Recovery Through Improved Systems and Expenditure Support Program (RRP PAL 54284-001)

Recovery through Improved Systems and Expenditure Support Program (RRP PAL 54284-001)

PROGRAM IMPACT ASSESSMENT

A. Macroeconomic Context

1. This assessment summarizes the expected impacts of public sector management reforms supported under subprogram 1 of the Recovery through Improved Systems and Expenditure Support (RISES) Program on the economy of Palau. The potential impact of policy reforms is gauged through reviews of empirical studies related to the program’s reform areas as well as through simulations of anticipated program impacts on Palau’s fiscal accounts.

2. Palau is among the most tourism-driven economies in the Pacific, with annual tourism receipts reaching the equivalent of 36.5%–53.4% of annual gross domestic product (GDP) during FY2010–FY2019. However, the tourism industry had struggled in recent years, even before the coronavirus disease (COVID-19) pandemic. From a peak of nearly 170,000 tourists—for a tourist– resident ratio of 9.5:1, among the highest globally, in fiscal year (FY) 2015 (ended September 2015)—arrivals declined to less than 90,000 by FY2019.1 The onset of the COVID-19 pandemic and resulting global travel restrictions brought an abrupt end to a nascent tourism recovery. From October 2019 to January 2020 (the first 4 months of Palau’s fiscal year), visitor arrivals were already equivalent to 46.4% of FY2019 full-year arrivals. However, the COVID-19 pandemic saw total arrivals fall by 43% year-on-year in February 2020, by 70% in March 2020, and by 99% during April 2020–September 2020. As a result, total arrivals fell by 53% to below 42,000 in FY2020, the fifth consecutive year of decline.

3. Despite the recent tourism downturn, Palau had maintained annual fiscal surpluses averaging the equivalent of 3.0% of GDP from FY2011 to FY2019. The government saved the bulk of fiscal surpluses, resulting in growth in the general fund reserve to the equivalent of about 11.2% of GDP by the end of FY2019. These achievements are even more notable considering the country’s severe vulnerability to external shocks. Palau ranks first among 145 economies globally in the United Nations’ Economic Vulnerability Index, a measure that comprehensively captures various structural constraints. Recent major external shocks include typhoon Bopha in 2012, typhoon Haiyan in 2013, and a severe drought in 2016. Palau’s vulnerability highlights the crucial importance of maintaining adequate fiscal buffers, including in the general fund reserve, to enable immediate response to disasters and other emergencies.

4. Overall, Palau’s economic performance is characterized by boom-and-bust cycles mainly driven by trends in the vital tourism sector and, to a lesser extent, the schedule and pace of construction of major infrastructure projects. As a small island developing state, geographic constraints, heightened economic vulnerability, and resulting fragilities particularly manifesting in thin capacities for effective governance further exacerbate volatilities in growth performance. The recent tourism downturn translated into successive economic contractions during FY2016– FY2019, with the exception of FY2018 when the economy was boosted by the advent of high- speed internet services. 2 Thus, over the half-decade from FY2015 to FY2019, the average coefficient of variation in real GDP growth—or the ratio of the standard deviation to the mean, with values greater than 1.0 indicating high variance—for Palau was a high 2.8. Although Palau’s private sector contributes about two-thirds of annual GDP, investment remains relatively low with private sector credit at only 11.9% of GDP during FY2015–FY2019. Increasing private investment to expand beyond tourism-related sectors will help reduce economic volatility.

1 Government of Palau. Visitor Arrivals (accessed 8 December 2020). 2 ADB. Palau: North Pacific Regional Connectivity Investment Project. 2

B. Reform Areas under Subprogram 1 and Effects of the Program

5. The proposed RISES program will help shift Palau’s economic recovery from the COVID- 19 crisis toward a more sustainable fiscal path. The specific reform areas will (i) strengthen the policy and legislative framework for public financial management (PFM); (ii) reduce fiscal risks from weak management of public revenue, expenditure, and liabilities; and (iii) support private sector development. The effects of the program will be measured through reductions in the fiscal deficit and reversion to annual surpluses upon economic recovery from the COVID-19 crisis, as well as sustained increases in Palau’s tax–GDP ratio underpinned by successful tax reform.

C. Impact Analysis

6. Impact of Reform area 1: Policy and legislative framework for public financial management strengthened. Under subprogram 1, policy actions to strengthen the policy and legislative framework for PFM include: (i) approval of a bill that sets out a fiscal responsibility act (FRA) with provisions for managing public revenue, expenditure, debt, and fiscal buffers for transmittal by the president to Palau’s national congress (OEK) for approval; and (ii) preparation of a medium-term fiscal strategy (MTFS) that applies a comprehensive and multiyear budgeting framework while adhering to FRA provisions. These policy actions are expected to contribute to containing the fiscal deficit in the near-term toward restoring annual surpluses over the medium- term as the economy fully recovers from COVID-19 impacts, through stronger management of public revenue and expenditure, as well as with improved fiscal planning.

7. The FRA includes provisions for: (i) maintaining operating expenditures within medium- term expenditure targets and operating revenues; (ii) managing capital expenditures to achieve rising national net worth over time; (iii) maintaining current and future debt at prudent levels; (iv) preserving the Compact Trust Fund as a perpetual fund; (v) adopting a modern and efficient tax regime suitable to a tourism-based economy and implement tax policies that allow for predictability over time; (vi) building and managing reserves as insurance coverage for cyclical downturns, disasters, and climate change impacts; and (vii) managing fiscal risks from public sector entities, including state-owned enterprises (SOEs) and social security funds. The FRA also prescribes a strict process for any departure from these provisions to allow for flexibility during fiscal shocks. The government may deviate from FRA provisions provided that the departure is temporary, with reasonable justification provided by the minister of finance and specification of a clear period after which fiscal policy must revert to adherence to FRA provisions.

8. On the MTFS, the government will release an updated strategy at the outset of each new administration’s 4-year term, or more frequently depending on the prevailing macro-fiscal context. Annual budget statements will supplement and update the MTFS, with an assessment of achievement of FRA provisions presented at the time of budget delivery.

9. Successful implementation of the FRA and MTFS is seen to drive steady and sustainable improvements in overall PFM in Palau, particularly in the areas of budget formulation and budget execution. Although empirical analyses of the relationship between the quality of PFM and resulting fiscal outcomes specific to the Pacific context remains limited, a few cross-country studies reveal some positive insights. Mustapha (2019) explores the relationship between the quality of PFM on one side and budget credibility and fiscal outcomes on the other, across fragile and non-fragile states.3 The study’s sample includes 8 of the 14 Pacific developing member

3 Mustapha, S. 2019. Budget Credibility, Fiscal Outcomes, and PFM Performance in Fragile and Non-Fragile Countries. In PEFA, Public Financial Management, and Good Governance. World Bank: Washington, D.C. 3

countries of ADB (i.e., Kiribati, Federated States of Micronesia, Fiji, Marshall Islands, Papua New Guinea, Solomon Islands, Tonga, and Vanuatu). Econometric modeling showed that better PFM quality is positively associated with improved compositional budget credibility in fragile states. For non-fragile states, better PFM is associated with budget credibility on both the compositional and aggregate levels. Although Mustapha (2019) finds no clear evidence that PFM quality is correlated with improved fiscal outcomes, several other studies establish this positive link. Results from Prakash and Cabezon (2008) show that improved fiscal balance outcomes (both including and excluding grants) are positively and significantly correlated with better PFM, based on a sample of countries from sub-Saharan Africa, a region similar to the Pacific with its high preponderance of fragile states. 4 Similarly, Dabla-Norris et al. (2010) established a positive relationship between stronger budget institutions—as measured by multidimensional indexes that use various data sources including public expenditure and financial accountability (PEFA) reports—and improved fiscal balance and public external debt outcomes, using data from 65 low- and middle-income countries.5 These results are relevant as although Palau is classified as a high income economy, its per capita incomes fall below some middle-income countries when adjusted for purchasing power parity. More specifically, Vlaicu et al. (2014) conclude that multiyear budgeting as supported by an MTFS and other similar frameworks improves the fiscal balance by about 2 percentage points, with larger positive impacts as frameworks mature, based on results from a global dataset. 6 In the case of Palau, similar improvements from the implementation of an MTFS will contribute toward reversing near-term fiscal deficits due to the COVID-19 crisis into fiscal surpluses over the medium-term.

10. Impact of Reform area 2: Fiscal risks from weak management of public revenue, expenditure, and liabilities reduced. Subprogram 1 supports (i) introduction of a tax reform bill; (ii) conduct of a fiscal review to identify cost-saving measures while the pandemic’s adverse impacts remain in place; (iii) preparation of a National Infrastructure Investment Plan; (iv) introduction of an external debt management framework bill; and (v) actuarial evaluation of the Palau Social Security Administration pension fund toward identifying reforms to promote longer-term sustainability. Policy actions under this reform area are seen to contribute to generating sufficient fiscal space for servicing COVID-19-related borrowing through both stronger domestic resource mobilization and more efficient public spending.

11. With COVID-19 necessitating unprecedented levels of borrowing, a combination of greater domestic resource mobilization, more efficient public spending, and improved debt management is necessary to create sufficient fiscal resources to service debt. Palau’s fiscal deficit is projected to increase from the equivalent of 11.2% of GDP in FY2020 to 15.7% in FY2021 and 14.4% in FY2022. These deficits translate to total financing requirements of about $103.5 million during FY2020–FY2022, which will be met through new external borrowing. Assuming new debt will be incurred under concessional terms, debt service requirements associated with COVID-19-related borrowing are estimated to reach about $5 million per year after loan grace periods. On top of historical debt servicing of $8 million–$9 million per annum in the years leading up to the pandemic, debt service requirements are expected to increase nearly $14 million per year by FY2026– FY2027. Even if Palau’s fiscal accounts can revert to pre-COVID-19 trends—where annual

4 T. Prakash and E. Cabezon. 2008. Public Financial Management and Fiscal Outcomes in Sub-Saharan African Heavily-Indebted Poor Countries. IMF Working Paper. No. 08/217. Washington, DC: International Monetary Fund. 5 Dabla-Norris, E., R. Allen, L.F. Zanna, T. Prakash, E. Kvintradze, V. Lledo, I. Yackovlev, and S. Gollwitzer. 2010. Budget Institutions and Fiscal Performance in Low-Income Countries. IMF Working Paper. No. 10/80. Washington, DC: International Monetary Fund. 6 Vlaicu, R., M. Verhoeven, F. Grigoli, and Z. Mills. 2014. “Multiyear Budgets and Fiscal Performance: Panel Data Evidence.” Journal of Public Economics 111 (March): 79–95. 4

surpluses equivalent to 4.0% of GDP were recorded during FY2015–FY2019—by FY2023 and onward, available resources could fall short of debt servicing requirements in some years (Figure).

Palau’s Debt Service Requirements versus Fiscal Balance (various scenarios) $ million 20

0 2023 2024 2025 2026 2027 2028 2029 2030 Debt service Fiscal balance: Baseline Fiscal balance: Increased tax-to-GDP Fiscal balance: Higher growth Fiscal balance: Combined reforms

GDP = gross domestic product. Source: Asian Development Bank estimates.

12. To avoid sudden cuts to expenditure, which can create fiscal space but likely at the expense of forgone stimulus to the economy, Palau is pushing forward with revenue-raising reforms to tax policy along with a shift to a more growth-enhancing expenditure mix that prioritizes capital spending. The tax reform program, which involves the introduction of a value-added tax (VAT) as well as a shift to a net profits tax and adjustments to the wages and salaries tax, can help boost Palau’s tax–GDP ratio through collection efficiency gains. Using a global dataset that includes some island economies in the Caribbean that are comparable to those in the Pacific, Keen and Lockwood (2007) estimated that adoption of a VAT is associated with a long-run increase in the overall government revenue–GDP ratio of about 4.5%. 7 ADB’s simplified simulations show that, if tax reform can raise Palau’s tax–GDP ratio gradually by 0.25 percentage points per year from FY2023—such that it increases by a full percentage point by FY2026 and onwards—the higher debt service requirements stemming from COVID-19 related borrowing can largely be covered (Figure). Further, prioritization of capital spending, not only by controlling growth in recurrent expenditure including on the wage bill as well as on transfers to SOEs, social security funds, and other public and quasi-public bodies, but also through more strategic public investment planning can also help create fiscal space by boosting economic growth. Aghion and Howitt (2009) and Buffie et al. (2012), and Ghazanchyan and Stotsky (2013), among others, establish positive links between efficient public investment and economic growth through the productivity channel.8 Simulation results suggest that if gains from tax reform are combined with higher economic growth resulting from productivity gains through prioritization of capital spending,

7 Keen M. and B. Lockwood. 2007. The Value-Added Tax: Its Causes and Consequences. IMF Working Paper. No. 07/183. Washington, DC: International Monetary Fund 8 Aghion, P., and P. Howitt, 2009, Economics of Growth. Cambridge, MA: MIT Press; Buffie, E., A. Berg, C. Pattillo, R. Portillo, and L. Zanna. 2012, Public Investment, Growth, and Debt Sustainability: Putting Together the Pieces. IMF Working Paper No. WP/12/144. Washington, DC: International Monetary Fund; and Ghazanchyan, M., and J. Stotsky, 2013, Drivers of Growth: Evidence from sub-Saharan Africa. IMF Working Paper No. WP/13/236. Washington, DC: International Monetary Fund. 5

including through the implementation of a national infrastructure investment plan, further fiscal buffers can be generated.

13. Other policy actions supported under Reform Area 2 will also contribute to ensuring that Palau’s debt remains sustainable and serviceable. This includes implementing cost-saving measures on non-essential spending amid COVID-19 impacts to generate further fiscal space, as well as introduction of an external debt management framework that requires the creation of a debt management advisory committee responsible for technical due diligence, quality assurance, and debt sustainability analyses of any proposed new borrowing.

14. Impact of Reform area 3: Private sector development supported. The RISES program includes measures to support a broadening of the revenue base through expanded business and employment opportunities. This will be more critical for broader-based long-term growth after the pandemic. Subprogram 1 supports (i) introduction of an international arbitration bill to recognize international arbitration of commercial disputes and encourage more foreign direct investment in Palau; (ii) initiating work for the preparation of a policy statement for a public-private partnerships (PPP) framework; and (iii) updating of a bill for a new Corporations Act to include provisions for the complementary development of an electronic companies registry that supports increased transparency on beneficial ownership to increase tax compliance and reduce integrity risks. These reforms support a broadening of the revenue base through increased private sector activity and expanded business and employment opportunities. This will not only be critical for broader- based long-term economic growth after the pandemic but will also contribute toward achieving a more sustainable fiscal position.

15. These policy reforms are seen to encourage not only foreign but also domestic investment by reducing both the financial and time costs associated with engaging in business activity in Palau, while also stimulating greater private sector participation in public service delivery. Empirical analyses demonstrate a positive link between reforms to improve business regulations and increases in the number of new firms. Using panel data from 91 economies, Klapper and Love (2011) showed that the financial costs as well as the number days and procedures required to start a business are important determinants of new firm registrations.9 At a country level, Kaplan, Piedra, and Seira (2011) estimated that business start-ups in Mexico increased by about 5% per month in eligible industries with the implementation of a program that streamlined firm registration procedures. 10 A new Corporations Act that includes the creation of an online companies registry is seen to reduce the time associated with registering companies and filing annual returns, which, in turn, reduces the overall costs of doing business. ADB, through the Pacific Private Sector Development Initiative, has supported similar reforms in other Pacific economies, including Solomon Islands in 2010 and the Cook Islands in 2019. In Solomon Islands, about 4,900 new private companies have registered since the creation of an online business registry, particularly benefitting women, demonstrating a clear positive impact on private domestic investment.11

16. International arbitration involves a private dispute resolution mechanism applicable to cross-border commercial transactions through a neutral arbitrator or panel. Establishing such a mechanism has been shown to encourage increased cross-border trade and investment by

9 L. Klapper and I. Love. 2011. The Impact of Business Environment Reforms on New Firm Registration. Policy Research Working Paper 5493. Washington, DC: World Bank. 10 D. Kaplan, E. Piedra and E. Seira. 2011. Entry Regulation and Business Startups: Evidence from Mexico. Journal of Development Economics. 95. pp.1501–1515. 11 ADB. How flexible and fast PSDI is developing the Pacific’s private sector. 6

reducing perceptions of risk in developing countries that may be deemed to have weak or uncertain dispute resolution systems locally. Using data on bilateral investment treaties and regional trade and investment agreements across Asia and the Pacific during 2000–2016, ADB (2016) analysis shows that arrangements that specifically provide for investor-related dispute mechanisms such as international arbitration clauses have large, positive, and statistically significant impacts on foreign direct investment inflows.12

17. In turn, greater business activity and private investment has been widely shown to positively contribute to improved economic growth outcomes. This robust body of literature harkens back to Khan and Reinhart’s (1990) disentangling of investment impacts on growth, establishing that private investment has a larger direct impact on economic growth relative to that of public investment, based on data from 24 developing countries.13

18. On PPPs, Lee et al.’s (2018) empirical results derived from a panel data of 19 developing economies from Asia and the Pacific—including Fiji—suggest that raising the ratio of PPP investment to GDP improves both access to, and quality of, infrastructure services. 14 Further, greater PPP investment also appears to be positively correlated with higher economic growth, partly through increased private investment, but such a result may be contingent upon adequate technical and institutional capacities to manage PPP contracts toward achieving desired development results.

12 ADB. 2016. ASEAN Economic Integration Report 2016. Manila. 13 Khan, M. and C. Reinhart. 1990. Private Investment and Economic Growth in Developing Countries. World Development 18 (1). 19–27. 14 Lee, M., X. Han, R. Gaspar, and E. Alano. 2018. Deriving Macroeconomic Benefits from Public-Private Partnerships in Developing Asia. ADB Economics Working Paper Series No. 551. Manila. August.