Report No. 12787-EE Estonia Public ExpenditureReview Public Disclosure Authorized July 12, 1994
Europeand CentralAsia Region
FOR OFFICIAL USE ONLY Public Disclosure Authorized
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ACB annual capital budget DCF discountedcash flow DEM German mark DH district heating EBF extra-budgetaryfund EBRD EuropeanBank for Reconstructionand Development EC EuropeanCommunity ECO enhancedcredit operations EEK Estonian kroon EF EnviromnentFund EEB EuropeanInvestment Bank EU European Union EU-PHARE EuropeanUnion's TechnicalAssistance Program FDI foreign direct investment FY fiscal year G-24 Group of 24 G&D generationand distribution (of heat) GDP gross domestic product IBRD InternationalBank for Reconstructionand Development IFC InternationalFinance Corporation IFI internationalfinancial institution ILO InternationalLabor Organization IMF InternationalMonetary Fund JEXIM Japan ExportImport Bank LIBOR Londoninterbank offer rate MIF Medical Insurance Fund MIGA MultilateralInvestment Guarantee Agency MIP municipal investmentplan MoEd Ministry of Education MoF Ministry of Finance MoSA Ministry of Social Affairs OECD Organizationfor EconomicCooperation and Development PER Public ExpenditureReview PIP public investmentprogram PIPWG Public InvestmentProgram Working Group PPL proposed project list PPR public/privaterole ROR rate of return RUR Russianruble SNA systemof national accounts SSF Social Security Fund USD U.S. dollar VAT value added tax FOR OFFICIAL USE ONLY
Conventions
Government - Refers to the Council of Ministers. When reference is made to the Governmentof Estonia in general, the lower case "government"is used. State - Refers to the Central Government.
- = zero or negligible n.a. = not available mil = million
Units of Measure
ha = hectare km = kilometers m = meter m2 = square meter
EstonianFiscal Year
national calendar year municipal April 1 through March 31
Currencies
EEK 8 = DEM 1 (fixed rate since June 1992) EEK 13-14 = USD 1 (at recent DEM/USD cross rates)
This documenthas a restricteddistribution and may be used by recipientsonly in the performanceof their official duties. Its contents may not otherwise be disclosed wit'noutWorld Bank authorization. COUNTRY DATA - ESTONIA
GNP per capita in USD in 1992 2,750.0
General Area (thousand square km) 45.0 Population, 1992 mid-year (thousands) 1,544.0 Growth rate, 1980-90 (percent) 0.7 Density, 1992 (per square km) 35.0
Social indicators Population characteristics Crude birth rate, 1990 (per 1,000) 14.2 Crude death rate, 1990 (Per 1,000) 12.4 Health Infant mortality rate (per 1,000 live) 14.2 Life expectancy at birth, 1991 70.0
......
NATIONAL ACCOUNTS (Percent of GDP)
Gross domestic product 100.0 100.0 100.0 Agriculture 15.1 12.1 9.3 Industry 43.7 40.9 33.5 Services 41.2 47.0 57.2
Consumption 73.1 71.9 79.5 Gross investment 22.5 26.2 23.6
Net trade 4.5 1.9 -3.1 Exports, GNFS .. 55.4 66.5 Imports, GNFS .. 53.5 69.6
Gross domestic savings 26.9 28.1 20.5
Memorandum items: Gross domestic product (current EEK millions) 1,991.7 13,786.0 26,274.0 Gross domestic product (current USD millions) 166.0 1,148.8 1,987.0
GDP GROWTH RATE (Percent change) Real gross domestic product -11.0 -14.2 -3.0 Real gross domestic product per capita -8.2 -13.0 -8.8 - Hii -
COUNTRY DATA - ESTONIA
gR', g g: Sg L 0' ;:.S'"*Sg.-...... g ......
PRICES & WAGES (Percent change) Consumer prices 211.0 1,069.0 89.0 Nominal wage index 98.0 619.6 100.4
MONETARYINDICATORS Broad money (M2) as percent of GDP, (end-of-year) 50.3 20.8 25.4 Growtd of nominal M2 (percent) .. 196.4 95.3
GENERAL GOVERNMENTBUDGET (Percent of GDP) Currentrevenues 33.5 29.8 32.3 Currentexpenditures 26.1 27.8 30.1 Currentsavings 7.4 2.0 2.2 Capitalexpenditures 3.1 1.2 2.0 Financialbalance 4.3 0.8 0.2 Net lending 0.0 -0.3 -1.6 Fiscalbalance 4.3 0.5 -1.4
BALANCEOF PAYMENTS(USD millions)
Exports (GNFS) .. 626.4 1,117.0 Merchandise .. 457.2 801.0 Imports (GNFS) .. 636.3 1,206.3 Merchandise .. 519.9 903.0 Resource balance .. -9.9 -14.0 Factor services, net .. -1.9 -29.0 Net current transfers (incl. official currenttransfers) .. 94.7 53.9 Current accountbalance (after official capitalgrants) .. 82.9 9.0
Net private foreign direct investment .. 57.9 145.0 Long-term loans (net) .. 13.2 86.4 Official Private
Othercapital (net, includingerrors and omissions) .. 83.4 -73.0
Changein net reserves (- = increase) -202.9 -142.0 - iv -
COUNTRY DATA - ESTONIA
DIRECTION OF TRADE (Percent of Totals)
Main export markets Former Soviet Union(FSU) 94.8 47.0 43.2 Russia 56.5 20.8 22.9 Others 38.3 26.2 20.3 Non FSU 5.2 53.0 56.8 Finland 2.3 21.1 20.9 Others 2.9 31.9 36.0
Main import markets Former Soviet Union (FSU) 84.7 47.3 26.4 Russia 45.9 28.4 16.0 Others 38.8 18.9 10.4 Non FSU 15.3 52.7 73.6 Finland 2.0 22.9 36.4 Others 13.3 29.8 37.2 v PREFACE
This report was producedby the World BankPublic ExpenditureReview mission that visited Estonia in October and November 1993. Membersincluded John Hansen (team leader), Rajesh Dewan (budgetprocesses), Tapio Saavalainen(resource availabilities) and Milan Vodopivec(labor markets). The principal authors of the report were: John Hansen, Chapters 1 and 3; Tapio Saavalainen,Chapter 2; and Rajesh Dewan, Chapter 4. Milan Vodopivec prepared the sections of Chapter 2 on social safety net issues. Chapter 3 draws heavily on materials prepared by sectoral experts in the EC4 Sector Operating Divisionsof the World Bank. Sectoral backgroundpapers were prepared by Aaron Adiv (transport); EustaciusBetubiza and Eric Peterson (housing);Anna Bjerde (energy);John Flora (municipaltransport); Simo Juva (education);and Milan Vodopivec(labor). Carlos Hinayonassisted with modeling resource availabilitiesand prepared the projects list on Annex A. Ibrahim Akoumprepared the charts and graphs for Chapter 3. Maha Armaly prepared a note on procurementfor Chapter 4.
The report was prepared under the general direction of Adil Kanaan (Division Chief) and Basil Kavalsky(Director). The missionteam wishes to thank the Estonianauthorities for their excellent supportand cooperation,including importantdiscussions and commentson an earlier draft of this report.
- vi - ESTONIA: PUBLIC EXPENDITUREREVIEW
TABLE OF CONTENTS
Executive Summary ...... x
CHAPTER1. Strategic Prioritiesfor InvestmentProgram Design ...... 1
A. Introduction. B. EconomicStabilization and the InvestmentProgram5 Total Feasible InvestmentLevel. 5 Government's Role in Total InvestmentActivity. 6 Financial Resources Availableto the Public Sector. 7 Resource Requirementsof the Proposed Project List. 8 C. StructuralReforms and Sectoral Investments .11 Economic Strategy for Public Investment.12 Role of Public Investmentby Sector .13 Sectoral Allocationof Proposed Project List .14 Binding Constraints on EconomicGrowth .15 Regional Development .18 D. ProjectPrioritization within Sectors.23 Rates of Return. 23 Maintenanceand Repair .23 Energy Efficiency.24 Completion of Ongoing Projects.24 Future Operating Costs.25 E. Conclusionsand Agenda for Action .26 Agenda for Further Action .26
CHAPTER2. ResourceProspects ...... 29
A. Introduction.29 B. Recent Fiscal Patterns.30 Expenditures.30 Sources of Revenue.31 Overall Fiscal Balanceand Macro Stabilization.34 C. Major Issues in RecurrentExpenditures .34 Financingthe Social Safety Net .34 Public Sector Salaries.42 Extraordinary Transition Expenditures.43 D. ResourceProspects over the MediumTerm .44 Real GDP Growth .44 Net Resources Availablefor InvestmentExpenditures .44 Government Revenuesand Expenditures.45 Government Borrowing .47 - vii -
CHAPTER 3. Preliminary Assessment of Proposed Projects ...... 52
A. Introduction ...... 52 B. Public Sector Domain (Group 1) ...... 53 Education ...... 53 Environment ...... 54 Government Administration ...... 56 Highways ...... 57 Labor/Employment Services ...... 58 Municipal Streets and Lighting ...... 59 Public Safety and Defense ...... 59 C. Public Sector Majority (Group 2) ...... 60 Air Transport ...... 60 Culture ...... 60 District Heating and Energy ...... 61 Forest Resource Management ...... 61 Health and Social Assistance Services ...... 62 Municipal Solid Waste ...... 64 Municipal Transport ...... 64 Port Infrastructure ...... 64 Railways ...... 65 Water Supply and Sewerage ...... 66 D. Private Sector Majority (Group 3) ...... 66 Communications ...... 66 Electricity ...... 66 Finance ...... 67 Housing ...... 68 Mining ...... 70 Port Superstructure ...... 71 Shipping ...... 71 Sports ...... 71 E. Private Sector Domain (Group 4) ...... 72 Agriculture ...... 72 Fishing ...... 73 Manufacturing ...... 73 Sales and Services ...... 74 Tourism ...... 74 F. Action agenda ...... 74
CHAPTER 4. Review of Budgetary Processes ...... 76
A. Introduction ...... 76 B. The Budget Calendar ...... 76 C. Revenue Budget Formulation ...... 77 Revenue Structure ...... 77 - viii - ForecastingRevenue Availabilities ...... 77 State/LocalRevenue Sharing Procedures ...... 77 Local Fiscal Discretion ...... 79 Tax Arrears ...... 79 Tax Administrationand Enforcement ...... 80 D. Current ExpenditureBudget Formulation ...... 80 Guidelines...... 80 Negotiation ...... 81 Extra-BudgetaryItems ...... 84 1994 State Budget and ExpenditurePriorities ...... 86 Local Government Budgets ...... 87 E. Budget Implementation...... 91 Revenue Receipts ...... 91 Distribution ...... 91 SupplementaryBudgets ...... 93 Reporting and Monitoring...... 93 Payment Mechanisms ...... 93 New Budget Law ...... 94 InformationTechnology ...... 94 Procurement ...... 95 F. Capital Expendituresand RevenueBudgeting ...... 95 Current Practice ...... 95 Public InvestmentPrograms and Annual Capital Budgets ...... 98 Public InvestmentPlanning at the MunicipalLevel ...... 99 Technical AssistancePlanning and Budgeting ...... 99 G. Conclusionsand Recommendations.100
ANNEXES
Annex 1. The Role of Government and Public Expenditures in a Market Economy .... 102 Annex 2. Modeling Social Safety Net Expenditures.107 Annex 3. PPL: Proposed Project List, 1995-97.110 Annex 4. Index to Sectors by Public/PrivateRole .119 Annex 5. Project InformationForm .121
BIBLIOGRAPHY
MAP IBRD 26004
TEXT TABLES
1-1. Total Public and Private Investment, 1995-97. 7 1-2. Sources of Public InvestmentResources, 1995-97. 8 1-3 Central GovernmentInvestment Budget, 1994. 9 1-4. Proposed Projects by Public/PrivatePriority Group, 1994-97 .10 1-5. Sectoral Allocation of Public Investment, 1970-89 .16 2-1. General GovernmentExpenditures ...... 31 - ix -
2-2. General Government Capital Expenditure in Selected Countries ...... 31 2-3. General Government Revenues ...... 33 24. General Government Financing ...... 33 2-5. Summnaryof Social Safety Net Expenditures ...... 37 2-6. Average Wage in the First Quarter of 1993 ...... 42 2-7. Key Economic Indicators, 1993-1997 ...... 45 2-8. General Government Saving and Investment ...... 47 2-9. Financing Plan and Debt Indicators by Scenario ...... 49 4-1. Central Government Revenues, 1992-94 ...... 78 4-2. 1993 Budget and 1994 Requests ...... 82 4-3. 1994 Requests and Ministry of Finance Recommendation ...... 83 4-4. 1994 Ministry of Finance Recommendation and Draft Budget ...... 83 4-5. Extra-Budgetary Funds: Social Security, 1992-94 ...... 85 4-6. Extra-Budgetary Funds: Medical Insurance, 1992-94 ...... 86 4-7. Extra-Budgetary Funds: Environmental Fund, 1993-94 ...... 87 4-8. Central Government Expenditures by Organizational Unit, 1992-94 ...... 88 4-9. Local Government Revenue and Expenditures by Unit, 1993 (est.) ...... 89 4-10. Guidelines for Formulation of Local Government Budget, 1994 ...... 90 4-11. Staffing Level and Wage Guidelines for Local Governments, 1994 ...... 90 4-12. 1994 Capital Budget by Organizational Unit ...... 97
ANNEX TABLE
A2-1. Labor Market and Social Safety Net Expenditures .109
TEXT BOXES
1-1. Public Investment Programs Defined ...... 2 1-2. The Failure of Rates of Return Across Sectors ...... 3 1-3. Public Investment Programming and Non-Marginal Shadow Prices ...... 4 1-4. The Core Public Investment Program Strategy ...... 11 1-5. Draft Statement of Economic Strategy ...... 14 1-6. PPR Groups: Proposed Public/Private Roles by Sector by the Year 2000 ...... 15 1-7. Analysis of Ongoing Projects ...... 24 1-8. High and Low Priority Projects for the PIP ...... 28
TEXT FIGURES
1-1. Distribution of Investments by Public/Private Priority Groups ...... 16 2-1. Composition of General Government Expenditures, 1993 ...... 32 2-2. Composition of General Government Revenues, 1993 ...... 32 2-3. Social Safety Net Expenditure Shares, 1994 ...... 36 2-4. Social Safety Net Expenditure Trends, 1992-96 ...... 36 2-5. Government Revenues and Per Capita GNP ...... 46 Executive Summary
A. Introduction
Purpose of the PER Mission
1. A World Bank public expenditurereview (PER) mission visited Estonia in October 1993. The mission found the government'sgeneral budgeting and expendituremanagement practices to be quite satisfactory. Evidenceof this is demonstratedby the government'sability to maintain a balancedbudget despite the extreme resourcescarcities and highlyunstable economicconditions that have marked the first two years since Estonia regainedits independence. The PER mission was thus able to focus primarily on the narrower issue of the development of the public investment program (PIP) for 1995-97 and beyond.
2. This report was designed to help the governmentdevelop an approach to public investment programmingthat is consistent with the needs of a market-orientedeconomy, and avoid the problems associatedwith investmentplanning that characterizedthe previous regime. In additionto this Executive Summary, the mission's report includes the following chapters:
1. Strategy. This chaptercovers methods for establishingstrategic priorities that the government can use to help select projects for a public investment program, taking into account the nation's developmentobjectives and constraints to growth.
2. Resources. This chapter analyzes the resources that will be available to finance public investmentprojects.
3. Projects. This chapter reviews the proposed project list (PPL), which contains projects suggestedby ministriesand agenciesfor public investment,based on the strategic priorities developedin the Strategy report.
4. Budgeting. This chapter examinesthe areas where budgetary practicescould be improved, and discusses methods for developinga rolling three-year public investmentprogram and translating it into annual capital budgets (ACBs).
3. The executivesummary brings together the key messagesof the report againstthe background of a brief statement regarding Estonia's recent economicdevelopments and prospects for the future.
Recent EconomicDevelopments
4. During the first two years after Estonia regained its independence,the governmenthad to focus all availableresources on stabilizingthe economy. As a result, direct public investmentfell to less than 2 percent of GDP after the end of 1991, compared to investmentrates of more than 30 percent during the 1980s. Outputdeclined nearly 40 percentduring this time. The loss of markets in the former Soviet Union (FSU) for Estonia's exports and the terms of trade shock generated by Estonia's loss of access to inputs from the FSU, which were priced far below world market levels, were the most critical factors driving this decline. During the 1980s, the FSU markets had absorbed about 90 percent of Estonia's exports, the equivalentof about 50 percent of GDP. Exports to FSU markets dropped sharply because of the economic collapsein the FSU republics and the breakdownin inter-republicantrade and paymentssystems. The terms of trade shock reducedEstonia's purchasingpower, and the much higher - xi - cost of inputs for its inefficient agricultural and industrial sectors severely curtailed their domestic profitabilityand their internationalcompetitiveness.
5. Rapid inflation between 1990 and 1993 contributed to the decline in domestic economic activity, particularly investment. As part of a broader effort to move toward a more market-oriented economy, Estonia began to liberalize prices in 1991, about a year before price reforms began in Russia. The removal of price controls acceleratedin 1992, and by the end of 1993 inflationhad increasedprices by about ninety times over levels at the beginningof 1990. Althoughdisruptive, inflationhas played an important role in the transition process. Inflation allowed overall prices to rise to market clearing levels, thereby eliminatingthe monetaryoverhang that had developedunder the Soviet systemof artificiallylow prices and allocation through queuing. Inflation also facilitated Estonia's reintegrationwith the global economy. Major changes in relative prices were required to align domestic economic values with relative prices in world markets, and changing relative prices almost inevitably requires increases in absolute prices, because prices tend to be sticky downwards. Rapid inflation also helped reduce the significance of the inter-enterprisearrears before 1992.
6. The domestic and foreign exchangeresources available for investmentfell sharply after re- independence. The decline in economic activity and the increase in transitional current expenditures reduced the government'sbudgetary savings availablefor public investment. The move to world prices for imported fuels sharply increasedthe cost of heating housingand public buildings. Simultaneously, the government faced higher expenditures for public sector salaries, unemployment compensation, pensions, and other social safety net expenditures. The government rightly imposed a hard budget discipline on public enterprises, which effectivelycontrolled wage pressures. Consequently,real wages fell roughly in line with the decline in GDP, reducing householdincomes to the point that most household incomewas consumed. This reduced the pool of domesticsavings potentiallyavailable to financepublic investment.
7. The foreign exchange resources available for public investment were also reduced to negligiblelevels. Estonia no longer had access to foreign exchangethrough Moscow, and while its own export industries were quickly reorienting sales toward hard currency markets, this could not take place immediately. Many of Estonia's products that were previouslyexported to the Soviet Union were of low quality, and Estonian enterprises needed to develop their own contacts and trading relationshipswith customers in hard currency markets. Furthermore, when Russia reduced the supplies of petroleum, oil and lubricant products shipped to Estonia, raised prices almost to world market levels, and demanded payment in hard currency, Estonia was forced to allocate a major share of its scarce foreign exchange to oil imports. The foreign exchange scarcity became so acute in early 1992 that Estonia became critically short of all imported goods, not just oil, but also medical supplies, fertilizer, spare parts, and food for both human and animal consumption.
8. The internationalcommunity quickly mobilized exceptionalemergency balance of payments assistancefor Estonia. In addition to generouscommitments of humanitarianand technicalassistance on a grant basis, the international community made commitmentsfor balance of payments support that totaled about USD 200 million during 1992 and early 1993. Total disbursementsof grant plus loan aid have been estimated at nearly USD 175 million for 1993. To put this into perspective, these disbursements averaged USD 110 per capita, compared to average per capita official development assistancedisbursements from all sources in 1991 of USD 25 for low-incomecountries excluding India and China, USD 24 for lower-middle-incomecountries, and USD 5 for upper-middle-incomecountries like Estonia. - xli - 9. Estonia used this exceptionalassistance to secure essentialimported inputs and to provide the foreign exchangereserves needed to stabilizethe economy. The relative stability attained would not have been possible, however, without the excellenteconomic policies that the government has introduced. These include the following:
(a) Currency. The Estonian kroon, introduced on June 20, 1992, is fully backed by foreign exchangeunder a currency board arrangementand has remainedpegged at EEK 8 per DEM since its introduction. Net foreign assets have increased more than three fold since the currency reform.
(b) External policies. Estonia has virtually no external duties or quantitative restrictions on either importsor exports, and has establishedfree trade arrangementswith the other Baltic countries as well as with many other European countries.
(c) Internal policies. Estonia has no price controls except on a few public goods and services such as housing and municipal transport, no subsidies to public enterprises, and an increasinglysolid banking system.
These solid economicpolicies, backed by good externalsupport, helped reduce inflationfrom an average of 75 percent per month in the first quarter of 1992 to an average of 3 percent per month during 1993. Real wages have risen, but are still highly competitive. Estonia's exports to hard currency markets increasedfivefold in 1992 and doubled in 1993. In the process, Estonia reduced its share of exports to the FSU from about 90 percent in the late 1980sto barely one-thirdof total exports today. The domestic currency is fully convertible for all current account and most capital account transactions. External reserves have risen to more than four months of imports. Domestic interest rates for loans have fallen from more than 50 percent per year in 1992 to 20-30 percent at present. 'the budget has been balanced for the past three years, and Parliamentapproved a balanced budget for 1994. Fiscal control, together with a prohibitionon borrowing from the central bank by either the governmentor the commercialbanks (except to prevent a major banking crisis), indicates that inflationary pressures will not renew fiscal imbalances or, deficit-driven monetary expansion. Most important, the decline in GDP apparently stoppedduring 1993 and GDP actually expandedduring the last two quarters of the year. During 1994 Estonia expects growth of 5-6 percent, making it the first of the FSU republicsto move from stabilization to growth.
FutureEconomic Prospects
10. Substantialchallenges lie ahead despite Estonia's progress to date. Inflationis not yet fully under control. The rate dropped to about 2.0 percent per month in the third quarter of 1993, rose to 4.0- 5.0 percent per month in the last quarter of 1993 and to 8.9 percent in March 1994, then dropped back to about 1 percent in May and June. The resurgence of inflationappears essentiallyto be the result of external factors such as the real increase in the price of goods from Russia, the increased export of domesticgoods to Russia, and the substantialinflows of foreign exchange.The balanceof paymentscrisis has clearly passed, and a new crisis will not emerge if Estonia can prevent the real exchangerate from appreciatingexcessively. The government is now clearly in position to begin focusing domestic and foreign resources on public investmentsto support future growth. However, resources will continue to be scarce, which underscoresthe importanceof developinga good public investmentprogram. - xiii -
B. Strategic Priorities for Program Design
11. Estonia's ultimate objective is to provide, on a sustainablebasis, the best possible standard of living to the largest possible number of people living in Estonia. This can only be attained with solid economicgrowth. As a country in transitionto a market economy,Estonia has two overarchingstrategic priorities in its quest for growth: stabilization,and structuralchange and growth.
Stabilization
12. A reasonable degree of price stability is vital for growth. Without this, establishing an environment favorableto investmentwould be difficult. Continuedsuccess in stabilizingthe Estonian economy will require the governmentto continue living within its means. Excessive borrowing, even if done to support worthwhile projects, could destabilize the economy. Excessivedomestic borrowing would create increasedinflationary pressures if the funds were borrowed from the monetaryauthority, because this would increasethe aggregatemoney supplyregardless of whether the funds were borrowed directly from the central bank or indirectlythrough the commercialbanking system. Excessivedomestic borrowing by the government could take place without expanding the money supply, but this would crowd the private sector out of domesticfinancial markets, preventingit from fulfilling its intendedrole as the leading growth sector in Estonia's market-basedeconomy. Excessiveforeign borrowing would create debt service problems within a few years, which the governmentclearly wants to avoid.
13. To assure continuedmacroeconomic stability, the total resources that can be allocated to the public investmentprogram must be defined in advance,and the total cost of projects selectedfor inclusion in the PIP must not exceed the computed resource envelope, even if this means that projects with rates of return that are acceptable by normal standards must be excluded from the PIP. Estimates of the resources that will be availablefor the Estonian PIP for 1995-97are discussed below in the section that summarizesthe findings of Chapter 2.
StructuralChange and Growth
14. Structural change and growth will take longer to attain than stability. In a transitional economy like Estonia, structural change will require the following:
(a) Changingthe relative roles of the public and private sectors so that private investmenttakes the lead, supported by public investmentsin basic infrastructurefacilities;
(b) Attainingeconomic efficiency by world price standards, with particular emphasison energy conservationbecause of the sharp change in fuel prices;
(c) Rehabilitatingthe physical assets that have deteriorated in recent years because of extreme resource shortages;
(d) Reorientingthe economyto produce goods that are competitiveon internationalmarkets in terms of price and quality.
15. Strategic priorities such as these are an important screening device in public investment program design. Rates of return will generallybe required for making final decisionson whether or not to financespecific projects, but strategic priorities will play a leadingrole in establishingthe initial size and compositionof the PIP for three reasons. First, the data required to calculate rates of return are - xiv - often not availablewhen a project is first proposedfor inclusionin a PIP. Second, in addition to having an acceptablerate of return, a project must be of high priority for public investment;scarce public funds should generally not be used to finance projects that would be attractive to private investors. Finally, rates of return can give misleading results when applied across sectors because of variations in the way that shadow prices are calculated. Thus, rates of return and strategic priorities should be regarded as complementarytools, both of which have importantroles to play in selecting projects for inclusion in public investmentplans, and ultimately for financingthrough annual capital budgets.
16. Chapter 1 develops a four-way categorizationof sectors in terms of the degree of public sector involvement that appears warranted in Estonia by the year 2000. The categories, which are summarizedin Box 1-6, range from sectors such as health and educationthat are likely to remain almost entirely in the public sector's domain, to others like manufacturingand agriculturethat shouldbe almost entirely in the private domain by the turn of the century. Sectors such as municipal transport and port cargo handling facilitiesare likely to fall between these extremes, and to involve significantamounts of both public and private participation. Box 1-6 focuses on ownership responsibility; the private sector construction industry (see Category 4) will usually undertakethe actual work of creating public sector assets, such as highways, schools,hospitals, and districtheating plants, and of maintainingthese facilities.
17. This taxonomyin terms of public/privateroles (PPR), togetherwith the other strategiccriteria listed earlier, proved to be a useful device for eliminatingprojects that should probably not be included in Estonia's 1995-97PIP. Withoutspending valuable staff resourceson project design and rate of return calculations,the mission was able to suggest a set of projects out of the original list that is much more focused on areas that require public sector involvement, while at the same time reducing the overall resourcerequirements to a level consistentwith prospectiveresource availabilities. Figure 1-1 shows the impact on overall program compositionof applyingthe strategic criteria to the proposed project list.
C. Resource Prospects
18. Chapter 2 estimatesthe public investmentexpenditures that Estonia could undertakeduring 1995-97 without excessiveborrowing from domestic or foreign sources. Resource availability will be determinedprimarily by current budgetarysavings and foreign borrowingcapacity as domesticborrowing for public investment is expectedto be negligible. Chapter concludes that EEK 4.8 billion (USD 360 million) should be available, of which 45 percent would come from budgetary savings, and 55 percent from foreign borrowing.I
Current BudgetarySavings
19. Governmentbudgetary savings (current revenues less current expenditures)are expected to generate resources equivalent to almost 2 percent of GDP during 1995-97. The availability of these savings will, however, depend heavily on the impact of the recent tax reforms on tax revenues; on the government's efforts to improve the efficiency of the tax collection system; on its ability to control pressing demandsto increasecurrent expendituresfor civil service salaries and social safety net programs; and on the policy measurestaken by the governmentwith respectto potentiallycostly economictransition
All numbers given in the resources section of this Executive Summary and in Chapter 2 are approximate and have been rounded, often to multiples of five in the last digit, to avoid the appearance of spurious accuracy. Consequently, numbers derived from calculations based on numbers in the text (e.g. the EEK/USD exchange rate based on estimates of investment resources in EEK and in USD), will generally not be precise. - xv - activitiessuch as bank reform, enterprisearrears, and privatization. Mobilizingcurrent budgetarysavings equal to about 2 percent of GDP will be very important to the financing of the public investment program. Withoutthe government'scontribution to local cost financingout of current budgetarysavings, external donors will generally find it difficult to provide the correspondingforeign exchangefinancing for projects in the public investmentprogram.
20. Tax Revenues. On regaining independenceEstonia moved quickly to establish a tax system that is consistent with European standards and that avoids the erosion of governmentrevenues common in countries suffering high rates of inflation. Today Estonia has an almost textbook tax system that is elegantly simple and avoids economicdistortions. A flat rate 18 percent value added tax (VAT) applies to virtually all goods and services. Estonia recentlyconsolidated the personal and corporate incometaxes into a single income tax with a flat rate of 26 percent, a high basic exemptionto protect the lower-income classes, and few allowable deductionsto limit the scope for tax avoidance. Payroll taxes of 20 percent for social security and unemploymentand 13 percent for health are the only other major taxes. Estonia maintains an essentiallyfree trade regime with almost no import or export taxes. Taxes are charged on a few imported luxury goods, but these goods are generally not produced in Estonia, and the taxes are to be convertedinto luxury excise taxes.
21. Almost all taxes are ad valorem, which has given the tax system excellent buoyancy. Althoughtotal general governmentrevenues have fallen as a percentageof GDP-from about 40 percent in the late 1980sto about 30 percent in the past two years-virtually all of this decline relates to nontax revenues, mainly earnings from the large Soviet-stylepublic enterprise sector. Tax revenues have been stable at around 30 percent of GDP. The decline in nontax revenues reflects a consciousdecision to reduce the government's role in production. The government placed hard budget constraints on the public enterprises, eliminatedprice controls on enterprises, and cancelledsubsidies to enterprises (these have fallen from 13 percent of GDP in 1987-89 to almost nothing at present). The loss of nontax revenues,equivalent to about 10 percentof GDP, has thus been matchedby a similar reductionin subsidy expenditures,and the governmentbudget has remained in balance for the past several years despite the disruptionsof the transition to a market economy.
22. CurrentExpenditures. The largest pressures on current expenditurearise from social safety net programs and civil service salaries, which in 1993 accountedfor 28 percent and 15 percent of total general governmentexpenditures, respectively.
23. Estonia has succeededin restricting social safety net expensesto about 10 percent of GDP, largely through pension reforms that replaced the old Soviet system with a flat rate pension. The new pensionoffered an incomereplacement rate of only about 30 percent, which is well below levels in most other European countries. The authorities recently added a second tier to the pension system that increases monthly benefits accordingto years of service. The cost of this will be offset in the medium term by the decision to increasethe retirementage by 6 monthsper year for the next 10 years, ultimately raising the age to 60 for womenand 65 for men. As the current base pension is only slightlyabove the subsistence level for a single adult living alone, strong arguments exist for assuring that this minimal pension level is protected against inflation. However, the authoritiesshould gradually raise the rate to levels more in line with the replacementrates of Europeanpension systemsto avoid creating undue fiscal pressures. Ideallythis shouldbe done throughcomplementary fully-funded pension systems operated by the private financial sector once a strong, well-regulatedfinancial sector has developed.
24. Unemploymentcompensation is not expected to rise above 0.5 percent of GDP (about 1.5 percent of budgetary expenses) in the next few years. This projection is based on two factors. First, - xvi - Estonia continuesto enjoy very low levels of official openunemployment (less than 3 percent of the labor force, although other estimates place total unemployment, including various types of disguised unemployment,closer to 10 percent). This low unemploymentrate reflectsthe rapidly expandingprivate sector; the willingness of workers to accept reduced pay to retain access to social services such as housing, health care, and child care facilitiesprovided by enterprises; a general preference to get help from family rather than from the government;and the decline of real wages in line with output. The latter development, which was more the result of hard budget constraints on enterprises than explicit incomes policies, has prevented wages from rising significantlyas a share of the value of enterprise output despite output declines, thereby making it easier for enterprises to retain workers. Second, the replacementrate for unemploymentinsurance is very low, only 60 percent of the minimum wage, which itself is set close to the poverty line. As people cannot live on the unemploymentbenefits without assistancefrom friends and family, pressuresto increasethese benefitsare likely. However, the preferred solution would be to improve the social assistanceprogram to provide a means-testedsafety net in the event of long-term unemployment.
25. Social assistance costs are not expected to rise much above 1.5 percent of GDP during the next few years, despite the economicdislocations of the transition process. Although Estonia should gradually depend more heavily on means-testedsocial assistance programs rather than less targeted programs such as family and unemploymentbenefits, some time may be needed to develop the capacity to administer widespreadmeans-tested programs. The current policy of keeping social assistance and other social safety net benefits close to subsistencelevels will enhancelabor mobilityand wage flexibility, thereby facilitating the transitionprocess. It will also help establisha virtuous circle: modest benefits today will help assure budgetarysavings that can be used to support investmentsthat will generategrowth and employment,thus reducingthe need for social assistanceprograms in the future and allowingbenefits to be improved for those requiring help from the social safety net.
26. Exceptional TransitionExpenses. The mission's estimates of the current budgetary savings that will be availableto help finance a capital investmentprogram assume that Estonia will continue its present policies, which are designed to minimize the fiscal cost of reforms in the banking system, the privatizationprocess, and the cleanupof enterprise arrears.
27. As concernsbanking system reforms to date, the governmenthas generallytaken a hard line against bailoutsfor depositorsor owners. This has contributedto spontaneousinternal reforms of banks, to mergers and liquidation of banks without adequate capitalization,and to a much greater degree of caution in lending than existed previously. Further banking sector reforms are clearly needed, but based on announced government policies, the mission assumes that the government will not use budgetary resources to support these reforms, although it may borrow from abroad and re-lend funds to help strengthen the banking system. Furthermore, as in the case of the proposed recapitalizationof the North EstonianBank, the mission also assumesthat any capital injectionswill be on a short-term basis and will be repaid by selling the publicly-ownedshares within one to three years.
28. With respect to privatization,the PIP resourceestimates presented here assume, on the basis of governmentpractice to date and announcedpolicies, that the government will not undertake costly preprivatizationinvestments in public enterprises, but will instead leave these to the private sector. The estimates also assume that the governmentwill continueto allow enterprises to go bankrupt rather than subsidizingthem, and that it will avoid the costly Treuhand approach of paying investors a "negative purchase price" to assumeresponsibility for failing public enterprises and their employees.On this basis, Chapter 2 assumesthat proceedsfrom privatizationwill be sufficientnot only to cover the administrative - xvii -
costs of the privatization process, but also to generate funds that can be used to help clear up the residual debts of public enterprises.
29. A key weakness of the banking system in Estonia today, and a major factor slowing down the privatization process, is the stock of nonperforming accounts receivable and accounts payable of enterprises. The real value of enterprise arrears has been reduced sharply by inflation during the past two years, but these arrears still create significant legal and financial problems. The appropriate strategy for resolving these arrears depends on the nature of the creditor. As a first step, the inventory of interenterprise arrears that the external advisor to the Estonian Accounting Board has started compiling should be completed and used as a basis for netting out as much of the web of debts as possible. In the case of residual liabilities, if the creditor is the government, the debts should be taken as a write-down of the government's net worth. One interesting subset of interenterprise arrears are the inter-republican interenterprise arrears from Soviet days. Inflation has largely eroded their significance, but the remaining liabilities should be treated as sovereign debt and handled through negotiations on the resolution of assets and liabilities from the Soviet period with other republics.
30. Debts owed to foreign commercial banks and enterprises outside the FSU should generally be cleared up through payment, or bankruptcy proceedings if necessary, to preserve Estonia's potential for normal access to international capital markets. Between the extremes of debts that can be netted out or written off and those that should be paid lie many other kinds of debt. Appropriate treatment will require a case-by-case analysis. In dealing with old debts, however, the government should avoid throwing good money after bad. In particular, it should avoid borrowing funds from abroad to repay old debts, especially domestic currency debts. The bankruptcy route is generally preferred, because this tends to place the burden of bad business decisions on the enterprise's managers and owners.
31. The government should also avoid allocating current revenues for resolving long-term debt problems. Current government resources have a high opportunity cost and are needed, for example, to help finance the public investment program. If a government bailout or refinancing of a bad debt is needed to protect an otherwise healthy bank or enterprise from bankruptcy, borrowing on the domestic market through a bond instrument would be preferable. The recipient bank or enterprise would receive interest from the government, making the bond a yielding asset. The direct budgetary cost of such payments would be much lower than outright cash compensation of the enterprise or bank holding a nonperforming asset. If the enterprise or bank needed the cash before the bond matured, it could sell the bond on the secondary market. Estonia's secondary market is currently thin and informal, but introducing government-backed securities could facilitate its development as well as help to solve the inter-enterprise arrears problem. Regardless of the type of debt, any solution involving debt write-offs should be done only in the context of privatization and restructuring to avoid moral hazard problems.
32. The estimates presented in Chapter 2 assume zero net budgetary claims caused by bank bailouts, privatization, and the resolution of enterprises, debts. However, the resources that flow into the public investment program will be available to help resolve problems in these areas because the government intends to relend up to half of the PIP resources to the enterprise sector through the domestic banking system. If these onlending programs are well structured, the government can use the resources to help recapitalize commercial banks, to extend loans to viable enterprises that are short of cash because of nonperforming accounts receivable, and to extend loans to private sector investors who have purchased public enterprises through the privatization program and need additional resources to restructure them. Such onlending should carry an interest rate sufficient to cover the cost of borrowed funds, a premium to cover the risk of nonpayment, and if the resources are onlent in kroons rather than in foreign exchange, a premium to cover the currency risk. - xviii - DomesticBorrowing
33. The mission has assumed that the governmentwill not borrow from the domestic banking sector to finance public sector investmentsduring 1995-97. This is consistent with the government's desire to avoid crowding out the private sector in the domestic capital markets. Revenue-earning corporate enterprises in sectors such as district heating and municipal transport, which are likely to remain under public ownership for several years, may borrow in their own names from commercial banks, however, to help finance their own priority investmentprojects. As noted in Chapter 1, at this point the PIP should only include projects that have a direct impact on the state budget. Some investmentsundertaken by public enterprises that are operatingon a commercialbasis but have not yet been privatized may thereforefall outside the public investmentprogram. Once the initial PIP has been formulated, the government should consider developingparallel PIPs for local governments and for enterprises that are likely to remain under public ownership.
34. Chapter 2 also assumes that the governmentwill not borrow directly from the general public through the sale of bonds or other financial instrumentsto help financethe public investmentprogram. Although individuals exist in Estonia who could afford to invest in such instruments, the domestic economy will need to become more stable before such investmentsbecome attractive to significant numbers of individual investors comparedto the other investmentsthat are available both inside and outside Estonia. Currency swapsbetween banks and the governmentcould, however, be considered in the context of the government's plans to onlend to the private sector through the banking system a substantialportion of the foreign exchangeborrowed from abroad for the public investmentprogram (see paragraph 41).
Foreign Borrowing
35. With the assumptionof no domesticborrowing, foreign borrowing will be the only source of PIP funding other than current budgetary savings. In estimatingthe resourcesthat could be mobilized from abroad to support the public investmentprogram, the mission developeda macroeconomicmodel that allows explicit consideration of the key factors that are likely to determine Estonia's external borrowing and debt servicing capacity. These includedomestic growth, export performanceand import demand, and access to foreign savings.
36. Domestic Economic Growth. Significantgrowth took place in the second half of 1993, and prospects for annual growth of perhaps 5-6 percent during 1994 and beyond are excellent. This growth will be based primarily on output from the rapidly expanding private sector, assuming that the government can provide the necessary supporting infrastructureand other services through the public investment program. The privatization program has already placed most of small enterprises in the private sector, where many are developingrapidly. Some large enterpriseshave also becomeoperational under private sector ownership, and more are expected to make the transition in the near future. Bankruptcyhas played an importantrole in stimulatinggrowth by releasingphysical assets into the hands of entrepreneurs who can use them efficiently.
37. Exports and Imports. The mission expects exports to continue providing a major stimulus to growth. Estonia's merchandiseexports to convertiblecurrency markets increasednearly tenfold in the past two years. While this explosive growth will not continue, Estonia's average wage of just over USD 100 per month; a highly skilled and dedicated work force; some domestic raw materials such as wood, farm land, and nonmetallic minerals; and a large established industrial base will provide the foundationfor continuedexport growth. With modest levelsof investmentto improve the quality, design, - xix - and efficiencyof Estonian goods, they should continueto gain acceptancein Western markets. Estonia enjoys a substantialinflow of foreign direct investment,equivalent to about 7 percent of GDP. This will play a critical role in future export development,because in addition to investmentresources, foreign direct investment provides access to modern industrial technology and design and external markets. These factors indicatethat an annual 8 percent growth in export volume shouldbe attainableduring 1994- 97, and could continueat 6 percent per year through the end of the decade.
38. Imports of goods and services are likely to increaseeven more rapidly than exports during 1994-97because Estonia will need to import equipmentand suppliesto implementthe anticipatedsharp expansionof public and private investment. After an initial catch-upphase, imports would grow more in line with GDP.
39. Despitethe anticipatedrapid growth of importsduring the next few years, the current account deficit should peak at around 6 percent of GDP, then decline to an average of 3 percent of GDP during 1998-2004. Continued strong performance in service exports, especiallyshipping and tourism, which are already importantsources of foreignexchange for Estonia, will hold the growth of the current account deficit in check.
40. Access to Foreign Savings. In early 1992 Estonia had almost no access to foreign savings exceptofficial grants, and most of this came in kind as humanitarianand technicalassistance. Since then Estonia has succeed in arranging a variety of loans from internationaland bilateral official sources, and more recently has been approved for export credit agency cover by a number of European trading partners. Most of Estonia's commercialborrowing is still only for short-term funds, but with some export credit agency cover, it can gradually gain access to funding on longer terms, particularly for investmentsundertaken as part of foreignjoint venture agreements. Such agreements will continue to bring in substantialdirect investmentflows.
41. SustainableBorrowing Levels. The above factors indicate that the Estonian economy will probably need external financing of somewhat more than USD 200 million per year in terms of disbursementsduring 1994-97 to cover its current account deficit, external debt service, and reserves buildup. Of this, about half of the flows may come in through private sector transactions, leaving a public external borrowing requirementof about USD 100 million per year on a disbursementbasis from foreign loans and grants. After allowing for reserves buildup and external debt service, about USD 70 million would be availableto support the public investmentprogram. The governmenthas indicatedthat it would like to onlend up to half of this to the enterprise sector through domestic commercial banks. The remainingforeign resources,around USD 40 millionper year, would be availableto support physical investmentprojects in the public investmentprogram.
42. The mission's projections indicatethat Estonia should have no problem sustainingthis level of external borrowing. By the latter part of the decade, when debt service payments will have risen to a steady-statelevel, the debt service ratio would remain well under 10 petcent and external debt would remain below 25 percent of GDP, which are both comfortableratios. These levels are conservativeby internationalstandards, and as Estonia's absorptive capacityin terms of implementingpublic investment projects develops, higher future levels of borrowing may become feasible.
43. The mission does not believe that a more aggressiveexternal borrowing strategy would be advisablefor two reasons. First, as the private sector will have limiteddirect accessto foreignborrowing during this decade, the public sector would have to acquire virtually all the debt, and to service this debt would have to maintain a larger claim on resources than would be consistent with the government's - xx - strategy of letting the private sector take the lead in the nation's economic development. Second, Estonia's absorptive capacity is still limited, and attemptingto implementtoo many projects too quickly could result in wasting resources, which would generate debt repaymentproblems in the future. Also, Estonia's debt ratios are low because it started with virtually no external debt. Consequently,a pattern of debt accumulationthat resulted in an averagedebt service ratio of 10-15 percent during this decade could lead to serious debt servicing problems in the next. Thus the base case appears to be an optimal, sustainablepath that assures good growth without overheatingthe economy or creating other problems.
AggregateResource Availability
44. Budgetary savings of about 2.0 percent of GDP, together with foreign borrowing for the public investmentprogram of about 2.5 percent of GDP, indicatea total resource availabilityfor the PIP of about 4.5 percent of GDP, equivalentto about EEK 4.8 billion during the program period, or roughly USD 360 million.
D. Preliminary Assessment of Proposed Projects
45. Chapter 3 reviewsthe proposedproject list compiledby the government. The review is based on the strategic criteria from Chapter 1 as discussed earlier. The chapter suggests modificationsthat would make the list more consistent with national economic priorities and with likely resource availability.
Prelniinary Project List
46. At the request of the mission, the governmentasked ministries and agencies to submit lists of the projects that they would like to undertake. The resulting unedited "wish list" includedmore than 280 projects with a total cost of about EEK 21 billion, more than four times the resources expected to be availableduring 1995-97. The foreign exchangerequirement of the proposed project list (PPL) is nearly ten times the likely availabilities. These comparisonsof the PPL requirements with 1995-97 resource availabilitiesare not entirely justified because many of the projects in the PPL would not be completed during 1995-97, but the comparison does indicate the magnitude of the problem that the governmentwill face as it tries to sift through the list and identifywhich projects shouldbe included for detailed review in the PIP, and which shouldultimately be implementedthrough annual capital budgets.
SuggestedProject List
47. The public/privaterole criteria that were developedin were appliedto the PPL to determine the extent to which it was initiallyconsistent with what appears to be a reasonableapproximation of the relative roles that the government foresees in various sectors for the public and private sectors respectively. The distributionof projects in the PPL was almost the reverse of what would be desirable for a PIP (Figure 1-1). The value of projects in Categories3 and 4, which should be primarily private sector activities, accounts for nearly two-thirds of the total cost of projects in the PPL. Most projects in these categories should be a lower priority while those in Categories 1 and 2 are assigned a higher priority provided they are consistent with strategic criteria, such as a focus on improving energy efficiency and on rehabilitatingexisting assets. This would have two benefits. First, the total cost of projects in the revised PPL would fall to levels that are consistent with the financing likely to become available accordingto analysis in Chapter 2. Second, more than 85 percent of the projects by value in the revised PPL would fall into Categories 1 and 2, indicatinga much sharper focus on investment in - xxi - sectors where a continuingpublic sector presence is vital for overall economicgrowth and the provision of adequatesocial services.
PIP Preparation
48. Chapter 3 suggests that as the next steps in preparing a public investment program, the governmentwill need to (a) formulate its own statementof basic economicobjectives to provide the basis for setting strategic priorities; (b) review the strategic criteria suggestedin Chapter 1, paying particular attention to the categorizationof sectors in terms of the relative roles desired for the public and private sectors; (c) use these criteria to select projects from the PPL that should be included in a PIP for the period 1995-97; and (d) develop a 1995 annual capital budget, taking into account the highest priority projects in the 1995-97 PIP.
E. Review of Budgetary Processes
49. As noted above, the PER mission focused primarily on budgeting for investmentprojects becausethe governmenthas alreadyestablished budgeting and control proceduresfor current expenditures that are quite effectivein terms of attaining the government'stop objective, a balancedbudget. As noted in Chapter 4, however, improvements did appear to be possible in the negotiation process and in disbursingfunds, points that also apply to capital budgetingand implementation.The mission also found considerableinterest in knowing more about methods that could be used to prepare a budget for public investmentsthat would be consistentwith the developmentof a market economy, and that would not risk reintroducingthe problems associatedwith the Soviet system of public investmentplans.
Budget Negotiations
50. When public resourcesare as limitedas they have been in Estonia during the past two years, conflictsabout their allocationare inevitable. Under the circumstances,the Ministry of Finance has been very effective in restrictingexpenditures to levels consistentwith incomes. Staff in both the Ministry of Finance and in other ministries acknowledged,however, that the process was often ad hoc, responding to crises rather than following a well-consideredplan. As a result, the rules and criteria by which decisions are made were often not clear to those affected.
51. To a certain extentthe problem could be relievedby agreeingon statementsof objectivesand strategiccriteria such as those suggestedin Chapter 1 for capital investments. The problem will diminish over time as spending patterns become more established, an improved process of negotiation is also needed. The negotiatingprocess between the Ministry of Finance and the other ministries for the 1994 budget was compressed into about three weeks in early August so that the draft proposal could be sent to Governmentby the end of August, and to Parliamentby the end of September. A major lengthening of the negotiationperiod would not be justified; this would unduly stretch out a process that is already fairly long. It could also open the door for special interest groups to become involved in lobbying, thereby creating political pressures that would lead to an inflationarybudget. However, if the budget guidelinescould be issued a few weeks earlier withoutstarting the overallbudget formulationprocess any sooner, this could improve the quality of the discourse on budget allocations.
52. One way to accelerate the issuance of budget guidelines, and thus leave more time for negotiations,would be to present the guidelinesas aggregatetotals for each ministry, not as guidelines for each specific expenditurearea for each ministry. This change would provide managers with more - xxii - flexibility to respond to changing relative prices and priorities without relaxing the overall budget constraints, which the governmentmust maintain to help assure macroeconomicstability.
TreasuryFunction
53. As part of its stabilization effort, the government has eliminated the budget deficit by spendingonly resourcesthat it has received. If resourcereceipts are delayed, budget disbursementswill be delayed,which can cause considerableproblems for ministriesand agencies. Consequently,ministries and agencies outside the Ministry of Finance often feel that the budget process is opaque because they do not receive their budgeted resourcesas scheduled.
54. Even if the governmentreceives tax revenueson a regular basis, given the significantseasonal variations in economicactivity typical of a Nordic country, expendituresand revenuesare unlikely to be synchronized. For example, a major share of the maintenanceof roads, heatingsystems, and buildings must be done during the relativelyshort summer months, leadingto exceptionalresource demandsduring this period. Schools will need more resources during the late summer to purchase books and other suppliesfor the openingof school in the fall. Finally, operatingcosts, especiallyfor hospitals, are likely to rise in the winter with higher fuel bills and more illness because of the cold weather. Seasonal variations are also common on the revenue side, reflecting factors such as the seasonal nature of agriculturalproduction and the impact of summer vacationson industrial output.
55. The governmentshould begin investigatingthe possibilityof establishinga treasury function to smoothout the seasonalmismatch between revenuesand expenditures. This shouldbe done cautiously and in close consultationwith the IMF. To succeed, a treasury functionneeds to be able to borrow short- term funds, which has significantmonetary implications. A treasury function also has the advantage of providing centralizedinformation on fiscal flows, while at the same time facilitatinga more decentralized approach to cash managementfor individualministries.
Public InvestmentProgram
56. The Government of Estonia does not currently have a public investment program largely because it has not had enough resources availablefor investmentsto justify the effort. As indicated in the introductoryand resourcessections, however, Estonia is now in a position to initiate such a program. A good public investmentprogram will help assure that scarce public funds are used only for the highest priority projects will provide an agreed basis for refusingadditional requests for funds that have not been budgeted and will help the governmentmobilize external funding for the program.
57. The public investmentprogram shouldnot be confusedwith the annual capital budget (ACB), which is discussed in the next section. The PIP provides a frameworkfor planning and developinggood investment projects, while the ACB provides a commitment to undertake these projects and an authorizationfor ministries and agencies to commit funds for such activities. The public investment program is a medium-termplanning framework,while the ACB forms part of the annual state budget.
58. Projects will first appear on a proposedproject list such as that the Governmentof Estonia has already developed. This will be a wish list that greatly exceeds the level of resources likely to be available and, being based on the efforts of sectoral experts, will probably lack prioritization from the macroeconomicperspective. The governmentwill reject projects in the PPL that are not consistent with the nation's strategic objectives for public investment, leaving only those projects that seem to have promise to be includedin the public investmentprogram. Once the PIP process has been under way for - xxiii - two or three years, new projects that meet the strategic criteria will generallyfirst appear in the outermost year of the three-year PIP.
59. Once a project has been acceptedfor inclusionin the PIP, the ministry or agency responsible for the project will begin to invest staff time in (a) defining the project's objectives more precisely; (b) designing a project to meet these objectives; and (c) doing rate of return or least-costanalysis to make certain that the chosen design is acceptablein terms of the minimum acceptablerate of retum, and that it represents the best possible choice among alternativedesign options.
60. A year or more may be required to carry out this design work and rate of return assessment. Once the analysis establishesthat the project will be viable, efforts shouldbe made to identify financing for the project, to establish an executing agency (if one is not already in place) and ensure that it is adequatelystaffed, and to implementany macroeconomicor sectoral policies needed to help assure the project's success. Once a project has passed all relevant tests and is ready for implementation,it will move to the first year of the PIP.
61. The public investmentprogram documentshould have three major sections: (a) a statement of developmentobjectives and strategic priorities; (b) an analysis of the resources that are likely to be availableover the programmingperiod (the medium-termfinancial framework); and (c) a list of potential projects that seem to be of high priority and appear likely to have acceptable rates of retum. In developing its PIP, the governmentmay be able to draw ideas from Chapter 1 of this report for the first section, Chapter 2 for the second,and Chapter 3 for the third. On completionof the design and appraisal of potentialprojects in the PIP, those projects that pass the standard internal rate of return and other tests of project viability would be included in the annual capital budget.
AnnualCapital Budget
62. The ACB is similar to the annual operatingbudget, but commitsresources over a multiyear period. A multi-year commitmentis necessary for a capital budget to assure that physical investment projects, which commonlytake several years to complete, will have the required funding.
63. The governmentwill prepare a new annual capital budget each year. Although approaches vary, the best method of moving forward from one year to the next is to roll the previous year's ACB into the present ACB so that all relevant data are in one document. Under this approach, the expendituresapproved in the ACB for the prior year have a presumptiveright to be includedin the new ACB with full fundingfor all remainingyears of implementation.This roll-up approachalso encourages the authorities to review progress on projects' physical implementationand to adjust the funding if necessary. Because a project's funding must be reviewed each year in connectionwith the ACB, it is less likely to encounterimplementation difficulties that go unnoticedby the state authorities. The annual review provides an opportunityto take corrective action if needed to get projects back on course.
64. Once ongoingprojects have been fully funded (or canceled if appropriate), ACB resources can be allocated to new projects, which should be drawn from the first year of the most recent PIP. - xxiv -
F. Conclusions
65. Estonia is now in position to design and begin implementinga public investmentprogram. Projects should be selected for inclusionin the PIP on the basis of strategic and sectoral objectives. A total of EEK 4.8 billion of resources(in constant 1994 prices) is likely to be availableduring the 1995-97 program period for public investment,including about EEK 2.1 billion from current budgetary savings and EEK 2.7 billion from foreign borrowing. The availabilityof domesticcost financingthrough current budget savings will be vital for obtaining the correspondingexternal financing for projects. Proposed projects in the PIP should be designed carefully and subjected to standard rate of return or least-cost analysis as soon as possible. Once a project's design has been finalized, its economic and financial viability has been established, and appropriate institutional arrangements have been made for its implementation,it can be included in the next multi-year annual capital budget that, together with the annual operating budget, will constitutethe state budget.
66. The Governmentof Estoniashould proceed with developinga PIP for 1995-97and an annual capital budget for 1995 sothat necessaryfinancing can be arranged and priority investmentprojects can be initiated in a timely manner.
CHAPTER 1
Strategic Priorities for Investment Program Design
A. Introduction
Background
1.1 The public investmentprogram (PIP) of Estonia was virtually suspendedduring the first two years of independence so that all available resources could be focused on stabilizing the economy. During that period, the governmentmade major progress on the stabilizationeffort through a combination of liberal economic and conservativefiscal policies. The governmentabolished virtually all tariff and non-tariff trade barriers, removedprice controls, launcheda major multi-trackprivatization program, and began to break up monopolies. On the fiscal front, it maintaineda reasonably balanced budget-a remarkable achievement made possible through a strong political consensus and a currency board structure that prohibits government borrowing from the central bank. As a result of these policies, inflation was brought down from about 1,000 percent during 1992 to only 36 percent during 1993. At the same time, the economicdecline appearsto have stopped; growth in the last half of 1993 is estimated to have reversed first half declines,with some estimates indicatingno net decline for the year. Prospects are excellentfor growth of around 5 percent in 1994.
1.2 Having made major progress toward stabilizingthe economy,the governmentcan now begin to expand its public investmentprogram. As a first step towardpreparing, a publiLinvestment program (PIP) for 1995-97, the Ministry of Finance has collecteda tentativelist of proposed investmentprojects. A review of the proposed project list (PPL) indicatesthat the total cost of the proposed projects exceeds by over four times the resources that are likely to be available for public investmentsduring the next three years. The next step is thus to select the highest priority projects so that they can receive adequate funding.
1.3 To help the governmentagree on priorities across sectors for the public investmentprogram, the Ministry of Finance has established a Public Investment Program.Working Group (PIPWG), comprised of senior representativesfrom all key ministries. This chapter offers suggestionsregarding ways in which that committee can establish inter- and intra-sectoralpriorities for guiding the selection of projects for the PIP. These suggestionstake into account the government's strategic development objectives of stabilizationand structural reform for economic growth and social justice.
1.4 The remainder of this introductorysection defines the conceptof public investmentprograms in terms of what should and should not be included. It also examinesthe reasons that Estonia needs to take a macro-level strategic view, rather than a project-based, rate of return (ROR) approach in formulating its public investmentprogram.
Definingthe Scope of a Public InvestmentProgram
1.5 The definition of what does and does not constitute part of a public investment program is the topic of an extensiveand unresolveddebate. The most practical approach is to include only capital expendituresthat have a direct impacton the central government(state) budget. The ramificationsof this basic principle are explored in Box 1-1. -2-
Box 1-1. Public Investment Programs DJfited
* Capital versus recurrent costs: The PIP should include any project involvingthe purchase or transfer of capital assets. The dividingline betweencapital and other assets can be ambiguous,particularly in the case of large deferred maintenanceprojects involving work that shouldhave been handledon a recurrentbasis. Such projects should, however, be part of the PIP if they involve borrowed resources. On the other hand, programs that are not primarily designed for physical fixed asset creation, even if they are multi-yearand financed with borrowedfunds, should be excludedand treated as current expenditures(for example, training programs for human capital development). (Such programs often require substantial foreign technical assistance and should be part of a separate Public Technical AssistanceProgram.) Although the details of defense-relatedinvestments would normallynot be shown in a PIP, the aggregate amount should be included as one of the claims for public investmentfunds that must be consideredin allocatingthese scarce resources.
* Physical/financial:The PIP should cover all governmentcapital expenditures,including physical investments and financial investments. The latter may be in the form of equity investmentsor net lending, regardless of whether this is financed by current savings, domesticborrowing, or foreign borrowing.
* Level of government: The PIP should only include capital budget expenditures by the central (state) govemment. Separate municipalinvestmnent plans (MIPs) should be developedfor localitiesas information becomes available. Local projects financed by the central governmentshould be included in the PIP. At some point, Estonia may want to develop a comprehensivepublic investmentprogram that covers all parts of public investmentby sector. Today, however, the required informationis not available and would, in any event, have to be built up separatelyfor each level of government.
* Public enterpriseprojects: Investmentsfinanced by public enterprises through capital reserves, domestic borrowing, or foreign borrowing without sovereign guarantee should be excludedfrom the PIP. Such projects have no govemmentalbudgetary or debt service obligationsand should be treated like any other commercialventure.' In fact, it would be more appropriateto refer to the program in a rapidly privatizing country like Estonia as a state investmentprogram (SIP) rather than as a public investmentprogram, because an SIP explicitlyexcludes all investments(other than those from the state budget) in public enterprises that have been corporatized (that is, where the central governmentis no longer a physicalowner and operator but a financial shareholder).
If the government extends a loan to a public enterprise, the net lending will be included in the PIP as a financial investment,but use of the loaned funds by the public enterprisewill be excludedfrom the PIP, as will the cost of the project financedin part with these funds.
If the govemmenttakes equityin a project in exchange for its financialsupport, the equity portion is included as a direct investmentin the PIP, but the remainder of the project will be excluded (except possibly as a memo item).
* Joint sector projects: The treatmentof joint sector projects involvingthe private sector and the govemment shouldbe treated like other public enterpriseprojects; the inclusionor exclusionof the project in the PIP will depend on the nature of the financialtransaction.
* Guarantees: Governmentguarantees of loans for private investmentprojects can be an importantstimulus to economic growth. Although the full value of the guarantee does not need to be included in the public investment program (as would be the case for on-lending of a similar amount to the private sector), the expected loss should be included (for example, a non-paymentrisk of 5 percent on a USD 50 million loan should be covered with an entry of USD 2.5 million in the PIP.)
A. Creditorsmay hold the governentliable for repayingunguamnteed debt in the eventof bankruptcyof a publicenterprise owned by the government,and in somecases governments have been forcedto assumethe responsibility.In principle,however, the governrentis notliable forthe samereason that a personowning stock in a limitedliability corporation is notpersonally responsible for the debtsof the corporation. -3- Public InvestmentProgramming in a TransitionalEconomy
1.6 In an ideal world, developinga public investment program would be easy. All potential projects would be listed in descendingorder accordingto their economicrates of return, and starting from the top of the list, all projects that could be financedgiven the availableresources would be included in the public investmentprogram.
1.7 In the real world, however, other techniques must be used to develop a public investment program. Rates of return fail the task for at least three reasons. First, the enigineeringand financialdata required to calculate rates of return for projects are usually not known at the time the PIP is being formulated. In fact, such informationcommonly becomes available only when projectpreparation is well advanced. Second, it is almost impossibleto create "shadow"prices that will result in the selection of
Box 1-2. The Failureof Rates of Return Across Sectors
Ranking projects by their internal rates of return is valid when projects produce goods with clear, undistorted market prices that reflect consumer willingnessto pay, and economicopportunity costs. Ratesof return can even be used when market prices are distorted if the goods are internationallytradable and thus have reasonablyunambiguous shadow prices. Almost all manufacturingprojects qualifyby these criteria. Some infrastructureservices such as electricityand telecommunicationsalso do, but problems may arise in the valuation of consumer surplus (the amount that consumers would be willingto pay above the market price for electricityor phone service, for example).
If used with caution, rates of return can also be used to help select the best projects across such sectors where market-basedshadow prices are available. Ratesof return are not valid, however, for comparingprojects across sectors that do not have clear, competitivelydetermined prices for their outputs. Governmentand socialservices are particularly difficultto evaluateusing rate of return analysisbecause they commonlyhave no market price (for example,coast guard services, fire protection, and primary education). In other cases, the market price for such services reflects social prioritiesrather than economic costs (for example, subsidizedcharges for health services and higher education).
In an economy such as Estonia's where the governmentis actively seeking to reduce public sector involvementin the productionof marketed goods and services, the most important projects in the public investment program will increasinglybe those that are almost impossibleto evaluateusing rate of return analysis. What can be done?
Conventionalrate of return analysis can be modifiedby inventing values or weights for benefits that seem to producethe 'right" answers in terms of PIP composition. Weightsare commonlyused for socialbenefit-cost analysis, for example,to accountfor incomedistribution impact. However,this approach tends to be obscureand really does not solve the problemsince it assumes a consensus regardingthe desired compositionof the public investmentprogram. Without such a consensus, there is no way of knowing whatthe 'right' answers are in terms of the sectoralbalance of the PIP.
Instead of trying to make rate of return analysiswork by creatingweighted shadow prices, it is generally better to allocate resources across sectors in the public investmentprogram, on the basis of agreementson a national economic strategy, and on the relative priority for public investmentin each sector in terms of strategic nationalobjectives. The consensusbuilding process should includean assessmentof the current state of public servicesin each sector, the need for improved services, and the best approach to providing such services. Once a consensus has been developed on the relative prioritiesacross sectors for public and for private investment,rates of return can be used to help choose the most cost-effectiveway to attain the goals in each sector, such as the delivery of education to a given number of children. Rates of return should not be used to balance investmentsacross sectors, particularlyacross sectors that are not of equal priority for public investment. -4 -
Box 1-3. Public Investnent Programmingand Non-MarginalShadow Prices
Discountedcash flow techniques like rate of return analysis are widely used to determine if a project should be finar,ced. Does this mean that a public investmentprogram can be developedsimply by calculatingthe rate of return for all possible projects and including in the program only those that have an acceptablyhigh rate of return? Unfortunately, this will not work. Aside from the well-knownimpossibility of establishingcomparable monetary values of the benefitsof projects across sectors such as education,health, and highwaytransport, where outputsare not internationallytraded (Box 1-2), the rate of return approach to public investmentprogramming also fails because current market and shadow prices become irrelevant if the total demand for resources for public investmentprojects exceeds the supply. Most market and shadow prices are computedon the willingnessto pay, or the opportunitycost for one additional unit of input or output, such as a dollar of foreign exchange, an hour of work, or a ton of wheat. Shadow pricing assumes that the project's demand for a given resource will be small or "marginal" relative to its total supply and thus will not change the price of the resource. Using marginalprices is valid when appraising a single project, because the project generallywill not demand enough of the input, or produceenough of the output, to change the market price. The picture changes dramatically, however, when evaluating the entire public investmentprogram. When the entire public investmentprogram is added up, the demand is "non-marginal"for resources, particularlyfor universally used resources like foreign exchange and implementationcapacity, and will affect the implicitvalue of the resource. In Estonia, for example, the projects in the proposed project list (PPL) would require about ten times the foreign exchange that is likely to be available. With the possibleexception of a few, very large projects, no single projectof the 280 in the PPL would need enough foreign exchange to change the shadowprice of foreign exchange. However, even if all 280 projects had a high rate of return at present shadow prices, implementingall of them simultaneouslywould be completely out of the question because, in total, they would demandmore resources than are likely to be availableat the aggregate macro level. Consequently,the shadow prices for resourcessuch as foreign exchangewould rise far above present levels. Calculatingthe rate of return for projectsusing a shadowprice for foreign exchangethat would reflect its value in the face of a demand ten times the availablesupply, for example, would almost certainly result in such a high shadow price that none of the projects would show an acceptablerate of return. Because of the absurdlyhigh shadowprice that foreign exchange would have if all projects were implemented,no projects would be included in the public investment program if the rate of return methodwere used! This simple example demonstrateswhy rate of return analysis cannot be used to determine the overall size of a public investmentprogram. While rates of return shouldplay a vital role in establishingthe project-specificcontent of the program, the overall size must be established instead with a macroeconomic model that estimates total resource availabilities.
It must be added, however, that in some countries(for example,those with exceptionaloil or mineral wealth and very small populations)the scarcity of good projects, rather than financial resources, may be the binding constraint. In such cases, rate of return analysis will determine the size of the investment program. If there are not enough good projects to use up the availableresources, the residual shouldbe investedabroad. projects that accuratelyreflect strategic priorities across sectors (Box 1-2).1 Third, shadow prices that are realistic for a single project become meaninglesswhen considering a list of projects whose total resource requirementssignificantly exceed the availableresources (Box 1-3). Thus, while rate of return analysis plays an important role in selecting among alternative designs for a given project, other approaches must be used to capture the strategic issues that are so important in formulating a public investmentprogram.
I Shadowprices are developed by adjusting market prices to remove distortionsintroduced by price controls, trade barriers, and market failures that prevent market prices from revealingthe true value (in terms of their true cost of productionand of consumers' willingnessto pay for them)of the goods and services being shadowpriced. In the absenceof marketdistortions, shadow and marketprices will basicallybe the same. Financialproject analysis is based on market prices, while economic project evaluationis based on shadow prices. A further refinement in project evaluationis to do 'social' rates of return, whichtake into accountthe incomedistribution impacts of a project. This is usually done, however, by revaluingthe incomestreams flowing to different sectors, rather than by revaluing the inputs and outputs directly through shadow pricing. 1.8 A strategic approach to planning public investmentprograms is particularly important in a transitional economy like Estonia. In establishedmarket economies, capital expenditure budgets are generally not part of an effort to bring about fundamentalchanges in the economy. In such economies, the main task is only to refine resource allocationsat the margin. Consequently, efficiency-orientedrate of return analysis may be sufficient. But in transitional economies,major changes are required in three importantareas-economic stabilization,asset ownership,and the structure of production-and these can only be addressed through top-down public investmentplanning. However, once the overall sectoral resource envelopehas been defined, and unacceptableproject proposals have been rejected on the basis of strategic criteria, then rate of return or least cost analysisshould be used to select the optimal design for such projects, and to determine the projects that are actuallyincluded in the PIP. Once projects have passed ROR screening, they becomeeligible for inclusionin annual capital budgets, which are the basis for implementingmulti-year public investmentplans.
1.9 The remainder of this chapter examines the strategic issues that should be considered in designing a public investmentprogram to assure the desired stability, ownership change, and structural reform. Section B examinesthe challenge of economicstabilization, paying particular attention to the need to estimate resourceavailabilities accurately, and to avoid designing an excessivelylarge program that could reverse the important stabilizationthat has already been accomplished. Section C examines the problems of structural reform at the sectoral level, starting with a review of basic economic objectives, sectoralconstraints to achieving these objectives, the relative roles by sector that public and private investmentare likely to play in attaining these objectives,the consistencyof the PPL with these roles and directives, and the role of regional developmentin public investment planning. Section D reviews some of the economic efficiency criteria that cut across all sectors, along with some basic techniques for selecting between alternative projects within each sector. Section E summarizes the conclusionsof Chapter 3 regarding high and low priority projects, based on the criteria developedin this chapter, and concludes with recommendationsfor the next steps in completing the public investment program.
B. Economic Stabilization and the Investment Program
1.10 Estonia has respondedexceptionally well to the challengesof stabilizationthat accompanied the breakup of the former Soviet Union (FSU). Continuedprogress toward lowering inflationrates and achieving real economicstability (in the face of a serious contraction in economic output and pressing demands for improved living standards)means that Estonia's overall investment levels will have to be constrainedcompared to past levels to keep expenditurescc nsistent with available resources. Given the government's desire to have the private sector play a much more active role, the governmentlevel of investment relative to gross domestic product (GDP) will have to be far less than before 1992. Determiningthe overall size of the public investmentprogram involvestwo steps. First, the total amount of investment in the economy for the period must be determined. Second, the share of total investment that will be undertakenby the governmentmust be decided.
Total Feasible InvestmentLevel
1.11 In the last half of the 1980s, fixed capital formation averaged about 30 percent of GDP. Stocksgrew at about the same pace as GDP, bringing the total investment rate to around 33 percent of GDP. While generally in line with the rate of investmentelsewhere in the former Soviet Union during that period, this rate was considerablyabove the 20-25 percent pace that was typical in other countries (with the exceptionof East Asia and the Pacific where investmenthas averaged closer to 30 percent of -6 - GDP). While Estonia's investmentrate was similar to that of East Asia, its performance was not. Growth in East Asia averagednearly 8 percent per year during the 1980s. Despite some episodes of growth during the 1980s, Estonia's real GDP in 1990 was essentiallyunchanged from that of 1980. This reflected the very low efficiencyof investmentunder the Sovietsystem and the beginningsof the breakup of the FSU toward the end of the period. After 1989, investmentdeclined sharply, both absolutelyand relative to GDP, accountingfor only 18 percent of GDP in 1992. In a radical break with the past, virtually all of this was in the private sector; public investmentwas only 1.3 percent of GDP in 1992, and about 2.0 percent in 1993.
1.12 Although total GDP and investment fell sharply in real terms after 1989, prospects for substantial improvementsin both indicatorsare excellentfor the period 1995-97. As indicated in Chapter 2, GDP is expected to grow by about 5 percent per year through 1997. Althoughthe need for higher personal consumptionis likely to reduce the current savings rate slightly, from the 1993 level of about 29 percent of GDP, the investment rate will increase due to Estonia's growing access to foreign financing. Consequently,a gross investmentrate of about 34 percentof GDP is anticipated. Within this total, fixed investment will constituteabout 30 percent of GDP. This translates into a total investment outlay of about EEK 30.5 billion over the 1995-97period (in constant 1994 prices).
Goverrunent'sRole in Total InvestmentActivity
1.13 Given the total investmentactivity that can be anticipatedfor the 1995-97period, the overall size of the public investmentprogram depends on the desired role of governmentin the nation's economic activity, as well as the financial resources of the public sector. Of these, the first is by far the most important strategic consideration;the government'sfinancial resources depend heavilyon the role people want their governmentto play in national economic life, and thus on their willingnessto be taxed.
1.14 The government'srole is changing fundamentallyfrom the one it played when Estonia was subject to a centrally planned economicsystem. Parliament and the governmenthave made it clear that the public sector's role in the economy will be reduced sharply from the virtual monopoly it had on investment and production under the Soviet system, and that the private sector should assume responsibility as soon as possible for all activities where public sector ownership and control is not necessary. This means that the private sector should, with very few exceptions, assume responsibility for all production of goods and services, and that the role of the governmentshould be limited almost exclusively to government services. The exceptionsmay be (a) natural monopolies, such as municipal transport and water supply, where competitivemarket forces cannot control monopolisticbehavior; and (b) activities such as education, public health, and defense with large social externalities and limited private profitability.2
1.15 Changing the virtual monopoly the public sector had on economic activity under the Soviet system will require allocatingthe highest possibleshare of the nation's investmentcapacity to the private sector. Privatizationof existingpublic assets is very importantand is moving ahead quickly in Estonia in areas such as small enterprises, but is moving more slowlyin other areas. Throughoutthe economy, most of the existing assets are not competitive in today's global economy. Consequently, when privatized, these assets will require substantialadditional private sector investmentto increaseefficiency, product quality, and competitiveness.
2 A moredetailed discussion of the role of governmentis providedin Annex 1. -7 - 1.16 Despite the need to sharply enhanceprivate investment,a strong public investmentprogram remainscritically important. Withoutsubstantial public investmentin areassuch as infrastructure,health, education, and public safety, private sector investmentwill not be productive, and national objectives related to social justice will not be attained. Establishing the appropriate balance between public and private investment is difficult, but it appears that reserving 10-15 percent of investmentresources (4-5 percentof GDP) for central governmentinvestmnent would be appropriategiven the government's desire to have the private sector manage a major share of the nation's investableresources (Table 1-1). As discussedin Chapter 2, up to one-halfof this amount is expectedto be allocatedto financial investments (net lending) to support investmentsby the private sector, but the majority would be retained by the governmentfor its own physical investmentprojects. The estimatedlevel of public investmentin Estonia is based on the experienceof other countries, the resources availableto the public sector through current budgetarysavings, and the potentialfor borrowing from domesticand foreignsources. Furthermore, the analysis in Chapter 3 indicates that this level of public resources would allow the government to both undertake the investmentsneeded to make private investmentsproductive, and provide essential social services.
Table 1-1. Total Public and Private Investment,1995-97 (percentagesand constant 1994 EEK) Item Share of GDP (%) EEK million
State (central government)investment 4.5 4,800 Physical 2.5 2,700 Financial 2.0 2,100 Municipal 1.0 1,100 Private 28.5 30,300
Total investment 34.0 36,200 Fixed capital formation 30.0 32,000 Change in stocks 4.0 4,200
Source: Mission estimates.
1.17 Computingthe investmentresources that shouldbe reserved for local authorities lies beyond the scope of this report. However, it seems reasonable to suggest that, in addition to the central government'spublic investmentactivities that will directly benefit the municipalities,another 1-2 percent of GDP might be required at this level, bringing total public investmentto 5-6 percent of GDP, or about one-sixthof gross domestic investment.
FinancialResources Availableto the Public Sector
1.18 The total resources availablefor public investment during 1995-97 have been estimated at EEK 4.8 billion (USD 360 million).3 The projected resources would come from budgetary savings, domesticmarket borrowing, and foreign borrowing (Table 1-2.)
3 All resource requirementand availabilityestimates in this chapterare presentedin terms of constant1994 prices unless otherwise indicated. See Chapter 2 for more details. - 8 - 1.19 The annual level of state investmentof EEK 1.6 billion (impliedby the EEK 4.8 billion for 1995-97in Table 1-1) is considerablyhigher than the EEK 550 million actually in the state government budget for 1994 (TaHle1-3). However, becausethe governmentis required to present a balancedbudget to Parliament, the approved budget is based primarily on estimates of current savings, and excludes foreign borrowings not already known. Also, it is not clear that the 1994 budget figures include all financialinvestments. Consequently,as additionalborrowings are arranged, and better data on financial investmentbudgets become available,the total availableresources are likely to rise closer to the mission estimates.
Table 1-2. Sources of Public Investment Resources, 1995-97 (percentagesand constant 1994 EEK) EEK million Share Source in constant 1994 prices of GDP (%)
Current budgetary savings 2,100 2.0 Foreign Borrowing 2,700 2.5 Total 4,800 4.5 Source: Governmentof Estonia and missionestimates.
1.20 Table 1-3 includes EEK 25 million that the state plans to transfer to the municipalitiesto support their investmentprojects. (As indicatedin Box 1-1 above, includingthis amount in the PPL as a financial investrnentis appropriate.) An additionalEEK 100 million that the state has assumed will be mobilized by the municipalitiesthrough their own efforts is not included, for this has no impact on the state budget. What remains to be confirmedis that the projects shown in the PPL do not includeprojects that are exclusively financed by municipalities. The PPL should also exclude the portion of jointly financedprojects that does not represent a claim on the central governmentbudget.
Resource Requirementsof the ProposedProject List
1.21 Total Resource Requirements. The preliminary list of projects indicates total expenditures of nearly EEK 21 billion (USD 1.5 billion) (Table 1-4).4 This is over four times the total resources likely to be available in 1995-97 (Table 1-2).5 Once better data become available, the total resources
4 It must be stressed that the list of proposedprojects does not represent the viewsof the governmentor of the World Bank regarding which projects should be includedin a public investmentprogram. The list is no more than a 'wish list' of projects proposed withoutconstraints by various ministriesand agenciesin late 1993. The governmenthas already begun to revise the list, which is presentedhere in its original form because (a) it shows the challengesthat the governmentfaces in preparingan actualpublic investmentprogram and an annualcapital budget, and (b) a fully revised list will not be availableuntil the second half of 1994.
5 Resourceavailabilities are calculatedhere in termsof constant 1994 kroon prices. The resource requirementsfor the proposed project list are given in mixed and often undocumentedprices. As many of the project costings are out of date, it appears that the EEK 21 billioncost of the proposed projects is a minimumestimate of the actual cost, and that the cost is likely to increase once the estimatesare updated. - 9 - Table 1-3. Central Government Investment Budget, 1994 (EEK million) Item EEK million
State budget 273 Roads (transport) fund 252 Transfers to municipalities 25 Total 550 Source: Government of Estonia. required are likely to rise significantly. High priority shouldbe given to refining data on the anticipated expenditure patterns of proposed projects, for without this information, the governmentcould commit itself to an excessivenumber of projects. To avoid destabilizinginflationary pressures and excessive external borrowing, some projects would have to be dropped or implementedover a longer time period. Either approach would involve substantialcosts. Strategiesfor assuring consistencybetween resource requirementsand availabilitiesare discussed in Box 1-4.
1.22 ForeignExchange Resource Requirements. No details are availableon the time phasing of foreign and domestic costs, but most of the EEK 14.3 billion of foreign exchange indicated in the preliminary project list will probably be required during the program period. Bank mission estimates indicate, however, that only EEK 2.7 billion of foreign exchangeis likely to be availablefor the public investmentprogram during 1995-97. Furthermore, sincethe governmentplans to make up to half of the proceeds of its foreign borrowing available to the private sector through on-lending to the banking system, the amount of borrowed foreign exchangethat is likely to be available to support physical projects in the public investmentprogram will be even smaller. The current list of projects thus includes foreign exchangerequirements that are about ten timesthe levels likely to be available during 1995-97.
1.23 Even using all of the borrowed foreign exchangefor public investmentprojects would not solve the problem. First, since the private sector will have limited access to badly needed foreign exchangethrough borrowing (until Estonia developsa strong track record for foreign debt repayments), the government'sdecision to allocatea substantialpart of the resourcesthat it mobilizesas sovereigndebt to the domestic private sector is correct. Second, even if the government were to use all of the foreign exchangeborrowed from abroad for public investment,leaving nothing to support the private sector, the requests in the PPL would still exceed availabilitiesby five times.
1.24 Becausethe Estonian kroon is fully convertible, it would be possible for the governmentto purchase the additionalforeign exchangeneeded to fund the projects, providedthat throughtaxation, non- tax revenues, and borrowing, it could mobilize more domestic resources than are needed to meet the domestic resource cost of the proposed projects. However, the EEK 1.6 billion domestic resource estimate presented in Table 1-2 is based on maximum probable levels for each source of domestic revenue, and this amount is less than one-fourthof the estimatedEEK 6.6 billion that would be required to meet all of the domestic resource requirementsfor the proposed projects. Consequently,even with a convertible local currency, no excess domestic currency funds will be available, and the domestic purchase of additionalforeign exchangewith domesticcurrency resources is therefore not an option. - 10 -
Table 1-4. Proposed Projectsby Public/PrivatePriority Group, 1994-97 Remaining Total Project Costs Number ExpendituresNeeded EEK EEK Public/privatesector roles' million Percentage Total Percentage million Percentage
1. Public sector domain 2,454.54 12.0 80 28.6 2,375.63 11.7 Education 720.37 3.5 45 16.1 699.78 3.5 Governmentadministration 143.19 0.7 6 2.1 143.15 0.7 Highways 928.55 4.5 4 1.4 928.50 4.6 Municipal 29.18 0.1 9 3.2 28.55 0.1 Municipalsolid waste 9.30 0.0 3 1.1 9.30 0.0 Public safety and defense 623.95 3.0 13 4.6 566.35 2.8
2. Public sector majority 4,840.33 23.6 143 51.1 4,737.35 23.4 Airports 228.00 1.1 2 0.7 228.00 1.1 Culture 307.73 1.5 20 7.1 300.11 1.5 Energy and heating 677.99 3.3 41 14.6 659.61 3.3 Forest resource management 26.00 0.1 1 0.4 26.00 0.1 Health and social assistance 118.36 0.6 17 6.1 100.19 0.5 Port infrastructure 1,567.87 7.6 5 1.8 1,567.65 7.7 Railways - - - - - Water and sewage 1,914.38 9.3 57 20.4 1,855.78 9.2
3. Private sector majority 7,578.56 36.9 26 9.3 7,561.28 37.3 Communications 28.43 0.1 2 0.7 28.40 0.1 Electricity 908.00 4.4 2 0.7 908.00 4.5 Housing 59.50 0.3 2 0.7 52.50 0.3 Mining 73.20 0.4 2 0.7 71.60 0.4 Municipaltransport 391.00 1.9 2 0.7 388.60 1.9 Port superstructure 6,006.00 29.3 5 1.8 6,006.00 29.6 Shipping 19.50 0.1 1 0.4 19.50 0.1 Sports 92.93 0.5 10 3.6 86.68 0.4
4. Private sector domain 5,651.10 27.5 31 11.1 5,584.48 27.6 Agriculture 10.30 0.1 2 0.7 10.30 0.1 Finance 765.00 3.7 5 1.8 765.00 3.8 Manufacturing 4,834.89 23.6 18 6.4 4,769.79 23.5 Tourism 40.91 0.2 6 2.1 39.39 0.2
GRAND TOTAL 20,524.52 100.0 280 100.0 20,258.74 100.0 Source: Derivedfrom data supplied by the Ministry of Finance. Note: 'Remaining ExpendituresNeeded" is equal to "Total ProjectCost' less expendituresprior to 1994. The grand total for this column indicatesthe resources requiredto completethe proposedprojects. This exceedsthe amountthat will actually be required during 1995-97. A. As explained in Section C, the sectors are classified accordingto probable degree of dominance by the public and private sectors by the year 2000; the classificationis naturally quite tentative. Box 1-4. The Core Public Investment Program Strategy
Two schools of thought exist regarding the desirable relationshipbetween the size of the public investment program and the anticipated revenues. One school holds that the program should be larger than anticipated revenues, because some projects will drop out or be delayed, and it is importantto have additionalprojects identifiedand ready to go to make the best possible use of availableresources. The other school holds that project costs almost always rise as better information becomes available and as implementationproceeds, and that resource shortfalls, particularly from budgetary savings, are common. Consequently,to assure that adequateresources can be made availablewithout excessive domesticor foreign borrowing, the program should be smaller than the best estimateof available resources to provide a cushion.
The most appropriate solutionfor these two very different points of view is to create a "core' public investnent program that is equal to the best estimateof resource availabilities,and to have a 'non-core" set of projects that have been identified, designed, and costed, at least on a preliminarybasis. These could be executed without significantdelay if other projects slip, or if more resources than originallyanticipated should becomeavailable. Non-core projects would also be potential replacementsfor projects that looked promising but failed more detailed benefit-costanalysis and thus could not be includedin the annual capital budget for actual finding.
Assuming that reasonably good estimates of resource availabilitiesand project costs have been prepared, this core/non-core approach covers the base and high cases in terms of resource availabilities. Because some projects will inevitablydrop out of the pipeline, it also provides reasonable protectionfor the low case as well, where resources are less than anticipated,because of, for example, slower than anticipatedeconomic growth, or external trade shocks.
1.25 The convertible kroon does, however, have an important implication for implementingthe PIP. Convertibility will make it easier for the governmentto match the domestic and foreign resource availabilities with the project requirements for these resources, once total resource requirements and availabilitieshave been broughtinto line by reducingthe project list. If borrowed foreign resourcesare less than what is needed, the government can purchase the remainder with excess local currency. Conversely, if borrowed foreign resources exceed project requirements, the residual can be sold domesticallyfor kroons. However, if the government were to borrow more foreign exchange than is actually required to carry out the projects, this could create two potential problems. First, the governmentwould assume a foreign exchange risk if it sells the borrowed'foreign currency for kroons. Second, this debt reduces the country's future capacity to borrow abroad and raises the debt service burden. Therefore, unless foreign exchangeis needed for economicallyjustified purchases of imported investmentgoods, it should not be borrowed.
1.26 This section has shown that the suggestedinvestments in the PPL outstrip by wide margins both the domestic and the foreign exchangeresources that are likely to be availableduring 1995-97,and that the constraint on foreign exchangeis likely to be the binding constraint. The priority of all projects should therefore be reviewed carefully. Many of the suggestedprojects will have to be left to private sector initiative, postponed, or canceled to reconcile resource requirementsand availabilities.
C. Structural Reforms and Sectoral Investments
1.27 The strategic structural reforms that Estonia needs to make at the sectoral level in order to move from a centrally-plannedeconomy to a market-basedeconomy include changes in the ownership offixed capital and its sectoralallocation. Estonia is makingprogress through its privatizationprograms in transferring the ownership of existingfixed capital to the private sector. The process needs to be - 12 - accelerated, however, especially for housing, farm land, and large-scaleenterprises. The effectiveness of privatizationefforts also needs to be enhancedby establishingprivate property rights and registration procedures that are fully in line with European standards.
1.28 The allocationof newfixed capitalformationin the public investmentprogram shouldbe fully consistent with the privatizationprogram. The public sector should not invest in sectors that it is trying to turn over to the private sector through privatizationfor at least three reasons. First, scarce public resources should be reserved for investmentsin sectors where the private sector cannot meet the needs of the economy. Second, such investmentswould have to be privatized within a few years to complete the privatization strategy; the privatizationprocess itself involvessubstantial costs that could be avoided by not undertaking the investmentsin the first place. Third, public investmentsin sectors being turned over to the private sector discouragesprivate sector investors, who rightly fear that the public sector enterprises will be given preferentialtreatment in terms of access to capital and markets, thus making it difficult for the private entrepreneurto compete.
1.29 The first part of this section proposes a brief economicstrategy statement that could serve as the foundation for deciding on strategic sectoral priorities, in terms of both sectoral balance and public/private roles in each. The next part identifies key sectoral bottlenecksthat need to be overcome in order to accelerate Estonia's transitionto a growing, market-basedeconomy. The third part suggests a taxonomy of sectors in terms of the roles foreseen for their public and private ownership by the year 2000. A taxonomylike this could play an importantrole in helping the governmentdecide which sectors shouldbe given priority in the public investmentprogram. The fourth part examinesthe proposed project list in terms of the degree to which it focuses on projects in sectors of highest priority for public investment. The final part examinesthe role that public investmentcan play in regional developmentto improve overall social justice, and improve income levels for those currently living in regions that have been most seriously affectedby the transition process.
EconomicStrategy for Public Investment
1.30 The priority of proposed investmentprojects can be determinedonly if the government has a clear strategy regarding the desired respectiveroles of the private and public sectors. For example, an industrial project that uses domestic resources, generates substantialemployment in a poor region, is highly competitive on export markets, and has high economic and financial rates of return is clearly a high priority project. But would it be a high priority project for public investmentunder Estonia's post- Soviet economic policies? Probably not. Conversely, a project to build a clinic that would serve a remote rural area might have a low financialrate of return, yet be of high priority as a public investment project because it meets urgent social needs, but would not attract private investment.
1.31 A consensushas developedin Estonia that the public sector should only undertakeactivities where the private sector is unlikely to be successful. This same view is emerging in most transitional socialistcountries-and in countriesas diverse as India, Argentina,and Great Britain. Disenchantedwith the results of public ownershipand managementof productiveassets, these countries are privatizing not only industrial activities, but in many cases infrastructureas well.
1.32 The mission fully agrees with Estonia's strategy of reducing the public sector's role in the production of goods while enhancingthe quality of governmnentactivities in areas such as education, social services, public utilities, and public safety. These are areas where the private sector is generally not well suited to providing the necessaryservices. The planned reductionof public sector involvement - 13 - in economic activities is to be accomplishedboth by privatizing existing industrial and commercial activitiesand by avoiding new public investmentsin these areas.
1.33 To carry out this basic strategy, tactical questions must be addressed regarding the pace at which the devolution of economic activities from the public to the private sector takes place. If the governmentwished to privatize housing, electricitygeneration, or port operations within the next three years, for example, it would undertakevery little investment,leaving this entirely to the private sector. However, if the privatization of these sectors were to take place more slowly-over fifteen years, for example-the government would have to make most priority investmentsin these sectors. Pending a formal government statement of its economicdevelopment strategy, the draft statement of economic strategy in Box 1-5 would seem to be broadly consistent with the government'sviews.
Role of Public Investment by Sector
1.34 On the basis of the draft statement of economic strategy in Box 1-5, sectors have been categorizedinto four groups in terms of decliningimportance for public sector investment (Box 1-6). Within each group, the sectors are listed alphabetically.This categorizationof sectors by public/private role (PPR) provides a useful means of establishingproject priorities across sectors. The classification looks forward to the year 2000, by which time much of the transition now underway is likely to have been completed. This forward look is importantwhen reviewingproposed public investmentprojects, becausethe public sector should avoid committingresources to sectorsthat will soon be in private hands. Of course, exceptionsshould be made where investmentsare needed to preserve assets until privatization.
1.35 Activitiesin Groups 1 and 4 are expectedto be dominatedby, and in some cases exclusively operatedby, the public and private sectors respectivelyby 2000. Groups 2 and 3 have been presented separatelyto give some indication of which sectors might be privatized more quickly and which will probably stay primarily in the public sector beyond the year 2000. The allocation is inevitably approximate,but may provide a usefulbasis for discussingpriorities for public investmentduring the next three years-and for the privatization process after the sectors listed in Group 4 have been largely privatized. For example, the classificationof sectors shown in Table 1-4 above was based on the scheme in Box 1-6. The classificationof sectorsaccording to priority for public as opposed to private investment is heavily influencedby the sector work that the World Bank has conductedin Estonia over the past two years-including that work done by the initialeconomic mission in January and February 1992, as well as more recent work done explicitlyfor the Public Expenditure Review.6
1.36 The mission also drew on a variety of sectoral studies prepared by Estonian and foreign experts, some of which are listed in the bibliography. Althoughthe missiohbenefited from these studies in suggestingpossible sector classificationsin terms of their priority for public as opposed to private investmentas shown in Box 1-6, the govermnentshould review these classificationscarefully. Where the World Bankbelieves that additionalanalysis is required to determine the need for public investment, or the need for improved public policies to facilitate and encourage private investment, it would be pleased to help the government arrange for such work to be done with resources from the World Bank and other bilateraland multilateraldonors. Such technicalsectoral analysis is importantin order to avoid any risk of slipping back into Soviet-styleplanning, where priorities were establishedon the basis of political dogma, and not on the basis of a careful analysis of the sectoral investmentsneeded by the country, or whether the private or the public sector is best suited to undertake such investments.
6 The 1992 work was published as a World Bank Country Study entitled Estonia: The Transition to a Market Economy. - 14 - political dogma, and not on the basis of a careful analysis of the sectoral investmentsneeded by the country, or whether the private or the public sector is best suited to undertakesuch investments.
Box 1-5. Draft Statement of Economic Strategy
General. To help assure maximumeconomic efficiency and growth, the productionand sale of goods should lie primarily with the private sector. The governmentshould focus on assuring socialjustice, providingessential social and infrastructureservices, and fostering a stable economicenvironment favorable to private sector development.
Exit. The public sector will exit as quickly as is feasible from the following sectors: agriculture, finance, manufacturing,housing, sales and service, and will accelerateprograms to privatize assets in these lines of activities. At the same time, it will avoid new investmentsin these areas unless such investmentsare essentialfor the preservation of existing assets prior to privatization.
Private Sector Facilitation. Efficient private sector production in the sectors listed above depends on good infrastructure services. Although experience in other countries indicates that these services can be privatized, full privatizationwould be premature at this time in Estonia. However, some degree of privatizationis likely by the year 2000 in areas such as communications,ports (particularlysuperstructure), shipping, housing, and electricitygeneration. In some areas, this has already begun.
Public Goods. Governmentprograms are needed to provide services that are importantto societyas a whole, but which may be difficult for the private sector to provide because of barriers to recovering costs from the beneficiaries. These services generally include education, environmentalprotection, public safety, defense, and health care. Because Estonia does not yet have a fully adequatemedical insurancesystem that would assure access to adequatehealth care from private sector providers for people at all incomelevels, public resourceswill continueto be focusedon this sector as well.
Social Justice. Income disparities are naturally wider in a market-basedeconomy than in a planned socialist economy. Such differences must be allowed in order to provide incentivesfor innovation,risk taking, and hard work. However, strong social safety net programs are needed to protect those afflictedby age, infirmity,or bad fortune from poverty. High priority will be given to assuring that adequateresources are available for safety net programs, for they are essential to preserving the integrity of the Estonian nation, and thus the basis for economic and social progress. In addition to direct income transfers to the poor throughsocial safety net programs, additionalreal incomesupport will be providedthrough the high exemptionlevel for the personal incometax, as well as through enhancedsocial services, such as health and education.
Sectoral Allocation of Proposed Project List
1.37 As shown by the unshadedcolumns in Figure 1-1, the distributionof projects (in terms of relative priority for public investment)that emergesfrom the PPL is almostthe oppositeof what would be consistentwith the government's objectiveof reducingits role in areas where the private sector could better do the work. By value, only 37 percent of the proposals fall into the top two categoriesfor public investment,while nearly two-thirds of the proposals by value fall into sectors that should be of lowest priority for public investment. A different balance would appear advisable in the public investment program. Chapter 3 demonstrates ways in which the strategic criteria outlined in this chapter can be applied to projects in the current PPL to develop what would appear to be a more appropriatebalance in the public investmentprogram. The impact of applying these criteria on the level and distributionof public investmentresources across sector groups is shown by the dark shaded columns in Figure 1-1. Applyingthe strategic criteria simultaneouslyreduces the total level of investmentto an amount that is consistentwith resource availabilitiesand shifts the allocationso that most of the expenditureswill be on projects located in sectors where public investmentis most urgently needed. - 15 -
Box 1-6. PPR Groups: ProposedPublic/Private Roles by Sector by the Year 2000
1. Public sector domain 2. Public sector majority Educationa Culture Environment District heating and energy Government administration Electricity generation Highways Health and social assistance Labor and employment services Natural resource management Public safety and defense Forests, minerals, water Transport infrastructureb Airports, municipal transport, ports, railways Water supply and sewerage
3. Private sector majority 4. Private sector domain Communication Agriculture Electricity distribution Construction Finance Manufacturing Housing Natural resource use Mining Logging, mining, fishing Transport superstructureb Sales and service Airlines, sea freight and shipping, ports Tourism Sports (professional, spectator) Trucking a Education includes normal academic education (K through 12 plus university), plus other forms of education, such as physical education, vocational education, adult education, agricultural extension, and labor retraining. b Infrastructure includes basic facilities like landing strips, highways, channels, piers, wharfs, and rail connections, while superstructure is ancillary facilities like terminals, cold stores, general warehouses, specialized cargo handling equipment. and services for passengers.
Binding Constraints on Economic Growth
1.38 The sectoral structure that Estonia inherited at independence reflected decisions made by a socialist government for political as well as economic reasons. The future allocation of public investment across sectors needs to be consistent with Estonia's own structural reform strategy, which involves changing the relative importance of sectors to help establish a market-based economy.
1.39 During 1990, about 12 percent of general government expenditures was for investments. Additional funds for public enterprise investments were made available directly through transfers from Moscow, often through the banking system. The investments under the Soviet regime were focused primarily on industry, agriculture, transportation, and housing (Table 1-5). New investments tapered off rapidly in the 1980s, however, as the former Soviet Union encountered increasing economic problems. After independence, the government had to focus all available resources on stabilization and on meeting priority recurrent expenditures, such as salaries and social safety net payments. By 1992, public investments had fallen to 4.2 percent of government expenditures and only 1.3 percent of GDP.
1.40 As Estonia's integration with the global economy continues, and its economic structure responds to world prices and global competitive pressures, substantial changes can be anticipated in the relative importance of sectors. Those based on highly subsidized inputs (particularly energy) will have to shrink relative to more intrinsically competitive sectors, unless the energy efficiency of such sectors can be raised to world standards at a reasonable cost. The relative importance of those which depended on protected FSU markets and subsidized output prices will also have to decline. Sectors with a natural comparative advantage based on Estonia's resources, including forests and skilled workers, will rise in - 16 -
Figure 1-1. Distribution of Investment by Public/Private Priority Groups (Million EEK)
6.000 ......
5,000 . _7 7.
3.000- . Xt...ii
2.000- l| ......
I PublicSector Domain 2. PublicSector Majority 3 PrivateSector Majonty 4. PnvateSector Domain
| Submissions I Proposal m %jh%estpipXprcectsxls
Note: The four pairs of bars reflectgroups of sectors of similar priority in termsof their claimson public investmentresources. Group I has the highest priority for governmentinvestment expenditures, while sectors in Group 4 are most suitablefor private sector investment. The submissionsbars reflect the total expendituresthat appear for each sector group in the proposed project list. The proposal bars reflect the sectoraldistribution that resilts from reducing the total cost of projects to a level that is consistentwith the projectedresource availabilities for 1995-97;this reductionis accomplished by eliminatingprojects regarded by the missionas having lowestpriority for the public investment program. The reduced set of projects is not only consistent with available resources, but also significantly reduces the share of investmentallocated to sectors where the private sector could and should play a more significantrole.
Table 1-S. Sectoral Allocation of Public Investment, 1970-89 (percentages) Average Sector 1970 1980 1987-89
Industry 28.8 25.7 0.7 Agriculture 16.7 21.4 15.8 Transportation 1.2 7.3 15.6 Housing 29.1 18.1 30.4 Other 24.2 27.5 37.4 Total 100.0 100.0 100.0 Memo item: Total net fixed investment (RUR million) 347.6 509.3 432.7 Source: World Bank. Estonia: The Transitionto a Market Economy, Washington,D.C., 1993. - 17 - rise in relative importance, while those not as well suited to Estonia's nordic climate and limited energy and mineral resources will naturally decline. Experience to date has shown the following patterns emerging.
* Agriculture is undergoinga major downsizing. In Soviettimes it dependedheavily on highly subsidized energy, fertilizer, and other inputs from the FSU, and on FSU markets for its products. Today the subsidiesare gone, along with a large share of the FSU markets for Estonian agricultural goods. Since fully compensatingfor the loss of FSU markets with exports to Western markets will be difficult within the foreseeable future, little if any investmentin new agriculturalcapacity will be needed. Investmentsto improve quality and efficiency will be needed, however, in both agriculture and agro-processing. Investmentsin agro-processingand distributionwill increasecompetition for farm inputs and for consumer sales, thus reducing the current tendencyof factoriesto delay payments to farmers for inputs and charge higher prices to retail stores. Investments are also needed for on-farm infrastructure to convert the large Soviet-era collective and state farms into smaller commercial
farms of an economic size, for example, of around 300 hectares each (see paragraph 1.58). While the public sector may help through lines of credit on reasonablecommercial terms, the investmentsper se should be undertaken largely by the private sector.
a Industry in Estonia is in a somewhatsimilar situation, having lost its access to cheap energy and its market for low quality goods. Prospects are brighter for this sector than for agriculture, however, becausetrade barriers in Western marketsare generallyfar less severe for manufacturedproducts. Also, industry does not face the same nordic climate problems that agriculturedoes, and Estonia's skilledwork force is an importantasset for manufacturing activity. Investmentswill be needed both in new industrial capacity and in improvingthe efficiency and quality of existing capacity. But as in agriculture, virtually all of this investmentshould be undertakenby the private sector.
* Housing, a third major sector in Estonia, faces a completelydifferent set of issues, because this is a non-tradableproduct. The market for housing is entirely domestic. A strong, repressed demand exists for better quality and more energy-efficienthousing, and with the rapid growth of the private sector, an entrepreneurialclass is emerging in Estonia that can afford such housing. Meeting this demand could result in a major impetus to growth in ancillary industriessuch as buildingmaterials, construction,real estate development,and the provision of municipal infrastructure. The bulk of this investmentshould be undertakenby the private sector, but important supporting investments in municipal infrastructure, for example, will be required from the public sector.
* Transportationis the final major sector, and substantialinvestments, both public and private, will be required to avoid serious bottlenecks to Estonia's rapid economicdevelopment. In the longer term, much of the transport sector should be privatized; good scope exists for competitionin the sector, and a clear market price exists for transport services. However, for the rest of this decade, transport services such as rail, municipal transport, and port infrastructure are likely to remain in public hands and will create demands for substantial public sector investment. - 18 - 1.41 Although this analysis indicatesthat the share of public investmentgoing into sectors such as industry, agriculture, housing, and certain parts of the transportationand energy sectors will be lower than in the past, the ministries responsiblefor these sectors will continueto play important roles. Most significantly, these ministries will need to monitor these sectors on a continuing basis to identify developmental bottlenecks that require government intervention, either through policy changes, investmentsin complementarypublic services, or even additional resourcesmade availableby on-lending through the financial system. Becausethe levers of control are less direct when ministries work through policies rather than through direct investmentand ownership, the challengeof facilitatingdevelopment in these sectors will be even greater than before. Investmentsmay have to be made in the human capital of these ministriesthrough appropriatetraining courses, both in Estonia and abroad, to help them fulfill their new, more policy-orientedrole.
RegionalDevelopment
1.42 Regional disparities were not significant before independencebecause the Soviet planning system sought to minimize income differences. With few exceptions, the state owned all productive assets, and everyone was an employee. Consequently,attaining a uniform distributionof income across sectors, regions, and social groups was relatively easy, but involved heavy costs. Less productive employees, enterprises, and sectors were subsidizedat the expense of the more productive ones, thus reducing or eliminating any incentives for economicefficiency.
1.43 Significant regional disparities in unemploymentrates and in average income levels have emerged in Estonia since independence. These are an entirely normal part of the transition process, but have becomea matter of genuine concern in Estonia. Lessening regionalincome differences and assuring more adequateemployment opportunities has thus become a strategicallyimportant issue, one that should be considered in designing the public investment program. This issue must be handled with care, however, for substantial resources can be spent on regional developmentwithout attaining the desired results.
1.44 Efforts to equalize income across sectors and regions of the country by focusing public investmentfunds on areas that have sufferedduring the transitionto a market economy,are almost certain to result in a double loss. First, the resourceswill by definition go into the least productive areas and activities,which will reduce the return on public funds. Second,by artificiallysupporting production and incomes in the less productive areas, the market signals regarding relative competitiveness and profitabilitywill be obscured,and lead to furtherdiversion of scarce national resourcesinto areas of low efficiency. For example, investingin a major factory in a remote area solely for regional development objectivesis likely to result in high cost future production, a need for additionalpublic investmentsto provide supporting economic and social infrastructure facilities, and the risk that subsidies will be required indefinitely to cover ongoing operating losses. Regional development investments in other countries have commonly led to demands for protection from importedgoods that have been produced more efficientlyelsewhere. Granting such protection reduces the fiscal burden for the government, but often results in an even greater cost to the entire nation in the form of higher cost goods. If predatory, short term dumping of importedagricultural goods can be proven, temporaryanti-dumping measures are allowed under the General Agreementon Tariffs and Trade (GATT), but such measures should be used sparingly because they tend to be converted into long-term protection, which fosters economic inefficiency.
1.45 Public investmentsfor regionaldevelopment can, however, be justified when market failures make it unattractivefor the private sector to undertakeinvestments that would otherwisebe well justified - 19 - and would contributeto improved incomes in the region, or when pressing social objectivesmake such expenditures essential. The main types of market failures relevant to regional development are externalitiesand risk.7
1.46 Externalities. A private firm must be able to capture at least part of the benefits generated by an investmentto repay the investmentand make a profit. The benefits of some investments,however, are difficultfor a private investor to capture. For example,if industries that could just as well be located in Parnu, Tartu, or Narva are moving instead to Tallinn because of its better infrastructurefacilities, public investmentsin social and physical infrastructuremay well be justified in these secondarycities. The justificationfor such investmentscomes not only from the social benefitsof a more balancedpattern of growth in the country, but also from the fact that the cost of providing infrastructure in secondary cities, where there is less congestion and lower land values, may be lower than in cities like Tallinn, provided the secondarycity is of sufficientsize and density. No single firm could afford to install such infrastructure, which benefits many producers and, especially in the case of social infrastructure, generatesbenefits that are hard to capture throughuser charges. However, if the governmentmakes the investment, all will benefit, raising overall economic activity. Any costs that the government cannot recover directly throughuser charges can be recoveredthrough taxation of the increasedoverall tax base. Externalitieslike this, which are one of the most importantcharacteristics of a public good, are a rnajor argument for public investmentsfor regional development.
1.47 Risk. Two types of risk may possibly justify government intervention for regional development objectives-excessive perceptions of risk, and risks that are indeed excessive from the perspective of a single investor, but which, if shared by society at large, would be acceptable.
1.48 Excessiveperception of risk is very commonin transitional economies,particularly among bankers who have not yet developedthe credit risk assessmentskills and ability to evaluatebusiness plans that are the mark of a good banker in a developedmarket economy. Proposed projects in less developed regionsof the country may be sound, but if the banks cannot evaluate the proposals with confidence,they will hesitate to lend. (This natural caution has becomeeven more pronounced since the banking crisis of late 1992 when the government made it clear that there is no safety net for banks; they must take responsibilityfor their own survival.) Excessiveperceptions of risk are a major problem today for lending to farmers. The banking sector does not yet have the ability to evaluate agriculturaloperations in a market economy. Banks are hesitant to lend to farmers because they perceive the risks as greater than they actually are. Even efficient farmers can be forced out of business by the lack of access to credits neededto purchase inputs and equipmentfor improvingthe quality and efficiencyof their farming operations. In such cases, governmentintervention is clearly justified.
1.49 Any agricultural credit program must be launched with great care. Much of the risk in agricultural lending is not only perceived but is also quite real. As discussed in the previous section, Estonia's agricultural sector faces many constraints-a hostile nordic climate, fifty years of mismanagement,a heavy dependence on energy that is no longer highly subsidized, and the loss of markets for a major share of its output. Banks are properly cautious about lending into this situation. Any government-sponsoredfinancial investmentsin lending to the agricultural sector should face these realities squarely. Valuablefiscal resourcescould be wasted trying to sustain an agriculturalsector that is larger than can be justified given these constraintsand risks. The importance of agriculture relative to other economic activities is diminishing in industrializedcountries around the world. The need for
7 A more general discussion of these issues is provided in Annex 1. - 20 - agriculture to contract relative to other sectors seems inevitable in Estonia as well. Estonia has the opportunitynow to avoidthe costly path taken by its Europeanneighbors, one of distortingmarket prices and making large fiscal transfers to agriculture to protect a rural lifestyle for a relativelysmall share of the total population. Thus, any credit operations to support rural developmentshould be undertakenon the basis of solid financial criteria. Promising areas for developmentin the rural sector that are likely to pass financial and economictests include, for example, forestry(thinning, road building, logging, and sawmills), inland fisheries, service activities (custom sowing and harvesting, local goods transport, vehicle repair, wholesaleand retail trade), some light industrial activities (particularlythose based on rural inputs such as food processingand millwork), rural tourism (guest cottages, restaurants,and tours) and, of course, a varietyof traditionalfarming activities, which-if done on a commnercialscale with good techniquesand appropriateinputs and equipment-may be competitivedespite the overalldownsizing of the sector.
1.50 The need to spread excessive real risk is another possible justification for government intervention on behalf of regional development. The need to spread risk is particularlygreat in the case of large infrastructure projects. For example, small industry development may be discouraged in secondary cities by the lack of access to buildings and land with adequate infrastructure. Consequently, the public sector may be justified to invest in a zone for industrialand commercialdevelopment, where enterprises can buy or lease land and have good access to basic infrastructure. The scale of such a venture would create risks beyond the ability of most individual firms to handle, but could promote economicallyviable development. Such public investmentsshould, however, be done in partnershipwith the private sector whenever possible. The public sector should invest directly only in facilities which, because of externalities, would not be attractive for private sector investors, but which do have an acceptable rate of return. However, given that substantialrisks are involved in such investments,such projects should be kept small relative to the overall public investmentprogram.
1.51 The other main argument for public investmentfor regional developmentrelates to social objectives. Given the priority that the governmentof Estoniarightly places on socialjustice, some public investmentsto improvethe physical qualityof life will bejustified in disadvantagedareas. Health clinics, elementary schools, water and sewerage,and police and fire protection facilitiesare all potentiallygood public investmentswhere local populationsdo not have enoughincome to support such facilitieson their own. Such facilitiescan be used to improve inter-regionalequity in quality of life withoutdirect income transfer payments. Such investments,together with limiteddirect incometransfers, may also be justified in the case of older displacedagricultural workers who are unlikelyto be willing or able to leavethe rural sector to take jobs in urban areas. The economic cost of retaining such people in the rural sector will generally be considerablylower than would be the cost of supportingthem as unemployedpersons in urban areas. First, they already have housing in the rural areas; second, some food self-sufficiencyis usually possible through garden plots and small livestock; and, third, in some cases, energy self- sufficiencybased on wood is also feasible.
1.52 Labor Mobility. It is generallycheaper to take the people to the jobs than it is to take the jobs to the people. The private sector creates jobs in locationsthat offer the greatest potential for efficient production and profit. Economicefficiency, and thus worker incomes, are likely to be maximizedby facilitating the movementof workers to parts of Estonia where the private sector is creatingjobs, rather than by trying to stimulate the artificial creation of jobs in districts that offer limited prospects for efficient production. The relative advantagethat the major cities have over the rural areas in terms of the potential for creating new jobs is clearly seen in the distribution of business establishments. For example, Tallinn had 43 businesses per 1,000 people at the end of 1993, while East Virumaa (the northeastern area of Estonia) had only 12 businessesper 1,000 people. In addition to a larger number - 21 - of businessesper thousandpeople, the businessesin Tallinn tend to be larger and more prosperous,which further increases their employmentgeneration potential.
1.53 Major efforts to improve labor mobility would be justified in Estonia so that workers find it easier to move to the areas wherejobs are being created. Fortunately,Estonia is relatively compact and has a highly developedroad and rail system. Consequently, distanceis not an importantbarrier to labor mobility. The main problems relate instead to housing, education,tradition, and language. Housing has long been a barrier to labor mobility, a barrier once made even more severe by the infamouspropiska, a system of residency cards that made it virtually impossibleto move from one town to another. That system is now gone, but housingshortages remain a difficultproblem. The economic decline associated with the transition to a market systemhas been most notable in the agriculturalareas and in towns with one or two large, inefficientmanufacturing plants that are no longer competitive. In both cases, people are tied down by housing. Because of the overall scarcity of housing, rental units are commonly not availablein the urban areas wherethe rapidly developingprivate sector is creatingjobs. Home ownership is also not an option for the unemployedwho would like to move to these areas. First, very few private residentialunits are availablefor sale becausethe housingprivatization program has not yet really begun, and the existingstock of privatelyowned urban housing is negligible. Second, the governmenthas only recently begun to take the measures-such as selling land to private developers-that are needed before real estate developerscan build new private housing. Third, the unemployedhave almost no savings that can be used as a down payment on housing. Fourth, even if the unemployedwere to be given their existing housing through privatization,it would be difficult to acquire the necessary savings by selling such housing because of its limitedvalue in the depressedmarkets where unemploymentis most severe. One of the most effectivestrategies for raising the incomes of people currently living in depressed areas thus may be to accelerate the policy reforms needed to encouragethe private sector to develop more adequatehousing in the urban areas where jobs are also being created by the private sector.
1.54 Other barriers to labor mobility, such as social services, educationand training, tradition, and language, can also be addressed through appropriate governmentpolicies. Restricted access to social services is a problem closely related to housing availability and, though less serious, seems to be a significant barrier to labor mobility. Under the Soviet system, factories, enterprises, agricultural collectives, and state farms provided not only housing for the workers, but also social services such as day care, schools, and clinics. Under a market system, such services are generally provided by the governmentor, for the more affluentclasses, by the private sector. However, a lack of resources and time has made it difficult for governmentagencies, particularly at the local level, to begin providing these services on a community rather than an enterprise basis. Likewise, the lack of purchasing power in a depressed economyhas limitedthe incentivesfor the private sector to begin offeringsuch services. Until this happens, workers will be tied to their old places of employment-even if they are effectively unemployed. In fact, retainingaccess to social services appears to be a key reason for the exceptionally low reported levels of unemploymentin Estonia; people are willingto acceptreduced hours and furloughs to maintain access to these services. The system clearly discourageslabor mobility.
1.55 Education and training appear to be manageableproblems, particularly for workers in the industrial sector. Overall levels of educationare very high in Estonia compared to most countries of a similar income level. Therefore, modest technicaltraining programs designed to help people gain new skills-such as how to use a computer and how to search for a job in a market economy-may be sufficient. Tradition is a more intractableproblem, particularlyfor farm workers. Rural life has a very special meaning in Estonian society, and nothing can or should be done directly to try to change this. However, the transition to a more urban life style with better accessto the new jobs being developedin the private sector can be encouragedfrom two directions; first, by limitingartificial supports to rural life, - 22 - such as uneconomicpublic investmentsin rural areas, protectionist agriculturalpolicies, and subsidized agriculturalinputs; and second, by making the move to urban areas easier throughjob skills training and policies that are friendly to housing development. The role of languagedoes not appear to be a major problem with respect to labor mobility for workers in rural areas. It may, however, be a hindrance for workers in some of the affectedindustrial areas, especiallyin the northeast. These workers would find it easier to move into the most dynamicarea of the Estonian economy, the services industry, if they were fluent in conversationalEstonian and even English. Languagetraining could be arranged by the public sector at relatively low cost and could have major benefits for labor mobility and for integration of the national society.
1.56 Even in these areas, however,private sector ownership and control may be feasible. Once adequateregulatory mechanismsand skills have developedwithin the government, natural monopolies can be owned and operated by the private sector under the government's regulatorycontrol-as shown by the success of the privatization of railways, telecommunications,water supplies, and other basic infrastructure in Europe and Latin America during the past decade. Also, once Estonia's economic transitionand recovery is further advanced,a sufficientlylarge affluentclass will develop that can support private schools, clinics and hospitals. In fact, some such activity is already seen today.
1.57 Other Considerations. The following points should also be considered when reviewing potential public investmentsdesigned to address regional developmentobjectives:
e Social Safety Net. Personal incomeenhancement is the key reason for considering regional development projects, and it may be more cost effective to offer means-tested income transfers as part of the national social safety net than to make high-cost investments in physical assets that may or may not generate the desired improvementsin personal incomes.
- 'Export-oriented' RegionalDevelopment. A standard approachto developingrelatively poor regions is to offer grants and concessionalloans for individualsto start up small businesses. These commonlyfail becausethe new small businessesproduce goods like bread or services like catering that are designed to serve the local community. When the entire local community is impoverished,small enterprises have trouble staying in business. Starting a successful new enterprise under such conditionscan be very difficult. A strong preference should therefore be given in regionaldevelopment projects to encouragingthe production of goods and services that can be sold to people outside the region. This could include not only goods "exported"from the region, but also services, like tourism facilities, that draw money from outside the region.
* Border Areas. Pressures exist to help farmers establish and maintain operations in sensitive areas in the eastern part of the country. To the extent that governmentexpenditures are seen as justified and necessaryto support such efforts, the costs shouldbe allocatedto defense and public safety rather than to agriculture, if agriculture would not otherwise be viable in such areas.
1.58 In sum, proposals for public investmentdesigned to improve incomes for people living in rural and affected industrial areas should be reviewed very carefully. The best way to attain the social objectives,which are very important, may be through expenditures,programs, and policies that facilitate the movement of labor to rapidly growing areas of the country rather than through direct efforts to develop the economicallyaffected regions. Nevertheless, some investmentsin restructuring the rural sector to convert large Soviet-erafarms averagingaround 3,000 hectares each into smaller conmmercial - 23 - farms averaging250 to 350 hectares, may well be justified. Investmentsto improve facilitiesfor food processing in rural areas may also be justified. Most of this "investment,"which will involve sheds, equipment,and housing,should be undertakenby the private sector. Somepublic support,however, may be required to assure that adequate banking services are available. Programs such as the Rural DevelopmentFund and the Rural BusinessFund may contribute to this effort. Such services should be made availableat charges that cover costs.
D. Project Prioritization within Sectors
1.59 Strategicissues by definitionapply more to macro and sectoralbalance than priorities within sectors. This section, however, notes some cross-cutting issues of strategic importance that the governmentwill face in selecting specificprojects for the public investmentprogram. These criteria, which play a major role in the recommendationsmade in Chapter 3, relate primarily to various aspects of economicefficiency.
Rates of Return
1.60 The best known measures of economicefficiency are various forms of discountedcash flow (DCF) analysis, such as rates of return. However, as discussed earlier, the informationneeded to do discounted cash flow analysis generally does not exist when the public investment plan is being formulated. Consequently,for selectingprojects within sectors, strategic concerns and priorities, such as maintenanceand repair, energy efficiency, completion of ongoing projects, and future estimated operatingcosts, must be used for the initial screeningof projects to be includedin the public investment program. Nevertheless,before projects are actuallyincluded in the annual capital budget, a detailed rate of return analysis should be done to computefinancial and economic rates of return. This analysis will help assure that only economicallyacceptable projects are identifiedand financed, and that the optimal technicaldesigns are chosen for these projects. If rate of return analysis is not possiblebecause benefits cannot be quantified, alternative types of analysis, such as cross-over discount rates and least cost analysis, shouldbe used. Least cost analysismight be appropriate, for example, in the case of schools or clinics wherethe educationand health servicesare not sold at competitivemarket prices that cover all costs. 8
Maintenanceand Repair
1.61 Buildingnew projects is almostalways more appealing than fixing up old ones. However, experiencefrom around the world indicatesthat investmentsin deferred maintenanceand rehabilitation of otherwiseviable facilities that have been allowedto deterioratecan have far higher rates of return than the construction of new projects. In fact, unless the existing facility has suffered serious structural damage or would need to undergo major modificationsbecause of fundamentalchanges in its intended use, it can generally be assumed that rehabilitationwill be more cost effective than new construction. This is particularlytrue in a country like Estonia,which enjoyed an exceptionalendowment of productive assets comparedto most countries under the FSU, but which has gone through a period when resources were not available to maintain and repair these facilities. Priority should generally be given then to rehabilitationand repair projects, rather than to new ones when framing the PIP. But each project will need to be evaluatedon its own merits since exceptionsdo exist. For example, some of the old manor
8 The Bibliographyat the end of this paper lists referenceson these techniquesof project analysis. - 24 - houses now being used as long-term care facilities for the aged and infirm would be very costly to rehabilitate and upgrade to modern facilities that are energy efficient and cost-effective. In such cases it may be better to build new facilities specificallydesigned for their purpose.
EnergyEfficiency
1.62 Estonia's physical capital stock was largely designedfor an environmentwhere energy costs were so low compared to world prices that energy efficiency was basically irrelevant. Now that the energy prices paid by Estoniaare close to world prices-including energy importedfrom Russia-energy efficiency is of critical importance. Thus, as a general strategy, projects that enhance energy efficiency should be includedon a priority basis in the public investmentprogram.
Completionof OngoingProjects
1.63 Of the 281 projects in the PPL, 103(37 percent)are ongoing. Of these, most are in the early stages of execution-only 5 percent of the anticipatedcost of these projects had been spent by the end of 1993. However, the remainingcosts of these ongoingprojects (EEK 4.9 billion) exceeds by nearly two times the EEK 2.7 billion of resources likely to be available during the PIP period for physical projects in the public sector. Expenditureson one-fifth of the ongoing projects by value will thus have to be stopped or postponedbeyond 1997 to bring expendituresinto line with the resources expected to be availableduring 1995-97. Even sharper reductionsin expenditureson ongoingprojects will be needed if any new projects are to be undertakenduring the PIP period. Box 1-7 presents some of the key issues that must be examinedin deciding whether or not ongoingprojects should be completed or dropped.
Box 1-7. Analysis of OngoingProjects
Ongoing projects present special analytical problems for countries in transition. Virtuallyall of these projects were started under Sovietoccupation in response to prioritiesthat often had little to do with economic efficiencyor social justice. On the other hand, some incompleteprojects may, if finished, have benefits that exceed the costs of finishing them because of substantialsunk costs. Abandoningsuch projects couldbe a mistake. Determiningthe appropriateaction requires a careful economicand financial analysis of every project in the proposed portfolio.
Ongoing projects are particularly important in Estonia because of the many projects begun in 1991, when a combinationof favorable terms of trade and non-paymentof taxes to Moscow generated exceptionalpublic resources. The resulting euphoria led to the start of projects that would not have been undertakenin current circumstances. Many of these appear to be at the municipallevel and thus may not have a major impacton the state budget, but special care will be needed at the local level in deciding their future.
The lack of detailedproject-specific data makes it impossibleto indicateat this time which ongoingprojects should be dropped and which shouldbe completed. In general, however, the followingcriteria might be used to determinewhich ongoing projects should be subjected to particularlyclose scrutiny:
a Projects with estimatedcosts exceedingEEK 10 millionwhere more than20 percentof the expenditureshave yet to be made;
* Projects with only ceremonial or recreationalpurposes (except possibly tourism projects needed to attract clients from abroad and where such facilitiescannot be provided by the private sector);
* Projects in sector groups with a relativelylow priorityfor public investment. - 25 - 1.64 Fortunately, little would be lost in terms of "sunk costs" by abandoninga major share of the ongoing projects in the current PPL if they should prove to be inconsistentwith public investment priorities in Estonia's emergingmarket-based economy. Nearly 50 percent of the money already spent on ongoing projects is comprised by only three projects (Lekto Potato Processing, Coast Guard, and Tallinn Water Ozonization). Less than EEK 10 million each has been spent on the other 100 ongoing projects, and on 57 of these, less than EEK 1 million has been spent.
1.65 In addition to the three ongoing projects mentionedabove, the following proposals may be worth special review because of their large size: Tallinn water and environment project (EEK 725 million); municipalwater and environmentproject for Estonia (EEK 688 million); joint road constructionproject with Russia (EEK 650 million);bus reconstruction(EEK 390 million);Tallinn long distance heating (EEK 203 million); Tartu University medical buildings (EEK 185 million); Valga hospital projects (EEK 61 million). These eight projects, with total costs of EEK 3.2 billion, together with the three on which substantialsums have already been spent, accountfor EEK 4.0 billion or nearly 80 percent of the cost of ongoingprojects. Many of these projects are clearly of very high priority and should be completed, but examining only these eleven ongoing projects would provide excellent information on reductions that might be possible so that the highest priority ongoing projects can be assured adequate funding for their timely completion, and so that funds could be made availablefor any new projects that might be of even higher priority. A close examinationof these large projects may indicatethat some of them actuallyconsist of a number of separable,smaller components. By eliminating components that do not pass appropriatetests of efficiencyand priority, the net benefits of the projects could be increased, and costs could be reduced at the same time.9
Future Operating Costs
1.66 The analysis of future operatingcost requirementsis particularlyimportant for public sector investmentsbecause public sector investmentsare often not self-financing-a major reason, of course, that they have to be done by the public rather than the private sector. Of particular concern are investmentsin schools and health services. Such services are quite labor intensive, and their staffs tend to command relatively high salaries. In addition, medical facilities require ongoing expenditures on expensive supplies and equipmentto function effectively. Heating and other energy costs are also a particular burden because of Estonia's nordic climate. Maintenanceof the physical facilities can be a miajorcost, not only for public buildings, but also in many other areas, includingports, public safety, highways, and municipal infrastructure. If the government cannot afford to supply the budgetary resourcesthat will be required in the future, the facilities should not be constructedtoday. Recurrent costs are thus a key strategicfactor that should be consideredin decidinghow much to invest in physical facilities. The analysis of recurrentcosts, which has to be done in the context of the total government budget, may lead to the conclusionthat the total size of the public investmentprogram shouldbe curtailed so that adequate recurrent budget funds are availablefor operating and maintenancecosts.
9 A more detailed examination of individual projects is presented in Cbapter 3. - 26 - E. Conclusions and Agenda for Action
1.67 Many strategic criteria for project selectionhave been discussedin this chapter. Inevitably, when multiplecriteria must be considered,tradeoffs will have to be made. Judgment will be required, and each individual project will in the end have to be evaluated on its own merits. Some general conclusionscan, however, be drawn regardingthe types of projects most likely to be of particularlyhigh or low priority in terms of these criteria. A sample of such conclusions for Estonia's 1995-97 public investmentprogram is shown in Box 1-8.
Agenda for Further Action
1.68 From a strategic perspective,the following actions are needed to facilitate formulating the public investmentplan for 1995-97. The Public Investment Program Working Group (PIPWG)and its Secretariatin the Ministry of Finance or Economywould logically take a leading role in this work. The work will probably involve more consensus-buildingthan technical issues, like macroeconomicresource projectionsor project cost analysis. The PIPWG may wish to review basic decisions with the Council of Ministersand key parliamentarycommittees as the work progressesto avoid problems at later stages. The key stages include the following:
- Economic Strategy. Endorsea brief statement of national economicstrategy for the medium term, including an indicationof the priority of each sector for investmentby the public as opposed to the private sector.
- OverallLevel of PublicInvestment, 1995-97. Confirm or modify estimates of the probable feasible size of the 1995-97public investmentprogram (see Chapter 2).
* On-lendingto Private Sector. Reviewand confirm the share of borrowed foreign resources to be allocated to the private sector by on-lending through the financial system; this will be the binding constrainton the feasibletotal size of the public investmentprogram for physical investmentprojects.
* Efficiency CriteriaIssues. Agreethat investmentsin maintenance,repairs, renovation,energy efficiency and, where still appropriate, completion of ongoing projects should be given priority over new construction, particularly if the costs of new construction are large. Calculate rates of return on projects where this is feasible.
* Clarificationof Data. Much of the informationneeded to appraise the priority of individual projects is not yet available. In fact, the limited quality of the present data makes it difficult to determine the degree to whichthe PPL is out of line with probableresource availabilities. The PPL needsto be reviewedcarefully to eliminateduplicate projects and to includeprojects that have been omitted. Total cost estimates should be reviewed and updated. Data on expendituresper year shouldbe collectedfor all projects and, where possible, disaggregated in terms of domesticand foreign costs. Improved informationis needed on the amountsand timing of anticipatedproject benefits.
* Prioritization of Projects. With a solid definition of public investmentpriorities by sector, and with good data on project costs and benefits, the most difficult part of the job can begin-developing a consensuson the projects to be eliminatedfrom the PPL for the 1995-97 PIP. - 27 - * PIP Drafting. The main purpose of developing a PIP is to establish the government's investmentpriorities so that high priority projects can be assured of adequate and timely funding. For this purpose, the project list resulting from the previous step might seem sufficient. However, a formal public investmentprogram documentshould be prepared to inform others in both the public and private sectors of the priorities that have been established,and to serve as a basis for mobilizingthe foreign exchangeresources that will be required from external sources, primarily internationalfinancial institutionsand bilateral donors.
* Annual Capital Budget. As soon as the draft PIP is ready, prepare a draft annual capital budget (ACB) for 1995.
* Local GovernmentInvestment. The current PIP work focuses on projects having a direct impact on the state budget. Parallelwork is needed to establish a rolling three-yearplan and annual budget for investmentat the municipal level. - 28 -
Box 1-8. High and Low Prioriy Projectsfor the PIP
This box summarizesthe kinds of projects that would typicallybe of particularlyhigh or low priority for public investmentin Estonia during 1995-97, based on the strategiccriteria developedin this chapter. Within each group, the sectors are listed in alphabeticalorder.
The priority ratings in this list are only in terms of public investment during the 1994-96 planning period. Projects with a low rating in this list are not necessarilybad. Some could well be of high priority for private sector development,or even for public investmentat a later date after more immediatepriorities have been addressed.
Higher priorityprojects
* Airports: Completionof safety-relatedand air traffic control investments. * District Heating: Boiler conversions; reductionof generationand distribution line losses; heat control and measuringequipment in substationsof major buildings. * Education:Energy efficiency; structural repairs and renovations;development of some rural schools. * Finance: Export credits; revolvingfund for bank recapitalization. * Governance:Real estate registry; public safety (police, fire, ambulance service, and courts). * Health:Completion of well-designedprojects; investmentsin renovationsand energyefficiency; conversion of spare hospitalcapacity to alternativehealth care uses. * Highways:Maintenance, including top dressing and overlays; rehabilitationand reconstructionof roads. * Housing: Essentialstructural repairs, low cost investmentsin energy efficiency. * Ports: De-bottleneckingof basic infrastructurefacilities, deferred maintenanceand repairs. * Water Supply:Completion of major ongoing water treatmentprojects; small projects to improvelocal water and sewage treatmentfacilities; initiationof more comprehensivewater and sewerage projects as resources permit.
Lower priorityprojects
* Agriculture: Investmentsin productionfacilities. * Culture and Sports: Major investments that can be postponed (for example, existing buildings can be renovated, thus avoidingthe need to build major new buildings,and small investmentscan stabilizeexisting monumentsand other cultural buildings, thus avoidingthe need to undertake large-scale renovationsat this time). * Education:Major new educationalbuildings, wheretemporary alternative facilities can be used temporarilyto attain the key educationalobjectives. * Health: Construction of new hospitals and clinics, and completion of ongoing projects that are poorly designed and executed. * Housing: Constructionof new public sector housing. * Manufacturing:All investmentsare questionablebecause the private sector should take over assets in the sector throughprivatization and be responsiblefor all future investments. * Mining: Private sector initiativeshould be tapped. * Municipal:Market place development(if this could be done by the private sector). * Ports: All investmentsin superstructurefor the Muuga Port, includingterminals for dry bulk, oil, coal, and containers; such investments could almost certainly be financed by the private sector, which is already involved, for example, in two oil terminals. CHAPTER 2
Resource Prospects
A. Introduction
2.1 In the past, the main function of Estonia's public expenditure management was to ensure control over expendituresin compliancewith planning norms and targets. As the financingarm of the central plan, the budget directly controlledthe allocationof resourcesthrough state orders, subsidies,and loans to enterprises. With the transition toward a market economy, the role of the government has changed. Instead of directivesand controls, the governmentnow generallyallows free prices to influence actions of firms, individuals,and local governments. The tax and budget reforms in 1991 helped reorient the Estonian governmentto perform functionsneeded in a market economy. Subsidies and lending to state enterprises were cut down, the system of state orders was abolished, and the budgetary functions were delinked from the state enterprise sector. Within the limits of the nation's capacity to pay taxes, the government now providesbasic public services, and supports an active private sector as an engine of overall economic activity.
2.2 Work on the maintenanceand enhancementof social and economic infrastructuresis off to a good start. Expenditureson public administrationhave increased rapidly from a very low level, reflectingthe costs of buildingup the institutionsrequired for a nation that has regained its freedomafter fifty years. These institutionshave included, for example, a newlyestablished local governmentsector, expanded functions of ministries,new embassies,national defenseand security forces, coast guard, and customs check points. Expenditureson marketed goods and services have become less important. Earlier, these expendituresconsisted largely of producer subsidiesto agriculture, housing, and public utility and service enterprises. With new price liberalizationand cost recovery policies, these subsidies have been mostly dismantled. Remaining support to the economic infrastructure, which is still substantial, consistsmainly of road building, maintenanceof governmentforests, railroads, airports and waterways, support to agriculture, and subsidiesto local transportation.
2.3 Social services and transfers to households have become' the main functions of the government. Expenditureson the social safety net have increasedpartly in response to the shifting of public services (day care, health services, housing), from the balancesheets of state enterprisesand large collective farms to the domain of the government, and partly in response to the reduced subsidiesand price liberalizationmeasures that have caused hardship to vulnerablegroups of the population.
2.4 Althoughthe government'sdirect involvementin economic activity will continue to decline with the private sector increasinglyovertaking the economicfunctions previously carried out solely by the government, the public sector will need to maintain an active role in providing infrastructureand social services. This chapter examinesthe resources that are likely to be availableduring the next three to five years for these activities.
2.5 The chapterbegins with a brief review of the rapidlychanging pattern of expendituresduring the period since re-independence(Section B). Against this background, it examines the high priority recurrent expendituresthat are likely to arise-particularly for expandedsocial services and government wages, and the extraordinarytransition expenditures that will have to be covered in areas such as banking sector reform and privatization(Section C). The chapterconcludes with an analysis of the resourcesthat - 30 - can reasonably be expected to be available to finance public investments, taking account of current savings, and domestic and foreign borrowing prospects (SectionD).
B. Recent Fiscal Patterns
Expenditures
2.6 General governmentexpenditures (excluding net lending)amounted to 30 percent of GDP in 1992. In 1993, this increased to slightly over 31 percent of GDP because of pension reform, rising unemployment, and increasedtransfers to support householdheating costs. I Mainly as a result of two supplementarybudgets, actual expendituresexceeded those initiallybudgeted by 11 percent. Additional revenues were mobilized during the year, however, resulting in a more or less balanced budget for the year. In 1994, total recurrent governmentexpenditures are expectedto increase slightly slower than nominalGDP to compensatefor a slight reductionin tax rates under the Income Tax Law that was passed in December 1993. A balanced central government budget for 1994 totaling EEK 5.8 billion was approved by Parliament in late December.
2.7 In 1993, about one-half of the initially budgeted general government expenditures was allocated to the social sectors-mainly to social welfare, health, and education expenses. Expenditures on administration and public order covered some 10 percent of budgetedoutlays. The defense budget accountedfor 1.8 percent of total expenditures. Publicspending on economicsectors declined from more than 40 percent of total expenditurein the late 1980sto only 14 percentin 1993. In additionto budgeted expenditures, the government usually introduces a safety margin into the budget. For 1993, the government allocated about 2 percent of revenues to the reserve fund, from which unexpected outlays were covered during the year. In addition,about 1 percent of revenueswere allocatedto the stabilization fund, which was partly used to financeoutlays in the second supplementarybudget related specifically to the stabilizationprocess.
2.8 By economic classification,the largest expenditure category consists of transfers to the household sector, 28 percent of total, of which pensions cover almost two-thirds(Table 2-1 and Figure 2-1). Due to the low number of persons receiving unemploymentcompensation, and reflecting low coverageof the benefit system,appropriations for unemploymentcompensation were only some 1 percent of total government expenditures. Wages in government agenciesare estimated at 15 percent of total outlays, and purchases of goods and services at 23 percent. Due to the lack of proper economic classificationof expenditures,one-fifth of expendituresremain unidentified, a problem that is now being addressed with technical assistancefrom Finland. Less than 5 percent of total expenditures(2 percent of GDP) was allocated to capital expenditures. This is low by internationalstandards. For example, in major European and Nordic countries where the need to build up public infrastructure is much smaller, government capital expendituresaverage 3-5 percent of GDP (Table 2-2).
I All general governmentdata presentedhere for 1993 are estimatedon the basis of performanceduring the first three quarters of 1993. - 31 - Table 2-1. General Government Expenditures (EEK millions)
1992 Percentage 1993 Percentage Expenditure Actual of Total Budget of Total
Wages and salaries 662 15.9 1,150 14.8 Social security contributions 218 5.2 380 4.8 Purchases of goods and services 891 21.4 1,752 22.5 Subsidies 223 5.4 275 3.5 Transfers to households 1,128 27.1 2,181 28.0 Pensions 676 16.2 1,362 17.5 Family benefits, etc. 267 6.4 486 6.2 Sicknessbenefits 45 1.1 65 0.8 Unemploymentbenefits 10 0.2 96 1.2 Heating support 43 1.0 134 1.7 Other 87 3.1 38 0.5 Capital expenditures 176 4.2 378 4.9 Other expenditures 825 19.8 1,644 21.1 Interest payments - - 26 0.3 Total expenditures 4,166 100.0 7,785 100.0
Source: Damaprovided by Estonian authorities.
Table 2-2. General Government CapitalExpenditure in Selected Countries
Country Percentage of GDP
Estonia 2.2 Hungary 2.0 Uruguay 2.2 Sweden 2.5 Denmark 3.0 Norway 3.5 Germany 4.0 Finland 4.6 France 4.9 United Kingdom 5.2 Malaysia 5.9
Source: Government Finance Statistics for comparator countries for years between 1990 and 1991; data on Estonia. which were provided by the Estonian authorities, are for 1993.
Sources of Revenue
2.9 The structure of Estonia's tax system evolved considerably between 1992 and 1993 as shown by the changing percentage contributions of various revenue sources between the two years (Table 2-3). In 1993, the major sources of revenue consisted of social security conttibutions (27 percent of total revenue), receipts from value added tax (24 percent), personal income tax (21 percent), and corporate - 32 -
Figure 2-1. Composition of General Government Expenditures, 1993
Wages & Salaries
Pensions 18%
6% Family Benefits Purchases of Goods & Services 5% 4% Capital Expenditures Other Transfers To Households
Figure 2-2. Composition of General Government Revenues, 1993
Other Corporate Tax 14% 14%
Personal Income Tax 21%
Value Added Tax 24%
Social Security Contributions 27%
Source:Govenunent of Estonia - 33 - income tax (14 percent) (see Figure 2-2 and Table 2-3). In 1994, the share of personal income tax is expected to decline due to lowering of tax scales to a flat 26 percent tax rate. The revenue shortfall is expectedto be offset by the new land tax. Similarly, corporatetax receipts may increaseless than other revenues because of falling rates of inflation, hardening budget constraints, and the reduction of the corporatetax rate to the same 26 percent rate that appliesto individualincomes. The drop will, however, be significantlyless than would be indicatedby the reductionfrom the previous 35 percent rate because of reduced allowancesfor exemptions and deductions. Also, efforts are being made to improve the enforcementof tax laws.
Table 2-3. General Government Revenues (EEK millions) Percentage 1993 Percentage Revenue 1992 of Total Budget of Total
Corporate profits tax 720 16.9 1,054 13.8 Personal income tax 857 20.2 1,587 20.8 Social security contributions 1,170 27.5 2,068 27.1 Value added tax 901 21.2 1,815 23.8 Excise duties 182 4.3 386 5.1 Import duties 74 1.7 120 1.6 Land tax - - 78 1.0 Pollution tax 7 0.2 17 0.2 Natural resource tax 4 0.1 27 0.4 Forestry tax 12 0.3 96 1.3 Other taxes 0 0.0 61 0.8 Non-tax revenue 271 6.4 312 4.1 Other income 53 1.2 0 0.0 Total revenues 4,251 100.0 7,621 100.0 Source:Estonian authorities and missioncalculations.
Table 2-4. General Government Financing (EEK millions) 1992 1993 Government financing Percentageof GDP Percentageof GDP
Gross current savings 2.1 2.4 Gross investment 1.3 2.2 Financial savings 0.8 0.2
Source: Estonian authoritiesand mission estimates. - 34 - 2.10 In 1992, the governmentdid not borrow fundsdomestically. In fact, governmentnet deposits in the banking system increased. Similarly, a sound fiscal position did!not warrant borrowing from domestic markets in 1993. Arrangementswith internationalfinancial organizationscame into force in mid-1992, and foreign borrowing increased. Disbursementswere initiallyslow, but have begun to flow as planned in recent months.
Overall Fiscal Balance and Macro Stabilization
2.11 To support the stabilization and reform of the Estonian economy, fiscal policies have remained tight since the currency reformnin mid-1992. The 1993 budget of the general governmentwas implementedon a broadly balancedbasis. Followinga financialsurplus of 1 percent of GDP in 1992, the first half of 1993 recorded another budget surplus of 1.5 percentof GDP. With a slight deficit in the second half of 1993, the general governmentbudget for 1993 remained in balance (Table 24). The sound fiscal position during the transition has been preserved through revenue enhancingtax measures, strong measures to encouragepayment of tax arrears, strict control over expenditures, and lower-than- budgeted spending on unemploymentbenefits. The governmentexpects to achieve a balanced general government budget again in 1994.
C. Major Issues in Recurrent Expenditures
2.12 Prospects are good for controlling recurrent expendituresto levels that allow a rising level of current budgetary savingsto help financethe public investmentprogram. Estonia has achieved major success in stabilizing its economy. Inflation declined from 24 percent per month in 1992 to less than 3 percent per month in 1993; output has started to recover; and monetary and fiscal conditions have remained sound. To preserve macroeconomicstability, maintaining sound fiscal policy will be an important but challengingtask. Substantialdownside risks exist in each of these areas. Current policies of fiscal restraint could be reversed; a sudden slowdownin the private sector expansioncould allow open unemploymentto rise, thus generatinga sharp increasein social safety net expenditures;pressures could build for substantial increases in public sector wages; the governmentcould respond to a major bank failure with a budget-based bailout; and the privatization agency could find privatization revenues inadequateto cover the outstandingenterprise liabilities that cannotbe written off. Any of these problems could create demandsfor additionalbudgetary resourcesthat would seriouslyjeopardize the stabilization process. However, the examinationbelow of the key fiscal pressure points-social safety net financing, government wages, and extraordinarytransition costs-indicates that prospects are good for controlling these expendituresto levels that will allow modest savings for financingthe public investmentprograuis.
Financing the Social Safety Net
2.13 Background. The historic recent changesin the Estonianeconomy have a strong bearing on the design and financingof the social safety net. The transitionprocess has produced groups that need programs to facilitate their re-absorptioninto productivesectors of the economy, and they need income transfers to support them during the transition. Moreover, in addition,to imnprovingthe allocative efficiency in the economy, the reliance on market forces has changed the previously flat distributionof earnings. The significantlyincreased need for social assistanceprograms, together with severe budgetary constraints, emphasizethe need for targeting the social transfer payrnents. Instead of providing general benefits to broad categoriesof people, transfers to householdswill increasinglyneed to be means-tested. - 35 - 2.14 Estonia has been quite successfulin addressingthe challengeof providing an adequatesocial safety net. The pension system has been overhauled, and excessive spending has been trimmed. Unemploymentbenefits have been introduced, together with some initial active labor market programs. A targeted, means-testedsocial assistanceprogram was also initiated in 1993.
2.15 Overview of Current Problems and Prospects. Although Estonia's social safety net is reasonablyeffective, several problemsremain. First, the pensionsystem needsto be enhancedto provide more adequate benefits and better protection against inflation, a process that should be undertaken graduallywith rising fiscal resources. Second, the social assistanceprogram needs to provide a properly designed, reliably funded, and nationwidestandardized system of assistanceof last resort. Third, with the bulk of adjustment in the labor market still ahead, Estonia needs to develop a more adequate active labor market program.
2.16 This section examines these issues, provides policy recommendations, and discusses projectionsof the resourcesneeded during 1994-96. A summaryof actual and projected spending on the main social safety net components is presented in Table 2-5. A more detailed breakdown of major components, along with assumptionsunderlying the projections, is provided in Annex 2.
2.17 The projectionsanticipate an increaseof social safety net expendituresfrom an estimated 8.7 percent of GDP in 1993 to 9 percent of GDP in 1994, followed by a decline during 1995-96. The increase in 1994 reflects anticipated increases in expenditureson pension, labor market, and social assistanceprograms. Despite the expectedrise in labor market expendituresin the later years (both as a percentageof GDP and in real terms), the projectionsforesee a declinein spendingon the overall social safety net as a share of GDP during 1995-96because of the relative decline in the pension bill. This is anticipatedprimarily because of the government'spolicy of raising the pensionableage, which will help offset increasedpension benefitrates. Figures 2-3 and 2-4 respectivelyshow the shares of various social safety net activities in the total social safety net program in 1994, and projected movements in the expendituresas a share of GDP over time.
2.18 Pensions. Over the mediumterm, the biggest challengefacing Estonia's pensionsystem will be to maintain fiscal affordability while assuring at least minimally adequate benefits. In addition, continuedefforts should be made to convert the pensionscheme from a flat-rate system to an insurance- based system. Affordability will be significantly enhanced by the decision in 1993 to raise the pensionableage by six months each year, with these effects being spread over the next ten years.2
2.19 The April 1993 pension reform represented a move toward an insurance-basedsystem by adding a second, length-of-servicetier to the existingflat-rate pension. However, by disregarding many other factors influencingindividuals' lifetime earnings (most notably,education), the present system still bears only a remote resemblanceto an insurance scheme. The NationalSocial Insurance Board is thus advocating future enhancementof the insurance character of the scheme by gradually taking accountof the individual's earnings as a determinantof the replacementratio. Moreover,such a system will reduce incentivesto avoid the payment of pension contributions.
2 It is interestingto note that Estoniahas not followedthe temptingbut counterproductivepath of seekingto reduce open unemploymentthrough early retirements,as did Poland and Slovenia,for example. That approach assures that those taking early retirementwill be unemployed(or willbe drawingpension payments while working on an unreportedjob); it also increases the fiscal cost from relatively low, temporaryunemployment benefits to usually higher, permanent pension payments. - 36 -
Figure 2-3. Social Safety Net Expenditure Shares, 1994
Labor Market Intervention 5% Social Assistance 18%/ ' :.
Fam-ilyBenefits 59% 18%
%~~~~ of GDP-r: f Family~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~...... fts......
S # .S S~ /Pensions Figure 2-4. Social Safety Net Expenditure Trends, 1992-96
l SocialAssistancT
2 + ...... ------...... ------...... --.....------...... i
rourceFmily Beenent9s ' Penslons~Pensions ~ ~ ~ ~~~ntrvntorMrktXntrvnto
139 19.19 p..... po..p....99.99
Sore:Mniily Benefibt.s - 37 - Table 2-5. Summaryof Social Safety Net Expenditures (percentageof GDP) Actual 1994 Projected Expenditure 1992 1993 Projection Budget 1995 1996 Pensions 5.0 5.1 5.4 5.5 5.0 4.7 Family benefits 2.0 1.8 1.6 1.6 1.4 1.3 Social assistance 1.3 1.6 1.6 1.2 1.5 1.5 Labor market interventions 0.1 0.2 0.5 0.5 0.7 0.8
Total 8.4 8.7 9.0 8.8 8.7 8.3 Memorandum item: GDP in current prices 13,786 26,274 31,723 31,723 35,974 38,906 (EEK millions) Source: Governmentof Estonia and missionestimates.
2.20 Anotherguiding principle regardingthe current pension system is full protectionof pensions against inflation. The current level of the majorityof pensions is not much above the poverty line. Thus, failing to adjust these pensions for inflation would bring pensioners into a precarious situation.3 Since inflation linkedadjustments could lead to indexationschemes more widely in the country, a development that could fuel inflationaryexpectations, adjustments for inflationshould be done on a discretionarybasis.
2.21 Missionprojections anticipate a rise of pensionexpenditures from 5.1 percentof GDP in 1993 to 5.4 percent in 1994, followed by a declineto 5.0 percent and 4.7 percent of GDP in 1995 and 1996, respectively. These projections assumethat the level of all pensions will be fully adjusted for inflation. Moreover, the projection takes account of demographic changes, including the age structure and emigration flows, as well as the rising pensionableage under the new pension law. With the new law, the inflow to retirement will be roughly halved during the next ten years, which will help ease the fiscal burden of modest improvements in pension benefits. Enhancing pension benefits beyond the levels projectedcould, however,have adversefiscal impactsthat would reduce the resourcesavailable for public investment.
2.22 In the longer term the governmentshould consider modifyingthe current pension scheme to make it more consistentwith the best practicesin industrializedcountries. The pensionscheme presently in place could be modified to accomplishthis objective. However, it would probablybe better to limit the coverageof the present pension schemeto a flat "basicneeds" coverage and to provide benefits linked to earnings level as well as years of service under separate pension schemes. These schemes could be in addition to the basic needs coverage for everyone, but it would probably be better to make the basic needs pension means-testedand available only to those with incomes below a level. This would allow scarce public resources to be focusedon providingbasic pension benefits for those with minimal lifetime
3 In mid-1993,the ratioof the averageold-age pension to averageearnings was 0.31. This ratio is generallylow in FSU countries(usually below 0.4). The ratio tendsto be considerablyhigher in Eastern Europe; in Poland, for example, the ratio was 0.74 in 1992, and in Slovenia, the ratio was 0.67 in June 1993, one of the highest among Eastern European countries. - 38 - earnings. Those with higher incomes would contributeduring their working years to an income-based pensionplan that wouldoffer significantlyhigher benefits. Income-basedpension plans shouldprobably be fully funded through a worker's lifetime contributionsrather than operatingon a pay-as-you-gobasis that requires current budgetary subventionsto meet current benefit payments. Finally, income-based pension benefits should ultimately be made available through private pension plans. However, introducing private pension schemes like this would be premature now, and should be delayed until Estonia has a strong, well-regulatedfinancial sector in which the safety and security of an individual's pension funds can be assured.
2.23 Family Benefits. While it is suggested that pension benefits be fully protected against inflation, this principle should not be applied to family benefits. Although the current level of the Estonianallowances is modestas comparedwith Organizationof EconomicCooperation and Development (OECD) countries (family allowanceswere 4.7 percent of average family earnings in 1992, compared to an average of 7.5 percent in OECD countries), its universal eligibility makes it an inefficientmeans of poverty alleviation. Its incomedistribution effects are considerablysmaller than thoseof means-tested, targeted family benefit programs. However, as a transitionalmeasure until a good means-testedsocial assistance program is in operation, a general family allowancehas a role to play in Estonia's benefit system. Therefore, rather than abolishingthe familybenefits system, a gradual reductionin its generosity is recommended.
2.24 To reduce the real value of total family benefits without taking the politicallydifficult step of reducing their nominalamounts, the Governmentmay wish to consider leaving the nominal level of family benefits remain unchanged. In 1994, family allowancesare estimated at 1.6 percent of GDP. This share is projected to decline to 1.4 percent and 1.3 percent in 1995 and 1996, respectively, with inflation and the growth of GDP.
2.25 SocialAssistance. The transitionto a market economywill ultimately improve the standard of living of the Estonian people, but many will face a short-term decline in their real incomes. Significant progress has been made toward establishinga comprehensivesocial assistance program, including social assistance in cash. In 1993, the two largest programs were transfers to support households' housingand heating expenditures(0.9 percentof GDP) and institutionalcare for elderly and children (0.5 percent of GDP), while social assistance in cash was a modest 0.1 percent of GDP (see Annex 2).
2.26 The major part of social assistance is expectedto continuebeing given as housingand heating support. In 1994, these transfers amounted to 54 percent of the total social assistanceprogram. This support is relativelywell targeted and varies within the targetedpopulation according to income. Under this program, subsidiesare made availableto assure that housingand heatingcosts do not exceed25 per- cent of the household's gross income. In 1994 the program will cover about 605,000 people, or 40 percent of population. The shift from a producer subsidythat was used in the 1992-93heating season to a targeted income support is welcome, for it creates fewer distortions and is thus better in terms of allocative efficiency. Subsidies for urban transport, which have social objectives, also impose a substantialclaim on budgetary --.sources.
2.27 Institutionalcare for the elderly and childrenamounts to 0.4 percentof GDP. Currently these services are supplied in obsolete facilities, many of which are old manor houses in unsuitable rural locations. Institutionalcare servicesshould be made more efficientthrough appropriate investments under the public investmentprogram. Alternative, cheaper providers, such as foster homes, should also be considered. - 39 - 2.28 Social assistance in cash was initiated in 1993 under the so-called "crisis" program, mostly financed through the European Community's counterpart grants. Total assistance in cash under this program amountedto EEK 24.1 million. Assistancein kind was also offered in the form of meals, food coupons, and drugs. However, the amount of social assistancebudgeted for 1994, EEK 30 million, does not seem adequate. Basedon the number of people who are likely to qualify for means-testedassistance and the existing poverty gap, the projections indicate that about EEK 130 million is needed to provide the minimumstandard of livingfor those who are likelyto fall below the poverty line.4 Therefore, these expenditurescan be expected to increase faster than other budget outlays over the medium term. The program will need to be strengthenedby providing a properly designed, nationwidestandardized criteria for means-testing. Social assistanceshould not, however,be raised above the levels required to close the poverty gap; once benefits move above the poverty line, it is hard to resist pressures to increase them even further, and this could produce serious fiscal pressures.
2.29 Labor Market Interventions. Radical changes in the Estonian labor market have already produced a significantdecline in effectiveemployment. Even larger numbers of workers are anticipated to be laid off in the near future. Experience elsewhereshows that governments have an important role not only in ensuringthe incomesupport of unemployedworkers, but also in assisting their re-employment efforts and helping them minimizetheir post-unemploymentearning losses. Resourcesfor labor market programs will have to increase to accelerate the redeployment of labor to more productive uses. Increasing expendituresfor active labor market programs may be more important than unemployment compensation in terms of solving the employmentproblem, though unemploymentcompensation is a critically important transitionalmeasure.
2.30 Althoughthe number of persons officially recorded as unemployedhas been declining since May 1993, this unemploymentis likely to increase well above the current levels in the near future.5 Judging from the experience of Eastern Europe, there is a lag between the fall of production and the increaseof unemployment. The pattern of adjustmentsuggests a sluggishresponse of employmentin the beginning of the transition, with forced vacations,shorter working hours, and wage cuts taking the brunt of adjustment. Later during the transition, labor sheddingexpands beyond attrition, and people become unemployedrather than move to new jobs.6 Meanwhile,Estonia's sharp output decline since 1990 (quite in line with the experienceof Eastern European countries), and a recentestimate of unemploymentof 7.8 percent (compared with a lower official estimate), suggest that the rate of hidden unemploymenthas increased since 1990, thus increasing the number of workers who could become recipients of unemploymentcompensation. Moreover, privatizationmay well prompt enterprises to shed redundant
4 Unless helped by social assistance,an estimated 11.3 percent of population(170,500 people) will live in poverty in 1994, and the poverty gap to be bridged-measured as a differencebetween the age- and size-adjustedpoverty line and the average per capita incomeof familiesliving in poverty-will be 48 EEK per month, or 20.8 percent of the poverty line (see detailsof the projectionsin Annex 2).
S This chapter adheres to the InternationalLabor Organization(ILO) conceptof unemployment(thus referring to an unemployedperson as one whodoes not work, but is able to work, willingto work, and actively searchingfor work). Estonia's officially recorded unemployment, in contrast, is restricted to those who receive unemployment compensation. Findingsof EMOR (a firm in Estonia performinghousehold surveys) put unemploymentrate at 7.8 percent (56,000) in July 1993, about three times the official count.
6 See 0. Blanchard, S. Commander, and F. Coricelli, 'Unemploymentand Restructuringin Eastern Europe," paper presented at the conferenceUnemployment, Restructuring, and the Labor Market in East Europe and Russia, World Bank, October 1993. - 40 - workers, forcing many to becomeopenly unemployed. Bankruptcy, whichis becomingmore common, will have the same effect.
2.31 Estonia is already implementingthe most effective strategy to prevent unemploymentfrom becoming persistent-which is to establish a stable, undistorted economic environmentthat fosters the development of private sector enterprises. However, as a transitional measure, Estonia may need to strengthen its active labor market programsto help control the duration of unemploymentfor individual workers. These measures shouldbe designed to enhancethe flexibilityin the labor market, that is, to improve real wage flexibility and geographicalmobility of labor resources; to reduce skill mismatches and youth unemployment;and to reduce the duration of unemploymentspells. Againstthis background, the governmnent'splans to expand training, public works, and youth measuresare warranted. Training has been shown to reduce the duration of unemploymentin developedmarket economies. Training can play an important role in transitional economieslike Estonia, becausemost workers from the Soviet era received a very narrow technical education that gave them little flexibility, and most have spent their entire career in a single job. Training in areas such as languagesand computeruse could significantly increase labor mobility and thus shorten unemploymentepisodes. With the weak labor demand that Estonia is likely to face in the next few years, public works can also help reduce persistent unemployment. Public works programsshould offer only temporary work opportunities,however, and should avoid displacementeffects. They should not merely replace existingpublic projects or supplant private activity. To improve young workers' access to jobs, the governmenthas also considered new measures, such as apprenticeship and related forms of interventions, to help school-leavers become qualified and find jobs.7
2.32 The governmentis also considering the expansionof its program to give grants and credits to unemployedworkers who want to start their own business. Evaluationsof such programs in other countries have produced mixed results, but it seems clear that such programs can only be successful if the resources are given on the condition that predeterminedmilestones are reached. These milestones should includenot only developinga business idea and a businessplan, but possibly also obtainingbank credit as a commercialcheck of the viabilityof the proposed business. Employmentoffices shouldhelp the unemployedachieve these milestonesthrough consultationson technical, legal, and financial aspects of the business. Subsidizationof such services could be substantial,but some charges should be imposed to improve workers' commitmentto follow through on the advice received.
2.33 As far as cash unemploymentbenefits are concerned, the key issue is the choice between insurance and social assistance. At present, the system works as a supplemental social assistance program. Finances come from the budget, and eligibility for unemployment compensation is not conditionalon work history. The present level of unemploymentcompensation is so low that it does not remove the incentive for people to seek jobs.8 The system suffers, however, from several weaknesses that could be mitigated under the insurance scheme. For example, the low level of unemployment compensation-a feature that is hard to avoid when finances come directly from a balancedbudget-does
7 Some of these programs reimburseemployers for a portion of wages whenthey employ unemployedschool-leavers, thus trying to overcome the reluctanceof employersto hire first-timejob seekers that is associatedwith (a) the costs of screening in the absence of the previouswork history and (b) the difficultyof individualemployers in capturingthe benefits of training, which accrue to other employers as an externalitywhen workers move on to other jobs.
8 As of August 1993, Estonianunemployment compensation was EEK 180, or 15.7 percentof the average wage. This ratio has been much higher in Eastern Europeaneconomies; for example, in 1992 all of them had the ratio above 30 percent. - 41 - not provide an adequatemeans for smoothingthe pattern of consumptionover longer periods. The very low replacementrate-about 16 percent of the average wage-means that periodsof unemploymentare, on average,accompanied by an extremely sharp drop in incomefor the worker. If both husband and wife face unemploymentsimultaneously, a commonproblem in single-enterprisetowns, total family income drops sharply. Since inflation during the past two years has wiped out most of the real value of household savings from the 1980s, the unemployedmust depend on extended family and friends for assistance. The low replacement rate thus forces people to cut the duration of job-seeking, which may produce sub-optimaljob-matching. The provision in the current system that those accepting social assistance must be willing to work in a public works program mitigatesabuse of the system.
2.34 Because unemploymentis not insurablein private markets, the governmentshould consider introducing an unemployment scheme based on the insurance principle-a system financed by contributions,with the level of compensationdepending on such contributions. With the introductionof a true social assistanceprogram in 1994, the diversificationand focus of social programs would be even more desirable. Moreover, one should expect a gradual change in the attitude of the society toward unemploymentas the economy moves from the Soviet system of very low open unemployment to a system with open unemploymentin line with the experienceof market economies. Unemploymentwill no longer be regarded, as it was in the Sovietperiod, as a sign of low moral character, but rather as an unfortunate developmentthat often reflects circumstancescompletely beyond the individual's control. The social stigma of unemploymentwill becomeless severe as more people experiencetemporary spells of unemployment. Consequently,people who need to move from onejob to anotherwill be more willing to seek help.
2.35 The above considerationsabout active and passive labor market programs indicate the need to sharplyincrease expenditures for theseprograms. 9 These expendituresare anticipatedto increasefrom 0.2 percent of GDP in 1993 to 0.5 percent in 1994 (the same level as approved in the budget), and to 0.8 percent of GDP by 1996 (see Table 2-5 and Annex 2). With these,appropriations, the focus of expenditureswould shift from passive unemploymentbenefits towardactive labor market programs. The projected level of spending on labor market interventions for 1996 of 0.8 percent of GDP is still, however, much lower than in most OECD countries. Fortunately, the low expenditurelevels in Estonia seem to reflect the relatively low cost of providing active labor market services; for example, the projected 12,000participants in training in 1994puts Estonia approximatelyin line with OECD countries in terms of the number of trainees as a percentageof the labor force, but three times below the OECD average in terms of cost as percentage of GDP. The projections also anticipatethe increaseof spending on public works, to 0.1 percent of GDP during 1994-96, and on youth measures, to reach 0.1 percet of GDP by 1996.
2.36 Even with a substantial increase in unemployment, the projected cost of unemployment compensationis expectedto remain below 0.5 percent of GDP during the next few years. This ratio is low compared to other Eastern European countries-with the exception of the Czech Republic. The projections for Estonia in 1994 anticipate that the government will keep the level of unemployment compensationunchanged at EEK 180 for 1994, then gradually raise it to the official poverty line during 1995-96.
9 The projectionsassume that recipients of unemploymentcompensation will number approximately40,000 in 1994 (equivalentto 5.6 percent of the labor force, more than double the current number), and 50,000 for both 1995 and 1996 (reflecting intensifiedlayoffs as privatizationproceeds). See Annex 2 for details. - 42 - Table 2-6. Average Wage in the First Quarter of 1993 Government Number of Employment Category EEK per month Employees (percentage)
Total economy 898 - - Health and social care 684 34,164 25.7 Culture and sport 707 7,751 5.8 Education 777 61,637 46.3 Science 806 2,701 2.0 Administration(including defense) 925 26,823 20.2 General government - 133,079 100.0
Weighted average 780
Source: Estonian authoritiesand mission calculations.
Public Sector Salaries
2.37 The decliningtax revenue relative to GDP during the transitionprocess has made it necessary for the governmentto contain wage expendituresby adhering to strict income policies. Otherwise, it would have been difficult to achieve its balanced budget target, which has been necessary for macroeconomicstabilization. As a result, the averagewage in the governmentsector has lagged behind the rising average wage in the private sector. 10
2.38 In the first quarter of 1993, the average government wage was EEK 780 per month, 13 percent lower than the national average wage of EEK 898 per month. (Table 2-6). By the end of 1993, the national average had risen to EEK 1,300 per month, and according to available information, wage differentialsbetween the public and private sector widenedfurther.
2.39 These developmentscause two problems. First, with the average governrent wage lagging behind the rapidly increasingnational average wage, budgetary pressures are likely to intensify as the government seeks to narrow the gap with the private sector. Second, maintaininga skilled labor force in the public sector will become increasingly difficult, which will make it difficult to improve the efficiency of public administration. At present, top governmentsalaries (at the department head level) are considerablylower than those in the private sector, which has already led to "brain-drain"from key ministries. Establishinga reasonablebalance between fiscal disciplineand demandsfor competitivewages in governmentagencies will be an important but difficulttask. Two possible solutionsare proposed for consideration. The first is to expand the practice of not filling vacanciesfrom natural labor turnover (for example, voluntary resignations and retirements)and using the savings to increase average wages for remaining public employeesby up to 25 percent. This solution is unsatisfactory in the longer term,
10 In September 1992, governmentwages were raised in the eight lowestpay categoriesout of thirty-twoin total. At the lowest level, the average wage was increasedby close to 50 percent, but for higher categories,the increase was smaller, and no increase was granted for the ninth category and above. In November 1992, the number of pay categorieswere increasedby adding four new ranks at the top of the scale. After this change, the lowestgovernment salary was at EEK 300 per month, and the highestEEK 3,900 per month. In February 1993, all pay categorieswere raised by 25 percent. A further increase was approvedin early 1994. - 43 - however, for it creates an incentive for departmental managers to hang on to vacancies and not restructure, and it allows a continuationof the fiction that a person can do more than one job effectively for an extendedperiod. Restructuringand more adequatepay levels are much more appropriate longer- term solutions. Another solution would be to increasethe differentiationof the wage structure to better reflect skill and educationaldifferences. This would allow narrowingthe gap between the remuneration of high quality labor force in the public and private sectors. Finally, by eliminating low priority programs and cutting back wherepossible on non-salaryexpenses, room can be created for a sustainable government wage policy that would be consistentwith the requirementsof fiscal soundnessand quality in public service. These considerationsargue, however, for avoiding pressures to downsizegovernment revenues substantially with respect to GDP. Excessive efforts to control costs in ways that lead to excessive work loads and the loss of key staff can seriouslyundermine the quality of governmentservices and decision-making,thus damaging the nation's economic prospects. The adequacyof public sector salaries should be kept under review, and measuresto improve salaries should be part of an integrated program of continuingefforts to improve the professionalcivil service system in Estonia.
Extraordinary Transition Expenditures
2.40 During the transitionprocess, the governmentfaces extraordinary expenditure obligations that will reduce the resourcesavailable for the public investmentprogram. Though temporary, these can add to difficulties in public expendituremanagement over the longer run if not properly handled. Estonia's major areas of extraordinaryexpenditures are support to the banking system and privatization.
2.41 Banking System. Estonia's banking system faced increasingsolvency and liquiditypressures in late 1992. These difficultieswere due partly to non-performingloans and partly to the blocking of Estonian banks' accounts in Vneshekonombankin Moscow. The banking crisis was resolved in early 1993 by liquidatingone bank (Tartu CommercialBank) and merging two others (Union Baltic Bank and Northern Estonian Bank) into a new entity (NorthernEstonian Bank)under governmentownership. This new bank was recapitalizedby the government issuing EEK 300 millioniworth of long-term bonds. Interest payments on these bonds started in 1993, and repayment of capital will begin in 1998. One further step in recapitalizationis expected, but it is hoped that proceeds from the bank's planned privatization (one to two years from now) will offset this second capital injection.
2.42 To help avert similar problems in the future, the Bank of Estonia is now inspectingthe health of the Estonian banking system, includingestimating the size of bad loan portfolios in individualbanks. The implementationof the new Credit InstitutionLaw in early 1994 should improve the effectivenessof controls on banks. In this respect, it is importantthat early action is taken to restructure those bank operations that have been shownto have either solvencyor liquidityproblems, or both, lest further fiscal intervention be necessary. Assuming that a detailed review of the current portfolios of the banks plus enhancedoff-site and on-site supervisionwill prevent the emergenceof additional major problems in the banking sector, no claims on budget resources are anticipatedin the next few years other than the debt service on the bank recapitalizationbonds that were issued in early 1993. In fact, it is expectedthat part of the profits from the currency board operations in the Bank of Estonia will be transferred into the budget during this period to cover the expensesfrom the debt service of existing bonds.
2.43 Privatization. The privatizationprocess could becomea major burden on public financesover the medium term-or it could increase significantly the resources available for the public investment program. The outcomedepends heavily on the policy decisionsthat the governmentmakes regarding the way in which the privatizationprocess is conducted. The experiencein Germany indicatesthat high costs can arise from privatizationif the governmentagrees to pay investorsto take companiesthrough negative - 44 - purchase prices, or if the governmentbecomes involvedin major pre-privatizationphysical restructuring. The way in which the governmenthandles the outstandingdebts of public enterprises will affect the net fiscal impact of privatization. One extreme would be for the government, as ultimate owner of the enterprises, to try to raise the resourcesneeded to pay all outstandingdebts. The other extreme would be to treat all public enterprisesas limitedliability corporationsand let them go into bankruptcywith no attempt to cover their debts, Neither extreme is viable, but this does point out the overwhelming importance of decisionsby the governmentregarding the privatizationprocess.
2.44 The governmenthas announcedthat it will not try to make plants more attractive for sale to private owners by undertaking significant investments in improved physical capital, although minor investmentsmay be needed to protectphysical assets until privatization,nor will it split up conglomerates so that manageableparts can be privatized separately. However, even if the worst risks of excessivedebt repayment and excessive pre-privatizationinvestments are avoided, it now seems clear that the windfall from the sale of governmentassets that was once anticipatedwill not be forthcoming. Privatizationto date of the larger enterprises has been more or less cash-neutralfor the government, and it is assumed in this chapter that privatizationwill, on balance, continue to have an essentially neutral impact on the governmentbudget, with privatizationexpenses being covered by proceeds from privatization sales.
D. Resource Prospects over the Medium Term
Real GDP Growth
2.45 After declining for the first half of the year, Estonia's economystarted to recover during the second half of 1993, and real GDP is expected to grow by 5-6 percent in 1994. The recovery is based on a solid foundationof price liberalization,macroeconomic stabilization, and a highly open foreign trade regime that has shifted productiontoward trade with industrialcountries. Over the mediumterm, growth is conservativelyexpected to continueat around 5 percent per year. Growth is expectedto be led mainly by exports and rapid expansion of private sector activity, and supportedby the productivity gains that shouldresult from supportingEstonia's skilledlabor with modestbut highly productivenew investments to upgrade and refocus Estonia's existing capital stock. Given the initialover-staffing in the enterprise sector and the need for restructuring, employment is likely to grow' only moderately, and true unemploymentcould rise to over 9 percent of the labor force during the coming years. The projections on key economic variablesare presented in Table 2-7; more completeprojection details are presented in Table 2-9.
Net Resources Available for Investment Expenditures
2.46 Estonia's gross savingsratio, estimatedat 26 percentof GDP in 1993, is projected to increase to about 28 percentover the mediumterm. With unchangedtax and expenditureratios, the government's current savings would stay positive,but the governmentwill find it difficult to increase savings through tighter fiscal policy given strong pressures to develop the nation's social services and the government's apparentdesire to reduce the tax ratio. Therefore, the domesticsavings needed for investmentfinancing must be created by the private sector. Over the longer run, householdsavings could start recovering, but in the short term, savings are likely to remain low because of the pent-up demand for consumer goods. If inflation remains under control and productivity recovers as expected, business profits could remain the primary source of domesticsavings. - 45 - 2.47 The recoveryof growth and employmentis not likelyto occur, however,without considerable foreign borrowing to support investment. Estonia's gross investmentratio, estimated at 26 percent of GDP in 1992, could rise to 34 percent in 1994. The recovery of investment will be helped by disbursementsof committedforeign financialassistance. With a savings ratio of 26 percent, the current accountmight show a deficit of 8 percent in 1994. Thereafter, the external deficit would decline with less extensive international financial assistanceand higher domestic savings. External borrowing from commercialsources will develop only gradually as the country's creditworthinessbecomes established. For 1994-97, the average external deficit is projected at about 6 percent of GDP, but only 3 percent during the rest of the decade. Given the real GDP growth prospects, this level of external borrowing shouldbe sustainableover the longer term. Estonia's capacity to absorb this level of external funding is limited today, but should improve with ongoing efforts to strengthen the banking system, privatize enterprises, and develop a solid capacity in the governmentfor the design and implementationof public investmentprograms.
Table 2-7. Key Economic Indicators, 1993-97 (averagepercentage change in constantprices)
Indicator 1993 1994-97
GDP -3 5 Private consumption -1 4 Fixed investment 0 10 Export 30 8 import 34 10 Investmentratio (% of GDP) 29 34 Savingsratio (% of GDP) 26 28 Current account (% of GDP) -2 -6 Real wage 6 4 Inflation(Jan. to Dec.) 36 8
Source: Mission projections. Note: See Table 2-9 for more completeprojection details.
Government Revenues and Expenditures
2.48 Over the long run, a government'sability to provide social and infrastructureservices depends on the nation's capacity and willingnessto collect taxes. Estonia's gross tax ratio, at 29 percent of GDP in 1992, is well below the average in industrialcountries, though somewhathigh for a country at its level of GDP per capita (Figure 2-5). In the 1994 budget, the governmentreduced the effective tax rate on personal incomes. Coupled with the expectedslowdown in the inflowof corporatetaxes, this will reduce the gross tax ratio to about 28 percent. For 1994-97it is assumedthat the gross tax ratio would remain at the budgeted 1994 level of about 28 percent of GDP, which reflects the adopted tax policy. This policy, with the eliminationof progressivityin personal incometaxation and constant rates on payroll and corporate taxation, aims at eliminatingthe tax bracket creep while maintainingthe tax system's revenue - 46 - generatingcapacity. Accordingly,personal incomeand payroll tax receiptswould increasein 1994-97 in line with the GDP, due to the flat rate in the tax scales and assumed constant factor income shares. The latter impliesthat corporate taxes will also increaseat the same pace as nominalGDP. With export- led and investment-ledgrowth, value added tax revenues may increase more slowly than income and payroll taxes, as the tax base of the value added tax (VAT) (proxied by the private consumption)will increase more slowly than GDP. However, this shortfall is expected to be offset by the new land tax, increased excise taxes, and taxes on pollution, natural resources, and increases in non-tax revenues. Includingnon-tax revenues, governmentincome is expected to average about 30 percentof GDP during 1994-97. Assuring this level of income will, however, require the continuation of strong efforts to improve the effectivenessof the tax collectionsystem.
2.49 The share of recurrent expendituresof GDP is budgeted to decline between 1993 and 1994. Assumingthat the governmentwill continuetaking measuresboth to maintain fiscal stability and to avoid crowdingout the private sector, the share of governmentrecurrent expendituresin GDP would thereafter remain broadly unchanged at the anticipated 1994 level of 28 percent of GDP (Table2-8). As a result, the current savings ratio is estimatedat 2 percentfor 1994-97. However, as discussedabove, expenditure pressures-in particular on governmentwages and the social safety net-are strong, and alignment of total expenditures with the requirements of macroeconomic stability calls for continuous overhaul of expenditurepriorities, and improvedefficiency in producingpublic services. If the governmentwere not able to generate current budgetary savings equal to about 2 percent of GDP, this could jeopardize the entire public investmentprogram. Externaldonors generallyrequire that governmentscover most, if not
Figure 2-5. Government Revenues and Per Capita GNP
5 - 0 - .,...... -''''''''''''-'-''''-'....
45 ------... ------...... U...
40 - - ...... SPER GRM 35 .-. ------EST -DEN ------
30 - ...... - ...... IN...... PER~ ~ ~ ~ R 20 - ......
Solrce:W, idBui arl aa,a PerCapita GNP in USS
11 In countrieswith progressive tax rate5, inflationraises nominalincomes, pushingpeople intohigher tax bracketseven though the real income is unchanged. Consequently,bracket creep reduces their real incomes. This problemcan be avoided either with a flat rate, as Estoniahas done, or by adjusting tax brackets in line with inflation. - 47 - Table 2-8. General GovernmentSaving and Investment
Estimate for 1993 Annual Average 1994-96 Category (% of GDP) (% of GDP) (1994 EEK m)
Revenues 32.3 29.7 10,550 Tax 30.8 27.7 9,850 Non-tax 1.5 2.0 700 Recurrent expenditure 30.1 27.7 9,850 Current saving 2.2 2.0 700 Public investmenta 3.6 4.5 1,600 Direct investment 2.0 2.5 900 Net lending 1.6 2.0 700 Overall balance 1.4 -2.5 -900 (Public Sector BorrowingRequirement) Domestic borrowing -1.0 0.0 0 Foreign borrowing 2.4 2.5 900 Memorandum items: Financial savingb 0.2 0.5 -200 GDP (EEK million) 26,274 100.0 35,530
Source: Mission estimates. a. Public investmentcovers general governmentdirect investments(financed by current savings, domesticand foreign borrowing), and investmentsto public infrastructurethat are financed by budgetary on-lendingof governmentforeign borrowing. The resource estimatesshown here for general governmentby definitioninclude local governmentas well as central governmentinvestments. In estimatingthe resourcesthat can be made availablefor projects to be implemented by the centralgovernment, the governmentwill need to determinethe resources that will need to be set aside for projects implementedby local governmentauthorities. b. Under performancecriteria in the IMF stand-byarrangement for 1994, net lending is limitedto 4 percent of GDP and the financial deficit to I percent of GDP. (Financial saving equals current saving minus general government direct investment.)The split shownhere betweendirect investmentand net lending is only indicative. The governmenthas not yet decided on the appropriatebalance, but the share going to the private sector is likely to be half or less of the total. all, of the domesticcost of projects and of domesticbudgetary savings. If these savings do not exist to provide the required counterpart financing, it may be difficult, if not impossible, to obtain the foreign financing.
Government Borrowing
2.50 Pressures for increased governmentcurrent expendituresand resistanceto higher taxes are likely to hold governmentsavings to no more than 2 percent of GDP over the medium term. Limiting total public investmentto a level allowed by governmentsavings would cause the real capital stock of the public sector to decline to levels that would have a detrimentaleffect on overall economic growth. Increasingpublic investmentfrom this level requires internaland externalborrowing. The government's borrowing potential in the domesticmarket remains limited. The currency board arrangementprevents borrowing from the central bank, and the government should avoid excessive borrowing from the domestic commercial banking system, so that it doesn't crowd out the private sector. Therefore, the government has to rely mainly on foreign financing to help build up the public sector capital stock. - 48 - However, the government's agreementwith the IMF for 1993-94sets limits on foreign borrowing. As borrowing from both domesticand foreign sources is constrained,the central governmentintends to limit its financial deficit (current savings less direct investment)to around 2 percent of GDP in 1994. Net lending by the governmentto public enterprisesand the private sector would be limitedto about 2 percent of GDP in 1994; both the financial deficit and the net lending would be financed through foreign borrowing. It is estimated that Estonia should restrict its use of internationalborrowing for financing public investmentsto about 2.5 percent of GDP, which would mean a total of about EEK 2.7 billion for the public investment program during 1995-97 or about EEK 0.9 billion per year (Table 2-8). Gross foreign borrowing on a disbursement basis would, of course, be somewhat higher to cover the government's share of debt service and reserves buildup. Of the net foreign borrowing, up to half may be allocated for financial investmentswithin the public investmentprogram to provide long-termfunding to help develop the domestic banking and private enterprise sectors, while half may go to direct investment.
2.51 The government'sdecision to allocate a substantialshare of its borrowed foreign resources for on-lending to the enterprise sector reflects the assessment that the enterprise sector's need for long-term capital cannot be met with domestic sources due to the short-term structure of deposits in Estonia's still underdevelopedfinancial sector. Given the anticipatedstructure of capital flows to cover the anticipated current accountdeficit of about 6 percent of GDP during 1995-97, the public sector could expect to have access to the foreign exchangeneeded to supplyan averageof about USD 70 million per year to the public investmentprogram-about USD 210 million over the three years. This implies that up to USD 35 million of foreign exchangecould be made availableeach year to the enterprise sector.
2.52 Estonia's capacityto support the levelof foreignborrowing proposed here has been confirrned through the use of a macroeconomicmodel that computesdebt servicing capacity, taking into account a broad range of variables, such as GDP growth, export and import growth, and the terms of foreign borrowing. The results of this analysisare shown in Table 2-9. This table reflects the outcomeof three alternative scenarios. The base or most likely case assumes continuedgood progress with stabilization and a modest pace of continuedstructural reforms. The low case assumes significantproblems in both of these cases. The high case assumes not only continued progress with stabilization, but also a considerable acceleration in the pace of structural reforms. Several important facts should be noted in the external financing patterns shown for Estonia in 1993 and in the planning period 1994-97 that are shown in the base case in Table 2-9. Estonia's gross externalfinancing was a relativelyhigh 16 percent of GDP in 1993 despite Estonia's continuing success in expanding its exports of goods and services to the West and its very low debt service ratio (1 percent of exports). Of the USD 319 million of financing received, nearly USD 200 million went into reserves, leaving Estonia with reservesequal to nearly five months of imports at the end of 1993. The high rate of external financingand reserves buildup in 1993 is due to a number of exceptionalfactors. First, Estonia continuedto attract foreign direct investment (FDI) at an exceptionallyhigh pace-about 7 percent of GDP; rates of half that level or less are common even in well-performingmiddle income countries. This exceptionalpace of FDI, which is not expected to continue in the future, reflectsthe fact that Estonia was probably the best focus for foreign investment activity in the entire former SovietUnion (FSU) in 1993;it combinedthe low prices in foreign exchange terms that were common in most FSU countries with an exceptionally open and stable economy. Estonia's solid if somewhat slow privatization program provided attractive assets for sale. Most important, its excellent economicpolicies attracted many greenfield investments. Although Estonia's economic policies together with its low cost, highly skilled labor force, and its proximity to European markets will assure that it remains an excellent location for foreign investments in the future, the exceptional levels for FDI during 1992-93 are expectedto taper off as prices in Estonia rise and some of the most attractive enterprisesare sold. - 49 -
Tabk 2-9. Financing Plan and Debt Indicatorsby Scenario (USD millions) 1994-97 1998-2004 1993 Annual Average Annual Average Category Estimate Base Low High Base Low High
Financing Requirements 319 223 137 271 . 247 120 374 Current account deficit (excluding interest paid) 43 150 102 184 40 6 93 Debt service 13 22 23 24 176 107 200 Amortization 12 7 8 7 123 77 142 Interest 1 15 15 17 53 30 58 Others (including errors and 73 10 - - 0 - - omissions) Reserve build-up 189 42 12 63 31 7 81
Possible Financing Sources 319 223 137 271 247 120 374 Private sources 145 122 48 133 147 42 266 Foreign direct investment 145 100 37 104 72 30 179 Commercial credits 0 22 11 29 75 12 87 Public sources 174 101 89 138 100 78 108 Official grants 54 8 15 13 0 10 0 Loan disbursements 120 93 74 125 100 68 108 International financial institutions 99 56 44 66 64 38 67 Bilateral donors 21 37 30 59 36 30 41 Memorandum items GDP growth (%) -3.5 5 1 8 5 0 6 Export growth (%) 30.0 8 2 8 6 1 9 Import growth (%) 34.0 10 3 11 5 1 7 Ratios to GDP Exports (goods) 40 38 36 31 41 36 36 Imports (goods) 45 49 46 42 53 44 44 Current account deficit -2 -6 -5 -6 -3 -1 -3 Medium and long term debt, 7 12 12 12 22 16 19 outstanding and disbursed (% GDP) Debt service ratio (%) I 1 2 2 6 7 7 IBRD share of total debt (%) 22 16 16 13 24 25 21 IBRD share of debt service (%) 1 15 15 15 14 15 13 GDP (USD million, average) 1,987 2,643 2,367 3,139 4,094 2,966 5,327 Source: Mission estimates. Note: The key assumptions behind the three scenarios are as follows: base-continued stabilization success and modest pace of structural reforms in areas like privatization; low-reversal of stabilization progress; and high-accelerated structural change and increased efficiency with continued price stability. - 50 - 2.53 Second, during 1992 most donor efforts focusedon technicalassistance, humanitarian aid, and emergency balance of payments support. Additional efforts made that year to establish a solid, longer-termprogram of assistanceto Estoniabegan to bear fruit in 1993, and loan disbursementstotaled USD 120 million, including almost USD 100 million from internationalfinancial institutions. Foreign loan disbursements,largely for projects rather than program aid, are expectedto averageabout USD 90- 100 million per year during 1994-97. The terms assumed for these loans are as follows: commercial debt-8 years maturity with a 3-year grace period and interestat 0.5-2 percentover the London interbank offered rate (LIBOR); IBRD debt-17 years maturity with a 5-year grace period and interest at 7.4 percent; bilateral debt-13 years maturity with a 3-year grace period and interestat 5.0-7.5 percent; other multilateraldebt-10 years maturity with a 3-year grace period and interest of 6.0-7.5 percent.
2.54 Third, with the passing of the post-independencecrisis, grant aid, in the form of food, emergencymedical supplies, and other critical inputs, is expected to drop back from the very generous levels realized during 1993 (USD 54 million). It appears unlikely that grant aid will exceed USD 8-10 million per year during the planning period.
2.55 Fourth, Estonia is likely to gain access to significantcommercial credits during the 1994-97 period, somethingthat was not possibleduring the first two years of renewed independence. This is not expectedto counterbalancethe decline in private source flows from FDI, however, and should remain a modest componentin total external financingflows during the planning period.
2.56 In addition to borrowing abroad for relendingto the enterprise sector, the governmentmay wish to consider loan guarantee operationsto cover country risk. These could provide enterprises with increasedaccess to foreign capital markets withoutdirectly reducing the government'sborrowing capacity and debt service liability. Loan guaranteesshould be introducedwith caution,however, given the limited track records of most Estonian enterprises, the still unsettled domesticeconomic conditions, and the lack of fully effectivemortgage and stock marketmechanisms that would facilitatethe government's recovery and liquidationof assets in the event of a default.
2.57 One way to reduce the risk of guaranteeoperations would be to work throughan international financialorganization such as the World Bank, whichhas instrumentssuch as EnhancedCredit Operations (ECOs) to assist with loan guarantees. The World Bank's Multilateral InvestmentGuarantee Agency (MIGA), which provides country risk guaranteesfor foreign investors, could stimulateadditional FDI. Such guaranteeswould make it easier for domesticenterprises to attract foreign partners. This, in turn, would reduce the foreign exchangeresources that the governmentwould need to mobilizethrough its own efforts.
2.58 The base case in Table 2-9, which is regarded as the most likely scenario, results in a fully sustainableexternal payments position throughthe 1998-2004period when many of the loans will have to be repaid. Debt service as a percentageof exportswould averagea modest 7 percentduring this outer period, and the 19 percent ratio of debt to GDP would also be quite manageable. In fact, the debt service ratios are so low that one must ask if it would not be possibleto accelerateEstonia's growth by accepting somewhathigher debt indicators.
2.59 The mission does not believe that a more aggressive external borrowing strategy would be advisable for the following reasons. First, since the private sector will have limited direct access to foreign borrowing during this decade, the public sector would have to acquire virtually all of the debt. To service this debt, the public sector would have to maintain a larger claim on resourcesthan would be consistent with the government's strategy of letting the private sector take the lead in the nation's - 51 - economic development. Second, Estonia's absorptive capacity is still limited, and attempting to implementtoo many projects too quickly could result in wasting resources, thus creating future debt repaymentproblems. Also, Estonia's debt ratios are low because it started with virtually no external debt. Consequently, a trajectory of debt accumulationthat resulted in an average debt service ratio of 10-15 percent during this decade could lead to serious debt servicing problems in the next. The base case, therefore, appears to be an optimal, sustainablepath that assures good growth without overheating the economy or creating other problems.
2.60 The low case in Table 2-9 assumes that, in addition to a slowdown in the structural reform process, the stabilization effort is also derailed by fiscal pressures arising, for example, from high unemploymentpayments and subsidiesto adversely affectedenterprises and workers, particularlythose in agriculture and industry. This would quickly lead to a resurgence of inflation that would discourage private investment, leadingto the projectedslowdown of GDP growth to about 1 percent per year. The debt service ratio would not rise appreciably under this scenario, however, because under these conditions, Estonia would have limited access to foreign borrowing.
2.61 The high case in Table 2-9 assumes not only continued success with stabilization, but a significant increasein the pace of structural reforms, led by accelerated enterprise privatization,sale of land with clear ownership rights for the developmentof enterprises and housing by the private sector, rapid developmentof the financial sector includinga decline in interest rates to levels closer to European levels, excellentprogress in reducing energy costs through investmentsin increasedenergy efficiency, and rapid implementationof infrastructure projects in the public sector to support accelerated private investmentactivity. The debt service ratio does not rise appreciably from the base case because of the assumptionthat more rapid structural change would significantlyincrease GDP growth, which would be accompaniedif not led by excellentexport performance. Thus, while foreign borrowing would increase significantlyunder the high case, exports and GDP would also rise, thus moderatingthe debt service and debt-to-GDPratios. The high case is conceivable. However, it is also very demanding. Given the many challengesthat lie ahead in completingthe economictransformation, the base case appears to be the most likely.
2.62 With the planned shift from fast disbursing balance of payments support toward slower disbursing project financing, the annual commitmentrate for 1994-97 wbuld have to be considerably higher than the indicatedlevel of disbursementsto assure the desired flow of borrowed foreign exchange. This underscoresthe importanceof working with donors to coordinateinternational and bilateral support. With the shift in emphasistoward project financing,a well-preparedpublic investmentprogram will be needed.
2.63 Close collaboration with the donor communityon the basis of a good public investment program will also allow the governmentto secure accessto the technicalassistance that may be needed to help implementthe public investmentprogram in a timely manner that gets the highestpossible returns from the resources available for investment. Estonia received very considerable benefits from the technicalassistance provided to date, but increasedcoordination is needed to avoid duplicatedwork on the one hand and unmet needs on the other. The governmentmay therefore want to consider developing a TechnicalAssistance Plan as a documentthat complementsthe Public Investment Plan. If it decides to pursue this possibility, the World Bank would be pleased to assist with the process.
CHAPTER 3
Preliminary Assessment of Proposed Projects
A. Introduction
3.1 As a first step toward developing a public investment plan for 1995-97, the Ministry of Finance sent a questionnaire to ministries and other government agencies soliciting suggestions for investmentprojects in their respective sectors. No constraintswere placed on the amount that a sector could request. The Ministry of Finance has compiledthe replies, which are sunimarizedin the proposed project list (PPL) shown in Annex 3. However, it has not yet begun the difficult task of eliminating lower priority projects to bring the total cost down from nearly EEK 21 billion to about EEK 4.8 billion, the amount likely to be availableduring the 1995-97planning period.'
3.2 This chapter evaluates the investmentsproposed for the 1995-97 public investmentprogram against the backgroundof national, sectoral, and project priorities that have been outlined in Chapter 1. The top national priorities, as reflected in governmentactions since Estonia regainedits independence, have been to maximizeeconomic growth and social justice by (a) bringing Estonia into the community of modern, market-based nations; (b) reducing the role of government in economic activity; (c) strengtheningthe kinds of services traditionallysupplied by governmentsin market economies; and (d) fostering the developmentof a dynamicprivate sector.
3.3 Chapter 1 proposed categorizingsectors into four public/privaterole (PPR)groups depending on the relative degree of public versus private involvement that the government believes should characterizethe sector by the year 2000. These groupsare summarizedin Box 1-6. Within each sector, Chapter 1 recommendsgiving priority to projects that focus on emergencyrepairs, stabilizationto prevent further deterioration,rehabilitation and restorationof valuable physical assets that are likely to remain in the public sector, investmentsin improvedenergy efficiency, and completionof ongoingprojects where these are economicallyjustified. Conversely,it suggeststhat low priority be given to new construction, unless importantdevelopmental objectives can otherwisenot be accomplished. Reachinga consensuson these priority-settingcriteria within the Public InvestmentProgram Working Group (PIPWG),and then within the Council of Ministers, is of high priority.
3.4 Proposed projects are examinedhere not in terms of their absolute quality, but in terms of their priority for inclusion in the public investmentprogram. A project could be economicallyand financiallyattractive but still receive a low rating for the PIP if it should be carried out instead by the private sector.
3.5 Figure 1-1 summarizesthe proposed numberand cost of projects in the potentialproject list by public/privaterole groups. The allocationby number of projects is very consistentwith the apparent priorities of the governmentregarding the desired relative roles of the private and public sectors; nearly 80 percent of the number of projects falls into the groups where the public sector will maintain a dominant or majority role. Of concern, however, is the fact that 70 percent of the cost of proposed projects is in areas where the private sector should play a dominant or majority role.
I See the Executive Summary regardingthe highly provisionalnature of the proposed project list shown in Annex 3. See Chapter 2 for details of the estimationof the resources availablefor the 1995-97public investmentprogram. - 53 - 3.6 A carefulproject-by-project review is needed to determine the highest priority projects that should be included in the PIP. The information available on most projects is still limited, but the followingsections, whichconstitute the main body of this chapter, provide some preliminary impressions regarding projects that may be of particularlyhigh or particularlylow priority for inclusionin the public investmentprogram. These sections follow the structure of Table 1-4, grouping sectors accordingto the relative importance of public and private activity. SectionsB and C discuss PPR Groups 1 and 2 where the public sector is dominant. Sections D and E discuss sectoral investmentsin Groups 3 and 4 where the private sector is expectedto play the leading role by 2000. Within each group, the sectors are listed in alphabetical order (Annex4 provides an alphabeticallist of sectors that indexes them to PPR groups for easy reference).
B. Public Sector Domain (Group 1)
Education
3.7 Education projects in the PPL total EEK 720 million, and specific requests for EEK 101 million have been made for 1994. The Ministry of Education(MoEd) list of investmentneeds for 1994 totals EEK 58 million. The gap of over EEK 40 million between these two lists needs to be reconciled. State funds budgeted for capital investment in education facilities during 1994 total only EEK 10 million, less than one-fifth even of the smaller MoEd list. Some additional funds may be available from the municipallevel, but the sector faces a major task in reconciling available funds with requests.
3.8 A substantialshare of the MoEd's 1994 requestsfor capital funds were to help completeeight unfinisheduniversity buildings and three unfinishedcollege buildings. Also included were requestsfor funds to initiate constructionof the proposed Estonian National Defence Academy (EEK 200 million), the Estonian Academyof Music (EEK 63 million), and a new training building at the MedicalSchool in Tartu (EEK 185 million). Out of the EEK 101 million in the Ministry of Finance (MoF) list for 1994, EEK 37 million is for the Tartu project, which alone exceeds the central government capital budget allocation for all constructionin the education sector by almost four times. (This constraintcould be relieved, however, by obtainingexternal financingfor the project, and such financingis currently under discussion with the World Bank.) Most of the other projects are small ones in secondary cities and towns.
3.9 One of the highest priorities in capital investmentsfor Estonian educationduring the next few years shouldbe to increasethe energy efficiencyof the existingschool buildings. Energy savings of 5-15 percent could be realizedthrough investmentswith payback periods of under five years. As energy costs currently take about 20 percent of the total budget for education (based on the experience in Tallinn), investmentscould significantlyincrease the resourcesavailable for education. Also of high priority is major renovationson buildingssuffering major structuraldamage, such as leaking roofs, brokenwindows and doors, and problems with mechanicalsystems that could jeopardize the continued operationof the buildings and could result in high reconstruction costs at a later date if the repairs are delayed.
3.10 New schoolbuildings are very expensivecompared to the badly needed renovationsoutlined above and should generallynot be given high priority now. New school buildings accountfor 80 percent of the EEK 720 million in the PPL for the educationsector, but only 25 percent of the number of projects for the sector. Much of the problem arises within the first year of the planning period. The capital investment requests for 1994 exceed the total state investment budget in 1994 for capital projects. - 54 - Postponingonly six of the fifty-one projects listed for the educationsector for 1994 would reduce the demand to only EEK 35 million. By delaying new projects, Estonia could increase the resources availablefor high priority repairs and upgrading of existingbuildings, as well as for meeting recurrent expenditure requirements including better teaching materials and higher teacher salaries. Ongoing projects should be reviewed carefully to see if they are worth completingat this time, or if they should be "moth-balled"to prevent weather damage and completedat a later date.
3.11 Postponingnew schoolconstruction should have no significantadverse effects on the sector's effectiveness. The current physical plant is basicallyadequate, and Estonia does not expecta significant increase in students for several reasons. First, populationgrowth is close to zero. Second, school enrollmentrates are alreadyvery high. Third, to the extentthat Estonianuniversities will no longer train as many foreign studentsfrom other parts of the FSU, the totaluniversity enrollment may shrink slightly. Fourth, the sharp incomedeclines in recent years may lead people to seek employment,even at relatively low pay, instead of attendinguniversity. Fifth, the recent reductionin stipends for university students, together with lower overall income levels, will tend to reduce attendance at institutions of higher education. Until more adequatepublic investmentresources become available, efforts should be made to find existing buildings that can be used with minor modificationsto meet educationaldemands, thus avoiding the high cost of new buildings.
3.12 There are two exceptionsto the conclusionthat Estoniashould not invest now in new school buildings: specializedtraining facilitiesthat must be located in institutionswithout any spare capacity available;and schools in rural areas that cannot be served with existingelementary schools. With respect to the former, the proposed pre-clinical and public health training facility'at the University of Tartu is a good example. The existing building is over 100 years old, crowded, and unsafe from a health perspective. Becausethe facilitymust adjoin other classroombuildings and dormitoriesused by the same students, it must be on the Tartu Universitycampus. The campus alreadysuffers an overall shortage of space, and no other building exists that could be adaptedto meet the requirements of the high priority public health programs.
3.13 With respect to rural schools, Estonia is trying to reversethe forced concentrationof rural populationsinto collective and state farm communitiesduring the Soviet period, and to bring rural areas more fully into the national life. In addition to returning family farms to their previous owners, the government is increasing the number of schools in rural areas. Some economic as well as social justifications exist for this program. At the elementarylevel, specializedequipment for science and vocational training is not required, economiesof scale are few, and building construction is relatively inexpensive. At the same time, a better geographicdistribution of elementaryschools can reduce the cost of transporting children to central locations-a problem that will increaseas collective farms are broken up and people regain control of family farms. To avoid major investments in new rural schools, however, every effort should be made during the next few years to find existing buildings that can be converted at low cost to serve as schools.
Enviromnent
3.14 Stand-alone,single purpose environmentalprojects, such as ones to increase biodiversityor reduce global warming, do not appear in the current PPL. However, a substantial share of the projects have environmental improvement and protection as a major objective or as an important secondary benefit. The remainder of this section discusses ways in which the proposed projects address environmentalconcerns in each of the priority environmentalareas-air, 'water,land, biodiversity, and energy conservation. The projects themselvesare discussed in the relevant sectoral sections. - 55 - 3.15 Air Quality. From an environmentalperspective, top priority should be given to projects offeringthe most cost-effectivereductions in dangersto humanhealth. On this basis, projects that control air pollution in urban areas deserve the highest priority. Estonia needs to control pollution from three major sources-smoke from district heatingplants throughout the country, dust from the Kunda cement plant, and emissionsfrom the Baltica and Estonia power plants.
3.16 In district heating (DH), the government is already launchingprojects with assistance from the European Bank for Reconstructionand Development(EBRD), the World Bank, and other donors. With these projects, DH systems in Tallinn, Tartu, and Parnu will undergomajor renovations involving enhancedenvironmental controls as well as higher thermal efficiency. The renovationof smaller boilers throughout the country is also under way. Extensive environmentalreviews have been undertaken to assure that the domestic fuel conversioncomponents of the projects will not have adverse environmental impacts.
3.17 The InternationalFinance Corporation(IFC) recently approvedits participationin the Kunda Cement project, which will cut dust emissionsfrom the plant by about 95 percent from the current level of 70,000 tons per year, as well as significantlyimprove production efficiencyand quality. This project does not appear in the public investmentprogram because the Kunda plant is being privatized as part of the project, and budgetary funds will not be involved in its implementation.
3.18 Investments in emissions reduction from the Baltica and Estonia power plants have been difficult for Estonia to justify financially since the pollution, while serious, is carried offshore by prevailingwinds and does not have a significantadverse impact on the Estonian environment. Also, the necessary investmentsare quite large, requiring modificationor replacementof boilers as well as flue stack pollutioncontrol equipment. Althoughsome minor improvementshave been made recently, major investmentsmay have to be delayeduntil support has been arranged from neighboring countries which benefit from controls on this pollution.
3.19 Water Quality. Second-order priority should be given to environmental investments that reduce water pollution. While some of this pollution can be reduced without investment (for example, through more careful application of chemicaland natural fertilizers by the agricultural sector), major investmentswill be required in sewage treatment plants throughout Estonia, particularly in the larger towns and cities. Since work in the first priority area of air pollution is already under way, it is appropriatethat Estonia has alreadyidentified a large number of potential wastewater treatmentprojects. (Water and waste water projects are discussed in more detail in Section C.)
3.20 Land. Water quality is also endangeredby poorly manageddumps for municipal solid waste and toxic waste (includingmilitary atomic waste at Paldiski). Anothermajor source of pollution is the oil shale waste piles in the northeast. Projects addressingmunicipal solid waste are discussed below in the section for that sector. Control of pollution from the oil shale waste is potentially a very serious problem. In addition to dust blowing from the piles, evidenceexists that water is leaching through this waste, carrying toxic materials into both surface and underground water supplies, thus endangering drinking water supplies, aquatic life, and marine life. The problem is too massive to leave to local environmentboards or to the companiesproducing these wastes, because these parties do not have the required financial and technicalresources. Action should be centered at the national level where plans for the entire country can be formulated,financed, and executed. Raising the cost of oil shale closer to world prices and using the incrementto finance part of the environmentalcleanup would help. - 56 - 3.21 Biodiversity. Given the many pressing claims on public funds, significantinvestments will have to be delayedfor projects that do not immediatelyimprove humanhealth, such as projects designed solely to protect and improve biodiversity, unless such projects can be funded with highly concessional loans or grants designed specificallyfor such projects. Grant resources from the Global Environment Fund, for example, should be considered. Biodiversityactivities are very important in the longer term, but the present focus should be on low-cost administrativeactions that will limit further environmental destruction, such as controls on toxic waste dumping, timberland cutting, and poaching in wildlife preserves. Fortunately,many of the projects designedprimarily to protect human life also have direct benefits for protecting biodiversity. For example, sewage treatment plants designed to improve raw drinking water supplies for downstream commnunitiessharply improve the quality of the water in the rivers, wetlands, and marine coastal areas, thus helping to preserve biodiversity. Other projects to improve the quality of human drinking water supplies, such as control of agriculturalrunoff, also have a direct positive impact on biodiversity.
3.22 Energy. Inefficient and poorly controlled use of energy, which is widespread in Estonia today, pollutesthe environment, endangersbiodiversity, contributes to global warming, and wastes non- replaceableresources. Projects to improve combustionefficiency, reduce smokestackemissions, control pollution from post-combustionwastes, reduce distribution losses, and improve end-use efficiency will all have tangiblebenefits for the environment.
3.23 The EnvironmentMinistry in Estonia can be expected to play a major role in assuring that appropriatepriority is given in the PIP to projects in the above sectors, and to designingthe projects with maximumcost effectiveness. Achievingthis will require continuedresearch on Estonia's environmental issues. Such research, as well as other environmentalwork, is facilitatedby Estonia's establishment of an EnvironmentFund (EF). Funded almost entirelyby earmarkedpollution fines and environmentuser charges, it operates as an extra-budgetaryfund (EBF) and is the only non-insuranceEBF left in Estonia (the other EBFs are the insurance-basedSocial and Health Funds). As an EBF, it is subject to the standard doubts regarding EBFs. For example, why shouldn't the EF compete for resources along with all other activitiesof national economicand socialpriority? Besidesthe lack of flexibilitythat comes with earmarked revenues, the lack of competitionfor resources reduces the outside scrutiny of the fund's activitiesand priorities. Until such time as the EF might be placed on a more normal funding basis, it shouldbe required to provide Parliamentwith an annual review of the expendituresand accomplishments of the past year, together with a statementof objectivesand priorities for the coming year, if this is not already done. This would help assure that the EF makes the most effective contribution possible to resolving Estonia's many pressing environmentalproblems.
GovernmentAdministration
3.24 Governmentadministration is not linkedto specificsectors, such as health, culture, education, public safety, water and sanitation, highways, or streets. It includes, for example, the national government buildings and equipment in Tallinn, the municipal government buildings throughout the country, courts, customs and border posts, and the data and communicationssystems needed by these offices.
3.25 Of the potential project list, EEK 143 million (0.7 percent of the total) is for government administration. The largest project is for developinga real estate registrationsystem. This project should be accorded high priority and, if this has not already been done, the informationmanagement systems shouldbe expandedto support the privatizationof land, housing,and commnercialand industrialbuildings. In parallel, systemsshould be developedto provide informationto tax authorities regarding the assessed - 57 - value of property and to handle the registration of third-partyclaims on property offeredas collateral for loans.
3.26 The other projects under governmentadministration are considerablysmaller and do not raise obvious questions,but they should be reviewedto assure that the most cost-effectivesolutions have been identified, and that the timing is appropriate. The list should also be reviewed to identifyprojects that should be added to the list. For example, the State Tax Department has proposed installation of a computerizedsystem for tax data and revenue allocationthat would link the nation's twenty-seventax offices electronically. The system, which would cost about EEK 1 million, looks worth examining in more detail as part of the public investmentprogram. Other projects that would improve the efficiency and cost effectivenessof governmentadministrative services may also exist.
Highways
3.27 Highway investments (excludingmunicipal streets and secondary rural roads) account for about EEK 930 million (4.5 percent) of the proposed investments. Highways are vital to Estonian life. Trucks carry an estimated70 percent of the total inland cargo volume, and as improvementstake place in the Via Baltica, Estonia can expect rising volumes of road traffic between Scandinaviaand northern Europe. The current highway system is quite good, at least for current traffic volumes, but action is urgently needed to protect the road surfaces against the rapid deterioration that takes place with heavy trucks in a sub-Arcticclimate. Surfacedressing can prevent this damage and costs only about USD 5,000 per kilometer. However, if cracked surfaces are not sealed, the bitumen surface can be destroyed, forcing a surface overlaythat costs about USD 50,000 per kilometer. If preventivemaintenance is further delayed, the roadbedmay have to be rebuilt at an averagecost of roughly USD 200,000 per kilometer. Physical improvementsin the Via Baltica should be supportedby reductions in border crossing delays. Present delays, which significantlyincrease vehicle operationand transport costs, could be reduced with small investments;thus, physical improvementsshould be given high priority.
3.28 Only four highway projects are listed in the PPL. The two lakgest, which together account for 97 percent of the total, include an EEK 650 millionjoint road constructionproject with Russia, and an EEK 250 million project for transportand communicationsdevelopment in Voru county. Both appear to focus primarily on new constructionrather than basic maintenance. The timing of the joint project with Russia needs to be reviewed carefully in view of its high cost, and the fact that, accordingto some large trucking enterprises, road traffic with Russia has dropped about 70 percent during the past year. This drop reflects the general decline in economic activity to the East and Estonia's rapid economic reorientation to the West. Given the relatively large size of these projects, their apparently limited geographiccoverage, and their focus on new constructionrather than maintenance,their priority at this time is open to question. Virtually nothing has been spentso far on either project, so little would be lost by delayingthese projects. As the situationin Russiastabilizes and economic growth resumes, however, an improved highwaymay be warranted;Russia providesa potentiallymassive market both for Estonian goods and for goods in transit to and from Western markets.
3.29 The highest priority activity for the highwaysector, a maintenanceproject, does not appear in the PPL. This project, which involves top dressing plus selective overlays and reconstruction,will generate an estimated rate of return of about 30 percent through avoided highway repair and reconstructioncosts in the future and through reducedvehicle maintenance and operatingcosts. It clearly deserves high priority in the PIP. The PPL does include a new asphalt cement mixer for highway maintenance,as well as road constructionequipment that could be used for maintenance. The need for a new asphalt cement mixer is under review in the context of the proposed World Bank Highway
------~~~~~~ - 58 - Rehabilitationloan. A more cost-effectiveoption may be to purchase a used, transportable mixer of modern design that could work in multiplelocations, and refurbishone of the existingstationary mixers. Aside from minor equipment for pothole repairs and the like, most equipment should probably be purchased by private highway contractors. More will be known about the relative benefits for using private contractors for maintenancework, as opposed to using the Estonian Road Administrationwork force, once the study of force accountversus contractingout has been completed under the World Bank's proposed highway loan. Until the results of this study are available,new public investment in highway maintenanceequipment should be minimized.
3.30 The omissionof the highway maintenanceproject may reflect a definitionalproblem. Such work is normally classified as maintenance and, until the recent budget crunch, was covered by the current expenditure budget or the Road Fund.2 However, because the present backlog of deferred maintenance cannot be handled within the normal budget of the Estonia Roads Administration, and because external financingis being arranged for a project to carry out the work, the portion of the road maintenanceprogram exceedingthat covered by annual budget allocations should be in the PIP.3 At a minimum, the PIP should include the USD 14 million of proposed external financing for highway maintenance(including USD 12 million of proposed World Bank funding).
3.31 Including the highway and other work to be financedfrom abroad in the PIP is important because the maximum sustainable amount of foreign borrowing by the government has already been counted in computing the total feasible size of the public investmentprogram. Failing to include the planned USD 14 million for highways in the PIP would overstateby that amount the foreign exchange availablefor other projects.
Labor/EmploymentServices
3.32 On the employmentfront, Estonia facesan unusual,but very welcomesituation where a sharp decline in output has been accompaniedby modest rates of open unemployment. The need for investmentsin labor market training facilitiesand unemploymentoffices is thus relatively small. The National Labor Market Board has identified a need for EEK 12 million for software and hardware to establish an effective, interconnectedinformation system for local unemploymentoffices. Of this, about 60 percent is expected to be financed by the European Union's Pologne Hongrie Action pour la ReconversionEconomique (EU-PHARE) on a grant basis. Another EEK 5 million has been requested for equipment for centers to train the unemployed. Given the extensive training facilities already availablein Estonia, and the potential for the Labor Board to purchasetraining from facilities run by the Ministry of Education, the investmentin training center equipmentcould be postponed. However, the NationalLabor Market Board projectbeing financedwith EU-PHAREassistance does belong in the PIP.
2 Although termed a 'Road Fund," this is not an extra-budgetary fund. It receives resources from the annual state budget. No linkage exists between the fuel excise tax that was introduced in 1993 and the Road Fund. Its resources are allocated out of general revenues.
3 See Chapter I for a discussion of the criteria for determining if a project should be included in the public investment program. s - 59 - MunicipalStreets and Lighting
3.33 Despite recent resource shortages, Estonia's urban infrastructureis still in reasonably good condition, a reflection of the country's relativelyhigh level of incomeduring the Soviet period and the emphasis placed on urban development. These urban investments need to be protected now through acceleratedmaintenance programs. Withoutbasic and relatively inexpensivemaintenance, the facilities will decay, resulting in costly rebuildinglater. Like highways, urban roadwaysare at particular risk in this climate, because frost wedgingquickly destroys any pavementsurfaces that are not well maintained. The mission noted, for example, a substantialdeterioration of the roads in Tallinn between November 1993 and April 1994, the result of a single winter.
3.34 The municipal infrastructure investmentsidentified in the PPL are modest, accounting for only EEK 29 million (0.1 percent of the total). Of this, EEK 25 million are for a single wholesale-retail market project. It is not clear why such a large share of the meager resourcesproposed for municipal investment should go into a single community for a project that could probably be undertaken by the private sector on a concession basis if the project is economicallyjustified. Maintenance of existing municipal buildings, roads, and infrastructurefacilities is clearly of higher priority.
3.35 Many of the investmentsat the municipal level will be the responsibilityof local government authoritiesand thus should not appear in the nationalgovernment's public investmentprogram. The PIP should, however, include as financialinvestments any contributionsto locally funded capital investment projects. The centrally financedshare of the cost of any municipalprojects physically implementedby state-level authorities should be included as physical projects in the PIP. This might include, for example, improvementson portions of state highways passing through localities.
Public Safety and Defense
3.36 Public safety includesactivities needed to protect people from harm other than that associated with war (which falls under defense). The main public safety activitiesare coast guard, police, fire, ambulanceservices, and searchand rescue. The PPL includes investmentsin public safety totaling about EEK 624 million (3 percentof the total), of whichEEK 245 million are slated for 1994. Of the proposed EEK 624 million, two-thirds is for coast guard activities. As such services were previously handled by the Sovietmilitary, Estoniadid not have its own coast guard facilities,and has been forced to make major investmentssince independence. With a coast line of nearly 4,000 kilometers, extensive shipping and fishingactivity in the adjacent Baltic Sea, and high levels of transit traffic (includingthrough the Straits of Finland to St. Petersburg),good coast guard services are a high priority. Estonia has joined the Global Maritime Distress and Safety Systemand consequentlyis obligatedto installa coastal VHF radio system. Funds from the EBRD and the European InvestmentBank (EIB) are beirig sought to help finance this EEK 60 million investment. The proposed coast guard investments,which constitute a modest share of total proposed investmentsand are partly mandated by internationalagreements, are almost certainly justified.
3.37 Other significantinvestments are proposed for police, fire, stations, and ambulance stations. These investments seem appropriate. For example, although a recent study gave low priority to upgrading the Via Baltica roadway, it gave high priority to developing highway support facilities including ambulance and police services. The proposed investmentsare modest and probably well justified. -60 - 3.38 Great concern has been expressedregarding the rising levels of crime in Estonia and the other BalticStates. The proposed investmentsin an improvedpublic safety communicationssystem shouldhelp in fighting crime. The government may wish to consider additional investments in police, police equipment, courts, and correctional facilitiesthat might make a significant contributionto controlling crime. Crime imposes high private costs. Direct injuries and losses are the most obvious costs, but hidden costsmust also be considered. For example,private individuals are forced to pay private agencies for protection from criminal elements when the police are unable to provide this protection.
3.39 External defense is a classic "public good" for obvious reasons and is thus a reasonable priority area for public investment. A specialneed may exist in the case of Estonia to the extent that it finds it necessaryto convert its arms from Sovietto NATO standards. The PPL does not, however, show any defenseprojects. From a nationalaccounts perspective, defense expenditures are consumptionrather than investment expenditures. However, from the government's budgetary planning perspective, expenditureson military facilitiesand weaponshave features in common with public investments. These include, for example, a life expectancygreater than one year; the production over time of services for the common public good where cost recovery is difficult; and the need for direct government control. Furthermore, defense expenditurescan represent a major claim on public resources as indicated by the agreementin 1993 to purchase USD 60 million of arms from Israel. Therefore,even if the details of the militaryexpenditures are not revealedin the public investmentplan, the governmentmay wish to include the total amount of such expendituresas a memorandumitem in the public investmentplan to facilitate balancingclaims from this sector with claimsfor development-relatedexpenditures.
C. Public Sector Majority (Group 2)
Air Transport
3.40 Two air transportationprojects in the PPL constituteEEK 228 million(1.1 percentof the total list). The projects, one for the runwaysand one for the terminal at the Tallinn airport, are progressing quickly. An initial resurfacing of the main landing strip was accomplished in 1993 with EBRD assistance. This will be followed by further investmentsto allow heavier planes to land and to improve the lighting and air traffic controls. Financing for the project has been approved by EBRD, and implementationis to start in early 1994. Investmentsin the runwaysand traffic control are important for improved air safety. The terminal renovationsbuild on work already started and should help improve Estonia's attractivenessas a tourist destination.The work being planned seems to be of high priority as it is well justified, modest, and has already attracted international financing. If not already done, investmentsshould be made to bring lowerair space traffic control facilitiesup to internationalstandards; the current plan for contracting with Finland for control of upper air space seems sensible for now. As with seaport facilities, private sector investment should be encouraged for any future ancillary superstructure,such as hangars, repair facilities,and other facilitiesoutside the main terminal and control tower. Although no investmentswere indicatedfor the national airlines, it should be noted that, given the low occupancy rates and the high overhead costs of running a small nationalairline, further public investmentsin this part of the air transport sector would not seem justified, exceptpossibly in the context of creating a regional airline involvingcooperation among the Baltic states.
Culture
3.41 Cultural projects constitute 7.5 percent of the total number of projects in the PPL, but the total costs are considerablymore modest-only EEK 308 million or 1.5 percentof the total. One project - 61 - accounts for nearly one-fourthof the total-the KukruseMansion (EEK 78 million). This plus another six projects accountfor two-thirds of total expendituresproposed for cultural projects; the remaining projects are all small and focus primarily on renovation and restoration-which is almost certainly justified given the importance of Estonia's old buildingsfor touristic and historic reasons. Target dates for completing the two large projects might be reviewed in light of overall budget constraints, and existing cultural buildings should be reviewed to see if additional repairs and investments in energy efficiencyshould be advanced. However, the total size of expenditureson cultural projects seems modest and defensible.
District Heating and Energy
3.42 The PPL includes EEK 678 million (3.3 percent of the total) for district heating (DH) projects. DH project expenditures of EEK 675 million are anticipated. A USD 40 million energy efficiencyproject (with EBRDfinancing of USD 35 million)is being implemented,and a USD 65 million DH project planned for financing by the IBRD, the European Investment Bank, and the Swedish governmenthas been recently appraised.
3.43 The highest priority today appears to be investmentsto reduce the losses in the generation and distribution(G&D) of heat to the consumers. Losses in some heat distributionnetworks in Estonia are 25 percent, comparedto only 10 percent in Finland, and top priority shouldbe given to cutting these losses. The unit cost of saving energy is lower at the G&D level than at the end-user level for two reasons. First, major energy savings can be realized becauseof the very low efficiencyof current G&D equipment.Second, investments at the G&D level can be focusedon a small number of physical locations compared to investmentsat the end-user level; this makes it possible to design and implementenergy saving projects more quickly. However, as discussedbelow, substantialscope also exists for relatively low cost-high return energy conservationinvestments in housing and public buildings as well.
3.44 Of the forty-oneDH projects in the proposed project list, twenty-eightare less than EEK 10 million and constituteonly 12 percent of the total cost of DH projects. To the extent that these small projects are fairly standard in design and apply proven technology,most should go ahead quickly. The rehabilitationof DH systems in the major towns like Tallinn, Parnu, and Tartu, however, is far more complexand expensive,and they shouldbe based on carefulanalysis of options for technicaldesign, time phasing, fuel mix and supply, financial structure, and administration. Such analysis has recently been completed as part of the DH project to be financedby the World Bank.
3.45 Given the high economicrate of return of well-designedDH projects, the allocationsto this sector in the PPL seem warranted and should possibly even be increased (though the capacity to administer a larger number of projects could be a constraint). The environmentaladvantages of these projects in terms of more efficient combustionand less pollution adds to their priority.
Forest ResourceManagement
3.46 Only one small project of EEK 26 million (0.1 percent of total) is includedin the PPL for forest resource management. Consideration should be given to the possible need for additional investmentsin this sector. Forests, which cover 40 percent of Estonia, suffered years of neglect under the Soviet regime. Consequently, a substantial share of the forests are now at or beyond normal harvesting age and need to be cut to reduce the danger of insect damage and fire. Thinning is also needed to allow the remaining trees to develop into commercially valuable, large-diameter timber. - 62 - Expenditures on forest management,including access roads, surveys, related equipment, and ultimate replanting, would thus appear justified.
3.47 All harvestingand processinginto intermediateand finished wood productsshould, however, be handled by the private sector, which could also be held responsiblefor developingaccess roads for areas to be harvested in the near future, for thinning operations, and for replanting. Natural resource usage fees for timber cut should be set at levels sufficientto recoup other public costs and to generate net revenues for the governnent-subject to the constraintthat the fees should not price Estonian timber above world markets.
Health and Social AssistanceServices
3.48 Like many of the FSU republics, before 1991 Estonia had an unusually high density of hospital beds-an average of 12.1 acute beds per 1,000 population,compared to the European average of 9.4 per 1,000. Throughclosures of 16 facilitiesand downsizingof some of the remainingones, nearly 4,000 acute beds were eliminated,and as of 1993, acute beds had been reduced to 9.5 per 1,000. This is still considerablyhigher, however, than in Norway (4.7), Denmark(5.7) and Sweden (6.1). Reducing the number of beds to 7 per 1,000 by 1998 would be desirable. However, this target can be met only if economic growth produces improved living conditions over the next five years. Under present circumstances, most elderly and chronic patients cannot be discharged early to their homes because of poor heating and inadequate living standards. Improved living standards in the future will make it possible to abandon some of the most seriously inadequatehospital buildings, consolidateand improve the utilization of staff and equipment in the better buildings, attain a higher density of use per square meter, and substantiallyreduce energy costs. In addition to excess capacity, the health facilities and equipment in Estonia are in such bad conditionthat the overallquality of health care is poor, despite well- trained medical personnel. Also, the range of services is limited. Funds are clearly needed to remedy these problems.
3.49 Energy costs account for 20-25 percent of hospitaloperating costs. As in other sectors of the economy, reducing the high levels of energy waste is probably the highest priority (along with emergency repairs of leakingroofs, for example)for hospitalsand other long-termhealth care facilities in Estonia. This may be an especiallyhigh priority for the health sector since ambient temperatures in hospitals cannot be reduced as much as they can be in schoolsand offices, for example. The cost savings from increasedenergy efficiencycould help resolve the current fiscal crisis that prevents hospitals from paying medical personnel adequate salaries, obtaining the surgical supplies and medicines that are required, and purchasing the modern equipment needed to provide a wider range of quality medical services.
3.50 Unfortunately,the necessarypriority on energy efficiencyinvestments is not reflected either in the list of capital investmentsproposed by the Ministry of Social Affairs (MoSA) or in the PPL prepared in the Ministry of Finance (see Annex 3).4 The MoSA list focuses exclusively on the construction of new hospitals, only one of which (Maarjamoisa)appears to be a priority at the present.
4 The two lists are not consistent. The MoSA list shows EEK 225 million of investments,while the MoF list shows only EEK 118 million-and does not yet includethe Seppa, Parnu, and Maarjamoisahospital investmentsthat, along with one at Valga, that is on the MoF list, comprise the MoSAlist. Major expenditureshave already been made on most of the hospitalsin the MoSA list. If one countsonly the remainingexpenses and adds this to the costs shown on the MoF list, the total for the two lists is similar. These discrepanciesclearly need to be resolved in the near future. - 63 - New constructionof extended-carefacilities for the aged and infirm may, however, be justified in cases where existing facilities were not designed for their current use (for example, drafty old manor houses that are now being used as nursing homes).
3.51 The Parnu hospitalis a particularlynotable example of the questionsthat must be raised about ongoingprojects. Though started in 1988, only 15 percent of the works had been completed by the end of 1993, and most of the estimated EEK 70 million cost still lies ahead. The existing design and constructionare seriously deficient, and the unfinished structure has been badly damaged by weather. Consequently, starting over might cost less than making the necessary design changes and repairs. Fortunately, the existing Parnu Hospital appears suitable for modificationsthat could bring it up to modern standards at a fraction of the cost of buildinga new hospital.
3.52 In Valga, although40 percent of the hospital-polyclinichas been completed, the design and engineeringof the project would require substantialreview and revision to meet modern standards. The cost of the project, estimated at EEK 50-60 million, is substantial,and a careful review is justified, but this may be a fairly high priority project. More informationis needed regarding the benefits and costs of the proposed Seppo Traumatologyand OrthopedicsHospital, but as a new project, it appears to be of low priority at this time.
3.53 The one high priority hospital project appears to be the Maarjamoisa Policlinic in Tartu. Begun in 1983, 88 percent of its estimatedEEK 45 millioncost has alreadybeen incurred. The project is moving ahead steadily, and completion appears well justified. Other than the Valga and Parnu facilities, the only project large enough to raise particular question on the MoF list is the construction of an EEK 19 million children's policlinic, apparently in Narva. Although construction has already begun, sunk costs are minimal, and all new constructionlike this should be questioned under current economic conditions.
3.54 One important health project not included in the cost totals from the health sector is the proposed health project that is currently under discussionbetween the World Bank and MoSA. It has been classified in the proposed project list as an educationproject, because its largest single component is a classroom building for pre-clinicaltraining at Tartu University. However, the focus of the project is clearly on the health sector, and it promises to bring about major improvementsin the entire public healthcare delivery systemof Estonia. The rest of the health projects on the MoF list also seem modest and justified. The PPL includes a reasonablevariety of investments,ranging from rehabilitation and repair of various facilities to developmentof medical services and a medical database. A careful review is needed to see if additional renovationprojects can be identified that deserve higher priority than the large and questionableexpenditures on new hospitaland policlinicconstruction. Such renovationprojects should be designed primarily to (a) increase energy efficiency; (b) improve the quality of patient treatment; (c) prevent further physical deterioration; and (d) convert excess hospital capacity to other health-relateduses, such as long-termcare facilitiesand sheltersfor those worst affectedby the economic transition.5
3.55 The fiscal viabilityof investmentscannot be judged on the basis of constructioncosts alone. Facilitiesmust be operated at close to full capacity to realize anticipatedbenefits, and any operatingcosts that cannot be recovered from the users must be paid out of the state or local budget. A careful
5 Hospital occupancy rates rise significantly in the winter months. While winter-rela,ted illnesses account for part of this, it is reported that hospitals are also sought out during these months for the shelter, warmth, and food that they offer in a harsh climate. - 64 - assessmentof operating costs is particularlyimportant for health projects, because medical facilities are very labor intensive and require highly trained staff who commandrelatively high wages. All projects should thereforebe subjected not just to constructioncost analysis, but to a lifetime cash flow analysis. Constructinga facility is a waste of money if the resources needed to keep it operating as designed are not going to be available.
MunicipalSolid Waste
3.56 About EEK 9.3 million (less than 0.5 percent)of the PPL is for projectsto handle solid waste disposal. These projects shouldbe subjectedto the normal least-costanalysis for designoptimization and should be based on careful environmentalassessments. However, the present cost estimates are modest, and the projects seem to be of reasonablyhigh priority. As with other investmentsat the local level, only the direct central government share of the cost should be includedin the PIP, though the total cost and its financing could usefully be noted separately.
MunicipalTransport
3.57 The PPL shows requests for EEK 391 million (1.9 percent of the total) for municipal transport. Virtually all of this is for bus rehabilitation. This sector deserveshigh priority in the public investmentprogram for several reasons. First, althoughmunicipal transport systemshave been privatized with considerablesuccess in many countries, the sector should probably remain in public hands for the next decade in Estonia due to the shortage of private investmentcapital; the higher priority that must be accorded to privatizing industry, agricultureand housing; and the losses that must be covered by public subsidies at present. Efforts should continue to be made, however, to transfer full ownership and operating responsibilityfrom the central governmentto local authorities. Second, the rolling stock and infrastructureof the municipal transport system is seriously deteriorated, requiring major investments simply to maintain equipment availability. For example, only 50-70 percent of the buses are currently availablefor use on average, and this figure is droppingsteadily, causing serious overcrowding even by Soviet standards, long waiting times, and problems of access to schools and jobs. Third, the energy efficiencyof the buses is very low. Fourth, because of basic design deficienciesand poor maintenance, the buses are an important source of environmentalpollution.
3.58 The allocationof EEK 391 million for bus rehabilitationthus appears to be of high priority. However, this shouldbe done in the contextof a more comprehensiveurban transport project that would seek to (a) decentralize to the lowest possible level the responsibilityto raise revenues and provide governmentservices; (b) provide greater participationof the private sector in the provision of services; (c) provide training and technicalassistance in urban transport operations during the transition from a centrally controlled to a market-basedeconomic environment; (d) reverse the deteriorationof municipal transport infrastructure; (e) improve transport services as quickly as possible; and (f) increase the share of transport costs covered by farebox revenues.
Port Infrastructure
3.59 Port projects are by far the largest single category in the current public investmentprogram list, constituting 36 percent of total PPL costs. Therefore, the decision regarding whether these investmentsshould be made by the public or the private sector has major implicationsfor the entire public investmentprogram. - 65 - 3.60 Based on actions already taken by the Estonian government and on what is done for ports elsewhere in the world, it seems reasonable to suggest that port infrastructure-the wharfs, channels, rail lines, and roadways-should remain in public hands for the foreseeablefuture. As natural monopolies, ports are difficult to turn over to the private sector, and developing sufficient competition to control predatory pricing is virtually impossible. Instead of investing in the extensive public regulation and control mechanismsthat would be required if the ports themselveswere privatized, it is probably best to leave port infrastructureunder direct public ownership and control. This should be done through independent public enterprises that are responsible for providing quality services while making a reasonable return on capital. However, investments in the port superstructure, such as oil terminals, warehouses, and cold stores, should be made by the private sector wherever effective competitioncan be developed.
3.61 By these criteria, only EEK 1.6 billion of the EEK 7.6 billion proposed for port projects shouldbe part of the public investmentprogram. Of the EEK 1.6 billion, EEK 0.7 billion is for Muuga Port extension work, and EEK 0.9 billion is for railway infrastructureat Muuga. Even this part of the total ports investmentlist is substantial, and should be reviewed carefully in terms of priority. Such a review will require considerableeffort; it needs to take into accountlikely developmentsnot only in other Estonian ports, but in ports throughout the Baltic region, includingthe St. Petersburg and Kaliningrad areas. The remainder of the port projects are for port superstructure, which is discussed in a separate section below.
Railways
3.62 Railwaysplay an important role in the Estonian transportationsystem, carrying about one- fourth of inland freight. Although railways are operated by the private sector in some countries, the shortage of local investorswith sufficient capital, along with the lack of effective competition,indicates that the Estonian railway system should be retained by the public sector for the foreseeable future. Railwaysare thus a reasonablefocus of public investments. However, as in other sectors, the emphasis of such investmentshould be rehabilitationand maintenanceof existingroadbeds, rolling stock and fixed facilities, not on investmentsin new equipment. A possible exception would be additionalflatbed cars that may be needed if container traffic continues to expand quickly.
3.63 At present, no railway investmentprojects are shown in the proposed project list, even though the World Bank and the Japan Export/Import Bank (JEXIM), for example, are financing investments. Sector staff indicate that Estonian Railways has substantialinvestment plans, but because depreciation allowancesand reserves are seriously inadequate, the railways will not be able to finance the desired investmentsout of their own resources. Thus, the PIP needs to include necessary rail investments.
3.64 The first significantinvestments in the rail sector since Estonia regainedits independenceare the replacementengines and gearboxesfor mainlinelocomotives which are being financedfrom the World Bank/JEXIMRehabilitation Loans. This work is vital to assuring that locomotiveswhich had reached the end of their normal economic life and were becoming unreliable could remain in service. The improved design of the replacementengines will also increasefuel efficiency and reduce environmental pollution.
3.65 The projectlist does includeone rail-relatedinvestment-the EEK 910 million "rail extension" to serve the Muuga Port. This project, which is discussed along with the other Muuga projects in the Ports Section, would develop rail marshaling yards as part of the port's infrastructure facilities. - 66 - Water Supply and Sewerage
3.66 Projects listed for this sector total EEK 1,915 (9.3 percent of the total). This sector, which is likely to remain under public control indefinitely, is also notable in having the largest number of projects in any sector-fifty-eight, or 20 percent of the total. Virtuallyall of the projects are expected to cost less than EEK 10 million, and the majority are small projects in scattered locationsand cost less than EEK 1 million each. Many, if not most of these smallprojects are likely to be of high priority, with potentially major benefits both for human health and the environment.
3.67 The followingprojects deservespecial mention because of their relativelylarge size. A major ozonation complex is being built in Tallinn for treating water. This project is already under way and appears well justified. Another water and environmentproject for Tallinn of about EEK 600 million has been included in the list, as well as a municipal water and environment project for Estonia of EEK 688 million. All of these projects may be well justified for health and environmentreasons and are being reviewedwith assistancefrom EBRDand EU-PHARE. One project with importantenvironmental as well as water supply and sewerageelements appears to be missingfrom the list-the Matsalu/Haapsalu project, which was developed as part of the Baltic Sea Environmental Programme and is under consideration for World Bank financing.
D. Private Sector Majority (Group 3)
Communications
3.68 The presence in the PPL of only EEK 28 million (0.1 percent) for investments in communicationsprojects reflects the government's decision to rely heavily on private enterprise to develop this sector. Joint venture agreements with Scandinavianpartners have been signed, and the installationof digital exchanges, fiber optic trunk lines, and improvedinternational connections is under way. Financing has been obtainedfrom various sources, includinga recent Nordic InvestmentBank loan of about USD 24 million. The very modest public investmentsthat are proposed are almost certainly justified, particularlybecause of communication'simportance to developingEstonia's export industries, international shipping, tourism, and governmentalservices.
Electricity
3.69 Of the EEK 908 million (4.4 percent) allocated to this sector, EEK 900 million is for constructing a Tartu power station. According to the present draft list, n6 constructionis scheduled in the near future, so this appears to be a lower priority projectdesigned for implementationin the future. This seems appropriategiven the sharp decline in total electricitygeneration and consumptionduring the past two years. Substantialexcess capacity now exists, and most investmentsshould go into improving the efficiencyand environmentalquality of existinggenerating capacity, particularly in the northeast, and to reducing losses in the transmissionand distributionsystems. Althoughthe list includesonly two stand- alone power projects, some work on the system is being done in the context of other projects. For example, the District Heating project, which has recently been approved for financial support by the World Bank and others, includes an EEK 79 million componentfor modernizing the Iru power plant, although the primary focus is on the heat production equipment.
3.70 Althoughthe electricitysector is classifiedhere as a sector where the private sector could play the leading role by the year 2000, some in Estonia feel that, while power distributioncould be privatized - 67 - by 2000, the generation of electricity should remain largely in the public sector, as shown in Box 1-6. On the other hand, experiencein other countrieshas indicatedthat, with appropriateregulatory control, generationand transmission can also be privatized while protecting the interests of the public at large.
Finance
3.71 The PPL list from the Ministryof Finance includesfive financial investmentprojects totaling EEK 765 million (3.7 percent of the PPL). Theseprojects seem to be focusedprimarily on making funds available to enterprises through various mechanisms for a variety of worthwhile purposes including export, small and medium enterprises, and innovation. Resources to support these projects will be borrowed from international financial institutions(IFIs), thus making available to domestic banks the long-termfunding that has been lacking. The lack of long-termfunding, along with high perceived risk levels, explains why domestic banks have been unable to make long-term investmentfunds available to domesticborrowers.
3.72 A main purpose of creating these funds should be to develop a core of people who become knowledgeableabout the targeted sectors and thus able to properly assess businessplans and risks. This would help overcome the artificially high risk premia that make it difficult for entrepreneurs in these sectors to borrow at reasonableterms. As with credit to the agriculture sector, care should be taken to assure that the funds are on-lent at close to market terms to avoid distorting financial markets and providing incentivesto rent seeking.
3.73 These proposed investmentsin the PPL should be reviewed to make sure that they meet the normal criteria for any project, such as clear plans regarding the purpose, procedures, managementand staffing, cost recovery, and the like. In addition, these proposed financial investments need to be evaluated to make certain that access to capital is really a significant constraint. A closer look may indicate, for example, that unclear property ownership rights and the lack of access to urban land and buildings are more serious barriers. Such barriers should be removed before investing substantial resourcesin the proposed funds. Otherwisethe beneficiarieswill either (a) press for concessionallending terms to offset the costs of the real problems that have not been addressed; (b) fail to respond to the program because, despite the availabilityof funds, private investmentsare still not profitable; or (c) be forced to default on the loans.
3.74 The proposed project list includesno physicalor financialinvestments for the financialsector. This is most welcome. With the privatizationand corporatizationof the banking sector in the past two years, the banks-including the Bank of Estonia-now lie outside the government budget and are responsiblefor their own physical capital investmentsin, for example, branch offices.
3.75 The World Bank understandsthat the governmentplans to move ahead with one project not listed in the PPL-the recapitalizationof the North Estonian Bank. Both the World Bank and the governmentview this project as an exceptionthat is part of a program to privatize the only bank that is still 100 percent state-owned. It is hoped that the proceeds from privatizationwill replenish the share capital supplied by the government within a fixed time period (one to two years). In the future, the governmentshould excludeany reservesfor bank recapitalization,and continueits sound policy of letting banks go bankrupt if they becomeinsolvent through bad management. It should continueto avoid costly bailouts, because these could absorb a major share of availablepublic investmentresources. If bank recapitalization is justified in certain cases, it should be financed through foreign joint venture participation, domestic bank consolidationand takeover, foreign borrowing, or domestic bond issues, roughly in that order of priority. - 68 - Housing
3.76 The PPL includes only two housing projects amounting to less than EEK 60 million (0.3 million percent of the total). Of this, EEK 57 million is designatedfor the constructionof "dwelling houses." Since housing should move as quickly as possible from public into private hands, any investment by the government now in new housing units should be questioned. Even the modest investmentlisted in the PPL should be reviewed in terms of current priorities, especiallyin view of the fact that the governmenthas announced that uncompletedhousing projects are to be sold to the private sector whenever possible. Unlike market economies,where some low cost public housingmay have to be constructedto meet the needs of the poor, Estonia has just finished fifty years of intensivepublic housing developmentand now needs to focus on developingprivate housing.
3.77 Any public resources that are availablefor housingshould be put into the repairs needed to protect the integrity and basic operability of buildingsuntil they are privatized. Bank staff estimates indicatethat 600,000m 2 of housing stockneed routine renovationeach year, but in 1992, only 87,000 m2 were done. The backlog of capital renovationsis even more severe. In Tallinn, for example,such repairs dropped from EEK 10 million in 1992to less than EEK 4 million in 1993 (less than 1 percentof the city budget). Roofs and joints between panels need repairs, as does any major structural damage. Estimates for the cost of urgently needed capital repairs alone run from EEK 100 million to EEK 500 million. A full maintenanceprogram includingcapital repairs would probably cost over EEK 800 million per year.
3.78 Beyondcritical structural repairs, highest priority should be given to improvingthe energy efficiency of Estonia's housing stock. The overall energy use per square meter is about four times the average in neighboringScandinavian countries. The low energy efficiency of Estonia's housing stock reflects primarily housing designs based on energyprices that were only a fraction of world prices. As a result, window and roof designs inappropriateto today's energy prices account for major heat losses in some buildings. In many others, the windowdesigns were adequate, but the windowswere so poorly built and maintainedthat they allow major heat losses through air infiltration. The thermal resistance in the walls of housing (especiallythe pre-cast, multi-storypanel houses) is three to four times lower than in neighboring countries (Tenno and Veski, 1993, p. 11). Furthermore, the houses were built without adequatemeans of controlling temperatures,with the result that people often control room temperatures by opening windows in mid-winter.
3.79 Substantial energy efficiency gains can be made with simple investments, such as fixing broken windows and doors. Other more substantial investments in improved energy efficiency for existing dwellings will also be justified after the easy measures have been taken. Somepilot tests have already been conducted to determine which energy conservation investments have appropriately fast payback periods (Schipper and Martinot, 1993). A recent study indicates a 20 percent reduction in energy losses could be realized with high-return investmentshaving payback periods of less than five years (Ministry of Construction, 1993). For example,plugging air leaks around windowsand doors has a payback period of six months to two years, while insulatingattic ceilings can repay its costs in three to ten years (Tenno and Veski, 1993, p. 12). Cost-effectiveenergy savings of up to 40 percent might be achieved with some apartment blocks-but the cost of attaining higher energy savings in existing buildings might exceed the benefits in some cases. For example, because of the high constructioncosts, the paybackperiod on insulatingexterior walls may not alwaysbe cost effective. Economicallyjustified energy efficiencyinvestments have been estimatedat a minimumof nearly EEK 5.0 billion, and may be - 69 - as high as EEK 12-15 billion6 -about three times the total public resources that are likely to be available for all investmentsin 1994-96.
3.80 Investmentsthat would make buildings more liveableand more attractiveto potentialbuyers should generally not be undertaken by the government. The government should focus instead on privatizing the units and letting the private sector undertakedeferred maintenance, rehabilitation,and remodeling investments.
3.81 Despite a generalpolicy of turning housingover to the private sector, should the government continue investingin housingfor low incomeindividuals and families? As of 1989, 49,000 familiesand 46,000 singles were living in shared apartmentsand hostels. At least one-half of the families and one- third of the singles in these accommodationsshould probably be provided access to independentunits. Investments in some 40,000 new housing units are thus needed to overcome current crowding. As the current housing stock (includingprivate as well as public units) amounts to about 620,000 units, the deficit is equal to 4.4 percent of the existingstock.
3.82 Even thoughmost of the additional units are required by relatively low income familiesand individuals, which appears to make an argument for public investments in subsidized housing, the investmentshould insteadbe made by the privatesector in qualitydwellings for relativelyaffluent people. For years virtually all new housing was Soviet-stylemid-rise apartment blocks. Consequently, the emerging middle and upper classes find it difficult to purchase modern, Euro-standard housing. If appropriate policy measures are implementedto facilitate the access of private real estate developers to land, housing finance, and basic municipal infrastructure,the demand for such housing could easily be met on a market basis through quality units built by private developers. As relatively well-off people moved into these units, they would vacate apartmentsthat could be made availableto others. The very poor are unlikely to move into the relatively good units vacated by the affluent, who would be moving into privately developed housing. Instead, a cascadingseries of moves should develop with people "'movingup" in housingstandards, freeing lower quality units that would become available at modest rental rates for the relativelypoor who now live in crowded multi-familyapartments or hostels.
3.83 Housing policiesthat facilitatethe transferof dwellingownership and occupancyrights would have to be put in place to allow a chain reaction of housing transfersto take place. For example, rents should be raised to full costs as quickly as possiblewith direct income support for the most needy, and units should be privatized rapidly so that the necessary flexibility in ownership and tenancy develops. The necessary policy actionscan be implementedat low cost, and these efforts are in fact already under way. If these policies are fully implementedin a timely manner, the governmentwill be able to focus the majority of its resourceson investmentswhere only the public sector can succeed, leaving housing sector developmentalmost entirely in private hands. The feasibility of this strategy is underscored by the fact that Estonia is relatively well endowed in terms of the quantity of housing availableand only needs to increasethe total numberof housingunits by less than 5 percent. If, for example, the stock had to be increasedby 20 percent instead of 5 percent, it could be quite difficult to find 120,000 relatively wealthy families who could afford to move out of panel housinginto Euro-standardhousing constructed by the private sector, thus leaving space for the moving-upprocess to work. However, finding about 25,000 families over the next five to ten years who could afford to purchase a privately built dwelling should be entirely feasible.
6 The high estimateis based on full retrofittingat USD 90 per m2 of the buildingenvelope and mechanicalsystems of public sector housingunits, discountedat 50-75 percentto reflect less-than-fullaverage retrofittingneeds; the lower estimateuses USD 131m2 for minimum repairs. - 70 - 3.84 The moving-upprocess will not work, however, withoutmajor policy initiativesby the state and local governments. To stimulateprivate sector developmentof housing, the government needs to (a) establish the required administrativemechanisms for cadastral surveys, land registration, and land titling; (b) facilitate the developmentof mortgage-basedfinancing, including a system for registering third-party claims on property; (c) make urban land available for sale through competitive bidding to builders, real estate developers, and individualswilling to constructhousing; and (d) reduce the barriers to housing constructioncreated by local jurisdictions through excessivelyrestrictive licensing, building codes, architectural reviews, and permits.
3.85 The poor state of repair and low quality of existinghousing may be an even greater problem than the shortage of dwellingunits. For reasonsjust noted, however,the public sector funds should not be used to upgrade the existingstock; on the other hand, individualfamilies will not be able to undertake this work on a significantscale for some time. The followingapproach should thus be considered. Local municipalitiescould transfer land suitable for developingupper income residences to private developers in exchangefor a commitmentfrom the developersthat they will rehabilitatea certain number of publicly owned apartment units. The number of units and standardsof rehabilitationcould be adjusted to suit the value of the land. In fact, given current market conditions,the most effective and transparent approach would be to set the land to be privatized and the standards to which the apartment units would be rehabilitated,then let interested parties bid in terms of the number of units that they would be willing to rehabilitateunder these conditions. This approachwould simultaneouslystimulate private sector housing developmentand the upgrading of publicly owned flats (thus making them easier to privatize) all at no cost to the government. This could help solve housing problems for people of all income levels. It would also stimulate extensive economic activity that has a low import'and high labor content, thus fostering sustainableeconomic growth.
3.86 Until Estonia develops a securities-basedfinancial sector with strong participation from institutionalinvestors, thus creatinga financial marketthat generatesits own sources of long-term funds, the government may be justified in borrowing long-term funds abroad and making them available for mortgagelending to support housingdevelopment. Experiencearound the world indicatesthat the lack of access to such funds is a far more importantbarrier to housingdevelopment than the cost of the funds. Consequently, to avoid market distortions and to help assure the strength of the domestic financial institutions, such funds should be on-lent at a positive real spread that covers both reasonable administrativecosts and the foreign exchange risk.
3.87 If rapid progress is made in these areas, the housingmarket could becomemuch more flexible within the next few years, allowingthe moving-upprocess to take place. This would resolve the worst of Estonia's housing problems without requiring any public expenditures,except to develop supportive governmentservices, the costs of which could easily be covered through the sale of urban land, either directly or as part of land-rehabswap deals as suggestedabove.
Mining
3.88 Investments totaling EEK 73 million (0.4 percent of the total) have been proposed for the miningsector, with EEK 70 millionfor the Vana Vigala project, and EEK 3 million for a mineral wealth prospecting program. The latter probably makes sense, because it could attract private mineral explorationand exploitation,which should take place under appropriategovermnent regulations, and on the basis of paying royalties for natural resource use. The proposed Vana Vigala project looks more questionable. The cost is substantial, and almost nothing has been invested in the project so far. If commercial prospects are good, the project could be developedby the private sector. - 71 - Port Superstructure
3.89 Of the EEK 7.6 billionshown in the public investmentproject for port work, EEK 6.0 billion (29 percent) is for superstructure (support facilities) that should probably be undertaken by the private sector, including foreign investors. Locatedat the Muuga Port, these includeterminals for oil products, dry bulk, coal, and containers. The "generaluse buildings" in the PPL could be built by the private sector if their intendeduse is warehousing. But if the buildingsare intendedfor port administration,they shouldprobably be undertakenby the public sector.7 EliminatingEEK 6.1 billion of port superstructure from the public investmentprogram wouldmake a major contributionto scaling it back to levels that are consistent with resource availabilities.
3.90 Preliminary analysis of the proposed investments indicate that these facilities may well be economicallyjustified and financiallyattractive to private investors. Estoniahas already had considerable success in mobilizingprivate participationin, for example, the PAK oil terminal. With good policies regarding access to the necessaryland and wharf facilities, attractingprivate sector investorsto carry out additional port superstructure projects should be possible. In fact, some reports indicate that foreign investors have already expressed interest in these projects, and the Port of Tallinn authority is very interested in financing these facilities through this approach. (For a more detailed discussion of the relative roles of public and private sectors in ports, see the discussionabove on port infrastructure. For a discussionof financing as a determinantof whether or not a project should be included in a PIP, see Box 1-3 in Chapter 1.)
Shipping
3.91 The PPL shows only one project in this sector-EEK 19.5 million (0.1 percent) for modernizingships, most of which would take place in 1994. In principle, shippingshould be moved into the private sector as rapidly as possible through the privatization of government-ownedships. Shipping operations, if run well, are commerciallyviable and self-financing. As owners of the ships, the private sector should be fully responsiblefor upgradingthe ships. The informationcurrently availableon this particular project is not sufficient, however, to allow a clear recommendation. The project might be justified, for example, if required to prevent rapid deterioration and more costly repairs for otherwise viable vessels for which private owners have not yet been found. In general, however, the shipping industry shouldcontinue to follow the practicealready establishedby Ookeanfor fishing vessels-selling surplus tonnage whenever possible to the private sector, and using the revenues to help finance the sale of additionalvessels or meet other high priority investmentrequirements. The sector's net claim on the public investmentprogram should be minimal. In fact, the governmentpolicies that apply to the use of funds generated by privatizing manufacturingfirms should be followed here as well, which means that the sector could possibly generate resources for use in other sectors of higher priority for public investment.
Spors
3.92 The PPL includes EEK 93 million for sports (0.5 percent of the total program). Sports are an important part of Estonian life and deserve public support, but not necessarilygovernment support,
7 Governments commonly find it advantageous to leave the construction and operation of buildings to the private sector and lease the office buildings that are required. However, this applies more to general office buildings in environments, such as downtown Washington, D.C. where many well-established real estate developers are competing for business. These conditions do not apply to port-based buildings in Estonia. - 72 - other than in the case of physical education facilitiesfor schools. As in most industrializedcountries, sports should either be organized on a voluntary community basis for popular participation, or on a professionalbasis by the private sector for spectatorsports. This said, the amountsinvolved in most of the proposed projects are so smallthat their inclusionor exclusionwill not have much impact. However, the VooremaeSports Center (EEK 35 million), the indoorskating rink (EEK 25 million), and the Kohtla- NommeSports Center (EEK 10 million)deserve careful scrutiny and might wellbe postponedor canceled because the amounts involved are relatively large and virtually nothing has been spent to date on the projects.
E. Private Sector Domain (Group 4)
3.93 As noted above, sectors in Group 4 accountfor a larger claim on public resourcesin the PPL than do those in either Group 1 or Group 2-even though the public sector should play a minimal role in Groups 3 and 4. Consequently,substantial cuts may be appropriatein the investmentslisted for Group 4 sectors. Eliminatingprojects in these sectors from the public investmentprogram shouldhave virtually no impact on Estonia's economic developmentbecause, to the extent these projects are economically attractive, they will also be financiallyattractive to the private sector.
3.94 This symmetry between economic and financial viability, it might be noted, is somewhat unusual. Trade barriers and distorted domestic prices can easily make production investments very profitable financiallyeven though they result in a net economicloss to the country-and may make some activities, commonly those in the agricultural sector, unattractive finaniciallyeven though they are economicallyviable. Estonia's excellent economicpolicies virtually assure, however, that if a project is economicallyviable, it will also be financiallyattractive. The main exception to this symmetry in Estonia arises from excessive perceptionsof risk. Such perceptions have resulted in interest rates that can make otherwise attractive projects financially doubtful. Herein lies the main argument for the government's planned net lending interventions. In addition to making funds availableto the private sector through the banking system, the governmentwould provide technical assistanceto the banks to help them develop the ability to assess risk levels more accurately, thus reducing the "wedge" between perceived and actual risks.8
Agriculture
3.95 Investments listed for this sector are a negligible EEK 10 million (less than one-tenth of 1 percent of the total). Nevertheless, questionscan be raised about the priority of the projects that have been identified,because they appear suitablefor privatesector participation-homestead constructionand processing of sheep products. Governmentinvestments are needed, however, to provide supporting services with externalitiesthat benefit the nation but are difficult to recoup from individualfarmers, such as agricultural research and extension services. Such work, which is part of the education sector and deserves high priority as an area for public investmentand expenditure,can improvethe productivityand quality of agriculturaloutputs while reducing negative environmentalimpacts.
3.96 The agriculturalprojects currentlyin the list understateby a substantialmargin the likely total claims of the sector on public investmentprogram resources. None of the financialinvestments by the
8 For a more complete discussion of justificationsfor government interventionin the case of a market failure, see Chapter 1, especially the section on RegionalDevelopment. - 73 - public sector in agriculturehave been includedin the draft list. For example, Estonia alreadyhas in place an Agriculture and Rural Life Credit Fund based on a substantial financial investment from the governmentand from a European Union (EU)-fundedprogram.
3.97 To the extent that financial investmentsby the governmentincrease the supplyof resources availableto the agriculturalsector at terms that provide a return on government's money comparableto what it could obtain by lending at normal commercial rates, they are a responsible use of government funds that do not raise any particular questions. Furthermore, as noted above, they may be justified if the banking sector is excessivelyrisk adverse and lacks the expertise needed to properly access risks in agricultural lending. However, the tendency worldwide has been for governments to make credits available on concessionalterns to agriculture. The implicit subsidies could delay the structural readjustmentand downsizingthat is required in the Estonian agricultural sector, and could weaken the financial system.
3.98 Direct means-testedincome transfers, combinedwith active labor market policies designed to facilitate the transfer of farm workers to good jobs in more urbanized areas, would be a more appropriateresponse to the clear social problemsassociated with the ongoing agriculturaltransformation. Policies to facilitate flexibility in urban housing markets and to free up low cost housing through the private constructionof new, high quality housingand the rehabilitationof existing units would also help the movement of agricultural workers to new jobs. The program of public physical and financial investmentsto support agriculture should be reviewed with these considerationsin mind.
Fishing
3.99 Commercialfishing, particularly in distant waters, has been a public sector activity for the past fifty years. Recently, however, the sector has suffered the loss of fishing rights to Russia, a collapsing demand in the FSU for fish, and financial losses aggravated by vessels that have high fuel consumption rates, inadequate fish-finding instruments, and on-board freezers that do not meet the standards required for exporting fish to Western markets. Consequently, fishing has dropped dramatically. The government strategy now is to sell some of the ships to pay existing debts, and to break up and privatize the remainingparts of the fleet as rapidly as possible, with the hope of attracting foreign partners where possible. No public investmentsare shown for the sector, which is appropriate.
Manufacturing
3.100 In addition to the significant financial investmentsthat the government intends to make to support manufacturingenterprises, physical investmentstotaling EEK 4.8 billion (23 percent of the total PPL) have been proposed. Many of the projects, such as peat processing equipment, spirits, and furniture, appear to be fully consistentwith Estonia's comparativeadvantage. However, any projects that are economicallyjustified should also be financiallyattractive for the reasons noted above, and should be left to private sector initiative.
3.101 Given the high cost of the proposed projects, the serious constraints on public resources, the probable financial attractivenessof the projects, and the government's announced policy of privatizing manufacturingactivity, virtually all of the manufacturingprojects on the current list should be assigned low priority in the PIP. A few of the small projects (for example,up to EEK 1-2 million) mightpossibly be justified on the basis of regionaldevelopment objectives in areas hard-hit by the closure of large public enterprises. Even these, however, should be examined closely to see if the same objectives could be - 74 - attained through private sector developmentand ownershipof the projects, combinedwith govermnent- financed, means-testedincome transfers and active labor market policies.
3.102 Of particular concern in the manufacturinglist is the project of EEK 3.7 billion for the Haapsala Transport and Industry Center. This project alone constitutes 18 percent of the PPL. If the project is economicallyand financiallyviable, it should be undertakenby the private sector. If not, the public sector should also avoid it. The project might possibly be done as a joint sector venture. The public sector could make availablethe land at no budgetary cost, and the private sector could create the physical facilities with its own resources. Nothing has been spent so far on the project, and no expendituresare scheduledduring the next three years. As a public investment,the project shouldalmost certainly be cancelled, a view which seems to be shared by senior governmentofficials.
Sales and Services
3.103 Aside from some relativelysmall investmentslisted with municipalprojects, the current PPL does not propose any significant investments in wholesale or retail sales facilities, or in service establishmentssuch as restaurants or repair shops. The omission of such investmentsfrom the PPL is fully justified. As already demonstratedin Estonia, the private sector is fully capable of mobilizingthe resources and implementingthe projects needed to develop this sector.
Tourism
3.104 Tourism projects, totaling EEK 41 million, rightly accountfor a negligible0.2 percent of the PPL. While the amountsare small, even those shouldbe reviewedto make certain that strong arguments exist for public rather than private sector development.A significantshare of the total project costs has already been spent on only one of the projects, the Vana-VigalaEstate. As the total amount for this project is modest (EEK 1.9 million) and as it appears to have cultural and historic as well as touristic value, the expense may be justified.
3.105 At the other extreme, the proposed EEK 20 million for constructing a hotel seems a doubtful use for public funds. If economically justified, it is a good candidate for private sector investment. Several other motel and hotel construction projects of more modest size have also been proposed and should be reviewed for the same reason. The EEK 10 million project for "tourism development" might also be examined. Although details are not available, this project may involve recurrent expenditures that should be included instead in the current budget of the relevant ministry.
F. Action Agenda
3.106 The following priorities have been identified for further action in preparing the public investmentprogram:
* Public/Private Roles and Sector Strategies. The categorization of sectors in terms of the relative roles of the public and private sectors needs to be agreed upon by the Public InvestmentProgram Working Group as the basis for selecting projects for the PIP).
* Clarificationof Data. High priority shouldbe given to reviewingand updating project cost estimates, which in many cases are likely to be out of date. The PPL also needs to be reviewed carefully, both to eliminate any duplicate projects and to include physical - 75 - and financialprojects that were omitted from the original draft list that is reproduced in Annex 3. Data on implementationschedules (expenditures per year) shouldbe collected for all projects, as should basic informationon anticipatedproject benefits.
* Prioritizationof Projects. With a solid definitionof public investmentpriorities by sector and good data on project costs and benefits, the most difficult part of the job can begin-the actual elimination of low priority projects from the PPL. Although not reflected in Annex 3, whichreflects the original, uneditedcollection of project proposals, this process has already begunwithin individualministries. However, the process needs to be formalized through discussions within the Public Investment Program Working Group to assure a broad consensuson project priorities.
* Drafting of PIP. While the main purpose of developing a PIP is to establish government'sown investmentpriorities, another importantreason is to be able to present to external donors a documentthat explains why they should provide foreign exchange to support the proposed projects. A substantialeffort will be required by the government to develop a documentthat clearlystates its priorities, plans, and justificationsfor public investmentsover the next three years.
* CapitalBudget. The PIP is a forward planning instrumentand does not constitute either a commitmentor an authorizationto spend. This comes only with the annual capital budget that is approvedby Parliamentas part of the state budget. If well formulated, the first year of the PIP will provide an excellent basis for preparing next year's capital budget. Before projects are accepted into the annual capital budget for the first time, a rate of return or least-costanalysis should be completed to make certain that the project is financiallyand economicallyviable, and that the most efficientdesign option has been selected. CHAPTER 4
Review of Budgetary Processes
A. Introduction
4.1 The Estonianbudget consistsof central government,local budget, and three extra-budgetary funds. The primary focus of budget processes in Estonia is to ensure that expendituresare balanced against expectationsof revenue, a principle to which the governmentadheres strictly. Total general governmentexpenditures for 1993 are estimatedat EEK 7.3 billion (28 percent of GDP).
4.2 This chapter provides an overviewof the budget calendar, revenue and expenditure budget formulation, budget implementation,and capital expenditures in Estonia, It concludes with a set of recommendationswhich, if adopted, wouldfurther improve a system that already reflectsmajor progress in establishinga modern, market-basedbudgetary system.
B. The Budget Calendar
4.3 The fiscal year is from January 1 to December 31, except for the local governments, whose fiscal year has been shifted to April 1 to March 31 beginning in 1994. This change was introduced to allow the local governmentsto formulatetheir budgets based on knowledgeof the resource that would be available from the central government. The Estonian central government budget cycle commences with an analysis of economicprospects prepared by the Ministry of Finance (MoF) in February. This analysis projects producer and consumer price levels, employment,domestic and foreign demand for goods and services, and tax receipts. The analysis is reviewed by the Council of Ministers, and appropriate adjustments are made during the second quarter as warranted by changing economic conditions.
4.4 Budget guidelines are dispatchedin late June to the various ministries. These guidelines indicateexpected inflation by object of expenditure,and administrativeunits are advisedto formulate and submittheir requests by July 31. These requestsare then reviewed by the Ministry of Finance, generally in consultationwith the concernedministries, and adjusted as needed to maintaina balanced budget.
4.5 Based on this review, the Ministry of Finance develops revised resource envelopesfor each unit. The decisions are communicatedto the respective ministries by mid-August. These decisions are then subject to negotiationat the ministeriallevel, after which the draft budget is presentedto Parliament no later than October 1. Through their Minister, units may appeal the decisionsmade by the Ministry of Finance during the parliamentary discussions-though significant changes to their envelopes are unlikely at this stage. By law, the Parliamentmust approve the budget within five months (that is, by the end of February).' The process, however,is normally completedbefore the new fiscal year begins.
4.6 The fiscal year for local governmentscommences about three months later. The process underlying budget formulation is similar to that of the central government, except that expenditure
I It is interesting to note that the Parliament will automatically be dissolved if it cannot reach agreement within this period. Also, should the discussions spill over into the next fiscal year, spending authority is automatically granted to the units at one-twelfth of their prior year's budget on a monthly basis. - 77 - ceilings for local government budgets are based primarily on coefficients linked to existing physical facilities (for example, kilometers of roads) and to population.
4.7 At present, budgetsonly have a one-yearperspective. However, the new budget law, adopted in June 1993, includes a provision that units should focus on a multi-year perspectiveand, starting with 1995, will require submissionsto includethree-year forecasts of expenditurerequirements. This approach is essential if Estonia is to begin developinga solid three-yearrolling public investmentprogram.
C. Revenue Budget Formulation
Revenue Structure
4.8 Estonia's revenue structure has been modifiedsignificantly in the past few years and is now very similar to that in modern market economies. Revenues include income taxes, a VAT, duties, property taxes, fees, fines, interest receipts, and carryoversfrom prior years (see Table 4-1). In addition, revenuesinclude domestic and internationalborrowing. However,borrowings have so far played a minor role in initial budget submissions, which tend to be balanced on the basis of borrowing that has already been arranged; a supplemental budget can be submitted, at which time additional resources from borrowing can be included.
ForecastingRevenue Availabilities
4.9 Resourceavailability for governmentexpenditure is based on a prognosis of GDP growth and related GDP variables. The prognosis, which is prepared by the Ministry of Finance and presented to the Prime Minister in February, includesboth pessimisticand optimisticscenarios. These forecastsdefine the outer bounds of expectedgross domesticproduct levels for the following year and form the basis for budgetaryallocations by program. This prognosisis revisedduring the secondquarter of the year, taking into accountrecent developments and revisedprospects for inflation,employment, and economicgrowth. These revised forecastshelp provide the basis for the "supplementarybudgets," which can be produced one or more times during the budget year. The prognosis for 1994 that was issued in June estimated a nominalGDP growth of 15 percent and centralgovernment expenditures excluding expenditures for extra- budgetary funds of EEK 5.7 billion, or 22 percent of GDP.
State/Local RevenueSharing Procedures
4.10 The total local governmentbudget for 1993 covered 15 countiesand 252 local administrative units including6 large county-leveltowns like Tallinnand Tartu, 40 medium-sizetowns, and 206 smaller municipalities. Sources of revenue for local governmentsinclude income taxes, land tax, licensing fees, and other revenues. Until the end of 1993, localgovernments retained 100 percentof all personal income taxes. Officials of the National Tax Board, who work at the local level, managepersonal incometax and land tax collection.
4.11 Major changes have been made for 1994 in state/local governmentstructures and in the formulas for sharing revenues between the state (central) governmentand units at the local level. The main structuralchange was to reduce the importanceof the county level of government. Previously, in addition to elected officials at the municipal and national levels, Estonia had elected officials for 15 countries plus 6 county-level cities. This was changed in October 1993. Although the 15 county governmentswill continueto exist as administrativebodies, they will now serve with officialsappointed - 78 - Table 4-1. Central Government Revenues, 1992-94 (EEK million and percentage) Actual 1994 Change 1994/93 Revenue 1992 1993 Budget Share (%) EEK m %
Income taxes 472 1,032 2,219 38.3 1,187 115 Individual income tax - 0 893 15.4 893 n.a. Corporate income tax 472 1,032 1,326 22.9 294 28
Value added tax 896 1,994 2,260 39.0 266 13
Excise duties 182 403 540 9.3 137 34 Alcohol 172 346 320 5.5 -26 -8 Fuel 4 45 194 3.3 149 331 Other excisea 6 12 26 0.4 14 117
Other 320 379 774 13.4 395 104 State fees - 0 65 1.1 65 n.a. Customs duty 15 39 70 1,2 31 79 Customs revenues 59 81 97 1.7 16 20 Land tax - 15 101 1.7 86 573 Forestry revenue (stumpage) 12 44 30 0.5 -14 -32 Otherb 234 200 411 7.1 211 106
TOTAL INCOME 1,870 3,808 5,793 100.0 1,985 52%
Residual at beginning of year 36 58 - - - - External loans - 40 - - - - Loan income - 3 - - - - Transfers from local budgets 177 242 - - - - Other 1 - - - - -
TOTAL REVENUE 2,084 4,151 5,793 100.0 - -
Source: 1994 Draft Budget, Ministry of Finance. Note: The figures in this table cannot be compared directly with those in Chapter 2, because the latter shows general governmentrather than central governmentresources. (Central governmentexcludes the three extra-budgetaryfunds and local government.) a. Includes tobacco and furs. b. Includesnatural resource tax, revenue fromuse of airspace/seas/ports,income from Eesti Pank, and other taxesand fees. - 79 - by the state, will have no independentrevenue sources, and will act primarily as an administrative conduit for funds being shared between the state and local level units. The details of the legal and administrativestatus of county-levelcities like Tallinn is yet to be determined.
4.12 The revenue sharing formulas have also been changed, effective January 1, 1994. Instead of retaining almost 100 percentof the personal incometax revenues, 52 percent of the personal income taxes collected at the local level by the local offices of the State Tax Department will go to the local jurisdiction, leaving 48 percent for the central government. As part of the agreement on these revenue sharing arrangements, the central government is now obligated to pay teachers salaries, to provide additional support for fire and rescue services, and to make compensation payments for municipal transport services. With the changed revenue allocationformulas, about two-thirds of the local budgets will come from their own resources, and about one-third from the central governmentbudget.
4.13 Resourcescollected at the local level and transferred to the state account for 37 percent of central government tax revenues. Some 22 percent of central government revenues are derived from excise duties, fees, customsduties and fees, natural resource taxes, and so on. The land tax, which became effective on July 1, 1993, should provide about 2 percent of total revenues in 1994, a share that is expectedto increaseonce a formal system of land registry and transfer is in place. In 1994, however, the VAT will remain the single most important revenue source for the central government,accounting for about 40 percent of the total.
Local Fiscal Discretion
4.14 Local governmentauthorities cannot independentlychange tax rates in support of revenue needs; such increases must be approved at the state level. They may receive accelerated budget disbursements during the year to cover short-term cash shortages, but only at the cost of lower disbursements later in the same year. During 1993, the local governments on this basis borrowed, interest free, approximatelyEEK 18 million from the central government,reserve account. This is of some concern, for instanceshave arisen where advanceswere made from the state reserve and could not be retired without creating a fiscal crisis at the local level. Local governments may borrow from commercialbanks (for example,Tartu borrowed EEK 0.9 million during 1993), but this borrowing has been subject to limits under IMF agreements. Any borrowing by local authorities is supposed to be cleared in advance with the Ministry of Finance.
Tax Arrears
4.15 As of October 1, 1993, tax arrears excludingaccumulated penalties amountedto an estimated EEK 384 million-9 percent of central government revenues for 1993. These arrears included EEK 173 million for corporateprofit tax, EEK 202 millionfor VAT, and EEK 3 millionfor excise taxes. The arrears increased by 62 percent over the year ending September30, 1993. During this period, corporate delinquenciesincreased by an estimated 28 percent, while those related to the VAT increased by 104 percent. Most of the increaseoccurred in the last quarter of 1992. Since then the increaseshave generally reflected accumulatingpenalties on old balances rather than new tax arrears. By December 1993, tax arrears totaled EEK 389 million, further evidence that the accumulation of arrears has stabilized. State enterprises account for the largest share of delinquencies and, because there is no provision to write off bad debts, it is likely that this debt will be carried forward. As serious as the tax arrears problem may be, it actually affects a relatively small number of taxpaying units. Three enterprises account for 48 percent of all arrears, and six accountfor nearly 80 percent. Furthermore, - 80 - the arrears are inflated by the 300 percent penalty applied to understatedincome, so the actual tax loss is considerablyless than the arrears includingpenalties.
4.16 Income tax arrears tend to be large for several reasons. A major cause, of course, is the financialpressure that firms face with the economictransition; many are essentiallybankrupt and cannot afford to pay their obligations, includingtax liabilities. The problem, however, goes beyond ability to pay. Other factors contributing to the arrears problem include the following: (a) until recent tax law changes, the Tax Department had the responsibility of verifying and proving income levels; and (b) likewise, the Tax Departmentcould not recover arrears by appropriatingfunds from bank accounts.
Tax Administrationand Enforcement
4.17 After an extendeddebate in Parliament, a revised incometax law was recently approved and became effective in January 1994. The law replaced the previous corporate and personal income taxes with a single flat rate tax of 26 percent. The new tax legislation,which was stimulatedin part by the tax arrears problem, improvesthe powersof the tax authoritiesto collect taxes, and shifts the burden of proof onto the taxpayer. Amongthe importantnew powers is the authorityto attach the accounts receivableof firms in cases of tax delinquency. Under the previous law, the tax authorities lacked incremental measures for tax enforcement;in most instancesthey either had to rely on moral suasion and penalties that were commonly not paid, or they had go to the other extreme and take delinquent tax payers to bankruptcy court. Some firms have in fact been forced into bankruptcyby the tax authorities, which helps explain the success in holding down the growth of tax arrears over the past year.
D. Current Expenditure Budget Formulation
Guidelines
4.18 The interactionwith the organizationalunits for the 1994budget started in June when detailed guidelines are dispatched with a cover letter by the Minister of Finance. The guidelines, which were distributedby the Ministryof Financeafter negotiationsin government,provided price indicesby expense category for all agenciesand establisheda budget ceiling for each. Units were expectedto maintaintheir requests within the adjusted envelopeand provide detailed explanationsto account for deviations. The submissionswere to exclude requestsfor new activitiesunless there was a regulation endorsingthe new activity.
4.19 Restrictionswere not placedon capital expenditurerequests for the 1994 budget; units were encouragedto submit all proposals so that decisions could be made with full knowledge of the project options. The guidelinesfor 1994 providedno indication of governmentpriorities, long-term strategies, or criteria for planning and evaluatingcapital expenditures. Therefore,budget requests had a short-term focus and were uncoordinatedat the national level. To avoid these problems in the future, budget requests will have a three-year perspective.
4.20 Requests are expectedto conform to a classificationschedule determined by the Ministry of Finance. The budget for each area covers a variety of different types of expenditures including
2 See Chapter 3 for a discussionof the list of proposed projects that has recentlycome to the Ministry of Finance. - 81 - expendituresrelated to paymentsof interestand principal, grants to local budgets,and other expenditures. In addition, governmentguidelines call for the expendituresto be detailed at the departmentallevel.
4.21 For the 1994 budget, the expense categories and their allowable growth (including both volume and price) included the following: salaries (20 percent); electricity (45 percent); rentals (no index, to be based on specific anticipatedrates); heating and other economic expenditures(5 percent); businesstravel (0 percent); catering (25 percent);and other expenditures(15 percent)of whichthe largest items must be shown separately. As noted below in the section on budget implementation,units have little flexibilityto reallocate among these categories,which can create problems. Units are also expected to provide separate aggregates for the social sphere (education, art and culture, sports, health, science, and social security) and for economic expenditures(agriculture, industry, trade, transport and other expenditures). This system of detailed guidelines by expenditure category encourages ministries and agencies to focus more on what they are buying than what they are supposed to produce. It also introducesrigidities in the budgetingsystem in terms of expenditurecategories. In an environmentwhere relative prices are still changing fairly quickly, units should be given the flexibilityto respond to these changes,and to changesin their program requirements. They shouldbe able to reallocateresources from one traditional expenditure category to another without seeking prior approval, provided they remain within the overall budget ceiling.
4.22 The mission supports the government'srecent decision to consider placing more emphasis on attaining agreed program objectives by introducinga budget guideline system for 1995 that focuses on the total resources that will be given to each unit, not on the allocation of these resources by expenditurecategory. The MoF could make its own detailed calculationsregarding the likely inflation for critical categories of inputs, and the balance of these input categories in the total requirements for each ministry based on past experience. But the guidelinesgiven to each ministry would indicate only a total increase in its budget. While this increasewould be driven in part by the weighted averageof the inflationfactors, the strategic importanceof the ministry or agency and its need for resources to attain the government's economicand social objectiveswould be the most importantconsideration.
4.23 The organizational units are expectedto respond within a month of receiving their budget guidelines. For example, the 1994 submissionswere received in early August 1993, with requests totaling EEK 9.5 billion excluding the extra-budgetary social security, medical insurance, and the environmentfund (see Table 4-2). This was more than twice the EEK 4.1 billionbudget for 1993, and well in excess of the EEK 5.7 billion that the government had estimated would be available. The submissionsstressed the need for additionalresources on the salary account,based on an expectationof a 42 percent increase in wages. Units also requested higher adjustmentsfor economic expenditures. Given the preliminary central government budget envelope of EEK 5.7. billion and the necessity of maintaininga balanced budget, these requests required extensivenegotiation and modification.
Negotiation
4.24 The negotiation phase regarding the budget requests involves a two stage adjustment process-first by the Ministry of Finance and then by the Council of Ministers. Once the requests are received by the Ministry of Finance, there is an internal review, coupled with formal and informal discussionsbetween the Ministry of Finance and representativesof the concernedministry to adjust the request-usually downwardby significantamounts. The Ministry of Finance, which has final authority over resource envelopes, then communicatesthe results of this exercise to the respectiveministries in a brief that outlines the broad reasons for the adjustments. - 82 -
Table 4-2. 1993 Budget and 1994 Requests (EEK million) FY93 FY94 RevisedBudget Requests NominalChange Item EEKm Share(%) EEKm Share(%) EEKm % 1,910 46.1 4,019 42.3 2,109 110 Economicexpenditures 1,089 26.3 3,064 32.2 1,975 181 Law and order 405 9.8 909 9.6 504 124 Defence 155 3.7 300 3.2 145 94 Administration 284 6.9 502 5.3 218 77 Registration 11 0.3 75 0.8 64 578 Supportto localbudget 105 2.5 124 1.3 19 18 Reservefund 58 1.4 200 2.1 142 245 Stabilizationreserve 38 0.9 - - -38 -100 Investment 68 1.6 274 2.9 206 303 Architecturalrepair 18 0.4 39 0.4 21 114 Total 4,141 100.0 9,504 100.0 5,363 130 Source: Ministryof Finance.
4.25 For the 1994 budget, this initial round of discussionsresulted in a EEK 3.3 billion reduction in the initialrequests (Table 4-3). These adjustmentsreflected the Councilof Ministers' views regarding the changing role of the public sector in a market-basedeconomy. Notable, for example, was the reduction by over half in the requests for funds for economic services; this area of activity should increasinglybe left to the private sector. On the other hand, requestsfor registrationof property, support to local budgets, the reserve (contingency) fund, architectural repair, and capital investment were approved at levels recommendedby the relevantauthorities.
4.26 The concernedministries have six days to appealthe decisionsand negotiatewith the Ministry of Finance. The draft budget is then forwardedto the Councilof Ministers for further considerationand adjustmentjointly by all ministers and the Prime Minister. At the same time, pendingdisputes may be forwarded to the Council of Ministers for considerationwithin five days. This is the third opportunity for concernedministries to appeal decisionsof the Ministry of Finance.
4.27 Closingthe gap betweenrevenues and expendituresfor the 1994budget involveda consensus- based approach. At the request of the Prime Minister, the Ministry of Finance presented the budget shown in Table 4-4 to an informal meeting of the Council of Ministers. This budget containeda deficit of about EEK 1.5 billion, which could be eliminated only by reducing the allocation for social expenditures. The Prime Minister wanted to develop a consensuswithin his cabinet on the need for this before the cut was actually made. This was done on an informalbasis, and the budget that the Ministry of Finance formally presented to the Council of Ministers was balanced. (The Ministry of Finance intends to submit a balanced budget to governmentfrom the outset for 1995.) Law and order was the only area granted an increase during the Council of Ministers' discussions, a reflection of the nation's desire to control criminal elements and enforce the rule of law. In terms of percentage cuts, the distributionwas somewhatdifferent with the most severecuts being made in architecturalrepairs, public investment,and property registration (Table 4-4). - 83 - Table 4-3. 1994 Requests and Ministry of Finance Recommendation (EEK million) FY94 FY94 Requests Recommendation Nominal Change Category EEK m Share (%) EEK m Share (%) EEK m %
Social sphere 4,019 42.3 2,592 41.9 -1,427 -36 Economic expenditures 3,064 32.2 1,429 23.1 -1,635 -53 Law and order 909 9.6 697 11.3 -212 -23 Defense 300 3.2 282 4.6 -18 -6 Administration 502 5.3 477 7.7 -26 -5 Registration 75 0.8 75 1.2 - - Support to local budget 124 1.3 124 2.0 - Reserve fund 200 2.1 200 3.2 - Stabilization reserve - 0.0 - 0.0 - n.a. Investment 274 2.9 274 4.4 - Architectural repair 39 0.4 39 0.6 - - Total 9,504 100.0 6,186 100.0 -3,318 -35
Source: Ministry of Finance.
Table 4-4. 1994 Ministry of Finance Recommendationand Draft Budget (EEK million) FY94 FY94 MoF Draft Budget to Parliament Nominal Change Category EEK m Share (%) EEK m Share (%) EEK m %
Social sphere 2,592 41.9 1,563 33.4 -1,029 -40 Economic expenditures 1,429 23.1 1,300 27.8 -128 -9 Law and order 697 11.3 714 15.3 17 2 Defence 282 4.6 261 5.6 -21 -7 Administration 477 7.7 357 7.6 -120 -25 Registration 75 1.2 44 0.9 -31 -42 Support to local budget 124 2.0 115 2.5 -9 -7 Reserve fund 200 3.2 195 4.2 -5 -3 Stabilization reserve - 0.0 - 0.0 - n.a. Investment 274 4.4 120 2.6 -154 -56 Architecturalrepair 39 0.6 6 0.1 32 -83 Totala 6,186 100.0 4,674 100.0 -1,512 -24
Source: Ministry of Finance. a. Excludes extra-budgetaryfunds and transfers to local government. - 84 - 4.28 After the negotiationshave been completed, the Ministry of Finance formulates the central governmentbudget bill. The Councilof Ministers reviewsthe budgetbill, makes necessaryamendments, and submits the revised bill for considerationby Parliamentbefore October 1. This document includes an analysis of economic prospects, historical data, and recommended budget ceilings by unit and department. The budget bill is also published for public knowledgewhen presented to Parliament. The 1994 budget bill presentedto the Parliamentwas 51 percentbelow the total resources originallyrequested in July 1993-clear evidence of the government's ability to take hard budget decisions as required to maintain a balanced fiscal position.
4.29 Parliamentary discussions take place at two levels. Initial reviews, which often involve detailed consultationswith Ministry of Financestaff, are conductedby the Budgetaryand Tax Committee of Parliament. The budget bill then passes to the full Parliament for three formal readings. The discussionsin Parliamentoften result in requestsfor additionalinformation from the ministriesand could lead to an addendum for additionalresources. This is the final forum where ministers can make a case for additional resources. The parliamentarydeliberations usually require two to three months but may spill over into the next fiscal year. If and when this happens, the budget law provides for automatic funding of unit expendituresamounting to one-twelfthof the previous year's expenditures. Parliament has a maximum of five months within which to pass the budget, or else it will be dissolved.
4.30 The budget bill can become effective when it has passed three readings in the Parliament. During this process, the budget may be changedor redistributedas long as there is documentaryevidence ensuring budget neutrality. Once the budget is approved by the Parliament and signed by the President, the units must distributetheir budgetsat the sub-departmentlevel and provide details of this distribution to the Ministry of Finance.
4.31 The negotiationprocess is rather compressedand may not provide the units with enough time to discuss the merits of their requests. A somewhat earlier start of the negotiation process may be warranted. This could be accomplishedwithout lengtheningthe total budget cycle by completing and distributing the budget guidelinesmore quickly; as noted above, this is planned for the 1995 budget. The process could also be facilitated by reachingagreement in advance on basic strategic priorities for governmentexpenditure. It would thus be worthwhilefor the Ministryof Finance to prepare a long-term plan that identifies priority areas while discouraging requests for expenditures that do not merit consideration during the budget formulation process. This would foster transparency and result in requests that are more in line with resource availabilities.3
4.32 The Reserve Fund accountsfor 3 percentof the draft 1994 centralgovernment budget. Given the acute resource constraints faced by units and the related risk that minsters will spend considerable time during the year trying to claim part of this sizablecontingency fund, it would ultimately be desirable to reduce this share to, say, 2 percent and allocate the funds to units. Such a reduction might be premature at this time, however,given the large uncertaintiesfacing Estonia as an economy in transition, but it should be considered as the economy becomes more stable.
Extra-Budgetary Items
4.33 The above discussionhas not includedthree itemsof major fiscal impact-the Social Security Fund, the Medical InsuranceFund, and the EnvironmentalFund.
3 The need for a basic strategy statementregarding government expenditures is a key theme of Chapter 1. - 85 - 4.34 Social SecurityFund (SSF). The Social SecurityFund is fundedby the collectionof the social tax (20 percent of nominal wages) and grants from the state (see Table 4-5). For 1994, total revenue sources are expected to be EEK 2.3 billion. Over 75 percent of these resources will be utilized for pensions, and another 23 percent will be spent on child and family benefits. The adequacyof resources for this fund could be jeopardized if unemploymentcontinues to rise, and the economy does not begin to recover. Under this scenario, social tax contributionswould fall while needs for social programs are rising, thus placing an addedburden on the state budget, which has limitedability to mobilize incremental resources or to divert resources from other areas.
Table 4-5. Extra-Budgetary Funds: Social Security, 1992-94 (EEKmillion and percentage) 1992 1993 1994 NominalChange 1994/93 SocialSecurity Fund Actual Budget Budget EEKm Percentage Carryoverfrom prior year 30.3 66.7 79.9 13.2 20 Revenues 1,033.4 1,890.0 2,294.6 404.6 21 Socialtax 730.7 1,236.0 1,900.0 664.0 54 Otherincome 31.1 6.3 10.0 3.7 58 Grantsfrom state 271.6 647.7 384.6 -263.1 41 Totalrevenue (including carryover) 1,063.6 1,956.7 2,374.5 417.8 21 Expenditures Pensions 694.1 1,349.1 1,720.2 371.1 28 Childrenand familybenefits 282.7 485.9 518.0 32.1 7 Miscellaneousexpenditures 9.2 20.0 20.5 0.5 3 Administrativecosts 2.5 6.4 7.5 1.1 18 Agriculturalinstitutions costs 4.9 3.0 - -3.0 n.a. Additionalvacation - 12.5 - -12.5 n.a. Otherexpenditures 3.6 - - - n.a. Totalexpenditure 997.0 1,876.8 2,266.2 389.4 21 Surplus/(deficit) 66.7 79.9 108.3 28.4 36 Source: 1994 Draft Budget, Ministryof Finance.
4.35 Medical Insurance Fund (MIF). The Medical Insurance Fund revenues are based on a 13 percent tax on nominalwages, which is expectedto generate EEK 1.2 billion during 1994 (see Table 4-6). In addition, the MIF is expected to receive EEK 105 million by way of grants from the state. Approximately82 percent of these funds will be utilized in the maintenanceof health care institutions, and an additional 12 percent will be utilized for expenditures on birthing and child care. Despite a relativelystable population,the cost of providinghealth care is increasingrapidly and may, in the future, require the state to assume additionalburdens that it can ill afford.
4.36 EnvironmentalFund (EF). The EnvironmentalFund receivedits fundingalmost entirely from pollution fines and resourceuse taxes in 1993. Startingin 1994, the resourcesgenerated by resource use taxes go into general budget revenues, leaving pollution fines as the only earnarked, extra-budgetary source of revenues for the EnvironmnentalFund. The resources are used to help prevent further environmentaldamage. A significantanount is also spent on new technologyto gather and disseminate - 86 - information (Table 4-7). It may be desirable to increase funding for research, which now receives a mere 2 percent of the fund's resources.
Table 4-6. Extra-BudgetaryFunds: Medical Insurance, 1992-94 (EEK million and percentage) 1992 1993 1994 Nominal Change 1994/93 Actual Budget Budget EEK m %
Carryover from prior year - 108.6 75.5 -33.1 69.5 Revenues 519.5 990.8 1,365.0 374.2 137.8 Social tax 439.0 866.0 1,235.0 369.0 142.6 Estonian medical insurance association 0.5 - - - n.a. Grants from state 56.6 99.8 105.0 5.2 105.2 Other receipts 23.5 25.0 25.0 - 100.0 Total revenue (including carryover) 519.5 1,099.4 1,440.5 341.1 131.0 Expenditures Medical instrument maintenance 335.7 830.0 1,117.5 287.5 134.6 Ambulatory treatment 5.5 35.1 40.0 4.9 114.0 Dental benefits for pensioners 1.9 4.9 6.0 1.1 122.4 Cure 1.4 5.1 6.0 0.9 117.6 Birth and child care 56.6 140.0 168.0 28.0 120.0 Sick-fund administrative costs 8.6 8.1 9.0 0.9 111.6 Other expenditures 0.7 0.8 14.0 13.3 n.a. Fixed capital of medical insurance association 0.5 - - - n.a.
Total expenditure 411.0 1,023.9 1,360.5 336.5 132.9 Surplus/(deficit) 108.6 75.5 80.0 4.5 106.0
Source: 1994 Draft Budget, Ministry of Finance.
1994 State Budget and Expenditure Priorities
4.37 The 1994 budget provides significant increases for the Ministries of Economy, Interior, Defense, and Justice, each of which grew at over 50 percent in nominal terms, though organizational changes account for some of the apparent growth at the unit level (Table 4-8). On the other hand, the Ministry of Finance shows negative growth (despite significant real increases for all but one departrnent) due to a reduction of EEK 63 million in the Agricultural and Rural Credit Fund, which is expected to be replenished to its level of EEK 126 million through repayments by borrowers in 1994. The 21 percent reduction in the Ministry of Social Affairs is accounted for solely by the decrease in the state grant to the Social Security Fund. - 87 -
Table 4-7. Extra-BudgetaryFunds: EnvironmentalFund, 1993-94 (EEK million and percentage) 1993 1994 Nominal Change 1994/93 Budget Budget EEK m Percentage Carryover from prior year (January 1994) 1.3 0.1 -1.2 n.a. Receipts 17.8 19.1 1.3 7.0 Total revenue (includingcarryover) 19.1 19.3 0.1 1.0 Expenditures Environmentalprograms and activities 7.4 8.0 0.6 9.0 Additionalfinancing of supervision 1.6 1.5 -0.2 -10.0 Nature protection programs 1.1 1.7 0.5 47.0 Research 0.9 0.5 -0.4 -47.0 Informnationtechnology 0.8 0.8 0.1 8.0 Consolidationof material base 3.3 3.2 -0.1 -3.0 Training 0.5 0.7 0.2 31.0 Internationalcooperation 0.9 0.6 -0.3 -28.0 Support for environmentalprotection technologies 1.7 1.5 -0.3 -17.0 Indemnificationfor damages 0.1 0.2 0.1 42.0 Administrative costs 0.3 0.3 - - Reserves for accidents 0.6 0.3 -0.2 -39.0 Total expenditure 19.0 19.0 0.0 0.0 Surplus/(deficit) 0.1 0.2 0.1 100.0
Source: 1994 Draft Budget, Ministry of Finance.
4.38 In setting budget allocations since re-independence,wages and salaries have been given priority. Now that the economicsituation has becomemore normal, increasedpriority can now be given to maintenance,repairs, and investmentsthat will help control energy costs. Issues relatedto investmnents should be addressed in the context of a three-year public investmentprogram. The public investment program (PIP) now being prepared should provide a concise statement regarding the government's strategic objectives and the relative priorities of various types of investmentexpenditures.
Local GovernmentBudgets
4.39 The formal budget process for local governments is initiated after approval of the state budget, which had not taken place at the time of the mission's visit to Estonia. Consequently,there was insufficientdata to analyzeexpenditure patterns for 1994. However, the data availablefor 1993 provides the basis for a reasonableanalysis of revenue and expenditurepatterns-despite significantchanges in the methodologyfor 1994 budget formulationat the local government level (Table 4-9). - 88 -
Tablk 4-8. Central GovernmentExpenditures by OrganizationalUnit, 1992-94 (EEK million and percentage) 1992 1993 1994 Nominal Change 94/93 OrganizationalUnit Actual Budget Budget EEK m Percentagea
President's Chancellery - 6.0 7.9 2.0 33 .0 Parliament Chancellery 7.5 27.0 40.0 13.0 48 .0 Commissionfor RepressedPersons - 0.0 0.0 0.0 2 .0 State Audit Office 1.5 3.0 5.2 2.2 72 .0 State Court 1.0 12.3 6.8 -5.4 -44 .0 Legal Chancellery - 0.9 2.8 1.9 207 .0 State Chancellery 19.3 229.3 135.2 -94.2 41 .0 Ministries Justice 48.0 155.8 233.9 78.1 50.0 Defense 59.4 169.1 265.9 96.8 57.0 Environment 86.5 191.5 267.2 75.7 40.0 Education and Culture 530.0 920.4 1,102.4 182.0 20.0 Economy 16.7 77.2 282.3 205.1 266.0 Agriculture 241.8 179.6 207.6 28.0 16.0 Finance 36.7 196.8 197.6 0.8 0.0 Interior 149.1 306.2 495.0 188.8 62.0 Social Affairs 416.3 1,019.1 910.9 -108.2 -11.0 Transport and Communications 231.3 475.3 601.0 125.7 26.0 Foreign Affairs 5.8 48.8 66.7 17.9 37.0 Subtotal 1,850.8 4,018.4 4,828.5 810.1 20.0 Loans to students - 36.7 30.2 -6.5 -18.0 Interest and principal payment 26.0 26.0 84.5 58.5 225.0 GovermnentReserve Fundb 182.6 202.0 194.6 -7.4 -4.0 Transfers to local budget 500.0 406.6 528.1 121.5 30.0 Land tax transfer to local budget - - 26.0 26.0 n.a. Other - 211.9 - -211.9 n.a. Total expenditure 2,559.4 4,901.7 5,692.0 790.3 16.0 Of which transfers to: Social Fund 271.6 647.7 384.6 -263.1 59.0 Medical Insurance Fund 56.6 99.8 105.0 5.2 105.0 EnvironmentalFund - 9.6 9.6 0.0 100.0
Source:1994 Draft Budget. Note: Thedata in this tableare indicativeof the generalpattern of centralgovernment expenditures in Estonia. Theyare, however,subject to revision.Minor changes have reportedlybeen madeboth in the 1993budget (through a record budgetsupplement) and in the 1994budget as finallyapproved by Parliament. a. In somecases, the growthor declinemay be the resultof organizationalchanges. b. IncludesStabilization Reserve. - 89 -
Table 4-9. Local GovernmentRevenue and Expenditures by Unit, 1993 (est.) (EEK million) Revenue Expenditure Surplus/ Transfers City EEK m Share (%) EEK m Share (%) (Deficit) To State From State
Tallinn 781.2 47.3 461.4 27.9 319.8 -319.8 Tartu 78.1 4.7 110.0 6.7 -31.9 31.9 Narva 110.9 6.7 95.6 5.8 15.2 -15.2 Pamnu 46.5 2.8 61.5 3.7 -15.0 15.0 Kohtla-Jarve 45.1 2.7 73.8 4.5 -28.7 28.7 Sillmae 14.9 0.9 28.0 1.7 -13.1 13.1
Laane 27.2 1.6 54.2 3.3 -27.1 27.1 Harju 109.2 6.6 88.7 5.4 20.5 -20.5 Hiiu 11.8 0.7 21.6 1.3 -9.9 9.9 Jogeva 29.3 1.8 45.8 2.8 -16.5 16.5 Saare 32.5 2.0 53.9 3.3 -21.4 21.4 Ida-Viru 36.4 2.2 40.3 2.4 -3.9 3.9 Jarva 32.0 1.9 48.9 3.0 -16.9 16.9 Polva 25.0 1.5 42.9 2.6 -18.0 18.0 Parnu 32.8 2.0 51.6 3.1 -18.8 18.8 Laane-Viru 64.7 3.9 68.7 4.2 -4.0 4.0 Rapla 32.9 2.0 49.9 3.0 -17.0 17.0 Tartu-Viru 42.1 2.5 72.0 4.4 -29.9 29.9 Valga 25.6 1.6 60.2 3.6 -34.6 34.6 Viljandi 49.7 3.0 70.4 4.3 -20.8 20.8 Voru 25.1 1.5 53.3 3.2 -28.2 28.2
Total 1,652.8 100.0 1,652.8 100.0 - -355.5 355.5
Source:Ministry of Finance.
4.40 The cities of Tallinn, Narva, and Harju were expected to be the only surplus generating jurisdictions in 1993. Tallinn accounted for 47 percent of total local government revenues. Of local revenues of EEK 781 million, 40 percent was to be transferred to the state to be distributed to revenue- deficit areas. Understandably, this pattern of transfers caused considerable concern for city officials, especially since major changes have recently been made in the formula for sharing personal income tax receipts between state and local authorities. Local jurisdictions previously retained 100 percent of personal income tax receipts. Starting in 1994, however, 48 percent of such receipts will accrue to the central government. The potential impact on localities is significant; in Tallinn, for example, personal income taxes accounted for 80 percent of revenues in 1993.
4.41 The guidelines for preparing local government budgets (expenditures and staffing levels) specify the allocation of resources on the basis of infrastructure and population (Tables 4-10 and 4-11). The guidelines also specify that administrative expenditures are to be contained to 7.6 percent of all budgetary expenditures, while other expenditures are expected to account for 52.4 percent. - 90 - Table 4-10. Guidelinesfor Formulation of Local Government Budget, 1994 Rate Category Unit City Medium Town Small Town Roads ('000 EEK/km) 54.0 45.0 36.0 Side roads ('000 EEK/km) 4.0 4.0 4.0 Illuminated roads ('000 EEK/km) 5.0 4.0 4.0 Total green area ('000 EEK/ha.) 1.0 1.0 1.0 Asphalt roads between villages ('000 EEK/km) 20.0 20.0 20.0 Non-asphalt roads between villages ('000 EEK/km) 3.6 3.6 3.6 Capital housing repair (EEK/m2) 2.5 2.2 2.2 Schools (EEK/child) 2.3 2.5 2.5 Cultural activities (EEK/Resident) 43.4 63.8 63.8 Sports and athletics (EEK/Resident) 12.0 9.0 9.0 Social expenses (EEK/Resident) 18.0 10.0 10.0
Source: Ministry of Finance.
Table 4-11. Staffing Level and Wage Guidelinesfor Local Governments,1994 Number of Residents Number of Administrative Staff
< 2,000 7 2,000 - 5,000 11 5,000 - 10,000 17 10,000 - 50,000 21 City of Tallinn 720
Grade Level Average Wage/Staff EEK
15 (for small towns) 942 16 (for medium towns) 1,002 17 (for cities) 1,062 20 (Tallinn only) 1,248
Source:Ministry of Finance.
4.42 Local governments are given total expenditure allocations independently of their revenue generating ability, and the central government decides on the reallocation of resources between revenue surplus and deficit counties based on the balance between the allowable expenditure levels and the resources that can be generated locally. As a general rule, the central government can reallocate to other counties revenues exceeding 110 percent of the Estonian per capita average. This is of particular concern to the city of Tallinn, whose revenues represent 137 percent of the Estonian per capita average. - 91 - 4.43 Sharing personal income taxes in return for a limited number of servicescauses concern for governmentsof revenue surplusjurisdictions-especially the city of Tallinn-because estimatingthe costs of these specificservices is difficult under current budgetaryprocedures. Consequently,it is difficult for municipalitiesto determine if the new formulaswill provide them with adequate revenues. Analysis by the Ministry of Finance indicates, however, that the net impact is close to zero after taking into account the reduced expenditureresponsibilities. Local governmentsare consideringadditional commercialreal estate and other taxes to supplementrevenues. Such initiativesare, however, subject to approval by the Ministry of Finance.
E. Budget Implementation
Revenue Receipts
4.44 The Ministry of Finance normallyreceives revenues from the NationalTax Board offices in the municipalitiesevery five days and, on average, daily from the city of Tallinn. These funds are generally transferred through leading commercialbanks. Tax collectionon wages is generally at source by the enterprises, while state fees, licensing, and rents are periodically collected from individuals through commercialbanks. Enterprise taxes accrue to the state, and starting in 1994 personal income taxes will be shared between local governmentsand the central government.
4.45 Revenuecollection tends to be erratic, and there is a frequent bunchingof revenuecollections, which results in an uneven pattern of resource distribution to governmental offices (see next section). Consequentlythe units at year-end are likely to show budget underruns due to their inability to spend resourcesquickly at year-end when they finally arrive. (Such underruns were EEK 58 million in 1992, estimated at EEK 60 million for 1993).
Distribution
4.46 Unit budgets (includingfunds for capital projects) are distributedby the Ministry of Finance in accordancewith the department and expensecategory classification specified in the approved budget. Allocationsare generally made through the Social Bank according to daily decisions by the Ministry of Finance. This system is now being revised. The dominant role of the Social Bank as a channel for public funds will be reduced. Other banks will also be used to reduce the risk of holding such a large share of public funds in one bank and to increasecompetition among banks regarding terms offered to the governmentfor the services rendered. This developmentstrengthens the argumentspresented below for introducing a treasury function within the governrnent. Because the funds available are rarely sufficient to meet all claims, the budget is not disbursed on a straight-line basis, but according to the particular needsof each ministryat any given point in time and the priority whichthe Ministry of Finance attachesto meeting these needs. The disbursementsare largely dependenton revenue collectionand the priority of the receiving unit.
4.47 Becausethe funds are disbursed in accordancewith budgetary ceilings, there is little scope for exceeding budgetary levels-except by accruing liabilities and not retiring them. Often the bank transfers are conductedon a daily basis, whichresults in considerableuncertainty at the unit level. Year- end savings, which often result from an inabilityto expend the resourcesduring the last few days of the fiscal year, are assignedto the state budget reserve and carried forward to the next year for reassignment based on overall governmentpriorities. - 92 - 4.48 The problemsarising from the current budgetdistribution system are particularlydifficult for units that have seasonalvariations in resource requirements. For the Ministryof Education, for example, the typical disbursementpattern involves twelve tranches, and sometimesthese were insufficientto pay teacher salaries. Also, exceptionalfunds are typicallyrequired at the commencementof the school year for bulk purchase of textbooks, and to ensure that facilitiessuch as heatiiig systems are working well. This pattern of financingresults in a budget deficit for many units of the Ministry of Education. The deficit accumulatesbecause the Ministry is unableto pay for energy costs or social security contributions and tends to accrue liabilitieson these accounts. The Ministryadheres to a monthlyreporting pattern for internal use, with a quarterly analysis of expendituresforwarded to the Ministry of Finance. Working groups have been establishedto deal with the Ministry of Finance on budget matters.
4.49 The system provides for very limited fungibility between accounts in cases where departmentaland expensecategory line itemsare specifiedby the Parliament in the state budget bill. The Ministry of Finance can authorizesmall reallocationsamong expenditure categories for a given ministry, but the Council of Ministers must approve any major reallocationsacross categories for a ministry. Parliament must approve reallocations across ministerial lines, but this is rarely done. This system provides strong controls, but gives the units very limitedflexibility in redeployingresources to respond to changing needs and prices. Estonia may want to move toward a more modern performance-based system, where output standards are clearly set and managers are allowed to reallocate resources within their total budget limits to attain these performancegoals.
4.50 The new budget law includes a provision that permits units to contract obligations on the following year's budget, as long as these obligationsdo not exceed 50 percent of the current year's spending authority. Exceptionsto this rule are subject to approval by the Ministry of Finance. The Ministry of Finance may, in times of temporarycash shortfalls, use the state budget reserve to distribute funds to units. However, the reserve must be replenishedbefore the end of the fiscal year. The reserve may also be used to cover revenue deficits in the state budget, and when the reserves are inadequate, the governmentmay submit a borrowing plan to Parliament. Any assignmentsfrom the reserve are made with the approval of the government, and the receivinginstitution is expected to account separately for these assignments. Local governmentauthorities may receive advances from the reserve in the event of temporarycash shortages. Requestsfor advancesare reviewedby the Ministry of Finance, and any funds disbursed are repayablebefore the end of the fiscal year. All end-of-year savings are channeledback to the reserve and carried forward.
4.51 The current system of assuring a balancedbudget by restrictingexpenditures to cash available has allowed the governmentto maintain tight fiscal control, which has been a high priority during the stabilizationperiod. The system also has substantialcosts. Most important, the stop-and-gonature of paymentsthat results from matching cash outflows to cash inflows makes it very hard for ministries and agencies to handle their expendituresin an orderly fashion. Cash is often not availablewhen needed to purchase critical supplies and to pay bills that are due. The current system also absorbs a considerable amount of managementtime by ministries pleading their case with the Ministry of Finance to have resources released. In other countries this kind of system has led to "rent seeking" behavior where inducementsare offered to those controlling the release of funds, a situation that the governmentdoes not want to see develop in Estonia. To avoid the stop-and-goproblems of a cash matching expenditure control system and other related difficulties, the governmentmay wish to consider the measures that would be required to introducea treasury function like that found in industrializedcountries.
4.52 A well-designedtreasury would provide a number of benefits. It would allow a rule-based, transparent system of cash managementwhere agreed budgets, not on the government's daily cash flow - 93 - position, determines the funds that are released each month to the ministries. This would reduce the current high degree of centralizeddiscretionary control. A good treasury with electronicconnections to ministries and agencieswould also allow better centralizedinformation on cash flows. Commitmentand verification stages would be includedto link the existingoperating budget to the actual releaseof funds.
4.53 The biggest advantageis a treasury's ability to compensatefor the uneven inflowand outflow of cash during the year. To smooth cash flows, however, a treasury would need to be able to engage in financial market transactions-selling and buying treasury bills, notes, and bonds. Such financial market operations have significantimplications for both fiscal and monetary control. Consequently,any moves toward establishinga treasury function shouldbe done in close coordinationwith the International Monetary Fund.
SupplementaryBudgets
4.54 The state budget may be augmented by Parliamentwhen excess revenues are generatedor additional borrowed funds become available. These changesare enacted as supplementarybudgets. As with budget formulation,the supplementsmust specify revenue sources and spending assignmentsalong with a justification for the additionalfunding requirement. Any bill for supplementarybudgets must be presented to Parliamentbefore October 1. Revised budgetsare consideredeffective after they have been approved by Parliament and are announcedby the President. Supplementarybudgets have no effect on the planning for the forthcomingyear. Two supplementswere approved for the 1993 budget, effective at the end of June and September.
Reporting and Monitoring
4.55 The Ministry of Finance specifiesaccounting procedures and reporting formats for all units. Expendituresare recorded on an accrual basis. In general, each unit is expectedto maintain (internally) a monthly summary and provide the Ministry of Finance with quarterly results. Local governmentand central governmentaccounts may be audited by the state as and when deemed necessary.
4.56 The Ministry of Finance is expected to provide Parliamentwith a retrospectivereview of the prior year by June 1. This report shouldaccount for carryover balances,expenditures by unit and object of expenditure, assignmentsfrom the reserve account, informationon subsidies,loans and guaranteesby the state, data on public debt, and the economicactivities of state enterprises.
4.57 Despite the existence of reporting mechanisms,accountability for the use of resources is weak. For example, hospitals lack adequatecontrol systems,and there is no legal frameworkthat makes them responsible for reporting expenditures. Consequently,their expenditure levels can be difficult to control. Estonia has an Office of the State Controller that is responsible for auditing all public sector activity on behalf of Parliament. Although the office has actively sought a more appropriate legislative basis for its work, more adequatefunding, and external technicalassistance, its resourcesare still unequal to the task. At present it can at most audit 5-10 percentof the public sector units includinggovernmental ministries each year. A good audit system is vital for sound, decentralized budget administration. Priority should be given to further strengtheningthe system.
Payment Mechanisms
4.58 Enterprisesand ministriespay by bank transfers. Ministriesgenerally pay through the Social Bank, though it does not have a monopolyover ministerialaccounts. Individualsgenerally receive wages - 94 - in cash. Budgetaryresources are provided to the ministriesby way of transfer orders-often issued on a daily basis. For small accounts it is possible to transfer the entire monthly budget in a single transaction. For larger budgets there are weekly and often daily transactions.
New Budget Law
4.59 The 1993budget was formulatedaccording to principlesin place since 1989. The new budget law, which was presented to Parliament in June 1993, introducedmajor changes, many of which have been discussed in the preceding sections. The law makes specific provisionsto ensure a medium-term focus by the units. Consequently,starting with the 1995budget, units will be required to submit rolling three-yearprojections. The new budget law explicitlyrequires that, if a legislativechange during the year increases expenditure or decreases revenues for a unit, the legislationmust indicate how the resource shortfall is to be covered. Some items of the new budget law (especiallythe three-year projectionsand fungibility provisions) could not be incorporated in the 1994 fornulation process because of time constraints. However, it is expectedthat the 1995 budget will includeall provisionsof the law. It is also expected that the 1995 budget will permit limited fungibility between accounts; this will alleviate immediatepressures and provide greaterflexibility to units in terms of using resources in a more optimal manner.
InformationTechnology
4.60 Though the governmentis allocatingfunds to improvethe use of informationtechnology, the benefits of this exercise may be limitedbecause each ministry has essentiallyits own system for budget data. There is no outline for planningthe process of data collectionand dissemination. It is normal to fulfill requests through paper reports only, rather than in electronicformat. Becauseof limitationsin the current local phone networkand the lack of specializedwiring in existingbuildings, networks are difficult to establish. It is not clear that there will be significantproductivity gains by introducingthem on a large scale at this time, but with the rapid pace at which the domesticphone system is being improved, such innovationcould be considered in the future.
4.61 Significant efficienciesmay be realized by first systematizingthe budget process and then implementinglarge-scale information technology plans. It is essentialto focuson streamliningthe manual systemby improvingdata classificationmethods, report generationstandards, and data storage standards. The use of diskettes to transfer data should be encouraged-especially since the use of PCs is already widespread and is increasing rapidly within the government. One or two departmentsshould initiate a pilot project to standardize the data storage mechanisms;this pilot should be completed and evaluated sometime in 1995. The result of this exercise should form the basis for large-scale budget data sharing sometime in 1996, by which time the communicationsnetwork should also have improved.
4.62 To avoid major problems in the event that delays or other difficulties arise with the new system, the two systems should run in parallel for one budget cycle before the full changeover takes place. Also, the actual transition to a PC-based schemeshould await completionof the conversionof the budget to the System of National A classificationsystem. The budget is still based on the old Soviet system, but the governmentis now working to convert the system to one that is compatiblewith the SNA classification. (As a transitional measure, the government may choose to continue working with the current system, but enhance it so that budget presentations that are fully compatible with the SNA classificationcan be generatedautomatically.) A group of Finnish consultantshas conducteda study to map 1993 data to the SNA methodologythrough a bridge system. The mapping of data prior to 1993 - 95 - is unlikely to be completed in the near future, but this is of low priority given the radically changed priorities for public expendituresince independence.
Procurement
4.63 A transparentprocurement system that encouragesdemonopolization and privatizationwould complementEstonia's efforts to move to a market-basedeconomy. A public sector procurement system that fosters competition,promotes private enterprisedevelopment, and helps curtail public monopolies, could support enterpriserestructuring and privatesector development. Internationalfinancial institutions encouragethe adoption of open domestic and international competitionto improve national economic performance and require the use of competitivebidding in projects that they finance. A competitive public procurement system can be a catalyst in attracting domestic and foreign capital and is widely acceptedas necessary to ensure economy, efficiency,quality, and timely delivery of required goods or services.
4.64 The govermnentof Estonia recognizesthe importanceof introducingcompetitive procedures to the provision of goods and services in the public sector and has initiated the process of establishing the necessary regulations. A draft law on procurement has been prepared. International competitive bidding has been used for procurement under the RehabilitationLoan financedby the World Bank and, with the assistanceof procurementexperts from Finland, the process has worked well. The governrment has indicateda need for additional internationalexpertise in this area and has requested assistance from Finland and the World Bank.
4.65 The main objective of the requestedforeign assistance is to assist the government in three major areas: (a) establishingand implementingpublic procurementregulations including legal, economic, and institutional considerations, based on international standards adapted to the Estonian situation; (b) designingthe institutionalstructure needed to implement and monitor the new regulations; and (c) trainingofficials in sector ministries on the new regulationsas well as the broad spectrumof procurement issues includingpossible visits to Eastern Europeanand other countries. Training for the private sector on internationalbidding procedures,as well as other training related to contractmanagement and business practices, would also be required at a later stage. While Estonia already has the systemsin place needed to assure that expendituresstay within budget, these efforts to improve the procurement system should help assure that Estonia gets the best quality productsand the best possibleprice with its resources.
F. Capital Expenditures and Revenue Budgeting
Current Practice
4.66 Capital projects are budgeted separately, and there are no coefficientsor ceilings that apply to this category. The only guideline provided during the 1994 budget formulation was that new constructionor projects generally not be considered. Total requests for capital projects at the state and local levels combinedamounted to over eight times the availableresources for 1994 (Table 4-12).
4.67 Each unit prepares and forwards a list of capital projects to the Ministry of Finance durin budget formulation. For the 1994 central governmentbudget, these requeststotaled EEK 275 million,
4 Excludinginfrastructure projects, which are includedin the Ministry of Transport and Communications'budget. - 96 - and allocations amountedto EEK 96 million (Table 4-12). The Ministry of Social Affairs made a total request for EEK 63 million and receivedan allocationof EEK 24 million. The requests by units were primarily for completionof unfinished facilities(for example, residential flats, electrificationprojects, school buildings, universities, etc.), many of which had been initiated during the constructionboom of 1991. New activitiesincluded border guard stationsand communicationsprojects. Aside from a notional payback analysis, there is little evaluationor economicjustification, at the unit level or by the Ministry of Finance, for project feasibility.5
4.68 Funds for the repair of architecturalmonuments required an additionalEEK 38 million, and are shown as a separatecategory in the budget;the same is true for road maintenance,which is separate from the capital budget.6 The Ministry of Transport and Communicationhas a special road fund that deals with highways, rail, waterways,and airways. For 1994, a total of EEK 1.2 billion was requested, including: airports, EEK 19 million; district roads, EEK 88 million; railway, EEK 348 million; state highways, EEK 734 million; and waterways,EEK 20 million. The draft budget recommendeda resource ceiling of EEK 252 million excludingsubsidies; a budget on EEK 198 million was approved.
4.69 Total requests by local governmentsfor capital budgets amountedto EEK 703 million. The final decision was that the central governmentwould make no budgetedcontribution to investmentat the municipallevel. Local projects include, for example, the constructionof water supply and purification systems, sewer systems,schools, and museums. The governmentdecided that local governmentsshould mobilize their own resources from local budgets and business activities, rather than rely on central funding for their capital expenditures. This was justified on the basis that central ministries cannot mobilizeadditional funds, while local governmentsmay do so through tax policies (with the approval of the Ministry of Finance). Of the total request for 1994of EEK 703 million, new constructionaccounted for only EEK 31 million-the remainder was for finishingconstruction initiatedduring past years.
4.70 Funds for capital projects are transferred to the ministries under separate account classifications. The ministries further disburse these funds to the concerned agencies, which then formulateproposals and request bids for evaluation.Actual implementationof capital projects is generally initiated through the transfer of funds from the concerned ministry to an account of the concerned institutionin a localbank, usually the SocialBank. Further disbursementsare usually made on a monthly basis and depend on revenue collection efforts and tax proceeds. The implementing authority is responsiblefor requestingbids and has flexibilityin awardingthe final contract after evaluatingthe bids.
4.71 One department is assigned the authorityto monitor progress and provide feedbackto the local agency as well as the central government. In addition, the state forms a commissionthat monitors the progress of the project, requires periodicfeedback, and evaluatesquality. The commissionsare also
5 The total capital expenditure requests reported here are only a fraction of those reported in Chapter 3. The list there covers three years rather than only one, and was totally unconstrainedin terms of what could be requested. Among other differences, it includesnew constructionas well as ongoing projects.
6 Althoughthe 'Road Fund' raises manyquestions conceming the problemsof extra-budgetaryfunds, this one does not seem to suffer the standard shortcomings. Althoughcalled a 'fund,' it functionsmore like a special administrative unit. Unlike many extra-budgetaryfunds, the Road Fund is transparent; funds are allocatedto it from the central government budget, and the use of these funds is documented by the Estonian Road Administration,which is responsiblefor managing the fund. And unlike many extra-budgetaryfunds, the Road Fund does not depend on earmarked taxes or other revenues. The fuel excise tax, for example, goes directly into the general budget, and allocationsto the Road Fund are not linkedto receipts from this tax. - 97 -
Table 4-12. 1994 Capital Budget by OrganizationalUnit (EEKmillion and percentage) 1994 NorninalChange Budget/Requests Unit Request Budget EEK m Percentage
Central government President's Chancellery 1.2 - -1.2 n.a. State Chancellery 5.7 1.0 -4.7 -82 Ministries Justice 37.4 30.0 -7.4 -20 Environment 25.9 16.1 -9.8 -38 Education and Culture 97.4 10.0 -87.4 -90 Economy 0.4 0.4 - - Agriculture 19.1 7.5 -11.6 -61 Finance 5.5 2.0 -3.5 -63 Interior 17.8 5.0 -12.8 -72 Social Affairs 65.5 23.6 -42.0 -64
Total central government 274.6 95.5 -179.1 -65
Local government Tallinn 280.7 - -280.7 n.a. Tartu 22.0 2.0 -20.0 -91 Narva 62.0 - -62.0 n.a. Parnu 15.0 1.0 -14.0 -93 Kohtla-Jarve 17.0 1.3 -15.6 -92 Sillmae 14.5 4.2 -10.2 -71 Harju 41.0 - 41.0 n.a. Laane 16.2 3.0 -13.2 -81 Hiiu 10.4 1.1 -9.3 -89 Jogeva 10.7 1.0 -9.7 -91 Saare 37.0 1.6 -35.4 -96 Ida-Viru 22.6 1.0 -21.6 -96 Jarva 13.8 1.5 -12.3 -89 Polva 16.0 0.1 -15.9 -99 Parnu 6.9 - -6.9 n.a. Laane-Viru 20.7 2.7 -18.0 -87 Rapla 11.8 1.4 -10.4 -88 Tartu-Viru 19.2 - -19.2 n.a. Valga 29.2 1.0 -28.2 -97 Viljandi 21.4 0.8 -20.6 -96 Voru 15.5 0.7 -14.9 -96
Total local govermment 703.4 24.5 -678.9 -97
Total capital expenditure 978.0 120.0 -858.0 -88
Source: Ministry of Finance. - 98 - entrusted with inspections(each town has an inspector), and a certificateof completion is issued after the project has been implemented. The members of commissions are from different ministries, and the compositionof the panel is project dependent.
4.72 Payment for services rendered are through bank transfers. Capital projects are also sometimesfinanced by contractors. The Ministry has an inspectionfunction with four persons to review projects and one to plan financing. Initial discussions on budgetary issues are held between representativesand the Ministry of Finance, and final negotiationsare held at the Minister/Chancellor level.
4.73 The paucity of funds earmarked for capital expendituresunderscores the need for a public investment program that will help develop and coordinate external funding. And the abundance of requestsreceived for capital projectsunderscores the need for a well-preparedpublic investmentprogram that will select the highest priority projects, thus maximizingthe economic and financial returns from plannedpublic sector investments. Giventhe importanceof projects at the municipallevel for the quality of every day life for the averageperson, special attentionneeds to be given to assuring adequatefunding for municipal projects, such as water supply, sewerage, electricity, heating, and municipal transport.
Public InvestmentPrograms and AnnualCapital Budgets
4.74 Public investmentprograms are a planning tool and do not provide budgetary commitments or authorizations to spend for capital investments; such are provided only by the annual budget. However, a well-structuredmulti-year public investmentprogram is needed to provide a solid basis for developing the capital componentof annual budgets. Since annual capital budgets have to show both expenditures and the sources of funding for these expenditures, the PIP should provide similar information.
4.75 Time Periods Covered. The public investmentprogram should be revised each year, thus maintaininga rolling three-yearperspective. The first year of the three year program shouldprovide the basis for establishingthe capital expenditurebudget for the coming fiscal year. The governmentshould focus in the next few months on the public investmentprogram for the period 1995-97so that, when the 1995 budget is being prepared, a 1995-97public investmentprogram will be available and can be used as the basis for the capital componentof the 1995 central governmentbudget.
4.76 ProjectExpenditures. The three-yearpublic investmentprogram shouldindicate expenditures by project and sector to make it possible to check for overall balance and consistency with national economic priorities. For each project the PIP should show total project cost, share of cost to be supportedfrom the budget with savingsor borrowed funds, expendituresto date, expendituresanticipated in each year of the PIP, and total expendituresbeyond the end of the PIP. Expenditures should also be broken down in terms of domestic and foreign currency expenditures.
4.77 PIP Financing. The three-year public investment program'should show the sources of financingthat can be anticipatedfor the investment expenditures. The central governmentbudget will be the main source of domestic financingfor investmentcosts, because domestic borrowing should be avoided at this stage of Estonia's transitionto avoid crowdingout the private sector in domestic financial markets. Foreign financingwill be particularlyimportant for Estonia's public investmentprogram during the foreseeable future, and wherever possible, likely sources of financingshould be indicated for each project. Total anticipatedfinancing from each external sourceshould also be shown by year to make sure that the aggregate proposed financinglevels by source are realistic. - 99 -
4.78 Multi-YearFinancial Framework. Since the budgetary savings availableto help financethe public investmentprogramn will depend on the balance betweenrevenues and recurrent expendituresover the three-year planning horizon, the PIP should include estimates of these budgetary resource flows as well. These flows, together with estimatesof domestic and foreign financing, can be presented as a multi-year resource framework within which the proposed investment expenditures must be accommodated. A sample of a simple but effectivemulti-year financial frameworkis shown in Chapter 2. The governmenthas now begun to undertakesuch work on its own.
4.79 Payment of interest and principal on loans taken out to finance public investment projects shouldbe recorded within the multi-yearfinancial framework and in the annual operatingbudget for each year. The recurrent operating costs of projects should be handled in a similar way. Budgetingthe recurrent and debt-servicingcosts of projects within a multi-year resource frameworkwill help assure that the governmentdoes not become over committedin its investmentprogram.
4.80 Project InformationForm. In additionto these basic financial data, which can be shown in tabular form for all projects, a project informationform should be maintainedon each project accepted for the PIP. These forms should record all of the above data, plus informationon the executing agency, project location, project time schedule,main benefits (quantifiedif possible as cash flow streams so that an internal rate of return can be calculated),and possible financingsources. A form like that shown in Annex 5 could be used for this purpose.
Public Investnent Planningat the MunicipalLevel
4.81 The PER mission focused almostexclusively on investmentsthat would have an impact on the nationalbudget. The missionfound evidence,however, that significantinvestments are being planned at the municipallevel with municipalfunds, augmentedin some cases with money from other sources. Since municipalinvestment projects could generatedemands for fundingfrom the same sources that will financethe national-levelpublic investmentprogram-the state budget, the domesticbanking system, and foreignborrowing-municipalities shouldbe encouragedto develop three-yearinvestment plans for their own activities. The central governmentcould assistin this effort. It shouldaggregate the results to make certain that the total investmentplanned at the state and local levels is consistentwith the total resources that are likely to be available, taking into consideration the resources required for private sector investments.
TechnicalAssistance Planning and Budgeting
4.82 This chapter has concentratedon financialbudgeting. However, the technicalassistance that is being made availableby foreign donors, often on a grant basis, is a valuable resource and needs to be well-coordinatedat the national and local levels to assure that it is used as effectivelyas possible. A three-yeartechnical assistanceplan and an annual technicalassistance budget should also be prepared to support the plans and budgets for public investment. Moreover, the two efforts should be closely integrated. While the skills needed to carry out much of the project research and implementationwork are availablewithin Estonia, advanceplanning for the foreign technicalassistance needed to complement domesticresources will help assure the successfuldesign and implementationof investmentprojects. - 100- G. Conclusions and Recommendations
4.83 The budget process is elegant in its simplicityand unique in many ways for it achieves the government'sobjective of maintaininga balancedbudget despite socio-politicalpressures to the contrary. The process has enabled Estonia to quickly stabilize its economy and to begin considering longer-term plans for public investmentprojects, which have been severely curtailed since independencein order to give priority to the stabilizationprocess.
4.84 Planning Framework and GovernmentPriorities. While the budget process succeeds admirablyin its objectiveof maintaininga balancebetween sources and uses of funds, its implementation process results in a short-term focus that may be detrimental to efficient economic development. Governmentpriorities should be formulatedand conveyedto the relevant ministries to ensure long-term developmentstrategies. There is a clear needto focus on the long-termissues of investments,repair, and maintenanceof facilities. This is best achieved through the development of a three-year investment program that specifies:
* Priority areas for resource allocationwith expectedbenefits from expendituresin these areas; * Analysis of investmentrequirements and an implementationplan; - Evaluationand ranking of desired projects; Mechanismsfor monitoringprogress and ensuring accountability. Implementingthe above would signal the government'spriorities to the public and private sectors and would result in national expenditures that are well coordinated and in line with national strategic objectives. To be successful,the plan shouldbe updated annuallyto account for new priorities, and the changing domesticand internationalenvironment. Mechanismsshould be establishedto monitor progress toward stated objectives.
4.85 Budget Calendar. The budget formulationprocess is spread over a ten month period, which is more than adequate. However, the time allocatedto the negotiationphase is tight, leaving little time for consensus building regarding priorities. Given the gap between resource requirements and availabilities, this approach may be appropriate; the short negotiation phase helps to prevent the units from actively involvingpublic interest groups in making a case for their proposals. The governmentis therefore planningto issue the 1995 budget guidelinesat least a month earlier than was done for the 1994 budget, thus giving additional time for reviewing and discussingbusiness priorities and needs.
4.86 Analysis of Requests. The current systemallows resource requeststhat exceedtotal resource availabilities. Once these requests are received, there is little time (given the tight budget calendar) to screen them in terms of quality and developmentalimpact. It would be desirable to institute a process where requests for additional funding are receivedand evaluated throughoutthe year. Actual inclusion in the PIP and funding in the annual capital budget would, however, only be done on an annual basis for capital projects-except in the event of an emergency,such as the collapse of a bridge. All proposals, especially for capital investments, should be evaluated for consistency with national development priorities. When alternative projects are being reviewed that have benefits that can be quantified, the selection process should generally seek to maximizethe economic and financial rates of return.
4.87 TreasuryFunction. One resource flows stabilize, budgets should be distributedby ministry or by program, rather than on a daily, micro-levelbasis, as is presently done. Ministries should be - 101 - granted authorityto distributebudgets at the departmentallevel-with guidelinesfor fungibilitybetween accounts. A seasonalityfactor for units shouldbe developed,where applicable, and disbursement patterns should be modifiedto accommodatethis need. This may be supplementedthrough the use of an active treasury managementpolicy that allows for the issuanceof short-termdebt to financeseasonal variations between revenuesand expenditures. This would provide units with much greater flexibilityand permit them to be responsiveto a changing environment.
4.88 Budget Classification.The systemof budgetorganization and classificationshould correspond to the SNA classification. An internationallyaccepted form of data classification will ensure the consistent reporting and monitoring of budgets needed to support long-term planning mechanisms.
4.89 Budget Reportingand Auditing. More adequate reporting is needed on the use of reserve funds, state and public enterpriseperformance, and loans and interest to state enterprises. Funds such as those for roads and for subsidizedcredits shouldbe shown separatelyfrom administrativebudgets to foster transparency. An independent internal audit system should be established to confirm that expenditure reports are accurate and to evaluate whether or not the funds were used effectively. This could be done in cooperationwith the Office of the State Controller.
4.90 Reserve Funds. While it is desirableto maintaina reserve for unexpectedevents, it may be advisable to maintain reserves that reflect a somewhatsmaller percentage of the total budget to allow more adequateup-front funding to units and to reduce the tendencyof units to lobby during the year for access to these reserve funds.
4.91 Information Technology. The manual system should be streamlined by improving data classification methods, report generation standards, and data storage standards. Data should be transferred in a machine-readableformat by increasingthe use of diskettes. One or two departments should initiatea pilot project to standardizethe data storage mechanisms;this should be completedand evaluated sometimein 1995. The result of this exerciseshould form the basis for large-scalebudget data sharing sometime in 1996.
4.92 Capital Expenditure. The government is now seeking to increase the public investment program from the excessivelylow current level, about 2 percent of GDP, and to reduce the nearly complete dependenceon external financingto fund the investmentprogram. Rolling three-year public investmentprograms shouldbe created for state and municipalinvestments. These should includemulti- year financial frameworksof the type presented in Chapter 2, indicatingsources of domesticand external financing for the investmentprogram. The first year of these plans should be the basis for the annual capital budget for the followingfiscal year. Funds shouldbe budgeted on a multi-yearbasis for capital investment programs, thus providing more continuity and a longer-term focus than at present. In addition, efforts need to be made to improve the analysis of capital projects and their economicimpact. Programs shouldbe establishedto train staff in sectoralministries and agenciesregarding project analysis techniquesto help assure that proposals presented to the Ministries of Finance and Economicsare well prepared and reliable. The three-year public investmentprograms should be complementedby similar plans for the use of technicalassistance. ANNEX 1
The Role of Government and Public Expenditures in a Market Economy
1. Chapter 1 briefly discusses the role of government and public expenditures in Estonia's transition to a market economy. This discussion was based on both economic theory and the practical experience in many market economies,which have resulted in a broad mainstreamconsensus on the main functions of governmentin a market economy that is shared by most, if not all, economic theorists and policy makers. According to this consensus, governmentfulfills three main economic functions in a market economy:
* Ensuringthe provisionof selectedgoods and servicesthat markets fail to provide completely, either in sufficientquantities or efficiently;
* Facilitating the effective functioning of markets in other areas by establishing a legal, institutional,and policy environmentconducive to private sector developmentand effective market competition;
* Alleviatingpoverty and pursuing broader social equityand fairness objectivesthrough income transfers and other measures of income and wealth redistribution.
These three functionsof governmentand the degree to which they warrant government interventionand expenditures are discussed in some detail below. The discussion is mostly generic and non-country specific, focusing on those issues that underlie the conclusionsin Chapter 1 for Estonia. It is deliberately limitedto those areas where there is broad agreementamong economistson the role that governmentcan play, leaving out topics that are still the subject of debate and disagreement.
Government Intervention in the Provision of Goods and Services
2. Governmentintervention in the provisionof goodsand services is limitedto those few sectors and areas of market failure where competitive private markets cannot function efficiently. Commonly, a distinction is made between four main cases of market failure:
* Public goods, such as defense, law and order, energy security, or environmental protection. Once such public goods are supplied, everybodyautomatically shares their benefits. People expect to receive them whether they pay for them or not, and they are therefore neither willing to pay for them individuallynor can they be forced to do so in a voluntary market transaction. Therefore,profit-oriented private markets will not supply public goods, but the government can do so, and can impose their cost on the general public through the tax system.
Note: This Annex was prepared by Ulrich Zachau and has been adapted for this report. - 103 - * Goods with positive externalities, such as public health or education, which competitive private markets tend to undersupply. One person's consumptionof such goods also benefits others, though generally not automatically and not to the same extent. For example, immunizationshelp not only thosebeing immunized,but they also reduce the risk of infection for others; education increases society's overall knowledge base and makes people more productive. Such goods are worth more to society as a whole than to any individual purchasingthem. Competitiveprivate markets reflect only individuals' lower, not society's higher, valuation of these goods. Therefore, market demand is lower, and markets provide these goods in lower quantitiesthan what would be efficient from society's point of view. The governmentcan complementthe private provisionof these goods and ensure an overall efficient supply.
* Essential infrastructureservices that are natural monopolies,such as roads, water supply systems, or gas, heat, and electricity transmission and distribution. The physical characteristics of these goods are such that they can be produced most cheaply in large quantitiesby one single supplier. Competitiveprivate markets cannot provide these goods efficientlybecause the structure of their production and distributioncosts makes it profitable for private suppliers to restrict their supply.
* Selected social insuranceservices (primarily unemploymentinsurance and basic pensions), to the extent that the associatedrisks cannot be insuredthrough private markets. In the case of unemploymentinsurance, this is due to imperfectinformation of the employer and insurer about the employee's behavior, which creates the possibilityof "moral hazard" (people can have themselvesfired and receivebenefits). In the case of pensions, one critical issue is the risk of uncertain inflation. Inflationis an event that affectsall pensionrecipients equally, not an independentrisk that can be efficientlypooled throughcommercial insurance. Therefore, private pensions are generally not inflation indexed, but public pensions can be because the governmentcan finance risk sharing by raising current or future taxes.
3. Among the four major causes of market failures that may require government intervention and expenditures in the provision of goods and services-public goods, positive externalities, natural monopolies, imperfect information-pure public goods are the only unambiguous justification for governmentinvolvement. As indicatedabove, the voluntary privateprovision of defense, environmental protection, and similar goods is by definition(almost) impossible,and they are (almost) alwaysprovided by governments.
4. In contrast to pure public goods, such as defense or law and order, goods with positive externalities(health, education)and goods that are natural monopolies(some infrastructureservices) or characterizedby imperfect information(social insurance)can in principlebe provided by private markets on a voluntary, commercialbasis, and in advancedmarket economiesthis is frequently the case. (The key difference of these goods from pure public goods is that people are willingto pay for them and that private suppliers are able to enforce payments and exclude non-payingconsumers, which makes their profitable provision by private markets possible.) But private markets tend to provide inefficientlylow quantities of these goods and services. This creates a potential rationalefor governrmentintervention on efficiency grounds. However, governmentintervention and expendituresin supplyingthese goods and services should be subject to several crucial qualifications. - 104 - 5. First, market failures are a possible reason for governmenteconomic involvement, not proof of its necessity. For example, although the private sector may find it difficult to provide a certain good or service efficiently, the public sector may find the task even more difficult. As the general shift in Estonia is toward less governmentintervention, the working assumptionshould be that the private sector, if appropriatelyregulated, can provide goods and services as well as or better than the governmentcan. The burden of proof should be on the case for governmentintervention to disprove this.
6. Second, for the reasons mentionedabove, if government intervention is considered to be justified, indirect intervention through regulation and incentives to private enterprises is generally preferableto the direct supply of these goods and services by the government.
7. Third, regarding the provisionof a good or service by a state-ownedenterprise, the key issue is whether this involves direct or indirect financingfrom the general government budget or creates an actual or potential future budgetary liability. If so, the good or service must be considered (at least in part) "governmentprovided." In contrast, if it is provided by a "fully commercialized"state-owned enterprise, which has no current or future, actual or potential, links to the budget and can be expected to act essentiallylike a private enterprise (that is, in accordancewith the commercialprinciples followed by private enterprises), then the good or service can be considered "privatelyprovided." In this sense, regulationof a state-owned,but fully commercialized,natural monopolyproviding, for example, district heating is preferable to the direct provision of the service by the government itself (that is, a budgetary organization)or a non-commercializedstate enterprise.
8. Fourth, where the governmentdoes directly supply such goods and services, it should as a rule complementrather than replace ("crowd out") the private sector, and privatesector entry and activity in the sector shouldbe facilitatedand activelyencouraged. To the extent that, for infrastructureservices with natural monopoly properties, private sector entry is difficult and parallel private and government supply is inefficient, this makes the case for regulation rather than direct governmentprovision even stronger.
9. Fifth, where the governmentdoes directly supply some goods and services such as roads, health, education, or social insurance, it should increasinglynot provide them for free, but charge user fees or "contributions"(in the case of social insurance)to achievepartial (or full) cost recovery. Passing on some of the cost of these goods and servicesto consumersincreases efficiency. User charges and cost recovery also facilitate the parallel competitiveprovision of these goods by private markets, and they contribute to general government revenues.
10. Sixth, a case can be made for-the continuation of some governmentfinancing of selected investments, particularly in physical infrastructure and other sectors where investments can raise productivity, encourage private sector development, and promote economic growth. However, this argument is valid primarily for the short term, as long as financial markets are still developing and medium-or long-term credit is not easily available,and only to the extent that investmentsare carefully screened to maximize economic returns. - 105 - Creatinga Legal, Institutional,and Policy Frameworkfor Private Sector Activity
11. In most market economies, the government's role as general facilitator and regulator of private economic activity (and that of fully commercialized state-owned enterprises) is even more important than interventions in cases of market failure. An appropriate legal, regulatory, macroeconomic, and sector policy environment is essential for private activity and especially for the functioning of the enterprise sector. It creates the incentives for private individuals to engage in and benefit from economic activity; it lowers the cost of private economic activity by standardizing transactions and making them enforceable; and it serves to reduce the uncertainties and risks associated with volatile macroeconomic aggregates (inflation, exchange rates, etc.) to manageable levels.
12. Facilitating private sector activity includes the maintenance of macroeconomic stability, which entails, among other things, balancing the expenditure requirements of various government functions with expected revenues in order to avoid substantial budget deficits and contain inflation. Sustained macroeconomic stability is critical to the development and the functioning of both product and factor markets. Only with predictable low inflation can prices, wages, and interest rates function effectively as signals of market supply and demand and allocate goods, labor, and capital efficiently. Economic stability is also a requirement for attracting any significant foreign investment. Ensuring a continued stable macroeconomic environment is therefore essential to facilitate and accelerate private sector development and enterprise restructuring throughout the economy, but especially in the financial sector and wherever medium- and long-term financing is important, such as in the industrial, infrastructure, energy, and housing sectors.
13. In addition to macroeconomic stability, an appropriate regulatory and policy framework is a prerequisite for the liberalization and full devolution of government functions to the private sector. At a general level, many components of the regulatory, institutional, and policy framework in a market economy can be seen as directly or indirectly supporting private sector activities. Some of the most important elements of the regulatory and policy framework in a market economy may be the following: (a) clear and unambiguous property rights; (b) a simple contract law that, while standardizing and codifying general principles, leaves plenty of room for private negotiations and deal making; (c) enforceable credit and mortgage legislation; (d) enterprise legislation that facilitates effective enterprise governance and ensures transparent accounting and public reporting; (e) legislation and policies that promote competition and commercial and financial discipline of enterprises, including through antitrust provisions, open trade, and effective and enforceable bankruptcy and liquidation provisions; (f) minimal bureaucracy, that is, a distribution of responsibilities within government and policies that facilitate access by the private sector to information and systematize, but minimize, the number of institutions and time required for the processing of bids, requests, claims, etc.; and (g) a judicial system of adequate size and efficiency to address cases within reasonable time periods.
Social Assistanceand Other Income RedistributiveTransfers
14. The governrnent's role in income redistribution serves primarily social equity and fairness objectives. The most important redistributive programs in market economies by far involve direct income transfers to targeted groups of low income or otherwise deserving individuals and households, which are financed from general government revenues. Apart from ethical, social, and political reasons, most economists agree that there is an economic rationale for income redistribution, as it minimizes the total burden of taxation on society as a whole by disproportionately taxing the rich who can most easily afford - 106 - a reduction in their incomeand spendingpower and making incomeor in-kind transfers availableto the poor who are likely to have the greatest benefit from it. In this context, it is interesting to note that income transfers, because they are financed from the general tax system, create some indirect market distortions and disincentivesto private sector development of their own, but fewer than government interventions in the provisionof goods and services, which distort relative prices, directly and through the tax system. Whereverthe governmenthas a choice in supportingdisadvantaged groups through direct income transfers on the one hand or through the subsidizedor free distribution of goods and services or similar indirect measures on the other hand, the latter should thus be avoided. In fact, any increase in redistributiveincome transfers would strengthen consumers' capacityto pay, and thus the case and scope for partial cost recovery in the provision of social services (health,education, public housing) and public infrastructure facilities.
Integration of NationalObjectives and Priorities
15. Although the above principles can provide broad guidance to government policy in most market economies, there is no standard recipe for the precise mix between private and public sector activity and an appropriatepublic expenditurestrategy that couldbe applieduniversally. Countriesdiffer, for example, in:
* The definition of "free publicly provided goods" with implications, for example, for the structure and funding of health and education;
* The desirable level of differentiation in personal incomes, with implications for the determinationof public sector salaries, among other things;
* The ownership, control, and expectedreturn on public assets, with implicationsfor the extent and pace of privatizationand commercializationof enterprises and thus the magnitude and length of time of direct or indirectgovernment financing of typically private sector activities;
* The intergenerationaldistribution of the costs of economictransition, with implications,for instance,for the levels of total governmentexpenditure and borrowing and the mix of current and capital expendituresover time.
Estonia's choices in these areas-which will influence the speed, sequencing, and extent of the expenditure reforms-will depend on its particular nationalobjectives and priorities regarding the degree of market orientation and the distribution of incomes and wealth. A medium-term strategy for expenditure reform shouldtry to reflect a national agreement or consensus on these issues, which can only be reached over time. A key objective of Chapter 1 is to highlightthe critical policy tradeoffs and to assist the Governmentin clarifying the options and consequencesinvolved.
ANNEX 2
Modeling Social Safety Net Expenditures
1. This annex provides detailed projections of expendituresand the assumptionsthat underlie the projectionsof expenditureson social safety net programs in the text. The projectionsare developed on the basis of the model that incorporatesboth demographicsand institutionalfeatures. Expenditures incurred in 1992-93, as well as thoseapproved in the 1994 budget, are also presented (see Table A2-1).
Pensions
2. The assumptionsbehind the projectionsfor pensionexpenditures are as follows:
* A decrease of the number of old-age pensioners of 2.3 percent per year during 1994-96, which is based on the projectionof the number of people of pensionableage produced by the Ministry of Social Affairs;
* A decrease of working pensionersfrom 67,000 in 1993 to 42,000 for 1994-96;
* Full protection of the level of pensions to inflation (that is, increase of the benefits by 13.3 percent in 1994, 5.5 percent in 1995, and 5.7 percent in,1996).
SocialAssistance
3. The poverty gap used in projectionsis EEK 48 per person per month, and the initial number of people living in poverty is 11.3 percent of the population(170,500).
* The poverty gap. The poverty gap is obtained as the difference between the age- and family size-adjustedpoverty line, estimated to be 231 EEK, and the average per capita income of families living in poverty, estimatedto be EEK 183 (estimatesas of mid-1993). The poverty line for an adult living alone, based on the physiologicalminimum intake of food, as well as the basket of industrial products (excluding heating), is EEK 280. The poverty line for families is based on the coefficients for expenses for additional adults (an addition of EEK 196)and for additionalchildren (an additionof EEK 140;children above 14 are counted as adults). The above factors, togetherwith the estimatedtypical composition of familiesthat live in poverty, produce the weighted estimate of the poverty line. The Ministry of Social Affairs is the source of the data on the poverty line; data on family consumption and compositioncome from householdsurveys.
* 7Theinitial number of people living in poverty. Based on the household survey, 125 out of 1,429 families, or 8.7 percent, lived in poverty in mid-1993 (source: Dr. Arvo Kuddo, former Minister of Labor). Adjusting for the fact that poor families are larger, and for the likely bias against poor families in the selection of the sample (conversationwith Dr. Kalev Katus, PopulationResearch Center, Tallinn), our estimate of the people living in poverty in the beginning of 1994 is 11.3 percent. This estimate is adjusted for the anticipated increase in unemploymentin the near future. - 108 -
* It is assumed that the poverty gap will remain unchanged, in real terms, during 1994-96. The two opposing factors that will affect incomes of the poor-the restored growth and deepening of incomes inequality-are thus assumed to cancel out each other.
Labor Market Interventions
* For 1994, it is assumed that the average number of recipients of unemployment compensation will be 40,000 (equivalent to 5.6 percent of the labor force), and that the level of the compensation will be EEK 180. It is further assumed that the number of the recipients will peak at 54,000 in September 1994 when the recent school-leavers become eligible for unemployment compensation. For both 1995 and 1996, the number of recipients of unemployment compensation is expected to stagnate at 50,000, and unemployment compensation is expected to increase in real terms to match the poverty line of EEK 280 in 1993.
* Real training expenses per participant will increase by 100 percent in 1994, either because of higher expenses per day for more adequate programs or because the average duration of training is increased; a further 50 percent increase is assumed in 1995 and in 1996. Moreover, during 1994-96, it is anticipated that the intake rate will double, bringing 9.4 percent of the unemployed into training programs.
* The intake of public works is assumed to triple to include half of the stock of unemployed, and the level of compensation is assumed to be 50 percent of the minimum wage (EEK 150).
* It is assumed that, throughout 1994, the government will provide monthly employment subsidies amounting to EEK 240 for 3,000 previously unemployed school-leavers, and that the expenditures of the program will double, in real terms, both in 1995 and 1996. Table A2-1. Labor Market and Social Safety Net Expenditures
1992 1993 1994 1995 1996 Actual Actual Projection Budget Projection Projection Item % of GDP Amount % of GDP Amount % of GDP Amount % of GDP Amount % of GDP Amount % of GDP Amount
Total 8.4 1,164.00 8.7 2,286.00 9.0 2,847.00 8.8 2,777.00 8.7 3,031.00 8.3 3,194.00
Pensions 5.0 694.00 5.1 1,349.00 5.4 1,700.21 5.5 1,720.20 5.0 1,759.08 4.7 1,823.57 Old age pensions 4.3 592.00 4.2 1,093.00 4.5 1,427.85 4.6 1,463.58 4.2 1,471.73 3.9 1,519.84 Disabilitypensions 0.5 69.00 0.6 159.00 0.5 162.46 0.5 146.91 0.5 171.40 0.5 181.17 Survivor pensions 0.2 22.00 0.2 57.00 0.2 64.58 0.2 53.53 0.2 68.13 0.2 72.02 Other 0.1 11.00 0.2 40.00 0.1 45.32 0.2 56.18 0.1 47.81 0.1 50.54
Family Benefits 2.0 283.30 1.8 484.87 1.6 505.65 1.6 517.98 1.4 505.65 1.3 505.65 Child allowances 1.7 230.60 1.5 388.80 1.3 410.94 1.3 406.08 1.2 410.94 1.1 410.94 Care for children 0.3 36.70 0.2 64.10 0.2 63.36 0.2 65.20 0.2 63.36 0.2 63.36 Birth grants 0.0 6.90 0.1 16.20 0.0 13.50 0.0 15.03 0.0 13.50 0.0 13.50 Other 0.1 9.10 0.1 15.77 0.1 17.85 0.1 31.68 0.1 17.85 0.0 17.85
Social Assistance 1.3 175.44 1.6 411.84 1.6 490.94 1.2 390.16 1.5 530.85 1.5 561.11 0 Institutional care (central and local) 0.4 48.96 0.5 122.89 0.4 124.52 0.4 124.52 0.4 131.37 0.4 138.85 In cash - - 0.1 24.10 0.4 130.78 0.1 30.00 0.4 150.88 0.4 159.48 Housing and heating subsidies 0.9 123.00 0.9 244.50 0.7 211.00 0.7 211.00 0.6 222.61 0.6 235.29 Other 0.0 3.48 0.1 20.34 0.1 24.64 0.1 24.64 0.1 26.00 0.1 27.48
Labor market interventions 0.1 10.92 0.2 40.15 0.5 150.10 0.5 148.50 0.7 235.77 0.8 303.49 Training 0.0 - 0.0 1.82 0.1 19.14 0.1 22.20 0.1 37.86 0.2 75.04 Public works 0.0 - 0.0 0.24 0.1 35.94 0.0 (x)** 0.1 37.92 0.1 40.08 Youth measures 0.0 - 0.0 0.00 0.0 8.64 0.0 (x)** 0.1 18.23 0.1 38.54 Unemploymentcompensation 0.1 10.92 0.1 38.09 0.3 86.38 0.4 126.30 0.4 141.75 0.4 149.83
Memorandumitems GDP in current prices 13,913 26,266 31,559 34,906 38,669 Projected growth of real GDP (%) 6.0 4.8 4.8
Source: Ministry of Social Affairs -- NationalLabor Market Board; National Social InsuranceBoard; Ministry of Finance. Note: t Data was anualized based on the incurred expendituresin the irst nine months of 1993. The amount has not yet been determined (both Public works and youth measuresare financed from the funds earmarked for unemploymentcompensation.)
ANNEX 3
PPL: Proposed Project List, 1995-97
This annex presents the original "wish list" of projects suggested in late 1993 by various ministries and agencies to the Ministry of Finance for inclusionin the public investment program. As such, this list does not reflect the views of the government regarding the projects that actually will be included in the PIP. In fact the, list is already being revised. The data are organized by column as follows:
Column Indicator
Project Name Brief project name
Type Sector
Sector Roles The rankings correspondto the rankings 1-4 in the text (for example, Box 1-6), with 1 indicatingsectors that the mission believes are most likely to continueto require a strong public sector presence by the year 2000.
Priority Rating This column indicates the priority that would attach to each project based on the inter- and intra-sectoralpriorities describedin this chapter. (The priorities shown here wereassigned on the basis of thesecriteria by the Public ExpenditureReview mission, not by the Estonian government.)
Project Cost Initial estimates of project cost, broken down by foreign and domestic. These estimates are likely to require substantial revision as updated information on design and costs becomes available.
Phy/Fin Physical/financialinvestment: Projects that involve financial transfers through loans or equity from the central governmentto an executingagency with separate legal status (for example,a corporatizedbank or public enterprise)will be flagged with an F. Obvious onlending projects are so marked now; many of the other projects may later be identified as falling in that category.
Proj. Status Project Status: "0" indicatesthat no expenditureshave taken place, that the project is new; "1" indicates that the project is ongoing. The number at the end of each group is the count of the number of projects in this group.
Invest. Type InvestmentType: To be used to indicatepart of public sector responsiblefor the project. "G" = central government; "M" = municipal government; "E" = public enterprise.
Govt. Share GovernmentShare: Will indicate the central government's share of total project cost. - ill -
Env. Obj. Environmental Objective: Will be used to flag projects with a significant environrmentalobjective.
Inv. Made InvestmentsMade: Total expensesreported as having taken place by the time the informationwas submittedto the Ministry of Financein September/October1993.
Investments Indicates the expected total expenditures by year for the remainder of the Needed project life. Where details were not given in the original data, the total amount has been placed in the column "1997+," which certainly understates the investmentsbeing conceivedfor the 1994-96period. PPL: Proposed Project List
Sector Priority Project Cost (EEK million) Phy/Fin Proj. Invest. Govt. Env. Inv. Investments Needed Project Name Type Roles Rating Total Foreign Domestic Inv. Status Type Share Obj. Made 1994 1995 1996 1997+ (I - 4) 1/2/3 (PS) (G, M E) (%) construction of farrnsteads AGR 4 3 6.00 0.00 6.00 0 0.00 3.00 3.00 0.00 0.00 processing of sheep-rearing products AGR 4 3 4.30 0.00 4.30 0 0 00 0.00 0.00 0.00 4.30 Agriculture 10.30 0.00 10.30 2 0.00 3.00 3.00 0.00 430 landing track for Tallinn Airport AIR 2 1 221.00 0.00 221.00 0 0.00 0.00 0.00 0.00 221.00 reconstruction of Tallinn Airpor terminal AIR 2 1 7.00 0.00 7.00 0 0.00 0.00 0.00 0.00 7.00 Air Transport 228.00 0.00 22.00 2 0.00 0.00 0.00 0.00 228.00 phone equipment COM 3 2 23.43 21.60 1.83 1 0.03 0.00 0.00 0.00 23.40 Soinaste district communicattions(heat, roads, etc.) COM 3 2 5.00 0.00 5.00 0 0.00 0.00 0.00 0.00 5.00 Communications 28.43 21.60 6.83 2 0.03 0.00 0.00 0.00 28.40
? restoration works CUL 2 2 45.00 0.00 45.00 0 0.00 3.00 3.00 4.00 35.00 EstonianTheatre workshop complex CUL 2 2 3.48 1.89 1.59 1 0.38 0.40 0.21 0.60 1.89 light and sound equipment for Tartu choir stand CUL 2 2 7.40 0.00 7.40 0 0°00 0°00 0°00 0°00 7-40 Noo culture park CUL 2 2 5.00 0.00 5.00 0 0.00 0.00 0.00 0.00 5.00 Puppet Theatre hall and stage equipment repairs CUL 2 2 1.60 0.00 1.60 0 0.00 0.00 0.00 0.00 1.60 reconstruction of architectural monument CUL 2 2 0.40 0.00 0.40 0 0.00 0.00 0.00 0.00 0.40 reconstruction of sound. video, and comm. syst. E.T. CUL 2 2 0.68 0.57 0.11 0 0.00 0.04 0.64 0.00 0.00 renovation of Puppet Theatre building CUL 2 2 8.58 0.00 8.58 1 1.58 3.50 3.50 0.00 0.00 restoration of building in K5rdla CUL 2 2 1.40 0.00 1.40 0 0.00 0.70 0.70 0.00 0.00 restoration of building in Kirdla CUL 2 2 2.20 0.00 2.20 0 0.00 0.30 1.00 0.90 0.00 restoration of Jasni church CUL 2 2 8.00 0.00 8.00 0 0.00 0.00 0.00 0.00 8.00 Sooru club CUL 2 2 0.50 0.00 0.50 0 0.00 0.50 0.00 0.00 0.00 stage lighting system of Estonia Thetre CUL 2 2 2.70 2.70 0.00 1 0.27 2.43 0.00 0.00 0.00 Valga museurm CUL 2 2 17.20 0.00 17.20 1 1.20 0.60 5.00 5.00 5.40 Kukruse mansion CUL 2 3 78.00 0.00 78.00 0 0.00 0.00 0.00 000 78.00 Maidia cultureand sports centre CUL 2 3 26.11 20.80 5.31 1 0.11 5.20 5.20 5.20 10.40 new stage equipment for Drama Theatre CUL 2 3 25.70 25.70 0.00 0 0.00 0.00 0.00 0 00 25.70 renovation of M5o mansion CUL 2 3 26.78 15.60 11.18 1 0.78 7.80 15.60 2.60 0.00 stageequipment of Estonia Theatre CUL 2 3 22.00 17.00 5.00 1 3.30 12.00 6.70 0.00 0.00 Trade and culture centre in Vo central library CUL 2 3 25.00 0.0G 25.00 0 0.00 0.00 0.00 0.00 25.00 Culture 307.73 84.26 223.46 20 7.62 36.47 41.55 18.30 203.79
Ala school gym EDU I I 1.20 0.00 1.20 1 0.30 0.40 0.50 0.00 0.00 building of new schoolhouse at Kambja EDU I 1 28.00 0.00 28.00 1 0.09 0.00 0.00 0.00 27.92 connecting Tartu schools to international database EDU I 1 0.00 0.00 ? 0 0.00 0.00 0.00 000 0.00 construction of a schoolhouse with swimmingpool EDU I 1 30.00 0.00 30.00 0 0.00 0.00 15.00 15.00 0.00 construction of Kaarmnaschool EDU I 1 9.50 0.00 9.50 0 0.00 0.00 0.00 0 00 9 50 construction of Lepna school EDU I 1 10.70 0.00 10.70 1 0.70 7.00 2.65 0.00 0.35 construction of school-home for child.w/ spec.needs EDU I 1 3.91 2.53 1.38 1 0.01 1.95 1.95 0.00 0.00 construction of Hageri school EDU I 1 12.00 0.00 12.00 1 0.05 0.00 3.00 3.00 5.95 construction of Lepna school EDU I I 10.00 0.00 10.00 1 4.50 4.00 1.50 0.00 0.00 dwelling house for teachers in V-Maarja EDU I 1 4.46 0.00 4.46 1 1.58 0.75 1.35 0.00 0.78 extensionof Hagudi school EDU I 1 8.80 0.00 8.80 1 0.31 0.00 0.00 0.00 8.49 extension of larvakandi school EDU I 1 2.80 2.80 0.00 0 0.00 0.70 0.70 0.70 0.70 Jirlepa nursery school EDU I 1 3.00 0.00 3.00 1 1.00 1.00 0.00 0.00 1.00 Jirvakandi secondary school extension EDU I 1 2.80 0.00 2.80 0 0.00 0.70 0.70 0.70 0.70 Kaiuschoolsportsstadium EDU I 1 1.49 0.00 1.49 0 0.00 1.23 0.15 0.11 0.00 Koorkula nursery school EDU I 1 0.80 0.00 0.80 0 0.00 0.00 0.30 0.50 0.00 PPL: Proposed Project List
Sector Priority ProjectCost (EEK million) Phy/Fin Proj. Invest. Govt. Env. Inv. lnvestmentsNeeded Project Name Type Roles Rating Total Foreign Domestic Inv. Status Type Share Obj. Made 1994 1995 1996 1997+ (1 - 4) 1/2/3 (PS) (G, M, E) (%)
new teachingdevices - Tsirguliina secondaryschool EDU I 1 0.40 0.00 0.40 1 0.02 0.10 0.10 0.10 0.08 Patkulaschool EDU I 1 16.80 0.00 16.80 1 2.00 4.00 4.50 6.00 0.30 Raikk0ilaschool for children with specialneeds EDU I 1 3.60 0.00 3.60 1 0.60 1 55 1.05 0.20 0.20 reconsructionand extensionof Illuka school EDU I 1 12.00 5 00 7 00 1 3.00 5.00 4.00 0.00 0.00 reconstructionof heatengineering (kindergardens) EDU I 1 4.84 0.00 4 84 0 0.00 0.00 0.00 0.00 4.84 reconstructionof sportshall for Vana-Kuusteschool EDU I I 0.00 0 00 0 00 0 0.00 0.00 0.00 0 00 0 00 repair of Sinimic school EDU I 1 10.55 0.00 10 55 1 0.95 3.20 3.20 3 20 0.00 repairsof Anija nurseryschool EDU I 1 0.35 0.00 0 35 0 0.00 0.35 0.00 0.00 0 00 repairsof Tartu Sanatoryschool EDU I I 10.00 0.00 10.00 0 0.00 0.00 0.00 0.00 10.00 Suurem6isaschoolhouse EDU I 1 3.55 0.00 3 55 1 0.05 1.50 1.50 0.50 0.00 training program EDU I I 1 00 0.00 1.00 0 0.00 0.00 0.00 0.00 1.00 Tsirguliina club EDU I 1 0.50 0.00 0.50 0 0.00 0.00 0.50 0 00 0.00 turning schoolsand kindergardenswarmth-preserv EDU I 1 24 00 24.00 0.00 0 0.00 0.00 0.00 0 00 24 00 Vigala Agriculture schoolfarmstead EDU I 1 2.30 0.00 2.30 1 0.80 1.50 0.00 0.00 0.00 medicalbuildings for Tartu University EDU I 1 184.56 155.90 28.66 1 1.15 36.88 36.88 48 10 61 54 renovationof schoolsin Valgamaavillages EDU 1 2 12.00 0.00 12.00 0 0.00 0.00 0.00 0.00 12.00 restorationof Kiltsi schoolhouse EDU I 2 5.16 0.00 5.16 1 0.07 0.56 4.53 0.00 0.00 buildings for EstonianNational DefenceAcademy EDU I 3 200.00 0 00 200 00 0 0.00 0.00 0.00 0 00 200 00 extensionofLoo school EDU I 3 8.17 000 8 17 0 0.00 8.17 0.00 000 000 extensionof Mirjamaa secondaryschool EDU I 3 3.50 000 3.50 1 0.02 0.00 0.00 000 3 48 housesfor Murastechildrens' home EDU I 3 3.40 0.00 3 40 0 0.00 3.40 0.00 000 000 new building of EstonianAcademy of Music EDU I 3 63.00 0.00 63.00 I 3.00 3.00 20.00 37 00 0.00 Oru school gym EDU I 3 6.62 0.00 6.62 0 0.00 6.62 0.00 000 000 Puhajirve schoolgym EDU 1 3 3.20 0.00 3.20 1 0.40 2.80 0.00 0.00 0.00 reconstructionof Jirvakandi schoolsports stadium EDU I 3 1.70 1.70 0.00 0 0.00 0.43 0.43 0.43 0.42 reconstructionof schoolsports stadium EDU I 3 1.70 0.00 1.70 0 0.00 0.43 0.43 0.43 0.42 reconstructionof Tsirguliina kindergarden EDU I 3 0.50 0.00 0.50 0 0.00 0.00 0.25 0.25 0.00 sportscentre for Tabasalusecondary school EDU I 3 6.50 0.00 6.50 0 000 3 50 3 00 0.00 0.00 Tagulakindergarden-nursery school EDU I 3 1.00 0.00 1.00 0 0.00 000 000 0.40 0.60 Education 720.37 191.93 528.44 45 20.59 100.72 108.17 116.62 374.27 constructionof Taru power station ELC 3 3 900.00 0.00 900.00 0 0.00 0.00 0.00 0.00 900.00 Elva-Otepii high-voltagetransmission line ELC 3 3 8.00 000 8 00 0 000 0.00 2 50 2.50 3.00 Electricity 908.00 000 90800 2 000 000 2.50 2.50 903.00 extensionof primary capital of smallenterprise fund FIN 3 2 130.00 13000 000 F 0 0.00 000 000 0.00 130.00 extensionof export creditfund FIN 3 1 195.00 19500 0.00 F 0 0.00 000 000 000 19500 formationof revolvingfund-primary capital FIN 3 1 260.00 26000 000 F 0 0.00 000 000 000 26000 sumsto EstonianInnovation Fund FIN 3 2 130.00 13000 000 F 0 000 000 0.00 000 13000 support for financingprivate SMEs FIN 3 2 50.00 000 50.00 F 0 000 1000 1000 1000 2000 Furnce 765.00 71500 50.00 5 000 1000 1000 1000 73500 extensionof forestry in Estonia FOR 2 2 26.00 2600 0.00 0 0.00 0.00 000 000 2600 Forestry 26.00 2600 000 I 000 000 000 000 2600 dev. of transportand tax-free storehousesystem GOV I 1 15.00 0.00 15.00 0 000 500 10.00 000 000 issuingof documents GOV I 1 33.98 0.00 33.98 1 0.04 18.67 8.49 3.39 3.40 real este registerof Estonia GOV I 1 78.00 78.00 0.00 0 0.00 0.00 0.00 0.00 78.00 repair of municipal building GOV I 1 1.49 0.00 1.49 0 0.00 000 000 0.00 1.49 controlof documents GOV I 2 14.20 0.00 14.20 0 000 5.68 5.68 2.84 0.00 PPL: Proposed Project List
Sector Priority Project Cost (EEK million) Phy/Fin Proj. Invest. Govt. Env. Inv. InvestmentsNeeded Project Name Type Roles Rating Total Foreign Domestic Inv. Status Type Share Obj. Made 1994 1995 1996 1997+ (I - 4) 1/2/3 (PS) (G, M, E) (%) new administrationbuilding GOV 1 3 0.53 0.00 0.53 0 0.00 0.00 Governance 0.00 0.13 0.39 143.19 78.00 65.19 6 0.04 29.35 24.17 6.37 83.28 children's home HLT 2 1 1.10 0.55 0.55 0 0.00 0.28 0.50 0.33 0.00 developmentof medicalservices in N6o HLT 2 l 2.03 0.00 2.03 1 0.03 1.00 1.00 0.00 0.00 dwelling-housefor agedpeople HLT 2 1 1.80 0.00 1.80 0 0.00 0.54 0.90 0.36 0.00 garageof Valga centralhospital HLT 2 1 0.36 0.00 0.36 1 0.29 0.07 0.00 0.00 0.00 Hageri homefor agedpeople HLT 2 1 6.00 0.00 6.00 1 2.00 2.00 2.00 0.00 0.00 homefor agedpeople in Keeni village HLT 2 1 3.92 0.00 3.92 1 0.12 0.60 2.40 0.80 0.00 Jirvakandi hospitalservice house HLT 2 1 0.34 0.00 0.34 0 0.00 0.27 0.07 0.00 0.00 medicaldatabase HLT 2 1 1.02 0.00 1.02 1 0.09 0.30 0.19 0.25 0.20 renovationof Paju carehome HLT 2 1 2.00 0.00 2.00 0 0.00 0.00 0.00 1.00 1.00 repairsof infectionhospital HLT 2 1 11.42 0.00 11.42 1 2.92 3.50 5.00 0.00 0.01 restorationof Pajusticare home HLT 2 1 1.20 0.00 1.20 0 0.00 0.72 0.48 0.00 0.00 Vigala care home-hospital HLT 2 1 4.50 0.00 4.50 1 0.15 0.00 0.00 0.00 4.35 Valga centralhospital with polyclinic HLT 2 2 57.10 34.26 22.84 1 7.10 10.00 15.00 15.00 10.00 constructionof children's polyclinic HLT 2 3 18.97 0.00 18.97 1 3.97 15.00 0.00 0.00 0.00 dwelling houseand drugstorein Arukiila HLT 2 3 0.80 0.00 0.80 0 0.00 0.80 0.00 0.00 0.00 housefor medicalpersonnel in Valga HLT 2 3 4.50 0.00 4.50 1 1.50 3.00 0.00 0.00 0.00 reconstructionof Vaanacare home HLT 2 3 1.30 0.00 1.30 0 0.00 1.30 Health 0.00 0.00 0.00 118.36 34.81 83.55 17 18.17 39.37 27.53 17.74 15.55 constructionof 2 dwelling housesat Tudu HSG 3 3 2.50 0.00 2.50 0 0.00 0.00 1.00 1.50 0.00 constructionof dwelling houses HSG 3 3 57.00 0.00 57.00 1 7.00 25.00 25.00 Housing 0.00 0.00 59.50 0.00 59.50 2 7.00 25.00 2600 1.50 0.00 kettles,steamturbine, cold-house HTG 2 1 2.41 0.20 2.21 1 0.05 1.64 0.73 0.00 0.00 P6llu poik containerboiler HTG 2 1 1.00 0.00 1.00 0 0.00 1.00 0.00 0.00 0.00 centralboiler houseof Valga HTG 2 1 8.50 8.50 0.00 1 0.50 8.00 0.00 0.00 0.00 connectValga hospitalto centralheating system HTG 2 1 1.20 0.00 1.20 0 0.00 0.00 1.20 0.00 0.00 constructionof boiler w/ gastrack for Ulenurmesch. HTG 2 1 0.50 0.00 0.50 0 0 00 0.00 0.00 0.00 0.50 constructionof boiler house HTG 2 1 2.20 0.00 2.20 1 0.01 0.00 0.00 0.00 2.19 Kotka 12 boiler HTG 2 1 6.20 0.00 6.20 0 0.00 6.20 0.00 0.00 0.00 Otepia boiler house HTG 2 1 1.00 0.00 1.00 1 0.30 0.70 0.00 0.00 0.00 Piiskula container-boiler HTG 2 1 1.10 0.77 0.33 0 0.00 1.10 0.00 0.00 0.00 reconstructionof Ulenurme boiler HTG 2 1 0.84 0.00 0.84 0 0.00 0.00 0.00 0.00 0.84 reconstructionof 2 kettlesat Luunjaboiler HTG 2 1 40.00 30.00 10.00 0 0 00 0.00 0.00 40.00 0.00 reconstructionof 2 kettlesat Luunjaboiler HTG 2 1 60.00 45.00 15.00 0 0.00 60.00 0.00 0.00 0.00 reconstructionof boiler HTG 2 1 0.85 0.00 0.85 0 0.00 0.00 0.00 0.00 0.85 reconstructionof boiler HTG 2 1 1.53 0.00 1.53 1 0.03 0.80 0.40 0.30 0.00 reconstructionof boiler HTG 2 1 2.00 0.00 2.00 1 1.00 0.00 1.00 0.00 0.00 reconstructionof distantheating system HTG 2 1 0.90 0.00 0.90 0 0.00 0.30 0.30 0.30 0.00 reconstructionof Kambja boiler HTG 2 1 0.40 0.00 0.40 0 0.00 0.00 0.00 0.00 0.40 reconstructionof Laukaboiler HTG 2 1 0.50 0.00 0.50 0 0.00 0.50 0.00 0.00 0 00 reconstructionof Ronguboiler HTG 2 1 0.60 0.00 0.60 1 0.01 0.00 0.00 0.00 0.59 reconstructionof T6rvandiboiler HTG 2 1 1.68 0.00 1.68 0 0.00 0.00 0.00 0.00 1.68 reconstructionof Viru-Jaagupiboiler HTG 2 1 2.00 0.00 2.00 0 0.00 2.00 0.00 0.00 0.00 reconstructionof boilers HTG 2 1 10.00 0.00 10.00 0 0.00 0 00 0.00 0.00 10.00 renovationof Valga centralheating system HTG 2 1 4.00 0.00 4.00 0 0.00 0.00 0.00 0.00 4.00 renovationof Valga centralheating system HTG 2 1 3.40 0.00 3.40 0 0.00 0.00 1.40 2.00 0.00 PPL: Proposed Project List
Sector Priority ProjectCost (EEK million) Phy/Fin Proj. Invest. Govt. Env. Inv. InvestmentsNeeded Project Name Type Roles Rating Total Foreign Domestic Inv. Status Type Share Obj. Made 1994 1995 1996 1997+ (I - 4) 1/2/3 (PS) (G. M, E) (%) replacementof heat engineering HTG 2 1 75.00 63.00 12.00 0 0.00 0.00 25.00 25 00 25.00 replacementof heatengineering HTG 2 1 25.00 20.00 5.00 0 0.00 0.00 0.00 0.00 25.00 Vindi 18 container-boiler HTG 2 1 1.20 0.84 0.36 0 0.00 1.20 0.00 0.00 0.00 warm waterpumping station HTG 2 1 2.50 0.00 2.50 0 0.00 2.50 0.00 0.00 0.00 warm watertubing HTG 2 1 4.00 0.00 4.00 0 0.00 0.00 0.00 0.00 4.00 warm watertubing HTG 2 1 2.50 0.00 2.50 1 1.20 0.00 0.00 0.00 1.30 yearly maintenanre HTG 2 1 31.00 0.00 31.00 1 3.00 8.00 10.00 10.00 0.00 circular line of heatengineering HTG 2 2 15.00 0.00 15.00 0 0.00 0.00 0.00 0.00 15.00 heat metres HTG 2 2 12.00 0.00 12.00 1 2.00 10.00 0.00 0.00 0.00 heating of dwelling houses HTG 2 2 100.00 0.00 100.00 0 0.00 0.00 0.00 0.00 100.00 municipal boiler housesin Valgamaavillages HTG 2 2 6.90 0.00 6.90 1 2.00 1.90 2.00 1.00 0.00 reconstructionof boiler and heat engineering HTG 2 2 2.30 0.00 2.30 0 0.00 0.00 0.00 0.00 2.30 reconsuructionof Ropkaboiler HTG 2 2 8.00 0.00 8.00 0 0.00 0.00 8.00 0.00 0.00 reconstructionof Tallinn long-distanceheating HTG 2 2 203.28 203.28 0.00 I 8.28 0.00 0.00 0.00 195.00 starting using peatbog HTG 2 2 20.00 15.00 5.00 0 0.00 10.00 10.00 0.00 0.00 connectionof heat engineering HTG 2 3 3.00 0.00 3.00 0 0.00 0.00 0.00 3.00 0.00 constructionof Valga central boiler house HTG 2 3 13.50 13.50 0.00 0 0.00 5.50 5.00 3.00 0.00 Heating 677.99 400.09 277.90 41 18.38 121.34 65.03 84.60 388.65 new asphaltconcrete mixer HWY I 1 23.00 0.00 23.00 0 0.00 16.10 6.90 0.00 0.00 roadconstruction equipment HWY I 1 5.50 0.00 5.50 0 0.00 0.00 0.00 0.00 5.50 roadconstruction (joint with Russia) HWY 1 3 650.05 650.05 0.00 1 0.05 0.00 85.00 100.00 465.00 transport/conununicationdcv. project (V6ru County) HWY 1 3 250.00 0.00 250.00 0 0.00 70.00 70.00 70.00 40.00 Highways 928.55 650.05 278.50 4 0.05 86.10 161.90 170.00 510.50 equipmentfor peatmanufacturing MFG 4 2 1.00 0.00 1.00 0 0.00 0.00 0.00 0.00 1.00 A.O. IMBI wrapand pfinting industry MFG 4 3 20.60 0.00 20.60 1 5.50 15.10 0.00 0.00 0.00 AS LEKTO potatoprocessing plant MFG 4 3 263.00 195.70 67.30 1 52.00 192.90 18.10 0.00 0.00 cold storageof Tartu meatprocessing plant MFG 4 3 2.60 0.00 2.60 1 0.60 1.00 1.00 0.00 0.00 constructionof cold storagesfor meat and milk MFG 4 3 36.22 36.22 0.00 1 1.22 15.00 20.00 0.00 0.00 enterprise(small-scale industries) incubator MFG 4 3 1.00 0.00 1.00 0 0.00 0.00 0.50 0.50 0.00 furniture factory MFG 4 3 7.36 2.60 4.76 1 0.01 0.00 0.00 0.00 7.35 Haapsalutransport and industry centre MFG 4 3 3,705.00 2,340.00 1,365.00 0 0.00 0.00 0.00 0.00 3,705.00 Haaslavaglass wool processingfactory MFG 4 3 22.00 0.00 22.00 1 4.00 0.00 0.00 0.00 18.00 knitting and sewingenterprise MFG 4 3 20.25 0.00 20.25 0 0.00 10.25 5.00 5.00 0. 00 milk industry MFG 4 3 1.10 0.00 1.10 1 0.10 1.00 0.00 0.00 0.01 milk-powdermanufacturing MFG 4 3 24.01 1.02 22.99 1 0.55 0.00 0.00 0.00 23.46 Paopetimber processing complex MFG 4 3 0.00 0.00 0.00 0 0.00 0.00 0 00 0 00 0 00 peatmanufacturing MFG 4 3 3.40 0.00 3.40 1 0.70 2.20 0.50 0.00 0.00 SE-Estoniatextile concern MFG 4 3 20.25 6.14 14.11 1 0.08 0.00 0.00 0.00 20.17 spiritsmanufacturing MFG 4 3 2.00 0.00 2.00 0 0.00 0.00 0.00 0.00 2.00 Tanu meat factory pork evaluation system MFG 4 3 703.30 501.02 202.28 0 0.00 0.00 0.00 0.00 703.30 Tartu meatfactory's car washsystem MFG 4 3 1.80 0.00 1.80 1 0.34 1.00 0.46 0.00 0.00 Industry 4,834.89 3,082.70 1,752.19 18 65.10 238.45 45.56 5.50 4,480.28 mineral wealthprospecting program MNG 3 2 3.20 0.00 3.20 0 0.00 0.00 0.00 0.00 3.20 Vana-Vigalamineral depositprojec MNG 3 3 70.00 0.00 70.00 1 1.60 0.00 0.00 0.00 68.40 Mining 73.20 0.00 73.20 2 1.60 0.00 0.00 0.00 71.60
Otepai wastesite MSW 1 2 1.30 0.00 1.30 0 0.00 0.00 0.50 0.80 0.00 PPL: Proposed Project List
Sector Priority Project Cost (EEK million) Phy/Fin Proj. Inv:st. Govt. Env. Inv. InvestmentsNeeded Project Name Type Roles Rating Total Foreign Domestic Inv. Status Type Share Obj. Made 1994 1995 1996 1997+ (I -4) 1/2/3 (PS) (G, M. E) (%)
T6rva wastesite MSW I 2 2.00 0.00 2.00 0 0.00 0.00 0.00 1.00 1.00 Valga wastesite MSW I 2 6.00 0.00 6.00 0 0.00 0.00 0.00 0.00 6.00 Municipal Solid Waste 9.30 0.00 9.30 3 0.00 0.00 0.50 1.80 7.00 bus reconstruction MT 2 2 I.W 0.00 1.00 0 0.00 0.00 0.00 0.00 1.00 bus reconstruction MT 2 2 390.00 1.00 389.00 1 2.40 65.00 85.00 110.00 127.60 Municipal Transport 391.00 1.00 390.00 2 2.40 65.00 85.00 110.00 128.60 carrying acrossToila-Vasknarva MUN I 2 1.00 0.00 1.00 0 0.00 0.00 0.00 0.00 1.00 generalplanning project of Kehtnavillage MUN I 2 0.26 0.00 0.26 0 0.00 0.08 0.09 0.09 0.00 Jirvakandi marketwith extension MUN I 2 0.29 0.00 0.29 1 0.14 0.12 0.02 0.00 0.01 Jirvakandi service-houserepairs MUN I 2 0.35 0.00 0.35 0 0.00 0.00 0.12 0.18 0.05 Kuusiku estate MUN I 2 1.00 0.00 1.00 1 0.05 0.10 0.40 0.45 0.00 N6o roads MUN 1 2 0.00 0.00 0.00 0 0.00 0.00 0.00 0.00 0.00 streetconstruction in Keila MUN 1 2 0.54 0.00 0.54 0 0.00 0.54 0.00 0.00 0.00 Tartu generalcorrection work MUN 1 2 0.30 0.00 0.30 0 0.00 0.00 0.00 0.00 0.30 constructionof a marketplace MUN I 3 25.44 25.44 0.00 1 0.44 10.00 15.00 0.00 0.00 Municipal 29.18 25.44 3.74 9 0.63 10.84 15.63 0.72 1.36 coastguard PSD I 1 406.57 0.00 406.57 1 54.95 146.58 89.01 49.91 66.13 constructionof borderguard farmsteads PSD I 1 30.00 0.00 30.00 0 0.00 10.00 10.00 10.00 0.00 constructionof police station PSD I 1 2.80 0.00 2.80 0 0.00 0.00 0.00 0.00 2.80 constructionof fire station PSD I 1 1.90 0.00 1.90 0 0.00 0.95 0.67 0.29 0.00 dev. of data connectionsystem for Est.Saving serv. PSD I 1 8.51 0.00 8.51 1 0.06 5.49 2.96 0.00 0.00 fire-fighting and saving-servicecentre PSD I 1 5.50 0.30 5.20 0 0.00 0.50 2.00 2.00 l.00 hydrografics PSD I 1 74.60 0.00 74.60 0 0.00 21.10 33.90 18.90 0.70 ice-breakers PSD I I 0.00 0.00 0.00 0 0.00 0.00 0.00 0.00 0.00 modernizingof buoys PSD I 1 14.30 0.00 14.30 1 2.60 2.80 0.00 0.00 8.90 modernizingof floating signs PSD I 1 9.10 0.00 9.10 0 0.00 0.00 0.00 0.00 9.10 pagingsystem for Estonianpolice PSD I 1 2.99 2.99 0.00 0 0.00 0.00 0.00 0.00 2.99 piloting centre PSD I 1 67.50 0.00 67.50 0 0.00 57.50 10.00 0.00 0.00 storehousefor rescueservice PSD 1 2 0.18 0.00 0.18 0 0°00 0.18 0.0 0.00 0.00 Public Safety and Defense 623.95 3.29 620.66 13 57.61 245.10 148.53 81.10 91.62
KArdlaPon (communication,water supply. sewer,etc.) PTI 2 2 4.68 0.00 4.68 1 0.03 1.82 2.83 0.00 0.00 MuugaPort extensionprojection work costs PTI 2 2 650.00 650.00 0.00 0 0.00 0.00 0.00 0.00 650.00 MuugaPon extension:railway PTl 2 2 910.00 910.00 0.00 0 0.00 0.00 0.00 0.00 910.00 S6ru Port PT! 2 2 0.19 0.00 0.19 1 0.19 0.00 0.00 0.00 0.00 KUrgessaarePort PTI 2 3 3.00 0.00 300 0 0.00 1.50 1.50 0.00 0.00 Port Infrastructure 1.567.87 1.560.00 7.87 5 0.22 3.32 4.33 0.00 1,560.00
MuugaPort extension:oil productsterminal PTS 3 3 923.00 923.00 0.00 0 0.00 0.00 0.00 0W00 923.00 MuugaPort extension:dry bulk terminal PTS 3 3 858.00 858.00 0.00 0 0.00 0.00 0.00 0.00 858.00 MuugaPort extension:coal terminal PTS 3 3 1,430.00 1,43000 0.00 0 0.00 0.00 0.00 0.00 1,430.00 MuugaPort extension:container terminal PTS 3 3 1,560.00 1,560.00 0.00 0 0.00 0.00 0.00 0.00 1.560.00 MuugaPort extension:port buildings in generaluse PTS 3 3 1,235.00 1,235.00 0.00 0 0.00 0.00 0.00 0.00 1.235.00 Port Superstructure 6,006.00 6,006.00 0.00 5 0.00 0.00 0.00 0.00 6,006.00 modernizingof ships SHP 3 2 19.50 0.00 19.50 0 0.00 11.60 6.80 1.10 0.00 Shipping 19.50 0.00 19.50 1 0.00 11.60 6.80 1.10 0.00 PPL: Proposed Project List
Sector Priority Project Cost (EEK million) Phy/Fin Proj. Invest. Govt. Env. Inv. InvestmentsNeeded Project Name Type Roles Rating Total Foreign Domestic Inv. Status Type Share Obj. Made 1994 1995 1996 1997+ (I - 4) 1/2/3 (PS) (G, M, E) (%) constructionof Ihastehorse-racing centre SPT 3 3 1.60 0.00 1.60 1 1.20 0.40 0.00 0.00 0.00 constructionof indoor skatingrink SPT 3 3 25.17 0.00 25.17 1 0.17 0.00 5.00 10.00 10.00 Jirvakandi schoolgym repair with extension SPT 3 3 2.10 2.10 0.00 0 0.00 0.70 0.70 0.70 0.00 Jarvakandiswimming-pool repairs SPT 3 3 0.13 0.00 0.13 1 0.03 0.10 0.00 0.00 0.00 Keila sportscentre SPT 3 3 6.00 0.00 6.00 0 0.00 6.00 0.00 0.00 0.00 Kohtla-Nommesports centre SPT 3 3 10.00 0.00 10.00 0 0.00 0.00 0.00 0.00 10.00 Linnakillaswimming pool SPT 3 3 3.20 0.00 3.20 1 1.20 0.50 0.50 1.00 0.00 sportsstadium for Valga schools SPT 3 3 3.50 0.00 3.50 1 0.40 0.50 1.00 0.60 1.00 swimmingpool SPT 3 3 6.23 0.00 6.23 1 3.25 1.35 0.00 0.00 1.63 Vooremie sportscentre SPT 3 3 35.00 0.00 35.00 0 0.00 10.50 10.50 14.00 0.00 Sports 92.93 2.10 90.83 10 6.25 20.05 17.70 26.30 22.63 hotel in Kirdba TOR 4 2 6.58 0.00 6.58 I 0.08 4.00 2.50 0.00 0.00 tourism development TOR 4 2 10.00 0.00 10.00 0 0.00 0.00 0 00 0.00 10.00 tourism developmentcomplex plan TOR 4 2 0.50 0.00 0.50 0 0.00 0.00 0.00 0.00 0.50 Vana-Vigalaestate TOR 4 2 1.90 0.00 1.90 1 1.20 0.20 0.50 0.00 0.00 constructionof a hotel TOR 4 3 20.24 20.00 0.00 1 0.24 10.00 10.00 0.00 0.00 motel reconstruction TOR 4 3 1.69 0.00 1.69 0 0.00 0.00 0.00 0.00 1.69 Tourism 40.91 20.00 20.67 6 1.52 14.20 13.00 0.00 12A19
Tallinn ozonationcomplex WSS 2 1 70.00 55.00 15.00 1 20.00 50.00 0.00 0.00 0.00 Ahtmc wastewatertreantment plant reconstruction WSS 2 1 0.06 0.00 0.06 0 0.00 0.00 0.00 0.00 0.06 Ahtme-Johviwastewarer main pipe WSS 2 1 0.02 0.00 0.02 0 0.00 0.00 0.00 0.00 0.02 constructionof waterpipe WSS 2 1 28.45 28.45 0.00 1 4.45 18.00 6.00 0.00 0.00 constructionof water reservoir WSS 2 1 18.00 18.00 0.00 0 0.00 8.00 10.00 0.00 0.00 constructionof water supplynetwork and sewerage WSS 2 1 45.25 45.25 0.00 0 0.00 0.00 5.00 8.00 32.25 constructionof w.water treatmentfacilities in Rapla WSS 2 1 4.40 0.00 4.40 1 1.10 0.00 0.00 0.00 3.30 constructionof wastewatertreatment facilities WSS 2 1 63.18 63.18 0.00 0 0.00 5.00 10.00 20.00 28.18 constructionof seweragecollector WSS 2 1 4.00 0.00 4.00 0 0.00 0.00 0.00 0.00 4.00 cxtensionof Raplaenvironmental control lab WSS 2 1 0.10 0.00 0.10 0 0.00 0.00 0.00 0.00 0.10 extensionof watersupply in Kambjavillage WSS 2 1 0.35 0.00 0.35 0 0.00 0.00 0.00 0.00 0.35 Hageri wastewatertreatment facilities WSS 2 1 1.50 0.00 1.50 1 0.10 0.06 0.30 0.30 0.74 Hagudiwastewater treatment facilities WSS 2 1 0.62 0.00 0.62 0 0.00 0.30 0.32 0.00 0.00 Ihastecollector WSS 2 1 1.00 0.00 1.00 0 0.00 0.80 0.20 0.00 0.00 Johvi treatmentplant-sewage main pipeconstruction WSS 2 1 0.08 0.00 0.08 0 0.00 0.00 0.00 0.00 0.08 K-J. Ahtmereconstruction of sewagenetwork WSS 2 1 0.01 0.00 0.01 0 0.00 0.00 0.00 0.00 0.01 K-J investigationof useof mine waterresources WSS 2 1 0.01 0.00 0.01 0 0.00 0.00 0.00 0.00 0.01 K-JAXK-0reconstructionofsewagepumpingstations WSS 2 1 0.15 0.00 0.15 0 000 0.00 0.00 0.00 0.15 K-JoJ6new waterwells WSS 2 1 0.03 0.00 0.03 0 0.00 0.00 0.00 0.00 0.03 K-i Jo6K-0automatation of waternetwork, watermetres WSS 2 1 0.05 0.00 0.05 0 0.00 0.00 0.00 0.00 0.05 K-1Jo.1(K4reconstructionofwaterpipelines WSS 2 1 0.10 0.00 0.10 0 0.00 0.00 0.00 0.00 0.10 Kirdla catchmentarea WSS 2 1 10.00 0.00 10.00 1 6.70 3.30 0.00 0.00 0.00 Kirdla wastewatertreautment facilities WSS 2 1 2.00 0.00 2.00 0 0.00 2.00 0.00 0.00 0.00 Korgessaarewater supply system WSS 2 1 0.40 0.00 0.40 0 0.00 0.40 0.00 0.00 0.00 K6rgessaarewastewarer treatment facilities WSS 2 1 2.08 0.51 1.57 1 0.12 0.96 0.49 0.00 0.51 Maujamaacatchment area WSS 2 1 1.50 0.00 1.50 0 0.00 0.00 1.50 0.00 0.00 Masalu and HaapsaluBay economical program WSS 2 1 65.00 65.00 0.00 0 0.00 0.00 0.00 0.00 65.00 mud treatmentof wastewatertreatment facilities WSS 2 1 18.00 13.50 4.50 0 0.00 7.20 7.20 3.60 0.00 municipalwater and environmnetprojea of Estonia WSS 2 1 688.00 344.00 344.00 1 2.16 0.00 0.00 0.00 685.84 PPL: Proposed Project List
Sector Priority Project Cost (EEK million) Phy/Fin Proj. Invest. Govt. Env. Inv. Investments Needed Project Name Type Roles Rating Total Foreign Domestic Inv. Status Type Share Obj. Made 1994 1995 1996 1997+ (1 - 4) 1/2/3 (PS) (G. M, E) (%) municipal water service WSS 2 1 35.04 35.04 0.00 1 0.04 0.00 5.00 10.00 20.00 Otepii wastewater facilities WSS 2 1 8.50 0.00 8.50 1 3.50 3.00 2.00 0.00 0.00 pumping statton of water supply WSS 2 1 2.00 1.40 0.60 0 0.00 0.50 1.50 0.00 0.00 reconstruction of communal economy systems WSS 2 1 20.00 0.00 20.00 0 0.00 4.00 4.00 4.00 8.00 reconstr. of V-Maarja wastewater treatment facilities WSS 2 1 5.43 1.00 4.43 1 2.23 1.18 2.01 0.00 0.00 reconstruction of wastewater treatment facilities WSS 2 1 0.30 0.00 0.30 0 0.00 0.30 0.00 0.00 0.00 Suuremoisa wastewater treatment facilities WSS 2 1 2.55 0.00 2.55 1 0.05 1.00 1.00 0.50 0.00 T6rva wastewater facilities WSS 2 1 41.40 0.00 41.40 1 2.40 13.00 13.00 13.00 0.00 Tallinn water and environment projea WSS 2 1 600.00 300.00 300.00 1 2.30 50.00 100.00 100.00 347.70 Tartu seweragemain complex WSS 2 1 50.00 28.00 22.00 1 9.00 16.40 16.40 8.20 0.00 tunnel collector no.I WSS 2 1 12.70 0.00 12.70 1 2.70 6.50 3.50 0.00 0.00 Viike-Maarqa wastewater treatmentfacilities WSS 2 1 1.00 0.00 1.00 0 0.00 1.00 0.00 0.00 0.00 V6ru wastewater treatment facilities WSS 2 1 1.00 0.00 1.00 0 0.00 0.00 0.00 0 00 1 00 Valga wastewater facilities WSS 2 1 30.00 0.00 30.00 0 0.00 10.00 10.00 10.00 0.00 Vinnm-Pajustiwastewater treatment facilities WSS 2 1 4.60 0.00 4.60 0 0.00 1.84 2.76 0.00 0.00 Otepai catchment area WSS 2 2 10.00 0.00 10.00 1 0.80 2.00 2.20 4.00 1.00 construction of colletors WSS 2 2 1.00 0.00 1.00 0 0.00 0.00 0.00 0.50 0.50 construction of water conductors WSS 2 2 1.00 0.00 1.00 0 0.00 0.20 0.20 0.20 0 40 extension of Keila wastewater facilities WSS 2 2 4.00 0.00 4.00 0 0.00 2.00 2.00 0.00 0.00 Haabneeme water supply and severage WSS 2 2 1.50 0.00 1.50 0 0.00 1.50 0.00 0.00 0.00 Kehra wastewater sewerage WSS 2 2 1.00 0.00 1.00 0 0.00 1.00 0.00 0.00 0.00 Otepaa garden city wastewaterfacilities WSS 2 2 4.00 0.00 4.00 1 0.05 0.65 0.65 0.65 2.00 Raasiku wastewater facilities WSS 2 2 12.00 0.00 12.00 0 0.00 6.00 6.00 0.00 0.00 reconstruction of Rapla central sewerage WSS 2 2 0.89 0.00 0.89 0 0.00 0.00 0.00 0.00 0.89 reconstruction of sewerage WSS 2 2 0.23 0.00 0.23 0 0.00 0.00 0.00 0.00 0.23 seweragecollector WSS 2 2 4.00 0.00 4.00 0 0.00 0.40 1.80 1.80 0.00 tunnel collector no.2 WSS 2 2 15.00 0.00 15.00 0 0°00 3.00 5.25 5.25 Valga catchment area 1.50 WSS 2 2 20.90 0.00 20.90 1 0.90 0.00 0.00 Water Supply and Sewerage 6.00 14.00 1,914.38 998.33 916.05 57 58.60 221.49 220.28 196.00 1,218.01 TOTAL ###f##r 13,900.60 6,623.68 280 265.79 ####N #N#### 850.14 17,100
Note: Secor Roles: I = Public Sector Domain; 2 Public Sector Majority; 3 = Private Sector Majority; 4 = Private Sector Domain. Priority Rating: I =High; 2=Medium; 3=Low. Physical/Financial Investment (Phy/Ft Inv.): F=Financial (net lending) activities; Blank=otherwise. Project Status (PS): I =Ongoing; 0=Inactivc. Investment Type: G = Govcrnment; M= Municipal; E= Enterprise. Environmental Objectives (Env Obj): I =Primary; 2=Important but secondary; 3=Minor impact; Blank=no particular relevance.
ANNEX 4
Index to Sectors by Public/Private Role
4.1 This annex allocatesall standardsectors into one of the four public/privaterole (PPR) groups, as shown in the basic PPR matrix (see Box 1-6). The sectors are listed below in alphabeticalorder. The number to the right indicates the approximatedegree of public versus private involvement in the sector over the medium term, with "1" for sectors that will remain virtually 100 percent in the public sphere and "4" for those that will be largely privatized by 2000, though neither is likely to be only public or private. Investment and ownership by both the private and public sectors is expected for sectors in Groups 2 and 3, but based on current trends, activities in Group 3 will probably be privatized more quickly than those in Group 2. In the transport sector, a distinction is drawn between "infrastructure" and "superstructure." The former refers to the basic facilities such as landing strips, highways, and wharfs. The latter refers to ancillary facilities such as general warehouses,specialized cargo handling equipment, and services for customerssuch as food and fuel. Where two numbers are given in the list below, the first refers to infrastructureand the second to superstructure.
Agriculture 4 Airlines 3 Airports 2 Coommunications 3 Construction 4 Culture 2 District heating and energy 2 Education 1 Electricity distribution 3 Electricity generation 2 Environment 1 Finance 3 Fishing 4 Forest ResourceManagement 2 Governmentadministration 1 Health and social services 2 Highways 1 Housing 3 Industry 4 Infrastructure 2 Labor and employmentservices 1 Logging 4 Mining 3 Municipal solid waste 2 Municipal streets & lighting 1 Municipal transport 2 Natural resource management 2 Natural resource use 4 Ports (infrastructure) 2 Ports (superstructure) 3 - 120 -
Public safety and defense 1 Railways 2 Sales and service 4 Sea freight and shipping 3 Superstructure 3 Tourism 4 Trucking 4 Water supply and sewerage 2 ANNEX 5
Project Information Form
ProjectName:
Starting Date: State/Local/Enterprise: Project Code: Completion Date: Ongoing (yes/no): Sector Code: Priority (1/2/3): Location Code: Total Cost:
(EEKmillion) ProjectLocation: ExecutingAgency:
ProjectDescription:
AnticipatedBenefits and SuccessCriteria: Rateof Return:
Costs (EEKmillion): BudgetaryCost Recurrent Total Domestic Foreign OtherCost TotalCost Cost Domestic Foreign Total
ExpenditureProfile: Total Domestic Foreign Completed 1994 1995 _ 1996 1997 Beyond 1997
Foreign Financing Sources: Agency Amount Status Comments
Bibliography
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Gittinger, J. Price. EconomicAnalysis of Agricultural Projects. Baltimore: Johns Hopkins, 1982.
Hansen, John R. Guide to PracticalProject Appraisal: Social Benefit-CostAnalysis in Developing Countries. New York: United Nations, 1978.
Little, I. M. D., and J. A. Mirrlees. ProjectAppraisal and Planningfor Developing Countries. London: HeinemannEducational Books, 1974.
Ministry of Construction. Energy Savings in Housing in Estonia, Report No. 1, Energy Audits and Catalogueof Energy Saving Measures, (preliminary). Hosholm, Denmark: Danish Building Research Institute and COWIconsult,Lyngby, Denmark, 1993.
Ray, Anandarup. Cost-BenefitAnalysis: Issues and Methodologies. Washington, D.C.: World Bank, 1984.
Schipper, Lee, and Eric Martinot. The Structureand Efficiencyof Energy Use in Estonia: Summnary of an InternationalComparison. Stockholm: StockholmEnvironment Institute and Lawrence Berkeley Laboratory, 1994.
Squire, Lyn, and Herman G. van der Tak. EconomicAnalysis of Projects. Washington, D.C.: World Bank, 1975.
Tabtinen, Markus, and Heinar Nurste. Energy Use and Emission Scenariosto the Year 2000for Estonia. Espoo, Finland: Technical Research Centre of Finland, 1992.
Tenno, Koidu, and Ellen Veski. Energy Saving Program and Restructuringof Energy in Estonia. Tallinn: Estonian Academyof Sciences, 1993.
World Bank. Estonia: The Transitionto a Market Economny.Washington, D.C.: International Bank for Reconstructionand Development(IBRD), 1993.
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