Policy Issues

Fiscal Management Issues

Post-Conflict Fiscal Management

The International Monetary Fund (August 2002) studied the fiscal effects of armed conflict and terrorism in low-and middle-income countries.⁶⁴ It found that there are three main ways in which armed conflict and terrorism can affect the fiscal account: by changing the composition of government spending; adversely affecting both the tax base and the efficiency of the tax administration; and influencing real economic activity (GDP) and therefore, government revenues. More specifically, the share of government revenue in GDP tends to fall during the conflict period, and to pick up in the immediate postconflict period.

Despite the collapse of the tax base following outbreaks of armed conflict in the 1990s in two African countries, after some years of peace and normal production the tax revenues managed to even exceed pre-conflict levels. On the expenditure side, in comparison to the pre-conflict period, government expenditures and net lending as a percent of GDP appear to increase significantly during the conflict period. These fiscal consequences have repercussions on economic growth, further affecting public finances. The high defense spending during the conflict period and in the years immediately preceding it tend to come at the expense of macroeconomic stability, reflected in a higher budget deficit and higher inflation. However, if internal security is achieved, defense spending can have a positive resource mobilization effect through augmented savings and investments. Since conflict is associated with lower real GDP growth, the implication is lower real per capita government spending on education and health.

The end of armed conflict can result in several different "peace dividends," releasing fiscal resources to be used for lowering the deficit, raising the allocation for spending in social sectors, or reducing taxes. This process helps to restore macroeconomic stability. However, successful post-conflict reconstruction takes time. It involves ensuring that grievances due to perceived biases in fiscal policies will be addressed, improving trust among the formerly warring parties, renewing the social contract, and rebuilding damaged infrastructure and institutions. Consequently, it is highly critical, especially in countries that have experienced prolonged conflicts, that the involvement of the international donor community continues and not be just one-shot assistance.⁶⁵

To maximize donor impact, it is essential that the government and the donor community consider, and act, with the awareness that donors have different respective comparative advantages in providing fiscal support. Furthermore, experience in the past reconstruction efforts has shown that the preferred approach is for each donor to provide support for a well-defined project, such as tax administration, expenditure management, or customs administration. In comparison to a situation where the resources are cobbled together from a variety of donors, a single-donor approach to a specific component encourages ownership and leaves no question about oversight to ensure the desired outcome. This strategy worked very well in Kosovo, where the US government provided the resources for establishing an institution with the same function as the ministry of finance. In contrast, funding for the same institution in Timor-Leste was provided by many different sources; it was difficult to achieve sustainability, and there was always a question about responsibility.⁶⁶

In general, the reform of fiscal policies and institutions lies at the heart of structural adjustment in developing countries, with the immediate aim to reduce fiscal imbalances and achieve macroeconomic stability. Efficient revenue mobilization can help the funding of public goods and services and help cut fiscal imbalances. Making revenue mobilization efficient requires reforms of the tax and tariff systems and their administration. The tax administration is usually reformed through the wider registration of taxpayers, simplification of procedures for taxing the informal sector, establishment of large-taxpayer units, and staff training and computerization. The appropriate sequencing of tax reform is important for the overall success of the reform strategy, especially given limited administrative capacity in developing countries. An early focus on implementing a value added tax (VAT), beyond its importance for revenue, may be justified in terms of motivating necessary improvements in overall revenue administration (IMF 1998). On the expenditure side, fiscal consolidation calls for reorienting public spending toward growth-promoting investment in physical infrastructure and in social and human capital.

Rebuilding the Fiscal Infrastructure in Afghanistan

The extent to which the above general observations apply to Afghanistan will have to be tested in the next few years during the course of the initial reconstruction phase. Wars and conflicts in the last four decades in Afghanistan have led to the discontinuance of budgeting, worsened the structural and macroeconomic problems of the economy, and distorted the composition of public spending, eroding the tax base and lowering the efficiency of the tax administration. The increase in defense expenditures has had a "crowding-out effect" on the resources available for private investment, and on public spending on sectors that could have had a strong and positive impact on growth. Since the majority of defense spending was on imported armaments, there were no positive supplyside spillover effects on the non-defense sectors. Since internal security was not achieved, the focus on defense expenditures failed to boost private savings and investments or attract foreign investment, and thus had a negative effect on the long-run sustainable growth rate.

The successful reconstruction of Afghanistan's fiscal management will take time, implying the reconstruction of fiscal institutions, generation of a sense of trust among the warring parties, and addressing possible perceived biases in fiscal policies. Due to the limited established representation of the authorities in the countryside, time is needed for the transitional government to bring about an appropriate apparatus for fiscal management. Given the extension of the central government's authority over the entire country, a substantial increase of revenue collections from both direct and indirect sources will follow. An expected fiscal effect of the decrease in civil conflicts will be falling military spending and a reduction of other related expenditures. It is important, however, that the distribution of public spending and tax burden are not perceived to be unequal, as critical opinions could have negative effects on the present armed conflicts. Developing a good system of revenue collection could have a positive effect on the process of strengthening national unity. To gain taxpayers' trust, the current government will need to deliver economic results. Support for fiscal management from the donor community will not only help bring a relative economic continuity, but also political stability.

The Ministry of Finance (MOF) requires support in the areas of policy setting, training, project implementation and donor coordination.⁶⁷ A fiscal policy analysis unit should be supported as a means to project revenues, analyze revenue options, coordinate macroeconomic planning with the Central Bank and other government agencies, simulate policy changes, make recommendations on fiscal and tax policy, and provide input into the budgetary process. This unit should assume responsibility for policy coordination with international donors, in particular the IMF, World Bank and ADB. It should also encourage the efficient spending of the development budget according to the national priorities set by the NDF.

Budget Execution and Financial Control⁶⁸

An immediate priority had to be placed on upgrading budget execution and financial controls in the MOF in order to provide donors with the fiduciary assurances they requested to realize their assistance pledges. In June 2002, the World Bank provided grant support for an Emergency Public Administration Project to fund qualified international contractors in the areas of financial management, government procurement and audit. The project's financial management contractor developed, along with the MOF Treasury Department, a computerized system for expenditure recording, payment processing and financial reporting for budget spending (known as Afghanistan's Financial Management Information System or AFMIS). In order to deliver immediate results, the AFMIS did not change the procedures and functions specified in the Afghan regulations, but merely computerized the existing manual system using a simple software package. Starting in October 2002, the AFMIS has provided timely and reliable information on expenditures paid at the center, broken down by source of funding (domestic revenues or grants), spending units, and economic and functional classification. AFMIS has significantly accelerated the expenditure payments through the automation of the printing of checks.

In the initial period, however, AFMIS faced several limitations: (i) its coverage was limited to central government expenditures, and not to revenues and non-wage provincial expenditures; (ii) no budget management facilities (appropriations, allotments, transfers) were available; (iii) expenditure commitments were not recorded; and (iv) the system did not perform reconciliations between treasury information and central bank statements. The system's functionalities were significantly expanded at the beginning of 2003/04 to include revenue information, the reporting of provincial expenditures, and budget management functions. Although further improvements are still needed—especially with regard to the recording of 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 provided a concrete illustration of the authorities' commitment to fiscal transparency. The project has been successful in progressively transferring AFMIS operations from contractors to Afghan staff following intensive training and capacity-building.

Since the beginning of fiscal 2003/04, the MOF has given priority to resolving the fact that provinces do not report their nonwage expenditures to the center; and the center, in the absence of provincial expenditure reports, refuses to transfer resources to the provinces. Forty Afghani fiscal advisors have been trained in the MOF under USAID funding and sent to all provinces to provide assistance with financial reporting on both revenues and expenditures. Six were assigned to the six provinces, collecting the bulk of domestic revenues⁶⁹ to coordinate the activities of the other provincial advisors. Similarly, satellite communication facilities will be set up on a pilot basis in the largest provinces to facilitate the exchange of information between the central MOF and its regional offices (Mustufiats). The rolling out of AFMIS to the provinces has recently begun, and Herat's Mustufiat is expected to be the first to use the system. These initiatives have begun to yield important and tangible results. For example, while Mustufiats did not report their non-wage expenditures in 2002/03, they have started doing so in 2003/04. However, fiscal reporting still requires improvement, especially on revenues, as there are indications that the major provinces report less revenues than they collect and that most send their reports to the center only after significant delays.

Fiscal accountability is inevitably constrained by the absence of or inadequacies of the statistical system. Capacity building for the development of a minimum of statistics is therefore critical for fiscal policy formulation and monitoring. The overall framework necessary for compilation exists, but the breakdown of the manual financing reporting chain has impeded the production of statistics. Once accounting procedures have been computerized and communications with the provinces are reestablished, it will be possible to resume the production of government finance statistics. While steps are being taken to computerize the accounting system, through for instance the installation and repair of computers in provincial offices, provincial staff must first be trained in computer operations. The plan is currently to computerize in three stages, with the first phase covering 10 provinces (6 large cities and 4 areas around Kabul).

Cash Management

While in theory Afghanistan was supposed to operate with a "Treasury Single Account," as do most governments internationally, there has been in practice a proliferation of accounts, interfering with the proper consolidation of cash resources, hindering prompt information on the government's fiscal situation and leading to the fragmentation of revenues. There is a need to consolidate the government's accounts in the center and the provinces and eliminate the accounts of line ministries. In line with IMF recommendations, the authorities streamlined the number of MOF bank accounts operated at the center for domestic revenue and expenditures, managing to reduce them from 26 to 2 excluding the specific accounts to track donor funded expenditures. Most importantly, in August 2003, the MOF treasury instructed the central bank (DAB) to close all the provinces' accounts and to transfer their balances into two new accounts, one for expenditures and the other for revenues, with the latter being operated on a "deposit basis" only. This means that the 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 the regular consolidation of these accounts into the central government's accounts and making timely transfers to the provincial accounts to allow provinces to make expenditures according to their budget allotments.

To address the issue of inadequate predictability of in-year cash requirements, the MOF treasury has recently established a cashmanagement unit charged with 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, as it is a highly technical task, which will need to be supported by external assistance.

Budget Formulation

The MOF and line ministries have received significant external assistance for the preparation of the 2002/03 and 2003/04 budgets. The budget preparations for 2003/04 marked a vast improvement over the previous year, reflecting great 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, the quality of budget submissions by the line ministries, revenue projections, construction of the macro-fiscal framework to underpin the initial budget estimates, introduction of hard budget constraints at the beginning of budget preparation, and the development of a medium-term fiscal framework.

Various donors, including ADB, have assigned a number of resident budget preparation experts to the MOF, and they are providing hands-on support during the budget preparation process as well as training and restructuring of the MOF budget department. This assistance, which 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. IMF also intends to provide short-term technical assistance for the establishment of a macro-fiscal coordination unit, which will be responsible for coordinating macroeconomic forecasting and analysis with the central bank (DAB), Central Statistics Office (CSO), and other government agencies.

Debt Management

During the two decades of war and conflict, Afghanistan fell into arrears in payments to the IFIs. Through significant international collaborative efforts, the arrears to ADB, World Bank and IMF were cleared by February 2003. Now Afghanistan has entered into new loans with these IFIs. On paper, there is a debt management unit within the Department of Treasury in MOF, but in practice, this unit has been inactive, with a U.S. Treasury budget adviser having to serve as the interlocutor with the IFIs to make sure that debt service payments are made in a timely fashion. There is an important issue of bilateral debt in arrears (especially to Russia) that must be addressed sooner or later. Capacity building in this area is an urgent issue.⁷⁰

Donor Fund Coordination

Since much of the ordinary budget and all of the development budget is currently financed externally, the coordination of donor resources is of critical importance. Afghan officials' efforts to date in this regard have been commendable. The main instrument to avoid the duplication of donor projects has been the preparation of the National Development Budget (NDB). The transitional government, led by the MOF and assisted by the Afghan Assistance Coordination Authority (AACA),⁷¹ launched a new aid coordination system in January 2003. It has streamlined previously fragmented donor consultations into a government-centered Consultative Groups (grouped by priority programs in NDF) and enhanced the country ownership of external aid. The new system is still in an experimental stage and the latest meeting was held in August 2003 in Kabul to discuss the lessons learned and improvements.

The first Afghanistan Development Forum (AfDF), held in March 2003 also in Kabul, brought various donor forums into a unified venue and was also used to announce the FY2004 (SY1382) consolidated recurrent and development budget. The AfDF is to be held in March every year. This shows the clear intent of the government to integrate all donor activities into a transparent budgeting exercise and to steer donor fund allocation according to the priorities set by the government.

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

Customs Policy and Administration

Collecting $200 million in domestic revenue in fiscal year 2003/4 will require strong and early implementation of the customs reform package. Furthermore, the MOF aims to fully finance the ordinary budget through domestic revenues by 2006. Meeting this ambitious objective will require increasing revenue collection from about $130 million in 2002/03 to $600 million in 2006/07. 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 key elements of the reform include using the market exchange rate for customs evaluation, streamlining tariffs, and strengthening revenue administration.⁷² Given the existence of functioning fiscal processes in the past, Afghanistan is not an institutional tabula rasa. Therefore, reforms should be built on existing institutional arrangements.

The 1974 customs law specifies the import duties, fees, and charges levied on international trade and transactions. The customs tariff includes 25 bands with rates ranging from 7 percent to 150 percent, allocated across 888 tariff headings. Duty is currently calculated on the c.i.f. Afghan value of imported goods, using artificially low exchange rates ranging between Af2 and Af4.5 per US dollar⁷³ – compared with a market rate of about Af48 per US dollar. In addition, there are a number of fees levied on imports, including in particular a 2.5 percent fee collected by the Chamber of Commerce for the valuation of imported goods. 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 (e.g. automobiles, tobacco products). Imports of petroleum, diesel, and kerosene for transportation purposes are exempt from duty, although there appears to be a "monopoly tax" on petroleum products equal to 20 percent of the import value.

The use of different and artificially low exchange rates for customs valuation creates uncertainty for traders and confusion for customs officers and has a negative impact on revenue collection. Similarly, the extremely complex tariff structure is difficult to administer and is subject to corruption and abuse. In line with the IMF's recommendations, the MOF has prepared a draft presidential decree recommending the revision of the customs law with a view to: (i) mandating the use of the market exchange rate of the afghani in customs valuation; (ii) reducing the number of tariff bands from 25 to 4 (0, 5, 10 and 20 percent); and (iii) lowering the tariff rates from the current 0-150 percent to 0-20 percent.

The customs administration, like other government offices, is currently weakened by a lack of experienced managers, poorly trained staff, inadequate facilities and equipment, all of which create the environment 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. To address this issue, the transitional government adopted on July 4, 2003 a decree to immediately simplify customs procedures including: (i) the adoption of the internationally recognized "single administrative document" for customs clearance; (ii) improved monitoring of exemptions; (iii) the progressive introduction of harmonized tariff codification for commercial goods; (iv) development of a comprehensive computerized data base for customs valuation; (v) establishment of a simplified customs regime for travelers; (vi) licensing by the MOF of "customs brokers" to assist traders with the clearance of commercial goods; (vii) the assignment of a taxpayer identification number (TIN) to each taxpayer; and (viii) the gradual phasing out of Chamber of Commerce involvement in customs valuation.

In addition, the government has designed a comprehensive 2003- 7 five-year plan, at an incentive cost of around $100 million, 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 the customs infrastructure, equipment, and communications. 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 2004.

Effective customs administration requires assisting provincial governors with their existing structures and links to ministries, including monitoring of goods in transit and clearance procedures and merchandise dispatch. As the Afghan economy develops, there will be an increasing need to gain custom revenues from the high-value goods currently banned on the ATTA negative list by Pakistan authorities. A short-term need for the Afghan customs is to improve cooperation with their Pakistani counterparts in efforts to reduce the level of smuggling of transit back to Pakistan. Medium-term improvements such as an introduction of a simple computerized control and record system will assist in strengthening the transit control system. This measure could help to reduce the current manipulation of the transit system.

Other Tax Policy and Administration

The existing tax regime is defined by the 1965 income tax law, which provides for a progressive personal income tax, with rates varying from 4 percent to 60 percent, a flat 20 percent corporate income tax, 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 (see Appendix 5, "Existing Tax Regime"). It is currently difficult to ascertain all the details of the 1965 tax law and its application, since it has been amended by 18 separate decrees and not all amendments have been included in a comprehensive consolidated version. 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.

The tax law includes a number of serious deficiencies: (i) the current rule imposing taxation of worldwide income on Afghan citizens wherever they live leaves a large number of expatriate Afghans with disincentives to return to Afghanistan; (ii) the top marginal rate for personal income tax (60 percent) is high compared to international standards and cuts in at a modest annual earnings level (less than half of the average annual salary), creating incentives for tax evasion and fraud; in addition, the existing 32-tax-rate structure is complex and difficult to administer; (iii) 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; and (iv) the current limitations of the loss carryover period and depreciation allowances for the payment of the corporate income tax discourage investment.

To address these deficiencies and to enhance tax efficiency, the MOF 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 on individuals from 60 to 25 percent and increase the personal exemption; (c) restore wage withholding for higher-income employees; (d) introduce a rent tax and an airport departure fee; (e) expand the business receipts tax to cover the services most likely to be provided to expatriates and other high income-earners (e.g., hotels, restaurants, telecommunications, rental vehicles); (f) extend the loss carryover period; and (g) liberalize the depreciation allowances allowed for tax purposes.

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 Mustoufiats. This plan includes the establishment of a large taxpayer unit (LTU) in Kabul, which will be responsible for administering the personal income tax, the business receipt tax and the rent tax. The Kabul LTU will then be complemented by model tax offices for medium-sized taxpayers, in which new operational procedures and concepts can be piloted. Although initial steps have been taken by the authorities to reform tax policy and administration, progress has been somewhat slow, partly due to the priority given to customs reform, and partly due to the Cabinet's reluctance to adopt a tax reform with the potential for vast social implications. However, a sizeable amount of technical assistance has been recently mobilized and decisions are expected to be reached by Cabinet in this area during 2003/04.