Document of The World Bank FOR OFFICIAL USE ONLY PROGRAM DOCUMENT ON A PROPOSED GRANT (FROM THE TRUST FUND FOR GAZA AND WEST BANK)

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY PROGRAM DOCUMENT ON A PROPOSED GRANT (FROM THE TRUST FUND FOR GAZA AND WEST BANK) IN THE AMOUNT OF US$40 MILLION TO THE PALESTINE LIBERATION ORGANIZATION (FOR THE BENEFIT OF THE PALESTINIAN AUTHORITY) FOR A PALESTINIAN NATIONAL DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT V April 25, 2013 Poverty Reduction and Economic Management Department West Bank and Gaza Country Department Middle East and North Africa Region Report No.: GZ This document is being made publicly available prior to Board consideration. This does not imply a presumed outcome. This document may be updated following Board consideration and the updated document may be made publicly available in accordance with the Bank s policy on Access to Information.

2 WEST BANK AND GAZA FISCAL YEAR January 1 December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of April 22, 2013) Currency Unit US$1.00 New Israeli Shekel NIS WEIGHTS AND MEASURES Metric System ABBREVIATION AND ACRONYMS AHLC Ad Hoc Liaison Committee MoLG Ministry of Local Government CPAR Country Procurement Assessment Report MoSA Ministry of Social Affairs CTA Central Treasury Account NCDs Non-communicable diseases CTP Palestinian Cash Transfer Program NDP National Development Plan DA Dedicated Account NIS New Israeli Shekels DAC Development Assistance Committee OECD Organization of Economic Cooperation and Development DPG Palestinian National Development Plan PA Palestinian Authority Development Policy Grant EU European Union PCBS Palestinian Central Bureau of Statistics GDP Gross Domestic Product PFM Public Financial Management GoI Government of Israel PMA Palestinian Monetary Authority ICR Implementation Completion and Results PMT Proxy Means Test Report IEC Israeli Electric Corporation PRDP-TF Palestinian Reform and Development Plan Multi-Donor Trust Fund IDF Institutional Development Fund ROSC Report on the Observance of Standards and Codes IEG Independent Evaluation Group SG Strategy Groups IFMIS Integrated Financial Management SWG Sector Working Groups Information System IMF International Monetary Fund TAP Transition Assistance Program ISN Interim Strategy Note UN United Nations LDF Local Development Forum VAT Value-Added Tax LDP Letter of Development Policy WB World Bank MoF Ministry of Finance WB&G West Bank and Gaza MoH Ministry of Health Vice President: Country Director: Sector Director: Sector Manager: Task Team Leader: Inger Andersen Mariam J. Sherman Manuela Ferro Bernard G. Funck Orhan Niksic

3 WEST BANK AND GAZA PALESTINIAN NATIONAL DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT V TABLE OF CONTENTS I. INTRODUCTION...3 II. COUNTRY CONTEXT...3 A. POLITICAL CONTEXT...3 B. RECENT ECONOMIC DEVELOPMENTS...4 C. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY III. THE GOVERNMENT S PROGRAM AND PARTICIPATORY PROCESSES A. GOVERNANCE B. SOCIAL DEVELOPMENT C. ECONOMY D. INFRASTRUCTURE E. PUBLIC ACCOUNTABILITY F. CONSULTATIONS IV. BANK SUPPORT TO THE GOVERNMENT S PROGRAM A. LINK TO CAS AND BANK S MENA STRATEGY B. COLLABORATION WITH THE IMF AND OTHER DONORS C. RELATIONSHIP TO OTHER BANK OPERATIONS D. ANALYTICAL UNDERPINNINGS V. THE PROPOSED DPG V A. OPERATION DESCRIPTION B. POLICY AREAS VI. OPERATION IMPLEMENTATION A. POVERTY AND SOCIAL IMPACTS B. ENVIRONMENTAL ASPECTS C. IMPLEMENTATION, MONITORING AND EVALUATION D. FIDUCIARY ASPECTS E. RISKS AND RISK MITIGATION ANNEXES ANNEX 1: LETTER OF DEVELOPMENT POLICY ANNEX 2: OPERATION POLICY MATRIX ANNEX 3: FUND RELATIONS NOTE ANNEX 4: PUBLIC FINANCIAL MANAGEMENT AND FIDUCIARY ASPECTS ANNEX 5: COUNTRY AT A GLANCE (INCLUDES COUNTRY MAP) The PNDP Development Policy Grant V was prepared by a core team consisting of Orhan Niksic, Team Leader; Nour Nasser Eddin, Economist; Pierre Prosper Messali, Senior Financial Management Specialist; Nikolai Soubbotin, Senior Counsel; Samira Hillis, Senior Operations Officer; Soraya Goga, Senior Urban Specialist; Lina Tutunji, Procurement Specialist; Nadi Yosef Mashni, Financial Management Specialist; Basheer Ahmad Fahem Jaber, Consultant/Procurement Specialist; Maha Muhammad Bali, Program Assistant; Muna Abeid Salim, Senior Program Assistant. Guidance has been provided by Mariam Sherman, Country Director; Bernard Funck, Sector Manager; Udo Kock, International Monetary Fund (IMF) Resident Representative to the Palestinian Authority. This program document is the result of a close cooperation between the Bank staff and officials of the Ministry of Finance of the Palestinian Authority.

4 GRANT AND PROGRAM SUMMARY WEST BANK AND GAZA PALESTINIAN NATIONAL DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT V (DPG V) Borrower Implementing Agency Financing Data Operation Type Palestine Liberation Organization (PLO) (for the benefit of the Palestinian Authority (PA)) Ministry of Finance (MOF) of the Palestinian Authority Terms: Grant from the Trust Fund for Gaza and West Bank (TFGWB) Amount: US$40 million Standalone, single-tranche Main Policy Areas Key Outcome Indicators Program Development Objective(s) and Contribution to CAS The operation will focus on two specific policy areas: (a) strengthening the PA s fiscal position by undertaking reforms to (i) increase government revenues and (ii) improve the efficiency of public expenditures; and (b) enhancing governance and transparency in the public sector. Selected Key Outcome Indicators for 2013 are as follows (baseline is 2012): Domestic revenues from Value-Added Tax (VAT), customs, and income tax combined in 2013 have increased by at least 10 percent in nominal terms and are higher as a share of GDP compared to The 2013 central government nominal wage bill growth has not exceeded 4.25 percent (in Shekel terms) and is lower as a percent of GDP than the 2012 wage bill. The number of households in the vulnerable category has not exceeded 19,200. The share of outside referral costs to total public healthcare spending has decreased by at least two percentage points in 2013 compared to the 2012 figure of 31 percent. The conduct of public procurement is based on new implementing regulations to the Public Procurement Law, as well as on the National Standard Bidding Documents for Goods, Works and Consultants Services, and Procurement Manual. DPG V has been designed to support the achievement of the following development objectives in the context of the PA s National Development Plan (NDP): (a) strengthening the fiscal position by undertaking reforms to (i) increase government revenues and (ii) improve the efficiency of public expenditures; and (b) laying the institutional foundations for improved governance and transparency in the public sector. The operation will directly contribute to Pillar 1 of i

5 Risks and Risk Mitigation Operation ID the ISN, aimed at strengthening the institutions of a future state to efficiently manage public finances and ensure services to citizens. The NDP s success depends on parallel actions by the PA, the Government of Israel (GoI) and the donor community. The key risks are: A highly volatile and uncertain political situation, primarily due to the lack of progress in peace negotiations and the political split between the West Bank and Gaza. Dependence on large levels of donor aid, not only to finance recurrent budget expenditures but also as a driver of growth. Lower than expected economic growth due to external and internal stressors. Substantial fiduciary risks. The above risks cannot be fully mitigated by the current operation. However, the operation was designed to minimize the likelihood and the potential impact of some of the abovementioned risks. The proposed fifth DPG sends a strong signal to donors that the World Bank places great importance on progress of the NDP and that donors should continue to support it. Most importantly, the operation leverages around US$200 million per year in additional financing through the multi-donor PRDP Trust Fund, which the Bank administers. This mitigates the risk of declining levels of donor assistance to the PA s finances. A simple design and strong PA ownership of the reform program supported by this operation, which contribute to fiscal consolidation and consequently reduced reliance on donor assistance, are also mitigating factors. Fiduciary risks are mitigated through additional arrangements discussed in Chapter VI, Section D. On balance, the potential benefits of the operation justify the Bank s engagement despite the significant risks identified above. P ii

6 PROGRAM DOCUMENT FOR A PROPOSED FIFTH DEVELOPMENT POLICY GRANT TO THE PALESTINE LIBERATION ORGANIZATION (FOR THE BENEFIT OF THE PALESTINIAN AUTHORITY) I. INTRODUCTION 1. The proposed DPG V is a standalone operation aimed at supporting the Palestinian Authority (PA) in implementing some of the reform priorities under its National Development Plan (NDP) as well as some recently emerged reform priorities. 1 Against the backdrop of shrinking donor support in recent years and the associated fiscal challenges, the PA is making efforts to keep the NDP on track, while responding to some new reform challenges. The DPG V will provide support to the PA s 2013 budget in the amount of US$ 40 million. While this is a standalone operation, it builds upon the reform progress of the previous four DPGs in several policy areas. 2. DPG V will support the reforms designed under the NDP in two broad areas: (a) strengthening the PA s fiscal position; and (b) laying the institutional foundations for improved governance and transparency in the public sector. The operation supports efforts seen as crucial by the PA to overcoming the urgent fiscal issues, reducing the PA s reliance on foreign assistance for recurrent expenditures while increasing the efficiency of government expenditure programs. In addition, the operation supports improving governance and transparency in the areas that are important for better management of public finances. 3. DPG V, as envisaged in the Interim Strategy Note, remains a key instrument aimed at supporting the PA s strategic priorities, advancing the policy dialogue, and also providing essential financing for the PA s budget. Given the severity of the political situation, in particular the constraints to the PA s authority in Gaza, it receives few revenues from Gaza. Public sector investment and growth are constrained by various restrictions imposed by the Government of Israel (GoI), and donor assistance continues to provide a life line to the PA s budget. The financial significance of this operation is not only in that it provides US$ 40 million in Bank financing, but that it directly leverages the support of other donors through the PRDP Trust Fund in the amount of roughly US$ 200 million per year. The operation also provides a positive signaling effect to other donors who provide assistance directly to the PA. II. COUNTRY CONTEXT A. POLITICAL CONTEXT 4. There has been no recent progress on the Israeli / Palestinian political dialogue, and peace negotiations have been on hold for a period of three years. Palestinians continue to refuse negotiations until Israel halts all settlement activity in the West Bank and East Jerusalem, while the Government of Israel has continued to expand settlements at an increasing rate. Despite strong opposition from Israel, the PA submitted a new application to the United Nations (UN) General Assembly seeking recognition as a non-member state, after failing to secure full membership the previous year. The UN General Assembly voted in favor of this application on November 29, The positive vote opened the door to the Palestinian Authority to apply for membership in different UN agencies but put a further strain on its relationship with Israel. Israel unexpectedly suspended 1 New reform priorities are related to heightened fiscal challenges, which are primarily the result of faster-thananticipated reduction in the levels of donor aid flows. Details of the support program are discussed in Chapter V. 3

7 payments of clearance revenues collected on behalf of the Palestinian Authority in December 2012 and remitted lower than accrued amounts in January, February and March to collect utility and other debts owed to it by different entities of the Palestinian Authority. 2 Recent diplomatic moves are receiving considerable attention and some are optimistic that the peace process will restart. 5. Reconciliation talks between Fatah and Hamas were recently revived, but no final agreement has yet been reached. The military confrontation between Hamas and Israel that took place in November 2012 rekindled internal calls to end the Palestinian divide. The Palestinian President Mahmoud Abbas and the Hamas leader, Khaled Meshaal, met in Cairo last January and agreed to renew efforts to implement the unity deal that was signed two years ago. Among other things, they agreed to form a national unity government headed by Abbas and to hold the long overdue presidential and parliamentary elections. The two sides have since showed signs of good will and allowed rallies supporting each other s parties in the West Bank and in Gaza for the first time since the 2007 divide. Hamas also permitted the central election committee to resume the registration of voters in the Gaza Strip. Recent statements by both parties, however, confirm that they have not yet agreed on a joint program to end the institutional division. Furthermore, disagreements over which party should be in charge of organizing the elections continue to stand in the way of a final unity deal. The Palestinian Legislative Council has not been operational since the internal divide emerged. This has made the reform process increasingly difficult as Presidential decrees to pass laws are used sparingly. 6. The Arab Spring has added new variables to the Palestinian-Israeli equation. Revolutions in the region have signaled the risk of the status quo to both Palestinian and Israeli leaders. Events in Egypt placed uncertainty on the future of Arab states relations with Israel, while the unrest in Syria could have implications for the support to the political party of Hamas, which forms the de facto authority in Gaza. Moreover, these events in the region further complicated the peace process. 7. Civil unrest and repeated civil service strikes have recently added to the complex political situation. In September, Palestinian protestors took to the streets of the West Bank to demonstrate against the rising cost of living. Protests began after the four percent increase in fuel prices that came into force in early September 2012, in line with a recent price hike in Israel. The PA has also raised the VAT rate from 14.5 to 15 percent following an increase in the VAT rate in Israel. 3 These measures immediately translated into higher prices for Palestinians whose real wages had already declined by almost 3 percent in In addition, more than 154,000 civil servants have been on regular strikes to protest against frequent delays in their salary payments, which have been paid in tranches since June This has led to a decline in the quality of public service delivery in the West Bank and Gaza (WB&G). B. RECENT ECONOMIC DEVELOPMENTS 8. After growing at an annual rate of 11 percent during , growth of the Palestinian economy has recently slowed down significantly. According to the Palestinian Central Bureau of Statistics (PCBS), the real GDP growth rate in the West Bank and Gaza declined to 5.9 percent in 2012, as growth dropped both in Gaza and the West Bank. For instance, between 2010 and 2011, Gaza was growing at an average annual rate of 15 percent. This high growth rate reflected the low base from which it started and could be attributed to a combination of higher aid inflows, the 2 The Government of Israel has publically stated that it is not withholding revenues from the Palestinian Authority, but that it is deducting utility and other debts owed to it by different public agencies of the Palestinian Authority. 3 The Paris Protocol of the Oslo Peace Accords indicates that the PA will maintain its VAT rate within two percentage points of that in Israel and that the differential in oil derivative product prices should not exceed eight percent. 4 PCBS estimates. 4

8 easing of restrictions on entry of goods from Israel, and increased imports through tunnels from Egypt. In 2012, however, Gaza s growth rate dropped to 6.6 percent. This is attributed to the waning of the rebound effect and to a strong decline in the agriculture and fishing sector due to frequent electricity blackouts and unfavourable weather conditions. Growth in the West Bank has mainly been driven by an expansion of the services sector, particularly real estate activities, health, and education in addition to wholesale and retail trade. Average real GDP growth in the West Bank exceeded 9 percent between 2010 and 2011, but it declined to 5.6 percent during 2012 reflecting lower donor aid and the absence of further progress in easing of restrictions on internal movement and exports. Consequently, growth in the exports of goods accounted to a mere 3 percent in nominal terms. Table 1: Selected Macroeconomic Indicators for the West Bank and Gaza, Estimate Projections Output and prices (Annual percentage change) Real GDP (2004 market prices) West Bank Gaza CPI inflation (period average) CPI inflation (end of period) Investment and saving (In percent of GDP) Gross capital formation, of which: Public Private Gross national savings, of which: Public Private Saving-investment balance Public finances (commitment basis) (In millions of US$) Total net revenues Recurrent expenditures and net lending Recurrent balance Overall balance (before external support) Monetary sector (Annual percentage change) Credit to the private sector Private sector deposits External sector (In percent of GDP) Exports of goods and nonfactor services Imports of goods and nonfactor services Net factor income Net current transfers Private transfers Official transfers Current account balance (excluding official transfers) Current account balance (including official transfers) Memorandum items: Nominal GDP (in millions of US$) Per Capita nominal GDP (US$) Unemployment rate (average in percent of labor force) Sources: MoF, IMF and WB staff estimates. 9. The decomposition of recent growth trends in the West Bank and Gaza underscores the importance of aid in driving the economy. Most of the growth witnessed over the last years was in the public and non-tradable sectors and was driven by donor-supported PA expenditures. To illustrate, public administration and defence and other public services 5 grew from 20 percent of GDP in 1994 to 25 percent in 2012 (Figure 1 below). Meanwhile, the manufacturing and agriculture sectors, constrained by the Israeli restrictions on movement and access, declined from 19 to 10 percent and 13 to 5 percent respectively. The pattern was similar in both the West Bank and Gaza. 5 Including health, education, water and electricity. 5

9 Figure 1: Structure of the economy changed drastically away from the tradable sectors. Figure 2: In recent years, consumption was the main driver of growth. 30% 25% 20% 15% 10% 5% 0% Consumption Investment Net Exports Sources: PCBS, national accounts data. 10. Economic activity in the private sector has not expanded sufficiently to enable the PA to significantly reduce its dependence on donor aid. On the contrary, the restriction system put in place by the GoI continues to stand in the way of potential private investment. 6 Movement into and out of the West Bank remains severely constrained, and Area C, which makes up about 60 percent of the West Bank territory, is still off limits to almost all Palestinian development. 7 Businesses in the West Bank are hurt by the tight restrictions on import procedures including the sizeable list of dual use items that cannot be imported because the GoI views them as security threats 8. Restrictions on visas for foreign investors and tight restrictions on access to resources such as water and the electromagnetic spectrum are some of the other constraints affecting private investment. Access to Gaza remains highly controlled, and only consumer goods and construction material for donor supervised projects are allowed in. Exports from Gaza are also prohibited, except for certain agricultural products. In sum, the conditions for sustainable economic growth have not been put in place. 11. The recent slowdown in economic growth has also been reflected in higher unemployment levels, especially among the youth. When compared to Q4 2011, the overall unemployment rate in the West Bank and Gaza increased by 2 percentage points to reach 22.9 percent in Q In the West Bank, unemployment increased to 18.3 percent even though the labor force 6 The Government of Israel states that these restrictions are necessary for security purposes. 7 The 1995 Interim Agreement between the Palestinian Liberation Organization (PLO) and the Government of Israel (GoI), Chapter 2, Article XI, 3c, divided the West Bank into three areas under different jurisdictions; Areas A, B and C. Area A represents 18 percent of the West Bank and is under full Palestinian security and civil control and consists primarily of urban centers. Area B comprises 21 percent of the West Bank and is under Palestinian civil control and Israeli security control and includes mostly peri-urban areas and small towns. Area C was defined by the Interim Agreement as "areas of the West Bank outside Areas A and B, which, except for the issues that will be negotiated in the permanent status negotiations, will be gradually transferred to Palestinian jurisdiction in accordance with this Agreement. 8 The dual use list contains goods, raw materials and equipment that in addition to their civilian use can be utilized for military purposes, and therefore cannot be imported by Palestinian businesses. Dual use trade restrictions are not uncommon internationally and may serve legitimate security concerns. The list of dual use items, the import of which to West Bank and Gaza is banned by GoI, is relatively extensive. Consequently, these restrictions raise the cost of inputs and force Palestinian businesses to use an inefficient input mix and in some cases drop certain product lines. Most Palestinian industries are negatively affected by the dual use list, particularly food and beverage, pharmaceuticals, textiles, ICT, agriculture and metal processing. 6

10 participation rate decreased from 47.3 to 46.1 between Q and Q Gaza s unemployment rate continues to be amongst the highest in the world at around 32.2 percent in Q with a labor force participation rate of 40 percent. Youth unemployment continues to pose a serious concern. In the West Bank, only 40.3 percent of young Palestinians aged were active participants in the labor force in Q4 2012, and 27.9 percent of those were unemployed. In Gaza, the youth unemployment rate was 48.9 percent with a participation rate of 34.2 percent. The persistence of high unemployment reflects the skewed nature of growth with the expansion of the labor intensive sectors, in particular manufacturing, constrained by the Israeli trade restrictions. Palestinian youth feels highly discouraged from joining the labor force because of the lack of opportunities. Previous to the year 2000 when the second Intifada broke out, a large portion of Palestinian youth was employed in Israel. However, Israel s share in the overall West Bank and Gaza employment has declined from 21 percent in 2000 to around 12 percent 9 since Box 1: Poverty in the West Bank and Gaza Almost 26 percent of Palestinians lived in poverty in The overall figure at the national level masks a wide regional divergence. In Gaza, the poverty rate was 39 percent, which is more than twice as high as that in the West Bank at 18 percent. This regional contrast was driven by the severe economic shock that hit Gaza following the internal divide, which led to a dramatic poverty increase in 2007, leaving one in two Gazans living below the poverty line. Similar to other countries, larger households in the West Bank and Gaza tend to suffer from higher poverty levels. In 2011, the highest poverty rate of 50 percent was amongst individuals who are part of households comprising 10 or more members. Additionally, the incidence of poverty amongst households headed by civil servants was ten percentage points less than those headed by workers in the private sector. This is explained by the ongoing strain on private sector activity caused by the Israeli restrictions. Notably, social transfers have continued to play a key role in reducing poverty levels, especially in Gaza. In the absence of all social programs, the official poverty headcount rate in 2011 would have been 11 percentage points higher. If these social payments were to be reduced or discontinued, it is expected that a large number of households would fall back below the poverty line. 12. Average inflation for the West Bank and Gaza was contained at 2.8 percent in In the West Bank, the average CPI increased by 4.1 percent when compared to 2011 mainly due to increases in the VAT and fuel prices. The PA raised the VAT rate from 14.5 to 15 percent in September 2012 following a hike in the VAT rate in Israel. The PA also raised the price of certain fuel products by 4 percent after fuel prices in Israel were increased. These measures have immediately translated into higher prices for Palestinians, but not in Gaza. Gaza s inflation, at 0.5 percent, continues to be lower than the West Bank s due to lower prices of petroleum and other products imported through the tunnels from Egypt, as well as increased and diversified imports of cheaper consumer goods and foodstuffs as a result of the easing of Israeli restrictions. 13. In recent years, the PA has succeeded in substantially reducing the recurrent budget deficit. The Bank estimates show that the deficit has dropped from as much of 23.7 percent of GDP in 2007 to 14.2 percent of GDP in The trend from the earlier years was reversed in 2012, as the deficit increased by 1.1 percentage points. This is largely due to the slowdown in growth from 12.2 to 9 This figure does not include any workers from Gaza because movement of Gazans into Israel has been completely banned since the year 2000, following the second Intifada. 7

11 5.9 percent in 2012, the failure of the government s optimistic revenue forecast to materialize, and the doubling of net lending, the growth of which was commensurate with the deficit increase The PA has been making efforts to strengthen domestic revenues performance, but the results of these efforts have not substantially materialized yet. Raising income tax revenue has been a key aim for the PA. Several measures were taken during the current year which raised income tax revenue to 1.7 percent of GDP in 2012 from 1.5 percent in These measures include raising the income tax rate on high income categories from 15 to 20 percent, effective January Additionally, income tax exemptions for 15 of the leading private sector companies were suspended for a period of two years ( ). More recent efforts by the PA have been focused on modernizing the tax administration system, widening the tax base and improving compliance. Work is currently underway to unify the structure of the tax administration and strengthen the Large Taxpayer Unit (LTU). The PA has also been discussing with the GoI methods for enhancing clearance revenues procedures given their importance as the PA s main source of income representing around two thirds of total revenues. The two parties have already exchanged letters specifying precise steps; however, no final agreement has yet been reached. 15. The PA has also made significant progress in reducing government spending. Recurrent public expenditure already fell from 48 percent of GDP in 2009 to 34 percent in 2012 (see Table 2 below). The PA has recently adopted additional measures aimed at controlling the wage bill, the largest spending item, representing 50 percent of current expenditure. These include a complete hiring and promotions freeze that was announced on August 25, 2012 by a presidential decree to be followed by a net zero hiring policy in The PA has also applied cuts to the salaries of high ranking employees, and has cancelled all abroad travel allowances. As a result, the wage bill was reduced from 26 percent of GDP in 2006 to 17 percent in 2012 (Figure 3 below). 10 Net lending stems from Israel s deductions from clearance revenue payments to the PA on the account of debts owed to it by the Palestinian power distribution companies, other utility companies and municipalities for purchased electricity and water services. 11 This figure is still below the 3-4 percent of GDP rate in other developing countries in the region such as Jordan and Lebanon. 8

12 Table 2: Central Government Fiscal Operations, Estimate Projections Public finances (commitment basis) (In millions of US$) Total net revenues Gross domestic revenues Tax revenues Nontax revenues Clearance revenues Less tax refunds Recurrent expenditures and net lending Wage expenditure Non-wage expenditure Net lending * Recurrent balance Development expenditures Overall balance (before external support) Financing External budgetary support Development financing Net domestic bank financing Domestic arrears Net clearance due or repaid Other Public finances (commitment basis) (In percent of GDP) Total net revenues Recurrent expenditures and net lending Wage expenditure Non-wage expenditure Net lending Recurrent balance (before external support) Overall balance (before external support) Memorandum items: Nominal GDP (in millions of US$) Sources: MoF, IMF and WB staff estimates. *This figure includes US$124 million in unexpected deductions by GoI from clearance revenues on the account of utility debts that accrued in previous years. 16. In spite of the PA s reform efforts, lower than expected foreign aid, in addition to hindering growth, are putting the PA s fiscal situation under significant stress. Donor aid for recurrent spending and development projects has declined from US$1.98 billion in 2008 to US$930 million in This has been compounded by shortfalls in revenue in addition to higher than expected expenditures, particularly pension payments. 12 The lower than expected level of donor aid had to be compensated from domestic sources instead. This has been causing frequent delays in salary payments to public employees, accumulation of arrears to the private sector (which now amount to around US$600 million), and increased borrowing from local commercial banks. 17. The PA s external debt, estimated at around 10 percent of GDP, is relatively low, but the stock of government debt to domestic banks has been growing. External debt, contracted in earlier years and on largely concessional terms, has been dropping. On the contrary, debt to domestic banks increased to US$1.4 billion or 14 percent of GDP at end-december 2012 from 10 percent in The PA reports that the majority of the higher than target pensions are payments to retirees from the security sector. These pension payments were not accounted for in the 2012 budget, however, the PA has continued to make them. 9

13 USD Million Figure 3: After growing continuously since 1998, the share of wage bill expenditures to GDP peaked in 2006 and has been dropping quickly since then. Figure 4: Growing budget support supported expenditure growth until 2008, but that trend had to be reversed following a drop in donor support since % Wage bill to total expenditures Wage expenditures to GDP % PA revenue in percentage of GDP PA expenditure in percentage of GDP Budget deficit Recurrent budget sopport 0 Sources: MoF, PCBS and WB staff calculations 18. When compared to 2011, the external current account deficit as a percentage of GDP is estimated to have declined by 0.4 percentage points in Estimates by the IMF indicate that imports as a percentage of GDP increased from 59 percent in 2011 to 61 percent in Exports of goods and services marked a slight increase from 15.4 percent of GDP to 15.8 percent of GDP, but still remain among the lowest in the world. Finally, while both net factor income and official transfers are estimated to have dropped slightly, private transfers are estimated to have increased from 2.7 percent of GDP to 4.9 percent of GDP. 19. The Palestinian banking sector continues to perform well. The Palestinian Monetary Authority (PMA) continues to enhance its institutional capacity and is steadily building the capabilities of a central bank. The PA has recently passed a new payments law which enables the PMA to introduce a national centralised system for the automated settlement and clearance of financial transactions. This system will also enable banks to provide modern e-banking services including e- signature. The year-on-year growth of the sector s net assets was 7.5 percent in December The continuous improvement in the financial markets infrastructure carried out by the PMA has enabled the rise in the private credit-to-deposit ratio from 30 percent at the end of 2010 to 38 percent in December However, the sector s overall loan-to-deposit ratio continues to be lower than in most countries at around 56 percent as of December 2012, reflecting a high level of perceived systemic risk. At the end of 2012, the percentage of nonperforming loans to total credit remained low at 3.3 percent. 20. However, the banking sector is significantly exposed to the PA and this is becoming a source of concern. As of end 2012, the PMA reports that the Palestinian banking sector has provided around US$1.4 billion in credit facilities to the PA, - about 14 percent of the sector s total assets and 112 percent of its equity. Credit to the public sector and PA employees combined represented around 50 percent of the sector s gross credit as of December The PMA has been carefully monitoring risks associated with the banking sector s high exposure to the PA through quarterly stress tests according to Basel II principles. These tests have been carried out on all banks operating in the West Bank and Gaza since March The results are used to evaluate the banking system s resilience to numerous economic, political and concentration shocks that can lead to delay of loan instalments by the PA in addition to loan 10

14 delinquency by PA employees and private businesses. These shocks are tested in nine different combinations and the banking sector s capital adequacy is evaluated under each. The latest stress tests results indicate that the banking system as a whole is resilient to a variety of shocks and is well capitalised with the Tier 1 capital as a ratio of risk weighted assets at 22.1 percent by the end of December The Tier 1 ratio fell close to the required minimum of 8 percent only under two extreme scenarios. In order to further strengthen the resilience of the banking sector, the PMA has ordered some of the larger and more exposed banks to raise their capital, increase their risk reserves, and diversify their portfolios. Individual banks are also instructed by the PMA to perform their own semi-annual stress tests using customized scenarios tailored to the specific characteristics of each. Table 3: Selected Banking Indicators (percentage) Indicator Dec-11 Dec-12 Share of non-performing loans (NPLs) Loan loss provisions/npls Return on average assets PA and PA employees loans/gross credit Average interest rate on US$ denominated loans * Loans to deposits Source: PMA. * This is the average rate for the first three quarters of C. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 22. Further growth slowdown in the West Bank and Gaza is expected in This projection assumes no significant easing in various movement and access constraints in the West Bank and Gaza. Controls on trade with East Jerusalem, as well as imports and exports to Israel and foreign markets are expected to be only modestly eased, and it is assumed that there will be no significant easing of restrictions on economic activity in Area C. These restrictions pose a binding constraint to tradable sector growth and consequently to private sector-led growth. As foreign aid to the public sector is not expected to increase enough to offset the impact of the restrictions on the private sector, as was the case in earlier years, and space for new domestic borrowing is highly constrained, some fiscal tightening, liquidity constraints in the private sector caused by PA s payment arrears, along with the other factors described above are expected to result in a one percentage point drop in GDP growth to approximately 5 percent. 23. Inflation is expected to remain at roughly the 2012 level of around 2-3 percent, but the West Bank and Gaza remain vulnerable to increases in food and fuel prices. Due to constrained finances in the public sector and limited fiscal space for public sector wage growth, combined with the liquidity-constrained private sector, the contribution of wage growth to inflation will be moderate. In addition, the projected inflation figure takes into account the expectation of Israeli inflation not exceeding 3 percent and relatively stable prices at international commodity markets. However, given the dependence on imports for virtually all fuel and much of the food products, the West Bank and Gaza remain highly vulnerable to international commodity price shocks and import restrictions that may limit the supply of these goods and result in higher prices. Recent protests in the West Bank over moderate increases in the rate of VAT and fuel prices attest to that price sensitivity. 24. The PA s recurrent fiscal deficit is expected to drop from 14 percent of GDP in 2012 to 10 percent of GDP in 2013, but the financing need would remain large at US$1.2 billion, only to cover recurrent expenditures and the repayment of salary arrears in the amount of US$72 11

15 million accumulated in A further US$350 million are needed to finance development projects, bringing the total financing need for the 2013 budget to US$1.5 billion. Notably, the PA is pursuing a two-pronged strategy to improve its fiscal stance. On one hand, it has intensified efforts to enhance domestic revenue performance through a range of measures (discussed in detail below) and it is introducing a number of measures to reduce public expenditures. As a result of these measures, and in particular because of an increase in the excise tax on tobacco, revenues are expected to increase by 2.2 percentage points while expenditures are projected to decline by 1.9 percent. On the other hand, the PA has intensified efforts to mobilize donor assistance, which it sees crucial to maintaining the achievement of recent years against the backdrop of restrictions to private sector investment and growth. 25. With technical assistance from donors, the PA has prepared a new revenue strategy and has already started implementing it. The PA is improving the efficiency of tax administration through measures like the merger of the VAT and customs administrations, and strengthening of the Large Taxpayers Unit. 14 It also plans to simplify tax laws and procedures, introduce risk-based verification programs and also to introduce taxpayer education and assistance programs. The establishment of the Tax Identification Unit, which will collect information from third parties and conduct compliance verification, is expected to boost Personal Income Tax (PIT) compliance. 15 These reforms are expected to increase domestic tax revenues by about 0.5 percentage points of GDP already in 2013 and further in subsequent years. Furthermore, the PA understands that even a modest improvement in clearance revenue receipts (which account for 70 percent of all domestic revenues) would have a substantial payoff. Thus, in July 2012 an understanding was reached between the Israeli Minister of Finance Steinitz and the PA s Prime Minister Fayyad, the main objective of which is full data-sharing pertaining to clearance revenues. Although discussions have been held on the issue, the final agreement is not in sight yet due to significant differences between the two parties over implementation modalities. Finally and most significantly, revenue performance in 2013 is expected to get a sizeable kick from an increase in the excise tax on tobacco by about New Isreali Shekels (NIS) 2 per package, which alone is expected to contribute about US$100 million to revenue growth The PA announced a number of short-term measures and some structural reforms to improve efficiency and sustainability of public spending. A Cabinet Decision was adopted in March 2013 introducing a net zero hiring policy for 2013, which means that the number of newlyhired staff shall not exceed the number of those who retire or depart for other reasons. The wage bill is expected to drop by about 0.3 percentage points of GDP in 2013 as a result of this and a few other measures, the PA announced at the very final stages of the budget preparation. In shekel terms the wage bill is expected to increase by only about two percent. If civil service reforms proceed as expected, the share of wage bill in GDP will continue dropping over the medium term. The PA s line ministries completed the production of job classifications, an important initial step of the much needed civil service and pay and grading reform. Furthermore, the PA is introducing measures to improve the targeting and sustainability of social expenditures by improving the efficiency of the cash transfer program which currently costs US$105 million per year. Measures are also underway to improve the efficiency of health expenditures, in particular through streamlining the referral costs which increased 13 The estimate for financing requirements, like the PA s budget, does not assume a reduction in previously accumulated non-salary arrears, which would further increase the financing requirement. The PA has stated that any unexpected excess financing would be used for this purpose. 14 After some delays a new director was appointed to head the Large Tax Payers Unit. 15 According to an international expert working on this reform, only about 10 percent of all doctors and lawyers currently pay PIT. Only by broadening the PIT base by these two categories of professionals, it would be expected to increase the number of tax payers by 3,000-4,000 individuals. Currently, only around 14,000 individuals pay Personal Income Tax. Thus, the potential for increasing the base is significant and the marginal return on tax compliance measures is expected to be high. 16 The increase in tobacco excise tax was done by the Government of Israel and the PA followed with an equivalent increase. 12

16 twenty fold between 2000 and 2011 to a staggering US$150 million per year. Both of these reforms are supported by this operation (see the Policy Areas section for more details) and have a significant potential not only to curb two rapidly-growing categories of expenditures, but also to significantly reduce inefficiencies in social assistance and healthcare programs financed through the PA s budget. 27. Unsurprisingly, the reform efforts that are needed to address some of the main sources of inefficiency in public spending are constrained by political economy and social considerations. Further reductions in the size of the public sector wage bill, which at 17 percent of GDP remains high by international standards, requires a reduction of staff assigned to certain functions and comprehensive pay and grading reforms. Intensified efforts are needed to improve the solvency of the power sector, which, despite some recent improvements, currently still requires about US$160 million in subsidies annually just to stay afloat. As it is, the pension system is not sustainable in the long run and requires comprehensive reform. 17 However, the cost of such reforms in terms of jobs and living standards cannot be offset by private sector growth under current constraints. Nevertheless, given the persistent shortage of donor aid, which will probably not be reversed in the near future, the PA will need to consider additional measures to further contain public expenditures. A number of such measures have been proposed by the IMF in their March 2013 staff report for the meeting of the Ad Hoc Liaison Committee. 28. In any case, despite the significant fiscal tightening that is foreseen in 2013 and other structural reforms, which should lead to continuous fiscal consolidation over the medium term, external financing requirements are expected to remain high in the interim. Export growth will probably remain sluggish and the West Bank and Gaza will continue to heavily depend on imports to meet even some of the basic needs. Consequently, although expected to shrink further by 3.6 percentage points, the current account deficit (excluding official transfers) will remain extremely high in 2013 at 30 percent of GDP. Absent significant improvements in the investment climate, the large deficit is bound to persist unless sharp downward adjustments are made to the fiscal deficit. However, this this could have severe social and stability implications. 29. The Palestinian economy requires sustained, substantial and predictable donor aid and therefore, the reinvigorated donor pledges, which are expected to significantly increase the level of donor budget support in 2013 compared to 2012, are both welcome and essential. 18 The aid needs to be in the form of grants. With debt to domestic banks at US$1.4 billion (as of December 2012) and equivalent to 112 percent of banking sector equity and 14 percent of its total assets, further domestic borrowing is becoming increasingly unfeasible. Under the current circumstances, the PA does not have access to international finance even on concessional terms for a number of different reasons. Therefore, there is no immediate alternative to grant assistance. Predictability of donor aid is also important, as unpredictable aid flows introduce an additional layer of uncertainty to decision making and prioritization activities for the PA. 30. With a combination of aid mobilization and ongoing fiscal tightening efforts, the macroeconomic framework is expected to be adequate for the purpose of this operation. While this macro-fiscal framework is subject to a number of risks, many of them beyond the PA s control (see Chapter 6, Section E), there is probably no feasible alternative to a framework that relies on the 17 Although West Bank and Gaza have introduced a funded pension system, individual accounts are not increasing due to arrears to the system by the PA and it de facto operates as a pay-as-you-go system. The PA has accumulated arrears to the pension system of close to US$2 billion. 18 Table 2 above projects identified external aid for recurrent deficit at US$1.1 billion, which is a significant improvement over 2012, when short of US$800 million in recurrent budget support was received from external sources. Saudi Arabia has pledged significant additional financing at the March 2013 meeting. Any financing in excess of the deficit and planned reduction in wage arrears could be used to reduce some of the US$600 million in arrears to the private sector. 13

17 large amounts of donor aid on the one hand, and on the other, efforts to boost domestic revenues and curb public expenditure growth as much as feasible, without causing politically and socially untenable impacts on citizen welfare and social stability. III. THE GOVERNMENT S PROGRAM AND PARTICIPATORY PROCESSES 31. The NDP that was approved in April 2011 is the roadmap for PA s reform program, but within this framework, recent unexpected developments have given rise to some new priorities. It had been assumed that the relaxation of the GoI restrictions on movement and access and a slower than observed reduction in donor aid inflows would underpin challenging structural reforms envisaged in the NDP. Neither of the two assumptions has materialized. Consequently, while the PA remains committed to implementing the NDP and continues doing so, it has delayed some of the planned reforms and is pursuing others more vigorously to respond to the new circumstances. Specifically, reforms aimed at reforming the pension system have been delayed. Moreover, the pace of civil service and electricity sector reforms has considerably slowed down. On the other hand, reforms aimed at enhancing revenue performance, short-term measures to contain the cost of the wage bill, and reforms aimed at eliminating important sources of inefficiency in healthcare and social protection systems have gained priority. 19 Despite some reprioritization, the NDP is the anchor of the PA s reform program. 32. The NDP builds upon the Palestinian Reform and Development Plan (PRDP) of The NDP outlines the government s policy agenda, macroeconomic and accountability framework. The PA is looking forward to future statehood and forging ahead with improving institutions, and with 23 new sector strategies that were developed through numerous consultations with many stakeholders such as various NGOs, civil society and international organizations as well as the private sector and local government actors. The government s program incoprorates targets and sector objectives to guide implementation and allow monitoring. 33. The NDP has been developed with the purpose of establishing a solid foundation for the future creation of a Palestinian state. The authorities goal is to provide a framework that is able to rise to the challenge of providing its citizens with adequate service delivery. In line with the recommendations of the 2011 World Development Report entitled Conflict, Security, and Development, the NDP maintains the PA s commitment to developing public institutions and local communities towards dampening the ramifications of conflict on the economy of the West Bank and Gaza. The NDP also strives to reduce the social disparities among the Palestinian population that have been adversely affected by various restrictions on access and movement in the West Bank and Gaza. The authorities hope that this policy agenda will consolidate institutions which will spur investment and invigorate the private sector. This NDP has four major sector strategies which include governance, social development, economy and infrastructure. A. GOVERNANCE 34. The authorities have been improving their institutional capacity since the 1990s. Through consultations with relevant ministries and non-governmental agencies and stakeholders, the authorities have laid plans to continue to build institutions for the public expenditure and governance component of the NDP. The governance policy has been broken down by sectors: justice and rule of law, security, international relations, administrative development, local governance and administration, public financial management, public information, statistics and research, and land management. 19 DPG V has been designed to support the PA in implementing the NDP, but also its newly emerged priorities. A more detailed discussion of these new policy priorities supported by DPG V is presented in the Policy Areas section of the PAD. 14

18 35. The NDP has outlined several strategic objectives for the governance sector: i. To provide national security and public safety throughout the country This objective builds upon the successes of the PRDP in imposing public order and a rule of law and building infrastructure for the security sector. For the NDP, the authorities have outlined priority policies to provide that all citizens are ensured the fundamental right to safety and security. ii. To deliver justice and the rule of law for all citizens This strategy envisions improving the institutional capacity of the justice sector over the next three years. The justice sector objectives build upon the reforms outlined for the PRDP iii. To modernize and streamline public administration This objective has been developed around a framework which outlines a unified approach to upgrading the organizational structure of ministries and agencies, as well as strengthening institutional capacity. iv. To empower local government and bring public services closer to citizens In order to tackle the fragmentation of service delivery, authorities have put in place a strategy to build local government units (LGUs) capacity to provide adequate service delivery to local municipalities. v. To attain financial independence and economic stability The PA is committed to continuing the prudent fiscal policy measures such as were outlined in the PRDP , with the goal of increasing growth and in due course, financial self-sufficiency. 36. The objectives have all been developed with quantifiable goals in order to measure the improvement or deterioration in areas targeted by specific reforms. This will ensure that authorities have a clear framework to monitor and evaluate progress of the proposed programs. B. SOCIAL DEVELOPMENT 37. In the social sector, the PA s aim is to improve service delivery among its citizens and to reduce disparities that are occurring in service delivery to certain groups. The authorities intend to work with private sector and non-governmental organizations to guarantee more effective and higher quality service delivery. The PA is also striving to preserve its cultural heritage and create new employment opportunities for all citizens. Specifically, these objectives include: i. To support and empower the poor and other vulnerable citizens and their families This objective outlines a continuation to the refinement and implementation of the Palestinian National Social Safety Net Program (PNSSP). The authorities plan to offer more development assistance to the poor as well as implement appropriate legislation for the protection of vulnerable populations; ii. To prepare children and youth for a fulfilling life and productive work This commitment to shaping and molding human capital by preparing them for work with either the private or public sector will ensure quality education is provided to citizens; iii. To restore excellence in higher education and academic research In order to meet the demands of the labor market, the PA is committed to provide education that will prepare the students to be able to develop up-to-date skills including the existing vocational educational curriculum. This will ensure the progression into a knowledge-based economy as well as create prosperity; 15

19 iv. To promote and sustain a healthy society Public investment in the health sector has allowed better service delivery in the sector. Thanks to external financing the health sector has been able to improve many facilities. The authorities aim to establish an affordable healthcare system for its citizens; v. To safeguard and renew Palestinian heritage and culture The PA has established a Culture Fund in order to support and develop cultural centers across the West Bank and Gaza, as well as support events throughout the year; vi. To promote the full participation and empowerment of women in society The authorities strive to create an equitable society for all citizens, including women, to participate fully in the job market. As of now, female participation is rising but not quickly enough. The PA is committed to enforce laws that abolish discrimination based on gender and laws that punish violence against women; and vii. To invest in youth to enable them to reach their full potential in their homeland The authorities are aware that with 30% of their population aged between age 15 and 29, they must pay special attention to ensure youth participation in the workforce by providing education that will develop their skills. The authorities also wish to ensure that the youth participate in their political institutions. C. ECONOMY 38. The PA has committed itself to pursuing reforms in different areas to support sustainable economic growth. Given the various constraints on economic activity and political challenges that both the public and private sectors face daily, it is paramount to have a sound economic policy that will foster growth. The authorities would like to counteract the constraints in order to be able to have a sustainable growth path and they have outlined the following strategic objectives: i. To ensure a positive investment environment The authorities are aware of the importance of the private sector as a driver of growth and will continue to partner with them. The authorities are also aware of the legal and regulatory framework reforms that must be implemented; ii. To enhance the competiveness of Palestinian products and services The authorities strive to encourage investment in sectors that already enjoy a competitive advantage. This will not exclude other sectors that have high growth potential, which the authorities look to expand; iii. To promote economic integration and access to external markets The authorities are consolidating the economic institutions that will be needed to manage stronger economic growth that is expected to ensue once statehood is achieved. Authorities remain committed to pursue economic policies to promote investment and increase productivity and quality across sectors; iv. To ensure a vibrant labor market and combat unemployment The authorities are cognizant that skills are important for employment. They are determined to foster a capable, qualified workforce that can compete with outside labor markets as well as attract foreign investors to invest in the West Bank and Gaza. Authorities plan to integrate the education sector as an integral part of building a competent workforce; and 16

20 v. To strengthen consumer protection institutions The goal of this strategy is to ensure public safety and the assurance of high quality goods to citizens. The authorities plan to ensure quality standards and enforce penalties on non-compliant parties. D. INFRASTRUCTURE 39. The authorities continue to build on the previous goals of connecting marginalized areas to public infrastructure networks. The current program relies on community-based initiatives to provide service delivery. Due to the stalled political situation this sector has experienced setbacks as restrictions have long delayed major public infrastructure projects. The authorities plan to continue the dialogue and consultation with international partners in order to achieve their strategic objectives. These include the following: i. develop integrated and sustainable national infrastructure networks; ii. secure an adequate supply of energy and natural resources; iii. protect the environment; iv. maintain the long-term quality, affordability and safety of infrastructure systems; and v. ensure adequate, safe and affordable housing. E. PUBLIC ACCOUNTABILITY 40. The authorities are committed to ensuring an adequate allocation of resources for quality public services, positive socio-economic outcomes and good governance for citizens. In order to improve accountability for public interest, the NDP outlines four main elements: (i) transparency; (ii) performance; (iii) partnership; and (iv) oversight. These four elements are a part of an institutional reform agenda which will allow the PA to build upon its recent achievements as well as improve on areas that still need attention. 41. The NDP is a clear framework complete with tangible goals and objectives in order to keep the authorities accountable for their progress. The fact that the NDP has been conceived through dialogue and consultation with a multitude of stakeholders both domestically and internationally enhances the accountability framework. F. CONSULTATIONS 42. The NDP is based on 23 new sector strategies that were developed through numerous consultations with many stakeholders such as NGOs, civil society organizations, and international organizations as well as the private sector and local government actors. The NDP as a whole was the subject of further consultations. In sum, more than 240 consultation events were conducted with over 2,000 participants representing various stakeholder groups. The government also built partnerships with local communities through its program of Community-Based Projects which integrates community participation into the identification of priorities and needs. Over the course of the plan s implementation, the government has been using public consultation as a means to help with monitoring and evaluation. 43. One of the more challenging reforms drawn from the NDP and included in the current operation is public procurement. The new procurement law was developed in a highly transparent and participatory process. Professional Associations such as the Palestinian Contractors Union, the Engineers Association and the Lawyers Association have been involved in the dialogue with the PA 17

21 for the reform of the country s procurement system and are supporting the enactment process of the new procurement laws and regulations. 44. Finally, it is noteworthy that the Bank held consultations with PRDP-TF donors during the preparation of this operation on the content of the government s program it aims to support. IV. BANK SUPPORT TO THE GOVERNMENT S PROGRAM A. LINK TO CAS AND BANK S MENA STRATEGY 45. Since the West Bank and Gaza is not a member of the World Bank, there is no Country Assistance Strategy. Instead, the Bank relies on strategy notes to guide its work and keep the Executive Directors informed of its activities. This operation has been designed to support the Interim Strategy Note for the West Bank and Gaza (the ISN), which was discussed by the Board on April 6, The ISN was designed to support the implementation of the PA s NDP in areas where the Bank has a competitive advantage over other donors. The Bank s program under the ISN has a two-pillar focus: i. Pillar 1. Strengthen the institutions of a future state to efficiently manage public finances and ensure services to citizens; and ii. Pillar 2. Supporting the creation of an enabling environment for private sector-led growth. 47. This operation had been envisaged as one of the core operations under the ISN and it has been designed to support Pillar 1 objectives of the ISN. 20 The ISN specifically notes that ongoing series of development policy grants will maintain their focus on fiscal management and public financial management. The ISN also notes that the Bank will regularly monitor the reform agenda supported by the DPGs. The operation will directly support the achievement of all three ISN Pillar 1 outcomes: 1.1. Greater economic stability and transparent financial management; 1.2 Reinforced public administration; 1.3. Public services more responsive to users needs. Under outcome 1.1, DPG V will cover each area of engagement proposed by the ISN: (i) Revenue and expenditure management; (ii) Public financial management (PFM); and (iii) Public procurement. Under outcome 1.3, DPG will cover targeting poverty-related assistance. 48. It is noteworthy that this operation is also well-aligned with the Bank s strategic priorities in MENA in the areas of governance, growth and inclusion, among others. The government program supported by the operation aims to improve social inclusion through better targeting of social assistance to the neediest segments of the Palestinian population. While measures supported under the first policy area of this operation aimed at strengthening the PA s fiscal position have also been designed to improve the efficiency in public sector governance, measures under the second policy area of this operation are specifically geared towards this strategic objective of the Bank s engagement in MENA. B. COLLABORATION WITH THE IMF AND OTHER DONORS 49. The Bank works closely with the IMF and other donors to support the PA s implementation of the NDP. Consultations have been held with the IMF and other donors on the 20 The ISN does not have a base case and high case lending scenarios. 18

22 operation s design. The IMF team was closely involved in the development of the policy matrices for the Bank s previous DPGs, as well as DPG V. 50. In the West Bank and Gaza, the IMF and the World Bank have a complementary division of labor and regularly share information and consult on policy advice to the PA. The IMF monitors the macroeconomic framework and helps the PA produce accurate and timely accounts. The Bank also conducts its own macro-fiscal monitoring and closely consults with the IMF in this area, but it concentrates on helping the PA address the underlying structural issues such as power sector net lending, transfer payments or pension arrears. 51. The IMF has resumed full contact with the PA following the establishment of the Caretaker Government in June 2007 and is providing technical assistance on a variety of issues. The IMF helped the PA produce the macroeconomic framework used in the NDP and continues to work with them to regularly update the macroeconomic projections. The IMF also provides technical assistance to strengthen public financial management and in doing so works closely with the Bank s resident Public Financial Management (PFM) expert. Both the Bank and the IMF are providing technical assistance to the Palestinian Central Bureau of Statistics (PCBS) to help them develop better basic statistics. Good basic economic data is essential to monitor progress of the NDP reforms. Therefore, the Bank has provided funding to support building the capacity of the PCBS. In this effort, the Bank is coordinating closely with the IMF statistics team to identify exactly how the funds are best utilized. 52. In addition to the IMF, the Bank has held consultations with all donors who provide financial support for the PA s budget. As they have done with the earlier DPGs, PRDP TF donors will continue to rely on the DPG V policy and results matrix as the sole criteria to evaluate the PA s performance in implementing NDP for the purpose of quarterly disbursements under the TF. This has proven to be an efficient and effective way to leverage donor support around important structural reforms. Thus, the importance of the DPG program goes significantly above and beyond the operation itself. 53. More broadly, a more formal aid coordination mechanism in the West Bank and Gaza was set up following a decision made at the December 14, 2005 meeting in London of the Ad Hoc Liaison Committee (AHLC). The aim behind this mechanism is to improve the effectiveness of aid coordination structures in providing coherent technical assistance and financial support based on national priorities to the Palestinian people in line with the OECD-DAC Paris Declaration on Aid Effectiveness. The AHLC is chaired by Norway and brings together in a meeting on a semi-annual basis several donors as well as the PA and the Government of Israel. The Bank acts as Secretariat to the AHLC, submitting a report prior to every meeting that provides an update on recent economic and fiscal trends, as well as on broader economic and institutional developments in the West Bank and Gaza. The Bank s report has often helped to set the agenda and frame the discussion at the AHLC meeting. The Bank s report for March 2013 AHLC meeting provided an assessment of long-term impacts of the political status quo. 54. At the local level, the donor coordination structure comprises the Local Development Forum (LDF), in addition to four strategy groups (SGs), each one supported by roughly five sector working groups (SWGs). The LDF includes representation from the PA as well as all donor and aid agencies. The four SGs cover the clusters of economic policy, governance, infrastructure, and social development, and are intended to focus on overarching issues such as policy formulation and programmatic coordination. Each of the SGs and SWGs is co-chaired by a PA agency and a donor agency. The Bank acts as a co-chair of the Economic SG (together with the PA s Ministry of Finance) as well as the Private Sector Development and Trade SWG (together with the PA s Ministry of National Economy). 19

23 C. RELATIONSHIP TO OTHER BANK OPERATIONS 55. Since the establishment of the Trust Fund for Gaza and West Bank (TFGWB) in 1993, a wide range of lessons have been learned, enabling largely successful Bank engagement in a fragile political and security environment. The Bank has been continuously active in the West Bank and Gaza since 1993 and this operation is the fifth DPG since The preparation of this operation benefited from lessons learned in the ICR for DPG IV, as well as earlier operations and the lessons of implementation experience drawn in the ISN The IEG s review of the World Bank Group s program in found that, despite some progress, institutional development was uneven. The evaluation concluded that the program was affected by factors outside of Bank s control and noted that this issue has to be recognized to improve long-term effectiveness of the Bank s program. The IEG report, in particular, highlighted the importance of supporting the PA in efforts to reduce aid dependency, which is one of the indirect objectives of this operation to be achieved through fiscal consolidation. 57. Several important lessons have been drawn from the ICR for DPG IV and earlier DPG ICRs. Below is the summary of some of the main ICR lessons: Even in an environment of high risk, DPGs can be successful if the design adequately takes the risks into account and ensures government ownership of the reform program. Client commitment to the program is a key for success under difficult circumstances. DPG IV was firmly embedded in the government's own medium-term economic program, which is the main reason the operation was relatively successful in achieving its intended development objectives, despite a truly difficult operating environment. Furthermore, the operation was designed with another important objective in mind: to provide indispensable financial assistance to ensure the provision of essential public services. Even single tranche operations can and should be designed with a medium-term agenda in mind. While it would probably not be appropriate to design a programmatic DPG given the high level of uncertainty in the West Bank and Gaza, this operation was designed with some medium-term objectives in mind and was used as a platform to support dialogue on the medium-term program and a tool to prepare a follow up operation. However, due to a rapidly-changing operating environment which can cause a drastic shift in priorities, it would be unrealistic for the Bank to commit to a medium-term program. Political economy analysis of potentially controversial reforms should be carried out to minimize the likelihood of slippage. Technical challenges of implementing specific reforms ought to be taken into account in operation design. 58. Finally, the Bank continues to manage the PRDP-TF, through which donors provide budget support based on the Bank s monitoring of the PA s progress in implementing the NDP reform program. The PRDP-TF provides a key mechanism for donor coordination in support of implementing the PA s NDP. Collaboration with other donors, especially through the Trust Fund, helps focus the dialogue with the authorities on key issues considered critical for reform. This collaboration provides significant weight to common points in the reform agenda and therefore should be maintained and enhanced. 20

24 D. ANALYTICAL UNDERPINNINGS 59. The preparation of this operation has been informed by a number of analytical pieces produced by the Bank, but also other development partners, such as the IMF. In addition to the standardized formal studies, including an investment climate study, a public expenditure review and a study of the fiscal management of local government, other informal analytical pieces have been produced (in the form of hand-over notes), in particular in the area of fiscal management and public finance management, which have benefited the preparers of this operation. While the Bank and other institutions have produced a considerable number of analytical publications, those most relevant to the design of this operation are listed below. 60. In September 2011, a comprehensive poverty assessment report titled Coping with Conflict: Poverty and Inclusion in the West Bank and Gaza was released. The report concluded that the labor market outcome is one of the strongest drivers of poverty in the West Bank and Gaza, with the unemployed facing the highest risk of poverty. The report also notes that public sector employment is increasingly playing the role of a safety net in combating poverty, especially in Gaza. The findings of this report were taken into consideration in crafting the prior actions supported by this operation, in particular those pertaining to wage bill management and social safety net reforms. 61. In May 2011, the WB&G Improving Governance and Reducing Corruption study was issued. This report is the first to assess governance reforms, measure corruption in the delivery of public services as well as to shed light on weaknesses that need to be addressed in order for the West Bank and Gaza to further reduce corruption as well as build sound institutions for good economic governance and a favorable investment climate for businesses. This study covered the experiences with corruption in the West Bank and Gaza as well as the perceptions of corruption. The report concluded that Palestinian perceptions of corruption were much higher than actual experience in the access of public services. It also found that the West Bank and Gaza ranks well compared with other countries in the region in terms of the effects of corruption on business activity. 62. An assessment of Public Expenditure and Financial Accountability (PEFA) practices was made by the Bank in 2011 drawing upon the PEFA methodology. It provided a rough indication of the relative strengths and weaknesses in the PA s public financial management system and the areas of progress since The exercise informed the preparation of DPG V. As the next step, the Bank intends to build on these efforts by leading the work on a full PEFA assessment which was initiated in January 2013, in cooperation with other donors. The completion of a comprehensive PEFA assessment would validate or disprove the indicative ratings of the previous one, and help in setting reform priorities for the coming period. 63. Building upon the recommendations of the 2007 Public Expenditure Review of controlling the wage bill, the World Bank produced, in September 2010, a report on Governance and the Wage Bill. This report was produced in order to assess the effectiveness of the existing systems for controlling the payroll. This report also identifies future measures to support aggregate fiscal control and more effective human resource management. Supported by this operation, the PA has launched the process to complete job classifications in all line ministries. 64. The World Bank issued the Report on the Observance of Standards and Codes (ROSC) Accounting and Auditing in September This report analyzed the corporate sector accounting and auditing practices in the West Bank and Gaza using the International Financial Reporting Standards (IFRS). This study was limited by the blockade in Gaza and therefore focused more on the West Bank and its practices. 21 The recommendations of this ROSC were for authorities to improve 21 In spite of the difficult political environment, the authorities have been able to offer a financial sector with most services available: banking, securities, and insurance. The Palestinian Monetary Authority (PMA) has 21

25 ethics, quality control and professional standards to be consistent with international practice. The World Bank also recommended that the accounting and auditing professionals have adequate training and capacity to carry out their functions and that a properly funded system of monitoring and enforcement should be established. 65. In February 2010, the World Bank produced the report Rationalizing Pensions for Government Workers in West Bank and Gaza. This is the first systemic quantitative analysis of the main obstacles to long-term sustainability of the current pension schemes. The report includes recommendations for short-, medium-, and longer-term pension reform options to ensure fiscal sustainability of the new pension scheme during the transition period until its maturity and the phase out of old schemes. Parametric reforms recommendations included increasing retirement age, reducing accrual rates, adjusting indexation mechanisms and eliminating early retirement. While this operation will not support any pension reform-related actions, the policy dialogue in this area continues, and it is expected that the next development policy operation will support government policy actions in this area. 66. Finally, in July 2012, the IMF prepared a study titled Improving Income Tax and Tax Incentives Proposed Tax Policy Topical Trust Fund. This report is based on the analytical work carried out by the IMF staff to understand the reasons behind relatively low Personal Income Tax (PIT) and Corporate Income Tax (CIT) revenues collected by the PA and to design a reform plan to enhance revenues, increase tax progressivity, and reduce opportunities for tax avoidance and abuse created by numerous loopholes that exist under the current PIT and CIT legislative and administrative arrangements. The report also addresses issues such as different approaches to taxing different sources of income, primarily capital income, and simplifying and rendering more effective tax administration for SMEs. Notably, the report recommends the continuation of reforms the PA is conducting to reform the Buildings and Land Tax, recommending updating property tax evaluations for all municipalities as the top reform priority at the moment. The findings of this report were discussed in the dialogue with the PA as this operation was prepared. However, while the report s findings are expected to guide tax reforms in the coming years, they cannot be implemented within the timeframe of this operation. Other analytical work carried out in the context of ongoing technical support to the Ministry of Finance by the IMF, DFID, and USAID has enabled the PA to design a revenue strategy, specific aspects of which are supported by this operation. A. OPERATION DESCRIPTION V. THE PROPOSED DPG V 67. The proposed operation aims to support the PA in strengthening its fiscal position and laying the institutional foundations for improved governance and transparency in the public sector. The program supported under DPG V will be organized in two policy areas to support the following aspects of the PA s NDP: (Policy Area 1) Strengthening the fiscal position by undertaking reforms to (i) increase government revenues, and (ii) improve the efficiency of public expenditures; and (Policy Area 2) laying the institutional foundations for improved governance and transparency in the public sector. Given a sharp and larger than expected reduction in donor budget support in recent years, the urgency of conducting these reforms has increased substantially. The operation will directly contribute to Pillar 1 of the ISN aimed at strengthening the institutions of a future state to efficiently manage public finances and ensure services to citizens. DPG V builds upon the achievements of the previous four DPGs and its strategic focus is unchanged from that of DPG IV (see Box 2). acted as the Central Bank of WB&G, and due to its high level of technical competence it has been making great strides with improving the financial sector. 22

26 Box 2: A summary of previous World Bank budget support operations in WB&G The Bank has already conducted four budget support operations in the West Bank and Gaza between 2008 and 2011 (DPG I, II, III and IV). The previous programs all focused on two main policy areas: I) Strengthening the PA s fiscal operations; and II) Increasing government transparency and accountability through improved public financial management. Objectives targeted under policy area 1: I.1 Control public sector wage bill. I.2 Reduce net lending and improve targeting of social safety net. I.3 Improve domestic revenue collection. Objectives targeted under policy area 2: II.1 Improve efficiency and transparency of the budget preparation process. II.2 Establish upgraded institutional and regulatory procedures to support PFM reforms. II.3 Strengthen PFM infrastructure and improve auditing functions. II.4 Increase financial accountability through improved and more transparent municipal accounts. Main results achieved: While work on meeting the above objectives under DPGs I-IV still continues and progress is hampered by factors outside of the PA s control, substantial results have already been achieved. First, the size of the wage bill, although still unsustainable under the circumstances, has dropped from a peak of 26 percent of GDP in 2006 to 17 percent in Second, while net lending remains a problem, specific and important actions have been taken to bring it under control. Third, the targeting of social assistance has been in particular improved through the introduction and continuous improvements to the cash transfer program, which is considered among the best in MENA. Fourth, the efficiency and transparency of the budget preparation and execution process has also been significantly improved. For instance, regular monthly fiscal reports are published on the MoF website and their quality and content has been continually improved. A new computerized financial management system was introduced with a connection to all line ministries. The internal audit process has also been strengthened. Finally, it is also noteworthy that a new modern legal framework for public procurement has been introduced and further actions have been taken to develop the institutional foundations to reform the public procurement process. 68. DPG V will support the PA in implementing a set of revenue boosting measures. As the shortage of revenues to finance even the basic government operations has made the fiscal situation extremely difficult, with technical support from DFID and the IMF in particular, the PA has recently accelerated efforts to improve domestic revenue performance and has prepared a revenue strategy; implementation of the strategy is well underway. The reforms are currently focused on increasing the tax base through better compliance. They are underpinned by measures to enhance tax enforcement capacity of domestic institutions and an agreement with the Israeli authorities is under discussion on data sharing relevant to clearance revenues, which would be an important tool in identifying noncompliance. 69. On the expenditure side, the program will support both short-term measures and some structural reforms the PA is undertaking to improve the efficiency and sustainability of public expenditures. Short-term measures are aimed at reducing the government wage bill relative to GDP, primarily, but not exclusively, through hiring control. The PA has commenced some structural reforms aimed at improving public sector efficiency and sustainability of the wage bill, 22 albeit at a relatively slow pace. 22 Although the size of the wage bill as a percent of GDP has fallen impressively in the past four years from 22 percent in 2009 to 17 percent in 2012, the wage bill is still large by international standards. Further reduction in the size of the wage bill will require deep structural reforms of the civil service, including a pay and grading 23

27 70. This Development Policy Grant will not support reforms in some important policy areas that were supported under the previous DPG as progress has been hampered by different exogenous factors. For instance, with regard to the pension system, the majority of the administrative reforms supported under DPG III and IV were implemented, while the parametric reforms are not progressing as planned. The decrees that were specified by the PA s pension reform plan have not been issued. This is partly because the Palestinian legislative council has not been operational since 2007 and the President is reluctant to issue decrees as an alternative. Additionally, in the short run these reforms may inflict costs in terms of poverty and living standards. At the time when private sector growth remains constrained and unable to offset such costs and when the PA is unable to offset them either through temporary social programs, due to the fact that its finances are already under stress as a result of recent reductions in donor aid, the PA has decided to delay the pension reforms. A similar logic applies to the electricity sector reforms. The PA continues paying part of the electricity bills owed by Palestinian electric utilities and municipalities to the Israel Electric Corporation (IEC), as the former are insolvent due to a combination of technical losses, theft, and poor bill collection rates. Electric utilities lack investment capital to address the technical losses, but efforts to strengthen the financial performance of the sector continue. The PA is currently developing a broad sector strategy and is also working with international consultants on an effort to identify the key factors that contribute to payment arrears to the Israeli Electric Corporation (IEC), but no reform actions that would lead to concrete results were taken during the preparation of DPG V. Consequently, the DPG V will focus on reforms deemed feasible under the existing exogenous and other justifiable constraints. However, reengagement in some important reform areas not pursued by DPG V is expected in subsequent operations. 71. This operation will also continue to support reforms in the area of public sector governance, in particular public finance management. Strengthening public finances is important both in terms of building the capacity of the PA to independently, transparently, and efficiently manage its economy, but also for instilling donor confidence that the financial support which they provide to the PA in generous amounts is appropriately used. 72. The Bank s DPG program not only provides support to the PA s reform program and essential budget financing, it also leverages a significantly larger financial support from other donors. The results framework developed in the context of the DPG is also used to assess the PA s reform progress. These assessments, conducted by the Bank on a quarterly basis, are used to decide on disbursement of budget support financing from the PRDP Multi-Donor TF, which the Bank administers. Thus, in addition to providing US$40 million per annum in direct budget support, the DPGs leverage additional budget support, which in 2012 amounted to US$225 million. reform. The Bank has produced a paper with concrete recommendations for civil service reform at the PA s request. The implementation of civil service reform and pay and grading reform has started, but its pace is slow, primarily due to political economy considerations. 24

28 B. POLICY AREAS Policy Area 1: Strengthen the PA s Fiscal Position Domestic Revenue Performance Description of the situation: 73. Domestic revenue performance has stagnated in recent years. Since its formation in 1994, the PA s capacity to collect revenues has been built virtually from scratch with a good degree of success. Between 2003 and 2007, public revenues increased by about 5 percentage points of GDP. However, since 2008, revenue performance has deteriorated. Clearance revenues (70 percent of all revenues) dropped from 18 percent of GDP in 2008 to 14 percent in 2011 and remained at that level in Then, the portion of tax revenues collected internally by the PA fluctuated between 4 and 5 percent of GDP over the same period. Unsatisfactory revenue performance can be explained by two factors. After having dropped already in 2007, revenues from Gaza have remained stagnant in nominal terms and in 2012 they amounted to 4.4 percent of total clearance revenues (down from 17 percent in earlier years). Furthermore, tax revenue collection in the West Bank has also lagged GDP growth, dropping from 16 to 14 percent of GDP. This is explained by tax enforcement leakages. Enforcement weaknesses are, in particular, evident with PIT, where the collections amount to only 1.7 percent of GDP, which is very low even by regional comparison. Policy Challenge: 74. Given the current fiscal challenges the PA is facing, enhancing domestic revenues has become necessary. To a large degree, revenue performance is contingent upon the political situation in the West Bank and Gaza. The effectiveness of clearance revenue collection largely depends on the actions taken by the GoI and to a lesser extent those of the PA. However, even internally collected revenues, which depend much less on the actions taken by the GoI, have been low relative to GDP in comparison to other countries in the region. Thus, the main policy challenge is to boost internally collected revenues primarily by eliminating different loopholes in the system and strengthening tax enforcement, while at the same time continuing discussions with GoI to strengthen clearance revenue collection. Government actions to date and future activities to address the challenge: 75. With the support of the IMF, DfID, and USAID, the PA is taking a number of measures to boost revenue performance. In 2012, it increased the rate of VAT from 14.5 to 15 percent and the top corporate income tax rate from 15 to 20 percent along with a number of measures to increase the tax base. A comprehensive action plan to reform tax administration has been developed, with the main objective to enhance VAT, Customs and income tax compliance. The plan, whose implementation has already advanced, includes the creation of unified revenue administration, strengthening of the Large Taxpayer Unit, expanding the number of companies under its jurisdiction, and the computerization of taxpayers records. An important step being taken, which is expected to bear early fruit is to create the Tax Identification Unit to collect third party information and use it to verify accuracy of personal income tax liabilities. 23 To strengthen clearance revenues, the PA has reached an understanding at the technical level with the GoI on a set of measures, which would, inter alia, enable both sides to have 23 Information will be collected on bank accounts, vehicle registration, property tax, etc. This information will be cross checked against individual tax liabilities and given some evidence that, for instance, currently 90 percent of doctors and lawyers are not registered to pay tax, the marginal return on this investment is expected to be substantial. 25

29 full access to data collected through shared electronic interfaces. An agreement with the GoI to facilitate clearance revenue enforcement could substantially boost PA s revenues, but it has not yet been finalized. Prior actions supported by the operation: The VAT Administration and the Customs Administration have been successfully merged in accordance with a decision of the Ministry of Finance and a new single administration has a new organizational chart and is fully staffed and operational. A new Tax Identification Unit has been established within the Revenue Administration of the Ministry of Finance and is adequately staffed. Expected results: 76. As a result of the measures taken by the PA, domestic revenues from VAT, customs, and income tax combined in 2013 will increase by at least 10 percent in nominal terms and will be higher as a share of GDP compared to Ultimately, the PA s dependence on external financing for its recurrent expenditures will be reduced. Public Sector Wage Bill and Civil Service Reform Description of the situation: 77. Despite having dropped substantially in recent years from 26 percent of GDP in 2006 to 17 percent in 2012, the public sector wage bill in the West Bank and Gaza remains very high by international standards. The main driver behind the high wage bill is high public sector employment relative to the population, which is well above the regional average, approached only by some far wealthier Gulf States. 78. The public service is widely percieved to be overstaffed. This is considered a consequence of the PA operating as an employer of last resort particularly in the period following the second intifada from 2000 to 2005, together with patronage hiring in those early days. Efforts have been made in the past to retire redundant staff in the security sector and restructure it into three branches, but overstaffing remains, even though effectiveness has been increased. Policy challenge: 79. Addressing the issue of a large and unsustainable wage bill, which the PA is currently struggling to fund, requires both short-term measures to contain the growth of wages and staff on the PA s payroll, but also wide ranging structural reforms. Some reforms cannot be implemented quickly and require adequate know-how at the technical level, including the right instruments to minimize the potential social and poverty impacts of these measures, and finally a strong political commitment. The reforms will need to bring mandates, reporting lines, structures and staffing into better alignment with the PA s strategic priorities (relying on functional reviews and other reform tools) and ensure fiscal sustainability of the aggregate wage bill. The current political situation, which limits private sector employment opportunities, has given an important social dimension to public sector employment, thus hampering the accumulation of political capital necessary for these reforms. Thus, the reforms have to be planned and executed carefully to prevent negative social and political consequences. 26

30 Government actions to date and future activities to address the challenge: 80. The PA has introduced some short-term measures to control the wage bill. It introduced a hiring and promotions freeze for 2012 starting in August 2012, and adopted a zero net hiring policy for 2013, which aims to limit new recruitments in 2013 to ensure they do not exceed the number of retirement-related and other kinds of departures from the PA. This is expected to keep the number of staff on the PA s payroll in 2013 at the December 2012 level. This new policy represents a sharp departure from policies exercised in recent years when 3000 net staff increase limits have been set. Furthermore, during the final stages of the 2013 budget preparation, and after this operation had already been negotiated, the PA announced other control measures of public sector pay practices. Together, the PA projects these measures will cap the wage bill growth in shekels at about 2 percent. 81. Furthermore, in recent years, the PA has also launched structural reforms of the civil service, introducing in particular more transparency in recruitments with the July 2005 Civil Service Law and consolidating the databases for both civil and security sector payroll from Recently, the General Personnel Council (GPC) launched a general review of all posts in each line ministry or agency, called Job Descriptions and Job Classification (JDs and JC). This review was undertaken following key recommendations made by the World Bank in The ultimate objective is to rely upon the job classifications as criteria to determine budget allocations for staff costs to various ministries. GPC also intends to carry out a series of functional reviews, looking at the overall machinery of government and major ministries and departments. Specific measures proposed to be undertaken: 82. Having in mind the importance of a fast enough reduction in the relative size of the public sector wage bill to the overall fiscal stance of the PA, this operation will support the following measures: All new hiring and promotions of the employees of the Palestinian Authority have been effectively frozen during the period of August 25 December 31, 2012 in accordance with a decree of the President of the Palestinian Authority. The Cabinet of Ministers has adopted a decision mandating zero net hiring of civil and security personnel in the 2013 Budget of the Palestinian Authority. Expected results: 83. The 2013 central government nominal wage bill growth has not exceeded 4.25 percent (in Shekel terms) and is lower as a percent of GDP than the 2012 wage bill In addition civil service reforms supported by this operation, it is noteworthy that the PA is also upgrading its HR management systems. It has developed an in-house HRMIS with impressive capabilities. It introduced electronic archiving of files on each employee, including the PA staff in Gaza. The system has been designed to manage staff performance evaluations and promotions. The system has been designed to benefit five different groups of users: managers in line ministries, employees, auditors, and job seekers. The system enables easy access to data and statistics on public sector employment and pay. 25 As noted above, after this operation had already been negotiated, the PA announced additional actions, which it hopes would limit the wage bill growth in the 2013 budget to around 2 percent. 27

31 Social Assistance Description of the situation: 84. The PA has been a regional leader in the social protection reform efforts and has improved benefit targeting to those most in need, as well as the overall transparency and accountability of the system. It implemented a formula based targeting, which takes into account easily identifiable characteristics and recent poverty data. The Ministry of Social Affairs (MoSA)- managed Palestinian Cash Transfer Program (CTP) provides quarterly cash transfers to approximately 95,000 poor households throughout the West Bank and Gaza and is funded by the PA, European Union (EU) and the World Bank. CTP targeting, which relies on a proxy means test (PMT) formula is effective with errors comparable to programs widely considered successful worldwide. The program s Management Information System (MIS) with a poverty-targeting database contains information on approximately 150,000 households and monitors and tracks CTP applications, enrollment and payments. This database is used by various development partners for their own programs. 85. However, between 2010 and 2011 the number of CTP recipients has increased from 64,000 to 95,000 households, which costs US$105 million per year, and is not covering only those identified as poor. By design, the CTP eligibility is contingent upon a household s poverty level based upon the application of the PMT formula. But faced with pressures against graduating ineligible households from the CTP, the MoSA decided to expand the CTP to also include the following population categories, which may not meet the PMT formula based criteria: (i) households falling in between the deep (or extreme) poverty line and the national poverty line; (ii) households who were previously receiving benefits under the Transition Assistance Program (TAP); and (iii) households characterized as "vulnerable" (this included households whose head is female, elderly, disabled, and/or chronically ill). Most of the households classified under TAP are poor and receiving the minimum amount of benefit. However, close to a half of households classified as vulnerable were not poor and were, therefore, receiving cash assistance through the CTP to the exclusion of extremely poor households which were on waiting lists. It is estimated that the benefits accruing to non-poor within the vulnerable group amount to around US$8 million per year. Policy challenge: 86. To ensure that the CTP is effective (providing regular adequate cash transfers to poor households) and sustainable, households which no longer qualify for CTP assistance should be graduated into other social assistance programs. This would require extending the application of the CTP formula to the vulnerable group, whose eligibility for social assistance is currently categorical and not formula-based. Government actions to date and future activities to address the challenge: 87. The PA is conducting a range of activities to enhance efficiency and sustainability of its social assistance programs. It has been active in increasing outreach to the poorest households to ensure that all of them are included in the database, which is necessary for achieving the CTP s objective of providing assistance to all poor households. In June 2012, MoSA has completed the database update campaign whereby about 33,000 households across the West Bank were recertified. As a result, the total of 2,466 households was excluded from the CTP for being no longer eligible. A few others were diverted to non-cash assistance programs while MoSA is currently in the process of determining the status of 4,471 households. Furthermore, to ensure fiscal sustainability of the CTP program and further increase the percentage of social assistance going to the poorest segment of the population, MoSA has decided to extend the application of the PMT formula, also to beneficiaries under the vulnerable group. 28

32 Specific measures proposed to be undertaken: The Ministry of Social Affairs of the Recipient has adopted a decision mandating the application of a proxy means test formula set forth in the Cash Transfer Program s Operational Manual to determine the eligibility of households categorized as the vulnerable group to receive cash benefits under the Cash Transfer Program. Expected results: 88. The planned reforms will support continued development of an effective and fiscally sustainable social protection system, which can effectively meet various needs of disadvantaged and marginalized households throughout the West Bank and Gaza. In particular, the aim is to create a system that can effectively provide assistance to the neediest categories of the population. The immediate result in 2013 will be to limit the growth of CTP households under the vulnerable group to a maximum of 19,200. As the non-poor households are excluded from the program, savings of around US$8 million per year will be generated that will enable additional poor beneficiaries to become eligible for benefits under the CTP. Medical Referral System Description of the situation: 89. In recent years there has been a steep increase in PA s health expenditures on outside treatment referrals, usually at the tertiary care level for those services that are not available in Ministry of Health (MoH) facilities. The number of referrals has increased from 8,123 in 2000 to 56,468 in The corresponding expenditure has also increased significantly from less than US$10 million in 2000 to as much as US$125 million in This high and increasing level of expenditure on outside referrals is not fiscally sustainable. Currently, unpaid bills to outside service providers amount to more than NIS 72 million (US$ 18 million). Finally, according to an assessment conducted by the Bank, this rapid growth in referral costs cannot be explained by demographic or epidemiological factors alone, although the demographic transition and the increase in the incidence of non-communicable diseases (NCDs) may have played a minor role. Thus, there is a large scope for efficiency improvements. 29

33 Thousand cases Million NIS Figure 5: As the number of patients referred for outside treatment increased, referral costs have increased very rapidly West Bank (left axis) Gaza (left axis) Cost (right axis) Source: Palestinian Ministry of Health, World Bank staff estimates. Note: Data for and 2004 do not differentiate between WB and Gaza. Cost estimates refer to budget spending ( ) and estimated cost based on contracts (starting 2003). The drop in 2006 was due to the suspension of services over several months. Policy challenge: 90. The high level of MoH spending on outside referrals is of increasing concern and has been the focus of World Bank technical assistance (TA) efforts in the past several months. This TA has identified specific issues related to sustainability, access, efficiency, purchasing and overall processes that need to be addressed in order to improve equity and efficiency of outside referrals. 91. The immediate challenge for the PA is to address excessive referrals while ensuring equitable access to appropriate and needed care for populations throughout the West Bank and Gaza. The PA has identified health sector reform as a major priority, with a future aim of adopting universal health coverage, while acknowledging that it must first focus its efforts on cost containment of the current health sector system. 92. The Bank has previously been engaged in unsuccessful efforts to reduce the cost of medical referrals in the Palestinian public healthcare system. The current Minister of Health has, however, demonstrated firm commitment to reforms of the healthcare system, giving top priority to the reduction of referral costs. While risks to the success of the current reform efforts certainly exist, in particular given the high financial stakes involved, the commitment shown by the current government, and in particular the Minister of Health to these reforms, along with the importance of such reforms for overall fiscal sustainability, provide a strong rationale for the Bank s renewed engagement in this area. Furthermore, a detailed assessment that the Bank has conducted clearly identifies the sources of growth in referral costs and the Bank is providing technical assistance to help the authorities address the main problems on the basis of the recent assessment. 30

34 Government actions to date and future activities to address the challenge: 93. The PA put forth the Palestinian National Health Strategy (NHS) for the period of 2011 to 2013 Setting Direction Getting Results, with the main focus on health financing and insurance system reform, and improved financial management. One major accomplishment has been the institutionalization of the National Health Accounts (NHA) system, which enabled the production of an insightful report in This system, along with Bank technical assistance, will be critical in assessing the fiscal and financing implications of various reform options to improve efficiency and equity in the health sector and specifically with respect to outside treatment referrals. To this end, the Government has brought the administrative unit in charge of the special treatment referrals under the authority of the General Directorate for Health Insurance, and now all referrals are channeled through the Directorate, while at the same time more stringent criteria and controls for outside treatment referrals are being applied. The PA has also been supported by the Bank-funded TA. The TA missions collaborated closely with MoH staff, including health care workers, staff from NGOs, research institutions, centers and international organizations. 26 Specific measures proposed to be undertaken: 94. A number of areas need to be addressed in order to improve the equity, efficiency and sustainability of outside treatment referrals: (1) reducing benefit coverage by improving effectiveness of primary and secondary services; (2) reducing the number of service providers and strengthening regionalization; (3) identifying criteria for provider selection; (4) addressing contract management weaknesses and improving information management and monitoring approaches; and (5) improving existing processes by integrating clinical and financial information into one system, developing authorization guidelines, revising classification of procedures and strengthening diagnostic capacity at a facility-level. A medical committee was recently established with clear terms of reference to rationalize the referral process in a transparent, equitable and efficient manner. This operation supports the following action, which represents an early, but a decisive step to reform the medical referral process: The medical referral process has been strengthened through formal decisions and instructions taken by the Minister of Health to expand and refresh the membership of medical referral committees, to centralize the process by bringing the referral audit function under the direct authority of the General Directorate for Health Insurance, and instructions to medical referral committees to make referrals to medical institutions in Israel only when absolutely necessary and with the Minister's prior approval. Expected results: 95. It is expected that through these efforts, the number of outside treatment referrals will fall compared with 2012 and the associated costs will decrease as a share of total public expenditures on healthcare by at least two percentage points in 2013 from 31 percent in Furthermore, through a number of the recommended actions related to design, organization, management and quality of services, the MoH is expected to provide more equitable and effective primary, secondary and tertiary care services. 26 The overarching objective of the TA is to increase efficiency of public health expenditures with a view to ensuring fiscal and financial stability of the proposed universal health coverage. To achieve these aims, in addition to improving equity and efficiency of outside referrals, this TA is undertaking an assessment of the fiscal space from the expenditure side and sustainability for universal health coverage and institutional capacitybuilding. 31

35 Policy Area II: Improve Governance and Transparency in the Public Sector Public Procurement Description of the situation: 96. The Country Procurement Assessment Report (CPAR), prepared by the Bank in 2004, highlighted several shortcomings in the legal framework, institutional setup, and the capacity of the procurement staff. The CPAR provided recommendations to assist the PA develop its capacity to plan, manage, and monitor public procurement effectively. It also provided recommendations to improve accountability, integrity, and transparency of the system, in addition to those aimed at preventing corruption and harmonizing the national procurement law and regulations with internationally accepted principles and practices. One of the proposed reform objectives was also to increase opportunities for local suppliers, contractors and consultants. In response to the CPAR recommendations, the PA launched, with Bank support, the reform of the public procurement system by the drafting of the new public procurement law (the PPL) and detailed implementing regulations starting in early The law was finally enacted on December 25, 2011 and further activities to ensure its implementation are underway, albeit at a slower pace than had been anticipated. Policy challenge: 97. A key challenge for the PA now is to develop the supporting institutional infrastructure to implement the PPL. The enactment of a good procurement law is only the first step in the development of a sound procurement system. Other critical components of the procurement system need to be put into place, including the adoption of the supporting regulations for the new law, establishing an independent public procurement policy body, implementing national standard bidding documents, instituting a training program of the procurement workforce, and taking additional measures necessary to make the law effective. The reforms represent a major institutional transformation which will take a couple of years to complete and building institutional and human resource capacity to support it is a particular challenge. Government actions to date and future activities to address the challenge: 98. Pursuant to the new procurement law of December 25, 2011, the Council of Ministers approved on September 25, 2012 a decree establishing the Higher Council for Public Procurement Policies and determined its membership. The Higher Council consists of a Chairman and eight members, four representing PA ministries and the other four from outside the public sector. A draft report on the structure, roles and responsibilities of the Higher Council and related institutional arrangements was recently prepared by the international legal expert, hired through the Institutional Development Fund (IDF) grant. An action plan for the first year has been prepared. An important activity that the Council has already completed is the preparation of a complete set of draft procurement regulations, which will govern the operations of the reformed public procurement system based on the Public Procurement Law. Specific measures proposed to be undertaken: The Higher Council for Public Procurement Policy has been established by a cabinet decision of the Cabinet of Ministers, its members have been appointed and it has completed prepared a set of draft regulations on public procurement. 32

36 Expected results: 99. While it will take several years to achieve the intended objectives of the ongoing public procurement reforms, some specific results are expected to be achieved before the end of These results are: (1) The conduct of public procurement is based on new implementing regulations to the PPL; and on (2) the National Standard Bidding Documents for Goods, Works and Consultants Services, and the Procurement Manual. Ultimately, after the procurement reforms have been fully put into practice (beyond the scope of this operation), the system will be made more transparent, as all the information will be provided online and based on the standardized documents and procedures. A formal complaint mechanism will also be introduced. Other Public Finance Management Reforms Description of the situation: 100. Since its inception, the PA has implemented a wide range of reforms and other activities to build public finance management capacity. Reform progress in recent years has been impressive, despite the fact that the connection with the MoF office in Gaza was severed in 2007 creating a massive loss of capacity. However, the progress has been uneven across different areas of PFM. The budget preparation procedures in particular are highly centralized and still relatively basic. On the other hand, more progress has been made to strengthen the budget execution process In the face of recent fiscal challenges, two issues have repeatedly resurfaced as bottlenecks to more efficient and effective public finance and fiscal management. One specific problem cited by the MoF is the absence of a formal cash management system, which makes shortterm expenditure planning more complicated than necessary. Furthermore, while the MoF now has a much better infrastructure for PFM especially through the new accounting system it introduced- it is underutilizing the system for management and reporting purposes. Consequently, some important information on public expenditures was not until recently publicly available and easily accessible to all relevant stakeholders. Policy challenge: 102. The PA needs to improve the transparency of its expenditure reports to inform budget planning and structural policies. Budget planning and cash forecasting at the municipal level are hampered due to the lack of clarity on the mechanism applied by the PA to allocate property tax receipts to municipalities. Property tax is one of the most viable sources of revenue for municipalities. Although property tax collection has increased, the amounts received by the municipalities have been fluctuating substantially due to the fact that the PA deducts the utility bills (called the intercept ) owed by municipalities to the GoI and transfers only netted amounts to municipalities. The lack of transparency in the calculation of the intercept makes it almost impossible for municipalities to use it as a reliable source of income for planning purposes. Finally, while budget execution reports have improved in recent years and the MoF is now producing reports based on the IMF GFS 2001 manual, transfer expenditures are not disaggregated in budget execution reports. This clouds policy making related to this growing category of expenditures. Government actions to date and future activities to address the challenge: 103. In recent years, the PA budget execution system has been improved in several ways. The following actions are noteworthy: (i) the implementation of an Integrated Financial Management Information System (IFMIS) to strengthen expenditure control and prevent significant deviations from the approved budget; and (ii) the devolving of budget execution payments to line ministries through banking arrangements (treasury single account) ensuring the necessary spending oversight by the 33

37 Treasury. Efforts are also underway to improve cash planning and forecasting, assisted by the Bank. Public expenditure reporting has also improved in recent years and the MoF now produces monthly fiscal reports reflective of GFS 2001 methodology Furthermore, the authorities are taking action to improve the transparency and predictability of municipal tax receipts and strengthen municipal finances in general. Specifically, the PA and its Ministry of Local Government (MoLG) have demonstrated reform commitment through the following actions: (i) the formation of the Inter-Ministerial Committee on Municipal Finance Reform; (ii) support to improving municipal capacity in financial management; (iii) measures to improve municipal revenues, particularly the property tax. Since 2008, the MoF has been rolling out a program to improve property tax collection. Collection has increased from US$10 million in 2006 to US$30 million in 2010; and (iv) the interest of the PA/MoLG in designing a system with effective incentives for efficient municipal behavior through the Municipal Development program The PA plans to improve reporting on its transfer expenditures, which until recently have not been broken down into subcategories in official fiscal reports. New reporting practices will better inform policymaking pertaining to this continuously growing category of expenditures. Specific measures proposed to be undertaken: As of January 2013 the MoF has started the practice of publishing quarterly reports on the allocation of property tax to municipalities that specifically indicate each deduction from the amount collected and the amounts paid to local government units. Starting in January 2013 monthly fiscal reports published by the MoF on its website are revised to include a breakdown of transfer expenditures into main subcategories (e.g. pensions, social benefits). Expected results: 106. The implementation of the proposed measures will enable the PA to better plan expenditures, reduce the accumulation of arrears pertaining to lower priority expenditures and improve fiscal sustainability. The immediate results expected in 2013 are that municipal authorities, other stakeholders, and the general public will be able to easily access information that indicates the amount of property tax collected, deductions from property tax collected by the central government and the breakdown of transfer expenditures into main subcategories from the Ministry of Finance website. Given that these reforms have already been implemented, it is noteworthy that more details on transfer expenditures are now provided than had been discussed with the Bank when the prior action was agreed. 34

38 Box 4: Summary of Prior Actions for DPG V Prior Action 1: The VAT Administration and the Customs Administration have been successfully merged in accordance with a decision of the Ministry of Finance and a new single administration has a new organizational chart and is fully staffed and operational. Prior Action 2: A new Tax Identification Unit has been established within the Revenue Administration of the Ministry of Finance and is adequately staffed. Prior Action 3: All new hiring and promotions of the employees of the Palestinian Authority have been effectively frozen during the period of August 25 December 31, 2012 in accordance with a decree of the President of the Palestinian Authority. Prior Action 4: The Cabinet of Ministers has adopted a decision mandating zero net hiring of civil and security personnel in the 2013 Budget of the Palestinian Authority. Prior Action 5: The Ministry of Social Affairs of the Recipient has adopted a decision mandating the application of a proxy means test formula set forth in the Cash Transfer Program s Operational Manual to determine the eligibility of households categorized as the vulnerable group to receive cash benefits under the Cash Transfer Program. Prior Action 6: The medical referral process has been strengthened through formal decisions and instructions taken by the Minister of Health to expand and refresh the membership of medical referral committees, to centralize the process by bringing the referral audit function under the direct authority of the General Directorate for Health Insurance, and instructions to medical referral committees to make referrals to medical institutions in Israel only when absolutely necessary and with the Minister's prior approval. Prior Action 7: The Higher Council for Public Procurement Policy has been established by a decision of the Cabinet of Ministers, its members have been appointed and it has prepared a set of draft regulations on public procurement. Prior Action 8: As of January 2013 the Ministry of Finance has started the practice of publishing quarterly reports on the allocation of property tax to municipalities that specifically indicate each deduction from the amount collected and the amounts paid to local government units. Prior Action 9: Starting with January 2013 monthly fiscal reports published by the Ministry of Finance on its website are revised to include a breakdown of transfer expenditures into main subcategories (e.g. pensions, social benefits). 35

39 Box 5: Good Practice Principles for Conditionality Principle 1: Reinforce Ownership The operation supports the Palestinian National Development Plan (PNDP) which was developed through wide consultations within the government and with elements of civil society. The PA therefore has strong ownership of the proposed operation. Reforms supported by the operation focus on key measures that are politically feasible and are also necessary for achieving goals of the PNDP. Principle 2: Agree up front with the government and other financial partners on a coordinated accountability framework The operation s policy matrix, which is attached to this document, is at the core of the accountability framework. The matrix outlines key prior actions that have clear outcome indicators in addition to other proposed activities that go beyond the time frame of DPG V. The matrix reflects reform priorities that were developed jointly with the PA during preparation of DPG V. The matrix was also discussed with the IMF and other key development partners operating in West Bank and Gaza including DFID, Norway, Australia, and France in order to ensure maximum aid coordination. Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances Bank staff and PA officials from various ministries have worked closely to identify the reform program supported by this DPG V. It focuses on strengthening the PA s fiscal position and enhancing governance and transparency in the public sector which are key priorities for the PA especially given its current stressful financial situation. The majority of sensitive policy reforms covered by the operation are backed by analytical work by the Bank or the IMF. Even though additional reforms needed to address some of the main sources of inefficiency in public spending were identified by the DPG team, those were not pursued by this operation due to specific country circumstances related to political economy and social considerations. Principle 4: Choose only actions critical for achieving results as conditions for disbursement The number of prior actions has been reduced as the operation was developed, keeping only those actions that are critical for the success of the reforms supported by the operation. The prior actions are rooted in the reform priorities of the PA and in the ISN for West Bank and Gaza. The program focuses on outcomeoriented actions that will enable the program to achieve its overall objectives. Principle 5: Conduct transparent progress reviews conducive to predictable and performance-based financial support The PA has put in place a mechanism for regular quarterly monitoring of implementation progress. It has been producing quarterly reports on DPG implementation. This very same monitoring and evaluation framework and the DPG results framework are used to monitor progress against the PRDP Trust Fund. The Bank reviews these reports in consultation with the IMF. The DPG program is expected to provide predictable financial support that is incorporated into the PA s budget and is consistent with its macroeconomic framework. 36

40 VI. OPERATION IMPLEMENTATION A. POVERTY AND SOCIAL IMPACTS 107. Government actions supported under this operation are not expected to have any negative impact on poor and vulnerable groups in the West Bank and Gaza. For instance, measures aimed at improving tax revenue collection will not change tax rates or increase the tax liability of the poor and vulnerable groups. They are aimed at improving the collection efficiency and reducing tax evasion by private enterprises and wealthier individuals. 27 Measures aimed at containing government expenditures and improving their efficiency will not cut any benefits to the poor. No negative effects are expected as a result of the measure to limit hiring, as it entails that all vacancies created as a result of retirement, or other eventualities will be filled through new recruitments On the contrary, these measures are aimed at protecting the fiscal space for pro-poor expenditures. For instance, the prior action that will apply the proxy means targeting methodology as criteria for the inclusion of new beneficiaries into cash transfer programs will prevent non-poor households from receiving cash benefits at the detriment of poor households that have not yet been included in the program due to limited budget. Currently, it is estimated that about US$8 million worth of CTP benefits per year accrue to non-poor. By expanding the use of proxy means targeting to determine CTP eligibility for the so called vulnerable group, and graduating the households who are no longer poor from the program, fiscal space is being created to provide benefits to those who are most in need. These measures are expected to further increase the proportion of benefits going to extremely poor from the current estimate of about 80 percent. The measure aimed at rationalizing the cost of medical referral, by preventing unwarranted referrals for outside treatment, will improve the sustainability of health care spending, while ensuring a more equitable access to outside treatments and is not expected to have a negative impact on poor and vulnerable categories of the population Over the medium-term, the reforms supported by this operation are expected to translate into augmented fiscal space for essential poverty-reducing programs and improved prospects for employment opportunities in the private sector. Measures aimed at increasing government revenues combined with measures to reduce inefficiencies in public expenditures will increase the fiscal space for essential poverty-reducing expenditure programs. Improved fiscal management is also an important requirement for economic growth and job creation. The measures supported by this operation to strengthen the public procurement process should reduce the procurement costs and thereby increase the fiscal space for essential public services; these reforms should also enhance business opportunities for more domestic companies and consequently support growth and employment of the private sector. This would have a positive poverty and social impact. Other PFM reforms supported by this operation are aimed at strengthening public finance management practices, which usually strengthen accountability of public officials, increase efficiency and efficacy of public expenditures, all of which are important determinants of economic growth and development. B. ENVIRONMENTAL ASPECTS 110. DPG V will not have significant effects on the country's environment, forests and other natural resources. The environmental and natural resource implications are driven by the activities embedded in the design of an operation. In the proposed operation, none of the prior actions as listed in the policy matrix will have environmental impacts or risks. 27 Individuals with gross taxable annual income of less than NIS 50,000, which is significantly above the household poverty line (NIS 27,516) are within the 5 percent tax bracket and with allowances pay a maximum of NIS 1,000 of tax. 37

41 C. IMPLEMENTATION, MONITORING AND EVALUATION 111. The PA has put into place a mechanism for regular quarterly monitoring of implementation progress. The PA has been producing quarterly reports on DPG implementation. This very same monitoring and evaluation framework and the DPG results framework are used to monitor progress against the PRDP Trust Fund. The Bank reviews these reports in consultation with the IMF. The Bank focuses on progress on structural reforms while the IMF provides detailed input on fiscal and PFM issues. In the previous Reform Trust Fund, monitoring proved to be a major challenge. Many of the benchmarks had been developed without input from the PA line ministries. However, in PRDP DPG I - IV, the policy matrix was anchored in the PRDP/PNDP, which was developed after wide consultation throughout the PA and among other stakeholders. The policy matrices reflected what all parties, not only deemed important, but also achievable and what could be monitored. The PNDP DPG V continues this approach. The matrix is based on the PNDP and reflects lessons learned from the last operation The Bank team managing the PNDP DPG V is located in the Bank s Jerusalem office and is thus able to have daily contact with their PA counterparts. The Bank team continues to include a Senior Public Finance Management Specialist in the Jerusalem office to work alongside the TTL/Country Economist monitoring the PNDP DPG V. The task team leader for the social safety net reform projects is also resident in the local Bank office. The main ministries responsible for implementing the reforms supported by the PNDP DPG V are the MoF, MoSA, and the Ministry of Health, with which the Bank has developed a strong relationship. The IMF has a resident advisor to the MoF s macro-fiscal unit and the Bank team works closely with him and the rest of the IMF mission to provide assistance to the MoF, and to review implementation progress on budget-related and PFM issues. D. FIDUCIARY ASPECTS Public Financial Management System 113. While several challenges in the PFM system remain, reforms are underway, but need to be further developed and enhanced. DPG V will be executed through the Government s PFM systems. Based on the information from the Bank, IMF, and donor reports on PFM, the Palestinian PFM system is deemed to be adequate insofar as the Bank s criteria and standards for approval of development policy operations are concerned. Recent improvements in PFM include the following: Launch of the Integrated Financial Management System (Unified Bissan) that helped consolidate budget implementation processes, strengthen payment controls and improve fiscal reporting. This system has been rolled out in all line ministries. All PA revenues are accounted for in the Central Treasury Account. Transformation of line ministries and agency bank accounts into zero-balance accounts. MoF is exercising control over budget expenditures, and has imposed strict limits on nonwage expenditures and makes adjustments as needed. Additionally, the Budget is published on MoF s official website and is made available to the public. MoF established a central internal audit function; the internal audit department s role is gradually evolving in line with international standards and has begun to be decentralized from MoF to 15 key line ministries. 38

42 Salaries of the PA s civil and security servants have been paid through direct deposit into personal employee bank accounts. A practice of auditing the final accounts has been initiated and final accounts for the FY 2010 were audited by the State Audit Administrative and Control Bureau (SAACB) though with some delays (published in the SAACB website in March 18, 2013). The SAACB issued a qualified opinion on some components of the financial statements that need to be addressed However, more improvements need to be adopted to further consolidate progress and address the challenges facing the PFM systems. As part of the NDP process a PFM strategy was developed by the PA. Key elements of the strategy with respect to fiduciary controls include: Further developing cash management by strengthening cash forecasting and improving the link with the commitment control system. Building capacities for financial management at both the MoF and line ministries, given the objective of devolving more financial management responsibility from MoF to line ministries. Further enhancing the internal audit function and continuing the decentralization of this function to all line ministries. Strengthening accounting and reporting by fully adopting International Public Sector Accounting Standards, and by increasing budget transparency. Continuing to build the State Audit and Administrative Control Bureau audit capacities as well as the legislative framework. Ensuring better integration of donor programming into the annual development budget The fiduciary risk related to this operation is considered to be Substantial. An ongoing PEFA (first quarter 2013) will provide a more updated insight on the current situation of the PFM system. The 2010 financial and compliance audit report by the SAACB also points to PFM weaknesses that need to be addressed, in some cases requiring technical assistance. In view of the substantial fiduciary risk, the following additional arrangements will be applied to this operation: a) a dedicated foreign currency bank account will be used to segregate grant proceeds from the PA s other bank accounts so as to enable an audit of the account; and b) The PA will hire an independent external auditor acceptable to the Bank to perform an audit of the dedicated account. See Annex 4 for further details on the PFM environment. Disbursement 116. Once the Grant is approved by the Board and becomes effective, the PA will submit a withdrawal application to the Bank. Similar to DPG IV disbursement arrangements followed by the PA, the Grant proceeds will be disbursed against satisfactory implementation of the development policy program. Once the World Bank is satisfied with the program being carried out by the PA and with the appropriateness of the PA's macroeconomic policy framework, the Grant proceeds will be disbursed in a single tranche to a US Dollar Dedicated Account that forms part of the PA s official foreign exchange reserves to finance budgeted activities/expenditures. In the absence of a central bank, the dedicated account will be held at the Bank of Palestine, a commercial bank that is deemed acceptable to the World Bank. Transactions and balances of the account will be promptly and fully incorporated into the Government accounting records and financial statements. The PA will confirm to the Bank within 30 days of disbursement, the receipt of Grant funds and that the Grant proceeds have 39

43 been credited to the Central Treasury Account (CTA) (including the date and number of the CTA account in which the funds have been deposited), as well as the exchange rate applied. Flow of Funds 117. Upon effectiveness of the Grant, the Bank will disburse the funds to a dedicated US Dollar Account (DA) maintained by MoF under the CTA at the Bank of Palestine. Within one week of the receipt of funds in the deposit account, the MoF will convert the US dollar amount into NIS at the prevailing exchange rate at the date of conversion. If any portion of the credit is used to finance ineligible expenditures as defined in the Grant Agreement, the Bank shall require the PA to refund the ineligible amount. Diagram 1: Flow of funds arrangements for PNDP DPG V Grant proceeds to U.S. $ Dedicated Account Grant proceeds converted to NIS Dedicated Account MoF Central Treasury Account- NIS Account Expenditure on eligible budget activities External Auditing of the Grant Dedicated Account 118. The PA will hire an independent external auditor acceptable to the Bank to perform an audit of the DPG V dedicated account. The audit will be conducted in accordance with international standards and with terms of reference acceptable to the Bank. The audit report will be approved and signed by the MoF before it is submitted to the Bank. The audit report will be submitted to the Bank within six months from the release of the single tranche payment. The external audit fees will not be financed from the Grant funds. For DPG IV, MoF submitted an acceptable external audit report in a timely manner, the external auditor expressed unqualified clean opinion on the related dedicated account, and the management letter did not include significant weaknesses in the PA internal control system In general, the auditor will be required to: Validate the transfer and deposit transactions relating to the Grant; Verify the extent to which the Bank s requirements under the Grant agreement are being met, and whether the PA s procedures are adequate to serve that objective.; Verify that no funds are kept in or paid into the Dedicated Account other than those disbursed by the Bank for this particular operation; Ensure that all payments from the Dedicated Account are for eligible budgetary purposes, following procedures established by the PA's MoF; and Ensure that the MoF follows adequate disbursement procedures as per PA and governmental standards, including accuracy of exchange rate prevailing at the date of conversion from US Dollar to New Israeli Shekel and within one week of the receipt of funds in the deposit account. 40

44 E. RISKS AND RISK MITIGATION 120. The implementation of the government s reform program under the NDP and likewise this operation which is designed to support it are exposed to multiple and significant risks. These risks are primarily related to the internal political situation in the West Bank and Gaza, as well as the actions of the Government of Israel (GoI) and the donor community The key risks are: Risk mitigation i. The political and security situation in the West Bank and Gaza is very fragile, as demonstrated by the very recent outbreak of conflict in Gaza, which remarkably increased the level of uncertainty pertaining to the economic and political situation. The recent social unrest and civil service strikes also attest to the fragility of the political situation. The highly volatile political situation could deteriorate, with the consequence of stalled reforms. If the security situation relapses, private sector confidence and investment will decline, public revenues will fall and government reforms may stall. What is critical at this juncture is that the PA has continued to implement structural reforms despite the highly difficult economic environment and fiscal pressures and remains committed to continued reforms. 1 ii. The PA is striving to improve its fiscal position, but for the foreseeable future it will remain dependent upon high and predictable levels of aid. While the PA has charted a course toward lesser dependence on external aid and is actively undertaking the relevant reforms, it will take many years for the PA to achieve fiscal sustainability and that will only be possible if there is a political settlement that allows for strong private sector-led growth. Thus, a further reduction in donor assistance is a significant source of risk to PA s finances and the Palestinian economy as a whole. iii. The PA will not be able to meet its fiscal goals without substantial economic growth. However, under the recent political uncertainties, the broad relaxation of movement and access restrictions imposed by GoI in both Gaza and West Bank and restrictions on economic activity in Area C slowed down. The international donor community is continuing to monitor the closure system and its economic impact. iv. Fiduciary risks are also substantial, as discussed in Section D above The above risks cannot be fully mitigated by the operation. However, the operation was designed to minimize the likelihood and the potential impact of some of the abovementioned risks. This proposed fifth DPG sends a strong signal to donors that the World Bank places great importance on progress on the NDP and that donors should continue to support it. Most importantly, the operation leverages around US$200 million per year in additional financing through the PRDP Trust Fund, which the Bank administers. This will mitigate the risk of reduced donor assistance on PA s finances. A simple design and strong PA ownership of the reform program supported by this operation, which contribute to fiscal consolidation and reduced reliance on donor assistance over the medium term, are also mitigating factors. On balance, the potential benefits of the operation justify the Bank s engagement despite the significant risks identified above. 41

45 ANNEXES 42

46 ANNEX 1: LETTER OF DEVELOPMENT POLICY 43

47 44

48 45

49 46

50 47

51 48

52 ANNEX 2: OPERATION POLICY MATRIX Objectives Proposed prior action (to be met by end Dec 2012) EXPECTED RESULTS Indicator Baseline (2012) Target (2013) Proposed activities beyond DPG V (implementation in ) I. Strengthen the PA Fiscal Position Prior Action 1 I.1.Enhance public revenue performance The VAT Administration and the Customs Administration have been successfully merged in accordance with a decision of the Ministry of Finance and a new single administration has a new organizational chart and is fully staffed and operational. Prior Action 2 A new Tax Identification Unit has been established within the Revenue Administration of the Ministry of Finance and is adequately staffed. Domestic tax revenue from VAT, customs and income taxes in nominal terms and as a percentage of GDP. US$480 million or 4.7 percent of GDP Domestic revenues from VAT, Customs, and income tax combined in 2013 have increased by at least 10 percent in nominal terms and are higher as a share of GDP compared to Continue implementing the MoF Revenue Strategy with the focus on strengthening the enforcement capacity of the Large Tax Payer Unit. Launch reforms to the legal framework for personal income tax and corporate income tax based on the recommendations of the IMF Topical Trust Fund. I.2.Improve efficiency and sustainability of public expenditures CIVIL SERVICE: Continue with efforts to reform the civil service and reduce the share of the government wage bill to GDP. 49

53 Prior Action 3 All new hiring and promotions of the employees of the Palestinian Authority have been effectively frozen during the period of August 25 December 31, 2012 in accordance with a decree of the President of the Palestinian Authority. Prior Action 4 The Cabinet of Ministers has adopted a decision mandating zero net hiring of civil and security personnel in the 2013 Budget of the Palestinian Authority. Prior Action 5 The Ministry of Social Affairs of the Recipient has adopted a decision mandating the application of a proxy means test The central government wage bill in nominal terms and as a percent of GDP. Number of households in the vulnerable group (not meeting PMT criteria) receiving cash benefits. The central government wage bill equaled US$1.767 billion in 2012 and amounted to 17.2 percent of GDP. 19,200+ and continues to grow. The 2013 central government nominal wage bill growth has not exceeded 4.25 percent (in Shekel terms) and is lower as a percent of GDP than the 2012 wage bill. Number of households in the vulnerable category not exceeding 19,200. Specifically, launch functional reviews to assess staffing requirements for individual line ministries and other budget organizations. Launch a pay and grading reform. PENSIONS: Continue with parametric and FM reforms aimed at ensuring long-term viability of the pension system. NET LENDING/POWER SECTOR REFORMS: Intensify efforts to reduce net lending to the sector by improving financial performance of power utilities through reforms aimed at reducing technical losses, power theft, improving the collection rate and other reforms deemed appropriate for effectively achieving the same objective. 50

54 formula set forth in the Cash Transfer Program s Operational Manual to determine the eligibility of households categorized as the vulnerable group to receive cash benefits under the Cash Transfer Program. Prior Action 6 The medical referral process has been strengthened through formal decisions and instructions taken by the Minister of Health to expand and refresh the membership of medical referral committees, to centralize the process by bringing the referral audit function under the direct authority of the General Directorate for Health Insurance, and instructions to medical referral committees to make referrals to medical institutions in Israel only when absolutely necessary and with the Minister's prior approval. Referral costs as a share of total public healthcare spending. 31 percent. The share of outside referral costs to total public healthcare spending has decreased by at least two percentage points in 2013 compared to the 2012 figure of 31 percent. MEDICAL REFERRALS: Complete the reforms of the referral system to ensure that all medical referrals are conducted based on clear and transparent criteria that eliminate unnecessary referrals and substantially reduce the share of referral costs in aggregate public health expenditures. 51

55 II. Improve Governance and Transparency in the Public Sector II.1.Strengthen effectiveness, efficiency and transparency of public finances. Prior Action 7 The Higher Council for Public Procurement Policy has been established by a decision of the Cabinet of Ministers, its members have been appointed and it has prepared a set of draft regulations on public procurement. Prior Action 8 As of January 2013 the Ministry of Finance has started the practice of publishing quarterly reports on the allocation of property tax to municipalities that specifically indicate each deduction from the amount collected and the amounts paid to local government units. Prior action 9 Institutional arrangements to implement the new Public Procurement Law. Ability of municipal authorities, general public, and other relevant stakeholders to access information on specific public revenues and expenditures. Implementing regulations for PPL are not in place, the Higher Council is not operational, standard bidding documents in line with the new PPL have not been adopted. Municipal authorities, citizens, and other non-government stakeholders have no easy access to information on the amount of property tax collected, deductions from property tax collected by the central government, or the breakdown of transfer expenditures into (1) The conduct of public procurement is based on new implementing regulations to the PPL as well as on the (2) National Standard Bidding Documents for Goods, Works and Consultants Services, and Procurement Manual. Municipal authorities, other stakeholders, and general public can easily access information that indicates the amount of property tax collected, deductions from property tax collected by the central government and PUBLIC PROCUREMENT: Complete trainings in all line ministries to prepare staff to implement the new PPL. OTHER PFM: Implement formal cash planning procedures. Continue with reforms to introduce internal audit in line ministries. Harmonize the accounting practices with International Public Sector Accounting Standards (IPSAS). 52

56 Starting with January 2013 monthly fiscal reports published by the MoF on its website are revised to include a breakdown of transfer expenditures into main subcategories (e.g. pensions, social benefits). main subcategories. the breakdown of transfer expenditures into main subcategories from the Ministry of Finance Website. 53

57 ANNEX 3: FUND RELATIONS NOTE West Bank and Gaza Assessment Letter to the World Bank January 15, 2013 Contact person: Mr. Christoph Duenwald, (202) , and Mr. Udo Kock ( ; EST + 7 hours) Economic Conditions and Outlook The Palestinian economy is facing serious risks, with a slowdown in growth and rise in unemployment in both Gaza and the West Bank. During , the West Bank s real GDP grew by an annual average rate of 9 percent, reflecting sound economic management and reforms supported by donor aid, and an easing of Israeli internal barriers. However, growth declined to 5.5 percent in January-September 2012, while unemployment rose to 19 percent on average from 18 percent in the same period the year before. The economic slowdown reflects continued fiscal retrenchment combined with severe financing difficulties, declining donor aid, and very limited easing of restrictions on movement and access. In Gaza, after a rebound in real output by about 20 percent on average in following the easing of tight restrictions, growth has declined to 7.7 percent in January-September 2012, and unemployment has risen to 31 percent from 28 percent in the same period last year. Looking ahead, with persisting restrictions, financing difficulties due to aid shortfalls, and a stalemate in the peace process, there is a high risk of a continued economic slowdown and a rise in unemployment. The Palestinian Authority (PA) s severe financing difficulties in 2011 and in 2012 have led to a substantial rise in domestic payment arrears and debt to commercial banks. In , donor aid for recurrent spending and development projects has been lower than needed to finance the already tight budgets. The consequent liquidity difficulties have been compounded by shortfalls in revenue in the context of a decline in economic growth and slower-than-expected implementation of clearance and domestic tax administration measures, as well as higher pension payments. Domestic payment arrears, including to the private sector and public pension fund, are estimated to have risen by about US$0.3 billion in the first half of 2012 with the increase in the second half of 2012 yet to be determined. The stock of government debt to domestic banks has increased to US$1.2 billion (12 percent of GDP) at end-november 2012 from US$1.1 billion at end Inflation has remained low so far in 2012, despite a moderate jump in the West Bank s CPI due to increases in the VAT rate and fuel prices. The WB&G s CPI inflation rate (in NIS) was 2.2 percent in November 2012, compared to 2.8 percent at end Inflation was significantly lower in Gaza (-0.4 percent) than in the West Bank (3.6 percent), reflecting the relaxation of the blockade on imports of consumer goods and foodstuffs and supply of goods through the tunnels with Egypt. Inflation in the West Bank increased to 6 percent (yoy) in September October 2012 following increases in the VAT rate and fuel prices. While Gaza s inflation had risen sharply above that of the West Bank during the blockade, it has been on a declining trend since 2009 following the end of the Gaza war. The WBG s banking system continues to perform well, with limited exposure to global markets and conservative practices in private sector lending, although the Palestinian Authority (PA) s debt to domestic banks has risen. Significant improvements in financial market infrastructure including a credit registry with a modern credit scoring system have enabled a rise in the private credit to deposit ratio from 33 percent at end-2010 to 38 percent at end-september The rise in private sector credit, in the year ending in September 2012, was sharper in Gaza (47 percent) than in 54

58 the West Bank (7 percent), reflecting Gaza s increased consumer credit demand as restrictions on imports were relaxed. The share of non-performing loans in total loans has fallen steadily, from 7 percent at end-2008 to about 2 percent at end-september Risks and Challenges To stem the risks of a continued economic slowdown, a rise in unemployment, and a deepening fiscal crisis, urgent and concerted actions are needed by the PA, the GoI, and the international community. It is important for the PA to adopt a 2013 budget that limits as much as possible the expected financing gap. Along with its efforts to address the immediate financing difficulties, it is also important for the PA to employ its enhanced institutional capacity to press ahead with measures to further raise public sector efficiency and phase out reliance on recurrent aid. It is essential that the PA continues to build on its track record by taking measures toward comprehensive pension and civil service reforms, further strengthening the social safety net, completing the commercialization of electricity distribution, and enhancing the legal and regulatory framework facing businesses. Additional aid is essential to sustain orderly reforms and fiscal adjustment. There is increased public anxiety that, even with additional austerity measures by the PA, much needed social spending would be cut and wage payments would continue to be delayed. The PA s persisting domestic payment arrears could lead to liquidity difficulties by private sector suppliers and public sector employees, which in turn could lead to a rise in banks nonperforming loans. It is thus critical that the PA s efforts be complemented by the prompt disbursement of additional aid to help cover the financing gap expected in Sustained economic growth requires the easing of restrictions on the WB&G s external trade, and access to the West Bank s Area C. The easing of these controls would relax a key constraint on private sector growth and employment, raise the WB&G s economic and budgetary revenue potential, and help ensure a sustained rise in Palestinians living standards. Joint PA-Government of Israel measures to raise clearance revenue should be implemented promptly to support the fiscal adjustment efforts. Status of IMF Relations WB&G is not a member of the IMF and therefore not eligible for financial assistance. Since the 1993 Oslo Accord, the Fund has been providing policy advice and technical assistance in the macroeconomic, fiscal, and financial areas. IMF staff is producing regular reports on implementation of the PA s financial sector reforms, public finance reforms and budget execution. Together with World Bank reports focused on structural reforms, the assessment of overall reform progress will be taken into consideration by donors in their disbursement decisions. 55

59 ANNEX 4: PUBLIC FINANCIAL MANAGEMENT AND FIDUCIARY ASPECTS The proposed DPG will be executed through the PA s public financial management (PFM) systems. In order to assess the fiduciary risks with respect to the proceeds of this operation, this annex summarizes the current state of certain aspects of these systems as well as ongoing reform efforts to further enhancement. This annex builds upon current analyses and previous reports, including the IMF and several PFM related assessments reports, and particularly the fiduciary assessment which was conducted by the World Bank in December 2011 and was updated in December The Palestinian PFM system is considered to be reasonably adequate as far as the Bank s criteria and standards for approval of general budget support operations are concerned. The following description of ongoing reform activities provides a more detailed assessment of the certain aspects of PFM reform in West Bank and Gaza. State Audit and Administrative Control Bureau The State Audit and Administrative Control Bureau (SAACB) is the supreme institution for oversight and external audit over actions of all entities receiving funding from the Palestinian National Authority. 28 The SAACB has been operating for several years, continually building its capacity. While the audit of the FY 2011 financial statements has not commenced yet, SAACB has completed the audit of the FY 2010 financial statements and issued a qualified audit opinion on the PA financial statements as well as on PA compliance with applicable laws and regulations for the year ended December 31, The SAACB identified significant issues in the PFM system that should further be addressed by the PA, such as: 1. Absence of an accounting policy on how to present and calculate arrears. 2. Lack of clear internal control policy regarding the management of the advance accounts 3. Discrepancy in budget and cash statements 4. Non-completion and inaccuracies in the bank reconciliations of the Petroleum Authority According to the audit law, the financial statements should be audited in a period of 24 months after the end of the fiscal year. However, MoF and SAACB are striving to comply with international practices which require the finalization of auditing the financial statements in period of six months after the end of each fiscal year. Currently, the EC is providing funding for an audit advisor which is the firm of PKF (UK LLP). The PKF advisors have started their three year contract which will require them to achieve the following objectives (a) build audit capacity, (b) improve the management structure of SAACB, (c) conduct a legal review of laws and regulations to identify areas for improvement, and (d) address the shortage of IT skills within SAACB. In addition they are providing technical assistance for the FY 2011 financial audits. 28 The SAACB is the responsible party for the external audit of the public institutions including NGOs and local government entities including Municipalities. A total of more than 1000 institutions fall under the SAACB mandate. SAACB is responsible for three area of audits; operational, financial, and compliance. 56

60 Going forward, there are several issues affecting the SAACB operating environment that need to be addressed, such as: Independence: The SAACB is not fully independent of the government and MoF. Although SAACB is legally independent, it is beholden to the MoF for funding in a challenging fiscal environment. SAACB s independence is critical if the organization seeks to comply with international standards. Staffing and administrative issues: SAACB has approximately 150 staff. SAACB staff is part of the civil service and thus their salaries are paid centrally from MOF. SAACB is working on hiring, and enhancing its staff capacity, as well as conducting the required audit to meet its mandate. Also, in Gaza there are 50 auditors who cannot perform their duties due to political reasons. SAACB personnel are under the civil service regulations which may hinder the strategic planning for human resources strategy aimed at orderly conducting mandated audit assignment. These human resources and administrative issues are being addressed through a review of the civil service law and work on position structures for all PA institutions. Mandate and scope of work: The SAACB has a broad mandate under the law; it is mandated to carry out ex-post audits for all the Palestinian Authority (PA) organizations. SAACB s mandate includes conducting external audit assignments of institutions at the levels of central government, local government, and non-government organizations. Also, it is mandated to monitor financial and administrative performance and to identify financial and administrative irregularities, including fraud and corruption. SAACB small size is disproportionate with its scale of activity. SAACB cannot exercise its mandate fully due to a scarcity of resources on one hand and weak administrative and financial independence on the other. With 150 staff only, the SAACB suffers from limited human resources, which affects its ability to perform its control functions. During the past few years, several donors have been involved with SAACB. The European Union has financed a consultancy to develop SAACB capacity as an external audit agency. The Bank intends to work with SAACB to roll out the use of country systems and it is planned that a road map will be developed to enable the SAACB to audit some Bank-financed projects on a pilot basis. Financial Controllers A key component in the MOF internal control framework is the function of the Financial Controller. This is the traditional ex-ante model (pre-audit) used by governments. The current MoF financial controller mandate requires each financial controller at the respective line ministry to review and clear all transactions, including those relating to the Bank financed projects before being processed for payments. Financial Controllers are appointed by the Accountant General and are decentralized and housed in line ministries. Going forward, it is important to have a strategic design for the internal control framework at the MoF, of which, the internal audit function and financial controllers will be important components. This design should organize and coordinate how and to what extent various elements of a modern internal control framework interact and complement each other. One current weakness is the absence of a comprehensive policies and procedures manual. 57

61 Internal Audit The Internal Audit Department (IAD) was created in 2004 within the MoF with the dual mandate of performing the central internal audit, and decentralizing the internal audit function from the MoF to line ministries. The scope of the Internal Audit Function across the Palestinian National Authority (PNA) is governed by regulation No. 11/2011 (the Charter) issued in August 2011, which clarifies roles and responsibilities of the IAD as well as reporting requirements. Recently, a Central Harmonization Unit (CHU) was established within the MoF pursuant to article No. 5 issued by the Minister of Finance. According to the law, the CHU is responsible for setting and updating the internal audit methodology as well as proving advice to the internal audit units in line Ministries. The CHU also supervises the decentralization transition process to ensure that each line ministry has an effective internal audit function. The IAD adopted the International Internal Auditing Standards (published by the Institute of Internal Auditors) that were customized to meet West Bank and Gaza. In practice, the internal audit and the CHU are not fully operational and decentralized due to capacity and financing constraints. The EC has been providing support to the decentralization of the IAD through a private consultant. During the past years, the IAD has been decentralized to 15 line ministries and has issued more than 30 risk assessment and internal audit reports. Accounting and Reporting The Auditor General opinion and the audited financial statements for the FY 2009 were published and are made available to the public. Also, the audit of the 2010 financial statements has been completed and the Auditor General expressed a qualified audit opinion. The Auditor General qualifications were related to the fairness of the financial statements as well as to the compliance with applicable laws and regulations (see above). The Chart of Accounts (COA) is now compliant with the including the date and number of the CTA account in which the funds have been deposited (Unified Bisan) requirements. The COA is an integrated chart of accounts reflecting the concept of a uniform account code structure. This incorporates both the budget structure and accounting structure. As the government moves towards program budgeting, this will require some modification to the COA. At the present, the major weakness in the financial system is on the revenue side. It is stated that the problem was the reliability and completeness of tax information. There is a need to upgrade the tax systems to provide better accounting and reporting of tax revenue. The MOF has developed a module for budget commitment control in the Bisan mainframe to provide additional controls over the budget as well as to provide information for cash management. However, this module has not been yet implemented and rolled out. Implementation of Integrated Financial Management System The MoF developed an Integrated Financial Management System and has been rolled out to all line ministries and is considered the official country system to account for public financial resources. Transactions are entered by the line ministries with approval for the transaction by Financial Controllers who are housed in all line ministries. The system is a data-based system that uses a uniform account code structure that is a single coding structure for all financial information; as a result, the quality of management reporting has improved. 58

62 The IFMIS is used by all Bank supported projects. A system audit was conducted in 2008 by an independent accounting firm, and pointed out a number of weaknesses. The MoF stated that corrective actions were implemented to address these issues, but a further review is merited. It is advisable to conduct another system audit to review the integrity of information. Use of Country Systems for Bank Financed Projects At the present, all Bank financed projects are being audited by private external auditors due to limited operating capacity of the State Audit and Administrative Control Bureau (SAACB). The Bank fully relies on the financial controllers review for Bank-financed projects related disbursements. However, for Bank-financed projects, the Bank uses the following country systems: MoF Financial Controllers, and Central Treasury, and the Government Integrated Financial Management System. While external audit and internal audit are still aspects to be considered for future utilization for Bank financed projects. Central Treasury System and Bank Funded Projects Due to the lack of a fully-fledged central bank in the West Bank and Gaza, MOF created a Central Treasury Account to account for all national revenues and disbursements at the Bank of Palestine. The Central Treasury Account includes sub accounts managed by each line ministry and disbursing units as needed. To enhance control and cash management, MoF introduced the concept of the zero-balance account as a main component of a Single Treasury Account. Accordingly, sub accounts were created for every disbursing line ministry with a disbursement ceiling based on its operational budget; ministry disbursements are deducted from its ceiling on a daily basis. At the end of the day, the balances are transferred and netted in the main Single Treasury Account of the MOF. Bank reconciliations and consolidations are performed daily at the ministries and MoF levels through the Unified Bisan with acceptable reliability. Currently, World Bank funds as well as all donor funds are not channeled through this Single Treasury Account but rather through separate dedicated accounts held under at the Bank of Palestine for funds receipts and disbursements. Each implementing Ministry has the management responsibility of the Dedicated Account for disbursements on project related disbursements. Withdrawal Applications are reviewed and signed by MOF before submitting to the Bank. Anti-Corruption Overview A 2011 World Bank study summarizes the progress made and challenges ahead in this areas as follows: First, the PA has made significant strides to improve economic governance over the past decade. Second, reform efforts have achieved varying degrees of success and the PA needs to prioritize and address the ongoing challenges. Finally, the PA should take a more proactive approach to investigating and prosecuting corruption, as well as communicating its anti-corruption activities to build public confidence in government accountability. 29 However, the report indicates some positive actions that have been implemented recently. There is now an anti-corruption law and a fairly new Anti-Corruption agency. These two developments will need some time to have an impact on the corruption perception. Another positive note is that CSOs and media play a very important role. This is critical in addressing corruption issues. 29 Improving Governance and Reducing Corruption in West Bank and Gaza, the World Bank, May

63 Management of Foreign Exchange Due to the fact that there is no Central Bank in West Bank and Gaza, the foreign currency management is carried out through the Ministry of Finance. DPG proceeds will be deposited in a dedicated bank account under the Central Treasury Account held at Bank of Palestine. Bank of Palestine financial statements for the year ending December 2011 were audited by Ernest &Young, and expressed an unqualified clean opinion. The annual report and semi-annual reports for 2011 are published on Bank of Palestine website. Selected Key Areas for Future Actions More remains to be done to further improve the PFM system. This includes the following key actions: Ensure better integration of donor programming into the annual development budget. A clear action plan with commitments by all parties should be developed by the Ministries of Planning and Finance as part of the ongoing effort to develop a medium-term planning process. Fully implement internal audit function. Significant effort is already underway, but it will need considerable effort and support from the donor community and continued ownership and commitment from the PA to enhance the internal audit function in the WB&G and continue the decentralization plan into line ministries. Although external audit development has started, building the capacity of the institution to a satisfactory level will require more extensive and further capacity development. Improve cash forecasting and planning in order to address the current challenging fiscal conditions. Developing a Complaint Handling System: The PA should develop a public Complaints Handling System to promote more transparency and accountability and to help monitor Governance and Anti-Corruption risks. Conclusion In recent years, the PA has made significant progress in reforming PFM. This progress includes the partial implementation of the Single Treasury Account Concept, the Government Integrated Financial Management System, implementation of initial steps toward program budgeting. While the effectiveness of SAACB is being strengthened with donor support, this effort is a work in progress. There is significant effort to improve internal controls and implement modern internal audit, but much remains to be done in terms of implementation. While these reforms are underway, the tangible benefits of these reforms are not yet fully realized, particularly with respect to weak capacity at both the MOF and line ministries and the internal control framework not being fully implemented. Also, SAACB needs much additional work to carry out external audits of government s programs according to international standards. In light of the fact that the fiduciary risk is assessed as Substantial and that reform is ongoing, the Bank proposes implementing additional fiduciary measures appropriate for such level of fiduciary risks. 60

64 ANNEX 5: COUNTRY AT A GLANCE (INCLUDES COUNTRY MAP) West Bank and Gaza at a glance West M. East Lower Key D evelo pment Indicato rs Bank & North middle & Gaza Africa income 2011 Population, mid-year (millions) Surface area (thousand sq. km) Population growth (%) Urban population (% of total population) Age distribution, 2009 Male Female GNI (Atlas method, US$ billions) GNI per capita (Atlas method, US$) GNI per capita (PPP, international $) GDP growth (%) GDP per capita growth (%) percent of total population (mo st recent estimate, ) Poverty headcount ratio at $1.25 a day (PPP, %) Poverty headcount ratio at $2.00 a day (PPP, %) Life expectancy at birth (years) Infant mortality (per 1,000 live births) Child malnutrition (% of children under 5) Adult literacy, male (% of ages 15 and older) Adult literacy, female (% of ages 15 and older) Gross primary enrollment, male (% of age group) Gross primary enrollment, female (% of age group) Under-5 mortality rate (per 1,000) Access to an improved water source (% of population) Access to improved sanitation facilities (% of population) West Bank and Gaza Middle East & North Africa N et A id F lo ws (US$ millions) Net ODA and official aid Top 3 donors (in 2012): PEGASE The World Bank PRDP Trust Fund Arab Donors Aid (% of GNI) Aid per capita (US$) Lo ng-t erm Eco no mic T rends Growth of GDP and GDP per capita (%) Consumer prices (annual % change) GDP implicit deflator (annual % change) GDP GDP per capita Exchange rate (annual average, local per US$) Terms of trade index (2000 = 100) (average annual growth %) Population, mid-year (millions) Constant GDP (US$ millions) (% of GDP) Agriculture Industry M anufacturing Services Household final consumption expenditure General gov't final consumption expenditure Gross capital formation Exports of goods and services Imports of goods and services Gross savings /28/

65 West Bank and Gaza B alance o f P ayments and T rade (US$ millions) Total merchandise exports (fob) Total merchandise imports (cif) 2,490 4,491 Net trade in goods and services -2,270-4,730 Current account balance -1,025-2,193 as a % of GDP Workers' remittances and compensation of employees (receipts) 1, Reserves, including gold.... Governance indicators, 2000 and 2009 Voice and accountability Political stability Regulatory quality Rule of law Control of corruption C entral Go vernment F inance (2012) (% of GDP) Current revenue (including grants) Source: Kaufmann-Kraay-Mastruzzi, World Bank Tax revenue Current expenditure T echno lo gy and Infrastructure Overall surplus/deficit Paved roads (% of total) Highest marginal tax rate (%) Fixed line and mobile phone Individual.. 15 subscribers (per 100 people) Corporate.. 15 High technology exports (% of manufactured exports).... External D ebt and R eso urce F lo ws Enviro nment (US$ millions) Total debt outstanding and disbursed Agricultural land (% of land area) Total debt service.... Forest area (% of land area) Debt relief (HIPC, M DRI) Terrestrial protected areas (% of surface area) Total debt (% of GDP) Freshwater resources per capita (cu. meters) Total debt service (% of exports) Freshwater withdrawal (billion cubic meters).... Foreign direct investment (net inflows).... CO2 emissions per capita (mt) Portfolio equity (net inflows).... GDP per unit of energy use (2005 PPP $ per kg of oil equivalent).... Composition of total external debt, 2009 (data are not available) Energy use per capita (kg of oil equivalent) Country's percentile rank (0-100) higher values imply better ratings Wo rld B ank Gro up po rtfo lio (US$ millions) IBRD Total debt outstanding and disbursed Disbursements Principal repayments Interest payments US$ millions IDA Total debt outstanding and disbursed Disbursements P rivate Secto r D evelo pment Total debt service Time required to start a business (days) 49 IFC (fiscal year) Cost to start a business (% of GNI per capita) 93.7 Total disbursed and outstanding portfolio Time required to register property (days) 47 of which IFC own account Disbursements for IFC own account 18 0 Ranked as a major constraint to business Portfolio sales, prepayments and (% of managers surveyed who agreed) repayments for IFC own account 0 1 n.a..... n.a..... M IGA Gross exposure Stock market capitalization (% of GDP) New guarantees Bank capital to asset ratio (%).... Note: Figures in italics are for years other than those specified data are preliminary. 3/28/13.. indicates data are not available. indicates observation is not applicable. Development Economics, Development Data Group (DECDG). 62

66 Millennium Development Goals West Bank and Gaza With selected targets to achieve b etween 1990 and 2015 (estimate closest to date shown, +/- 2 years) West B ank and Gaza Go al 1: halve the rates fo r extreme po verty and malnutritio n Poverty headcount ratio at $1.25 a day (PPP, % of population) Poverty headcount ratio at national poverty line (% of population) Share of income or consumption to the poorest qunitile (%) Prevalence of malnutrition (% of children under 5) Go al 2: ensure that children are able to co mplete primary scho o ling Primary school enrollment (net, %) Primary completion rate (% of relevant age group) Secondary school enrollment (gross, %) Youth literacy rate (% of people ages 15-24) Go al 3: eliminate gender disparity in educatio n and empo wer wo men Ratio of girls to boys in primary and secondary education (%) Women employed in the nonagricultural sector (% of nonagricultural employment) Proportion of seats held by women in national parliament (%) Go al 4: reduce under-5 mo rtality by two -thirds Under-5 mortality rate (per 1,000) Infant mortality rate (per 1,000 live births) M easles immunization (proportion of one-year olds immunized, %) Go al 5: reduce maternal mo rtality by three-fo urths M aternal mortality ratio (modeled estimate, per 100,000 live births) Births attended by skilled health staff (% of total) Contraceptive prevalence (% of women ages 15-49) Go al 6: halt and begin to reverse the spread o f H IV/ A ID S and o ther majo r diseases Prevalence of HIV (% of population ages 15-49) Incidence of tuberculosis (per 100,000 people) Tuberculosis case detection rate (%, all forms) Go al 7: halve the pro po rtio n o f peo ple witho ut sustainable access to basic needs Access to an improved water source (% of population) Access to improved sanitation facilities (% of population) Forest area (% of total land area) Terrestrial protected areas (% of surface area) CO2 emissions (metric tons per capita) GDP per unit of energy use (constant 2005 PPP $ per kg of oil equivalent) Go al 8: develo p a glo bal partnership fo r develo pment Telephone mainlines (per 100 people) M obile phone subscribers (per 100 people) Internet users (per 100 people) Personal computers (per 100 people) Education indicators (%) 125 Measles immunization (% of 1-year olds) ICT indicators (per 100 people) Primary net enrollment ratio Ratio of girls to boys in primary & secondary education West Bank and Gaza (..) Middle East & North Africa Fixed + mobile subscribers Internet users Note: Figures in italics are for years other than those specified... indicates data are not available. 3/28/13 Development Economics, Development Data Group (DECDG). 63

67 64