Budget execution and financial management

128. Immediate emphasis had to be put on urgently upgrading budget execution and financial management in the MoF in order to provide donors with the fiduciary assurances they requested for realizing their pledges.

129. At the request of the AIA, in June 2002, the World Bank provided grant support for an Emergency Public Administration Project to fund the hiring of qualified international contractors in the areas of financial management, government procurement and audit, with the tasks of (a) assisting the authorities in the performance of these functions; and (b) building local capacities in order to hand over these functions to the authorities as soon as possible.

130. The financial management contractor hired by the government under the World Bank project developed with the treasury a computerized system for expenditure recording, payment processing and financial reporting for budget spending (“Afghanistan’s Financial Management Information System” or AFMIS). In order to deliver results immediately, the AFMIS did not change the procedures and functions specified in the Afghan regulations but only computerized the existing manual system using a simple software package. Starting in October 2002, the AFMIS has provided timely and reliable expenditure information on expenditures paid at the center, broken down by the source of funding (domestic revenues or grants), spending units, economic and functional classification; and it has also significantly accelerated the expenditure payments through the automation of the printing of checks. In the initial period, however, this system suffered from important limitations: (a) its coverage was limited to central government expenditures only, excluding revenues and nonwage provincial expenditures;⁶⁹ (b) no budget management facilities were available (appropriations, allotments, transfers); (c) expenditure commitments were not recorded; and (d) the system did not perform reconciliation between treasury information and central bank statements. To address these issues, the system’s functionalities were significantly expanded at the beginning of 2003/04 to include revenue information, reported provincial expenditures, and budget management functions. Although further improvements are still needed—especially with regards to recording financing sources for the operating budget, bank reconciliation and monitoring the development budget—the introduction of the AFMIS in a very short period of time critically improved expenditure management in the treasury and gave a concrete illustration of the authorities’ commitment to fiscal transparency. One of this project’s major achievements has been the progressive transfer of the AFMIS operations from the contractor to Afghan staff following intensive training and capacity-building.

131. In addition to the support provided to the MoF under the World Bank Emergency Public Administration project, the authorities have recently taken important steps to improve budget execution and reporting in the provinces. This task, which has received priority attention since the beginning of 2003/04, aims at moving away from the current impasse where (a) provinces do not report their nonwage expenditures to the center; and (b) the center, in the absence of provincial expenditure reports, refuses to transfer resources to the provinces. To do so, forty Afghan fiscal advisors have been trained in the MoF under USAID funding and sent to all provinces to assist them with financial reporting on both their revenues and expenditures. Six of them were assigned to the six provinces collecting the bulk of domestic revenues⁷⁰ to coordinate the activity of the other provincial advisors. Similarly, satellite communication facilities will be set up on a pilot basis in the largest of these provinces to facilitate exchange of information between the MoF and its regional offices (Mustufiats). The rolling out of AFMIS to the provinces has recently started and Herat’s Mustufiat is expected to be the first to use the system (by the beginning of October 2003). These initiatives have started yielding important and tangible results: in particular, whereas the Mustufiats did not report on their nonwage expenditures in 2002/03 (Chapter III), they have started doing so in 2003/04. However, fiscal reporting still requires improvement, especially on revenues, as there are solid indications that major provinces report less revenues than they collect and most provinces send their reports to the center with significant delays.⁷¹ The progressive consolidation of the provinces’ accounts into the accounts of the central government will help to address these issues (see next section).

Cash management and banking arrangements

132. Management of government cash resources is universally regarded as one of the central responsibilities of the MoF treasury. Cash management is a critical element of public resource management, especially in environments characterized by high demands on scarce public revenues. Government banking arrangements exert a strong influence on the ability of the treasury to effectively discharge its cash management responsibilities. Learning from international experience, most governments have opted for concentrating all government cash resources in a single bank account (the “Treasury Single Account”, or “TSA”) to strengthen treasury control over cash flows, reduce the cost of borrowing operations, and minimize idle cash balances.

133. While in theory Afghanistan was supposed to operate with a “TSA,” there has been, in practice, a proliferation of accounts in recent years that interferes with proper consolidation of cash resources, hinders prompt information on the government’s fiscal situation and leads to fragmentation of the budget revenues. The IMF has submitted to the authorities a progressive plan to consolidate the government’s accounts in the center and the provinces and eliminate the accounts of line-ministries which do not serve the public interest. In line with these recommendations, the authorities streamlined the number of MoF’s bank accounts operated at the center for domestic revenue and expenditures.⁷² Most importantly, they recently undertook a complete overhaul of the government’s banking arrangements in the provinces to improve revenue centralization. In August 2003, the treasury instructed the central bank to close all the provinces’ accounts and transfer their balances into two new accounts, one for expenditures and one for revenues, the latter being operated on a “deposit basis” only, meaning that provinces will no longer be authorized to draw on their revenue account to spend without explicit authorization from the MoF. The next step will involve ensuring regular consolidation of these accounts into the central government’s accounts and making timely transfers to the provincial accounts to allow provinces to make their expenditures according to their budget allotments.

134. The treasury does not currently undertake cash or financial planning. As a result, the MoF cannot inform the central bank of its in-year cash requirements, nor can it request donors to adjust their disbursement schedule according to government’s cash projections. This results in a lack of predictability in the resources made available to line-ministries, leading to delays and inefficiencies in budget execution. To address this issue, the treasury has recently established a cash-management unit charged with the responsibility for estimating revenue inflows, forecasting future disbursements, and developing an in-year cash-plan. However, the development of a full-fledged cash planning regime can only be envisaged in the medium term since this is a highly technical task, which will first require full introduction of a TSA and will need to be supported by extensive dedicated technical assistance.

Budget formulation

135. Significant support has been offered to the MoF and line-ministries for the preparation of the 2002/03 and 2003/04 budgets. The budget preparation for 2003/04 marked a vast improvement over the procedures followed in 2002/03 reflecting major efforts by the Cabinet, MoF, and line-ministries toward information compilation, strategy formulation, prioritization, and coordination. However, further progress is needed in terms of better integration between the ordinary and development budgets, quality of budget submissions by the line-ministries, revenue projection, construction of the macrofiscal framework to underpin the initial budget estimates, introduction of hard budget constraints at the beginning of budget preparation, and development of a medium-term fiscal framework.

136. Various donors have assigned a number of resident budget preparation experts to the MoF, whose tasks—in addition to hands-on support during the budget preparation process—focus on training, capacity building, and restructuring of the MoF Budget Department. This assistance, which has mainly dealt with the ordinary budget so far, has recently been expanded to the development budget, with the establishment of a development budget unit in the treasury supported by a budget resident advisor. Similarly, chief financial officers funded by the World Bank will be appointed to key line-ministries to enhance their budget formulation (and execution) capacities.

137. The IMF also intends to provide short-term technical assistance to assist the MoF with the establishment of a macrofiscal coordination unit, which will be responsible for coordinating macroeconomic forecasting and analysis with the central bank, Central Statistics Office (CSO), and other government agencies, making recommendations on fiscal and tax policy, and providing input into the budgetary process.

Coordination of external assistance

138. In a context where budget financing comes mainly from external sources and where a large number of multilateral and bilateral donors are involved in the reconstruction efforts, coordination of donor resources is of critical importance. The main instrument used by the authorities to avoid duplication of efforts and overlapping of donor projects, has been the preparation and adoption of the National Development Budget (NDB) through which most of the donor assistance has been channeled (Chapter III). In addition, the authorities established on April 1, 2002, the Afghan Aid Coordination Agency (AACA) as a public body within the government, to track the disbursement of foreign aid. The AACA’s primary activities include: (a) coordinating development efforts from bilateral and multilateral donors; (b) reviewing and endorsing projects and programs carried out by multilateral/bilateral agencies and nongovernmental organizations; (c) developing a comprehensive information system for tracking foreign assistance and monitoring development investments and programs; and (d) serving as secretariat for the Consultative Groups set up within the NDB. The AACA’s main achievement since its creation has been the development of a comprehensive donor information database recording the pledges, commitments, and disbursements from all donors.⁷³

139. In addition, in December 2002, the MoF established (with the support of the World Bank) a Grant Management Unit (GMU) within the treasury which is responsible for assuring that donor contributions are utilized as specified in the grant agreements and reported accordingly. The GMU will act as the repository and custodian of all grant agreements, authorize off-shore payments when government spending will not be channeled through the budget, maintain payment records, and report to donors and the MoF. The GMU is in its infancy and it is too early to determine what the real scope of its interventions will be, as the authorities have apparently decided to merge the GMU and AACA functions into a new department to be established in the MoF.

Customs policy and administration

141. As customs duties account for more than half of total domestic revenue collection, improving customs policy and administration has been one of the authorities’ top priorities. The 1974 customs law specifies the import duties, fees, and charges levied on international trade and transactions. The customs tariff includes 25 tariff bands with rates ranging from 7 percent to 150 percent allocated across 888 tariff headings (for an unweighted average tariff rate of 43 percent).⁷⁴ Duty is currently calculated on the c.i.f. Afghan value of imported goods, using artificially low exchange rates of Af 2 per U.S. dollar to Af 4.5 per U.S. dollar—compared with a market rate of about Af 48 per U.S. dollar (Box IV.1). In addition to the customs duties, there are a number of fees levied on imports, especially a 2.5 percent fee collected by the Chamber of Commerce for the valuation of imported goods (customs valuation is not currently performed by the customs administration but by the Chamber of Commerce). Although there is no excise tax, customs tariffs achieve the same result by imposing higher tariffs on certain goods that are not produced domestically and would normally be excised (automobiles, tobacco products). Imports of petroleum, diesel, and kerosene for transportation purposes are exempt from duty.⁷⁵

142. The use of different and artificially low exchange rates for customs valuation distorts the value of international trade, has a negative impact on revenue collection and creates uncertainty for traders and confusion for customs officers. Similarly, the extremely complex tariff structure is difficult to administer and is subject to corruption and abuse. In line with the IMF’s June 2002 recommendations, the MoF has prepared a draft presidential decree recommending the revision of the customs law with a view to (a) mandate the use of the market exchange rate of the Afghani in customs valuation; (b) reduce the number of tariff bands from 25 to 4;⁷⁶ and (c) lower the tariff rates from the current range of 0 to 150 percent to rates ranging from 0 to 20 percent. The streamlining and reduction of the tariff rates will partly offset the effect of the adoption of the market exchange rate on the average level of customs duties. This draft decree has been already extensively discussed with the interested parties (merchants and traders), who apparently received it favorably. Its adoption by the Cabinet is now imminent.

143. These customs policy reforms, which are key to enhancing revenue collection, will not be successful unless enforced by a capable and effective customs administration. However, customs administration is currently weakened by a lack of experienced managers, poorly trained staff, inadequate facilities and equipment, and outdated and cumbersome policies and procedures, all of which create avenues for potential corruption and abuse. In particular, customs regulations are apparently not applied consistently throughout the country and, in some cases, customs duties are “negotiated” between taxpayers and customs officers. Building on the June 2002 IMF recommendations, the authorities prepared—and adopted on July 4, 2003—a decree to immediately simplify customs procedures. The provisions of this decree include the (a) adoption of the internationally recognized “single administrative document” for customs clearance; (b) improved monitoring of exemptions; (c) progressive introduction of the harmonized tariff codification for commercial goods; (d) development of a comprehensive computerized data base for customs valuation; (e) establishment of a simplified customs regime for travelers; (f) licensing by the MoF of “customs brokers” to assist traders with the clearance of commercial goods; (g) the assignment of a taxpayer identification number (TIN) for each tax payer; and (h) gradual phasing out of the Chamber of Commerce involvement in customs valuation.⁷⁷ In addition, the Afghan Transitional Administration (ATA) has designed a comprehensive five-year plan to strengthen the administration of customs. This strategic document calls for a complete revamping of the customs department and its regional offices, training of customs officials, reform of customs procedures (including investigation, enforcement and controls), centralization of customs revenues collected by the provinces, and progressive rehabilitation of customs infrastructure, equipment, and communications. This plan covers the years 2003–3007 and has an indicative cost of around US$100 million, of which two thirds would be allocated to technical assistance. The opening in May 2003 at Kabul airport of a model customs house, featuring a renovated warehouse and training facilities, has been a first step towards the implementation of this strategy and the authorities plan to extend this pilot to all provinces by the end of 2003/04.

Tax policy and administration

144. Around half of the domestic revenues collected in 2002/03 are noncustoms tax revenues. Therefore, improving revenue mobilization will require—in addition to reforming customs—the establishment of a fair, transparent, and easy to administer tax system.

145. The existing tax regime is defined in the 1965 income tax law which provides for a progressive personal income tax (PIT) with rates varying from 4 percent to 60 percent, a flat 20 percent corporate income tax (CIT), a 2 percent business receipts tax (a form of sales tax on corporate entities’ turnover), withholding taxes on imports and exports, and various fixed (presumptive) taxes (Annex IV.1). It is currently difficult to ascertain all the details of the 1965 tax law and its application, since the law has been amended by 18 separate decrees and not all amendments have been included in a comprehensive consolidated version. In addition, tax administrators in the MoF and its financial regional offices (Mustufiats) have different views about the applicable tax provisions, which are not applied consistently throughout the country. In particular, a Taliban decree of May 1999 seems to have reformed the personal income tax to introduce three rates of taxation (1, 8, and 20 percent) together with a series of exemptions. It is unclear if these provisions are still currently enforced.

146. The tax law includes a number of serious deficiencies:

• The current rule imposing taxation of worldwide income on Afghan citizens wherever they live, leaves a large number of expatriate Afghans intending to return to Afghanistan with a potentially crippling legal tax liability on all the income they earned abroad. This tax provision creates disincentives for these individuals to return to Afghanistan and participate in the country’s reconstruction;

• The top marginal rate for PIT (60 percent) is too high compared to international standards and cuts in at a modest annual earnings level (less than half of the average annual salary), which hampers voluntary tax compliance and leads to massive tax fraud. In addition, the existing 32 tax rate structure is complex and difficult to administer;

• The coverage of the business receipts tax does not include certain services provided to expatriates and other high-income earners, resulting in revenue losses for the government;

• The current limitations of the loss carryover period and depreciation allowances for the payment of the CIT discourage investment. Liberalization of these regimes should be used to stimulate new investment.

147. In view of these deficiencies, the authorities are committed to amending the income tax law in order to improve the efficiency and equity of the tax system. In line with the IMF June 2002 recommendations, and with the support of resident tax advisors, the ATA is now preparing draft decrees to (a) impose the income tax on the basis of whether an individual is a resident or nonresident of Afghanistan; (b) reduce the top marginal tax rate for individuals from 60 to 25 percent and increase the personal exemption; (c) restore wage withholding on higher-income employees; (d) introduce a rent tax and an airport departure fee; (e) expand the business receipts tax to cover certain services most likely to be provided to expatriates and other high income-earners;⁷⁸ (f) extend the loss carryover period; and (g) liberalize the depreciation allowances allowed for tax purposes.

148. These tax policy reforms are closely linked to a program to strengthen the capacity of the revenue department in the MoF and improve tax operations in the Mustufiats. This plan includes the establishment of a large taxpayer unit (LTU) in Kabul by the end of 2003, responsible for administering the personal income tax⁷⁹, the business receipt tax and the rent tax. The Kabul LTU will then be complemented by model tax offices for medium-sized tax payers, in which new operational procedures and concepts would be piloted.

149. Although initial steps have been taken by the authorities to reform tax policy and administration, progress has been somewhat slower than in customs, due to the priority given by the authorities to the customs reform, limited technical expertise in the MoF, and the Cabinet’s reluctance to adopt a tax reform with potential vast social implications without an in-depth understanding of all its elements. However, a sizeable amount of technical assistance has been recently mobilized and decisions are expected to be reached by the Cabinet in this area by the end of 2003.

150. Without underestimating the burden put on the scarce MoF capacities by the finalization of the customs reform, it is essential that tax and customs reforms be closely coordinated. In addition, the revenue policy reforms envisaged by the authorities will not ease the pressures on the financing of the ordinary budget unless provinces, which collect most of the tax and nontax revenues, transfer their revenues to the center on a timely and regular basis. In this regard, the agreement recently reached with the provincial governors on this issue, is an important step toward effective centralization of revenues and improvement of revenue collection (see Chapter III).