wage system burdensome (at the level o f individual institutions, subsidiary entities, and offices) as well as making it difficult (at the republic level) to monitor implementation and ensure that funds are allocated as intended.55 Furthermore, the effectiveness and targeting o f these payments i s unclear. Several allowances appear to serve similar purposes and, while the criteria for certain allowances (most notably, seniority) are clear, others involve a significant degree o f discretion. Such discretion can easily be abused, particularly in a country like the Kyrgyz Republic in which managerial accountability i s weak. Similarly, with few real incentives to focus staff on quality performance, and little inthe way o f meaningful measures o f actual staff perf~rmance,~~allowances that ostensibly reward good performance may not actually achieve that objective. A new initiative that i s intended to mitigate inadequate salary levels by awarding increases to particularly valuable staff, while well intentioned, will add to the existing weaknesses, since it will take the form o f a new allowance (the "class rank"). '*The "GovernanceandServiceDelivelyintheKyrgvzRepublic. Decreedetails25 sub-scalesfor employees throughout the civil service, as currently defined. 53For example, payment of the seniority allowance is mandatory, whereas the quarterly bonus (which is generally considered to be an entitlement rather than a real bonus tied to individualperformance) can be reducedor suspendedas a function ofavailable funds. 54 Category, seniority, qualifications, rank, complexity, academic credentials, hazardous working conditions, highaltitude, vacation, materialassistance (twice yearly), and quarterly bonus, Certain groups suchas militaryandpolice employeesalso receiveadditionalbenefits, for example, reducedutility bills. ''Indeed, the Ministry of Finance discovered in spring 2002, in the course of collectingdetailed pay and employment data, that certain entities had been following obsolete regulations. The cause in this case is unclear, but the large number of regulations (and amendments) issued in the Kyrgyz Republic, and the difficulty indisseminatingthis information effectively, compoundthe complexityofthe wage system. 56 For example, the new system of attestation asks about employee characteristics and attitudes, but contains no evaluation of specific work performed, nor does it set substantive, performance-relatedtargets for forthcomingwork. Similarly, one official notedthat his unit is evaluatedprincipallyon whether it meets deadlinesand on the number of papers it processes; neither of these measures assesses the actual quality of work done. 73 199. As Figure 7.5 illustrates, even in much more developed public administrations with a stronger performance orientation (and, in theory, a greater ability to evaluate performance) it is unusual for allowances to comprise a large proportion of total earnings. Inthe mediumterm, it would be advisable for the Kyrgyz Republic to consolidate most allowances into base pay, in order to build a more transparent system in which base salary accounts for a majority of a worker's earnings. This is likely to be a multi-year undertaking that should be carefull 7 planned and supportedwith sufficient analysis of the impacts o f such structural reform.5 Figure 7.5: Base Salary as Percent of Total Earnings Base salary as percent of total earnings 100 80 60 40 20 0 Sources: Kyrgyz Republicestimate is basedon datacompiledby the Ministry of Finance. Source for other datais Trends in Public Sector Pay in OECD Countries, OECD, 1995. Where the source gives ranges, the chart uses the midpoint. 200. While the civil service wage scale is significantly higher than the tariff net used by the social sectors, civil service pay levels remain modest at best, and are considered inadequate by most observers. Based on 2001 data and estimates for nine of 12 mini~tries,~' one o f the lowest civil service posts (specialist, category 1) in a ministry headquarters earns about 1,960 som (US$40) per month, including all allowances and bonuses, while a deputy minister earns about 9,105 som (US$188) in total. Table 7.4 gives an indication of salaries-as well as the importance of allowances-for selected positions inministries. Owing to data issues, these figures may somewhat underestimate actual earnings.59 57 For example, one consideration is to avoid reducing a worker's earnings in connection with such consolidation. 58The data were compiled by the Ministryof Financeand include all ministries exceptDefense and Interior (whose data are confidential) and Foreign Affairs. 59 Because of data uncertainties regarding two important payments the twice-yearly material assistance - and the quarterly bonus - the calculations assume that each payment amounts to one base salary (in total, six base salaries per year). Particularly in the case of the quarterly bonus, actual payments may be higher, though they may also be reducedor suspended subject to the size ofthe wage bill allocation. 74 201. The civil service salary scale i s in fact a set o f 25 sub-scales for different entities and levels of government, with prominent republic-level institutions tendingto pay more, and headquarters offices paying more than deconcentrated offices or territorial bodies. Table 7.4: Monthly Earnings for SelectedMinistry Posts Base salary Est.actual total earnings Som $US Som $US Deputy minister 4,500 $93 9,105 $188 Head o f office 3,800 $79 6,378 $132 Head o f chief dept. 3,600 $74 6,498 $134 Head o f division 3,100 $64 6,018 $124 Sector chief 1,800 $37 3,740 $77 Chief specialist 1,3 50 $28 3,139 $65 Specialist, category 1 1,000 $21 1,960 $40 Specialist 900 $19 Not available Sources: Base salaries from the official civil service salary scale. Estimated total earnings from 2001 data compiled by the Ministryo f Finance. 202. Given the underdeveloped nature o f the private sector, publidprivate salary comparisons are difficult to make and are of limited practical relevance. Salary surveys are unavailable and, for all but a few staff with niche skills (lawyers or financial specialists with Western expertise) or special opportunities, moving to a comparable post outside the administration (without leaving one's profession for commercial undertakings) i s not a real option. Indeed, numerous civil servants expressed an eagerness to leave for higher paying jobs while at the same time lamenting the lack o f such opportunities. While some individuals in Bishkek may find employment in connection with donor projects, the majority o f rank and file staff have few options butto try to make ends meet by minimizing expenditures. Inli ht o f the fact that the minimum monthly "consumption basket" i s 1,316 som (US$28), 6 fthis can mean going as far as relying on garden plots and in-kind assistance from relatives in order to reduce expenditures on food. 203. An additional feature o f the pay system (less important than earnings levels but worth noting nevertheless) i s that the salary scale i s somewhat compressed.6' High- ranking ministry staff at the top o f their careers earn perhaps four to five times more than the mostjunior civil service position. This means that the official salary provides only a moderate incentive for an individual to take on the greater responsibilities and the added workload that i s presumably associated with more senior posts. By contrast, indeveloped economies where the public sector must compete with private opportunities for top skills, compression ratios between 7 and 10 are not uncommon.62Thus, decompressing earnings 6oAverage for 2001. 6'In addition to the base salary scale, some managers report redistributing "extra" wage bill funds (from vacancies or other under-spends) in a manner that gives preference to lower level staff, who are particularly hard hitby low salaries. 62For example, compression ratios are 9.8 in the United Kingdom, 8.9 in the United States, and 8.2 in the Netherlands (Readyfor Europe: Public Administration Reform and European Union Accession in Central and Eastern Europe, World Bank, 2000). Compression ratios serve as a rough and easily available 75 i s clearly a lesser priority than addressing the low pay levels, and the structural problem o f allowances andbonuses. 3. Wage BillIssues 204. In 2001, government expenditures on wages and salaries amounted to an estimated 5.8 percent o f GDP.63 As with employment numbers, owing to the high level o f aggregation o f such data, to concerns regarding data accuracy (particularly for countries with under-developed information systems), and to legitimate variations in country needs and contexts, cross-country comparisons o f wage expenditures are o f limiteduse except at the extremes.By this limitedmeasure, the Kyrgyz Republic's wage bill is not excessive, and even falls at the low end o f the ranges. Judged by more meaningful criteria such as the sustainability and effectiveness-in terms o f administrative performance-of wage expenditures, however, there is little reason for complacency. A further reason to pay close attention to practices related to the wage bill i s that, since budget flows inthe Kyrgyz Republic often take the form o f in-kindtransfers rather than monetary transactions, the wage bill i s in fact one o f the larger monetary flows. 205. Under the present system, any cost savings resulting from employment cuts are returned to the general budget, with none kept by the body that bears the cuts. As o f spring2002, a pilot initiative was under way to officially allow the saving institution-in this case the Ministryo f Education-to retain a portion o f funds thus saved for its own use. Such measures could help institutions focus on attaining a rational employment structure, and could mitigate somewhat the damage to morale caused by staff reductions. It must be noted, however, that retrenchments do not immediately translate into savings, owing to severance and unemployment costs. Furthermore, any savings that do eventually arise may not necessarily be sufficient to finance a noticeable rise in salaries for the remaining staff. 4. Oversight 206. In the absence of computerized payroll and personnel systems, the Kyrgyz Republic does not have a robust system for monitoring whether wage bill funds are well spent. The monitoring o f employment expenditures relies on paper submissions (such as detailed accounting forms for individual salary payments) and rote compliance checks o f paperwork as it i s passed up through the system; these reports are highly aggregated by the time ministries submit them to the Ministry o f Finance and the Treasury to request transfers o f their wage bill allocation. It i s difficult to see how such a system could indicator o f earnings potential, though they are not as insightful as other, more data-intensive methodologies. 63 The actual cost o f the government workforce is higher, since some entities use self-generated revenues ("special resources") to finance additional posts or to supplement budget-funded salaries. An analysis of the 2001 budget execution report shows that 414 million som (0.6 percent of GDP) of the total amount of special resources was used for salaries and contributions to the Social Fund. This means that about 10 percent o f total salaries is financed from special resources. The extent of reliance on these funds varies significantly among functions, with little or no salary-related use o f such funds in defense, public order, social protectiodsocial insurance, and mining. In contrast, such financing amounts to 39 percent of total salaries inthe transport and communications sector, 19 percent in housing, and 16 percent in education, 76 safeguard against intentional misappropriation o f funds or simple errors (such as the recently discovered cases o f organizations using obsolete wage guidelines). While audits by the Chamber o f Accounts might theoretically uncover some problems after the fact, that body presently lacks sufficient qualified staff to adequately scrutinize personnel expenditures. 207. Untilnow, central records of employment levels have consisted primarily of an annual paper-based report that compiles total employment figures submitted by each organization. Employing organizations and their subsidiary units do hold more disaggregated data, although such data are not always in readily accessible electronic form. However, such data had not been systematically compiled until the Ministry o f Finance's spring 2002 initiative to create an electronic database detailing employment and expenditures down to the level of individual posts and allowances. This initiative i s a good interim solution to the current dearth o f data and deserves to be continued, with expanded coverage and updates at appropriate intervals; giventhe limited capacities that the Ministryo f Finance can devote to the project, as well as the fact that organizations are already burdened with overly frequent reporting requirements, an appropriate interval would probably be every 12(or at most, 6) months. 208. However, such a database does not replace the need for multi-purpose management information systems that track actual (not simply reported) expenditures and contain built-in safeguards to ensure that payments are legitimate. Given the administration's heavy reliance on paper records, the introduction o f electronic systems will entail significant design and planning work, as well as a considerable investment in hardware andtraining. 5. Designingof Pay and Employment Reforms 209. Inspring2002 the Ministryo fFinance begancompiling position-by-position civil service data for individual entities as part o f a collaborative effort with the World Bank to improve fiscal impact analyses o f pay and employment policies. These data were usedto construct a pilot model that automatically calculates the costs that a given set o f changes in civil service pay and employment levels (down to specific positions) would incur in wages, employer contributions, severance payments, and unemployment insurance over a series o f years. The model, which allows users to set key parameters and to decide the speed and extent o f reforms, i s designed to be easy to use, with minimal software skills needed. While the pilot model is restricted to central ministries, with adequate data it could easily be expanded to the rest of the civil service.64 Annex 4 contains a number o f sample reform scenarios, developed with the model as a means o f highlighting some o f the issues and trade-offs that such reforms will involve. 210. The type o f fiscal impact analysis demonstrated here should be part o f any reform proposal. So, too, should consideration o f qualitative issues, including equity (for example, should all posts receive the same increase?), the possibility o f targeting key 64The model is available from the Ministry of Finance's State Sector Department, and the World Bank (ECSPE). 77 skills that are in short supply, the social impact of any employment reductions, and the question o f whether such reductions would damage the delivery o f core services or functions. 211. The Kyrgyz economy i s not presently capable of absorbing large numbers ofjob seekers. If any substantial employment changes are to take place (including in overall employment levels as well as inturnover in the types o f staff, as organizations seek out new skills to suit their changing roles), it is imperative to develop proactive strategies for providing real assistance to any displaced workers. This goes far beyond relying on a few piecemeal retraining programs. It means developing a robust strategy that not only identifies a variety o f mechanisms for helpingworkers make the transition to viable new jobs (including, for example, providing start-up capital or micro-credits for small businesses) but that also designs sound means of delivering such assistance so that it reaches those who need it, whether they are in cities or in remote areas. Since such undertakings are not without cost, either interms of effort or money, any strategy must also include realistic cost calculations and must identify financing sources. 6. InstitutionalCulture 212. In-depthanalyses by donors such as the UNDP and TACIS, as well as the World Bank's own assessments, have identified a variety of systemic problems facing government workers.65A brief characterization of the prevailing culture could hardly fail to point out difficulties such as: Persistent politicization, with a weak distinction or no distinction betweenpolitical appointments as opposed to apolitical career posts, and little real protection from political intervention indaily operations An excessively centralized, rigid management system that keeps executive branch entities busy churning out rote reports on orders from above and responding to numerous inspections, but allows little room for substantive work, analysis, and strategic thinking A combination of little real managerial autonomy (over budgets and work programs) and little accountability for performance 213. There is no doubt that these and other problems are the legacy of the Soviet era and that such dynamics are extremely difficult to change. The Kyrgyz Republic has made laudable efforts to spur better functioning of the government and its workers; these efforts include the passage o f the civil service law in 1999 (see Box 3.1 inVolume 11) as well as a stream of decrees and resolutions intended to push reform. However, it must also be stressed that real change needs careful design as well as persistent support for implementation. Ongoing efforts to create a robust civil service framework and to ensure organizational performance illustrate this point well. 214. The 1999 civil service law and related regulations include provisions governing recruitment, promotion, and attestation (a form of personnel evaluation). At the ministry 65See for example, Civil Sewice Reform in the Kyrgyz Republic. 78 level, officials are familiar with the law and refer to specific provisions as guiding their actions.66 This is, initself, a positive feature. Inmany respects the formal provisions are not unreasonable. They include a requirement for the advertising o fjob openings, and the formation o f committees for hiringand promotions decisions. At the same time, there i s room for improvement. For example, while the attestation process collects feedback from multiple evaluators as well as the employee, it focuses on characteristics and attitudes, rather than emphasizing actual performance inspecific tasks. 215. It is impossible to determine the extentto which actual practices truly embody the principles o f merit, objectivity, and competition. Countries like the Kyrgyz Republic have decades-long experience with command-and-control management and an ingrained understanding o f the importance o f following the letter, ifnot necessarily the spirit, o f the law. Anecdotal evidence includes reports o f job applicants being asked to withdraw in favor o f a preferredcandidate, and o f money or favors being given to obtainjobs. While such practices can occur anywhere, inmore developed countries, they are often restrained by robust oversight mechanisms and by the fact that managers are held accountable for the performance o f their unit (which motivates them to hire competent staff). That neither o f these practices is in evidence in the Kyrgyz Republic suggests that, until the real incentives governing the workplace begin to change, performance and integrity problems will remain a significant drain on the public administration. 216. Indeed, existing attempts at ensuring compliance-in the narrowest sense of the term-are themselves a problem. The numerous and frequent inspections provide an opportunity for rent-seeking, in addition to demanding significant resources in the form o f the inspectors themselvesand inthe time that they require o f units being inspected. In one ministry, the director of the financial department estimated that the department ' undergoes about two inspections per month and added, only half injest, that as soon as one inspection i s finished, another one starts. The point here i s not to argue that there should be no oversight. Rather, oversight should be substantive rather than rote, and should be part o f a system that gives managers autonomy to do their jobs well, in conjunction with appropriate incentives and rewards. Clearly, such a system i s not created overnight, but it is important to bear the principle inmindwhen devising reform measures. In addition, the Kyrgyz Republic can draw on the positive experiences o f existingpilot projects (such as the health sector's hospital management initiative) as well as other pilots infuture. 7. FutureAgenda 217. Reforming the system o f government employment, and the environment inwhich government employees work, will require a sustained effort. Among the important projects that must be tackled (many o f which are outside the scope of this chapter but have been analyzed elsewhere) are the following: 66This observation is supported by surveys, which found that 72 percent of officials reportedbeing fairly familiar with the Law (Governance andsewice Delivery in the Kyrgyz Republic), 79 Improving the formal framework governing the workforce, including, but not limitedto, the civil service law and secondary legislation. Changing the informal practices that govern everyday working life, and the actions o f rank-and-file staff and managers and, in turn, o f organizational units. At issue i s the extent to which individuals have real behavioral incentives to focus on doing their jobs well. For example, are they held accountable for the substantive quality and impact o f their work-or only for the quantity o f reports and the number o f deadlines met? Designing and implementing a transparent, fair salary system that is fiscally sustainable and manageable. Over time, this will certainly necessitate consolidating allowances into base salary, and reducing the excessive discretion that pervades the current system. Given the lack o f detailed data to date, an important practical step should be the continuation and expansion o f the Ministry o f Finance's data collection effort. Data on their own, however, are o f little use; the government should cultivate permanent staff with the technical expertise needed to develop sound wage policies. At minimum, such staff should be able to fully use analytical tools to conduct rigorous fiscal analyses o f policy proposals. Facilitating employment adjustments in line with sectoral or substantive systemic reforms. Sector managers should have appropriate authority and incentives to ensure that staff numbers and skills are appropriate for actual needs, and should be held accountable for using that authority effectively. The government should seriously explore the possibilities o f expanding successful elements o f pilot projects currently taking place incertain sectors. Providing proactive strategies and programs to support displaced workers. Particularly in an economy such as the Kyrgyz Republic's, where employment generation i s difficult and even employed workers are under financial pressure, developing proactive policies to help displaced workers make the transition to other livelihoods i s essential. This should certainly include supporting sector-specific initiatives as well as developing a crosscutting program o f options for those who leave government employment because o f restructuring. The complexity o f this task should not be underestimated. Real time, efforts, and resources will need to be allocated and care taken to ensure that the resulting proposals are viable and produce results. This undertaking should draw on technical expertise and the experience o f other countries (for example, Colombia) that have faced similar challenges. Developing personnel management practices (and information systems) consistentwith the above. 218. None o f the undertakings in this brief agenda i s particularly simple; the intended outcomes cannot be achieved simply by mandating them. Overall management o f these reforms i s in itself a challenge, one that will be best served by a politically impartial entity that has both the technical expertise and the authority to see the agenda through to 80 success. The Kyrgyz Republic does not presently have a unit o f suitable stature and staffing-a shortcoming that should be addressedwith care and expedience. C. RATIONALIZINGINTERGOVERNMENTAL FINANCES 1. Contextof the CurrentIntergovernmentalFiscal System 219. Effective governance requires coordinated and specialized execution of public responsibilities by governmental and administrative units through the range of geographic, functional and hierarchical divisions. Complete centralization and uniformity i s neither possible nor desirable inany state; the Kyrgyz Republic is, again, no exception. Service delivery wants and needs differ with regionalhub-regional geographic, demographic and economic structural characteristics; as do the abilities o f sub-regional areas to provide for these wants and needs. The tremendous regional variation in economic structure and revenue potential in the Republic creates pronounced disparities inservice needs andlocal capacities to satisfy these needs. Economic structure is heavily agricultural/extractive, at 56 percent o f employment, with 65 percent o f the population being rural, and 47 percent living in poverty (see Table 7.5). However, regional variations are substantial, with average agricultural employment proportions varying by 60 percent across oblasts (with Bishkek City at 2 percent), urban population varying by 82 percent. Likewise the average intra-regional variation inpoverty i s 31percent. This results indramatic differences inthe regional fiscal base. Per capita sub-national revenue derived from the regional economic base varies dramatically (by an average o f 84 percent). The high i s 921 som in Bishkek and the low i s 95 in Naryn. Adequately dealing with regional (and inter-regional) disparities o f these magnitudes requires a robust intergovernmentalfiscal framework. Table 7.5: Selected Regional Indicators, 2001 Per capitaRevenue I/ 355 921 130 284 95 112 165 524 209 313 84 Per capita Total RegionalExpenditures 101 1002 621 623 843 567 796 737 595 724 19 PercentofPopulation Urban 35 100 19 30 18 23 17 22 23 32 82 Percentof Population Mountain 21 0 21 43 81 21 4 4 19 24 105 PercentPopulation 1-24 39 35 41 38 40 41 40 35 41 39 6 Percent Population 60 or Over 8 1 0 7 1 0 8 6 8 1 1 1 8 2 0 EducationalAttainment (secondary & above) 13 83 72 72 11 74 68 63 12 12 1 Monthly Per PersonSpending 497 811 337 387 214 468 338 656 348 452 39 PercentPopulation in Poverty 41 26 48 55 12 51 66 25 56 51 32 Percentof over 15 PopulationEmployed 55 45 59 53 56 63 61 51 60 56 10 Average Age of Employed 37 36 35 41 45 33 36 41 32 31 11 PercentEmployment primary sectors2/ 56 2 71 63 69 10 72 48 10 58 60 1/ Derived from the Local Economic Base (Sharedand Local Sources) 2/ Agricultural, Fishing or Extraction 81 220. An appropriate intergovernmentalfinance structure must marry regional and sub-regional discretion in expenditure planning with an appropriate revenue distribution between and across government levels. It must provide appropriate incentives for revenue mobilization, expenditure and service delivery effectiveness, and general fiscal responsibility. It must provide resources sufficient to meet national expenditure priorities and provide clear indication o f those priorities while allowing sufficient sub-regional flexibility to assure that resources are deployed effectively. The current structure does not adequately provide for these requirementsand, therefore, puts at serious risk the ability to adequately and efficiently provide for basic public service needs o f more and less affluent regions alike. 221. At present the system is ad hoc in its application andfails toprovide stability or any reasonable level of certainty for budgetary planning by sub-national and sub- regional governments. It reinforces inefficiencies lingering from the Soviet structure. While previous reforms entailed a systematic restructuring o f intergovernmental fiscal relationships, backsliding has since produced a seriously distorted structure in which elements are implemented in a manner, individually and as a whole, which fails to produce desired outcomes. The implicit overriding objective o f the present implementation appears to be to provide budgetary flexibility and insulation to the Central Government by allocating the major elements o f budgetary risk to regional and sub-regional governments: those levels less able to accommodate such risks. 2. BluePrint of PreviousReformvs. The Realityof it Implementation 222. Previous elements o f Kyrgyz intergovernmental finance reforms have intended to include: (i)rationalized and fixed expenditure responsibility; (ii)revenue assignment consistent with expenditure responsibilities; (iii)a system o f transparent, specific ("categorical") grants to support specific service provision at the regional and sub- regional level via central government resources; and (iv) a formula-based equalization grant to provide a transparent and non-negotiated mechanism for augmenting revenue availability ina manner inversely relatedto local resource capacity and directly related to expenditure needs. Together, these would provide a framework for generating a fiscal system consistent with the vertical distribution of expenditure responsibility, and able to deal with horizontal imbalances in revenue capacity while simultaneously providing proper economic incentives for both sub-national revenue mobilization and the efficient delivery o f services consistent with the needs o f local populations and the priorities o f the national government. 223. However, while progress has been made in sorting out expenditure responsibility through the Law on the Principles o f the Budget (1997), establishing revenue assignments (includinga tax sharing system and local revenue options), and codifying the framework for intergovernmental transfers between the national government and the oblast level, implementation has been erratic and problematic. Service delivery responsibility between different levels o f government varies considerably across and within oblasts. Enhanced stability between Central and regional governments has not been mirrored sub-regionally. Rayons routinely shift controlled expenditure responsibility down to village levels to correspond with any additional revenue capacity a 82 village my have achieved, eliminating incentives for revenue generation and any meaningful level o f local discretion and in manners inconsistent with sector reform strategies. 224. The equalization structure has not been formalized and is far from stable. Revenue transfers (up and down) between villages, rayons, oblasts and the Central Government remain ad hoc and negotiated. "Excess" revenuei s routinely siphonedaway from Bishkek and Chui on an ad hoc basis to provide "gap-filling" transfers to other oblasts. While, due to their relative fiscal strength, these two regional units will be the major source o f net transfers, the structure by which these transfers are made undermines incentive for revenue mobilization. Fixed sharing rates are meaningless when categorical, equalization and ad hoc transfers are manipulated. Transparent, non- negotiated, formula-based equalization grants, which transfer resources in inverse proportion to local revenue capacity (based on a predetermined pool o f available resources), have yet to be implemented. Those that exist muddle equalization with the categorical grants and mid-year (unbudgeted) transfers from the republican budget. Categorical grants have been used for covering predetermined wages and social contribution requirements inthe sub-national health and education sectors, rather than as instruments for allocating resources based on established national minimum service standards. Beyond this, the coverage o f these grants i s incomplete and varies considerably between oblasts, and the final allocations are made through non-transparent ad hoc arrangements. 225. Regional and sub-regional revenue discretion remains too weak to effectively providefor localpriorities or produce beneficial localfiscal incentives. Establishment of local revenue sources has been unsystematic, and administrative arrangements have been weak, though recent developments suggest progress.67 The intergovernmental finance framework between the national government and oblasts has not been extended (even conceptually) to the lower levels o f government, where public service delivery actually takes place. Local revenue initiatives are easily and routinely siphoned away by shifts in expenditure responsibility and revenue sharing. Local revenue retention and the local budget envelope are based on annual negotiations between villages, rayons and oblasts. The lack o f stability in revenue allocations adversely affects budget planning and produces disincentives for expenditure efficiency and revenue generation. At present, additional regional and local revenue mobilization generally results in a decrease in resources contributed from above. In addition, the capacity of local governments for budget management i s limited. While villages have recently established staffed fiscal offices, their budgets are largely determined by rayons. Sub-regional and local budgets are based on norms established and reviewed from above and mechanisms for prioritization o f local government expenditures are inadequate. 67Thefull implementation of the regional tax on sales and services, the introduction of the land tax albeit with limited flexibility in determining applicable tax rates, the recent provision in the proposed Law on Communal Property for the sub-regional governments to retain the proceeds from the land sale, and the proposedurbanproperty tax are all positive steps. 83 226. The intergovernmental structure must be rationalized, and made transparent and stable. Improvements inintergovernmental fiscal relations are directly linked with better budget formulation and overall improvements in revenue generation and expenditure management. These reforms will improve resource predictability and stability for sub- national and regional levels of government, and enhance their stability as well as the ability o f these governments to provide for the needs o f their populations. 227. Areas requiring particular attention include: (i)refinement and stabilization o f expenditure and revenue assignment; (ii)continued development o f local revenue sources; (iii) refinement o f the character of the categorical grants, specifically moving away from their use as a vehicle for covering predetermined wages and social contribution requirements in the sub-national health and education sectors to allocated instruments based on an established national standard o f minimum service requirement; (iv) establishment of a transparent, non-negotiated, formula-based equalization grant which transfers resources inverse to local revenue capacity, while maintaining incentives for local revenue mobilization; and (v) defininga consistent pool o f resources committed by the national government to these transfer programs. Box 7.2: IntergovernmentalElements Requiring Attention in the Kyrgyz Republic 228. Essentially, the needi s to: (i) strengthen the development o f the basic elements o f intergovernmental finance reforms begunpreviously; and, thus, provide for the (ii) design and extension o f a correspondingly rationalized system o f transfers to the sub-regional levels o f the public sector (rayon, cities and ail okmotu). 84 CriticalArea 1:FunctionalResponsibility(Expenditure)Assignment 229. Rational structuring o f fiscal relationships between levels o f government requires functional responsibilities to be defined. This i s essential to promoting efficient resource allocation, equity in finance and service availability, and budgetary stability. Stability in expenditureassignment is a pre-requisite to the designo f an effective structure. 230. Problem: InformaVFluid Assignment. Inappropriate, ambiguous and fluid assignments create: (i)problems in ascribing accountability between levels o f government for providing services to populations and maintaining service levels; (ii) difficulties in assuring regional compliance with national expenditure priorities; (iii) difficulties inbudgetary and service planning and prioritization; (iv) fiscal gaps; (v) poor pricing signals and inefficient resource allocation (including tendencies to use budgetary resource frivolously); and (vi) lack o f maintenance and ineffective capital investment. 231. Solution: Dejned Responsibility. Sectoral expenditure responsibilities should be defined for all levels. This definition should include: (i)central govemment functions; (ii)regional functions; (iii) functions; (iv) and shared functions (along with relative local responsibilities). It i s not requiredthat the split between regional and local functions be consistent across regions. The specific assignment between levels o f government within a region can be left to the discretion of those governments involved. However, economic principles suggest appropriate assignments and it i s essential that the assignment made be stable. The nationalhegional split and the regional/local split should not be subject to annual manipulation. It i s also highly desirable for local units o f government within a regionto be treated uniformly inthe assignment devised. 232. Problem: Ill-dejned Service Standards. In order to assure local fulfillment o f regional and national priorities, minimum service requirements must be defined for priority services. At a minimum, this requires service standards for education and health. Without this, there i s no basis to determine the appropriate financing nor for holding sub- national governments accountable for the proper execution o f expenditure responsibilities within theses areas. Similar requirements exist for the appropriate standard setting and monitoring o f functions regulated by the oblast or rayon. Unfortunately, to the degree that standards currently exist, they are based on physical and facility norms and are not conducive to assuring any meaningful level o f service accomplishment. Muchdiscussion and some effort have been expended in this area, but little in the way o f demonstrable results has been achieved. 233. Solution: Minimum Service Standards tied to Service Outcomes. Establishing appropriate minimum service standards i s a particularly critical and difficult component o f the intergovernmental system. Standards are necessary to assure that appropriate resources are being directed to regional and national priority service areas and must be devised within the context o f a reasonable budget constraint. However, meaningful measures o f minimum output levels for these standards have not been determined. Any performance/output-based standard must be developed within the bounds o f budgetary balance; fiscal control must place a strict limit on the definition o f minimum service standards. As a first step, a system for determining the basic level o f important public 85 services, that should be available to a population, needs to be developed and specified in terms o f expected per capita funding levels associated with expected levels o f service. Implicitly, a link must be made between levels o f funding and appropriate types o f expenditures and service level outcomes. To be effective, regionahb-regional standards must be consistent with national standards. Regional and sub-regional officials must be held legally accountable for ensuring that any resources allocated by the Central Government or oblast for particular purposes are expended only for the identified purposes. 234. Problem: Operating Expenditure Bias. Existing budgetary structures often implicitly (ifnot explicitly) separate responsibility for capital, maintenance and operating expenditures between levels o f government and are heavily biased toward generating revenue to cover operating expenditures and against financing capital and maintenance. Because o f this implicit split, all truly "local" capital expenditures must be finance by current revenues. Day-to-day needs for operating expenditures, however, crowd-out capital expenditures. In fact, budgetary practices of superior jurisdictions routinely set budget envelopes (by manipulating locally available revenues) in a manner which eliminates maintenance resources. This creates a long-term serious degradation inservice levels and service capacity. Additionally, the differential assignment o f capital responsibilities to the republican and oblast levels and operating/maintenance responsibilities to local (sub-regional) levels promotes a lack o f maintenance, resulting in a serious threat to the health o f the government sector and long-term economic growth. 235. Solution: Unified Consideration of Capital, Maintenance and Operating Issues and a Capital Projects Board. Capital and operational/maintenance expenditure responsibilities for a function should be assigned to the same level o f government and a method o f systematically considering and financing needed capital and maintenance should be established. Specifically, provisions for the long-term financing o f regional/local capital projects i s required. One recourse i s a national bond bank and public infrastructure review board to allow regional and sub-regional governments to propose meritorious projects for debt financing. Financing costs should be funded through a mix o f republican, oblast and sub-regional revenue sources, and resources for repayment should be identified with reasonable certainty and committed prior to project approval. Local governments must be held fully responsible for their portion o f such debts, and the liability for repayment must assume a first position claim on local budgetary resources. CriticalArea 2: RevenueAssignment and Transfers 236. The Kyrgyz Revenue System in Practice. A continuing difficulty in the Kyrgyz Republic (common across the FSU) is a mismatch between sub-national and sub-regional public service responsibilities and available local revenue instruments. The prevailing practice has been to provide flexible tax sharing arrangements and "gap-filling" transfers (inthe form o f subventions, mutual settlements and budget loans) to balance approved sub-national expenditureprograms with available resources. The consequences o f such a system have included serious disincentives for local revenue generation, service 86 inefficiency and inadequacy and a general inability to adapt service complements to local conditions. Since 1997, the Kyrgyz government has taken steps to improve this situation by establishing fixed tax-sharing rates for republican taxes, establishing a set o f specific fiscal transfers for health and education, replacing subventions with a system o f equalizing transfers and by authorizing augmented local regulated revenue instruments. These include an optional local retail sales and service tax, assignment of the land tax to sub-national budgets, and the current consideration o f a local property tax. Still, significant improvements in the development o f local "discretionary" revenue instruments, the establishment o f a structural budgetary framework which truly provides for local control o f resource allocation at the margins, and in establishing mechanisms which adequately compensate for dramatic differences in local fiscal capacity arerequired. The structure o f these intergovernmental reforms has been highly compromised inrecent years and does not extent to sub-regional levels. 237. Revenue System: RegionaVSub-regional Requirements. The intergovernmental finance system should be structured in a manner compatible with a set o f objectives. These include: (i)an assignment o f revenue consistent with the expenditure responsibilities of lower levels o f government; (ii)mechanisms to equalize resources between geographic areas in line with variations in expenditure needs and resource capacities; and (iii) a distribution o f revenue (in the form o f specific grants) to finance services which are a priority to the Central Government, but better administered at the local levels; or (iv) to create price incentives which foster an economically efficient service level. The current system inthe Kyrgyz Republic does not perform as well as it might along these dimensions. 238. In addition, the intergovernmental finance structures needs to promote the realization o f sub-regional, regional and national priorities and promote socially desirable expenditures on services for which the benefit streams can not be contained within the confines o f a single sub-regional government (or oblast). This structure requires grants designed to promote specific functional purposes (e.g., educationor health), inaddition to those designed to redistribute resources to relieve disparities (producing horizontal balance) or provide basic capacity (vertical balance). Sub-National Fiscal Reform Priorities. 239. Problem: Negotiation, "Soft" Budget Constraints & Implicitly Flexible Tax Sharing. Fluid revenue assignments and transfers create the impression that the assignment o f resources i s arbitrary and subject to equally arbitrary change. The lack o f local revenue responsibility creates little incentive for constraint and prioritization o f expenditures at the oblast and sub-regional level. In the past, if oblasts overspent in a function, or planned expenditures turnout to be significantly greater than actual revenues, oblasts looked to the republican level for subventions. While the establishment o f fixed and uniform sharing rates has stabilized the structure somewhat, the manipulation o f the categorical transfer system has created an implicit return to negotiated aggregate tax shares in Bishkek and Chui, with the same destructive effects. This i s coupled with the continued use o f categorical and equalizing transfers as a form o f "gap-filling" transfer in 87 other regions. The result is a "soft budget constraint" and encouragement of over spending, as oblasts vie to squeeze greater amounts of resources from the republican level. This lack of fixed assignment encourages andrewards fiscal irresponsibility. 240. The current system does not provide adequate incentive for the development of sub-regional revenue systems. It continues the perverse effect of penalizing local governments which do so by implicitly reducing their revenue envelope through implicit or explicit reductions in sub-regional transfers and aggregate retained taxes or increasing local expenditure responsibilities by shifting superordinately controlled expenditures to local budgets. This discourages revenue raising efforts and encourages continued dependence on non-local resources. Explicitly and implicitly fixed and uniform tax sharing rates partially corrects for this problem, however, it must be assured that a fixed structure be maintained through to the lower level of the sub-regional governance structure. 241. Solution: Hard Constraints and Fixed Financing. Local government shares of regional tax collections and oblast shares of national tax collections both need to be clearly defined and stable. Law should (i)define taxes to be shared and (ii) establish fixed sharing rate amendable only legislatively at national, regional and local levels. Ideally, sharing rates should be set at uniform levels across sub-regional formations. However, variations in expenditure responsibilities suggest the need for corresponding adjustments in fixed sharing rates. Local revenues and a supplemental (and objectively determined) transfer system should be relied upon for equalization purposes and to provide unmet resource capacity. 242. Problem: Limited Regional/Local Revenue Authority and Budgetary Autonomy. The revenue system for the sub-national level remains one dependent on transfers and shared revenues. The broadest definition of 1995 oblast own source revenue collections generally placed them at less than 10 percent of expenditures.68By 2000, significant improvements were achieved with own source revenue comprising 26 percent of the total. However, many o f these are only own source inname due to the fact that the oblast often has no control over the definition of the base or rate applied. The variations between oblasts are significant, ranging from 3.8 percent in Osh to 21.5 percent in Bishkek for 1995 and 9 percent inNarynto 47 percent for Bishkek in2000. The overall system's lack of locally controllable revenue sources creates dubious incentives and anomalous results. 243. Variability in revenue assignment between levels has created budgetary uncertainty regarding revenues available to satisfy oblast and sub-regional expenditure 68Thisdefinition of own source revenues consists of sources which have been assigned to oblasts, including the enterprise property tax, land taxes, transportation taxes, natural resources taxes, various fees and charges, and taxes on shares and stock revenue. While the land tax is technically a republican revenue source, we have classified it as local because of its assignments, However, this tax and many o f the others lack a critical feature normally associated with "own source" revenue, Le., the ability to control the tax base and rate. The most promising current development in this area is the proposal for a local tax on real property. This coupled with previous institution o f a retail sales and services tax may provide an important basis for meaningful local revenueautonomy. 88 situation. However, the absence o f substantial local revenue sources across regions divorces budgetary expenditure decisions from revenue responsibility, impeding the balancing o f budgetary cost (tax effort) against expenditure benefits. Current local revenue systems also fail to communicate pricing information and incentives to appropriately consider the relative costs and benefits o f local government expenditures. This is a function o f both the implicit soft budget constraint and a lack o f local revenue determination. 244. Solution: Augmented Local Revenue Instruments, Stable Revenue Assignment and Fixed Transfers. To establish the appropriate economic incentives and promote responsible sub-nationalhub-regional budgeting, local governments needto rely on local revenue sources for funding the marginal expenditures within their budgets. To provide proper price signals, local jurisdictions should have discretion in the usage o f and tax rates applied to these local instruments. Sub-regional jurisdictions need to be provided the appropriate incentives to generate revenue. The transfer system has allowed revenue effort in one year to be siphoned away from local jurisdictions in the following year through either a reduction in subsidy levels or manipulation o f the sharing rates or expenditureassignments. The result is a negative incentive for revenue collection. These are damaging incentives that can only be eliminated by a stable revenue assignment and the elimination of ad hoc subsidies infavor o fa stable and objective transfer system. 245. Broader based revenue instruments should be made available to regional and sub- regional units. Adoption o f a particular instrumentand the selection o f an approved rate structure should be at the discretion o f the local government and the revenue generated should be available for general local expenditures.As a solution to revenueinsufficiency, alternative sources o f local revenues should be considered. Prominent candidates include complete and formal assignment o f the land tax to local governments, with the desirable addition o f a tax on the value o f physical structures (the current Property Tax Proposal). The institution o f local retail sales taxes has been a useful addition. A local surcharge on the personal income tax i s a potential additional option. In order for these sources to provide the necessary incentives (Le,, to be truly local), localjurisdictions must be able to set and manipulate either the rate or base o f the tax. Because there are significant administrative and compliance efficiencies to be achieved by fixing the base over time and across oblasts, these incentives should be achieved by allowing individual local governments to vary the tax rate, with the tax base standardized. Lastly, for those services which produce more divisible and private benefits, local governments should adopt user charges to function as an efficiency enhancing pricinghignaling system. Critical Area 3: Structuring Intergovernmental FiscalTransfers TheEvolving Kyrgyz Transfer Structure 246. The primary objectivedfeatures o f the on-going Kyrgyz intergovernmental finance reforms include: (i) rationalized and fixed expenditure responsibility and (ii) revenue assignment consistent with expenditure responsibilities, as discussed above. These are coupled with critical transfer elements comprised o f (iii)a system o f 89 transparent, specific ("categorical") grants to support specific service provision at the regional and sub-regional level via central government resources, and (iv) a formula- based equalization grant to provide a transparent and non-negotiated mechanism for augmenting revenue availability in a manner inversely related to local resource capacity and directly related to expenditure needs. To be effective, this structure must (v) be extended to governing the fiscal relationships at sub-regional levels as well. Together these components provide a framework for generating a fiscal system consistent with the vertical distribution o f expenditure responsibility, and able to deal with horizontal imbalances in revenue capacity, while simultaneously providing proper economic incentives for both sub-national revenue mobilization and the efficient delivery o f services consistent with the needs o f local populations and the priorities o f the national government. 247. Current implementation is, however, haphazard and undisciplined, and fails to meet the intended objectives. Each o f the elements o f the intergovernmental transfer system (categorical grants, equalization grants, and transfer pool) continues to have problematic features intheir implementation. They remain non-fixed and non-transparent inapplication, with amounts and allocations subject to arbitrary annual manipulation in establishing the annual budget law. Still, these transfers (with shared taxes) form the bulk o fregional and sub-regional budgetary resources. 248. Problem: Non-Transparency of the Transfer System. Transfers should be specified inadvance o f establishing the budget, should be calculated inan objective (non- negotiated) and uniform manner, and should have permanency. They should be established based on agreed upon formulas for the distribution o f revenue between the Republican Government and oblasts and between oblasts and rayons and below. Once established, these formulas should remain consistent over the medium-term. Unfortunately, the current structure also falls short along these dimensions. It has not been institutionalized with permanency, i s not objectively derived, i s un-uniform in application, fails to provide certainty and i s non-transparent. It fails to achieve appropriate incentives for revenue mobilization and expenditure efficiency. 249. Transfers via health and education categorical grants are most significant, providing 59 percent o f actual transfer revenue received and 29 percent of actual sub- national budget resources. Equalizing grants are relatively inconsequential, at 12 percent o f transfers and 6 percent o f total sub-national revenues. What might appear most surprisingis the significance of ad hoc transfers inthis "reformed" structure. While not a component of the initially adopted budget, 30 percent of transfers (and 15 percent o f total sub-national revenues) are allocated in response to within year wage, tariff and price changes. Justification might be found in adjustingfor republican required price increases (such as salary increases) after budget adoption; however, resources allocated via these means appear quite unrelated to any objectively derived allocation system. Ifcategorical and equalizing distributions were objectively and transparently derived, necessary mid- year supplemental allocations could be piggy-backed off these formulas for their distribution. Objectivity and transparency is, however, lacking throughout the transfer system. Categorical transfer mechanisms for Bishkek and Chui are manipulated to 90 provide much lower proportionate support for health and education in these oblasts. In essence, they have become intertwined and indistinguishable from equalizing instruments. 250. Solution: A Stable Transfer Framework. The existing transfer systems should be restructured in a manner consistent with expenditure assignments and any desires to promote minimum service levels. Commonly recommended components include: (i)a formula-based, unrestricted grant for equalizing the revenue available between regional and sub-regional units for the delivery o f services; (ii)specific lump-sum grants to finance minimum levels o f services inpriority areas; and (iii) incentive (matching) grants to facilitate efficient service levels; and (iv) capital project grants. The first two o f these are a basic requirement, the second two are desirable. The existing set o f regional subventions, subsidies and mutual settlements must also be eliminated. For clarity and transparency purposes, each objective should ideally be pursued through separate mechanisms and the mechanisms established must be stable, objective and non- negotiatedifthe appropriate budgetarylfiscal incentives are to be achieved. Box 7.3: Components of a RestructuredIntergovernmentalTransfer System 251. Solution Element 1: Real Formula-Based, Unrestricted Equalizing Grants. To provide budgetary stability and certainty, formula-based transfers should be made from the republican government to regional governments and from regional governments to 91 sub-regional formations (usingrepublican and regional government revenues) to equalize their ability to provide basic services. The formula should include measures o f both (i) revenue raising capacity (not actual collections), and (ii) expenditure need in its basic construction. This foundation formula should be used to allocate a predefined pool o f revenues to regional and sub-regional jurisdictions in the form of per capita transfers in direct inverse proportion to the local jurisdiction's local revenue raising capacity and in direct proportion to its relative expenditure needs. Once established, this formula should be fixed and stable. These transfers augment the resources available to the local jurisdictions through the tax sharing and local revenue systems and should be used for general local government expenditures. The current system i s ad hoc at best and particularly lacking instructure sub-regionally. 252. Equalizing grants in the Kyrgyz Republic are quite limited in the level o f sub- national resources provided (5.8 percent). While the "reformed" structure intended for these to be allocated via an objective formula inverse to levels o f fiscal capacity and need, as yet there has been no systematic mechanism for establishing their allocation or levels. Only five o f the eight regional units receivedthese grants during fiscal year 2000 in an amount averaging 14 percent of regional budget revenue (withthe implication that local resources combined with shared taxes and categorical transfers were sufficient to meet basic revenue needs for those not receiving transfers). Naryn received the greatest proportionate transfers at 25 percent o f regional revenues (and 209 som per capita), followed by Batken and Talas at approximately 15 percent o f revenue ( 104 and 119 per capita). For these regions, equalizing transfers are between 42 and 48 percent o f categorical transfers. Equalizing transfers in the other two regions equaled 10 and 19 percent o f categorical transfers. The two oblasts receiving the highest per capita categoricalallocations also received the greatest per capita equalizing transfers. 253. The equalization grants have not reached the level o f stability or transparency required to achieve either necessary revenue equalization or revenue mobilization incentives. While the MoF expended effort toward the development of a formula basis for these transfers, the allocation means actually used continues to be subject to negotiation and resembles that o f a budget "gap filling" transfer rather than a transfer intended to equalize some ability to provide for basic public sector needs. Work i s necessary to develop an appropriate formula basis for these grants and to establish the aggregate level o f resources to be transferred. This will require high level policy decisions regarding basic fiscal capacity requirements across levels o f government and intensive effort at establishing a consistent allocation mechanism. 254. Solution Element 2: Restructuring Education & Health Categorical (Specijk) Grants. An efficient grant structure often entails separate "lump-sum" categorical grant instruments for each service area which the nationalhegional govemment wishes to establish a minimum. In an effective system, funds should be distributed between local units on the basis o f a formula which equates revenues provided with the expenditures requiredto meet minimum service levels per service recipient. These service standards, and the financing o f them, are intended to provide a floor below which resources allocated per recipient will not fall. These amounts should be set annually in order to 92 adjust for price changes in the delivery o f services; however, the substantive level o f service provided should remain relatively constant from one year to the next. The current structure has established grants for education and health, though they are not objectively determined or stable inapplication. 255. During their initial implementation in 1998, categorical grant allocations to the sub-national level were tied directly to budgeted wage and social contributions in the health and education sectors. Subsequently, the MoF devised an allocation method based on weighted pupiland population characteristics inan effort to de-couple the grants from the existing facility and staffing norms. The allocated amounts remained dedicated to covering wage and social contributions, however, amounts were not sufficient to cover sub-national totals. While this is not particularly problematic, the methods o f grant calculation have not beenstandardized, have not been formalized inMoF regulations and are in fact subject to rather arbitrary determination regarding both totals and allocations across oblasts. 256. In actual implementation o f the health and education grants, their role has been mingled with that of the equalization instruments. This has occurred through implicitly varying the level of wage and social contribution across oblasts by manipulating the allocation formula. For example, the categorical grants for education going to Bishkek and Chui cover approximately one-third o f requiredwage and social contributions, while the same grants provide for more than 95 percent in Naryn, Jalal-Abad, Batken and Talas. Furthermore, the 2002 Budget Law passed by Parliament, November 20, suggested a major breakdown inthe categorical grant program, with grant levels initially at zero for both Chui and Bishkek City. While the Budget Law finally adopted restored partial (2/3) funding to Chui, Bishkek's allocationremainedat zero.69 257. A properly executed grant requires a foundation based on policy identifying the basic, "guaranteed" level o f threshold service (to be nationally financed) across all regions o f the country, linkedto a methodology for calculating the appropriate allocation to each region. This should be a national commitment and grants should be provided to all regions at a level consistent with resources required to provide for this service threshold. To provide effective sub-national revenue mobilization and efficiency incentives, the structure needs to be fixed across a period o f time, perceived as being transparent, and not subject to annual manipulation. Much work i s still required in establishing the exact elements o f this basic service level within each sector and the development o f a methodology for allocating resources accordingly. To date, this has not beenaccomplished. 258. Solution Element 3: Establishing Categorical Grant Levels and the Equalization Pool. The national government must establish a fixed method o f determining its commitment o f national resources to the intergovernmental finance structure. In principle, the categorical grant structure for health and education should be based on 69Parliamentalso passeda requirement in 2001 that 100 percent o f education salaries and social contributions be fundedthrough the Republican budget. With the categorical grant as the mechanism for this, it appearsthe final allocation for Bishkek and Chui are not incompliance with this requirement. 93 some measure o f the per student/patient spending requirement necessary to achieve some expected level o f basic educatiodhealth outcome, and the government should fund these grants consistent with that necessary for achieving this outcome across oblasts. This requires both specification o f the level o f achievement desired and a realistic identification o f the corresponding per pupil/patient expected costs on an annual basis. Giventhe rather open-ended nature of an equalization grant, its operationalization is best achieved by establishing a fixed pool o f resources for transfer based on an initial policy decision regarding relative levels o f need and level o f national transfers necessary to meet these relative needs. An ideal system would identify a specific percentage o f national revenueto be annually devoted to a pool from which relative distributions to sub-national units would be based on a fixed, rational and transparent formula. This is necessary to provide a solid foundation for the intergovernmentalfinance system. 259. Solution Element 4: Incentive (Matching) Grants. In addition to fixed (lump- sum) minimum expenditure grants, efficiency enhancing "incentive" grants can be used to encourage local expenditure on services for which benefits accrue to populations beyond the boundaries o f the sub-regional (or regional) jurisdiction or for those services simply felt desirable by the natiodoblast. Inmany cases, the priority o f the service is not such that a lump-sum transfer (in the form o f a minimum service level grant) i s warranted. The higher leveljurisdiction can stimulate additional spending in such areas with minimal levels o f outlays by providing service price reductions to regional or sub- regional formations in the form o f a matching grant and allowing them to select expenditures accordingly. Additionally, incentive grants can be used to stimulate local spending above the minimum defined by a lump-sum grant. While provided for in the Budget Procedures Law,the Kyrgyz structure has not yet operationalized these transfers. 260. Solution Element 5: Capital Project Grants. Transfer systems should avoid ad hoc distributions o f resources to lower level governments. This withstanding, there are purposes for which a regional (and/or national) government would appropriately share the burden o f financing capital projects with local jurisdictions. This can be done through a system of capital project grants. These grants would be allocated based on applications made by local governments for assistance in areas defined by the regional and national governments. They may be lump-sum or matching in their funding characteristic. It i s important, however, that the eligible projects for such a grant be well defined and that the criteria for allocation be objective. This would extend the intergovernmentalframework to the financing o f infrastructure ina manner that promotes both efficiency insuch investment spending and appropriate incentives for maintenance. 261. Solution Element 6: Elimination of Subventions and Ad Hoc Transfers. As a final mechanism to solidify the restructured intergovernmental finance system (and the efficiency incentives it entails), all existing subventions, subsidies and mutual settlements should be eliminated. Local and regional governments should be held accountable for executing their budget within the boundaries o f the revenue available through the formalized tax sharing and intergovernmental grant system, and revenues available from local sources. Oblasts should not provide resources to local governments beyond these unless extraordinary circumstances require, nor should the rayon or oblast extract 94 resources basedon "over execution" or revenues. The same i s the case for transfers from the republicanlevel to the oblast. 262. Ad Hoc Downward Transfers in Practice. The "reformed" intergovernmental structure envisioned a component o f the transfer system composed o f capital project grants available based on application and review by a capital projects board. All other forms o f "gap-filling" transfers were to be eliminated. The second most important component o f the actual transfer system inapplication (accounting for 15 percent o f sub- national revenue) is, however, ad hoc in nature. This ad hoc system, bears no resemblance to the capital project grants provided for inthe 1998Budget Principles Law amendments. All regions receive ad hoc grants, however, they vary significantly in magnitude. The range is from 6.5 percent o f budget resources (64 som per capita) in Bishkek to 29 percent o f budget resources (228 som per capita) in Talas. While the highest per capita recipient of ad hoc grants was the second highest recipient of categorical and equalizing grants and the second lowest recipient o f ad hoc was the lowest recipient o f categorical and equalizing grants, beyondthis, the allocation o f ad hoc grants appears rather random. The oblast with the highest categorical and equalizing allocations was fifth in ad hoc grants and the oblast with the second lowest categorical and equalizing allocation was second in ad hoc grants. The lack o f a clear pattern suggests that these grants neither systematically reinforce nor offset the previous elements o f the transfer structure. They appear quite haphazard in effect, and the exact nature o f their role i s unclear and suspect. Their apparent negotiated nature results in a return to soft budgetconstraints at the local level. They should be eliminated. 263. Ad Hoc Reverse Transfers in Practice. In addition to transfers from above, negotiated transfers also take place from Chui and Bishkek to the Republican budget. These transfers are outside o f the structured process and completely defeat the objectives o f fixed tax sharing coupled with objective intergovernmental flows. Chui's 2002 required transfer to the Republican budget is 41 million som, Bishkek's is 150 million. This amount is determined based on a review of estimated revenue and approved expenditures. Any projected "excess" i s transferred upwards. Failure to achieve the actual targeted level of excess revenue does not reduce the required transfer. Regional budgets are required to be reduced to free resources to complete the transfer and/or a budgetdebt is incurred to the Republicanlevel for the amount o f the shortfall. The same structure i s applied for reverse flows between rayons and oblasts and between villages and rayons. Rayons manipulate local budget envelopes to generate upward transfers. Rayons inChui have assigned some rayon tax revenue to villages, specifically retail sales and service taxes. Ifthese villages fail to meet revenue targets, irrespective o f whether this shortcoming is from local or assigned sources, the rayon will force a reduction in village budgets (across non-protected categories) to maintain the required upward tran~fer.~'This allows the rayon to circumvent the provisions o f the Law on Local Self- Government which requires "local resources" to be retained in local budgets. These transfers defeat the purposes o f the intergovernmental fiscal system. 70 The reduction can be up to the level ofthe plannedamount o fthe assigned tax, providing a cushion for upward resource extraction. 95 Critical Area 4: Sub-Regional Extensions 264. The government has made progress in previous reforms in sorting out nationalhegional expenditure responsibility (see the Law on the Principles o f the Budget), establishing an appropriate nationalhegional revenue assignment (including a stable tax sharing system and improved local revenue options), and codifying the framework for a system o f intergovernmental transfers. Areas requiringfurther attention include: (i)continued development of local revenue sources; (ii)refinement of the character and objectivity o f the categorical grants, specifically moving away from their use as a vehicle for covering predeterminedwages and social contribution requirements in the sub-national health and education sectors to instruments allocated based on an established national standard of minimum service requirements; (iii) establishment o f a transparent, non-negotiated, formula-based equalization grant which transfers resources inverse to local revenue capacity, while maintaining incentives for local revenue mobilization; and (iv) defining a consistent pool o f resources committed by the national government to these transfer programs. Further extension of these reforms to the sub- regional level i s critical. 265. To achieve desired public sector outcomes in the form o f (i) providing for basic needs in critical health and education sectors, (ii) rational support for local public sector activities in areas with poor fiscal capacity, and (iii)maintaining proper incentives for efficient service delivery and revenue mobilization, the intergovernmental framework must be extended to sub-regional (local) levels. It is the local rayon, city and ail okmotu governments which actually deliver basic public services to populations. It is, therefore, the composition o fresources provided intheir budgets, andthe economic incentive which the revenue and expenditure system entails, which determines the overall outcome. To achieve this, however, requires a solidification of the nationalhegional structure as indicated above. ANNEXES 97 ANNEX 1: INTERNATIONAL COMPARISONS Figure 1: SelectedECA Countries,Relationshipof GDP Per Capita and Public Spending, 2000 57 52 Bosnia ' 47 Belarus $ Bulgaria 42 Yugoslavia A a /Russia 37 Uzbekistan mraine 7 ' .z1 KR95 *A 'Romania 32 .u 27 -z 22 17 Kazakhstan a ' Tajikistan Georgia w 12 7 1 I 6.8 7.3 7.8 8.3 8.8 9.3 US%GDP per capita PPP (log values) Note: Inthis figure we use the GDP per capita inPurchasingPower Parity (PPP) US dollars to assess the relativeconsistency betweenthe levelsof spending inthe Kyrgyz Republicand its overall income per capita with regard to the other ECA countries. This overstates, however, the Kyrgyz economy's true spending capacity as the PPPmeasure for the Kyrgyz Republicdoes notyet capturethe sharp real exchange depreciationduringthe 1999-2000 period. Sources: Recent Economic Developments, IMF; World Development Indicators, World Bank; authors' calculations. Figure 2: Selected ECA Countries, Relationshipof Tax Revenueand Income Per Capita,2000 K Georgia r 6.8 7.3 7.8 8.3 8.8 9.3 US$ GDP per capita PPP (log values) Note: Inthis figure we use the GDP per capita inPurchasingPowerParity (PPP) US dollars to assess the relativeconsistencybetweenthe levelsoftax revenueinthe Kyrgyz Republicandits overall income per capitawith regardto the other ECA countries. This overstates,however, the Kyrgyz economy's true revenueraisingcapacityas the PPP measure for the Kyrgyz Republicdoes not yet capturethe sharp real exchange depreciationduring the 1999-2000 period. Sources: Recent Economic Developments, IMF; World Development Indicators, World Bank; authors' calculations. 98 ANNEX 2: PUBLICINVESTMENT PROGRAM 1. Overview of thePublic CapitalExpenditure in 1999-2002 International context. Public capital expenditures in Kyrgyz Republic have been high relative to other countries, such as OECD countries, economies in transition, and developing countries, although after the recent adjustment they almost converge to the mean level for 79 countries (see Table 1). This i s explained by the launching o f various large projects almost simultaneously around 1997 and 1998 (i.e the reconstruction o f the Bishkek-Osh road, the Bishkek Airport, and the irrigation facilities). They were added to a relatively large program o f investments in power (transmission lines) and agriculture. As these projects are completed-and most are now well into their fourth year o f implementation-capital expenditures could be expected to converge to much lower levels, unless o f course new large initiatives are undertaken. Table 1. Capital Expendituresof Consolidated Government in the Kyrgyz Republic(1998,1999,2001) and SelectedOECD Countries(1998) (percent of GDP) Kyrgyz Republic (1999) 10.5 OECD-29 median 4.0 Hungary 6.7 Russia 3.2 Kyrgyz Republic (1998) 6.6 Finland 3.1 CzechRepublic 5.9 United States 2.7 Kyrgyz Republic (2001) 5.3 United Kingdom 2.5 Albania 5.2 Sweden 2.4 79 country median 5.0 Turkey 2.3 Norway 4.1 Kazakhstan 2.2 Bulgaria 4.0 India 1.6 Poland 4.0 Romania 1.o Sources: IMF, Bank staff estimates. The large capital spending program brought about a number of complications. First, it accelerated the contraction o f external debt, which became unaffordable in the aftermath o f the regional financial crisis. Second, it stretched the budget substantially, crowding out recurring spending in most sectors but, even after that, raising counterpart funding has been an issue. Thus, from the external sustainability and budget management point o f view, the Kyrgyz capital expenditure program i s over-dimensioned. These factors have compromised the expected rate o f return o f many o f these projects- many o f which had to be delayed over the course o f the past two years for a number o f different reasons related to the lack o f counterpart funds or to the need to impose borrowing limits. As a result, the expected growth effect from these projects has inmany cases not materialized. While it could be argued that the returnon irrigation rehabilitation has materialized in the form o f a significant growth in the agricultural sector and the avoidance o f floods and other calamities-such arguments are hardto extrapolate to other projects inthe capital-spending program. 99 Even for the case of irrigation, the investments were accompaniedby a strong policy packageto reformagriculture, which mutually reinforcedthe investmentsandresultedin growth. Capital programs in other sectors were implemented in the absence of such strong policy reforms and thus their growth effects are still to be registered. This applies particularlyto investmentinthe power anddistrictheatingnetworks. Structure of public capital expenditures in the Kyrgyz Republic. Public capital expenditures in the Kyrgyz Republic are highly centralized: about 90 percent of total public capital expenditures fall in the republic budget, the rest being split between subnational budgets, special funds of budgetary entities, and four public enterprises7'as can been seen from Table 2. Inthe republic budget, the share of domestically financed investment projects was between 8 and 13 percent in 1999-2002, the rest falling to the PIP. It is worth notingthat during 1999-2002, the governmentreducedboththe PIP and the domestically financed part of its capital budget. More preference i s now given to cost-savingspending on capital repairs and less to new investment. As opposed to the republic level, at the subnationallevelbudgetexpenditureson new investmentprevail. Table 2. Public CapitalExpendituresinthe KyrgyzRepublic in 1999-2002 (percent of GDP) 1999 2000 2001 2002 Republic" 10.18 8.83 5.78 6.67 Foreign financed'* 8.45 7.20 4.56 5.69 CounterpartfundsI2 0.90 0.5 1 0.47 0.48 Domestically 0.82 1.12 0.75 0.50 financed Olw: New investment 0.29 0.72 0.33 0.14 Other 0.53 0.39 0.41 0.36 Subnational 0.24 0.30 0.25 0.13 New investment 0.10 0.16 0.14 0.13 Other 0.13 0.14 0.11 NIA Specialfunds 0.02~~ 0.02'~ NIA 0.0914 Public enterprises/' 0.90 0.91 0.72 0.54 Total 11.34 10.06 6.75 7.43 Reference: GDP,million som 48,321.1 62,202.0 71,282.0 80,271.7 Votes: 1. Does not includecapital expenditures made by EBFs. 2. Includesnet lendingas well as some current expenditures. 3. Without republican entities. 4. Without sub-nationalentities. 5. Kyrgyzguz, Kyrgyzenergo,Kyrgyzultyn and Kyrgyztelecom(except 2002, for which only Kyrgyzenergodataare available). Sources: Ministry of Finance, State Property Fund, WB staff estimates. "AlthoughpublicenterprisesdonotfallintothegovernmentsectorandthusarenotrecordedinGFS,they are a part of the public sector and information on their operations should be recorded as reference pints to enable an analysis ofthe public sector to be made. 100 As noted earlier, the Development Budget72o f the Kyrgyz Republic (or the Public InvestmentProgram - PIP) consists mainly of projects in infrastructure and agriculture. In 1999-2001, transport and communications were the largest recipients of foreign investment aid (Table 3), accounting for about half o f the total Development Budget. About one-third o f all investments from the Development Budget went to the road sub- sector, which i s the single largest item. A share o f investment to the agriculture and water sectors grew from 11 percent in 1999 to almost 25 percent in 2001. The health, education, social security, and general public services sectors received surprisingly low investment from the Development Budget. These four sectors accounted for 8.6 percent o f the total in 1999 andjust 6.7 percent in2001. Table 3. Structure of the Development Budget of the Kyrgyz Republic in 1999-2001 (percent of total) Functions 1999 2000 2001 GeneralPublic Services 0.3 0.0 0.0 Civil Defense 0.0 1.6 2.6 Education 1.7 3.7 2.9 Health 5.7 2.0 0.8 Social Security 0.9 0.7 3.O Transport and Communications 53.6 56.1 42.6 o/w: Roads 27.8 38.0 37.3 Airports 23.6 10.5 0.0 Public Transport 0.0 1.3 4.3 Telecoms 2.2 6.3 1.1 Energy 22.6 16.2 10.3 Agriculture and Water 11.0 14.6 24.4 o/w: Agriculture 6.4 8.3 14.8 Water 4.7 6.3 9.7 Other Economic Affairs 4.1 5.1 13.4 0.0 0.0 0.0 Total 100.0 100.0 100.0 Sources: Ministryof Finance; WB staff calculations. Disbursementprofile of investmentprojects in the PIP portfolio. The prevailing part of the PIP portfolio consists of the mature projects, which are well advanced in implementation, as illustrated in Table 4. During the 1996-2001 period, about four new projects enter the PIP portfolio, with few fmalized duringthis period. These resulted in a substantially large portfolio by the end of2001. Table 4. Structure of the PIP Portfolio by the Start-up Year (as of end-2001) Start up year . . 1994-1995 1996-1997 1998-1999 2000-2001 Average age of portfolio, years Amount of 2 9 10 9 3.5 projects Sources: Ministry o f Finance; World Bank staff assessments. 72 Itconsistsofthe foreign financed public investment program and co-financing from the republic budget. 101 The average annual disbursement rate for this portfolio i s relatively low, at about 16 percent during the first three years of project implementation, as follows from an analysis of 11 World Bank investment projects being implementedinthe Kyrgyz Republic (Table 5). Disbursement profiles of individual projects begin to significantly vary starting from the second year of project life. After the four-year period, during which average accumulated disbursements reaches 72 percent, the disbursement rate falls to about 6 percent untilthe completion of the project. Table 5. DisbursementProfileof the WB Investment Portfoliowith ProjectActive Life 3+ Years (as of end-2001) Average Amount disbursed, <20 <40 <60