Report No. 18791-KH

CambodiaPublic Expenditure ReviewEnhancing the Effectiveness of Public Expenditures(In Two Volumes) Volume I Summary

January 8, 1999

Povertv Reduction and Economic NManagement Sector UnitEast Asia and Pacific Region

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CURRENCY EVALUATIONSCurrency Unit = Cambodian Riel

AVERAGE VALUE OF US$1.00IN

1995 1996 1997 December 19982451 2,624 2,946 3,700

WEIGHTS AND MEASURESMetric System

GOVERNMENT'S FISCAL YEARJanuary I - December 31

ABBREVIATIONS AND ACRONYMS

ADB - Asian Development BankADD - Accelerated District Development ProgramBIS - Bank for International SettlementsASEAN - Association of South-East Asian NationsCCC - Cooperation Committee for CambodiaCDC Council for the Development of CambodiaCIF - Cost, Insurance and FreightCG - Consultative GroupCR - Cambodian RielCRDB - Cambodia Reconstruction and Development BoardCSES - Cambodia Socioeconomic SurveyCVAP - Cambodia Veterans Assistance ProgramDHC - District Health CenterDFW - Department of Forestry and WildlifeEPI - Expanded Program of ImmunizationFAO - Food and Agriculture Organization of the United NationsFDI - Foreign Direct InvestmentGDP - Gross Domestic ProductGSP - General System of PreferencesMEF - Ministry of Economy and FinanceMFN - Most Favored NationMOEYS - Ministry of Education, Youth, and SportsMOH - Ministry of HealthMOP - Ministry of PlanningMTEF - Medium-Term Expenditure FrameworkNBC - National Bank of CambodiaNGO - Non-Govemmental OrganizationO & M - Operations and MaintenanceODA - Official Development AssistancePER - Public Expenditure ReviewPIMS - Public Investment Management SystemPIP - Public Investment ProgramPSI - Pre-shipment InspectionsRCAF - Royal Cambodian Armed ForcesSEDP - Socioeconomic Development PlanSWAP - Sector-Wide ApproachUNTAC - United Nations Transitional Authority in CambodiaTA - Technical AssistanceTVET - Technical and Vocational Education and TrainingUNDP - United Nations Development ProgrammeUNESCO - United Nations Educational, Scientific and Cultural OrganizationUNICEF - United Nations Children's FundUSAID - United States Agency for International DevelopmentVAT - Value Added TaxWHO - World Health OrganizationWTO - World Trade Organization

Vice President: Jean-Michel Severino, EAPChief Economist: Masahiro Kawai, EAPCountry Director: Ngozi Okonjo-Iweala, EACSMActing Sector Manager: Kyle Peters, EASPRTask Manager: Su-Yong Song, EASPR

TABLE OF CONTENTS

Page No.

A. INTRODUCTION ..........................................................

B. RECENT ECONOMIC DEVELOPMENTS AND STRUCTURAL REFORMS ..............................................

C. PROSPECTS FOR DOMESTIC REVENUE MOBILIZATION .......................................................... iii

D. ANALYSIS OF THE LEVEL AND COMPOSITION OF PUBLIC EXPENDITURES ................ ................... vii

E. ASSESSMENT OF PUBLIC EXPENDITURE MANAGEMENT: INSTITITUTIONAL DIMENSION ................. X

F. MACROECONOMIC FRAMEWORK, RESOURCE ENVELOPE, AND PUBLIC EXPENDITURES ............. xiv

G. CONCLUSION ......................................................... xvi

SUMMARY OF RECOMMENDATIONS ......................................................... xvii

ACKNOWLEDGEMENTS

This report was prepared on the basis of an economic mission that visitedCambodia in March 1998. The report was prepared by a team led by Su-Yong Song (taskmanager), and composed of Bill McCleary (advisor), Tom Hart (revenue mobilization),Govinda Rao (public expenditure analysis), Geoff Dixon (public expendituremanagement), Wijaya Wickrema (accounting and audit), Marc Quintyn (macroeconomicframework, IMF), Bill Magrath (forestry issues), Markus Kostner (militarydemobilization), Anil Deolalikar (health and education), Vin McNamara (education), andKy Tran (statistics and projections). Contributions were also made by RamaLakshminarayanan, Peter Moock, and Christopher Thomas. The peer reviewers wereVinaya Swaroop, Malcolm Holmes, Jeffrey Hammer, Pascale Kervyn De Lettenhove. Itwas prepared under the guidance of Masahiro Kawai (Chief Economist, East Asia andPacific Region), Ngozi Okonjo-Iweala (Country Director, EACSM), Kyle Peters (ActingSector Manager, EASPR), and Richard Newfarmer (Lead Specialist, EASPR). Themanuscript was edited by Emily Evershed and typed and formatted by Lily Tsang. Theteam would like to express its gratitude to various ministries and agencies of theGovernment of Cambodia throughout the preparation of this report, in particular theMinistry of Economy and Finance, the Council for the Development of Cambodia, theMinistry of Health, and the Ministry of Education, Youth, and Sports. The team wouldalso like to express its gratitude to various donor and NGO agencies, especially WHO,UNESCO, UNICEF, and MEDICAM. The report was discussed with the Governmentof Cambodia in December 1998 and revised on the basis of these discussions.

A. Introduction

1. After two decades of conflict, Cambodia remains one of the poorest countries in Asia--with a percapita income of less than US$300, widespread poverty, and weak social indicators. 36 percent of thetotal population is below the poverty line. Poverty is concentrated in the rural areas, with 40 percentestimated as poor, four times higher than the II percent poverty incidence in Phnom Penh. To reducepoverty significantly and enhance economic and social well-being, Cambodia has to implement acoherent economic program that will produce rapid and broad-based economic growth over the longterm.

2. As the centerpiece of such a program, the government must tackle its underlying governanceproblems. In particular, the government must take decisive actions in the areas of economicmanagement, including weak domestic revenue mobilization, inadequate and inefficient publicexpenditure management, and environmentally unsustainable forestry management.

3. To be sure, since 1993 Cambodia has made remarkable initial progress in stabilizing theeconomy, in restoring economic growth, and in undertaking policy reformns to transform the economy intoa market-oriented one. In particular, inflation which averaged 140 percent per annum during 1990-92was reduced to single digits during 1995-97. Since 1996, however, despite the government's piecemealefforts the progress in implementing key fiscal and structural reforms stalled due partly to the politicaldevelopments. The medium-term prospects remain bleak unless the government swiftly takes determinedactions in addressing the interrelated fundamental fiscal and governance problems. The Prime Minister'sspeech on October 22, 1998 and the subsequent Royal Government of Cambodia's Platform on SecondTerm, 1998-2003 demonstrate an awareness of this need and reaffirm the new government's commitmentto implementing the necessary fiscal and structural reforms. While it is encouraging that they are broadlyconsistent with the recommendations made in this report, the challenge for the government is to fullyfollow through with its renewed commitments.

4. Weak physical infrastructure and, more important, the inadequate capacity of human resourcesseverely constrain Cambodia's medium-term development potential. The majority of people lack accessto potable water and the schools and health clinics are yet to be rebuilt. Rural areas lack serviceableroads, irrigation systems, and agricultural extension facilities. Industry and trade are hampered by hightransport costs, the low quality and unstable supply of electric power, and poor telecommunicationsfacilities. The effects of conflict have been even more devastating on human resources. Almost 35percent of the total population is illiterate and only about 10 percent is engaged in skilled occupations.About a third of the population aged five years and above has had no education, only 20 percent have hadschooling beyond the primary level, and only 4 percent have completed lower secondary education. Theinfant mortality rate, at 90 per 1,000 live births, is one of the highest among the countries in the regionand about 50 percent of children suffer from malnutrition. Moreover, the lack of adequate physical andsocial infrastructure limits access to public services by the poor households. Most poor households,particularly in rural areas, have lower access than more affluent households to important economic andsocial services. All of these factors place severe limitations on labor productivity.

5. Public expenditure policy plays an essential role in reconstructing physical infrastructure,developing human resources, and improving the accessibility of public services to the poor. First, thelevel of public expenditures and the methods employed to finance them are important from the viewpointof macroeconomic stability. Second, spending on social and economic services directly contributes topoverty alleviation and broad-based economic growth. Third, the allocation of public expendituresamong various activities determines their efficiency and the ability of the economy to deliver social and

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economic services. Fourth, the assignment of fiscal responsibilities among different levels ofgovernment deternines the responsiveness and incentives in the provision of public services according tothe diversified needs in different regions. The regional distribution of public expenditures determines theaccessibility of public services to the poor. Fifth, the institutional mechanisms for formnulating andimplementing expenditure policy contribute to accountability and incentives, and also determines theefficiency with which expenditures are translated into public services.

6. This Public Expenditure Review (PER) undertakes, for the first time, a systematic review of theadequacy and effectiveness of public expenditures in Cambodia. Rather than narrowly focussing onexpenditure issues, the PER takes a broader approach--it closely links public expenditure issues torevenue mobilization and governance problems as reforms to enhance the effectiveness of publicexpenditures need to be implemented in a comprehensive context. While the PER analyzes sector-specific issues for various sectors within the overall framework, it provides a more in-depth analysis ofthe health and education sectors because of their direct relevance to poverty reduction strategy throughhuman resource development. The PER aims to help the government strengthen its capacity to managepublic expenditures. The PER is composed of two volumes. This volume summarizes the findings of themain report. A summary of recommendations is presented in the matrix in this volume.

7. Throughout the preparation, the PER greatly benefited from close collaboration of the variousministries and agencies of the Royal Government. In particular, the PER benefited from the extensivediscussions with the Ministry of Economy and Finance (MEF) and the numerous reports issued by theMEF on the occasions of the preparation of budget and the reporting of its implementation which havemade a broad analysis of the fiscal situation focusing on the lack of discipline in fiscal management andthe failure in implementing proper management procedures. The PER also benefited from theconsultations with various donor and NGO agencies, especially on the health and education sectors.

B. Recent Economic Developments and Structural Reforms

8. The Royal Government, a coalition government forned in 1993, performed well during its initialyears and made remarkable economic progress. Continued Khmer Rouge insurgencies, however, led topressures on defense expenditures. Since 1996, tensions between the two main coalition partners overpower sharing escalated and culminated in the July 1997 events. Partly reflecting this, the govemment'sreform efforts weakened considerably, which adversely affected economic performance. Whilemacroeconomic stability has largely been maintained, little progress has been made in implementing themeasures to address the interrelatedfundamentalfiscal and governance problems, namely weak domesticrevenue mobilization, inadequate and inefficient public expenditure management, and the lack ofgovernance in economic management (forestry management in particular). More recently, the politicaland security situation improved significantly with the formation of the new coalition governmentresulting from the national elections held on July 26, 1998 and the marked weakening of the KhmerRouge elements.

9. Since mid-1997, the economy has suffered two shocks. One was the political events of early July1997 and the ensuing suspension of a substantial part of donor assistance. The other was the regionalfinancial crisis. Although it is difficult to separate the respective impact of the two shocks, the impact ofthe political events appears to have been initially more severe than that of the regional financial crisis.While the July 1997 events and the ensuing political uncertainty substantially affected growth,particularly through undermining investors' confidence, the impact of the regional financial crisis to datehas been mitigated by the highly dollarized nature of the economy. The adverse impact of the regionalfinancial crisis has been manifested mainly in the cancellation/delay of committed investment projectsand in the drop in tourism.

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10. The macroeconomic outcome for 1997 was somewhat better than had been expected immediatelyafter the onset of the two shocks, thanks to the government's fiscal discipline. After registering an averagerate of 6 percent during the previous five years, GDP growth decelerated to 1 percent in 1997. Tourismand construction were the hardest hit. Stagnation deepened in 1998. GDP growth in 1998 is estimated atzero percent due to the draught and continued regional financial crisis and political uncertainty. Fiscalperformance in 1997-98 largely repeated the fragile pattern of the past few years: civilian non-wageoperating expenditures were compressed significantly to sustain macroeconomic stability in response to arevenue shortfall and an overrun in defense and security outlays. Budgetary developments in 1998 wereparticularly worrisome. The government has borrowed CR 82 billion (or 0.8 percent of GDP) from theNational Bank of Cambodia (NBC)--for paying salary arrears, integrating Khmer Rouge defectors, andalso financing a part of the election costs--after having avoided bank financing of the budget deficit since1994. The most significant monetary development during 1997-98 was a sizable withdrawal of foreigncurrency deposits as a combined result of the political developments and regional financial crisis, whichled to significant deceleration in monetary growth. Substantial declines in dollar-denominated prices ofimports from neighboring countries that were undergoing financial crises mitigated inflation in 1997, andthus it was contained at 9 percent. In 1998, inflation accelerated to 12 percent owing mainly to the riceprice increase resulting from a rice harvest shortfall and also from the hoarding of some commoditiesahead of the July election. The exchange rate remained largely stable during the first half of 1997, butdepreciated by 20 percent during the second half. In 1998, the exchange rate has stabilized after a rapidrise during May-July owing to the uncertainty in the runup to the July election. Although the rate ofdepreciation of the riel has been substantially lower than that of the currencies of other countries in theregion, this has as yet had little significant effect on exports as Cambodia has no quota on garmentexports whereas most regional competitors have already filled their quotas.

11. Whereas some progress has been made in the areas of banking supervision and the privatizationof state-owned enterprises, progress in implementing key structural reforms was not satisfactory and insome cases took a backward step. While the adoption of the Law on Taxation was a major step towardrevenue enhancement, the measures under the Law on Taxation have not been fully implemented; theinitial introduction of Value-added Tax (VAT) for about 800 large taxpayers, which was to be effectivefrom 1998, has been postponed until January 1, 1999; the granting of ad hoc tax and customs exemptionshas continued; the exemption from pre-shipment inspections has been extended; and the ImplementingRegulations for the Law on Investment have allowed granting tax holidays for virtually every sector inthe economy. Moreover, despite the government's piecemeal initiatives, no significant improvement inaddressing the fundamental problems in forestry has been made (see paras 19-20).

C. Prospects for Domestic Revenue Mobilization

12. Current Situation. Domestic revenue as a share of GDP doubled between 1991 and 1994. Sincethen, however, it has been flat at about 9 percent during 1995-97 and worsened further to 8 percent in1998. This level of domestic revenue in Cambodia is about half of the average for low income countries.The main reasons for poor revenue performance are: (i) inadequate implementation of the Law onTaxation and delay in introducing a VAT; (ii) generous tax exemptions granted under the Law onInvestment; (iii) ad hoc tax and customs duty exemptions, often associated with unwarranted politicalinterference; (iv) weak capture of forestry revenue; and (iv) limited capacity in tax and customsadministration.

13. The current low revenue effort is extremely detrimental to achieving sustainable developmentover the medium term. Nevertheless, there exists substantial revenue enhancing potential. Foregonerevenues in 1996 and 1997 estimated by the PER based on known information were large, amounting to

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5-6 percent of GDP each year (equivalent to two-thirds of actual budget revenue). In addition, owing tothe delay in implementing a VAT, another 1.7 percent of GDP was foregone during 1998. To realize theexisting revenue potential, the government needs to decisively implement the followingrecommendations, the core of which lies with improving governance.

14. Implementing the Law on Taxation and the VAT. In terms of revenue generation, about 80percent of the new tax measures under the Law on Taxation are currently being implemented. Thesemeasures--the tax on turnover charged on the first sale after import, the excise tax on automobiles, thebase expansion of the tax on salary, the fringe benefits tax, the new tax accounting rules for the tax onprofits, and the introduction of withholding taxes under the tax on profits--need to be fully implemented.

15. The government has decided to implement the VAT initially for about 800 large taxpayersbeginning January 1, 1999. The preparation for the implementation--training tax officials, drafting sub-decrees and supporting regulations, publicity campaign, taxpayer registration, education, and advisoryvisit--has been largely on track. After some delay since the elections in July 1998, the preparation for theVAT implementation accelerated during the last few months. For the effective implementation, thegovernment needs to swiftly issue necessary sub-decrees and regulations, and continue and intensify thetraining at the Tax Department, education of taxpayers, and publicity campaign. The whole yearimplementation of the VAT would add 1.7 percent of GDP to revenue collection, because a significantportion of turnover tax (which is transformed into the VAT at a single rate of 10 percent) was collected atthe border in the form of a consumption tax at a standard rate of 4 percent. As it would take some timebefore becoming fully operational, the expected revenue enhancement from the VAT implementation in1999 would be somewhat lower than the full effect.

16. Limiting Tax and Duty Exemptions. The Law on Investment is one of the most criticalimpediments to improved revenue mobilization. The Law provides too generous incentives: tax holidaysof up to eight years; a permanent 9 percent corporate tax rate after the end of the holiday period; duty freeimportation of capital goods and other fixed and movable assets; duty free importation of raw materialsfor export enterprises; and restrictions on the taxation of remissions abroad. There is little justification forthe tax incentives provided under the Law on Investment. The corporate tax rate (20 percent) is 10-15percentage points lower than those of other ASEAN countries. In addition, the tax on profits providesother incentives which include rapid depreciation and a five-year operating loss carry forward. Thecombination of these two provisions would eliminate the need to grant tax holidays. Moreover, theexperience of other countries indicates that tax incentives rank low on the list of the major determinantsof investment flows as compared with political and economic stability, a sound legal environment, and anadequate quality of physical infrastructure. Furthermore, the exemption of certain earnings, dividends,and interest, paid abroad, is hard to justify on the grounds that they in fact represent a subsidy to foreigngovemments, as most of the payments exempted in Cambodia are taxable in the home country of theinvestor.

17. In addition to the exemptions granted under the Law on Investment, various ad hoc taxexemptions, such as on rubber exports, play a significant role in undermining the revenue potential of thetax system. Even more serious, the government has granted a quasi-legal character to the exemptions, asin the case of logging and cement production. This has been accomplished through the ImplementingRegulations which now extend the scope for exemptions to virtually every sector, in particular to naturalresource exploitation, beyond the initial intent to limit them only to manufacturing activity.

18. The combination of the Law and the Regulations has eliminated any room for the businessincome tax to be a policy instrument in the revenue mobilization effort. With the Law on Investment inits present form, tax revenues would be limited to domestic taxes on goods and services and trade taxes.

Once Cambodia becomes a member of ASEAN shortly, revenue from trade taxes will be limited, andtherefore, the only real revenue potential will be constrained to domestic consumption taxes. Thus, thegovernment is urged to revise the Law on Investment and the Implementing Regulations by:

* Removing all the incentives currently granted to resource and resource processing firmsfrom the Implementing Regulations.

* Removing the production of consumption goods from the preferred sectors in theImplementing Regulations. (However, the revision of the Implementing Regulations to thiseffect should not be retroactive.)

* Repealing the 9 percent tax rate, the tax holiday period, and the profits reinvestment rule inthe Law on Investment, with grandfathering up to three years.

While the implementation of some of the above recommendations (except for the first and the second onewhich can be undertaken quickly) could be carried out over the medium term, the legislative preparationneeds to be carried out in next few months.

19. Proper Capture of Forestry Revenue. Forests are Cambodia's most developmentally importantnatural resource and could bring in significant revenues. The current forestry situation, however, posesserious governance problems and shows evidence of pervasive corruption. Conditions in the forestrysector have continued to decline and illegal logging and log smuggling have reached alarming levels. Itwas estimated that illegal logging in 1997 totaled between 3 and 4 million cubic meters. This isthree-eight times levels that are sustainable. If the current anarchic situation continues, the commercialpotential of Cambodia'sforest resource would disappear in less than five years.

20. The revenue loss arising from illegal logging to the government in 1997 is estimated as well inexcess of US$60 million, or 2 percent of GDP (as compared with the actual collection of one-fifth of thatamount in the budget). It was reported that private and unofficial rent amounted to US$14 per cubicmeter, in addition to the official royalties and the unofficial charges associated with the original fellingoperation. Thus, in the short tern, much of the potential for increasing government revenue would comefrom re-channeling private and unofficial rent capture. Toward this end, the government must take thefollowing "emergency measures" immediately to arrest the deteriorating situation:(i) stop granting newconcessions; (ii) freeze approving all new investments in wood processing; (iii) establish mechanisms tomonitor and prevent illegal log felling and exports; (iv) enforce cancellation of all permits for "collection"of logs and stop issuing new permits; and (v) strengthen the Forestry Department.

21. Furthermore, over the medium term the government must implement the recommendations of thefour studies it has conducted with the aid of Bank Technical Assistance--which are essentially completedand embody the framework suggested by the Bank/UNDP/FAO and also by the government's own forestpolicy consultants--with a view to establishing an environmentally sustainable, economically sound, andmarket-oriented forestry management:

* Log Control and Monitoring. The current forest law enforcement crisis justifies a specialeffort to control illegal logging, increase revenue collection, and facilitate movement towarda more efficient log trade regime. A set of protocols for assessing the scope, spatialdistribution, and character of illegal logging has been tested and needs to be developed fortransfer to the government.

* Legal Study. Concession contracts are badly biased against the government, but they dospecify performance obligations which are likely to form the basis for a structured andlegally defensible challenge to individual contracts on a case-by-case basis. A draft model

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contract has been prepared, comments on the draft forest law have been submitted, and atraining program has been conducted. Forest legislation needs to be resubmitted to theNational Assembly, following revision. An earlier draft did not provide an effective platformfor forest exploitation, risks perpetuating the current system of arbitrary allocation of forestresources, and does not resolve key institutional issues.

* Forest Concession Management. Concessions can provide the basis for sustainable sectoraldevelopment provided a satisfactory policy framework is put in place, regulations arestrengthened, and security and technical guidelines are enforced. A framework of planning,harvesting, and revenue systems will be provided and, following review and consultation,will need to be formalized through appropriate legislation or regulation and implementedthrough pilot projects.

* Forest Policy. Elements of the government's forest policy are at odds. Pressures forimmediate revenues are now swamping the concerns about sustainability; strong measuresand commitments will be needed to redirect privately appropriated rent to the publictreasury; land allocation is chaotic and arbitrary; community involvement in forestdevelopment is severely limited; and public statements are inconsistent.

22. The government recognizes the importance of decisively implementing the recommended actionsof the four studies, and has indicated its willingness to embark on these challenging tasks. To achievethese medium termn objectives, the government must take the following actions for the next few months:prepare a proposal for illegal logging control; prepare the illegal logging monitoring program; undertakea performance review of concessions; and prepare the Cambodia Code of Forest Practice (CCPF) whichis essentially an operational manual that lays out the rules for concession operations. In the subsequentfew months, these actions should be followed by: the preparation of the revised forest law; decisions onthe termination or renegotiation of concession contracts; the preparation of a sub-decree establishing theoperational manual for concession management; the strengthening of the implementation capacity offorestry management; and the strengthening of law enforcement capacity regarding illegal logging.

23. Strengthening Tax Administration/Governance. While strengthening tax administration,especially in the audit capacity and in VAT implementation, would be important, more fundamentalimprovements must be made in governance, particularly in the elimination of the unwarrantedintervention that undermines the rule of law and the authority of tax administration. The Law onTaxation was the first serious attempt to consolidate tax legislation into a code. Legislation passed priorto the Law, however, remains outside the Law. In addition, there are several draft laws in circulation thatalso contain tax provisions. All issues relating to taxation should be included in the Law on Taxationwith the MEF responsible for legislative drafts, implementation, and administration. As part of theadministrative protest procedure under the Law on Taxation, the final step in the process involves theCommittee of Arbitration. Constraints must be placed on this Committee so that it does not legitimize theprocess of appealing to the Prime Minister's Office or the Council of Ministers for special relief or ad hocexemptions. The authorities need to amend the Law to require that any other exemptions not specified inthe Law should be void. Regarding customs administration, the government extended the exemptionfrom pre-shipment inspections (PSI) to imports for the projects approved under the Law on Investment,garments, and cigarettes which together amount to about three-fifths of total customs imports. To protectthe import tax revenue base and to generate the revenues that should be collected at import, thegovernment must place more reliance on the PSI. The PSI should be required on all shipments over someminimal c.i.f. value. The government should require that the official PSI valuation be used as thecustoms value for duty and domestic tax purposes. Finally, rents and fees collected by some of the lineministries should be fully transferred to the Treasury, as they are often collected and used in a non-transparent manner.

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D. Analysis of the Level and Composition of Public Expenditures

24. Scope of Public Expenditures. It is difficult to obtain a reliable picture of the total expenditureof a public nature because a significant portion of aid-financed expenditures are not captured in thegovernment's official budget. Thus, with a view to presenting a more complete picture, in collaborationwith the government, the PER constructed a consolidated database covering the period from 1994 to1997, combining the budget data at the MEF and the donor aid database at the Council for theDevelopment of Cambodia (CDC) in a consistent manner by function, by economic classification, and byregion. This resulted in evaluation of three different concepts of spending on public services: (i) publicexpenditures financed from domestic revenues raised by the government; (ii) expenditures included in thegovernment's official budget; and (iii) total spending on public services financed from the government,donors, and NGOs.

25. Level of Spending on Public Services. In 1996, expenditures financed from the government'sown revenues amounted to only 8.4 percent of GDP. Expenditure estimates included in the officialbudget were 17.2 percent of GDP. On the other hand, aggregate expenditures on public services from allsources constituted 24.8 percent of GDP. Total spending on public services from all sources as a shareof GDP was more or less constant at about one-quarter during 1994-96 (while it dropped to 22 percent in1997 owing mainly to the partial suspension of external assistance). This means that expenditures

financedfrom the government's own revenues contributed about one-third of total spending on publicservices. It also implies that about one-third of total spending on public services would be lost if theanalysis is limited to the official government budget. The budgetary expenditure level in Cambodia wasmuch lower than the average expenditure levels prevailing in East Asian economies--for example,Vietnam (24.7 percent) and Lao PDR (22.1 percent)--and most of the regional averages.

26. Role of Government and AidAgencies. From the viewpoint of expenditure maneuverability, thesources of financing expenditures are important. Financing from the government's own revenue sourcesformed only about 42 percent in 1994 and steadily declined to 34 percent in 1996. Thus, a majorproportion of financing for public services was from external donor and NGO assistance, especially insocial and economic services. In 1996, for example, government financing of social services was about34 percent, and for economic services it was a mere 12 percent. In 1997, donors suspended theirassistance mainly in the economic sectors in the aftermath of the July 1997 events, but continued andeven strengthened their assistance in the humanitarian/social sectors.

27. The predominance of donor financing of public services limits the ability of the government todetermine expenditure allocations according to its own priorities. The issue of sources of financing,however, is immaterial if resources are fungible. While there exist some empirical evidence in othercountries that aid may be partially fungible, it is difficult to assess the extent of fungibility in Cambodia.

28. Functional Composition of Public Spending. The most conspicuous feature of the functionalcomposition of expenditures incurred from the government's own revenue efforts is that outlays ondefense and security have crowded out resources for spending on development activities. In 1996, forexample, the preemption of almost a half of government revenues for defense and security left thegovernment with only about one-third for spending on the reconstruction of physical and socialinfrastructure. (It should be noted, however, that these expenditures included some spending of social andeconomic nature such as allocations for the families of defected Khmer Rouge soldiers and infrastructurerehabilitation for them.)

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29. Defense expenditure during the period 1994-97 varied from 3.3 percent to 5 percent of GDP,owing mainly to continued Khmer Rouge insurgencies. This level of spending compares unfavorablywith the average of 2 percent in 1990 for the East Asian countries and 2.3 percent for the developingcountries taken together. To make expenditure reorientation toward development spending possible, itis critical to significantly reduce and rationalize military expenditures. In this regard, decisiveimplementation of the Cambodia Veterans Assistance Program (CVAP)--which has been put on holdowing mainly to the political events--will be essential. With the effective implementation of thedemobilization program (demobilizing 43,000 soldiers over the next three years, for example), the shareof defense expenditure in GDP could be reduced from 3.3 percent in 1997 to 1.9 percent by the year 2002("peace dividend'). Toward this end, the government needs to take the following preparatory steps forthe next few months: (i) the updating of the CVAP (especially in view of Khmer Rouge defectors); (ii)the identification and registration of special target groups; and (iii) the pilot demobilization of specialtarget groups.

30. In Cambodia, as elsewhere, the poor do not have adequate access to land or capital, andinvestment in human resources is a critical policy component of the development strategy to accelerategrowth and reduce poverty. The development experiences of successful countries in the region underlinethe importance of investment in education and health in improving labor productivity and increasing theshared basis of economic growth. However, the outlay for human resource development from thegovernment's own resources has been extremely low. In 1996, for example, expenditures on educationand health from the government's resources constituted only about I percent and 0.5 percent of GDP,respectively. Even when total expenditures on public services (i.e., financed from government, donors,and NGOs) are considered, the education and health sectors together secured only 5 percent of GDP,which is inadequate in view of the massive human resource development needs. Similarly, the totalexpenditure available for physical infrastructure was limited to less than 4 percent of GDP. In particular,in a country where 85 percent of the population and 88 percent of the poor are concentrated in ruralareas, the agriculture and rural development sectors received only 22 percent of the total expenditureallocation. It is of critical importance to allocate adequate expenditures to irrigation, rural roads, andagricultural extension service to help extend a market economy to rural areas and enhance incomeearning opportunities for the poor.

31. In addition to increasing the level of spending on economic and social services, the efficiency andequity of public expenditure within the sectors needs to be enhanced. In the health sector, Cambodianhouseholds are paying far more than they can afford for health care (US$33 per capita per annum) andgovernment-financed health spending is woefully inadequate (US$7 per capita per annum). Thus, thereis a need to increase government spending on health significantly, particularly through greater costrecovery. The Ministry of Health (MoH) is piloting programs of cost recovery on a trial basis. One ofthe highest priorities for the MoH should be to see how the large informal fees that are already being paidby individuals to public health providers can be formalized and internalized. It is important that the userfee collection process be transparent and the collected revenues be kept at the facility level to improve thequality of services. Equally important, government health facilities need to increasingly target theirservices to the poor individuals and underserved provinces since the private sector catersdisproportionately to the more affluent groups. To the extent that secondary and tertiary based facilitiesare disproportionately used by the better-off while primary care facilities such as health centers are usedmostly by the poor, government health policy needs to shift its focus from secondary and tertiary care toprimary care.

32. In the education sector, there is substantial scope for increased cost recovery through chargingofficial school fees. The Ministry of Education, Youth, and Sports (MoEYS) has yet to establish a costrecovery policy to benefit from regularizing or formalizing the currently widespread unofficial fees and

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contributions. The MoEYS needs to consider introducing user fees especially in higher educationinstitutions, with transparent collection mechanism at the facility level. Tertiary and technical education(including language, technical, and management training) takes up a disproportionately large share of thetotal public spending (i.e., including donor aid) on education. While tertiary and technical studentsaccount for merely 0.5 percent of all students in Cambodia, public spending on tertiary and technicaleducation took up 30 percent of total public spending on education in 1996. At this stage ofdevelopment, the government needs to focus spending more resources on the provision of basic educationand lower secondary education. At the same time, it needs to put in place policies which encourageprivate sector involvement in upper secondary, tertiary, and technical education. Such policies need toinclude a regulatory and quality control framework, public information systems, and policies whichensure access for the poor.

33. Economic Composition of Public Spending. Owing to substantial over-employment, salaryexpenditures in 1996 constituted about 43 percent of current expenditures despite the low salary levels ofgovernment employees. Low salary levels tend to reduce productivity levels in the public sector. Lowsalary levels also encourage a high degree of absenteeism on the one hand and rent seeking on the other.In this regard, effective implementation of public sector reform including civil service reform, which hasbeen stalled owing to lack of consensus and political uncertainty, will be critical. While there may not bemuch scope for expenditure reduction, the scope for rationalizing expenditures to make them effective,efficient, and productive is immense. In order to achieve this medium term objective, the followingactions need to be taken over the next several months: (i) strictly limit new hiring and reduce the numberof civil servants through eliminating ghost workers and also through normal attrition; (ii) carry out a civilservice census to provide a record of numbers and grades, education attainments, experience, and skillswhich will facilitate personnel planning; and (iii) prepare options for the appropriate role of government,the appropriate structures for that role, the needed skills mix for the reformed government, and the pay,training, and recruitment policies to support that mix.

34. Expenditures for civilian non-wage operations and maintenance have been squeezed to the bareminimum in the course of budget implementation (an average of 23 percent shortfall as compared withthe budgeted allocation during 1994-97) because of revenue shortfalls and overruns in defense non-wageO&M. This has resulted in underuse, or inefficient use, of capital investment and ineffective servicedelivery. It is of the utmost priority to secure an adequate amount of non-wage O&M to ensure theefficiency of capital investment and the quality of service delivery.

35. A very low level of local funding of investments has affected the government's ability toinfluence investment in public services so as to implement its development strategy, and insignificantcounterpart financing has adversely affected the technical efficiency of developmental projects. Theminimal level of counterpart funds has led to ineffective implementation of externally financedinvestment. Although some progress has been made to link the Five-Year Socio-economic DevelopmentPlan (SEDP) with the investment allocations included in the annual budget more closely through thePublic Investment Program (PIP) process, the linkage between the medium term plan and the annualbudget remains weak. In particular, public expenditure financed from government revenues during 1996-97 (which is essential for the effectiveness of public investment by providing O&M support) allocatedonly 5 percent to agriculture and rural development, which raises concerns as to how the target ofallocating 65 percent of public expenditure benefits can be channeled into rural areas where 88 percent ofthe poor live.

36. Regional Composition of Public Spending. Cambodia has a highly centralized system of publicfinances. The provincial share of expenditures financed from the government's own revenues in 1996was only about 22 percent. Almost 97 percent of provincial budget expenditures were of current

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spending. Thus, the provinces have scarcely any role in building physical infrastructure. As they lackthe powers to raise revenues or vary the level and composition of expenditures, the provinces haveneither the incentives nor the accountability to provide public services efficiently to match thepreferences and requirements of different regions. (However, the government recently approved theProvincial Budget Management Law, which devolves certain limited revenue and expenditure powers toprovinces.)

37. The spending by the aid agencies is concentrated in the better off regions, particularly PhnomPenh. In 1996, for example, Phnom Penh, which has only 7.5 percent of the total population, received apredominant share of 51 percent of the total donor assistance (excluding nationwide programs). Thiscould be explained by the fact that the bilateral and multilateral donors tend to dispense funds in areaswhich are more accessible, have facilities, and can be monitored more effectively. Although morebalanced than the donor-financed expenditures, the regional distribution of the government's budgetaryexpenditure also seems to favor the relatively better off provinces. The consequence of these two factorshas been the concentration of expenditures in Phnom Penh: total expenditure on public services percapita in Phnom Penh was ten times higher than that in the other provinces together in 1996. Sincepoverty is heavily concentrated in rural areas, this pattem does not serve the equity objectives of thegovernment well.

E. Assessment of Public Expenditure Management: Institutional Dimension

38. Overview. The effective translation of government expenditures into expenditure outcomesdepends critically on institutional arrangements through affecting incentives that govern the size,allocation, and use of budgetary resources. Institutional arrangements influence the quality of theoutcomes on three levels: (i) aggregate fiscal discipline; (ii) resource allocation and use based onstrategic priorities (allocative efficiency); and (iii) the efficiency and effectiveness of programs andservice delivery (technical or operational efficiency). Institutional arrangements alone, however, may notnecessarily have any effect. For such arrangements to be binding, the mechanisms that make adherenceto these rules transparent and that hold the government and its ministries accountable for badperformance are necessary.

39. To better assess the budgetary process in Cambodia, it is essential to understand the current fiscalsystem, adopted with the Organic Budget Law in December 1993. Under the previous system, althoughtax and expenditure policies were determined by the central government, the provinces were empoweredto collect revenues and the center depended on the transfers from the provinces to meet its expenditurerequirements. The unification of the budget in 1994 swung the pendulum completely in the oppositedirection, from a rather anarchic to a highly centralized system of public finances. Under the currentsystem, local governments do not have revenue-expenditure decision making authority. They merely actas agents or implementing bodies of the central government. The recently approved Provincial BudgetManagement Law, however, recognizes provinces as independent budgeting entities and devolves somelimited revenue and expenditure powers.

40. Budget institutions and processes in Cambodia have made a remarkable contribution tomacroeconomic control. In the late 1980s, unsustainable large budget deficits funded by new moneycreation contributed to galloping inflation. This peaked at 150 percent in 1991 and continued at highlevels until 1994, before decreasing markedly to single digits, with the adoption of the Organic BudgetLaw and the subsequent reforms aimed at improving budget management. Budget institutions andprocesses in Cambodia, however, have been very detrimental to allocative and technical efficiency. Thefundamental problem is that the Cambodian budgetary process has sacrificed too much in terms ofallocative and technical efficiency to maintain aggregate fiscal discipline. Thus, the challenge is to

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enhance the allocative and technical efficiency of the budget process without compromising the highlevel of aggregate expenditure control which is being achieved by highly centralized budgeting practices.This involves improving the current unnecessarily large trade-off between aggregate fiscal discipline onthe one hand and allocative and technical efficiency on the other. In fact, in the longer run there isevidence that improving allocation and operational performance can support improved fiscal discipline.

41. Linking Planning, Policy, and Budgeting. Closely linking planning, policy, and budgeting isone of the most important factors contributing to desirable budgetary outcomes. The Five-Year SEDP(1996-2000) sets out the developmental objectives and strategies for the medium term and makes anindicative allocation of the investment pattern. This has to be translated into concrete expenditureprograms in the annual budgets. Over the last four years, some important progress has been made to linkthe Plan with the annual budget through three-year rolling PIPs; nevertheless, the linkage between themedium term plan and the annual budget remains weak. A critical institutional weakness is the absenceof a proper system of monitoring. There is no system in place to monitor whether the actualdisbursement of assistance to these sectors and sub-sectors has, in fact, occurred. The government hasrecognized this problem and a system for monitoring of the PIP is to be established under the PublicInvestment Management System (PIMS).

42. Budget Preparation. Budget preparation takes place in several elaborate stages. Despite thiselaborate system, although some progress has been made in involving other ministries and agencies in theprocess, in practice the MEF largely dominates the entire budget preparation process. The involvement ofstrategic agencies such as the CDC, the Ministry of Planning, and the NBC is limited. Although everyline ministry has to prepare its budget allocation on the basis of the expenditure ceiling provided, thefinancial controllers--officials of the MEF--attached to line ministries play the lead role. The involvementof the provinces is even less. The preparation of the budget by different departments of the provinces iscarried out under the guidance of the financial officials deputized to the province by the MEF. While thisis due largely to the weak capacity of other agencies as well as the need to exercise strict fiscal discipline,it brings up problems of incentives and accountability.

43. Budget Execution. Budget execution is very highly centralized, with the MEF approving theindividual spending decisions of line ministries to an extent which has few parallels. Expenditureapproval processes in the provinces are even more complex. A single expenditure action can involveapprovals from the responsible line ministry, the Department of Financial Affairs at the MEF, theprovincial governor, and the provincial treasury. Expenditures are subject to complex central controlsintended to tightly control the evolution of the budget deficit through the course of the year. The veryhighly centralized approach to budget execution ensures a high level of expenditure discipline. However,these controls render the proactive management of programs by line agencies extremely difficult and alsosignificantly reduce the allocative and operational efficiency of the budget process.

44. Owing to the uncertainty of government receipts from month to month and the ad hoc (and oftenunwarranted) injection of new spending priorities (in particular in defense and security) into the budgetprocess, budget execution is dominated by a monthly cash allocation process at the MEF. This prioritizesthe access each line ministry will have to the cash expected to be available during the month. However,the process of authorization is a long and complex one. Financial controllers employed by the MEF andassigned to line ministries, provinces, and municipalities play a central role in this process. Financialcontrollers undertake a pre-audit of each expenditure proposal by line ministries. Payment orders issuedby the financial controllers in response to a purchasing activity which they approve are cleared throughthe MEF. Notification of MEF approval is then given to the national or provincial treasury, authorizingthe treasury to make a direct payment to the external supplier.

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45. The monthly cash allocation process does take account, to some extent, of the claims of thecompeting ministries, and involves a form of ad hoc reprioritizing in the face of unforeseen cash flowconstraints. However, the reprioritizing is undertaken without the same transparency and reviewmechanisms that characterize the budget preparation phase, thus reducing the allocative efficiencyof thebudget process. More serious is the effect on the technical efficiency. The technical inefficiency createdby the highly centralized system of cash allocation to line ministries relates particularly to the tendencyfor cash release to be irregular and unpredictable during the budget year. Operational units of lineministries are uncertain about how long each allocation will last, distorting the manner in which theydetermine their own spending priorities. Lack of resources to finance the projects on a continuous basiscan also result in time and cost overruns. For example, while the Ministry of Public Works and Transportwould like to spend on road repairs when the road conditions are bad after the monsoon, they cannotundertake these repairs until the end of the year. In addition, there exists a practice of informallyborrowing from local moneylenders at exorbitant rates of interest to meet immediate expenditureobligations and repaying the money when the liquidity position improves. The monthly allocationpractices during budget execution, often resulting from unwarranted political intervention, raise questionsabout the value of the elaborate processes associated with budget preparation and also point to theimportance of developing the capacity for reliable and honest revenue projection.

46. A further reason why ministerial and provincial departments effectively fail to receive theirbudgeted allocation is associated with the informnal diversion of funds released to individual agencies foruses unrelated to the agency program ("leakages" of funds). These leakages fall into two categories: thediverted funds are used for other programs, compromising the allocative efficiency of the budget; and thediverted funds supplement the personal income of those processing the payments (outright corruption),resulting in technical inefficiency owing to the higher than necessary budget cost of achieving givenprogram deliverables.

47. Budget Monitoring and Reporting. Although the government has taken several steps to improvefinancial management and public accountability, efforts to increase transparency and accountability in thepublic sector have yet to bring the expected outcomes because of weaknesses in implementation and lackof a proper accounting and auditing system and sound financial management at line agencies. Thus,budget monitoring and reporting remains very weak. The severe limitations of the accounting andauditing systems are detrimental to technical efficiency because they create an environment that is moreconducive to widespread leakages. There is an urgent need to establish a standard accounting system forline agencies which offers greater transparency of transactions and helps to curb leakages. Linked withthis is the need to establish an audit capability, both internal and external, for line agencies. A draft AuditLaw is under consideration to establish an independent Auditor General's Office reporting to the NationalAssembly. When the Audit Law and the relevant decrees under discussion are approved in current form,the laws would establish the basis for a modem auditing function.

48. Recommendations. Given the history of fiscal and macroeconomic instability, it is clearlyundesirable to introduce changes to budget processes which might weaken the current effectivemanagement of the budget deficit. However, considerable scope exists for improved allocative andtechnical efficiency in the budget process consistent with the present high levels of fiscal discipline. Thisrelates particularly to the institutions and processes involved in budget execution. Because of the weaktechnical capacity at the central and provincial levels, the government should focus on the pragmaticremoval of impediments to effective budget operation. The six key directions for reform are:

* Ensuring political commitment to an authoritative budget process* Establishing responsibility for perforrnance at the level of spending units* Rationalizing the roles of the central and provincial administrations

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* Developing financial participation schemes (user charging)* Improving the allocative and technical efficiency of donor funding* Strengthening the Public Investment Management System.

49. The top priority is for the government to respect the budgetary process, because if thegovernment does not abide by its own budget rules and procedures (which has often been the case inCambodia), there is little point in making efforts in designing budget reforms. In this regard, reducingunwarranted political interference in the budgetary process should be considered as the prerequisite forany budget reforms. Another prerequisite is to improve the managerial and accounting and reportingcapacities at the spending units. This is especially so if responsibility for performance at the level ofspending units is to be established--which is the key to improving the trade-off between fiscal disciplineand allocative and operational efficiency--without unacceptable loss of financial control.

50. Toward this end, the government needs to take the following concrete steps:

* Ad hoc spending decisions taken outside the budget preparation context should beminimized. Where new spending measures are proposed during the course of the budgetyear, they should not exceed the reserve budgeted for this purpose.

* The foremost medium-term direction for change is to increase responsibility for effectiveprogram performance at the program agency level. The government needs to graduallyextend the scope for lump sum program allocations rather than detailed line allocations. Thegovernment introduced the Accelerated District Development System (ADD) which providesmore efficient and flexible funding for hospitals and health centers in a small number ofdistricts as a pilot approach toward program-based budget allocation. An evaluation of theeffectiveness of the ADD needs to be undertaken and a trial of a similar program-basedscheme needs to be planned in other agencies.

* Before introducing more devolved budgeting, good financial management skills within lineagencies need to be established. The MEF needs to establish a financial managementimprovement team to help agencies introduce ministry-wide accounting systems forreporting, analyzing, and benchmarking resource use by each of their functional units.

* If financial decision making is to be devolved, the responsibility for program performanceneeds to be clearly assigned to the program units. To this end, the MEF needs to prepare atimetable for introducing activity-based budget bids by line agencies over a five-year period.

* A priority should be given to separating the roles of the line ministries and provincialgovernors in the disbursement of budget funds. In parallel, the financial management skillsof the regional units of line ministries should be upgraded within each line ministry.

* The existence of financial participation (user charging) schemes should be acknowledged asa significant budget tool, and the incidence and terms of such arrangements should beprogressively documented over time. A set of guidelines should be developed by the MEFon the circumstances in which user charging is appropriate, the appropriate basis fordetermining charges, and the handling of associated equity issues.

* To improve the efficiency of donor funding, aid coordination needs to be strengthened, inaddition to strengthening the capacity to identify, design, and implement projects. Apromising way to move toward better aid coordination would involve the adoption of theSector Wide Approach (SWAP), under which responsibility for sector development is sharedcollectively between donors and the government. Preparation for a SWAP needs to beinitiated in the health sector, as the MoH has established a better capacity for this andcoordination between the MoH and donors is relatively close. Even at the MoH, however, anumber of system-wide issues, such as managerial decentralization, reforms in accounting

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and budgeting systems, and changes in staffing incentives, should be addressed for a SWAPto be adopted effectively.

* The line ministry's capacity for monitoring the implementation of the PIP needs to bestrengthened. The development of PIMS needs to be extended beyond a broad frameworkfor linking capital budgeting institutions, to become a vehicle for developing concretestrategies aimed at overcoming the current weak links in the operation of the capital budgetcycle.

51. Donors' Role. To effectively complement the government's efforts, donors need to play asignificant role in two areas: well-coordinated capacity building and better aid coordination. The currentsituation is such that much donor assistance bypasses the budget and involves direct funding of projectcontractors. This reflects a lack of donor confidence in line ministry capacity to identify, design, andimplement projects. Magnifying the problem is the weak coordination at the sectoral level. This hasresulted in a fractionalized public sector effort with little central organization and control and with anumber of adverse side effects such as: (i) the absence of strong government ownership of many projects;(ii) piecemeal efforts by aid agencies toward sectoral issues and institution building; (iii) weakcoordination among donor programs; (iv) a proliferation of different procurement, disbursement,auditing, and progress monitoring activities among agencies; and (v) the creation of special project units,staffed by expatriates or by nationals with "topped up" salaries, with adverse impacts on institutionbuilding.

52. Thus, the donors' first role is to provide well-coordinated technical assistance and training tostrengthen the line ministry's capacity in a more systematic and programmed manner. Ad hoc approachesto capacity building would make the proposed budget reforms more difficult to implement. The donors'second role is to move toward better aid coordination, such as through a SWAP. The effectivesubordination of donor activities to mutually negotiated sector-wide strategies would be not be easy andthere would be problems of agreement among individual donors regarding responsibility for specificinputs or outcomes. However, this approach would link donor funded capital spending more closely withthe priorities identified in the SEDP. Furthermore, a sector-wide approach would move toward commonmanagement arrangements and could lead to more coordinated and explicit donor involvement in sectordevelopment to help strengthen the institutional capacity in line ministries.

F. Macroeconomic Framework, Resource Envelope, and Public Expenditures

53. Whether the government would implement the recommendations of the PER--in terms of revenueenhancement, improvement in governance, expenditure rationalization, and improved budgetarymanagement--would have significant implications for medium-term sustainability. With a view tohighlighting the importance of decisively implementing the policy recommendations, two alternativescenarios are presented: the full reform scenario and the status quo scenario.

54. The Full Reform Scenario. This scenario assumes that the government will take decisiveactions to reinforce macroeconomic stability, mainly through prudent fiscal policies, and, more important,to implement structural reforms at an accelerated pace. Under this scenario, it is expected that domesticinvestment would pick up and foreign investment would accelerate. As the government would decisivelypursue the reforms, the international donor community would be willing to continue its financial support.As a result, economic growth would start to accelerate from 2000 and would reach 6-7 percent by 2002.Inflation would gradually decrease to 5 percent by 2002.

55. Revenue would increase from the current 8-9 percent of GDP to 13-14 percent by 2002. Itshould be noted that revenue enhancement would be gradual after a one shot jump in 1999 with the initial

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introduction of the VAT as this scenario assumes the step-by-step implementation of policyrecommendations, in forestry management in particular, over the medium term. In addition to benefitingfrom growing tax and non-tax revenue, the government's full implementation of structural reform wouldengender higher foreign inflows which would be needed for the successful transition toward sustainabledevelopment. This would require commitments of official assistance of about US$405 million (excludingIMF assistance which is for international reserve accumulation) per year during 1999-2001, of whichabout US$50 million would be budget/balance of payments support to cover some recurrentexpenditures--especially for civil service reform and military demobilization.

56. The growing resource envelope would allow the government to increase spending and to bringabout the required reorientation in spending. Current expenditure would reach around 11-12 percent ascompared with the current 8-9 percent, which would allow for some long-awaited wage increases for civilservants--which should go hand in hand with the civil service reform--and for increases in non-wageoperations and maintenance. Capital expenditure could be increased to 7-8 percent from the current 3-4percent. Expenditure reorientation would also be facilitated by the peace dividend of militarydemobilization. Benefiting from the peace dividend and increased revenue, expenditure for thenon-defense sectors could be doubled in GDP terms by 2002. In particular, spending for health andeducation financed by the government's own revenues, taken together, could grow from the current 1.5percent of GDP to nearly 5 percent by 2002.

57. In sum, this scenario underlines the critical need for enhanced revenue performance, improvedgovernance, and expenditure reorientation as the core of the government's macroeconomic stabilizationand structural reform policies. Credible policies, aimed at stabilizing the economy and providing theframework for durable economic growth and at increasing government revenue through consistent taxpolicies, would also increase foreign aid inflows and enable the government to pursue its expenditureplans. Given Cambodia's current level of economic development, this is the only possible way to reducepoverty and rebuild the country.

58. The Status Quo Scenario. This scenario assumes that the government would not demonstratethe decisive political will to implement a package of far-reaching structural measures and to reinforcemacroeconomic stability. This would be reflected in minimal increases in budgetary revenue and only aslight improvement in defense and security expenditures. Moreover, the lack of credible reforms wouldreflect on the business climate, leading to a lack of growth in domestic, and in particular foreign,investment. As a result, output growth would be 2-2.5 percent and inflationary pressures would intensifyand keep inflation in the 16-20 percent range. Under these circumstances, revenue would still be about 9percent of GDP by 2002. Without major improvements in the country's economic situation, severaldonors would reduce their grants and loans, so that foreign finance would decrease in GDP terms.

59. This insignificant revenue growth would prevent the government from improving expenditurepatterns. Moreover, the government would not be able to finance the overall deficit entirely with foreigninflows, so that it would become necessary to resort to domestic bank financing, which would threatenfiscal sustainability. Under this scenario, no improvements could be expected in sectoral allocation.Outlays for defense and security would remain high without the effective implementation of militarydemobilization. This, in conjunction with low revenue, would limit spending on key sectors such ashealth and education.

60. Between the two extreme scenarios, a host of intermediate cases and outcomes are possible,depending on the extent of the efforts made to address the issues discussed in the PER. One probablescenario is that the government would only implement reform measures minimally affecting powerfulentrenched interests. Any effort to raise revenues above the path envisaged in the status quo scenario, as

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well as any effort to reduce military expenditure, would open up the possibility of increasing and/orreorienting some civilian expenditure categories. Such a policy might lead some bilateral donors to lendmore funds or give more grants, taking away some pressures for domestic financing of the budget deficit.A likely outcome would be higher GDP growth and lower inflation compared with the status quoscenario.

61. Downside Risk. One distinct downside risk is afurther deepening of the regionalfinancial crisis.This would threaten macroeconomic stability and limit the scope for growth over the medium term.Under the full reform scenario, the effects of such a risk could be reduced with prudent macroeconomicpolicies. In addition, the high degree of dollarization and the fact that the country is still largely agrarianwould also help mitigate some of the effects of the regional crisis. Nevertheless, it is likely that foreigndirect investment inflows from the region would slow down, which would have a negative impact ongrowth and employment. A slowdown in tourism would also have a negative impact. Withdrawals offoreign currency deposits could further weaken the already fragile financial system, and a furtherdepreciation of currencies in neighboring countries would erode Cambodia's export competitiveness. Inaddition, a further slowdown in the economy would have a negative impact on government revenue,which would slow down the reorientation of government expenditure. It is obvious that the impact of theabove effects would be all the more dramatic under the status quo scenario, and a prolonged regionalcrisis under this scenario is likely to render the economic situation deeply unsustainable over the mediumterm.

G. Conclusion

62. The current economic situation poses a serious threat to medium-term sustainability. To make atransition toward sustainable development with significant poverty reduction and broad-based economicgrowth, Cambodia must substantially upgrade the current weak physical infrastructure and the poorquality of human resources. Toward this end, the government must decisively implement therecommendations made in the PER--as summarized in the attached matrix--to resolve the interrelatedfundamental fiscal and governance problems. As the political and security situations improvedsignificantly, the new government is now in a position to demonstrate clearly strong political will inrenewing its efforts to reinforce macroeconomic stability and implement structural reforms.

SUMMARY OF RECOMMENDATIONS

Issues Recommendations Time FrameImmediate: < 3 mondhsShort-i..: -c I year

|Medium-term: > I ear

1. Increasing Domestic Revenue MobilizationThe current low revenue effort is extremely detrimental to achieving sustainable development. The effectiveness of public expenditure policy as an instrument foraccelerating growth and reducing poverty is severely constrained by weak revenue effort. The authorities must address weak governance which is the core of thecurrent low revenue performance.

I . The new measures of the Law on ' Fully implement the measures of the Law on Taxation. > ImmediateTaxation are partiallyimplemented.

2. The implementation of the VAT z' Effectively implement the VAT initially for 800 largest taxpayers beginning January 1, 1999: > Immediatehas been delayed. * Swiftly issue the sub-decree on the VAT and supporting MEF regulations. => Immediate

* Continue and intensify the training at the Tax Department, education of taxpayers, and =, Immediatepublicity campaign.

3. The Law on Investment and the => Remove all the incentives currently granted to resource and resource processing firms from the = ImmediateImplementing Regulations are too Implementing Regulations.generous, posing one of the most = Remove the production of consumption goods from the preferred sectors in the Implementing > Immediatecritical impediments to improved Regulations (but not retroactive).revenue mobilization. =: Repeal the 9 percent tax rate, the tax holiday period, and the profits reinvestment rule in the Law > Medium-term

on Investment, with grandfathering up to three years.4. Despite its significant revenue > Immediately take "emergency measures" to arrest the deteriorating situation: stop granting new

potential, forestry continues to concessions; freeze approving all new investments in wood processing; establish mechanisms to = Immediatemake a very limited contribution, monitor and prevent illegal log fellings and exports; enforce cancellation of all permits foras the severity of illegal logging "collection" of logs and stop issuing new permits; and strengthen the Forestry Department.has worsened. > Implement the recommendations of the four studies assisted by the Bank TA (i.e., legal review,

forest concessions management, forest policy, and log control and monitoring) with a view toestablishing an environmentally sustainable, economically sound, market-oriented forestry = Medium-termmanagement over the medium term:

* For next three months: prepare a proposal for illegal logging control; prepare the illegallogging monitoring program, undertake a performance review of concessions, and > Immediateprepare the Cambodia Code of Forest Practice (CCPF).

* In the subsequent few months: decide on the termination or renegotiation of concessioncontracts; prepare a sub-decree establishing the CCPF; strengthen the implementation

Issues Recommendations Time FrameImmediate: c 3 monthsShort-tem: < I year

-_____-____M____-_________-_____.____._ M4edium-term: > I year

capacity of forestry management; and strengthen law enforcement capacity on illegal > Short-termlogging.

5. Tax administration and > Ensure that all issues relating to taxation are included in the Law on Taxation with the Ministry of =: Immediategovemance in tax collection are Economy and Finance (MEF) responsible for legislative drafts, implementation, andweak. administration.

=> Eliminate the exemption from pre-shipment inspections for import for the projects approved > Short-termunder the Law on Investment, garments, and cigarettes. => Immediate

=> Fully transfer non-tax revenues collected by line ministries to the Treasury.z Amend the Law on Taxation to require that any other exemptions not specified in the Law on

Taxation should be void. => Short-term_ Strengthen the audit capacity of tax administrators. = Medium-term

II. Improving the Efficiency and Equity of Public Expenditures through Expenditure RationalizationXDespite its critical role in the development strategy through reconstructing physical infrastructure, developing human resources, and improving the accessibility of

public services to the poor, the effectiveness of public expenditures is constrained not only by weak revenue efforts but also by low efficiency and equity associated -with the allocation of public expenditures.

I. Defense expenditure crowds out z Decisively implement military demobilization as envisaged under the Cambodia Veterans > Medium-termresources for spending on Assistance Program (CVAP):development activities. . Update CVAP. = Immediate

* For the following few months: identify and register special target groups; and implement zo Short-termpilot demobilization of special target groups.

2. Despite the urgent need for => Substantially increase outlays for social sectors financed from revenue enhancement and also > Medium-termhuman resource development savings from military demobilization.which is critical to povertyreduction and economic growth,outlays on social sectors fromgovernment's own resources arevery low.

3. The efficiency and equity of = Increasingly target services of government health facilities toward poorer individuals and =:> Medium-termpublic expenditure within the underserved provinces and also from tertiary to primary facilities since the private sector caterssocial sectors needs to be disproportionately to the more affluent.enhanced. => Implement pilot programs for cost recovery in the hospitals, including user charges, community-

Issues Recommendations 1 Time FrameIImmediate: < 3 mionthsShorl-tem: < I yearMedium-term: >I year

based prepaid insurance schemes, and contracting out of specific services in public facilities to > Medium-termthe private sector.

=> Focus spending more on the provision of basic education and lower secondary education, withputting policies which encourage private sector involvement in upper secondary and tertiary > Medium-termeducation.

=> Regularize the current informal cost recovery program especially in higher education, withtransparent user fee collection process and the collected revenues kept at the facility level. > Medium-term

4. Owing to substantial over- z> Decisively implement civil service reform: => Medium-term

employment, the wage bill is high * Strictly limit new hiring and reduce the number of civil servants through eliminating => Immediate

despite the low salary level. The ghost workers and also through normal attrition.combined result of over- . Carry out a civil service census to provide a record of numbers and grades, education =, Short-term

employment and low salary level attainments, experience, and skills which will facilitate personnel planning.

leads to low operational * Prepare options for the appropriate role of government, the appropriate structures for that > Short-term

efficiency of public service role, the needed skills mix for the reformed government, and the pay, training, anddelivery. recruitment policies to support that mix.

5. The squeeze in civilian non-wage = Substantially increase outlays for civilian non-wage O&M and counterpart fund from revenue => Medium-term

O&M and counterpart fund for enhancement and also savings from military demobilization.externally financed investmentresults in the underuse, orinefficient use of capitalinvestment, and in ineffectiveservice delivery.

6. Public expenditures are > Reorient expenditures to rural areas as envisaged in the SEDP. =' Medium-term

concentrated in Phnom Penh,which is not desirable as povertyis heavily concentrated in ruralareas.

Ill. Enhancing the Effectiveness of Public Expenditure Management

While highly centralized institutions and processes make a remarkable contribution to macroeconomic control, they are very detrimental to allocative and technical

efficiency. The fundamental problem is that the Cambodian budgetary process has sacrificed too much in terms of allocative and technical efficiency to maintain

aggregate fiscal discipline. Thus, the challenge is to improve the current unnecessarily large trade-off between the aggregate fiscal discipline on the one hand and the

allocative and technical efficiency on the other. The top priority is for the government to respect the budgetary rules and processes. In this regard, reducing political

interference in the budgetary process is a prerequisite for other reforms.

Issues Recommendations Time FrameImmediate: < 3 monthsShort-tern: < I year

.=________________________ _ _ ______.__. M edium -term : > I earI. Ensuring political commitment to , Minimize ad hoc spending decisions taken outside the budget preparation context. '> Immediate

an authoritative budget process. ' Ensure that new spending measures do not exceed the reserve budgeted for this purpose, where ' Immediatethey are proposed during the course of the budget year.

2. Establishing responsibility for ' Undertake an evaluation of the effectiveness of the Accelerated District Development (ADD) z> Medium-termperformance at the level of System of the Ministry of Health (MoH) and plan a trial of a similar program-based scheme forspending units in parallel with the other agencies (with Ministry of Education, Youth, and Sports as a priority).strengthening of technical, => Establish a financial management improvement team at the MEF to help agencies introduce > Medium-termfinancial managerial capacities. ministry-wide accounting systems for reporting, analyzing, and benchmarking resource use by

each of their functional units.

n Prepare a timetable for introducing activity-based budget bids by line agencies over a five-year Medium-termperiod. Meimtr

3. Rationalizing the roles of the => Give a priority to separating the roles of the line ministries and provincial governors in the ' Medium-termcentral and provincial disbursement of budget funds.administration. z> In parallel, upgrade the financial management skills of the regional units of line ministries within => Medium-term x

each line ministry.

4. Developing financial participation => Acknowledge the existence of financial participation schemes as a significant budget tool and => Medium-termschemes (i.e., user charging). progressively document the incidence and terms of such arrangements.

z> Develop a set of guidelines on the circumstances in which user charging is appropriate, the => Medium-termappropriate basis for determining charges, and the handling of associated equity issues.

5. Improving the allocative and = Initiate a Sector-Wide Approach (SWAP) in the health sector as the MoH has a better capacity > Medium-termtechnical efficiency of donor and coordination between the MoH and donors is relatively close.funding. > Address a number of system-wide issues-such as managerial decentralization, reforms in > Medium-term

accounting and budgeting systems, and changes in staffing incentives--in the health sector for aSWAP to be adopted effectively.

6. Strengthening the Public r Strengthen the line ministry's capacity in monitoring the implementation of the PIP. => Medium-termInvestment Management System = Extend the development of the PIMS beyond a broad framework for linking capital budgeting(PIMS). institutions, to become a vehicle for developing concrete strategies aimed at overcoming the ' Medium-term

current weak link in the operation of the capital budget cycle.

7. Donors need to play a significant z Provide well-coordinated technical assistance and training to strengthen the line ministry's > Medium-termrole to effectively complement capacity in a more systematic and programmed manner.the government's efforts. => Move toward better aid coordination, such as through a SWAP. => Medium-term