Report No: ACS18454
West Bank and Gaza
Public Expenditure Review of the Palestinian Authority
Towards Enhanced Public Finance Management and Improved Fiscal Sustainability
MIDDLE EAST AND NORTH AFRICA
1. The difficulty of pursuing a conventional market-oriented development strategy in the Palestinian territories led in the early part of the 2000s to a "second-best" reliance on public sector employment and wage bill expansion to boost aggregate demand. This approach was underwritten by the international community, in response to the reduction in employment for Palestinians in Israel and the movement and access restrictions that intensified with the Second Intifada coupled with the donors' wish to help create the institutions and services appropriate for a future Palestinian state. The main focus was on aggregate fiscal stimulus rather than the quality of public services delivered by the PA — frequently resulting in poorly targeted and high cost interventions.
2. The main objective of this Programmatic Public Expenditure Review (PER) is to inform policy and institution-building efforts of the Palestinian Authority (PA) and its donor partners about improving the sustainability of public expenditures and the efficacy and efficiency in the provision of essential public services. In particular, this PER aims to provide an assessment of public revenue and expenditure policies offering specific policy and institutional measures to reduce the size of the Palestinian territories' fiscal deficit and make it more sustainable. This will create fiscal space for public investments that could catalyze economic growth. The PER analyzes sector-specific expenditure policies and the adequacy of existing intergovernmental fiscal relations, and provides reform recommendations to improve efficacy, efficiency, and sustainability in the provision of certain public services.1
3. The fiscal situation of the Palestinian Authority is not sustainable. The Palestinian Authority's (PA) budget deficit stood at over 10 percent of Palestinian GDP in 2014 (See Table 1). Although this represents a reduction from almost 25 percent of GDP in 2007, it has been financed by budget support and a progressive accumulation of domestic debt including arrears, the stock of which is now approaching US$3 billion: the majority is owed to the Palestinian public pension system, while the rest is to the private sector. Without a significant correction, the public pension system will become insolvent within five years, while private sector suppliers may refuse to supply important goods and services (such as pharmaceuticals) any longer: the PA's coping strategy is thus reaching its limits.
4. The difficult fiscal situation facing the Palestinian Authority today results from a unique confluence of challenges. First, Palestinian economic growth and PA revenue potential remain significantly depressed by movement and access restrictions. The inability of Palestinians to exploit economic opportunities in Area C, for example, has been estimated by the Bank as reducing potential Palestinian GDP by up to US$3.5 billion per year, and potential revenue by up to US$800 million a year. Low tax effectiveness in Gaza and lower than hoped for compliance in the West Bank also affect the PA's revenue potential. Furthermore, donor budget support intended to help offset fiscal impairments is in decline. Between 2012 and 2014, budget support averaged just over US$1 billion per annum, equivalent to only 10 percent of Palestinian GDP in 2013 (See Table 1). At its height in 2008, donor contributions to the Palestinian budget equaled 26 percent of GDP. In 2014, they had shrunk to 8 percent of a significantly larger GDP (in nominal terms, budget support fell by 28 percent, from the above-noted average of US$1.42 billion per annum between 2008-10, to an annual average of US$1.02 billion between 2012-14).
5. The commendable efforts made by the PA to reduce the relative size of the recurrent deficit have not managed to offset the combined effects of the above-mentioned phenomena. It is important to note that the rapid growth in the public workforce described in the World Bank's previous (2007) Public Expenditure Review was curtailed by determined PA policy action, and that the size of the wage bill relative to GDP has been cut from a startling 24 percent of GDP in 2007 to 16 percent in 2014. As shown by the 2013 PEFA (Public Expenditures and Financial Accountability Assessment), PA public financial management practices have also improved significantly in recent years. The recurrent deficit was brought back from almost 25 percent of GDP in 2007 to just over 10 percent by 2014; this was largely achieved by a reduction in the size of the wage bill and of net lending2 relative to GDP (the wage bill peaked at 24 percent in 2006 and has since been reduced to 16 percent of GDP, in part due to hiring control and wage growth restraint; net lending dropped from nearly 10 percent of GDP in 2007 to just over 2 percent in 2014). Nonetheless, arrears continue to accumulate (See Table 1).
Source: PA MoF.
7. However, the PER notes that there are limits to what can be achieved by PA fiscal policy alone. Growth in the Palestinian territories has been unconventionally based, with investment playing a limited role in a process largely sustained by consumption and consumption-related import substitution3 -enabled, in turn, by compensatory high rates of donor disbursements to the Palestinian budget. In fact, on the assumption that movement and access restrictions will continue in much the same form as currently, any credible PA reform program of the type advocated in this report must be met by a proportional donor response.
8. The PER is organized as follows: Chapter 1 provides an overview of recent macroeconomic and fiscal developments; it also contains a brief assessment of priority fiscal policy issues facing the PA, and serves as an introduction to the in-depth analysis of the issues that follow in subsequent chapters. Chapter 2 analyzes the factors driving the size of the PA's wage bill, and shows how these can be tackled. Chapter 3 reviews expenditures in the public health sector. Chapter 4 analyzes the Palestinian public pension system, and looks into how its sustainability can be assured. Chapter 5 assesses the quality of intergovernmental fiscal transfers, including net lending transfers. Chapter 6 reviews the way in which public investment projects are planned and implemented, and identifies steps to improve investment quality. Further details on health and pensions are provided in the annexes.
The Central Government Wage Bill
9. In relative terms, the Palestinian public sector wage bill is among the highest in the world. For the majority of countries, public sector wage bills do not exceed 10 percent of GDP; in the Palestinian territories they currently amount to 17 percent of Palestinian GDP4 (See Figure 1). Notably, these figures do not include the cost of civil servants and security staff employed by the Hamas government in Gaza, the amount of which is not known but is estimated at an additional 3-4 percent of GDP.5 The central government wage bill alone is equivalent to 16 percent of GDP, 55 percent of recurrent expenditures, and as much as 83 percent of public revenues.
Sources: MoF and PCBS data.
Average public pay as a multiple of per capita GDP
Source: World Bank staff calculations and World Bank 1999.
12. The report proposes measures that can help reduce the wage bill to sustainable levels. This can be accomplished by:
• Integrating most allowances into base pay;
• Freezing the wages of PA staff whose pay is substantially higher than Palestinian private sector employees at an equivalent level until the wage gap has been substantially reduced; and
• Reducing the number of higher ranked staff in the substantially "over-ranked" security sector.
14. An acceleration of economic growth will also help reduce the wage bill to GDP ratio further, provided wages are not increased. The removal of movement and access restrictions, in particular the restrictions on economic activity in Area C and the blockade of Gaza, will be a key determinants of the rate of growth in the Palestinian territories. Strong growth will contribute to revenue growth. Figure 3 also shows that a further 5 percent of GDP reduction of the wage bill/GDP ratio would be achieved with a strong economic growth in the 6 percent per annum range projected by the IMF as a plausible consequence of a breakthrough in the peace process.
Figure 3: The impact of controls on PA hiring, wage growth containment and reduced over grading in the security sector plus and wage growth, plus strong economic growth
Note: These savings have been calculated after five years, as compared with a baseline of 3 percent
employment growth and wage growth equal to inflation plus 1.25 percent per annum—a baseline that would leave
the wage bill/GDP ratio would remain relatively unchanged over the period.
15. Public pension expenditures in the Palestinian territories are high and unsustainable. Total pension expenditure exceeded US$300 million in 2013, around 3 percent of GDP. Even though this is close to the MENA average of 3.6 percent, it is extremely high in the Palestinian context given the territories' demographic profile, with only 3 percent of today's population above the age of 65. The transfers required to service the system confront the PA with an enormous fiscal burden, which it is already failing to meet (accumulated arrears already amount to some US$1.6 billion8 or 13 percent of GDP), and without parametric reforms these obligations will either fail to be fmanceable, and/or will crowd out more equitable spending on important social priorities: welfare, healthcare and education.
16. The pension system is fragmented, consisting of four schemes, two of which were inherited from Jordan and Egypt with another two created subsequently. All schemes provide extremely generous benefit formulae, with payment rates of up to 100 percent of final salary. The system also offers early retirement options from the age of 45 onwards. Eligibility criteria are broad, permitting large numbers to draw survivorship and disability benefits.
17. The combination of high benefits and low coverage raises important equity concerns. The system provides generous and unsustainable retirement benefits for those few Palestinians of retirement age who had worked in the public sector, who as mentioned, are relatively well remunerated. However, it leaves out more needy individuals who have not been employed or have worked in the private sector. According to World Bank estimates, the system will cease to pay for itself in five years if present management practice continues; even if the PA stops accumulating arrears, the onset of the deficit will only be put off another decade.
18. Restoring the Palestinian pension system's sustainability requires a number of significant adjustments. The onset of the deficit could be delayed to 2041 by a combination of raising the retirement age to 65, reducing the accrual rate of pension benefits to 1.5 percent9, and indexing pensions to inflation. Achieving long-term financial sustainability, though, will require additional action. The PER recommends the adoption of 'actuarially fair' reduction coefficients in the case of early retirement10, as well as reducing the eligibility for survivorship and disability benefits along with the limitation (or gradual elimination) of the option to purchase years of service instead of serving them. For the critical Scheme II 11 the report also recommends that the funded Defined Contribution (DC) component be changed to a pay-as-you-go Defined Benefit (PAYG-DB) system, which is much easier to implement. Again, alongside these cross cutting measures, it would be useful to fully integrate the cost of the pension system into the employment costs for each area of government activity to reflect the full cost of staff and support better resource management by service delivery units.
Local Government Financial Management
Energy Subsidies -- The Net Lending Issue
19. Net lending, resulting in unplanned energy subsidies paid through local governments' budget, has become one of the thorniest fiscal issues facing the PA. To a significant extent, local government units (LGUs) finance their operating budgets by selling electricity and other utility services provided to them by Israeli companies, and leaving the PA to repay some or all of the costs (these are deducted by Israel from clearance revenues due to the PA, along with an 11 percent late fee). As a result, the PA finds itself providing unplanned subsidies of over US$200 million per year (2 percent of GDP) to the LGUs. Inadequate investments in maintenance and upgrading of the electricity sector have led to significant technical losses, estimated at a further US$200 million in purchased, but lost, electricity. The MoF attempts to recover those losses by withholding revenues otherwise due to LGUs (municipal property tax, professional permit fees, transportation tax for example), but these intercepts by no means offset utility non-payments and lead to disputes and chaotic budgeting.
20. Reducing this drain on the PA budget will require steps in two directions: first, reforms that will increase own-source LGU revenues, and second, the commercialization of electricity and water distribution services: utility management requires skills and governance structures not generally found in local governments. The transfer of these functions to dedicated public distribution corporations would also reduce the fragmentation of service provision, leading to some efficiency gains. Resolving the net lending problem cannot be undertaken overnight and will need to be managed over time. Arrears are in some cases massive in comparison to actual or potential own-source revenues, and the PA will need to consider writing off a portion of the debt in order to put a stop to the current dysfunctional system of intergovernmental finance.
Intergovernmental Fiscal Relations
21. From an LGU perspective, the availability of utility subsidies focuses excessive attention on the provision of electricity and water as a means of acquiring revenue. In consequence of this and of MoF intercepts of own-source revenues, attention to other local public services is neglected or is of substandard performance. As mentioned earlier, ensuring that LGUs are financially better-situated will require an increase in local own-source revenues. Bank analysis, however, shows that some LGUs will remain unviable without access to intergovernmental transfers to replace their net lending income.
22. As a result, LGU revenues are insufficient to fulfill many assigned mandates (80 percent of LGUs deliver an average of only 12 of the 27 services they are mandated to provide). Local government revenues amount to only 11 percent of total revenues, while local government expenditures account for 6 percent of total public expenditures: this compares with 18.3 and 19.7 percent respectively for the Eastern Europe/Central Asia region, for example. Put another way, LGU revenues amount to less than 5 percent of GDP, roughly one third of the level observed in East Asia and one half of that observed in Europe. The revenue scarcity is in fact worse than this, because roughly half of all municipal revenue comes in the form of utility income. In many countries, electricity, water and sewerage are provided by public utilities and are not part of the municipal budget.
23. Increasing LGU own-source revenues is essential. Theory and best international practice in fiscal decentralization show there are many advantages to own-source revenue financing, including increased accountability and better fiscal responsibility and decreased corruption by local officials.12 If local revenue collections are increased, LGUs will need to address local residents' probable lack of willingness to pay (given that they may be concerned at the excessive costs in the provision of some services and are unlikely at this stage to see any clear link between tax and fee payments to LGUs, and the services they receive). This will require increased transparency alongside improved service delivery.
24. An obvious source of additional local revenue is property tax, which is currently collected in only about 20 percent of all municipalities, and not at all by village councils. The PER estimates that LGUs could easily double or even triple property tax collections. Additional revenues will also need to be mobilized, for example through the modernization and enhancement of the professional tax as well as the gradual introduction of new taxes such as the so-called 'betterment levies'''. There is also scope to increase revenues from service fees, but it is important to prevent the emergence of 'nuisance levies' 13 that impose heavy burdens on individuals and businesses without raising significant revenues.
25. Even if own-source revenue potential is maximized, it will be difficult for LGUs to cover their expenditure needs. Thus, the PA needs to reform the current system of irregular and small-scale transfers to LGUs. The centerpiece of a new transfer system should be a conventional equalization grant across municipalities and VCs -- one that uses an objective, stable, and explicit formula based on the expenditure needs and revenue capacity of LGUs. Since it is supposed to equalize, only those LGUs with predictable deficits should receive funds. Although arriving at an acceptable formula will not be easy, the larger difficulty will be generating a sizable pool of stable and predictable resources. As already discussed in the Public Expenditure and Financial Accountability (PEFA) report, one possibility would be to dedicate 100 percent of transportation taxes to the equalization poo114, though this alone would likely be insufficient. The practice followed in many countries is to set aside a certain percentage of central tax revenues, often lagged by one year so that planning can be carried out within a defined fiscal framework. This can help create the firm budget constraint necessary to encourage the service delivery units within LGUs to focus on better resource management to enhance the quality of service and minimize their costs. Any new system of transfers would also benefit from conditional grants to incentivize LGUs as well as to address inter-jurisdictional issues such as environmental protection.
The Public Health System
26. The Palestinian health sector is at a crossroads. The financial sustainability of the healthcare system is in doubt. The recent conflict in Gaza exposed major weaknesses in institutional and regulatory systems, and highlighted the precarious fiscal position in which the sector finds itself. Moreover, uncertain foreign aid flows, the increasing costs of referrals, inefficiencies and duplications of service, and an excessive focus on tertiary care are together straining the fiscal position of the health sector. Health expenditures are on the rise, while health outcomes are below potential for current levels of spending. Overall health expenditures (public and private) more than tripled in the last decade, reaching US$1.3 billion in 2012, or 12 percent of GDP—one of the highest shares of GDP in the world (See Figure 4). Public spending on health is close to 5 percent of GDP, and exceeds the MENA average of 2.6 percent and the Low and Middle Income Country (LMIC) average of 1.7 percent of GDP.
27. The rise in public spending on health is being driven mainly by the salary bill, the cost of medical referrals outside the public health system, and high spending on pharmaceuticals (See Table 2). At the same time, public expenditures are allocated mostly to curative care, with hospital inpatient treatment representing a significant proportion of spending. In addition to introducing economies in these three areas (see below), global evidence shows that non-communicable diseases are best addressed at the primary health care level through cost-effective preventative interventions15, and the PA can improve the allocative efficiency of the health system significantly by shifting resources into preventative care and disease prevention.
• The cost of outside medical referrals is heavy and has been increasing. The lack of availability of certain treatments, medications, medical staff, equipment and infrastructure within the public system has led to the creation of a referral system whereby large numbers of patients requiring tertiary care are referred to not-for-profit or commercial providers. Between 2000 and 2013, expenditure on referrals increased from US$8 million to US$52 million, and now corresponds to 48 percent of non-salary public health spending. MoH lacks a clear decision making mechanism to determine which services it would like to develop, which it would like to purchase from other service providers within the Palestinian territories, and which it should refer abroad. A 2013 World Bank study reviewed the appropriateness of outside medical referrals and concluded that a significant majority of referral documents were of doubtful quality, and that a large proportion of patients had circumvented the existing referral system. In 2015, the PA started to implement measures to control outside health referrals, and has already achieved some success in lowering the cost of referrals to Israeli hospitals.
• Pharmaceutical expenditures accounted for 44 percent of non-salary public expenditures in 2013. While expenditures on drugs have shown large fluctuations, they have been a significant factor in driving up public health expenditure. There is an urgent need to improve the efficiency of pharmaceutical purchasing through more competitive procurement and attentive international price benchmarking.
Source: MoH, 2014.
29. The financial sustainability of the Government Health Insurance (GHI) scheme is also in doubt, placing further pressure on the finances of the sector. The GHI scheme was established in 1994 to provide health insurance, including on a non-contributory basis to those facing hardship. Over the past decade, the number of non-contributing GHI enrollees increased compared to contributing members, damaging the scheme's financial structure. In 2000, GHI revenues reached US$35 million; by 2009 they had declined to US$23 million, and continue to do so. In the meantime, GHI expenditures have been increasing rapidly (see Figure 5): as a percentage of total health expenditures, GHI costs amounted to 5.2 percent in 2000 but have increased steadily since 2005 and reached 15 percent of total health expenditures by 2010. Thus, the health sector faces a growing internal financial crisis,16 as well as placing considerable pressure on the PA budget. Addressing this situation will require significant adjustments to budget planning, budget discipline, staff deployment and management, and a set of policy priorities that currently prioritize unaffordable levels of tertiary care. It will likely require institutional changes that promote an increased focus on resource management at the front line to deliver the appropriate levels of service at the least cost.
Source: PCBS & MoH, 2011, 2012, 2014.
30. One of the key issues facing the PA's Public Investment Management (PIM) is the lack of a coherent system applying to both donor-funded and domestically-funded projects. Public investment in the Palestinian territories has until recently been funded almost entirely by international development partners (IDPs). While the implementation of capital investment projects has either been directly by the IDPs or through PA ministries, direct IDP funding for public investment has been channeled outside of the Treasury system and for the most part has not been reflected in the PA's budget. Since 2009, the PA has funded a significant capital investment program from domestic resources. This situation has resulted in an incoherent approach to PIM in addition to a lack of consolidated data on commitments and spending.
31. Responsibilities for PIM have similarly been fragmented. In practice, prior to the recent merger between the Ministry of Finance and Ministry of Planning, responsibility for PIM has been divided between the MoF for domestically financed development expenditure and the Ministry of Planning and Administrative Development (MoPAD) for IDP financed projects. The situation is further complicated since on IDP funded projects many PIM functions, including project identification, appraisal and implementation, are carried out directly by IDPs or with very limited PA involvement. Also, a significant capital spending program is undertaken by the local government units (LGUs). Even though the Ministry of Local Government (MoLG) is required to approve LGU budgets and development projects, it currently undertakes no consolidated analysis of LGU budgetary operations.
32. Putting in place a comprehensive PIM system requires a combination of measures. Initially, a clear definition of public investment that is based on expenditure on fixed capital assets and related equipment costs needs to be agreed. Also, formal procedures should be established for screening projects at the identification/concept stage so that only those which are consistent with PA priorities and appear technically and economically sound proceed further to detailed preparation and appraisal. Procedures should also be developed for project selection and approval for financing. The PA should also put in place procedures for budgeting, managing, and monitoring projects against their total approved cost and implementation plans. A plan should be made to work with donors and bring all IDP funded projects into the budget. The responsibilities and functions of the MoLG with respect to the oversight and reporting of public investment by local governments should be fully elaborated and the required analytical capacities put in place.
i Due to time and resource constraints, the report is not a comprehensive assessment of the PA's public expenditures. The themes/sectors covered in-depth in the report were chosen based on the following criteria: (i) their importance to the objectives of the PER; and (ii) a knowledge gap in the sector/policy area. For example, education was not specifically covered in the report, but the chapter on the wage bill does assess staffmg and wage issues in the education sector given its significance in wage bill issues.
2 Net lending is a term that describes the deductions made by Israel from clearance revenues as a result of utility (mostly electricity) bills, which have not been paid by Palestinian municipalities and electricity distribution companies. These deductions from PA tax revenues amount to a de facto fiscal transfer to Palestinian municipal governments.
3 The report notes that data quality issues make it difficult to be defmitive about the exact nature of net export growth, which was positive for six of the eight years 2006-2013. It would appear that this growth, which contributed almost a half of GDP growth in the period, was driven by a significant reduction in reliance on imports to fuel growth. The share of imports to GDP fell 19 percentage points over the period.
4 The PA is currently revising its national accounts, and it is likely that estimates of the wage bill/GDP ratio will change. This is unlikely to result in a substantially lower ratio, however.
5 Available data indicates that in Gaza, Hamas employs 50,112 civil servants. This includes blue uniform security personnel (i.e., police); figures on the number of green uniform security employees (i.e., security services) are unavailable. The addition of known Hamas staff would raise the cost of the wage bill to at least 18 percent of GDP.
6 LABORISTA database, ILO.
7 Africa, in turn, has a significantly smaller proportion of government employment to population: c. 2 percent of the population, as opposed to almost 5 percent in the Palestinian territories — see International Labor Organization's Laborista database for 2008, and World Bank World Development Indicators database for 2008; calculations for the Palestinian territories are made by the World Bank.
8 This amount represents arrears accumulated to civil servant schemes only since the amount owed to the security services schemes is currently unavailable.
9 The 'accrual rate' is the rate at which a beneficiary builds up his/her pension benefits while a member of a defined benefit scheme. The rate is multiplied by the person's earnings to calculate how much money he or she will eventually be entitled to, and is typically expressed as a fraction: the bigger the fraction, the greater the pension benefit.
10 "Actuarially fair" coefficients are based on an individual's age and gender, and take account of projected mortality rates and pension indexation rules, and apply a specific discount rate. Such coefficients equalize the net present value of a reduced benefit stream given at an earlier age, and a regular benefit stream awarded at the statutory retirement age.
11 Schemes I, III and IV are being phased out; Scheme II covers all workers who were 46 years or younger in 2006 (the other three cover civilian and security employees who were older than 46 in 2006). Projections show that by approximately 2020, all PA government workers will be covered under Scheme II.
12 Martinez-Vazquez, J., et al., The Impact of Fiscal Decentralization: A survey. International Center for Public Policy Working Paper 15-02, 2015.
13 Betterment levies, used in many countries at the local level, are one-time charges on the increased value of properties associated with urban improvements, such as the introduction of street lighting, sidewalks, or the construction of new roads, drainage, etc. in newly developed areas.
14 The West Bank and Gaza PEFA Public Financial Management Performance Report, 2014 update.
15 World Economic Forum/World Health Organization, From Burden to "Best Buys": Reducing the Economic Impact of NCDs in Low- and Middle-Income Countries, 2011.
16 The report also points to the severe welfare implications for the poor caused by rising outofpocket expenditures. Outofpocket spending accounts for 40 percent of total health expenditure and exceeds public spending. The poorest are at the greatest risk of impoverishment since they bear a higher share of outofpocket expenditures as compared to their share in national income. Expenditures on medications needed to treat chronic conditions drive these expenditures.