Chapter

III. Institution Building and Developments in the Fiscal Area

Author(s):
Milan Zavadjil
Published Date:
February 1997
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A. Institution Building

Following the “Agreement on the Gaza Strip and Jericho Area”5 of April 29, 1994, the PA had systematically begun to assume control of the basic public sector tasks that were performed by the Israeli Civil Administration during 1967–94. To meet these responsibilities, the PA needed to establish a system of institutions, and to raise the necessary resources to finance them. The strategy adopted in the institution-building process was as follows: when necessary, institutions were created to meet challenges that arose from the new arrangements but, whenever possible, existing institutions which could be expected to continue to function relatively efficiently in the new regime were maintained. In this way, limited resources would be applied to the most urgent needs.

The PA has assumed, on the revenue side, full responsibilities in the WBGS for the income tax and the VAT (on domestic transactions), and nontax revenues. In addition, as a partner in the de facto customs union with Israel, it participates in a revenue clearance system that administers customs duties, the VAT on Israeli-Palestinian transactions, petroleum excises, and income tax and health fees paid by Palestinian workers in Israel and in the Israeli settlements (see Box 4 for discussion of the revenue clearance system).

To minimize the risk of revenue loss associated with the transfer of powers, the PA has maintained, with minor exceptions relating to income tax rates, all earlier tax policies while focusing its main efforts on establishing a modern tax administration. Progress in improving the latter has been encouraging. By mid-1995, concrete steps were already being adopted to reverse the initial decline in revenue collection associated with the disruption in the tax administration immediately following the transfer of powers. By early 1996, 8 VAT and 8 income taxes offices had commenced full operations and the dissemination of taxpayer information, especially in the West Bank, had begun to improve considerably. More recently, the training of tax officers and the recruitment of staff have gathered pace while the documentation and computerization of a unified invoice system for the VAT, which was introduced in January 1995, were enhanced.

Other key steps to strengthen tax administration are also planned for the near future. Specific measures are the operationalization of large taxpayer units and the implementation of an issue-oriented audit strategy to maximize revenue productivity. Courts for resolving tax disputes are also in the process of being established.

Mirroring developments in the assumption of control of fiscal revenues, the PA has also gradually taken over responsibilities for public expenditures since April 1994. The most important functions of the PA are currently related to health, education, and security, which account for about 80 percent of recurrent expenditures.

Progress in institution building in expenditure management, after a slow start, also accelerated recently. Among the positive developments was the promulgation of a modern Organic Budget Law in 1996, which lays the foundation for rational expenditure management. In addition, a budget circular that provided guidelines for budgetary preparation was issued to line ministries, while Budget, Treasury, and Audit Departments were established, with several senior officials appointed by mid-1996. Finally, physical facilities such as offices and office equipments have improved markedly. However, recruitment in general has been hampered by the difficulties of bringing qualified Palestinians to work in the Gaza Strip, where much of the PA administration is located.

The PA has also undertaken to bring all revenues and expenditures, including revenues from PA commercial activities (particularly import monopolies), under the control of the Ministry of Finance by March 1, 1997. This is a crucial decision, as up to one-fourth of domestic revenues are currently being diverted to accounts outside of the Ministry of Finance, which has been putting pressure on the liquidity position of the Ministry of Finance; this lack of control by the Ministry of Finance (and the resulting incomplete data) has also impeded fiscal analysis.

Other steps envisaged for strengthening expenditure management in the near future are (a) the recruitment of additional staff in various departments where a clear organizational structure has been adopted, (b) the approval of financial regulations, including the Palestinian Monetary Authority Act and the Audit Law, (c) the placement of financial comptrollers in the line ministries under the control of the Ministry of Finance, and (d) the strengthening of recruitment procedures.

As the PA has not yet decided on its overall trade policy option,6 no significant customs administration capacity has so far been established, although the nucleus of the PA customs organization has been put in place. Nevertheless, measures which have recently been adopted to strengthen customs administration include a plan for the expansion of storage facilities at border crossing points to accommodate the expected growth in trade.

B. Fiscal Structure and Recent Fiscal Developments

Under very difficult conditions, the PA succeeded in 1996 to hold down the budget deficit to a moderate level. Confronted with continued high start-up costs in establishing a fiscal administration and the frequent border closures that affected revenue performance while imposing substantial additional government expenditures to alleviate the attendant economic hardship, the increase in the recurrent budget deficit in 1996 was kept to some 1 percent of GDP. Specifically, it reached 3.5 percent of GDP or US$112 million (Chart 4).7 The PA achieved this mainly by protecting revenue through further improving tax administration (as noted above) and by prioritizing expenditures. These measures should also lay the grounds for reducing the recurrent deficit to 1.5 percent of GDP in 1997, as envisaged under the draft budget, and for eliminating the recurrent deficit in 1998.

Chart 4West Bank and Gaza Strip: Fiscal Indicators, 1994-97

(In millions of U.S. dollars)

Sources: Palestinian and Israeli authorities; and IMF staff estimates and projections.

1/ According to 1997 budget.

Recurrent expenditures in 1996 were 24 percent (US$153 million) higher than envisaged under the budget, in part reflecting emergency expenditures to deal with the border closure. Of this amount, US$116 million was offset by better than expected revenue performance. The remainder was financed by a combination of modestly higher than envisaged external assistance and withdrawals from government deposits that were built up in 1995 when external financing exceeded the recurrent deficit. This enabled the PA to maintain its operations without incurring substantial arrears, although its bank position deteriorated significantly, reaching an overdraft of US$35 million at end-September 1996.8

As in the preceding year, revenues performed very strongly in 1996 due to the greater than expected improvement in tax administration outlined above, and particularly the superior performance of the unified invoice system. As a result, total revenue exceeded the budget target by about 21 percent to reach 20.7 percent of GDP. Since improvements in tax administration are still under way, in 1997, total revenue is projected to rise to about 23 percent of GDP or US$814 million (Table 5). Revenue collection from the clearance system has been strong and tax evasion appears to be limited in this area. In contrast to revenue clearances, revenue collections from domestic sources (tax and nontax) were below potential, mainly due to the lack of enforcement (notably penalties and tax courts) in the income tax area. Thus, notwithstanding recent improvements in tax administration, there is still scope for strengthening domestic revenue performance.

Table 5.West Bank and Gaza Strip: Revenue of the Palestinian Authority, 1995–97(In millions of U.S. dollars)
1995

Draft

Budget
1995

Est.
1996

Draft

Budget
1996

Proj.
1997

Draft

Budget
Revenue216.0424.9554.3670.1814.2
Domestic tax revenue84.7108.2136.6169.4205.1
Income tax26.244.431.945.755.8
VAT55.055.866.859.970.5
Customs duties2.77.38.226.337.5
Property tax0.70.70.60.81.0
Excises 1/----29.136.740.3
Other0.1--------
Revenue clearances101.4266.4346.8422.9513.1
Customs duties 2/16.318.930.686.0109.3
VAT 2/54.1191.9210.4221.8267.9
Petroleum excise 3/25.533.582.2100.8116.5
Income tax1.45.05.82.24.8
Health fees3.610.111.65.47.1
Other0.57.06.26.77.5
Nontax revenue29.950.370.977.896.0
Transportation fees7.811.126.414.322.5
Health insurance9.512.711.314.017.3
Health fees6.711.99.210.312.2
Other nontax revenue5.914.624.039.244.0
Sources: Palestinian and Israeli authorities; IMF staff estimates and projections.

In 1996, domestic collections of tobacco and alcohol excises were transferred to a bank account outside the control of the Ministry of Finance. In 1995, these collections were not included in the budget.

Estimates of clearance revenue from customs duties and VAT are based on data provided by the Israeli authorities. Estimates are gross of deductions made to settle utility and medical product arrears accumulated by the Palestinian Authority against Israeli suppliers.

In 1995 and 1996, petroleum excise clearance revenues were transferred to a bank account outside the control of the Ministry of Finance.

Sources: Palestinian and Israeli authorities; IMF staff estimates and projections.

In 1996, domestic collections of tobacco and alcohol excises were transferred to a bank account outside the control of the Ministry of Finance. In 1995, these collections were not included in the budget.

Estimates of clearance revenue from customs duties and VAT are based on data provided by the Israeli authorities. Estimates are gross of deductions made to settle utility and medical product arrears accumulated by the Palestinian Authority against Israeli suppliers.

In 1995 and 1996, petroleum excise clearance revenues were transferred to a bank account outside the control of the Ministry of Finance.

Box 5.Social Safety Net

In the WBGS, social assistance to help the poor is provided by the PA, as well as UNRWA, NGOs, and foreign donors. Two types of programs are available. First, a well-targeted, direct assistance program in the form of food vouchers or small cash transfers is in place to help vulnerable groups. It is estimated that about 170,000–180,000 people in poor households annually benefit from this program, which is co-financed by the PA, UNRWA, and NGOs. Second, public works programs, which have been intensified in recent years in response to the border closures, provide employment opportunities for unemployed workers. It is estimated that some 40,000 temporary jobs were created under this scheme in 1995 and 1996. The public works programs are predominately financed by UNRWA and other donors.

The gradual assumption of functions by the PA, coupled with the desire to strengthen security, and services in education and health, has resulted in a strong increase in the recurrent expenditure to GDP ratio to 24.1 percent in 1996, from about 10 percent of GDP in 1994. As the PA hardly intervenes in the economy and has virtually no debt, expenditures on subsidy or interest payments are negligible. Wages, however, represent a sizable portion of recurrent expenditures—51 percent in 1996—which is unusually high by international standards. The rest is made up largely of expenditures on materials and supplies which increased sharply in 1996 owing to continuing administrative start-up costs and emergency expenditures to offset the prolonged border closure, as outlined above (Table 6).

Table 6.West Bank and Gaza Strip: Expenditure and Financing Operations of the Palestinian Authority, 1995–97(In millions of US. dollars)
1995

Draft

Budget
1995

Est.
1996

Draft

Budget
1996

Proj.
1997

Draft

Budget
Total expenditure587.1682.0902.1995.3
Current expenditure443.7492.0629.3782.2866.0
Wages and salaries284.5304.3397.0401.3495.0
Civil service187.9193.8249.7247.6296.0
Police force96.6110.5147.3153.7199.0
Interest payments----2.23.10.3
Transfer to other governments16.616.916.322.025.0
Closure emergency programs 1/------23.0--
Other unbudgeted programs 2/------36.6--
Other budgetary expenditure 3/142.6170.8213.8264.2345.7
Other expenditure 4/------32.0--
Current balance excluding foreign––227.7–67.1–75.0–112.1–51.8
financed employment programs
Foreign–financed employment programs------53.1--
Current balance including foreign––227.7–67.1–75.0–165.2–51.8
financed employment programs
Capital expenditure143.4190.0272.8160.0
Of which: PMA capital10.0--------
Overall balance–371.1–257.1–347.8–325.2
Total financing225.4272.8
Domestic financing----
Foreign financing225.4325.0272.8266.8
Recurrent budget financing92.0135.0--53.7
Holst fund67.1114.3--29.7
EU24.920.7--19.0
Israeli clearance advance------5.0
Employment generation programs------53.1
Holst fund------28.8
UNDP/UNRWA/PECDAR------24.3
Capital expenditure133.4190.0272.8160.0
Grants133.4144.8208.0
Loans--45.264.8
Financing gap145.775.051.8
Memorandum item:
Settlement of arrears7.717.314.5--
Sources: Palestinian and Israeli authorities; IMF staff estimates and projections.

Costs of emergency programs related to the border closure including increased social assistance payments, the net cost of importing and distributing basic foodstuffs to alleviate market pressures, and budget transfers to the PA’s own–financed employment–generation programs.

Other unbudgeted programs include the operating costs of the Palestinian National and Legislative Councils, the operating cost of the new Gaza airport, and additional recurrent cost related to new administrative structures and functions.

Other budgetary expenditure estimates include deductions from clearance revenues made to settle utility and medical products arrears accumulated by the Palestinian Authority against Israeli suppliers.

These are closure–related expenditures from accounts not directly controlled by the Ministry of Finance.

Sources: Palestinian and Israeli authorities; IMF staff estimates and projections.

Costs of emergency programs related to the border closure including increased social assistance payments, the net cost of importing and distributing basic foodstuffs to alleviate market pressures, and budget transfers to the PA’s own–financed employment–generation programs.

Other unbudgeted programs include the operating costs of the Palestinian National and Legislative Councils, the operating cost of the new Gaza airport, and additional recurrent cost related to new administrative structures and functions.

Other budgetary expenditure estimates include deductions from clearance revenues made to settle utility and medical products arrears accumulated by the Palestinian Authority against Israeli suppliers.

These are closure–related expenditures from accounts not directly controlled by the Ministry of Finance.

The rise in the wage bill in 1996 mostly reflects the growth of PA employment and only to a very minimal extent that of higher wages—the last general wage increase of 10–15 percent was granted in January 1995. In fact, PA remuneration continues to be lower than in the private sector—though less so than in some neighboring countries—which has hampered recruitment in some areas. In contrast, the size of government employment has continued to increase rapidly. Civilian employment rose from 34,800 in December 1995 to 39,000 in September 1996 while police employment increased from 24,000 to 33,000 in the same period. The rapid growth in PA employment since 1994 reflects several factors including the assumption of employees of the former Israeli civilian administration, the determination of the PA to provide better services to the population, difficult security conditions, and, to a lesser extent, the efforts of the PA to reduce unemployment. Police wages, at 4.8 percent of GDP in 1996, are a particularly heavy burden for the PA.

Capital expenditures, estimated at US$160 million in 1996, were somewhat less than in the previous year. While this represents a significant share of GDP (4.9 percent), it is considerably less than pledged by donors and envisaged as necessary to revive the neglected physical and social infrastructure. The weak implementation performance, though worsened by teething problems on the part of the PA administration and donors, was largely a result of difficulties in the movement of goods and persons caused by the border closures. However, based on the conclusions of the Consultative Group meeting of November 19–20, 1996, efforts to accelerate the implementation of the public investment program, including through closer monitoring by the AHLC, are expected to be made in 1997.

While the PA has begun to adopt measures to trim the budget deficit, there remain structural issues that should be tackled if fiscal sustainability is to be achieved in the future.

  • Currently, there is no single, comprehensive social insurance scheme in the WBGS. While the autonomous Gaza Pension Fund has accumulated a substantial financial reserve, there is no segregated pension fund in the West Bank. There, modest employee contributions are merged with other PA revenues and the responsibility for covering any operating deficits rests with the PA. In addition, the PA is also in the process of creating a pension fund for the police. Unless an appropriate, consolidated pension scheme is developed, and the growth of PA employment is curbed, the net fiscal outlays for pensions are expected to rise sharply in the near future, thereby exerting mounting pressure on the fiscal position. The IMF is assisting the PA to address this issue.
  • Health, education, and some other services to refugees from Israel are currently provided by UNRWA. It seems likely that the provision of these services will gradually be assumed by the PA, which could put further pressure on its fiscal position.
5This was the first of several agreements that map out the systematic transfer of powers in the WBGS from the government of Israel to the PA, as noted above. This agreement transferred all agreed self-governing responsibilities and authorities in the Gaza Strip and Jericho areas. In December 1994, the Agreement on Preparatory Transfer of Powers and Responsibilities handed over to the PA five spheres of activity in the West Bank (health, education, social welfare, tourism, and direct taxation and VAT on domestic production). In addition, the Protocol on Further Transfer of Powers and Responsibilities handed over, as of September 1995, an additional eight spheres of activities in the West Bank to the PA. Lastly, under the Israeli-Palestinian Interim Agreement on the West Bank and Gaza, which supersedes all earlier agreements, all remaining spheres of activity, with minor exceptions (water and sewage), were to be transferred during the 18 months following the elections of the Palestinian Council in early 1996.
6See Section VI.
7In 1995, the recurrent deficit was US$67 million. Both 1995 and 1996 recurrent expenditures and deficits may be understated as they may include only partial expenditure information from accounts not under the control of the Ministry of Finance.
8The overdraft may have been collateralized by PA deposits not under the control of the Ministry of Finance.

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