Report No. 24443-LA Lao PDR Public Expenditure Review Country Financial Accountability Assessment Joint Report of World Bank, International Monetary Fund and Asian Development Bank (In Two Volumes) Volume 1: Summary Report June 28, 2002 .1, 4 . f~~~~~~~~~~~~~~~~~~~~~4 U,.- Asian~~~~~~~~~~~~~~~~~~~~~~~~ Deelpmn Ban Inlernalional~~~~~~~~~~~~~~~~ MoeayFn World~~~~~~~~~~~~~~~~~~~~~ Bank CURRENCY EQUIVALENTS (as of end March 2002) Currency unit = Lao Kip US$1 = Kip 9480 FISCAL YEAR October 1 - September 30 WEIGHTS AND MEASURES Metric System ABBREVIATION AND ACRONYMS AAC - Annual Allowable Cut ADB - Asian Development Bank ADS - Agricultural Development Services AFTA - ASEAN Free Trade Area AIDS - Acquired Immune Deficiency Syndrome APB - Agricultural Promotion Bank BECL - Banque Pour Le Commerce Exterieur Lao BOT - Build Operate and Transfer BPKP - Bolisat Phathana Khet Phoudoi CPC - Committee on Planning and Cooperation COA - Chart of Account DAFI - Development Agricultural Forestry Industry DOF - Department of Forestry EdL - Electricite de Lao FIL - Foreign Investment Law FIMC - Committee for Investment Management & Foreign Economic Cooperation FOMACOP - Forestry Management and Conservation Project FMU - Forest Management Units FY - Fiscal Year GDP - Gross Domestic Product GFM - Government Forest Management GOL - Government of Lao PDR HIV - Human Immunodeficiency Syndrome IDA - International Development Agency IUCN - International Union for the Conservation of Nature IMF - International Monetary Fund IPRSP - Interim Poverty Reduction Strategy Program IPP - Independent Power Producer IRR - Implementing Rules and Regulations JFM - Joint Forest Management Lao PDR - Lao People's Democratic Republic LECS - Lao Expenditure and Consumptions Survey LSFP - Lao Sweden Forestry Project LTU - Large Taxpayer Unit MAF - Ministry of Agriculture and Forestry MCT - Ministry of Commerce and Tourism MCTPC - Ministry of Communication, Transport Post and Construction MIH - Ministry of Industry and Handicraft MOF - Ministry of Finance MOH - Ministry of Health MOUR - Memorandum of Understanding on Restructuring MTEF - Medium Term Expenditure Framework NAO - National Audit Office NBCA - National Biodiversity Conservation Area NEM - New Economic Mechanism NETG - National Electricity Transmission Grid NOFIP - National Office Forest Inventory Project NPL - Non Performing Loans NSEDP - National Socio-Economic Development Plan NTFP - Non Timber Forest Products ODA - Official Development Assistance PAFO - Provincial Agricultural and Forestry Offices PER/CFAA - Public Expenditure Review/Country Financial Accountability Assessment PHC - Primary Health Care PIP - Public Investment Program PMO - Prime Minister's Office PMO - Procurement Monitoring Office PPA - Participatory Poverty Assessment PPP - Purchasing Power Parity PRSP - Poverty Reduction Strategy Program PSP - Permanent Sample Plots RTM - Round Table Meeting SIDA - Swedish Intemational Development Agency SOCB - State Owned Commercial Bank SOE - State Owned Enterprises SPC - State Planning Committee (now CPC) STD - Sexually Transmitted Disease UXO - Unexploded Ordinance VAT - Value Added Tax VFA Village Forestry Association VFM Village Forestry Management Asian Development Bank Director General, Mekong Department Rajat M. Nag Director Operations and Coordination Division Kazu Sakai Programs Officer Gil-Hong Kim International Monetary Fund Deputy Division Chief, Asia and Pacific Department Peter J. Winglee Country economist, Asia and Pacific Department Stephen A. Cook Technical Advisor, Fiscal Affairs Department Pokar D. Khemani World Bank Regional Vice Preseident: Jemal-ud-din Kassum Country Director: Ian C. Porter Sector Director: Homi Kharas Task Team Leader: Ronald Hood TABLE OF CONTENTS Executive Summary ..........................................i Introduction and Objectives ..........................................I The Three Main Themes ..........................................2 Organization of the Report ..........................................3 The Macroeconomic Framework and Resource Envelope ............... ...........................4 Budget Execution and Control ..........................................5 Public Expenditure Planning and Preparation .........................................8 Poverty ......................................... 11 Scope and Depth of Poverty ................... 11 The Nature of Poverty ......................................................... 13 The Determinants of Poverty ................................... 14 Poverty Monitoring and Assessment ................................... 14 The Sectors ................................... 15 Education ................................... 15 Health ................................... 17 Energy ................................... 20 Forestry ................................... 22 Improve Forest Management and Utilization ................................... 24 Agriculture ................................... 25 Transportation ................................... 27 Matrix of Policy Recommendations ................................... 31 Acknowledgements This report was a joint collaborative effort of the Asian Development Bank, the Intemational Monetary Fund and the World Bank. It was written by a team including Ron Hood (team leader, World Bank), David Husband (ADB consultant) and Stephen Cook (IMF). The report-includes contributions from Nihal Femandopulle (consultant) David Howarth, Pokar Khemani (IMF), Behdad Noroowzi (World Bank), Marc Paoletti (consultant), John Richardson (consultant), Francois Vaillancourt (consultant), John Zohrab (consultant). Many valuable comments were received from Gil Hong Kim (ADB), Keiko Miwa, Allister Moon, Anand Rajaram, Klas Rasmusson (SIDA), Eric Sidgwick (IMF), Vinaya Swaroop, Paul Tumer (ADB), Peter Winglee (IMF). Nancy Mensah processed the report. The report was written with guidance and consistent support from the Director of the Budget Department of the Ministry of Finance, Mr. Sunthom Manodharm. The team would like to express its sincere thanks for the support and cooperation it received during its work in Lao PDR. In particular the team would like to thank Madam Khempheng Pholsena, Mrs. Thipphakorn Chanthavongsa, Mr. Langsey Sibounheuang, and Mr. Anouphab Toulalom, In addition thanks goes to the many officials who supported us in the line ministries and provinces as well officials in the National Audit Office, State Inspection Authority, and the National Statistical Office. Sincere thanks go to Linda Schneider who provided many insights and contacts as well as Malarak Souksavat who supported the team in the field. The report was discussed with the govemment during a workshop in February 2002. The Workshop was attended by Vice Minister H.E. Mr. Liane Thykeo and officials from the Ministry of Finance, the Ministry of Foreign Affairs, the Ministry of Education, the Ministry of Industry and Handicraft, and the Ministry of Communication, Transport, Post and Construction, the Ministry of Health, the Bank of Lao PDR, the National Statistical Center, the Committee for Planning and Cooperation and the Business Promotion Center in the Prime Minister's Office. During the production of the report the Sector Director was Homi Kharas and the Country Director was Ian Porter. EXECUTIVE SUMMARY This PERICFAA examines the means by which Lao PDR, which is one of the poorest countries in Asia, can improve the planning and management of public resources to establish sustainable economic growth and reduce poverty. A clear priority is correcting the serious weaknesses that exist in the basic systems for budget execution and control. While some progress has been made on expenditure control, expenditures, especially at the provincial level do not conform fully to the budget and basic information about expenditure outcomes is lacking to the point that up to this year there have been no consistent, reliable figures on spending by sector. Judging the impact of public expenditures is therefore hard, and the effectiveness of expenditure planning is undermined. Provinces, which collect the bulk of revenues, do not consistently remit collections to the center as required, creating pressure for central government deficits and undercutting the central government's ability to redress marked regional imbalances. Solutions to these problems must be found in improving the basic cash management, reporting, auditing, control and procurement systems that should govern public expenditures. Development partners, particularly the ADB, are offering technical assistance directed at these problems. These are useful first steps but much more remains to be done. Success will be critical to building confidence within the donor community that there is sufficient integrity and transparency of Lao PDR budget systems to warrant continuation of the sizeable flows of donor grants and loans, and to give evidence that increased revenues from future investments, including those in the hydropower sector, will be used effectively. Equally important are efforts to improve budget-planning processes. Consistently evidence from the various sectors shows a pattern of inadequate spending for wages, maintenance and other recurrent items, and heavy emphasis on economic over social sectors. These outcomes are not simply a result of local preferences. They reflect the' fact that the future recurrent costs of capital projects are not estimated and are therefore not adequately taken into account when decisions are made. They reflect the fact that revenues are chronically overestimated and since donors cover as much as 80 percent of the capital budget the only place where ad hoc cuts can fall is on recurrent spending and this tends to be concentrated in the social sectors. Real public sector wages have fallen by half and have and have not appropriately recovered in almost four years. Teachers and hospital workers are paid far less than regional averages, even as a percent of GDP, and as a result are leaving their jobs. These were not planned outcomes. They are the result of flawed systems. Solutions to these problems lie in improving the capacity to do budget planning and costing in a way which will bridge the substantial gap that exists between the setting of plan targets, and the determination of the annual budget. Closer integration of recurrent and capital budgets and more effective use of investment appraisal are needed. Donors must play a part since they have a such a dominant role in the determination of the capital budget. The government must also seek first to measure, and then to contain the losses and contingent liabilities arising from state owned commercial banks and state owned enterprises. Tariffs and fees must be adjusted to reflect full cost recovery especially in the power sector, and to capture more completely the value of sustainable forest resource exploitation. The government's drive for decentralization holds the promise of allowing public services to come into closer alignment with people's needs. But this must be done with appropriate pacing and sequencing. There is a risk that it may frustrate the achievement of budget control and reporting objectives and overburden the lower levels of government - especially the districts - undertaking new budget preparation and management functions. The recommendations offered in the PER/CFAA reflect the fact that progress will be faster in some areas than others. In particular, the need to address the budget control and reporting is urgent. Improvements in budget preparation and planning by their nature will take longer to develop. There are some recommendations expressed in terms of broad expenditure allocation targets and these are consistent with what has been presented in the I-PRSP, the PRGF and the Poverty Reduction Partnership Agreement. However, the main focus is on correcting underlying planning and execution processes in line with the view that this is the best way to ensure appropriate outcomes. Consistent with this is the idea that while special arrangements such as social, environment and maintenance funds can help to achieve better expenditure outcomes, these must be complemented by more fundamental system reforms. It is desirable to reduce off- budget expenditures through improving the Government's capacity for budget management. This PER/CFAA is the result of a full collaborative effort by the Asian Development Bank, the World Bank and the International Monetary Fund in partnership with the Government of Lao PDR. LAO PDR PUBLIC EXPENDITURE REVIEW COUNTRY FINANCIAL ACCOUNTABILITY ASSESSMENT INTRODUCTION AND OBJECTIVES 1. This PER/CFAA examines the means by which Lao PDR can improve the planning and management of public resources to establish sustainable economic growth and reduce poverty. It is meant to support the goals of the government's National Poverty Eradication Program, as well as those of the Interim Poverty Reduction Strategy, the Poverty Reduction and Growth Facility and the Poverty Reduction Partnership Agreement. 2. The challenges in meeting these goals are many. Lao PDR has a relatively sparse population of just 22 persons per square kilometer as compared with 121 in Thailand and 238 in Viet Nam. The economy is overwhelmingly agricultural (53 percent of GDP) and rural (77 percent of the population). Moreover, much of the rural population is widely scattered. Ethnic minorities inhabit remote areas that are regularly cut off from the rest of the country by seasonal rains and some groups move periodically as they practice swidden agriculture. 3. The cost of delivering services such as health and education in this demographic and geographic context is high. The climate and terrain make transportation services costly to build and maintain over long distances that connect relatively small numbers of people. Being land- locked, the country has no coastal waterway and the Mekong river is navigable only through certain seasons. While the population of 5 million is small in relation to the landmass, it is growing at 2.6 percent annually. This rate is high even by lower income country standards and creates greater need for health, education and other public services. 4. In addition to demographic and geographic challenges, Lao PDR faces institution- building challenges as well. For over a quarter century the country has struggled to find an appropriate balance of responsibilities between central, provincial and district levels of government. The current "decentralization" drive will severely test the capacities of the lower levels to perform as needed. Human capital constraints are important but there are also serious weaknesses in the basic systems and procedures for budget planning, execution and control. The distribution of authority, responsibility, and accountability among the various public sector agents is not well designed and is not always clear. Even where the intended roles of the various levels are clear, there are serious gaps between what is supposed to happen and what happens in practice. As a result, expenditures do not fully conform to the budget, and basic information about expenditure outcomes is lacking. Judging the impact of public expenditures is therefore hard, and the effectiveness of expenditure planning is undermined. 5. The ultimate test of policies is the impact on poverty. Despite some recent strides, poverty remains high. Life expectancy at birth has increased to about 59 years, higher than in Cambodia but much lower than for Thailand and Vietnam (about 72 and 68 years, respectively). 2 The infant mortality rate has dropped to 82 deaths per thousand, and the number of children dying before age five years has fallen from 170 deaths per 1000 in 1995 to 107 in the year 2000. These rates are better than in Cambodia but compare very poorly to those in Vietnam, Thailand and other countries in the region. Similarly, there has been improvement in the literacy rate over the past decade but illiteracy in Lao PDR is almost three times the average rate for East Asia. 6. In short, there is ample room for improvement in public expenditure policies and practices. However, these improvements cannot all be achieved at once. Certain steps should be taken immediately, particularly in the areas of improving budget transparency, cash management and expenditure control, adjusting the balance of spending between social sectors and economic sectors and between recurrent and capital spending, and reducing fiscal risks and burdens associated with state owned enterprises in the civil aviation, water supply, logging, energy sectors. Such steps, while important in themselves, will also serve to build confidence within the donor community that there is sufficient integrity of Lao PDR budget systems to warrant continuation of the sizeable flows of donor grants and loans and to give evidence that increased revenues from future investments in the hydropower sector will be used effectively. 7. The PERICFAA also emphasizes that there are other reforms that can only be implemented over time. Better coordination between central ministries and the provinces needs to be developed. Better systems of costing are needed to bridge what is now a fairly substantial gap between the planning process and the annual budget, and to establish a Medium Term Expenditure Framework. The benefits of decentralization will not be realized unless adequate systems of reporting and control as well as training have been implemented first. Greater flexibility and autonomy for lower levels of government need to be supported by fuller development of audit and ex post budget controls. Finally, the enhancement of severely eroded civil service wages and the restructuring of health service charges must be geared to the pace of progress on revenue mobilization. These are all initiatives that must be pursued steadily over a medium-term horizon. The Three Main Themes Spend What You Plan 8. The first theme is that better management and control systems are needed to maintain fiscal discipline and ensure spending has the intended results. It is best summarized by the idea that the government should tax and spend according to the budget plan. Only then can the execution of the public expenditure program and its associated financing be done in a manner that maintains the macroeconomic stability necessary for sustained growth and poverty reduction. This requires exercising control over the budget in two main areas. The first includes implementation of appropriate budget systems and procedures such as budget classification, expenditure control and cash management systems. The second involves minimizing the risks to fiscal stability arising from weaknesses in revenue forecasting, from failure to mobilize revenues, or from unanticipated expenditure demands related to underperformance of state enterprises or banks. The Ministry of Finance has primary responsibility for these matters. 3 Plan What You Spend 9. The second theme is that the expenditure planning process should result in balanced, poverty-focused budgets that use public resources effectively and efficiently. The PER/CFAA suggests that key issues in this area include achieving an appropriate balance between recurrent and capital spending (in part through better donor coordination), shifting the balance between social and economic spending, improving the links between the planning process and the annual budget, enhancing capacity at lower levels of government (especially in the context of decentralization) and the improving coordination between provinces and the central ministries. The Committee for Planning and Cooperation and the Ministry of Finance are the key agencies responsible for these issues. Tell the Public What You Plan and What You Spend, and Hold those Doing the Spending Accountable 10. The third theme reflects the need for transparency and accountability in the budget process. This is probably the most critical issue for the multi-lateral and bilateral donors who currently regard fiduciary risks in Lao PDR as high, and it constitutes the single most important barrier to continued high levels of financial support. Information about expenditure plans and outcomes should be made public in a timely fashion and with a coverage, format and level of detail that allows all stakeholders including the public, the donors and the various levels of government to see and understand how public resources are used. Key elements of this process include publication of the budget and expenditure outcomes, supported by mechanisms that ensure accountability such as the conduct and publication of audits, implementation of appropriate procurement procedures. In addition transactions involving off-budget funds should be moved on budget or at least made public in a transparent manner. The Ministry of Finance and the Prime Minister's Office are the main government bodies with responsibility in this area. Organization of the Report 11. The PER/CFAA is presented in six chapters. Following this introductory chapter, Chapter Two focuses on the macroeconomic framework and the resource envelope. Chapter Three considers issues of budget execution and control. Chapter Four is on budget planning and preparation. Chapter Five explores the dimensions of poverty in Lao PDR and how expenditures planning and management can support the objective of poverty alleviation. The final chapter provides an analysis of public expenditure issues in the context of six major sectors: education, health, agriculture, energy, transportation and forestry. These explore further the means alleviating poverty, as well as highlighting the cross-cutting issues relating to public expenditure planning and management. 12. The principle recommendations regarding policy actions are presented in a matrix following Chapter Six. The policy matrix draws from the broader set of recommendations made in the PERJCFAA but constitutes a smaller set of key actions that focus primarily on budget planning, management and execution as well as policy actions in four of the sectors: Education, Health, Energy and Forestry. The recommendations highlighted in the matrix are of higher priority and are ones that the GOL should be able to put into practice. In each case a timeframe is indicated which takes into account implementation constraints. Some of the policies relating to 4 budget execution and control should be implementable relatively quickly. Others, particularly in the area of budget planning will take longer, and both may require some technical assistance from donors. In addition there are some policy recommendations such as those dealing with forestry, energy and state owned enterprises that will require that the authorities take hard decisions in order to move forward with necessary changes. 13. The PER/CFAA is presented in two volumes. Volume One is a shorter summary. Volume Two follows the same structure but provides more detailed analysis. THE MACROECONOMIC FRAMEWORK AND RESOURCE ENVELOPE 14. The authorities have managed to calm the macroeconomic instability created by sharp increases in investment expenditures in the late 1990s. However, the costs imposed by the contractionary monetary and fiscal policies needed to arrest inflation and stabilize the exchange rate were high. The authorities recognize that given the small size of the domestic (kip) monetary base and the very limited scope for financing the budget by borrowing from the banking system, prudent fiscal policies are essential to create the conditions for sustained growth and poverty reduction. Moreover, Lao PDR remains dependent on donors for funding of a significant portion of its public expenditures and this support will only continue if the donors have confidence in the authorities' ability to manage resources well and in a transparent manner. 15. With GDP growth of 5.7 percent in 2000, rising to 7 percent by 2005 and donor support continuing at about 9 percent of GDP, government revenue should be able to rise gradually from 13.2 percent of GDP in 1999/00 to about 15 percent within 5 years. This would be consistent with a decline in the deficit to around 4 percent of GDP (including grants) and could be funded from foreign sources with minimal recourse to domestic bank financing. However, this result depends critically on the success in mobilizing revenue which in tum depends on establishing a healthy and growing private sector. Without this, macroeconomic stability will be threatened and there will be restricted scope for increasing severely eroded civil service wages and increasing the recurrent expenditures needed to improve service delivery in the social sectors. There is a further threat from the contingent liabilities arising from the banking system and the non- performing loans of state owned enterprises. 16. There has been a persistent pattem of overestimating revenues, perhaps motivated by a desire to enhance collections by setting "optimistic" revenue targets. This results in revenue shortfalls and necessitates either ad hoc expenditure cuts that sharply reduce the effectiveness and efficiency of public spending or give rise to destabilizing bank financing. The current practice needs to be reformed so that estimates reflect most likely outcomes rather than targets. Adoption of a simple, medium-term macroeconomic framework linking growth, inflation, and the fiscal, monetary and extemal sectors would provide a more formal underpinning to budgetary projections and help guide policy discussions. 17. The present system in principle allows the authorities the flexibility to adjust the budget to take into account the inevitable variations in revenue collections over the course of the year. However, the absence of reliable quarterly data on the economy makes judgments on the need for revisions more difficult to implement. Reducing the political costs of a mid-year budget 5 adjustment would allow expenditures changes to be made to accommodate revenue fluctuations in a more coordinated and systematic manner. 18. Currently the "above-the-line" items are not reconciled with the financing, especially as measured by the bank accounts of the treasury. Requiring this reconciliation at all levels of government would provide the incentive to be more conscious of the number of banks accounts used, be more accurate in the recording of revenue and expenditure, and to better monitor the macroeconomic impact of budgetary policies. 19. Recommendation. Improve the budget systems and procedures for revenue forecasting and for mid-year budget adjustments, and introduce better reconciliation between revenue, expenditure and budgetfinancing. 20. Recommendation. Continue with revenue enhancement measures. Improved mobilization of domestic revenues is critical to support the development program particularly as regards the funding of recurrent costs which are difficult to fund with donor resources. These efforts will be needed in part to offset the declines in future AFTA related import duties. There are two main areas for improvement: * Implement the VAT by 2004 to replace the narrower-based turnover tax, thereby raising as much as an addition 1.5 percent of GDP. * Introduce improvements to tax and customs administration including at the Large Taxpayer Unit, and reduce the scope of exemptions. 21. Beyond failure to build revenue collection, contingent liabilities of the government in respect of state owned commercial banks (SOCB) and SOEs represent the most serious threat to fiscal sustainability over the medium term. These issues are the subject of active discussion between the authorities the World Bank and the Asian Development Bank, in the context of anticipated adjustment operations, and the IMF. Specific recommendations on the reform program are not offered here. However, it is clear that broad elements of the program will have to include bank restructuring, recapitalization and operational management improvements. This needs to be accompanied by a cessation of directed and subsidized lending practices. The government needs to take immediate steps to determine the size actual and potential liabilities arising from the operations of SOEs (including those in the forestry sector), to stop further lending to the loss makers and to eliminate non-commercial social mandates at SOEs. In addition to recognizing and provisioning for NPLs and implementing recapitalization programs for banks, processes for working out NPLs between the borrowers, the banks and the other creditors need to be implemented. BUDGET EXECUTION AND CONTROL 22. Since 1993 the GOL has introduced specific reforms in an effort to improve public expenditure management, including the installation of a network of Treasury services and the introduction of a State chart of accounts. More recently, projects for a pilot computerization project for the expenditure chain and for general State accounting have been initiated, and a National Audit Office was created in 1998 -- all with assistance from the Asian Development Bank. 6 23. Furthermore, in fiscal year 2000/01, the authorities implemented a decentralization/deconcentration initiative to give more management autonomy to the provinces and districts. This is reflected in new responsibilities both in terms of determining spending priorities and undertaking financial management. 24. Notwithstanding these reforms however, there remain acute weaknesses in budget preparation, budget execution and expenditure controls. These hinder the design and implementation of sectoral policies and also pose a threat to macroeconomic stability. The weaknesses have recently been compounded by the swift implementation of the decentralization initiative without a sufficiently robust institutional framework that clearly defines new lower government level responsibilities, and adequate. technical capacity to fully implement these responsibilities. For instance the devolution of expenditure authority to the provincial level has proceeded more quickly than the capacity of the National Audit Office to develop effective post audit systems. 25; These weaknesses appear to result from a variety of factors, including; a central planning system which obscures the distinction between planning targets and budgetary allocations; a focus on short-term budgetary pressures; the inertia that prevents modifications to the budgetary system to give greater accountability in budgetary management to provinces and districts; an undeveloped banking system which does not enable the authorities to have an accurate knowledge of the Treasury's consolidated balance on a timely and regular basis; and poor cash management procedures. In addition, a shortage of financial resources to invest in the planning and execution of improvements has also hindered development of public expenditure management capacity. 26. There are coordination problems between the Ministry of Finance and the provincial authorities that are exacerbated by civil service hiring and payment practices. The Ministry of Finance has a small number of staff in Headquarters in Vientiane. But the majority of the central ministry staff, including those in the Treasury, Tax and Customs Departments are located in the provinces. While these staff are officially central ministry employees, the province pays their salaries and benefits. The central ministry, but the actual recruitment set hiring standards and hiring is done by the province. Locally based treasury officials find it difficult to follow centrally mandated expenditure control and financial management practices in the face of conflicting local pressures from the Governor. 27. A clear example of this control problem is the persistent failure of provincial authorities to remit taxes and duties collected at the provincial level to the central treasury as required under the law. This starves the central government of revenues it needs to effect redistribution between rich and poor provinces. The problem is compounded by weak capacity of local staff and by an unusual arrangement of tax administration wherein the provinces collect a number of taxes (including Customs) assigned to the central government, and by an awkward splitting of collection responsibilities between the center and the provinces according to tax payer rather than tax type. 28. In order to better control expenditures, Budget Department review of expenditures was introduced in 2001/02 on quarterly wage and provincial level recurrent expenditures and individual investment projects proposed to help to ensure that, ex ante, spending authorizations 7 are only for budgeted programs, and that there are sufficient funds for this spending, in case of revenue shortfalls. The main challenge is to provide sufficient training and implementation support to ensure that the controls are effective in respect of provincial and district expenditures The level of success will become evident as fiscal 'outcomes are evaluated against budgeted amounts. 29. The GOL is aware of the need to reform the Public Accounting framework to improve transparency and accountability. The ADB is providing technical assistance to produce Public Accounting regulations and guidelines under the Public Accounting Act. These, along with Treasury Department regulations and procedures to be prepared separately will help establish the intemal control framework within the ministries and provinces. To be effective they need to provide detailed procedures for preparation of year end financial statements, for commitment controls on expenditures, for delegation of authority for decentralization of certifying officers, for banking arrangements covering deposit of govemment funds and for intemal controls on use of the retained revenue. In the medium term the Public Accounting Act itself may need to be revised to further clarify roles and responsibilities of various government agencies, to introduce stronger financial management accountability in public sector so that, in addition to compliance with fiduciary and regulatory record-keeping responsibilities, economy and efficiency in use of public resources and the achievement of objectives are also covered. 30. Recommendation. Unify the chart of accounts and the budget classification and revise the budgetary nomenclature to enable expenditures to be identified not only by type (as occurs presently) but also in terms of its administrative and functional classification. The existing budgetary and financial information system is currently unable to show how planned expenditures will implement government policies, and to demonstrate that budget execution is in line with these policies. For example, the current nomenclature does not adequately allow the tracking of expenditures in sectors and programs most likely to benefit the poor. A revised budgetary nomenclature would therefore facilitate the tracking, of aggregate expenditures on priority activities, such as social policies targeted at poverty reduction. 31. Recommendation. Simplify the management of Treasury accounts in the banking system by streamlining the management of bank accounts, and establishing a single bank account for each administrative level of government. At present the unified management of government finances is complicated by the large number of bank accounts opened by local governments in the state-owned commercial banks (SOCBs). As a result the Treasury's position can only be determined on an approximate basis and after some delay. There are, throughout the year, significant positive balances in different Treasury bank accounts throughout the country, and substantial amounts of currency notes in safes in different Treasury offices, at the same time as there are delays in expenditure approvals and payments in other parts of the country. 32. Recommendation. Effective expenditure controls at the commitment level are needed to avoid the risks of undermining both macroeconomic stability and sectoral policy plans during budget implementation. The systems implemented starting this fiscal year through the Budget Department should be monitored closely as budget outcomes become available, and changes to thresholds and other procedures introduced as appropriate. The program also needs extensive training and implementation support especially in respect of provincial and district expenditures. A system for accurate tracking and reporting of arrears should also be developed. 8 33. Recommendation. Further steps toward fiscal transparency and accountability should be taken, including the annual publication of a the budget document shortly after it is approved by the National Assembly and publication of detailed expenditure plans and previous year outcomes as soon afterwards as is practical. While the publication of the detailed 2001/02 budget was a welcome initial step toward greater transparency, this should be an annual undertaking and accompanied by a report on budget execution, reflecting all budgetary operations, both for the State and lower levels of government. The practice of delaying finalization of budget allocations up to six months after the beginning of the fiscal year needs to be significantly tightened, if necessary, by including such detail in the budget passed by the National Assembly. In addition accounts should be prepared and published for off-budget funds. This public dissemination of fiscal information would contribute to greater awareness of government policy and in turn enhance government accountability. 34. Recommendation The GOL needs to significantly improve the accounting and auditing framework and institutions to ensure accountability in the use of public resources including those in the SOEs. The capacity of the National Audit Office should be deepened and in the medium term the statutory basis of its autonomy strengthened. In line with these developments the NAO audits should eventually be made public. A shift towards international standards for public accounting and auditing needs to be underpinned by a comprehensive training program and improved regulation of the private auditing and accounting profession. The govemance, financial reporting and internal controls of SOEs need to be strengthened through improved internal and external audits, use of outside directors and establishment of audit committees. 35. Despite substantial technical assistance from the ADB and the adoption of enabling legislation for procurement systems there is an urgent need to establish a Procurement Monitoring Office in the Ministry of Finance to oversee procurement on a countrywide basis and to undertake necessary procurement training programs. The enabling legislation for procurement is adequate but changes are needed to key implementing rules and regulations. PUBLIC EXPENDITURE PLANNING AND PREPARATION 36. Despite having a budget and planning system that incorporates strong bottom-up and top- down features, a look across results in the various sectors reveals key patterns of weakness in outcomes. Notwithstanding recent improvement, the system still produces expenditures that are too heavily weighted toward investments in the economic sectors, particularly in infrastructure. Spending in social sectors is small in relation to regional standards, in relation to development needs and even in relation to historical pattems in Lao PDR. There is inadequate provision for recurrent spending, not only in the social sectors, which tend to be less capital intensive, but even in the economic sectors where the amounts budgeted for recurrent items such as maintenance and operations are inadequate. There are several underlying reasons for this. One is that the balance of recurrent and investment spending in each budget is effectively determined by planning targets relating to the share of investment spending in GDP rather than by trading off the benefits from additional capital spending versus additional recurrent spending at the margin. This aggregate investment ceiling is relatively high by intemational standards, and forces a lower level of recurrent spending than would otherwise be the case. 9 37. Recurrent and capital budgets are prepared separately and this affects the balance between capital and recurrent spending within sectors as well. In the education sector, for instance, achieving the right balance between new buildings (capital) and books (recurrent) depends on the items being considered simultaneously rather than in separate budgets. A further difficulty arises from the fact that until now capital spending projects submitted to the PIP do not include estimates of the implied future recurrent cost they will entail and are these cannot therefore be consistently taken into consideration in formulating expenditure plans. Excessive capital spending today creates undue pressures on recurrent budgets in later years. However with technical assistance from the ADB and the World Bank the authorities have just issued Decree 58 PM on PIP Management to take effect from the 2002/03 budget cycle and including a requirement that medium and large scale project proposals include estimates of future recurrent costs needs. 38. These difficulties reflect a more general problem of a disconnect between the planning process and the annual budget. The five year and the annual plans are typically specified in terms of outputs or outcomes: tons of rice or literacy rates. Yet the annual budget is specified in terms of inputs, usually expressed in kips. Bridging the gap between the two requires a capacity to do budget costing both for the current year and, in the case of recurrent expenditures, for future years as well. With support from SIDA some initial work has been done in the education and transportation sectors. ADB has supported some recurrent cost estimation for programs in the health sector. But in general, the capacity for doing budget costing is limited. Building the capacity is made much more difficult by the absence of disaggregated budget and expenditure data. These are longer term problems. Adoption of comprehensive program budgeting and a well-costed Medium Term Expenditure Framework with full forward budgets is well beyond current capabilities in Lao PDR. The challenge is to define the first steps and a process towards achievable goals. These should include a requirement that estimates of ongoing recurrent costs be submitted along with proposals for new projects in the Public Investment Program (PIP), and steady development of unit cost measures in each sector along the lines begun in education and transportation, and supported by the collection and dissemination of disaggregated budget and expenditure data following the recommendations in Chapter 4. 39. There is a further need to strengthen information flows between different government agencies. In particular communications between the provinces and the line ministries have weakened, partly as a result of decentralization. Although the Provincial Service Departments of the central sector ministries are supposed to report to their parent ministry, in many instances these departments just report to the provincial Governor and through the provincial authority to the Ministry of Finance and the Committee for Planning and Cooperation. Budget submissions and expenditure outcomes are not consistently reported to the sector ministry and this weakens coordination and planning at the sector level. CPC and MOF approve the budget submissions but they do not have the sectoral expertise needed to ensure that sectoral plans are well designed and are balanced across provinces and districts. While provinces are to become the "strategic units" according to the new decentralization plan, there is a need to ensure some degree of standardization of services and costing practices across regions. The sector ministries should play a role in this, but they cannot do so effectively if they are cut out of the information loop. 40. As noted above the rapid pace of decentralization has made implementation of better financial controls at the provincial level a priority. However, it is also straining capacities at the 10 district level both for budget preparation and financial management. According to the decentralization plan districts are to take on a key role as the principle units responsible for planning and budgeting. Many districts lack the human resources to undertake these new functions. It is therefore critical that the devolution be accompanied by enhanced training in budget preparation and especially district level budget line items are created. 41. Recommendation. Improve the balance between recurrent and capital spending through better costing of operating and maintenance costs of projects and through enhanced dialogue with donors. According to Decree 58/PM proposals for large and medium sized projects submitted to the PIP, including those supported by donors, must include estimates of the future recurrent costs associated with the projects. The estimates associated with projects in the approved PIP should be made available to all the donors as soon as the budget is passed. The government should meet collectively with the donors to evaluate the recurrent cost demands of the new PIP projects included in the budget. This should be done with a view to seeing how these costs compete with other main recurrent funding needs including the recurrent costs of existing projects. The purpose would be to improve the process of subsequent year's PIP formulation. The first opportunity for this would be in the context of the 2002/03 budget. 42. Recommendation. Improve the capacity for project selection, appraisal and management. Through programs such as the ADB Public Investment Management and Project Financial Management the GOL is striving to improve systems for PIP formulation and management. Significant progress has been made in designing manuals and procedures supported by a draft decree on Public Investment Plan Management. These are intended to ensure that a project can only be included in the PIP if it has been approved by the appropriate authority. The new rules require that medium and larger project submissions include recurrent cost estimates and that large projects include cost-effectiveness or cost-benefit analysis to support project selection decisions of CPC and MOF. In the longer run the GOL should promulgate common standards for investment appraisal and it should develop mechanisms for judging individual investment proposals on their merits in the budget preparation process (including competing against recurrent spending proposals). However all of these improvements need to be supported by a sustained program of capacity building in investment preparation and appraisal in both central and line agencies to ensure that provisions of the Decree on PIP Management and the new guidelines and procedures can be implemented and to lay the basis for longer term improvements. 43. Recommendation. The government should build up basic sets of unit cost information to support the budget formulation process. With the introduction of accounting, coding and reporting changes, more useful information on actual spending by program/project will be generated over the budget cycle. These data should be used to support estimation of unit cost measures weaving in data from existing norms where appropriate. Building on this over time, a medium term expenditure framework should be developed to integrate three key aspects of budgeting - the macro fiscal constraints, the (PIP) and annual budget preparation. The MTEF should be formally linked with the core components of the PIP by including projects the commencement of which has been approved. These steps, combined with improved cost information will allow the MTEF to develop more of a 'bottom up' focus than at present. Eventually it would contain all future budget costs associated with each of the Government's spending programs. I1 44. Recommendation. The Government should ensure that all provincial and district level budget submissions and budget outcomes for both recurrent and capital budgets are made to the respective sector ministries as well as to the CPC and MOF. Coordination challenges might also benefit from a case study of the handling of some specific programs and projects proposals in the budget preparation cycle. This would throw light on such issues as the consultation practices within MOF, between MOF and key line ministries and between MOF and the CPC. It would also indicate how far agencies proposing an investment project are required to seek coordination comments from all other affected agencies ministries. 45. Recommendation. Provide adequate support for decentralization. In order to ensure that mechanisms for accounting, budget management and financial control are in place, the devolution of responsibilities to districts needs to be accompanied by enhanced training, especially where new district level budget line items are created. 46. In the medium term the government needs to undertake a comprehensive civil service reform. This would likely entail significant increases in real wages and perhaps changes in the classification and pay scales which separate social service workers in health and education from workers in ministries and government administration. However, budgetary constraints are such that the authorities should concentrate first on training measures, completing the survey of staffing needs, a modest staff retrenchment and implementation of the proposed merit pay and performance review measures. The authorities need to come to a firmer view about the practical limits to the decentralization policy before committing to deeper civil service reforms. POVERTY 47. Public expenditures in Lao P.D.R are on the order of 20 percent of GDP. This is similar to Viet Nam and is even a bit higher than Thailand. However, the composition of Laos PDR's expenditures differs sharply from that of its neighbors. Capital expenditures have consistently exceeded recurrent expenditures whereas in Thailand capital spending was just 36 percent of total spending and in Viet Nam the figure is 29 percent. The wages earned by civil servants including teachers and health care workers are substantially lower than in other countries even as a share of per capita GDP. Although total spending is above average, donor contributions to the budget are considerable and tax effort revenue effort at 10.6% of GDP is among the lowest in the region. 48. Public expenditures should be directed at establishing sustainable economic growth and reducing poverty. Are the policies in Lao PDR well tuned to reaching these objectives? We begin the analysis of this issue by assessing the nature and determinants of poverty. Scope and Depth of Poverty 49. Two expenditure and consumptions surveys in 1992/93 and 1997/98 and a participatory assessment in 2000/01, provide information on poverty. Based on an analysis of the amount of income needed to satisfy the nutritional requirements of household members, and assuming that nonfood requirements approximate 20 percent of the food poverty line, and taking into account 12 regional variations in prices, overall poverty lines were established for each province and district. Table 1 shows the regional and provincial results. ' Table 1: Poverty Situation in Lao IDR, 1997198 Region/Province Povet Incidence Poverty Depth Poverty Severity growth growth growth rate % rate % rate Vientiane Municipality 03.5 -18.2 2.8 -18.5 0.8 -18.3 Northern Region 47.3 -1.7 13.9 0.8 5.8 3.7 Phongsaly 57.9 -4.4 17.0 0.9 7.1 8.3 Louang Namtha 51.1 4.6 14.4 6.7 5.4 9.1 Oudamxay 66.1 7.3 24.7 18.8 12.1 29.5 Bokeo 38.9 -1.7 9.5 6.1 3.5 14.7 Louang Prabang 40.8 -7.2 9.8 -9.1 3.6 -8.8 Houa Phanh 71.3 0.0 23.4 -1.0 10.1 -2.1 Xaygnaboury 17.7 -4.6 3.1 -9.0 0.8 -12.7 Central Region 39.4 -2.7 9.7 -1.1 3.4 -0.1 Xieng Khoang 42.9 -7.7 11.9 -8.4 4.6 -7.8 Vientiane Province 27.8 -2.0 5.7 -2.5 1.8 -1.9 Borikhamxay 27.9 10.4 7.4 23.1 2.8 35.9 Khammuane 44.5 -1.1 11.3 -0.5 3.9 -2.3 Savannakhet 41.9 4.7 9.8 -2.6 3.2 -1.2 Xaysomboom-SZ 26.8 - 19.9 - 8.5 - Southern Region 39.8 -2.8 10.0 -3A 3.7 4.0 Saravanh 39.2 -2.1 10.0 2.8- 3.6 7.2 Xekong 49.7 -6.0 15.0 -8.9 6.5 -9.6 Chanpasak 37.4 -2.0 9.0 -2.5 3.3 -2.9 Attire 48.0 -4.6 12.1 -12.3 4.3 -17.3 Lao PDR 39.1 -3.3 10.3 -1.6 3.9 0.0 Source:Kakwani, Datt, Bountavy, Phonesaly and Wang "Poverty in Lao PDR: 1992/93-1997-98", March 30,2002 50. Almost 40 percent of the Lao population is below the poverty line. The North is the poorest region, with a poverty incidence of 53 percent; by comparison, in the Southern and Central Regions the incidence of poverty is 38 and 35 percent, respectively. The depth and severity of poverty is also most pronounced in the North, particularly in Oudomxay and Houaphanh provinces. 51. Table 2 indicates the improvement in the poverty situation between 1992/93 and 1997/98. These data are less reliable, due to survey limitations for the earlier period, but the trends are instructive. ' The depth of poverty measures the mean distance below the poverty line, while the severity of poverty heavily weights those for whom consumnption falls far below the poverty line. 13 Table 2: Change in Poverty Situation: 1992/93-1997/98 Urban Areas Rural Areas Total Regions 1992-93 1997-98 Growth 1992-93 1997-98 Growth 1992-93 1997-98 Growth Rate Rate Rate Incidence of Poverty ( percent of Poor) Vientianne 26.9 14.9 11.8 52.9 11.1 -31.2 33.6 13.5 -18.2 North 32.7 34.8 1.2 55.5 48.6 -2.6 51.6 47.3 -1.7 Central 26.8 24.3 -1.9 48.5 '41.5 -3.1 45.0 39.4 -2.7 South 13.3 22.9 10.8 51.9 41.6 -4.4 45.7 39.8 -2.8 Laos 26.5 22.1 -3.6 51.8 42.5 -4.0 46.0 39.1 -3.3 Depth of Poverty (Poverty Gap Ratio) Vientianne 5.6 3.5 -9.5 11.1 1.6 -39.0 7.0 2.8 -18.3 North 6.6 7.8 3.2 14.8 14.6 -0.3 13.4 13.9 .08 Central 5.4 5.1 -1.2 11.2 10.4 -1.5 10.3 9.7 -1.1 South 3.1 5.4 11.2 13.5 10.5 -5.1 11.9 10.0 -3.4 Laos 5.5 4.9 -2.0 12.9 11.4 -2.5 11.2 10.3 -1.6 Severity of Poverty (Foster-Greer-Thhorbeck index) Vientianne 1.6 1.1 -7.9 3.4 0.4 -43.4 2.1 0.8 -18.3 North 1.8 2.7 7.5 5.4 6.1 2.4 4.8 5.8 3.7 Central 1.5 1.7 2.0 3.8 3.6 -0.8 3.4 3.4 -0.1 South 1.0 2.0 14.6 5.2 3.9 -5.8 4.5 3.7 -4.0 Laos 1.6 1.7 1.2 4.6 4.4 -1.1 3.9 3.9 0.0 Source: Kakwani, Datt, Bountavy, Phonesaly and Wang "Poverty in Lao PDR: 1992/93-1997-98", March 30, 2002 52. The data indicate that the incidence of poverty declined from 46.0 percent to 39.1 percent, a significant improvement - but again with the North lagging the other regions. The rural/urban poverty gap widened. Most noteworthy, rural poverty rates are roughly twice those in urban areas; the rural poor account for 90 percent of all poor. 53. Income inequalities are another dimension of poverty in Lao PDR. The bottom income quintile of the population accounts for 7.4 percent of total consumption, whereas the top income quintile accounts for 45.3 percent. Moreover, the disparities widened between 1992/93 and 1997/98, suggesting that economic growth during the period disproportionately benefited the top income group. The bottom 20 percent of the population experienced -0.3 growth rate in real consumption, compared to a 4.2 percent growth rate for the top quintile. The Nature of Poverty 54. Notable characteristics of the poor include their ethnic minority status and dependency on swidden agriculture and forest products. Interest in education is minimal, due to the priority concern for securing rice and other necessities. Because of their remoteness, basic services (health, potable water, roads, electricity) are limited or nonexistent. Poverty is reflected in low life expectancy, high infant and maternal mortality rates, and malnutrition. Women tend to be more severely affected by poverty than men due to disparities in labor burden and time allocation. 14 55. The poor tend to live in areas where infrastructure is scarce.2 Only 17.1 percent of poor population is linked to electricity networks, compared with 40 percent for the non-poor. About 38.6 percent of the poor population has access to piped water or protected wells compared with 57.1 percent of the non-poor population.3 The Determinants of Poverty 56. According to the participatory poverty assessment, the foremost deterninants of poverty are land problems, including the quality and amount of land. Small plots or reduced allocations for swidden agriculture without adequate integrated assistance have meant falling yields and very low labor productivity. Livestock disease threatens the main source of savings. Lack of roads and hence lack of access to markets blocks commercialization of slope agriculture. Workable irrigation systems, improved extension services, livestock disease prevention, basic infrastructure and financial services, and family planning are among the solutions identified by the poor. 57. Multivariate quantitative analysis supports and augments these views. Gender, household size, and literacy are key determinants of poverty with female-headed households and larger households tending to be poorer. The literacy rate among the poor is only 57.1 percent as compared with 74.5 percent among the non-poor. Poverty Monitoring and Assessment 58. The authorities have made important strides in measuring poverty through survey work and the establishment of poverty line indicators based on the two household consumption surveys conducted with the support of SIDA and the ADB as well as the Participatory Poverty Assessments and ongoing work on poverty monitoring and evaluation being conducted with the support of the ADB. This information gives good indications of the distribution and severity of poverty. However, from a policy perspective more needs to be done to assess the links between the incidence of poverty and the incidence and impact of public spending. Weaknesses in budget classification and coding mean that the geographic and sectoral distribution of spending cannot be mapped against the incidence of poverty and the distribution of needs. The PER/CFAA makes recommendations about how these shortcomings in the budget reporting system should be overcome. 59. Recommendation. As new budget coding systems are adopted, use the resulting data in conjunction with LECS III and other poverty indicators to explore more fully poverty- expenditure links and more effectively reveal the impact that public expenditures have on poverty reduction by region and expenditure program. 2N. Kakwani, Gaurav Daft, Bounthavy Sisouphnthong,, Phonesaly Souksavath and Limin Wang, "Poverty in Lao PDR: 1992/93-1997/98", March 2002. The study develops poverty lines taking into account regional and monthly costs of living differences and is based on calorie requirement of 2100 calories per person per day. 3Participatory Poverty Assessment Lao P.D.R. State Planning Committee National Statistical Center and Asian Development Bank June 2001 15 THE SECTORS 60. The PER/CFAA deals with two social sectors health and education. These were chosen because of the overwhelming international evidence that they are central to reducing poverty in the medium term and because expenditure polices are critical to determining the quality and access of these public services. The PERICFAA also examines two resource sectors: power and forestry. In both of these sectors there are opportunities for improving management of government's fiscal resources. The extension of rural electrification offers the potential of enhancing the lives of the rural poor and there are clear indications that involvement of local communities in the management of forest resources can have the dual benefit of increasing rural incomes and making a greater contribution to government revenues. Education 61. Education services in Lao PDR are suffering from a combination of poor access, quality, and relevance. While progress has been made over the 1990s in expanding and improving the system, this progress was badly undermined by the deep cuts in recurrent expenditure for education after 1997. Salaries for teachers declined in real terms by almost two-thirds and, in many districts and villages, salaries fell into lengthy arrears. Most teachers have other sources of income, which in rural settings usually means farming. While salaries were increased in 2000, they are still far below their former value and arrears persist. Enrolment in teacher training schools has dropped sharply, and a growing number of graduates have chosen other careers. 62. In the absence of teachers or qualified teachers, and as a result of the lack of schools or complete schools, enrolment rates continue to be low. While net enrolment rate and completion rates have recently begun to increase, growth in enrolment at the primary level in recent years has been little more than the continued rapid growth rate of school-aged children. Some 20 percent of primary school children are effectively "out of the system". Dropout and repetition rates are very high. Low efficiency and effectiveness of the system is further as reflected in the fact that the average time to graduate from primary school is more than twice the normal number of years. 63. Nonetheless, increasing numbers of students are entering lower and upper secondary schools, and even progressing on to tertiary or vocational/technical training. The number of secondary school students has been growing at 3-4 times the rate of primary school enrolments. This poses a serious resource allocation problem for the Lao Government, as the cost per student of secondary education is twice that of primary education. For every university or vocational school student supported by the Government, primary school services could be extended to ten children. 64. The Government's top education priority is universal primary education by 2015. This focus is critical, particularly in overcoming gender and regional disparities. International experience shows unequivocally that the social and individual returns to primary education are substantial, and essential to poverty reduction. Clearly, though, graduates from upper levels are also needed as the Lao economy diversifies and modernizes. Yet'the Government simply doesn't have the resources both to realize universal primary education and allow unlimited access to higher education for all those that wish to pursue further studies. 16 65. Recommendation. Substantially increase the budget allocation for education. After letting the budget share fall to less than 6 percent in 1997/98, or only 1.2 percent of GDP, the Government is now seeking to increase the share to more reasonable levels. It has indicated it will increase the budget share to 12 percent by FY2002. In light of projections under the medium-term expenditure framework, this will still be insufficient. While making allowance for capacity constraints the Government should strive by 2005 and beyond to increase the budget share to 15 percent. This would result in more than 3 percent of the GDP being allocated to education, more in line with the regional norm and the resources necessary for the Lao Government to reach its medium and long-term education goals. 66. Recommendation. Ensure that the majority share of its resources are dedicated to primary education. Currently, somewhat less than 50 percent of budgetary resources for education are for the primary level. This share should be raised to 55 percent or more. Vocational and tertiary education should not be provided at the expense of primary education. Fees should apply to vocational and tertiary students, both because this form of education is highly proprietary and the participants tend to be from better off families. Fellowships, which now are a substantial cost to the Government, should be limited to those most in need. Private institutes already account for more than half of all enrolments in vocational/technical training, apparently with superior results. 67. Recommendation. Rebalance the serious misalignment between recurrent and capital expenditures. Most countries in the region assign 70 percent or more of the education budget to recurrent expenditures, notably salaries for teachers and support staff. The regional norm is for annual teachers' salaries to be equal to almost three times per capita GDP. In Lao PDR, in contrast, the recurrent/capital expenditure ratio is little more than 50/50, and annual salaries for teachers are less than the country's average per capita income. Bonuses and other benefits must overcome the limitation on salaries caused by teachers being part of the public service remuneration system. Supplementary benefits are especially important to attract teachers to remote areas, and to correct unduly favorable student/teacher ratios in urban and better-off rural areas. 68. Recommendation. The donor community must assist the Government in augmenting resources for education, especially in support of recurrent expenditure. To date, donor assistance has been heavily weighted in favor of building schools and other facilities; some 75 percent of capital investment in education has been funded by donors. While constraints on absorptive capacity must be taken into account, programs in support of teacher training, teaching materials and textbooks, education management and other forms of recurrent expenditure must complement capital investment. The fact remains that concerns for access, quality and relevance of the education system in Lao PDR reflect critically on the quantity and quality of teachers. In turn, these reflect the extremely poor levels of remuneration and the relatively flat salary scale, undermining the teaching profession. Broad-based fiscal assistance, coupled with reforms of the remuneration system, is required. 69. Recommendation. The Government and the donor community must combine forces to address regional disparities. The poorest areas of the country have the poorest access to schools and the quality and relevance of the education is especially poor. Poverty is highly correlated with poor education services and low attendance. Many remote villages lack schools or have 17 schools only for the first two years of primary education. Teaching materials and textbooks are almost totally lacking. Provincial education expenditures per capita vary widely, in a regressive manner. The intergovernmental fiscal transfer system, and the system of governance more generally, must be reformed to ensure that all provinces, districts and villages provide at least an acceptable minimum of education services. Donor assistance must be better directed to where it will do the most good. 70. Recommendation. Partnership with communities and improved accountability are essential. Decentralization of responsibility for education is intended to reinforce community participation in the planning and direction of the school system. However, district and village capacity to accept this responsibility is weak; time and resources are needed to build the capacity. Too rapid decentralization appears to have resulted in management breakdowns, such as arrears in teachers' salaries and cessation of proper information flows. Because of the latter, the Government can no longer track public expenditures for education. There is an information and analytical disconnect between goal setting, budgeting, and implementation. And because management has been poor, communities and parents have been called upon to contribute even more to supporting their local schools. Regional disparities have been exacerbated. The implications of decentralization for the education system should be reassessed and only be undertaken at a pace consistent with local implementation capacities' and line ministry monitoring capacity. 71. Recommendation. Partnership with the private sector is important. Private schools account for less than 2.5 percent of the total student population, but even so they offer important supplementary resources to the public system and help gear education to the needs of the labor market. This is most obvious concerning vocational/technical training. Students educated privately free up resources for the public system. In the interest of conserving public funds, the Government could consider tax concessions or a grant system in support of private schools and training institutes. 72. In summary, the challenges facing the Government concerning education are considerable. The goal of "education for all" will likely be elusive, at least for many years. Realism must guide how best to allocate scarce resources, recognizing that many factors bear upon success. Perhaps most important will be the attitudes of parents. Since some 80 percent of families continue to be dependent on subsistence farming, livelihoods take precedence over having children attend school. Efforts to commercialize the agricultural sector and diversify the rural economy should run parallel to extension and improvements of the education system. The greatest need is for qualified teachers, with skills in the interests and language capabilities of their students. The curriculum and schooling period need to respond to local conditions. These factors hold the key to improved enrolment rates, lower dropout and repetition rates, and progression of students through the education system. The savings from greater efficiency will help soften the trade-off between the quality and quantity of education services. Health 73. Despite considerable improvements in life expectancy and a number of basic health indicators during the past decade, Lao PDR continues to compare very unfavorably to other countries in Asia. Infant and maternal mortality rates are 2-3 times those in neighboring Viet 18 Nam and Thailand; only Cambodia's situation appears to be worse. High fertility rates, incomplete immunization, malnutrition, limited knowledge about proper health practices and a weak primary health care system are contributing factors to the poor health status of the Lao people. Ethnic minorities living in remote areas have mortality and morbidity rates that are much higher than the national average. 74. The health system in Lao PDR suffers from severe under-funding and deficiencies in administration. Of total expenditures on health, the public sector accounts for only about 15 percent. Most expenditure (60 percent) is by households, and most of this is for drugs or traditional medicines supplied by the private sector. The remaining 25 percent is from foreign aid. Fees paid for public health services are also significant, reflecting the cost-recovery policy introduced by the Government in 1995. Cost-recovery rates are high compared with those of other developing countries. Donor support accounts for about 85 percent of capital expenditure for the health sector. 75. For most of the past decade or more, expenditure for the public health system has focused on building or upgrading hospitals, particularly the central, regional and provincial hospitals. District hospitals and health care centers have also been of concern, the later in response to the collapse of the cooperative-based network that existed up to the late 1980s. In short, the focus was on curative rather than preventive health services. 76. A series of vertical programs were introduced during the 1990s to help overcome weaknesses in high priority basic services, including for malaria and tuberculosis control, mother and child health, eye care, immunization, iodine supplementation, potable water and sanitation, and reproductive health. Despite their benefits, the vertical program approach to basic health services has proven fragmentary and inefficient. Now the Government, with the support of the donor community, is concentrating on strengthening the primary health care system. Numerous projects and programs have been introduced, each individually beneficial but collectively lacking in coherence and standards. The many ministries and agencies in Lao PDR with roles in health services, and the move to decentralization compound the problem of coherence. 77. Utilization rates for public health services remain very low, due to the poor quality of services, user fees, and the difficulty of access for many villagers. The patient/medical staff ratio is much below the regional norm, and doctors and nurses are concentrated in urban areas. Misdiagnosis rates in district hospitals and health centers are high and the referral system is weak. Less than 30 percent of people in need of medical services turn to the public health system for help. 78. The Government's record in supporting the health sector has not been as consistent as it should. During the first half of the 1990s, the share of the budget for the health sector increased steadily, from 2.5 percent to almost 7 percent. However, after 1997, the budgetary share contracted sharply, to just 4.7 percent in 1998/99 - or less than one percent of GDP. This was among the lowest level in Asia. The drop in recurrent expenditures severely affected salary levels for medical personnel, as well as much needed drug and other essential supplies. For the past two years the Government has begun to strengthen the budgetary share for health. Budget projections to 2005 indicate an increased share of the public investment program will go to the 19 health sector, but more critical is the share for recurrent expenditure - which remains a question mark. 79. Regional disparities in health serves are serious. Basic health services are most deficient in areas where the poor are concentrated. The northern region has the highest incidence of poverty and the poorest level of medical services. Variations in medical services are particularly severe at the district and village level. The non-poor have better access to medical practitioners, community health workers and immunization programs. 80. Achievement of "health for all" will depend upon the Government designing and implementing a comprehensive approach to health care. The Health Strategy up to the Year 2020 includes five priorities: improved quality of services through better qualified and paid health personnel, renovation and improvement of existing healthcare facilities, improved budgetary support, clarification of the legal and regulatory framework, and clean water for all. While these elements are critical to strengthening the health system, they are too general to provide a clear guide for efficient and effective resource mobilization for the sector. Also, there are other issues or concerns that need to be addressed. 81. Recommendation. Strengthen incentives for improvement in quality of health services. The Government should provide for: * proper salaries and benefits to attract qualified medical personnel; * supplementary benefits for medical personnel serving in rural areas; * retention of treatment fees in support of improving salaries for medical personnel; * removal of the 20 percent tax on cost-recovery revenue; * a central/local government cost-sharing provisions in support improvements in health services; * strengthening local capacity to manage health resources. 82. Recommendation. Respond to market failure. Government resources should be directed to areas where market failure is most pronounced and positive externalities the strongest, notably preventive care. Accordingly, the Government should provide for: * free or highly subsidized immunization and advisory services (e.g., family planning), and medical supplies (e.g., impregnated bed nets, nutrition supplements) related to population and major disease control; * education and information programs to heighten awareness of good health practices (e.g., hygiene, nutrition, birth spacing, HIV/AIDS); * partial subsidization of rural water supply and sanitation, together with implementation of a price system to encourage private sector participation in the supply of such services; * maintenance of high quality, affordable essential drugs in public health facilities; * proper regulation of private sector provision of medical supplies and drugs 83. Recommendation. Rationalize resource use. Devolution of responsibility for health services offers the opportunity to rationalize resource use. Accordingly, the Government should provide for: 20 * reassessment of health targets and associated resource needs, consistent with the government's medium-term expenditure framework; * reassessment of central/provincial responsibilities respecting health care, ensuring that essential national interests (e.g., standards for medicines) are respected while maximizing flexibility in response to local needs; * realignment of health resources in favor of preventive health care, particularly for programs and measures important to the health status of the poor; * integrated health services at the provincial level, leading to comprehensive preventive care systems incorporating the vertical programs of the central government and funds expended under the Rural Development Program; * a much strengthened referral system, ensuring that curative care is provided where it is most effective and efficient; * improved quality of services, so ensure better utilization rates of health facilities; * a better spatial and professional distribution of medical personnel; * an integrated approach to health services, incorporating education, transportation and other factors; * effective coordination of donor assistance, resulting in a coherent health system. * expanded integration of the vertical programs in basic health. 84. The above recommendations will not be easy to implement, especially since the resource constraints are so tight. The key to improving public health services is strengthening the budget for recurrent expenditures, which in turn depends on strengthening domestic revenues. Energy 85. Lao PDR's hydropower resources have the potential to contribute substantially to the goal of poverty reduction provided the revenues are used to benefit the poor. Exports of electricity to Thailand, Lao PDR's only export market for electricity to date accounted for almost 30 percent of total exports in 2000. They added some 8 percent to gross domestic product and generated US-$45 million for the Government, potentially adding more than 15 percent to fiscal revenues. These earnings and contributions will continue to grow, as the result of sales and ownership provisions associated with existing hydropower facilities - even though they tap only 3 percent of Lao PDR's estimated hydropower potential. 86. Eamings will grow much more rapidly if the proposed 1088 MW Nam Theun 2 project goes forward. If commissioned in 2007, by 2010 it would add some $25 million annually to Government revenues - a boost of more than 5 percent. The total benefit to the Government at that time from electricity exports would be some $136 million. Beyond 2010, the revenue growth from hydropower sources would be rapid. A great deal of study and planning has gone into ensuring that such benefits will not be compromised by environmental or social setbacks. 87. Hydropower represents renewable wealth that can greatly advance the Government's goal of having Lao PDR graduate from the status of least developed country. Improved transportation, education, health and other services are critical to helping people break the dependence on subsistence farning and the cycle of poverty. While donors are providing valuable assistance, recurrent expenditures supporting these services are the responsibility of the Government - and 21 are ultimately dependent on the revenue base. Revenues must be increased and hydropower development is vital. 88. It is also important for extending electrification to the rural population. Less than 20 percent of the rural population has electricity service, which is one of the factors limiting commercialization and diversification of the economy. The incidence of poverty strongly correlates with the lack of electricity. Since so many rural people live in remote areas without ready access to roads, extension of electricity services to them will require off-grid facilities as well as transmission lines - where feasible - from the on-grid system. The Government expects that by 2020 electricity will be available to 90 percent of the population. 89. The financial and technical resources necessary to both expand Lao PDR's export capacity and extend electrification to the rural population are far beyond the means of the Government. Partnership between domestic and international investors, representing public and private interests, is necessary. Partnership, however, will be conditional on a series of reforms and measures designed to put the energy sector on a sounder footing, and to ensure that the people of Lao PDR share equitably in the benefits of hydropower development. 90. Effective exploitation of hydro resources will require fundamental changes in the institutional and regulatory framework. The government's efforts to commercialize Elecricite de Lao (EdL) started in the mid-1990s under technical assistance support of the World Bank and ADB. Since then, EdL has been established as a separate juridical entity with a functioning Board of Directors. Also, EdL has strengthened its financial management capability, has been reorganized on the basis of cost centers that facilitate accountability of each operation, and the utility has divested from some non-core activities. This process was supported by the enactment of the Electricity Law which supports the commercialization of the sector. Following the 1997 regional financial crisis, EdL's financial situation was seriously affected by exchange losses. In response to this situation, in December 2000 a Financial Recovery Plan was proposed for EdL calling for: (i) conversion of some debt to equity; (ii) temporary relaxation of onlending conditions to EdL, particularly for debt associated to social-oriented investments; (iii) undertaking a tariffs study and the subsequent implementation of a new tariff policy; (iv) revaluation of fixed assets; (v) signing of a performance agreement between EdL and the government; and, (vi) review of EdL's investment plan. In spite of the slow implementation of this Plan at the onset and some asset revaluation is still ongoing, almost all of the measures have been implemented at this stage. New tariffs approved in early April 2002 and EdL will most likely be able to comply with financial covenants for the first time in more than four years. 91. The Electricity Law, passed by the National Assembly in 1997, established a basic legal framework to attract, direct and control optimal investment in power projects. Then in March 2001, MIH issued a Power Sector Policy Statement setting out the conditions for the beginning of a power sector reform, providing possibilities for a greater private sector participation and competition and establishing the following four goals: (a) maintain and expand an affordable, reliable and sustainable electricity supply within the country to promote economic and social development; (b) promote power generation for export to provide revenues to meet GOL development objectives; (c) develop and enhance the legal and regulatory framework to effectively direct and facilitate power sector development; and (d) reform of institutions and institutional structures to clarify responsibilities and streamline administration. These polices are 22 necessary and appropriate for the development of the sector but neither the Power Sector Policy Statement nor the specific actions needed to support the goals have been formally adopted by the government. In discussions with the World Bank and the ADB, the government has undertaken to hold a workshop to open debate on power sector reform strategy. During this process the authorities need: i) to reconsider the requirement that EdL take an equity position in all IPPs and instead allowing benefits to flow through fees, royalties and taxes rather than dividends; ii) to consider the separation of EdL from its off-grid and IPP responsibilities, and iii) to establish an independent regulator for the power sector. The workshop process should underpin formulation of a specific action plan, which would then be formally adopted by the government. 92. Recommendation. Complete tariff reform to eliminate use of revenues from export sales of electricity to subsidize domestic beneficiaries. The Government has steadily increased domestic tariffs for electricity for the past two years and is now committed to a schedule of 36 monthly consecutive increases of 2.3 percent. However tariffs presently are still only half the level needed for full-cost recovery. Consequently, EdL, the state agency responsible for the generation and distribution of electricity, suffers large losses from its domestic sales, which are offset by profits from its exports. Only 25 percent of the profits from export sales were passed forward to the Government. Revenues that should flow to the Government in support of essential services, such as transportation, health and education, are used instead in support of domestic electricity consumption - predominately by urban and industrial users. Subsidies for rural electricity, if necessary, should flow through the budget. International support for further hydropower development, including the NT2 project, will require that domestic tariffs move steadily towards full cost recovery. International support can only be justified if there is assurance that the benefits will flow to the people, including the poor through improved public services. 93. Recommendation. Hold workshop on power sector reform and, adopt a time bound action plan for its implementation. 94. Recommendation. Donor assistance for the energy sector should promote equity, effectiveness and efficiency, together with protection of the environment and respect for social concerns. Donor assistance for rural electrification should encourage private sector investment in, and management of, power facilities and there is a need to identify suitable and sustainable mechanisms to promote private sector investment in off-grid rural electrification. Pilot projects should endeavor to minimize creating expectations of free services, giving rise to claims for equal benefits by other communities. Energy conservation should receive more attention, including assistance to EdL to reduce its distribution losses. Forestry 95. Several factors set Lao PDR apart from other countries in the way in which the forestry sector is linked to public expenditures. The economic value and the size of the forest sector relative to other economic sectors means that forest policy is unusually important in helping to shape overall levels of economic activity, and public revenues (both direct royalties and fees as well as indirect revenues on processing and other activities). The share of forest based revenues to the public budget, which have recently been as low as 5 percent per year, could, through a set of reforms be sustainably increased to about 15 per year. In addition, the ways in which forest 23 resources, including forest land, timber and non-timber forest products, enter into the economic life of poor rural communities means that forest policy does a great deal to shape the demands placed on the public expenditure system for poverty alleviation and rural services. The Government has the opportunity to use forests directly for poverty reduction through innovative, participatory institutional arrangements such as village forestry. 96. Eighty percent of Lao PDR is forested, with more than half covered by extremely degraded forest. Two and one-half million hectares are designated as production forests, but these are not mapped, criteria for their designation are not published, and logging is not confined there. Deforestation is occurring at 0.6-0.8 percent. per year. Log production has grown at an increasing rate since the 1980s. Only 57,000 hectares of plantations have been established, of which less than half is available for production. 97. Forestry contributes 7-10 percent of Lao GDP and 15-20 percent of non-agricultural GDP. In rural areas forest exploitation is one of the few available economic activities, and non- timber products provide more than half of family income. The sector contributes 34 percent of total export value, and even more of net foreign exchange. There is also in-kind barter trade with neighboring countries. Forestry royalties as a share of GOL revenues has decreased from 20 percent in the mid-1990s to 6 percent of tax revenues and 5 percent of all revenues last year. Collection rates are low, around 50 percent, and royalty revenues have been declining since mid- 1990s. Over the last five years, Treasury has realized only about one-third of the estimated market value of the timber harvested and there are problems in accounting for forestry revenues that have been reported as collected but not transferred to the central government budget. 98. Current wood industries' capacity largely exceeds long-term sustainable harvest rate, and despite heavy investment, their performance has not met expectations. In the early 1990s, some 39-49 percent of operating capacity was owned by state-owned enterprises (SOEs). There is no evidence that wood production has had a positive impact on rural poverty; rather it has had a negative one by destroying the environment on which the poor depend. 99. Forest management regulations, timber export restrictions, and log royalties are among the most important incentives affecting resource users. Unfortunately, the way in which royalties are applied, quotas set, and operations regulated provides few signals to users of the actual scarcity of forest resources, promotes excessive demands on the resource base, and discourages resource management and conservation. 100. Progress of industrial plantation initiatives are encouraging. With an appropriate regulatory environment there is increased scope for commercial plantation that will build on the demonstrated willingness of individual farmers and enterprises to engage in production forestry. 101. Village-managed forestry (VFM) has been demonstrated successfully in terms of production, sustainability, revenue generation, and equity. Analysis suggests that 54 percent of the production forest area and 51 percent of annual volume growth has potential for village management, with a potential beneficiary population of 1.5 million people. VFM and government forest management (GFM) are complementary, and about half of the country's forest area needs to be put under effective government management. 24 102. Among governance concerns, there are inconsistencies in the legislative and regulatory framework, unaccountable SOEs, and local-central assignment of responsibilities that may be failing to provide consistent protection of the national interest. Logging in particular, has grown increasingly independent and secretive, and is not monitored in any significant way. Decentralization could lead to substantial improvement in forest management. It is necessary, however, to retain national control where there are divergences between national and provincial priorities, such as in biodiversity conservation, watershed protection, foreign trade, and revenue collection. Illegal and illicit logging are major governance issues. Improve Forest Management and Utilization 103. Recommendation. Define Forest Management Units and Prepare Management Plans. A first task is to define specific forest management units (FMUs) and prepare management plans for them, which in turn requires a clearly defined and mapped national forest estate and the establishment of management entities. 104. Recommendation. Strengthen the Regulatory Apparatus. GOL needs to complete, clarify, and simplify the legal and regulatory framework and establish an effective regulatory body to oversee forestry operations. 105. Recommendation. Increase Reliance on Market Approaches and Mechanisms. GOL should move away from intervening in commercial decision-making in the wood market and in the wood industries sector. 106. Recommendation. Restructure State-owned Enterprises. SOE reform should begin with disclosure of financial audits, non-performing loans, and data on logging activities, and then extend to discontinuation of preferential logging contracts, harvesting quota allocations, access to domestic and foreign markets, and clearing for land conversion. Community Participation in Forestry: 107. Clarify the legislative and regulatory framework. GOL should establish clear predictable procedures for the rapid expansion of the area under village management. 108. Ensure commercial autonomy for VFAs. GOL needs to provide assurance that Village Forestry Association can conduct the full range of commercial and marketing activities needed to maintain themselves as viable commercial forest management entities. 109. Improve village land allocation. GOL should more substantively integrate the lessons leamed from community forestry pilots into its village land allocation process to make it more equitably sustainable and productive. Controlling Illegal Logging 110. Curb sources of pressure on the resource. The government should stop promotion of excess wood processing capacity by prohibiting licensing of new wood processing plants, as stipulated in the Prime Minister's Order No. 10/PM/2000 and by allowing inefficient mills to go out of business. 25 111. Enhance law enforcement effort. A progranm to control illegal logging needs to address prevention, detection, and suppression activities. GOL can help in preventing illegal logging by starting a forest crime monitoring program to systematically collect data on illegal logging and improve to monitor log exports crossings and to prioritize needs for suppression and prevention efforts These steps could be taken quickly and at low cost. Agriculture 112. The agricultural sector is central to poverty reduction in Lao PDR, since more than 80 percent of all households in the country are dependent on it for their livelihoods. Accelerated progress in moving beyond subsistence farming to a more commercial, diversified and productive basis is essential. The role of the Government in this process is vital, for it must complete the transition to a more market-based economy and ensure that its interventions in the agricultural sector are consistent with supply and demand forces - rather than a continuation of central planning. 113. Food security is the top priority of the Government, designed to overcome local and seasonal shortages that in the past resulted in great hardship for the people. Accordingly, the budget for agriculture (8-10 percent of the total) is relatively strong, complemented by considerable expenditure for rural development. The main focus of support under the agricultural budget has been investment in irrigation systems, so as to increase yields during the wet season and to enable double-cropping during the dry season. Although inefficiency and inadequate operations and maintenance budgets for irrigation investments remain a concern, these projects helped sustain 50 percent increase in rice output during the 1990s. However, in many respects the most important support for the sector has been improvement of the transportation network, which is beginning to free many households from subsistence farming - still the defining characteristic of the rural economy. 114. The agricultural sector generates slightly more than half of total GDP, a considerable drop in significance relative to the start of the 1990s. The decline in importance is expected to continue, even if the growth rate of five percent per annum for the past five years is maintained as targeted. The downward trend in share of GDP reflects much faster rates of growth for the service and industry sectors, especially the later. In turn, this reflects the contribution of hydropower and other industry to Lao PDR's economy. The long-term restructuring of the economy parallels the experience of other developing countries in the region. Indeed, this experience underscores the importance of restructuring, for agriculture alone cannot be counted on to overcome rural poverty. Nevertheless given Lao P.D.R's mountainous, land-locked situation and lack of human resources, agriculture will remain a key sector which the government needs to support through provision of necessary rural infrastructure, policy reforms, and development of market access and information. 115. There is considerable potential for diversification into selected cash crops, as illustrated by the sharp rise in coffee exports. There are also many impediments to major gains in agricultural production. Low input/low output characterizes the sector, perpetuating the cycle of poverty. The Mekong flatlands present a positive outlook for advances in productivity and commnercialization, as they have benefited from transportation improvements, electrification, and proximity to markets in Thailand. The slope or upland areas, in contrast, pose much more 26 difficult challenges, as the land base is not well suited to agriculture and the basic infrastructure is so limited. 116. Public resources in support of the agricultural sector have not been used to the best advantage, as too much as been invested in irrigation systems and too little in research, extension and other essential services. The Government continues to set targets for agricultural subsectors, and to subsidize key inputs such as credit, resulting in a less favorable environment for private investment and enterprise than should be the case. Foreign investment in agriculture has been insignificant, slowing technology and management advances and development of export markets. 117. Recommendation. A number of basic steps are needed to realign Government support for the agricultural sector: * The Government should refrain from setting production targets, and programs in support of these targets, and focus instead on ways it can support commercialization of the agricultural sector. Factors critical to commercialization are technology, information, land, credit, and access to markets. * Strengthen research and extension services. Only 30 percent of households use improved varieties of rice; advances in livestock breeding and disease protection are also important; extension services continue to be very weak, limiting the benefits from research. * Promote commercialization and private participation in agriculture. State owned commercial enterprises in agriculture absorb budgetary resources and depress production by lowering the prices paid to farmers. Their role should be scaled back to allow for greater private sector participation. * Accelerate land titling and amend the Land Law to allow accumulation and economies of scale. The average farm size is 1.6 ha, broken into two parcels; 80 percent of cropland is for paddy production; the Government should more closely evaluate the land base, and modify its strategy for the sector in light of what is more realistic. * Phase out the practice of heavily subsidizing and directing lending related to its priority programs (e.g., food production). Poor financial intermediation has resulted in failure to mobilize domestic savings and has limited growth of the agricultural sector; subsidies through the Agricultural Promotion Bank amount to about $6 million annually, the equivalent of 15 percent of the total agricultural budget. * Ensure that infrastructure investments in roads serve agricultural interests effectively and efficiently. Strengthen the trade regime and support for marketing of agricultural products. Past focus on the national and provincial core network must be complemented by a strong farm-to-market network. 118. Realign recurrent and capital expenditures for the agricultural sector. Recurrent expenditures fell sharply after 1997, particularly for O&M costs. Factors relevant to this realignment including the following: * Apply cost/benefit analysis of alternative uses of scarce public funds. Government- sponsored investment in irrigation pumps in 1997/98 was undertaken without thorough analysis of the expected returns or risk. * Encourage private investment as a substitute for to public investment, including through security of land title and the right to own larger farms; foreign investment in the 27 agricultural sector should be encouraged; SOEs in the agricultural sector should be limited. * Create strong institutional and incentive arrangements for the rehabilitation and maintenance of existing facilities. Establishment of water users' associations has been slow and irrigation systems have not been properly maintained; full-cost recovery principles should apply to water and electricity used for irrigation. * Learn from international experience, including well-developed extension services to introduce new seed varieties, livestock breeding, disease prevention, and proper use of pesticides and fertilizers, are low cost and yield high rates of return; extensive investment in human resources is needed, especially for field staff. 119. Promote rural diversification, acknowledging that poverty reduction will not result from improvements in agricultural production alone. In the case of Malaysia, China, Thailand and many other developing countries, agriculture contributed very little to improvements in per capita income - as output did little more than match rural population growth. According the Government should: 120. Encourage off-farm employment through support for sustainable development of the forestry and other rural-based opportunities (e.g., mining, tourism). * Reassess the roles of MFA and the Leading Committee on Rural Development in promoting rural diversification. * Close the infornation disconnect between national plans and actual expenditures. Transportation 121. Continued improvements in Lao PDR's road network are vital to transformation to a more market-based economy. Better access to markets, as well as access to education, health, electricity and other services, is essential if the rural poor are to move beyond subsistence fanning into more productive uses of labor, land and capital. 122. Despite expenditure amounting to nearly $600 million over the past decade, and additional amounts financed through forestry concessions, only 40 percent of the national network is in good or fair condition; provincial and district networks are in much worse condition. Almost half of all villages are more than six kilometers from a main road and are not accessible during the rainy season. 123. Traffic volumes remain very low, reflecting the small and widely dispersed population, and Lao PDR's least developed country status.4 Nevertheless, rehabilitated or newly constructed roads are deteriorating at a much faster rate than would normally be expected. Maintenance has been minimal and regulations against vehicle overloading (mostly related to logging) have not been enforced effectively. Lack of trained staff has resulted in poor planning, while lack of equipment and inadequate standards have resulted in poor repairs. District and rural roads have been neglected almost entirely. 4The ADB evaluation reports indicate, however, that on its road projects traffic volume increases are generally significantly higher that projected. 28 124. Recognizing that it makes no sense to continue to devote more than 55 percent of total public investment to road rehabilitation and extension while the network overall deteriorates through lack of maintenance, a Road Maintenance Fund was established in late 2001 to rebalance recurrent and capital expenditure for the transportation sector. The fund pools resources from a special fuel levy and heavy vehicle surcharges, together with an expected $35 million in contributions from donors (IDA, SIDA, ADB) over a four-year period. Establishment of the Fund runs counter to "best practice" principles of public expenditure management. However, it will help to allocate maintenance activities in a more effective and efficient manner. It may also help to offset the sharp drop since 1997 in revenues from fuel taxes and import duties on vehicles and related parts. The project was made conditional on the establishment of Road Management System (RMS), which is designed to help maximize effective use of Ministry of Communication, Transport Post and Construction's (MCTPC) limited resources and is supported by the World Bank and SIDA. In addition SIDA and the World Bank helped establish a Financial Management System for the road sector at centrally at MCTPC and in nine provinces. This has been closely coordinated with the ADBs Financial Management project that is currently being piloted in four ministries including MCTPC. Substantial capacity building work remains to be done however to ensures that the RMF is successful in rationalizing resource use, ensuring a more consistent work flow and encouraging the development of local contracting firms. 125. During recent years, public expenditure for the transportation sector has been equivalent to 7 percent of GDP, which is much higher than the regional norm of 2.5 percent. The (PIP) to 2005 indicates a moderately declining share for the sector, to a level of about $100 million annually - or 10 percent below current levels of expenditure. Donor assistance has financed some 85 percent of road investment during the past five years, and this level of support is expected to be largely sustained. Feasibility studies prepared by donors play a major role in project design and allocation of public investment for the transportation sector. 126. With no railway and with civil aviation and water transportation playing relatively minor roles, the focus will continue to be on the road sector.5 The expenditure emphasis will shift from exclusive focus on national and provincial roads to include district and village roads. Such a broadly "pro-poor" policy, can potentially create considerable agricultural productivity and employment gains, but it must be affordable and sustainable. The investments need to generate sufficient additions to the economy and the revenue base to fund necessary maintenance. On most of the secondary road network, the average traffic flow is less than 50 vehicles per day. The shift also raises trade-offs between national and regional growth objectives, especially in light of the transition - however gradual - to a more diversified, industrial and urban economy. Decisions made conceming road investments should be integrated with other dimensions of development - notably the opportunity for sustainable productive employment. 127. Provincial responsibilities extend to management of all provincial road projects within the province concerned as well as the maintenance, procurement and contract management for national roads within the province, while district and village authorities are responsible for the construction and maintenance of roads in their jurisdiction. However, the latter lack the funds and capacity to fulfill their responsibilities. Also, linkages between levels of government have 5The importance of civil aviation is nevertheless expected to increase in line with tourism development necessitating a greater focus on aviation safety. 29 yet to be clearly defined, and financial and accounting systems have not been fully harmonized. Decentralization appears to have pushed ahead of capacity, resulting in no real system for ownership and maintenance of the road networks. Technical, institutional and logistical support is needed, as well as procedures for greater transparency and accountability. 128. Regional disparities in transportation services are serious and they correlate strongly with the incidence of poverty. The very poor tend to live in areas where the road network is especially weak; 70 percent of the very poor have no road access during the rainy season. The northern region has the poorest ranking in terms of road access. Lack of road access, in turn, severely limits access to education and health facilities. In some cases it may take 1-3 days for villagers in remote areas to reach health facilities, and between 2-3 hours for children to reach the nearest primary school. Due to lack of road access, continuation of subsistence farming is the only option for most of the rural population, especially for those in the uplands. Transportation is a necessary condition of development. 129. Resources for the transportation sector will likely tighten somewhat over the next five years, as the Government and donors give more attention to the social sectors and other priorities (e.g., rural development). Consequently, it is increasingly important that resources for the transportation sector be used effectively and efficiently, and in a manner that is both "pro-poor" and maximizes growth. 130. Recommendation. Structure transportation investment to more effectively contribute to the goal of poverty reduction. The critical relationship between poverty and road access must feature in criteria for project selection. Road design should reflect the needs of the poor (e.g., non-motorized transport), rather than international standards used by donor agencies. Further, consideration should be given to labor-intensive methods for road construction and maintenance. Transportation investment should be coordinated with improvements in other services (e.g., education and extension services), better ensuring that improved access leads to improved productivity. 131. Recommendation. Reconsider the quantity/quality tradeoff concerning transportation investment. A program approach to transportation investment should be adopted, subject to the Government's capacity rather than the project-by-project approach. Subject to efficiency concerns, design standards for rural roads should favor quantity of transport services rather than quality. Rural development and poverty reduction may best be served by maximizing access rather than reductions in vehicle and travel time costs. A Road Management System should be implemented on a nation-wide basis to enable more consistent evaluation of road projects and design options. Institutional capacity for proper road maintenance should be strengthened both at the national and provincial/local levels. 132. Recommendation. Strengthen management of transportation services. The Ministry should focus exclusively on transport services. Road-related departments in MCTPC should be strengthened. Audit and monitoring functions should be strengthened at all levels, but especially at the district level. Weight limits must be enforced and safety of road travel enhanced. 133. Recommendation. Decentralization of the transportation sector should be better paced with capacity, and in a manner that internalizes externalities. The goals and objectives of 30 decentralization should be better clarified, and better matched with institutional capacity at the local level. National roads should either be under the responsibility of the Central Government or a fiscal transfer system introduced that ensures provincial governments maintain such roads in a manner that meets national interests. The information disconnects between the central and provincial governments should be rectified; provinces and districts should be required to report their transportation plans and expenditures on a detailed subsectoral basis. 134. Recommendation. Strengthen the policy framework for transportation services and for participation of the private sector. The Government should push hard with other Mekong countries for early implementation of the Agreement on the Cross-Border Movement of People and Goods prepared with ADB sub-regional assistance and signed in 1999 by Lao PDR. Thailand and Viet Nam. ADB is working with all the countries of the Greater Mekong Sub- region to achieve full application of the agreement by 2005. Additional boarder crossing points would help to achieve optimal returns on road investments. Completion of main corridors (e.g., the East/West and North/South Road Corridors) would further strengthen links between Lao PDR and its regional markets. Private sector participation in the transportation sector should be encouraged by greater transparency of relevant laws and regulations. While joint ventures, management buyouts and transfers to provincial governments have featured in the organization of road construction industry further commercialization and privatization in the transportation sector including road construction are needed. Lao Aviation should be privatized or a public/private sector partnership formed. Domestic air fares should be set on a cost-recovery basis. A new Civil Aviation Act should receive early passage and implementing regulations promulgated as quickly as possible. 135. Recommendation. Ensure that environmental and social concerns associated with transportation projects are fully assessed in a transparent and accountable manner. Standards and guidelines for this purpose should be developed, and provision made for full and rapid compensation in the event of unforeseen consequences of a transportation project. Assistance from the ADB will support the enforcement of the Environmental Protection Law through improved regulation and compliance and institutional development. Under the auspices of the Mekong River Commission, a full environmental impact assessment should be undertaken concerning expanded transport on the Mekong River. 31 MATRIX OF POLICY RECOMMENDATIONS Issue Action Timin The Macroeconomic Framework and the Resource Envelope Revenue estimates Improve macroeconomic forecasts, especially revenue projections, to avoid persistent revenue Immediate shortfalls, which necessitate ad hoc spending cuts and unplanned financing requirements. Implement a regular practice of making systematic budget adjustments to reflect macroeconomic FY 02/03 developments and revenue realizations. Enhanced revenue collection Replace the turnover tax with VAT. FY 04/05 Introduce improvements to tax and customs administration, and reduce the scope of exemptions. Immediate Budget Execution Control and Transparency Budget Nomenclature and Revise budget classification to allow identification of expenditures by ministry/province, service, FY 02/03 budget Government Accounts program and item. (Medium term for program classification) Refine COA through eliminating redundant spending items, and adopt a simplified COA for FY 03/04 budget provinces/districts. Harmonize and unify coding for budget classification and COA. Strengthen institutional capacity of financial officials, especially at lower government levels, to Medium-term implement reforms to budgetary processes through developing training program. Expenditure monitoring Extend MOF/ADB pilot computer system to all line ministries following revision of budget FY 03/04 classification. Extend MOF/ADB pilot computer system to major provinces following revision of budget FY 03/04 classification. Treasury operations Rationalize treasury accounts in banking system; close unauthorized accounts; reduce number and Medium term consider single account for each autonomous administrative unit. Prepare an action plan for the phased establishment of a network of single Treasury Accounts. FY02/03 Budget controls Retain the recently implemented system of prior commitment control for large capital FY02/03 expenditures and for quarterly wage and provincial recurrent expenditures. Review their effectiveness closely as budget outcomes become available, and make changes to thresholds and other procedures introduced as necessary. Develop a system for accurate tracking and reporting of arrears. Fully implement the provisions of Presidential Decree #127 putting provincially located MOF FY 02/03 staff under the direct supervision of directors at headquarters. Place the hiring authority and payment and responsibility practices for these staff clearly with the Central MOF. Fiscal transparency Ensure budgetary data is fully comprehensive including all revenue and expenditure and currently Medium term off-budget items Publish the budget immediately following its passage by the National Assembly. Publish the Ongoing detailed approvals under the 2002/03 budget with explanatory notes and the detailed 2001/02 outcome by March 2003, and seek to shorten this lag in subsequent years. Over time move towards a best practice system, which specifies full budget allocation detail prior to the beginning of the fiscal year. 32 Implement new Public Accounting and Treasury Department regulations and guidelines to Immediate (Accounting) underpin the introduction of the new accounting, reporting, control systems, and clearly delineate 2003 (Treasury) the roles and responsibilities of all parties in the expenditure and reporting chain. Strengthen accountability in use of public resources through adoption of intemationally accepted Medium term public auditing standards and intemational public accounting standards. Strengthen the autonomy of the National Audit Office. Tighten the financial reporting and auditing requirements for SOEs. and improve their governance structures through use of outside directors and audit committees. Establish a fully functioning Procurement Monitoring Office within the Ministry of Finance with December 2002 countrywide procurement responsibility. Provide it with adequate staff supported by a (training ongoing) comprehensive procurement-training program. Strengthen the implementing rules and regulations and tighten bid evaluation criteria especially in respect of non-autonomous SOEs. Tax collection Assign taxes to levels of government based on the nature of the tax, rather than the taxpayer. Shift FY02/03 budget the responsibility for the administration of taxes more closely into alignment with the assignment of revenues sources and where necessary adopt revenue sharing arrangements in preference to splitting collection administration. __Move a significant portion of larger taxpayers back to the central LTU. Immediate Budget Planning and Preparation Allocation of expenditures between Include estimates of the future recurrent costs associated with new medium and large projects FY02/03 budget recurrent and capital budgets submitted for the PIP. Distribute a package of all the estimates of projects included in the budget to the donors as soon as the budget is passed. Meet collectively with the donors to evaluate the consistency of the recurrent cost demands of the December 2002 new PIP projects with the likely availability of government's own revenues and the other main recurrent funding needs including the recurrent costs of existing projects. Develop mechanisms for judging individual investment proposals on their merits in the budget Medium term preparation process (including competing against recurrent spending proposals). Allocation of expenditures between From FY 2003 on, all medium and larger donor supported projects submitted to the PIP should FY02/03 budget sdcial and economic sectors include basic cost benefit analysis and estimates of the economic rate of return to support project selection decisions of CPC and MOF. Establish commnon guidelines and standards for the appraisal of investment project proposals and Medium term exclude projects from listing in the PIP unless these standards are met. Integration of Planning process with With the introduction of accounting, coding and reporting changes in line with the Medium term annual budget recommendations of Chapter 4, more useful information on actual spending by program/project will be generated over the budget cycle. These data should be used to build up basic sets of unit cost information for core programs/projects weaving in data from existing norms where appropriate. Coordination and communication Ensure that all provincial and district level budget submissions for both recurrent and capital FY02/03 budget between central line ministries and budgets are made to the respective sector ministries as well as to the CPC and MOF. the provinces . 33 Decentralization to districts Provide sharply increased training and for support for improved systems and capacities for hImmediate accounting, budget management and financial control as responsibilities are devolved to the districts, especially where new district budget line items are being created. Main Sector Issues and Actions Education Resource allocations for education Allocate 12% of FY02/03 budget to education FY02/03 budget must be significantly enhanced to Allocate 55% FY02/03 education budget to primary education reach Universal Basic Education goal Eliminate arrears in payments to teachers Allocate 13% of FY03/04 budget to education October 2003 Ensure FY02/03 outcome is line with budget Allocate 55% FY03/04 education budget to primary education Health Inadequate funding, especially for Increase share of budget to health care by reducing expenditures in econormic sectors. FY/02/03 budget staff compensation compromnises Give priority to primary health care and to financing of recurrent costs, especially salaries. quality resulting in very low Retain user fees but remove 20 percent tax on cost recovery. FY02/03 utilization rates Equity of the health care system Improve system for exempting poor from user fees Medium term Provide supplementary benefits for medical staff serving in rural areas Focus on preventive health care measures important to the health status of the poor Power EDL needs to be put on commercial I Complete implementation of new tariff policy to guarantee the financial sustainability of EdL and 2002 - 2005 basis progressively eliminate cross-subsidies Power sector policies to improve Hold workshop on power sector reform including legal and regulatory framework and further December 2002 competition, regulatory practices and restructuring actions private participation. Finalize action plan for power sector.reform and submit to the GOL for approval February 2003 Forestry Launch village forest management Adopt the laws and regulations necessary to allow VFA to engage in commercial timber Immediate program transactions Forest sector SOEs Disclose audited financial and operational audits of Forest SOEs Medium Term Prepare restructuring and privatization plans for SOEs Medium Term Forestry monitoring to ensure Piloting of Forest Resource Monitoring based on Prime Minister Order No. 15 December 2002 sustainability, enhance revenue Complete Forest Monitoring design. March 2002 collection and curb illegal logging Full Implementation. 2003