1. INTRODUCING A REVENUE SHARING SYSTEM IN LAO PDR 1. Legal FrameworkArticle 36 of the Budget Law mentions as “division of Central and Local Budget Revenue Source”,“revenue apportioned between the central and the local budget”. Further, Article 34 of the Lawstates that “The Government determines the detailed budget revenues and expenditures of the localAdministrations in accordance with the laws and regulation”, and Article 39 detailed “the sources ofrevenues apportioned between the central and local level” and stipulates that “the apportionmentratios by type of revenue are decided by the Government”.The Revised Budget Law Implementing Decree of 14-02-2008 has clarified some of those points.Article 16 details the shared pool of revenues. Article 20 specifies that provinces can receive “generalgrant and earmarked grant” those funding “includes revenues apportioned between the central andlocal levels. 2. MethodologyAt an early stage the Ministry of Finance has opted for a revenue sharing approach to the problem ofapportionment of shared revenue between the central Government and the provinces. From theonset it was decided that the revenue sharing formula will be based on several indicatorsrepresentative of provincial budgetary needs.After reviewing all issues and options, it was decided that the methodology used will be based on (a)a policy framework, and (b) a macroeconomic model to test the revenue formula. 2.1. Policy FrameworkThe policy framework has been defined along a number of principals.The objectives to be achieved by the revenue sharing system have been defined as followed: The revenue sharing system should be a fair and transparent system for apportioning shared revenue between provinces on an equitable basis.
2. The System should aim at correcting horizontal imbalance between provinces, i-e existing disparities in fund allocation and spending per capita The System should be pro-poor with the aim of providing additional resources to the poorest provinces to accelerate their social and economic development. The System should provide incentives for improving the delivery of Government’s services, the provincial economic environment and good public finance management.Based on those principles, it was decided that the revenue sharing formula should have the followingcharacteristics: • The formula should use several indicators representative of the social and economic development in key sectors • The Formula should tend to correct gradually disparities between provinces over a several year period of time by providing a balance between revenue allocation based on population and transfers based on poverty alleviation strategy. • The Formula should not increase significantly the budget deficit. • The Formula should not reduce transfers made to any province under the previous budget law.Additionally, the revenue sharing system should be completed by a system of equalization grantsbased on the same principles and tied to a number of objectives such as revenue targets andimprovement of the Human Poverty Index. 2.2. The Macroeconomic ModelIn the absence of an updated Medium Term Financial Framework, a simple macroeconomic modelhas been developed to test various formulas. The model integrates all budget data since fiscal year2004-2005 and a number of assumptions to make projections for the next two years.It should be underline that the macroeconomic model has not been developed with the objective ofpredicting next years provincial revenues and expenditures but rather with the objective of ensuringthat the revenue sharing formula can apply under various budgetary circumstances such as high /low GDP growth, high / low inflation, etc.The Ministry of Finance is not in position at the moment to analyse in details provincial revenues andexpenditures, even less to understand provincial economy. With the introduction of revenue sharingand budget norms, the Ministry will feel the need to devote more resource to the analysis ofprovincial fiscal data in order to ensure that each provincial budget is in line with the national policy.
3. 3. Lessons learned from the macroeconomic modelUsing the macroeconomic model, a number of important lessons have been learned regardingchanges in revenue assignment, size of the shared pool, revenue disparities between provinces,expenditure disparities, impact of foreign investments, etc. 3.1. Changes in revenue assignmentThe Macroeconomic Model developed for testing the revenue sharing formula includes data from allfiscal year since 2004-2005. This model shows that there have been considerable changes in revenueassignment over the years.This table shows that shared revenues after knowing a sharp increase of 106% in FY 2005-2006 havedecrease to 23% of the previous year due to a change in the fiscal regime. Growth in 2007-2008 isslightly under GDP and we can assume that for FY 2008-2009 and FY 2009-2010 the shared revenuewill stabilize between 1.40 and 1.50% of GDP.1Changes in provincial revenues have been more erratic and cannot be fully explained by changes inrevenue assignment. There has been a sharp decline from 2.09% of GDP in FY 2004-2005 to 1.15% inFY 2007-2008. It will be essential to reverse this trend to make the new revenue sharing systemsustainable.1 The 2007-2008 figure for Shared Revenue does not include SOE revenues for Atapeu province as the figureswere not available. However, we believe that it can only have a minor incidence on the total number.
4. 3.2. Size of the shared pool and province revenue (100%)The change in revenue assignment has caused a reduction of the pool of shared revenues. Whereasin FY 2004-2005 and FY 2005-2006 provincial domestic expenditure were representing 40% of theshared revenue, in FY 2007-2007, the total shared revenue represents only 24.17% of provincialdomestic expenditures and the total provincial revenue 19.83%. That lives a structural deficit of 56%to be covered by equalization grant.Even Savannakhet province, that used to run an important budget surplus, under the revised budgetlaw, covers only 29.5% of its domestic expenditures against 48.9% for Vientiane Capital and 41.3%for Kammouane. Under the new revenue sharing system, the amount of shared revenue transferwould represent only 11.12%. Savannakhet would need receiving an equalization grant equal to 40%of its domestic expenditures.In that context, the new revenue sharing system will not affect significantly the provinces’ level offunding. Provinces will see the grant policy as more critical than the revenue sharing policy.The fact that domestic provincial revenues represent less than 20% of total domestic expendituresand shared revenues less than 25% reveals that the vertical imbalance that existed previously infavour of the provinces has been reversed in favour of the Government. In the short term, the newrevenue assignment system will facilitate treasury centralization and fiscal disciple, in the mediumterm (three to five years) the system will need to be revised. 3.2. Disparities in revenuesThe table below shows that important disparities in revenue exist between provinces. Whenprovinces have revenues covering less than 10% of their domestic expenditures they become dependon the central government for grant transfer and the revenue sharing system is politically and fiscallyundermined.Revenue assignments and poverty are not enough to explain such disparities. Room exists to improvetax collection in some of the provinces. Each province must develop a revenue policy. Equalizationgrants must be linked to revenue targets.
5. 3.3. Disparities in expendituresAs shown in the table below, although the Government has already made considerable efforts tocorrect them, disparities also exist in expenditures. However, the size of pool of shared revenue willnot allow the shared revenue system to play a significant role in reducing those disparities.
6. 4. Revenue Sharing Formula 4.1. Total Shared Revenue and Total Provincial AppropriationBecause the pool of shared revenue is small, the Total Provincial Appropriation (TPA) is equal to theTotal Shared Revenue (TSR). TPA = TSR 4.2. Component of the FormulaIt has been decided that the formula will be based on three components: Population
7. Land Area Poverty Index (a) Population is always a major factor for revenue transfer. Population growth needs also to be taken into consideration. According to the Statistic Office’s report on population, the average population growth in Lao PDR is 2.24% per year. Although differences in population growth and in migrations might exist from province to province, it is recommended to apply the same population growth ratio to all provinces for the next three years, until more reliable data are published. (b) Taking into consideration land area is a way for differentiating between densely populated provinces that will receive important transfer for population and provinces with low density population that might beneficiate from land area based transfers. (c) Revenue Sharing Formula must include a component that transfers funds to poor provinces with large fiscal deficits. Fiscal deficits can have several causes such low population density, low urbanisation, absence of large tax payers, of etc. In the case of Lao DPR the main cause is low social economic development resulting in the lack of taxable activities. Because of this lack of social economic development, we need selecting an indicator that not only will measure the degree of poverty, but by linking it to the budget will have a direct influence on the type of expenditure that can boost social and economic development. This indicator is the Human Poverty Index (HPI-1) which is available from the Statistic Office for all provinces. We will say more on the poverty index in the section on poverty based transfers.Based on this approach, the revenue transferred from the pool to the provinces will have threestreams: one stream based on population, one stream based on land area and one stream based onthe poverty index.Provincial Allocation = (Population Based Transfer) + (Land Area Based Transfer) + (Poverty BasedTransfer)4.3 Weight of the three revenue sharing componentsVarious transfer ratios have been tested using the Macroeconomic model. One of the criteria usedfor selecting the ratios is that the formula should not increase budget deficit or increase provincialbudget by more than 10% in one year. The introduction of a revenue sharing system has usually anegative effect on budget deficit because poor provinces received more funding while it is impossibleto reduce rich provinces funding. That negative effect can easily reach 10 to 15%. In the case of LaoPDR, there will be no deficit increase because the pool of shared revenue is smaller than the total ofdomestic provincial expenditures. However, we have tested the formula on the fiscal years 2004 to2006 when the pool was much larger and we have selected ratios that do not increase the total ofprovincial appropriation by more than 4%.
8. Land Area based transfers are high in country which have a high level of investments ininfrastructures which are relatively independent from population density such as roads, canals,electricity transmission lines, telephone cables, airports, etc. In the US or Australia, even desertsmust have roads while there is no population to pay for it. Such is not the case of Lao PDR, which hasa low level of infrastructures and does not need to maintain a large road network. For that reason itwas decided to give to the land area based transfer a low weighting of 10% of the total sharedrevenue.Following that first decision, it has been decided to divide the remaining 90% equally betweenpopulation based transfers and poverty based transfers, giving 45% for population based transfersand 45% for poverty based transfers. 4.3. Calculation of Population Based TransferThe Population based transfer is given by taking the percentage of the province populationcompared to the country population and applying it to the fund available for population basedtransfers.If we take the example of FY 2007-2008:Total Shared Revenue = 605 301.71Fund for population based transfer = (605 301.71 x 0.45) = 272 385.77
9. Luangphrabang province population is 437 055 inhabitants representing 7.24% of the totalpopulationLuangphrabang will receive 7.24% of the population based transfer fund: 272 385.77 x 7.24% = 19,722.36 (new table) 4.4. Calculation of the Land Area Based TransfersThe same principle applies to land area based transfers. The land area based transfer is given by thepercentage that represents the province land area compare to the national territory and applied tothe fund available for land area based transfers.If we take the example of FY 2007-2008:Total Shared Revenue = 605 301.71Fund for population based transfer = (605 301.71 x 0.1) = 60 530.17
10. Luangphrabang province land area is 16,875 square miles representing 7.02% of the nationalterritory.Luangphrabang province will receive 7% of the land area based transfer fund: 60 530.17 x 7.02% = 4 247.594.5 Calculation of the Poverty Based TransfersPoverty Based Transfers are slightly more complicated to explain because it uses the poverty indexthat needs to be explained.The Human Poverty Index (HPD-1)2 is an indication of the standard of living in a country, developedby the United Nations. It is a measure of the extent to which people in a country are not benefitingfrom development. The three components of HPI-1 are:2 HPI-1 is the poverty index for developing countries and HPI-2 is the poverty index for developed countries.
11. 1) Longevity - measured by the proportion of the population not expected to survive to the age of 40 years. 2) Knowledge - measured by the adult illiteracy rate. 3) Standard of living - a composite value measured by the proportion of the population without access to clean water, health services, and the proportion of children under the age of 5 years who are underweight.Investments in health, education and sanitation can easily improve the poverty index, making it agood instrument for budget allocation.In Lao PDR, the Statistics Office of the Ministry of Planning is responsible for publishing the HPI-1 byprovince. The last survey was conducted in 2005 and it has not been possible yet to check themethodology used.The two main constrains on the use of HPI-1 are periodicity and reliability.Periodicity: Using the HPI-1 in a revenue sharing formula supposes that the HPI-1 will be calculatedon a regular basis. A periodicity of three years is usually considered as good practice. Introducing theHPI-1 in the revenue sharing formula supposes that MoF will have an agreement with the Ministry ofPlanning for recalculating the index in 2009.Reliability: When read in a table, the poverty index appears as a very precise number; for example,1.17 for Vientiane Capital and 1.19 for Champasak Province, or 1.42 for Xiengkhuang and 1.43 forSavannakhet. Based on these indexes Champasak should get slightly more funds for poverty transferthan Vientiane Capital and Savannakhet slightly more than Xiengkhuang. However because at theprovincial level precise data are often not available and must be estimated, no one can be sure thatthe variations that we see are not affected by data quality. The Human Poverty Index is not a goodinstrument for budget fine tuning unless we can ensure that the same methodology is applied acrossall provinces and no data results from an estimate.
12. After testing various formulas on the macroeconomic model, it was decided that the poverty basedtransfer will not be a mathematical function of the poverty index and a more empiric approach wasadopted.Based on the second digit of the poverty index, provinces have been classified in 5 categories asfollowed:
13. This approach does not require frequent recalculation of the poverty index.Based on the simplification of mathematic formula, percentages of the poverty based transfer fundhave been assigned to each poverty level as follows:
14. (new table) 5. SummaryThe Revenue Sharing Formula can be summarized as follows:If TSR is the Total Shared RevenueIf PA is the Provincial AppropriationIf the population index (pop. Ind.) is Total population/ Province PopulationIf the Land Area index (LA.ind.) is Total Land Area/Province Land AreaIf the Poverty Transfer Ratio (p.t.r) is a function of the Human Poverty Index (HPT-1)Then we have the formula: PA= (LA. Ind.)(TSR x 0.1) + (pop. ind.)(TSR x 0.45) +(p.t.r)(TSR x 0.45)
15. 6. Consequences for the MoF and way forward(a) Revenue Sharing will give great importance to the analysis of economic and budgetary data from provinces. At the moment we cannot measure the GDP by province and we cannot explain variations in revenues and expenditures. As a result, we do not have any forecasting system for provinces. In future, MoF will need to devote more resources to the monitoring and forecasting of provinces revenues and expenditures.(b) The Ministry of Planning needs to be consulted as the revenue sharing might affect marginally investment policy.(c) The Revenue Sharing System must be implemented in parallel with a grant policy. Large size equalization grant might be given for covering operating expenditures and block grants for covering investments. However the grant policy must be linked to revenue targets and the development of specific revenue policy for each province.(d) An up-dated MTFF would considerably help the formulation of provincial budgetary policy including the grant policy.(e) The introduction of budget norms will be essential for the good functioning of the revenue sharing system.
16. (f) The Budget formulation process at the provincial level must be reformed to bring it in line with national policies.