ASIAN DEVELOPMENT BANK RRP: SRI 36168 REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE BOARD OF DIRECTORS ON PROPOSED LOANS TO THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA FOR THE FISCAL MANAGEMENT REFORM PROGRAM November 2004 CURRENCY EQUIVALENTS (as of 19 November 2004) Currency Unit – Sri Lanka rupee/s (SLRe/SLRs) SLRe1.00 = $0.01 $1.00 = SLRs104.9 ABBREVIATIONS ADB – Asian Development Bank ADF – Asian Development Fund BOI – Board of Investment CBSL – Central Bank of Sri Lanka CCPI – Colombo consumer price index CEO – chief executive officer DPL – development policy letter EA – Executing Agency FMRP – Fiscal Management Reform Program IICC – interagency implementation and coordination committee IRD – Inland Revenue Department IMF – International Monetary Fund IT – information technology LIBOR – London interbank offered rate LTU – Large Taxpayer Unit MIS – management information system MOFP – Ministry of Finance and Planning MRA – Modernizing Revenue Administration MTFP – Medium-Term Fiscal Program OCR – ordinary capital resources PAFMIS – Public Accounting and Financial Management Information System PAYE – pay-as-you-earn PC – provincial council PIU – project implementation unit PRGF – Poverty Reduction and Growth Facility RAMIS – Revenue Administration Management Information System TIN – taxpayer identification number VAT – value-added tax NOTES (i) The fiscal year (FY) of the Government and its agencies ends on 31 December. FY before a calendar year denotes the year in which the fiscal year ends, e.g., FY2003 ends on 31 December 2003. (ii) In this report, "$" refers to US dollars. This report was prepared by a team consisting of B. Carrasco (team leader), K. Lao-Araya and X. Peng. J. Zveglich supported the Mission during the early stages and was responsible for the preparation of the project preparatory technical assistance. CONTENTS LOAN AND PROGRAM SUMMARY i I. THE PROPOSAL 1 II. THE MACROECONOMIC CONTEXT 1 III. THE SECTOR: PERFORMANCE, PROBLEMS AND OPPORTUNITIES 3 A. Sector Description and Performance 3 B. The Government’s Reform Program 5 C. Issues and Opportunities 7 IV. THE PROPOSED SECTOR DEVELOPMENT PROGRAM 11 A. Objectives and Scope 11 B. The Program Loan 11 C. The Project Loans 24 V. PROGRAM BENEFITS, IMPACTS, AND RISKS 31 A. Benefits 31 B. Impacts 31 C. Risks 32 VI. ASSURANCES 33 A. Specific Assurances 33 B. Conditions for Loan Effectiveness 34 VII. RECOMMENDATION 34 APPENDIXES 1. The Government’s Fiscal Program 2. Fiscal Objectives and Reporting Requirements under the Fiscal Management (Responsibility) Act 3. Background Studies and Chronology of the Fiscal Management Reform Program 4. Development Policy Letter and Policy Matrix 5. Program Framework 6. Task List for the Modernization Program of the Revenue Administration 7. List of Ineligible Items 8. Revenue Administration Management Information System 9. Terms of Reference for the Strengthening of the Fiscal Management Institutions Project 10. Organization Chart of the Fiscal Management Reform Program Implementation and Coordination Arrangements 11. Planned Summary Projects Implementation Schedule 12. Indicative Procurement Packages 13. Summary Poverty Reduction and Social Strategy 14. Development Coordination Matrix SUPPLEMENTARY APPENDIXES (available upon request) 1. Sri Lanka-Economic Indicators, 1999–2003 2. Sri Lanka-Summary of Government Fiscal Operations, 1999–2004 3. Sri Lanka-Key Debt Indicators 4. Primary Balance and Debt Sustainability 5. Medium-Term Fiscal Program (2005–2008) 6. Sri-Lanka-Economic Classification of Revenue by Component 7. Sri Lanka-Economic Classification of Expenditure and Lending minus Repayment, 1998–2003 8. Expenditure and Revenues at the Provincial Councils and Intergovernmental Transfers 9. Summary of the National Budget Process 10. Summary of the Budget Classification System 11. Detailed Financing Plan 12. Consulting Service Selection Criterion LOAN AND PROGRAM SUMMARY Borrower Democratic Socialist Republic of Sri Lanka Proposal The proposed Fiscal Management Reform Program (FMRP) is a sector development program and comprises three loans. Two loans are from the Asian Development Bank (ADB) ordinary capital resources (OCR): (i) a program loan of $45 million to support fiscal management policy reforms; and (ii) a Modernization of the Revenue Administration (MRA) project loan of $15 million mainly for procurement of the Revenue Administration Management Information System (RAMIS). The third loan of SDR 6,672,000 ($10 million equivalent) from ADB’s Special Funds resources is a project loan for Institutional Strengthening of Fiscal Management Institutions through capacity building, including implementation of the FMRP. Classification Targeting Classification: General intervention Sector: Law, economic management, and public policy Subsector: Public finance and expenditure management Themes: Sustainable economic growth; Governance Subthemes: Promoting macroeconomic stability; Financial and economic governance Environment Category C Assessment Rationale The Government of Sri Lanka (the Government) is facing increasing fiscal stress from mounting and unsustainable fiscal deficits and a concomitant large public debt. Without meaningful fiscal consolidation, unsustainable current expenditure in combination with an impaired revenue administration will increasingly erode physical and social capital expenditures and crowd out private investment, preventing Sri Lanka from reaching a higher and sustainable path of economic growth. Under the circumstances, addressing the country’s weak public finances will be critical in order for the country to successfully fulfill its development objectives, including its evolving poverty reduction strategy. The Government has responded to the serious fiscal challenges by placing fiscal reform—and in particular revenue augmentation—at the forefront of its economic policy reform agenda. A three-pillar strategy has been adopted to strengthen public finances. This includes a revamped fiscal framework established under the Fiscal Management (Responsibility) Act, an enabling policy environment based on the overhaul and streamlining of taxation policy, as well as institutional strengthening of the revenue administration supported by the creation of a modernized revenue administration . The ii FMRP supports the Government’s strategy of fiscal consolidation compatible with medium-term fiscal sustainability. The thrust of the FMRP is on developing and implementing systems and procedures to ensure effective and sustainable compliance with fiscal objectives. The ADB assistance is expected to be complemented by an International Monetary Fund (IMF) Poverty Reduction and Growth Facility (PRGF) and Enhanced Fund Facility (EFF), currently suspended, that is likely to include taxation policy reform measures. The second tranche release of PRGF was originally due in December 2003. However, following political developments, including the dissolution of Parliament in February 2004 and the general elections of April 2004, the new Government is firming up key macroeconomic policies and is in discussions with IMF on the resumption of PRGF. Looking forward, the PRGF is not likely to be renewed before early 2005 following the Government’s 2005 budget and supporting economic policy framework action plans. Estimated FMRP December 2007 Completion Date Program Loan Objectives The FMRP supports the strengthening of public finances by improving public resource and expenditure management systems, promoting fiscal discipline, and supporting fiscal decentralization. To achieve these objectives, the FMRP will support: (i) improving effectiveness of tax administration, (ii) improving the budget framework, (iii) improving expenditure management and control systems, (iv) strengthening fiscal discipline, and (v) improving fiscal coordination. More generally, the FMRP will help create an enabling environment to foster mobilization of tax revenues, improve effectiveness of public expenditures and, ultimately, place public finances on a sustainable path. Financing Plan ADB will provide a loan of $45 million equivalent from OCR. The FMRP loan will have a 15-year term including a grace period of 3 years, an interest rate determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility, a commitment charge of 0.75% per annum, and such other terms and conditions set forth in the Program Loan Agreement. Period and Tranching The FMRP loan period will be 3 years from December 2004 to December 2007. The loan will be released in three equal tranches of $15 million each. The first tranche will be released upon loan effectiveness. The second and third tranches are expected to be released within 18 and 36 months, respectively, from release of iii the first tranche, subject to the satisfactory compliance with second and third tranche release conditions, respectively. Executing Agency The Executing Agency (EA) of the program loan will be the and Implementation Ministry of Finance and Planning (MOFP). MOFP will set up an Arrangements interagency implementation and coordination committee (IICC) headed by the secretary to the treasury and comprising representatives from the Fiscal Policy Department, National Budget Department, External Resource Department, National Planning Department, Public Enterprises Department, State Accounts Department, Revenue Board, Central Bank of Sri Lanka, and Finance Commission. ADB will also be a member of the IICC. The IICC will meet every quarter to monitor, coordinate, and ensure the effective