ASIAN DEVELOPMENT BANK RRP: SRI 36168

REPORT AND RECOMMENDATION

OF THE

PRESIDENT

TO THE

BOARD OF DIRECTORS

ON

PROPOSED LOANS

TO THE

DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA

FOR THE

FISCAL MANAGEMENT REFORM PROGRAM

November 2004

CURRENCY EQUIVALENTS (as of 19 November 2004)

Currency Unit – Sri Lanka rupee/s (SLRe/SLRs) SLRe1.00 = $0.01 $1.00 = SLRs104.9

ABBREVIATIONS

ADB – Asian Development Bank ADF – Asian Development Fund BOI – Board of Investment CBSL – Central Bank of Sri Lanka CCPI – Colombo consumer price index CEO – chief executive officer DPL – development policy letter EA – Executing Agency FMRP – Fiscal Management Reform Program IICC – interagency implementation and coordination committee IRD – Inland Revenue Department IMF – International Monetary Fund IT – information technology LIBOR – London interbank offered rate LTU – Large Taxpayer Unit MIS – management information system MOFP – Ministry of Finance and Planning MRA – Modernizing Revenue Administration MTFP – Medium-Term Fiscal Program OCR – ordinary capital resources PAFMIS – Public Accounting and Financial Management Information System PAYE – pay-as-you-earn PC – provincial council PIU – project implementation unit PRGF – Poverty Reduction and Growth Facility RAMIS – Revenue Administration Management Information System TIN – taxpayer identification number VAT – value-added tax

NOTES

(i) The fiscal year (FY) of the Government and its agencies ends on 31 December. FY before a calendar year denotes the year in which the fiscal year ends, e.g., FY2003 ends on 31 December 2003.

(ii) In this report, "$" refers to US dollars.

This report was prepared by a team consisting of B. Carrasco (team leader), K. Lao-Araya and X. Peng. J. Zveglich supported the Mission during the early stages and was responsible for the preparation of the project preparatory technical assistance.

CONTENTS

LOAN AND PROGRAM SUMMARY i

I. THE PROPOSAL 1

II. THE MACROECONOMIC CONTEXT 1

III. THE SECTOR: PERFORMANCE, PROBLEMS AND OPPORTUNITIES 3

A. Sector Description and Performance 3 B. The Government’s Reform Program 5 C. Issues and Opportunities 7

IV. THE PROPOSED SECTOR DEVELOPMENT PROGRAM 11 A. Objectives and Scope 11 B. The Program Loan 11 C. The Project Loans 24

V. PROGRAM BENEFITS, IMPACTS, AND RISKS 31 A. Benefits 31 B. Impacts 31 C. Risks 32

VI. ASSURANCES 33 A. Specific Assurances 33 B. Conditions for Loan Effectiveness 34

VII. RECOMMENDATION 34

APPENDIXES

1. The Government’s Fiscal Program 2. Fiscal Objectives and Reporting Requirements under the Fiscal Management (Responsibility) Act 3. Background Studies and Chronology of the Fiscal Management Reform Program 4. Development Policy Letter and Policy Matrix 5. Program Framework 6. Task List for the Modernization Program of the Revenue Administration 7. List of Ineligible Items 8. Revenue Administration Management Information System 9. Terms of Reference for the Strengthening of the Fiscal Management Institutions Project 10. Organization Chart of the Fiscal Management Reform Program Implementation and Coordination Arrangements 11. Planned Summary Projects Implementation Schedule 12. Indicative Procurement Packages 13. Summary Poverty Reduction and Social Strategy 14. Development Coordination Matrix

SUPPLEMENTARY APPENDIXES (available upon request)

1. Sri Lanka-Economic Indicators, 1999–2003 2. Sri Lanka-Summary of Government Fiscal Operations, 1999–2004 3. Sri Lanka-Key Debt Indicators 4. Primary Balance and Debt Sustainability 5. Medium-Term Fiscal Program (2005–2008) 6. Sri-Lanka-Economic Classification of Revenue by Component 7. Sri Lanka-Economic Classification of Expenditure and Lending minus Repayment, 1998–2003 8. Expenditure and Revenues at the Provincial Councils and Intergovernmental Transfers 9. Summary of the National Budget Process 10. Summary of the Budget Classification System 11. Detailed Financing Plan 12. Consulting Service Selection Criterion

LOAN AND PROGRAM SUMMARY

Borrower Democratic Socialist Republic of Sri Lanka

Proposal The proposed Fiscal Management Reform Program (FMRP) is a sector development program and comprises three loans. Two loans are from the Asian Development Bank (ADB) ordinary capital resources (OCR): (i) a program loan of $45 million to support fiscal management policy reforms; and (ii) a Modernization of the Revenue Administration (MRA) project loan of $15 million mainly for procurement of the Revenue Administration Management Information System (RAMIS). The third loan of SDR 6,672,000 ($10 million equivalent) from ADB’s Special Funds resources is a project loan for Institutional Strengthening of Fiscal Management Institutions through capacity building, including implementation of the FMRP.

Classification Targeting Classification: General intervention Sector: Law, economic management, and public policy Subsector: Public finance and expenditure management Themes: Sustainable economic growth; Governance Subthemes: Promoting macroeconomic stability; Financial and economic governance

Environment Category C Assessment

Rationale The Government of Sri Lanka (the Government) is facing increasing fiscal stress from mounting and unsustainable fiscal deficits and a concomitant large public debt. Without meaningful fiscal consolidation, unsustainable current expenditure in combination with an impaired revenue administration will increasingly erode physical and social capital expenditures and crowd out private investment, preventing Sri Lanka from reaching a higher and sustainable path of economic growth. Under the circumstances, addressing the country’s weak public finances will be critical in order for the country to successfully fulfill its development objectives, including its evolving poverty reduction strategy.

The Government has responded to the serious fiscal challenges by placing fiscal reform—and in particular revenue augmentation—at the forefront of its economic policy reform agenda. A three-pillar strategy has been adopted to strengthen public finances. This includes a revamped fiscal framework established under the Fiscal Management (Responsibility) Act, an enabling policy environment based on the overhaul and streamlining of taxation policy, as well as institutional strengthening of the revenue administration supported by the creation of a modernized revenue administration . The ii

FMRP supports the Government’s strategy of fiscal consolidation compatible with medium-term fiscal sustainability.

The thrust of the FMRP is on developing and implementing systems and procedures to ensure effective and sustainable compliance with fiscal objectives. The ADB assistance is expected to be complemented by an International Monetary Fund (IMF) Poverty Reduction and Growth Facility (PRGF) and Enhanced Fund Facility (EFF), currently suspended, that is likely to include taxation policy reform measures. The second tranche release of PRGF was originally due in December 2003. However, following political developments, including the dissolution of Parliament in February 2004 and the general elections of April 2004, the new Government is firming up key macroeconomic policies and is in discussions with IMF on the resumption of PRGF. Looking forward, the PRGF is not likely to be renewed before early 2005 following the Government’s 2005 budget and supporting economic policy framework action plans.

Estimated FMRP December 2007 Completion Date

Program Loan Objectives The FMRP supports the strengthening of public finances by improving public resource and expenditure management systems, promoting fiscal discipline, and supporting fiscal decentralization.

To achieve these objectives, the FMRP will support: (i) improving effectiveness of tax administration, (ii) improving the budget framework, (iii) improving expenditure management and control systems, (iv) strengthening fiscal discipline, and (v) improving fiscal coordination.

More generally, the FMRP will help create an enabling environment to foster mobilization of tax revenues, improve effectiveness of public expenditures and, ultimately, place public finances on a sustainable path.

Financing Plan ADB will provide a loan of $45 million equivalent from OCR. The FMRP loan will have a 15-year term including a grace period of 3 years, an interest rate determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility, a commitment charge of 0.75% per annum, and such other terms and conditions set forth in the Program Loan Agreement.

Period and Tranching The FMRP loan period will be 3 years from December 2004 to December 2007. The loan will be released in three equal tranches of $15 million each. The first tranche will be released upon loan effectiveness. The second and third tranches are expected to be released within 18 and 36 months, respectively, from release of iii

the first tranche, subject to the satisfactory compliance with second and third tranche release conditions, respectively.

Executing Agency The Executing Agency (EA) of the program loan will be the and Implementation Ministry of Finance and Planning (MOFP). MOFP will set up an Arrangements interagency implementation and coordination committee (IICC) headed by the secretary to the treasury and comprising representatives from the Fiscal Policy Department, National Budget Department, External Resource Department, National Planning Department, Public Enterprises Department, State Accounts Department, Revenue Board, Central Bank of Sri Lanka, and Finance Commission. ADB will also be a member of the IICC. The IICC will meet every quarter to monitor, coordinate, and ensure the effective implementation of the proposed reforms under the FMRP.

Procurement The loan proceeds will be used to finance the full foreign exchange costs of items produced and procured in ADB member countries, excluding ineligible items and imports financed by other bilateral and multilateral sources. In accordance with the provisions of ADB’s Simplification of Disbursement Procedures and Related Requirements for Program Loans, the proceeds of the FMRP loan will be disbursed to the Government as the Borrower. The Government will certify that the volume of eligible imports exceeds the amount of ADB’s projected disbursements under the loan for the given period. It is expected that the loan proceeds will be utilized over a period of 36 months from the date of loan effectiveness. ADB reserves the right to audit the use of the loan proceeds and to verify the accuracy of the Government’s certification. Loan proceeds may be used to finance eligible imports for which expenditures were incurred 180 days before the FMRP loan becomes effective.

Counterpart Funds Counterpart funds generated from the FMRP loan will be used to meet FMRP expenditures and associated costs of reform.

Project Loan Objectives The two project loans will support: (i) institutional strengthening focusing on the procurement of equipment primarily for the RAMIS to ensure a prompt and smooth transformation of the revenue administration; and (ii) capacity building for the MRA, MOFP departments, and other agencies to strengthen implementation of processes and procedures outlined in the FMRP through the engagement of consultancy services and training activities.

Financing Plan ADB will provide two project loans. The first project loan is in an amount of $15 million from ADB’s OCR with a term of 25 years, including a grace period of 5 years, and with interest to be determined in accordance with ADB’s LIBOR-based loan facility, a commitment charge of 0.75% per annum, and such other terms

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and conditions set forth in the Program Loan Agreement. The second project loan is in an amount of SDR 6,672,000 ($10 million equivalent) from ADB’s Special Funds resources. The loan will have a 32-year term including a grace period of 8 years and an interest charge of 1% per annum during the grace period and 1.5% per annum thereafter, and follow such other conditions as set forth in the Program Loan Agreement.

Executing Agency MOFP will oversee and coordinate project loan implementation. and Implementation Project implementation will be carried out by: (i) the IICC; and Arrangements (ii) a project implementation unit for the MRA project, headed by a project manager (consultant) who will report jointly to the chief executive officer of the Revenue Board and to the secretary to the treasury.

Procurement and Procurement of goods and services will be in accordance with Disbursement ADB’s Guidelines for Procurement. Expenditure procedures will be in accordance with ADB’s Loan Disbursement Handbook. Consultants to be financed from the project loans will be recruited in accordance with ADB’s Guidelines on the Use of Consultants and other arrangements acceptable to ADB for recruitment of domestic consultants. A total of 160 person-months of international and 270 person-months of domestic consulting inputs will be required. In view of the size of the consulting services component, a management coordination team will be hired to be fully responsible for all administrative and managerial aspects of the capacity-building activities under the Strengthening of the Fiscal Management Institution Project. In view of the importance of capacity-building to the success of FMRP, where firms are to be engaged, the quality-based selection (QBS) method will be utilized for selection of consultants. Where possible and appropriate, simplified technical procedures will be applied.

FMRP Benefits and The FMRP will help establish a well-functioning, coordinated, and Beneficiaries semiautonomous revenue administration that is expected to comprise inland revenue, customs, and excise departments, and that would be responsible for all aspects of revenue collection. As part of the automation of the revenue administration, the FMRP will contribute toward establishing e-government. The FMRP will also help streamline budgeting procedures and expenditure control processes within MOFP.

As part of the reform agenda, the FMRP will support measures to strengthen fiscal discipline through increasing transparency and accountability, and will be based on legislative and rules-based reporting requirements.

The FMRP will support the reorientation of budget management from a compliance-based system to one incorporating elements of results-based budgeting. This should set the stage for addressing

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concerns of efficiency and effectiveness of public spending and eventually improve service delivery.

Finally, support for fiscal decentralization will comprise measures to reduce the overlap of public expenditure functions across levels of government and other reforms to improve funding and effectiveness of devolved assignments.

Notwithstanding an increase in effective tax contribution, direct beneficiaries will include business at large who despite paying higher taxes on average (as loopholes are closed and effective tax compliance strengthened) over the medium term, will benefit from clearer, simplified, and more business-oriented tax and customs administrations. In addition, those segments of the population most dependent on the provision of public goods and services—particularly across subnational constituencies—should expect an eventual improvement of the quality of these services. This would reflect FMRP measures supporting the curtailing of duplication of expenditures and other nonproductive use of public resources. Finally, the population at large should benefit from the reduction of domestic imbalances; higher, sustainable, GDP growth; and attendant development objectives.

Risks and Assumptions There are multiple risks to the successful implementation of the FMRP. Foremost, consolidation of the peace process and political stability will be critical for the Government to oversee meaningful economic reforms. Fiscal consolidation efforts, in particular, will require strong government commitment and any slippages in the security or political fronts may weaken the Government’s resolve. Although limited disbursements were realized in 2004, resources committed under the June 2003 Tokyo Donor Conference, and subject to progress in peace talks, should facilitate the fiscal consolidation process.

On the economic front, exogenous shocks to the economy could impair the Government’s ability to undertake aggressive fiscal consolidation as observed in 2004 following the oil price shock and the prolonged drought. However, over the medium term, fiscal consolidation leads to improved macroeconomic stabilization and greater flexibility to cope with these shocks, thereby creating a reinforcing link between the deepening of fiscal reforms and the ability to cope with these shocks. In addition, the Government has undertaken reform measures including moves toward a more flexible exchange rate system to mitigate the impact of these shocks.

Other risks include the power of vested interests that could support the status quo and that may successfully mobilize public opinion (i.e., through strikes and other forms of industrial action) to dilute the reforms and possibly prove detrimental to the FMRP objectives. There are also institutional risks given the relatively

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overstretched resources in key ministries and the revenue administration. These, combined with the comprehensive nature of the FMRP and the close links with political risks, may slow implementation of the FMRP.

Safeguards include the “additionality” of a renewed and constructive policy dialogue between the Government and IMF on conducive macroeconomic policies and fiscal consolidation following the suspension of its PRGF. In addition, supporting project loans under FMRP will mitigate institutional risks and others through the increased supply of resources—including consulting services, equipment and training—which should help overcome institutional constraints, build capacity, and facilitate FMRP implementation. For this reason, close coordination between ADB and the Government is of fundamental importance especially with respect to monitoring of FMRP and, in particular of consultants’ performance.

I. THE PROPOSAL

1. I submit for your approval the following report and recommendation on three proposed loans to the Democratic Socialist Republic of Sri Lanka for the Fiscal Management Reform Program (FMRP). Asian Development Bank (ADB) support would comprise: (i) an ordinary capital resources (OCR)-funded program loan (policy component) for FMRP policy reforms; (ii) an OCR-funded project loan for Modernization of the Revenue Administration; and (iii) an Asian Development Fund (ADF)-funded project loan for Strengthening of the Fiscal Management Institutions.

II. THE MACROECONOMIC CONTEXT

2. Sri Lanka’s economy continues on a strong recovery phase with gross domestic product (GDP) growing by 5.9% annually in 2003 compared with 4% in 2002 and a contraction of 1.5% in 2001. Growth was relatively broad based—on the production side—with the services sector recording 7.7% growth (year on year) and accounting for a 55% share of the economy. The industry sector recorded 5.5% growth and the agriculture sector 1.5% growth. More generally, economic growth has remained robust supported by accommodative monetary policy and fiscal consolidation (prior to the oil shock) leading to seven consecutive quarters of GDP growth in excess of 5.5%, including 6.2% growth in 2004Q1 before slowing to 5.2% in 2004Q2. (See Supplementary Appendix 1 for economic indicators, 1999–2003.)

3. On the aggregate demand side, the recovery has been driven by domestic demand and mainly reflects a combination of improved security conditions in the country and the impact of the Government’s macroeconomic policy reforms. Domestic consumption in real terms in 2003 remained strong, growing by 6.1% (year on year) in 2003 against 6.5% in 2002, reflecting the effects of pent-up household demand as the security situation improved and disposable income increased. More significantly, investment growth accelerated to 17% in 2003 from 6.7% in 2002, as investor confidence picked up from the initial increase in consumer confidence, reflecting the continuation of the cease-fire agreement and cautious optimism on the outlook for peace combined with the introduction of more market-friendly policies. In particular, lower lending rates and increased government investment, particularly in the North and East, have led to strong expansion in power, roads, telecommunications, and building construction. The upsurge in investment continues apace with import of investment goods in 2004Q1 increasing by 56%. Finally, buoyed by a recovery of the world economy, exports of goods and nonfactor services grew by 4.8% in 2003.

4. More importantly for long-term growth, the recovery reflected a strengthening of the macroeconomic environment. In particular, fiscal consolidation—the primary deficit improved to 0.9% of GDP in 2003 from 1.6% in 2002 and 4.1% in 2001—and exchange rate stabilization— the Sri Lanka rupee’s real effective exchange rate depreciated by a moderate 2.8% in 2003— led to a deceleration of inflationary pressures with inflation, as measured by the Colombo consumer price index (CCPI), declining to 6.3% in 2003 from 9.6% in 2002. This led to a reduction in total resources raised in the domestic market,1 paving the way for a reduction of the prime lending rate to an average of 9.3% in 2003 from 13.2% in 2002 and 19.4% in 2001.

5. On the external side, the overall balance of payments recorded a surplus of $502 million in 2003 (or 2.8% of GDP), the highest since 1993. This reflected a reduced current account

1 The total amount of resources raised in the domestic market in 2003 decreased to 4.5% of GDP from 8% of GDP in 2002. 2 deficit (0.6% of GDP) and an increased surplus in the capital and financial accounts. The reduced current account deficit was driven by a fast recovery in tourism, strong performance in the ports subsector, and higher worker remittances. In 2003 both merchandise exports and imports grew by 9% (year on year) in dollar terms. Meanwhile capital flows into the country increased in 2003 led by inflows of foreign direct investment of $229 million compared with $197 million in 2002, due to larger privatization proceeds of approximately $30 million in 2003. Total long-term loan capital increased to $908 million from $542 million in 2002, largely attributed to improvements in development assistance utilization rates, which increased to 21% in 2003 from 15% in 2002. Consequently, in 2003 Sri Lanka’s gross official external reserves increased to $2.3 billion, equivalent to 4.2 months of import cover. During the first half of 2004, the overall balance of payments pointed to a deterioration resulting in an estimated deficit of $223 million. This reflected a widening deficit of the trade and income accounts driven by higher oil prices that could not be fully offset by lower inflows to the capital and financial accounts.2 As of August 2004, gross official external reserves stood at $1.9 billion, a decline of 17% since the end of 2003 and equivalent to 3.1 months of imports.

6. Over the medium term and subject to an early resumption of peace negotiations, the economic outlook remains favorable despite a difficult short-term patch reflecting the impact of high oil prices on the economy. The Central Bank of Sri Lanka (CBSL) has recently revised its annual GDP growth estimates for 2004 to 5.0–5.5%, slightly below the 6% growth target under its Monetary Program for 2004. CCPI average inflation is targeted at 4–6% in 2004, although the latest CCPI figure for October 2004 at 11.6% (point-to-point), and reflecting the impact of high oil prices suggests that the annual CCPI inflation target may be breached. Money supply (M2) continues to grow at 16% in August 2004 in excess of the 13.5% projected in the Monetary Program due to higher than expected increases in credit to the private sector and in net credit to the government. Accordingly, corrective policy measures need to be introduced over the short- to medium term including tightening fiscal and monetary policies to curtail potential imbalances. The Government has reacted to these imbalances and in its meeting of early November 2004, the Monetary Board raised benchmark interest rates by 50 basis points.

7. However, the most critical challenge to sustained growth remains the current fiscal stance and, particularly, impaired revenue collection. Following efforts to stem the adverse impacts of higher oil prices and a drought and coinciding with the two elections in 2004 (national and provincial) and delays in tightening revenue legislation, the target fiscal deficit has slipped from 6.8% of GDP in the 2004 budget to 7.3% in the Preelection Budgetary Position Report and 8.6% of GDP in the Budget Economic and Fiscal Position Report 2005 of November 2004. The slippage on the fiscal front has already led to a weakening of the Sri Lanka rupee, which has depreciated by approximately 8% against the dollar since the beginning of 2004 and 3-month SLRe/US dollar forward rates in November 2004 were pricing in a further depreciation of 1.7%. Similarly, and despite evidence of financial repression, there has been upward pressure on interest rates, reflecting expectations of increased government demand for loanable funds particularly at longer-term maturities in the secondary market.

8. In response to the weakening of the fiscal stance, and following the provincial elections in July 2004, the Government has begun reducing the subsidies on oil prices. These subsidies have cost the treasury approximately SLRs8 billion according to preliminary estimates, placing further pressure on the budget. In these circumstances, the Government is expected to tighten fiscal policy and introduce a higher degree of fiscal discipline over the coming months. Indeed,

2 The Government is facing a shortfall of foreign funding on the balance of payments of approximately $300 million in 2004 including the $150 million “temporary relief” credit line from the Government of India. 3

the Government has committed to a fiscal consolidation strategy, which will need to be closely adhered to if stable and sustainable GDP growth is to be maintained. More importantly, while the fiscal targets under the Fiscal Management (Responsibility) Act are not expected to be achieved by targeted date of end-2006, the Government will need to undertake prompt corrective action and publicly commit to avoiding any further slippages beyond the expected 2- years delay announced in the 2005 Budget.

9. During the first nine months of 2004, tourism revenues remained buoyant as tourist arrivals increased by 11%. Similarly, the stock market continued its bull run as market capitalization at the Colombo stock exchange increased by 38% in Sri Lanka rupee terms during the first 10 months of 2004. Similarly, in international trade, merchandise exports during the first nine months of 2004 increased by 9% while merchandise imports during this period soared by 20.5%. The acceleration of imports is mostly due to the hike in oil prices, which is expected to lead to expenditures on oil imports of $1.6 billion, almost double the import bill in 2003. In these circumstances, the growing current account deficit is projected at approximately 4% of GDP, up from 0.6% in 2003.

10. More generally, the outlook will be largely dependent on the overall prevailing security conditions and, in general, progress in peace talks between the Government and the Liberation Tigers of Tamil Eelam (LTTE). If progress is faster than expected, growth could be somewhat higher, aided by the $4.5 billion in foreign assistance committed at the June 2003 Tokyo Donor Conference for the period 2003–2006. The challenge in this scenario would be the need to increase the Government’s absorptive capacity—including both at the national and subnational levels. If there is a setback to peace talks, investor confidence could plummet, potentially affecting private capital flows and undermining growth prospects. Political stability, given the wide ideological spectrum of the parties forming the governing alliance, will also weigh heavily on this front.

11. From a policy perspective, the outlook is subject to continued progress in strengthening the macroeconomic framework. Two of the key issues undermining stable and sustainable growth include reducing the fiscal deficit and, closely related, lowering the public debt. The Government’s ability to meet the development objectives established in its Economic Policy Framework will depend on success in strengthening the macroeconomic framework and, in particular, addressing these economic imbalances.

III. THE SECTOR: PERFORMANCE, PROBLEMS, AND OPPORTUNITIES

A. Sector Description and Performance

12. Fiscal consolidation remains key to improving the macroeconomic performance in Sri Lanka. Over the years, mounting defense spending on top of generous social sector expenditure led to increasing pressure on the budget. Attempts to raise tax revenues failed given the narrow revenue base and weak tax administration. Debt financing proved a temporary reprieve. Financial liberalization eroded the captive pool of available funds, forcing the Government to pay higher interest on its domestic debt. In addition, strains on the balance of payments led to exchange rate devaluations, raising the local currency value of the external debt. Increasing budget deficits, in turn, led to a crowding out of needed physical and social capital and private investment, weakening GDP growth. As a result, in 2002 the budget deficit, excluding grants and privatization proceeds, reached 8.9% of GDP and public debt increased to 106% of GDP.

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13. On the revenue side, the problem is traced fundamentally to the complex tax policy that prevailed in Sri Lanka in combination with the myriad of tax exemptions. These inherent distortions multiplied over the years due to government largesse and, in particular, industrial policy objectives, which dominated tax revenue and other fiscal objectives. In addition, relatively weak revenue administration in the inland revenue, customs and excise departments, and Board of Investment (BOI)—reflecting a shortfall of skilled and adequately paid staff—further constrain effective revenue collection. Over the years, enforcement capabilities were further strained and there was a general perception of prevalent corruption among many customs and tax officers. To make matters worse, governments were frequently granting tax amnesties, creating leakage in the system and further undermining tax collection and enforcement efforts. Further abetted by the elimination of taxes on international trade, tax yields declined by 4.6 percentage points from 17.8% of GDP in 1995 to 13.2% in 2003.

14. On the expenditure side, Sri Lanka is characterized by a framework that until recently was rather lax in terms of both expenditure ceilings and controls and had a weak link between fiscal objectives and the budget framework. In addition, Sri Lanka’s large and overstretched public sector, including commercial public enterprises, was unable to meet spiraling costs and tended to subsist thanks to direct subsidies and/or subsidized lending by the state, placing additional pressure on state accounts (and state banks). The internal conflict in Sri Lanka also contributed to increased budgetary pressure as scarce resources were directed to financing relatively large military spending. Finally, there has been a pattern of politically induced loosening of the fiscal policy stance in the run-up to elections, and once again witnessed in 2004. Against this backdrop, current expenditures in 2003 were estimated at 19% of GDP, down from 20.9% in 2002. Public investment absorbed a significant part of the expenditure cutbacks, falling to 4.6% of GDP in 2002, the lowest in a decade, before increasing to 5% in 2003. (See Supplementary Appendix 2 for a summary of government fiscal operations.)

15. As government revenues were unable to cover the increased spending requirements, the deficits were increasingly financed through domestic borrowing. However, rising deficits placed upward pressure on interest rates, increasing debt service payments. In parallel, the Government also borrowed overseas for the purchase of defense equipment, putting further pressure on state revenues. In addition, external borrowing was contracted primarily in dollars, which combined with the depreciation of the Sri Lanka rupee led to even higher debt-servicing payments.3 Finally, given the nature of the debt market, there was an overconcentration of short-term debt that limited effective debt management.

16. In these conditions, public debt soared to 106% of GDP in 2002 from 87% in 1997—58% public domestic debt and 48% public foreign debt. In 2002, and realizing the importance of fiscal consolidation, the Government prepared a fiscal consolidation program in line with its fiscal sustainability strategy. As part of the strategy, the Fiscal Management (Responsibility) Act was approved in early 2003. The overall budget deficit target under the Act was set at 5% by the end of 2006. On the basis of a tightening of expenditures, and coinciding with significant interest rate declines reflecting an inflation stabilization-oriented monetary framework, the overall budget deficit in 2003 was reduced to 8% of GDP. While above target, it nevertheless represented a significant improvement compared with the 8.9% recorded in 2002. The year 2003 also marked the first time that the Government’s outstanding debt stock was contained as a percentage of GDP. Total debt-servicing payments in 2003 increased to almost 20% of GDP comprising

3 According to CBSL Annual Report 2002, the cumulative increase in the foreign debt stock due to exchange rate depreciation during 1996–2002—amounting to SLRs251 billion—was about 35% of the total outstanding foreign debt stock at the end of 2002, equivalent to 15.8% of GDP in 2002. 5

almost 12.5% in amortization and over 7% in interest payments, the latter almost entirely in domestic debt. More critically, higher debt servicing places undue pressure on capital spending. In 2003, interest payments accounted for over one third of current expenditures and exceeded capital spending by a ratio of 1.4:1. To make matters worse, due to a spike in debt amortization payments, debt service payments exceeded total revenue collection in both 2002 and 2003. (See Supplementary Appendix 3 for Sri Lankan key debt indicators.)

17. On the fiscal front, the first half of 2004 resulted in a mixed picture. On the expenditure side, performance was disappointing. The impact of relief assistance to drought-stricken households and subsidies to cushion the effect of higher international oil prices against the backdrop of national and provincial elections explain the setback. Despite the oil subsidies not being fully reflected on the budget, current expenditure for 2004 has been revised to a provisional figure of SLRs353.1 billion for 2004 compared with SLRs330.2 billion in 2003, an increase of 6.9%. Public investment also increased to a provisional SLRs361.9 billion in 2004 compared with SLRs334.5 billion in 2003, an increase of 8.2% over the same period in 2003.

18. On the revenue side, the performance was slightly more promising. Despite the carryover of outstanding revenue loopholes from 2003, total revenues in the first half of 2004 reached a provisional figure of SLRs143.1 billion compared with SLRs136.8 billion during the same period a year earlier, an increase of 4.6%. These loopholes included (i) administrative shortcomings; (ii) the complexity in determining types of value-added tax (VAT) bases and (iii) high refund incidences. Nevertheless, the Government has responded by tidying up loose ends and in September 2004, amendments to the VAT4 and Inland Revenue acts were submitted to Parliament.

19. Deepening of audit measures also had a positive impact and contributed SLRs2.7 billion to revenue collection during the first half of 2004. Of this amount, SLRs1.2 billion was collected from VAT and SLRs0.9 billion from income tax. The customs department also exceeded its target for the first half of 2004 having collected total revenues of SLRs82.4 billion against the targeted revenue of SLRs74 billion. Buoyed by strong imports, including higher oil prices and more recently the impact of the depreciation of the Sri Lanka rupee, VAT collection on imports was SLRs33.7 billion against a target of SLRs31.9 billion. On the negative side, corporate income tax collection, however, was a disappointing 64% of the target for the first 6 months of 2004. This reflected a combination of investment allowances and lower profits due to offsetting losses traced to restructuring measures in some cases and the writing off of bad debts on the part of banks.5 On the nontax revenue side, privatization receipts during the first half of 2004 were SLRs2.4 billion against an annual target of SLRs13 billion. Similarly, central bank profits— a major source of nontax earnings in 2003—totaled only SLRs1 billion in the first half of 2004, against an annual target of SLRs5 billion.

B. The Government’s Reform Program

20. The Government has responded to the fiscal challenge by placing reforms to the revenue administration at the forefront of the economic reform agenda with the objective of setting public finances on a sustainable path. (See Appendix 1 for the fiscal program underpinning the Government’s new Economic Policy Framework and Supplementary Appendix 4 for an analysis of the primary balance and debt sustainability.)

4 VAT is estimated to generate 45% of total tax revenue in Sri Lanka. 5 This also brings to light the weakness in the preparation of revenue estimates.

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21. The Government’s reform program for strengthening public finances is based on a three- pillar strategy: a revamped fiscal framework established under the Fiscal Management (Responsibility) Act, an enabling policy environment in the form of an overhauled and streamlined taxation policy, and institutional strengthening of the revenue administration supported by the creation of a modernized revenue administration.

22. The Government is committed to the Fiscal Management (Responsibility) Act, approved by Parliament in January 2003, albeit with a delay that reflects the impact of the 2004 elections and more recently the external oil shock. The Act requires the Government to reduce the overall budget deficit to 5% of GDP and total debt to 85% of GDP, respectively, in a phased manner, by the end of 2006. It will also contribute to greater fiscal transparency and accountability, as the Government is required to report to Parliament every 6 months on the performance relative to the intended fiscal objectives. (See Appendix 2 for a description of the Government’s fiscal objectives and reporting requirements under the Act.) The Government’s Medium-Term Fiscal Program (2005–2008) (MTFP) (see Supplementary Appendix 5) released in November 2004, however, targets a 5.7% of GDP budget deficit by the end of 2007 and 4.4% of GDP by end of 2008.

23. A centerpiece of the reform agenda is the strengthening of the revenue administration. The Modernization of the Revenue Administration (MRA) aims to integrate into one Revenue Board the various revenue department heads including inland revenue, customs and excise departments. The Revenue Board will be a semiautonomous corporate body chaired by the commissioner general of the Inland Revenue Department (IRD) and with a chief executive officer (CEO) reporting to a board of directors. The Revenue Board will have authority over all aspects of revenue administration and will be based on the improved coordination of core functions of inland revenue, customs and excise departments. A new human resource policy will be designed based on a more flexible and competency-acquired employment system; it will also provide for an improved incentives scheme. As part of the reforms to human resource development, IRD has already announced the promotion of 620 of the better performing IRD staff from tax collectors to tax assessors. In addition, a new information technology (IT) development strategy will be introduced based on the automation of tax administration and thereby contribute toward e-government.

24. The MTFP seeks to achieve a stable macroeconomic environment supported by policies that focus on generating revenue, thereby augmenting fiscal space to ensure greater investment and stable growth. On the revenue side, supported by the FMRP’s modernizing and strengthening of the revenue departments, overall revenues are targeted to increase by 3.3 percentage points from 15.6% of GDP in 2004 to 18.9% in 2007 (19.5% in 2008). This reflects an expected strong increase in tax revenues from 14.1% of GDP in 2004 to 17.1% in 2007 and a moderate increase in nontax revenues from 1.5% to 1.8% during the same period. On the expenditure side, the FMRP balances cutbacks in current expenditure in favor of increases in public investment with the aim of accelerating the national infrastructure development program, including expanding rural infrastructure facilities and supporting human resource development facilities. Indeed, total expenditures are targeted to increase moderately from 24.2% of GDP expected in 2004 to 24.6% by 2007 (and a decline to 23.9% in 2008); however, this is based on a reduction of current expenditure by 2.6 percentage points to 16.7% of GDP in 2007 and an increase in public investment by 2.8 percentage points to 7.8% of GDP in 2007 (and 7.9% in 2008). The budget deficit is targeted to decline from 8.6% of GDP in 2004 to 5.7% in 2007 (and 4.4% in 2008).

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25. As a means to enhance revenue, the 2005 Budget presented on 18 November 2004 includes a comprehensive set of revenue measures. Revenue policy measures reflect the introduction of: (i) higher excise duty rates on various luxury (and non-luxury) items; (ii) increased customs valuation of 5% across a range of intermediate and final imported goods together with an additional 10% excise duty levied on these goods; and (iii) increases in import cess (duty) as well as port and airport levies. In addition, civil servants will be brought into the tax net and will become liable for pay-as-you-earn (PAYE). Finally, income tax will be applied at a 15% rate, up to a threshold, with step-wise marginal rate increases up to 30%. VAT bands will be expanded (after the previous government had consolidated them) from 0% and 15% to 0%, 5%, 15% and 18%. While the standard rate is 15%, a basic commodity rate on essential food items will be introduced at 5% and a luxury rate of 18% will be applied to selected consumer items. The recently introduced Economic Service Charge (ESC) will be reduced to 0.5% of wholesale or retail trade from 1%. In a nod to the business community, and with the view to deepening the corporate debt market, withholding tax on corporate debt will be removed and only the final tax retained. A host of existing deductions on corporate taxes will be tightened. On non-tax measures the major item includes profits from central bank operations. Financing of the budget will also benefit from privatization of assets from the hospitality industry. In total, revenue measures are projected to lead to a 1.6 percentage points increase in revenues in 2005 to 17.2% of GDP. (See Supplementary Appendix 6 for the economic classification of revenue by component.)

26. Expenditure rationalization measures will need to accommodate a 40% increase of current basic salary of civil servants starting in December 2004. While the exact increase is determined by a formula according to pay scales, the overall wage bill is projected to increase by approximately 27% in 2005 (against an estimated 10% increase in inflation). This increase in the wage bill subsumes an increase of 42,000 new recruits into the civil service in 2004. In parallel, pension payments will increase by 15% of basic pension effective from December 2004. Other expenditure cutback measures will include introducing procurement management, tighter expenditure controls, and improved accounting and auditing standards. (See Supplementary Appendix 7 for the economic classification of expenditure and lending minus repayment.) In addition, debt management treasury functions are being strengthened to restructure higher-cost with lower-cost debt. Public enterprises will also be restructured, both operationally and financially, to reduce their dependence on budgetary support. Finally public expenditure programs will be reprioritized according to the Government’s pledge to increase support for rural development in line with improved cost efficiency and better quality of services.

C. Issues and Opportunities

27. Against this backdrop, activities in the past 2 years under the previous Government have been impressive in the range and breadth of the systems introduced to address the problems. The real question facing Sri Lanka is not whether the determination to solve the problem of persistent budget deficits exists––indeed even the new Government is keenly aware that there is no alternative even if 2004 has been a lost year—but whether these activities are likely to succeed. In many cases, success will depend on understandings and actions in areas where strategies are currently being developed, including public sector pay, persistently loss-making parastatal corporations, the narrow tax base, the development of an effective tax collection administration, the integration of medium-term planning with the annual budget round, control over liabilities created by past promises, effective fiscal devolution, and the pressures that a

8 rapidly aging population will put on the national budget.6 The success of the proposed government reform program will be closely linked to concrete measures to address these issues as they are ultimately related to the wider goals of strengthening public finance.

28. The following provides a diagnostic of some of the more critical constraints in three core areas under FMRP, namely, revenue collection, budget programming and expenditure controls, and fiscal decentralization. The assessment of these constraints will set the stage for the program-supported proposed reform solutions.

1. Constrained Revenue Collection

29. Revenue collection in Sri Lanka is constrained by various factors. The most critical of these is a weak and underfunded tax administration and a tax policy regime that effectively discourages timely taxpayer compliance. Accordingly, the tax base is very narrow comprising 789,221 PAYE taxpayers and 194,824 income taxpayers, including 19,582 corporate taxpayers of which 2,850 paid income tax in 2003. Moreover, there is a large parallel economy; granting of tax holidays is a frequent practice; civil servants are exempt from paying income tax; and the retail and wholesale sectors are exempt from VAT. Furthermore, tax collectors tend to arbitrarily sanction the legitimate taxpayers, often reflecting poorly designed incentive clauses and lack of taxpayer rights.

30. More generally, there is a compartmentalized and fragmented approach to tax administration reflecting institutional constraints that hinder effective tax administration. This is traced to deep-rooted segmentation between inland revenue, customs and excise departments, each having its own distinct institutional culture. Lack of resources has undermined the development of skilled and specialized tax administration staff as well as the modernization of integrated IT systems across tax departments. Reforms to human resource development and IT systems would thus prove critical in exploiting economies of scale and lead to positive externalities from sharing functions across different tax departments.

31. To aggravate matters, the tax regime is beset by distortions of various types. First, taxation policy in Sri Lanka has traditionally been used as a means to attract investment through tax holidays and other tax concessions, and thereby redirect resources to selected sectors of the economy. Taxation policy has thus remained subservient to industrial policies to the detriment of effective tax collection, but also creating additional sources of “tax leakage,” thereby increasing the costs of effective enforcement. Second, governments have frequently resorted to tax amnesties or exonerations, which have proven costly to the state. Indeed, the 2003 general tax amnesty represents the 11th time in 40 years that a tax amnesty has been granted in Sri Lanka. This has resulted in lost potential tax revenue, as tax collectors forfeit revenues from the backlog of tax arrears under investigation. More detrimentally, tax amnesties have seldom had much impact in terms of increasing either tax revenue or the tax net. The amnesties prove even more costly to the state in terms of induced moral hazard. Indeed, negative signaling results from the Government’s actions to future taxpayers (i.e., nontax registered/nontax-declaring corporations and individuals) who will reason that they are better off remaining outside the tax net and waiting for a future amnesty.

2. Weak Budget Programming and Expenditure Control Framework

32. Budget programming in Sri Lanka is in an evolving state and has yet to benefit from a full-fledged, medium-term budget programming and expenditure framework. Critical constraints

6 A more detailed analysis of these issues was presented to the Government under an ADB-funded report, Structural Fiscal Imbalances in Sri Lanka, August 2003. 9

include systems and procedures within the budget department, which prevent line departments from effective management of a steady stream of committed yet discontinuously disbursed resources. In particular, there is limited predictability in the allocation of revenues across departments and over time, given the narrow outreach of the existing framework. For example, the budget department is only now beginning to introduce international practices in using forward estimate techniques for budget programming. In addition, the budgeting framework has inherent limitations resulting from an outdated classification system that fails to link up current and capital expenditures. These constraints often result in difficulties in ensuring effective and timely resource allocation, thereby limiting the returns from public investment projects.

33. In a related area, expenditure control systems are weak and difficult to enforce within the context of revenue streams that are discontinuous over time and subject to the fluctuations of external shocks and, more generally, the business cycle. This creates difficulties in expenditure management as expenditure (and revenue) targets are often missed. Against this background, Sri Lanka needs to pursue effective fiscal consolidation if the structural deficits are to be reduced. Over time, automatic stabilizers will become effective in helping to steer the economy by provisioning during boom years and using these savings to make up for the revenue shortfall in downturns. In the meantime, effective fiscal consolidation will be critical in supporting the Government’s macroeconomic stabilization efforts.

34. Control systems are also constrained by limited monitoring capability of off-budget expenditures and borrowings. The problem is exacerbated by a lack of clear procedures and treasury systems for registering and managing financial obligations. As a result, unaccounted commitments across departments often accumulate, which eventually become due and have to be liquidated by the Government imposing further and at times, sudden “leakages” on the expenditure side.

3. Limited Fiscal Decentralization

35. From a public policy perspective, fiscal decentralization can be welfare enhancing as it brings spending (and revenue) powers and decisions closer to those who will most benefit from these public projects. The more typical of these delegated public expenditure assignments are, for example, road maintenance, local irrigation, schools, and community health posts. These spending initiatives are often the ones that have the highest effect on poverty reduction. Hence, supporting effective fiscal decentralization can enhance poverty reduction.

36. With the approval of the 13th amendment of the Constitution in 1987, the legal underpinning for devolution of power from the center to the provinces was established. However, neither self-sufficiency of subnational government nor efficiency considerations in the fiscal framework was part of the underlying principles. Henceforth, and despite the introduction of reforms granting spending and revenue powers to provincial councils (PCs), there has been limited fiscal devolution. Provincial governments spend only about 10–11% of the combined expenditure of the center and the provinces, and own revenue accounts for less than 17% of their expenditures. This has led to a vertical imbalance between the provinces and the center, thereby fostering dependency. There are also significant horizontal imbalances across PCs.

37. Piecemeal and limited devolution, however, has not prevented the overlapping of functions and responsibilities between central and provincial departments of the administration. This has resulted in a misuse of scarce resources that is compounded by the fact that salaries of provincial civil service staff account for over 65% of provincial government total expenditures while capital expenditures account for only 16%. On the institutional side, a Finance

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Commission oversees fiscal devolution. However, a combination of limited decentralization skills and resources and weak accountability has resulted in limited progress in meeting the objectives of the 13th amendment.

38. These weaknesses are overshadowed by a more critical factor in the form of a poorly designed, combined block and matching grant formula for intergovernment revenue transfers. The nature of the formula is such that it creates moral hazard by effectively discouraging greater effort of revenue mobilization at the provincial level and further entrenching dependency. This is due to the fact that for any additional revenues generated at the provincial level from the matching grant element, there is an almost offsetting loss of block grant from the center, resulting in only a net marginal gain to the province. As a result, block grants accounted for 81% of total intergovernment transfers versus 1% for matching grants in 2003. (See Supplementary Appendix 8 for expenditure and revenues at the PCs and intergovernment transfers.)

39. Finally, capital expenditure funding from the center to the provinces is based solely on grant financing. A move toward debt financing over the medium-term and subject to increased absorptive capacity could free up additional resources and help create greater incentives for the provinces to make more productive use of these funds.

4. Lessons Learned

40. ADB has had limited experience in operational support for fiscal management reforms. However, ADB has had relevant experience in public expenditure management reforms. A special evaluation study7 raised important issues, highlighting that “public expenditure management is a core function of governments and that external assistance needs to build a government’s capacities to fulfill these functions.” The FMRP follows this approach with the thrust on developing and implementing systems and procedures to ensure effective and sustainable compliance with fiscal objectives.

41. The study also stressed that “ownership is one of the key ingredients to develop capacities,” which entails conducting policy dialogue and capacity mapping. There was no better example in this regard than the shortcomings in the previous Government’s unsuccessful attempt to introduce the concept of the Sri Lanka Revenue Authority (SLRA). While the concept had some very good initiatives, the process was not satisfactorily managed, with limited ownership among critical stakeholders and ultimately set aside by the new Government. The capacity mapping, in turn, should focus on a comprehensive approach to the budget cycle, integrating the various agencies involved, instead of focusing on one core agency.

42. The FMRP follows this approach by strengthening coordination of participating agencies across a wide spectrum, providing institutional support to these agencies, and introducing policy reforms that promote a more enabling, fiscally sustainable, environment. As part of institutional strengthening, the focus will be on creating a coordinated revenue administration based on developing greater commonality in core functions through IT integration and more supportive, and incentives-based, human resource development policies. Furthermore, the FMRP will include an assessment of the performance of the revenue administration toward the end of the FMRP, based on institutional performance indicators to be designed as part of the supporting modernization strategies. Subject to a favorable assessment of the revenue administration

7 ADB. 2000. Special Evaluation Study of Effectiveness and Impact of Asian Development Bank Assistance to the Reform of Public Expenditure Management in Bhutan, India, Kiribati, and Lao PDR. Manila. 11

reforms and continued government support, there may be scope for deeper integration of revenue administration reforms over the medium-term.

43. The FMRP has benefited from close coordination with development partners, particularly the International Monetary Fund (IMF) and the World Bank. Blueprints for modernization plans for the revenue departments were discussed at a workshop hosted by Canada Customs and Revenue Agency and organized by ADB and IMF in early 2003. Close coordination between ADB and the Government has also been critical. A task list or road map for the modernization of the revenue administration was proposed by ADB and presented to senior management of the Ministry of Finance and Planning (MOFP) at a workshop in January 2004 and chaired by the secretary to the treasury (para. 55).

IV. THE PROPOSED SECTOR DEVELOPMENT PROGRAM

A. Objectives and Scope

44. ADB together with IMF had been supporting the previous Government’s fiscal framework, in particular, the implementation of public resource and expenditure management reforms under the erstwhile Regaining Sri Lanka. (See Appendix 3 for the list of background studies and chronology of events in the processing of the FMRP.) The FMRP builds on this initial support and following two rounds of intensive policy dialogue with the new Government has amended the FMRP in line with the new Government’s fiscal management priorities. In summary, the revisions reflect primarily a stronger focus on revenue augmentation efforts, and a prioritization on fiscal consolidation consistent with enhanced capital spending.

45. The proposed ADB assistance is to comprise a program (policy) loan component targeting critical policy measures in support of fiscal management reforms, a project loan in support of institutional strengthening focusing on establishing the MRA, and another project loan in support of capacity building to assist in the implementation of policy and institutional strengthening components of the fiscal management institutions. The FMRP will support the Government’s reform agenda and provide, in particular, support for fiscal consolidation through assistance for improving public resource and expenditure management systems, promoting fiscal discipline, and supporting fiscal decentralization. More generally, the FMRP will help create an enabling environment to foster mobilization of tax revenues, improve effectiveness of public expenditures and, ultimately, place public finances on a sustainable path.

B. Program Loan

1. Objectives

46. The FMRP will seek to strengthen public finances by improving resource and expenditure management systems, promoting fiscal discipline, and supporting fiscal decentralization.

2. Goals and Outputs

47. The FMRP has five goals: (i) improving effectiveness of tax administration, (ii) improving the budget framework, (iii) improving public expenditure management and control systems, (iv) strengthening fiscal discipline, and (v) improving fiscal coordination including supporting the groundwork for fiscal decentralization.

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48. A list of policy recommendations has been identified with the purpose of addressing the sector constraints identified above. The set of time-bound policy actions proposed under the FMRP and the development policy letter are in Appendix 4. The FMRP framework is in Appendix 5.

3. Policy Framework and Actions

49. The program loan (policy component) focuses on key measures for improved fiscal management and sustainable compliance with fiscal objectives.

a. Improving Effectiveness of Tax Administration

i. Creation of a Modernized Revenue Administration

50. To address the fragmented and compartmentalized nature of the revenue administration, the Program will set the foundations for the reorganization of the three departments under a unified Revenue Board. The Revenue Board will be established based on three key principles of moving toward greater operational autonomy, coordinating better the core common functions, and creating the basis for a merit-based employment policy. Based on the performance of the reforms, the Government will review the prospects of deeper integration toward the end of the FMRP.

51. Moving toward greater operational autonomy—or government delegation of the powers to ensure effective revenue collection—will shield the revenue administration from political or other vested interests and, accordingly, represents an important step forward. Full autonomy is not being pursued under the FMRP, as the revenue administration will continue to be financially dependent on the Government. Nevertheless, the Revenue Board and the revenue administration in general will follow best practices on transparency and accountability as part of increased autonomy. This would include strengthening reporting requirements and greater accountability to Parliament and to the public.

52. Limited resources and a host of separately managed, common functions across inland revenue, customs and excise departments underline the need for functional integration. As a first step, the FMRP will support common IT and human resource development programs across revenue departments. There will also be a coordinated effort to introduce common standards across tax collection and accounts, taxpayer services, tax audit and investigation, legal services, inspection, and training.

53. Ultimately, functional integration requires a revamping of employment policies. The FMRP sets in practice a thrust toward staff specialization, which will facilitate longer-term functional integration. Staff specialization, in turn, will require a change in mindset, opening up greater opportunities for those who are willing to take on this challenge. Certainly, not all will stand to benefit and this will require political will to usher in new policies based on a competency-acquired and merit-based employment system. However, specialization is considered a necessary policy direction in support of the modernization of the revenue administration and will form part of creating better incentives for workers who will be endowed with the training needed to improve performance.

54. The Government is committed to this undertaking and is aware that the three key principles outlined above are an integral part of the institutional reform process. Any piecemeal 13

approach consisting of the adoption of any one of these principles without the others is bound to call into question the likely success of the reform process. The Cabinet, in one of its first economic policy decisions, approved a memorandum on 3 June 2004 supporting the modernization of the department of inland revenue, including its restructuring, thereby setting the stage for the transformation of the revenue administration.

55. The creation of a modernized revenue administration will take time. Capacity building and procurement of key IT components will promote a gradual and effective modernization reform program of the revenue administration. A key design feature of the FMRP is its commitment to avoiding disruptions to tax revenue collection. Some of the more critical intermediate steps identified in the modernization program for the revenue administration include: (i) the establishment of the Revenue Board; (ii) the appointment of a CEO; (iii) the design and approval of modernization strategies for the different arms of the authority inland revenue, customs, and excise departments; and (iv) the design and approval of strategies for human resource development and an integrated IT plan. (See Appendix 6 for a plan of activities or task list to support the modernization program of the revenue administration.) IMF had prepared drafts under (iii) above and the Strengthening of Fiscal Management Institutions project loan will support (iv) among others.

ii. Strengthening Tax Collection and Compliance

56. To complement effective tax administration, the FMRP seeks to strengthen tax collection and tax compliance. To begin, the tax net will be broadened. This will involve implementing the Economic Service Charge, removing income tax exemptions on nongovernment salaries of civil servants (paras. 87–88 below), and rationalizing the use of tax holidays on investment.

57. In addition to widening the tax net, MOFP will establish a central accounts database that provides a uniform system of numbering and the ability to cross check related taxpayer transaction and revenue information. Furthermore, MOFP will approve clear regulations establishing a unique and unified taxpayer identification number (TIN). While there is a TIN in place it suffers from various deficiencies, which undermines its effectiveness. First, it is not compulsory. Second, it is not unified across revenue departments. Third, some taxpayers are thought to have multiple TINs. The new TIN will be designed to address these issues and thereby serve as a critical instrument in monitoring compliance of tax payments and facilitate targeted enforcement. As part of this process, the tax registry will need to be strengthened, as the current system requires updating, with particular attention to cleaning out defunct and multiple name taxpayers.

58. However, effective tax compliance will require persuasive enforcement on the part of the revenue administration and complementary institutions. Accordingly, it is expected that by the end of the FMRP the TIN will be used in a comprehensive manner and required in day-to-day activities such as opening a bank account and purchasing property. To strengthen enforcement, the FMRP will also support the development of a central accounts database for tax collection purposes and linked to the TIN.

59. International experience suggests that investing in taxpayer services goes a long way in increasing tax revenues. The modernization of the revenue administration will include the creation of a new Taxpayer Service and Education Department. The move toward considering taxpayers as clients is part of this change in focus of the new revenue administration. Education of clients in taxpayer filing and other essential services are also being integrated into the reform program. To ensure that taxpayer or client rights are being ensured, the FMRP also calls for

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MOFP to prepare and approve a Taxpayer Bill of Rights and Duties. Along these lines, the FMRP also supports the appointment of a tax ombudsperson to oversee and uphold taxpayer (client) rights.

60. In order to enhance tax collection and compliance, reporting requirements are to be strengthened in the Large Taxpayer Unit (LTU). The LTU covers about 1,300 companies and accounts for 85% of corporate tax revenues in Sri Lanka. Increasing reporting requirements will allow for greater compliance and can serve as a monitoring mechanism by the MRA to assess compliance across companies. As a means of facilitating efficient processing of tax files, and in order to set the foundations of the management information system (MIS), the FMRP supports moving toward a fully electronic tax filing system by companies registered under LTU by 2006.

61. In addition, as part of the improved systems and procedures specifically related to streamlining processing and reporting requirements, the FMRP will see to it that the LTU appoints individual account managers across all targets for the largest 1,000 taxpayers. These individual account managers will be responsible for all tax administration services for each particular taxpayer, equivalent to establishing an individualized one-stop taxpayer-servicing outlet. Finally, the Government also commits under the FMRP to revise the tax code in order to consolidate all revisions under an updated and user-friendly, single reference instrument.

b. Improving the Budget Framework

i. Streamlining Budgeting Procedures

62. Sri Lanka operates a traditional, centralized, and compliance-based budget system. A set of policy objectives is determined at the beginning of the cycle. Subsequently, and following a process of review where sector spending limits are set based on an expenditure framework, resources are committed to the spending agencies to meet these objectives. Budget execution follows, with ensuing disbursements based on agreed-on appropriations. Finally, rudimentary ex post monitoring takes place with limited accountability for the implementation of line ministries’ programs. (See Supplementary Appendix 9 for a summary of the national budget process.)

63. Ambiguities in the established budget classification system together with difficulties in enforcing hard budget constraints on spending agencies translate into limited ability to manage expenditure plans. To make matters worse, actual expenditures are not always in line with approved budgets and the flexibility needed to adjust fiscal aggregates is not in place. In addition, forward expenditure estimates seldom go beyond 1 year. Under the FMRP, MOFP is introducing an internationally accepted budget classification system and is implementing effective expenditure ceilings to strengthen budget management. (See Supplementary Appendix 10 for a summary of the budget classification system.) In addition, through ADB technical assistance (TA),8 MOFP introduced in the 2004 budget 3-year rolling forward estimates of current and capital budgets based on a medium-term budget programming and expenditure framework.

64. Other reforms under the FMRP will include amending the budget circular by fixing a firm date for its issuance to ensure ample time for budget preparation and so avoid the disturbances related to a relatively tight budget calendar. Similarly, to enhance intra-year budgeting

8 ADB. 2003. Technical Assistance to the Democratic Socialist Republic of Sri Lanka for Strengthening Public Expenditure Management Systems. Manila (TA 3301-SRI, which commenced in January 2000 and was finalized in July 2003). 15

adjustments and improve timely delivery of resources, a transparent supplementary budget appropriations system will be developed to reduce the ad hoc nature of adjustments. The system will be complemented with timely reporting requirements.

65. Further reforms under the FMRP include establishing guidelines for use of advance accounts and unifying capital and current budget procedures. These measures will serve to improve budget management and overall efficiency, given common linkages between the two sets of procedures.

66. A review of the budget preparation process suggests the need to strengthen certain aspects linked to integration and coordination of budget estimates. In particular, on the capital expenditures side, policy and implementation activities need to be more closely integrated.9 Indeed, in the recent past, while the National Planning Department was responsible for identifying capital expenditure ceilings across line ministries, Regaining Sri Lanka provided the policy framework for identification of capital spending requirements. Moreover the Regaining Sri Lanka committees were, in turn, responsible for recommending and monitoring implementation of investment projects, calling into question the involvement of line ministries and the National Planning Department. Following the election of the new Government, the responsibility for prioritization of core expenditures has been removed from the committees and returned to the central ministries in coordination with the line ministries.

67. In addition, as part of budget management reforms over the medium-term, the FMRP is setting out preliminary actions supporting a reorientation toward results-based budgeting. The key is to move gradually from a budget management system that focuses on inputs and how they are employed to focusing on outputs and eventually outcomes and how they fulfill their original budget objectives. This phased approach recognizes that compliance-based systems tend to face complex restrictions that diminish the allocative and operational efficiency of budget execution. In addition, accountability tends to be limited in terms of program results. Under the FMRP, MOFP will establish a working group or committee to oversee the change toward a system that introduces elements of results-based budgeting. Indeed, MOFP has already introduced in the 2004 budget circular performance indicators at the central government level for the purpose of moving toward results-based budgeting reporting. A move toward a results- based budgeting system in fact could lead to fiscal stabilization objectives that complement, rather than compete with, efficiency objectives. However, this transformation in Sri Lanka needs time, and the compliance-oriented systems and the use of expenditure controls are still expected to prevail over the medium term.

ii. Rationalizing Expenditures

68. As part of the Government’s structural reform initiatives in support of rationalizing public resources, MOFP has issued a circular requesting all ministries to submit restructuring plans. The FMRP will provide continuity to this initiative by supporting restructuring plans for key ministries and the Western Province provincial council. The restructuring plans will include identification of activities classified according to priority goals to support the mandate of the particular ministry and the required inputs to meet those activities. Savings are to be identified from cost-cutting measures with a particular focus on reducing overlap across the sector, and these may be allocated to other priority areas in the ministry. On a pilot basis, the Western Province provincial council will undertake a similar restructuring exercise with a view to possible

9 According to the World Bank’s 1998 Public Expenditure Management Handbook, the failure to link policy making, planning, and budgeting may be the single most important factor contributing to poor budgeting outcomes.

16 replication in other PCs. These restructuring plans should be fully implemented by the end of the FMRP.

c. Improving Public Expenditure Management and Control Systems

i. Strengthening Management of Off-Budget Expenditures and Borrowings

69. With increased fiscal pressures, many countries have turned to off-budget financing through contingent and implicit liabilities as a means of deferring the recognition of committed cash expenditures. Conventional budget methodologies tend to ignore the proper accounting of contingent liabilities except when a cash flow is created. As a result, financial accounting systems generate insufficient data for adequate budgetary control of such policies.

70. The FMRP will focus on putting in place the required fiscal accounting framework to adequately address budget and off-budget expenditures and borrowings both on a cash and an accruals basis (on the latter, see para. 79). To begin with, MOFP will prepare guidelines for proper classification of off-budget liabilities as actual or contingent. Second, MOFP is to undertake actuarial balance analyses of the greatest sources of contingent liabilities, including both government, i.e., social security and pension10 funds, and parastatal agencies, i.e., Ceylon Electricity Board and Ceylon Petroleum Corporation. Finally, MOFP is to prepare a feasibility study on funding and liquidating government liabilities through the eventual creation of a provisioning fund.

71. The Government also operates various statutory and nonstatutory special funds. Many of these funds are permitted to raise revenues and spend outside the budgeting process. These include (i) the President’s Special Fund of SLRs40 million–50 million financed by the national lottery, (ii) the Cess Fund of SLRs800 million funded by a levy on tea, and (iii) the Customs Reward Fund funded by fines and sales proceeds. Two issues arise. First, from the perspective of budgetary program and planning, unless the funds are properly accounted for in the budget,11 efficient use of resources is compromised. Second, unless these funds are subject to published annual audits and other performance reporting, there is limited public accountability of the means and use of these funds. Under the FMRP, the Government commits to preparing an exhaustive inventory of the existing, operating funds and publishing performance-reporting systems. Under the FMRP, measures will be introduced to take stock of the magnitude of the problem, adopt guidelines to prevent further build-up of off-budget liabilities on nonstatutory funds and, finally, initiate measures to liquidate these liabilities.

ii. Improving Budgetary Cash and Asset Management Systems

72. Poor cash management results in the tying up of scarce resources for unnecessarily long periods of time. This may translate into costly delays of public projects through deferred completion dates or, in extreme circumstances, may lead to costly overdrafts or even bridge financing arrangements. Under the FMRP, MOFP will introduce a budgetary allotment system across the budget year to synchronize with treasury receipts including transfers to other levels of government, and thereby minimize cash deferrals.

10 According to Regaining Sri Lanka, there is an unfunded pension liability of approximately SLRs550 billion, which is increasing due to a rapidly aging population. 11 A list of 31 such funds was provided by MOF but without details of amounts raised and disbursed. 17

73. The introduction of a computerized and fully integrated Public Accounting and Financial Management Information System (PAFMIS)—to include (i) payroll, (ii) civil service pensions, (iii) drawing and disbursing offices, (iv) capital projects budget, and (v) public sector borrowing requirements—will be critical to improve expenditure management. The World Bank and the Government of the Republic of Korea are providing complementary support to public expenditure management. The World Bank is supporting the public expenditure review (PER) exercise with a view to prioritizing the Government’s expenditure objectives across key sectors. The Government of the Republic of Korea has had discussions on providing a credit line to the Government for the procurement of a PAFMIS. The FMRP will support the eventual integration of the PAFMIS with the proposed Revenue Administration Management Information System (RAMIS).

74. The current cash management system also adversely affects disbursement ratios for foreign aid projects, as counterpart funds are unavailable or available with significant lags. To improve disbursement ratios, the National Budget Department along with the External Resource Department and the State Accounts Department will create an MIS to link foreign aid-related government counterpart funds to budget implementation. This will include commitments, warrant requests, and release of funds.

75. Finally, in order to strengthen management of government income streams, the State Accounts Department will develop an asset management system to support the monitoring and recovery of government onlending activities.

d. Strengthening Fiscal Discipline

i. Improving Budget Estimates

76. As an important step to fiscal discipline, the new Government has established a Fiscal Policy Committee under the leadership of the secretary to the treasury, which should provide an important source of discipline to budget design, preparation, execution, and monitoring.

77. However, the critical issue is the need to strengthen the process for the planning and preparation of the budget. In the past, inputs have been provided by the Fiscal Policy Department, National Budget Department, CBSL, and the revenue administration. However, the process was rather fragmented, lacking effective coordination and limiting the interaction, thus straining efforts to achieve consensus. Often the pressure fell on the revenue administration, which tended to have its initial revenue estimates raised given the assumptions underlying the economy. Accordingly, budget outturns often missed budget estimates, resulting in difficulties in achieving fiscal targets (para. 83). The FMRP will support effective coordination by establishing a budget preparation consulting process, gathering all of the relevant MOFP departments and revenue administrations to discuss and reach agreement on realistic and credible annual and medium-term revenue estimates.

78. To improve budget estimates, MOFP will also need to properly account for items that are currently off the budget. Under the FMRP, MOFP will build on actions under section 3.a. above to assist State Accounts Department to (i) develop guidelines and reporting procedures to monitor all commitments accumulated by government departments, (ii) prepare and update the registrar on such commitments, and (iii) publish the commitment details on the Government’s web site.

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79. Another key government policy involves moving current cash-based government accounting procedures toward an accrual-based accounting system by 2008. As part of this broad objective, the Government, supported by FMRP, has agreed to integrate accruals-based accounting systems on government accounts for (i) movable government assets and (ii) the net positions of public enterprises.

80. Finally, extending earlier work initiated under the Public Expenditure Management Systems project, a key policy action will involve deepening the expenditure ceilings framework. This will consist of improving the determination of ceilings based on a more rigorous analysis of expenditure priorities. Assumptions and scenarios underlying the establishment of such ceilings will be prepared in conjunction with the treasury’s Economic Policy Research Department and with a closer link to the macroeconomic program and the CBSL. In addition, the Government is establishing a commitment monitoring system in the National Budget Department to begin in 2005 to improve budget planning and management.

ii. Increasing Fiscal Transparency through Improved Reporting Procedures

81. The latest IMF Report on the Observance of Standards and Codes on fiscal transparency in Sri Lanka highlights achievements, including a reasonably well-developed legal and administrative framework for fiscal management and the publication of comprehensive fiscal accounts. However, areas that need strengthening remain, including systematic accounting of off-budget liabilities, parliamentary oversight, and audit.

82. Key fiscal transparency and parliamentary oversight responsibilities fall to the Government by virtue of the recent Fiscal Management (Responsibility) Act (and according to objectives highlighted in para. 22 above). In particular, under the Act, the Government will prepare a fiscal strategy statement, increase public awareness of the Government’s fiscal policy, and establish standards for evaluating the Government’s conduct of its fiscal strategy. In addition, MOFP will be responsible for presenting in Parliament a budget economic and fiscal position report. The report will set out the Government’s fiscal performance and key estimates and assumptions on fiscal accounts for the current and 2 succeeding fiscal years. An additional midyear fiscal position report will be prepared by the Minister of Finance to explain any deviations from stated fiscal objectives. To date, reporting requirements have been fully complied with, including the presentation of the Preelection Budgetary Position Report in March 2004.

83. Realistic revenue targets are critical to strengthen the Government’s perceived credibility, especially in view of the Fiscal Management (Responsibility) Act. However, in addition to realistic revenue estimates, expenditure ceilings will also need to be tightly enforced. Indeed over the latest period for which data are available, 1999–2001, the average budget outturn as a share of the original estimate was 89% for revenue, 103% for current expenditure, and 71% for capital expenditure. To ensure greater discipline and maintain expenditures on target, MOFP has started publishing on its web site bulletins of monthly expenditures and revenues, which track flows according to different classifications and over time. Subjecting the Government’s public spending and revenue collection programs to public scrutiny is expected to raise general awareness and further enhance budget discipline.

84. Under the FMRP (as part of the assurances), MOFP will be required to achieve a high degree of transparency in the reporting of contingent and implicit liabilities with the objective of strengthening coverage in the Government’s half-yearly statements. More specifically, MOFP 19

will report on the general Government’s financial position, both on- and off-budget items, including commitments, guarantees, and contingent liabilities. Along these lines, the FMRP will support initiatives so as to quantify the total value of off-budget expenditure and borrowing and propose means to (i) increase financial disclosure of off-budget expenditure and borrowing, (ii) transform such expenditure to on-budget items, and (iii) reduce possible distortions resulting from the modalities of off-budget expenditure and borrowing.

85. Improved transparency is a necessary condition for effective fiscal discipline. Accordingly, the Government will continue its commitment to improve reporting requirements. In addition to the publication of monthly expenditure and revenue accounts, the Government will begin publishing (i) results-based reporting standards including the auditing of all ministries with budgetary commitments on an annual basis, and (ii) annual departmental accounts within a specified time frame by 2005. An important reform in this area is the preparation of a compendium of all treasury circulars for easy reference, which is to be made available as operations manuals for treasury officers. A more abbreviated version will also be made available to the public on the Government’s web site.

iii. Reducing Distortions

86. Past practices of granting exemptions to tax evaders has created moral hazard among taxpayers and generated deep misgivings among potential future tax defaulters about coming clean and among honest taxpayers who feel cheated due to government leniency. Another set of distortions arises from the Government’s involvement in directing tax exemptions through income tax holidays and other misguided BOI incentive schemes to selected sectors of the economy, a strategy that according to empirical evidence does not lead to the intended objectives of promoting sustainable investment. According to Regaining Sri Lanka, the estimated revenue losses from various BOI tax concessions amounted to 2–3% of GDP annually. The FMRP will require the Government to halt these practices throughout the course of the FMRP (and beyond) and serve to create a level playing field for all eligible taxpayers (see Assurances, below).

87. Similarly, civil servants benefit from income tax exemption on their earned government income. This is clearly a second best (or non-optimal) policy. While a policy of moving toward increasing gross income and taxing the resulting income could result in resource equivalence on the state accounts, it could lead to positive externalities. In particular, greater awareness of taxation issues among the population and overall improved tax education resulting from these measures could improve compliance among taxpayers. In addition, equity concerns between taxpayers and tax-exempt individuals would be smoothed, likely reducing tax-evasion behavior and supporting a wider tax net. Finally, taxing civil service income would increase the policy instruments available to the Government to pursue income distribution measures.

88. More generally, tax exemption on civil service employment income cannot correct for a civil service that is unable to match salaries in the private sector. Public sector employment reform is hence essential in terms of overcoming a binding constraint to economic growth and ensuring the flexibility needed to adjust to a changing economy. Accordingly, the previous Government had introduced a requirement that all government employees be subject to income tax on their nongovernment incomes. In the maiden 2005 budget, the Government has made the provisions for all civil servants to be liable for a PAYE coming into effect in 2005. However, to reduce opposition to this reform, the Government of Sri Lanka has accompanied this measure by including a substantial civil service pay increase and a reprieve on PAYE, as income will be (initially) assumed to be half of the gross salary.

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e. Improving Fiscal Coordination

i. Strengthening Fiscal and Macroeconomic Coordination

89. Following the slippages in the fiscal deficit targets for 2004, the Government is expected to start anew on a fiscal consolidation strategy based on well-defined fiscal objectives and thereby adhere to the principles under the Fiscal Management (Responsibility) Act (Appendix 2). The strategy recognizes the importance of unwinding domestic imbalances built up over the years by containing fiscal deficits and reducing public debt. The adoption and implementation of clear objectives under the Act is an example of the benefits of strengthened macroeconomic and fiscal coordination and acknowledges the importance of fiscal consolidation as part of overall macroeconomic stabilization and sustainable GDP growth.

90. In parallel, and as part of greater integration of relevant departments in support of effective budgeting at the operational level, the Government has mobilized senior National Planning Department officials to work with the National Budget Department. The National Planning Department has been strengthened through recruitment of specialists and is now assigned the responsibilities of formulating a broad public investment plan consistent with the medium-term budget programming and expenditure framework. This should lead to an improved articulation of government policy priorities on the expenditure side by better aligning current and capital expenditure requirements. The Government’s commitment to increasing public investment underscores the need for these reforms, particularly in the elaboration of the public investment program. On debt management, the Government has decided to adopt a more gradual approach to creating an independent public debt management office. Accordingly, the Government will support the preparation of a feasibility study to review the merits of an independent public debt management office. In the meantime, work will commence on developing a monitoring system for foreign and domestic liability management.

91. Other measures to improve fiscal coordination will involve developing a web-based integrated aid MIS, which is already in preparation with bilateral support from the Government of Norway. This system will serve to better monitor and track implementation of development assistance projects and will be linked to the proposed PAFMIS to improve realization of budgeted disbursement targets, thereby improving performance of foreign assistance.

ii. Strengthening Fiscal Decentralization

92. Consolidation of the peace process is likely to be closely linked to progress in strengthening subnational governments. This will inevitably require public finances to be restructured to accommodate these changes. While the exact nature of any future change to the federal structure of government has yet to be defined, there are—even at this early stage— welfare-enhancing actions in support of fiscal decentralization that can be pursued by sub- national governments independently of the chosen federal structure. While fiscal stress has dampened fiscal devolution it should not be considered an impediment to further decentralization. More importantly, the nature of the reforms suggested under the FMRP essentially aims to bridge the gap between sanctioned devolution and the actual state of affairs.

93. Under the 13th amendment of the Constitution, introduced in 1987, the powers to be devolved from the center to the provinces, via PCs, were clearly defined according to subject. The underlying principle for devolution consists of the assignment of expenditure, revenues, and transfers from the central government to the PCs. However, to date, these powers have not 21

been fully devolved. Moreover, neither the promotion of self-sufficiency at subnational government level or efficiency at all government levels through the system of intergovernment transfers was among the principles pursued in the 13th amendment. Many of the PCs have not followed through in approving the statutes for levying the relevant devolved taxes, resulting in dependency on the center. Average total revenue as a share of total expenditure across PCs in 1998–2000 is estimated at 18%. The current situation has thus given the central Government and line ministries the rationale to maintain their presence and involvement in devolved subjects, thereby fostering duplication of functions across various areas.

94. Deficiencies in the current arrangements are numerous. The Finance Commission as the main arbiter in center-province financial relations is entrusted with overseeing the implementation of fiscal devolution. However, until recently, it met only occasionally, lacked focused technical expertise (as four out of five budgeted positions were vacant), and had limited accountability to key stakeholders. Consequently, the FMRP supported appointing a full-time chairperson and secretary, filling the Finance Commission’s vacancies, and vesting it with clear rules and procedures governing its responsibilities.

95. Since the appointment of a new chairperson of the Finance Commission, there has been significant progress in various areas. First, the Finance Commission has been restructured in line with a larger operating budget. In addition, a new Finance Commission Act is in preparation, supported by the FMRP. Finally, a Committee for Capacity Building in Fiscal Devolution has been established and is meeting regularly to identify key recommendations under a United Nations Development Programme study on fiscal decentralization and to propose that the Government adopts these recommendations.

96. The Finance Commission is also responsible for defining the criteria for the set of central government transfers to the PCs. Despite changing circumstances, the criteria have not been modified since first introduced in 1989. Under the FMRP, the Finance Commission will review the existing criteria and report on the appropriateness of the current arrangement based on principles of efficiency, transparency, simplicity, equity, and predictability. Criteria such as the degree of provincial fiscal management—to better realign incentives—and poverty considerations—to target poverty reduction and greater equity—should be considered.

97. Another important step in the devolution of revenue and expenditure powers from the center to the provinces involves creating a more solid base for provincial revenues. Accordingly, the FMRP recommends the identification of a defined tax that could either form the basis for the initial source of central transfer to the PCs or alternatively result in the actual transfer of tax collection responsibility to the PCs.

98. On the expenditure side, the PCs do not have full absorptive capacity to undertake the assigned expenditure provisions vested in them by the Constitution. In this context, the FMRP supports the preparation of a time-bound implementation plan that will assess the capacity improvements needed to transfer expenditure responsibilities in selected sectors from the center to the provinces, including education, health, and roads.

99. Certainly, PCs will need to be subject to increased scrutiny and accountability as greater expenditure and revenue powers are devolved to them. The FMRP will therefore call for a redressing of any potential imbalance between authority and accountability at the provincial government level, through the publication of an annual performance report to include achievements with regard to devolved revenue and expenditure powers as well as audited financial statements.

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100. Surprisingly, federal fiscal policy dialogue has been characterized by the absence of an institutional forum where government leaders from the two levels of government can discuss interprovincial and center-provincial issues. This is an important missing link in the current institutional setup as in any federation, the process of coordination is as important as the coordination itself. The FMRP will support the convening of high-level and working-level meetings to oversee and implement agreements reached. The following items could be part of the agenda of these meetings: (i) Finance Commission recommendations, (ii) means to reduce vertical and horizontal imbalances, and (iii) proposals to remove overlapping of responsibilities between central and provincial governments.

101. Finally, and in recognition of the central Government’s prerogative in determining the pace of future devolution, the FMRP will support the preparation of studies that will provide the analysis and technical considerations for informed decision-making. The first study would analyze the scope for moving toward increased devolution of capital expenditures to the provincial level. The fostering of provincial powers with regard to capital spending would, over the long term, assist in improving income generation at the provincial level and begin addressing the dependency syndrome. It would also explore the scope for improved realignment of incentives by moving gradually and, when recommended by the Government, from pure grant financing to loan financing, in line with increased capacity at the provincial level.

102. The second study would analyze ways to improve the efficiency and effectiveness of decentralized expenditure and revenue assignments. As part of the integration of the various activities under the FMRP, it would also seek to integrate the center-provinces’ revenue sharing into the medium-term budget programming and expenditure framework. Last, it would assess the capacity building required to successfully accommodate greater fiscal decentralization and aim to strengthen such capacity.

4. Financing Plan

103. It is proposed that ADB support the Government’s policy reforms through a policy loan of $45 million. The borrower will be the Democratic Socialist Republic of Sri Lanka. The loan will be from the OCR. The FMRP loan will have a 15-year repayment period including a grace period of 3 years, an interest rate determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility and a commitment charge of 0.75% per annum. (The front-end fee of 1.0% is waived for public sector loans approved during 1 January 2004–30 June 2005.) The Government will provide ADB with: (i) the reasons for the decision to borrow under ADB’s LIBOR-based lending facility on the basis of these terms and conditions; and (ii) an undertaking that these choices were its own independent decision, not made in reliance on any communication or advice from ADB.

104. The adjustment costs of the reforms under the FMRP are tentatively estimated at about $80 million and include the following:

(i) Restructuring of MOFP including staffing enhancements and preparation of annual audits of key ministries ($5 million); (ii) MRA project including development of the electronic direct interface program, recruitment of a CEO and additional advisors as per the new Revenue Board structure, implementation of reforms under the FMRP, and expenditure on training including consulting services ($30 million); (iii) Government financing for the PAFMIS ($20 million); 23

(iv) Government financing for the integrated aid MIS ($2 million); (v) Procurement of customs container inspection equipment ($20 million); and (vi) Staffing and institutional strengthening of the Finance Commission ($3 million).

5. Implementation Arrangements

a. Program Management

105. MOFP will be the FMRP Executing Agency (EA). MOFP will set up an interagency implementation and coordination committee (IICC) headed by the secretary to the treasury and comprising representatives from the Fiscal Policy Department, National Budget Department, External Resource Department, National Planning Department, Public Enterprises Department, State Accounts Department, Revenue Board, CBSL, and Finance Commission. ADB will also be a member of the IICC. The IICC will meet every quarter to monitor, coordinate, and ensure the effective implementation of the proposed reforms under the FMRP and will assist the EA in ensuring successful completion of the FMRP.

b. Period of Implementation

106. The implementation period is 3 years and is to be completed by December 2007.

c. Procurement and Withdrawal Procedure

107. The loan proceeds will be used to finance the foreign exchange costs of items produced and procured in ADB member countries (other than items specified in the List of Ineligible Items included in Appendix 7) and imports financed by other bilateral and multilateral sources. The Government will certify that the volume of eligible imports exceeds the amount of ADB’s projected disbursements under the loan for the given period. It is expected that the loan proceeds will be utilized over a period of 36 months from the date of loan effectiveness. ADB reserves the right to audit the use of the loan proceeds and verify the accuracy of the Government’s certification. Loan proceeds may be used to finance eligible imports for which expenditures were incurred 180 days before the FMRP loan becomes effective.

d. Counterpart Funds

108. The Government will use the local currency funds generated by the FMRP loan to meet FMRP expenditures and associated costs of reform.

e. Monitoring and Tranching

109. The loan will be released in three equal tranches of $15 million each. The first tranche is to be disbursed upon loan effectiveness and government compliance with all prior actions under the FMRP. The second and third tranches are expected to be released within 18 and 36 months, respectively, from the release of the first tranche, subject to satisfactory compliance with second and third tranche release conditions, respectively. Both the Government and ADB will regularly and closely monitor FMRP implementation. (See Appendix 4 for the list of tranche release conditions.)

f. Program Performance Monitoring and Evaluation

110. The IICC will establish and maintain a program performance monitoring system that will include a database on the status of policy measures and program indicators based on the policy matrix. This will be linked with the projects’ performance management systems (para. 132). The

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IICC will benefit from the wealth of experience accumulated by MOFP over the years with ADB and other development partners in project management.

g. Program Review

111. The Government and ADB will conduct a comprehensive midterm review at the end of year 2 to evaluate the progress of the reform measures and their impact on fiscal management. In addition, ADB will also monitor implementation through periodic reviews and progress reports. ADB will conduct annual reviews throughout the implementation period. These will assist in identifying further actions for continued improvements to fiscal management.

C. Project Loans

1. Objectives

112. The first project loan, MRA, will promote the institutional strengthening of the three revenue departments and the Finance Commission through the procurement of an integrated RAMIS and ancillary equipment, respectively. RAMIS will, in turn, link with the IT systems for financial management in the areas of treasury, payment, expenditure, and budget progamming. The second project, Strengthening of the Fiscal Management Institutions, will provide capacity- building support for institutional development, including that required to implement the Modernization Program for the Revenue Administration (Appendix 6). This would comprise promoting the development of skills and know-how of officials through the contracting of external expertise and transfer of knowledge via training and workshops. (See Appendix 8 for a description of RAMIS and Appendix 9 for the terms of reference for the capacity-building component of the project loan.)

2. Focus and Outputs

a. Enhancing the Revenue Administration

113. Automating the work place will be the driving force behind the modernization strategy of the revenue administration for the three revenue departments. In particular, adopting a fully integrated and comprehensive MIS will be critical to improve efficiency in revenue administration and by moving toward a script-less system with security checks rendering it less prone to abuse, and thereby assisting in rooting out circumspect practices of the past. The MRA project will therefore contribute to integrating the tax data and information from each of the three revenue departments and the BOI into a common platform. Accordingly, RAMIS aims to help the revenue departments develop an electronic organization system (also known as “e- organization”) and ensure that the standard is maintained on an ongoing basis. (See component 2 under terms of reference for the capacity building component of the project loan in Appendix 9 for a more detailed description.)

114. Assistance will also be provided for procurement of computer hardware and software for the Finance Commission.

b. Strengthening of the Fiscal Management Institutions

115. Institutional development of the revenue departments will be critical for effectively achieving the goals of the revenue modernization strategy. Foremost among the priorities will be the transformation of the current cadre at the respective tax administrations into well-qualified 25

experts. This will imply establishing a balance between acquiring specialized technical expertise that adapts international best practices to the requirements of the modernized revenue departments, on the one hand, and building expertise through training and working alongside international advisors including those seconded from successful revenue collection authorities on the other (see component 3 under terms of reference for the capacity building component of the project loan in Appendix 9 for a more detailed description).

116. Assistance will also be provided to support institutional development in the Finance Commission with emphasis on MIS, including integration and linkages across relevant associated institutions, and on skills development.

3. Cost Estimates and Financing Plan

117. The total cost of the two projects is estimated at $33.4 million equivalent, including contingencies and financing charges, comprising $22.4 million in foreign exchange costs and $11 million equivalent in local currency costs. A summary of cost estimates is given in Table 1.

Table 1: Cost Estimates ($ million)

Foreign Local Total Item Exchange Currency Cost

A. Project Administration 0.0 7.3 7.3 B. Capacity Building and Training 6.2 3.1 9.3 C. Revenue Administration 13.2 0.0 13.2 Management Information System D. Contingencies 1.9 0.6 2.5 E. Financing Charges12 1.1 0.0 1.1 Total 22.4 11.0 33.4 Source: Asian Development Bank.

118. The two project loans will comprise: (i) $15 million from OCR for the MRA, with a maturity period of 25 years including a grace period of 5 years, an interest rate determined in accordance with ADB’s LIBOR-based lending facility, and a commitment charge of 0.75% per annum; 13 and (ii) SDR 6,672,000 ($10 million equivalent) from the Asian Development Fund (ADF) resources for Strengthening of the Fiscal Management Institutions and will have a 32- year repayment period, including a grace period of 8 years, and an interest charge of 1.0% during the grace period and 1.5% thereafter. The borrower of the two project loans will be the Democratic Socialist Republic of Sri Lanka. The Government will provide ADB with (i) the reasons for the decision to borrow under ADB’s LIBOR-based lending facility on the basis of these terms and conditions; and (ii) an undertaking that these choices were its own independent decision, and not made in reliance on any communication or advice from ADB. The Government has indicated that interest during construction will be capitalized. A financing plan for the two projects is provided in Table 2 (see Supplementary Appendix 11 for the detailed financing plan).

12 Includes interest during construction and commitment fees. 13 Front-end fee of 1.0% is waived for public sector loans approved during 1 January 2004–30 June 2005.

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Table 2: Financing Plan ($ million)

Foreign Local Total Item Exchange Currency Cost Percentage

Asian Development Bank 22.4 2.6 25.0 75 Government of Sri Lanka 0.0 8.4 8.4 25 Total 22.4 11.0 33.4 100 Source: Asian Development Bank.

4. Implementation Arrangements

a. Project Management

119. MOFP will oversee and coordinate the implementation of both projects through delegation to: (i) the IICC headed by the secretary to the treasury and comprising senior representatives of the fiscal management institutions (see para. 105 for the composition of the IICC); and (ii) a project implementation unit (PIU) for the MRA project, headed by a project manager (consultant) who will report jointly to the CEO of the Revenue Board and to the secretary to the treasury. The project manager will have the authority to make decisions essential to ensuring progress of the MRA project with regard to facilitating procurement of equipment, and will liaise closely with the management coordination team (para. 122 below) on the recruitment of consulting services. The project manager will be assisted by a deputy project manager funded by the Government. Coordination across the two projects will be ensured by the IICC on administrative matters and by the Revenue Board on more substantive issues. The Revenue Board oversees the CEO’s activities and many of its members are also members of the IICC. The secretary to the treasury as head of the IICC and member of the Revenue Board will have full information and reinforce coordination of the FMRP. The secretary to the treasury will have the authority to make decisions essential to ensure progress of the projects with regard to facilitating procurement of equipment and recruitment of consulting services under the project loans. PIU will submit quarterly reports in compliance with international accounting practices and will ensure internal controls. Activities related to the Strengthening of the Fiscal Management Institutions project in support of National Budget Department, Fiscal Policy Department, and State Accounts Department will fall under the responsibility of the respective directors general while those for the Finance Commission will fall under the responsibility of the chairperson of the Finance Commission. They are all members of the IICC. (See Appendix 10 for an organizational chart on the coordination and implementation arrangements under FMRP.)

b. Period of Implementation

120. The implementation period is 3 years to be completed by December 2007. (See Appendix 11 for the planned project implementation schedule.)

c. Procurement

121. Under the MRA project, three procurement packages have been identified and are outlined in Appendix 12. Procurement of goods and services will be subject to the provisions of ADB's Guidelines for Procurement. Equipment will be procured through international competitive bidding for package 1 on a turnkey basis and to include the purchase, installation, testing, and training of the integrated RAMIS. Packages 2 and 3 will be procured under either 27

international competitive bidding for urgent packages not exceeding $100,000 or direct purchase for urgent packages not exceeding $500,000 equivalent. Package 2 will support the procurement of business machines and office equipment for the Finance Commission to complement United Nations Development Programme-supported MIS systems recently procured to ensure prompt link-up of the Finance Commission with the provincial councils’ finance departments. Package 3 will support the procurement of business machines and office equipment for the newly created Revenue Board and other urgent requests in the revenue departments. ADB has approved advance action for procurement packages 2 and 3 to enable immediate initiation of activities subsequent to loan effectiveness. The Government has been advised that approval of advance action does not commit ADB to finance the project.

d. Consulting Services

122. The Strengthening of the Fiscal Management Institutions project loan will finance a total of 160 person-months of international and 270 person-months of domestic consulting services. All international and domestic consultants will be engaged by ADB in accordance with its Guidelines on the Use of Consultants and arrangements satisfactory to ADB for the engagement of domestic consultants. The Strengthening of the Fiscal Management Institutions project will also hire a management coordination team to facilitate selection, recruitment, and management of consulting services including the capacity-building and training components of the project. The management coordination team will be provided by a firm through quality-based selection (QBS) and recruited in accordance with ADB’s Guidelines on the Use of Consultants. Up to 30% of the total costs of the consulting services under the Strengthening of the Fiscal Management Institutions project are to be allocated for recruitment under QBS because (i) the assignment is critical as it affects a basic pillar of the economy, namely the Government’s ability to generate revenue that not only affects its running but provides the basis for articulation of government policies through its spending program; (ii) institutional constraints in Sri Lanka pose risks for the favorable outcome of the FMRP and henceforth, quality-based consulting inputs, which are critical in capacity-building initiatives under FMRP, need to override other considerations in selection of consulting firms; (iii) the assignments are complex and highly specialized and process oriented, which does not allow the writing of very detailed terms of reference; and (iv) there is a high downstream impact and risk of program failure if the best consultant is not selected. QBS will be used for recruitment of the head of the management coordination team and head of PIU as well as revenue administration, human resources and IT specialists, and an actuarial expert. (See Supplementary Appendix 12 for the consulting services selection criterion).

123. Separate subcontracting of the services of individual consultants or firms may be required for other components of the Strengthening of the Fiscal Management Institutions project. Consulting services for such other components will be provided through quality-and cost-based selection (QCBS) by one or more consulting firms or individual consultants recruited in accordance with ADB’s Guidelines on the Use of Consultants and other arrangements satisfactory to ADB for the engagement of domestic consultants. In the case of selection of consulting firms, simplified technical proposals will be used wherever suitable. The Government of Sri Lanka has reached a preliminary agreement with the Revenue Department of the Government of Thailand to have officials from Thailand sent to impart training and advisory services to Sri Lanka. The recruitment of these consultants will be included under direct selection as part of the overall support for the institutional enhancements of the revenue administration in view of Thailand’s recent transformation of its own revenue administration and unique benefit resulting from such collaboration. The Government of Sri Lanka will be responsible for funding the deputy project manager, and various human resources and IT

28 specialists, as well as selective revenue administration training courses both in country and abroad.14 All other funding of consultants will be financed by ADB.

124. The following components and illustrative activities are identified for financing under the Strengthening of the Fiscal Management Institutions project loan:

(i) Component 1: Project Implementation and Coordination

(a) The PIU under the leadership of the project manager will, in addition to its day-to-day oversight and implementation functions, also assist in overseeing procurement and consulting services inputs pertaining to the MRA project in coordination with the IICC. There will be close coordination between the PIU project manager and the head of the management coordination team including (i) design of terms of reference, (ii) selection of consultants, (iii) identification of necessary expertise to ensure successful project implementation, (iv) supervision of consultants, and (v) quality control based on evaluation of consultants’ inputs and reports. Coordination will be in close liaison with the Government and ADB. The PIU project manager will also regularly assess performance and effectiveness of capacity-building inputs in support of the MRA project.

(b) The management coordination team will assist in designing terms of reference and facilitating recruitment in close liaison with the PIU project manager, the Government, and ADB, managing the consultants and reporting performance and effectiveness of capacity-building inputs in support of project-related activities. The head of the management coordination team will have overall responsibility for administrative issues on the capacity-building component and technical oversight other than in the modernizing of the revenue administration component below. She or he will liaise with the PIU project manager on all matters related to the modernizing of the revenue administration component below.

(ii) Component 2: Modernizing of the Revenue Administration. This component will support the implementation of the Modernization of Revenue Administration project (as identified in Appendix 6, task list for the modernization program of the revenue administration).

(iii) Component 3: Fiscal Management Institutions (non-MRA). This component will support effective implementation of the policy actions identified in the Program and will include:

14 The Government will obtain ADB concurrence on consultant selection under government funding. 29

(a) developing a comprehensive management audit of key ministries to support their restructuring;

(b) building capacity to improve results-based budgeting procedures through workshops and other training;

(c) preparing an actuarial balance analysis to identify stock of unfunded government liabilities;

(d) developing a liability management system that registers obligations at the commitment stage;

(e) designing and implementing an effective foreign-aid related counterpart fund management system;

(f) developing training systems for provincial level cadres in such areas as tax collection, accountancy, and MIS; and

(g) strengthening the Finance Commission MIS.

125. ADB has approved advanced actions for component 1 to enable immediate initiation of activities subsequent to loan effectiveness.

e. Disbursement Arrangements

126. CBSL on behalf of the Borrower will open within 1 month of loan effectiveness, two imprest accounts denominated in dollars, one for each of the project loans and managed by MOFP (the EA). The imprest accounts will be operated and maintained in accordance with ADB’s Handbook on Loan Disbursements dated January 2001. ADB will advance 3 months of estimated expenditures (about $1.5 million) into the imprest accounts for each of the loans. Foreign exchange payments or letters of credit, as well as local currency expenditures, may be paid out of the imprest accounts. The ADB statement of expenditures procedure will be used to liquidate and replenish the imprest accounts for individual payments not exceeding $50,000.

127. The EA will maintain separate records and accounts, adequate to identify goods and services financed out of the loan proceeds. Auditors acceptable to ADB will audit such accounts and records annually.

f. Accounting, Auditing, and Reporting

128. An audit of the use of the loan proceeds will be undertaken and ADB retains the right to (i) audit any account, and (ii) verify the validity of the certification issued by the Government for each withdrawal application. Prior to withdrawal, the Government will open an account at CBSL to receive all loan proceeds. The account will be managed, operated, and liquidated in accordance with terms satisfactory to ADB. The IICC and the PIU will send quarterly progress reports to ADB on project implementation.

129. The Government will maintain records and accounts for the imprest funds and project expenditure in accordance with sound accounting principles and will have such accounts and records audited annually by auditors acceptable to ADB. The Government will ensure that the submission of project reports, audited accounts, and financial statements are in compliance with

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ADB's guidelines. Certified copies of the audit reports together with the auditors’ opinion will be submitted to the Government and ADB not more than 6 months after the close of financial year. The audit reports will include a separate opinion on the use of the imprest account and statement of expenditures procedures.

130. Each component of the projects will be implemented in three phases. During the inception phase, the consultants of the various components will revalidate the objectives and assess priorities, key issues, and capacity-building needs. At the end of this phase, resource inputs may be adjusted, as appropriate, within the overall budget and project scope, to better align the terms of reference, activities, and outputs with client expectations and needs. During the design phase, the consultants will formulate in detail the capacity-building and operational development plans. Finally, in the implementation phase, the consultants will document required regulations, procedures, and systems, as well as arrange for training and skills development, as appropriate.

131. The consultants for each component will prepare an inception report within 2 months of the start of their services, which will fine-tune and detail the work program and establish time- bound outputs. A first review report will be submitted at the end of 6 months, a second review report at the end of 12 months, an interim report at the end of 24 months, and a draft final report including complete documentation at the end of 30 months, with the submission of the final report at the end of the assignment after incorporation of comments of ADB and the Government.

132. The PIU will submit quarterly reports on the two projects to ADB within 1 month of the end of each quarter in accordance with ADB’s program performance management system (PPMS) guidelines. The reports will contain a narrative description of progress made during the period, changes to the implementation schedule if any, problems or difficulties encountered and the remedial actions taken, the performance of the project consultants where applicable, and the work to be carried in the upcoming period. The reports will also include a summary financial account for the two projects, consisting of the projects’ expenditures to date. Project completion reports will be submitted to ADB within 3 months of the completion of the projects.

g. Project Performance Monitoring and Evaluation

133. In addition to regular and ongoing interaction among the EA, ADB, and its consultants, the Government and ADB will periodically review project implementation based on quarterly reports of the PIU and consultant reports. The reviews will include evaluation of project scope, implementation arrangements, consultations with MOFP and PIU, and progress with the policy reform agenda and capacity-building measures. On an annual basis or more frequently if warranted, the EA will submit a report to ADB on the overall assessment of the quality of inputs.

h. Project Reviews

134. The Government and ADB will periodically review project implementation. The reviews will include evaluation of the project scope, implementation arrangements, consultation with EA and PIU, and progress with the policy reform agenda and capacity-building measures. ADB will also field regular review missions, including midterm, and project completion review missions. A comprehensive midterm review at the end of year 2 will be undertaken to evaluate actual physical and financial progress. Based on this review, modifications and improvements will be considered.

31

V. PROGRAM BENEFITS, IMPACTS, AND RISKS

A. Benefits

135. The proposed FMRP is expected to address constraints highlighted under Section III by strengthening public finances including improving public resource and expenditure management systems, promoting fiscal discipline, and supporting fiscal decentralization. The FMRP will help establish a well-functioning, coordinated, and semiautonomous revenue administration comprising inland revenue, customs and excise departments, which would be responsible for all aspects of revenue collection. As part of automation of the revenue administration, the FMRP will also contribute toward e-government. The FMRP will also help streamline budgeting procedures and expenditure control processes within MOFP. As part of this reform agenda, the FMRP will assist in reorienting budget management from a compliance-based system to one incorporating elements of results-based budgeting. Fiscal discipline will be strengthened under the FMRP through measures to increase transparency and accountability and based on legislative and rules-based reporting requirements. Finally, support for fiscal decentralization will include measures to reduce the overlap of public expenditure functions across levels of government as well as other reforms to improve funding and effectiveness of devolved assignments. These measures are expected to support the implementation of the Government’s fiscal strategy, emphasizing fiscal consolidation compatible with medium-term fiscal sustainability, and to improve fiscal performance.

136. The MRA project will focus on the procurement of the RAMIS and ancillary equipment to assist in the creation of the MRA and thereby ensure a prompt and smooth transformation of the revenue administration. Under the Strengthening of the Fiscal Management Institutions project, support will be provided to, among others, carrying out the activities on the task list for the modernization program of the revenue administration, thereby complementing the RAMIS automation process. In addition, implementation plans have been prepared on strategic inputs to support a well-running revenue administration including organization and management, human resources and training, and IT. The equipment procured under the project loan will provide the necessary infrastructure to facilitate efficiency and effectiveness of tax collection and compliance.

137. The non-MRA capacity-building components under the Strengthening of the Fiscal Management Institutions project will support the implementation of the reform program under FMRP. As part of this assistance, training activities as well as highly specialized consulting services will be financed to improve the effective operations of the fiscal management institutions. While some activities under the capacity-building component have been identified, others have yet to be defined, thereby providing greater flexibility for the Government to manage resources under this project loan. The project loans will therefore serve to (i) strengthen the revenue administration and other fiscal management institutions and, ultimately, improve compliance with fiscal objectives; and (ii) help mitigate risks, particularly in the setting up the modernization of revenue administration and thereby ensure successful program implementation.

B. Impacts

138. The FMRP will seek to strengthen public finances, focusing on improving the budget framework and expenditure control measures while enhancing revenue mobilization efforts. Direct beneficiaries will include business at large who, despite paying higher taxes on average (as loopholes are closed and effective compliance strengthened) over the medium term, will

32 benefit from a clearer, simplified, and more balanced tax and customs administration. Under the Government’s reform program, fiscal consolidation may result in cutbacks on current expenditures in the social sector, which may affect the poor. However, these cutbacks will be offset by measures to increase the effectiveness of these expenditures and by outright increases in capital expenditures in the social sector that over the medium term more than offset the current expenditure cutbacks, in relative terms.

139. On the positive side, the FMRP will strengthen macroeconomic stabilization by reducing the country’s imbalances, thereby supporting higher and more sustainable growth prospects. This is expected to contribute to poverty reduction. In addition, under the FMRP, measures to strengthen fiscal decentralization and performance monitoring would also target the social sector spending agencies thereby providing greater effectiveness of spending assignments, especially for those segments of the population that are more reliant on public goods and services. Finally, under the envisaged reforms to intergovernment transfer setting, equity considerations and, in particular, poverty incidence will be given greater prominence, thereby supporting poverty reduction. (See Appendix 13 for the summary poverty reduction and social strategy.)

140. FMRP is classified as category C under ADB’s environmental classification system. The FMRP is expected to have no direct environmental impact.

C. Risks

141. There are multiple risks to the successful implementation of the FMRP. Foremost, consolidation of the peace process and political stability will be critical for the Government to oversee meaningful economic reforms. Fiscal consolidation efforts, in particular, will require strong government commitment and any slippages on the security or political fronts may weaken the Government’s resolve. Although limited disbursements were realized in 2004, resources committed at the June 2003 Tokyo Donor Conference, subject to progress in peace talks, should facilitate the fiscal consolidation process.

142. On the economic front, exogenous shocks to the economy could potentially impair the Government’s ability for aggressive fiscal consolidation. Current high oil prices have weighed heavily on Sri Lanka’s stabilization efforts and in particular on the balance of payments. Furthermore, attempts to cushion the effect of high oil prices on domestic users have indeed added further pressure on the fiscal balance. As fiscal consolidation leads to improved macroeconomic stabilization and greater flexibility to cope with these shocks, there is a reinforcing link between the deepening of reforms and ability to cope with these shocks.

143. Other risks include the power of vested interests that could attempt to block reforms. The greatest risk here comes from trade unions, which may successfully mobilize public opinion (i.e., through strikes and other industrial action) in a manner so as to dilute the reforms, potentially proving detrimental to the FMRP’s objectives. There are also institutional risks given the relatively overstretched resources in key ministries and revenue administration. These, combined with the comprehensive nature of the FMRP and the close links with political risks, may slow implementation of the FMRP.

144. Safeguards include the “additionality” of a continuing and constructive policy dialogue between the Government and IMF on conducive fiscal consolidation and stabilization-based macroeconomic policies. In addition, supporting project loans will mitigate risks through the increased supply of resources—including consulting services, equipment and training—which 33

should help overcome institutional constraints and facilitate program implementation. For this reason, close coordination between ADB and the Government is of fundamental importance especially with respect to close monitoring of FMRP and of consultants’ performance. ADB’s proposed Private Sector and Financial Markets Development and the ongoing Power Sector Development programs15 will also reinforce measures such as improving governance in commercial public enterprises, power sector restructuring, and cost recovery in electricity tariffs, thereby reducing pressures on state budget. (See Appendix 14 for the development coordination matrix.)

VI. ASSURANCES

A. Specific Assurances

145. In addition to the standard assurances, the Government has given assurances that (i) the policies adopted and actions taken prior to the date of the Program Loan Agreement and Project Loan Agreements, as described in the Development Policy Letter, will continue in effect for the duration of the FMRP; and (ii) it will promptly adopt the other policies and take the other actions included in the FMRP as specified in the Development Policy Letter and Loan Agreement to ensure that such policies and actions continue in effect for the duration of the FMRP.

146. Program Loan.16 The following program loan assurances will be complied with during the FMRP period:

(i) The Government shall effectively adhere to a fiscal consolidation adjustment path in accordance with its medium term fiscal program and its fiscal consolidation strategy;

(ii) MOFP will produce half yearly comprehensive statements of the general Government’s financial position in the budget, showing all financial assets and liabilities, including commitments, guarantees, and contingent liabilities by 15 March and 15 September of each year;

(iii) the Government will stop tax exemptions under BOI schemes to be transferred to IRD;

(iv) the Government will stop providing tax amnesties; and

(v) MOFP will set up an FMRP interagency implementation and coordination committee to meet every quarter to coordinate and ensure the effective implementation of the proposed reforms.

147. Project Loans. The following project loans assurances will be complied with during the FMRP period:

15 Subprogram II of cluster loans ADB. 2000. Report and Recommendation of the President to the Board of Directors on Proposed Program Cluster for and Loans and Technical Assistant Grant to the Democratic Socialist Republic of Sri Lanka for Private Sector Development Program. Manila; and ADB. 2002. Report and Recommendation of the President to the Board of Directors on Proposed Loans to the Democratic Socialist Republic of Sri Lanka for the Power Sector Development Program. Manila. 16 Additional program loan assurances are included under Appendix 4.

34

(i) The Government will provide counterpart staff and financing to implement the projects; and

(ii) The EA will submit a report to ADB on an annual basis or more frequently if warranted on project implementation and overall assessment of the quality of inputs.

B. Conditions for Loan Effectiveness

148. In addition to the first tranche conditions as described in Appendix 4, the effectiveness of the project loans will be a condition of the program loan. The effectiveness of the program loan will be a condition of the effectiveness of the project loans as well.

VII. RECOMMENDATION

149. I am satisfied that the proposed loans would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve:

(i) the program loan of $45 million to the Democratic Socialist Republic of Sri Lanka for the Fiscal Management Reform Program from ADB’s ordinary capital resources with interest to be determined in accordance with ADB’s London interbank offered rate (LIBOR)-based loan facility, a term of 15 years, including a grace period of 3 years, and such other terms and conditions as are substantially in accordance with those set forth in the draft Program Loan Agreement presented to the Board;

(ii) the project loan of $15 million to the Democratic Socialist Republic of Sri Lanka for the Modernization of the Revenue Administration from ADB’s ordinary capital resources with interest to be determined in accordance with ADB’s LIBOR-based loan facility, a term of 25 years, including a grace period of 5 years, and such other terms and conditions as are substantially in accordance with those set forth in the draft Project Loan Agreement presented to the Board; and

(iii) the project loan in various currencies equivalent to Special Drawing Rights 6,672,000 to the Democratic Socialist Republic of Sri Lanka for the Strengthening of the Fiscal Management Institutions project from ADB’s Special Funds resources with interest charge of 1.0% during the grace period and 1.5% thereafter; a term of 32-years, including a grace period of 8 years, and such other terms and conditions as are substantially in accordance with those set forth in the draft Project Loan Agreement presented to the Board.

Tadao Chino President

23 November 2004 Appendix 1 35

THE GOVERNMENT’S FISCAL PROGRAM

A. Introduction

1. In June 2004, the Government of Sri Lanka introduced its new Economic Policy Framework. As part of the framework a revised medium-term fiscal program and strategy for 2004–2007 was launched.

2. Four challenges are identified in the Economic Policy Framework, namely: (i) increasing employment, (ii) overcoming the public debt crisis, (iii) mobilizing resources for reconstruction, and (iv) increasing income levels. To meet these challenges, the Government has prepared a Medium-Term Macro Fiscal Policy Framework (MFPF) 2005–2008 submitted with the 2005 Budget to Parliament on 18 November 2004. Salient features of the MFPF include: (i) continued increase in annual gross domestic product (GDP) growth rate from 6% in 2005 to 7.5% by 2008, (ii) a decrease of the GDP deflator from 8% in 2005 to 4.5% in 2008, (iii) a consecutive increase of total investment from 28% of GDP in 2005 to 34% in 2008, (iv) a consecutive increase of national saving from 23.3% of GDP in 2005 to 30.8% in 2008, (v) a reduction in overall budget deficit from 7.6% of GDP in 2005 to 4.4% in 2008, (vi) an improvement in the revenue balance from a deficit of 1.3% of GDP in 2005 to a surplus of 3.6% of GDP by 2008, and (vii) a decrease in total government debt from 103.9% of GDP in 2005 to 93.5% in 2008 (Supplementary Appendix 5).

3. Fiscal reforms constitute a key element under the medium-term macroeconomic policy action plans. The fiscal program in this medium-term strategy aims to restore fiscal sustainability and concurrently make available adequate resources for (i) priority spending on pro-growth capital and social spending, and (ii) post-conflict needs. The following section describes the medium-term fiscal measures under this medium-term strategy.

B. Medium-Term Fiscal Program

4. In view of the importance of creating fiscal space and significantly reducing large fiscal deficits and public debt, the Government has embarked on fiscal consolidation aiming at (i) generating higher revenue; (ii) reducing current expenditure in order to enable higher capital expenditure; and (iii) reducing demand on state resources by controlling leakages resulting from lending and transfers to public enterprises, contingent liabilities, and high debt service cost.

1. Revenue

5. Under the MFPF, total revenue as a percentage of GDP will increase by 3.9 percentage points from an estimated 15.6% in 2004 to 19.5% in 2008. This comprises an increase in tax revenues from 14.1% of GDP in 2004 to 17.7% in 2008 driven by increases in value-added tax (VAT) collection, which accounts for approximately 41% of total tax revenue. VAT including economic service charge is targeted to increase from 5.9% of GDP in 2004 to 7.7% of GDP in 2008, an increase of 1.8 percentage points. Excise taxes accounting for approximately 23% of total revenue are targeted to keep constant at approximately 3.2% of GDP in 2004 through to 2008. Income tax, accounting for approximately 15% of total tax revenue, is expected to generate a more moderate increase of up to 0.9 percentage points from 2.2% of GDP in 2004 to 3.1% in 2008. On nontax revenue, there will be a small increase from 1.5% of GDP in 2004 to 1.9% of GDP in 2008 as there will be minor contributions from privatization proceeds. The increase in nontax revenues will reflect increasing contributions from strategic enterprises by way of profit and dividend and the impact of cost recovery on state enterprises. The main 36 Appendix 1 sources of nontax revenue in the past have been profits from the Central Bank of Sri Lanka and interest payments on government lending. The former accounts for approximately 30% of total nontax revenue, and the latter for approximately 20%.

6. Key elements in support of revenue augmentation measures include (i) tax administration, (ii) tax policy, and (iii) tax legislation. The tax administration measures essentially comprise the Asian Development Bank (ADB)-supported Modernization of the Revenue Administration project described in the main text. On tax policy, measures will target: (i) a broadening of the tax base including the major achievement of integrating civil servants under the pay-as-you-earn (PAYE) tax; (ii) increasing the number of VAT and customs duty bands as well as their rates; (iii) introducing the turnover tax; (iv) implementing a simplified tax code; and (v) introducing a tightening of existing deductions on corporate taxes. On tax legislation, the onus will be on providing clear legislation that closes loopholes in tax laws and that phases out the myriad of tax concessions. A significant reform submitted under the 2005 Budget includes improving the powers of the revenue administration by introducing dedicated tax courts to deal with recovery and other tax administration disputes. The tax legislation will also be amended to provide the authority to the Commissioner General of Inland Revenue advanced rulings that are binding in law.

2. Expenditure

7. On the expenditure front, the Government plans to reduce current expenditures mainly through: (i) a significant reduction in subsidies and transfers to households and public enterprises; (ii) cutbacks in interest payments and defense spending; and (iii) prioritizing public expenditure1 while increasing capital spending on rural infrastructure facilities. From 2003 to 2007, the Government plans to contain total expenditure to just below 24% of GDP by 2008. This comprises a reduction in recurrent expenditure from 19.3% of GDP in 2004 to 15.9% in 2008. However, capital expenditure is set to increase by 2.9 percentage points from 5% in 2004 to 7.9% in 2008. Debt service payments are targeted to decline from 11.7% of GDP in 2004 to 7.5% in 2008 reflecting the expected lower interest rate environment and improved debt management operations. Government subsidies and transfers which in 2004 are projected to account for a record, 21% of total expenditures—due to oil price subsidies and drought assistance relief—are expected to decline to 16% of total expenditures in 2005. In relation to GDP, Government subsidies and transfers will decline from 5.1% in 2004 to 3.8% by 2008. The Government has announced plans for 2005 to convert SLRs90 billion of loans (with an average rate of interest of 11–13%) to non-convertible, lower interest rate bonds. Accordingly, interest payments will decline from 6% of GDP in 2004 to 5.6% in 2005 and onwards to 4.5% by 2008. The Government is also committed to streamlining defense spending which is projected to decline marginally from 3.5% of GDP in 2004 to 3.2% in 2008, subject to the continuation of the effective cease-fire and ensuing peace process. On public expenditure prioritization, the Government has identified various measures including (i) deepening expenditure control measures supported by the FMRP, (ii) strengthening accounting and auditing standards, and (iii) introducing improved practices in procurement management. These are expected to reduce significant wasteful expenditure.

8. The reductions in recurrent expenditure are projected to be partially offset by increases in capital expenditure largely reflecting the positive externalities from a targeted focus on reconstruction of the north and northeast. The underlying strategy on capital expenditure is for

1 Nearly 20% of the Government’s current expenditures are used for transfers to households, similar to patterns observed in upper-income Organisation for Economic Co-operation and Development nations. Appendix 1 37 the Government to absorb the maximum available foreign concessional investment, and by putting in place measures to improve monitoring of incoming development assistance and strengthened links with the budget to increase the disbursement rate of concessional borrowing.

3. Public Enterprises

9. There are more than 150 statutory boards and fully owned government companies and at least 40 commercial companies under partial government shareholding. Failure to restructure and introduce timely cost-recovery pricing will increase the deficits and resulting quasi-fiscal drainage of resources from the budget. To contain further pressure on the state budget caused by public enterprise operations,2 the Government is addressing inefficient operations of public enterprises through comprehensive restructuring programs of 12 key public sector undertakings.

10. The Strategic Enterprises Management Authority (SEMA) was created by the Government shortly upon assuming office with the objective to manage as independent enterprises 12 strategic enterprises—with combined assets in excess of $10.5 billion. A key element will be to improve profitability and accordingly restructuring plans have been approved by SEMA and the respective board of directors, which were submitted for cabinet approval in late October 2004. As far as the impact on the budget is concerned, the restructuring plans contain strict budget ceilings to reduce the strategic enterprises' impact on public finances and to prevent losses of the strategic enterprises from being financed through state-owned banks.

11. The results from the restructuring plans should lay the foundations for increases in nontax revenue remittances from public enterprises, reduction of accumulated tax arrears, and reduced subsidies and guarantees to public enterprises. The last point is particularly of a greater concern due to the existing subsidies and other contingent liabilities supported by the Government under its direct transfer and lending program to public enterprises and institutions.

4. Public Debt Management

12. To reduce the debt service cost, the Government has introduced measures to control interest payments by refraining from using expensive domestic borrowing (such as overdraft facilities), smoothing the debt amortization schedule, and issuing longer-term debt. The Government is also assessing the merits of establishing an independent public debt management office at the Ministry of Finance to steward debt management reforms.

13. Interest payment on government debt peaked at 7.5% of GDP in 2003, and according to the Economic Policy Framework is projected to gradually decline to 5% in 2007 as the primary deficit moves into balance. Interest payment, which accounted for 35% of current expenditure in 2003, was the largest item of current expenditure. This reflected a combination of the accumulation of high-cost domestic debt together with constraints to debt management including limitations on including a callable option on issued debt. In particular, the Government continued to expand budget deficits throughout the late 1990s and early 2000 despite a shortfall in financing sources. Consequently, the interest rate was pushed up to 20–22% between late 2000 and mid-20013 due to persistently high fiscal deficits. Furthermore, large amortizations,

2 The Government provided an estimated capital injection of $166 million for five strategic public enterprises in 2003 and another $113 million is estimated for 2004. 3 Weighted average of bank prime lending rates. 38 Appendix 1 reflecting a past overconcentration of rolled over short-term debt issuance in 1999 and 2000, fell due in 2002 (and 2003)4 adding greater fiscal stress in the form of larger debt-servicing costs.

14. In 2002, the Government replaced high-cost overdrafts with marketable debt instruments such as treasury bills and treasury bonds. As a result, the outstanding overdraft was reduced from SRs38 billion (12% of current liabilities) at end-2001 to SRs3.6 billion (2% of current liabilities) at end-2002. This measure not only lowered the interest cost but also reduced the pressure on government cash flow. This effort will need to be further consolidated over the coming years.

4 According to the government accounts reported in CBSL Annual Report 2002, total amortization payments (both domestic and foreign) are SRs167,843 million and SRs187,754 million in 2002 and 2003, respectively, compared with total revenue of SRs270,763 million and SRs316,223 million in 2002 and 2003, respectively.

Appendix 2 39

FISCAL OBJECTIVES AND REPORTING REQUIREMENTS UNDER THE FISCAL MANAGEMENT (RESPONSIBILITY) ACT

Table A2.1: Fiscal Objectives under the Fiscal Management (Responsibility) Act

Criteria Objective Timing (% of GDP) 1. Budget Deficit 5 End of 2006 2. Total Government Liabilities 85 End of 2006 60 End of 2013 3. Government Guarantees 4.51 Throughout 1 Comprising sum of current financial year along with the two preceding financial years. Source: Gazette of the Democratic Socialist Republic of Sri Lanka, 10 January 2003.

Table A2.2: Reporting Requirements under the Fiscal Management (Responsibility) Act

Name of Date of Report Submission Objectives Major Contents Fiscal Strategy With the budget Increasing public Government's medium-term fiscal policy. Statement speech awareness and Broad strategic priorities on which the budget is (second establishing standards based. Key fiscal measures relevant for the reading). for evaluating the implementation of the fiscal strategy. Government's conduct of Fiscal objectives and targets related to fiscal fiscal policy. indicators, especially government debt.

Midyear Fiscal End June or Providing updated Estimated and actual expenditure, revenue, and Position lapse of 6 information on the cash flow for the first 4 months of the year. Report months from the Government's fiscal Estimated and actual government borrowing, and date of the performance in the first 4 any other statements reflecting the Government's passing of the months to enable the financial position for the first 4 months of the Appropriation public to evaluate it with year. Act, whichever the Government's fiscal is later. strategy.

Final End May of the Providing updated Estimated and actual expenditure, revenue, and Budgetary year following information on the cash flow for the year. Position the budget. Government's fiscal Estimated and actual government borrowing, and Report performance for the any other statement reflecting the Government's whole year to enable the financial position during the year. public to evaluate it with Reasons for shortfalls in the estimated revenue the Government's fiscal and overruns in expenditure and borrowings. strategy.

Preelection Within 3 weeks Announcing the current Estimates of revenue and expenditures and Budgetary of the fiscal position of the economic and other assumptions used for these Position announcement Government to the public estimates. Report of a general to avoid election (submitted by election. handouts. the Secretary to the Ministry of Finance)

Statements of With the Stating the responsi- Statement signed by the Minister to the effect Responsibility Preelection bilities of the Minister that the Minister has disclosed all the known Budgetary and the Secretary in information required for the preparation of the Position Report preparing the preelection budgetary report, within one week of preelection budgetary an announcement of an election. Statement by position report. the Secretary stating that the preelection report contains information to the fullest extent possible. Source: Annual Report 2002 of the Central Bank of Sri Lanka. 40 Appendix 3

BACKGROUND STUDIES AND CHRONOLOGY OF THE FISCAL MANAGEMENT REFORM PROGRAM

1. The FMRP is based on intensive rounds of consultation with two governments spanning a period of almost 18 months starting in April 2003. The background studies in preparation for this FMRP included findings from (i) the Public Expenditure Management Systems (PEMS) Technical Assistance approved in November 1999 for $3 million, (ii) Preparing the Public Sector Resource Management Project approved in August 2001 for $500,000, and (iii) a staff consultant report on Structural Fiscal Imbalances in Sri Lanka in August 2003.

2. The following key processing steps involved in the formulation of the FMRP together with major political developments are highlighted:

(i) Mission to Canada Customs and Revenue Agency 28 April–2 May 2003

(ii) Reconnaissance Mission 18–27 June 2003

(iii) Fact-Finding Mission 18–25 August 2003

(iv) Quality Assessment and Facilitation Meeting 24 September 2003

(v) 1st Management Review Meeting 13 October 2003

(vi) Pre-Appraisal Mission 20–30 October 2003

(vii) President dismisses two Government Ministers November 2003

(viii) TA Tripartite Review Meeting 8–14 January 2004

(ix) Parliament dissolved February 2004

(x) General Elections and new Government formed April 2004

(xi) Contact Mission 10–15 May 2004

(xii) Consultation/Appraisal Mission 19–29 July 2004

(xiii) 2nd Management Review Meeting 26 October 2004

(xiv) Loan Negotiations 8–9 November 2004

3. The ADB processing team responsible for FMRP formulation and associated assistance components comprised: Bruno Carrasco (Principal Financial Economist and Mission Leader), Xiaohua Peng (Principal Counsel), Joseph Zveglich (Senior Economist), Kanokpan Lao-Araya (Public Sector Resource Management Specialist), Johanna Boestel (Economist), Kamal Ahmad (Counsel), Myra Teresa Mendoza (Administrative Assistant), and Nick Morris (staff consultant).

Appendix 4 41

DEVELOPMENT POLICY LETTER AND POLICY MATRIX

I. DEVELOPMENT POLICY LETTER

42 Appendix 4

Appendix 4 43

44 Appendix 4

Appendix 4 45

II. POLICY MATRIX FOR THE 46 FISCAL MANAGEMENT REFORM PROGRAM

Program Objective: To strengthen public finances by improving public resource/expenditure management systems, promoting fiscal discipline and supporting fiscal Appe decentralization. ndix 4 Policy Actions to be Taken Prior to Policy Actions to be Taken Prior to Focus of Reform Policy Actions to be Taken Prior to First Tranche Release Second Tranche Release Third Tranche Release

A. Improving Effectiveness of Tax Administration

1. Supporting the creation of Government to (i) approve creation of RB to design, approve, and begin RB to have fully implemented (i) task the Revenue Board (RB) RB, and (ii) complete appointment of implementation of (i) human resource list; (ii) strategic plans for inland the RB including selection of senior development plan based on a more revenue, customs, and excise deputy commissioner general/chief flexible, merit-based and competency- departments; and (iii) completed the executive officer (CEO) and two acquired employment system; and implementation of human resource appointed external members of the RB. (ii) an integrated information technology development plan and IT development (IT) development plan.a plan. Ministry of Finance and Planning (MOFP) to prepare and approve a task RB to approve RB strategy and RB to prepare (i) evaluation of list with clearly defined time-bound strategic plans for inland revenue, and performance of modernized revenue actions to support the creation of a MOFP to approve strategic plans for administration based on these findings, modernized revenue administration. Customs and Excise departments. and (ii) a policy paper to deepen integration of revenue administration.a

MOFP to establish computerized and fully integrated revenue administration management information system (MIS) to include integrated revenue information across all three revenue departments with linkages to Board of Investment (BOI) and public accounting and financial MIS.a

2. Strengthening tax Large Taxpayer Unit (LTU) to appoint MOFP to formulate a strategy to MOFP to have fully implemented (i) TIN collection/tax compliance individual account managers for largest establish a unique and unified taxpayer system, and (ii) risk management 1,000 taxpayers who will be responsible identification number (TIN) and begin system for cargo clearance. a for all tax administration services for the implementation. particular taxpayer.

Policy Actions to be Taken Prior to Policy Actions to be Taken Prior to Focus of Reform Policy Actions to be Taken Prior to First Tranche Release Second Tranche Release Third Tranche Release Customs Department to introduce a full MOFP to establish a central accounts risk management system for cargo database that provides for a uniform clearance. system of numbering and cross checking tax-related transactions and revenue information.

MOFP to submit to Parliament MOFP to give notice by 2005 to all amendments to Value-Added Tax (VAT) companies registered under LTU and inland revenue acts to introduce requiring them to submit electronic tax revenue enhancing measures as files starting 2006. presented under the budget 2004. Inland Revenue Department (IRD) to revise/update tax code in order to make it a simpler, practical and more effective reference instrument.

B. Improving the Budget Framework 1. Streamlining budgeting National Budget Department (NBD) to MOFP to introduce results-based procedures introduce in conjunction with Fiscal indicators at central government level Policy Department (FPD) and State (on a pilot basis) for the purpose of Accounts Department (SAD) moving toward results-based budgeting internationally accepted budget system. classification system (leading to Classification of the Functions of Government). NBD and National Planning Department NBD to prescribe in the annual budget (NPD) to establish budget and planning circular a specific timetable and guidelines for the purpose of unifying requirements across relevant ministries medium-term capital and recurrent for medium-term budget preparation. budgeting procedures.

NBD to introduce effective use of

expenditure ceilings for budget A preparation of line agencies. ppe

ndix 4 MOFP to introduce rolling 3-year forward estimates on current and capital budgets both at the central and line ministry levels based on medium-term

budgeting framework (MTBF). 47

Policy Actions to be Taken Prior to Policy Actions to be Taken Prior to 48 Focus of Reform Policy Actions to be Taken Prior to First Tranche Release Second Tranche Release Third Tranche Release

MOFP to establish a committee and Appe approve an action plan to move from a

consolidated compliance-oriented ndix 4 budget system to one that incorporates elements of results-based budgeting.

MOFP to develop guidelines for establishing (i) intrayear budgeting adjustments including, in exceptional circumstances, supplementary budgets; and (ii) timely reporting requirements of budget adjustments.

2. Rationalizing expenditure Key central ministries including (i) Key ministries and Western Province to Finance, (ii) Transport, (iii) Health, (iv) have implemented restructuring plans. Education, (v) small and medium enterprise (SME), and (vi) Foreign Affairs to submit restructuring plans for rationalization of expenditure.

Western Province (Colombo) to prepare a restructuring plan on a pilot basis, taking into account the evolving intergovernment fiscal responsibilities.

C. Improving Public Expenditure Management and Control Systems

1. Strengthening management MOFP to prepare inventory list of MOFP to prepare guidelines for MOFP to consolidate nonstatutory funds of off-budget expenditures special funds both statutory and classification of off-budget liabilities as through closure and mergers. and borrowings nonstatutory (and to be updated actual or contingent for central annually) according to size and use of government. funds. MOFP to (i) issue guidelines regarding MOFP to develop an action plan to the formation and administration of support the recommendations of the nonstatutory funds; and (ii) establish feasibility study on funding and and publish performance reporting liquidating government liabilities. systems including annual audit of statutory funds.

Policy Actions to be Taken Prior to Policy Actions to be Taken Prior to Focus of Reform Policy Actions to be Taken Prior to First Tranche Release Second Tranche Release Third Tranche Release MOFP to establish (i) actuarial balance analyses of the greatest sources of contingent liabilities, and (ii) monitoring system of contingent liabilities.

MOFP to prepare a feasibility study for the purpose of funding and liquidating outstanding government liabilities.a

2. Improving budgetary MOFP to introduce effective budgetary NBD in conjunction with External MOFP to establish computerized and cash/asset management allotment system across the budget Resources Department (ERD) and SAD fully integrated public accounting and system year to synchronize with receipts to the to establish management information financial MIS to include: (i) payroll; (ii) treasury including transfers to other system to link foreign-aid related civil service pensions; (iii) drawing and levels of government. government counterpart funds to budget disbursing offices; (iv) capital projects implementation, including commitments, budget; and (v) public sector borrowing warrant requests, and release of funds. requirements.

SAD to establish government asset management system to support the monitoring and recovery of government onlending activities.

D. Strengthening Fiscal Discipline 1. Improving budget estimates MOFP to create fiscal policy committee SAD to integrate accruals-based SAD to (i) develop mechanisms (i.e., (FPC) chaired by the secretary of the accounting systems into government guidelines, report procedures, and treasury to include senior management accounts for (i) movable government declarations) to monitor all from all relevant fiscal management assets, and (ii) net position of public commitments accumulated by departments to formulate fiscal policy enterprises.a government departments, (ii) prepare framework, monitor fiscal performance and update registrar on such and ensure discipline in budget As part of budget preparation, MOFP’s commitments, and (iii) publish the preparation and execution. NBD, FPD, Research Department (RD), commitment details on the and RB to meet, discuss, and reach Government’s web site.

agreement on annual and medium-term A revenue estimates by source and based ppe

on reporting of critical assumptions for ndix 4 revenue projections.

As part of budget preparation and to strengthen expenditure controls, FPC to

prepare annual expenditure ceilings 49

Policy Actions to be Taken Prior to Policy Actions to be Taken Prior to 50 Focus of Reform Policy Actions to be Taken Prior to First Tranche Release Second Tranche Release Third Tranche Release

report to include analyses, supporting Appe assumptions and scenarios underlying

establishment of such ceilings. ndix 4

2. Increasing fiscal MOFP to publish (i) bulletin of monthly MOFP to review all circulars issued by transparency through expenditures according to economic the treasury and consolidate them into a improved reporting and accounting classifications; and (ii) (i) new concise operational manual, and procedures bulletin of monthly revenues according (ii) brief compendium for easy reference to tax sources (with a maximum and to be posted on NBD’s web site.a reporting lag of 2 months) that include interannual comparisons.

Government to issue a circular requiring the publication of (i) results-based reporting standard including the auditing of all ministries with budgetary commitments on an annual basis, and (ii) annual departmental accounts within specified time frame.

3. Reducing distortions Tax exemptions on nongovernment Government to amend Board of IRD to fully implement enforcement of salaries and incomes for government Investment Act to ensure all granting of tax filing requirements. employees to be removed. exemptions and other fiscal holidays are fully consistent with the revised tax code.

E. Improving Fiscal Coordination

1. Strengthening fiscal/ Enact Fiscal Management MOFP to (i) complete a feasibility study MOFP to improve prioritization of macroeconomic (Responsibility) Act. to develop an independent Public Debt development needs by creating coordination Management Office (PDMO); and (ii) institutional and operational linkages in develop a monitoring system for foreign order to integrate the annual budgetary liability management.a process with (i) the macroeconomic forecasting and planning exercise; (ii) Sri Lanka development strategy action

Policy Actions to be Taken Prior to Policy Actions to be Taken Prior to Focus of Reform Policy Actions to be Taken Prior to First Tranche Release Second Tranche Release Third Tranche Release ERD to establish a web-based plans; and (iii) the public investment integrated aid management information program. system to strengthen monitoring of project implementation and improve realization of budgeted disbursement targets.

2. Strengthening fiscal Government to appoint to the Finance Finance Commission Act to be Government to extend the use of decentralization Commission (FC) a full-time submitted to Parliament. national standards and performance chairperson and a full-time secretary. indicators to PCs with the objective of Government to establish (i) a high-level strengthening service delivery system. biannual meeting (held in March and September) comprising secretary of FC to review intergovernment transfers finance, chairperson of FC, and PC criteria and report on the optimality of chief secretaries to discuss the current arrangement based on interprovincial and center-provincial principles of efficiency, transparency, issues, and (ii) quarterly working group simplicity, equity, and predictability. meetings comprising NBD and SAD directors general, a representative of FC to publish an annual report and FC, and PC deputy chief secretaries to detailed explanatory memorandum to discuss PCs’ implementation of Parliament outlining key resolutions of the high-level meeting recommendations and status of and on interprovincial and center- implementation of recommendations.a provincial issues.

Government to prepare plan to improve the efficiency and effectiveness of decentralized revenue and expenditure assignments with the aim to: (i) embed center-provinces’ revenue sharing into medium-term budget programming framework, and (ii) strengthen capacity building to successfully accommodate greater fiscal decentralization.

A

Government to undertake a study to 4 ppendix analyze preconditions for: (i) increasing capital expenditures transferred to PCs, and (ii) transferring funding from grant to partial loan financing. a Refers to non-tranche release actions. 51

52 Appendix 5

PROGRAM FRAMEWORK

Performance Monitoring Assumptions (A) Design Summary Indicators/Targets Mechanisms and Risks (R) GOAL

Strengthened public Improved overall Government reports on finances. performance assessed macroeconomic indicators, according to actual trends midyear fiscal position,1 achieved on revenue and bulletin of monthly expenditure sides under the expenditure and revenues, Government’s medium-term annual public expenditure, reform program compared and intrayear budget to quantified and time- adjustments bound targets in the Medium-Term Fiscal Budget speeches at Program (MTFP)1 national and provincial levels Fiscal discipline to be assessed against Budget estimates compliance with transparency and reporting Audited budget accounts requirements under the Fiscal Management Central bank annual report (Responsibility) Act Asian Development Bank Fiscal decentralization (ADB) project completion assessed in accordance report with increased own provincial share of Technical assistance (TA) expenditure and revenues reports in total provincial budgets International Monetary Key fiscal reforms are Fund (IMF) Poverty successfully identified, Reduction and Growth prioritized, sequenced, and Facility reports, recent built into agreed economic developments, frameworks, policies, staff reports strategies, and time-bound action plans World Bank public expenditure review

Purpose/Objectives

Necessary conditions for Tax and nontax revenue MTFP1 (A) Consolidation of peace improved public finances yields meeting time-bound process in place and functioning targets laid out in the Midyear fiscal position as intended MTFP1 report (R) Political stability might not be maintained Timeliness and effectiveness Final budget position report of budget preparation, (A) Improved security execution, and monitoring conditions based on medium-term budget framework. (R) Exogenous shocks to the economy are not More effective tax Medium-term public disruptive administration to be expenditure reports assessed against time- Commitment and bound targets in MTFP for consistency of Government overall and primary fiscal to develop and carry out deficits1 appropriate strategies and

Appendix 5 53

Performance Monitoring Assumptions (A) Design Summary Indicators/Targets Mechanisms and Risks (R) action plans for addressing priority reforms

Improved budget framework Budgets/supplementary (A) Continuous dialogue budgets with key stakeholders and skillful negotiations with Enhanced public expenditure Narrowing of gap between trade unions management control budget estimates and systems assessed in actuals as per audited (R) Government ownership accordance with targets in budget accounts of reform process might not MTFP including public debt be maintained. outstanding and debt service cost1 (A) Effective Fiscal Management Reform Greater fiscal discipline to Evolution of Government’s Program (FMRP) delivery. be assessed against time- public sector borrowing Timely delivery of bound targets in MTFP requirements equipment and other regular and timely complementary publication of key fiscal development assistance by indicators other development partners Strengthened fiscal Finance Commission decentralization to be annual report assessed against targets for provincial council (PC) share of general government expenditures and revenues

Outputs

Creation of a Approved cabinet policy Progress reports by head (R) Political commitment to modernized revenue paper on modernized of management revenue reforms might not administration revenue administration coordination team and be maintained. (November 2004) head project implementation unit

Ministry of Finance and ADB quarterly review (A) Effective Planning (MOFP) approves missions communications policy on and implements a task list revenue reforms is carried with clearly defined time- out bound actions to support the creation of the (A) Commitment of staff to Modernizing Revenue human resources (HR) Administration (MRA) enhancement. (November 2004) (A) Capacity, and authority Modernization Strategies of Revenue Board (RB) to for inland revenue, lead and introduce drivers customs, and excise of change. departments in place (November 2004)

Better tax collection/ MOFP submits to Amendments to VAT and (A) Stakeholders (including compliance and Parliament amendments to IR acts passed by employees) committed to strengthened systems Value-Added Tax (VAT) Parliament/Official Gazette institutional restructuring and Inland Revenue (IR) acts to introduce revenue (R) Stakeholders might enhancing measures seek legal injunctions (November 2004)

54 Appendix 5

Performance Monitoring Assumptions (A) Design Summary Indicators/Targets Mechanisms and Risks (R) Introduction of Economic 2005 budget (A) Institutional capacity is Service Charge (November sufficient to address 2004) constraints and adapt to new business processes Tax code updated and Tax code issued simplified (June 2006)

National Budget Budget circulars (R) Line ministries might A streamlined Budget Department (NBD) not conform to reduced procedure introduces effective use of spending expenditure ceilings for budget preparation of line (A) Training of key agencies (November 2004) government officials on ceilings framework is NBD and National Planning MOFP circulars carried out effectively Department (NPD) to establish budget and (A) Effective coordination planning guidelines for the between NBD and NPD purpose of unifying staff medium-term capital and recurrent budgeting procedures (June 2006) (R) Vested interests among Management of off- Inventory of special funds Budget report ministries benefiting from budget and expenditure finalized and disclosed these funds might not be borrowings strengthened (November 2004) contained

(R) Development partners’ Guidelines for classification MOFP circulars requests for creation of of off-budget liabilities as special funds might be actual or contingent for refused central Government (June 2006) (A) Collaboration and full disclosure from State Accounts Department (SAD) and line ministries

Improved budget Creation of fiscal policy Cabinet policy paper (A) Ensure continuity of estimates committee (FPC) FPC in light of significant responsible for formulating demands on directors fiscal policy framework, general monitoring fiscal performance, and ensuring discipline in budget preparation and execution (November 2004)

As part of budget Resolutions from minutes (A) Incentives for reliability preparation, MOFP’s NBD, of meetings and accuracy of budget Fiscal Policy Department targets (FPD), Research Expenditure and revenue Department (RD), and RB analysis reports (A) Upgrading of policy to meet, discuss, and reach research unit in MOFP agreement on annual and medium-term revenue estimates by source and based on reporting of critical assumptions for

Appendix 5 55

Performance Monitoring Assumptions (A) Design Summary Indicators/Targets Mechanisms and Risks (R) revenue projections (June 2006)

Fiscal decentralization Finance Commission (FC) Official Gazette process strengthened Act to be submitted to Parliament (A) Upgrading of Recommendations of institutional capacity of FC Government to establish (i) Committee for Capacity a high-level biannual Building in Fiscal meeting to discuss Devolution interprovincial and center- provincial issues and (ii) (R) PCs’ limited absorptive quarterly working group Strategic plan for the FC capacity meetings to discuss PCs’ implementation of resolutions of the high level meeting and on interprovincial and center- provincial issues (June 2006)

FC to review Minutes of meetings intergovernment transfers criteria and report on the optimality of the current arrangement (December 2007)

Activities3

RB to design, approve, Recruitment of HR and IT Performance reports of (A) Consulting teams are and begin consulting teams (March project implementation unit fielded promptly; effective implementation of (i) HR 2005) (PIU) RAMIS and existing development plan based institutional buy-in of on a more flexible, merit- Institutional development of Minutes of RB meetings reforms based, and competency- HR and IT departments in acquired employment revenue administration Annual report of the RB (A) Swift implementation of system; and (ii) an (March 2005–June 2006) international competitive integrated information Midterm project evaluation bidding (ICB) requirements technology (IT) Recruitment of specialized development plan staff (March–June 2005) (A) Easy integration (June 2006) between management Timely procurement of Consultants’ reports information system (MIS) Revenue Administration MOFP to establish a Management Information unique and unified System (RAMIS) (June taxpayer identification 2005–December 2006) (A) Effective collaboration number (TIN) (June with supporting institutions 2006) Publicity campaigns (ongoing) MOFP to introduce rolling 3-year forward Tax files (June 2006) (A) Analytical capacity at estimates on current and Revenue Departments capital budgets both at Bank registration forms upgraded the central and line (June 2006) ministry levels based on medium-term budgeting MTFP (November 2004) framework (MTBF) (November 2004)

56 Appendix 5

Performance Monitoring Assumptions (A) Design Summary Indicators/Targets Mechanisms and Risks (R) Key central ministries Budget circular (September Budget circular (A) Leadership in ministries including (i) Finance, (ii) 2004) to implement restructuring Transport, (iii) Health, with a view to successful (iv) Education, (v) SME, Budget estimates Budget estimates rationalization and (vi) Foreign Affairs (December 2005) to prepare and submit restructuring plans for (A) Availability of technical rationalization of expertise expenditure (June 2006) Memo from secretary of the Restructuring plans treasury (September 2005) approved (R) Full disclosure is compromised Restructuring plans Savings from restructuring submitted (December 2005) (A) Vested interests contained MOFP to consolidate Budget circular (September Budget circular listing nonstatutory funds 2006) approved closed/merged (R) Collaboration from through closures and funds Board of Investment (BOI) mergers Submission of inventory of is inadequate (December 2007) funds (November 2004) (A) Customs clearance Budget documents Official Gazette streamlined (November 2005) (A) Effective and prompt Government to amend Updating of tax code operations of Customs BOI Act to ensure all (June 2005) Department’s green card granting of exemptions scheme and other fiscal holidays MOFP-BOI consultations are fully consistent with (June 2005) (A) Prompt and effective the revised tax code external assistance for this (June 2006) Compilation of BOI component contracts (Aug 2005)

BOI circulars (June 2006)

External Resources Feasibility studies Feasibility reports (A) Ensuring compatibility Department (ERD) to completed (Aug 2005) of information systems establish a web-based Tender documents integrated aid Tender process completed (R) Aid management is management (December 2005) Physical inspection by ADB decentralized information system to review team strengthen monitoring of Effective implementation of project implementation MIS (April 2006) PIU reports and improve realization of budgeted Link with RAMIS (June disbursement targets 2006) (June 2006) FC is fully functional (June FC Act 2005) (A) Consistent FC annual reports understanding of centre- FC to publish an annual FC Act provides for clear provincial relations report and detailed and effective mandate to Parliamentary reports between FC and PCs explanatory FC (June 2006) memorandum to Parliament outlining key recommendations and status of implementation of recommendations on fiscal decentralization (December 2007)

Appendix 5 57

Performance Monitoring Assumptions (A) Design Summary Indicators/Targets Mechanisms and Risks (R) Inputs

Finance: RB’s performance FMRP performance (A) Effective delivery of ADB loan of $70 million evaluation of modernized monitoring system ADB inputs equivalent comprising revenue administration a program loan of $45 Project performance (A) Strong team of million from ordinary Executing Agency (EA) and monitoring system consultants capital resources (OCR) coordination management and two project loans of team (CMT) heads to (A) Coordination between $25 million equivalent submit quarterly reports on ADB’s sector divisions and for the Modernization of consultants’ performance. Project completion reports country office is acceptable the Revenue Administration and Head of CMT to endorse Evaluation office special (A) Sufficient resources Strengthening of the quality assurance upon reports and priorities assigned by Fiscal Management receipt of consultants’ ADB to program Institutions reports. implementation activities

Midterm reports

Progress reports

Consultant reports

ADB review missions

1 For breakdown of quantifiable targets see paras. 25 and 26 and Table 3 in Supplementary Appendix 5. 2 For breakdown of reports on fiscal matters, see Appendix 2. 3 Achievement of activities supported by TA will be further monitored according to detailed reporting requirements as indicated in para. 130.

58 Appendix 6

TASK LIST FOR THE MODERNIZATION PROGRAM OF THE REVENUE ADMINISTRATION Task Reference Description of Task Start Date Resources End Date RB 1—Internal audit units to be created at HQ levels in all 01/06/05 Chief 01/06/06 departments to report directly to the department heads Advisor/Internal Audit Advisor 1 Revise organizational structure to ensure unit reports directly to head 2 Revise functional work of unit to ensure it exclusively deals with internal audit of systems and staff 3 Develop operational procedures for the unit and position descriptions for staff 4 Develop an annual work plan for the unit 5 Train staff in internal audit techniques and staff irregularity investigation RB 2—A code of ethics must be prepared, published and 01/03/05 Chief 30/06/05 disseminated to all employees, tax practitioners and the public Advisor/Internal Audit Advisor 1 Draft a code of ethics 2 Publish the code through posters and leaflets available at all revenue dept offices 3 Each employee must be given a copy and must sign declaration of receipt thereof RB 3—Design and deliver a program of education for 01/07/05 Chief 31/09/05 employees on ethics and integrity Advisor/Internal Audit Advisor 1 Design short seminar for all employees 2 Train managers in delivery of seminar 3 Managers to deliver seminar to all employees RB 4—Selected employees to make a declaration of assets and 15/04/05 Chief 15/04/05 liabilities Advisor/Internal Audit Advisor 1 Design declaration of assets and liabilities 2 Develop confidential secretariat to oversee and store declarations for commissioner secretaries and senior officers 3 Develop procedures for all operational staff to submit ‘open’ declaration 4 IA staff to analyze declarations and make enquiries where necessary RB 5, 7, 8, 9—Create a dedicated customer service department 01/03/05 Chief 01/03/06 within each revenue department and a pilot joint ‘one-stop’ shop Advisor/Internal Audit Advisor 1 Revise operational structure to establish dedicated CSD 2 Staff Department with appropriate personnel and develop position descriptions 3 Develop policies and procedures for CSD 4 Train personnel in customer service techniques 5 Draft leaflets and brochures for public distribution 6 Initiate a proactive taxpayer/trader education program 7 Create a pilot one-stop shop in Colombo manned by staff from all departments 8 Create dedicated CS desks in all departmental offices dealing with the public 9 Create a call center to provide information and consultation to taxpayers RB 6—Develop and publish a taxpayer charter and customs 15/04/05 Chief 15/07/05 charter Advisor/Internal Audit Advisor 1 Draft taxpayer charter and customs charter 2 Publish in media and through posters at all offices open to the public RB 10—Establish consultative committees 01/06/05 Chief 01/12/05 Advisor/Internal Audit Advisor 1 Establish high-level consultative committees for tax, customs and excise to include membership from accounting, legal and trade bodies as well as from all revenue depts. 2 Feedback from committees to be passed to Modernization Teams RB 11, 12—Centralize issue of rulings and ensure 01/03/05 Chief 31/07/05 dissemination Advisor/Internal Audit Advisor 1 Create a unit responsible for the drafting and consolidation of all rulings 2 Unit to publish and disseminate rulings to all operational staff and make such available publicly

Appendix 6 59

Task Reference Description of Task Start Date Resources End Date RB 13, 14, 15—Develop a streamlined appeals process across 01/05/06 Chief 01/11/06 all revenue departments Advisor/Internal Audit Advisor 1 Establish an independent administrative panel to review appeals and make recommendation to Ministry of Finance 2 Develop procedures for a transparent and independent appeals process 3 Draft clear and comprehensive guidelines to be disseminated to all staff and public RB 16, 17—Establish a comprehensive and integrated 01/04/05 Chief 31/09/07 management information system Advisor/Internal Audit Advisor 1 Interview functional heads and establish information requirements 2 Review information inputs (declarations etc) and establish deficiencies 3 Revise informational inputs to correct deficiencies 4 Develop functional specifications for an automated MIS and supported by appropriate performance indicators RB 18—Establish or a comprehensive human resource 01/04/05 Chief 31/12/07 development program for inland revenue, customs, and excise Advisor/Internal departments Audit Advisor 1 Assess human resource need based on (i) greater integration of revenue administration functions; (ii) implication of automation of workplace; and (iii) competency-based, skills acquired staffing. 2 Consolidate benefits and payment into basic wages in a transparent manner. 3 Develop an HR development program to be approved by RB and MOFP with appropriated performance indicators. RB 19—Develop strategic plans for all revenue departments 01/04/05 Chief 01/08/05 Advisor/Internal Audit Advisor 1 Draft strategic plans for all functional units 2 Draft strategic plan for each Dept. 3 Prepare institutional performance indicators for each functional unit/Dept. RB 20—Establish a joint MOFP/Revenue Depts.’ group to 01/04/05 Chief 01/08/05 examine all proposed changes to the revenue legislation Advisor/Internal Audit Advisor 1 MOFP to establish a consultative group comprising representative from all revenue departments to ensure legislative changes are thoroughly considered for administrative input and are introduced on a timely basis HR 15, 16, 17, 18—Establish a revenue administration training 01/06/05 Chief 30/06/06 unit Advisor/Training Advisor/Tax Proc./Customs/IT Advisors 1 Establish core training team through competitive selection process 2 Establish joint training facility in Colombo to include IT laboratory 3 Develop core training curriculum by priority 4 Establish three regional training units 5 Complete training needs assessment for all staff within the revenue departments 6 Develop an interim training plan 7 Complete train-the-trainer courses 8 Develop an annual training plan for each department 9 Training Plan implemented IRD1, CD10, IT9—Create a single taxpayer database operating 01/04/05 Chief 30/06/06 on a unique and unified taxpayer identification number and Advisor/Customs used for all revenue activities Advisor/IT Advisor 1 Form a working group to improve the registration process in all departments, to identify the requirements for a separate trader database, and to develop an integrated master file of all revenue payers based on TIN

60 Appendix 6

Task Reference Description of Task Start Date Resources End Date 2 Cleanse the master file to update all records that are inactive and to ensure that the same individual or company is not registered twice Inland Revenue Modernization Program IRD 2, 12—Develop simplified tax processes and 01/06/05 Chief Advisor/IT 31/05/06 procedures Advisor/Audit/Collection/Tax Admin-D. 1 Create a Tax Procedures Simplification Unit 2 Draft and agree TOR, reporting requirements and deliverable schedule for the unit 3 Fully document all current processes 4 Develop new simplified processes making best use of automation IRD 14—To identify and register taxpayers operating 01/04/05 Chief Advisor/Tax 30/03/06 outside the tax net (non-filers) Proc./Audit/Collection/Tax Admin-D. 1 Create a RMU to draft procedures for non-filer program 2 Draft and agree program including the setting of targets for district offices 3 Review and agree program and select pilot sites 4 Implement program in pilot sites 5 Review program and revise if necessary 6 Roll-out program for all district offices to implement IRD 13—To identify and resolve taxpayer who fail to 01/04/05 Chief Advisor/Tax 31/03/06 furnish tax returns (stop-filers) Proc./Audit/Collection/Tax Admin-D. 1 RMU to draft procedures for stop-filer program 2 Draft and agree program making full use of current automation 3 Review and agree program and select pilot sites 4 Implement program in all offices with adequate automation 5 Roll-out program to all offices as automation improves IRD 4, 5, 6, 7, 9, 10—Review the audit process and 01/04/05 Chief Advisor/Audit/Tax 31/03/07 develop new streamlined and efficient procedures Admin.-D./Bus. Proc. 1 RMU to review and modernize the audit process within IRD 2 Draft and agree TOR, reporting requirements and deliverable schedule for the WG 3 Draft report with recommendations on, as a minimum: Audit selection methodology Case selection, assignment and management Coordinated audits 4 Review/approve recommendations 5 Draft new procedures to be included within a comprehensive Audit Manual 6 Implement new procedures including training IRD 5, 6—Improve the efficiency and effectiveness of 01/05/04 Chief Advisor/Audit/Tax 31/12/06 the LTU Admin.-D./Bus. Proc. 1 Audit of large taxpayers should be conducted in coordination with audit of company directors 2 Audit of large taxpayers should be done using a team concept 3 Provide training to auditors in the LTU for computer audit skills 4 Draft procedures to streamline the data entry system in the LTU to provide for timely data input which would permit effective monitoring of compliance 5 Develop and implement an electronic tax filing and transaction database for comparative purposes Regulate requirement for all taxpayers to report transaction values above a certain limit Develop a database of transactions to be used for audit selection and comparative purposes, ongoing review of transaction value Extend the procedure to all large taxpayers outside the LTU Customs Modernization Program CD 1, 2—Develop simplified customs processes and 01/09/04 Chief Advisor/Customs 30/09/06 procedures Advisor/Customs Advisor-D 1 Create a CMU headed by Deputy Director General that will review and recommend actions regarding tasks described below 2 Draft and agree TOR, reporting requirements and deliverable schedule for the TF 3 Fully document all current processes

Appendix 6 61

Task End Reference Description of Task Start Date Resources Date 4 Develop and implement new simplified processes making best use of automation CD 3—Facilitate the payment of customs duties and 01/09/04 Chief Advisor/Customs 01/02/06 fees at commercial banks Advisor/Customs Advisor-D 1 CMU to work in collaboration with departments, ICT Agency, and commercial banks to establish a payment process for taxes and customs duties and electronic transfer of that information 2 Draft and agree TOR, reporting requirements and deliverable schedule for the CMU 3 Develop action plan 4 Approve action plan 5 Develop procedures and necessary automated support 6 Institute new payments system CD 4, 5, 6, 8—Introduce a full risk management system for 01/08/03 Chief Advisor/Customs 31/08/05 cargo clearance including the introduction of a ‘star’ class Advisor/Customs facilitation program and other facilitation measures Advisor-D 1 CMU to take responsibilities for the following tasks. 2 Draft and agree TOR, reporting requirements and deliverable schedule for the CMU 3 Evaluate current operational test of ASYCUDA selectivity module 4 Develop selectivity structure using three channel system—red/yellow/green 5 Approve the Introduction of the new selectivity system as pilot 6 Evaluate pilot and after any amendment approve roll-out nationwide 7 Develop ‘star’ class facilitation program 8 Select traders to participate in star class program 9 Approve introduction of star class program 10 Devise procedures and policies for random spot-checks 11 Approve procedures and policies for random spot-checks 12 Introduce random spot-checks 13 Devise procedures and policies for preimport rulings 14 Approve procedures and policies for preimport rulings 15 Introduce preimport rulings CD 7—Improve the customs valuation database 30/09/04 Chief Advisor/Customs 30/06/06 Advisor/Customs Advisor-D 1 CMU to enhance valuation database 2 Draft and agree TOR, reporting requirements and deliverable schedule for the CMU 3 Develop content and procedures for maintenance for valuation database including specifications for automation 4 Approve development of valuation database 5 Complete development work 6 Roll-out valuation database to all Customs posts CD 11—Complete an equipment needs assessment 01/05/05 Chief Advisor/Customs 01/03/06 Advisor/Customs Advisor-D 1 Complete an equipment (non-IT) needs analysis for Customs with a draft report that includes – Identified needs in excess of current inventory Justification for equipment needs Specifications for identified equipment needs Estimated costs Identification of any subsequent training needs 2 Review and consider assessment and prepare budgetary projections accordingly CD 12—Complete a review of examination and 01/01/05 Chief Advisor/Customs 31/12/05 storage facilities and consider the introduction of Advisor/Customs Advisor-D DPs 1 CMU to review the examination and storage facilities currently in use 2 Draft and agree TOR, reporting requirements and deliverable schedule for the CMU 3 Draft report with recommendations to improve facilities and to include consideration on the use of DPs. The latter to include location, costs, and operational procedures for operation of decided feasible. 4 Review/approve recommendations

62 Appendix 6

Task End Reference Description of Task Start Date Resources Date Excise Modernization Program ED 1—Transfer the Excise Special Provisions Unit 01/03/05 Chief Advisor/Customs 01/10/07 within Customs to the Excise Department Advisor 1 Create a EMU 2 Draft and agree TOR, reporting requirements, and deliverable schedule for the EMU 3 Draft report from WG with analysis and recommendations 4 Evaluate/approve recommendations 5 Fully integrate staff, resources, and work within the Excise Department ED 3—Develop simplified excise processes and 01/03/05 Chief Advisor/Customs 30/09/07 procedures Advisor/Customs Advisor-D 1 EMU to review and simplify excise tax procedures 2 Draft and agree TOR, reporting requirements, and deliverable schedule for the EMU 3 Fully document all current processes 4 Develop new simplified processes making best use of automation 5 Review and endorse new procedures as and when completed Legislative Issues Draft a new Administrative Code 01/03/05 Tax Lawyer/Attorney- 01/01/07 D/Chief Advisor/Tax Proc. 1 Complete a comparative study of tax administration procedures in all the relevant statutes 2 Draft a uniform Tax Administration Code 3 Review and approve draft with revenue dept. and other stakeholders 4 Review/approve draft 5 Submit draft to MOFP/Cabinet/Parliament 6 Draft regulations and rules for implementation 7 Review/adopt implementing procedures CD 20—Review and revise current customs legislation 01/06/05 Customs/Customs- 01/06/06 D/Attorney-D/Chief Advisor 1 CMU to oversee customs legislation 2 Review and approve draft amendments 3 Submit draft to MOFP/Cabinet/Parliament 4 Draft regulations and rules for implementation 5 Review/adopt implementing procedures ED 7—Review and revise current excise legislation 01/06/05 Attorney-D/Chief 01/06/06 Advisor/Tax Proc. 1 EMU to oversee the excise legislation 2 Review and approve draft amendments 3 Submit draft to MOFP/Cabinet/Parliament 4 Draft regulations and rules for implementation 5 Review/adopt implementing procedures ASYCUDA = Automated System for Customs Data, CD = Customs Department, CMU = customs modernization unit, CS = customer service, CSD = customer service department, DP = dry ports, ED = Excise Department, EMU = Excise Modernization Department, HR = Human Resources, HQ = headquarters, IA = implementation agency, ICT = information and communication technology, IRD = Inland Revenue Department, IT = information technology, LTU = large taxpayer unit, MIS = management information system, MOFP = Ministry of Finance and Finance, RB = Revenue Board, RMU = Revenue Mobilization Unit, TIN = tax identification number, TOR = terms of reference, WG = working group. Source: Asian Development Bank.

Appendix 7 63

LIST OF INELIGIBLE ITEMS

1. Loan proceeds will finance the foreign currency expenditures for the reasonable cost of imported goods required during the Fiscal Management Reform Program.

2. No withdrawals will be made for the following:

(i) expenditures for goods (included in the following Standard International Trading Commodity chapters or headings):

Table A7: Ineligible Items Chapter Heading Description of Items 112 Alcoholic beverages 121 Tobacco, unmanufactured; tobacco refuse 122 Tobacco, manufactured (whether or not containing tobacco substitute 525 Radioactive and associated materials 667 Pearls, precious and semiprecious stones, unworked or worked 897 897.3 Jewelry of gold, silver or platinum-group metals (except watches and watch cases) and goldsmiths’ or silversmiths’ wares (including set gems) 971 Gold, nonmonetary (excluding gold ore and concentrates) 718 718.7 Nuclear reactors, and parts thereof, fuel elements (cartridges), nonirradiated for nuclear reactors Source: United Nations.

(ii) expenditures in the currency of the Borrower or of goods supplied from the territory of the Borrower;

(iii) payments made for expenditures incurred more than 180 days before the effectiveness date of the loan;

(iv) expenditures for goods supplied under a contract that any national or international financing institution or agency will have financed or has agreed to finance, including any contract financed under any loans from the Asian Development Bank;

(v) expenditures for goods intended for a military or paramilitary purpose or for luxury consumption; and

(vi) expenditures for pesticides categorized as extremely hazardous or highly hazardous in classes I-a and I-b, Classification of Pesticides by Hazard and Guidelines to Classification.

64 Appendix 8

REVENUE ADMINISTRATION MANAGEMENT INFORMATION SYSTEM

1. The current information technology (IT) systems in the departments are 8–10 years old and were developed in an independent fashion with no view to integration. The Revenue Administration Management Information System (RAMIS) is now proposed to fully integrate and comprehensively cover the use of information and communications technology (ICT) to improve revenue mobilization in Sri Lanka. The fully integrated and comprehensive RAMIS will help the three revenue departments—Inland Revenue Department (IRD), Customs Department (CD), and Excise Department (ED)—in enhancing effectiveness, efficiency, and transparency of revenue administration through the use of new technology. RAMIS aims to help the revenue departments develop an electronic organization system (also known as ‘e-organization’) and ensure that the standard is maintained on an ongoing basis. RAMIS will also provide secure, efficient, and responsive systems for the users in the departments and for the clients of the departments. In other words, RAMIS will also promote voluntary compliance among taxpayers through, among others, wide information dissemination modes and a fully integrated one-stop shop for taxpayers. The integrated RAMIS will lay down synergies in revenue administration across departments, which in turn should enable tax collectors to cross-check tax information within and across departments.

2. The tax data and information from each of the three revenue departments and the Board of Investment (BOI) will be integrated in a common platform. These data and information include registration information, taxpayer accounting, and tax identity numbers. Selected information from the common platform will be available to authorized tax officials in each of the three revenue departments. (See the flow chart on information flow under RAMIS below.) A master plan will be developed to determine what functions are common and which are unique to each department, and it will identify a prioritized plan for development. During the reengineering process, the systems requirements will be clearly defined. Existing systems were built based on processes available at the time and are as inefficient as the processes themselves. The functionality of all systems must be expanded and in the case of the core systems, all tax types should be included.

Figure A7: Revenue Administration Management Information System

Common Platform Treasur y (Public Finance Accounting And Financial Registration Information Commission/ MIS) Taxpayer Accounting Provincial Council Taxpayer Identification Number Inland Revenue Dept Large Taxpayer Unit BOI System Customs Dept VAT, Income Taxes, etc.

ASYCUDA/EDI Excise Dept Tax Identification Number Customs Duties VAT on Imports Excise Tax Excises on Imports, Etc. Banks

ASYCUDA = Automated System for Customs Data, BOI = Board of Investment, EDI = Electronic Direct Interface, MIS = management information system, VAT = value-added tax. Source: Asian Development Bank.

Appendix 8 65

3. In each of the three departments, a modernization unit will be established to spearhead revenue modernization and mobilization reforms. The Revenue Modernization Unit (RMU) to be established in IRD will design and implement the reforms such as maintenance of tax systems, data entry of tax returns, hardware, and network support. The Customs Modernization Unit (CMU) to be established in CD will support the Automated System for Customs Data (ASYCUDA) system, hardware, and network support, and develop and support cargo control systems. The Excise Modernization Unit (EMU) will be established in ED will design and implement the administrative reforms of excise tax collection.

4. While seeking to introduce the new comprehensive and integrated ICT system, the RAMIS will maintain and update the existing systems used in each of the three revenue departments. The major existing IT systems include the ASYCUDA and Electronic Direct Interface (EDI) in the CD. Apart from the ASYCUDA system within CD, the existing IT systems provide a very limited range of support for revenue administration. Within the IRD there are separate systems to process and account for tax returns and payments for different types of taxes. It is not possible to obtain a clear indication of a taxpayer’s account with regard to the taxes within the tax administration that it controls. Therefore, it is also not possible to obtain critical information needed for auditing the status of the taxpayer who deals with all three revenue departments. In addition to the stand-alone IT systems, much important tax information is not entered into the system at all. For example, all import value-added tax information is transferred from CD to IRD in an ad hoc fashion without being systematically entered into the IT systems of the two departments.

66 Appendix 9

TERMS OF REFERENCE FOR THE STRENGTHENING OF THE FISCAL MANAGEMENT INSTITUTIONS PROJECT

A. Objectives and Scope

1. The primary objective of the Project is to support the key institutions responsible for public finance across various activities in order to improve fiscal performance. The secondary objective of the Project will be to support the implementation of the policy component under the Fiscal Management Reform Program (FMRP). The thrust of the Project will focus on developing new systems and procedures, which in combination with the procurement of the Revenue Administration Management Information System (RAMIS) and ancillary computer equipment, under the Modernization of the Revenue Administration project, will enhance capacity, efficiency, and effectiveness of the revenue and budget administrations.

2. The specific areas to be covered under the terms of reference of the project loan include strengthening skills and know-how at: (i) the three revenue departments of inland revenue, customs, and excise departments; (ii) National Budget Department (NBD); (iii) State Account Department; (iv) Finance Commission (FC); and (v) other government institutions linked to public finances and to be defined at a later stage. A Revenue Board (RB) was established to coordinate the tasks to be carried out by the three revenue departments under the Modernizing of the Revenue Administration (MRA) component. In addition, an Interagency Implementation and Coordination Committee (IICC) for the Project will be established to oversee the implementation of both the program and project components of the FMRP.

B. Outcomes

3. The Project is expected to support activities leading to the following outcomes:

(i) Modernizing Revenue Administration (under Appendix 4, A. Improving Effectiveness of Tax Administration comprising Supporting the creation of the Revenue Board and Strengthening tax collection and tax compliance)

(a) A human resource development plan (b) An integrated information technology (IT) development plan (c) Draft legislation on taxpayer bill of rights (d) Revenue forecast from both (i) macroeconomic indicators and (ii) tax bases that take into account changes in tax policy and administration

(ii) Fiscal Management Institutions

National Budget Department (under Appendix 4, B. Improving the Budget Framework, C. Improving Public Expenditure Management and Control Systems, and D. Strengthening Fiscal Discipline)

(a) Actuarial analysis of pension and other contingent liabilities (b) Feasibility study of the creation of a provisioning fund to liquidate government liabilities (c) An integrated management information system (MIS) linking foreign aid related government funding to the budget (d) A liability management system that registers all obligations in the budget

Appendix 9 67

(e) An integrated MIS linking the budgetary process to the Public Investment Program (PIP) and macroeconomic estimates

(iii) State Account Department (under Appendix 4, C.2. Improving Budgetary/Cash/Asset Management System and D.1. Improving Budget Estimates)

(a) Government Asset Management System (b) Migration to integrated accruals-based accounting system (c) Commitment monitoring mechanisms

(iv) Finance Commission (under Appendix 4, E. Improving Fiscal Coordination comprising E.1. Strengthening fiscal/macroeconomic coordination and E.2. Strengthening fiscal decentralization)

(a) Intergovernment public resource transfer formula (b) Methodology for integrating performance indicators within revamped public goods and services delivery framework (c) Annual reports of provincial councils (PCs) and FC

C. Inputs

4. The following provides some indicative and preliminary terms of reference under the Project:

Component 1: Project Implementation and Coordination

1.1. Project Implementation Unit

Objective 1: Provide procurement and coordinating service on project equipment 1

1. The project manager will manage the team of consultants, submit regular reports to Asian Development Bank (ADB), and provide back-up support during the periods of absence of the coordinator from the duty station. 2. Draft specific procurement notices and local press notices for publication by ADB, and issue copies of the notices to eligible firms as being interested in this project or type of consultancy including undertaking a feasibility study of the RAMIS. 3. Receive and review the expressions of interest and prepare short-list for the Government and facilitate the formal approval of the short list by both the Government and ADB. 4. Prepare request for proposal documents, facilitate their approval by the Government and assist ADB in the processing of these documents and receive proposals from ADB. 5. Facilitate the technical evaluation of proposal and reports by the Government including advising on contractual issues and potential areas in the proposal.

Objective 2: Manage oversight of the procurement and consulting inputs pertaining to the Modernization of the Revenue Administration (MRA) Project

1. Provide procurement and consultancy management services under the MRA Project.

1 The preparation for the procurement of this component will be subject to advance action.

68 Appendix 9

2. Establish the procedures, templates, quality control measures and reporting on inputs of Project consultants under the MRA Project. 3. Specify the communicating and reporting requirements between the consultants, IICC, and ADB. 4. Assist IICC in monitoring performance of the advisors, assistant advisors, and consultants and ensure quality inputs including performance reports are timely produced, approved, and submitted to ADB. 5. Provide additional services related to advertising, recruiting, mobilization, and demobilization of the consultants as required by IICC. 6. Ensure all procurement complies with ADB’s procurement guidelines. 7. Monitor commitments and disbursements against the project budget and ensure that all contracts and project running costs are in accordance with the budget and prepare regular reports for IICC and ADB.

1.2. Management Coordination Team

Objective: Manage the consultants in support of project-related activities

1. Specify the communicating and reporting requirements between coordinators, ADB, and IICC. 2. Assist the IICC in monitoring performance of the advisors, assistant advisors, and consultants and ensure quality inputs including performance reports are timely produced, approved, and submitted to IICC and ADB. 3. Facilitate the initial request from relevant departments in the treasury and assist with preparation of terms of reference (TOR), approval of the TOR by ADB, and liaise between ADB and IICC over any issue arising. 4. Establish the procedures, templates, quality control measures and reporting on inputs of Project consultants. 5. Specify the communicating and reporting requirements between coordinators, ADB, and IICC. 6. Assist IICC to monitor performance of the advisors, assistant advisors, and consultants and ensure quality performance reports are timely produced, approved, and submitted to IICC and ADB. 7. Provide additional services related to advertising, recruiting, mobilization, and demobilization of the consultants as required.

Component 2: Modernizing Revenue Administration

Objective 1: Provide applications to support e-enabled, IT-integrated revenue departments

1. Provide integrated core systems to support registration, general ledger and accounts, case management and MIS for all revenue departments. 2. Provide noncore systems to support unique requirements in each department, ensuring that these systems are integrated wherever possible to the core systems (including Automated System for Customs Data [ASYCUDA]). 3. Provide administrative systems to support the functions of payroll, accounting, and human resources ensuring integration with MOFP budget and expenditure systems

Appendix 9 69

Objective 2: Provide technology to support e-enabled, integrated revenue departments

1. Develop and implement an integrated communications strategy. 2. Procure and install the computer equipment required for the set up of the integrated ICT systems in headquarters of the revenue departments. 3. Procure and install equipment for the revenue departments and associated departments based on the requirements defined in reengineering.

Objective 3: Provide short term measures to enhance revenue mobilization

1. Improve processes in IRD for reporting, returns processing, user access, and cleanse master files. 2. Support revenue mobilization activities in the pre-project preparatory plan (PPP) that require IT.

Objective 4: Strengthen ICT capacity

1. Develop an ICT master plan including key components such as 1) the technology strategy; 2) application strategy which is a prioritized list of systems and applications; 3) implementation strategy including a timeline and resource requirements; and 4) an information management strategy that will ensure that the investment in systems is maintained over time. 2. Create and staff the organization based on the master plan direction regarding outsourcing of functions, the capabilities of existing staff and staffing and training activities. 3. Establish standards and procedures for development, project management, quality assurance, procurement, and reengineering. 4. Conduct training for staff in ICT. 5. Establish legal framework for e-initiatives.

Component 3: Fiscal Management Institutions

3.1 National Budget Department

1. Analyze and estimate the size of total contingent liabilities created by both old and new Pensions systems and other contingent liabilities. 2. Establish actuarial balance analyses of the greatest sources of contingent liabilities. 3. Prepare a feasibility study for funding and liquidating government liabilities. 4. Prepare guidelines, procedures, and framework including information flow chart for registering all obligations and commitments in the budget. 5. Prepare an integrated MIS linking the budget process to the public investment program (PIP) and macroeconomic estimates.

3.2 State Accounts Department

1. Review the feasibility study of the proposed Public Accounting and Financial Management Information System (PAFMIS).2

2 The identification and selection of the consultant to undertake this activity will be subject to advance action.

70 Appendix 9

2. Provide advice to SAD on the implementation of the proposed PAFMIS against the requirements of the treasury. 3. Provide suggestions on how best the proposed PAFMIS can integrate additional functions at a later stage. 4. Prepare a study on systems of treasury and payment management and cash management. Recommend how to improve the existing systems. 5. Capacity building for MIS regarding treasury and payment management system

3.3 Finance Commission

1. Review local revenue mobilization capacity for all existing and potential sources of local revenues. 2. Review budget transfer criteria based on principles of efficiency, transparency, simplicity, equity, and predictability. 3. Capacity building for PCs on tax collection, tax-related data entry and maintenance, and budget preparation and implementation. 4. Construct indicators for quantity and quality of local goods and service delivery. 5. Prepare guidelines and methodology to extend the use of national standards and performance indicators at PCs with the objective of strengthening service delivery system. 6. Prepare guidelines for standardizing the content of PCs’ annual reports and for outlining FC’s annual report and recommendations that contain sufficient information necessary for formulating greater fiscal decentralization strategies.

Appendix 10 71

ORGANIZATION CHART OF THE FISCAL MANAGEMENT REFORM PROGRAM IMPLEMENTATION AND COORDINATION ARRANGEMENTS

Management FMRP Interagency Implementation and Coordination Team Coordination Committee (mainly consulting services-based and administrative)

FMRP

Project Strengthening of the Modernization of the Implementation Unit Fiscal Management Revenue Administration (mainly Institutions Project Project procurement-based and substantive)

Revenue Board

FMRP = Fiscal Management Reform Program

PLANNED SUMMARY PROJECTS IMPLEMENTATION SCHEDULE 72

Year 1 (2005) Year 2 (2006) Year 3 (2007) 11 Appendix Activity Date 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6* 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12** 1. Key Output Milestones Human Resource Development Plan Integrated Revenue Administration MIS Introduction of Resulted-Based Indicators Feasibility Study for Liquidating Liabilities TIN Database Integrated Public Finance MIS Asset Management System Commitment Monitoring Mechanism Circulars Review and Consolidation Tax Exemptions Reduction Finance Commission Act Intergovernmental Transfer Formula Finance Commission Annual Report 2. Team Fielding of Core Team 15-Mar-05 X Inception X Fielding of Sub teams 15-Oct-05 X 3. Consulting Services and Months1 Procurement Component 1 Project Manager 20 Revenue Administration Specialist 12 Procurement Specialist 16 Component 2 Revenue Advisors (3) 3* 4 Revenue MIS Specialist 12 Human Resource Specialist 12 ICT Specialist 16 Component 3 Budget Specialist 20 Public Financial Management 20 Specialist Subnational Government Finance 20 Specialist

Continued on next page Planned Summary Projects Implementation Schedule—Continued

Year 1 (2005) Year 2 (2006) Year 3 (2007) Activity Date 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6* 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12** 4. Reporting PIU Quarterly Reports Quarterly X X X X X X X X X X X X Project Inception Report 15-Apr-05 X Project 1st Review Report 31-Dec-05 X Project 2nd Review Report 31-Jul-06 X Interim Report 30-Jun-07 X Final Report 30-Sep-07 X MIS = management information system, TIN = tax identification number, ICT = information communication technology, PIU = project implementation unit. 1 Based on the level of effort of the international consultants. Note: *denotes the tentative date for the second tranche release, and ** denotes the tentative date for the final tranche release. A ppendix 11 11 ppendix 73

74 Appendix 12

INDICATIVE PROCUREMENT PACKAGES ($ million)

Total Procurement Package Units Cost Mode 1. Package 1—Revenue Administration MIS a Information and Communications Technology 9.5 Office equipment/Business Machines 3.5 Subtotal 13.0 ICB

2. Package 2—Finance Commission Information and Communication Technology 0.5 Office equipment/Business Machines Subtotal 0.5 ICB/DP

3. Package 3—Revenue Administration MIS a Office equipment/Business Machines 0.5 Subtotal 0.5 ICB/DP

Total 14.0 DP = direct purchase, ICB = international competitive bidding, MIS = management information system. a Investment under the project loan for revenue departments and relevant departments of the treasury. Source: Asian Development Bank.

Appendix 13 75

SUMMARY POVERTY REDUCTION AND SOCIAL STRATEGY

A. Linkages to the Country Poverty Analysis

Sector identified as a national priority in country Sector identified as a national priority in poverty analysis? Yes country poverty partnership agreement? Yes

Contribution of the sector/subsector to reduce poverty in Sri Lanka:

The Fiscal Management Reform Program (FMRP) contributes to poverty reduction through promoting good governance by improving effectiveness of tax administration, budget framework, expenditure management control systems, fiscal discipline, and fiscal decentralization framework. The FMRP will strengthen macroeconomic stabilization by reducing the country’s imbalances, thereby supporting higher and more sustainable growth prospects. The lower the budget deficit is, the less intense the competition for resources between public and private sector, thereby reducing the price of borrowing, i.e., the interest rate. The private sector can obtain more resources at lower cost to expand investment and production. Through a better accessibility to such resources, the private sector can actively and efficiently generate economic growth and provide employment opportunities for the poor. This is expected to contribute to poverty alleviation. In addition, various activities such as fiscal decentralization and performance monitoring should provide greater effectiveness of spending assignments, especially for those segments of the population that are more reliant on public goods and services. Finally, the review of intergovernment transfers under the fiscal decentralization component of the FMRP should result in a revised formula that provides greater emphasis on equity considerations such as income per capita.

B. Poverty Analysis Targeting Classification: General Intervention

What type of poverty analysis is needed? With no reforms, not only the poor of the present generation will increasingly suffer from declining access to public goods and services but also the poor of future generations due to the resulting transfer of the large and uncontained debt burden. The FMRP assists the Government in the area of fiscal consolidation and structural reforms. Under the Government’s reform program, fiscal consolidation, resulting in cutbacks on recurrent expenditures in the social sector, may affect the poor in the short run. However, measures to increase the effectiveness of these expenditures and outright increases in capital expenditures in the social sector more than offset the current expenditure cutbacks over the medium term. In addition, the Government is committed to protecting public spending on services most important to the poor and indeed having public spending better focused on the needs of the poor. Fiscal consolidation is critical in order for the Government to overcome the serious problem of public debt crisis.

Under the FMRP, from the revenue side, cutting down on tax exemptions combined with the removal of economic distortions arising from an uneven tax system is expected to generate greater fiscal revenues. On the expenditure side, the FMRP will support the improved efficiency of public spending and greater public savings through: (i) restructuring efforts of departments, (ii) removal of duplication across governments and ministries, and (iii) greater transparency in the use of funds including special funds. The restructuring efforts may lead to some labor shedding, however this should be offset by more effective use of expenditures and social transfers.

In line with fiscal consolidation efforts supported by the FMRP and overall improved macroeconomic stabilization, the gross domestic product (GDP) growth outlook under the government economic development strategy is estimated to increase to 6.4% per annum over the medium term. This is expected to increase income per capita from $838 in 2001 to $940 in 2007. Similarly, inflation, a tax falling disproportionately on the poor, is projected to decline from 6.3% in 2003 to 5% in 2007. More importantly, unemployment is forecast to fall from 8.4% in 2003 to an estimated 7% in 2007.

76 Appendix 13

C. Participation Process

Is there a stakeholder analysis? Yes No Stakeholder analysis: A poverty reduction strategy developed over the years 1999–2002, which provides a foundation for the designing of the reform program, sought widespread participation and consultation with stakeholders and interest groups. The Government has undertaken extensive stakeholder consultation in the elaboration of the 2005 budget. The Government is currently in the process of updating the poverty reduction strategy.

Is there a participation strategy? Yes No Participation strategy: The participation strategy is applicable for the project component of the program loan, supporting to modernization of the revenue administration. The strategy is to maximize the involvement of and communication with labor unions of Inland Revenue Department, Customs Department, and Excise Department in the process of change. This is to be done by identifying substantive issues common to employees’ concerns and that would be dealt with in the project. The project will also provide the basis for an internal and external communication strategy. Under this strategy, revenue reform project would have transparent mechanisms for interaction within the agencies and with the Government to move reforms forward and to mitigate public and inter- and intra-agency conflicts.

D. Gender Development Strategy to maximize impacts on women: Strategy to maximize impacts on women: Not applicable. Recruitment of new staff for the revenue administration is merit-based. However, the human resources strategy is to ensure that women will not be disadvantaged by the project because of economic, political, or sociolegal discrimination. Has an output been prepared? Yes No

E. Social Safeguards and other Social Risks Item Significant/ Plan Not Significant/ Strategy to Address Issues Required None Resettlement Significant Not applicable. The interventions under the FMRP Full will not require any element of land acquisition. Not significant Short

None None Indigenous Significant Not applicable. The indigenous peoples will not be Yes Peoples affected by the interventions under the FMRP. Not significant No

None Labor Significant There is no voluntary retirement scheme as part of Yes institutional reforms under this program. Not significant No

None Affordability Significant Not applicable. Yes

Not significant No

None

Other Risks/ Significant Not applicable. Yes Vulnerabilities Not significant No

None

Appendix 14 77

DEVELOPMENT COORDINATION MATRIX

A. Introduction

1. In assisting the Government in strengthening public finances, the Asian Development Bank (ADB) and other development partners have provided relevant technical and financial assistance. ADB has provided technical assistance including (i) Public Expenditure Management Systems (PEMS)1, and (ii) Public Sector Resource Management (PSRM).2 The International Monetary Fund (IMF) has provided policy recommendations to achieve overall macroeconomic stability including fiscal stability through the Poverty Reduction and Growth Facility-Extended Fund Facility (PRGF-EFF) arrangements to stabilize foreign reserves. World Bank has provided assistances in, among other things, Country Financial Accountability Assessment (CFAA) study and will provide technical assistance in public expenditure review and public debt management. Other assistance includes United Nations Development Programme (UNDP) support for management information system (MIS) linkup between Finance Commission (FC) and Provincial Councils (PCs) and United States (US) Treasury Department support for budget operations (see Figure A.14 Structure of Reforms and Coordination).

B. Asian Development Bank Technical Assistance

2. PEMS has strengthened the preparation of the budget by introducing means to strengthen planning and programming including greater integration between the fiscal and budget departments. It has also strengthened expenditure controls resulting from the PEMS’ prior work on budget classification. The budget monitoring system has also been strengthened by introducing, on a pilot basis, elements of performance monitoring in land transport.

3. PSRM had been setting the groundwork for the creation of the Sri Lanka Revenue Authority (SLRA). In view of the change in policy thrust following the elections in April 2004, an implementation plan was designed based on the concept of the Modernization of the Revenue Administration (Appendix 6). Key inputs under the TA include the preparation of a blueprint for the modernized revenue administration (MRA) including a supporting time-bound action plan.

C. International Monetary Fund Poverty Reduction and Growth Facility-Extended Fund Facility Arrangements

4. On 18 April 2003, IMF approved a 3-year program under the Poverty Reduction and Growth Facility (PRGF) and the Extended Fund Facility (EFF) arrangements, in an amount of SDRs269 million under PRGF plus SDR144.4 million under EFF.3

5. The PRGF-EFF program aims to assist in restructuring the economy with the main focus on fiscal consolidation, given Sri Lanka’s high debt burden. During the 3-year period, the Government and IMF agreed on program monitoring and review that consists of a set of quantitative performance criteria and a structural performance criterion and benchmarks. Under the program, specific ceilings and floors for fiscal indicators were set including (i) net domestic financing of the central government budget, (ii) primary fiscal deficit, (iii) central government revenue, (iv) net claims on government by the banking system, and (v) credit to public

1 TA 3301-SRI commenced in January 2000 and was finalized in July 2003. 2 TA 3906-SRI commenced in November 2002 and will be finalized in September 2003. 3 The approved amount of PRGF arrangement is SDR269 million (65 % of quota). That of EFF arrangement is SDR 144.4 million (35% of quota).

78 Appendix 14 corporations by the banking system. These targets were derived from the medium-term fiscal targets to reduce the budget deficit, on average, by about 1.25% of GDP per year, i.e., from 8.9% of GDP in 2002 to 7.5% for 2003 and 4.3% by 2006. By 2006, the debt-to-GDP ratio was targeted to reach 84% and interest rate payments to amount to 5.5% to GDP. To date, IMF has disbursed only SDRs38.4 million from the PRGF and SDRs20.7 million from EFF.

6. The second tranche of the PRGF was originally due in December 2003. However, following political developments linked to the president’s dismissal of two cabinet ministers in November 2003, the Government’s resolve to pass through critical legislation was affected and consequently the second tranche was suspended. However, following the April 2004 elections and the formation of a new Government, the Government has prepared its Economic Policy Framework, including key macroeconomic and sector policies. The Government has met twice with IMF, once at the sideline of the IMF/World Bank Annual Meetings in early October 2004 and the second time during an IMF consultation mission to Colombo on 18–22 October 2004. This has led to preliminary policy dialogue on the Government’s macroeconomic and medium- term fiscal programs in preparation for the 2005 budget. Looking forward, the Government will be finalizing its economic policy framework action plans and will be presenting its findings to development partners in early 2005. In the circumstances, a revised PRGF is not likely to be renewed before early 2005.

D. World Bank

7. During the reform period, the World Bank has planned to provide nonlending technical assistance in the public sector through a continuous and yearly updated public expenditure analysis and country financial accountability assessment (CFAA).4 The public expenditure analysis for 2003 commenced in August 2003. The CFAA was finalized in June 2003.

8. CFAA is a tool designed to assess the urgent reforms needed to arrest further deterioration in public financial accountability. The assessment covers several areas including (i) parliamentary control of public funds, (ii) public financial management and reporting practices at the three levels of government including public enterprises, (iii) public audit, (iv) legislative scrutiny of public funds, and (v) rights to information. CFAA suggests two broad areas in response to address the problem. The first area is institutional reforms. New legislation and rules are needed to address institutional issues. The second area is capacity building for training and improving organizational efficiency and effectiveness.

9. In terms of lending program, the World Bank approved on 17 June 2003 a $125 million Poverty Reduction Support Credit (PRSC) for Sri Lanka that built upon Regaining Sri Lanka. PRSC aimed at strengthening governance in the public sector, implementing reforms in financial management and accountability, and addressing vital issues in environmental management. PRSC is a new lending instrument of the World Bank’s International Development Association, designed to assist with the policy and institutional reforms that governments have formulated to implement their own poverty reduction strategies. Unlike earlier policy reform support instruments, PRSC is placed firmly within the Government’s 3- to 4-year program, and a series of such credits over time is envisaged. Note that PRSC carries no policy conditions, since it recognizes progress achieved to date.

4 Country Assistance Strategy of the World Bank Group for the Democratic Socialist Republic of Sri Lanka. World Bank. April 23, 2003.

Appendix 14 79

10. It was envisaged that a second PRSC would follow in 2004, a third in 2005, and a fourth in 2006 in the amount of $90 million each year. The 2004 PRSC expected to focus on civil service reforms is now delayed in the wake of the change of Government and in anticipation of the new Poverty Reduction Strategy Paper. The PRSC carries no interest and 0.75% service charge, maturing in 40 years with a 10-year grace period.

E. Others

11. The United Nations Development Programme has provided assistance for MIS linkup between PCs and FC, to facilitate the flow of financial information across sublevels of government. Additional assistance will be required for strengthening FC’s capacity.

12. The US Treasury Department has also provided a budget advisor to the Ministry of Finance for a 2-year assignment beginning in mid-2003, mostly focusing on performance budgeting and operational support.

13. The Government of Korea is providing the Government of Sri Lanka a loan for the procurement of a Public Accounting and Financial Management Information System (PAFMIS). According to the feasibility study, the system will include three major procedures: (i) preparation of budget estimates (budgeting), (ii) distribution of treasury (warrant), and (iii) consolidation of expenditure summaries (accounting).

Figure A.14: Structure of Reforms and Coordination 80 ISSUES Large fiscal deficits and excessive debt The Problem

The Solution Fiscal consolidation compatible with medium term fiscal sustainability 14 Appendix

Government’s Reform Program Develo pment Strategy Government’s Economic Policy Framework

Fiscal Framework Fiscal Management (Responsibility) Act

Taxation Policy Overhaul of Tax Policy

Revenue Measures Modernization of the Revenue Administration

ADB AND OTHER ASSISTANCE Goal To Strengthen Public Finances

Policy Target Fiscal Management Sector Development

Constrained Revenue Collection Weak Budget Program and Expenditure Control Limited Effective Fiscal Constraints Framework Decentralization

ADB IMF ADB IMF A DB UNDP

Policy Component • Creation of a • Enabling • Establish • PRGF fiscal targets • Improve • Construct the Revenue Board legislation Medium-Term coordination MIS • HR and IT • Modernization Budget • Institutional Framework development strategies for Framework World Bank strengthening linking strategies for Inland • Introduce of Finance Provincial MRA Revenue and expenditure • Public Expenditure Review by Commission Councils with • Implement Customs ceilings end 2004. • Review Finance taxpayer identity • Improved tax • Restructuring of • Country Financial criteria for Commission number auditing key ministries Accountability Assessment inter- governmental • Introduce risk • Consolidate non A

management statutory funds transfers 13 ppendix system for cargo and bring into United States Treasury clearance at budget Customs Dept. • Introduce output • Performance budgeting and • Introduce indicators and operations support electronic tax filing eventually

for LTU taxpayers performance 80 indicators Government of Korea

• Treasury Management Information System

PROJECTS

Project 1 Modernization of the Revenue Modernizing Administration: Revenue Finance Commission Administration

RAMIS/

Equipment Equipment

Project 2 Strengthening of the Fiscal Modernizing Finance National Budget State Accounts Others Management Institutions: Revenue Commission Department Department Administration

Capacity building To be determined Consulting Capacity building for Capacity building for the and may include services across the strengthening of for the strengthening of enhanced debt a range of systems and strengthening of systems and management, and activities procedures of fiscal systems and procedures of improving fiscal decentralization procedures of cash management analysis budget preparation, and accounting reports implementation, and evaluation

PublicRELATED Enterprise ASSISTANCE Reform Power Sector Reform Reforms for Pension Reforms Infrastructure Development at Subnational Level ADB’s Private Sector and Financial ADB’s Power Sector Government Markets Development Program Development Program ADB’s proposed Basic FMRP Loan (2002) Social Infrastructure Sector • Introduce contributory Subprogram I • Unbundle power Development Program pension scheme for new • Introduce code of best practices in generation and (2005) recruits to the public corporate governance for state- distribution sector from 2003 owned enterprises • Move to cost recovery • Strengthen expenditure • Recommend ways to enhance pricing resource management of systems and procedures for local authorities privatization • Develop means to Subprogram II (2004) increase absorptive A A

capacity and transfer of 14 ppendix • Restructure and commercialize 14 ppendix state-owned enterprises funds for social infrastructure • Support SME • Implement financial market development governance reforms

ADB = Asian Development Bank, FMRP = Fiscal Management Reform Program, HR = human resources, IMF = International Monetary Fund, IT = information technology, 81 MIS = Management Information System, MRA = modernized revenue administration, LTU = large taxpayer unit, PRGF = Poverty Reduction and Growth Facility, RAMIS =Revenue Administration Management Information System, SME = small and medium enterprise, UNDP = United Nations Development Program.