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