Economic and Social Reforms for Peace and Reconciliation

Prepared by the World Bank

February 1, 2001

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UNMIK is making progress towards establishing a public administrative structure able to deliver improved public services to the population of Kosovo, within the available budgetary resources complemented by donor support. Such progress includes the establishment of the new Joint Interim Administrative Structure (JIAS)¹ and the regulatory framework which defines the responsibilities and functions of its various departments, as well as the establishment of the Central Fiscal Authority (CFA) and a budget management system that is able to provide resources in a timely manner and ensure that these resources are spent efficiently and transparently for the purposes intended. In addition, progress is being made to improve coordination in the reconstruction efforts, given substantial needs for capital investments and substantial donor commitments and financial support to finance these needs.

Despite progress, serious challenges remain as regards the fiscal performance and medium term fiscal sustainability in the coming years. . The budget data as of October 31, 2000 show considerable improvements in the revenue performance compared with the beginning of 2000. However, they also show expenditure shortfalls compare to pro-rata figures for the 10 months of 2000 and highlight important budget structural issues especially related to wage and employment as well as transfers to utilities. The data show a spending pattern with overspending trends on wages and subsidies and under-spending in non-wage categories raising concerns about the ongoing implementation of budget programs. More importantly, budget estimates for 2001 highlight additional pressures on expenditures coming from off budget items and expenditures financed from dedicated donor grants (DDG) (e.g. Kosovo Protection Corps) which should be included and financed from projected resources in the next year’s budget.

To ensure effective budget outcomes and effective service delivery over time, the policy formulation process should be closely linked with planning and budgeting in a coherent budget strategy and expenditure framework. The link between policy, planning and budgeting becomes essential in the specific circumstances of Kosovo given a unique multinational administrative structure and substantial donor involvement in financing a considerable part of the recurrent budget needs and almost the entire capital investment needs. The present separation of the recurrent and capital budgets into two wholly distinct entities, with the former being financed partly through local taxation and partly through external donor assistance and the latter entirely from donor support, inhibits the formulation of a coherent budget strategy undermining the effective and efficient use of budgetary resources. A non-unified budget may be unavoidable in an immediate post-conflict environment, but is clearly undesirable over the medium run. The following sections intend to discuss fiscal policy and budget management issues in more details and present some of the challenges UNMIK faces in building financial management institutions.

Fiscal policy in Kosovo can only take a rudimentary form, given Kosovo's present peculiar circumstances. In a cash-based deutsche mark economy with no domestic financial instruments, nor even domestic currency, there is scope for neither seignorage nor inflationary finance, and there is no other means for financing a domestic budget deficit. At present, there is no external debt service payable either, so this is neither a burden on the budget, nor does it require budgetary decisions.

In September 1999, UNMIK prepared estimates for the recurrent budget for the final four months of 1999 and a preliminary estimate for the year 2000 in consultation with World Bank and IMF fiscal teams. The estimates for 2000 were finalized and issued as a regulation by UNMIK at end-December 1999, thereby constituting the annual budget law for 2000 for Kosovo. With the creation of JIAS the budget regulation for 2000 was amended and approved in March to incorporate expenditures for the new administrative structure that includes local co-heads for all the departments of UNMIK (Table 1).

The taxes being levied today are a customs tariff of 10 percent, excise taxes at varying ad valorem rates on tobacco, coffee, oil and oil products, alcohol and soft drinks and certain electronic goods, amounting to between 5 and 50 percent, and a sales tax of 15 percent on imports. Taxes are today being collected at certain border points (the border points with Albania, Macedonia, and as of March also the boundary line with Montenegro); the coverage is to be gradually widened. A service tax, hotel food and beverage tax has also became effective at the end of February 2000. Excise taxes on domestic products, such as beer and cigarettes, sales taxes on domestic products in general, and certain municipal level taxes were to be phased in gradually in 2000 as tax administration capacity was built up. Other taxes that were proposed for implementation from 2000 were a wage withholding tax, a presumptive tax, and a profit tax, but so far as the yield of these new taxes is concerned, much depends on tax administration capability.

Chart 1: Kosovo Consolidated Budget

Weekly Revenues by Tax Type as of September 29th

Developments in the period since the customs and tax systems were put in place to end-1999 show that customs tariff and sales taxes were collected broadly satisfactorily, but there was disappointingly little collection of excise duties. Total revenues collected at the end of 1999 amounted to DM 30.5 million, in contrast to budget estimates of DM 47.7 million. The weakness in excise duty collection was, in significant part, related to incomplete coverage of entry points into Kosovo as well as weak tax administration capacity. Reports from the customs administration indicate that high value excisable items (beer, cigarettes, fuel oils) have entered in large quantities from Montenegro (a boundary crossing point where a tax post has only just been set up) and that some illegal "revenue" associated with these goods are being collected by "parallel organizations".

Tax and fee revenues were estimated at DM 200 million in 2000 – a substantial increase on revenues per month in relation to the final four months of 1999. Estimated growth of 23 percent of the real economy in 2000 is projected to boost the fiscal base. In addition, the extension of sales and excise taxes to domestic goods (not just imports), the institution of a wage withholding tax (the payroll tax), presumptive tax on businesses, a profits tax, Hotel Food and Beverage tax (HFB), and vehicle license and radio frequency user fees are new, significant sources of revenue. Some of these taxes, such as Hotel Food and Beverage tax, vehicle license fees and presumptive tax have been phased in already. Others were expected to be phased in during the course of 2000 as tax administration capacity allowed. However, at the time this report was being written no other taxes had been introduced. The institution of the wage tax – a highly important potential source of revenues – depends on authorization from UN New York headquarters to permit taxation of local staff employed by UNMIK. Without such authorization, the institution of the wage tax would be divisive and politically difficult, besides being based on a much narrower base. Additional customs officers have been recruited and tax administrators have been under training. Budget estimates for 2000 assumed that the Montenegro tax gap will be closed and the preferential trading agreement with Macedonia that provides for tariff free entry for Macedonian goods (but subject to a 1 percent fee) would be eliminated. However, they still remain outstanding issues constituting significant revenue losses for the Kosovo Consolidated Budget.

Developments in the first two months of 2000 showed an extremely weak revenue performance, with significant shortfalls in all categories of revenues, particularly excises. During the third month, however, revenues experienced significant improvements especially in customs and sales tax collections. Though the causes of these developments are not fully understood, it is likely that the tax coverage gap related to the Montenegro boundary line led to large leakages. UNMIK has, as noted, now set up a tax post at the Montenegro boundary line and expects to meet its budgeted revenue estimates on the basis of the new taxes to be instituted (as described above) and improved tax administration and coverage.

Following the poor performance of the first two months, revenue collections are now rising (see chart above). Excise taxes have shown strong increases due to the application of unified tax rates for heating oil and petroleum products. Hotel Food and Beverage Tax is now fully operational. Although its collections remain small, the experience gained through its administration was an ideal training ground for the staff and taxpayers for future inland taxes such as presumptive tax. Total revenues have shown significant improvements and are slightly above the pro-rata figures in the ten months ending October 2000, although they still rely largely on collections made at the Administrative Boundary Lines (ABL). Compliance activity is underway in both ABL and Inland Operations. ABL collections remain subject to seasonal factors, but continue to grow with increasing staff competence, a broadening tax base and increasing compliance/education activity. A review of ABL taxes will commence shortly to better integrate the tax portfolio through inland collections of excise and sales tax. Both the Customs and Taxation Administrations have plans to grow beyond current budgeted levels as inspections and enforcement activities expand.

Revenue projections for year 2001 assume improvements in both tax policy and tax administration and are expected to increase by 45 percent compare to 2000, to DM 330 million. (Table 1) Although such an increase is significant, it is necessary to ensure that Kosovo moves towards self-sufficiency and becomes less dependent on donor financing, especially for the recurrent expenditures. Increasing revenues in 2001 would be achieved by a rapid broadening of the tax base and removal of the large distortions associated with the existing customs tariff structure. Measures must be taken to move towards a sales tax and eventually a Value Added Tax (VAT) system and change the existing tax structure in favor of taxes being raised domestically. In addition, a rapid establishment of the legal framework for private sector development would open up opportunities for employment, growth and higher tax yields.

The major categories of budgetary expenditures in both 1999 and 2000 estimates relate to education and health, transfers for social assistance, and the civil administration (including police and justice), with salaries constituting the largest single item. The budgets provided that social assistance would be extended to a core group of the neediest families at the minimum wage level; it was also decided that pension payments would not be made at this stage. The outturn for expenditures in the final four months of 1999 showed a very substantial shortfall from initial budgetary estimates, DM 86.6 million vs. DM 121.6 million. The highest underspending was in the items of social assistance, education and health. The principal cause of the expenditure shortfalls can be found in tardiness in establishing the administration structure, in setting up the payroll for education and health, in working out safe ways of delivering cash for expenditures and putting in place effective budget execution and monitoring systems. In social assistance, establishing the needy and implementing the proposed assistance has taken considerable time. As social assistance spending was originally estimated conservatively and is targeted to the vulnerable, the shortfall is of particular concern, and it is hoped that, with improving implementation capacity, planned social assistance programs would be adequately funded and implemented.

The 2000 budget proposed a strong rise in overall expenditures (but at a rate less than the rise in tax and fee revenues) centering on education, health and social assistance. The key objectives of the education budget were to ensure full enrollment, initiate steps towards a unified curriculum, enhance pre-service teacher training, reform the Pristina university, and undertake comprehensive school mapping. The budget also funded the preschool sector. The major objectives for the health sector were strengthening primary care and building up the physical facilities for health care. The budget included some incentives for shifting doctors to rural areas. The social assistance budget focused on assistance delivery to the most needy, particularly elderly over age 70, single parent families and families with a handicapped person. Policy work on a permanent system of social assistance will be funded in coordination with health, pension and social insurance funds.

Expenditure estimates for the 2000 budget rested on the assumption of DM 273 per month for the average public sector wage (a rise of nearly 50 percent in relation to those who received wages in 1999) and a fall in public employment (particularly in education and health sectors) of an estimated 10 percent. There was also the intention to develop retraining and counseling for redundant public sector employees and to establish a framework for unemployment insurance in future years.

The 2000 budget was amended in March to incorporate expenditures for the implementation of the Joint Interim Administrative Structure. As a result of these amendments, overall expenditures were increased by DM 6 million. However, the introduction of additional revenue generating measures to offset the increase in expenditures left the overall balance unaffected. Budget outturn for the ten months of 2000 shows that expenditures have picked up considerably amounting to a total of DM 260.1 million or 60.3 percent of the annual budget. However, they still remain below the pro-rata figures by DM 99 million. The majority of expenditures have occurred in education, social assistance and fuel and energy and most of them have been used to pay wages and social assistance compensations. Several issues become evident when analyzing actual expenditures for the first ten months of 2000:

• Wages and Salaries: They amount to 72 percent of the annual appropriations. While this number appears reasonable, three significant issues should be noted: (i) the total number of persons employed under the budget exceeds authorized numbers, particularly in the Department of Education and Science and the Department of Health and Social Welfare, which together comprise 76.9 percent of the wages budget. The number of employees for the two departments grew in the first few months of 2000 before stabilizing in April; (ii) staffing levels for other departments were initially below authorized levels, as departments experienced delays in the start-up phase of their activities. As a result they continued to hire additional personnel during the course of 2000 ; and (iii) there are still unpaid salary obligations for the month of October that are expected to be paid in November. When adjusted for this factor expenditure is slightly higher than pro rata.

• Goods and Services: They are 50 percent of the appropriated amount (DM 103.5 million), representing significant under-spending compared to spending levels that might be expected at this time of the year. Slow spending is caused by delays for startup of various programs, and for establishment of local spending and procurement mechanisms. Because of these delays, procurement of various goods and services will be pushed back in time, potentially resulting in a considerable portion of the spending that would have occurred at the end 2000 to occur in early 2001. Remedial action may be needed for a coordinated strategy for developing procurement and cash management competencies across a range of agencies to ensure real goods and services needs are met effectively and efficiently.

• Public Utilities: The level of actual spending during the ten months in the form of subsidies to the electricity company under-represents the actual transfers that have occurred , as some of the transfers -- about DM54.2 million -- have been paid off budget through Dedicated Donor Grants (DDG). The amount recorded in the budget figures represents 54 percent of the amount budgeted for year 2000. If this amount is adjusted for off budget transfers the actual spending exceeds the budgeted amount by about 58 percent. The number of employees for Kosovo Electricity Corporation (KEK) increased from January to May 2000 while achieving cost recovery required reduction in employment levels. Non-payment of electricity bills continues to be an issue and only recently has been pursued aggressively. Recent actions by the Public Utilities Department have been directed at bringing the utility entities’ management to the point of fully understanding the situation, but overspending still seems likely. These facts show that electricity transfers remain a substantial risk for the fiscal balance considering that they would have to be sustained through the rest of the winter months for 2000. Moreover, unless the underlying structural issues in the sector are addressed these spending patterns will remain a major risk for the year 2001 budget and beyond.

Total expenditures in the 2001 budget are estimated at DM 480 million or about DM 50 million over the expected outturn for 2000. These estimates assume a very modest increase in the overall expenditures, mainly in social transfers and expenditures to support the new decentralized structure of municipalities, aiming towards self-sustainability for the Kosovo Consolidated Budget. There are no planned increases in wage levels. However, major risks will remain in the next year’s budget and in the medium term, if the structural issues in year 2000 budget are not addressed. They include (i) bringing employment to a sustainable level for 2001, especially in health and education that have been running in excess of planned levels, even in year 2000; (ii) reduce transfers to the utilities by reducing employment and preparing an implementation plan for introducing cost recovery measures: (iii) preparing a fiscally sustainable redundancy policy and implementing employment reduction measures consistent with the policy; (iv) carefully implementing an adequate fiscal decentralization plan consistent with the local government capacities for taking over financial management responsibilities.

Original budget estimates showed that the projected deficit for the last four months of 1999 would be DM 74 million or US$41 million. In the event the financing gap amounted to DM 56.1 million or US$31 million. Donor contributions, however, exceeded even the initial financing gap estimate and amounted to DM 85.3 million. This enabled the budget to close the year with a cash surplus of DM 29.2 million.

In the year 2000, the financing gap is estimated to be DM 200 million. Underlying this estimate is a revenue performance of DM 18.6 million per month in 2000 as compared to DM 7.6 million per month in 1999 and expenditures of DM 35.3 million per month in 2000 as compared to DM 21.7 million per month in 1999. Thus, the self-financing of the budget was expected to rise strongly in 2000, with the financing gap as a proportion of expenditures falling from 65 percent in 1999 to 47 percent in 2000.

The budget outturn for the ten months of 2000 as described above show that this limit of DM200 million in donor financing for the year as a whole is achievable, assuming that: (i) recent positive trends in revenue collections are maintained till the end of the fiscal year; and (ii) on the expenditure side there is partial catch-up in underspending, with discipline on wage and subsidy spending being exerted in the rest of the year. Were there to be pressures to spend beyond budgeted numbers, the external financing requirement would, of course, rise. On the other hand, any additional surpluses coming as a result of better than expected revenue performance should be used to ease up pressures on the next fiscal year by paying off arrears for the electricity imports as well as using some of the resources to support redundancies which otherwise must be financed out of the year 2001 budget. It appears that additional donor budgetary support would not be required till the end of the year, opening the way for medium-term sustainability in the Kosovo local cost recurrent budget.

Consistent with the self-sustainability principle and tight fiscal scenario in the year 2001 budget, donor support is projected at much lower levels of DM 150 million. The rise in the self-financing of the budget is, of course, a necessary condition for an eventual successful "exit" by donors from providing budgetary support. Other conditions are being created for a successful exit: the infusion of new technologies and skills in fiscal and banking system management and supervision (to name but the two most important developments thus far) and the creation of institutions of governance and management. Keeping fiscal spending within the limits of medium-term sustainability as determined by the likely capacity to raise domestic revenues and obtaining external funding for investment will be critical. Instruments and institutions of economic management of this kind are being constructed to be durable whatever may be the eventual political settlement applied to Kosovo.

The removal of Kosovo's autonomy and the consequent centralization of financial management functions in Belgrade during the last ten years created an institutional vacuum for the public administration in Kosovo. Essential functions of any public administration system, such as the management of public resources, either did not exist or existed in a rudimentary form that did not ensure adequate effectiveness and transparency in the use of resources. A parallel budget system, financed by voluntary taxes and contributions of the Kosovar diaspora was established during these years. Its funds provided resources for basic operating costs of primary and secondary education and health care for the Kosovar Albanians. Under the new situation, however, this system could not serve as a substitute for formal budgeting, although it is known to have functioned quite effectively in the past. In addition, payments bureau (SDK) ceased to carry out some budget execution functions they performed before the war leaving almost no alternative for the execution of financial transactions.

The current situation required immediate action for establishing basic administrative and financial management functions in the territory of Kosovo in order to facilitate the effective and transparent deployment of revenues that were being collected, as well as donor funds that were expected to enter into Kosovo to provide basic public services to the population of Kosovo and finance investments and reconstruction efforts. Since the establishment of the UNMIK administration, spending has been gradually taking place. Initially such spending was organized in an ad hoc fashion, outside the context of an overall fiscal framework and budget planning process. It was directed to finance the salaries of some health employees and judges in an effort to quickly address some urgent requests for financing in the public sector.

Despite these initial ad hoc developments work progressed expeditiously to establish suitable and well organized financial management institutions, which would be able to address the management of the resource flow and spending in the short run and form the foundations for building a modern system in the long run. In response to the existing situation the establishment of a Central Fiscal Authority (CFA) with the functions of a finance ministry was identified as a first priority.

The CFA was established by regulation 1999/16 at the end of 1999. After making an impressive start in December 1999 it is functioning admirably despite extremely difficult and complicated circumstances. Its main divisions for budget, treasury, tax policy and tax administration became operational within a very short period and are performing important functions including: (i) budget preparation and monitoring; (ii) execution of budgetary transactions through the Treasury Single Account (TSA) and their financial control; (iii) formulation of tax policy and the management of tax and customs revenues. In addition, the CFA has hired and trained many local staff who already performs several routine tasks in the budget and treasury divisions, as well as a large number of tax inspectors. These functions are being performed under a newly established legal and regulatory framework which includes regulations and procedures on the functioning of the divisions, procedures on expenditure authorization, accounting and reporting, regulations on procurement of goods and services as well as tax legislation and procedures on revenue collection and administration. Internal audit capability reporting to the highest level of UNMIK is also under preparation.

Despite this impressive progress challenges remain to complete the development of budget management institutions. The budget and treasury system should be extended beyond UNMIK's spending departments and the budgetary transactions should be carried out as appropriate by the spending units. This requires further developments in the treasury and payments system. It also requires significant strengthening of budget and financial management capacities to the spending units to ensure a transparent and accountable use of budgetary resources. This last link in the expenditure chain is being worked on by the CFA and UNMIK in cooperation with the Banking and Payments Authority. Although the 2000 budget was prepared in consultations with the spending departments, formal procedures need to be developed to guide the budget formulation process for 2001 and beyond. Moreover these procedures should include recurrent and investment expenditures in order to ensure an integrated approach to budget planning, the formulation of a coherent budget strategy, and better coordination of foreign donors that finance entirely investment expenditures.

Despite continuous progress in developing budget management institutions several challenges remain to ensure that the JIAS functions as a cohesive structure that is able to formulate and implement public policies and programs and take decisive actions to address the fiscal risks faced by the 2000 budget.

The task of a finance ministry in the circumstances of today’s Kosovo is an exceptionally difficult one. This applies to budget formulation as well as execution. The fiscal base is uncertain in view of the difficulties in projecting real rates of growth of the economy from a very low base under conditions of major institutional changes. Customs and tax administrations are being reinforced, but uncertainties surround their capacity, speed of strengthening, and willingness to apply the law fairly.

Closing the two major tax gaps: Montenegro and FYR Macedonia. A tax point was to have been established at the boundary point with Montenegro on January 1, 2000 but this was not done until March; the delay is estimated to have cost DM 20 million in revenues. The tax post took some time to be fully functional . There appears to be widespread evasion of excise taxes. With respect to FYR Macedonia, the budget assumes the repeal of the preferential trading arrangement, and it is hoped that UNMIK will soon take steps to this end as delay in closing this gap is leading to revenues losses associated with both Macedonian goods and false certificates of origins on goods purporting to be of Macedonian origin.

Delayed introduction and low compliance with hotel food and beverage tax. The later than expected introduction and low compliance with this tax has resulted in lower than expected revenues estimated for the 2000 budget. Actions would need to be taken to introduce more aggressive compliance measures to make up for some of the revenue loss, through training, education, and registration.

Prompt institution of domestic coverage for sales and excise taxes and the payroll tax. The delay in introducing the payroll tax has already caused loss of revenues for the budget. In addition, much will depend on tax administration capacity and the willingness of the populace to pay these taxes.

Adhering to the public sector wage bill as given in the budget. The major risks to an increase in the wage bill might come from two directions: (i) an increase in the average wage; and (ii) an increase in the number of budget employees. There are pressures to raise overall wages and to change relativities. Competition between several Spending Departments for qualified personnel is causing the salaries to raise, even while maintaining the current wage multiplier structure. This is being achieved by promoting persons to higher wage brackets in the wage structure and using supplementary benefits such as overtime and hazard pay, to effectively give salary increases. A higher average wage is unsustainable over the medium term and would lead to an irresponsible budget. The prompt implementation of the wage tax is vital. A decision is required from UN New York to authorize the implementation of this tax, covering, inter alia, local employees of UNMIK.

The budget estimates are based on a significant fall in public employment, particularly in education and health to eliminate ghost workers. Reducing employment numbers has proven difficult so far, while there has been new hiring in other departments that had experienced shortage of personnel. In addition, because of personnel hiring delays in the startup phase of the budget programs, the monthly personnel costs at the end of 2000 will be much larger than for the first few months, thus exceeding the average monthly cost for the year. As a result staffing patterns may be poised to put significant upward pressure on the wage bill for 2001. Therefore, maintaining the number of employment within the levels estimated in the 2000 budget makes indispensable elimination of overstaffing in education, health and public utilities. Achieving this will be difficult given the strong sense of entitlement to a job and public opinion that calls for a mainstreaming of all parallel system workers. At best, it may take considerable time.

There are likely to be pressures (within UNMIK itself) for subsidies to public enterprises in order to re-start certain enterprises (regardless of their ultimate economic viability). In addition greater-than-budgeted subsidies to the electric sector to make up for possible slow cost recovery and non-payment of charges as well as overstaffing pose a real threat to the overall spending levels for 2000. Public utilities have drawn 48 percent of their annual subsidy and a great danger remains for overspending these amounts until the end of the year. These pressures must be resisted with determination and serious remedial actions should be taken from the KEK to pursue payments of electricity bills.

As implementation of capital investment projects progresses, there will be pressure on the Kosovo Consolidated Budget for higher proportions of operating expenses to go towards maintenance of the investments, particularly in the case of roads and other infrastructure. This could also be a significant issue in the utilities sector, although in principle that pressure should be contained within the operating costs and pricing structure of the utility providers.

Although some progress has been made during the last few months, capacities for strategic policy formulation at the sector spending departments of UNMIK remain weak. A systematic process that defines main sector policy objectives and priorities and ways to implement them should be institutionalized as part of the overall budget formulation process. This would require strengthening capacities for:

• Setting overall objectives in the sector;
• Defining the appropriateness of public service provision in the sector consistent with these objectives and the overall economic program; and
• Defining strategic programs in the sector and identifying priorities for which budgetary resources (recurrent and investments) will be needed consistent with the overall resource framework.

The objective is to be able to have the right information and analytical work for the preparation of short strategy statements for each sector that can be used as an input into the preparation of a comprehensive budget strategy and expenditure framework and presented for discussions to a high level inter-sectoral decision making body and subsequently to the donor community. In this context, it should be noted that statistics services in Kosovo today are almost non-existent. Clearly, there is an urgent need to collect and process basic economic and social statistics; the strengthening of the statistical bureau must be a priority.

At present, and in particular for the preparation of the Kosovo 2001 budget, the preparation of sector strategy statements can benefit from the expertise and the analytical work that international organizations such as WB, EU, WHO, UNICEF and others have been providing in different sectors such as education, health, social protection, infrastructure, etc. However, given the involvement of so many donors sometimes even within one sector, it is imperative that capacities within the spending departments are created to ensure consistency with the overall policy objectives in the sector and timely implementation of budget and donor financed projects.

Given the unique and somewhat fragmented administrative structure in Kosovo, as well as significant amounts of foreign aid to finance reconstruction efforts and capital investment projects, there is clearly a risk of creating a segregated policy formulation and subsequently a dual budget process, undermining the formulation of a coherent budget strategy and expenditure framework. Experience from other countries in the region shows that such a segregated process has negative implications also for project and program implementation that are associated with delays in disbursement of funds from the donors and insufficient recurrent expenditures for operating and maintaining investment projects.

The establishment from UNMIK of the new Department for Reconstruction (DOR) has been a positive step in an effort to coordinate the donors and the reconstruction efforts in Kosovo, a process that earlier was taking place somewhat unsystematically by the individual spending departments of UMNIK. However, this department was created outside the CFA, with a mandate that goes well beyond just the coordination of the reconstruction efforts and into the formulation and implementation of a strategy for reconstruction. This organizational structure does not encourage an integrated planning and implementation process. While it is necessary to review, evaluate and coordinate external financed projects, there is a risk that such an exercise usually reflected in the preparation of a donor-funded Public Investment Program (PIP) would be accorded undue priority. As a result, the investment planning process would focus primarily on the need for donor coordination, thereby crowding out the vital need for the preparation of a comprehensive and integrated budget strategy that reflected the priorities of an overall program.

As a first step towards a more integrated process the mandate of the DOR should be revised to serve as a department for project coordination and evaluation (including maintaining formal contacts with the donor community) and ensure consistency between investment projects, policy priorities in the sector and overall program. It is vital that policy formulation and implementation should be left with the spending departments. DOR should, however, maintain responsibility for creating an information database and strengthening capacities for project evaluation, especially in the sectors where most of the donor financing is being directed. In the interim it should also take responsibility for coordinating the preparation of the KPIP. However, the preparation of the KPIP should be gradually subordinated to the broader task of preparing, from a very weak base, a comprehensive expenditure framework and be considered as a step in a process aimed at integrated sector expenditure programs within a comprehensive budget framework.

The benefits of an integrated process include, but are not limited to:

• Investment planning would not risk wasting resources by planning investments whose full costs, both investment and recurrent, are unlikely to fit within the overall financing resources of Kosovo;

• Investment projects can be assured that adequate resources, both investment and recurrent, will be available to allow their being both completed and subsequently maintained and operated as planned;

• Budget decisions can realistically address the recurrent cost requirements of investments at a point in the decision-making process that allows rational tradeoffs;

• Strategic decisions requiring tradeoffs between broad policy areas or sectors can occur at a point in the policy formulation process that allows rational tradeoffs;

• Overall fiscal policy decisions can occur at a point in the policy-making process that allows them to impose fiscally sound, realistic and binding budget constraints on the decisions affecting each of the individual components of the budget, both investment and recurrent; and

• Deliberate and carefully considered decisions, rather than donor preferences, can determine strategic priorities and budget allocations, both investment and recurrent.

There is wide latitude of organizational arrangements for achieving those benefits, but it is important that clear and enforceable rules are established to guide the interactions of different stakeholders.

Linking the policy formulation process with planning and resources (budgeting) in a resource constrained environment such as the one in Kosovo, requires that difficult decisions are taken on inter-sectoral and intra-sectoral tradeoffs, consistent with the policy objectives within the sectors and consistent with UNMIK's overall program. These broad policy and program tradeoffs can be made by a decision making body at the center of the administration that has the right incentives to make the necessary tradeoffs and has adequate authority to enforce them. Such a body should be the forum to ensure that policy formulation and budget decisions are made in the right sequence and also serve as a mechanism for ensuring accountability during the implementation of sector strategies and priority programs and ensure that intended results are being achieved.

Positive steps have been taken in Kosovo to establish such decision-making mechanisms. The Interim Administrative Committee (IAC) of JIAS, which includes the SRSG and his deputies as well as the highest representatives of Kosovar major political groupings serves currently as the highest level decision making body in the administration. However, there is a gap between IAC and individual Department Co-Heads which should be filled by a mid-level decision making body such as an Economic Policy Board that can be formed with Co-Heads of the Departments most concerned with economic policy and development issues. An Economic Policy Board would constitute a better exchange of information, views and ideas between the different departments of UNMIK, a more transparent and consultative decision making process and it will help the IAC take better informed decisions in their policy deliberations. It will also ensure consistency between sector policies and strategies and better implementation of their programs. This forum should replace the idea of the Investment Board which is associated with the DOR, which as discussed in the above section, would undermine an integrated policy formulation and budget process.

An Economic Policy Board as a decision making body would also ensure an appropriate sequence in the policy and budget formulation process. Major stages in such a process would include: (i) the approval of the macroeconomic framework which defines the resources and provides the context against which major budget issues are discussed (e.g., wage policy); (ii) the development of sector strategies and sector priority programs; and (iii) the preparation of expenditure plans to finance these priority programs. Maintaining this sequence is essential to ensure the link between the policy formulation and the budget process and at the same time ensure that policy and expenditure priorities are being defined consistent with the overall program and resource constraints.

Design of the structure of municipal finance in Kosovo presents a significant dilemma. Kosovo has a provincial government and 29 municipalities. The desire for devolution is strong and widespread, but the design of a devolved structure is complicated by large variations in the size, economic potential, income per head and capabilities of the municipalities. In view of the traditions of strong local government and the experience of locally financed and administered service provision in the operation of the parallel system, it appears inevitable that a significant role for local government will be a feature of any future long term system of government in Kosovo.

In view of the heritage of informal and in part illegal operations of the parallel institutions, especially in revenue generation, there is an urgent need to establish a transparent and legitimate framework for government institutions at local level. In particular, this must include clear and comprehensive assignment of revenue and expenditure functions and a transparent framework for financing of local government, embracing both transfers from the provincial government and external financing. Absence of clarity in all these features of the framework for local government will lead to continuing prevalence of informal operations, tending to subvert accountability of public sector institutions more generally and building up substantial long-term governance problems for future public administration in Kosovo.

While the urgency of establishing a clear framework for local government institutions is undeniable, the absence of representative institutions at any level as yet in Kosovo poses serious difficulties for establishing such a framework in the near future. The task for design of municipal finance is therefore the difficult one of identifying arrangements which give maximum transparency, accountability and efficiency in the near term while leaving open the possibility of radical restructuring in due course, following the development of representative institutions and an extensive process of consultation on long term goals for devolution within the province.

Expenditure assignment. The approach to fiscal devolution in the social sectors, as described separately in the chapters on education, health and social protection, generally advocates that a substantial proportion of expenditure in these sectors will be delegated to municipal level. However, the volume of such expenditure in each sector will be determined by criteria set at the center, rather than assigned as local responsibilities within a fully devolved budget. Service delivery will be delegated, but the municipalities will not at this stage have the option to switch resources between sectors. In education, it is proposed that services at municipality level would be financed as block grants on a per student basis. For health, financing will be handled through the health insurance fund managed at the level of the province. On social protection expenditure, central administration is recommended for contributory benefit schemes in due course, as operation of the pension system resumes. For social assistance, some discretion in the administration of such schemes would be desirable, constrained by imposing local budgetary limits or by including a local element in the financing of the scheme.

For other areas of expenditure at municipal level it is assumed that financing would continue to be covered by block grant from the center on a simple formula basis, supplemented in due course with local revenue, including cost recovery measures where appropriate. These areas will include municipal administration, and other local services such as waste management, district heating and fire services.

On the criterion of proportion of delegated expenditure within general Government expenditure, the net impact of the approach summarized above would be a relatively decentralized structure. Aggregation of all categories of expenditure assumed delegated to municipal level would amount to approximately 26 percent of general Government expenditure. Allowing for some delegated expenditure in infrastructure maintenance and some role of municipalities in direction of social assistance spending, the proportion might be somewhat higher. This compares with recent data for other countries in the region of around 20 percent for Albania and 12.5 percent for Croatia.

Measured on other dimensions, the degree of decentralization is relatively cautious. Own revenue at local level will take time to develop and is not in any case expected to cover a large proportion of local expenditure. In the approach described above, the municipalities will have relatively little discretion to switch funds between major programs. However, by ensuring that management of service delivery is generally maintained as far as possible at local level, building on existing capacity, the overall system remains poised for a program of fuller decentralization should political will be so expressed at a later stage.

Financing. The general revenue grant to municipal government as included in the FY 2000 budget should be retained as the main mechanism for financing core functions, including a fixed lump sum payment for each municipality and a per capita grant based on total population in each municipality. The population-based element of the grant is a proxy for basic needs of municipalities and widely used for defining intergovernmental transfer payments throughout the world. As a robust, simple and broadly equitable mechanism, this arrangement should be retained in this form at least for the period prior to any comprehensive review of local government institutions. Application of the formula should make use of more accurate population data as soon as possible, while recognizing that this will give rise to transitional difficulties for municipalities which currently benefit from grants based on excessive estimates of population and will probably require a limited period during which rates are gradually adjusted towards the new levels.

Municipalities also benefit from external financing, a substantial proportion of which remains outside the budget. It is as important at the municipal level as for the center that such financing is integrated within the budget, not least in order to permit a realistic assessment of fiscal sustainability at municipal level.

Financial management. While the long-term architecture of local government may need to await a broader political settlement, development of financial management capacity at municipal level may be one of the most important contributions that can be made now for accountable local government in the long term. An important contribution will be the development by the Department of Local Administration of the framework for municipal accounting consistent with system adopted in the CFA and training of municipal officials in budget management.

¹ See Volume 1, Chapter 2 of this report for further details.