Information about Asia and the Pacific Asia y el Pacífico
Chapter

2 Public Sector Activities

Author(s):
Christopher Browne
Published Date:
August 2006
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Information about Asia and the Pacific Asia y el Pacífico
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Christopher Browne and Edimon Ginting

Large and pervasive public sectors characterize the Pacific island countries. Despite the fact that low levels of private sector activity limit the domestic tax bases, budgetary receipts in relation to GDP are substantial compared to other countries with similar levels of income per capita. For several countries this reflects nontax revenues, especially from fishing fees, but for most countries, this reflects the very high levels of external grants that are typically channeled through the public sector. Current expenditure is also large in relation to GDP, reflecting primarily high wage and salary bills, as well as financial support for public enterprises. Public investment is sizable, although it is almost entirely financed with external concessional assistance. Governance is an important issue throughout the region, especially in ensuring expenditure control.

Most countries in the region inherited a conservative approach to budgetary management upon independence in the 1970s and 1980s. For several years thereafter, fiscal policy aimed to achieve approximate budgetary balance over the medium term, in recognition that a more expansionary policy stance could contribute to balance of payments pressures. The avoidance of fiscal deficits depended crucially on maintaining the buoyancy of receipts and tight control over expenditures, although some countries experienced difficulties in restraining spending.

From the mid-1990s, more widespread fiscal pressures emerged, and most of the Pacific island countries recorded budget deficits. Marshall Islands and Micronesia found it difficult to adjust fully to step-downs in the level of Compact funding from the United States, and had only limited success in reducing their public sector wage bills.1 In Papua New Guinea, political uncertainties contributed during several periods to the lack of fiscal discipline. In Solomon Islands, substantial payments were made to militants through the budget during and after the period of civil conflict that broke out in mid-1999. Fiji sharply increased overall spending, with a view to promoting economic recovery following a military coup in 2000. Kiribati greatly expanded spending from about 2003, drawing heavily on its external reserve assets. The only important exception was Samoa, which has pursued a comprehensive economic reform program consistently since 1994.

This chapter focuses on the main fiscal policy challenges facing the Pacific islands that must be addressed to secure fiscal consolidation and satisfactory debt management. Specific actions to strengthen revenues and improve expenditure management should include: simplifying tariff regimes, including by reducing the level and number of rates; introducing a final withholding tax on wages and salaries; introducing a presumptive tax, based on turnover, for hard-to-tax small businesses or self-employed taxpayers; reducing the number of exemptions, particularly for the corporate income tax; eliminating tax holidays; instituting better debt management and general enforcement procedures; allocating adequate budget resources to tax operations; controlling public expenditure; redirecting spending toward health, education, and infrastructure; and implementing public expenditure management reform.

Fiscal Policy

The overriding objective of fiscal strategy is to promote economic growth while ensuring macroeconomic stability and careful debt management. This requires action in four key areas. The first is to enhance the efficiency of the tax system by improving administration, broadening the tax base, and reducing tax incentives. The second is to institute measures to limit the spillover to the fiscal accounts of highly variable nontax receipts, including longer-term agreements for fishing licenses. The third is to redirect spending from public sector wages and salaries to education, health, and infrastructure. The fourth is to improve budget-monitoring techniques to closely track all types of spending. For all Pacific island countries, another important area is to ensure the effective use of donor funding: over the medium term, external concessionary support may trend downward, at least from some key donors, and all efforts should be made to demonstrate to donors that aid funds are being used effectively and should be continued to the greatest extent possible.

Although many of the Pacific island countries continue to face difficulties with achieving fiscal consolidation, there were dramatic improvements in the budgetary situations of Papua New Guinea and Solomon Islands in recent years. Papua New Guinea reduced its deficit from nearly 6 percent of GDP in 2002 to 1 percent in 2004, as a result of decisively tighter control of expenditures, as well as a boost to mineral tax revenue from strong commodity export prices. The overall budgetary balance in Solomon Islands moved from a deficit of 10 percent of GDP in 2002 to an estimated surplus of 10 percent in 2004, following increased grants from Australia and other donors after the restoration of law and order in mid-2003 and a marked improvement in budgeting discipline. However, external support is expected to run down in due course and, without firm adjustment policies, renewed fiscal pressures could emerge in these countries.

The size of the public sectors in the Pacific island countries will probably diminish only gradually relative to GDP in the coming years, notwithstanding efforts to strengthen private sector activity, because deep-seated structural impediments will prevent any rapid transformation of these economies. In such circumstances, prudent debt management policy is a vital element of fiscal strategy, and debt sustainability should be among the countries’ medium-term objectives. Indebted countries such as Marshall Islands, Papua New Guinea, and Solomon Islands should steadily lower their domestic and external debt, as envisioned by the authorities, and should steadfastly avoid external commercial borrowing to finance the budget.

Several countries in the region have trust funds. Kiribati’s approach is to limit drawdowns from the Revenue Equalization Reserve Fund in order to keep per capita assets constant, which is appropriate given that donor funds are generally available to finance worthwhile investment projects. Marshall Islands and Micronesia will need to steadily build up their Compact Trust Funds through budgetary surpluses to comply with Compact II, which envisions the end of U.S. grant assistance after 2023. It is crucial that they initiate the required fiscal adjustments without delay in order to meet these goals.

Table 2.1.Selected Pacific Island Countries: Structure of Tax Revenue in FY2002(In percent of GDP)
FijiKiribatiMarshall

Islands
Micro-

nesia
PalauPapua

New

Guinea
SamoaSolo-

mon

Islands
TongaVanuatu
Income6.88.19.23.64.813.64.55.34.90.0
Goods and services8.80.03.35.18.85.212.46.63.110.3
International trade4.517.25.73.24.52.83.97.715.26.8
Other tax0.10.11.00.40.00.00.50.00.10.0
Total tax revenue20.225.519.212.318.121.621.219.923.317.2
Sources: National authorities and IMF staff estimates.
Sources: National authorities and IMF staff estimates.

Revenue Issues

The countries in the region need to strengthen their revenue efforts to face several critical realities. First, many countries have been heavily dependent on external grants, which are projected to gradually decline relative to GDP. Second, they face declining receipts from natural resources, particularly from fishing license fees, which have constituted a large but inconsistent source of government receipts in Kiribati, Marshall Islands, Micronesia, Palau, Samoa, and Tonga. These countries should seek to secure longer-term contracts and to obtain a greater share of royalties from foreign fishing fleets. In Papua New Guinea, revenue from the mineral and petroleum sectors is expected to decline in coming years, even if world prices remain high, as a result of tax concessions and resource depletion. Finally, tariffs and other trade taxes remain an important revenue source, particularly for Kiribati, Solomon Islands, and Tonga (Table 2.1). However, the commitment to trade liberalization in the Plan and the reductions in tariffs to take place under the Pacific Island Countries Trade Agreement (PICTA) and the Pacific Agreement on Closer Economic Relations (PACER) both have the potential to steadily erode such revenues.

Faced with these prospects, there is a need to accelerate efforts to efficiently mobilize revenue. First, a number of countries in the region rely on relatively complex tax systems, and priority should be given to reforms that make the tax system simpler, especially in income tax arrangements. Second, the countries in the region need to improve tax administration to enhance compliance and collection across the board. Such efforts might include greater use of self-assessment procedures for income taxes, development of comprehensive audit programs, assignment of a single taxpayer identification number, development of modern computer systems to streamline operations, and perhaps establishment of large taxpayer offices. Third, the tax base should be expanded in numerous countries in the region by reducing exemptions that are overly generous, especially for industrial park developments and foreign investment, which can be a source of corruption as they are generally nontransparent (Box 2.1). Only after these three tasks are completed should new tax opportunities be considered.

About half the countries of the region now have a value-added tax (VAT) or a consumption tax. During the 1990s, Fiji, Papua New Guinea, Samoa, and Vanuatu successfully implemented a VAT, with basic rates in the range of 10-12.5 percent, which helped compensate for the revenue lost through steady tariff reductions. Tonga introduced a consumption tax (similar to a VAT) in 2005. In general, the VAT has been reasonably administered in the region. However, administration could be improved by faster processing of rebates, improved compliance at ports (where most revenue is collected), and upgraded capacity for conducting audits. There may also be problems in some countries where the threshold is set too low so that businesses that do not keep detailed books of account are forced to pay the tax despite their inability to properly calculate their liabilities; a presumptive tax for them might be preferable.

Improvements in customs administration are needed to facilitate both trade and more efficient collection of customs revenues. Over the longer term, elimination of customs duties under the regional trade agreements (PACER and PICTA) and the increasing importance of a VAT or consumption tax will require improved procedures for collecting taxes on imports. Some of the larger economies, including Fiji, Papua New Guinea, and Samoa, have had automated customs systems in place for several years. Modernized procedures based on such automated systems have been newly implemented in Micronesia, are being implemented in Palau, and are planned for a number of the smaller countries in the region. Regional initiatives to this end should be supported, including through the Pacific Financial Technical Assistance Centre, the Pacific Forum, donors, and perhaps the Oceanic Custom Organization.

Expenditure Rationalization and Management Reforms

Public expenditure is quite high in the Pacific island countries, especially in Kiribati, Marshall Islands, Micronesia, and Palau. Because of the difficulties associated with increasing revenues and the expected decline in donor assistance, expenditures will likely take the brunt of fiscal adjustment. Strong action is needed to improve the quality of expenditure throughout the region, in order to contain fiscal pressures, increase fiscal flexibility, and promote higher growth. Governments must implement over the medium term reforms to improve the productivity of public spending, promote governance and transparency, reduce subsidies, avoid crowding out the private sector, and strengthen expenditure controls. The optimal composition of government expenditure will differ in each country, depending on the structure of the economy, the requisite service delivery, and the relative costs of inputs.

Box 2.1.Tax Incentive Issues in Selected Pacific Island Countries

The principal policy and administrative weakness of the current tax systems lies in the proliferation of exemptions—both statutory and discretionary— which undermine integrity and revenue-raising potential. One of the most harmful features is the prevalence of income tax holidays that are of questionable value in promoting investment.

  • Fiji: Incentives include investment allowances on capital expenditure in the agricultural, information technology, and hotel sectors; accelerated depreciation on buildings used for agricultural, commercial, and industrial purposes; tax holidays of 10-20 years for qualifying investments in the hotel sector; a deduction of one-and-a-half times the wages paid to qualifying employees; exemptions of export income at decreasing proportions until 2009; and a duty-suspension scheme for both duties and the VAT to exporters who import inputs to be used in production of exports.
  • Kiribati: At least 20 percent of imports (by value) is exempted. Most forgone customs duties come from the government (60 percent), aid projects (18 percent), and diplomatic missions (10 percent).
  • Papua New Guinea: Tax incentives operate at three levels. First, incentives are granted to a number of large companies in several sectors (mainly mining and oil). Second, incentives are granted to specific companies in targeted sectors, such as export-oriented activities and agriculture. Third, there are immediate deductions for some other private sector activities, including deduction of 20 percent of the cost of investment, free depreciation for manufacturers who install industrial plants, 100 percent exemption from income tax of net income attributable to export sales, and full deduction of certain investment expenditures for primary producers.
  • Solomon Islands: Incentive packages may be granted, including a 3- to 6-year tax holiday for manufacturing and export-oriented manufactures; a 5- to 10-year tax holiday for investment for approved overseas promotions fostering tourism; concessions for export businesses involved in agricultural produce, manufactured or processed goods, or fresh seafood; and additional incentives for capital expenditures on new or expanded factory space.
  • Tonga: There are many exemptions for government, quasi-governmental bodies, and the private sector under the Development Incentives Act. About 30 percent of the value of government imports and 37 percent of quasi-governmental imports were exempted.
  • Vanuatu: Discretionary tax exemptions are granted to selected industries, with the director of customs holding final decision-making power to grant exemptions. Goods eligible for possible exemption include imports for manufacture, agriculture, horticulture, forestry, inter-island shipping, tourism development projects, mineral exploration and extraction, fisheries, and other development projects.

Public Sector Wages and Salaries

In most countries of the region, public expenditure is dominated by current spending, a large proportion of which goes to public service wages. Although no dramatic, sudden changes are expected in the size of the public sector in these countries, maintenance of the status quo will not contribute to faster sustainable growth. There are obvious political sensitivities in downsizing the public sector, especially in light of the limited private sector employment opportunities, but it is important that incremental progress is made in this area.

A number of countries have promoted efforts over the past decade to reduce their civil service wage bills. This issue is especially important for Marshall Islands, Micronesia, and Palau, where the government wage bill is 20-25 percent of GDP, although the wage and salary bills are also high in other countries, at about 10-12 percent of GDP. Marshall Islands implemented a Public Sector Reform Program in 1996, following the step-down in Compact funding, which focused on reducing the public payroll, but these steps were subsequently reversed by an increase in wage rates. Micronesia cut the public wage bill in the context of a similar program during 1996-99, but these changes were also partly reversed. Papua New Guinea has made some progress in improving payroll administration, identifying ghost workers, and eliminating overpayment of allowances, and the government has announced a strategic plan for public sector reform, focused on downsizing the public sector by 10 percent by 2007. It is also committed to implement the recommendations contained in the World Bank-led Public Expenditure Review and Rationalization report, but much remains to be done. Solomon Islands is now restructuring the public sector with the help of external advisors.

Health, Education, and Infrastructure

Successful efforts to reduce less productive expenditure, including the wage bill, could enhance the scope for redirecting spending toward health, education, and infrastructure without undermining fiscal consolidation. This is important to promote longer-term sustainable growth, raise the skills of the workforce, and encourage private sector activities. While social indicators, such as life expectancy, literacy, and infant mortality, have improved in recent years in the region, overall standards remain disappointing, especially given the substantial aid programs directed to these matters.

Public Expenditure Management Reforms

Effective expenditure adjustments need to be supported by institutional reforms to improve the quality of public expenditure throughout the region. Closer links are required between the annual budgeting exercise and medium-term development strategies. At present, forward estimates of expenditure, when undertaken, tend to be unrealistic, especially the (under)estimates of operating and maintenance costs for capital projects. Budget formulation tends to be incremental and expansionary, whereas lasting expenditure reduction must be driven by a comprehensive review rather than piecemeal cuts.

There is a strong need to improve expenditure control and accountability mechanisms. Capacity building is essential to establish and manage appropriate internal control systems. Internal audits should be strengthened, and greater attention should be given to better and more timely reporting. Where appropriate, emphasis should be given to eliminating existing arrears and avoiding new arrears.

Samoa has made progress over the past decade a part of its comprehensive structural reform process, and this has enhanced both its recent growth rate and its prospects for achieving sustainable high growth over the medium term. Government current spending was reduced sharply and has remained low by regional standards, and sustained reforms were implemented in government financial management. Output budgeting was applied to all departments, and the government budget now provides detail on performance in order to assess the accountability and efficiency of government spending.

A number of other Pacific island countries have recently launched public financial management reform. However, implementation progress has been limited due to weak domestic capacities and governance issues. Fiji has renewed its commitment to financial management reform, in view of the escalating budget deficits since the 2000 coup and the difficult structural issues that need to be addressed in the textile and sugar industries. Papua New Guinea is strengthening its expenditure control systems to implement best international practice standards.

Public Enterprises

In most countries of the region, the government is closely involved in commercial activities. Public enterprises operate in areas that in most countries are left to the private sector, such as wholesale and retail trade, hotels, agriculture, fisheries, shipping, and airlines. The financial condition of most state-owned enterprises remains weak, and public enterprises have added to budgetary pressures. High wage costs, overstaffing, and management problems in the state-owned enterprises have been common. For public utilities, problems have often arisen from insufficiently flexible utility pricing policies.

Efforts to limit budgetary subsidy contributions to public enterprises are crucial. Privatization should be pursued, where feasible, but there may be limited interest among investors in loss-making enterprises, especially in the smaller Pacific island countries. To support efforts to reduce the size of the public sector, governments should avoid new spending initiatives for public enterprises, especially in industrial and commercial areas, and should leave such investment to the private sector whenever possible. For example, the joint airline arrangements with foreign carriers now in place for Samoa, Tonga, and Vanuatu should help limit budgetary costs.

Conclusions

The Pacific island countries must strengthen revenues and improve expenditure management in order to ensure fiscal consolidation and satisfactory debt management. As discussed in this chapter, these efforts should include simplifying tariff regimes; improving the efficiency of tax systems; allocating adequate budget resources to tax operations; instituting better debt management; controlling public expenditure; redirecting spending toward health, education, and infrastructure; and implementing public expenditure management reform.

1Both countries have been closely affiliated with the United States under the Compact of Free Association. Compact I, covering 19872001, provided grants to Micronesia that comprised about half of total GDP and to Marshall Islands at a similarly high level. Compact II, covering 200423, entails lower U.S. assistance.

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