Public Finance
Analysis & Management
In a Low Income Country
Core Course
By PREM, HD and INF Networks
April 23-27, 2007
J-B1-080
The Problem
High economic growth in Limastan has been accompanied by remarkable achievements in poverty reduction over the past decade. The government has also been successful in achieving its developmental targets, in particular in education, health and infrastructure set out in the Poverty Reduction Strategy. However, for political reasons, the Prime Minister is keen on accelerating the attainment of these targets and has been pressing the Minister for Finance to ensure sufficient funding to finance these policy objectives in the medium term.
The Minister for Finance realizes that accomplishing this task is not going to be simple. Export-led growth that has facilitated revenue and expenditure increases so far will not continue indefinitely and the projected growth rate, although outstanding in regional terms, will not be sufficient to generate the required level of resources and may also cause the economy to “overheat”. On the other hand, the structural vulnerabilities of the government revenues whose largest increases have come from petroleum consumption and production of crude oil make it highly volatile to oil price shocks.
The recent meetings with donors did not give the Minister a sense that, in the near future, the predictability of aid will improve or aid flows will increase. Thus, the Minister is concerned that generating necessary resources to achieve the Prime Minister’s agenda potentially imposes a risk for the government of undermining fiscal prudence which is likely to affect macroeconomic stability in the long run. But, on the other hand, he understands that to sustain growth the government undeniably needs to continue investing in human capital and infrastructure.
The Minister for Finance is also aware that the budget system has a number of weaknesses and is not well-suited for efficiently reaching the development targets. Sector ministries are unable to ensure that resources are spent on priorities. An increased amount of resources are allocated by sub-national governments because of a decentralization process that has taken place in recent years. Priorities outlined in the Public Investment Program are not reflected in actual project selection. The Minister is convinced that these deficiencies need to be corrected if the government, facing a high marginal cost of raising additional funds, wants to achieve its ambitious development goals.
With all these challenges in mind, the Minister approached the Bank’s Country Director to ask his country team to help in designing a fiscal strategy and reforms to the budget system that would secure fiscal sustainability and growth.
Limastan has received wide acknowledgement for its fiscal prudence, with relatively small budget deficits and a relatively small stock of debt, both domestic and foreign. Over the recent period of 1999-2003, Limastan’s fiscal stance has remained extremely prudent, with the budget deficit averaging less than 2 percent of GDP and the stock of debt remaining under 40 percent of GDP. The country has received increasingly solid grades from international organizations, foreign governments and sovereign risk rating agencies. Despite these impressive achievements, however, a number of risks to fiscal sustainability have emerged and will require ongoing attention over the coming years.
Real GDP growth has been high both by regional and international standards. It averaged 6.4 percent in 1997-2000 and 7.1 percent over the period 2001-2003. In the recent years, GDP growth has been steadily rising: from 6.9 percent in 2001 to 7.1 percent in 2002 and 7.3 percent in 2003. In 2004, Limastan recorded a GDP growth rate of 7.7 percent despite the challenges posted by the surge in world energy prices and the avian flu. The performance has also been remarkable in terms of poverty reduction. Based on the 2002 Household Living Standards Survey (HLSS), 29 percent of the population had expenditures below the poverty line by 2002, compared to 37 percent in 1998 and 58 percent in 1993. Thus, Limastan lifted around 20 million people out of poverty in less than a decade.
Robust export performance has been a major driver of growth. During 1997-2003 exports grew at an average annual rate of 14 percent in value terms and now amount to half of GDP, with the share of manufactured products representing around 46 percent of the total. Exports grew by 21 percent in 2003, despite a lackluster global economy. The garments sector recorded the highest growth rate (45 percent) and equaled crude oil as the most important export for Limastan in value terms. Rapid export growth has been aided by production expansion and by bilateral and regional trade agreements that came into effect during this period. At the same time, strong growth has been accompanied by a rapid rise in imports. Import growth in 2003 stood at 28 percent compared with an average of 14 percent over 1997-2003. The main import categories witnessing increases in recent years are machinery and equipment, petroleum products, and other production inputs needed for the fast expanding export industries.
With imports outpacing exports in the last two years, the trade balance has widened from a surplus of 0.8 percent of GDP in 2000 to a deficit of around 7 percent in 2003. However, strong inflows of remittances helped keep the current account deficit at 4.7 percent of GDP in 2003. The Central Bank reported record remittances into Limastan of around US$2.6 billion in 2003 and over US$3 billion in 2004. If transfers operating through unofficial channels are taken into account, total remittances from abroad are probably in the range of US$3 to 4 billion a year. This is the equivalent of one fifth of export earnings. FDI inflows are estimated to have reached about US$1.5 billion in 2003. ODA disbursements reached US$1.1 billion. This helped foreign reserves to rise from US$3.7 billion in 2002 to about US$5.6 billion in 2003. This is the equivalent of 10 weeks of imports of goods and non-factor services.
The investment to GDP ratio stood at 35.1 percent in 2003 and 35.8 percent in 2004, compared with 28.3 percent of GDP in 1997. The share of the public sector in GDP has averaged 56 percent, while those of the domestic and foreign invested private sector has averaged 24 and 20 respectively. High levels of investment, especially in the public sector, have had an important impact on infrastructure development, economic transformation and implementation of national poverty reduction programs. However, concerns persist about the quality of investments, in the sense that more growth and poverty reduction could have been attained from the same level of investment.
In the recent years, Limastan has also maintained prudent macroeconomic policies. After two years of mild deflation, prices rose by 3-4 percent in 2002-2003. During the last year, inflation has accelerated to an annualized rate of 9.5 percent. This includes increases in food prices due to the avian flu outbreak and higher steel and oil prices. But there are also deeper economic forces behind the acceleration of inflation. Labor costs and prices in Limastan remain very low by international standards, and they are bound to increase in a context of rapid economic growth.
Fiscal Performance
During the period under review, strong economic growth was accompanied by strong growth in government revenues, as the table below illustrates. Even with a quite modest budget deficit, this has facilitated what as a share of GDP is a quite gradual and sustainable increase in total expenditure but what in absolute terms is a very rapid rise.
Revenue. In nominal terms, government revenue and grants increased by an average of over 14 percent per year between 1998 and 2003. As a percentage of GDP, revenue and grants rose from around 20 percent of GDP in 1998 to over 23 percent in 2003. The increase in revenues from consumption of petroleum products and production of crude oil from 4.1 percent of GDP in 1998 to 6.5 percent in 2003 explains the largest part of the revenue increase. The share of such revenues in total revenue and grants rose from 20 percent in 1998 to 22.4 percent in 2003. As a consequence, the public budget has become more vulnerable to oil price shocks. Furthermore, although the oil production outlook for the years ahead appears to be quite robust, crude oil exports cannot be relied upon as a source of revenues in the very long term.
To strengthen revenues as well as to encourage domestic and foreign investment, the State has lightened the tax burden through reduction of tax rates in many areas. Enterprise income tax rate has been reduced from 32 percent to 28 percent; the number of VAT tax rates has been cut from 4 to 3, including the abolishing of the highest rate of 20 percent. The National Assembly has decided to eliminate overseas profit remittance tax and surtax on enterprise income. Most notably, in 2002, agricultural land use tax has been reduced by 50 percent; and since 2003 nearly all farmers are exempted from such tax. Now approximately 75 percent of Limastan’s population pays no direct taxes.
Figures below provide a breakdown of tax revenue from different sources in 1998 and 2003. The shares of corporate income tax and VAT have both risen over this period. The increase in the share of VAT reflects in part the replacement of some “other” taxes by the VAT. The other noticeable trend is the fall in trade taxes as a share of total taxes, though they have risen by nearly 7.5 percent per annum in value terms. Corporate income tax has become the main contributor to tax revenue. Non-oil SOEs accounted for 38 percent of corporate income tax collections in 2003, while oil producing SOEs contributed 34 percent. The share of foreign invested non-oil enterprises stood at 7 percent. Personal income tax contributes only a small amount (3 percent) to total tax collections, although the share of this tax may be expected to rise as GDP grows. Revenue from land increased from 2.5 percent of the total tax revenue in 2000 to 6 percent in 2003. This upward trend is likely to continue in the near and medium term but not indefinitely. Taxes on international trade contributed around 17 percent of total revenue and grants (or 23 percent of tax revenues) during 2000-2003. A concern often expressed is that these revenues will decline sharply as Limastan implements its international trade commitments.
Share of Different Taxes in Total Tax Revenue
Revenue from the non-state sector have recorded a significant increase, with its share in total revenue rising from just 6.4 percent in 2000 to 7.3 in 2003 and 7.8 percent in 2004. This is indicative of the sector’s development both in terms of quantity and quality. In 2004, the sector accounted for 8.2 percent of GDP, representing a cumulative increase of 41 percent compared with 2000.
Finally, there is a wide gap between the revenues that should be collected on the basis of statutory duty rates and what is actually collected. This is due both to abuse of exemptions as well as weaknesses in tax administration.
Expenditure. The year 1999 marked a turning point in the size of overall government spending. After steadily declining as a ratio of GDP in the years preceding, government spending (excluding on-lending, carry-over, and expenditure from retained revenue) has recovered during the period 1999-2003. From a low of 20.5 percent of GDP in 1999, it reached 22.6 percent of GDP in 2000, 24.2 percent in 2001 and 24.1 percent in 2002. By 2003, this ratio was boosted to over 25 per cent. Between 1998 and 2003, total government spending rose at the remarkable average annual rate of 16 percent in nominal terms, with capital expenditure growing at some 20 percent. As a share of GDP, current expenditure rose from 14.7 percent in 1998 to 16.8 percent in 2003, while capital expenditure rose from 5.7 percent to 8.3 percent over the same period. Capital expenditure has averaged 34 percent of total expenditure over the last three years.
Budget Deficit, Off-Budget Items and Public Debt. The net result of these revenue and expenditure trends has been a budget deficit that has remained manageable, ranging between 0.1 percent and 2.8 percent over the period 1997-2003. The National Assembly has been prudent in stipulating that the budget deficit plus amortization should not exceed 5 percent of GDP. The revenues collected by the government fully financed recurrent expenditure and partly financed capital expenditure. Thus, in accordance with the so-called “golden rule”, borrowing was undertaken to finance only capital expenditure and borrowing was always less than capital expenditure.
Government Debt from On-Budget Operations. By the end of 2003, the government debt that is attributable to budgetary expenditures including ODA on-lending stands at around 33 percent of GDP. However, to get a more complete picture of the wider public debt position it is important to add items that are currently not reflected in the budget. Two such items are bonds issued to finance certain infrastructure and education projects and the recapitalization costs of State-owned Commercial Banks (SOCBs). Their inclusion in public debt numbers is likely to raise its level by about 3 percentage points. This is by no means an alarming level, but it would be prudent to be watchful of these trends.
On-budget capital expenditure is financed by ODA sources or by issuing domestic government bonds. In the last two years there has been increased reliance on domestic bonds for financing capital expenditures. This trend is reflected in figure below, which shows a divergence in the trends for total
and external public debt. One consequence of greater reliance on domestic finance is that the interest cost of debt has been rising. This is because virtually all foreign public debt is on concessional lending terms, while domestic debt carries higher interest rates. At the same time the share of interest payments in total current spending has also been rising. Given Limastan’s current level of development, it is expected that the government will continue to run budget deficits in the foreseeable future.