Belarus Public Expenditure Review

Transcription

1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Belarus Public Expenditure Review Enhancing Public Services in Times of Austerity Volume 2 Public Disclosure Authorized

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3 Report No BY Belarus Public Expenditure Review Enhancing Public Services in Times of Austerity Volume 2 February 21, 213 Poverty Reduction and Economic Management Unit (ECSPE) Europe and Central Asia Region

4 CURRENCY AND EQUIVALENT UNITS (as of December 31, 212) Currency Unit = Belarusian Rubel (BYR) US$1=8,545 BYR GOVERNMENT FISCAL YEAR January 1 December 31 Acronyms and Abreviations ACF Anti-Crisis Fund MOE Ministry of Education AMI Acute Myocardial Infarction MOF Ministry of Finance BoP Balance of Payment MOH Ministry of Health BYR Belarusian Ruble NBRB National Bank of the Republic of Belarus CIS Commonwealth of Independent States NCDs Non-Communicable Diseases CIT Corporate Income Tax OECD Organization for Economic Co-operation and Development CPI Consumer Price Index OOP Out-of-Pocket DRG Diagnostic Related Groups PER Public Expenditure Review ECA Europe and Central Asia PISA Program for International Student Assessment ER Exchange Rate PIT Personal Income Tax EU European Union PPG Public and Publicly Guaranteed FDI Foreign Direct Investment PPP Purchasing Power Parity GDL Government-Directed Lending PSF Per-Student Financing GDP Gross Domestic Product SOE State-Owned Enterprises GFS Government Financial Statistics SPF Social Protection Fund GG General Government SNGs Sub-national Governments HBS Household Budget Survey STA Single Treasury Account HDI Human Development Index STR Student-Teacher Ratio IMF International Monetary Fund TCM Thousand Cubic Meters LCU Local Currency Unit TOT Terms of Trade LITS Life in Transition Survey USD United States Dollars VAT Value-Added Tax WTO World Trade Organization Vice President Country Director Sector Director Sector Manager Task Team Leader Co-Task Team Leader Philippe Le Houerou Qimiao Fan Yvonne Tsikata Benu Bidani Sebastian Eckardt Marina Bakanova

5 Enhancing public services in times of austerity Contents Acknowledgements Preface Executive Summary vii viii ix Chapter 1. Fiscal Reforms: Addressing Macro-Structural Challenges 1 A. Recent Macro-Economic Developments Securing Stability in an Uncertain Environment 1 B. Fiscal Reforms Deepening Budget Restructuring 4 C. Why Look at Intergovernmental Fiscal Relations, Health and Education Spending? 11 D. Fiscal Challenges and Reform Options 16 Chapter 2. Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments 18 A. Intergovernmental Relations in Belarus Institutional and Administrative Structure 18 B. Trends in Sub-national Government Expenditures 2 C. Financing Sub-national Services 25 D. Managing Sub-national Fiscal Risks - Sub-national Borrowing and Guarantees 31 E. Reform Options 34 Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results 36 A. The Health Sector in Belarus Institutional and Administrative Structure 36 B. Health Sector Outcomes Achievements and Challenges 39 C. Financing Health Services Efficiency and Effectiveness of Public Health Expenditures 44 D. Reform Options 5 Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results 54 A. The Education Sector in Belarus Institutional and Administrative Structure 54 B. Education Sector Outcomes Achievements and Challenges 56 C. Financing Education Level and Composition of Education Expenditures 59 D. Changing Demand for Education Services Aligning Spending to Demographic Change 63 E. Reform Options 67 List of References 71 Annexes 73 Contents iii

6 belarus public expenditure review vol.2 Figures Figure 1. Belarus Significantly Reduced the Size of the Government Budget xi Figure 2. Belarus Contained Fiscal Imbalances, but the Fiscal Stance Is Pro-cyclical xii Figure 3. Rapid Expansion of Public Debt and Refinancing Risks Reinforce Need for Fiscal Restraint xiii Figure 4. Sub-national Expenditures Have Grown Sub-national Share in Government Expenditures Is Among the Highest in the Region xiv Figure 5. Per Capita Spending Is Higher in Rural Areas xiv Figure 6. Sub-national Governments Are Largely Financed by Shared Revenue and Transfers xv Figure 7. Sub-national Liabilities Have Increased Sharply and Vary Widely xv Figure 8. Health Spending Is Relatively Stable and Commensurate With Belarus Income xvii Figure 9. Belarus Has an Extensive Health Care Delivery System and Large Workforce xvii Figure 1. Public Spending on Education Is in Line With Region Average xx Figure 11. Student-Teacher Ratio Is Low xx Figure 12. Low Student-Teacher Ratio Is Driving Costs xx But not Leading to Better Outcomes xx Figure 13. Signs of Stabilization Since End Figure 14. Belarus Achieved Significant Fiscal Consolidation 4 Figure 15. Prudent Fiscal Deficits and Substantial Below-the-line Expenditures Fiscal Policy Has Exacerbated the Economic Cycle 5 Figure 16. Expansion of Public Debt and Refinancing Risks Reinforce Need for Fiscal Restraint 6 Figure 17 Belarus Reduced the Public Sector Footprint, But Tax Burden Remains High 7 Figure 18. Economic and Functional Composition of the Adjustment 8 Figure 19. Sharp Contraction in Capital Spending Brought Belarus Closer to ECA Average 9 Figure 2. Belarus Has the Highest Level of Subsidies in ECA 9 Figure 21. Public Sector Wages Contracted in 211, but Public Employment Remains High 1 Figure 22. The National Budget Took the Brunt of the Adjustment 11 Figure 23. Reforms Permanently Lowered the Tax Burden and Changed the Revenue Structure 11 Figure 25. Human Capital Investment Has Risen and Outcomes Have Improved 12 Figure 24. Sub-national Governments Account for More Than Half of Public Spending 12 Figure 26. Satisfaction With Education and Health Services: Belarus vs. Other ECA Countries 13 Figure 27. Male Mortality Crisis 14 Figure 28. Signs of Operational Inefficiencies in the Health and Education Sectors 14 Figure 29. Aging Population Is Changing Demand for Public Services 15 Figure 3. Intergovernmental Administrative and Political Relations in Belarus 2 Figure 31. Sub-national Expenditures Have Grown, Making Belarus One of the Most Fiscally Decentralized Countries in the Region 21 Figure 32. The Functional Composition of Sub-national Expenditures Is Relatively Stable 21 Figure 33. The Economic Composition Has Changed, With Rising Subsidies and Declining Capital Spending 23 Figure 34. Expenditure Equality 24 Figure 35. Spending in Rural Areas is Higher Than in Cities 25 Figure 36. Diseconomies of Scale 25 Figure 37. Subnational Revenue Composition Is Relatively Stable Over Time But Varies Across Levels 26 Figure 38 Effective Sharing Rates for VAT and CIT Vary Annually 27 Figure 39. Sources of Fiscal Inequality 28 Figure 4. Disparities in Per Capita Yield of Locally Retained Taxes, by Type of SNG, BYR per capita, iv Contents

7 Enhancing public services in times of austerity Figure 41 Composition of Intergovernmental Transfers, Figure 42. Equalization Performance of Transfers, BYR Per Capita, Figure 43 Capital Grants Finance a Growing Share of Sub-national Investment 31 Figure 44. Sub-national Liabilities Increased Sharply 32 Figure 45 Many SNGs Exceed Debt Rules 33 Figure 46. Health Sector Structure and Administration 37 Figure 47. Sources of Financing and Flows of Funds in Belarus Health System, Figure 48. Life Expectancy Remains Low; Excess Mortality Contributes to Population Decline 4 Figure 49. NDCs Are the Major Cause of Low Life Expectancy in Belarus and ECA Compared With EU Figure 5. Out of Pocket Expenditures Mainly Cover Medicines 41 Figure 51. Less OOP Reliance Less Catastrophic Health Spending 42 Figure 52. Private Health Spending Is Moderately Regressive; Lower-middle Class Households Are Most Vulnerable to Shocks 42 Figure 53. Impact of Health Expenditures on Household Consumption 43 Figure 54. Reported Corruption Is Low But Increasing 43 Figure 55. Service Satisfaction Is Improving 43 Figure 56. Health Spending Is Relatively Stable and Commensurate With Belarus Income 44 Figure 57 A Large Share of Public Funding Is Channeled Through SNGs 45 Figure 58. Recurrent Spending Takes a Growing Share of Resources; Capital Expenditures Are Regionally Concentrated 45 Figure 59. Belarus Has an Extensive Health Care Delivery System and Large Sector Workforce 46 Figure 6. Hospitals and In-Patient Care Absorb the Largest Share of Spending 47 Figure 61. Belarusians Are Admitted to Hospitals Often and Stay for Long Durations 47 Figure 62. Hospitals Predominantly Provide Inpatient Care 47 Figure 63. Units Costs Vary Across Belarus 48 Figure 64. Number of Schools, Students and Teachers in Belarus, Figure 65. Education Sector Structure and Administration 55 Figure 66. Affordable Education 58 Figure 67. Distribution of Firms in ECA Region That Consider Worker Skills a Major or Very Severe Constraint, Figure 68. Public Spending on Education Is Adequate 6 Figure 69. Education Expenditures Declined After the Crisis, But Have Since Recovered 6 Figure 7. Sub-national Governments Account for Most Education Spending 6 Figure 71. Education Spending Composition Is Relatively Stable 6 Figure 72. Education Spending Is Dominated by Recurrent Spending 61 Figure 73. Education Sector Wages Have Declined 62 Figure 74. Rayons With Small Schools Have High Utility Cost Per Student 62 Figure 75. Number of Students Has Declined, Especially in Rural Areas 64 Figure 76. Consolidation of School Network 64 Figure 77. School Closures Are Well Targeted 65 Figure 78. Student-Teacher Ratios Are Among the Lowest in the Region 65 Figure 79. Most Students Are in Urban Area While Most Schools Are in Rural Areas 65 Figure 8. Class and School Sizes Are Small 66 Figure 81. STR Drives Per Student Cost 67 Contents v

8 belarus public expenditure review vol.2 but Does Not Improve Student Performance 67...Hence There Is no Relationship Between Spending and Student Performance 67 Tables Table 1. Summary of Proposed Policy Options xxii Table 2. Main Macro-economic Indicators, Table 3 Selected Sector Funding International Comparison 1 Table 4. Population of Sub-national Jurisdictions, Table 5. Assignment of Functions Across Levels of Government 22 Table 6. Public Expenditure by Level of Government, Share in Consolidated Expenditures Table 7. Spending Shares across Sub-National Levels of Government, 211 (% of Sub-national Spending) 23 Table 8 Variation in Expenditures Across Different Functions, Current Million BYR Per Capita, Table 9. Retention Rates for National Tax Revenue 27 Table 1. Sub-national Tax Assignments 28 Table 11. Evolution of Fiscal Rules on Sub-national Debt 32 Table 12. Variation in Indebtedness at the Sub-oblast Level, percent of Pre-subventions Revenues, Table 13. Regression Results on Debt Ratios 33 Table 14. Selected Health Outcome Indicators, Belarus in Regional Comparison 4 Table 15. Main Causes of Death in Belarus, Table 16. Estimated Fiscal Impact of Potential Health Sector Spending Pressures 49 Table 17. Attainment Rates 2-21 (Level of Completed Education of 25 to 29 year-olds, %) 57 Table 18. Key Advantages of Per-Student Financing Compared to Input-Based Systems 69 Boxes Box 1. Level of Government Spending Matters, But So Does Quality and Composition 7 Box 2. Extra-budgetary Revenues of Front-line Service Delivery Units 28 Box 3 Diagnostic Related Groups (DRG) Treatment Classification 52 Box 4. Social Standards in Education 63 Box 5. Estimating Fiscal Impact of School Optimization in ECA Countries 68 Box 6 Pilot on Per-Student Financing in Belarus 7 vi Contents

9 Enhancing public services in times of austerity Acknowledgements This report was prepared by a multi-sectoral team led by Sebastian Eckardt and Marina Bakanova and comprising: Maryna Sidarenka, Elena Slizhevskaya, Jorge Martinez-Vasquez, Andrey Timofeev (ECSPE), Paolo Belli, Emily Sinnott, Irina Capita and Anna Olefir (ECSHD). Additional contributions were made by Gallina A. Vincelette (ECSPE), Lars Sondergaard, Kirstin Sinclair, Igor Kheyfets (ECSHD) and Svetlana Matskevich (Local Consultant). Alina Gres (ECCBY) provided excellent support during preparation process. The team is grateful to Photo.ByMedia.net for supplying the photographs for the cover and to Irina Oleinik for advising the team on the designs of this report. The peer reviewers were Wolfgang Fengler (Lead Economist, AFTP2) and Marijn Verhoeven (Lead Economist, PRMPS). The team benefited from the guidance and advice of Yvonne Tsikata, Benu Bidani, Lalita Moorty (ECSPE) and Qimiao Fan (Country Director, ECCU2). This report also benefited from comments from World Bank and IMF colleagues made in internal presentations and informal discussions, including comments received at several review stages. The team is grateful to the authorities for their excellent collaboration during the preparation of this report. The intensive efforts of the Ministry of Finance, the Ministry of Taxes, the Ministry of Economy, the Ministry of Education, the Ministry of Health, the National Statistics Committee, the National Bank, Minsk Oblast and Minsk City Executive Committees and other agencies in helping to prepare this report are gratefully acknowledged. The team is particularly grateful to Maxim Ermolovich (Deputy Minister of Finance), Yuri Selivestrov (Head of Budget Policy Department), Svetlana Kretova (Head of Social Sectors Financing Department) and Victoria Shilovich (International Cooperation Department) for overall coordination from the Government side and for provision of timely inputs and feedback. The team is also grateful to Elena Tkacheva (Head of Economic and Finance Department of the Ministry of Health) and Irina Bebekh (Head of Economic and Finance Department of the Ministry of Education) for facilitation of the process from the side of their respective ministries and for constructive dialogue during report preparation. vii

10 belarus public expenditure review vol.2 Preface This report is the second volume of the programmatic Public Expenditure Review in Belarus. In 21 the Ministry of Finance requested that the Bank provide sequenced and targeted advice on the fiscal reform options across priority areas of the budget. Responding to this request, a programmatic PER was agreed upon. The first volume was delivered in November 211 and focused on providing policy options for a sustainable pension system, better targeted social assistance and rationalization of energy and agricultural subsidies. The objective of this volume is to identify reform opportunities to enhance the quality of key public services in a fiscally constrained environment. Specifically, the PER 2 will analyze three key areas of the budget: intergovernmental fiscal relations and public spending in the education and health sectors. These three areas were chosen because they are significant from a fiscal perspective. More than half of government spending is channeled through sub-national governments, while education and health spending together account for a quarter of government spending (largely at the sub-national level). Beyond their fiscal importance, enhancing the quality and efficiency of spending in these sectors is critical for improving living standards and human capital in Belarus. However, since public finances are expected to remain tight for some years to come, expenditures, even in priority sectors such as health and education, will remain constrained. Therefore, the focus of this report is on the productivity of public spending. The primary thrust is to enhance the allocative and operational efficiency of resources to allow for improved quality of services and social outcomes while containing overall costs. The report also examines the impact of Belarus changing demographic profile, which will have a significant and lasting impact on demand for both health and education services. The report has four chapters. The first chapter reviews recent macro-economic and fiscal developments, and in particular the impact of the macro-economic crises on public finances and its implications for fiscal policy choices going forward. The second chapter examines intergovernmental fiscal relations and the fiscal incentives they create for sub-national governments. The third chapter looks at health sector outcomes and expenditures to identify opportunities for improved spending efficiency and sustainable health care financing. The fourth chapter is focused on resource allocation and utilization in the education sector to provide options for improved efficiency and effectiveness of education spending. viii

11 Enhancing public services in times of austerity Executive Summary Belarus has emerged from two consecutive macro-economic crises, but risks remain. After a decade of strong economic growth, Belarus has faced recurring macro-economic turmoil over the past years. While macroeconomic stability has been restored, underlying structural problems such as stagnant productivity, loss of competitiveness and excessive reliance on external financing and cheap energy imports must be addressed to make the economy resilient to shocks. Imbalances could reemerge if macro-economic policies are loosened prematurely. Loose macro-economic policies would reverse recent disinflationary gains, erode exchange rate competitiveness and weaken external balances. Fiscal policy needs to remain tight, not only to complete the adjustment process but also to gradually reduce public debt levels and rebuild resilience in case of renewed macro-economic distress. However, budget discipline needs to be balanced with targeted investments to spur recovery, growth and social development. Since 28, Belarus achieved one of the largest contractions in the size of government in the region. Public expenditure contracted by 13.2 percentage points of GDP between 28 and 211, to reach 36 percent of GDP at the end of 211, while the tax burden fell (Figure 1). Capital expenditures took the brunt of the adjustment, while government consumption contracted at much slower pace. Further cuts in discretionary spending, especially in public investment and non-wage recurrent expenditure, would undermine the productivity of public spending, lead to a deterioration of public infrastructure and undermine growth prospects. It is therefore important to strengthen the strategic reallocation and efficiency of spending, including a further rationalization of subsidies and enhanced quality and efficiency of spending in key public services, including health and education. Figure 1. Belarus Significantly Reduced the Size of the Government Budget Percent of GDP General Government Expenditure to GDP Ratio 55 5 UKR BLR SVK BIH MNE HUN LVAHRV RUS 4 CZE SRB POL MDA BLR 21 SVN 35 KGZ BGR ROU EST TUR 3 LTU MKD 25 GEO ALB 2 ARM 1, 2, 3, Capital Expenditures Transfers and subsidies Goods and Services Per Capita GDP (Current US$) Wages Interest Source: World Bank staff estimates, MOF. Note: Net lending is not included due to insignificant share in GDP. Building on the fiscal reforms of the past years, this report offers reform options in macro-fiscal policy, intergovernmental fiscal relations and spending in health and education. These reform options are oriented towards sustaining macro-economic stability while addressing three key, inter-related challenges in financing public services in health and education. First, both the education and health sectors need to further improve outcomes, including addressing emerging challenges. Second, in light of significant spending commitments to Executive Summary ix

12 belarus public expenditure review vol.2 both sectors and tight fiscal constraints, further efforts need to focus on raising spending efficiency and containing costs at the national and sub-national levels over the medium term. This is particularly important as both sectors are characterized by large delivery systems (schools, hospitals, polyclinics) that could become fiscally unaffordable if wages were to rise. Third, the sectors need to adapt to an aging population, with fewer students and a greater burden of chronic and degenerative diseases, which will change public service demand and have important fiscal implications. Macro-Fiscal Policies Addressing Macro-Structural Challenges Public finances were severely affected by the macro-economic turmoil of the past years. The general government balance (including the Social Protection Fund) moved from a surplus of 1.3 percent of GDP in 28 to a deficit of 1.8 percent of GDP in 21. In response to the crisis, the Government sharply curtailed expenditures in 211, while revenue growth was fuelled by inflation, resulting in a 2.8 percent consolidated general government budget surplus. However, changes in the cyclically-adjusted balance show that the underlying fiscal stance was procyclical, especially during the pre-crisis years (Figure 2). In both 28 and 21, fiscal expansions driven mainly by rapid increases in wages and transfers fuelled domestic demand growth, which contributed to rising external imbalances and inflationary pressures. Figure 2. Belarus Contained Fiscal Imbalances, but the Fiscal Stance Is Pro-cyclical percent of GDP Output Gap 7 Counter-cyclical Contrac on Pro-cyclical Expansion Pro-cyclical Counter-cyclical -3 Contrac on Expansion General Government Expenditures General Government Revenue Fiscal Impulse (Change in Cyclically Adjusted Balance) Sources: World Bank staff estimates, MOF, SPF. In addition, the Government incurred substantial fiscal costs for recapitalization of major state-owned banks. These banks were recapitalized through the issuance of Government bonds, and the related cost was recorded as a financing operation in the fiscal accounts (below the line). Between 25 and 211, the state budget injected on average 1. percent of GDP annually to recapitalize major state-owned banks, peaking in 211 at 4.9 percent of GDP, as the banks capital adequacy was threatened by a significant increase in foreign liabilities, induced by the devaluation. As a result of bank recapitalization and devaluation, public debt has accelerated rapidly, and about half of Belarus public debt will mature in the coming four years. The public and publicly guaranteed debt-to-gdp ratio has more than doubled since 28, reaching over 31 percent of GDP by the end of 211 (up from 12.9 percent of GDP in x Executive Summary

13 Enhancing public services in times of austerity Figure 3. Rapid Expansion of Public Debt and Refinancing Risks Reinforce Need for Fiscal Restraint percent of GDP Debt Repayment, in million USD External PPG Domestic PPG Domestic External Source: World Bank staff estimates, MOF. 28). 1 Moreover, the redemption profile for public debt reveals a sizeable concentration of maturity in the short term, mainly due to repayments of IMF loans, maturing external bonds and repayment of bank recapitalization bonds. Rolling over this debt in the current environment will be challenging, especially given political tensions with the US and EU and heightened risk aversion of investors in sovereign debt markets related to the Euro crisis. The current macro-economic environment reinforces the need for credible and sustainable macro-economic and structural reforms, including continued fiscal reform efforts. Building on the fiscal reforms of the past years, this can be achieved by further rationalizing subsidies and enhancing quality and efficiency of spending in key public services, including health and education. The contours of such reforms would be based on the following priorities: 3, 2,5 2, 1,5 1, 5 a. Stabilize the fiscal stance within a consistent macro-economic framework: The fiscal stance should be determined within a consistent medium-term macro-economic framework, taking into account the overall position of the economy. This would imply sustaining a balanced budget over the medium term. b. Balance wage and income policies: Given the importance of the public sector in setting wage trends in the entire economy, long-run public sector wage growth should be linked to productivity growth. Structural changes to public sector employment and more differentiated pay policies could help containing the wage bill while allowing more competitive pay for certain positions. c. Further rationalize subsidies: Subsidies should be further reduced, notably in the utility sectors through achieving cost recovery. Moreover, broader structural reforms and liberalization of the economy could help dismantle the system of state support. d. Protect capital spending at current levels: While maintaining current capital spending levels, continue to prioritize strategic investments, for example in energy efficiency. 1 PPG debt and GDP are in current BYR. Foreign denominated debt is converted in local currency using official exchange rate as of January 1 of the following year. Executive Summary xi

14 belarus public expenditure review vol.2 Strengthening Incentives of Sub-national Governments Strengthening the incentives of sub-national governments (SNGs) 2 is crucial to increase the efficiency and effectiveness of public expenditures in Belarus. After the fiscal adjustment of the past years, SNG spending now accounts for more than half of consolidated general government spending (Figure 4). SNGs are important for providing key public services such as utilities, health, education and infrastructure. However, the current system of intergovernmental relations provides weak fiscal incentives to SNGs. The heavy reliance on transfers from the central government together with rising sub-national liabilities (both direct and guaranteed debt) soften budget constraints and discourage SNGs from exercising fiscal restraint and achieving efficiency gains in public spending. Figure 4. Sub-national Expenditures Have Grown Sub-national Share in Government Expenditures Is Among the Highest in the Region in percent in percent Sub-national Revenue % of General Government Revenues RUS KAZ BLR LVA LTU UKR 2. POL 15 CZE SRB HUN 1 1. ROU 1 BIH BGR.5 5 MKD Subnational Public Expenditures in constant 211 prices, mil. BYR (lhs) Sub-national Expenditures % of General Government Expenditures SNG share in GG expenditures (excl. SPF) SNG share in GG expenditures Source: World Bank staff estimate, MOF, IMF GFS. Belarus maintains high levels of interregional equity in public spending, but per capita spending is significantly higher in rural areas. The city of Minsk, which has the highest SNG spending, spends only 18 percent more on a per capita basis than Brest oblast, the region with lowest spending. This high level of equity is a result of both relatively low initial disparity, compared to many other countries, and the redistributional features of the intergovernmental transfer framework. However, per capita spending in rayons is on average about 38 percent above per capita spending in cities (Figure 5). This is partly due to lower population density and lack of economies of scale in rural areas, but the main reason is the lack of spending adjustment to increased urbanization, resulting in an oversized and underutilized rural service infrastructure. Figure 5. Per Capita Spending Is Higher in Rural Areas Thsnd. BYR, current prices, 211 3,5 3, 472 2, , 1, , , Rayons Ci es Housing and utilities Healthcare Recreation and culture Education Other Source: World Bank staff estimates, MOF. 2 Sub-national governments comprise all levels of government except the central level, e.g. regional (oblast), rayon and sub-oblast cities (primary level) and rural localities (base level) jurisdictions. xii Executive Summary

15 Enhancing public services in times of austerity Figure 6. Sub-national Governments Are Largely Financed by Shared Revenue and Transfers SNGs are predominantly financed by shared national taxes and transfers. Shared national taxes are the largest financing item, contributing roughly 6 percent of sub-national revenues (Figure 6). Transfers from the central government, including both block and earmarked grants, make up another 35 percent. The remaining 5 percent comes from own-source tax and non-tax revenues. Consolidated The current intergovernmental transfer allocation subna onal Oblast Rayon City system distorts incentives for SNGs to increase Non-tax Property taxes Local taxes Other taxes VAT Profits and income taxes spending efficiency. Block grants, which are the Source: World Bank staff estimates, MOF. largest transfers, are based on actual revenues and expenditures of the previous year, adjusted for inflation, growth and other parameters. As such, block grants essentially fill the gap between actual pre-transfer revenues and actual expenditures. SNGs therefore face weak incentives to rationalize inputs and to generate permanent fiscal savings, as any savings would most likely result in commensurate reductions in transfer amounts in subsequent years. In addition, SNG liabilities have increased rapidly over the past few years, although exposure varies across entities. Sub-national liabilities, including both explicit debt and contingent liabilities, peaked at close to 14 percent of GDP in 21 (Figure 7). High inflation in 21/11 brought down the debt stock to 1 percent of GDP by the end of 211 still about double its 27 level. As of 211 three oblasts Grodno, Mogilev and Brest and 17 rayons exceed the statutory limit set in the Budget Code for debt and guaranteed debt (which should not exceed 8 percent of pre-subventions revenue). Figure 7. Sub-national Liabilities Have Increased Sharply and Vary Widely percent of GDP percent of Pre-Subventions Revenues Minsk City Gomel Average Minsk Vitebsk Grodno Mogilev Brest Contigent Liabilities Explicit Debt Contigent Liabilities Explicit Debt Source: World Bank staff estimates, MOF. While Belarus has made progress in improving the intergovernmental fiscal framework, there are opportunities for further reforms, including: a. Increase tax authority by formally assigning property taxes to local governments to enhance fiscal incentives. Financing sub-national public spending at least at the margin with sub-national taxes can reinforce incentives for fiscally responsible behavior, as additional spending would require raising Executive Summary xiii

16 belarus public expenditure review vol.2 additional tax revenue (rather than inducing higher transfers from the central government). Local discretion to adjust property and land tax rates can be transformed into separate ranges of rates for each tier of local government. However, the discretion granted to local governments to set tax bases by granting exemptions and other favorable treatment is undesirable because it adds complexity to tax compliance and enforcement in a non-transparent manner. It would be desirable to remove this aspect of local discretion in the future. b. Simplify and apply the transfer formula to create more a predictable and transparent system of transfers. A more stable and explicit rule could be introduced to determine the pool of equalization funds in the oblast budget, reflecting overall fiscal constraints and calibrated against the overall share of sub-national spending. The current formula to equalize fiscal disparities among local governments on the basis of expenditure needs and fiscal capacity provides a sound framework, but it may need to be significantly simplified to apply in practice. On the revenue side, given limited revenue autonomy, the use of actual revenue seems appropriate at least for the initial years. On the expenditure side, given the fiscal importance of a few major expenditure categories, e.g. education, health, housing and utilities, the allocation should be primarily oriented towards meeting financing needs in these sectors. Implementing such a simplified formula-driven transfer scheme would strengthen incentives for fiscal restraint and savings at the sub-national level, as transfer would become less dependent on past spending levels. c. Reconsider the definition of public debt to include SNG liabilities. Given the strong fiscal interdependence between levels of governments in Belarus, sub-national liabilities should be included in overall public debt statistics to more accurately reflect the size of liabilities that will have to be covered by future general tax revenue. d. Work with most indebted localities to reduce liabilities. In line with the provisions of the Budget Code, the central government should assist highly indebted rayons and cities to determine the root causes for the accumulation of direct and/or indirect liabilities and to identify specific remedying actions to bring them into compliance with the 8 percent rule. Enhancing Spending Efficiency for Better Health Results While Belarus has done well on improving health indicators, challenges remain. The health system has delivered effectively on a range of indicators, including infant and maternal health and containment of communicable diseases, including HIV and tuberculosis. However, life expectancy while improving remains below pretransition levels largely due to high adult mortality, especially among men. Moreover, Belarus lags on outcomes and prevention of non-communicable diseases (NCDs), in particular of cardio-vascular diseases, which are now the main cause of mortality and the key reason for low life expectancy. Belarus health care system largely relies on the public sector to finance and deliver broad and affordable health service access to the population. Public health spending is equal to 3.5 percent of GDP (211), channeled primarily through SNGs (Figure 8). This compares favorably to CIS countries (on average 2.7 percent of GDP) and is roughly at the level of other middle-income countries in the Europe and Central Asia region (4 percent of GDP), xiv Executive Summary

17 Enhancing public services in times of austerity but it remains below the level of the 1 new EU member states (5.4 percent of GDP). Public health spending was largely protected from the recent fiscal consolidation. Most resources finance a vast network of public polyclinics and hospitals that provide free health care services. As a result, private spending on health care accounts for only about 2 percent of health spending, which is below other countries in the region and more in line with EU member states. Figure 8. Health Spending Is Relatively Stable and Commensurate With Belarus Income in percent Public Health Spending, percent GDP 9 8 CZE SVK 7 SVN 6 SRB HRV MDA 5 MKD MNE POL EST ROU 4 UKR BGR LTU LVA RUS HUN 3 KGZ BLR ALB KAZ 2 GEO TUR TJK ARM 1 1, 2, 3, Share of private OOP on health in GDP Share of public expenditures on health in GDP Per Capita, GNI, PPP Adjusted US$, 21 Source: World Bank staff estimates, MOF, HBS, ECA Fiscal Database. While the level of public health spending is broadly commensurate with Belarus level of income, there are signs of operational and allocative inefficiencies. The health care system is characterized by an expansive delivery structure with a focus on hospital-based services. For its population size, Belarus has a large number of hospitals, hospital beds, doctors, nurses and other personnel (Figure 9). 3 Belarusians get admitted to hospitals more often and remain hospitalized for longer periods than in most other countries in the region. However, these high levels of inputs and service use do not translate into above-average health outcomes. Moreover, there are large discrepancies in the internal efficiency of hospitals, with significant variation in the average length of stay and unit costs for similar treatments across the country. These problems are a result of input-based financing arrangements that encourage health care providers to use more staff, beds and other inputs to justify their budgets, but inadequately reward improvements in productivity, quality of care or health outcomes. Figure 9. Belarus Has an Extensive Health Care Delivery System and Large Workforce Number of Hospital Beds per 1, Population SWE GBR IRL ESP NOR PRT DNK ITA AUT SVN NLD OECD ave. GRC CHE EST FIN FRA SVK BEL CZE DEU CIS ave. UKR RUS BLR Health Sector Workforce, per 1, Population ESP GRC EST SVN FRA OECD ave. MDA NLD SVK UKR CZE CIS ave. AUT RUS FIN GBR DEU SWE NOR BLR 21 2 Nurses Physicians Source: OECD Health Data 212, and WHO Health for All Database. Source: OECD Health Data 212, and WHO Health for All Database. Note: Data reported for 21 or the latest year available. The latest year available for Belarus is 29 from WHO Health statistics. 3 National published data for 21 reports 4.8 physicians, 9.9 nurses and 11.5 hospital beds per 1, population (Statistical Yearbook, 212). The Ministry of Health provided additional data for 211 on the number of health care personnel and hospital beds, based on adjusted definitions, as follows: 3.5 doctors per 1, population, 8.3 nurses per 1, population and 8.7 hospital beds per 1, population. However, to ensure cross-country comparability the data reported here is based on the figures reported by the OECD/WHO Executive Summary xv

18 belarus public expenditure review vol.2 Going forward, continued spending pressures will strain health sector expenditures. These spending pressures stem from rising input costs and wages, introduction of new medical technologies, growing expectations for better health care quality and an aging population. In the short term, rising input costs could push up costs of health care delivery. Low compensation of health care personnel has contained the cost of health care provision. These costs are likely to escalate over the short to medium term if compensation of health care employees increases. Moreover, income growth is expected to lead to higher health care expenditures over the medium term. As living standards rise, there will be growing social pressure for increased health care quality and coverage. Over the longer term, the number of Belarusians above 6 years of age will increase from approximately 2.1 million in 21 to more than 2.4 million in 22. Demand for health care typically increases with age, notably above 55 for men and above 6 for women, due to higher morbidity and incidence of disability. International evidence indicates that the elderly use health services up to 3 5 times more than younger individuals, on average. Addressing these combined challenges in a fiscally-constrained environment will require re-prioritization of resources to achieve gains in efficiency and effectiveness in health spending. Reform options include: a. Sustain public health spending at current levels: Given the contraction in health spending over the past years and significant public health challenges, further reductions in spending as a share of GDP would likely lead to deterioration of health service quality and undermine financial protection for households, and therefore negatively affect public health outcomes. It is important that any savings achieved through increased efficiency be reallocated within the health sector. b. Optimize health care facilities, especially hospitals: The country needs to reduce overcapacity and limit the size of the hospital sector, but at the same time improve quality of infrastructure and equipment in a few selected hospitals. The remaining hospitals and polyclinics should be grouped into regional delivery networks, tentatively one hospital network for 2, 3, people. The resultant fiscal space could be used for investment in modernized equipment and infrastructure to improve service in the remaining hospitals. Regional hospitals outside Minsk need to be given priority. c. Increase emphasis on primary care and preventive services, especially for NCDs: The Government needs to continue to reallocate resources away from acute hospital care service towards preventive services, which are undersupplied. Strengthening primary care will help deliver preventive services better and will likely have the greatest potential impact on improving health outcomes. In addition, the content of prevention and treatment practices needs to be redesigned to respond to current needs, particularly in prevention of NCDs. d. Reform hospital payment system: Greater performance orientation should be introduced in the budget process and payment system. Initially, hospital financing could move towards global budgets allowing for greater flexibility in the use of resources, while a Diagnostic Related Groups (DRG) system could be introduced, initially as a way to monitor performance of hospitals. After 2 3 years, once the DRG classification system and recording of clinical information is established, the payment system could gradually move towards DRG-based payments for hospitals. e. Introduce capitation of primary care financing: Primary care could be financed on per capita plus performance bases. For this, primary care doctors and polyclinics could establish a patient registry and xvi Executive Summary

19 Enhancing public services in times of austerity be paid according to a capitation formula, with adjustments for their volume of activities and key quality indicators. f. Introduce Referral System: A new referral system needs to be established so that patients first seek care from primary care facilities and polyclinics, except in emergencies, and use hospitals only if referred by their primary doctors or specialists. Integration and coordination between primary, secondary and tertiary providers is key not only to deliver quality care but also to contain costs, because patients are directed to the appropriate point of delivery for a given diagnosis. Such a referral system could also provide financial incentives for doctors to treat patients on an outpatient basis, rather than bringing them into inpatient hospital care. g. Increase autonomy of providers: Continue the policy of linking hospitals and other medical facilities in regional care networks and progressively provide more management autonomy to facilities. Such managerial autonomy has two essential dimensions: (i) the ability to organize the production of services, including appointments/dismissals, staff working hours, remuneration, capital expenditures, medicine purchase and stock management, etc. with some flexibility; and (ii) managerial responsibility in case of cost overruns and the ability to retain savings. This would lead to better accountability for performance and financial results. In the absence of such autonomy, the incentives linked to different payment systems would be muted, because the Government would be compelled to micromanage inputs of budgetary institutions, take away any savings they are able to obtain and continue to sustain them even when they are redundant or wasteful. h. Strengthen quality management: Greater autonomy needs to be accompanied by greater accountability for results, which can be achieved only if the health system develops robust internal and external controls to manage risks and establishes a rigorous financial and performance audit process with robust data generation and use of data in operations, management and policy formulation. Enhancing Spending Efficiency for Better Education Results Belarus s educational system has performed well in improving access and enrollments. The gross enrollment ratio in primary education has remained at 1 percent since 2, and increased from 86.3 percent in 2 to 17.4 percent in 211 in general secondary school. Demand for tertiary education rose over the last decade, leading to a 1.6 times increase in the number of students per 1, population between 2 and 211. Belarus ranks high in terms of the Human Development Index (5th out of 187 countries in 212), largely thanks to the achievements in education. Household spending on education is moderate by regional standards, suggesting broad affordability. At 5 percent of GDP, public spending on education is in line with the regional average, but the focus needs to be on increasing efficiency, especially in view of the declining student population. Demographic change is impacting the demand for education services. Declines in school-age population and urbanization have reduced the number of students, especially in rural areas. As a result, student-teacher ratios at both the primary and secondary level are among the lowest in the region (Figure 11). Teacher salaries remain relatively low, making it difficult to attract Executive Summary xvii

20 belarus public expenditure review vol.2 and retain skilled labor in the teaching force. And while per-student costs have risen, this has not necessarily led to better learning outcomes (Figure 12). The current system of education financing provides little incentive to SNGs to efficiently allocate resources. Rather, existing input-focused financing arrangements encourage schools and local governments to retain large numbers of staff and maintain excess facilities. Figure 1. Public Spending on Education Is in Line With Region Average Figure 11. Student-Teacher Ratio Is Low Public Education Expenditures, percent of GDP MDA KGZ SVN LVA EST POL LTU TUR HUN CZE UKR MKD BLR MNE SVK BGR KSV HRV KAZ RUS TJK SRB ROU ALB GEO ARM TJK KGZ ROU SVK MKD UZB BGR MDA CZE POL UKR HUN KAZ SVN LTU LVA BLR AZE Source: World Bank staff estimates, Edstats, ECA Fiscal Database. Figure 12. Low Student-Teacher Ratio Is Driving Costs But not Leading to Better Outcomes Per student cost, thousand BYR 1, 8, 6, 4, 2, Student-teacher ratio Source: World Bank staff estimates, MOF, MOD. Average math scores , 4, 6, 8, 1, per student costs, thsnd BYR Moreover, there are signs of concern about the quality and relevance of education to the needs of the economy. Skills mismatch is increasingly an issue. More Belarusian firms than anywhere else in the region report finding skilled workers as a constraint to their growth. 4 Addressing these education challenges requires reorganization and prioritization of sector spending. Reform options include: a. Continue efforts to right-size the school network and teaching force. A simple estimation suggests that attaining student-teacher ratios comparable to the OECD average over the medium term could save approximately 11 percent of the education budget, or around.6 percent of GDP per annum, in the wage 4 In recent firm level survey, over 6 percent of Belarusian firms interviewed, consider skills as a major or severe constraint to firm performance, becoming an obstacle to firm growth (Business Environment and Enterprise Performance Survey 28/9). xviii Executive Summary

21 Enhancing public services in times of austerity bill alone. Additional savings could be achieved from a consolidation of the school network (including within-school consolidation of classes). These savings could be used to upgrade facilities, raise teacher salaries, invest in teacher qualification and procure other learning equipment, such as computers. b. Move to per-student financing to improve efficiency, equity and transparency in resource allocation. Following the pilot project launched in 213, the system should gradually move towards per-student financing, away from the current input-based financing arrangement. This would align spending more closely to demand, provide greater autonomy and increase incentives to schools to improve internal efficiency in resource use. c. Enhance quality and performance management to strengthen accountability for results. Monitoring and analysis of school-level performance information could help identify schools with performance challenges and allow for corrective action, including through resource allocations. Quality certification of schools, audits, internal benchmarking and centralized examination can all play a role in this regard. In addition, participation in international benchmarking, such as the OECD PISA, 5 would be useful in assessing Belarus s education performance against international standards. 5 Since 2, OECD s Program for International Student Assessment (PISA) has measured the quality of education in OECD countries, and over the years non-oecd countries have increasingly participated. Executive Summary xix

22 belarus public expenditure review vol.2 Table 1. Summary of Proposed Policy Options Time Frame Stabilizing Macro-Fiscal Policy Maintain a stable fiscal stance within a consistent macro-economic framework Short Term Expected Impact Macro-economic stability Balance wage and income policies to not exceed productivity growth Short Term Macro-economic stability Further rationalize subsidies Medium Term Fiscal savings % of GDP Maintain capital spending at current levels Medium Term Economic growth Increase tax authority by formally assigning property taxes to local governments Simplify and apply transfer formula to create more predictable and transparent system of transfers Modify the definition of public debt to include the liabilities of subnational governments Strengthening Incentives of Sub-national Government Short Term Medium Term Short to Medium Term Enhanced incentives for subnational governments Enhanced incentives for subnational governments Improved fiscal transparency Work with most indebted localities to reduce liabilities Short to Medium Term Mitigated fiscal risk Enhancing Spending Efficiency for Better Health Results Sustain public health spending at current levels Medium Term Sustained health outcomes Optimize network of health care facilities, especially hospitals Medium Term Fiscal savings (within sector) Increase emphasis on primary care and preventive services, especially for NCDs Short to Medium Term Improved health outcomes Increase autonomy of providers Short to Medium Term Improved operational efficiency Reform hospital payment system Utilize capitation for primary care Medium to Long Term Medium to Long Term Improved operational and allocative efficiency Improved operational and allocative efficiency Introduce referral system Medium to Long Term Improve health service utilization Strengthen quality management Short to Medium Term Improved health service quality Continue effort to right-size the school network and teaching force 6 Move to per student financing Enhancing Spending Efficiency for Better Education Results Medium Term Medium Term Fiscal savings.7 % of GDP (within sector) Improved operational and allocative efficiency Enhance quality and performance management for the sector Short to Medium Term Improved service quality 6 As an initial step towards teaching force optimization could be an increase in student-teacher ratio in urban schools uncomparable to the OECD countries average, which, according to Ministry of Education estimates, could result in savings in amount of.2 percent of GDP per annum in the wage bill alone. xx Executive Summary

23 Enhancing public services in times of austerity Chapter 1. Fiscal Reforms: Addressing Macro- Structural Challenges Summary: After a decade of strong economic growth, Belarus coped with recurring macro-economic turmoil over the past four years. The crises had a severe impact on public finances. Belarus achieved one the largest fiscal contractions in the region, with revenue falling from over 5 percent of GDP in 28 to 39 percent in 211 and spending dropping in the same period from close to 5 percent of GDP to about 36 percent of GDP. This was achieved primarily through cuts in capital spending and to a lesser extent by containing government consumption. While macro-economic stability has been restored, significant risks remain. External and domestic imbalances in the current account, exchange rate and inflation could reemerge if macro-economic policies are loosened prematurely. Coping with renewed distress would be more challenging, since previous crises used up most of the available fiscal and macro-economic buffers to absorb further shocks. Public and publicly guaranteed debt much of it external has more than doubled since 28, reaching almost 32 percent of GDP by the end of 211, and the country faces significant refinancing needs. These risks are exacerbated by uncertainties in the external environment related to the Euro area and Russia. Belarus faces a challenging fiscal reform agenda to secure macro-economic stability, rebuild fiscal buffers and support the structural transformation of the economy. The continued need for budget discipline will need to be balanced with carefully targeted investments to spur recovery, growth and social development. This chapter analyzes revenue and expenditure trends, including the composition of the fiscal adjustment since 28, and identifies options for continued fiscal reform. A. Recent Macro-Economic Developments Securing Stability in an Uncertain Environment After a decade of strong economic growth, Belarus faced recurrent macroeconomic turmoil over the past four years. During most of the 2s, a combination of favorable external factors and loose macro-economic policies boosted economic growth, with annual growth rates averaging 9 percent from However, this strong growth came at the expense of heightened macro-economic vulnerabilities and large external imbalances, which resulted in two crises in the last four years. The first was a direct outcome of the global 1

24 belarus public expenditure review vol.2 financial meltdown of 28/9, which was transmitted to Belarus through trade and financial channels. The second was triggered by loose monetary, fiscal and income policies in (pre-election) 21, which generated a short-term economic recovery but resulted in a widened in current account deficit (15 percent of GDP in 21) and heightened pressure on foreign exchange reserves. This eventually put the economy in a tailspin during much of 211, leading to the loss of control of the exchange rate and sharply accelerating inflation. After a period of multiple exchanges rates and severe foreign exchange liquidity constraints, the Belarusian Ruble (BYR) lost close to 7 percent of its value vis-à-vis the US dollar and inflation soared to 19 percent in December 211. Authorities counteracted the crisis through a combination of tightened macroeconomic policies and a new, more favorable energy deal with Russia. The policy response included the following measures, implemented during the second half of 211: (1) exchange rate unification on October 2, 211, after months of uncertainty; (2) fiscal tightening, resulting in a consolidated budget 7 surplus of 2.1 percent of GDP in 211; and (3) monetary tightening, including an increase in the refinancing rate to 45 percent in December 211 and a notable slowdown in government lending in late 211. In addition, authorities secured financial support from the Anti-Crisis Fund (ACF) of the Eurasian Development Bank (US$3 billion during ) and negotiated a new energy deal with Russia (signed in November 211) that reduced the price of gas by nearly a half from the level paid in Q4 211 (from US$26 to US$158 per 1, TCM), resulting in a terms of trade gain equivalent to about 5 percent of GDP. Together these measures have brought about initial stabilization of the economy. Credit tightening and administrative measures (including delayed utility tariff increases) helped to bring down monthly CPI inflation from the peak of 13.6 percent in September 211 to 2.3 percent m/m in December 211 and kept monthly inflation at below 2 percent during 212 (except for August, when inflation accelerated to 2.3 percent m/m), although producer prices signal persistent inflationary pressures, warranting a cautious approach to monetary relaxation. Following a sharp drop after the unification of the exchange rate in October 211, the nominal exchange rate Table 2. Main Macro-economic Indicators, Real GDP (change in percent) CPI, e.o.p. (change in percent) Terms of Trade (change in percent) Current Account Balance (percent of GDP) Foreign Exchange Reserves (in months of imports of G&S) Net FDI (USD billions) General Government Balance (percent of GDP) PPG Debt (percent of GDP), of which: Domestic External Memo: Nominal GDP (in billions of USD) GNI per capita (USD, Atlas method) 2,15 2,78 3,47 4,25 5,43 5,59 5,99 5,83 Source: National statistics, IMF, World Bank. 7 According to the Budget Code, the consolidated budget of the Republic of Belarus includes the republican budget and local budgets. The extra-budgetary Social Protection Fund (SPF) is not included in the consolidated budget. The consolidated budget combined with the SPF forms the general government budget. 2 Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges

25 Enhancing public services in times of austerity stabilized and appreciated modestly in early 212, as the devaluation subdued demand for foreign exchange. Both devaluation and terms of trade gains also helped to substantially improve the trade balance, which in turn eased pressures on the current account (Figure 13). The trade deficit improved from 13.3 percent of GDP in 21 to 3 percent of GDP in 211, and moved into a surplus of 3.8 percent of GDP in second half of After plunging to more than 15 percent of GDP in 21, the current account improved, coming in at 9.5 percent by the end of 211. This positive trend continued in 212 and the current account closed with a surplus of about US$.9 billion in the second half of 212 (1.6 percent of GDP). Official reserves increased to US$7.9 billion (two months of imports) by end-211 on account of privatization proceeds from the sale of the remaining 5 percent of stake of Beltransgas (US$2.5 billion), two tranches of the ACF of the Eurasian Development Bank loan (US$1.2 billion) and a US$1 billion loan from Sberbank (Russia). Figure 13. Signs of Stabilization Since End External imbalances have started to adjust Real GDP (change in percent) Current Account Balance (percent of GDP) PPI CPI Source: World Bank staff estimates, Belstat, NBRB. 4 2 and inflation subsided Jan-11 Mar-11May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12May-12 Jul-12 Sep-12 Nov-12 While immediate pressures have subsided, the macro-economic environment remains fragile, heightening risks that hard-earned stability could be undermined by a period of policy laxity. Imbalances could reemerge quickly if macro-economic policies are loosened prematurely. With signs of initial stability emerging, authorities have begun to ease credit conditions and relax restrictions on wage and pension increases. The NBRB has gradually cut the refinancing rate to 3 percent p.a. in September 212. After real wages and pensions fell by 17.2 percent and 21.9 percent y/y to November 211, respectively, they increased during the first nine months of 212, resulting in y/y real growth of 31.7 percent and 55.6 percent, respectively. This rise in real wages (in excess of productivity) has an adverse impact on competitiveness while supporting import growth. These domestic vulnerabilities could be exacerbated by a severe deterioration in the international economic environment. The high and growing concentration of exports to the Russian market exposes Belarus to terms of trade and export demand risks. The impact of a protracted economic contraction in the EU and even a modest slowdown in Russia could offset the export revenue growth that was spurred by the devaluation and the energy deal, and would intensify the need for containing domestic demand. In addition, energy prices may not stay low and the recent terms of trade gains would be reversed if Russia starts to raise prices again. 8 In 212, private Belarusian companies, with the participation of Russian raw materials companies, developed and successfully engaged in the production of solvents from Russian naphtha at Belarusian refineries. According to the rules of the Customs Union, this raw material is imported into the country duty-free. In accordance with national technical regulations, processed products are classified as other commodity and receive a customs code that allows their export without paying export duties. Production and export of solvents is a major source of the positive dynamics of the economy and foreign trade surplus in Belarus in H1 212, along with the export of petroleum products from the Russian oil. The solvents business was closed in July 212, which had an immediate impact on the export dynamics and GDP growth. Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges 3

26 belarus public expenditure review vol.2 To reinforce and consolidate macro-economic stability, fiscal policy will have to remain tight. A further loosening of policies, including of the fiscal stance, would counter recent disinflationary gains, leading to a faster erosion of exchange rate competitiveness and renewed weakening of external balances. Public finances will, therefore, remain constrained for some years to come. This continued need for budget discipline will need to be balanced with the intended reduction in the tax burden as well as carefully targeted investments to spur recovery, growth and social development. Building on the fiscal reforms of the past years, this can be achieved through a mix of sustained fiscal tightening combined with a realignment of expenditure priorities, including further rationalization of subsidies, and enhanced spending efficiency in key public services, including health and education. B. Fiscal Reforms Deepening Budget Restructuring Public finances were severely hit by the macro-economic turmoil, but prudent fiscal management contained the fiscal balance throughout the crises years. Since the 28/29 crisis, Belarus has experienced a sharp and continuous contraction of revenues. This was partially driven by a cyclical contraction of export duties on energyrelated exports, VAT and income taxes, but a series of tax reforms since 25 9 have led to a more permanent reduction in the tax burden and a change in the revenue structure. Revenue fell from over 5 percent of GDP in 28 to 41.6 percent in 21, falling down further to 39 percent of GDP in 211. Belarus avoided a substantial deterioration of the fiscal position through commensurate expenditure consolidation (examined in greater detail later in this section). The general government balance (including the Social Protection Fund, SPF) moved from a surplus of 1.3 percent of GDP in 28 to a deficit of 1.8 percent of GDP in 21. In 211, the crisis induced a sharp fiscal consolidation, and the Government curtailed expenditures, while revenue growth was fuelled by inflation, achieving a 2.8 percent consolidated general government budget surplus. Decomposing the overall general government balance shows that while the SPF has been in surplus throughout the years (mainly a reflection of favorable demographic conditions), changes in the fiscal stance are primarily driven by the state accounts, including central and local governments, which deteriorated in 29 and 21 but improved significantly in 211 Figure 14. Belarus Achieved Significant Fiscal Consolidation percent of GDP percent of GDP General Government Expenditures General Government Revenue State balance SPF balance GG balance Sources: World Bank staff estimates, MOF, SPF See PER1 (World Bank 211) for a detailed description of changes in taxation since 25. Doing Business 213 recognized Belarus as the country that has advanced the furthest in tax regulatory practice since 24. Since 25, Belarus abolished several taxes, reduced tax rates, broadened the tax base, simplified filing forms and the tax law and invested in electronic systems that make it easier to file and pay taxes. These changes reduced the number of annual payments from 125 to 1, the time from 987 hours a year to 338 and the total tax rate from percent of profits to 6.7 percent. 4 Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges

27 Enhancing public services in times of austerity (Figure 14). Overall, Belarus fiscal position compares favorably to most countries in the region the average general government balance across ECA countries in 211 stood at -2.2 percent of GDP. While fiscal discipline was maintained through the crisis years, the underlying fiscal policy stance tended to be pro- cyclical, exacerbating macro-economic imbalances. Changes in the cyclically-adjusted balance 1 show that the underlying fiscal stance was pro-cyclical, especially during the pre-crisis years (Figure 15). In both 28 and 21, fiscal expansions mainly driven by rapid increases in wages and transfers fuelled domestic demand growth, which contributed to rising external imbalances and inflationary pressures. While the state budget was approximately in balance in 28, the underlying structural deficit (taking into account the large positive output gap in 28) dropped to 3.4 percent of potential GDP, thus adding to economic overheating. The size of the underlying structural deficit improved in 29, reflecting a significant but pro-cyclical fiscal consolidation when the global crisis struck. In 21, the structural balance started to weaken again as a result of expansionary fiscal policy, followed by a sharp fiscal contraction as the Government tightened expenditures to counteract spiraling inflation during 211. Figure 15. Prudent Fiscal Deficits and Substantial Below-the-line Expenditures Fiscal Policy Has Exacerbated the Economic Cycle Bank recapitalization, percent of GDP Sources: World Bank staff estimates, MOF. 5.3 Output Gap 7 Counter-cyclical Contrac on Pro-cyclical Counter-cyclical -3 Contrac on Expansion In 211 the Government incurred substantial fiscal costs for the recapitalization of major state-owned banks (Figure 15). Banks were recapitalized through the issuance of sovereign bonds, and the related cost was recorded as a financing operation in the fiscal accounts (below the line). Between 25 and 211, the state budget injected on average 1 percent of GDP annually to recapitalize major state-owned banks, effectively compensating them for the losses incurred in directed lending programs. In 211, bank recapitalization expenditures peaked at BYR 14.6 trillion, or 4.9 percent of GDP, as bank capital adequacy was threatened by a significant increase in foreign liabilities, induced by the devaluation. 11 Given the state s interventionist role in the financial sector, contingent liabilities and fiscal risks associated with the large stock of quasi-fiscal debt under government-directed lending in the banking sector continue to threaten consolidation efforts Note: Consolidated Budget Balance. Fiscal Impulse (Change in cyclically adjusted balance) 28 Pro-cyclical Expansion The cyclically adjusted balance estimates the fiscal position eliminating cyclical effects. We statically estimate the permanent trend and cyclical component of GDP by applying the Hodrick-Prescott filter to annual GDP data for , extending it with projections to 216 to mitigate end-of-series bias. Cyclically-adjusted revenue is calculated from actual tax revenues adjusted according to the ratio of potential output to actual output and the estimated revenue elasticity (1.7). We assume expenditures are inelastic, taking into account labor market rigidities and the absence of comprehensive unemployment benefits and other automatic stabilizers on the expenditure side. Fiscal impulse is estimated as the year-to-year change in the cyclically adjusted balance. 11 Belarusbank (BYR 12.9 trillion), Belagroprombank (BYR 1.6 trillion) according to Presidential Decree 68 from December 29, 211; Belinvestbank (BYR 85 billion) according to the Council of Ministers Resolution 18 from December 3, 211. Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges 5

28 belarus public expenditure review vol.2 Despite moderate deficits, public debt has accelerated rapidly over the past few years. Public debt has more than doubled as a share of GDP over the last four years, from 12.9 percent in 28 to over 32 percent by the end of 211 (Figure 16). 12 Belarus contracted substantial external debt in both 29 and 21 to support the balance of payments during the global financial crisis, mostly through loans from multilateral lenders (IMF, World Bank and ACF) and through the issuance of Euro bonds in 29/21. The stock of Belarus largely external and foreign currency-denominated domestic liabilities was inflated by the impact of the exchange rate devaluation in 211. As a result of the growing debt burden, interest payments are on the rise, expected to amount to 2.1 percent of GDP in 212, exerting increased fiscal pressures. In addition, local government direct and guaranteed debt has been constantly on the rise from 2 percent of GDP in 24 to almost 14 percent in 21 before decreasing to 11 percent of GDP in 211. While the central government has no formal obligation to bail out local governments, the absence of a framework for dealing with default creates implicit liability (discussed in more detail in Chapter 2). Figure 16. Expansion of Public Debt and Refinancing Risks Reinforce Need for Fiscal Restraint percent of GDP in million USD Debt Repayment External PPG Domestic PPG Domestic External Source: World Bank staff estimates, MOF. 3, 2,5 2, 1,5 1, 5 In addition, about half of Belarus public debt will mature in the coming four years, adding significantly to gross financing needs and straining the balance of payment. The redemption profile for public debt reveals a sizeable maturity concentration in the short term, mainly due to repayments of IMF loans, maturing external bonds and repayment of bank recapitalization bonds. About half of the public debt outstanding, equal to about US$7 billion, will mature within the next four years. Rolling over this debt in the current environment will be challenging, especially given political tensions with US and the EU and heightened risk aversion of investors in sovereign debt markets (related to the Euro crisis). Over the past four years, Belarus reduced the size of the Government budget by 1 percentage points of GDP. Reflecting the state-driven economic model, Belarus has traditionally redistributed a significant share of GDP through the budget and the SPF. Especially prior to the 28 crisis, buoyant revenue growth fuelled an expansion of consolidated government expenditures from 45.9 percent of GDP in 24 to 49 percent of GDP in 28, making Belarus the country with the largest expenditure-to-gdp ratio in ECA. Since 28 and induced by the two macro-economic crises Belarus achieved one the largest contractions in the size of government in the 12 PPG debt and GDP are in current BYR. Foreign currency-denominated debt is converted in LCU using the official exchange rate as of January 1 of the following year. The sharp increase in the debt-to-gdp ratio in 211 is the result of both increased borrowing and sharp devaluation. 6 Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges

29 Enhancing public services in times of austerity Figure 17 Belarus Reduced the Public Sector Footprint, But Tax Burden Remains High General Government Expenditure to GDP Ratio 55 5 UKR BLR SVK BIH MNE HUN LVAHRV RUS 4 CZE SRB POL MDA BLR 21 SVN 35 KGZ BGR ROU EST TUR 3 LTU MKD 25 GEO ALB 2 ARM 1, 2, 3, Per Capita GDP (Current US$) Source: World Bank staff estimates, MOF, ECA Fiscal Database. percent of GDP Belarus Bosnia & Herzegovina Slovenia Ukraine Hungary Serbia Czech Republic Estonia Croa a Poland Moldova Russia Slovakia Romania Latvia Bulgaria Tax Revenue (percent of GDP) Box 1. Level of Government Spending Matters, But So Does Quality and Composition The role of government has increased since the end of World War II in many countries. As market economies became richer, governments grew. Government spending among the G7 countries doubled from about 2 percent of GDP in 195 to more than 4 percent in 21. Governments in Europe spend about 1 percent of GDP more than their peers, and this difference is largely explained by social spending. Growth is Slower as Government Gets Bigger Government size: 1995, 27 and 21 median growth by average government size, in percent, World Europe median government spending, percentage of GDP < >55 < >55 Source: Figure source. Note: The horizontal axis shows government spending as a percentage of GDP. North Center South Western Europe EU12 EU cand. E. prtn. Anglo- Saxon Japan Emerging peers Empirical research has shown that the size of government can affect economic growth. The impact of government spending on growth has been found to be negative for countries with initial government spending of 35 4 percent of GDP or more, but positive for countries with smaller government sizes. If expenditure levels exceed 35 percent of GDP or higher, an increase in general government expenditures of 1 percentage point of GDP has been found reduce growth by.3.4 percent per year (World Bank, 27). In addition to size, the type of spending matters too. While high levels of government consumption and transfers tend to undermine growth, public investment seems to support growth. Finally, the quality of spending is a key factor. Efficient governments have the ability to adjust spending patterns to shifting demographic trends, increase incentives for cost savings and improve equity through proper evaluation of policy outcomes. Sources: Gill, Indermit S.; Raiser, Martin Golden growth: restoring the luster of the European economic model. Washington D.C., World Bank. World Bank, 27. Fiscal Policy and Economic Growth: Lessons for Transition Economies. Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges 7

30 belarus public expenditure review vol.2 region (Figure 17). The overall expenditure envelope has contracted by 13 percentage points of GDP over the last four years, to about 36 percent of GDP at the end of 211. While this allowed for a substantial reduction in the tax burden, Belarus continues to have the highest tax-to-gdp ratio in the region. Important changes in the structure of expenditures came with this contraction in the size of the overall expenditure envelope. The composition of the adjustments largely reflects a contraction in discretionary spending and to a lesser extent reprioritization of expenditures across functions. Both the economic and functional structure of expenditures has changed significantly over the past four years (Figure 18). Primary expenditures contracted by 9 percentage points, while interest payments almost doubled as share of GDP from.6 percent in 28 to 1.1 percent in 211. In terms of economic classification, capital expenditures took the brunt of the adjustment, while government consumption, including transfers, good and services and the wage bill, contracted at much slower pace. The adjustment was concentrated in functions with large discretionary capital spending. Economic affairs, which include capital-intensive spending on transport, agriculture, energy and general administration, saw the sharpest reductions. Figure 18. Economic and Functional Composition of the Adjustment percent of GDP percent of GDP Capital Expenditures Transfers and Subsidies Goods and Services Economic Affairs General Administration Other Wages Interest Public Safety Housing and Communal Services Education Health Defence Social Protection (incl. SPF) Source: World Bank staff estimates, MOF. Capital spending contracted most sharply, accounting for 44 percent of the adjustment. At 1 percent of GDP, Belarus was an outlier in terms of the size of its public investment program before the crisis. Given its large size and the discretionary nature of capital spending, investment expenditures bore the brunt of spending cuts. Capital expenditures decreased from 1 percent of GDP in 28 to 5. percent in 211, equal to a 48 percent decline in real terms (Figure 19). Capital spending now accounts for about 14 percent of total expenditure, down from 2 percent four years ago. This reduction was achieved through a reprioritization of investment projects, whereby priority investments for example investments in energy efficiency were protected from cuts. At its current level, capital spending in Belarus remains moderately below the average level for all ECA countries (5.2 percent of GDP) and equals to the average level for ECA high- and middle-income countries (5. percent of GDP). However, given the significant contraction over the past years, additional cuts to public investment would not only threaten the quality and sustainability of public infrastructure, but also likely undermine the country s long-term growth prospects A recent cross-country report found that economies with sustainable periods of fast economic growth spend on average about 6 percent of GDP on public investments. The Growth Report: Strategies for Sustained Growth and Inclusive Development, World Bank, Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges

31 Enhancing public services in times of austerity Figure 19. Sharp Contraction in Capital Spending Brought Belarus Closer to ECA Average Capital Expenditures, percent of GDP Source: MOF, ECA Fiscal Database. Figure 2. Belarus Has the Highest Level of Subsidies in ECA Subsidies, percent of GDP Source: MOF, ECA Fiscal Database Capital Expenditures, percent of GDP Transfers and subsidies were cut, accounting for 33 percent of the adjustment, but the reform of subsidies remains incomplete. Current transfers and subsidies declined from 21.3 percent to 16.5 percent of GDP, a 17 percent drop in real terms (Figure 18). This reduction was achieved primarily through cuts in intergovernmental transfers to sub-national levels of government. In contrast, subsidies continue to be a major spending item. Apart from correcting for a specific subsidy that was paid to oil refineries during 27-9 to compensate for export duties paid to Russia (2 3 percent of GDP), only minor success was achieved so far in rationalizing other subsidies. The level of spending on subsidies from the consolidated budget (excluding SPF) 4.6 percent of GDP did not significantly change as compared to its 24 level. In 211 Belarus had the highest subsidies-to-gdp ratio in the ECA region. Reforming the extensive program of industrial and agricultural subsidies remains a key priority, both from a fiscal and a structural reform perspective. The need for subsidy reform is also reinforced by the requirement to comply with WTO prerequisites on state support. The public sector wage bill contracted, contributing another 17 percent to the adjustment. Wage restraint has reduced the wage bill from 1.3 percent of GDP in 28 to 7.9 percent in 211, an 18 percent decline in real terms (Figure 21). Most of this was achieved by a decline in real wages, which were eroded by high inflation in 211, while public sector employment was reduced by less than 1 percent. However, pressure for a rebound in nominal wages is rising. To sustain the positive impact of the adjustment on macro-economic balances, it is important that wage increases are undertaken cautiously to avoid re-emergence of inflationary pressures and imbalances in the economy. At the same time, the compensation system is the key to attracting, retaining and motivating competent employees, and therefore a crucial factor to enhancing public sector productivity. Containing the Ukraine Slovakia Croa a Russia Turkey Kyrgyz Rep. Albania Macedonia Hungary Slovenia Montenegro Serbia Bulgaria Lithuania Armenia Estonia Czech Rep. Latvia Moldova Belarus Romania Kazakhstan Poland Bosnia & Herz. Georgia Kosovo Tajikistan Azerbaijan Subsidies, percent of GDP Albania Latvia Lithuania Azerbaijan Romania Tajikistan Poland Armenia Kazakhstan Kyrgyz Rep. Bulgaria Estonia Hungary Slovakia Moldova Bosnia & Herz. Georgia Macedonia Ukraine Slovenia Czech Rep. Serbia Croa a Montenegro Kosovo Russia Belarus Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges 9

32 belarus public expenditure review vol.2 Figure 21. Public Sector Wages Contracted in 211, but Public Employment Remains High 24=1 Public Sector Wage Bill, percent of GDP Index of Real Public Sector Wages Index of Public Sector Employment Public Sector Employment (percent, population) Source: MOF, ECA Fiscal Database. wage bill without undermining workforce morale, commitment and performance will require structural changes to public sector employment and differentiated pay policies. While the overall expenditure envelope has contracted, interest payments are on the rise, reflecting the sharp increase in the debt burden. Interest payments are the only line item that increased in the past years, almost doubling as a percentage of GDP from.6 to 1.1 percent, as a result of the substantial increase in public debt. While interest payments accounted for 1.2 percent of total expenditures, they now absorb 4.7 percent of the available resource envelope, crowding out productive expenditures. The functional composition of the budget has also changed, with spending on economic affairs and general public administration experiencing the sharpest declines. The allocation for economic affairs accounts for the lion s share of the adjustment, declining from 12.7 percent to 5.3 percent of GDP in 211, equal to 7 percent of the adjustment. However, economic affairs expenditures are still well above the ECA average of 4.6 percent of GDP (Table 3). This reduction reflects the substantial reduction in capital spending in sectors such as transport and energy that are included under this function, as well as lower subsidy spending. General administration spending also fell on account of the wage bill contraction and cuts in the state investment program. Social sectors, including social protection, education and health, on the other hand, were largely protected from spending cuts and remain at or above regional averages. The brunt of expenditure reductions fall on the central government. The central government budget absorbed 8 percent of the spending cuts, while 2 percent of the cuts were passed on to sub-national governments (Figure 22). This mainly follows from the structure of the adjustment in terms of economic and functional spending items. Sub-national spending is dominated by recurrent spending in the education and health sectors, which were largely isolated from the adjustment. Sub-national expenditures now account for 55 percent of the consolidated government accounts (excluding the SPF). SPF expenditures, predominantly for pension benefits, have remained stable through the adjustment UKR ARM MDA POL SRB BGR TUR CZE HRV ROU SVN AZE SVK HUN LVA BLR EST LTU RUS Table 3 Selected Sector Funding International Comparison percent of GDP Education Health Economic Affairs 2 R=.2918 Social Protection Belarus ECA ECA MIC CIS EU Source: ECA Fiscal Database. 1 Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges

33 Enhancing public services in times of austerity Figure 22. The National Budget Took the Brunt of the Adjustment percent of GDP 6 Figure 23. Reforms Permanently Lowered the Tax Burden and Changed the Revenue Structure percent of GDP Republican Budget Local Government Budget Other Taxes Custom Duties Profit Tax Excises Social Protection Fund Budget Property Tax SPF Revenue Income Tax VAT Non Tax Revenue and Grants Source: World Bank staff estimates, MOF On the revenue side, tax policy reforms have permanently changed the structure and size of the tax burden (Figure 23). Major revenue sources, such VAT, income taxes and customs duties, were initially hit by a cyclical contraction in 29. However, since 29 tax reforms have become the major driver of the reduction in the overall tax burden and changes in the structure of revenues. Reforms in effect from January 1, 21 consolidate previous tax legislation comprised of numerous laws, presidential edicts and decrees, government resolutions and instructions an important step in making tax legislation more transparent and predictable. Major distortive and inefficient taxes such as turnover taxes, local sales tax on goods and services (in the presence of the national VAT) and the local development fee of 3 percent on net corporate profit have been abolished. This has affected revenue in the range of 4.5 percent GDP. In addition, as in other countries in the region, Belarus introduced a flat personal income tax with a statutory tax rate of 12 percent, which simplified the tax system without harming revenue performance. In 212 the Government lowered the profit tax rate to 18 percent, from 24 percent. To some extent, the resulting reduction in revenue will be compensated by excise taxes, which are set to rise. Overall, the pattern of adjustment has built up more budget rigidity, constraining future fiscal choices. As a result of the adjustment, the share of non-discretionary expenditure (defined as expenditures for wages, social transfers and interest payments) in total expenditures has increased from 65 percent in 28 to 73 percent in 211. Further cuts in discretionary spending, especially in public investment and non-wage recurrent expenditure, would likely undermine the productivity of public spending, lead to a deterioration of public infrastructure and undermine growth prospects. It is therefore important to strengthen the strategic reallocation of resources. Building on the fiscal reforms of the past years, this can be achieved by further rationalizing subsidies and enhancing quality and efficiency of spending in key public services, including health and education. C. Why Look at Intergovernmental Fiscal Relations, Health and Education Spending? Sub-national fiscal management has increased in importance with the fiscal adjustment of the past years. Subnational governments (SNGs) now account for more than half of consolidated government spending (Figure Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges 11

34 belarus public expenditure review vol.2 24). Moreover, SNGs provide critical public services, including health, education and utilities such as water, heating and sanitation. Infrastructure expenditures of local authorities have also become more critical, as central government capital spending has contracted. Finally, debt and more importantly guarantees of oblast (regional) governments have been on the rise, building up direct and contingent fiscal liabilities. Understanding the financing and incentives of SNGs is therefore important from both an overall fiscal management perspective and also for improving the quality and performance of public services such as health and education. Figure 24. Sub-national Governments Account for More Than Half of Public Spending Subnational Share in General Government Spending (excl. SPF) Source: World Bank staff estimates, MOF. The health and education sectors absorb significant fiscal space and are critical to improving living standards and human capital. The two sectors together account for about 26 percent of consolidated budget expenditures, up from 18.3 percent in 28. As a share of GDP, Belarus is spending about 5 percent on education and 3.5 percent on health. Current spending levels (as both percentage of government spending and GDP) in both education and health seem broadly adequate and in line with countries in the region. The major share of this spending is carried out through sub-national governments, which account for about 76 percent and 8 percent of spending in health and education, respectively. Together, health and education account for over 8 percent of sub-national spending, making them the two financially most important SNG sectors. Real spending in the two sectors was sustained, despite the fiscal contraction of the past four years. In real terms, per capita spending in both sectors has grown substantially over the past decade, especially during the pre-crisis years of high income growth but also throughout the crisis years (Figure 25). Real per capita spending in these sectors in 211 was double the 23 level, broadly in line with per capita income growth over the same period. Figure 25. Human Capital Investment Has Risen and Outcomes Have Improved , , , , , Life Expectancy at Birth Expected Years of Schooling at Birth Spending on health in 211 prices, thds BYR p.c. Spending on education in 211 prices, thds BYR p.c. Source: World Bank staff estimates, MOF, Belstat. With rising expenditures, a range of health and education outcomes have improved over the last decade. Belarus ranks high in terms of the Human Development Index (5th out of 187 countries in 212), largely thanks to the income level and high educational attainment. Sector outcome indicators have improved steadily over the 12 Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges

35 Enhancing public services in times of austerity past decade. Life expectancy at birth has recovered to over 7 years after a sharp decline during the early transition period, although it remains below the pre-transition level, largely due an early mortality crisis among the male population, which is yet to be addressed. Educational attainment also improved, as enrollment rates especially at the general secondary level have gone up. These positive developments in terms of sector outcomes are also reflected in perception indicators based on the most recent life in transition survey, conducted in 21, although the satisfaction with the health services remains significantly lower than with education services (Figure 26). Notwithstanding these improvements, the education and health sectors are confronted with a number of structural challenges that will have to be addressed within a fiscally constrained environment. Both sectors will have to tackle three key, inter-related challenges. First, both sectors need to push for Figure 26. Satisfaction With Education and Health Services: Belarus vs. Other ECA Countries Percent of Respondents Satisfied with Quality and Efficiency of Public Service Delivery Country Public health system Education Azerbaijan Kyrgyz Rep Albania Ukraine Tajikistan Kazakhstan Belarus Russia Armenia Uzbekistan Moldova 67 8 Turkey Georgia Source: 21 LITS. Countries ranked in order of average satisfaction across education and health sector in 21. further outcome improvements, including addressing new health and education challenges. Second, with already significant spending commitments to both sectors and tight fiscal constraints, further efforts need to focus on raising the efficiency of spending and containing costs over the medium term to free up fiscal space for needed human capital investment. Third, they need to adapt to an aging population, with fewer students and greater burden of chronic and degenerative diseases, which will fundamentally change public service demand with important fiscal implications. Further improving sector outcomes The signs of inefficiencies in resource use are coupled with new, emerging challenges in terms of improving outcomes in both education and health. Despite progress made over the past decade, both the health and education sectors continue to face important performance challenges. Belarus health system will need to adapt to an increase in degenerative (as opposed to communicable) diseases as the main public health risks. Non-communicable diseases, mainly cardiovascular diseases and cancer have become the leading causes of death among adults, and especially among men, whose life expectancy is 12 years lower than that of women and substantially below the level of countries with comparable income levels (Figure 27). The incidence of non-communicable diseases is expected to increase further with a growing share of the population above 65. To address this in a cost-effective manner, emphasis and resources will need to shift from the current hospital and secondary care-centered health system to primary care, including preventive care. Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges 13

36 belarus public expenditure review vol.2 Figure 27. Male Mortality Crisis Female Life Expectancy BLR , 2, 3, 4, 5, Source: World Development Indicators. Per Capita GDP, PPP Adjusted, Current US$ Male Life Expectancy BLR 1, 2, 3, 4, 5, Per Capita GNI, PPP Adjusted Current US$ The quality and relevance of Belarus s education system will need to meet the demands of more a dynamic economy and labor market. Skills mismatch is increasingly an issue. More Belarusian firms than anywhere else in the region report that finding skilled workers is a constraint to their growth. 14 The country also suffers from a skills mismatch by occupational profile: an oversupply of graduates in social sciences, business and law compared to the number of jobs requiring those qualifications. Meanwhile, there is an undersupply of qualified graduates in engineering and manufacturing. Business surveys indicate that the education sector will need reforms to enable it to better supply the skills needed for Belarus to compete as a middle-income country in the knowledge economy. Overcoming Inefficiencies in Public Spending With already significant spending commitments in the social sectors, the greatest challenge is to raise the efficiency of resource use. While specific issues vary, the education and health sectors share some commonalities. In both sectors, Belarus inherited extensive delivery systems characterized by dense networks of service facilities across the country, including schools, hospitals and other health care facilities. These structures reflect historical rather than current service demand and needs. Moreover, the financing of these delivery systems provides little incentive to local actors to rationalize inputs and allocate resources efficiently. For example, Belarus has more hospital beds per population and patients get admitted to hospitals more often and on average remain Figure 28. Signs of Operational Inefficiencies in the Health and Education Sectors Number of Hospital Beds per 1, Population Secondary Student-Teacher Ratio in ECA Countries in Georgia Armenia Uzbekistan Kyrgyz Rep. Estonia Serbia Latvia Slovakia Romania Poland Lithuania Czech Rep. Hungary Azerbaijan Kazakhstan Austria Ukraine Russia Belarus Tajikistan Kyrgyz Rep. Romania Slovakia Macedonia Uzbekistan Bulgaria Moldova Czech Rep. Poland Ukraine Hungary Kazakhstan Slovenia Lithuania Latvia Belarus Azerbaijan Source: World Bank, WHO. 14 Business Enterprise Performance Survey 28/9. 14 Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges

37 Enhancing public services in times of austerity hospitalized for longer periods than in most other countries in region (Figure 28). Equally, Belarus has more class rooms and employs more teachers per student than most countries in the region. As a result, salaries and utility costs absorb significant resources in both sectors (88 percent and 92 percent in education and health, respectively). These large recurrent costs do not necessarily lead to better service outcomes, and they crowd out spending on workforce training, investments in modern equipment and rehabilitation of debilitated facilities. Aligning Spending to Demographic Changes Belarus demographic structure is shifting, with important implications for demand in the education and health sectors. The population dependency ratio (the number of old age people for 1 working age people) projected to double from 57 in 28 to 115 in 25 (Figure 29). The number of citizens above the age of 6 will increase by 14 percent in the next decade alone. Fiscal policy will have to balance the needs of the old age population and younger citizens and cope with spending pressures in the pension and health systems. In the health sector, aging will amplify spending pressures and change the demands placed on the health system. Health expenditures tend to be high for young children, low and flat for age group 1-6, then increase sharply after age 6. Evidence from EU countries suggests that spending on the age group above 65 is four to seven times the average spending. Aging will also change the epidemiological pattern and further increase the incidence of degenerative diseases (discussed in more detail below), which require long-term preventive and curative care. These agingrelated spending pressures will compound other cost drivers in the health system, including escalating costs related to technological advances in the medical field. In education, the system will need to continue to adapt to the sharp decline in the student population. The number of school-aged children has declined from about 1.5 million in 2 to less than one million in 21 and is expected to remain at that level in the coming decade. The rationalization of the school network has been underway, but Belarus still has one of the lowest student-teacher ratios in the world. Figure 29. Aging Population Is Changing Demand for Public Services In addition to the changing age profile, Belarus has experienced significant internal migration, intensifying demand pressures in cities while reducing them in rural areas. Over the past 1 years about one million people have moved to cities, increasing the share of Belarus urban population from 67 to 74 percent, a trend that could intensify if the structural change of the economy accelerates. As a result, rural areas face declining service demand and under-utilization of infrastructure, while additional resources are required to meet the demands of a growing urban population. 3, 2,5 2, 1,5 1, Age 5 14 Age 65+ Source: UN Populations Statistics. Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges 15

38 belarus public expenditure review vol.2 D. Fiscal Challenges and Reform Options In the coming years, fiscal policy will have to balance prolonged austerity with investments in economic growth. While Belarus has emerged from a severe macro-economic crisis, further fiscal restraint is needed not only to complete the macro-economic and structural adjustment process (and to avoid a reversal of the gains already made), but also to stabilize and then gradually reduce public debt in order to rebuild resilience in case of renewed macro-economic distress. This continued need for budget discipline should be balanced with carefully targeted investments to spur recovery, growth and social development. Building on the fiscal reforms of the past years, this can be achieved through a mix of sustained fiscal tightening combined with a realignment of expenditure priorities both within and across sectors. The contours of such reforms would be based on the following broad priorities: a. Stabilize the fiscal stance: While the undervalued exchange rate and government-directed lending were the primary sources of the expansionary stance in 21 and 211, fiscal policy especially related to wages and income has tended to exacerbate macro-economic imbalances. The fiscal stance should be determined within a consistent medium-term macro-economic framework, taking into account the overall economic position. b. Balance wage and income policies: Nominal wages started to recover during 212, following the substantial real wage decline in 211. However, to sustain the positive impact of the adjustment, it is important that wage increases are undertaken cautiously to avoid re-emergence of inflationary pressures and imbalances in the economy. Given the importance of the budget in anchoring wage trends in the entire economy, long-run wage developments should not exceed productivity growth. At the same time, the compensation system is the key to attracting, retaining and motivating competent employees. Especially given the wage differential within the customs union with Russia and Kazakhstan, there is real risk of an outflow of the most productive and skilled labor force. Structural changes to public sector employment and differentiated pay policies could help contain the cost of the wage bill while allowing more competitive pay for certain positions. c. Further rationalize subsidies: Subsidies remains high in Belarus, absorbing fiscal space while imposing distortions in the real sector. A further reduction of subsidies is needed, notably in the utility sectors and in the extensive system of state support in both the agricultural and industrial sectors, in the context of broader structural reforms and liberalization of the economy. d. Protect capital spending at current levels: Capital spending has taken a significant hit during the adjustment process. While capital spending before the crisis was exceptionally high, especially for a middle-income country, it is now at levels commensurate with its income level. Since capital spending and effective public infrastructure are key to economic competitiveness and growth, a further contraction of capital spending would likely undermine future growth prospects. The focus should continue to be on prioritizing strategic investments, for example in energy efficiency, while maintaining current spending levels. 16 Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges

39 Enhancing public services in times of austerity e. Enhance spending efficiency in key public services, including health and education: Because of its positive effects on the formation of human capital and productivity, spending on education and health can boost economic growth while promoting equity and reducing poverty. How productive and beneficial spending on education and health is, however, depends on how funds are allocated within these sectors. With spending in both sectors already quite substantial, the key challenge is to enhance the efficiency of spending. Both the education and health sectors face significant challenges in this regard, including adjusting spending to the changing demands of an aging population, increasing the efficiency of spending and further improving sector outcomes. Enhancing fiscal incentives throughout the delivery system to rationalize and adjust the composition of inputs while focusing on results and service demands will go a long way in this direction. However, while fiscal reforms and changes in the financing arrangements of these sectors are critical parts of this agenda, they need to be embedded in broader sector reforms aimed at enhancing result orientation and performance. Moreover, given the crucial role of regional governments in financing and delivering these services, reforms and improvements are intrinsically linked to local government finance reforms and the intergovernmental fiscal framework. The following chapters will analyze spending efficiency in intergovernmental relations, health and education. The three chapters analyze the efficiency and quality of spending and provide specific policy options for reforms to strengthen intergovernmental fiscal relations (Chapter 2) and public spending in health (Chapter 3) and education (Chapter 4). Chapter 1: Fiscal Reforms: Addressing Macro-Structural Challenges 17

40 belarus public expenditure review vol.2 Chapter 2. Intergovernmental Fiscal Relations: Strengthening Incentives of Subnational Governments Summary: Strengthening the incentives of sub-national governments (SNGs) is crucial for increasing the overall efficiency and effectiveness of public expenditures in Belarus. SNGs are critical providers of public services such as utilities (water, heating and sanitation), health, education and infrastructure. Following the fiscal adjustment of recent years, SNG spending now accounts for more than half of consolidated government expenditures (excluding the Social Protection Fund). Belarus made progress in improving various aspects of its system of intergovernmental fiscal relations, including revising expenditure responsibilities between levels of government, developing a formula-based methodology for grant allocations and rationalizing local taxation. However, further reforms are needed. Revenue autonomy of local governments is weak and SNGs heavily rely on shared tax revenues and transfers to finance their expenditures. Expanding revenue autonomy would strengthen SNG fiscal incentives by linking marginal expenditure increases to the need to raise local revenue and generate fiscal savings. As well, direct and guaranteed debt of regional governments has been on the rise, creating looming fiscal risks that merit close attention. This chapter analyzes the current state of intergovernmental fiscal relations, including revenue, expenditure and debt trends at the sub-national level, and formulates reform options to enhance fiscal management of local and regional governments. A. Intergovernmental Relations in Belarus Institutional and Administrative Structure Belarus is a unitary state with a vertical structure, consisting of four tiers of government. The four levels include the central (republican) government, seven regional governments (six oblasts and the city of Minsk), 13 baselevel jurisdictions (118 rural districts, known as rayons and 12 municipalities subordinate to oblasts), and 1,357 primary level jurisdictions (1,288 villages, 55 rural settlements and 14 towns subordinate to rayons). The average population at the second tier of local governments, including both rural districts and municipalities, is about 72, people, rather large by 18

41 Enhancing public services in times of austerity international standards (Table 4). In contrast, the average size of the lowest tier jurisdictions is about 3,4, considerably smaller than the lowest tier governments in most European countries. Table 4. Population of Sub-national Jurisdictions, 211 Oblasts and the Base-level jurisdictions Primary level City of Minsk All Rural Districts Municipalities jurisdictions Number of units ,357 Mean 1,354,456 72,932 41,3 231,559 6,981 Min 1,66,1 1,894 1,894 62,75 n/a Max 1,864,9 51, ,325 51,312 n/a Source: National Statistical Committee. The current jurisdictional architecture increases administrative costs. With four tiers of government, Belarus is not an exception in international comparison, although a majority of countries, many with similar or larger population size, manage to operate with three tiers. 15 While jurisdictional delineations in all countries are the result of administrative history rather than of purely economic considerations, sustaining the fixed cost associated with the 1,357 primary-level councils and administrations absorbs resources that could be devoted to service delivery. This is especially true since most functions assigned to primary-level governments are relatively minor and duplicate those of the city/rayon level. 16 In addition, some of the primary-level jurisdictions may be too small to deliver services efficiently. 17 Some consolidation of smaller primary-level jurisdictions, especially of village councils, has already taken place and their number has been reduced by 69 from 1,426 entities in 29. Sub-national governments (SNGs) are an integral part of a centralized political and administrative structure (Figure 31). According to the Law on Local Government and Self-Government, each level of government comprises two parallel governance structures: 1) Executive Committees (the local government), which are centrally appointed with strong bounds of upward accountability to higher levels of government; and 2) Councils of Deputies (local self-government), which are elected locally. Executive Committees are responsible for managing sub-national service functions, including oversight of service facilities (schools and hospitals) and preparation and execution of regional budgets. 18 Elected councils in turn represent the views and preferences of local residents, approve regional government budgets and prepare and adopt local bylaws. As a result, SNGs face multiple, competing layers of accountability and subordination, limiting their ability to respond to community needs. Sub-national budgets are drafted by centrally-appointed executives and then adopted by locally-elected councils. On local issues, local executives report to the corresponding local councils. On national issues, local executives report to the president and higher-level executives. Local line departments report to both the corresponding local executive head and higher-level sectoral heads and ministries. Local executive heads have to obtain approval from a higher-level line department in order to appoint local sectoral heads. At the 15 In a recent analysis of data for 179 countries, 1 countries report having five tiers of governments, while 5 countries report four. However, more than half of the countries in the sample have only two sub-national levels of government, including countries vastly different in terms of population. See Gomez and Martinez-Vazquez (212). 16 Primary-level responsibilities include maintenance of public areas, water supply, public saunas and minor activities in roads, housing, and environmental protection. 17 The research on economics of scale is inconclusive. Evidence suggests that economies of scale are fully exploited for most public services at populations of 1,, although for certain services such as large brownfields, water purification and urban transport, the available economies of scale are exhausted for the larger size of 1,. At the same time, research also shows that few economies of scale can be gained by incorporating small jurisdictions into larger ones, especially in sparsely populated rural areas. 18 At the primary (bottom) tier, the Council Chair also serves as the executive head at that tier. Decree of the President on Certain Issues of Local Governance and Selfgovernance 66 (adopted February 22, 211). Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments 19

42 belarus public expenditure review vol.2 same time local executive heads are asked for no objection to the appointment of heads of territorial branches of national agencies (tax service, police, military recruitment centers, etc.) and state-owned enterprises. While this system is designed to ensure the balancing of national and local priorities, in practice the system limits the flexibility of SNGs to adapt public policies, services and spending to local circumstances and preferences. Figure 3. Intergovernmental Administrative and Political Relations in Belarus President Council of Ministers Central Government Line Ministries Oblast Tier Execu ve Commi ees of Oblasts and City of Minsk Councils of Depu es of Oblasts and City of Minsk Base Tier Execu ve Commi ees of Rayons and Oblast Subordinate Towns Councils of Depu es of Rayons and Oblast Subordinate Towns Ci zens Primary Tier Execu ve Commi ees of Rural Districts and Ray-on Subordinate Towns Councils of Depu es of Rural Districts and Ray-on Subordinate Towns Local Government Local Self-Government Source: World Bank staff based on national legislation. Law on Local Government and Self-government in the Republic of Belarus adopted January 4, 21 #18-Z (last amended December 22, 211 #328-Z) B. Trends in Sub-national Government Expenditures SNGs account for a large and growing share of general government expenditures. After a decline in 29, sub-national government expenditures have been growing in real terms and as a share of general government expenditure (Figure 31). In contrast, central government expenditures (excluding SPF) have contracted as a percentage of GDP each year since 29 (with the fiscal consolidation discussed in Chapter 1). As a result, SNGs now account for more than half of general government expenditures, or 41 percent of general government expenditures including SPF. This share is considerably above most countries in the region. In fact, only the Russian Federation and Kazakhstan have a higher sub-national share in public spending. SNGs play an important role in delivering key public services in Belarus. With the exception of three functions that are exclusively assigned to the national government defense, law enforcement and promotion of the national 2 Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments

43 Enhancing public services in times of austerity Figure 31. Sub-national Expenditures Have Grown, Making Belarus One of the Most Fiscally Decentralized Countries in the Region млн. бел. руб. % Sub-national Revenue % of General Government Revenues RUS KAZ BLR LVA LTU UKR 2. POL 15 CZE SRB HUN 1 1. ROU 1 BIH BGR.5 5 MKD Subnational Public Expenditures in constant 211 Prices, mil.byr (lhs) Sub-national Expenditures % of General Government Expenditures SNG Share in GG Expenditures (excl. SPF) SNG Share in GG Expenditures Source: World Bank staff estimate, MOF, IMF GFS. economy regional governments carry out important responsibilities in most core government functions. 19 The current assignment of expenditure responsibilities across levels of government by and large mirrors general principles in the distribution of government functions 2 and is similar to practice in many other decentralized countries. SNGs are responsible for many information-intensive services within their geographical scope, like the financing and management of schools, hospitals, polyclinics and other facilities, while the central government remains responsible for functions that affect the entire nation (Table 5). The assignment of specific responsibilities across levels of government, especially for functions that are shared, is not always clear. For many functions, the Budget Code assigns the responsibility for funding service facilities to a certain level of government based on the ownership of these facilities. For example, budget financing can be provided for maintaining institutions of education, health care, social services and others that are owned by or put under authority of the corresponding tier of local governments. While this provides clarity about what level is responsible for financing certain facilities, responsibilities for formulation of policies and regulations with regard to particular functions and services remains largely undefined. In practice, it appears that across most functions, responsibilities are shared between different levels of government, with the central government exercising important policy and regulatory functions and SNGs responsible for financing and managing service delivery facilities. Figure 32. The Functional Composition of Sub-national Expenditures Is Relatively Stable percent of GDP Housing and Utilities Healthcare National Economy Education Source: World Bank staff estimates, MOF. Other Articles of the Budget Code (adopted on July 16, 28) provide the assignments of expenditure responsibilities among the levels of government. Oblasts have only a few exclusive assignments: territorial defense, management of land resources and inter-city transport. For the city/rayon level, exclusive assignments are: city transit, fuel wood, coal and utility subsidies, public housing and saunas, ambulances, day centers and foster families. 2 Public finance literature generally proposes that the assignment of functions should be guided by the trade-off between costs and benefits of jurisdictional size in the provision of public services. The central government typically has an advantage in providing services with significant economies of scale and large catchment areas. In contrast SNGs have informational advantages in the provision of public service and are better able to match divergent preferences of communities. Musgrave and Musgrave (1989). Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments 21

44 belarus public expenditure review vol.2 Table 5. Assignment of Functions Across Levels of Government Level of Government Service Functions Central Regional (Oblast ) Base (Rayons and Cities) Primary Local Administration Education Pre-School Primary Secondary Vocational Tertiary Health Care Primary Care Secondary Tertiary Social Protection Housing and Communal Services Culture and Sports Economic Affairs Source: World Bank staff based on Budget Code. In financial terms, education, health, economic affairs and housing and communal services account for threequarters of SNG expenditures. Education, health, economic affairs, and housing and communal services are the most important functions of SNGs from a financial point of view. Together these four sectors absorb about 75 percent of sub-national expenditures. The functional composition of sub-national expenditures has been relatively stable (Figure 32). While spending in education and health decreased slightly after the crisis, spending on economic affairs remained largely flat. The importance of sub-national financing varies substantially across sectors. For housing and communal services, SNGs account for almost all spending, equal to 2.1 percent of GDP (Table 6). Almost three-fourths and two thirds of education and health expenditures, respectively, are accounted for at the sub-national level. But sub-national spending is also important in several other sectors with smaller resource allocations, including culture and sports (65 percent sub-national), environmental protection (34 percent sub-national) and social policy (35 percent subnational). The bulk of sub-national expenditure takes place at the third tier of government. Outside Minsk City, over twothirds of sub-national expenditures takes place at the sub-oblast level. Across most sectors, cities and rayons carry out most spending. The oblast level accounts for less than a fifth of sub-national expenditures on education, housing and utilities. However, oblast governments dominate other categories of expenditures; in particular they account for 8 percent of SNG expenditures on economic affairs (Table 7). Public investment by SNGs contracted since 28 as a result of fiscal consolidation. SNGs invested about 2.1 of GDP in 211, down from 3.35 of GDP in 28 (Figure 33). As at the central government level, capital expenditures 22 Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments

45 Enhancing public services in times of austerity Table 6. Public Expenditure by Level of Government, Share in Consolidated Expenditures CG SNG CG SNG CG SNG CG SNG CG SNG Total General public services Defense Public order and safety National economy Environmental protection Housing and communal services Health Physical culture, sports, culture and media Education Social policy Source: World Bank staff estimates, MOF. Note: CG = central government w/o SPF and transfers to sub-national governments; SNG = sub-national government. Table 7. Spending Shares across Sub-National Levels of Government, 211 (% of Sub-national Spending) Oblast Sub-oblast Level Cities Rayons Total expenditures Housing and utilities Health care Recreation and culture Education Other expenditures Source: World Bank staff estimates, MOF. Note: Some rows do not add up to 1 percent due to rounding. Figure 33. The Economic Composition Has Changed, With Rising Subsidies and Declining Capital Spending percent of GDP Personnel Goods and Services Interest Subsidies Social Benefits Other Operating Activities Capital Investments Source: World Bank staff estimates, MOF took the brunt of the expenditure contraction, accounting for more than half of the overall reduction in the sub-national expenditure-to-gdp ratio. Despite this contraction, SNGs now account for almost half of general government investments, due to even sharper cuts in capital spending at the central level. A further contraction of capital expenditures would likely result in underfinancing of local government infrastructure and deterioration of assets, including equipment and buildings of schools and hospitals, recreational facilities as well as transport infrastructure and roads. As result, SNG spending is skewed towards recurrent expenditures. Recurrent expenditure wages, subsidies and other operating costs accounted for 87 percent of sub-national spending in 211: Wages the largest spending item have been relatively stable. The wage bill accounts on average for about 35 percent of SNG expenditures. SNGs finance more than two-thirds of the total public sector Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments 23

46 belarus public expenditure review vol.2 wage bill. Many local public services are labor-intensive, and significant shares of the public payroll are allocated to cover personnel expenses related to service delivery including the salaries of teachers, doctors, health care workers and other front line service personnel. Goods and services expenditures have been curtailed. Similar to the central government, SNGs have absorbed the fiscal contraction by curtailing discretionary expenditures. Spending on goods and services fell by about 1.5 percent of GDP since 28. In contrast, subsidies primarily for district heating have been on the rise, and now accounting for about 19 percent of sub-national spending. Rising energy prices together with timid tariff increases have led to declining cost recovery in utilities over the past years. 21 As a result, budgetary subsidies for district heating have increased quite significantly. In addition, SNGs increased spending on industrial and agricultural subsidies. Belarus has maintained high levels of interregional equity in public spending. The city of Minsk, which has the highest expenditures of all SNGs, spends only 18 percent more on a per capita basis than Brest oblast, the region with lowest spending (Figure 34). While disparities among rayons and cities are somewhat more pronounced, they remain low by international standards. The coefficients of variation which measure standard deviation in per capita spending across the rayons and sub-oblast cities are.18 and.12, respectively, considerably below many other decentralized transition countries. 22 This high level of equity is a result of both relatively low initial Figure 34. Expenditure Equality Million BYR Per Capita, 211 5, disparity, compared to many other countries, and the redistributional features of the intergovernmental financing framework, in particular intergovernmental transfers, which will be discussed in more detail in the subsequent section on the financing of SNGs. However, per capita spending in rural areas is significantly higher than in cities, primarily due to higher education expenditures. Per capita spending in rayons is on average about 38 percent above per capita spending in cities (Table 8). This discrepancy is largely because average rayon per capita spending in education is 64 percent higher than the city average predominantly a result of lower student-teacher ratios and excess school capacity in rural areas (discussed further in Chapter 3). The main reason is the lack of adjustment in spending to increased urbanization, resulting in an oversized (and underutilized) rural service infrastructure, as well as lower population density and consequent higher costs to providing public services in rural areas (Figure 35). Furthermore, there are economies of scale in public spending across rayons. Per capita spending declines with larger population size (Figure 36). The differences are particularly stark for rayons with population of less than 4, 3, 2, 1, Brest Vitebsk Gomel Grodno Minsk Mogilev Housing and Utilities Healthcare Recreation and Culture Education Other Source: World Bank staff estimates, MOF. Minsk city 21 World Bank Public Expenditure Review Volume The coefficient of variation across rayons and cities is around 1.5 and.5 in Russia and Ukraine, respectively. 24 Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments

47 Enhancing public services in times of austerity Table 8 Variation in Expenditures Across Different Functions, Current Million BYR Per Capita, 211 Type of Jurisdictions Total Housing and Utilities Health Care Recreation and Culture Education Other Rayons Average 3, , Minimum 2, Maximum 5,177 1, ,218 1,142 Coef. of Variation Sub-oblast cities Average 2, Minimum 2, Maximum 3, , Coef. of Variation Source: World Bank staff estimates, MOF. Figure 35. Spending in Rural Areas is Higher Than in Cities Figure 36. Diseconomies of Scale Thsnd. BYR, current prices, 211 Thsnd. BYR, current prices, 211 3,5 6, 2 R= , 472 5, 2, , 2, 1, , 1, , 1, , Rayons Ci es 5, 1, 15, 2, Housing and Utilities Healthcare Recreation and Culture Population Education Other Source: World Bank staff estimates, MOF. 25,. Some of the difference could perhaps be explained by the negative correlation between population size and density, thereby necessitating higher resource requirements to supply the same service level in smaller communities. However, some of the difference reflects fixed costs in the provision of services, regardless of the client base served. The presence of these scale economies points to potential efficiency gains from consolidating smaller rural government entities. C. Financing Sub-national Services SNGs derive revenue from three major sources. Shared national taxes are the largest financing item and contribute roughly 6 percent of sub-national revenue. Transfers from the central government, including both block and earmarked grants, make up another 35 percent. The remaining 5 percent comes from own-source taxes Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments 25

48 belarus public expenditure review vol.2 and non-tax revenue. As a result of the financial crisis, local government revenues from all sources declined in 29, but have recovered steadily in subsequent years. Direct taxes were especially hard hit, but fully recovered by 211 on account of a rising share being transferred to SNGs. However, property taxes have declined steadily from 1.58 percent of GDP in 26 to.86 percent in 211 (Figure 37). Own-source tax revenues have virtually collapsed after the elimination of a number of distortionary taxes previously assigned to regional governments. 23 Intergovernmental transfers, excluding redistribution of value-added tax (VAT) revenue, contracted sharply during 29, but have recovered to pre-crisis levels, accounting for about 35 percent of sub-national revenues in 211 (up from 27 percent in 29). Figure 37. Subnational Revenue Composition Is Relatively Stable Over Time But Varies Across Levels Consolidated Subnational, percent of GDP Consolidated subna onal Oblast Rayon City Non-Tax Local Taxes Other Taxes Property Taxes Non-Tax Property Taxes Other Taxes VAT VAT Profits and Income Taxes Grants Profits and Income Taxes Grants Source: World Bank staff calculations based on MOF data. Note: Apart from the sales tax and profit surtax, reported in the local taxes category, other minor local taxes are reported in the other category along with other national taxes. The composition of revenues differs among SNG levels. Reliance on grant financing is greatest among rural local governments (rayons), where almost half of the revenue comes from intergovernmental transfers. In contrast, both oblasts and city governments generally generate most of their revenue from shared national taxes, with especially the portion of revenue flowing from personal and corporate income taxes (PIT and CIT) being markedly higher than in municipalities. This reflects differences in economic capacities and hence income tax bases, which tend be more concentrated in cities. Cities also receive a larger share of the VAT, reflecting higher population concentration in cities. Shared revenue from national taxes is the predominant source of sub-national finance. All significant tax bases, including VAT, personal income tax, property taxes and CIT, remain under the control of the national government, but the revenue is shared with oblast governments, who in turn share these revenues with constituent localities. 24,25 Property taxes, PIT and CIT are shared on a derivation basis, while VAT revenue is shared proportional to population. 26 The Budget Code sets retention rates for the shares of national tax revenues that are distributed 23 The most important are local taxes on goods and services and local development fees (profit surcharge). The elimination of these taxes reduced tax burden and compliance costs. Local sales taxes in the presence of a solid VAT created unnecessary duplication. These taxes had different rates and their elimination has helped to level the tax burden between service and non-service sectors of the economy. 24 Current legislation does not allow any level of government to introduce taxes beyond those enumerated in the Tax Code (Part I adopted on December 19, 22, last amended December 3, 211; Part II adopted on December 3, 29, last amended April 1, 212). The list of permitted taxes is broken into two categories: republican revenue sources and local revenue sources. Classification of a tax into the republican category does not always determine the level of government that receives the proceeds from this tax. 25 Property taxes and PIT are entirely (1 percent) transferred to SNGs. 26 This makes VAT sharing more akin to an intergovernmental transfer rather than a shared tax. 26 Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments

49 Enhancing public services in times of austerity Table 9. Retention Rates for National Tax Revenue Base-level Jurisdictions Primary-level Jurisdictions Consolidated Subnational Sub-oblast Cities Rayons Sub-rayon Cities Other Tax on real estate of physical persons Tax on real estate of legal persons Land tax paid by physical persons Land tax paid by legal persons PIT on wages PIT on business income Tax on profits of non-soes 1 Oblast discretion Oblast discretion Oblast discretion Oblast discretion Agro-tourism charge Small business taxes Gambling tax 1 1 Natural resource extraction tax 1 Source: World Bank staff, based on Budget Code. to oblast and lower tiers of governments. SNGs retain the full revenue of several national taxes, including property taxes and PIT (Table 9). Retention rates for PIT and real estate tax of legal entities are higher for rayons to partially offset unequal distribution of tax bases. Effective sharing rates for CIT and VAT have varied from year to year. While the Budget Code stipulates minimum retention rates for PIT, property taxes and a range of other national taxes, the sharing rates for VAT and CIT are set each year in the annual budget law. The effective VAT share distributed to SNGs has stayed close to 3 percent over the past years (Figure 38). The share of CIT increased substantially in 211 as a result of the changes in legislation, allowing for the retention of all profit tax payments by municipal owned and private enterprises in local budgets. Figure 38 Effective Sharing Rates for VAT and CIT Vary Annually Rep VAT Subnational VAT Rep CIT Subnational CIT Source: World Bank staff estimates, MOF. The lack of local tax autonomy weakens incentives for efficient SNG fiscal management. Belarus has implemented a number of important tax reforms that greatly improved the tax environment. Even before these reforms, local taxes contributed less than 1 percent of SNG revenues; after their implementation the yield of the remaining Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments 27

50 belarus public expenditure review vol.2 Box 2. Extra-budgetary Revenues of Front-line Service Delivery Units Front-line delivery units generate some marginal revenue by providing fee-based services and leasing premises. While all budgetary revenue is executed by the treasury department of the MOF, with cash balances consolidated in the Single Treasury Account (STA) at the National Bank of the Republic of Belarus (NBRB), the Budget Code requirement of treasury execution has been suspended for extra-budgetary funds. These extra budgetary revenues and expenditures are executed through separate bank accounts in commercial banks but reported along the financial hierarchy to the MOF according to a special form. However, no consolidation is made to get a complete picture of total outlays on public services including both budgetary and extra-budgetary resources. In the school visited by the mission, these fees covered about 2 percent of its annual expenditures. three local taxes (Table 1) accounts for less than.1 percent of sub-national budgets. The limited reliance on own-source revenue and lack of local tax autonomy may undermine fiscal incentives of SNGs, as the costs of any expenditure increases are generally financed through transfers and shared taxes. Financing sub-national public spending at least at the margin with sub-national taxes can reinforce incentives for fiscally responsible behavior, as additional spending would require raising additional tax revenue. Table 1. Sub-national Tax Assignments Tax name Who can introduce Who defines the base Who sets the rate Dog tag tax Resort fees Fee for flora harvesting Source: Tax Code (Sections I and VI). Oblast government City/rayon governments Oblast government National legislation (number of dogs over 3 month old) National legislation (resort treatment price) National legislation (harvest value based on the gate price) National government sets adjustment for dog size (x.5-1.5) City/rayon governments within national limit (3) Oblast government within national limit (5) Who receives the revenues Local governments Local governments Primary level government Per capita revenue from own and shared revenues show significant variation among localities. Revenue disparities among localities reflect differences in economic capacity and hence tax bases across regions. Per capita revenue in the Central Rayon of Minsk is the highest, and about 21 times higher than in Stolinskij Rayon, the one with the lowest level. 27 The largest disparity is generally observed for CIT, with an average disparity of 24 percent around the rayon mean and 73 percent around the mean of cities (Figure 4). Examining relative contributions of Figure 39. Sources of Fiscal Inequality Contribution of Individual Revenue Sources to Overall Inequality CIT PIT Property Other taxes Small business tax Source: World Bank staff calculations based on MOF data. 27 The Central Rayon of Minsk is a territorial unit, but it has no budget of its own. The tax capacity of this rayon of Minsk is included into the tax capacity of the Minsk city. 28 Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments

51 Enhancing public services in times of austerity Figure 4. Disparities in Per Capita Yield of Locally Retained Taxes, by Type of SNG, BYR per capita, 211 7, 6, 5, 4, 3, 2, 1,.32 1, , PIT CIT Property tax Small business tax Rayons Budgets Source: World Bank staff calculations based on MOF data. Coef. of varia on 2,4 1, PIT CIT Property tax Small business tax different taxes to inequality shows that while CIT accounts for about 36 percent of locally-derived revenue, it contributes more than 6 percent of the measured inequality (Figure 39). The system of intergovernmental transfers equalizes fiscal capacity and finances specific SNG expenditures. The Budget Code (Chapter 12) envisions several types of intergovernmental transfers: i) general purpose block grants (subsidies); ii) earmarked sectoral grants (subventions); and iii) other forms of intergovernmental transfers. The transfer system is a cascade system, where the republican budget provides grants to regional governments, which in turn provide intraregional transfers to their constituent local governments. Transfers account for 28 percent of revenue at the regional level and 43 percent at the base and primary government level. Over 75 percent of intergovernmental transfers are accounted for by subsidies and another 11 percent by capital grants (Figure 41). The rest are subventions earmarked for the mitigation of the effects from the Chernobyl accident, support to agriculture, housing vouchers, and so on. In the transfers from oblasts to cities and rayons, the largest share is again accounted for by subsidies (79 percent). Other intraregional recurrent transfers account for about 14 percent. Intraregional capital grants and subventions are relatively marginal (under 5 percent each) Sub-oblasts Cities Budgets.47 Figure 41 Composition of Intergovernmental Transfers, 211 Regional Governments (Oblasts) Base-level Local Governments (Rayons and Cities) Subsidies Subventions Other Recurrent Grants Subsidies Subventions Other Recurrent Grants Capital Grants Capital Grants Source: World Bank staff calculations based on MOF data. The general purpose transfer (subsidy) from the central government to oblast governments is designed to equalize fiscal capacity across SNGs. According to the Budget Code, the allocation of subsidies is to be determined based on the gap between the estimated expenditure needs and revenue potential of the recipient government (Art Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments 29

52 belarus public expenditure review vol.2 75). 28 The Budget Code specifies a formula to determine the fiscal gap based on revenue potential (as opposed to actual revenue) and expenditure needs (as opposed to actual expenditure), both of which are supposed to be based on a set of objective criteria of any particular locality. 29 In practice, however, transfers tend to be based on incremental adjustments of actual pre-transfer revenues and expenditures of the previous year. Currently, the higher-level government makes its own estimates for the revenues and expenditures of constituent jurisdictions. Revenue estimates for tax and non-tax revenue are based on incremental adjustments of the respective figures of the previous year. Similarly, expenditure estimates are derived from spending figures in previous years, adjusted for changes in the number of staff and enrollments reported by each local government. The system of transfers achieves high levels of fiscal equalization. After VAT and intergovernmental transfers, fiscal outcomes are very equitable for both rayons and cities (Figure 42). The five-fold difference between the poorest and the richest rayons in locally-derived revenues per person is reduced to four-fold after the allocation of the VAT grants and to two-fold after the allocation of subsidies. Transfers also equalize the difference between cities and rayons. While the per capita average of locally-derived revenues in rayons is 8 percent lower than the city average, rayons end up with 4 percent more revenue per capita than cities after the allocation of grants. Figure 42. Equalization Performance of Transfers, BYR Per Capita, 211 6, Coef. of Coef. of varia on varia on 5,37 5,453 5,441 5, 4,563 4,69 4, 3, 2,998 3,243 3,153 2, 2,486 2,352 1,664 1,768 2,218 2,8 1, 1, Locally derived Locally derived Locally derived revenues Plus VAT Plus other grants revenues Plus VAT Plus other grants revenues Plus VAT Plus other grants Consolidated oblasts budgets Rayons budgets Sub-oblasts cities budgets Source: World Bank staff estimates, MOF. However, the way the block grant is currently allocated potentially distorts incentives for SNGs to increase spending efficiency. Since block grants essentially fill the gap between actual pre-transfer revenues and expenditures, SNGs face little incentive to rationalize inputs and to generate permanent fiscal savings, as any savings would most likely result in commensurate reductions in transfer amounts in subsequent years. 28 The transfer is a so-called fraternal transfer, which redistributes horizontally between localities. This means that if the estimated fiscal gap is negative, the direction of the transfer is upwards. In 211, only nine out of 13 sub-oblast cities and rayons were required to make upward transfers to their oblast governments, ranging from 23 percent of total revenue for the Minsk rayon to 5 percent for the Soligorsk rayon to under 2 percent for the other seven. 29 According to the Budget Code, the estimation of the revenue side of the fiscal gap is to be based on revenue capacity, while the estimation of expenditures is to be driven by the norms of fiscal sufficiency and adjustment coefficients. The norms of fiscal sufficiency are to be applied to the number of local residents or the number of beneficiaries of public goods in a locality. Adjustment coefficients are to capture differences in the costs of providing public services arising from differences in population size, socio-economic, demographic, climatic, environmental and other characteristics of a locality (Art. 76). The methodology for calculating the financial norms, adjustment coefficients and amount of transfers was adopted by the MOF in July 211. However, it has not yet been implemented, due to the lack of disaggregated data required for calculating the formula parameters. A more detailed description of the grant formula is included in Annex 2. 3 Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments

53 Enhancing public services in times of austerity A transfer formula has been designed to mitigate these adverse incentives for SNGs, but it has not been implemented due to its complexity and data requirements. The formula proposed in the Budget Code is overly complex and data-intensive; to date this has inhibited its application. On the revenue side, the proposed approach to estimate potential revenue capacity for PIT, profit and property taxes is supposed to avoid incentives for SNGs to lower their revenue effort. However, this substantially complicates the transfer formula. Moreover, given the limited tax authority of SNGs and their limited control over tax collections (only indirectly by affecting the tax base), the incentive effect on the revenue side may be very marginal in practice. Therefore, it might be appropriate to use actual revenues, at least for the first years of the introduction of the formula. The large portion of additional ad-hoc recurrent transfers from regional to lower tiers of local governments further undermine incentives for their fiscal discipline. In addition to the gap-filling approach to allocating general purpose grants, budget constraints of local governments are further softened by the practice of unplanned other transfers allocated in the course of the fiscal year by oblast governments to cities and rayons. These transfers, which used to be called mutual settlements, are typically not budgeted ex ante, but rather result ex post from emergency situations. In 211, these other recurrent transfers accounted for about 14 percent of all intergovernmental grants to both rayons and sub-oblast cities. The size of these largely discretionary grants suggests that they are used to finance regular rather exceptional expenditures. Figure 43 Capital Grants Finance a Growing Share of Sub-national Investment percent of GDP 4 3 Increasing capital grants have helped to maintain SNG capital spending during the period of fiscal distress. The share of sub-national capital spending financed by capital grants increased from 4 percent in 28 to 32 percent in 211. This increase has protected critical investments when capital expenditures became a prime target for fiscal consolidation efforts SNG Capital Expenditure Capital Grants Source: World Bank staff estimates, MOF. D. Managing Sub-national Fiscal Risks - Sub-national Borrowing and Guarantees SNGs in Belarus are allowed to borrow on the domestic market and issue guarantees on third-party debt within specified fiscal rules. The Budget Code allows for three forms of sub-national debt (Art. 65): i) intergovernmental loans, primarily to finance in-year cash shortfalls; ii) issuance of securities; and iii) extension of credit guarantees to other parties. 3 The Budget Code also establishes fiscal rules on sub-national debt, which have changed frequently over the past four years (Table 11). Initially, the Budget Code limited the total amount of the outstanding subnational debt to 3 percent of pre-transfer revenue. In 21 this provision was replaced with a rule that limited total debt service expenditures to 15 percent of the current year revenues, excluding subventions. In 212 the 3 Entities with any outstanding liabilities to any level of government cannot be offered a new guarantee (Art. 65). Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments 31

54 belarus public expenditure review vol.2 Table 11. Evolution of Fiscal Rules on Sub-national Debt Fiscal Rule Limit on SNG debt stock <3 % budget revenues without transfers from other budgets Limit on debt service expenditure <15% of budget revenues without subventions Enforcement mechanisms Limit on SNG debt stock <8% budgets revenues without subventions If the debt limit is surpassed executive committees have to prepare debt reduction plan (endorsed by the MOF, or higher-level authority) and quarterly report to the MOF on implementation progress. Overall maximum amount of local government debt for the next fiscal year should be fixed in the budget, approved by local Council of Deputies. Source: World Bank staff based on Budget Code. Separate limits on local government direct debt and guaranteed debt have to be set by local Councils of Deputies in their decisions on approving budget for the next fiscal year (Art. 65-4). Limits on the oblast direct and guaranteed debt have to be endorsed by the MOF Limits on direct and guaranteed debt of the base tier of local government have to be endorsed by the oblast government. rules were revised yet again, reinstating a direct constraint on the debt stock, including guaranteed debt at 8 percent of pre-subventions revenue a markedly higher level than in 29/1. In addition, recent amendments to the Budget Code have strengthened enforcement mechanisms to ensure compliance and sanctions for noncompliance. Most importantly, the overall amounts for both direct debt and guarantees, set in the annual budget, now require ex ante approval of higher-level authorities. Since 21 the Budget Code also explicitly stipulates that there is no central government guarantee on SNG debt. However, current legislation does not spell out ex post sanctions for exceeding debt constraints other than disallowance of further borrowing. SNG liabilities have increased rapidly over the past few years. Sub-national liabilities, including both explicit debt and contingent liabilities, peaked at close to 14 percent of GDP in 21 with further reduction to 1.1 percent of GDP in 211 (Figure 44). Guarantees of thirdparty debt, including debt of farms and municipal Figure 44. Sub-national Liabilities Increased Sharply percent of GDP enterprises, have seen the most dramatic increases, 14 due to the expansion of directed credit programs over 12 the past years. Explicit SNG debt has also grown to 1 about 16.6 percent of their pre-subventions revenues 8 or 15.8 percent of total revenues. Guarantees 6 extended by SNGs for third-party loans account for 4 another 48.6 percent of pre-subvention revenues 2 or 46.4 percent of total revenues. This shows the quite significant exposure and growing fiscal risks, Contigent Liabilities Explicit Debt especially if this trend continues. Source: World Bank staff estimates, MOF. The aggregate level of sub-national debt masks severe indebtedness in several SNGs. The ratio of explicit debt to revenues before subventions varies from 3 percent in Minsk City to 29.4 percent in Grodno oblast (Figure 45). 32 Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments

55 Enhancing public services in times of austerity Figure 45 Many SNGs Exceed Debt Rules percent of Pre-subventions Revenues Minsk City Gomel Average Minsk Vitebsk Grodno Mogilev Brest Distribution of Indebtedness Across Rayons and Cities <.3 <.5 <.8 <1.5 <2.5 <3. Contingent Liabilities Explicit Debt Ratio of Debt Stock to Pre-subventions Revenue Source: World Bank staff estimates, MOF. 1 Similarly, while the ratio of implicit debt to revenues before subventions is under 2 percent in Minsk City, it has reached 7.4 percent in Mogilev oblast. Three oblasts Grodno, Mogilev and Brest do not comply with 8 percent rule. Similarly, the indebtedness of cities and rayons varies substantially. In the Malorit Rayon of the Brest Oblast the rayon with the highest debt stock the total public and publically guaranteed debt was almost three times of its presubventions revenues in 211. The level of contingent liabilities of Malorit rayon is over 2 percent of presubventions revenues while the average for all rayons is under 4 percent (Table 12). As of 211, direct and indirect debt in seventeen rayons and sub-oblast cities exceeded the statutory limit of 8 percent budget revenues minus subventions. While direct debt appears to be rooted in fiscal imbalances, contingent liabilities seem to be related to the economic performance of regions. Simple regressions indicate that direct debt of rayons is positively correlated with fiscal imbalances (Table 13). The greater the disparity between pre-transfer revenue and expenditure, the larger the stock of explicit liabilities. This suggests that direct borrowing finances mismatches in current expenditure obligations and revenue, rather than funding capital investment. The level of direct debt does not seem to be correlated with economic performance (measured by the average rayon level wage). In contrast, guarantees are correlated to the economic performance of a locality, Table 12. Variation in Indebtedness at the Sub-oblast Level, percent of Pre-subventions Revenues, 211 Type of Jurisdictions Explicit Debt Contingent Liabilities Rayons Average Minimum..4 Maximum Coef. of Variation Sub-oblast cities Average Minimum..1 Maximum Coef. of Variation Source: World Bank staff estimates, MOF. Table 13. Regression Results on Debt Ratios Direct Debt Guaranteed Debt Total Debt Monthly Wage *** -.184** Fiscal Imbalance* 6.796*** ** Brest *** * Vitebsk *** * Grodno 9.367*** *** *** Constant *** ** Observations R-squared Source: World Bank staff estimates, MOF Note: Fiscal imbalance is measured as the difference between pre-transfer revenue and expenditures. Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments 33

56 belarus public expenditure review vol.2 while fiscal imbalances do not seem to matter for the accumulation of contingent liabilities. This suggests that guarantees are likely being used to support ailing enterprises and farms in economically less developed regions. Finally, it appears that there are systematic differences across oblasts, especially for direct debt, which seems to be higher for rayons and cities located in Brest, Vitebsk and Grodno, suggesting more severe imbalances between expenditure and fiscal capacity in these regions. By law the central government is not responsible for sub-national liabilities, but a high degree of fiscal interdependence creates fiscal risks. The lack of local taxation and reliance on shared national taxes and grants exacerbates a high degree of fiscal interdependency between different levels of government. Moreover, the lack of a legal framework for municipal bankruptcy would make it difficult to deal with sub-national insolvency. In practice, it is therefore likely that liabilities would in one way or another be shifted to the central government. This may lead to a serious incentive problem, as local governments (or enterprises owned by local governments) have strong incentives to borrow, issue guarantees and even incur arrears, hoping that the costs would be borne by the national government if needed. Moreover, since sub-national liabilities will have to be covered by future general tax revenue, the current legal definition of public debt to only refer to central government debt understates the true size of government liabilities. E. Reform Options Belarus has made good progress in recent years in reforming and updating its system of intergovernmental fiscal relations. However, a number of areas could benefit from further reform and allow Belarus to realize gains in public sector efficiency derived from a well-structured system of intergovernmental fiscal relations. A number of specific reform options are offered: a. Increase tax authority by formally assigning property taxes to local governments. The discretion provided now for setting the tax rate for property and land taxes should be preserved and the tax formally reassigned to SNGs. However, the discretion granted to local governments to set tax bases by granting exemptions and other favorable treatment is undesirable because it adds complexity to tax compliance and enforcement in a non-transparent manner. b. Simplify and apply transfer formula to create a more predictable and transparent transfer system. First, a more stable and explicit rule could be introduced to determine the pool of equalization funds in the oblast budget, reflecting overall fiscal constraints and calibrated against the overall share of sub-national spending. Second, the current formula to equalize fiscal disparities among local governments on the basis of differences in expenditure needs and fiscal capacity provides a sound framework, but it may need to be significantly simplified to apply the formula in practice. On the revenue side, given the limited revenue autonomy, the use of actual revenue seems appropriate, at least for the initial years. On the expenditure side, given the fiscal importance of a few major expenditure categories, e.g. education, health, housing and utilities, the allocation should be primarily oriented towards meeting financing needs in these sectors. This could be achieved by estimating expenditure needs in education (per enrolled student) and primary health care (per capita) combined with some equalizing component to 34 Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments

57 Enhancing public services in times of austerity finance residual spending. Given differential cost structures in rural and urban areas, some adjustment coefficients could be applied. However, it is critical that expenditure needs are determined independent of the actual expenditures on specific inputs, such as staffing, to incentivize SNGs to generate savings and reallocate expenditures. Such a formula-driven allocation should be applied both to central-regional and regional-local transfers. c. Reconsider the definition of public debt to include the liabilities of SNGs. Given the strong fiscal interdependence between levels of governments in Belarus, sub-national liabilities should be included in overall public debt statistics to more accurately reflect the size of liabilities that will have to be covered by future general tax revenue. d. Work with most indebted localities to reduce liabilities. In line with the provisions of the Budget Code, the central government should assist highly indebted rayons and cities to determine the root causes for the accumulation of direct and/or indirect liabilities and to identify remedies to contain and reduce exposure to bring them into compliance with the 8 percent rule. Chapter 2: Intergovernmental Fiscal Relations: Strengthening Incentives of Sub-national Governments 35

58 belarus public expenditure review vol.2 Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results Summary: Belarus has made significant progress in improving health outcomes, but substantial challenges remain. From 199 to 21 infant and maternal mortality rates have been approximately halved and life expectancy at birth has recovered from its decline in the early transition years, although it remains below the level Belarus enjoyed in The incidence of noncommunicable diseases, especially cardiovascular disease, is growing rapidly and has become the most important public health concern. At 3.5 percent of GDP, public health spending the primary source of health financing is broadly commensurate with Belarus level of income, but there are signs of operational and allocative inefficiencies in the sector. For its population size, Belarus has a large number of hospitals, hospital beds, doctors, nurses and other personnel. Scarce resources are spread too thin to maintain existing facilities, preventing new and more cost-effective use of funds. Moreover, discrepancies exist in the internal efficiency of hospitals, with significant variation in the average length of stay and units costs for similar treatments across the country. Overcoming these inefficiencies is critical to contain health care costs and increase cost effectiveness, especially since further pressures are likely to arise from increased treatment costs and an aging population. This chapter investigates the performance of Belarus health care system, with a particular focus on resource allocation and utilization. The chapter identifies options to improve resource management in the sector, including a shift in emphasis towards primary care and preventive services for NDCs, restructuring the facility network and further efforts to strengthen quality management. A. The Health Sector in Belarus Institutional and Administrative Structure The government is the main provider of health services in Belarus. Institutionally, the health system is organized as a traditional, publicallymanaged and financed national health service. The system is built on an extensive network of public health facilities across the country, relying heavily on polyclinics and hospitals to provide mainly free health services to 36

59 Enhancing public services in times of austerity the population. The hospital sector is organized according to the Semashko 31 system with republican, oblast-level, and rayon-level hospitals providing inpatient and emergency services. Some line ministries (such as the Ministry of Defense) and large state-owned enterprises (SOEs) have their own parallel health systems, including both inpatient and outpatient facilities, which provide services to their current and, sometimes, retired employees. 32 Private health care delivery facilities are still very limited in number and capacity. Administrative relationships in the Belarusian health system are hierarchical and organized on a territorial basis. Responsibility for health policy formulation lies with president and the Council of Ministers, while its implementation is the responsibility of the Ministry of Health (MOH) (Figure 46). The MOH is accountable not only for the functioning of subordinate public health care facilities, but the whole range of clinics and hospitals, including private ones, as well as for the performance (outcomes) of the health system as a whole. Management of health care facilities at a regional level is also conducted by MOH in a delegated manner through six oblast Health Care Departments and Minsk city Health Care Committee (which, apart from being subordinate to the MOH, are units of corresponding Executive Committees with direct accountability to the deputy head of the local government). The Committees supervise health care organizations not only of the oblast tier, but also rayon and town-level health providers, after health care departments at the rayon and town level were abolished in Some of the functions previously performed by the rayon health care departments have been Figure 46. Health Sector Structure and Administration President Other Line Ministries Council of Ministers Ministry of Health High- tech and specialized hospitals Inpa ent and outpa ent health care facili es Execu ve Commi ees of Oblasts Health Care Department Financial Department Central polyclinics and hospitals of oblasts (in charge of central hospitals, emergency care hospitals, FAPs and other outpa ent facili es) Central polyclinics of towns and rayons (in charge of central hospitals, emergency care sta ons, FAPs and other outpa ent facili es) Execu ve Commi ees of Rayons and Towns Financial Department Central hospitals of rayons (including emergency unit, outpa ent unit, FAPs, etc) HEALTH SECTOR Private health facili es management funding flows Source: World Bank staff based on the legislation of Belarus and The Health Care in the Republic of Belarus: yesterday, today and tomorrow by Zharko V.I., Malakhova I.V., Novik I.I., Sachek M.M., Minsk, The distinction between different levels of care (primary, secondary, tertiary) in Belarus is blurred, because: (i) the place of first contact can be anywhere in the system; and (ii) the Semashko system defines hospitals by group of diseases they deal with rather than by level of care. 32 These include Ministries of Transport and Communications, Interior, Defense, Social Protection, Sports and Tourism, Presidential Administration and the Frontier Guard Troops. 33 Zharko et al., 212. Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results 37

60 belarus public expenditure review vol.2 transferred to the central polyclinics (hospitals), establishing groupings of hospitals and polyclinics into regional delivery networks. Government is the predominant source of financing in the health sector. Total health spending in Belarus is equal to about 5 percent of GDP, higher than in most CIS countries but below the average health spending in OECD countries (9.2 percent of GDP). In per capita terms, public and private health care expenditures together amounted to about BYR 914,852 in 21, equivalent to US$37, or US$732 in PPP terms. 34 Health expenditures are financed from three sources (Figure 47): (i) the national budget; (ii) out-of-pocket (OOP) expenditure by households; and (iii) financing for health services provided to employees by large SOEs. Public spending financed from general taxation and channeled predominantly through sub-national governments (SNGs) is the primary source of financing, accounting for over three-quarters of total health financing. Households contribute about 2 percent. The third source is the firms contributions to health services for their employees. Other sources of revenue, such as insurance, are marginal. All public health care providers are budget institutions financed according to their inputs. Regardless of their status (e.g. republican and sub-national), health care providers receive their annual budget from the respective government budget. Under the current system of financing, the budget of public health care providers is based on their current cost structure, e.g. their previous year expenditures on labor, non-labor recurrent inputs and capital, adjusted for prices and other parameters during the budget process. The current budget process therefore Figure 47. Sources of Financing and Flows of Funds in Belarus Health System, 21 Sources of Financing Financing Agents Providers Out of Pocket Expenditures Households 2.3% General Hospitals 32.4% Ministry of Health 12.6% Specialized Hospitals 14.4% State Budget Other Line Ministries 2.8% Regional Governments 61.3% Total Health Financing 5.2% GDP Ambulatory Centers and Polyclinics 3.9% Rehabilita on/long Term Care Ins tu ons 1% Private Funding Firms 2.3% Insurance.2% Providers/Managers of Public Health Programs 2.2% Retailers and Other Suppliers of Medicines 14.7% Source: World Bank staff, National Health Accounts. 34 PPP conversion rate of 1, BYR for US$1 in 21. In 21, official Belarus ruble-dollar average exchange rate was 2, Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results

61 Enhancing public services in times of austerity provides weak incentives (and limited authority) for health care providers to rationalize the use of inputs and inadequately rewards improvements in productivity, quality of care or health outcomes. B. Health Sector Outcomes Achievements and Challenges Belarus has made significant progress in improving selected health outcome indicators. Infant and maternal mortality indicators have improved significantly since 199 and compare favorably to many other countries in the region (Table 14). According to UN inter-agency estimates, under 5 mortality decreased from 17.2 to 6 per 1, between 199 and 21, while maternal mortality decreased from 21.1 to 4 per 1, over the same period. Belarus achieved near universal coverage of basic maternal and child health services, such as institutional delivery and child vaccination, during the Soviet Union period, and since independence has been able to maintain and further improve basic coverage. In addition, Belarus has been able to contain the threat from new communicable diseases more effectively than its neighbors. HIV prevalence among adults remains low compared to other countries of the region, and the epidemic is still concentrated among injecting-drug-users (prevalence of HIV among IDUs is 1.7 percent ±.7). Belarus has also achieved positive results in fighting tuberculosis (TB). In 21, according to the latest official data there were about 46 reported cases of TB per 1, population, relatively low in regional comparison. 35 Despite these achievements, life expectancy in Belarus today is lower than it was in 197s. Over a period of more than 4 years, Belarus has not seen improvements in life expectancy, and the country is currently ranked 119 in a sample of 17 nations in terms of life expectancy. Like several other post-soviet transition countries, Belarus experienced a sharp drop in life expectancy in the early transition years, and despite moderate progress in the past 1 years has yet to recover to pre-transition levels. In 197 average life expectancy at birth was 68 for men and 76 for women; by 199 it had decreased to 66.3 for men and 75.6 for women, and in 21 it was 64.3 for men and 76.9 for women. Life expectancy is particularly low in rural areas, where it can be as low as 58.7 years (among males in rural areas of Mogilev oblast in 21). The relatively high level of premature mortality among adults, particularly men, in comparison with other European countries is a main cause of the country s lagging life expectancy and population decline (Figure 48, right panel). The probability of dying between age 15 and 6 is 324 and 117 per 1, population respectively for men and women, 12 percent above the level in 199 (Table 16). In fact, since most other countries improved their indicators over the same period, Belarus moved from 81 to 15 in the international ranking for adult male mortality, and from 38 to 18 for adult female mortality from 197 to The World Health Organization (WHO), accounting for underreporting, estimates that Belarus had a higher TB incidence (all forms) of 7 (confidence interval 57 85) cases per 1, population, a prevalence of 98 (confidence interval 38 17) per 1,, and a mortality due to TB of 11 (confidence interval ) per 1,. In addition, the drug resistance survey completed in the city of Minsk in December 21 found multi-drug resistant (MDR) TB in 35 and 76 percent, respectively, of newly diagnosed and previously treated TB cases. XDR-TB was found in 11.9 percent (confidence interval ) of the MDR-TB patients. 36 A comparison with Sweden, a country with similar population, age distribution, and similar number of births every year, is illuminating: in 21, Belarus had over 4, excess deaths vis-a-vis Sweden, and most of the difference was in working age population groups. Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results 39

62 belarus public expenditure review vol.2 Table 14. Selected Health Outcome Indicators, Belarus in Regional Comparison Maternal Mortality Rate, 29 Under 5 Mortality Rate, 21 Life Expectancy at Birth 29 Adult Mortality, 29* Male Female Male Female Age Standardized Adult Mortality Rate** TB Incidence 21 Per 1, Pop. HIV Prevalence 29 Per 1, Pop. GNI per Capita PPP Current US$ Kazakhstan ,31 Kyrgyz Rep ,29 Tajikistan ,31 Azerbaijan ,2 Ukraine ,8 Russian Federation ,94 Uzbekistan ,44 Moldova ,67 Belarus ,56 Armenia ,14 Belarus n/a 8 48*** 4,64 Georgia ,39 Latvia ,82 Albania n/a 8,9 Lithuania ,69 Turkey ,34 Estonia ,83 Poland ,48 Czech Republic ,28 Sweden ,2 Source: WHO, World Health Statistics. Note: Countries are ranked according to average life expectancy. * Probability of dying between 15 and 6 years of age per 1, population. ** Age standardized adult mortality rate, cardiovascular diseases and diabetes, ages 3-7 per 1, population. *** Year 2. Figure 48. Life Expectancy Remains Low; Excess Mortality Contributes to Population Decline Life expectancy Per 1 Population BLR GDP, thousand per capita USD (current international $) Natality rate Death rate Net population change Source: World Bank staff estimates, World Development Indicators, Belstat. 4 Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results

63 Enhancing public services in times of austerity Table 15. Main Causes of Death in Belarus, 21 Number of deaths Percentage Coronary Heart Disease 56, Stroke 2, Lung Cancers 3, Poisonings 3, Other Injuries 2, Stomach Cancer 2, Suicide 2, Liver Disease 2, Colon-Rectum Cancers 2, Lung Disease 2, Road Traffic Accidents 1, Other Causes 6,18 5. Source: Government of Belarus Statistics. Figure 49. NDCs Are the Major Cause of Low Life Expectancy in Belarus and ECA Compared With EU-15 Number of years SVN POL ALB HRV CZE HUN SVK MKD ARM EST BGR TJK LVA LTU ROU BLR MDA GEO KGZ UKR RUS AZE UZB KAZ TKM Injuries IMR CVD Source: Rechel et al. (25). Belarus demographic and epidemiological profile is changing, with non-communicable diseases now the leading cause of death among the adult population. The leading cause of mortality are non-communicable diseases (NCDs), most importantly cardiovascular diseases (coronary heart disease and stroke), cancer and external causes such as accidents, injuries, homicides and suicides (Table 15). The incidence of degenerative NDCs, such as cardiovascular diseases and cancer, are expected to increase as the population over 6 years of age is expected to grow to over 2.4 million in the coming two decades. Containing the epidemic of NCDs, especially cardiovascular diseases, is arguably the primary public health concern in Belarus. Cardiovascular mortality accounts for over 5 percent of total mortality and 8 percent of the life expectancy gap of Belarus vis-à-vis western European countries (Figure 49). The current system achieves high levels of financial protection, mitigating health-related economic risks for households. As a result of tax-financed universal health services available to all citizens across the country, OOP expenditures by households are limited, accounting for about 2 percent of total health spending, equal to percent of GDP, or about 1.8 percent of total household expenditure. 37 Medicine accounts for 73 percent of total OOP expenditure, which is substantially lower than in most other countries in the region (Figure 5). Equally, the number of households experiencing catastrophic Figure 5. Out of Pocket Expenditures Mainly Cover Medicines 73 Hospitals Nursing care and attendance service providers Ambulatory care centers Medical goods providers Healthcare service providers Other Source: World Bank estimates, National Health Accounts This section analyzes trends in OOP payments for health services over the period 2-21, using the Household Budget Survey data (HBS) for 2, 25 and 21. In order to compare households across the sample, we adjust for household size using the adult equivalent scale. According to this scale, head of households is weighted 1, members above 13 years old are weighted.5, and other member equal to or below 13 years old are weighted.3. To obtain population estimates, the sample weights presented in HBS are applied. Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results 41

64 belarus public expenditure review vol.2 health-related expenditure shocks is also lower than in most countries in the region. In 21, about 11 percent of households incurred health expenditures exceeding 5 percent of household consumption, but less than 1 percent of households experienced catastrophic health expenditures exceeding 15 percent of household consumption (Figure 51). These levels of financial protection are comparable to those found in high-income EU countries. Despite the overall low level of OOP expenditure, there are important distributional differences across households. More affluent households account for a larger share of total private health spending (Figure 51, left panel). However, overall OOP expenditures are moderately regressive, as higher income households dedicate a smaller fraction of their total spending to health-related expenditures. However, the poorest households are not the most vulnerable, but lower-middle class households, which tend to spend the largest share of their household income on health-related expenditures (2 percent of household consumption). Similarly, the incidence of catastrophic health expenditures is generally highest among lower-middle class households: in 21 households in the second lowest consumption quintile were 17 times more likely to incur catastrophic health expenditures than households in top quintile (Figure 51, right panel). Figure 51. Less OOP Reliance Less Catastrophic Health Spending OOP exceeds 5% of total household consumption 5 OOP exceeds 25% of total household consumption UKR AZE GEO 2 15 AZE GEO 2 RUS BGR MDA TJK ARM 1 BYR SRB EU OOP Expenditure Share of Total Health Expenditures Source: World Bank staff estimates based on household surveys. 1 UKR ARM 5 RUS EU15 BGR MDA TJK BYR SRB OOP Expenditure Share of Total Health Expenditures Figure 52. Private Health Spending Is Moderately Regressive; Lower-middle Class Households Are Most Vulnerable to Shocks 21, in percent Incidence of Catastrophic OOP in 21, headcount Poor Rich Poor Rich Consumption Quintile Share of Private Health Expenditure in Total Private Health Expenditures, lhs >5 >1 >15 Share of Private Health Expenditure in Household Consumption, rhs Source: World Bank staff estimates, HBS 21. Consumption Quintile 42 Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results

65 Enhancing public services in times of austerity Figure 53. Impact of Health Expenditures on Household Consumption Consumption as Multiple of PL Cummulative Proportion of Population, Ranked from Poorest to Richest Pre-OOP Consumption Post-OOP Consumption Source: World Bank staff estimates, HBS 21. High levels of financial protection have contributed positively to poverty reduction. To measure the extent to which OOP payments for health care in Belarus impact poverty, we show several poverty measures 38 before and after accounting for household health expenditures. The result shows that the impoverishing impact of health expenditures in Belarus is fairly contained. The number of poor people increases by about 15, due to health expenditures. Equally, the impact of health expenditures on measures of poverty depth and intensity is moderate. 39 The same findings are illustrated by Figure 52, which shows the Pen Parade for household expenditure gross of health payments. 4 For each household, the vertical bar, or paint drip, shows the extent to which the subtraction of health payments reduces other expenditures, while the poverty line is displayed as a horizontal red line. The figure shows that health spending was distributed relatively evenly across households (although higher-income households tend to spend slightly more), and few households moved across the poverty line due to health expenditures. The prevalence of informal payments in the health system is relatively low in Belarus, although it has been increasing. In 21, the latest available year, 21 percent of respondents indicated that informal payments are prevalent in the health system, compared to 12 percent in 26 (Figure 54). Informal payments seem to be more common in the health system than in other public services, for example education, where only 6 percent of respondents reported informal payments. Perception data from citizen surveys suggests that customer satisfaction with health services has improved. The share of people satisfied with their health status and with the overall health services they receive has increased Figure 54. Reported Corruption Is Low But Increasing Respondents reporting informal payments EST GEO POL SVN CZE LVA MKD MNE BGR HRV TUR KAZ RUS MNG UZB BLR BIH LTU SVK SRB ARM ALB TJK HUN UKR ROU MDA KGZ AZE Figure 55. Service Satisfaction Is Improving Respondents satisfied with service quality UKR ALB MKD AZE MNG KGZ KAZ BIH TJK ROU RUS BLR HUN MNE SRB ARM BGR POL UZB LTU SVK CZE MDA SVN HRV LVA GEO EST TUR Source: LITS 26 and We use three standard indicators: i) the poverty headcount, which is the percentage of population living below poverty line; ii) the poverty gap, which denotes average distance of poor households from the poverty line, essentially capturing the depth of poverty; and iii) the normalized poverty gap, which is obtained by dividing poverty gap by the poverty line, showing the intensity of poverty. 39 Detailed results from this micro-analysis of OOP expenditures are presented in Annex 3. 4 Household consumption is expressed here as multiples of a national poverty line based on minimum budget requirement estimated by Belstat, which was 3,1 BYR and 275,2 BYR, respectively, in 2 and 21. Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results 43

66 belarus public expenditure review vol.2 in Belarus over the last decade, based on Household Budget Survey evidence and other sources. 41 The Life in Transition surveys indicate that satisfaction vis-à-vis government health services increased over last few years: 49 percent of citizens were satisfied with the quality of public health services in 26, while that number rose to 59 percent in the 21 survey (Figure 55). 42 C. Financing Health Services Efficiency and Effectiveness of Public Health Expenditures Public health spending is the primary source of health care funding in Belarus, accounting for about 8 percent of total sector financing. Public health funding is primarily financed from general taxation, although payroll contributions to the Social Protection Fund contribute to long-term care and rehabilitation. The health sector absorbs approximately 1 percent of total government spending, equal to 3.5 percent of GDP. While public spending has seen a modest contraction over the past two years, health spending, like other social spending, has been largely protected from the recent fiscal consolidation effort (see Chapter 1). The current level of public health spending is in line with other middle-income countries in the region but remains below high income economies (Figure 56). At 3.5 percent of GDP, public health spending compares favorably to CIS countries (on average 2.7 percent of GDP) and is roughly at level of other middle-income countries in the ECA region (on average of 4 percent of GDP), but it remains below the level of public health spending in the 1 new EU member states (on average 5.4 percent of GDP) and public spending levels in OECD countries (on average 7.2 percent of GDP). Figure 56. Health Spending Is Relatively Stable and Commensurate With Belarus Income Public Health Spending, percent of GDP 9 8 CZE SVK 7 SVN 6 SRB HRV MDA 5 MKD MNE POL EST ROU 4 UKR BGR LTU LVA RUS HUN 3 KGZ BLR ALB KAZ 2 GEO TUR TJK ARM 1 1, 2, 3, Share of Private OOP on Health Share of Public Expenditures on Health Per Capita, GNI, PPP Adjusted US$, 21 Source: World Bank staff estimates, MOF, HBS, ECA Fiscal Database. More than three-quarters of the total Government expenditure is channeled through SNGs. The third tier of government rayons and cities accounts for more than half of the spending in the health sector (Figure 41 Results were obtained from the respondents answers to the question regarding health status from HBS and then aggregated to the population estimates. Life in Transition surveys (26 and 21) report similar results. 42 Positive self-assessed health status has strong limitations as an overall measure of performance, particularly since objective life expectancy indicators do not show such positive trends. The improvement may reflect positive change in well being and reductions in morbidity because of sustained overall economic growth and reduction in poverty over the last decade. 44 Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results

67 Enhancing public services in times of austerity Figure 57 A Large Share of Public Funding Is Channeled Through SNGs Public Health Spending by Level of Government, 21 55,4 57). The remainder is split roughly equally between regional government (oblast level) and the central government. Of the latter, 8 percent is channeled through MOH and the remaining part through other central ministries. As discussed in Chapter 2, SNGs rely on shared tax revenue and intergovernmental transfers to finance these expenditures. 22 Recurrent spending absorbs the largest share of 22,6 spending. Personnel costs in government facilities are the largest expenditure item, absorbing more Central Government Oblast Rayon and Cities Source: World Bank staff estimates, MOF. than half of the total budget (Figure 58). Goods and services, including medical supplies and spending on utilities, account for about a third of the spending. Utility costs account for a large share (about 16 percent) of non-wage operating costs of health facilities. Utility costs are particularly high in rural hospitals/clinics: on average, rural hospitals/clinics spend around 38 percent of non-wage operating costs on utilities, presumably as a result of excess capacity. Figure 58. Recurrent Spending Takes a Growing Share of Resources; Capital Expenditures Are Regionally Concentrated City of Region of Region of Region of Region of Region of Minsk Brest Minsk Mogilev Grodno Gomel Capital Transfers Goods and Services Wages Capital Non-personnel recurrent Personnel Source: World Bank staff estimates, MOF. Note: Left panel is based on partial data, covering expenditures for the general health system but excluding health spending through other line ministries. Region of Vitebsk Investment has been declining, but remains high by international standards. Capital spending accounts for about 13 percent of total health spending. The economic composition has shifted due to the overall contraction of spending in the sector in past few years, with capital spending taking the brunt of the adjustment. Despite this contraction, overall investment continues to be high by international standards (OECD countries spend on average 4 percent on capital). Capital spending is highly concentrated in the city of Minsk and Brest Oblast, which together account for 65 percent of the total capital expenditures in the sector. While this concentration of capital spending is a reflection of strategic investment priorities in top-tier republic hospital facilities, it means investment activities in most other regions are fairly limited. Capital spending outside of the city of Minsk and Brest oblast is on average only 6.2 percent (half the national average) and can be as low as 5 percent of total spending (in Vitebsk), which likely impairs maintenance and modernization of existing health sector assets. Public spending funds an extensive network of public health facilities and a large health sector workforce across the country. Belarus is characterized by an extremely heavy delivery system, both in terms of number of Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results 45

68 belarus public expenditure review vol.2 hospitals and polyclinics as well as beds per capita (Figure 59). Over the last few years, there have been cautious attempts towards reducing hospital overcapacity, but in 211 the number of beds was still slightly above 11 per 1, population, higher than the CIS average of 8 per 1, and much above the OECD average. Equally, the size of the health sector workforce in Belarus appears to be among the largest in the world for its population size. Belarus has more doctors (5.2 per 1, population) and nurses (13.1 per 1, population) than both the CIS average (3.5 and 8., respectively) and the OECD average (3.1 and 7.2, respectively) 43. Figure 59. Belarus Has an Extensive Health Care Delivery System and Large Sector Workforce Number of Hospital Beds per 1, Population SWE GBR IRL ESP NOR PRT DNK ITA AUT SVN NLD OECD ave. GRC CHE EST FIN FRA SVK BEL CZE DEU CIS ave. UKR RUS BLR Health Sector Workforce, per 1 Population ESP GRC EST SVN FRA OECD ave. MDA 21 2 Nurses Physicians Source: OECD Health Data 212, and WHO Health for All Database NLD SVK UKR CZE CIS ave. AUT RUS FIN GBR DEU SWE NOR BLR The system has been kept fiscally affordable by containing health care wages. By comparing government employment in the health sector (which is comparatively high) and personnel cost data (which is comparatively low), it appears that one of the reasons that the public health system has been fiscally viable until now has been a tight containment of labor compensation at all levels. The average compensation in the health sector is approximately 87 percent of average gross wage in the economy, much below the levels observed in other countries, where compensation of highly qualified health care personnel tends to be above the average wage in the economy. There is risk that the most qualified health sector employees will leave the system, in particular since there is free movement of labor between Russia and Belarus. However, given the current fiscal environment, wage increases are not affordable and would quickly make the health sector fiscally unsustainable, unless some significant rationalization of the workforce would occur. Hospitals and inpatient care continue to dominate public health spending. Belarus allocates almost half of its health spending (47 percent) to general and specialized hospitals (Figure 6), well above the OECD average of 36 percent. Equally, inpatient treatments continue to absorb a large share of resources, accounting for more than a third of health spending. Polyclinics are the main providers of outpatient care, while general practitioners services are underdeveloped and home-based services are almost non-existent. At 2.5 percent of health spending, preventive care, including public health, is also slightly below the OECD average of 3.2 percent. This large allocation to hospitals and inpatient care reflects the heavy reliance on hospitals for health service provision. Belarus has a very high hospital admission rate, approximately twice the OECD average (Figure 61). Moreover, hospitals tend almost exclusively to provide inpatient care services, and more cost-efficient day 43 National published data for 21 reports 4.8 physicians, 9.9 nurses and 11.5 hospital beds per 1, population (Statistical Yearbook, 212). The Ministry of Health provided additional data for 211 on the number of health care personnel and hospital beds, based on adjusted definitions, as follows: 3.5 doctors per 1, population, 8.3 nurses per 1, population and 8.7 hospital beds per 1, population. However, to ensure cross-country comparability the data reported here is based on the figures reported by the OECD/WHO. 46 Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results

69 Enhancing public services in times of austerity Figure 6. Hospitals and In-Patient Care Absorb the Largest Share of Spending Health Spending by Type of Service, 21 Health Spending by Type of Provider, Inpatient Treatment Ambulatory Care Medicines (Outpatient Care) General Hospitals Polyclinics Unclassified Health Care Costs and Activities Supplementary Medical Treatment Services Medicines Suppliers Specialized Hospitals Preventive and Public Medical Services Rehabilitation Treatment Services Ambulatory Care Centers (excl. Polyclinics) Unclassified Health Care Providers Day-Time Inpatient Treatment Long-Term Nurse Care Services General Public Health Control and Medical Insurance Healthcare and Medical Insurance Management Psychiatric Hospitals for Substance Abuse Treatment Nursing Care Providers Source: World Bank staff estimates, NHA, 21. Figure 61. Belarusians Are Admitted to Hospitals Often and Stay for Long Durations Hospital Admissions per 1 Population, SPA NLD ITA IRE GBR OECD ave. SVN KAZ SWE EST DNK BEL MDA FIN CZE GRC CIS ave. SVK UKR DEU AUT BLR Source: OECD Health Data 212, and WHO Health for All Database. surgeries, for example, account for less than 1.5 percent of general hospital expenditures (Figure 62). As a result, length of hospital stay in Belarus is 11.3 days, lower than the CIS average (12.2 days) but much higher than the OECD average (seven days). The lack of a referral system contributes to the excessive use of hospital services, as individuals can seek care directly at secondary and tertiary care institutions. This extensive reliance on hospitals as providers of health care contrasts with an international trend towards allocating a larger portion of resources to more cost-effective outpatient care. In recent years several EU countries, such as the Netherlands, UK, Estonia and others, have rationalized their hospital networks to contain growing health care costs and to enhance service quality, following technological advances, aging and changes in the disease profile of the population. Intensive, acute hospital services have become more and more expensive to build and maintain, and even wealthy, industrialized countries cannot afford more than a few selected hospitals of Average Length of Stay, Days TUR DNK SWE NLD PRT IRL SVN AUT ITA ESP EST GRC OECD ave. CZE SVK GBR BEL DEU CHE MDA BLR FIN CIS ave. KAZ UKR RUS Figure 62. Hospitals Predominantly Provide Inpatient Care Health Spending, by Type of Service, General Hospitals Specialized Hospitals Polyclinics Inpatient Treatment Unclassified Health Care Costs and Activities Day-Time Inpatient Treatment Source: World Bank staff estimates, NHA. Ambulatory Care Rehabilitation Treatment Services Other Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results 47

70 belarus public expenditure review vol.2 excellence. Peripheral hospitals, which could not afford to be upgraded and were underutilized for acute cases (thus progressively becoming obsolete), were converted into long-term care or day care institutions. At the same time, hospitals have developed alternatives to hospitalization, such as day surgeries, thus reducing demand for inpatient hospital care and beds. While the current public health care system maintains high levels of equity in service access, there is evidence of variation in productive efficiency across the country. By looking at a few selected causes of hospitalization, one can see great variations in average length of stay and unit costs of provision across the country, especially among rural hospitals (Figure 63, left panel). For example, a comparison of average length of stay and unit costs for acute myocardial infarction (AMI), one of the most common reasons of hospitalization, reveals clear differences across different oblasts (Figure 63, right panel). Figure 63. Units Costs Vary Across Belarus Days in percent Days Region of Region of Region of Region of Region of Region of Mogilev Brest Grodno Gomel Minsk Vitebsk ALO Bed Stay, Rural Area (lhs) Cost of Bed Stay, Rural Area ALOS (AMI) BY Average OECD Average Source: World Bank staff estimates, MOF, MOH, OECD. Gomel oblast Mogilev oblast Brest oblast Minsk city Grodno oblast Minsk oblast Vitebsk oblast Going forward, rising input costs and wages, demand for more costly health services and an aging population are likely to place a greater burden on the fiscal sustainability of Belarus health system. Based on the experience of other transition economies and middle-income countries, three key drivers will likely affect the demand for and cost of health services: Rising Input Costs: Over the short term rising input costs could push up costs of health care delivery. As discussed above, current input prices for several key inputs of health facilities are distorted. Low compensation of health care personnel has contained the cost of the large health sector work force. It is likely that these costs will escalate over the short to medium term. If health sector salaries lag substantially behind salaries in the rest of the economy, the health sector will not be able to retain the necessary qualified staff. These pressures are amplified by the demand for skilled medical personnel in Russia and other European countries which offer substantially higher salaries. While the experience in other transition economies has shown that health sector salaries can result in substantial expenditure pressures even when the sector workforce is right-sized, the impact of rising costs of inputs can be mitigated through the rationalization and rightsizing of health care facilities. For simple estimates of the fiscal impact, we assume that the wage bill in the health sector will grow faster (+3 percent) than GDP to allow convergence of health sector wages to the average wage in the economy. This suggests that rising input costs could add between percent of GDP in health care expenditures, unless right-sizing would rationalize the existing network of health care providers. 48 Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results

71 Enhancing public services in times of austerity Income growth and health expenditures: Over the medium term, income growth is expected to lead to higher health care expenditures. In most middle- and high-income countries, health care expenditures tend to grow faster than income. This is the result of higher living standards, the fulfillment of basic needs and growing social pressure for increased health care quality and coverage, as well as progressively more expensive diagnostic and therapeutic technologies. 44 Depending on the economic growth rate, income growth could add expenditure pressure in the range of.3.7 percent of GDP over the next 1 years. Demographic change and health expenditures: Over the next two decades, the number of Belarusians older than age 6 will increase from approximately 2.1 million in 21 to more than 2.4 million in 22. The proportion of population 6 or above (65 or above) currently 2.9 percent (16.2 percent) of total is projected to increase to 24.8 percent (18. percent) by 22, and to 27.7 percent (22. percent) by 23. Unlike many European countries, Belarus finances its health system through general taxation as opposed to payroll taxes. The shrinking labor force will therefore have no direct impact on health care finances in Belarus. However, the age profile of the population affects the level and composition of health care expenditures. 45 Demand for health care is typically high at very young ages and during maternity years for women, and then generally increases exponentially with the age of a person, notably above the age of 55 for men and above 6 for women, due to higher morbidity and incidence of disability at older ages. International evidence indicates that the elderly on average utilize health services up to 3 5 times more than younger individuals. For Belarus, no age-specific expenditure profiles exist. Assuming the average expenditure profile from EU 12 countries, aging-related expenditure pressure could amount to about.3-.6 percent of GDP over the coming two decades. Table 16. Estimated Fiscal Impact of Potential Health Sector Spending Pressures Spending Pressure Time Horizon Fiscal Impact (Cumulative) Rising Input Costs Wages (Increase to average wage in the economy over 5 years) Short Term (-5 years) % of GDP Rising Incomes Medium Term (5-1 years).3-.7 % of GDP Aging Long Term (>1 years).3-.6 % of GDP Source: World Bank staff estimates. Input cost pressures present the most immediate concern for cost containment, given the short-term nature and size of the expected impact. The potential cost escalation that could follow from increases in input costs could be mitigated by rationalizing the existing facility network. Given the tight fiscal environment, such this would generate the fiscal space needed to finance more competitive compensation in the health sector. 44 While it is generally agreed that growth in per capita income increases health spending, the strength of this relationship remains uncertain. Some empirical estimates place the income elasticity of health expenditures at around Getzen, T.E., (2), Health care is an individual necessity and a national luxury: Applying multilevel decision models to the analysis of health care expenditures, Journal of Health Economics, Vol. 19(2), pp Studies have shown that demographic factors have only a secondary role in explaining cost escalation of health care, compared to income and technological change. OECD (26), Projecting OECD health and long-term care expenditures: What are the main drivers?, Economics Department, WP No Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results 49

72 belarus public expenditure review vol.2 D. Reform Options The Belarus health system faces the challenge of further improving health outcomes and maintaining high levels of financial protection while containing health care costs over the medium to long term. The system has delivered effectively on a range of health indicators and, in stark contrast many former Soviet Union countries, it has continued to provide good financial protection against potentially catastrophic health expenditures. In order to preserve these achievements, the first priority is to correct severe inefficiencies in the sector, including very high levels of hospital admissions, lengths of stay, bed supply and an excessively fragmented delivery system. Large variations exist in the unit costs of provision and the composition of such costs for similar services across the country. At the same time, Belarus is beginning to face similar health expenditure pressures observed in other middle-income transition countries. The proliferation of costly medical technology, growing health personnel salary pressures and aging of the population will all add to the fiscal burden of the health care system. Addressing these combined challenges within a fiscally constrained environment will require reprioritizing resources to achieve gains in efficiency and effectiveness of health spending. This chapter offers several reforms options to improve overall efficiency and effectiveness of the health care spending and service delivery. The focus is on health financing, which is one several control knobs that the Government can use to steer the health system towards greater efficiency and better results. The common guiding principle of the options presented here is that they aim to change the incentives faced by all stake-holders in the health care system and introduce new and stronger economic incentives promoting efficiency, results-orientation and quality of care. a. Optimize health care facilities, especially hospitals: The country needs to reduce overcapacity and limit the size of hospital sector, but at the same time improve quality of infrastructure and equipment in a few selected hospitals. The remaining hospitals and polyclinics should be grouped into regional delivery networks, tentatively one hospital network for 2, 3, people, and network management should be given autonomy and incentives to further rationalize the existing service delivery units (see point c below). Downsizing and reduced segmentation between service delivery institutions would save substantial operating costs, as in other countries (see, for example, Alban A., and Kutzin J., 26). The resulting fiscal space could be used to invest in modernized equipment and infrastructure to improve service in remaining hospitals. Regional hospitals outside Minsk need to be given priority. Moreover, since hospitals are an indivisible asset, it is rational to concentrate hospitals in cities. Rural-urban differences in a country such as Belarus (which is fairly densely populated) are not necessarily inequitable, provided the city hospitals are accessible for the rural population. b. Increase emphasis on primary care and preventive services, especially for NCDs: The Government needs to continue to switch resources away from acute care hospital care services towards preventive services, which are undersupplied. Preventive services ought to be delivered at the primary care level, and therefore strengthening primary care could have the greatest potential impact on health outcomes moving forward. In addition, the content of prevention and treatment practices should be redesigned to respond to current needs, particularly in prevention of NCDs. Clinical and populationbased statistical evidence shows that incidence of cardiovascular diseases is related to both genetic and behavioral risk factors that cause heart attacks and strokes, including smoking, adverse dietary patterns 5 Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results

73 Enhancing public services in times of austerity and physical inactivity. Controlling modifiable risk factors offers opportunities for prevention, including through evidence-based prevention services. 46 For example, individuals with high blood pressure, high cholesterol and diabetes are regularly checked and prescribed preventive medicines, which has led to a significant increase in life expectancy. This transformation towards prevention and primary care could be encouraged by paying doctors and facilities according to a capitation-based formula, and abolishing all the input-based service norms, which de facto link budgets to existing infrastructure. c. Increase autonomy of providers: It is equally important to make hospitals and other medical facilities, or groups of facilities linked together in a network and managed jointly, progressively more autonomous. Such managerial autonomy has two essential dimensions: (i) the ability to organize the production of services, including appointments/dismissals, staff working hours, remuneration, capital expenditures, medicine purchase and stock management, etc. with some flexibility; and (ii) the ability to retain savings, and managerial responsibility in case of costs overruns. In other words, there needs to be accountability for performance and financial results. In the absence of such autonomy, the incentives linked to different payment systems would be muted, because the Government would be compelled to micromanage inputs of budgetary institutions, take away any savings they are able to obtain and continue to sustain them even when they are redundant or wasteful. In turn, the change of the payment system away from historical expenditure, inputs and line item allocations would completely change the budgetary process (basically, eliminating the bottom-up discretionary negotiations on the budget based on existing inputs and introducing an objective top-down formula in the budget planning phase, and providing flexibility in budget implementation during the budget execution phase). It is therefore critical to empower managers and make them more autonomous. d. Capitation of primary care financing: Primary care could be financed on capitation plus performance basis. For this, primary care doctors and polyclinics could establish a patient registry and be paid according to a capitation formula, with ex-post adjustments for volume of activities and key quality indicators. e. Reform hospital payment system: Many inefficiencies are rooted in the current financing arrangements, which provide limited incentives to reduce costs or rationalize the existing delivery system. 47 Greater performance orientation should be introduced in the budget process. The key principle in health financing reforms should be that the Government finances appropriate health services for individuals, not institutions. Initially, hospital financing could move towards global budgets based on capitation-per capita formula allowing for greater flexibility in the utilization of resources, while a diagnostic related groups (DRG) system could progressively be introduced as a performance monitoring device (Box 3). After 3-4 years, DRG-based payment for hospitals could be piloted, and then rolled out to the whole country. f. Introduce referral system/clinical pathways: A new referral system needs to be established so that patients first seek care from primary care facilities and polyclinics, with the exception of emergency 46 Belarus has implemented some secondary prevention programs, such as opportunistic screening for cancers, including prostate cancer. But these programs are not evidencebased, and therefore not cost-effective. 47 Some individual facilities in Minsk have made timid attempt to introduce performance-based payment criteria in the remuneration of individual doctors and nurses. Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results 51

74 belarus public expenditure review vol.2 Box 3 Diagnostic Related Groups (DRG) Treatment Classification The DRG classification system is the most sophisticated and internationally-recognized treatment classification system. Under the DRG system, treatments are classified on the basis of primary diagnosis and main medical procedure. The DRG system was originally developed to compare the efficiency of hospitals, and to do this it was necessary to group diseases/treatments in categories entailing broadly similar diagnoses/treatment requirements, and then look at the differences in costs of treating such diseases across facilities. The relative efficiency of two hospitals cannot be established by simply looking at their average treatment costs per patient without taking into account the relative mix of complex versus less complex cases which they treat. Today DRGs are used by more than 2 countries as the basis of the public hospital funding systems. There are several DRG classification systems, ranging from 2 3 to several thousand different categories. The following are key features of DRG funding systems: Prices may be based on average treatment costs across the hospital system as a whole, or may be based on some estimate of what treatment should cost if carried out efficiently and in accordance with best practice treatment protocols. Basing prices on average costs penalizes any hospital with the above-average treatment costs. Basing prices on efficient costs is a tougher approach under which even hospitals with average treatment costs may find themselves penalized. Under all DRG-based systems, some treatments are not paid for on a DRG basis, but on the basis of either or both fee-for-service or patient bed-days. These are mainly outlier cases in which, for specific reasons, the patient requires considerably more expensive or longer duration treatment than the average patient with a similar condition. The majority of DRG-based systems do not include funding for major capital items such as new buildings in treatment payments. Hospitals make separate funding requests for major capital funding, in the same way that they did traditionally under line-item budgeting. In a minority of more advanced countries, major capital funding is included in the DRG-based payments. The prices paid for each DRG category may be adjusted by hospital type, although in general this is not a good practice. This is done in order to recognize (within limits) the different cost structures of differing types of hospitals. For example, small regional hospitals that lack scale economies may be paid higher prices for some treatment categories for which patients have to be treated locally, and cannot be expected to travel to lower-cost urban hospitals in recognition of this cost disadvantage. cases, and use hospitals only if referred by their primary doctors or specialists. Integration and coordination between primary, secondary and tertiary providers is key not only to deliver quality care but also to contain costs, as patients are directed to the most appropriate point of delivery for a given diagnosis. Such a referral system could also provide financial incentives for doctors to treat patients on an outpatient basis, rather than bring them into inpatient hospital care. Again, economic incentives are critical to achieve this goal. On the demand side, the Government could progressively introduce financial penalties for patients that skip the referral chain (for example, they would need to pay a higher copayment), with the exception of emergency cases. g. Strengthen quality management: Greater autonomy needs to be accompanied by greater accountability for results, which can be achieved only if the health system develops robust internal and external 52 Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results

75 Enhancing public services in times of austerity controls to manage risks and establishes a rigorous financial and performance audit process with robust data generation and use of data in operations, management and policy formulation. Quality control should also be applied to clinical practice, with standardization of diagnosis and treatment according to evidence-based clinical pathways, utilization reviews in hospitals and continuous quality assurance and quality improvement processes. It is critical to link part (at least 1 percent) of the payment facilities and doctors receive to the attainment of these quality improvement targets. In addition, the DRGbased payment system can lead to a greater standardization of clinical practices, and contribute to the enforcement of clinical pathways and diagnostic and therapeutic practices reflecting best international practices. Chapter 3. Health Financing: Enhancing Spending Efficiency for Better Health Results 53

76 belarus public expenditure review vol.2 Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results Summary: Belarus educational system has performed well in improving access and increasing enrollments at all levels of education, but the key challenge is to further improve efficiency, quality and relevance of education services. At around 5 percent of GDP, spending on education is adequate and in line with other countries in the region. However, spending efficiency requires attention. Severe declines in the school-age population and urbanization have reduced the number of students, especially in rural areas. As a result, student-teacher ratios at both the primary and secondary level are among the lowest in the region, while school (e.g. number of students per school) and class (e.g. number of students per class) sizes tend to be small. Salaries remain relatively low, making it difficult to attract and retain skilled teachers. While per-student costs have been increasing, this has not necessarily led to better learning outcomes. The current financing system provides little incentive for local actors to allocate resources efficiently. Rather, existing input-based financing arrangements encourage schools and local governments to retain large numbers of staff and maintain excess facilities. This chapter analyzes the efficiency and adequacy of education spending in the context of the country s growth and fiscal challenges. The chapter recommends improving spending efficiency by continuing to optimize the school network, enhancing quality management and moving gradually towards per-student financing. A. The Education Sector in Belarus Institutional and Administrative Structure Public schools and universities are the main providers of education services in Belarus. According to the Education Code (adopted in 211, last amended in 212), the education system in Belarus consists of pre-school, general secondary, 48 vocational, secondary specialized, higher and post-graduate education. At present, almost 1, educational institutions operate at 48 In Belarus, the term general secondary education refers to the entire sequence of primary, post-primary basic and general secondary education. 54

77 Enhancing public services in times of austerity Figure 64. Number of Schools, Students and Teachers in Belarus, 21 4,5 4, 3,5 3, 2,5 2, 1,5 1, Pre-school GSE VTE SS HE Students, thousand Teachers, thousand Schools, lhs Source: Ministry of Education , all levels, and around 445, educators provide training to more than two million students (Figure 64). Private participation in education is small but growing, especially in higher education. Private schools (nine out of 3,654 primary and secondary schools) provided education services to 558 students less than 1 percent of the student cohort. Similarly, there are only seven private vocational schools (of 229) and 12 secondary specialized institutions (of 22). Private providers are more active in higher education, where 1 out of 55 institutions are private, accounting for 13.6 percent of students. 49 The education system is highly centralized, fiscally and administratively. Administrative relationships are hierarchical and organized on a territorial basis (Figure 65). State policy in education is determined by the president, while the Ministry of Education (MOE) is responsible for implementing policies and quality control. The system is managed by the MOE in a delegated manner through six regional Education Departments and Education Department of Minsk City Executive Committee supervising education institutions at the oblast level and in City of Minsk. These departments, in turn, coordinate rayon Education Departments, which are responsible for the Figure 65. Education Sector Structure and Administration President Line Ministries Council of Ministers Ministry of Educa on Universi es, post-graduate educa on ins tu ons Secondary specialized schools Universi es, post-graduate educa on ins tu ons Secondary specialized schools Execu ve Commi ees of Oblasts Educa on Department Financial Department Voca onal schools Secondary specialized schools Private educa on ins tu ons (mostly universi es) Execu ve Commi ees of Rayons and Oblast Subordinate Towns Educa on Department Financial Department Preschool General secondary schools EDUCATION SECTOR management funding flows Source: World Bank staff based on the legislation of Belarus. Note: According to the Budget Code City of Minsk has features of the oblast and base tier budget and all types of education facilities (except for tertiary education) are financed from its budget. 49 According to the Regulation of the Council of Ministers 149, adopted August 4, 211, the Minister of Education is entitled to appoint directors of private tertiary institutions based on the suggestions of the institution s shareholders/founders. Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results 55

78 belarus public expenditure review vol.2 education institutions of their level. The central government is directly in charge of higher and post-graduate education financing. Secondary specialized schools operate on the central government as well as at the oblast level. Vocational schools are funded by the local government of the oblast level and City of Minsk. Pre-schools and general secondary schools operate at the base tier of the local government. 5 In addition, several other line ministries maintain specific field education programs through their own education institutions. B. Education Sector Outcomes Achievements and Challenges Belarus has achieved significant progress in improving enrollment and educational attainment. Major achievements include: Access to pre-school education has expanded through the creation of a network of specialized preschool institutions (pediatric medical childcare, special childcare and pre-school children development centers) and the adoption of new pre-school education models in response to parent requests (parttime childcare, family daycare, at-home childcare, at-home pre-school education programs, etc.). 51 In 211, the enrollment rate for children aged one to five was 75.3 percent, with enrollment in rural areas 55.8 percent a substantial increase as compared to 2 (7.9 and 46.3, respectively). All five-year olds have to be enrolled in preparatory programs for studying in general secondary schools. Gross enrollment in general secondary schools increased from 86.3 percent in 2 to 17.4 percent in All students have to complete lower secondary education, but the vast majority of them continue their study in high school. The Government is committed to achieving universal upper secondary education by 215. Another development is the proliferation of special schools with more in-depth study of particular subjects, including gymnasiums and lyceums. The share of the population with secondary education or above increased substantially. Between 2 and 21, the share of population with only primary education or less has almost disappeared, and the proportion of those with only general basic education has decreased dramatically (Table 17). There are, however, notable distributional differences, with attainment rates generally lower in rural areas and among the poor. 5 The only exception is the city of Minsk. Having the features of the oblast and base tier budget, all types of education facilities (except for tertiary education) are financed from its budget. 51 Currently, 14 pre-school children development centers operate in Belarus (compared to 7 in 26) as well as 87 pediatric medical childcare centers (59 in 26), 981 kindergartens (815 in 26), 2,518 part-time childcare groups (111 in 26) and 376 education groups for children with disabilities (173 in 26). Around 52, teachers provide instruction in pre-school institutions (5,4 in 26), and the number of teachers with a university degree in the sub-sector has grown by 6.6 percent in the past five years, reaching 49.4 percent. 52 The gross enrolment ratio (GER) in primary education (ISCED 1) is defined as the ratio of pupils enrolled in level 1 of general secondary education (grades 1-4) to the population 6 to 9 years of age. The GER in basic and secondary education (ISCED 2 and 3) is defined as the ratio of pupils enrolled levels 2 and 3 of general secondary education (grades 5-11), students in vocational technical education combined with general secondary education, and students in years 1 and 2 in secondary specialized education combined with general secondary education, to the population 1 to16 years of age. GER can exceed 1 percent due to the inclusion of over-aged and underaged students because of early or late school entrance and grade repetition. 56 Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results

79 Enhancing public services in times of austerity Table 17. Attainment Rates 2-21 (Level of Completed Education of 25 to 29 year-olds, %) Rural Urban Poor Rich All Year Higher education Secondary specialized Vocational school General secondary (upper secondary) General basic (lower secondary) General primary No education Total Source: World Bank staff calculations based on Belarus HIES data. Higher education has expanded very rapidly. Belarus has one of the highest student-to-population ratios in Europe. 53 During the last 1 years the number of students has doubled and currently amounts to more than 4, students (467 students per 1, residents). In 211 the enrollment rate in higher and postgraduate education reached 85 percent 54 one of the highest in the world. In over 416, specialists obtained a higher education diploma. Teacher qualification has improved. Between 2 and 211, the share of teachers with higher education increased in primary schools from 69.6 to 86.4 percent and in secondary schools from 87 to 9 percent. Private spending on education is moderate, suggesting broad affordability of education in Belarus. In 21 education spending as a share of total household spending was around 2.3 percent, which is very close to the regional average (Figure 66, left panel). While education itself is free, private households pay for school meals, although children of lower-income families and rural households are eligible to receive schools meals free of charge. Private expenditures also include tuition fees for out-of-school educational services (e.g. preparation for entrance examinations to higher education institutions) and/or charitable help to schools for repairs. Private expenditures are higher at the tertiary level, where 6 percent of students are enrolled in fee-based public education institutions. 55 The reported prevalence of unofficial payments for education in Belarus is higher than 53 Academic programs in 45 public and 1 private higher education institutions in Belarus are available in 15 fields, covering 438 specializations at the first level and 192 specializations at the master s level. 54 UNESCO Institute for Statistics. 55 ETF 29. Study costs are practically the same in the private and public higher education and secondary specialized training schools. However, private educational institution quality is seen as lower than that of public institutions, so that private educational institutions are mostly formed by students who cannot get into public institutions. Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results 57

80 belarus public expenditure review vol.2 Figure 66. Affordable Education Expenditures on education as a share of total consumption BIH ALB GEO TJK BGR KAZ TUR KGZ KSV AZE RUS BLR MNE EST MDA HUN ARM POL UKR ROU SRB HRV SVK LTU Reported prevalence of unofficial payments in education are relatively low UKR UZB MDA ALB SVK ARM MNG KAZ TUR RUS BIH BLR ROU HRV MKD CZE BGR SRB MNE HUN GEO SVN LTU POL EST LVA West. Europe Share of Education/Consumption (per Capita) Vocational Education Primary/Secondary Education Share of Education/Consumption (per Household) Source: World Bank staff calculations based on ECAPOV database. *The latest year available. Source: LiTS II (21). in neighboring Poland and Baltic countries, but below the levels reported in all CIS countries except Georgia (Figure 66, right panel). Despite these impressive results, Belarus needs to improve the quality of education and better align the system to the requirements of an increasingly competitive economic environment: Persistent inequalities in opportunities to obtain higher education for lower income quintiles and for rural population. Over the last 1 years, enrollment and attainment improved for all income groups (Table 17). However, the largest increase in higher education attainment was observed for the richest quintile. In addition, the difference between attainment rates in higher education between rural and urban population declined only marginally during the period. Quality and relevance. The number of students enrolled in vocational and secondary specialized education fell by 9 percent during At the same time, the number of higher education graduates has increased sharply. As in many neighboring countries, Belarus has accommodated this growth in a number of ways, including expanding the number of fee-paying students in public universities (to attract more revenues) and increasing enrollment in extramural studies (5 percent of tertiary students in 21). While it is encouraging to see the tertiary sector accommodating the booming demand in new ways, the rapid growth poses some difficult challenges that all countries in the region have struggled to overcome. Quality assurance mechanisms must be sufficiently strong for all students, both regular and extramural. In addition to strong basic and technical skills, the education system should provide broad and transferable competencies such as ability to work in teams, problem-solving, communicating and collaborating, to best respond to labor market needs. Mismatch in the demand and supply of skills. As evidenced by surveys, firms do not find workers with the right set of skills, even when there is a large pool of people who have high levels of formal education (Figure 67). 57,58 Skills mismatches are also evident in agriculture, where one-quarter of workers have attained higher or secondary specialized education and could presumably move to better jobs in more productive 56 When students complete basic secondary education (nine grades), they can go to secondary specialized, technical and vocational schools or continue studying at the upper secondary level. 57 Business Environment and Enteprise performance Survey 28/9. 58 Skills mismatches could be overestimated by firms not offering market clearance wages. Boston Consulting Group. Skills Gap is More Limited Than Many Believe (forthcoming). 58 Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results

81 Enhancing public services in times of austerity Figure 67. Distribution of Firms in ECA Region That Consider Worker Skills a Major or Very Severe Constraint, 28 TJK UZB AZE ARM CZE BIH GEO EST KSV KGZ HRV UKR MKD ALB LVA MDA MNE SRB BGR POL LTU KAZ HUN SVN TUR SVK ROU RUS Belarus Source: World Bank (211). Note: Based on BEEPS Surveys 28/9. sectors, but have not done so. While this can be partially attributed to the quality of education, mismatches in demand and supply of skills also stem from inefficient allocation of resources (e.g. labor), with a significant part of the labor force, including highly skilled workers, locked in state-owned enterprises. 59 Participation of Belarus in international benchmarking. The introduction of standardized tests for application to higher education is an important step toward increasing system transparency and more objectively assessing performance after secondary education. 6 At the same time, Belarus did not participate in international benchmarking such as the OECD Program for International Student Assessment (PISA). 61 This renders it impossible to assess education outcomes and skills in Belarus against international standards. PISA is also a measure of education quality, which is a good predictor of economic growth far better than average schooling levels. Evidence suggests that an increase of 5 points in PISA scores would yield around one percentage point higher annual growth rates. 62 C. Financing Education Level and Composition of Education Expenditures At about 5 percent of GDP, public education expenditures in Belarus is at the regional average. In 211, consolidated budget education expenditures accounted for 4.6 percent of GDP. This is around the GDP share spent on average in the OECD, but somewhat higher than most neighboring countries. In 211 education expenditures accounted for 13.5 percent of general government budget expenditures, close to that of many other transitional countries (Figure 68). 59 See World Bank (212). 6 The country recently centralized entrance examination for admission to universities, which allows for a comparison of student performance across schools. In 26 MOH introduced a 1-point scale for evaluating the educational level, which is used for initial testing of all those entering institutions of higher education. This information helps evaluate the quality of secondary education. Prior to this, university entry examination varied significantly across universities and even within a university. 61 Since 2, PISA has measured the quality of education in OECD countries, and increasingly non-oecd countries have participated as well. There are a number of other international assessments, like Trends in International Mathematics and Science Study (TIMSS), which is an international study on student achievement in mathematics and science, or the Progress in International Reading Literacy Study (PIRLS), an international study of reading achievement. More details about PISA, including results in neighbouring countries, are included in Annex Woessman and Hanushek (27). Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results 59

82 belarus public expenditure review vol.2 Figure 68. Public Spending on Education Is Adequate Public Education Expenditures, percent of GDP MDA KGZ SVN LVA EST POL LTU TUR HUN CZE UKR MKD BLR MNE SVK BGR KSV HRV KAZ RUS TJK SRB ROU ALB GEO ARM Public Education Expenditure, percent Total Government Expenditure KAZ MDA KSV TJK KGZ EST TUR LTU LVA MKD POL UKR SVN BLR ARM ALB BGR CZE HUN GEO SVK MNE HRV RUS ROU SRB Source: ECA Fiscal Database, 212. Figure 69. Education Expenditures Declined After the Crisis, But Have Since Recovered Expenditures on Education to GG expenditures Expenditures on Education to GDP Source: MOF. Real Expenditure Growth Rate, in percent Source: World Bank staff calculations based on MOF and Belstat data (CPI as denominator). Public spending on education declined in relative terms prior to the 28/9 crisis, but the trend has reversed from 21. Between 26 and 29, consolidated budget expenditures on education declined from 6.3 percent to 5.2 percent of GDP. As a share of total general government expenditures, education expenditures contracted from 13.3 percent to 11.2 percent during the same period (Figure 7, left panel). After declining by almost 9 percent in real terms after the crisis in 29, education spending has since recovered, increasing by 15.5 percent and 5.6 percent in real terms in 21 and 211, respectively (Figure 7, right panel). The share of education expenditures in general government expenditures exceeded pre-crisis level, reaching 13.5 percent in 211. Figure 7. Sub-national Governments Account for Most Education Spending Figure 71. Education Spending Composition Is Relatively Stable Republican Budget Local Budget Pre-school GSE VTE SS Higher and Postgraduate Other Source: MOF. Source: MOF. 6 Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results

83 Enhancing public services in times of austerity About 8 percent of education expenditures are channeled through local budgets, and their role in education financing slightly increased during the pre-crisis period (Figure 7). Pre-school, general secondary and vocational educations are financed primarily from local budgets. The central government budget covers expenditures on higher education and research and development activities, and over two-thirds of expenditures on secondary specialized education. Similar to other countries in the region, general secondary education accounts for the largest share of total educational spending in Belarus. In 211, this sub-sector accounted for 46.7 percent of public spending on education. Pre-school education constituted 21 percent, higher and postgraduate education 12.5 percent, vocational education 6.1 percent and secondary specialized 4.8 percent (Figure 7). Other expenditures of around 9 percent were directed towards research and development, extracurricular out-of-school education and for miscellaneous education activities such as the construction and rehabilitation of education institutions buildings. 63 The bulk of budget expenditures are for wages (including payroll taxes), but the sector wage level is relatively low. While the wage bill share in total education spending decreased somewhat (from 64.1 percent in 25 to 63.3 percent in 211), wage expenditures represent the largest spending category. This is true for all educational sub-sectors (Figure 72). High wage expenditures in Belarus are related to the size of the teaching force rather than to wage levels. Education employment accounts for close to 11 percent of total employment in Belarus, and the country employs more teachers per student than most countries in the region. In contrast, sector wages tend be compressed. In 211, the average sector wage was below 8 percent of the average economy-wide wage (Figure 73), lower than the ratio in other countries in the region. Uncompetitive salaries make it difficult to attract and retain qualified teachers, with long-term implications for education quality. Low salaries may also contribute to the solicitation of informal payments from students and parents. Figure 72. Education Spending Is Dominated by Recurrent Spending Pre-school The level of capital expenditures is adequate. Despite a contraction of capital expenditures since 28, investment continues to account for around 1 percent of total education expenditures, which is slightly higher than in Armenia, Bulgaria, Moldova and Poland, but slightly below Romania. The level of capital expenditures varies GSE VTE SS Higher and postgraduate Wages and Salaries Other Current Expenditures Wages and Salaries Other Current Expenditures Transfers to Population Capital Expenditures Transfers to Population Capital Expenditures Source: MOF. Note: Wages and salaries include social contributions. Transfers to population largely consist of post-secondary scholarships. Capital expenditures include mostly purchases of equipment and durable goods, capital construction and repairs. Other current expenditures encompass utilities, transportation and communication services, procurement of goods and services, business travel. Other 63 The structure of public education spending directed to the system under MOE supervision in 21 (even if funded from local budgets) was: general secondary education 52 percent, pre-school education 22 percent, higher education 9 percent, vocational education 7 percent, secondary specialized 2 percent, other expenditures 8 percent. Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results 61

84 belarus public expenditure review vol.2 Figure 73. Education Sector Wages Have Declined Education Sector Wages Relative to Economy-wide Wages, in percent Education Sector Wages Relative to Economy-wide Wages, in percent, Source: World Bank staff estimates, Belstat, Edstat Russia Belarus Ukraine Poland Hungary Estonia Czech Rep. across educational sub-sectors and, as in other countries, higher education has the highest ratio (15 percent of total expenditures) (Figure 72). However, a large share of investment is absorbed by maintenance and repair of the extensive network of educational facilities. 64 This crowds out space for other capital outlays for laboratories, computers, broad band internet connection and the like, which play a significant role in ensuring quality education. Utility expenditures are high, especially in small schools. Utility expenditures for electricity and heating account for 45 percent of non-wage school operating costs, or 13.5 percent of total sector spending. Utility costs are particularly high in rayons with small schools (which have excess capacity), contributing to high per-student costs (Figure 74). Excess expenses on heating and lighting in oversized school facilities absorb budgetary space that could be used for more productive spending on teaching materials, teacher qualification and equipment. Significant expenditures on salaries, utilities and school meals create a high degree of rigidity. Three protected budget categories wages and social contributions, utilities and school meals account for a major share of education budget expenditures. On average, these three categories take up about 84 percent of the available budget, rising to as much as 98 percent in some schools. This leaves very limited room for other essential inputs needed for quality Figure 74. Rayons With Small Schools Have High Utility Cost Per Student Per student utilities costs, thsnd BYR 1,8 1,6 1,4 1,2 1, , School Size Source: World Bank staff estimates, MOF. Note: Each dot represents a rayon. education and learning, such as instructional materials and teacher training. Education entities have the right to collect and use at their discretion fee-based services revenues (for example, for paid extracurricular courses) or charity donations, however, these are usually very small and can be as low as 1 2 percent of a school s total budget During 26-21, 267 educational facilities were built, including 31 pre-schools and 5 public schools. Over the same period around 2, education buildings (one-fifth of total) have undergone major renovations. Source: Implementing the internationally agreed goals and commitments in regard to education. National report of Belarus, UNDP, May 16, The share of paid education services rose from 6.6 percent of total education services in 26 to 7.4 by the end of 21, or to around.7 percent of GDP (1.2 trillion BYR). 62 Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results

85 Enhancing public services in times of austerity In addition, the budget allocation within the sector is dominated by incremental budgeting practices. For example, spending on wages is generally calculated by adjusting last year s spending with a projected parameter of wage increase for budget sector employees. Several sectoral spending norms and standards govern resource allocation. In particular, services of education institutions should meet approved social standards (Box 4). In addition, the MOE issues certain standards and spending norms. While some of these norms are linked to the number of students, some are related to inputs. For example, in schools with indoor swimming pools, an additional janitor (.5 of full-time equivalent) is introduced for each 25 square meters of the area of swimming pool subject to cleaning, irrespective of the number of students in the school. These norms further constrain discretion in spending decision at the facility level, while not necessarily leading to better learning outcomes, as shown in the subsequent section of this chapter. Box 4. Social Standards in Education In 23 the Government adopted social standards for services, including in the education sector. These define the minimal requirements that should be met by educational institutions. Compliance remains an issue in some areas. For example, the number of seats in pre-school institutions in Minsk rayon of Minsk oblast is still below the standard. Resolution of the Council of Ministers 724 of May 3, 23, and revision 47 of January 13, 213 specify the following standards in education: Number of seats in pre-school institutions to the number of children of pre-school age (85 percent) Net enrollment rate of 5 year-old children in pre-school education (1 percent) Minimum per student allocation in pre-school education (2,5, BYR per year) Minimum per student allocation in general secondary education of all types (1,37, BYR per year) Minimum per student allocation in special education institutions for children with disabilities (5.5 million BYR per year) Minimum per student allocation in vocational schools (3.5 million BYR per year) Minimum per student allocation in out-of-school training institutions (2, BYR per year) Minimum area of general educational institution per student (8 sq. m) Areas equipped with facilities for sports (1.62 sq. m per student) Premises for sports activities (.5 sq. m per student) Minimum number of personal computers in general secondary, special and vocational schools (one computer per 3 students or at least one computer lab per school) D. Changing Demand for Education Services Aligning Spending to Demographic Change The education system must adjust to a dramatic decline in the number of students. Belarus population is projected to decrease to 8 million in 25 from more than 1 million in The school-age population has decreased dramatically during the last 4 years: from 1.9 million in 197 to.9 in 21 (Figure 75). Just in the Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results 63

86 belarus public expenditure review vol.2 Figure 75. Number of Students Has Declined, Especially in Rural Areas Demographic trends (thousands) 12, 1, 8, 6, 4, 2, All ages Age 5 14 Age 5 24 Rural Urban Source: UN, Belstat. last four years, the number of students in general secondary schools declined by 14.1 percent. At the same time, the number of people living in cities has almost doubled during the last 3 years (from 4 million in 197 to 7.2 million in 211). As a result, the demand for education, particularly in rural areas, collapsed. Based on current fertility and internal migration rates, population dynamics among schoolaged cohorts in urban areas are expected to stabilize over next two decade, while the decline in rural areas is expected to continue. Figure 76. Consolidation of School Network 1991=1 Number of school closures Number of schools Number of students Number of Teachers Source: CISSTAT. Statistics of the Countries of the CIS, MOE (211). In response to these trends, the Government has begun to right-size the school network. Accommodating such large shifts in student enrollment is tremendously challenging for a school system because it involves closing down schools, a politically difficult task in any country. Nevertheless, Belarus has made progress consolidating its school network. Since the early 199s more than 1,2 schools were closed, equal to about 3 percent of the existing schools at the beginning of the period (Figure 76). School closures accelerated in the 2s, and every year since 22 more than 1 school have closed annually. 66 Impressively, school closures have kept pace with the declining number of student. Moreover, school closures have primarily taken place in the regions where population declines necessitated them the most. As one would hope, the regions with the largest population decrease have managed to close more schools (Figure 77). The only region with a positive population growth is the capital Minsk where the population increased by.7 percent, and no schools were closed. However, the size of the education workforce has not seen a commensurate adjustment, and consequently student-teacher ratios have declined, with significant implications for per-student costs. The number of teachers has remained relatively stable despite the significant decline both in the number of students and schools (Figure 66 At the same time, the number of teachers at general secondary school level declined by 9 percent. 64 Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results

87 Enhancing public services in times of austerity Figure 77. School Closures Are Well Targeted Schools closure and population growth by region, Population growth by oblast, in percent City of Minsk Brest oblast Vitebsk oblast Gomel oblast Grodno oblast Minsk oblast Mogilev oblast Source: MOE and Belstat. Note: Size of bubble corresponds to number of school closures. 76). Student-teacher ratios at both primary and secondary have continued to fall and are among the lowest in the region (Figure 78). Since teacher salaries are the single largest cost item, this increase in the number of teachers per student has been associated with a significant increase in per-student costs. Schools in rural areas are particularly resourceintensive. As a result of demographic change and urbanization, rural areas have seen the sharpest declines in population and student numbers. While rural schools tend to be smaller everywhere, there continues to be a quite substantial misalignment in Figure 78. Student-Teacher Ratios Are Among the Lowest in the Region Pimary school student-teacher ratios in the ECA region Secondary school student-teacher ratios in the ECA region KGZ TJK ARM CZE RUS BGR SVN UZB KAZ MKD ROU MDA SVK UKR BLR LTA AZE HUN LVA POL TJK KGZ ROU SVK MKD UZB BGR MDA CZE POL UKR HUN KAZ SVN LTU LVA BLR AZE Source: EdStats database. Figure 79. Most Students Are in Urban Area While Most Schools Are in Rural Areas Students Teachers Schools Student-teacher ratio in secondary schools the demand and supply of education services between rural and urban areas (Figure 79). While the majority of students (about 77.4 percent) now reside in cities, 6.4 percent of schools and 35 percent of teachers were located in rural areas. Equally, the student-teacher ratio is substantially lower in rural areas, or as low as 4.6 in rural areas of Vitebsk oblast. While rural schools are important in providing access to education, the resource intensity drives STR Urban Rural Rural Urban City of Minsk Brest oblast Vitebsk oblast Gomel oblast Source: Belstat, MOE. Grodno oblast Minsk oblast Mogilev oblast Belarus Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results 65

88 belarus public expenditure review vol.2 up per-student costs. School-level data would be necessary to understand whether such resource differentials are justified, and how they could be optimized either by within-school reorganization or school consolidation. Despite school closures, overcapacity is also evident in the size of classes and schools. The average class size is 16 students, compared to 21 and 24 students in OECD primary and lower secondary, respectively (Figure 8). Class size in rural areas is only 9.4, against 2.4 in urban areas. Overall, lower student-teacher ratios and smaller classes imply high costs per student. These costs do not necessarily lead to better learning outcomes. Figure 8. Class and School Sizes Are Small Number of Students per Classroom CHN CHL PRK JPN ISR IDN ARG TUR BRA GBR IRL AUS USA FRA DEU ESP HUN PRT BEL CZE MEX FIN CHE DNK AUT ITA POL SVN SVK EST ISL GRC RUS BLR Number of Students per Primary School West. Europe ROU LTU BGR LVA EST RUS MDA SVK SVN BLR GEO HUN UKR HRV POL Source: NSI except Poland (BOOST data), Slovakia (Ministry of Education), statistics authorities of CIS countries. Western Europe includes other members of the European Union not mentioned in the figure, less Malta and Cyprus, plus Norway, Iceland and Switzerland. OECD at a Glance, 211. Notes: Year of reference 28. Public institutions only (including for Belarus). While the student-teacher ratio drives per-student costs up, it does not translate into better education outcomes. 67 Differences in the student-teacher ratio drive differences in per-student cost (Figure 81, top left panel). However, rayons with a lower ratio and hence higher per-student costs do not perform better in learning outcomes (Figure 81, top right panel, lower left panel). 68 This can be illustrated by looking at Chausskiy and Zel venskiy rayons, which appear to be very similar in terms of the number of schools in rural and urban areas, number of student by education levels (primary, secondary, upper secondary), community population size, average wage, etc. Although Chausskiy rayon spent a bit more per student (around BYR 6,165, average in 29 21), it showed significantly lower education outcomes as measured by the math test scores (2 on average versus almost 32 for Zelvenskiy rayon in 21). 69 Chausskiy rayon has a larger number of teachers and thus slightly lower student-teacher ratio (4.9 versus 5.8 in Zelvenskiy rayon) but this does not translate into better student achievements (Figure 81, lower right panel). Overall, this evidence indicates that there is substantial room for further efficiency gains and savings that could be achieved by continuing the reorganization of the education sector. A simple estimation suggests that if, over the medium term, Belarus could attain a level of student-teacher ratio comparable to the OECD countries average, it could save approximately 11 percent of the education budget, or around.6 percent of GDP per annum. 7 The savings would be higher under consolidation of school network (including within-school consolidation of 67 For a recent review of the empirical literature on the links between school inputs and education quality, see Glewwe et al. (211). This relation is at best weak elsewhere. 68 Here we used the results of Belarus s own assessment of student learning outcomes. Former graduates taking this exam are also recorded in the data. 69 Both rayons had over 1 participants in math testing. 7 Social costs in terms of teacher positions to be terminated will be high. On average, there are 14 students per teacher at the secondary level (16 at primary level) in OECD countries; see Education at a Glance, OECD (211). 66 Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results

89 Enhancing public services in times of austerity Figure 81. STR Drives Per Student Cost but Does Not Improve Student Performance per student costs, thsnd BYR 1, 8, 6, 4, 2, student-teacher ratio...hence There Is no Relationship Between Spending and Student Performance average math scores , 4, 6, 8, 1, per student costs, thsnd BYR Source: World Bank staff calculations based on BOOST, MOE and Belstat data. Each dot represents a rayon. average math scores student-teacher ratio average score in math ,114 th.byr 6,165 th.byr , average wage, 21 (communities are very similar in terms of the number of schools, population size, share of children aged 6-16, wage level etc.) Zel venskiy rayon, Grodnenskaya oblast Chausskiy rayon, Mogilevskaya oblast classes). With the merging of facilities and a reduction of utility expenses and non-teaching staff, the potential gains are likely to be higher. 71 But to go beyond these rough estimates, one has to run micro-simulations using the distribution of students in classes at the school level, since potential savings largely depend on the school network and thus differ from country to country (Box 5). E. Reform Options The overall budget envelope for education in Belarus is adequate, but it needs to be spent more efficiently. The input-based system for general secondary education, which is non-transparent and not conducive to efficient and equitable resource allocation, should be replaced. The key objectives of the per-student finance reform should be improved efficiency, equity, transparency and accountability of public institutions, and it requires strong policy leadership. The reform should begin with per-student financing pilots that will allow making necessary adjustments to the formula before rolling it out nation-wide. The goal is to improve education quality by consolidating schools 71 As an initial step towards teaching force optimization could be an increase in student-teacher ratio in urban schools comparable to the OECD countries average, which, according to Ministry of Education estimates, could result in savings in amount of.2 percent of GDP per annum in the wage bill alone. Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results 67

90 belarus public expenditure review vol.2 Box 5. Estimating Fiscal Impact of School Optimization in ECA Countries A recent study by the World Bank 72 shows that the potential savings that could be realized through class consolidation within schools would differ significantly from one country to another. For Romania, Latvia, Bulgaria and Estonia, the authors estimate that optimizing the size of classes in big school only (which are likely to offer the best efficiency gains) could save from 3.2 percent of the wage bill in Latvia to 7.3 percent in Bulgaria. These simulations only deal with class size and not the other components that one may consider, including teacher work load, curriculum or teacher specialization. Savings From Within-school Class Consolidation Country Latvia Estonia Bulgaria Romania Base year Savings as % of wage bill 3.2% 3.7% 5.4% 7.3% and better utilizing resources (human and physical) in line with the demographic landscape. The following policy options emerge from the analysis: a. Continue effort to right-size the school network and teaching force. A simple estimation suggests that if Belarus could attain student-teacher ratios comparable to the OECD countries over the medium term, it could save approximately 11 percent of the education budget, or around.6 percent of GDP per annum, in the wage bill alone. Additional savings could be achieved by consolidating the school network (including within-schools consolidation of classes). 73 These savings could be used to upgrade facilities, raise teacher salaries, invest in teacher qualification and procure other learning equipment, such as computers. b. Move to per-student financing to improve efficiency, equity and transparency in resource allocation. Following the pilot launched in 213, the system should gradually move towards per-student financing, away from the current input-based financing arrangement. This would realign spending more closely to demand and provide greater autonomy and incentives to schools to improve internal efficiency. c. Enhance quality and performance management to strengthen accountability for education results. Monitoring and analysis of school-level performance information could help identify schools with performance challenges and allow for corrective action, including through resource allocations. Quality certification of schools, audits, internal benchmarking and centralized examination can all play a role. In addition, participation in international benchmarking, such as the OECD PISA, would be useful in assessing Belarus s education performance against international standards. 72 Monica Robayo and Lars Sondergaard, Downsizing ECA s education systems without closing schools, World Bank, As an initial step towards school size optimization could be an increase in student-teacher ratio in urban schools to the average OECD level, which, according to Ministry of Education estimates, could result in savings in amount of.3 percent of GDP. 68 Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results

91 Enhancing public services in times of austerity Table 18. Key Advantages of Per-Student Financing Compared to Input-Based Systems Input-based system Funding for salaries determined by number of staff in post and/or class size As student numbers decline, student-teacher ratio falls: cost per student increases School directors have incentive to maximise number of classes in order to maintain or increase the number of teachers Schools have no incentive to economise on utilities Per-student financing Improved efficiency due to PSF of local governments Improved efficiency due to PSF of schools Funding depends on number of students: cost per student remains constant as number of students falls Incentive for local government to rationalise school network by reducing number of classes and closing some schools School directors limited by the school budget in the number of staff they can employ Organise classes according to number of teachers that can be paid out of the school budget Improved efficiency due to schools deciding how to spend their budgets Local governments don t buy the goods and services that schools need most Schools can spend less on utilities and use the money on other items, e.g. learning materials, small repairs Schools can more easily procure the goods and services they need Improved efficiency due to locally determined performance-related pay Salaries based on qualifications and years of service: performance makes no difference to pay Teachers can be motivated by additional payments for effective teaching and greater effort Improved horizontal equity: students with similar needs funded the same Schools with similar educational phase and numbers of students have different amounts spent per student Similar local governments are funded with different amounts per student Schools with similar educational phase and numbers of students have the same amount per student Local governments with similar characteristics are funded the same amount per student Improved vertical equity: students with different needs funded differently Can be vertically equitable if students with special needs allocated to smaller classes or other extra resources, e.g. learning disabilities, minority language students, students in isolated rural areas Non-transparent: Lack of information on how much funding per student each local government and school receives and why Lack of accountability: Often no requirement for local officials or school directors to justify in public how funds are allocated and spent Funding formulae address vertical equity by allocating more money per student for specified categories Extra weights for: Special needs Minority language Social disadvantage Isolated rural location Improved transparency Transparent: Formula funding shows explicitly how much funding each local government and school receives and why Accountability: School-based financial management: school director held accountable for how school budget is spent and with what results. Very important role for School Board in holding school director accountable Source: Rosalind Levačić, Per Capita Financing of General Education and its Role in Creating Incentives for an Efficient School System: International Experience (World Bank, 21). Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results 69

92 belarus public expenditure review vol.2 Box 6 Pilot on Per-Student Financing in Belarus At the time of the writing of this report, the MOE and MOF are preparing a pilot project on per-student school funding. The aim of the pilot is to increase the autonomy of school management as well as raise the salary of school teachers. This is a laudable initiative. It has not yet begun, so the information may be incomplete. The authorities highlighted that the planned pilot will not decrease overall allocations to schools included in the pilot, which will be limited to fairly homogeneous, large urban schools. Pilot schools will be given flexibility to reallocate between budget line items and also to carry forward budget savings between fiscal years. The current draft of the regulation governing the pilot does not foresee a specific timeframe for the pilot, and the authorities expect the pilot to be continued beyond FY213. The main issues related to the introduction and scaling up of the pilot include: Medium-term time frame for pilot: While giving more flexibility to schools to deploy resources promises important efficiency gains, the authority to reallocate funds will at least initially be limited by preexisting commitments, including for teacher salaries and utilities, which in most cases cannot be adjusted in the short run. It is therefore important that pilot continue beyond FY 213 to allow schools to adjust their cost structures. Impact monitoring: It will be important to systematically evaluate the impact of the pilot on school budgets and management. The pilot should assess both the way individual schools use the flexibility granted to them as well as any issues that arise, for example regarding financial management capacity at the school level. The evaluation should rely on: i) ongoing documentation of issues raised by schools; ii) systematic gathering of selected financial data to compare school expenditure patterns in the fiscal years before and after the introduction of the pilot; and iii) interviews and focus groups with school principals and accountants. Reallocation across schools: The current approach of ensuring that overall allocations to individual schools do not decrease in real terms is suitable for the pilot, but will most likely not be feasible for a roll-out to the school network, as per-student financing by design would imply adjustments in allocations across the network to schools with more students. While increasing operational efficiency at the school level through increased flexibility is important, reallocations are also desirable to promote efficient use of available resources. Given the more serious implications of reallocations, it is paramount to provide sufficient time for the system to adjust and to accompany changes in financing with efforts to rationalize the school network. Design of formula to reflect objective differences in costs: The homogenous nature of the schools included in the pilot means that allocation of funds to these schools may be very simple. This will no longer be the case if roll-out is considered: the formula will need to take into account objective differences in cost per student of different types of schools (primary vs. secondary, vocational vs. general, urban vs. rural, integrated vs. mainstream. etc.). Need to reform financing as part of sector strategy: Reforms in financing should be envisaged as an integral part of a comprehensive education sector strategy, including managerial capacity and flexibility at the school level, professionalization of school leadership and mechanisms for quality management. Moreover, empirical evidence suggests that increased school autonomy needs to be accompanied by strong accountability procedures to achieve the intended impact. 7 Chapter 4. Education Financing: Enhancing Spending Efficiency for Better Education Results

93 Enhancing public services in times of austerity List of References ACIR, (1985). Bankruptcies, Defaults, and Other Local Government Financial Emergencies, Commission Report. Updates the Commission s 1973 report: City financial emergencies. Advisory Commission on Intergovernmental Relations. Alban, A. and Kutzin. (26). Scaling up Treatment and Care for HIV/AIDS and TB and Acelerating Prevention within the Health System in the Baltic States (Estonia, Latvia, Lithuania): Economic, Health Financing and Health System Implications. Copenhagen: WHO Regional Office for Europe Health Systems Financing Programme. Boston Consulting Group. Skills Gap is More Limited than Many Believe, (forthcoming). EBRD-World Bank. Business Environment and Enterprise Performance Survey (BEEPS) 29. Getzen, T.E. (2). Health Care is an Individual Necessity and a National Luxury: Applying Multilevel Decision Models to the Analysis of Health Care Expenditures. Journal of Health Economics, Vol. 19(2), pp Glewwe, Paul W., Hanushek, Eric A., Hunpage, Sarah D., Ravina, Renato. (211). School Resources and Educational Outcomes in Developing Countries: A Review of the Literature from 199 to 21. Gómez-Reino, Juan Luis & Martinez-Vazquez, Jorge (212). An International Perspective on the Determinants of Local Government Fragmentation, International Center for Public Policy (formerly the International Studies Program) Working Paper Series, at International Center for Public Policy (formerly the International Studies Program), Andrew Young School of Policy Studies, Georgia State University, paper1219. Government of Belarus. Law No. 18-Z, January 4, 21. Government of Belarus. Presidential Decree No. 68, December 29, 211. Government of Belarus. Presidential Decree No. 66, February 22, 211. Government of Belarus. Order of the Ministry of Finance No. 163, July 11, 211. Government of Belarus. Resolution of the Council of Ministers No. 724, May 3 мая, 23. Government of Belarus. Resolution of the Council of Ministers No. 18, December 3, 211. Government of Belarus. Resolution of the Council of Ministers No. 149, August 4, 211. Government of Belarus. Resolution of the Ministry of Finance No. 28, December 31, 28. Government of Belarus. Budget Code, July 16, 28. Government of Belarus. Tax Code, Part I, December 19, 22. Government of Belarus. Tax Code, Part II, December 3, 29. Honadle, Beth Walter. (23). The States Role in U.S. Local Government Fiscal Crises: A Theoretical Model and Results of a National Survey, International Journal of Public Administration 26, 13: Ma, Jun. (21). Monitoring Fiscal Risks of Subnational Governments: Selected Country Experiences, in Hana Polackova Brixi and Allen Schick, eds., Government at Risk. New York: Oxford University Press. OECD (26). Projecting OECD Health and Long-term Care Expenditures: What are the Main Drivers? Economics Department, WP No OECD (211). Education at a Glance 211: OECD Indicators, OECD Publishing. OECD (211). Government at a Glance 211, OECD Publishing. List of References 71

94 belarus public expenditure review vol.2 UNDP (211). Implementing the Internationally Agreed Goals and Commitments in Regard to Education. National report of Belarus, May 16. Woessman, Ludger., Hanushek Erick A. (27). The Role of Education Quality for Economic Growth. Policy Reserch Working Paper No World Bank. World Bank (213). Doing Business 213: Smarter Regulations for Small and Medium-Size Enterprises. Washington, DC: World Bank Group. World Bank (27). Fiscal Policy and Economic Growth: Lessons for Transition Economies. World Bank (29). The Growth Report: Strategies for Sustained Growth and Inclusive Development. World Bank (21). Per Capita Financing of General Education and its Role in Creating Incentives for an Efficient School System: International Experience./Rosalind Levačić. World Bank (211 _a). Belarus Public Expenditure Review: Fiscal reforms for a Sustainable Economy Recovery. Volume 1. Report No BY, August. World Bank (211_b). Downsizing ECA s Education Systems without Closing Schools./Monica Robayo, Lars Sondergaard. World Bank (212_a). Belarus Country Economic Memorandum: Economic Transformation for Growth. Report No BY, April. World Bank (212_b). Golden Growth: Restoring the Luster of the European Economic Model./Gill, Indermit S., Raiser, Martin. World Bank. Washington D.C. World Bank (212_c). Skills, not Just Diplomas: Managing Education for Results in Eastern Europe and Central Asia. World Bank and EBRD (26). Life in Transition Survey I: Satisfaction with Life and Services Delivery in Eastern Europe and the Former Soviet Union. World Bank and EBRD (21). Life in Transition Survey II: After the Crisis. World Health Organization. Health for All Database. World Health Organization. National Health Accounts. World Health Organization (211). World Health Statistics. World Health Organization (212). World Health Statistics. Zharko V.I., Malakhova I.V., Novik I.I., Sachek M.M. (212). The Health Care in the Republic of Belarus: yesterday, today and tomorrow. Minsk. 72 List of References

95 Enhancing public services in times of austerity Annexes ANNEX 1. Fiscal Indicators, Billions BYR Consolidated budget Revenue 23,42 29,7 36,726 51,54 46,741 48,765 85,68 Personal income tax 1,882 2,48 3,81 4,183 4,35 5,381 9,316 Profit tax 2,377 3,141 3,837 5,993 4,68 5,58 8,689 VAT 5,99 7,365 8,67 11,399 12,83 16,226 26,499 Excises 1,368 2,826 3,46 3,91 3,637 4,35 5,599 Property tax 1,149 1,268 1,519 2,5 1,627 1,85 2,549 Customs duties 1,682 2,69 6,281 1,613 7,97 5,776 15,147 Expenditure (economic classification) 23,821 28,765 37,24 5,922 49,21 52,971 79,428 Wages and salaries 5,276 6,511 7,481 8,626 9,258 11,528 18,616 SPF contributions 1,473 1,795 2,41 2,347 2,471 3,79 4,991 Goods and services 5,2 5,71 7,3 8,683 8,677 9,993 15,353 Interest ,69 1,111 3,296 Subsidies and transfers 5,95 6,668 1,137 14,934 16,127 13,71 21,591 Capital expenditures 5,377 7,595 9,579 12,98 11,162 13,631 15,157 Net lending , (81) Social Protection Fund Revenue 7,45 9,288 11,422 14,716 16,196 19,677 29,573 Expenditure 6,735 8,491 1,386 12,996 14,694 18,377 27,5 Balance (cash) ,35 1,72 1,52 1,3 2,73 3. General Government Revenue 3,825 38,294 48,147 65,77 62,936 68, ,2 Expenditure 3,556 37,256 47,627 63,918 63,895 71,348 16,767 Augmented General Government Balance 269 1, ,852 (958) (2,95) 8,254 State Balance (4) 242 (515) 132 (2,46) (4,25) 6,18 GDP 65,67 79,267 97, , , , ,158 Percent of GDP Consolidated budget Revenue Personal income tax Profit tax VAT Excises Property tax Customs duties Expenditure (economic classification) Wages and salaries SPF contributions Goods and services Interest Subsidies and transfers Annexes 73

96 belarus public expenditure review vol.2 Capital expenditures Net lending (.5).1 2. Social Protection Fund Revenue Expenditure Balance (cash) General Government Revenue Expenditure Augmented General Government Balance (.7) (1.78) 2.8 State Balance (.62).3 (.53).1 (1.79) (2.58) 2.1 GDP, bn BYR 65,67, 79,267, 97,165, 128,829, 137,442, 162,964, 297,158, Source: Ministry of Finance. ANNEX 2. Grant Formula Adopted by the Ministry of Finance In the 211 regulation, the grant allocation mechanism is based on the size of a fiscal gap according to the following mathematical formula: Tei = α*[ ENi.95*TRCi.95*NRCi OTi ] (1) Where: α the equalization parameter determined by the overall equalization fund; EN i estimated expenditure needs of region i; TRC i tax revenue capacity for region i; NRC i non-tax revenue capacity for region i; OTi all other transfers received excluding derivation-based tax sharing. Thus, the formula is slightly more sensitive to disparities in expenditure needs than in revenue capacity. The adopted methodology utilizes the Representative Tax System (RTS) to assess potential revenue for the main revenues sources (list not specified). For all other revenues, the capacity is estimated jointly using the RTS estimate as a proxy. In other words it is assumed that the capacity for all other revenue sources is proportional to the potential revenue estimated for the selected set of representative revenue sources. In the RTS, the estimate for tax j in locality i is computed by apportioning the forecast of the aggregate revenue collections from all localities in proportion to the share of a particular locality in the aggregate value of the indicator used as a proxy for the tax base. Furthermore, the share in the aggregated value of the tax base is calculated as a weighted average over the previous three years. Arithmetically, the computation can be represented with the following formula: RCij = RFj*[.25*St ij +.3*St-1 ij +.45*St-2 ij] 74 Annexes

97 Enhancing public services in times of austerity where RFj the forecast of the aggregate revenue collections for revenue source j from all constituent regions in the higher-level region for the coming fiscal year; St ij = Bt ij / Σi Bt ij is the relative share of region i in the aggregate value of the revenue base proxy Bt ij totaled for all regions combined. However, for sources that local governments had revenue from in the past, the shares are described in a more convoluted way, including past aggregate collections, which after canceling out in both the numerator and denominator, look as following: St ij = cij Bt ij / Σi cij Bt ij, where cij is an adjustment coefficient. As the calculations do no feature retention rates for the next year, it implies that the aggregate revenue collections (RF j ) only captures the sub-national share of the forecasted aggregated revenue and thus would not be compatible with differentiated retention rates. The adopted methodology utilizes a per client basis adjusted for the relative cost to assess expenditure needs for an unspecified range of functional (sub-) categories of expenditures: Expi = ci * Norm* pi where Norm is the per client average of the aggregate expenditure needs projected by the higher-level government for all constituent localities together, p i is the client population in locality i that benefits from the local service in question, and c i is the parameter measuring the higher (more than one) or lower (less than one) costs in the locality relative to the average cost of providing that service in the country. Cost adjustment coefficients for jurisdiction i are envisioned to be computed as: Ci= 1+a1*(x1i X1) / X1 + a2*(x2i X2) / X2 + + ak*(xki XK)/XK, ak signifies the relative weight of each cost factor; and x i /X represents the value of each factor that is recorded in locality i relative to the value of the same factor for all localities combined. Annexes 75

98 belarus public expenditure review vol.2 ANNEX 3. Distributional Analysis of Household OOP in the Health Sector Incidence and Intensity of Catastrophic Health Payments Threshold share of total household expenditure 5% 1% 15% 25% 4% 2, HBS Headcount Concentration index.83**.173**.167* -.275** ^ 21, HBS Headcount Concentration index -.95*** -.144*** -.233*** -.676*** ^ Threshold budget share of nonfood consumption 5% 1% 15% 25% 4% 2, HBS Headcount Concentration index , HBS Headcount Concentration index Source: Authors estimates using ADePT and HBS data. Shares of Total Expenditure Spent on Health Services Quintiles of per capita consumption, gross Share of capita consumption, gross Share of expenditures on taxes and social insurance OOP expenditures for health care 2, HBS Lowest quintile Highest quintile Gini coefficient.311*** Concentration Index.176***.347*** Kakwani index -.125***.396*** 21, HBS Lowest quintile Highest quintile Gini coefficient.2737*** Concentration Index.319***.2311*** Kakwani index.453*** -.436*** Source: Author s estimates based on HBS, 2 and Annexes

99 Enhancing public services in times of austerity Measures of Poverty Based on Consumption, Gross and Net of Spending on Health Care Indicator Consumption including health payments Consumption excluding health payments Change Percentage change Poverty line at 3,1 BYR per month* HBS, 2 Poverty headcount % Poverty gap % Normalized poverty gap % Poverty line at 275,2 BYR per month* HBS, 21 Poverty headcount % Poverty gap % Normalized poverty gap % Source: Authors estimates using ADePT, and Belstat and HBS data. *Note: Poverty lines are at current prices of respective years. ANNEX 4. Progress Toward Results-Based Financing of Pre-University Education in ECA Source: Skills, Not Just Diplomas: Managing Education for Results in Eastern Europe and Central Asia, World Bank 212. Annexes 77