Georgia: Managing Expenditure Pressures for Sustainability and Growth by World Bank in Europe & Central Asia

Public Disclosure Authorized

Georgia Public Expenditure Review

Managing Expenditure Pressures for Sustainability and Growth

Report No. 73701-GE

Georgia

Public Expenditure Review

Managing Expenditure Pressures for Sustainability and Growth

November 2012 Poverty Reduction and Economic Management Unit Europe and Central Asia Region

Managing Expenditure Pressures for Sustainability and Growth

CURRENCY EQUIVALENTS (Exchange Rate as of November 15, 2012) Currency Unit: Georgian Lari US$1.00 = 1.6662 GEL Weights and Measures: Metric System Abbreviations and Acronyms BCR BDD CAD CBA CEA CIF DBOMT

DPO EBRD

EC EU FDI GDP GEL GMI HBS HDM HUES IDA IDPs

Benefit-Cost Ratio Basic Data and Directions Current Account Deficit Cost-Benefit Analysis Cost Effectiveness Analysis Curatio International Foundation Design-Build-Operate-Maintain and Transfer

Development Policy Operation European Bank for Reconstruction and Development European Commission European Union Foreign Direct Investment Gross Domestic Product Georgian Lari Guaranteed Minimum Income Household Budget Survey Highway Development and Management Model Health Utilization and Expenditure Survey International Development Association Internally Displaced Persons

Vice President: Country Director: Sector Director: Sector Manager: Task Team Leader:

IMF LSMS MIP MIS MoF MoLHSA MRDI

MTEF OOP

PER RAMS RD RDD RHS SOEs SSA TSA VAT WHO

International Monetary Fund Living Standards Measurement Survey Medical Insurance Plan Management Information System Ministry of Finance Ministry of Labor, Health, and Social Affairs Ministry of Regional Development & Infrastructure Medium Term Expenditure Framework Out-of-pocket Payment

Public Expenditure Review Road Asset Management System Road Department Regression Discontinuity Design Reproductive Health Survey State-Owned Enterprises Social Services Agency Targeted Social Assistance Value Added Tax World Health Organization

Philippe Le Houérou Henry Kerali Yvonne Tsikata Ivailo Izvorski Faruk Khan

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Managing Expenditure Pressures for Sustainability and Growth

Contents Preface ix Executive Summary xi Chapter 1. Macroeconomic Context and Expenditure Composition 1 1.1. Introduction 1 1.2. Macroeconomic Context: Why is Fiscal Consolidation so Important? 2 1.3. Expenditure Composition 9 1.4. Conclusion: the way forward 17 Chapter 2. Social Protection Expenditures 19 2.1. Introduction 19 2.2. Overview of Social Protection Spending 20 2.3. Pension System 22 2.4. Social Assistance 32 2.5. Some Cross-Cutting Themes 39 2.6. Conclusion: the way forward 39 Chapter 3. Health Expenditures 41 3.1. Introduction 41 3.2. Overview of health spending in Georgia 42 3.4. Health spending and financial protection 47 3.5. Policy Issues 49 3.6. Conclusion: the way forward 58 Chapter 4. Capital Budgeting Systems 59 4.1. Introduction 59 4.2. Improving the Content and Presentation of Georgia’s Capital Budget 61 4.3. Strengthening the Broader Capital Budgeting System 69 4.4. Conclusion: the way forward 82 Chapter 5. Road Sector Expenditures 83 5.1. Introduction 83 5.2. Key Issues in Sustainability and Efficiency 84 5.3. The Road Network 86 5.4. Road Expenditures and Outputs to date 88 5.5. The Medium Term Road Investment Program 92 5.6. Institutional Arrangements for Improved Efficiency 97 5.7. Conclusion: the way forward 99

Contents

Georgia Public Expenditure Review 2012

List of Figures

Figure 1. GDP Growth, Investment, Savings Figure 2. External Debt, Current Account Figure 3. Fiscal Framework Figure 4. Composition of Public Expenditures Figure 5. Dependency Ratios in Georgia Figure 6. Pension Costs with Constant Replacement Rate Figure 7. Coverage of MIP Figure 8. Government and OOP Health Spending in ECA Figure 9. Road Network in Georgia Over Time Figure 1.1. GDP Growth, Exports, and Imports Figure 1.2. CA Deficit, Investment, FDI, Savings Figure 1.3. Fiscal Framework Figure 1.4. Fiscal Framework Figure 1.5. National, Public, and Private Savings Figure 1.6. Real Effective Exchange Rate Figure 1.7. Expenditure Composition, Functional Figure 1.8. Expenditure Composition, Functional Figure 1.9. Expenditure Composition Figure 1.10. Expenditure Composition Figure 1.11. Public Capital Expenditures Figure 1.12. Public Capital Expenditures Figure 1.13. Current and Capital Expenditures Georgia and Selected Countries, 2010 Figure 1.14. Composition of Expenditures, Economic Classification, Georgia and Selected Countries Figure 1.15. Composition of Expenditures, Functional Classification, Georgia and Selected Countries Figure 2.1. Social Protection Spending in Georgia and Region Figure 2.2. Poverty Trends in Georgia, 2003–09 Figure 2.3. Pension trends in Georgia Figure 2.4. Poverty Implications of Increases in Monthly Pension Benefit Figure 2.5. Demographic trends in Georgia , 1990–2050 Figure 2.6. Pension Indicators under Alternative Scenarios, Without Indexation Figure 2.7. Pension Indicators under Alternative Scenarios, with Price Indexation Figure 2.8. Pension Indicators under Alternative Scenarios, With Wage Indexation Figure 2.9. Pension Indicators with Combined Basic And Supplementary Pension Programs Figure 2.10. Incentivizing Voluntary Savings in the Presence of a Basic Pension Figure 2.11. TSA in Georgia Figure 2.12. TSA Targeting and Coverage By Decile, 2009–11 Figure 2.13. Coverage and Targeting of TSA in International Context

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xiv xiv xv xv xvii xvii xviii xviii xxi 3 3 6 6 8 8 11 11 12 12 13 13 14 15 16 21 21 23 23 24 25 26 27 28 29 33 34 34

Managing Expenditure Pressures for Sustainability and Growth

Figure 2.14. Cumulative Distribution of Consumption With And Without TSA 35 Figure 2.15. Generosity of Georgia’s TSA Vis-a-Vis Other Social Assistance Programs 37 Figure 2.16. Age Distribution of TSA Beneficiaries, 2009 37 Figure 2.17. Labor Force Status of TSA’s Working Age Beneficiaries 37 Figure 2.18. No Impact of TSA Receipt On Labor Force Participation, 2007 38 Figure 3.1. Population Priorities for Government Investment In Georgia, 2010 41 Figure 3.2. Public and Private Health Spending, Europe and Georgia 43 Figure 3.3. Govt and Out-Of-Pocket Spending on Health in Europe and Georgia (2010) 43 Figure 3.4. Life Expectancy at Birth, Georgia and the World, 1970–2008 44 Figure 3.5. Cigarette Taxes in Georgia and Europe, 2009 46 Figure 3.6. Coverage of Preventive Care Services, Georgia Vs. Comparators 46 Figure 3.7. The Impact of Household Spending On Health On Poverty, 2010 48 Figure 3.8. Financial Protection and Equity Indicators, Georgia and ECA Comparators 48 Figure 3.9. Coverage and Targeting Of MIP, 2009–11 51 Figure 3.10. Out-of-Pocket Spending per Episode 51 Figure 3.11. Pharmaceutical Price and Availability Trends, 2009–2011 55 Figure 3.12. Brand and Generic Drug Prices, Georgia and EU 55 Figure 3.13. Estimated Average Combined Wholesale and Retail Margins, Georgia and Selected EU Countries 56 Figure 3.14. First Place of Contact When Ill, Georgia and Regional Comparators 57 Figure 4.1. The Project Cycle 69 Figure 5.1. Evolution of Road Expenditures and Outputs 89 Figure 5.2. Condition of the International and Secondary Road Networks 90 Figure 5.3. Sharp Decline in Periodic Maintenance Funding in Recent Years 90 Figure 5.4. Periodic Maintenance—Actual 2007–10 versus Need 2010–19 96 Figure 5.5. Government Roads Program and Alternative Illustrative Scenario 97

List of Boxes

Box 2.1. Tax Treatment For Funded Pension Systems Box 4.1. Rationale for Introducing a ‘Capital Budget’ Box 4.2. A More Comprehensive Estimate of State Budget-Funded Capital Expenditure Box 4.3. Proposal for Preliminary Assessment Form for Major Projects Box 4.4. Examples of methodological guidelines from other countries Box 4.5. Main Contents of US Capital Programming Guide

31 62 66 75 78 81

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Contents

Georgia Public Expenditure Review 2012

List of Tables

Table 1. Policy Options for Consideration to Manage Fiscal Expenditure Pressures Table 2. Strengthening Capital Budgeting: International Practice in Identification, Preparation, and Appraisal Table 3. Road Network in Georgia in International Context Table 1.1. Georgia: Selected Economic Indicators, 2003–2011 Table 1.2. Georgia: External Financing 2007–15 Table 1.3. Georgia: Composition of Medium Term Expenditure Framework (2011–15) Table 2.1. Overview of Social Spending in Georgia, 2008–11 Table 2.2. Old-age Pensions Accounts for the Bulk of Social Spending Table 2.3. Poverty Rate in Georgia with and without Old-age Pensions Table 2.4. Incidence of TSA by area (rural/urban) Table 3.1. Average Annual Per Capita Out-Of-Pocket Payments, By Category (2010) Table 3.2. Utilization Rates in Georgia Are Low (2010) Table 3.3. Coverage of Key Health Interventions in Georgia is Low Table 4.1. Alternative Figures for Capital Expenditure from State Budget Table 1. Estimates of Total Capital Expenditure and its Functional Distribution Table 4.2. International Experience in Identification, Screening, and Appraisal Table 4.3. Assessment techniques by project value in Ireland Table 5.1. Road Network in Georgia Table 5.2. Road Coverage in Selected Countries Table 5.3. Expenditures on International and Secondary Road Networks (2004–2010) Table 5.4. State Government Transfers and Expenditures on Local and Urban Roads Table 5.5. Actual and Planned Road Expenditures, 2007–2014 Table 5.6. Asset Value of Road Network in Georgia Table 5.7. Alternative Illustrative Scenario for the Medium Term Road Program Table 5.8. Value for Money: Cost and Time Savings: State of Florida 1997–1998

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xix xxi 5 7 10 20 22 23 35 43 45 45 65 66 74 78 86 87 89 91 93 94 95 99

Managing Expenditure Pressures for Sustainability and Growth

Preface This public expenditure review (PER) is the result of a body of programmatic fiscal work directed at identifying policy options to manage fiscal consolidation in Georgia. The programmatic fiscal analysis has been conducted in close coordination with Government counterparts, and has used intermediate outputs of the ongoing analyses, including power-point presentations, just-in-time policy notes, and missions as inputs into a continuous dialogue on the Government’s fine-tuning of its public expenditure policy. Specific examples of inputs into this dialogue include a policy note and presentation on Strengthening Capital Budgeting in Georgia to inform preparation of the 2011 capital budget; a policy note and presentation on pension reform to inform the Government’s deliberations in 2011 on options to raise pensions; and a presentation on key findings and messages of the PER to inform the 2012 budget preparation; and an earlier presentation on policy options for refinancing Georgia’s Eurobond. The programmatic fiscal work has complemented the dialogue on the programmatic Development Policy Operation (DPO) series. This PER was prepared by a Bank team comprising Faruk Khan (Task team leader), Owen Smith, Anita Schwarz, Simon Groom, Mirtha Pokorny, Elene Imnadze, Mariam Dolidze, Sergiy Biletskyy, Nino Moroshkina, Elizabeth Currie, and Thordur Jonasson. The primary authors of the report are Faruk Khan (chapter 1, with inputs from Mariam Dolidze), Owen Smith (chapters 2 and 3), Anita Schwarz (pension part of chapter 2), Simon Groom (chapter 4), and Mirtha Pokorny (chapter 5). The report also benefited from comments and suggestions received from Jean-Francois Marteau, Benjamin Gericke, Joseph Melitauri, Rodrigo Archondo-Callao, Tamara Sulukhia, Ahmed Eiweida, Ramya Sundaram, Meskerem Mulatu, Rashmi Shankar, and Pedro Rodriguez. Zakia NekaienNowrouz assisted with formatting the report.

The team has benefited from the guidance of Henry Kerali (Country Director), Asad Alam (former Country Director), Yvonne Tsikata (Sector Director), and Ivailo Izvorski (Sector Manager). Kazi Matin provided guidance at earlier stages of the analysis. The peer reviewers were James Brumby and Marijn Verhoeven. Shabih Mohib and Rosa Maria Alonso Terme provided comments at concept stage.

The team is grateful to government officials from the Ministry of Finance, Ministry of Labor, Health, and Social Affairs, Ministry of Infrastructure, the Roads Department, the National Bank of Georgia, and other branches of government for their cooperation in conducting the analysis and for their comments and suggestions on various drafts of the work.

Preface

Managing Expenditure Pressures for Sustainability and Growth

Executive Summary Economic growth has rebounded strongly in Georgia during 2010–12 and commendable fiscal consolidation has been implemented, although considerable medium-term macro-fiscal challenges remain. Growth rebounded strongly to 6.7 percent a year during 2010–11, but the external current account deficit remains large at 11.8 percent of GDP in 2011. External repayment obligations during 2012–14 are significant, although the authorities have built fiscal buffers to help manage the payments due. Georgia also remains vulnerable to the possibility of a sharper global downturn related to the evolving euro-zone crisis. In addition, national savings are insufficient to finance the necessary investment and exports and tradables have not yet begun to serve as the engine of rapid economic growth. In this context, the authorities have implemented a commendable fiscal consolidation program, with the overall fiscal deficit down from 9.2 percent of GDP in 2009 to 3.6 percent in 2011, to serve as a cornerstone of sustainability. To meet the challenge of generating rapid and sustainable growth in an uncertain global environment, Georgia will need to continue to implement and potentially deepen its fiscal consolidation program. Addressing the growth and sustainability challenges noted above will require further reducing the overall fiscal deficit from 3.6 percent of GDP in 2011. This will create additional space for a fiscal response in the event of a sharp global economic shock and also further bolster debt sustainability. Furthermore, in the event of an upside growth scenario with higher foreign direct investment and capital inflows, deepening fiscal consolidation is an option that may help prevent erosion of national savings, avoid a widening of the current account deficit, and resist real exchange rate appreciation pressures.

This public expenditure review (PER) considers possible sources of expenditure pressure that may affect the fiscal consolidation program and suggests options to manage them. There is broad consensus, underpinned by the government’s medium term macro-fiscal framework, that fiscal consolidation will require reducing overall expenditures by about 3 percentage points of GDP through 2015. At the same time, considerable social and infrastructure needs remain in an environment where the opportunities to extract fiscal space from other areas has diminished. Social expenditure pressures arise from the need to provide adequate old-age income to an aging population that relies primarily on the basic publicly funded pension benefit. Additional pressures arise from the need to improve social assistance coverage of the poor and from the need to improve health outcomes and financial protection against impoverishing out of pocket health payments. Capital expenditure pressures arise from the need to rehabilitate and reconstruct a large backlog of the secondary and local road network in poor condition, as well as from continued improvement of the main international East-West Highway. Additional pressures arise from new investment needs in the energy, water, agriculture, and regional development areas. Continued implementation of the fiscal consolidation program will require managing these underlying pressures in a systematic fashion, so that expenditures do not exceed currently envisaged levels. This PER presents a number of options for consideration to manage fiscal consolidation, which can contribute toward greater selectivity in capital expenditures, enhanced sustainability of the road investment program, and containing medium-term social expenditure pressures. The specific options for consideration are outlined in Table 1. In the event of an upside growth scenario, deepening the planned

Executive Summary

Georgia Public Expenditure Review 2012

Table 1. Policy Options for Consideration to Manage Fiscal Expenditure Pressures Policy Area

Option for Consideration

Maintain fiscal discipline by further reducing overall fiscal deficit from 3.6 percent of GDP in 2011 through further consolidation of expenditures by 3 percentage points of GDP Macro-Fiscal by 2015 In event of upside growth scenario from higher FDI and capital inflows, deepen fiscal consolidation by saving additional revenues and bolstering fiscal buffers Enable capital expenditures to make a contribution to expenditure consolidation going forward, particularly as private investment picks up1

Expenditure Manage expenditure consolidation through Composition greater selectivity in capital expenditures, containing medium term social expenditure pressures, and enhancing sustainability of road investment program (greater detail on each below)

Selectively target any further significant onetime jumps in the basic pension benefit

Pensions

Social Assistance

Health

Sequencing

Short/Medium Create additional fiscal space term for response to global shocks; prevent erosion of national savings and widening of Short/Medium current account deficit term Collective impact on expenditure pressures in balance between Short/Medium Maintain social and capital expenditure 2015: term needs -2.8% of GDP (Breakdown below) Short term

Explore mechanism to limit medium-term growth of the basic pension benefit to no more Medium term than the rate of inflation

Develop voluntary savings for retirement by undertaking diagnostic of impediments and policy initiatives in the areas of tax treatment, Medium term opt-out vs. opt-in, and financial instruments

Improve TSA coverage of poor through improved outreach and proxy-means formula

Prioritize TSA over universal programs (e.g., pensions and energy vouchers) for any additional social spending increases

Link TSA recipients to employment opportunities and human capital investments

Avoid jump in fiscal costs and enhance equity

Protect purchasing power and set expectations at sustainable levels

Ease pressure for ad hoc and unsustainable benefit increases

Short term

Enhance equity of overall social benefits

Medium term

Reduce pressure on TSA in medium term

Reduce high out-of-pocket pharmaceutical spending by promoting use of generics

Short term

Expand state-funded health insurance coverage with focus on lower deciles on population

Medium term

Address weaknesses in supply of medical care, Medium term with focus on primary care

(continued to next page)

Expected Impact

-3.2% of GDP

+0.2% of GDP

Improve health outcomes and reduce impoverishing out of +0.3% of GDP pocket health payments

fiscal consolidation by saving a part of the additional revenues can prevent erosion of national savings and keep external imbalances in check, while encouraging a shift toward a sustainable growth path driven by tradables. Capital expenditures can make a greater contribution to adjustment going forward, with most adjustment to date coming from current expenditures. The pension options aim to avert large unsustainable jumps in pension costs, set expectations at sustainable levels, and ease pressure on the basic benefit. In social assistance, 1 The latest approved fiscal framework envisages a consolidation of overall expenditures by 3 percentage points of GDP from 2011 to 2015, with part of this coming from capital expenditures. The authorities have noted that the level and composition of the expenditure consolidation path needs to be tailored to the evolving local context, with the overall goal of staying on track with fiscal consolidation. The availability of concessional financing and evolving needs for competitiveness enhancing public investment are important considerations for maintaining fiscal stability and growth.

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Managing Expenditure Pressures for Sustainability and Growth

Table 1 continued Policy Area

Capital Budgeting

Option for Consideration

Further improve content and presentation of capital budget by extending coverage, demonstrating consistency in financial information, and deepening non-financial information

Introduce a systematic preliminary assessment and project identification process

Sequencing Short term Medium term

Develop uniform methodological guidance on appraisal techniques

Medium term

Develop systematic comprehensive capital budgeting system guidelines

Medium term

Strengthen strategic guidance

Increase routine and periodic maintenance expenditures in line with HDM recommendations, as allowed by resource constraints

As EW Highway investment winds down, phase in rebalancing of outlays for rehabilitation and new construction to Road Sector reduce backlog of secondary network in poor condition Develop a viable system for attending to needs of local road network by initiating rehabilitation of target subset

Put in place institutional arrangements to improve road expenditure efficiency

Medium term

Expected Impact Transparency/accountability; strengthen public investment programming Strengthen screening and selection among competing public investment project proposals

-0.8% of GDP

Short term Medium term Short term

Improve long run sustainability and efficiency of road investment program

+0.7% of GDP

Short/Medium term

the options aim to improve effectiveness of overall social benefits and reduce pressure on the targeted social assistance (TSA) program in the medium term. In health, the options seek to improve health outcomes and financial protection against impoverishing out-of-pocket payments. The options to strengthen capital budgeting seek to most effectively manage the growing pipeline of infrastructure project needs within the fiscal envelope by improving transparency and by improving screening and selection of projects. The options in the road sector seek to further improve long run efficiency and sustainability of the road investment program. Collectively, this set of suggested measures can help Georgia manage the expenditure pressures pertaining to the fiscal consolidation program, thus mitigating the risk of expenditures exceeding envisaged levels while supporting improved development outcomes.

The policy options discussed above could collectively curtail expenditure pressures estimated at about 2.8 percent of GDP by 2015. In other words, without the policy options, the underlying pressures could potentially push overall expenditures in 2015 to 31.8 percent of GDP instead of the currently envisaged 29 percent. While the exact magnitude of the impact would depend on the extent of the underlying pressures and the efficacy of the specific options adopted to curtail them, the impact would come from the following sources. A large part of the savings (3.2 percent of GDP) would come from averting large ad hoc jumps in the basic pension benefit by limiting its medium growth to no greater than the rate of inflation, while developing voluntary savings for retirement. Both of these measures would ease expectations from a growing old age population for a higher replacement rate from the basic benefit.2 The options to improve coverage of the targeted social assistance and 2

In the counterfactual scenario, the pension benefit replacement rate rises to about 24 percent of the real wage by 2015 (equivalent to the replacement rate if the benefit had increased to GEL 165 for all from September 2012), while the scenario for the recommended reforms is to index the basic benefit from nominal levels announced for September 2012 (GEL 100 for all and GEL 125 for those age 67 and over).

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Executive Summaryâ&#x20AC;&#x192; â&#x20AC;&#x192;

Georgia Public Expenditure Review 2012

medical insurance programs would cost about 0.2 percent and 0.3 percent of GDP, respectively, in 2015.3 The measures to induce greater selectivity and efficiency in capital budgeting are estimated to save 0.8 percent of GDP (assuming a 10 percent improvement in efficiency without impacting growth prospects). Finally, the measures to improve sustainability and efficiency of road investment are estimated to cost about 0.7 percent of GDP, with higher rehabilitation and maintenance expenditures for secondary and local roads offset in part by phased winding down of new construction expenditures by 2015.

Macro-fiscal context Georgia has established a record of sound macroeconomic management since 2004 that has contributed to robust growth and declining public debt levels. Following the Rose Revolution in 2003, far-reaching structural reforms to strengthen public finances and improve the business environment helped boost growth to 9.3 percent per year during 2004–07. Tax revenues increased from 14.6 percent of GDP in 2003 to 25.8 percent in 2007 and although the fiscal deficit rose during this period, it was more than fully financed by higher privatization receipts. External public debt declined from 45 percent of GDP in 2003 to 16.8 percent in 2007. As the dual shocks of the August 2008 conflict and the global financial crisis resulted in a sharp downturn in growth, the authorities responded with a countercyclical fiscal stimulus to restore confidence and support economic recovery. Growth rebounded strongly to 6.3 percent in 2010 and 7 percent in 2011, and fiscal adjustment was implemented to safeguard sustainability. The fiscal deficit declined from 9.2 percent of GDP in 2009 to 3.6 percent in 2011 and external public debt declined to 29 percent of GDP in 2011 from a peak of 33.6 percent in 2010. Figure 1. GDP Growth, Investment, Savings

Figure 2. External Debt, Current Account

in percent and percent of GDP

in percent of GDP

-25

-20

20 40 15

-15 30

10 20

-10

0 -5 2005 GDP growth

2006

2007

2008

National savings (% GDP)

2009

Source: Georgian authorities and World Bank staff estimates.

2010 Investment (% GDP)

2011

0 2003

-5 2004

2005

External public debt (lhs)

2006

2007

2008

Total external debt (lhs)

Source: Georgian authorities and World Bank staff estimates.

2009

2010

2011

Current account balance (rhs)

Notwithstanding the sound record, Georgia faces macroeconomic challenges on two fronts— sustainability and growth—and addressing both will require continued implementation and potential deepening of the commendable fiscal consolidation program. The current account deficit has declined from 3

For TSA, this assumes a 20 percent increase in coverage and 10 percent increase in benefits; for MIP, it assumes a 25 percent increase in coverage and 25 percent higher premiums as utilization starts to rise.

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Managing Expenditure Pressures for Sustainability and Growth

a peak of 21.8 percent of GDP in 2008, but remains high at 11.8 percent in 2011. Furthermore, while successful refinancing of Georgia’s Eurobond helped smooth out its public debt repayment schedule, total public and private repayment obligations remain significant at about $2.5 billion for 2012–14 or about 5 percent of GDP per year, and total external debt remained relatively high at 58 percent of GDP in 2011.4 A broader deterioration in the global economic outlook could negatively affect exports, FDI, and other capital inflows that support growth in Georgia. In this context, fiscal consolidation provides the key anchor of sustainability by creating additional fiscal space for repayments and any necessary response to a wider global shock. The Government’s Ten Point Strategic Development Plan targets sustaining rapid growth and reducing the current account deficit by 2015. However, national savings remains low at 14 percent of GDP in 2011 and the real exchange rate appreciated by about 15 percent between July 2010 and April 2012, thus potentially eroding the competitiveness of tradables that is essential for growth. An upside growth scenario with higher FDI and capital flows would likely exacerbate these pressures, which could be contained by deepening fiscal consolidation by saving part of the additional revenues, thus bringing about an accelerated reduction in the overall fiscal deficit.

Implementing further fiscal consolidation will require skillful management in balancing important infrastructure development and social expenditure needs. Georgia faces important infrastructure development priorities in the areas of roads, water, and rural development to catalyze private investment and to create the conditions for strong growth in the long run. In addition, social expenditure pressures will be substantial due to the aging population, the need to improve overall health outcomes, and the need to improve coverage of the poor while unemployment remains high. Identifying and illustrating the implications of policy options to balance these competing priorities is the subject of this public expenditure review (PER) for Georgia. Implementing further fiscal consolidation in an environment with parliamentary and presidential elections scheduled for 2012 and 2013, respectively, will require particularly cautious and pragmatic management of public expenditure priorities. Fiscal stimulus in 2008–09 was associated with a substantial rebalancing of the composition of public expenditures. Social expenditures and infrastructure investment were scaled up as part of the fiscal stimulus to mitigate the impact of the crisis and support economic recovery. The pension benefit was raised from GEL 38 per month in 2007 to GEL 70 in 2009 and coverage and benefits were also raised for the targeted social

Figure 3. Fiscal Framework

Figure 4. Composition of Public Expenditures

in percent of GDP, 2007–15

38.4

32.1 30 29.3 24.4 20

34.9

28.3

28.5 25.4

30 30.9

30.3

29.7

27.4

27.3

27.1

26.9

24.7

30.1

25 25 23.3

23.5

21.8

20 15 10

9.2

0 2009

2010

Total expenditures

3.6

3.5

2.7

2011

2012

2013

2014

Revenues & grants

Tax revenues

Source: Georgian authorities and World Bank staff estimates.

8.4

8.9 7.2

6.6 2 2015

Overall fiscal deficit

0 Current Expenditure 2007

2008

2009

2010

Capital Expenditures 2011

2012

Source: Georgian authorities and World Bank staff estimates.

2013

2014

2015

External public debt repayments are lower and the authorities have built fiscal buffers to help manage these obligations.

Executive Summary

Georgia Public Expenditure Review 2012

assistance (TSA) and medical insurance programs (MIP). Public investment was scaled up in roads, municipal infrastructure, and housing for internally displaced persons (IDPs). Fiscal space for the stimulus expenditures was generated through a marked reduction in defense, internal security, and other recurrent expenditures. Current expenditure increased from 25 percent of GDP in 2007 to 30 percent in 2009, while capital expenditure remained high at 8.5–9 percent of GDP, but was accompanied by a significant reorientation from defense and internal security investments toward road and housing investments. The overall fiscal deficit increased from 4.7 percent of GDP in 2007 to 9.2 percent in 2009 and was financed in large part through higher donor assistance on concessional terms.

Fiscal adjustment in 2010–11 was associated with a further rebalancing of the composition of expenditures. As the economy rebounded strongly in 2010–11, significant fiscal adjustment was implemented primarily through the consolidation of current expenditures, with the overall fiscal deficit declining to 3.6 percent of GDP in 2011. Current expenditures declined from 30 percent of GDP in 2009 to 23.3 percent in 2011 as defense, internal security, and general administrative expenditures were consolidated further. Social expenditures also experienced some consolidation during this period. The pension benefit was raised further to GEL 80 in 2010 and GEL 100 in 2011, while some savings were realized through improved targeting of TSA and renegotiation of premiums of the MIP. Capital expenditures were maintained at 8.5–9 percent of GDP as private investment and FDI inflows remained weak. New investments in water and energy transmission have been added to continuing priority investments in roads, IDP housing, and regional and municipal infrastructure. In 2011, fiscal consolidation also benefited from an increase in tax revenues from 23.5 percent of GDP in 2010 to 25.4 percent in 2011, with about half of the increase due to onetime clearance of arrears by a couple of state owned enterprises.

Continued implementation of the fiscal consolidation program going forward will have to rely on further expenditure consolidation. The Government’s most recently approved medium term fiscal framework projects a reduction in the overall fiscal deficit to 2.1 percent of GDP by 2015 from 3.6 percent in 2011. Total revenues are projected to decline to 26.9 percent of GDP by 2015 from 28.5 percent in 2011 due to a winding down of grants, non-tax revenues, and one-off tax settlements. Given tax rates, collections are quite high in Georgia and exemptions are few, so that the room for further increasing the productivity of collections is limited. Furthermore, the appetite for higher tax rates is low and restricted somewhat by the provisions of the Economic Liberty Act. Expenditure consolidation will, therefore, need to make a greater than one-for-one contribution to the reduction of the fiscal deficit going forward, with the medium term fiscal framework projecting a decline in total expenditures from 32.1 percent of GDP in 2011 to 29.0 percent by 2015.

Capital expenditures can make a contribution to fiscal consolidation during 2012–15. As private investment recovers, the pressures to maintain high levels of public investment should abate. This should enable some winding down of the hump in post-crisis capital expenditures. At the same time, given significant infrastructure development needs, containing current expenditure pressures will also be important. The most recently approved medium term fiscal framework projects that current and capital expenditures will make similar contributions to adjustment over the next three years, with capital expenditures declining from 8.9 percent of GDP in 2011 to 7.2 percent by 2015 and current expenditures declining from 23.3 to 21.8 percent during this period. Key options for further expenditure consolidation include greater selectivity in capital expenditures, containing medium-term social expenditure pressures, and enhancing the sustainability of the road investment program. Maintaining pension replacement rates for an aging population represents the key source

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of pressure on social expenditures and this can be contained by combining limited growth of the basic benefit with exploring measures to develop private savings for retirement. In addition, improved coverage and targeting of the TSA and MIP programs can be combined with measures to connect TSA recipients with employment opportunities and improve access to pharmaceuticals and preventative treatments for the population. Options for instilling greater selectivity in capital expenditures include further improving the capital budget including a consistent and comprehensive presentation of public funding for investment, as well as strengthening the broader capital budgeting systems, including systematizing the project identification process and developing methodological guidance for cost-benefit analysis. Options to enhance sustainability of the road investment program include a phased-in rebalancing of road expenditures toward maintenance and rehabilitation as investment in the main East-West highway winds down, along with institutional measures to enhance the efficiency of road investments.

Social Expenditures Georgia’s old-age pension benefit has a large poverty-mitigating impact, but maintaining replacement rates for all recipients will entail higher fiscal costs over time given demographic trends. Georgia’s population is aging and relies mostly on the publicly funded basic benefit for old-age income. This situation presents a trade-off: either the replacement rate of the basic pension benefit will erode or its fiscal costs will rise significantly over time. The pension benefit in Georgia is a flat benefit paid out of general revenues to all men 65 years of age or older and all women 60 years of age or older, with pension expenditures amounting to 3.3 percent of GDP in 2011. The pension program plays a major role in reducing the incidence of poverty in Georgia, with simulations indicating that the poverty headcount in 2009 would have been 38.1 percent instead of 25.7 percent without the pension benefit. While the pension benefit is un-indexed, it has periodically been increased, with the effect that the replacement rate has effectively been maintained at about 13 percent of the average real wage. Public expectations make it difficult to allow the replacement rate to erode considerably over time. On the other hand, a large one-time jump in the benefit could serve to raise public expectations for a higher replacement rate. Figure 6 shows that a large one-time increase, followed by periodic increases to maintain the higher replacement rate, could increase the fiscal cost of pensions to over 7 percent of GDP in the Figure 5. Dependency Ratios in Georgia

Figure 6. Pension Costs with Constant Replacement Rate

in dependents per 100 persons of working age

in percent of GDP

10 9

8 7

6 5

4 30

3 2

1 10 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 Total dependency ratio

Child dependency ratio

Source: UN and World Bank staff estimates.

Old-age dependency ratio

0 2010

2015

GEL 100 for all

2020

2025

2030

GEL 100 + GEL 125 if 67+

GEL 100 +GEL 125 if <100k

2035

2040

2045

2050

Raise female retirement under Scenario 2

GEL 165 for all from Sep. 2012

Source: UN and World Bank staff estimates.

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Executive Summary

Georgia Public Expenditure Review 2012

medium term. In all scenarios where the benefit replacement rate is held constant, the fiscal cost rises over time because of demographic pressures of an aging population. Options to manage the pension trade-off include a combination of setting expectations for the replacement rate at affordable levels and exploring measures to develop voluntary savings for retirement to ease pressure on the basic benefit. In the short term, a large one-time jump in the basic benefit leads to a jump in fiscal costs that can be contained by selectively targeting the higher benefit, as was done during the benefit increase that took effect in September 2012. In addition, a mechanism to limit medium term growth of the basic benefit to no more than the rate of inflation could help to set expectations at affordable levels, while also protecting the purchasing power of the benefit.5 Furthermore, measures to encourage private savings for retirement can ease pressure for ad hoc and unsustainable increases in the basic public benefit. Simulations suggest that combining a basic pension growing at an affordable rate with a supplementary private pension derived from voluntary savings could stabilize the overall replacement rate for old-age income over time.

The TSA program supports consumption among poor households, but coverage of the poor can improve further and “second generation” reforms can help link TSA recipients with job opportunities. TSA beneficiary households which meet the criteria of a proxy-means testing formula receive GEL 30 monthly as a base benefit plus GEL 24 for each additional household member. In 2011, around 415,000 individuals (or 10 percent of the population) received TSA for a total budget of about GEL 150 million (or 0.7 percent of GDP). Simulations indicate that the poverty headcount would have been 2 percentage points higher in 2009 without TSA. Compared to other social assistance programs in the region, Georgia’s TSA is an average performer with respect to targeting and above average in terms of coverage. Still, over 40 percent of the bottom decile does not receive TSA, and thus further expanding coverage of the bottom decile remains a key challenge. Another potential priority going forward is to better link TSA recipients with job opportunities and human capital investments more broadly. Although there is little evidence that TSA discourages beneficiaries from seeking work, neither does it actively help them find employment.

Figure 7. Coverage of MIP

Figure 8. Government and OOP Health Spending in ECA

in percent of each decile receiving MIP

out of pocket spending as share of total, in percent

Georgia 70 40 60 50

40 20

30 20

10 10 0

0 1

2009

2011

Source: UNICEF WMS.

5 Decile

Source: WHO and HUES.

government health spending, percent of GDP

5 The option under consideration is a mechanism to limit growth of the basic benefit over the medium term to no more than the rate of inflation, rather than explicit indexation of the benefit. The authorities consider that explicit indexation would reduce the flexibility of the fiscal framework by subjecting a large part of social expenditures to short-term swings in the rate of inflation that can be affected by a host of exogenous factors.

xviii | Executive Summary

Managing Expenditure Pressures for Sustainability and Growth

Health spending in Georgia is better targeted to the poor than in many other countries, but challenges remain in improving health outcomes and financial protection against impoverishing out-of-pocket payments. The Medical Insurance Program, which offers a comprehensive package of health benefits to poor households meeting the proxy-means test criteria, is received by about 900,000 individuals (20 percent of the population). The MIP budget accounts for about a half of public health expenditures and is the reason why Georgia’s health spending is better targeted to the poor than in many other countries. MIP also has a major impact in reducing out-of-pocket spending among beneficiaries. In terms of key health sector objectives, however, health outcomes along several dimensions have seen limited improvement. Key indicators of financial protection against impoverishing out of pocket payments also remain relatively weak in comparison to peer countries, with low public health spending and high private spending on pharmaceuticals among the key causes of this pattern. Addressing these challenges will require raising coverage and utilization of medical care. In spite of the success of the MIP, many low-income households still do not have adequate coverage of health care. In this context, the planned extension of insurance benefits to the elderly population in 2012 is a welcome step forward and can be followed up by expanded coverage of the still uncovered poor households. Part of the problem of excessive private spending on drugs can be addressed by promoting the use of generics, but it will also require reducing self-treatment by increasing utilization and extending the public drug benefit to take advantage of public purchasing power to reduce drug price markups. Addressing weaknesses in the supply of medical care, with a focus on primary and preventative care, is another important priority in addressing Georgia’s health sector challenges. Table 2. Strengthening Capital Budgeting: International Practice in Identification, Preparation, and Appraisal Dimension

Coverage of PIM System

Prominent assessment tools Proportionality in application of tools.

Chile

Project selection delegated to sector spending agencies within budget ceilings Involvement of central agencies other than the finance ministry Central agencies issue guidelines on project planning

Ireland

United Kingdom

Public investment projects at all levels of government and to investment proposals from state enterprises

Central government projects and to local government projects receiving central government subsidies

Capital expenditure Central government proposals in the public only sector

Yes

Yes – but deYes concentrated structure of autonomous provincial offices

Only for very large projects, e.g., road schemes >£500 million

Yes – Ministry of Yes – PIMAC organises Planning responsible for preliminary feasibility pre-investment phase studies for Ministry of Planning and Budget.

CBA/CEA

Requirement for Yes preliminary assessment before commencing preparation Project screening by central agency

South Korea

Yes

Yes –sector specific guidelines

Source: PER Background Note on Strengthening Capital Budgeting in Georgia. Note: CBA – cost benefit analysis; CEA – cost effectiveness analysis.

CBA and MCA

Yes – for projects >$50 m

Yes

Yes – sector specific guidelines

Single Criterion CBA/CEA and MCA Analysis, MCA and CBA/ CEA Yes

Yes

Yes No

Yes – general guidelines Yes – general guidelines

xix

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Strengthening Capital Budgeting Public investment consolidation going forward will require bringing capital budgeting systems in Georgia closer to international best practices. As noted, a key challenge faced by Georgia is that public investment consolidation will have to make an important contribution to fiscal consolidation during 2012–2015 while at the same time addressing key infrastructure development needs. International experience has shown that strengthening capital budgeting systems can serve as a key instrument toward achieving greater selectivity and improved efficiency in capital expenditures. Progress to date, supported by the World Bank’s Development Policy Operation (DPO) series, largely focused on improved presentation of the capital budget. These reforms include submission of a capital budget as a consistent annex to the annual budget law, increased coverage to a majority of public investment, the complete time profile of project financial information, nonfinancial information to include summary project justifications, and monitoring and reporting with physical monitoring indicators. Options going forward to strengthen capital budgeting include both further improving content of the capital budget, as well as strengthening the broader capital budgeting system. The capital budget presentation can benefit from further improving financial information and coverage (including more domestically financed projects, including organizational classification, and demonstrating consistency with figures in the main budget. A key priority here is to achieve a comprehensive and consistent presentation of public funding for investment. While this can include investment undertaken by state owned enterprises (SOEs), it would need to clarify the separation of the government’s balance sheet from that of SOEs. At present, there are several different sources of information on public investment that are not fully consistent, including the increase in nonfinancial assets in budget, the lists of projects in budget, the capital budget annex covering primarily donor funded projects, the Basic Data and Directions (BDD) document, and investments through on-lending to SOEs. Options in strengthening the broader capital budgeting system in Georgia include systematizing the project identification process and developing methodological guidelines for cost-benefit analysis. There are many positive features of Georgia’s current approach to budgeting for capital expenditure, including a clear sense of infrastructure priorities, a disciplined budget process as set out in the Budget Code, improving procurement with open and competitive bidding, and adequate internal control and reporting mechanisms. On the negative side, unified national procedures for project identification, preparation and appraisal are missing, and there is no explicit calendar linking activities in the project cycle to the budgeting and strategic planning cycles. This suggests that any reinforcement Georgia’s capital budgeting system should focus on “upstream” elements that emphasize moving away from ad hoc decision-making and informality to a system with procedurally determined decision-points, an official calendar, and sound guidance on analytical methods. In this context, a systematic project identification process with a preliminary project assessment step could serve to screen projects before they enter the preparation stage. Project identification would best be coordinated with early stages of BDD process (before budgetary ceilings are set). Furthermore, developing national methodological guidance on cost-benefit analysis for use by major projects that have passed identification would provide a uniform set of criteria for project appraisal and evaluation across sectors and regardless of source of financing.6

An important consideration in designing reinforcements to the broader capital budgeting system is to ensure that the procedures are “simple and light”, so that the impact on time and cost of project preparation and implementation are minimized. These reinforcements can also be phased in over time.

xx | Executive Summary

Managing Expenditure Pressures for Sustainability and Growth

Road Sector Investment Georgia faces significant road improvement needs and investment has accordingly increased significantly in recent years, but there is room to improve the sustainability of the overall road investment program. Improvement of the road network is critical to Georgia’s development priorities, including higher competitiveness through better connectivity with regional and international markets, developing Georgia’s potential as a regional transit and logistics hub, and enhancing rural access to markets, education, Table 3. Road Network in Georgia in International and health. In meeting these priorities, road Context investment has increased significantly in recent Road Km/ Road Km/ 1,000 sq km 1,000 people years and the Government has made much Azerbaijan 288 2.9 progress toward upgrading infrastructure and Kyrgyzstan 170 6.3 attaining international standards of serviceability. A key objective has been to upgrade the EastKazakhstan 40 7.1 West highway, with the result that the condition Georgia 291 4.57 of the international road network has improved Estonia 1320 41.2 markedly from 34 percent in good or fair condition Hungary 1733 15.7 in 2004 to 76 percent in 2010. On the other hand, FYR of Macedonia 342 4.3 the majority of secondary and local roads remain in Serbia & Montenegro 494 4.8 poor condition, with only 30 percent of secondary Slovenia 1007 10.2 roads and 15 percent of local roads in good to fair Albania 657 3.5 condition in 2010. Furthermore, while routine Europe and Central Asia 580 8.6 and periodic maintenance expenditures have Upper Middle Income 1076 9.2 increased in recent years, they remain inadequate Lower Income 328 4.9 and thus add to the long run costs of developing Source: WDI and IEF data bases. the road network. Figure 9. Road Network in Georgia Over Time in share of respective network

International Road Network Condition

Secondary Road Network Condition

34 26

23 18 13

12 4 2009

Good

Fair

2004 Poor

Bad

Source: Roads Department of Georgia, WDI, and IEF data bases.

2009 Good

Fair

11 8

2004 Poor

Bad

An important option for improving the long run sustainability of the road investment program is for the budget to include provisions for adequate levels of periodic and routine maintenance. In 2010, actual periodic and routine maintenance expenditure amounted to GEL 32 million. In contrast, the estimated periodic

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maintenance need was GEL 123 million and the estimated routine maintenance need was GEL 43 million. Such under-provision of maintenance expenditure results in progressive deterioration in condition of a significant part of road network and increases long run costs of maintaining and upgrading the road network. Neglecting maintenance also results in higher economic costs in the form of increased vehicle operating costs. Adequate provision of maintenance expenditures is thus an important option for consideration. At the same time, it should be noted that since maintenance is mostly financed from domestic resources while investment is mostly financed from external resources, the relative allocation is affected by the availability of resources from domestic and external sources.

A second option in improving long run sustainability of road investment is to phase in a rebalancing of outlays for new construction and rehabilitation over time in order to reduce backlog of the network in poor condition. This can involve incrementally introducing a program of rehabilitation and maintenance of the large and neglected secondary and local road network, so that road sector priorities balance capacity expansion with adequate emphasis on preservation and improvement. Rehabilitation expenditures have increased in recent years but remain below levels recommended by the HDM (Highway Development and Management) model. Furthermore, the economic rate of return of rehabilitation (~20–35%) is typically significantly greater than that of capacity expansion (~10–14%) through, for example, widening. With the large, high-priority investment in the East-West Highway continuing for the next few years, these recommendation can be planned to be phased in over a period of time.

A third option in enhancing road investment sustainability is to implement a range of efficiencyenhancing institutional measures. These measures can include: (i) moving toward the implementation of a comprehensive Road Asset Management System (RAMS); (ii) introducing and expanding the use of more efficient contracting mechanisms like, Design-Build and Performance-based contracting based on Design-Build-OperateMaintain and Transfer (DBOMT) principles; (iii) developing and implementing a viable system for attending to the needs of local roads; and (iv) improving Road Department capacity to assess rehabilitation benefits, including multi-criteria assessment with freight, efficient vehicle routing, safety, access for industry, benefitcost ratio (BCR), community access to essential services, emergency access, environmental sustainability, and agency risk.

Structure of Report he rest of this synthesis report is in five chapters. Chapter 1 summarizes the macroeconomic context and T assesses trade-offs associated in balancing the overall composition of public expenditures. The second and third chapters illustrate policy options and implications associated with containing social expenditure pressures and improving effectiveness of health expenditures, respectively. Chapter 4 reviews the international experience in strengthening capital budgeting and provides options for consideration for Georgia. The fifth chapter discusses options associated with rebalancing road sector expenditures.

xxii | Executive Summary

Managing Expenditure Pressures for Sustainability and Growth

Chapter 1. Macroeconomic Context and Expenditure Composition 1.1. Introduction

Georgia faces dual macroeconomic challenges of generating rapid growth with sustainability in an uncertain global environment and addressing both will require continued implementation and potential deepening of the fiscal consolidation program. On sustainability, the current account deficit has narrowed by about half from a peak of 21.8 percent of GDP in 2008 but remains among the highest in the ECA region at 11.8 percent of GDP in 2011. Georgia also faces external debt repayment obligations of about 5 percent of GDP per year during 2012–14 and total external debt was relatively high at 58 percent of GDP in 2011.7 The global economic outlook remains uncertain and a more widespread downturn could adversely impact exports, FDI, and other capital inflows. On growth, the economy has rebounded strongly by 6.7 percent during 2010–11, although investment remains lower than pre-crisis levels and higher investment without further widening the current account deficit will require raising low levels of national savings. The export share of GDP remains low and an appreciating real exchange rate does not help encourage a shift in the drivers of growth toward the tradable sectors. Given these challenges, continued implementation of the fiscal consolidation program would create additional space for fiscal response to sharp global shock and further bolster debt sustainability. In the event of an upside growth scenario with higher FDI and other capital flows, national savings could erode further, the current account deficit could widen, and the RER could appreciate further. In this event, these pressures could be countered by deepening fiscal consolidation through a more accelerated reduction in the path of the overall fiscal deficit. If the fiscal consolidation program goes off track, Georgia can quickly return to the precrisis imbalances of large current account deficits and unsustainable growth driven by nontradables.

Continued implementation of fiscal consolidation will require managing a growing body of competing social and infrastructure expenditure pressures in an environment where opportunities to extract fiscal space from other areas has diminished. The composition of expenditures has shifted considerably in the years since the crisis. Important social protection, health, and infrastructure expenditures have been scaled up with fiscal space coming from a reduction of defense and internal security expenditures. The opportunities for generating fiscal space from further expenditure reductions in defense and internal security have diminished. Going forward, Georgia faces further important infrastructure development needs in the areas of roads, regional development, water, energy, and agriculture. Social expenditure pressures come from needs on multiple fronts, including providing adequate pensions to an aging population, improving social assistance coverage of the poor, and improving health outcomes. Managing these competing needs within the context of the fiscal consolidation program is a key public finance challenge facing Georgia. Benchmarking against regional comparators shows that Georgia spends a greater share of total outlays on capital expenditures and a lesser share on education, health, and social protection. Expenditure consolidation to date has also emphasized current spending. All this suggests that capital expenditures can make a greater contribution to adjustment going forward.

External public debt repayments are lower and the authorities have built fiscal buffers to help manage these obligations.

Chapter 1. Macroeconomic Context and Expenditure Composition

Georgia Public Expenditure Review 2012

In order to address the challenges facing the macroeconomic framework and the composition of expenditures, this chapter discusses the following options for consideration: ●● Maintain discipline in implementing the fiscal consolidation program by reducing the overall fiscal deficit from 3.6 percent of GDP in 2011 to 2 percent by 2015, through a further consolidation of expenditures by 3 percentage points of GDP by 2015 ●● In the event of an upside growth scenario deriving from higher FDI and capital inflows, deepen fiscal consolidation by saving part of the additional revenues and bolstering fiscal buffers ●● Enable capital expenditures to make a contribution to expenditure consolidation going forward, particularly as private investment picks up

●● Manage expenditure consolidation by instilling greater selectivity in capital expenditures, containing medium term social expenditure pressures, and enhancing sustainability of road investment program (greater detail on each in subsequent sector chapters)

The structure of this chapter is as follows. The first section explores the macroeconomic challenges facing Georgia on two fronts: sustainability and growth. The section establishes the case for why sustaining and potentially deepening fiscal consolidation is important to address these challenges. The second section explores how the composition of expenditures has evolved in Georgia over time. This helps shed light at a broad level on how Georgia can balance expenditure needs in competing areas in order to successfully adhere to the fiscal consolidation program.

1.2. Macroeconomic Context: Why is Fiscal Consolidation so Important?

Georgia has succeeded in generating strong growth with declining public debt, with fiscal stimulus in 2008-09 being followed by adjustment in 2010–11. Far-reaching reforms following the Rose Revolution, along with a favorable external environment, helped stimulate foreign direct investment (FDI) and accelerate economic growth in Georgia. Growth averaged 9.3 percent per year during 2004–07 and after a crisis-related downturn, rebounded again to 6.7 percent during 2010–11. The external public debt ratio declined significantly during 2004–07 as reforms to streamline the tax regime and root out corruption resulted in considerably higher tax revenues. As government borrowing increased to finance a fiscal stimulus during the 2008–09 crisis, external public debt increased before beginning to decline again in 2011. The overall fiscal deficit rose to 9.2 percent of GDP in 2009 before fiscal adjustment helped lower the deficit to 3.6 percent in 2011. Addressing remaining challenges in narrowing the current account deficit and growing the tradable sector in an uncertain global environment will require continued implementation of the fiscal consolidation program. Georgia’s external current account deficit remained among the highest in the ECA region in 2011 at 11.8 percent of GDP, thus raising concerns about sustainability. External debt repayments in 2012–14 remain considerable and a sharper global economic downturn could impact Georgia’s exports, FDI, and financing costs. In this context, continued implementation of the fiscal consolidation program provides a key anchor of sustainability by creating space for a fiscal response to global shocks and facilitating further reduction

2 | Chapter 1. Macroeconomic Context and Expenditure Composition

Managing Expenditure Pressures for Sustainability and Growth

in the path of public debt. Generating rapid growth in Georgia will also require engineering a shift in the growth model toward one financed more out of domestic savings and driven more by the tradable sectors. National savings at 14 percent of GDP in 2011 remains too low to sustain the investment necessary for rapid growth. With exports at 36.6 percent of GDP in 2011, the tradable sectors have played a much smaller role in driving growth in Georgia than in regional and global comparators. Fiscal consolidation is important in addressing the growth challenge to prevent further erosion of national savings and contain further real exchange rate appreciation pressures. Given the low appetite for higher tax rates and the high productivity of collections, fiscal consolidation will need to rely on further expenditure consolidation. In the event of an upside growth scenario induced by higher FDI and other capital flows, saving part of the additional revenues realized can prevent a return to the large macroeconomic imbalances of the pre-crisis period. Figure 1.1. GDP Growth, Exports, and Imports GDP growth, in percent

exports, imports, in percent of GDP

Figure 1.2. CA Deficit, Investment, FDI, Savings in percent of GDP

-2

-10

30 25

-20

-4 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 GDP growth

Imports (rhs)

Exports (rhs)

Source: Georgian authorities and WB staff estimates.

2011

5 0 2001 CA deficit

2002

2003

2004

Investment

2005

2006

2007

FDI Inflows

Source: Georgian authorities and WB staff estimates.

2008

2009

2010

2011

National savings

Pre-crisis Developments, 2004–07 Georgia experienced strong growth from 2004 through mid-2008 facilitated by far-reaching reforms and large foreign direct investment (FDI) inflows. Following the Rose Revolution at end-2003, reforms were undertaken to strengthen public finances, improve the business environment, upgrade infrastructure services, liberalize trade, and improve social services. As a result of the reforms and a favorable global environment, economic growth averaged 9.3 percent per year during 2004–07. A key driver of this growth was substantial inflows of FDI, which increased from $331 million (8.3 percent of GDP) in 2003 to $1.67 billion (16.4 percent of GDP) in 2007. Growth during 2004–07 was associated with a significant widening of the current account deficit. Exports remained around 31–34 percent of GDP during 2004–07, suggesting that growth during this period was not associated with a substantial expansion of the export and tradable sectors. On the other hand, the large capital inflows, along with rapid credit growth, fueled an expansion of imports. Aggregate demand was driven in large part by the growth of consumption, particularly rapidly growing government consumption. Consequently, the external current account deficit widened from 7 percent of GDP in 2004 to 21.8 percent by 2008, raising concerns about sustainability. The real exchange rate appreciated by about 40 percent between 2004 to mid2008, thus impacting the competitiveness of tradables. Gross national savings fell from 25 percent of GDP in

Chapter 1. Macroeconomic Context and Expenditure Composition

Georgia Public Expenditure Review 2012

2004 to 12.4 percent in 2007 and 3.3 percent in 2008, thus shifting the burden of financing investment and growth largely to foreign capital inflows.

Tax reforms were highly successful in raising revenue, while lowering rates and streamlining administration. The tax regime was streamlined by reducing both the number of taxes and key tax rates. As a result, tax revenues increased from 14.6 percent of GDP in 2003 to 25.8 percent in 2007. Together with nontax revenues and grants, total revenues increased from 16 to 29.3 percent of GDP during this period. The number of taxes was reduced from 21 in 2004 to 7 in 2005 and tax rates were reduced across the board. At the same time, the tax base was broadened by eliminating several exemptions and special regimes. These tax policy reforms were supported by key institutional reforms to strengthen tax and customs administration and enforcement. Large numbers of tax and customs officials were dismissed and new staff was hired with higher wages, training, and certification tests. New rules reinforced professional behavior and deterred corruption by imposing severe penalties for misconduct and introducing bonuses for reporting fraud and corruption.

The public debt ratio declined during 2004–07 as higher revenues and privatization proceeds more than fully financed a substantial increase in public expenditures. Along with the rise in tax revenues, total public expenditures increased more than proportionally from 17.5 percent of GDP in 2003 to 34 percent in 2007. As a result, the overall fiscal deficit increased from 1.5 percent of GDP in 2003 to 4.7 percent in 2007, but was financed through higher privatization receipts which amounted to 5.2 percent of GDP in 2007. With the deficit fully financed from current proceeds, strong economic growth led to steady improvement in public debt burden indicators. External public debt declined from 45 percent of GDP in 2003 to 16.8 percent in 2007. On the other hand, private external debt increased considerably from 5.5 percent of GDP in 2003 to 21 percent in 2007 as the corporate and financial sector took advantage of available foreign capital for their medium and long term, as well as short term, borrowing needs.

Crisis and Response The shocks from the August 2008 conflict and the global financial crisis resulted in a sharp downturn in economic growth and adjustment of the current account deficit. The double shocks led to deterioration in investor and consumer confidence, contraction in FDI, exports, and remittances, and a cutback in bank lending. The economy grew by 2.3 percent in 2008 and contracted by 3.8 percent in 2009, which was a sharp slowdown from growth in excess of 9 percent during the preceding four years. FDI inflows collapsed from $1.67 billion (16.4 percent of GDP) in 2007 to $658 million (6.1 percent of GDP) in 2009, while exports fell from 31 percent of GDP in 2007 to 29.8 percent in 2009. With the fall in FDI and other private inflows, the current account deficit adjusted from 21.8 percent of GDP in 2008 to 10.6 percent in 2009 as imports fell by 10 percentage points of GDP in 2009. The large international crisis assistance package to Georgia enabled it to avert the even sharper adjustments experienced by other ECA countries with equally large current account deficits on the eve of the crisis. As consumption was smoothed somewhat in the face of falling incomes, national savings plummeted from 12.4 percent of GDP in 2007 to 2.4 percent in 2009. As the authorities responded with a fiscal stimulus to mitigate the downturn and restore confidence, the fiscal deficit and public debt ratio increased during 2008–09. Public expenditures increased from 34 percent of GDP in 2007 to 38.4 percent in 2009, while tax revenues declined from 25.8 percent of GDP in 2007 to 24.4 percent in 2009. As a result, the fiscal deficit widened from 4.7 percent of GDP in 2007 to 9.2 percent in 2009. The higher fiscal deficits were financed primarily through increased donor support, with the

4 | Chapter 1. Macroeconomic Context and Expenditure Composition

0.4

-9.6

46.7

331

External Current Account Balance

Imports of Goods and Services

FDI Inflows (M US$)

Source: Georgian authorities and World Bank staff estimates. Notes: p=projected; 1/ public and publicly guaranteed

Total External Debt

External Private Debt

Total Public Debt

External Public Debt 1/

Debt

Intl Reserves (M US$)

Intl Reserves (Mo of Impts of G&S)

FDI Inflows (% GDP)

Exports of Goods and Services

External

55.2

44.9

191

1.2

8.3

32.3

-1.5

Privatization Receipts

Overall Fiscal Balance

2.8

Capital Expenditure and Net Lending

Current Expenditure

14.7

17.5

Expenditure and Net Lending

Tax Revenues

16.0 14.6

21.7

31.3

Revenues and Grants

Fiscal

Gross National Savings (% GDP)

Investment (% GDP)

CPI (e.o.p.)

7.0

11.1

11.5

GDP Growth Rate

Unemployment Rate

860

2003

GNI per capita (US$, atlas method)

in percent of GDP, except where noted

40.0

5.5

43.6

34.5

383

1.8

483

9.4

48.6

32.1

-6.9

0.7

2.4

4.9

15.8

20.7

19.7

23.1

25.0

31.9

7.5

5.9

12.6

1,050

2004

Table 1.1. Georgia: Selected Economic Indicators, 2003–2011

32.3

5.6

34.0

26.6

474

1.7

542

8.5

51.8

34.1

-11.1

3.6

-1.8

5.9

20.1

26.0

20.8

24.2

22.4

33.5

6.2

9.6

13.8

2005 1,320

37.9

15.9

27.9

21.9

881

2.4

1,186

15.3

56.8

32.8

-15.1

5.2

-3.0

7.6

22.2

29.8

22.8

26.8

15.7

30.9

8.8

9.4

13.6

2006 1,680

3.3

26.0

5.5

2.3

16.5

2008 2,460

2.4

13.0

3.0

-3.8

16.9

2009 2,540

11.3

21.6

11.2

6.3

16.3

2010 2,700

14.0

25.7

38.5

21.0

22.3

17.5

1,361

2.8

1,675

16.4

57.9

31.1

-19.7

5.2

-4.7

9.0

25.0

34.0

25.8

29.3

44.0

23.1

25.0

20.9

1,480

2.4

1,523

11.8

58.3

28.7

-21.9

3.7

-6.3

8.6

28.5

37.0

24.9

30.7

58.0

26.6

37.0

31.4

2,111

4.8

658

6.1

48.9

29.8

-10.6

2.0

-9.2

8.4

30.1

38.4

24.4

29.3

61.8

28.2

39.1

33.6

2,265

4.4

817

7.0

52.7

34.9

-10.3

1.1

-6.6

8.8

26.0

34.9

23.5

28.3

2.0

7.0

15.8

2011 2,880

58.1

28.8

33.9

29.0

2,818

4.3

973

6.8

55.4

36.6

-11.8

1.6

-3.6

8.9

23.3

32.1

25.4

28.5

percent of GDP, except where noted

12.4

32.1

11.0

12.3

13.3

2007 2,090

54.5

26.9

32.7

27.7

2,734

3.6

964

6.1

56.5

39.2

-12.6

0.5

-3.5

8.4

22.5

30.9

24.7

27.4

13.0

25.6

5.0

6.5

15.3

3,050

2012p

51.6

26.3

30.9

25.3

2,528

3.1

1,032

6.0

57.7

42.2

-11.2

0.2

-3.0

8.0

22.3

30.3

24.7

27.3

13.0

24.2

6.0

5.5

14.8

3,220

2013p

50.1

25.9

30.1

24.2

2,590

2.9

1,095

6.0

59.0

46.5

-9.0

0.2

-2.7

7.6

22.1

29.7

24.7

27.1

14.7

23.7

6.0

5.5

14.3

3,400

2014p

47.0

23.8

29.4

23.2

2,752

2.8

1,190

6.0

60.5

50.2

-7.8

0.2

-2.1

7.2

21.8

29.0

24.7

26.9

15.9

23.7

6.0

5.5

13.8

3,590

2015p

Managing Expenditure Pressures for Sustainability and Growth

Chapter 1. Macroeconomic Context and Expenditure Composition

Georgia Public Expenditure Review 2012

international community pledging $4.5 billion in post-crisis assistance to Georgia over three years, in addition to a $1.15 billion IMF Standby Arrangement. As a result, external public debt increased from 16.8 percent of GDP in 2007 to 31.4 percent in 2009. Figure 1.3. Fiscal Framework in percent of GDP, 2003–11

real 2010 Lari, millions

8,000

38.4 34.9

Figure 1.4. Fiscal Framework

32.1

7,000

29.7 6,000

30 26 25

23.1

2017.5 16 15 14.6 10

20.7

26.7 24.4

19.7

30.7

29.3 25.8

24.9

29.3 24.4

28.3 23.5

5,000 25.4

22.9

4,000

20.8

3,000 9.2

2,000 6.6

6.3 4.7 5 1.6

1.5 0 2003

28.5

2004

Total expenditures

2005

3.6

2006

Revenues & grants

2007

2008

Tax revenues

Source: Georgian authorities and WB staff estimates.

2009

2010

2011

Overall fiscal deficit

1,000 394 0 2003

725

2004

Total expenditures

Capital expenditures

1,582

1,777

1,740

1,634

2006

2007

2008

2009

1,834

1,961

2010

2011

950

2005

Revenues & grants

Tax revenues

Source: Georgian authorities and WB staff estimates.

Current expenditure

Economic Rebound and Fiscal Adjustment Economic growth rebounded strongly by 6.7 percent in 2010–11, supported by public investment, strengthening confidence, and a rebound in both merchandise and services exports. The economy rebounded by 6.3 percent in 2010 and 7 percent in 2011. Participation by sectors in the rebound was broad based, with manufacturing and services making particularly strong contributions. The recovery benefited from a pickup in exports, tourism, bank lending, and continued high levels of public investment. The rebound in both merchandise and services exports have played a major role in the economic recovery. Exports of goods and services were up to 36.6 percent of GDP in 2011 from 29.8 percent in 2009. Merchandise exports (up 39 percent per year in 2010–11) were composed primarily of metals and metal products, repaired and remanufactured vehicles, wines and beverages, fertilizers, and fruits and nuts (together accounting for about 60 percent). The services sector benefited from vigorous expansion in tourist arrivals and growth in transit trade through Georgia. The number of tourists increased by 37 percent per year in 2010–11, with the bulk of visitors from Armenia, Azerbaijan, Turkey, and Ukraine. Azerbaijan and Armenia accounted for the bulk of transit trade through Georgia, with proceeds from exports of transport services up 13 percent per year in 2010–11.

The current account deficit widened to 11.8 percent of GDP in 2011, driven by strong growth of imports and higher capital inflows. Imports grew strongly by 34.5 percent in 2011, driven by higher food and oil prices, as well as higher demand from improved economic performance. FDI remained stable at about 6.8 percent of GDP in 2011, while other private inflows increased, most notably non-resident deposits in the banking sector as well as short term borrowing by banks. Official borrowing also contributed to financing the current account deficit. The authorities have implemented fiscal adjustment in 2010–11 as recovery has taken hold. As the economy rebounded in 2010–11, fiscal adjustment was implemented primarily through the consolidation of

6 | Chapter 1. Macroeconomic Context and Expenditure Composition

Managing Expenditure Pressures for Sustainability and Growth

current expenditures. Capital expenditures were maintained at 8.5–9 percent of GDP as private investment and FDI remained weak. Total expenditures declined from 38.4 percent of GDP in 2009 to 32.1 percent in 2011. As a result, the overall fiscal deficit declined from 9.2 percent of GDP in 2009 to 3.6 percent in 2011. Tax revenues edged up from 24.4 percent of GDP in 2009 to 25.4 percent in 2011, although this benefited from one-off items collected in 2011. With a decline in non-tax revenues and grants, total revenues declined from 29.3 percent of GDP in 2009 to 28.5 percent in 2011. Table 1.2. Georgia: External Financing 2007–15 in percent of GDP

Financing Needs

Current Account Deficit

Repayment of MLT Debt

Total Financing Requirement

Financing Sources

Public Sector flows

2007

2008

2009

2010

2011*

2012p

2013p

2014p

2015p

-19.7

-21.9

-10.6

-10.3

-11.8

-12.5

-11.2

-9.0

-7.8

-2.6

-22.3

-2.8

-24.8

-4.7

-15.4

-3.9

-14.2

-4.0

-15.8

-4.8

-17.3

-5.9

-17.2

-5.0

-14.0

-11.8

1.3

6.2

8.1

5.1

3.5

4.0

2.2

1.9

1.4

3.4

4.8

4.0

4.3

4.1

3.9

Foreign Direct Investment

17.1

12.2

Other Private flows

-0.8

-0.2

-1.8

Adjustments

-0.3

-1.4

-0.3

Private Sector MLT Borrowing IMF

Use of Reserves

Total Financing Sources

Source: Georgian authorities and WB/IMF staff estimates. Note: *=preliminary; p=projections

8.3

0.4

-3.7

22.3

5.9

2.0

-1.0

24.8

6.1

5.3

3.2

-5.7

15.4

7.0

2.6

-1.8

14.2

6.8

3.8

0.0

0.8

-4.0

15.8

5.9

3.3

0.0

0.2

17.3

6.1

3.2

0.0

1.4

17.2

6.0

1.9

0.0

0.1

14.0

-4.0

5.9

1.6

0.0

-1.1

11.8

External public debt declined to 29 percent of GDP in 2011 after peaking at 33.6 percent in 2010. The authorities have financed the fiscal deficit mostly through concessional external borrowing and small volumes of domestic T-bill issuances. As the fiscal deficit has narrowed and the growth rebound has been sustained, external public debt declined to 29 percent of GDP in 2011. New T-bill issuances amounted to only GEL 91 million in 2011, compared to GEL 260 million in 2009 and GEL 172 million in 2010. Consequently, total public debt also declined to 34.3 percent of GDP in 2011 from 39.3 percent in 2010. While private external debt has increased by about $ 550 million in 2010–11, the growth of nominal GDP has meant that private external debt edged up only slightly to 28.8 percent of GDP in 2011 from 28.2 percent in 2010. As a result, total external debt declined to 58.1 percent of GDP in 2011 from a peak of 62 percent in 2010.

Challenges With external exposure significant in Georgia, continued implementation of fiscal consolidation provides the key anchor of sustainability in an increasingly uncertain global economic environment. Georgia’s current account deficit is among the highest in the ECA region at 11.8 percent of GDP in 2011. The average CAD for non-oil ECA countries was about 5.5 percent of GDP in 2011, with only Albania, Armenia, and Belarus having CADs that were similar in order of magnitude to that of Georgia. This leaves Georgia particularly exposed to a broader global economic shock. While economic activity in Georgia has not yet been impacted by the evolving euro-zone crisis, a broader global downturn affecting Georgia’s main economic partners would likely affect

Chapter 1. Macroeconomic Context and Expenditure Composition

Georgia Public Expenditure Review 2012

its exports, tourism inflows, FDI, and financing costs. Continued implementation of fiscal consolidation while the growth outlook remains strong is important to create space for a fiscal policy response in the event of a downturn. The East Asian experience also offers lessons for Georgia in this regard. The ECA region itself offers a sharp contrast to East Asia where current account surpluses have been maintained on average following the financial crisis of 1997. The 1997 crisis led many Asian governments to considerably tighten government budgets, in addition to building large reserve buffers and tightly supervising banks and finance companies.

Georgia also faces external debt repayment obligations of about 5 percent of GDP per year during 2012– 14. While the successful refinancing of Georgia’s Eurobond in April 2011 helped smooth out its public debt repayment schedule, total public and private repayment obligations remain significant at about $2.5 billion for 2012–14 or about 5 percent of GDP per year. Total repayments due to the IMF during this period amount to about $885 million. With the current account deficit projected to average around 8.7 percent of GDP during 2012–14, Georgia’s external financing needs during this period average about 14 percent of GDP per year. The financing plan relies on continued public sector flows (3.2 percent of GDP), FDI (6 percent of GDP), other private capital inflows (4.9 percent of GDP), and the use of international reserves (0.4 percent of GDP). In an environment of uncertain global capital flows, sustaining and potentially deepening fiscal consolidation would provide additional space for meeting repayment obligations in 2012–14 and serve as a key anchor of sustainability. Fiscal consolidation is also important for sustaining strong economic growth in Georgia. Strong and sustained economic growth will require engineering a shift in the growth model away from one financed by inflows and driven by nontradables and toward one financed more by domestic savings and driven by tradables. Investment at 25.7 percent of GDP in 2011 remains significantly below pre-crisis levels (32 percent in 2007). Financing higher investment without widening the current account deficit will require higher national savings, which remained low at 14 percent of GDP in 2011. Although public savings recovered to 5.2 percent of GDP in 2011, it still remains below the pre-crisis peak of 7.3 percent in 2004, and can serve to further bolster national savings in an environment where private savings remains below levels needed to finance strong investment and growth. Beyond the financing of higher investment, sustaining rapid economic growth will also require a shift toward higher private investment in tradables. Private investment amounted to only 16.8 percent of GDP in 2011, with public investment in mostly infrastructure adding another 9 percent of GDP. The export share remains low at 37 percent and the real exchange rate appreciated by about 16 percent since July 2010. Sustaining and potentially deepening fiscal consolidation is essential to contain real exchange rate appreciation Figure 1.5. National, Public, and Private Savings

Figure 1.6. Real Effective Exchange Rate

in percent of GDP

Dec 1995=100

135 130

125 120

115 10

110 105

100 95

90 -5 2003

2004

National savings

2005

2006

Public savings

2007

2008

2009

2010

2011

Private savings

Source: Georgian authorities and WB staff estimates.

8 | Chapter 1. Macroeconomic Context and Expenditure Composition

85 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Source: Georgian authorities and WB staff estimates.

Managing Expenditure Pressures for Sustainability and Growth

pressures and engineer a shift toward higher private investment in tradables as part of a strategy to generate sustained and rapid economic growth in Georgia.

Fiscal consolidation going forward will have to rely on further expenditure consolidation. The Government’s medium term fiscal framework projects a reduction in the overall fiscal deficit to 2.1 percent of GDP by 2015 from 3.6 percent in 2011. Total revenues are projected to decline to 26.9 percent of GDP by 2015 from 28.5 percent in 2011 due to a winding down of grants, non-tax revenues, and one-off tax settlements. Given tax rates, collections are quite high in Georgia and exemptions are few, so that the room for further increasing the productivity of collections is limited. Furthermore, the appetite for higher tax rates is low and restricted somewhat by the provisions of the Economic Liberty Act. Expenditure consolidation will, therefore, need to make a greater than one-for-one contribution to the reduction of the fiscal deficit going forward, with the most recently approved medium term fiscal framework projecting a decline in total expenditures from 32.1 percent of GDP in 2011 to 29.0 percent by 2015. Deepening fiscal consolidation will be particularly important in the event of an upside scenario with higher FDI and capital inflows. Preventing a return to the large macroeconomic imbalances of pre-crisis period is an important priority. In the event of an upside scenario with higher FDI and capital inflows, the real exchange rate could appreciate further, imports could expand, and the current account deficit could widen. In such a scenario, accelerating fiscal adjustment by saving rather than spending part of the additional revenues can be important in preventing a return to the pre-crisis imbalances.

1.3. Expenditure Composition

Maintaining and potentially deepening fiscal consolidation will require skillful management in balancing and prioritizing expenditure needs in different areas. Georgia faces substantial social expenditure pressures arising from its aging population, the need to improve overall health outcomes, and the need to improve social assistance coverage of the poor while unemployment remains high. In addition, infrastructure development priorities are substantial in the areas of roads, water, and rural development, in order to catalyze private investment and to create the conditions for strong growth in the long run. Balancing and prioritizing these competing expenditure needs, while identifying expenditure savings from other areas, is at the heart of continued implementation of the fiscal consolidation program. Achieving these objectives in an environment with parliamentary and presidential elections scheduled for 2012 and 2013, respectively, will require skillful management of public expenditure priorities. The composition of public expenditures has evolved considerably in three stages since 2004. In the pre-crisis period (2004–07), as the new government moved to restore and reinforce essential functions of the state, public expenditures increased across the board, with particularly sharp increases in national and internal security spending, but also including increases in social expenditures and basic infrastructure investments. As the authorities implemented a countercyclical fiscal stimulus (2008–09) following the twin shocks of the August 2008 conflict and the global financial crisis, the composition of expenditures underwent a marked shift. Select social and capital expenditures were scaled up to mitigate the impact on the poor and vulnerable and to support investment and economic growth, while fiscal space was generated through a marked reduction in defense, internal security expenditures, and other recurrent. With economic recovery taking hold, fiscal

Chapter 1. Macroeconomic Context and Expenditure Composition

10 | Chapter 1. Macroeconomic Context and Expenditure Composition 2,219 2,028 79 112 2,433 2,040 468 506 171 0 621 0 274 394 307 87 -214

Revenues & Grants Tax Revenues Grants Other revenues Total Expenditures Current expenditure Wages & Salaries Goods & Services Subsidies Grants Social expenditure Other expenditure Interests Capital Expenditures Capital Net lending Overall fiscal deficit

Source: Georgian authorities and Bank/IMF staff estimates. Note: p=projected

16.0 14.6 0.6 0.8 17.5 14.7 3.4 3.6 1.2 0.0 4.5 0.0 2.0 2.8 2.2 0.6 1.5

2003

3,394 2,893 187 314 3,048 2,323 621 492 325 0 650 24 211 725 637 88 346

23.1 19.7 1.3 2.1 20.7 15.8 4.2 3.3 2.2 0.0 4.4 0.2 1.4 4.9 4.3 0.6 -2.4

2004

3,937 3,345 145 446 4,197 3,247 762 794 605 7 774 139 167 950 916 34 -261

24.4 20.8 0.9 2.8 26.0 20.1 4.7 4.9 3.8 0.0 4.8 0.9 1.0 5.9 5.7 0.2 1.6

2005

4,703 4,031 215 457 5,240 3,658 723 989 494 9 906 405 132 1,582 1,368 214 -538

26.7 22.9 1.2 2.6 29.7 20.7 4.1 5.6 2.8 0.0 5.1 2.3 0.8 9.0 7.8 1.2 3.0

2006

5,796 5,117 119 560 6,736 4,959 788 1842 465 16 992 741 114 1,777 1,708 69 -940

29.3 25.8 0.6 2.8 34.0 25.0 4.0 9.3 2.3 0.1 5.0 3.7 0.6 9.0 8.6 0.3 4.7

2007

2009

30.7 24.9 3.2 2.5 37.0 28.5 5.3 8.4 2.7 0.1 7.2 4.1 0.6 8.6 8.0 0.6 6.3

29.3 24.4 2.2 2.7 38.4 30.1 5.8 6.1 2.3 0.1 8.4 6.3 1.0 8.4 8.0 0.3 9.2

percent of GDP

2008 28.3 23.5 2.3 2.5 34.9 26.0 5.5 5.2 1.8 0.1 7.8 4.7 1.0 8.8 8.2 0.6 6.6

2010

6,227 5,055 656 515 7,512 5,772 1,072 1,709 545 13 1,466 839 128 1,740 1,621 118 -1,285

5,713 4,763 422 529 7,502 5,868 1,138 1,199 456 16 1,634 1239 186 1,634 1,567 67 -1,789

5,866 4,867 473 526 7,232 5,399 1,138 1,086 372 13 1,612 972 206 1,834 1,706 128 -1,366

Real 2010 Lari, millions

Table 1.3. Georgia: Composition of Medium Term Expenditure Framework (2011–15)

6,303 5,628 202 473 7,110 5,150 1,042 1,111 389 12 1,519 813 264 1,961 1,715 246 -807

28.5 25.4 0.9 2.1 32.1 23.3 4.7 5.0 1.8 0.1 6.9 3.7 1.2 8.9 7.7 1.1 3.6

2011

6,421 5,807 215 399 7,249 5,274 1,070 1,044 379 13 1,599 864 306 1,975 1,765 210 -828

27.4 24.7 0.9 1.7 30.9 22.5 4.6 4.4 1.6 0.1 6.8 3.7 1.3 8.4 7.5 0.9 3.5

2012p

6,771 6,127 211 433 7,513 5,533 1,126 1,096 400 14 1,738 884 275 1,980 1,823 157 -742

27.3 24.7 0.9 1.7 30.3 22.3 4.5 4.4 1.6 0.1 7.0 3.6 1.1 8.0 7.4 0.6 3.0

2013p

7,073 6,465 151 457 7,768 5,777 1,180 1,156 414 16 1,782 933 296 1,991 1,909 82 -694

27.1 24.7 0.6 1.7 29.7 22.1 4.5 4.4 1.6 0.1 6.8 3.6 1.1 7.6 7.3 0.3 2.7

2014p

7,423 6,821 119 482 7,988 6,008 1,231 1,209 425 15 1,828 984 316 1,980 1,939 41 -565

26.9 24.7 0.4 1.7 29.0 21.8 4.5 4.4 1.5 0.1 6.6 3.6 1.1 7.2 7.0 0.1 2.0

2015p

Georgia Public Expenditure Review 2012

Managing Expenditure Pressures for Sustainability and Growth

adjustment (2010–11) has been associated with further shifts in expenditure composition as priority capital expenditures continued to grow at the same rate as real GDP, social expenditures were held steady in real terms, and spending on defense and internal security were consolidated further. A closer examination of the shifts in expenditure composition over time, as well as benchmarking against regional comparators, can provide useful information to policymakers seeking to sustain and deepen fiscal consolidation in Georgia. Figure 1.7. Expenditure Composition, Functional in percent of GDP, General Government

Figure 1.8. Expenditure Composition, Functional in percent of GDP, General Government

3,000

13.4

13.1

11.3

10.9 9.5

9.4

6 3.9 4

4.4 3.7

1,500

1,242

0 2003

1,542

5.4 4.6

4.4

1,430

1,285 1,131 939

1,000 870

880

900

2007

2008

1,110

1,022

3.6 573

2 2 1.2

1,904

1,789 1,527

6.5 5.8

2,498

1,650

7.4

5.8

2,488

2,204 2,000

7.3 6.3

2,532

2,500

9.8 9

8.4 8

2,726 2,600

592

627

2005

2006

500 284

2004

Defense, internal affairs General public services

2005

2006

2007

2008

2009

Education, health, social prot Economic affairs

Source: Georgian authorities and WB staff estimates.

2010

2011

0 173 2003

291 2004

Defense, internal affairs General public services

2009

2010

2011

Education, health, social prot Economic affairs

Source: Georgian authorities and WB staff estimates.

Pre-Crisis Developments, 2004–07 Following the Rose Revolution, important functions of the state were restored and made credible, with public spending increasing across the board during 2004–07. Total public expenditures increased by 16.5 percent of GDP (from 17.5 percent in 2003 to 34 percent in 2007) during this period, which amounts to a 177 percent increase in real terms (from GEL 2,433 million in 2003 to GEL 6,736 million in 2003, in 2010 prices). This rise in public spending was driven in large part by considerable increases in defense and internal security expenditures, which together rose by 11.1 percent of GDP or by 815 percent in real terms, from GEL 284 million in 2003 to GEL 2,600 million in 20078.

The effectiveness of education, health, and social benefit spending improved considerably during this period and expenditures in these sectors increased from 6.3 percent of GDP in 2003 to 9 percent in 2007. This amounted to a 106 percent increase in social spending in real terms. More importantly, considerable improvements were made in the effectiveness and targeting of social spending during this period. At the end of 2003, social programs were characterized by major governance and institutional problems, nonpayment of benefits, and accumulation of large arrears. The education infrastructure was in disrepair, the teaching force poorly paid, and curricula and teaching methods were outdated. The health sector was characterized by overcapacity, poor service quality and infrastructure, and low utilization of health services, the lowest in the ECA region. Since 2004, the new government cleared pension arrears, established on-time payment, and increased the pension benefit from GEL 14 per month in 2003 to GEL 38 per month (in nominal terms) in 2007.

All real values are expressed in 2010 Lari.

Chapter 1. Macroeconomic Context and Expenditure Composition

Georgia Public Expenditure Review 2012

The targeted social assistance (TSA) program was introduced in 2006 and provided the extreme poor with a vital safety net. In health, a medical insurance program targeted to the poor and providing a comprehensive set of benefits was introduced in 2006. In education, a per-capita financing scheme was introduced, corruption in nationwide entrance examinations was eliminated, and the monitoring of school performance was strengthened. As a result of these improvements, the quality of spending in these sectors improved considerably. Figure 1.9. Expenditure Composition

Figure 1.10. Expenditure Composition

Economic classification, in percent of GDP

Economic classification, in real 2010 Lari

2,000

1,800

1,600

1,400 7 1,200 6 1,000 5 800 4

600

3 2 2003

400

2004

Capital expenditures

2005

2006

Social expenditure

2007

2008

2009

Goods & services

Source: Georgian authorities and WB staff estimates.

2010

2011

Wages & salaries

200 2003

2004

Capital expenditures

2005

2006

Social expenditure

2007

2008

Goods & services

Source: Georgian authorities and WB staff estimates.

2009

2010

2011

Wages & salaries

Public capital expenditures increased from 2.8 percent of GDP in 2003 to 9 percent in 2007, reflecting a 350 percent increase in real terms. A large part of the increase in capital expenditures took place in the defense and internal security sectors. However, there were also considerable increases in public investment in basic energy and transport infrastructure. At the end of 2003, electricity service was limited to seven hours per day, collection rates were around 35 percent, and large parts of the road infrastructure were in considerable disrepair. In the energy sector, the government invested in rehabilitation of generation capacity, and coupled these investments with reforms to unbundle and privatize electricity services. By 2007, electricity service approached 24/7 for all paying customers and collection rates improved to more than 90 percent. In the road sector, the government invested in rehabilitation of the international and secondary network, with total spending on new construction and rehabilitation of the international and secondary network increasing from GEL 67 million (0.7 percent of GDP) in 2003 to GEL 271 million (1.6 percent of GDP) in 2007. As a result, the share of the international and secondary road network in “good” or “fair” condition improved considerably.

Crisis and Fiscal Stimulus, 2008–09 The strategic objectives of the fiscal stimulus during 2008–09 were to support economic recovery and to mitigate the impact of the downturn on the poor and vulnerable. With private investment down sharply following the dual shocks to the economy, the authorities sought to support growth and employment by scaling up public investment in select areas. Another goal of the stimulus expenditures was to ensure that the investments were supportive of long run growth and employment generation. Toward this end, state government investment in construction and rehabilitation of international and secondary roads was scaled up from GEL 271 million (1.6 percent of GDP) in 2007 to GEL 509 million (2.8 percent of GDP) in 2009. This was complemented with investments in municipal infrastructure (roads, water, waste management, urban restoration) and in housing

12 | Chapter 1. Macroeconomic Context and Expenditure Composition

Managing Expenditure Pressures for Sustainability and Growth

for new internally displaced persons (IDPs) from the August 2008 conflict. Overall, capital expenditures actually declined from 9 percent of GDP in 2007 to 8.4 percent in 2009 (from GEL 1,777 million in 2007 to GEL 1,634 million in 2009 in real terms), although the composition of capital expenditures changed considerably. The share of capital expenditures going to defense and internal security declined from 60 percent in 2008 to 36 percent in 2009, while the share going to the transport sector increased from 21.5 percent in 2008 to 45.6 percent in 2009. Figure 1.11. Public Capital Expenditures Functional Classification, in percent of total

General public services

2008 5.7

2009 9.2

2010 11.7

2011 9.9

Economic Affairs

23.8

43.1

55.0

60.3

Defense

23.3

Public order and safety

36.6

of which:

15.9

19.9

9.2

6.4

13.1

9.3

Transport (principally roads)

21.5

36.9

45.6

46.5

Housing and community amenities

0.5

0.1

0.0

Energy

0.3

Environmental protection

0.6

Health

2.5

Recreation, culture and religion

Education

Social Protection

Total

1.4

5.4

0.3

100.0

Source: Georgian authorities and WB staff estimates.

0.1

1.3

0.5

2.0

4.3

2.7

0.7

2.8

3.1

100.0

1.3

0.2

1.0

5.0

2.4 3.5

100.0

1.3 6.5 0.4

100.0

Figure 1.12. Public Capital Expenditures composition, in percent of total

30 23.3 20 15.9 10 9.2 6.4 0 2008 Transport (principally roads) Defense

2009

2010

2011

Public order & safety

General public services

Source: Georgian authorities and WB staff estimates.

The fiscal stimulus during 2008–09 resulted in an increase in expenditures by 4.4 percent of GDP and although real increases were limited, the composition of expenditures shifted markedly. Total expenditures increased by 11.4 percent in real terms from GEL 6,736 million in 2007 to GEL 7,502 million in 2009 but underlying this limited increase was a marked reorientation in the composition of public expenditures. Education, health and social benefit expenditures increased from 9 percent of GDP in 2007 to 13 percent in 2009, which amounts to a 42 percent increase in real terms from GEL 1,789 million to GEL 2,532 million. Fiscal space for these increases came from a decline in defense and internal security spending from 13.1 percent of GDP in 2007 to 9.8 percent in 2009. Coverage and benefits were increased for pensions, targeted social assistance (TSA), and the medical insurance program (MIP). The pension benefit was increased from GEL 38 per month in 2007 to GEL 70 per month in 2009, so that the pension budget increased from GEL 455 million in 2007 to GEL 821 million in 2009 in nominal terms. The TSA benefit for additional family members was increased from GEL 12 per month to GEL 24 per month in 2009 and additional vulnerable households were accommodated into the program, so that the TSA budget increased from GEL 83 million in 2007 to GEL 160 million in 2009. The coverage of the MIP was also increased from 700,000 to 900,000 individuals and premiums were increased, so that the MIP budget increased from GEL 37 million in 2007 to GEL 133 million in 2009.

Recovery and Fiscal Adjustment, 2010-11 The strategic objectives of fiscal adjustment during 2010–11 were to augment priority infrastructure investments, hold the line on social expenditures in real terms, and continue to consolidate expenditures in other areas. As private investment and FDI remained weak and significantly below pre-crisis levels, the authorities sought to continue to support recovery and growth by augmenting priority infrastructure investments.

Chapter 1. Macroeconomic Context and Expenditure Composition

Georgia Public Expenditure Review 2012

Continuing investment areas included construction and rehabilitation of the international and secondary road network, regional and municipal infrastructure, IDP housing, and urban restoration. New investment areas coming on stream in 2010–11 included energy transmission and water. Total capital expenditures increased from 8.4 percent of GDP in 2009 to 8.8 percent in 2011, which reflected a 20 percent increase in real terms from GEL 1,634 million to GEL 1,961 million. Underlying this overall increase, however, was further shifts in the composition of public investment. The share of state government public investment in defense and internal security declined from 36 percent in 2009 to 15.7 percent in 2011, while the share in transport (principally roads) increased from 37 percent in 2009 to 47 percent in 2011.

Total public expenditures declined in real terms for the first time during 2010–11 as social expenditures held steady in real terms while expenditures in other areas were reduced. Total public expenditures declined from 38.4 percent of GDP in 2009 to 32.1 percent in 2011, which reflects a 5 percent decline in real terms from GEL 7,502 million to GEL 7,110 million. Defense and internal security spending was reduced further from 9.8 percent of GDP in 2009 to 6.5 percent in 2011, which reflects a 25 reduction in real terms from GEL 1,904 million to GEL 1,430 million. Against this backdrop of overall expenditure consolidation, spending on education, health, and social benefits held steady at about GEL 2,500 million in real terms during this period. Overall, the improved coverage and benefits of social programs was maintained, but some savings were realized through improved efficiency and targeting. Pension benefits were actually raised in nominal terms from GEL 70 per month in 2009 to GEL 80 per month in 2010 and GEL 100 per month in 2011. Coverage of the targeted medical insurance program was held steady at about 900,000 beneficiaries and a drug benefit was added to the package, but savings were realized from a renegotiation of premiums with insurance companies. TSA coverage was maintained around 440,000 beneficiaries, but the targeting of the poor was improved by proactively identifying and removing ineligible beneficiaries from the pool.

Benchmarking Expenditure Levels and Composition

14 | Chapter 1. Macroeconomic Context and Expenditure Composition

S. Africa

Chile

Costa Rica

Vietnam

Colombia

Thailand

Indonesia

Turkey

Slovakia

Slovenia

Romania

Lithuania

Macedonia

Croatia

Estonia

Bulgaria

Ukraine

Georgia

Moldova

Armenia

Figure 1.13. Current and Capital Expenditures Total public expenditure levels in Georgia are Georgia and Selected Countries, 2010 lower than in most ECA countries but higher in percent of GDP than in most comparators in East Asia and 50 Latin America. In 2010, total expenditures of 34.8 percent of GDP in Georgia were lower than 40 in most ECA countries, except for Lithuania and 30 Macedonia which had similar expenditure levels similar to Georgia, and Armenia which had lower 20 expenditure levels than Georgia. Most other comparators in the region had total expenditure 10 levels in excess of 40 percent of GDP, with Ukraine and Slovenia the highest at about 50 percent of 0 GDP. The source of the difference was current expenditures, where Georgia (26 percent of GDP) Current expenditure Capital expenditure spent decidedly less than most countries in the Source: World Bank/IMF Fiscal Databases. region other than Armenia. On the other hand, when comparing with countries in East Asia and Latin America, total expenditures in Georgia were generally higher. Current expenditures in Indonesia, Thailand, and Vietnam were between 17–20 percent of GDP in 2010, while levels in Colombia, Chile, and Costa were between 21–23 percent of GDP. Capital expenditures in most

Managing Expenditure Pressures for Sustainability and Growth

East Asian/Latin American comparators were also lower than in Georgia, except for Vietnam where capital expenditures amounted to more than 13 percent of GDP in 2010. Figure 1.14. Composition of Expenditures, Economic Classification, Georgia and Selected Countries in percent of total expenditures

in percent of total expenditures

Compensation of employees

Goods and services

Bulgaria

Croatia

Estonia

Lithuania

Macedonia

Romania

Slovakia

Slovenia

Bulgaria

Croatia

Estonia

Lithuania

Macedonia

Romania

Slovakia

Slovenia

Turkey

Ukraine

Turkey

Capital expenditures

Ukraine

0 Armenia

0 Slovenia

Slovakia

Romania

Macedonia

Lithuania

Estonia

Croatia

Bulgaria

Ukraine

Moldova

Georgia

Armenia

Moldova

Georgia

Social benefits 50

30 25

20 30 15 20 10 10

2009

2011

2007

2009

Turkey

Moldova

Georgia

Turkey

Slovenia

Slovakia

Romania

Macedonia

Lithuania

Estonia

Croatia

Bulgaria

Ukraine

Moldova

Georgia

Armenia

2007

Source: World Bank ECA Fiscal Database.

Armenia

2011

Comparing with other regional economies, Georgia directs a greater share of public expenditures to investment and lower shares to social benefits and compensation of employees. In 2011, the share of expenditures going to social benefits was 22.2 percent in Georgia, considerably below regional comparators which use between 35–45 percent of expenditures on paying social benefits. The high social benefit share of expenditures across the ECA region is a result of aging populations as well as a social contract that provides for relatively generous and universal publicly funded old-age benefits. For example, the share of the elderly receiving a public pension is 93 percent in emerging Europe versus 26 percent in emerging Asia and 59 percent in Latin America. In several countries, such as Ukraine, the high social benefit share of expenditures considerably reduces fiscal space for expenditures in other productive areas and generally makes fiscal policy much less able to respond flexibly to economic shocks. While Georgia has avoided this fate, the experience of other countries in the region provides Georgia with a reminder of pitfalls to avoid in managing the social benefit system for an aging population. In addition, the share of spending going to employee compensation in Georgia was 15 percent in 2011, considerably less than in most regional comparators where employee compensation accounted for around 22–28 percent of spending. This is primarily a result of the significant consolidation of public sector employment in Georgia since the Rose Revolution.

Chapter 1. Macroeconomic Context and Expenditure Composition

Georgia Public Expenditure Review 2012

In 2011, the share of public expenditures going toward investment was 22.5 percent in Georgia, substantially higher than other non-oil emerging economies in the ECA region. Among comparators, Bulgaria, Romania, Macedonia, Estonia, Lithuania, and Moldova invested between 11–15 percent of public expenditures, while Ukraine, Croatia, and Slovakia invested a particularly low 4–5 percent of public expenditures. In Ukraine, Croatia, and Slovenia, the investment share of expenditures has declined considerably since the onset of the crisis, while in Georgia it has remained relatively steady. Furthermore, as discussed, the share of expenditures going to non-defense investment has actually risen considerably in Georgia over the last four years (2008–11). With income levels and infrastructure quality and quantity in Georgia significantly below those in other Central and Eastern European economies, a higher investment share of expenditures in not unwarranted for Georgia. At the same time, the larger public investment program in Georgia also raises the importance of strengthening capital budgeting systems to enhance selectivity, efficiency, and sustainability of the public investment program. Figure 1.15. Composition of Expenditures, Functional Classification, Georgia and Selected Countries in percent of total expenditures

in percent of total expenditures

Defense

Education, health and social prot. 80

30 25

60 20 15

10 20 5

2009

2011

2007

2009

Turkey

Slovenia

Slovakia

Romania

Macedonia

Lithuania

Estonia

Croatia

Bulgaria

Ukraine

Moldova

Georgia

Turkey

Slovenia

Slovakia

Romania

Macedonia

Lithuania

Estonia

Croatia

Bulgaria

Ukraine

Moldova

Georgia

Armenia

2007

Source: World Bank ECA Fiscal Database.

Armenia

2011

Although the share of defense expenditures in Georgia has declined decidedly (and with it, the opportunities to readily generate further fiscal space), it still remains considerably higher than in regional comparators. The share of defense fell from 26 percent of total expenditures in 2007 to 9.5 percent in 2011. This remains considerably higher than in most ECA comparators where defense accounted for between 3–5 percent of total spending in 2011. Compared to Georgia, only Armenia spent a greater share of total expenditures (13.5 percent) on defense in 2011. The figure for Turkey was 5.2 percent. With the decline of defense expenditures in Georgia between 2007–11, the opportunities to readily generate fiscal space have diminished. On the other hand, the still high share going to defense in Georgia suggests that depending on its security needs, further opportunity to generate fiscal space through a reduction in defense expenditures may exist. This indication is bolstered by a cross comparison of the share going to defense with that going to education, health, and social protection. The share of total spending going to education, health, and social protection is less in Georgia than in most regional comparators. While part of this difference is due to more generous (and often unsustainable) pension benefits in many ECA countries (e.g. Ukraine), Georgia also spends a lower share of expenditures on education and health than in regional comparators.

16 | Chapter 1. Macroeconomic Context and Expenditure Composition

Managing Expenditure Pressures for Sustainability and Growth

Continued implementation of fiscal consolidation, 2012–15 Going forward, capital expenditure consolidation can make a greater contribution to fiscal consolidation than it has so far. As private investment recovers, the pressures to maintain high levels of public investment should abate. This should enable some winding down of the hump in post-crisis capital expenditures. At the same time, given significant infrastructure development needs, containing current expenditure pressures will also be important. Social expenditure pressures will remain considerable in the medium term: the aging population and expectations for maintaining the benefit replacement rate will create pressures for sustained increases in pension expenditures; overall health outcomes will need further improvement; and social assistance coverage of the poor can increase further while unemployment remains high. The medium term fiscal framework projects that current and capital expenditures will make similar contributions to adjustment over the next three years, with capital expenditures declining from 8.9 percent of GDP in 2011 to 7.2 percent by 2015 and current expenditures declining from 23.3 to 21.8 percent during this period. Social benefit expenditures are projected to increase at the rate of real GDP, while capital expenditures are projected to remain constant in real terms during 2012–15, at about GEL 1,980 million in 2010 prices. Key options for further expenditure consolidation include instilling greater selectivity in capital expenditures, containing medium term social expenditure pressures, and enhancing sustainability of the road investment program. Maintaining pension replacement rates for an aging population represents the key source of pressure on social expenditures. This can be contained over the medium term by combining limited growth of the basic benefit with measures to develop private savings for retirement. In addition, improved coverage and targeting of the TSA and MIP programs can be combined with measures to connect TSA recipients with employment opportunities and improve access to pharmaceuticals and preventative treatments for the population. Option to instill greater selectivity in capital expenditures include further improving the capital budget including a consistent and comprehensive presentation of public funding for investment, as well as strengthening the broader capital budgeting systems, including systematizing the project identification process and developing methodological guidance for cost-benefit analysis. In this context, developing a framework to avoid fiscal liabilities from state-owned enterprises and public-private partnerships can be particularly important. Options to enhance sustainability of the road investment program include a phased-in rebalancing of road expenditures toward maintenance and rehabilitation as investment in the main East-West highway approaches winds down, along with institutional measures to enhance the efficiency of road investments.

1.4. Conclusion: the way forward

The analysis in this chapter suggests that Georgia could move forward along one of several paths depending on the fiscal choices that it makes. One the one hand is the path of a growing body of public investment and ad hoc increases in untargeted pension and other social benefits progressively finding their way into the annual budget. Further fiscal consolidation would be delayed and even as capital inflows, private investment, and growth pick up, additional revenues would be used to finance the progressively higher spending. This path could lead Georgia back to an unsustainable growth path driven by nontradables, widen external imbalances, and raise financing costs in an uncertain global environment. One the other hand is the path of maintaining discipline in implementing further fiscal consolidation and in the event of an upside scenario with higher growth and capital inflows, accelerating fiscal consolidation by saving part of the additional revenues.

Chapter 1. Macroeconomic Context and Expenditure Composition

Georgia Public Expenditure Review 2012

The fiscal consolidation path would involve enabling public investment to make a contribution to expenditure consolidation going forward, particularly as private investment picks up, and exploring opportunities for further consolidation of defense expenditures as security needs permit. This path would lead toward a narrowing of the current account deficit, further bolster debt sustainability, and encourage a shift toward a sustainable growth model financed more out of national savings and driven more by tradables. It would also help ensure that considerable needs in education, health, and targeted social protection are not crowded out by inadequate screening of public investment and rapid growth of untargeted pension spending.

18窶ポ窶イhapter 1. Macroeconomic Context and Expenditure Composition

Managing Expenditure Pressures for Sustainability and Growth

Chapter 2. Social Protection Expenditures 2.1. Introduction

Against the backdrop of fiscal consolidation, a key challenge for Georgia is to manage social expenditure pressures while providing adequate pension income support for an aging population and improving social assistance coverage of the poor. The most recently approved fiscal framework envisages current expenditures falling and social protection expenditures remaining flat as a share of GDP during 2011–15. Most of the programmed real increase in social protection expenditures during this period will go toward the one-time increase in pensions from September 2012. Against this backdrop, Georgia faces considerable social expenditure pressures in the medium term. With the old-age population rising rapidly and most of the elderly population relying on the basic public pension benefit for old-age income support, the pension program will continue to exert pressure on social expenditures. Without private saving for retirement, maintaining the pension replacement rate will lead to higher fiscal costs over time. While maintaining at least the purchasing power of the benefit will be important given its poverty mitigating impact, even faster growth of the public pension benefit could potentially crowd out necessary increases in targeted social assistance (TSA). While the TSA program does a good job of supporting consumption among the extreme poor, more than 40 percent of the poorest decile does not receive TSA. An expansion of TSA coverage of the bottom deciles would exert some further pressure on social expenditures but would be better targeted than higher pension benefits. In order to address the challenges facing social protection expenditures in Georgia, the analysis in this chapter discusses the following options for consideration:

●● Further significant one-time jumps in the basic pension benefit can be selectively targeted, both in order to avoid a large jump in fiscal costs and due to equity considerations. (short-term) ●● A mechanism to limit medium term growth of the basic pension benefit to no more than the rate of inflation can be explored, both to protect purchasing power and to set expectations at affordable levels. (medium term)

●● Exploring measures to developing voluntary savings in the medium-term can ease pressure on the basic publicly funded benefit. This can begin with a diagnostic on constraints to private retirement savings in Georgia. Specific policy initiatives for consideration include an opt-out versus opt-in program, tax treatment of retirement savings, and identifying financial instruments for long-term retirement savings. (medium term) ●● Improving TSA coverage of the poor is an important priority. This will require improved outreach to those of the poor who have not applied for the benefit, as well as improvements to the proxy-means testing process to reduce denials for the poor who have applied. (short-term) ●● TSA can be prioritized over universal transfers (e.g., pensions and energy vouchers) for any additional social spending, to enhance overall equity of social protection expenditures. (short term)

Chapter 2. Social Protection Expenditures

Georgia Public Expenditure Review 2012

●● TSA recipients can be linked with employment opportunities and human capital investments more broadly to reduce dependency on the program, with further diagnostic needed of specific mechanisms to achieve this. Although there is little evidence that TSA discourages beneficiaries from seeking work, nor does it actively promote more secure livelihoods (medium term)

The structure of this chapter is as follows. The next section provides an overview of the composition and levels of social protection expenditures in Georgia. The third section looks in depth at the pension system in Georgia and shows that while it has been effective in providing old-age income support and mitigating poverty, maintaining the replacement rate of the basic benefit will lead to higher fiscal costs over time. The section then goes on to consider options to encourage private savings for retirement to supplement the basic pension. The fourth section looks at the TSA program and shows that while it has made important strides with regard to “first-generation” reforms such as benefit consolidation, benefits administration, and targeting effectiveness, challenges remain in expanding coverage of the bottom decile and better connecting beneficiaries to job opportunities. The final section considers some cross-cutting themes on the relative implications of the pensions and TSA programs on poverty reduction, labor force impact, and demography.

2.2. Overview of Social Protection Spending Social protection and health expenditures in Georgia, comprising primarily pensions, targeted social assistance, and health programs, account for a major share of the overall budget. Table 2.1 shows a budget breakdown for the Ministry of Labor, Health, and Social Affairs, which accounts for about 25 percent of the state government budget and represents the vast majority of social spending in Georgia. Social spending by local governments, as well as some small programs under other Ministries, is not reflected in the table. The major spending categories under social protection are pensions (old-age and disability) and targeted social assistance, with pensions accounting for the largest category of social spending in Georgia. The budget for both of these programs can be understood simply as a monthly benefit times the number of eligible beneficiaries. Nearly half of the health budget is the Medical Insurance Program for the poor (a premium allocated to private insurers times the number of eligible beneficiaries) and the remainder is mostly disease specific programs (e.g., for tuberculosis, diabetes, oncology, etc.).

20 | Chapter 2. Social Protection Expenditures

Table 2.1. Overview of Social Spending in Georgia, 2008–11 Ministry of Labor, Health, and Social Affairs

6.9%

in millions of lari and percent of GDP

% of GDP

Social protection programs % of GDP

Of which: Pensions

Old-age pensions

Disability pensions

Targeted Social Assistance

Health programs % of GDP

Of which:

Medical Insurance Program

Other (mainly diseasespecific)

2008

2009

2010

2011

1,293

1,503

1,605

1,666

990

5.2%

1,137 6.3%

1,070 5.2%

1,139

727

895

924

987

102

114

123

119

6.8%

509

8.4%

600

147

7.7%

635

147

4.7%

690

140

226

1.2%

291

1.6%

329

1.6%

1.1%

133

147

121

143

158

182

277

156

Source: MoF and SSA. Figures do not always add up as some small sub-categories excluded.

Managing Expenditure Pressures for Sustainability and Growth

Figure 2.1. Social Protection Spending in Georgia and Region

Social protection spending in Georgia is relatively low by international standards, although it is somewhat closer to the norm among countries at similar income levels. Social assistance spending, at about 1 percent of GDP, is typical of the region. Pension spending in Georgia is lower than average, but most of the higher spenders are also richer countries, many of which are saddled with unsustainable pension obligations. Unlike most other countries, Georgia does not have labor market programs (e.g., unemployment insurance), although it also has a large rural sector. Georgia is a clear outlier in terms of health spending (not shown, but discussed in the next chapter), which at less than 2 percent of GDP is about half the regional average and also low by global standards.

in percent of GDP

Tajikistan 09 Kosovo 09 Azerbaijan 09 Georgia 09 Armenia 09 Kyrgyz Republic 09 Albania 09 Turkey 09 Latvia 09 Russia 08 Moldova 08 FYR Macedonia 09 Lithuania 08 Bulgaria 08 Belarus 09 BiH 07 Montenegro 09 Romania 09 Croatia 09 Serbia 09 Ukraine 09

0 Social assistance

Source: ECA SP database.

Labor market

Social insurance

Social safety net programs have contributed to poverty reduction in Georgia. Since 2004, Georgia has established a viable social safety net by clearing pension arrears, increasing benefits, and by putting in place the targeted social assistance and medical insurance programs. Strong growth during 2004–07 was not associated with lower unemployment due to significant economic restructuring. Still, comparisons based on the annual national Household Budget Survey (HBS) suggest a reduction in the poverty headcount during this period, from 28.5 percent in 2003 to 22.7 percent in 2008 (figure 2.2). The decline in poverty is partly due to the social safety net programs put in place during this period, as indicated by survey-based simulations discussed in greater detail below. Following the economic crisis, poverty rose to 24.7 percent in 2009 (18.4 percent in urban areas and 30.7 percent in rural areas). Inequality also followed a similar pattern, with the Gini coefficient declining from 38.0 in 2003 to 33.8 in 2008, before rising to 34.1 in 2009. Figure 2.2. Poverty Trends in Georgia, 2003–09 in percent of population

in percent of population

Overall poverty

Extreme poverty 14

28.5

12.9

24.7 23.4

22.7

20 9.2

8.7

8 15

7.3 6

10 4 5

2 0

0 2003

2007

2008

2009

2003

2007

2008

2009

Source: Estimates based on 2007 LSMS, 2003 HBS, and 2008-09 HBS.

Chapter 2. Social Protection Expenditures

Georgia Public Expenditure Review 2012

2.3. Pension System Overview

Georgia’s old age pensions represent the largest category of social spending, accounting for well over half of total social protection expenditures. Since 2004 large arrears in the pension system have been cleared, minimum contributions have been abolished, categories were streamlined, and benefit levels significantly increased. As of mid-2012, all men over the age of 65 and women over 60 receive GEL 100 per month. The total number of beneficiaries is currently about 660,000, or 15 percent of a total population of 4.4 million. Eligibility is based exclusively on age and is not linked to past work history. A small top-up ranging between GEL 2 to 10 per month exists for some pensioners as a “long-service bonus”, but this accounts for only a small share of the total pension budget. There is also a larger “state compensation” program tied to service, particularly for retired police, military, and politicians. The old-age pension is financed through general tax revenues, as the previous payroll tax mechanism was abolished in 2008. As a non-contributory, flat social pension, this type of system is sometimes referred to as a “zero pillar” in the international literature. There is no mandatory (pay-as-you-go) first or (fully-funded) second pillar pension system in Georgia. There is also a disability pension program (GEL 70–100 per month for about 135,000 beneficiaries) and smaller survivor and political pension programs. Table 2.2 has further details. Table 2.2. Old-age Pensions Accounts for the Bulk of Social Spending in units as noted

Program

Age pensioners

Disability pension Survivor pension Political pension

Eligibility

Monthly benefit (GEL)

Male 65+, Female 60+

80; 100 in Sept.

Two benefit levels; currently most are <60 yrs For <18 yr old if parent dies Special category

MIP

Eligibility by proxy means

TSA

Eligibility by proxy means

Source: SSA and WB.

80 55

Total annual payment

Share of 2010 GDP

662,350 635,856,000

3.1%

2011 # eligible

110,472

92,796,480

31,700

20,922,000

25,550 2,495

24,528,000 1,646,700

~10 (premium)

~190,000 pensioners

22,800,000

30+24

~115,000 pensioners

38,640,000

~10 (premium) 30+24

~710,000 non-pens.

85,200,000

~325,000 non-pens. 109,200,000

0.4% 0.1% 0.1% 0.0%

0.1% 0.4%

0.2%

0.5%

The monthly old-age benefit is not indexed at present, and recent increments have been done on a frequent but ad-hoc basis. Adjustments have generally been done annually, and have maintained the replacement rate (monthly pension benefit as a percent of the average wage) at about 10–15 percent (Figure 2.3). Further increases in the monthly benefit have been announced, to GEL 125 for those of age 67 and over, from September 2012. These changes are discussed further below.

Georgia’s pensions play a major role in reducing the incidence of old-age poverty. Estimates of the poverty headcount with and without the GEL 100 monthly pension are shown in Table 2.3. The poverty rate is lowered by over 15 percentage points due to pensions. Moreover, the poverty-reducing impact is felt well beyond the elderly, as a high rate of inter-generational living means that about 52 percent of Georgian households include at least one pensioner.

22 | Chapter 2. Social Protection Expenditures

Managing Expenditure Pressures for Sustainability and Growth

Figure 2.3. Pension trends in Georgia in Lari

in percent of average wage

Monthly pension benefit, 2003–2011

Replacement rate, % of average wage, 2004–2010 16

120

14 100

13.7

100

13.4

12.6 11.9

11.5

80 80

10.3

2007

2008

70 60

8 55 6

40 38

33 28

20 14

0 2003

2004

2005

2006

2007

2008

2009

2010

2011

Source: SSA and GeoStat.

Table 2.3. Poverty Rate in Georgia with and without Old-age Pensions in percent of overall population

With GEL 100 Without GEL 100 pension benefit pension benefit

Overall poverty headcount Urban Rural

Source: Staff estimates based on 2009 UNICEF WMS.

2004

2009

2010

in percent of population

38.1

28.2

46.9

29.5

2006

Figure 2.4. Poverty Implications of Increases in Monthly Pension Benefit

22.9 17.7

2005

40 30

Additional pension increases currently planned 20 would further reduce poverty. Figure 2.4 shows 10 the cumulative percent of the population (on vertical axis) falling below poverty (red line) under alternative 0 0 50 100 150 200 250 benefit levels. The benefit increase from GEL 80 to GEL Monthly consumption per adult equivalent (GEL 2009) 100 for the elderly would reduce the poverty headcount 80 GEL pension 100 GEL pension 125 GEL pension for 67+ from 25.7 percent down to 22.9 percent, while an Source: WB staff estimates. increase to GEL 125 for the over-67 population would imply a poverty rate of 20.3 percent.9 It is important to note, however, that greater poverty reduction per GEL can be achieved through the TSA program, as discussed below.

The fiscal burden imposed by Georgia’s pension system is affordable at 2011 nominal benefit levels, but will require close monitoring due to an aging population and expectations for increased benefit levels in the future. Pension spending as a share of GDP is currently about 3.5 percent in Georgia, one of the lowest in Europe and Central Asia (Figure 2.1). Georgia is, however, at a considerably lower income level than most of the countries with higher pension burdens, and it has an older population structure than those (e.g., Armenia and Azerbaijan) with similar levels of pension spending. As a result, maintaining a sustainable pension program will remain a key imperative.

Implicit assumptions are that (a) the full pension amount is allocated to consumption, and (b) if pension income is lost then it is not replaced by other income such as private transfers or employment.

Chapter 2. Social Protection Expenditures

Georgia Public Expenditure Review 2012

The old-age dependency ratio is projected to rise considerably in Georgia. Over time the population share of children and working-age adults is expected to shrink, while the number of elderly will steadily increase (Figure 2.5). Georgia’s old age dependency ratio is higher than Armenia, Azerbaijan, Moldova, Poland, and Russia, but lower than Ukraine, the Baltics, other new EU members, and most of Western Europe. Figure 2.5. Demographic trends in Georgia , 1990–2050 in number of persons (thousands) and in percent of population

Population 0–14 years in Georgia 1,600 1,400

in number of persons (thousands) and in percent of population

Population 15–64 years in Georgia 4,000

3,500

3,000

2,500

2,000

1,500

1,000

500

1,200 20 1,000 15 800 10 600 5

400

200

Population 65+ years in Georgia 900

1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

800

Population 80+ years in Georgia 300

8 7

250

200

700

600

5 500 15

150

100

400 3 300

200

100 0

0 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

Number of persons

Source: UN.

Percent of population

0 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

Number of persons

Percent of population

Strengthening the Current Basic Pension System While Georgia’s basic pension achieves significant poverty reduction at affordable cost, significant shortterm and medium-term challenges lie ahead. In the short-term, the old-age benefit of GEL 100 per month is viewed by many as inadequate for those elderly without other income or saving. On the other hand, further significant increases in the benefit level involve large fiscal costs that could potentially crowd out more targeted expenditures. The major medium to long-term challenge is to balance fiscal affordability with adequate living standards for the elderly given that the current non-indexed benefit will erode vis-à-vis inflation and real wages over time. If pensioners expect that the benefit will be periodically increased to maintain the replacement rate, while the population continues to age, fiscal costs could rise considerably over time. The next section considers how to create an environment that encourages private savings for retirement to supplement the basic pension.

24 | Chapter 2. Social Protection Expenditures

Managing Expenditure Pressures for Sustainability and Growth

The short-term challenge has been addressed in part by targeting the increased benefit in 2012 to a subset of the elderly. As announced by the authorities, the basic benefit has been raised to GEL 125 for those over the age of 67 as of September 2012, to be accompanied by a health insurance package for all pensioners. The increase to GEL 125 is expected to impose an additional fiscal cost of about 0.6 percent of GDP in 2013, which is manageable within the context of the governmentâ&#x20AC;&#x2122;s medium term fiscal consolidation program.

A smaller, targeted increase in the pension benefit generates significant cost savings. Figure 2.6 shows the cost of the old-age pension benefit as a share of GDP, as well as the replacement rate, under five different scenarios.10 The first two scenarios show the implications of the GEL 100 for all and the GEL 125 for all over age 67 monthly benefits, respectively, while the final scenario shows the implications of a larger increase to GEL 165 ($100) for all pensioners. The targeted increase to GEL 125 costs approximately an additional 0.6 percent of GDP in 2013, which results in significant savings compared to a larger untargeted increase that would cost an additional 2 percent of GDP in 2013. Two other options for containing fiscal costs are also considered. In the third scenario, the higher age-targeted GEL 125 is maintained, but fiscal costs are defrayed by increasing the female retirement age gradually from 60 to 65 by 2020, thereby equalizing it with the male retirement age.11 Scenario 4 targets the increase to GEL 125 instead to the more needy elderly, as determined by those with a proxy means test score below 100,000. This is a smaller group than the entire over-67 cohort, and thus it is somewhat less costly. Figure 2.6. Pension Indicators under Alternative Scenarios, Without Indexation pension spending as percent of GDP

replacement rate, average pension, as percent of average wage

7 6

20 5 15

4 3

2 5 1 0 2010

2015

GEL 100 for all

2020

2025

2030

GEL 100 + GEL 125 if 67+

GEL 100 +GEL 125 if <100k

Source: WB staff estimates.

2035

2040

2045

2050

Raise female retirement under Scenario 2

GEL 165 for all from Sep. 2012

0 2010

2015

GEL 100 for all

2020

2025

2030

GEL 100 + GEL 125 if 67+

GEL 100 +GEL 125 if <100k

2035

2040

2045

2050

Raise female retirement under Scenario 2

GEL 165 for all from Sep. 2012

The targeted increases are a more cost-effective way to reach those in greater need. Targeting on the basis of the proxy means test would have a greater impact on poverty, while applying the age criterion would be easier to implement from an administrative standpoint and would allow all individuals to benefit from the higher pension as they age. Since living costs for the elderly, including medical care and assistance from a caregiver, tend to increase as individuals age, while the ability to generate income declines, increasing the benefit only for the oldest of the elderly could be seen as providing additional needed assistance. Over the 10 All scenarios assume an average 5 percent real GDP and real wage growth, and 5 percent CPI.

11 Unifying male and female retirement ages is increasingly common in other countries, particularly as female life expectancy is typically somewhat longer than for men (in Georgia the gap is nine years).

Chapter 2. Social Protection Expendituresâ&#x20AC;&#x192; â&#x20AC;&#x192;

Georgia Public Expenditure Review 2012

longer-term, the Australian model—whereby the richest 20 percent (approximately) are not eligible for the basic social pension—could also be considered as an option for Georgia.

An additional challenge is that in the absence of indexation (or future ad hoc increases in the monthly benefit), the replacement rate (the benefit as a percentage of the average wage) falls to inadequate levels quite soon. Adequacy in pension systems is typically measured by one of two metrics, absolute or relative. The absolute measure seeks to provide the elderly with enough income to afford a fixed consumption basket in old age. Indexing the benefit to the price of that basket or to the consumer price index would maintain this measure of adequacy. Noncontributory pension systems such as Georgia’s typically focus on this metric. An alternative relative measure of adequacy provides pensioners with income to maintain some percentage of the living standard of working-age individuals. Indexing pension increases to average wage growth has proved to be too costly in most countries, particularly those in which aging is well advanced, unless benefit levels are modest relative to average wage. Alternatively, retirement benefit levels in contributory systems are often related to the worker’s earning history and then indexed forward with inflation to maintain the purchasing power of the first pension received by a retiree. This mix would be more difficult to implement in the Georgian context. However, a complete absence of indexation, as is currently the case in Georgia, can lead to constant political pressure for ad hoc increases in the benefit level. One option to manage the trade-off is to devise a mechanism to limit medium term growth of the basic pension benefit to no more than the rate of inflation. Such a mechanism could be phased in over time. Figure 2.7 shows that such a mechanism would be fiscally affordable while also protecting the purchasing power of the basic benefit. Figure 2.7. Pension Indicators under Alternative Scenarios, with Price Indexation pension spending as percent of GDP

replacement rate, average pension, as percent of average wage

6 20 5 15

4 3

2 5 1 0 2010

2015

GEL 100 for all

2020

2025

2030

GEL 100 + GEL 125 if 67+

GEL 100 +GEL 125 if <100k

Source: WB staff estimates.

2035

2040

2045

2050

Raise female retirement under Scenario 2

GEL 165 for all from Sep. 2012

0 2010

2015

GEL 100 for all

2020

2025

2030

GEL 100 + GEL 125 if 67+

GEL 100 +GEL 125 if <100k

2035

2040

2045

2050

Raise female retirement under Scenario 2

GEL 165 for all from Sep. 2012

If expectations develop that ad hoc benefit increases will preserve a constant replacement rate, the fiscal costs of the flat old age benefit could rise considerably over time. Figure 2.8 depicts the five scenarios considered earlier, except with wage indexation to preserve replacement rates in each case.12 The simulations show that in contrast to the previous case, wage indexation would lead to an increasing pension burden as a share of GDP, which would be unsustainable within the current fiscal framework. The current replacement rate of about 15 percent is low by international standards. If ad hoc benefit increases raised expectations to 12 The average wage rate is assumed to grow at 5 percent per annum, equal to the growth rate of real GDP.

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a 25 percent replacement rate, the long term pension burden could approach 9 percent of GDP. In brief, the current zero pillar system by itself is unlikely to satisfy population expectations for retirement income while maintaining fiscal affordability over time, thus pointing to the importance of complementing it by encouraging private savings for retirement, as discussed below. Figure 2.8. Pension Indicators under Alternative Scenarios, With Wage Indexation pension spending as percent of GDP

replacement rate, average pension, as percent of average wage

9 25

8 7

6 5

4 10

3 2

1 0 2010

2015

GEL 100 for all

2020

2025

2030

GEL 100 + GEL 125 if 67+

GEL 100 +GEL 125 if <100k

Source: WB staff estimates.

2035

2040

2045

2050

Raise female retirement under Scenario 2

GEL 165 for all from Sep. 2012

0 2010

2015

GEL 100 for all

2020

2025

2030

GEL 100 + GEL 125 if 67+

GEL 100 +GEL 125 if <100k

2035

2040

2045

2050

Raise female retirement under Scenario 2

GEL 165 for all from Sep. 2012

Creating the right incentives for supplementary pension savings The key longer-term issue for Georgia’s pension system is how to ensure adequate pensions for the elderly without undue fiscal stress. What pension level is ‘adequate’ may be somewhat subjective. The International Labor Organization recommends that retirees have 40 percent of the average wage earned during their lifetime as retirement income. While the average wage earned over a retiree’s working life is likely to be lower than today’s average wage, the 15 percent replacement in Georgia pensioners is relatively low, and will either fall even lower over time or lead to higher fiscal costs. One approach to managing the trade-off in a fiscally affordable manner would be to focus the basic benefit on alleviating poverty and to encourage individuals to save during their working years to cover the difference between the basic benefit and their desired level. Figure 2.9 shows that a combination of a basic and supplementary pension can stabilize the replacement rate over time. The scenario assumes that the basic benefit reaches GEL 165 (about $100), is indexed to inflation, and is supplemented by a contribution of 5 percent of wages. Unlike the scenarios presented above, the combined replacement rate flattens out over time.

While the need for a supplementary pension system in Georgia is clear, the timing of adoption and key design issues raise a number of questions and challenges. Key issues would include whether the new savings vehicle is mandatory or not; the potential impact of any new tax on labor markets; where to invest the funds (e.g., banks vs. bonds; home vs. abroad); the readiness of regulatory and supervisory authorities to oversee investments; the tax treatment of pension savings; whether there would be a single or multiple pension funds, publicly or privately managed; whether to provide a public guarantee or not; and other issues. A mandatory second pillar system may be premature for Georgia at present. Mandatory systems generally require greater supervision, regulation, and availability of investment instruments. Furthermore, in countries like Georgia where significant economic activity takes place outside of formal wage employment, people can

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Figure 2.9. Pension Indicators with Combined Basic And Supplementary Pension Programs pension amount received, real GEL

Pension received by those who contribute 5% of wage since 2015 1,000

replacement rate

Pension as percent of average wage 35 30

800 25 600

20 15

400

10 200 5 0 2013 2018 2023 2028 2033 2038 2043 2048 2053 2058 2063 2068 2073 Basic pension

Contributory pension

Source: WB staff estimates.

Total pension

0 2013 2018 2023 2028 2033 2038 2043 2048 2053 2058 2063 2068 2073 Basic pension

Contributory pension

Total pension

avoid formal sector jobs where saving would be mandatory, thus making it essentially voluntary. Finally, the collection of a payroll tax to fund social insurance programs was abandoned in 2008 as a result of the difficulties associated with enforcing collection and the need for a simplification of the tax system. Reinstating a labor tax on a mandatory basis, even if it is used to finance pensions for today’s workers, would result in a return to the problems experienced earlier.

An alternative approach would be to initiate pension reform by building on what is currently an underdeveloped third pillar pension environment. There are presently only three main private pension funds, total liabilities are reportedly less than GEL 10 million, and there are fewer than 25,000 current contributors. There are no tax incentives to save, so that pension funds are often no more attractive as a savings vehicle than bank deposits. Most funds are invested in bank deposits anyway. A key step towards encouraging voluntary savings for retirement would be to announce that in the future the basic pension will grow at a rate no greater than inflation, so that any higher retirement income will need to come from a worker’s own savings. As long as individuals believe that pension benefits will be raised periodically to maintain replacement rates, they will be reluctant to engage in private savings. It needs to be widely advertised that politicians will no longer be in a position to raise basic pension benefits faster than inflation, and that individuals will need to be content with the basic pension or must save privately for their retirement.

Targeting the basic pension to the poor can save fiscal resources, although withdrawing the basic pension for those who save can also result in disincentives to save. As the population ages, the basic pension will represent a growing fiscal burden. The cost implications of a more targeted pension were illustrated in the scenarios above. By encouraging those who can save to do so and targeting the basic pension to those who cannot, the government can better target limited fiscal resources. At the same time, the juxtaposition of basic and supplementary pension income can lead to disincentives for individuals to save or contribute, particularly lower middle-income individuals, since they know they will receive the social pension even if they do not make contributions. This is particularly true if they believe that the likelihood of achieving a higher pension than the social one is not certain, in which case they may be better off not saving rather than having “wasted” their money by saving when they could receive the same benefit in either case.

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A recent innovation in Chile in 2008 offers one potential solution for harmonizing incentives under basic and supplementary pension schemes. Chile has a mandatory second pillar, although there are many people in the informal sector who do not make regular contributions. Incentives are even more important in a voluntary system, such as the one Georgia may consider, because there would be no requirements to contribute. In Chile, a social pension was established at a certain level for individuals who never contributed to the pension system, and a higher threshold of pension income was set at which point no social pension would be provided. In between these two points, the social pension provided is gradually withdrawn. Thus, for each contribution made, pension income is higher than if the contribution had not been made, thus providing incentives for individual contributions. Figure 2.10 shows how the Chilean example could be applied in the Georgian context. If the social pension is set at GEL 125 per month, then a (three-fold) higher threshold of GEL 375 per month could be set as the level of pension income beyond which an individual is no longer entitled to any amount of social pension. The actual pension received by individuals would always increase with every additional lari of contribution. In the example shown, for every GEL 10 that an individual earns as a pension from voluntary savings, roughly GEL 3 of the social pension is reduced. There still is an implicit tax of Figure 2.10. Incentivizing Voluntary Savings in the 33 percent on savings between GEL 125 and GEL Presence of a Basic Pension 375 per month of pension income, but individuals total pension, in Lari per month still do better by saving at all income levels. This scheme provides better contribution incentives than withdrawing the entire social pension from those who contribute any amount. The tradeoff is between limiting saving disincentives and 375 lowering the cost of the social pension, and the faster the social pension is withdrawn, the greater the saving disincentive. A social pension to all leads to the highest fiscal cost and lowest savings 125 disincentives, while removing the social pension social for anyone who saves leads to the lowest fiscal pensiun 45 costs with greatest saving disincentives. The self-financed pension scheme suggested here represents a potential Source: WB staff. middle path. o

Another scheme to enhance participation in voluntary savings is automatic enrollment with the option of not participating (“opt-out”) rather than having individuals explicitly make the decision to join the system (“opt-in”). Evidence from actual cases suggests that under opt-in, some 40 to 70 percent of workers participate, while under opt-out, as many as 85 to 95 percent participate. A number of behavioral reasons can help explain this. First, when people opt-in to a plan, they are required to choose a contribution rate (e.g. anywhere from 1 to 15 percent), as well as investment asset options. Evidence from psychology literature shows that people are more likely to put off making decisions as the process becomes more complex. The evidence also suggests that the difference in participation between opt-in and opt-out is the greatest for those who are least knowledgeable about the financial sector, those who are young, and those who earn lower incomes.13 13 Beshears, Choi, Laibson, and Madrian, “The Importance of Default Options for Retirement Saving Outcomes: Evidence from the United States,” in Lessons from Pension Reform in the Americas, Oxford University Press, 2008.

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Opt-out provides a genuine choice for people who do not want to participate, but allows the inclusion of those who want to participate (but would not have otherwise due to inertia or lack of knowledge). Finally, many people are undecided and look for a recommendation on what to do. They view an opt-out as a government recommendation that they should participate, and therefore join in as well.

In addition to the opt-in vs. opt-out decision, there are several other areas related to retirement savings where default options are useful. One is the contribution rate. For reasons cited above, if the default contribution rate is set at 3 percent, a large share of employees, as many as 60 percent, will remain at that level. One reason for starting with a low contribution rate is that younger workers have relatively low salaries and may need resources for lumpy investments (e.g. a car or property). As a result, they may be more likely to opt out if the contribution rate is set too high. Over time, however, a low contribution rate will not generate sufficient retirement savings. For this reason, some voluntary plans have an “automatic escalator” clause which raises the contribution rate annually unless the individual opts out of this feature. Automatic escalator clauses usually have some default ceiling above which the individual can opt for even higher contributions, but which will not happen automatically. Another choice that an individual participating in a voluntary pension plan might need to make is the choice of portfolio. Again, since people are not likely to make pro-active choices, it is important to design a default portfolio, ideally one which moves with the life-cycle. For example, a 25-year old can be defaulted into a portfolio with an 80/20 equity/fixed income asset mix, shifting over time such that by age 65, the portfolio would be composed entirely of fixed-income assets.

Default options can also be helpful at the payout stage. Individuals could be encouraged to annuitize their accounts rather than taking lump sums by making the annuity the default, with the option to take a lump sum. The lump sum is generally inferior to an annuity in terms of poverty protection, since it could be exhausted prematurely. Although there are some circumstances under which a retiree would prefer a lump sum (e.g., to invest in a business which could then generate returns to cover the retirement period), for the majority it would be better to make the annuity a default option. Similarly, annuities can be paid as individual annuities, good only as long as that individual is alive, or as joint annuities, which cover the lives of both members of a couple. The default could be for a joint annuity, with an opt-out for those preferring other arrangements. In sum, default options can help overcome incentive problems at every stage of the voluntary pension process. Given the complexity of these issues, providing a sensible default option which provides the best option for the majority of people may result in more optimal participation and contribution rates to ensure more adequate returns, portfolio choices which adapt to appropriate age profiles, and the best social protection over the retirement period, while allowing voluntary choice and flexibility. Another area where incentive issues can be important in relation to voluntary pension schemes is the tax treatment of pension savings. This is addressed in Box 2.1.

A final area that requires attention in voluntary pension schemes is the availability of sound long term investment instruments. The lack of long term investment instruments is particularly acute in Georgia, and current pension funds earn low returns. This lack of financial development may be due to an insufficient pool of long term savings, thus suggesting a chicken and egg problem. The lack of long term savings may reflect a low level of trust in domestic financial markets. Addressing this will require an extended period of financial stability, but it will also require efforts to identify sound instruments for long term retirement savings in Georgia.

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Box 2.1. Tax Treatment For Funded Pension Systems

Pension systems typically provide some type of tax incentives, both to contribute and to keep the savings in the accounts until they reach retirement age. While tax incentive does result in loss of revenue, the rationale is twofold: (i) long term savings can be used for longer term investment projects that benefit society as a whole; and (ii) private retirement saving lowers the probability of old age poverty and thus the need for government resources to support the elderly.

Typically, when individuals save through a savings account, they pay tax on the income initially earned and on interest accumulated, but not on the savings account balance at the time of withdrawal. One approach to taxation of pension savings is similar, with individuals contributing taxed income to the pension account, but the interest earned is not taxable, and the eventual benefits withdrawals are not taxable. Employer contributions to the pension account, however, are typically not taxed, so that the employee pays tax on withdrawals following retirement. Often withdrawals are taken as an annuity, with tax is paid on annuitized withdrawals. This tax deferral is favorable to the employee because taxes paid in the future are always more beneficial than taxes which have to be paid now, but even more so with a progressive tax code since income is typically lower during retirement years.

When both employers and employees contribute to the same pension account, one option would be for the employee to pay tax on the employer contribution and then let the interest and withdrawals on the account remain tax free. The disadvantage of this approach is that employer contributions are typically regarded as benefits, not as income, and if individuals have to pay tax on the income anyway, they may be inclined to withdraw it early and spend it. An alternative would be to not tax the employer contribution, but for the retiree to pay tax on some portion of the withdrawal, in proportion to the employer contribution. This approach typically works in mandatory systems where the contribution rates by employer and employee are well defined. When individuals can vary their own contributions from year to year, sort out the taxable portion of the withdrawals becomes more difficult. A final approach used typically for voluntary pension savings is that both employer and employee contributions are exempt from tax, with withdrawals following retirement subject to tax. This approach has two advantages. First, it provides some encouragement for voluntary savings as it lowers taxes during working years. As before, progressive income tax rates or exemption thresholds make this even more attractive. Second, it removes the policy uncertainty that the promise of tax-free withdrawals may not be honored by future governments. Other design issues for the tax treatment of pensions are as follows:

Restrictions on early withdrawal. In addition to taxes that will need to be paid on the full amount not previously taxed, early withdrawals are frequently associated with additional penalties. Examples of exceptions to the penalties often include significant medical hardship, disability, and occasionally the purchase of a first house. In each of these cases, the exceptions are not automatic and typically involve the individual petitioning the tax authorities for the exception. Limits on Contributions Subject to Favorable Treatment. Voluntary pension savings schemes are typically have a limit on the amount of contributions receiving favorable tax treatment. The limits, typically expressed as percentages of average economy wide wage or as a percentage of own wage, are meant to reduce the loss of tax revenue by reducing the extent of favorable treatment for higher income individuals who are less likely to fall into old age poverty and more likely to save a significant portion of their income even without incentives.

Matching Contributions. An alternative to favorable tax treatment is providing explicit matching contributions from the government. The idea is that the government charges tax on the income used for the contribution, but then uses that money to make a direct contribution to the individual’s account in proportion to the contribution made, so that the entire forgone “tax rebate” gets saved. This is a particularly useful alternative under progressive income tax rates, where the government might not want to reward higher income people who have marginal tax rates more than lower income people who have lower marginal tax rates for the same behavior.

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International Practice and Georgia. In practice, most countries allow tax exempt contributions and instead tax withdrawals following retirement.14 In the case of Georgia, there is no preferential tax treatment of pension contributions. All contributions are made based on after-tax income. Furthermore, interest and other returns earned on pension funds are also subject to taxation, whereas interest earned on a savings account is only subject to 5 percent withholding. For this reason, there may in fact be a tax disincentive to saving through pension funds. Removing any such tax disincentive should be a first step in encouraging long term savings for retirement in Georgia.

2.4. Social Assistance

Social assistance to poor and vulnerable households in Georgia comprises targeted social assistance (TSA) and several categorical benefits. The latter include the household allowance, which monetizes past in-kind benefits to certain groups (mainly war veterans and their survivors), and the family allowance (for poor pensioners, orphans, disabled children, the blind, and large families). Most categorical benefits are being phased out and are expected to be gradually replaced by TSA (e.g., the family allowance cannot be received jointly with TSA).

Social assistance programs are common around the world and typically have multiple objectives. These are sometimes grouped into three categories, “prevention” (against income and expenditure shocks, such as through unemployment or disability insurance); “protection” (from destitution and catastrophic human capital loss, such as through cash or in-kind transfers or subsidies); and “promotion” (of improved opportunities, livelihoods, and better jobs, such as through skills-building programs and demand enhancement for education and/or nutrition programs via conditional cash transfers). This chapter assesses the performance of Georgia’s social assistance programs with reference to a range of indicators that reflect these objectives. These include adequacy (program coverage and generosity), equitability (targeting of intended groups), sustainability, and incentive compatibility (avoiding unintended behavior changes by beneficiary households).

Georgia’s TSA program: Design, Coverage, and Poverty Impact TSA is aimed at providing income support and consumption smoothing among the very poor households in Georgia. It was launched in July 2006, after 18 months of intense preparation, including developing and testing a proxy means targeting mechanism, designing implementation procedures, establishing an agency, hiring and training of staff, developing an automated management information system (MIS), and receiving applications and collecting and processing information on more than 200,000 applicant households from all over Georgia. The proxy means-testing mechanism was chosen as suitable for Georgia because income from formal sources is a less accurate indicator of household welfare. All households are entitled to apply for TSA.

14 Further details are available in Whitehouse, Tax Treatment of Funded Pensions, Social Protection Working Paper No. 9910, World Bank, 1999 and Holzmann and Guven, Adequacy of Retirement Income after Pension Reforms in Central, Eastern, and Southern Europe, World Bank, 2009.

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TSA beneficiary households receive GEL 30 monthly as a base benefit plus GEL 24 for each additional household member. Both enrolment and expenditures have been relatively stable during the past two years. As of mid-2011, there were about 430,000 recipients out of a total 1.7 million individuals registered in the database (about 40 percent of the population of Georgia). TSA coverage is about 10 percent of the population, roughly corresponding to the estimated extreme poverty headcount in Georgia. In 2011 the TSA budget was just under GEL 150 million annually, or about 0.7 percent of GDP, which is similar to social assistance programs elsewhere in the region. Figure 2.11 has further details. Figure 2.11. TSA in Georgia TSA enrolment, 2008–11

Monthly TSA expenditures, 2008–11

number of persons, in thousands

in million Lari per month

2,000

1,800 12 1,600 10

1,400 1,200

1,000 6

800 600

400 2 200 0 Jan-08

Jul-08

Population in database

Source: SSA.

Jan-09

Jul-09

TSA recipients

Jan-10

Jul-10

Jan-11

0 Jan-08

Jul-08

Population in database

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

TSA recipients

The TSA program played a helpful role in mitigating the impact of the recent financial crisis on poverty in Georgia. In 2009, the TSA monthly top-up per additional family member was doubled from GEL 12 to GEL 24, resulting in a sharp rise in expenditures. TSA coverage also expanded, although more modestly, from about 400,000 beneficiaries in July 2008 to about 475,000 in July 2009. Already having a targeted safety net program in place clearly facilitated this policy response, and gave Georgia a head start in addressing the impact of the crisis on vulnerable households. The TSA program in Georgia proved to be one of the better performers in the region in this respect. However, a relative shortcoming in Georgia’s crisis response derived from the absence of “self-adjusting” programs such as public works or unemployment insurance, which elsewhere in the region was one of the main “automatic stabilizers” (expanding in hard times and contracting when the economy improves) among the tools available to policy-makers.15 Relying on the TSA program (or indeed pension benefits, which were increased from GEL 70 to 80 per month during the crisis) requires committing additional (and scarce) fiscal resources that cannot be easily scaled back once economic growth resumes. Targeting and coverage represent two of the most common performance indicators used to assess social assistance programs around the world. Targeting is a measure of how equitable a program is, and can be captured by the percent of total benefits received by each consumption decile (measured net of the transfer). Since the main objective of TSA is to provide income support to those living in extreme poverty, targeting is a key indicator. Figure 2.12 indicates that nearly 50 percent of TSA benefits reach the bottom decile of the population,

15 See World Bank (2011a), “The Jobs Crisis” and World Bank (2011b), “Do Social Benefits Respond to Crises? Evidence from Europe and Central Asia” (draft).

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and over two-thirds to the bottom quintile. No more than 15 percent of total resources go to the top half of the distribution. This is relatively unchanged since 2009. Coverage is an indicator of a program’s overall adequacy (an alternative indicator, generosity of the transfer to individual households, is discussed below), and can be measured as the percent of each consumption decile receiving TSA. This is shown in the right-hand panel of Figure 2.12. Almost 60 percent of the bottom decile is covered by TSA, and about 20 percent of the second decile. Coverage of the poor has thus improved since 2009 (although sample attrition poses a challenge to precise estimation). Figure 2.12. TSA Targeting and Coverage By Decile, 2009–11 in percent of total TSA benefits received by each decile

in percent of each decile receiving TSA

0 1

2009

2 2011

decile

Source: Staff estimates based on UNICEF WMS 2009–2011.

Compared to other social assistance programs in the region, Georgia’s TSA is an average performer with respect to targeting and well above average in terms of coverage. However, TSA is one of the stronger programs in the region if targeting and coverage are assessed jointly, as in Figure 2.13. In general, it is easier to achieve good targeting in smaller programs (i.e., with less coverage), and easier to achieve higher coverage by tolerating weaker targeting. Along with programs in Armenia and Kosovo, Georgia’s TSA manages to achieve a good combination with regard to both performance indicators (i.e., it is in the upper-right quadrant of the scatter-plot). It should be noted that these comparisons look at performance of the main last-resort social assistance program in each country. Elsewhere in the region there may be many additional programs (e.g., with categorical instead of means-tested benefits), in which case overall coverage would be higher.

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2009

decile

2011

Figure 2.13. Coverage and Targeting of TSA in International Context targeting, percent of benefits going to lowest quintile

100 90

Romania GMI

Kosovo SA

Georgia TSA 60 Armenia FPB

50 Serbia CA

40 Latvia GMI

30 20 10 0 0

coverage, percent of lowest quintile receiving benefits

Source: WB ECA social protection database. Note: Refers to main last-resort social assistance programs.

Managing Expenditure Pressures for Sustainability and Growth

An ongoing challenge is to improve upon the current TSA coverage of the bottom decile of the population, even while acknowledging that it already compares favorably with other countries. As shown in Figure 2.12, in excess of 40 percent of the bottom decile, who should in principle receive TSA, is currently not benefiting. Various reasons may explain this, including a lack of awareness, lack of understanding of how the program works, or the incorrect exclusion of those who do apply. UNICEF has undertaken a study of barriers to access. They found that nearly all households in the bottom quintile are aware of TSA, and about 72 percent of them have applied. Among those who have not applied, about 76 percent did not know where to apply, suggesting continued need for better information and communication about TSA. Among those who have applied, few reported barriers but many said the process was complex. It is clear, however, that many who applied were denied coverage, and thus improving the means testing process remains a continuing challenge.

Good program targeting and coverage in turn translates into poverty reduction. Due to the fact that TSA targets the poorest households, most of TSA’s poverty reduction impact is seen in the poverty gap, not the poverty headcount. This depends, of course, on the poverty line that is chosen. Figure 2.14 shows the cumulative distribution of consumption, or poverty incidence curve, for Georgia using the 2009 UNICEF data. The vertical line is the Georgia national poverty line of 89.7 GEL per adult equivalent per month. At that poverty line, the poverty headcount without TSA is almost two percentage points higher than the headcount with TSA (27.5 versus 25.7).16 The difference in the poverty gap is slightly greater than two percentage points (9.6 versus 7.5). Coverage of TSA is higher in rural areas, with a correspondingly larger effect on poverty reduction. As shown in Table 2.4, rural households are more likely than urban households to receive TSA. The average amount of TSA received is higher in rural areas. Because of the higher rural coverage, TSA helps keep a higher percentage of rural households from falling below the poverty line, as well as reducing the poverty gap. TSA thus also reduces rural-urban inequality. Ongoing reforms have been implemented in order to further improve the effectiveness of the TSA program. In mid-2010, changes to the

Figure 2.14. Cumulative Distribution of Consumption With And Without TSA in percent of population

0 -25

100

150

125

monthly consumption per adult equivalent (GEL 2009)

Consumption minus TSA

Source: WB staff estimates.

Consumption

Table 2.4. Incidence of TSA by area (rural/urban) in percent of population

Rural Urban

Households receiving TSA (%) Average amount received per recipient household (GEL/month)

Poverty headcount (using 89.7 GEL poverty line) Consumption

Consumption minus TSA

Poverty gap (using 89.7 GEL poverty line) Consumption

Consumption minus TSA

Source: World Bank staff calculations from UNICEF 2009 data.

Total

12.5

3.8

8.1

31.5

20.1

25.7

8.3

6.8

7.5

34.3

11.4

20.9

27.5

7.9

9.6

16 Implicit assumptions are that (a) TSA receipts are all allocated to consumption, and (b) if TSA income is lost then it is not replaced by other income such as private transfers or employment.

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proxy means test methodology were adopted based on the findings of a monitoring survey and consultations with various stakeholders. New measures include a greater role for communities in reviewing eligibility, and the exclusion of certain assets from the proxy-means testing formula. In addition, and on an ongoing basis, SSA continues to improve its business processes on several fronts, including network, software, and hardware development, rehabilitating local offices, and simplifying procedures for social worker evaluation of applicant households, with the result that waiting times between application and receipt of benefits have been cut in half, from six to three months. Furthermore, SSA has conducted numerous ongoing outreach activities, including developing TV and radio programs to inform the public and events in rayons to explain programs to the public, with an emphasis on transparency of the database and application procedures. To keep the database up-to-date, ongoing re-certification of beneficiaries is carried out on a rolling basis and is being undertaken on a wave-bywave and region-by-region basis, with SSA now re-certifying beneficiaries after four years. Finally, since mid2010, the government started to review the eligibility status of TSA beneficiaries by cross-checking responses to SSA interviewers with the data of other government agencies related to income tax, property, and vehicle registration. This has helped identify a significant number of ineligible beneficiaries who have been denied further benefits as a result, which should further improve targeting effectiveness. Preliminary figures indicate that these measures have resulted in improved coverage of the bottom deciles since 2009. In sum, Georgia’s TSA program has been successful on several fronts, and progress on most “firstgeneration” social assistance reforms has been strong. These include benefit consolidation, database development, and targeting effectiveness. A priority going forward will be to explore potential options to expand program coverage, particularly within the lowest decile and quintile. The next section looks at “second generation” challenges pertaining to linkages between TSA and the labor market.

Georgia’s TSA program and the labor market A common issue raised in the context of assessing the impact of a social assistance program is whether it discourages labor market participation and creates a culture of dependency. Opinion polls do not provide much support for this view in Georgia, as only 8.5 percent of respondents attributed the existence of poverty to “laziness and lack of willpower”, whereas 59 percent pointed to “injustice in society” or being “unlucky”.17 The more formal data available, reviewed in this section, indicates that there is little evidence that Georgia’s TSA is in fact discouraging labor force participation. This section also introduces some other considerations about the link between TSA and the labor market. A number of considerations can offer a preliminary indication of the likelihood that a social assistance program is discouraging labor force participation. One is generosity: that is, on average what share of a household’s total income is accounted for by the cash program? A second is the marginal tax rate of gross earnings of beneficiaries: to what extent would a beneficiary’s income be ‘clawed back’ through taxes or reduced benefits? A third consideration pertains to the demographic profile of beneficiary households with regard to their potential to join the labor market: for example, are they mostly young, old, disabled, care-givers, or otherwise?

17 World Bank-EBRD Life in Transition Survey, 2007.

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Figure 2.15. Generosity of Georgia’s TSA Vis-a-Vis Other Social Assistance Programs average transfer as share of total household consumption, in percent

35 30 25 20 15 10

Serbia CA

Latvia GMI + dwelling

Kazakhstan TSA Poland SW bene ts

Lithuania S. Bene t Ukraine XP program

Bulgaria GMI

Croatia S. Allowance

Armenia FB Prog Hungary Regular SA

Serbia MOP

Georgia TSA Estonia MT Bene ts Romania GMI Montenegro FMS/MOP

Kosovo SA

Macedonia SFA BosniaHerzegovina CSW Albania NE

Source: WB ECA social protection database.

Figure 2.16. Age Distribution of TSA Beneficiaries, 2009 in percent of population

Georgia’s TSA program for vulnerable families is one of the most generous such programs in the region. It has a cash benefit of GEL 30 per month for the household head, and GEL 24 per month for additional household members. The typical beneficiary household receives GEL 78 per month, which amounts to an average of about 28 percent of recipients’ total household consumption. As shown in Figure 2.15, this is the second highest such level among 19 similar programs across the region. Relative to these other programs, therefore, the TSA might in principle serve as a disincentive for finding a (formal) job or working longer hours. Unlike certain guaranteed minimum income (GMI) programs existing elsewhere, however, the gross earnings of recipients of Georgia’s TSA is not subject to a very high marginal tax rate.

Figure 2.17. Labor Force Status of TSA’s Working Age Beneficiaries in percent of beneficiaries

54.8 50 Not working but looking for job

Neither working nor looking for

24 Working

21.3

0 Under 15

Working age

Pensioners Student

Source: WB estimates based on UNICEF WMS.

Care-giver

Housewife

Pensioner

Has a job, temporarily not working

Would not be able to find

Other

Source: WB estimates based on UNICEF WMS.

Disabled

Due to illness

Does not want to work

The demographic profile of TSA recipients suggests that the program is not discouraging work. As shown in Figure 2.16, just over half of TSA beneficiaries are of working age (defined here as 16–64 for men and 16–59 for women). Among those who are of working age, about 62 percent are either working or looking for work (Figure 2.17). Among those who are neither working nor looking for a job, most say this is because they are a student, pensioner, housewife, disabled, or care-giver. About a quarter of those not working or looking for work said this was because they “would not be able to find” work, or because they “do not want to work”. However, these groups only account for about 5 percent of all TSA beneficiaries (i.e., including pensioners and those under 15). These responses are self-reported perceptions, and they consider the decision to work and not the number of hours worked, but nevertheless they do not suggest that TSA benefits are discouraging work.

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It is also possible to more rigorously evaluate the potential impact of TSA on labor force participation. In 2007, the Living Standards Measurement Survey (LSMS) carried out in Georgia included an extra sample of approximately 2000 households clustered around the TSA eligibility threshold (at the time, this was 52,000; it has since been raised to 57,000). More precisely, all households had scores between 50,700 and 53,000. Because this is a narrow range, it lends itself to analysis comparing TSA beneficiaries and non-beneficiaries on the assumption that these households are on average Figure 2.18. No Impact of TSA Receipt On Labor Force “the same” (i.e., regression discontinuity design, Participation, 2007 or RDD), except for their TSA beneficiary status. probability of working Indeed no differences were detected between 5 the two groups with regard to basic demographic 4.5 variables (e.g., age, gender, education level, etc.). 4 This allows us to isolate the impact of the TSA program on variables of interest from other 3.5 potential confounding influences. It should be 3 noted that in 2007, the TSA benefit for additional 2.5 household members was only GEL 12 per month, 2 not GEL 24 as it is now (the base payment of GEL 1.5 30 was the same as at present). Thus, the average household transfer was about one-third less at the 1 50,750 51,000 51,250 51,500 51,750 52,000 52,250 52,500 52,750 53,000 time, potentially mitigating the disincentive effect TSA score of TSA. Source: WB ECA social protection database. No differences in labor force participation were detected between TSA beneficiaries and non-beneficiaries using the 2007 data. There was no statistically significant difference for either the probability of working or the probability of looking for work, based on a comparison of means. When a fuller regression analysis was undertaken, including the proxy means test score, age, age-squared, gender, and educational attainment, the variable for beneficiary status was not statistically significant. The same result was found using more updated 2009 data but with a much wider range of scores: a simple comparison of labor market participation by those who receive the TSA (i.e., with a proxy means test score below 57,000) with those who do not get TSA but do receive medical insurance for the poor (i.e., those with a score between 57,001 and 70,000) did not detect any significant difference.

While there is no evidence that Georgia’s TSA discourages recipients from work, an important future reform agenda could embrace “activation”, or explicit measures designed to promote better job prospects for program beneficiaries. These are so-called “second-generation” reforms to social assistance programs that are increasingly common elsewhere in Europe. They would entail strengthening linkages between social assistance programs such as TSA and human capital development, including skills development, activation, the jobs agenda, and possibly conditional cash transfers linked to health and education. This is the “promotion” (as opposed to “protection”) aspect of well-performing social safety nets. While Georgia has opted against pursuing an active labor market agenda in recent years, as its social policy evolves, a full range of policy options may be revisited. As a concrete first step in an agenda of bringing more people into work, it may be possible to capitalize on the strong achievements in establishing local SSA centers by using these to link the poor (TSA beneficiaries) with job openings and training possibilities.

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2.5. Some Cross-Cutting Themes

While the discussion in this chapter has largely focused on pensions and TSA programs in isolation, some cross-cutting issues warrant attention. Both pensions and TSA have potential implications for poverty reduction, labor force participation, and demographic considerations, as summarized briefly here:

●● Poverty reduction: While pensions have a greater poverty-reducing impact, this is due to the large size of the program. Since TSA is targeted to the poor rather than a categorical age group, it offers better valuefor-money than pensions in terms of achieving poverty reduction at least cost. The same applies to other non-targeted spending programs, such as the universal food and electricity vouchers disbursed in 2011 and early 2012. Higher poverty reduction could be achieved if these had been targeted.18 ●● Labor force impact: As discussed, there is a common concern with social assistance programs that they deter labor force participation by beneficiaries. As above, there is no evidence this is the case at present with Georgia’s TSA. However, it is noteworthy that this concern is arguably more prominent for the old-age pensions, because over half of all Georgian households include a pensioner and working-age household members may be deterred from working due to household pension receipt. Some modest evidence that this is true has been found in the case of those who live with elderly female pensioners in Georgia.19 Balancing future increases in monthly TSA and pension benefits should bear this in mind.

●● Demography: An analysis of the age distribution of social spending in Georgia indicates that a large majority is received by the elderly. This is typical of most countries, due to the importance of pensions. However, it is also noteworthy that the age group that receives the smallest per-capita spending amount is the 0 to 5 age group. This may warrant future attention, since equality of opportunity is arguably best achieved through interventions at this stage of the life cycle.20

2.6. Conclusion: the way forward

The analysis in this chapter suggests that the profile of social protection programs in Georgia could move forward along one of several paths depending on the choices that are made. On the one hand is the path of continued ad hoc increases in the basic pension benefit with expectations being reinforced that the replacement rate will be maintained. Most of the population would expect to rely on the publicly provided pension for old-age income and would thus have little incentive to save. Public expenditure on pensions would grow as a share of GDP over time as the population ages and this would pose a serious challenge to the fiscal consolidation program. Pro-poor programs such as targeted social assistance would be crowded out as many non-elderly poor continue to find themselves without any social subsistence benefit to support consumption. On the other hand is the path where further pension increases are modest and selectively targeted to the 18 “Universal vouchers or targeted interventions? Evaluating impact on poverty in Georgia by type of intervention”. World Bank (2012).

19 “Demographic Change in Georgia: Implications for social programs and poverty”. World Bank (2011).

20 Ibid.

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Georgia Public Expenditure Review 2012

population in greatest need. A mechanism to limit growth of the benefit to no more than the rate of inflation could be developed to set expectations that pension increases would serve primarily to maintain the purchasing power of the current benefit. This would encourage the current working population to save for their retirement in expectation of more modest replacement rates from the basic benefit in the future. Additional initiatives in the areas of improved tax treatment, more attractive financial instruments for long term savings, as well as an opt-out enrollment process, would further encourage private savings for retirement. The fiscal consolidation program would remain on track in the medium term and fiscal space would be available for the TSA program. As a result, an increasing share of the poor and extreme poor would receive targeted social assistance over time. This trend would be further enhanced as TSA beneficiaries are matched with human capital investments and employment opportunities over time.

40窶ポ窶イhapter 2. Social Protection Expenditures

Managing Expenditure Pressures for Sustainability and Growth

Chapter 3. Health Expenditures 3.1. Introduction

Health spending is well targeted to the poor in Georgia, but key challenges remain in further improving health outcomes and financial protection against impoverishing out-of-pocket payments, which will likely require higher levels of public health spending. Georgia’s health reforms in recent years have led to a number of significant achievements. The Medical Insurance Program, which offers a comprehensive package of health benefits to poor households meeting the proxy-means test criteria, has meant that Georgia’s health spending is well targeted to the poor. The MIP also has a major impact in reducing out-of-pocket spending among beneficiaries. Over time, strong results have been achieved in the area of maternal and child health. Overall, however, considerable challenges remain in the health sector for Georgia. Like other countries in the region but in contrast to global trends, several dimensions of population health outcomes have seen relatively little improvement over the long term. An important reason is the low level of coverage and utilization of medical care in Georgia. In spite of the success of MIP, many low-income households still do not have adequate coverage of health care. In addition, common indicators of financial protection against impoverishing out-ofpocket payments remain weak in comparison to most countries, with low public health spending and high private spending on pharmaceuticals among the key causes of this pattern.

Public health expenditures may be analyzed with reference to the two major objectives of any health system: (i) to improve health outcomes and (ii) to protect against impoverishing out-of-pocket payments for health care. The first objective embraces the goal of reducing mortality and morbidity, usually with a particular focus on the health outcomes of the poorest segment of the population. The second objective addresses the goal of ensuring that people do not face medical expenditures that are either ‘impoverishing’ (driving them below the poverty line) or ‘catastrophic’ (exceeding some Figure 3.1. Population Priorities for Government threshold of household resources) as a result of an Investment In Georgia, 2010 episode of ill health. These two overarching health in percent of respondents system goals also correspond to the objectives 70 highlighted in major international reports.21 60

The health sector is perceived as an important priority by the population of Georgia. The World Bank-EBRD Life in Transition Survey asked households to identify their top two priorities for government investment. The health sector was the most common response among 1000 respondents, as shown in Figure 3.1. Other possible answers included education, helping the poor, pensions, housing, infrastructure, and the environment. The

50 40 30 20 10 0 Health 1st priority

Helping poor Education

Pensions

Housing Environment

Infrastr.

2nd priority

Source: World Bank-EBRD Life in Transition Survey.

21 For example, the WHO’s World Health Report (2000) and the World Bank’s Health, Nutrition, and Population sector strategy (2007).

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priority accorded to the health sector also appears to be an enduring sentiment, as a similar picture emerged in two separate waves of the survey (2006 and 2010), despite the intervening economic crisis. Of course, the pursuit of health objectives will need to take place within the broader economic and fiscal context, which calls for ensuring value for money and efficiency of health sector spending. In order to address the challenges facing health expenditures in Georgia, the analysis in this chapter discusses the following options for consideration: ●● Pursue initiatives to reduce high out of pocket pharmaceutical spending by promoting use of generics and enhancing public purchasing power over pharmaceuticals (short-term)

●● Enhance access to key medical interventions (preventative care and key pharmaceuticals) in order to increase utilization and improve health outcomes (short-term)

●● Address weaknesses in supply of medical care, with a specific focus on primary care, in order to improve low levels of utilization and ultimately health outcomes (medium term)

●● Expand coverage of state funded health insurance programs, with a focus on still uncovered poor households, and expand drug benefit in MIP to reduce excessive pharmaceutical OOP (medium term)

This chapter reviews health expenditure patterns in Georgia through the lens of the major sector objectives, followed by a discussion of key policy issues. The chapter is structured as follows. Section 2 provides an overview of health expenditures in Georgia. Section 3 focuses on the achievements and shortcomings of health expenditures with regard to long-term trends in health outcomes. Section 4 examines the impact of government health spending on the degree to which households are protected against impoverishing out-ofpocket spending. Section 5 addresses key policy issues, namely (i) the performance of the Medical Insurance Program for the poor; (ii) pharmaceutical prices; and (iii) strengthening primary care.

3.2. Overview of health spending in Georgia

Public health spending in Georgia is drawn from general tax revenues and allocated to various programs by the Ministry of Labor, Health, and Social Affairs. Overall, Georgia spent about 1.9 percent of GDP on health at the general government level in 2011, of which about half was spent on publicly funded health insurance and the other half on a range of disease-specific health programs. Nearly half the total health budget is accounted for by the Medical Insurance Program (MIP) for the poor, which targets the poorest 20 percent of the population (about 900,000 individuals) based on the same proxy means test that is used for the Targeted Social Assistance (TSA) program. The MIP then transfers a fixed monthly premium (about GEL 11 per capita) to private insurance companies, who are responsible for purchasing services from providers according to the benefit package. Most other health programs are for specific diseases (e.g., cardiology, tuberculosis) or population groups (e.g., children or pregnant women). For many of these programs, a voucher scheme was introduced in 2011 to help allocate funds according to population choices rather than for specific providers.

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Managing Expenditure Pressures for Sustainability and Growth

Total health spending in Georgia is at the upper end of the range commonly seen in lower-middle income countries around the world, but it is an outlier with respect to the balance between public and private sources. Almost all low and middle-income countries spend about 4 to 8 percent of GDP on health in total (public and private), as populations everywhere demand a certain level of health care goods and services. With total health spending of about 8 percent of GDP, Georgia is at the high end of the typical range. Georgia is a notable outlier, however, with respect to the share of total health financing that is from private out-of-pocket sources, which at over 70 percent is the highest in Europe and nearly twice the norm among lower-middle income countries in the region. Figure 3.2 shows some international comparisons. Figure 3.2. Public and Private Health Spending, Europe and Georgia in percent of GDP

Figure 3.3. Govt and Out-Of-Pocket Spending on Health in Europe and Georgia (2010) out of pocket spending as share of total, in percent

Georgia 70

2.2 8

60 50

6 1.7 5.8 4

7.5

30 20

4.7

3.2 2 0

10 0

EU-15 Public

2.3

Source: WHO and HUES.

EU-10

CIS

Georgia

Private

Source: WHO and HUES.

government health spending, percent of GDP

Georgia’s health spending profile is part of a global pattern whereby the share of health spending that is not covered by the government budget will be mostly out-of-pocket (OOP). Figure 3.3 depicts this relationship in the European region. This reflects Table 3.1. Average Annual Per Capita Out-Of-Pocket the fact that almost no low or middle income Payments, By Category (2010) country has successfully funded a significant share in lari of health spending through private voluntary Category GEL insurance, in large part due to the pervasive Inpatient Curative Care 28.8 market failures in this area. The only exception Outpatient Curative Care 63.3 is the typically formally employed top quintile of Ancillary services (lab, diagnostics, etc.) 25.8 the income distribution, where employers may Pharmaceuticals (and other medical non-durables) 194.3 help pool funds for health. Table 3.1 provides a Other 5.4 breakdown of out-of-pocket spending categories as of 2010. Total 317.7 Source: HUES 2010.

Health Spending and Health Outcomes With regard to the major objective of improving health outcomes, Georgia and neighboring countries have performed poorly in recent decades relative to other regions of the world. Figure 3.4 shows the historical trends of life expectancy in Georgia and selected comparator regions. In 1970, life expectancy in Georgia was not far behind the level in Western Europe and the United States, and well ahead of East Asia, Latin

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America, and the Middle East. However, since then, outcomes in Georgia have improved only slightly, while the middle-income regions have caught up and Western Europe and the U.S. have continued to make steady progress. Like Georgia, a similar trend of slow progress in improving several dimensions of health outcomes is visible in other countries of the ECA region. Moreover, health outcomes tend to be worse among the poorer segments of the population. It should be noted that although there is some uncertainty about the exact level of mortality in Georgia,22 the overall slow rate of progress is quite clear.

Figure 3.4. Life Expectancy at Birth, Georgia and the World, 1970–2008 in years

85 80 75 70 65 60 55 50 45

40 1970 EU

1974 US

1978

1982

Latin America

1986

1990 East Asia

1994

1998

Middle East

2002

2006

Georgia

The burden of disease in Georgia is similar Russia Source: WB. to that of most European nations. Noncommunicable diseases account for approximately 90 percent of mortality. About half of all deaths are due to circulatory diseases, and a further 20 percent due to malignant neoplasms. Respiratory illnesses account for an important share of morbidity.

Although they do not represent a large share of the disease burden, Georgia has made steady progress with regard to health outcomes in the area of maternal and child health. According to the 2010 Reproductive Health Survey (RHS), 98 percent of pregnant women had at least one ante-natal visit, and 90 percent had at least four such visits. The infant mortality rate declined from 41.6 per 1000 in 1995–99 to 21.1 in 2000–04 and 14.1 in 2005–09. Under-5 mortality has fallen by nearly 64 percent over the same time horizon. Future progress on these indicators will increasingly require reductions of neo-natal care (first 28 days). Overall, Georgia compares favorably to other countries with regard to achievement of Millennium Development Goals (MDGs).

International experience suggests that medical care becomes an increasingly important contributor to improved health outcomes in middle and higher-income countries. At earlier stages of development, major health gains typically arise from nutrition, clean water and sanitation, safe child delivery, and immunization. Georgia had made significant achievements on these interventions by the 1960s. On the other hand, most of the improvements in health outcomes during the late 20th century in Western Europe and the US have been due to tobacco cessation and especially improved medical care in the area of cardiovascular disease, neo-natal health, and certain cancers.23

While higher national income levels can help facilitate these advances, the evidence indicates that rising income alone does not cause mortality reduction. Several examples illustrate this. In rich countries, health outcomes tend to suffer during economic booms, and improve during recessions. In China, many gains in health were achieved before economic growth took off in 1978. Over recent decades, the trend in most global health indicators has been towards convergence, while income per capita has generally been characterized by 22 Duthe et al. (2010).

23 Cutler, D., A. Deaton, and A. Lleras-Muney (2006).

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divergence.24 During transition in ECA, the pattern has been the opposite: some convergence in GDP per capita, but divergence in health outcomes as in Figure 3.4 above. In brief, the evidence suggests that countries such as Georgia cannot expect improved health outcomes to follow automatically from higher incomes; reforms may be needed to improve access to, and application of, better knowledge and technology in the health care arena.

Against this background, a key link between low public spending on health in Georgia and the challenge of improving health outcomes can be seen in the low levels of health care utilization. Overall utilization rates in Georgia, whether measured as outpatient Table 3.2. Utilization Rates in Georgia Are Low (2010) contacts per person or acute care hospital in number of visits per person admissions per 100 population, are less than half Number of out-patient Country the level observed in Western and Eastern Europe contacts per capita or the CIS (although utilization in the latter may be Georgia 2.0 too high).25 Table 3.2 has details. The high reliance New EU member states 7.6 on out-of-pocket payments for medical care is one CIS region 8.6 factor behind the low levels of utilization. Source: WHO Health for All database. With regard to specific interventions, Table 3.3 shows the currently low coverage levels in Georgia of the five interventions that have had the largest impact on improved life expectancy in the West since the 1960s. Although not all of these interventions—such as wide coverage of heart bypass operations—may be affordable for Georgia at present, many of the others (e.g., basic pharmaceuticals) could be covered within a moderately expanded universal benefit package. This is discussed further below. Cigarette taxation (measured as total taxes as a share of the pack price) is higher in Georgia than among most of its neighbors, but lower than in the EU (Figure 3.5). Smoking prevalence among adults 15 and over in Georgia is estimated at 27 percent (about 55 percent among men and 5 percent among women); about three-quarters of them state that they would like to quit, and half have tried to quit at least once during the past year. Additional measures such as bans on advertizing or smoking in certain public places could also be adopted. Turning to several indicators of preventative care, EU citizens are four to five times more likely to have received a cholesterol test or breast cancer screening for women during the past 12 months (Figure 3.6). Since these are areas where medical care has made a substantial contribution to increased longevity in the EU, these

Table 3.3. Coverage of Key Health Interventions in Georgia is Low Five interventions that have had largest impact on life expectancy in West

Assessment of implementation in Georgia

Anti-tobacco policies (cigarette taxes, smoking bans, etc.)

Cigarette tax (as % of price) is higher than most CIS countries but lower than most of EU; advertising bans and cessation programs could be strengthened

Cardiovascular disease drugs (ACE-inhibitors, betablockers, statins) Cardiac surgeries (angioplasty, bypass)

About 90% of total drug spending is out-of-pocket; about 14% of hypertension cases are controlled; testing of cholesterol levels is rare Unknown number of people covered in 2009, but presumed to be a small fraction of total need

Early diagnosis and treatment Little coverage of diagnostic of breast and colon cancer tests for non-MIP individuals; pilot program for breast cancer underway Neo-natal intensive care Source: World Bank.

Unknown capacity outside of a few major hospitals; high OOP by family is often required

24 Ibid., and Becker, G., K. Murphy, and R. Soares (2005).

25 WHO Health for All database, 2011.

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Georgia Public Expenditure Review 2012

Figure 3.5. Cigarette Taxes in Georgia and Europe, 2009 in percent

100 80 60 40 20

Armenia

Kyrgyzstan

Azerbijan

Belarus

Kazakhstan

Uzbekistan

Russia

Moldova

Turkmenistan

Iceland

Albania

Georgia

Switzerland

Ukraine

Montenegro

Bosnia

Luxembourg

Serbia

Sweden

Norway

Cyprus

Macedonia

Croatia

Austria

Netherlands

Italy

Germany

Denmark

Malta

Slovenia

Belgium

Lithuania

United Kingdom

Spain

Turkey

Ireland

Portugal

Finland

Hungary

France

Czech Rep

Israel

Latvia

Slovakia

Romania

Poland

Estonia

Greece

Bulgaria

Source: WHO.

Figure 3.6. Coverage of Preventive Care Services, Georgia Vs. Comparators in percent

in percent

100

Received a cholesterol test, last 12 months 92

Blood pressure under control, % of hypertensives

80 77

75 60

60 50

40 38

8 0

Azerbaijan

Moldova

0 Georgia

Azerbaijan

Moldova

Russia

Georgia

Received a mammogram, last 12 months

Received flu vaccine, over-65 population

100

Russia

82 68

56 44

40 31

20 15 0

Georgia Yes

Azerbaijan

Moldova

Source: WB and Eurobarometer.

Russia

Georgia Yes

Azerbaijan

Moldova

Russia

gaps would need to narrow significantly over time in order to start on a similar path of improved life expectancy in Georgia. Although Azerbaijan, Moldova, and Russia also lag the EU along these indicators of preventative care, they out-perform Georgia to some extent on three of the four indicators.

46窶ポ窶イhapter 3. Health Expenditures

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In sum, addressing the challenge of improving health outcomes in Georgia will require higher utilization, broader population coverage, and an expanded benefit package to provide greater access to key interventions. A key public spending priority for consideration going forward in the health sector, subject to budget availability, could be to achieve expanded coverage of the interventions discussed above that are likely to have the largest impact on health outcomes. This is particularly applicable to the strengthening of primary care, as discussed below.

3.4. Health spending and financial protection

This section looks at public expenditures through the lens of the second major objective of a health system: to provide households with financial protection against ‘impoverishing’ or ‘catastrophic’ health payments in the event that they fall ill. As shown in Table 3.1 above, the largest share of out-of-pocket spending for health in Georgia is spent on drugs (about 61 percent), while the remainder is spent mainly on inpatient and especially outpatient care. A precise breakdown of formal vs. informal payments is difficult to estimate for a range of reasons, including a lack of full understanding by the population (and sometimes providers) about what services are covered by state programs.

Concerns about large household expenditures for health care stem from the fact that such spending is typically different from most other household purchases. At least three reasons stand out. First, the spending is often not ‘voluntary’ (for example, if arising due to an unwanted health shock), and may have more to do with overcoming illness than adding to a household’s overall consumption or living standards, as is usually the case with other goods. Second, the uncertainty and potentially high cost associated with health expenditures (we often do not know when we will become sick and how much it will cost if we do) make them amenable to prepayment and risk-pooling arrangements. Third, access to health care is often viewed as a ‘merit good’ which should not be determined primarily by ability to pay. For these reasons, a more desirable counterfactual to high out-of-pocket spending on health would be some form of pooling mechanism (whether through general taxes or a contributory insurance scheme), as well as cross-subsidization, to provide financial protection against health shocks. This has been achieved in many countries, but not yet in Georgia for those who do not benefit from statefunded insurance. High out-of-pocket payments for health can also cause a household to fall below the poverty line—that is, they can be “impoverishing”. If a household has total consumption expenditures (including OOP) above the poverty line, but their total non-medical spending (excluding OOP) is below the poverty line, they could be considered to have suffered impoverishment due to OOP for health. Figure 3.7 shows this graphically based on 2010 data. Households are ranked along the horizontal axis by total consumption. The vertical drip lines represent OOP for health, and the poverty threshold is indicated by the horizontal line. Applying this approach to 2011 household survey data and using an international poverty line of $5/day, it has been estimated that an additional 9 percent of Georgian households were poor as a result of OOP for health.26 Consistent with Georgia’s

26 Whether this is an accurate way to evaluate the true poverty impact of OOP is a matter for debate, since in reality households are likely to draw on several possible coping mechanisms that would allow for consumption smoothing, such as drawing down savings, borrowing, or selling assets. Thus, a costly illness episode in one period would not necessarily have an immediate and commensurate impact on total consumption in the same period. Nevertheless, the concept can be useful for international comparisons of financial protection.

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Figure 3.7. The Impact of Household Spending On Health On Poverty, 2010

high reliance on OOP as shown above, this level of poverty impact is notably higher than most other countries in the region or around the world.

household consumption per adult equivalent, in lari per month

1,000 900

An alternative approach for highlighting the impact of OOP on households is to measure the extent to which they are “catastrophic.” Impoverishing OOP puts the emphasis on crossing the poverty line irrespective of the size of payments. Catastrophic health expenditures occur when they exceed some threshold of either total or non-food expenditure. The choice of threshold is somewhat arbitrary, but 25 percent of total expenditure is commonly used. Nearly 20 percent of households in Georgia exceed this ratio, the highest in the region (Figure 3.8).

800 700 600 500 400 300 200 100 0 1

251

Source: HUES.

501

751 1,001 1,251 1,501 1,751 2,001 2,251 2,501 2,751 3,001

households ranked in ascending order of total consumption

Figure 3.8. Financial Protection and Equity Indicators, Georgia and ECA Comparators in percent of households and concentration index

in percent of households and concentration index

headcount

OOP exceeds 10% of total household consumption

OOP exceeds 25% of total household consumption

Georgia

UKR

AZB

TAJ ARM

BUL MOL

UKR

ALB RUS

SRB

KYR

ARM TAJ

ALB MOL RUS

EU 15

BUL EU 15

SRB

KYR

0 0

Government health spending as percent of GDP

Inequality of out-patient utilization

Inequality of in-patient utilization

concentration index of out-patient use

concentration index of in-patient use

0.4

AZB AZB

0.3

ARM

Georgia

0.2

MOL

ALB

UKR

0.2 TAJ

TAJ

UKR

Georgia

KYR

0.1

ALB

0.1

RUS

MOL

RUS SRB EU 15

KYR

SRB

BUL BUL

EU 15

-0.1

-0.1 0

Government health spending as percent of GDP

Source: WB staff calculations.

48 | Chapter 3. Health Expenditures

Government health spending as percent of GDP

Managing Expenditure Pressures for Sustainability and Growth

A high reliance on OOP also results in significant inequalities in utilization of health care by socioeconomic status. Cross-country data indicate that Georgia has higher inequality in both out-patient and in-patient service use than most ECA countries, but not as high as would be predicted based on its OOP levels; this may reflect the equalizing effect of MIP on health care use by quintile (Figure 3.8). The low utilization rates of health care noted earlier are rooted to a significant extent in the high reliance on OOP. Addressing the problems associated with high out-of-pocket spending for health in Georgia will require tackling the major causes, including the relatively low level of the government budget for health. As discussed in Section 2, total health spending is typically about 4 to 8 percent of GDP in all low and middleincome countries; the share that is not covered by public spending will largely be financed through OOP due to the market failures that pervade health insurance. At the micro level, this means that reimbursement of services covered under state programs should allow providers (e.g., hospitals and doctors) to achieve cost recovery. In addition to the sometimes low reimbursement of services, OOP also occurs because the population demands health goods and services that are not included in the non-MIP state programs, such as out-patient pharmaceuticals. In both cases, the way to address this source of OOP is through a larger health budget, subject to the availability of additional funds in a difficult fiscal environment.

An additional reason for out-of-pocket spending in some cases is rent-seeking by providers. In any health system, individual patients are usually in a weak position to negotiate with hospitals or doctors, because (i) they typically do not have the knowledge or expertise to diagnose and treat their illness, nor to judge the quality of care received; and (ii) in a state of illness they are usually not in a position to shop around for lower prices. As a result, providers can take advantage of their superior knowledge and advantageous position to extract higher payments from individual patients. There are a number of possible approaches to address rent-seeking by providers. One possible initial step would simply be to gather better information on doctor and hospital finances. A second approach is by providing better information to patients themselves, to ensure that they are aware of their rights and are not over-charged for services covered under state programs. Thirdly, rent-seeking by health care providers is addressed de facto in mature health systems through purchasing power: by pooling resources for health care purchasing by the government and a few private insurers, the ability of providers to extract higher prices for their services will be weakened. In sum, there is strong evidence pointing to a lack of financial protection in health in Georgia. Out of pocket payments for health are high whether measured relative to total household consumption or by international standards. Addressing this problem will require a two-pronged approach, combining an expanded population coverage and benefit package (and possibly higher reimbursement rates for services covered) with measures to weaken the ability of providers to undertake rent-seeking while delivering care (including in the case of pharmaceuticals).

3.5. Policy Issues

A vision for the health sector was recently elaborated in the form of the Georgia National Health Care Strategy 2011–15, entitled “Affordable and Quality Health Care”. This is based on seven key principles,

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as follows: (i) equal access; (ii) patient-focused health care system; (iii) affordable and efficient health care; (iv) public-private partnerships and enhancing free competition; (v) transparency and public involvement; (vi) adequacy of resources relative to needs; and (vii) an inter-sectoral approach. In this section we provide an overview of potential policy priorities for achieving this vision.

Medical Insurance Program and other state-funded insurance programs Georgia’s Medical Insurance Program for the poor was launched in 2006 and has been revised several times since then. The program offers a comprehensive benefit package to eligible households. Most emergency out-patient care and planned or emergency in-patient care is included, with few coverage limits and no copayments. Most of the non-MIP population only has access to the universal basic package. This offers a more limited package of services with significant co-payments, but suffers from a lack of clear definitions, chronic under-funding, and widespread informal payments. It is currently undergoing significant reforms itself, including the introduction of patient vouchers instead of direct institutional funding. Eligibility for the MIP program is determined by the same proxy means test (PMT) used for the targeted social assistance (TSA) program, but with a higher eligibility threshold. The PMT includes over 100 indicators and is administered by the SSA to any household that applies (about 40 percent of the population has done so). The state budget covers all households up to a score of 70,000, while Tbilisi also covers households with scores between 70,000 and 100,000. In 2011 the MIP covered 900,000 beneficiaries—about 20 percent of the population—and had a budget of GEL 136m, or somewhat less than half the state health budget. There have been ongoing expansions of MIP and other state-funded health insurance programs in recent years along several dimensions. First, in 2009, coverage of MIP increased from 750,000 to 900,000 persons. Second, in 2010, a small outpatient drug benefit was added to the program. Third, as of September 2012, all pensioners (i.e. all women over 60 and all men over 65), children 0–5 years of age, students, and persons with disabilities, will have access to a state-funded health insurance package. The premium will be about GEL 15 per month. The benefit package will replace and expand on some of the current disease-specific programs aimed at the elderly population. Current plans suggest the state will cover 80% of planned operations and urgent operations, as well as 50% of medicines up to a GEL 200 limit; thus it is less generous than MIP in some areas but more generous in others.

One of the strongest features of MIP to date is the explicit targeting of the poor. This makes the benefit incidence of the Georgian health budget more favorable to those with lower socio-economic status. Figure 3.9 shows that most recipients of MIP are concentrated in the bottom few deciles of the population. While this results in pro-poor coverage, there is still well over half of the bottom quintile who do not benefit from MIP. This is in part because the proxy means test used to determine MIP eligibility was originally developed for the TSA program, meaning that it was intended to identify the extreme poor (it is budgeted to cover about 450,000 beneficiaries), rather than to identify a much larger group of beneficiaries as in the case of MIP (which is budgeted to cover over 900,000 individuals). Another factor is that only 40 percent of the Georgian population has applied for inclusion in the database of socially vulnerable families. A better understanding of why many poor households have not applied may also lead to better coverage of the lowest quintile. Improved coverage of the poor in MIP is an important priority going forward. However, targeting and coverage have improved between 2009 and 2011, potentially reflecting the methodological changes to the PMT noted in Chapter 2.

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Figure 3.9. Coverage and Targeting Of MIP, 2009–11 MIP coverage

MIP targeting

in percent of decile receiving benefit

in percent of benefit going to each decile

45 20

40 35

30 25 20

15 5

10 5 0

0 1

2009

2 2011

decile

Source: Staff estimates based on UNICEF WMS 2009–2011.

2009

decile

2011

To assess the impact of MIP on key outcomes of interest, an impact evaluation was undertaken in 2009. The sample was about evenly divided into MIP and non-MIP beneficiaries. In order to ensure that the MIP participants who were surveyed—the “treatment” group—could be compared with the most similar possible “control” group of non-MIP households, the survey only collected data on households just above and just below the eligibility thresholds of 70,000 or 100,000 (regression discontinuity design). MIP has a significant impact on reducing outof-pocket expenditures for health care. As shown in Figure 3.10, for outpatient care in Adjara and Tbilisi, and inpatient care in all regions, MIP beneficiaries pay approximately 50 percent less than non-beneficiaries (there is no statistically significant difference for outpatient care in the regions with a cut-off score of 70,000). The survey also found that MIP beneficiaries were more likely to report receiving free or reduced-price care because of insurance, and less likely to report that they could not pay for the costs of care out of their usual income. Together these findings indicate that MIP has made a major contribution to reducing out-of-pocket spending among its beneficiaries, and is therefore achieving one of its key program goals.

Figure 3.10. Out-of-Pocket Spending per Episode in lari

700 600

596 500 431

400 300 200

233

221

100 63.6 0

85.2 52.2

Out-patient 70,000 MIP

43.6 In-patient 70,000

Out-patient 100,000

In-patient 100,000

Non-MIP

Source: Bauhoff, Hotchkiss, and Smith 2011.

The main reason why out-of-pocket spending has not fallen to zero among MIP members is because of drug expenditures. The study was undertaken prior to the recent introduction of an out-patient drug benefit as part of MIP. However, some respondents also reported paying for certain services that are supposed to be covered by MIP, indicating that informal payments may persist and there is scope to improve knowledge of the benefit package.

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The survey results also indicated, however, that the program has not had any impact on utilization. While it is difficult to pinpoint a single major explanation for this finding, various reasons are possible. First, many households reported that they were not aware of their beneficiary status, and thus various measures have been taken to improve implementation (including cancellation of the voucher mechanism in favor of competitive bidding for regional packages). Second, low quality of care is probably an important reason, and the current efforts to improve the supply-side (including new hospital construction program as part of MIP) should help in this regard. Third, the absence of a pharmaceutical benefit at the time of the evaluation (introduced in May 2010) may have reduced the motivation for the beneficiary population to seek care from their doctor. More up-to-date analysis is needed to monitor how these trends have evolved since 2009. The Health Utilization and Expenditure Survey (HUES) undertaken in 2010 provides mixed evidence on differences in utilization between MIP and non-MIP groups. For example, 62.2 percent of MIP beneficiaries and 59.6 percent of non-MIP beneficiaries who reported to be sick in last 6 months consulted a healthcare provider. But 63.7 percent of MIP beneficiaries and 72.1 percent of non-MIP individuals consulted a health care provider in episodes of acute sickness in the past 30 days. Preliminary evidence from 2011 indicates that MIP beneficiaries are using health care services more than non-MIP individuals. All these results compare full populations of MIP and nonMIP individuals, and therefore do not isolate the causal effect of MIP on outcomes of interest. A proposed study in 2012 could update the 2009 results in this respect. Recent reform initiatives related to MIP and the broader health system have focused on partnership with the private sector to strengthen the hospital infrastructure. A hospital construction program financed to a significant extent through government contracts with insurance companies under the MIP program is expected to result in about 150 fully-functioning, new or refurbished hospitals with out-patient departments by the end of 2013. While a new hospital infrastructure is an important step forward, it will not be sufficient to guarantee high quality health care services. The quality of care is a long-standing concern in Georgia’s health care system. To address this challenge will require stronger inputs and incentives on the human resource side.

Several medium-term issues related to strengthening MIP loom on the horizon, including in the area of the efficiency of spending. Private insurers receive premium revenue from the government and typically have four potential “uses” for these funds: (i) reimbursement of medical services (this share is often termed the “loss ratio”); (ii) marketing costs; (iii) administrative costs; and (iv) profits. Each of these items raises policy issues for the successful operation of MIP in the years to come.

Medical care costs: I n principle the private insurers could keep reimbursement costs down through smart or “active purchasing” of health care services, and this may be facilitated because they are increasingly integrated with the hospital system (HMO-style). In other systems with multiple insurers (e.g., the US), prices of health services tend to be higher because the fragmentation of purchasing gives greater bargaining power to the providers (especially hospitals, which typically enjoy substantial market power). This may be mitigated in Georgia due to the non-competition of insurers within a geographical area once MIP contracts have been signed, and because of the growing integration of insurers and providers. But the government and MIP beneficiaries together will need to monitor this in order to ensure accountability both with regard to covering the MIP benefit package as required as well as providing high quality of care. The Health Insurance Mediation Service (HIMS) and ongoing IT investments by SSA can help in this regard. An important concern here is if keeping costs down results in the lower provision of “necessary” care, including preventive care. One key consideration is the expected duration of the relationship between the insurance company and the patient: in the US, where there is high turnover in the market, there is evidence that insurers neglect many preventive services because they do

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not expect to be covering the patient in 5 or 10 years when a health condition may become more serious and therefore costly.

Marketing costs: T hese were quite high when competition took place through vouchers for beneficiaries prior to 2010, as insurers went to great effort to attract customers. The shift to competitive tendering for three-year contracts has reduced this cost pressure.

Administrative costs: T he approach of multiple private insurers has led to very high administrative costs in some other countries (e.g., the US), due to inconsistent procedures, duplication, and a proliferation of paperwork. Georgia’s recent efforts to establish a strong information technology platform, including standardization of reporting procedures, is a positive step. As Georgia’s insurance industry is relatively young, it is natural to expect higher fixed investments by insurers in IT and other systems than in the long-term. Profits: Some multiple insurance systems allow profits (e.g., US, Chile) while others do not (e.g., Germany, and Switzerland on the basic package) and yet others are mixed between for-profit and non-profit insurers (e.g., Netherlands). A clear picture on current insurer profits in Georgia is not available, although there is some evidence that the loss ratio (medical care expenses divided by premium revenue) has risen from about 50 percent in earlier years to about 80 percent at present. In the US, there has been recent talk of mandating a loss ratio of no lower than 85 percent. High insurer profits and concerns about collusion have been a source of debate in Chile. In general, a low loss ratio should raise concerns that an insurance program is getting poor value for money with the taxpayer’s health dollars.. The renewal of MIP contracts expected in 2013 provides an opportunity for reviewing many of these issues. A key longer-term issue facing MIP is that if and when utilization of services by beneficiaries starts to rise, there will be important implications for the required premium paid to insurance companies, and therefore for the health budget. In the long-term, broad population coverage under various health insurance programs will be a key requirement for achieving health sector objectives.

Pharmaceutical prices As noted, expenditures on pharmaceuticals account for about 60 percent of total out-of-pocket spending in Georgia, and an even greater share among the poorest quintile. The share of total health expenditures spent on drugs is therefore about 35–40 percent (the government also spends a small amount on drugs for specific programs), which is well over twice as high as the corresponding rate among most OECD countries (typically about 15 percent).27 According to the HUES survey, Georgian households spent a total of about GEL 700m annually on drugs, or in excess of 3 percent of GDP, which is also twice as high as the OECD average. Yet not much is gained in return: as noted, coverage of basic cost-effective treatments against cardiovascular diseases are low. High OOP on drugs reflects several factors. This is partly due to high levels of self-treatment, as the population directly visits pharmacies in order to avoid paying out-of-pocket at health facilities with low quality of care.

27 OECD Health at a glance 2009.

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Also, it is reported that vitamins and food supplements are among the top selling pharmaceuticals, often with uncertain therapeutic benefits. But high prices are almost certainly a part of the picture as well.

The level of drug prices in Georgia has been a focus of public debate in recent years. Access to affordable medicines is an issue for the whole population, as most out-patient drugs are not covered by the universal state health programs, and were only added to MIP in 2010 (and with a ceiling on reimbursement). High OOP spending for drugs is thus a key factor underlying Georgia’s weak performance on financial protection described in the previous section. Meanwhile, as noted, evidence from advanced countries suggests that pharmaceuticals have played a major role in extending life expectancy. Thus, access to medicines is an issue with relevance to both health outcomes and financial protection. The government has begun to take pro-active measures to address the issue of pharmaceutical prices. In November 2009, a law was passed which aimed to reform certain aspects of pharmaceutical policy in Georgia. This included three main objectives: (i) to ease the procedures for importing drugs already included on the approved lists in advanced countries; (ii) to make it easier for new market actors to import drugs directly (e.g., hospitals, insurers, etc.); and (iii) to loosen the requirements for retail pharmacy space (e.g., enabling supermarkets and others to sell medicines). The impact of these measures on pharmaceutical prices is now beginning to emerge. Against this background, two rounds of a survey of retail pharmacy prices and availability for 50 common drugs was conducted in December 2009 and June 2011 with World Bank support. A total of 146 pharmacies were surveyed across six regions of Georgia (Tbilisi, Batumi, Kakheti, Samegrelo, Kvemo Kartli, and Imereti). It included pharmacies in the major pharmacy networks, independent pharmacies, and hospital pharmacies. Price data was collected for both originator brand (OB) and their lowest price generic (LPG) equivalents. Some summary results are shown in Figure 3.11.

The evidence indicates a mixed picture on trends between 2009 and 2011. First, there has been an improvement in the availability of all drugs (5 percentage points for generics, 14 percentage points for brands), but the levels remain quite low (top left panel). Second, the prices of brand name drugs have fallen significantly between December 2009 and June 2011, while generic prices have not. Specifically, the average price change for brand name drugs during this time was -18 percent (in GEL terms), while the average price change for generic drugs was +1 percent (top right panel). Since consumer price inflation over the same period was about 12 percent, this represents a positive outcome. However, the cost and availability of generic drugs remains a key concern. Also, lower brand prices could be transitory if they reflect a “price war” that results in the failure of new entrants, followed by a reversion to the high prices of the past. Meanwhile, retail mark-ups have decreased significantly (bottom left panel), but there is still room for further decline, as discussed below. Lastly, the costs of standard treatments for common ailments are significantly lower for generic drugs (bottom right panel), as is usual. This serves to highlight why further improvement in generic availability is important from a population health standpoint. To provide an international benchmark using the end-2009 data, price comparison data for a list of 20 of those drugs was obtained for six European Union countries. Over 90 percent of pharmaceuticals in Georgia are imported. Figure 3.12 shows some indicative results for net pharmacy retail prices (most EU countries apply a VAT to drugs, but Georgia does not). Clearly salary and retail property costs would be more expensive in the (relatively rich) EU countries. The numbers suggest there is wide variation in price differences between Georgia and the EU countries (Greece, Italy, Czech Republic, Hungary, and Poland). A general pattern,

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Figure 3.11. Pharmaceutical Price and Availability Trends, 2009–2011 in percent and lari, as noted

in percent and lari, as noted

Drug availability, in percent

Median price changes, 2009–2011, in percent 15

61 56

11.1

52 47

0.9

2.8

-1.6 -5

32 29

-10

-15

-17.8 -19.5

-20 -25

0 Batumi

Samegrelo

Brand

Imereti

Kakheti

Tbilisi

2009 2010

Kvemo Kartli

Generic

Brand

Median mark-ups, in percent

2010 2011

2009 2011

Generic

Standard treatment prices, GEL 45

120

100

41.2 39.3

103 35 90

30 25

60 20 15

13.5

10.05

8.4

5 0

3.4

2.25

5.67

0 Brand

2009

Source: WB/CIF survey.

Generic

Hypertension

Arthritis

2011

Brand

ARI

Peptic ulcer

Generic

Figure 3.12. Brand and Generic Drug Prices, Georgia and EU in percent

in percent

Furosemide

Aciclovir

Ceftriaxone inj.

Atenolol

Captopril

Loperamide HCL

Carbamazepine

Enalapril

Amoxicillin

Amiodarone

Trimetazidin

Amox+clav

Biso Hemif

Furosemide

Atenolol

Drotaverin

Aciclovir

-100 Captopril

-100 Ceftriaxone inj.

-50

Biso Hemif

-50

Loperamide HCL

Trimetazidin

Enalapril

Isosorbide dinitrate

Amox+clav

100

Nifedipine Retard

100

Amoxicillin

Generic drugs

Amiodarone

150

Valproic acid

150

Carbamazepine

Brand drugs

Source: WB/CIF survey and OBIG.

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however, is that original (or reference brand) drugs are typically more expensive in Georgia than in the EU, often by a wide margin, while most generic drugs are cheaper in Georgia. This is consistent with reports that both primary care doctors and pharmacists receive payments from the pharmaceutical companies in order to encourage the population to purchase specific (higher-cost) drugs, although there have been legal efforts to prohibit this. The population, meanwhile, may distrust lower-cost drugs.

In addition to price comparisons, an analysis of mark-ups along the supply chain also provides important insights into market dynamics. Figure 3.13 shows estimates of the combined wholesale and retail margins for Georgia and five EU countries as of January 2010. The Georgian data is based on analysis of customs data, while EU data reflects actual ex-factory, wholesale, and retail prices obtained from OBIG/PPRI. The Georgian average is clearly much higher than in other countries. Because drugs are high-value, low-volume products, these large differences are unlikely to be caused Figure 3.13. Estimated Average Combined Wholesale by inefficiencies in the distribution system. The and Retail Margins, Georgia and Selected EU Countries Georgian retail margin is reportedly quite small, in percent margin as they are reduced to a minimum by wholesalers 120 (where the market is most concentrated). A major factor behind these results is that pharmacy 100 102 margins (in some cases both wholesale and retail) 80 are regulated in all 27 EU member states. Typically they take the form of either a linear mark-up or a 60 regressive scheme (higher mark-ups for cheaper 49 46 40 drugs, to encourage pharmacists to dispense 35 32 lower-cost formulas). The results in Figure 11 for 27 20 the EU countries reflect such policies. However, these are indicative results for fewer than 50 0 Georgia Czech Rep. Greece Hungary Italy Poland drugs, and thus represent a sub-set of the market Source: WB/CIF survey and OBIG. requiring further exploration.

Overall, a significant policy agenda remains in the area of access to pharmaceuticals. Potential policy actions on the supply side include reference pricing and controls on mark-ups (for example, higher margins on cheaper generic drugs, thereby motivating more dispensing of generics). On the demand side, measures could include expanded coverage of drugs and subsequent use of purchasing power to obtain lower prices; defining lists for insurance reimbursements; promoting a generic substitution policy; influencing demand of insured patients through higher cost-sharing for brand drugs and none for generics; and stricter controls on drug promotion, marketing, education and sponsorship gifts to doctors.28

Primary Care A final topic for strengthening health sector outcomes in Georgia relates to primary and preventive care, which is currently suffering from under-performance. According to the RHS 2010, 7 percent of ANC visits were to primary care clinics or family medicine centers, and only 14 percent of women report that a primary health care facility is their usual place for seeking care. Similarly, according to the HUES 2010, a full 68 percent 28 Curatio International Foundation, “Main Highlights of Pharmaceutical Price and Availability in Georgia, 2009-2011”. Presentation.

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of respondents reported that their first place of contact when sick was with a specialist, compared to 18 percent for whom the contact was with a district or family doctor (unchanged since the 2007 survey). Patients may be “voting with their feet” and going to the facilities where they believe the quality of care is better. But addressing the weakness of the primary care system will be a key long-term challenge for improving health outcomes. International comparisons also highlight the neglect of primary care in Georgia. Across six countries, survey respondents were asked the following question: “If you have been feeling unwell for a few days, who do you contact first when you become ill?” The results are shown in Figure 3.14. In Georgia, only 8 percent mentioned a family doctor, compared to over 40 percent in Moldova, Russia, Tajikistan, and Uzbekistan. Figure 3.14. First Place of Contact When Ill, Georgia and Regional Comparators in percent

in percent

Azerbaijan

Georgia

in percent

Moldova 75

51.6 50

18.1

3.9

0.9 0

4.6

4.1

4.2

2.7

Uzbekistan

45.2

4.7

Tajikistan

5.4

2.8

Russia

9.1

8.7

8.4

7.2

18.3

13.9

13.5

13.9 4.8

44.3

45.5

41.9

35.3 25

23.8

25 15.9 11.8

3.2

6.6

3.5

2.3

1.5

0 Nurse/feldsher

11.6

10.2 5.8

2.4

2.2

5.5

0 Family doctor

Source: WB staff estimates.

Polyclinic specialist

Private doctor

7.8 3.1

5.9

5.5

2.9

0.6 0

Hospital doctor

Pharmacist

Treat myself at home

Other

Indicators of the coverage of specific preventive care services shown earlier reinforce this message. As noted, the share of the population in Georgia that has received a cholesterol test, flu vaccine, breast and cervical cancer screening, and heart check-up is lower than in Azerbaijan, Moldova, and Russia, and far behind the Baltic countries and Western Europe.

A strong primary care system is essential for long-term improvements of health outcomes and overall health system efficiency. The out-patient management of chronic non-communicable diseases will be the most important ingredient to obtain lower mortality and morbidity in the future. Low levels of primary care use may also help explain the high levels of self-treatment and resulting wasteful pharmaceutical expenditure in Georgia.

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3.6. Conclusion: the way forward

The analysis in this chapter suggests that health programs and outcomes in Georgia could move forward along one of several paths depending on the choices that are made. On the one hand is the path with limited further improvement in health outcomes and weak financial protection by international standards. This path would be characterized by a relatively underfunded health sector, with continued resulting low coverage of key interventions (e.g. cardiovascular drugs) and limited further improvement in key health outcomes (e.g., life expectancy). Rates of utilization of medical care would remain low and high levels of self-treatment and rent-seeking by providers and pharmaceutical companies would continue to fuel high out-of-pocket payments. On the other hand is the path of expanded coverage of state funded health insurance programs. The planned expansion as of September 2012 to include the elderly, children 0-5 years of age, students, and disabled persons is an important step in this regard and could be followed up by expanded coverage of those among the poorer segments of the population who do not currently receive MIP. Strategies for gradual inclusion of additional population groups could be achieved through, for example, better tailoring the proxy-means testing formula used for MIP to further improve targeting, and raising the eligibility threshold score to draw new beneficiaries from lower socioeconomic groups. The overall efficiency of state-funded health insurance programs would be strengthened through close monitoring and supervision of health insurers. Over time, more and better quality public spending on health care would help improve health outcomes in line with global trends and reduce impoverishing OOPs to levels that are closer in line with regional averages.

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Chapter 4. Capital Budgeting Systems 4.1. Introduction

Georgia faces an important need to strengthen its capital budgeting systems, with public investment up markedly in recent years, new infrastructure investments coming on stream, and a fiscal framework that calls for capital expenditure consolidation going forward. Public investment has increased markedly in recent years, from 2.8 percent of GDP in 2003 to 8.5–9 percent during 2007–11. Since the crisis, the composition of public investment has shifted considerably, away from defense related capital spending toward infrastructure investments broadly supportive of growth. Capital expenditures have been scaled up in international and secondary roads, municipal infrastructure, housing for internally displaced persons (IDPs), and urban regeneration to support economic recovery. Moreover, significant new investments are coming on stream, in energy transmission and water, and the pipeline of projects could growth further to address important infrastructure development needs.29 International experience has also shown that public investment pressures intensify during election periods such as the one Georgia is currently entering. Against this backdrop, the most recently approved medium term fiscal framework calls for capital expenditures to make an important contribution to fiscal consolidation going forward, with capital expenditures projected to decline from 8.9 percent of GDP in 2011 to 7.2 percent by 2015. Strengthening capital budgeting systems to improve the efficiency and effectiveness of public investment is thus an important need in Georgia.

Strengthening capital budgeting systems can serve as a key instrument of public investment consolidation by most effectively managing the growing pipeline of infrastructure project needs within the fiscal envelope. International experience points toward several important components of a sound capital budgeting system, including: strategic guidance; project screening and appraisal; budget formulation and project selection; implementation and monitoring; and evaluation and audit.30 In Georgia, fairly strong strategic guidance on infrastructure priorities is provided by the government and project implementation mostly proceeds in a smooth, efficient, and timely manner. In addition, capital budgeting reforms to date have made some progress toward improving the content and presentation of the capital budget. Building on the reforms to date, this chapter discusses a two pronged approach to further strengthening capital budgeting systems in Georgia: ●● The first is to further improve the content and presentation of the capital budget. This would help to further strengthen the programming of public investment over a medium term horizon, as well as to enhance transparency and accountability, thus embedding incentives for improvements in the overall quality of public investment.

29 The next chapter shows that Georgia will continue to face considerable road infrastructure spending needs in the years ahead, increasingly in the rehabilitation and maintenance of its secondary and local network, but also in the main East-West Highway which remains a high priority for the authorities.

30 The analytical framework used in this chapter is based on Rajaram, Le, Biletska, and Brumby (2010), “A Diagnostic Framework for Assessing Public Investment Management”.

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●● The second is “a simple and light approach” to strengthen the broader capital budgeting system, including specifically procedures for preliminary assessment and identification of projects, as well as uniform methodological guidelines on cost-benefit analysis for use in project appraisal.

oth of these reform prongs will also become increasingly important as the public investment program in B Georgia reduces its dependence on donor financing and appraisal methods.

Specific options to further improve the content and presentation of the capital budget include the following: ●● Coverage: Further extend coverage to all capital projects, by including all domestically financed projects and all projects funded through the state budget, regardless of whether or not they contribute to nonfinancial assets of the central government, local governments, legal entities of public law (LEPLs), or stateowned enterprises (SOEs). ●● Financial Information: Demonstrate consistency between the figures in the capital budget with those in the main budget, program budget, and BDD through cross tabulations. Further improve project financial information by incorporating organizational and functional classification and distinguishing between ongoing and new projects. ●● Nonfinancial Information: Introduce deeper and more systematic non-financial information on project rationale and justification for major projects, including summary results of cost-benefit analyses, any available impact assessments, and project contributions to policy objectives in BDD and program budgets. Further extend and deepen physical monitoring indicators and provide estimates of recurrent expenditure implications.

Specific options on a “simple and light approach” to further strengthen the broader capital budgeting system include:

●● Preliminary Assessment and Identification: Introduce a systematic preliminary assessment and project identification process (best coordinated with early stages of BDD process, before budgetary ceilings are set) to screen projects before they enter the preparation stage. ●● Uniform methodological guidance on cost-benefit analysis: Develop national methodological guidance on cost-benefit analysis for use by major projects that have passed identification, to provide a uniform set of criteria for project appraisal and evaluation across sectors and regardless of source of financing.

In the medium term, the measures to strengthen the capital budget as well as the wider capital budgeting system, should deliver higher efficiency and effectiveness of capital spending through a number of channels. These include lifting the quality of capital projects proposed for budget funding so that value for money and consistency with government policy priorities improves. Second, improving efficiency in the implementation of projects selected, through well designed procurement, management and monitoring arrangements. Third, feeding timely information and analysis on capital budget execution and implementation performance back into budget preparation. Fourth, systematic use of information on the performance of completed projects in strategic planning, project identification and project design.

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A significant challenge in strengthening capital budgeting in Georgia is the informal and fragmented nature of the institutional arrangements. This is particularly true for institutional arrangements relating to project screening and selection, which can take place in an ad hoc manner, with decisions on major investments sometimes already made before budget presentation. While Georgia has a disciplined budget process as set out in the Budget Code, with the content of the capital budget improving over time, limited use is being made of the capital budget in actual decision making. An explicit calendar linking formal decision points in the project cycle to the budgeting and strategic planning cycles, with clearly defined roles and responsibilities for main participants, is also lacking. Strengthening institutional arrangements is addressed in the second part of this chapter, particularly in the subsection on systematization of capital budgeting procedures. A meaningful strengthening of institutional arrangements will also require commitment from high levels of government to utilize the procedures developed in actual decision making.

The structure of this chapter is as follows. The first part of this chapter begins by describing the progress of recent reforms that have been focused on improving the content and presentation of the capital budget and goes on to identify remaining challenges along this dimension. The second part of the chapter looks at the broader capital budgeting system, including international experience and the case of Georgia, and suggests ways in which Georgia might make improvements along this dimension to assist in more effective project screening and selection. In this context, the chapter sets out short term and medium term reform options that can be used by the authorities to further develop their blueprint to strengthen capital budgeting in Georgia.

4.2. Improving the Content and Presentation of Georgia’s Capital Budget

Together with the introduction of program budgeting, capital budgeting has become a focus of attention in the Government of Georgia’s PFM reform agenda. The new Budget Code, which came into force on 1 January 2010, reflects this emphasis and has been the impetus for the introduction of reforms. Article 9 makes explicit reference to the capital budget—defined as “an investment-type program budget”—and to the approval of a “methodology required for drafting program and capital budgets”. Articles 36 and 38 specify that budgetary requests and the draft state budget will include both program and capital budgets, with 1 January 2012 set as the date when this requirement comes into effect (Article 116). Reforms to date, supported by the World Bank’s Development Policy Operation (DPO) series, have largely focused on improving the content and presentation of the capital budget. As public investment has increased considerably in Georgia in recent years, the need for a detailed medium term capital budget has become increasingly apparent. The focus of the reform to date has been to develop and submit a capital budget as an annex to the annual budget law, and to improve its content and presentation over time. One of the first steps was to develop the capital budget annex to the 2010 annual budget. The budget circular for preparation of the 2010 budget was revised to include, for the first time, forms dedicated to preparing capital budgets and included guidelines for preparing, submitting, and selecting project proposals above a defined threshold. As a result, the Annual State Budget Law for 2010 was accompanied by an Information Annex on the capital budgets for two spending units (the Roads Department and the Ministry of Finance).

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Box 4.1. Rationale for Introducing a ‘Capital Budget’

A ‘capital budget’ is a medium term capital spending plan consistent with (but more detailed than) capital expenditures in the annual budget and the medium term budget framework. While capital expenditures (increase in non-financial assets in line with GFS 2001) are already a part of Georgia’s annual budget and medium term fiscal framework, supplementary information in the form of a ‘capital budget’ can help discipline project selection and facilitate scrutiny of public investment efficiency. Most capital expenditure is implemented through multi-year projects and decision-makers need to be able to see the likely spending implications for future budgets of this year’s budget decisions. Information on forward spending should also be an important input into resource allocation decisions for the following year’s medium term expenditure plans (as contained in Georgia’s BDD) as it will help in identifying the fiscal space for new projects and, thus, in setting capital expenditure ceilings. In addition, one year’s spending on an ongoing project needs to be seen in the context of the total cost of that project so that there is transparency, any cost increases are scrutinized by decision makers, and action can be taken if cost escalation becomes excessive. The capital budget can also provide a more comprehensive view of publicly funded investment. Some budget-funded investments do not show up as increase in non-financial assets, but are classified as capital transfers or on-lending (i.e., increases in financial assets) in cases where ownership of the capital asset created does not fall under a budget institution. The capital budget presentation should capture these, and provide a comprehensive overview of budget-funded capital expenditure for decision-makers. This discussion indicates that the capital budget supplements rather than supplanting the capital component of the main budget document and of the BDD, and is nothing to do with dual budgeting systems (which are generally frowned upon). The capital budget presentation is therefore a component of an integrated annual budgeting and medium term expenditure planning process. It also needs to be consistent with the program budget presentation.

A number of special features of capital expenditures call for capital spending decisions to be supported by an additional fuller set of analytical information than is the case for current expenditures. These special features of capital expenditures include: ●● Scale: capital spending tends to be large-scale and ‘lumpy’, i.e., not scalable, so mistakes are costly;

●● Irreversibility: unlike a recurrent expenditure decision, a capital expenditure decision cannot be reversed once implemented; ●● Upfront costs and long implementation periods: timing of decision is therefore more critical;

●● Inter-generational issues: benefits are spread through time and those who pay may not be the same as those who benefit;

●● Socio-economic impacts: capital investment can have a potentially significant impact on a government’s broader social and economic development objectives.

Initial Recommendations for Improving Content and Presentation of the Capital Budget As part of the World Bank’s programmatic fiscal work, a Policy Note on Strengthening Capital Budgeting in Georgia was presented to the authorities in 2010. The capital budget annex accompanying the 2010 budget provided valuable information for decision-makers, although there was considerable room for further improvement. The Policy Note set out further improvements that could be introduced on the way to meeting the legal requirement for comprehensive introduction of capital budgets from 2012. In addition to recommending an extension of coverage of the capital budget, recommendations were made to improve the content and presentation of the capital budget in four areas:

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i. Extending the financial information on multi-year capital projects; The first proposal involved extending the financial information to include: total estimated cost for multiyear projects; cumulative expenditures on ongoing projects; and balance to complete at the end of the medium-term budgeting horizon. This information is necessary for an adequate understanding of the full implications of expenditure proposals and was missing from the 2010 pilot capital budgets. ii. Deepening the non-financial information on the justification for projects; Supporting the second proposal, an extended form was designed providing more in-depth justification for proposed (major) capital projects, including the project rationale and demand, consistency with strategic objectives, appraisal results (if any) and assumptions and risks. Information on the recurrent expenditure implications of the completed project and on physical monitoring indicators (i.e., project deliverables) would also have been captured by the form. iii. Monitoring the capital budget and using the information in budgeting; Up-to-date monitoring information on implementation progress is important at budget time to make informed decisions, hence the third proposal. This information should be captured in capital budget submissions, which should ideally: ●● Identify differences between planned and actual expenditures; ●● Explain main deviations; ●● Assess the implications for the financial implementation profile and total estimated cost of projects; and ●● Compare physical progress to targets and financial progress. iv. Tightening definitions of capital expenditure and projects. Finally, improvements to capital budgeting guidelines were proposed to ensure consistency with GFS 2001 definitions of capital (thus excluding maintenance and repair from capital budgets) and to assist line ministries in scoping projects appropriately for strategic decision-making.

Improvements to date in the 2011 and 2012 Capital Budget Annex The Policy Note recommendations were taken up selectively and resulted in several important improvements to the 2011 and 2012 Capital Budget Annexes, while still leaving room for further progress. Specifically, the most notable improvements to the 2011 and 2012 capital budget annexes were the following: extension of overall coverage, improvement in financial information to include the complete time profile of project capital expenditures; nonfinancial information to include summary project justifications and physical monitoring indicators; and public reporting on actual versus planned project implementation for 2010. Furthermore, the requirements for the capital budget annex have been formalized as part of the program budgeting methodology issued by decree of the Minister of Finance in July 2011.

The coverage of the 2011–12 capital budgets have improved somewhat but remain short of comprehensive. In value terms, the 2011–12 capital budget annexes represent an extension of coverage compared to 2010: total expenditures reflected in the 2011 capital budget represented about 76 percent of estimated budget-funded capital expenditure (as estimated in Box 2 below). In terms of ministries covered, the 2011 capital budget was limited to projects under the Ministry of Regional Development & Infrastructure (MRDI) and the Ministry of Energy, which account for the largest share of capital expenditures, while the 2012 capital budget also extended

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coverage to seven other ministries.31 On the other hand, the capital budgets have been predominantly dedicated to recording donor funded projects (and associated co-funding from domestic sources). Although donor funded public investment is a large share of total public investment in Georgia, domestically funded investment expenditure is not insignificant and the budget instructions give no indication that the capital budgets should exclude it.

The comprehensiveness of financial information on individual projects included in the capital budget annex has improved significantly compared to 2010. This was in line with suggestions in the Policy Note32 and should help improve transparency and the quality of budget planning. Since 2011, the capital budget has included a fairly complete picture of total project expenditure covering: (i) Total project cost funded through the State Budget; (ii) Cumulative expenditure to end of prior year; (iii) Planned expenditure for current year and budgeted year; (iv) Forecast for each of next 3 years after the budget year; (v) Balance to complete after 3-year medium term horizon (dropped from 2012).33 The extent of non-financial information on projects has improved compared to 2010, but remain less detailed than desirable, especially for nationally significant capital projects. Summary project justifications are presented, including a statement of the project goal and expected result, and some forecasts of physical works to be completed during the budget year are given. These physical indicators of works are critical for monitoring purposes and should have provide a firmer basis for reporting on progress during 2011 (although it seems unlikely that this actually happened). While there have been some evident improvements in the nonfinancial information, it remains too limited, particularly with regard to summary quantitative information on such things as basic design standards, planned capacities, expected demand, estimated benefits and economic rates of return34. With many projects donor-financed and almost certain to have been subject to full feasibility studies and impact assessments, such quantitative information should be relatively easy to obtain. The project descriptions in the 2012 capital budget are more consistently informative than those in 2011, with links to government ‘priority areas’ more consistently made (although the priorities themselves suffer from being defined in rather general terms).

The definition of capital spending in the budget instructions excludes maintenance and repair of assets, although some shortcomings remain. Consistent with GFS 2001, the budget instructions define a capital project to ‘increase of assets’ covering ‘new construction, renovation and replacement of existing assets’. At the same time, the inclusion of a road maintenance project in the capital budget suggests there remains some confusion about the definition of capital. Classification issues relating to routine and periodic road maintenance expenditures also do not seem to have been resolved. The requirements for the capital budget annex have now been formalized as part of the program budgeting methodology issued by decree of the Minister of Finance in July 2011. This methodology makes more permanent the requirements set out in the annual budget instructions. On coverage, the methodology 31 The seven additional ministries include: Finance; Justice; Prison, Probation & Legal Assistance; Education & Science; Culture; Health, Labor & Social Affairs; IDPs.

32 For ease of interpretation and transparency, it might have been useful to have included a column ‘Estimate of balance to complete post-2010’ for ongoing projects, but this is not critical since this should be the sum of the last 5 columns of the budget table.

33 Unfortunately, a value for the balance to complete a project at the end of the medium-term framework was no longer presented in the 2012 capital budget, even though this is required in the instructions. The expected completion date for projects is also not systematically given.

34 The Policy Note suggested a format for presenting non-financial information on projects (Table 2 – Format for Summarising Project Rationale), but the MOF was concerned that the ministries would not be able to provide the level of details required.

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confirms that the capital budget can include projects not classified under non-financial assets, such as those classified as capital transfers and increases in financial assets. All investment projects involving full or partial funding from the State Budget are to be covered by the capital budget, including public-private partnerships. Financial information requirements include the full time profile of project capital expenditures, as was the case in the 2011 budget instructions. Financial information is required by project and by sub-project. Also in line with the 2011 budget instructions, non-financial information required includes: government priority to which the project relates; project implementing agency; expected result of the project; total value of the project (which will exceed the figure in the financial information if the state budget is cofinancing with another source, such as a PPP); project financing sources; and major activities for the planning year.

Remaining Challenges in Improving Content and Presentation of the Capital Budget Coverage of the capital budget, as well as comprehensiveness and consistency and of the financial information, remains a significant challenge, with different information sources not easily reconcilable. This is in spite of improvements introduced for 2011–12. These sources of information are:

i. Figures for increase in central government-owned non-financial assets (both project and non-project) in the budget and execution reports; ii. Figures for expenditures on named projects in the annual budget (and execution reports). Some of these projects are included in (i), while others involving capital transfers to local government or on-lending to SOEs are not. The two sets of figures are not directly comparable because some non-capital expenditure is also included in project costs in (ii). iii. The capital budget, which complements (ii) by providing a medium-term perspective, does not necessarily include the same set of projects, and particularly misses wholly domestically financed projects. iv. The BDD which provides medium term capital spending limits by ministry and major project does not necessarily agree with those presented in the capital budget and also may not necessarily be consistent from year to year, with figures for outer years found particularly lacking.

able 4.1 illustrates the significant differences between figures from the first three sources for the period 2008– T 2012. Table 4.1. Alternative Figures for Capital Expenditure from State Budget millions of lari

Total Increase in Non-Financial Assets

Total Value of Named Projects in Budget#

2011 & 2012 Capital Budget Annex*

2008 Actual

2009 Actual

2010 Actual

2011 Actual

2012 Budget

893.4

907.1

1,020.3

1,039.1

812.0

1,049.9

1,302.0

382.4 n/a

1,201.0 n/a

1,262.1 875.5

1,620.9

n/a

Source: Georgian authorities and WB staff estimates. Notes: # Includes capital projects contributing to increasing (central government) non-financial assets and others that do not. * Ministries of Infrastructure and Energy only in 2011. 2010 figure is planned expenditure. 2011 figure is original budget.

The difficulty in reconciling the different sources of information on public investments is illustrated in Box 4.2. This presents an approximate estimate of total state budget-funded capital expenditure and its functional composition based on an amalgamation of execution data for expenditure on increases in nonfinancial assets (source i. above) and for capital projects not classified as adding to central government’s nonfinancial assets (a subset of ii. above). The figures suggest that total public capital expenditure has exceeded the

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increase in non-financial assets by a significant margin, because of capital expenditures funded through capital transfers and acquisition of financial assets. It also shows that taking account of this component of capital expenditure significantly alters the overall functional composition.

Box 4.2. A More Comprehensive Estimate of State Budget-Funded Capital Expenditure

The figures on the left half of the table below give the functional breakdown of increase in non-financial assets as recorded in budget execution data for 2009–2011. These figures include both project and non-project expenditures. Specific projects and related annual expenditures are listed in the annual budget as a level within the organizational classification. From these listings and by cross-tabulating against expenditure on nonfinancial assets, it is possible to identify those projects that will not have been counted as adding to the central government’s non-financial assets. Combining expenditures for these projects with the values that form the basis for the figures in the left half of the table below, yields an estimate of total capital expenditure funded through the State Budget. These estimates are given in the right half of the table together with the functional breakdown. Table 1. Estimates of Total Capital Expenditure and its Functional Distribution in percent of GDP, except where noted

Function

General public services

Defense

Public order and safety Economic affairs of which

Transport (mainly Roads)

Energy

Other

Environmental protection

Housing and community amenities Health

Recreation, culture and religion

Education

Social Protection

Increase in Non-Financial Assets Estimated Total Capital Expenditure 2009 Actual 2010 Actual 2011 Actual 2009 Actual 2010 Actual 2011 Actual 9.2 11.7 9.9 6.8 8.6 6.9 15.9

9.2

19.9

13.1

36.9

45.6

43.1 0.1

6.1 1.3

0.1

2.0

2.8

3.1

2.7

55.0 0.5

8.9 0.2

0.0

4.3

2.4

3.5

0.7

6.4 9.3

60.3

46.5 1.3

12.5 1.0

0.0

5.0

1.3

6.5

0.4

11.8 14.8

43.3

28.5

6.8 9.7

60.2

34.7

4.5 6.5

60.9

34.8

5.6

13.7

15.6

14.4

6.6

11.3

9.1

0.9

1.5

2.1

2.3

2.0

11.4 0.1

3.2

1.8

2.6

0.5

10.6 0.7

3.5

0.9

4.5

0.3

Total

100.0

Total (GEL million)

907.1

1,020.3

1,039.1

1,219.8

1,382.9

1,483.8

Source: Georgian authorities and WB staff estimates.

These are approximate estimates only because some projects will probably have been missed and because some project costs include elements of ‘non-capital’ expenditures. The figures are nevertheless revealing. They show that capital expenditure is significantly higher than is indicated by looking at the figure for increase in nonfinancial assets alone, by over 40% in 2011. They also show that the functional breakdown of expenditure is badly distorted by looking narrowly at the increase in non-financial assets: in the bigger picture, Energy and Housing & Community Affairs (which includes water supply) are much more important, representing 16% and 11% of total spending in 2011, compared to a negligible contribution from the narrower perspective. By contrast, Transport becomes significantly less important.

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Specific options to extend coverage and improve the financial information in the capital budget include the following: ●● Ensure comprehensive coverage of all capital projects funded through the state budget, regardless of whether they contribute to non-financial assets of the central government, local governments, LEPLs, or SOEs and regardless of whether they are foreign-financed or domestically financed. There has been some progress along this dimension in the 2012 capital budget. ●● Financial information on projects should include organizational and functional classification and distinguish between ongoing and new projects, with subtotals for both cases. The capital budget annex does not identify explicitly the organizations responsible for projects and makes no distinction between continuing projects and new projects to start in the forthcoming budget year.35,36 A functional breakdown of total capital expenditure funded through the state budget should also be provided.

●● The financial information should demonstrate consistency between the figures in the capital budget with those in the main budget, program budget, and BDD. This can be done through a set of cross-tabulations that make it possible for decision-makers and the public to reconcile the figures from the different sources in a user-friendly way. This will mean distinguishing major projects that contribute to increase in non-financial assets from those that do not; distinguishing project costs that are classified as contributing to increase in non-financial assets from those that are not; providing aggregate figures on non-project expenditure on increasing in non-financial assets; and mapping the capital budget against the programs used in the program budget using a unified classification.

The definitions of capital expenditures can be tightened further. First, the treatment of supervision and project management costs is inconsistent. These costs are usually capitalized and included in asset values and this should be clarified. Second, while the budget instructions distinguish between rehabilitation, periodic maintenance, and routine maintenance, the capital budget is still not clear on this distinction, with the 2012 capital budget including a project on ‘road recurrent maintenance and rehabilitation’. Third, greater consistency in determining whether or not a capital project will contribute to central government non-financial assets may be required, e.g., with respect to water supply projects, some are recorded as adding to state non-financial assets while others are not.

The project non-financial information in the capital budget remains too general, limited, and uneven, and falls short of justifying why projects provide the best value-for-money and fit to strategic priorities. This does not provide an adequate basis for informed decision-making at budget time and for monitoring and evaluation. In presenting the rationale for a project, the facilities created are often presented as an end in themselves and the higher order objective relating to improved public service delivery often ignored. Although activities and outputs are frequently mentioned, these are not often quantified or given dates by which they will be achieved. The descriptions for two projects from the 2012 capital budget, the first much better than the second, illustrate these issues: 35 It is of course possible to identify ongoing and new projects: new projects show no expenditures in years preceding the budget year. It is, however, important for this distinction to be explicit and for the sub-totals to be presented so that base-line expenditure can be distinguished from new initiative spending within the available fiscal space.

36 With respect to new projects, the methodology should make clear that the capital budget only includes new projects starting in the relevant budget year (and not projects starting in outer years of the medium-term perspective, which should be covered in the BDD). The 2012 capital budget is consistent with this approach.

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●● Construction of Medical Facilities for Inmates with Tuberculosis To improve living conditions for inmates and avoid overcrowding the prison facilities, Government plans to build new establishments. The new medical facility No19, for medical treatment of inmates with TB will be built by the end of year 2012 to establish penitentiary system in accordance with international standards. The project took off in 2010. To implement the project successfully, in 2010–2011, 7,933.00 million GEL has been allocated. In new, five story building, each inmate will be provided with 8sq.m living space. The building will be equipped with ventilation system and ultraviolet lights. Furthermore, reconstruction of facility yard, as well as expansion of kitchen and dining areas, and reinforcement of safety dams is also planned. Overall, in 2012, 9,000.00 million GEL has been allocated for these refurbishments.

●● East-West Transit Highway IV The project involves construction and rehabilitation of Tbilisi-Senaki-Leselidze highway of 96–143 km section. The project is financed by the World Bank on basis of credit and the total estimated cost is 256 million GEL. WB contribution totaling 196 million GEL, while Georgia’s contribution is – 60 million GEL. The scheme intends reconstruction and replenishment of Tbilisi-Senaki-Leselidze highway of Ruisi-Rikoti for the 48km section. Appliance of concrete surface, laying aggregate concrete blocks, installation of safety barriers, building gabions, introducing New Jersey style concrete barriers and concrete cuvettes, placement of traffic signs will be carried out. In addition, top layers of the roads will be covered and drain pipe system works will be arranged on road conjunctions and local roads.

Specific options to deepen the non-financial information on projects in the capital budget include the following:

●● Elaborate on strategic fit, value for money, and sustainability of major projects. This should include: project contribution to achieving stated policy objectives (rather than broad ‘priority areas’ as is presently done) in the BDD and program budgets; capacities of the infrastructure being generated; summary results of cost-benefit analyses including current and forecast demand, the economic rates of return (e.g. in the case of the road project); conclusions of any impact assessments (e.g., environmental or social); and estimated future recurrent cost obligations. It is not be necessary to go to the same level of detail for smaller projects. ●● Introducing a more structured hierarchy of performance terminology with clear definitions could be helpful. A logical framework approach that uses the following terms, could be applied in the case of Georgia: ●● Goal: higher level strategic objective to which the project contributes ●● Purpose: summary project impact, usually expressed in terms of benefits (services) for the target group. ●● Project outputs/results: Specific outputs for which project management can be held directly accountable, such as the specific infrastructure facilities created. ●● Activities: Actions to be undertaken to deliver the outputs/results.

The new capital budgeting methodology does not make a clear enough distinction between project outputs, purpose and goal, thus making it difficult to understand the project rationale and to monitor achievements. The methodology also, mistakenly, dismisses the need for performance indicators for projects believing

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that these will be captured at the program or sub-program level of the program budget. While it is true that projects should contribute to achieving indicators at the program/sub-program level, finer indicators are usually required at the level of project activities, outputs and purpose.

Monitoring and reporting of the capital budget along financial and physical dimensions should take place in a regular and systematic manner. Reporting should take place at key points in the budget preparation and decision-making cycle—and not just at the year-end—so that informed decisions can be taken. Spending agencies should report progress against capital expenditure plans in order to inform budget preparation. Monitoring should be required within year to identify problems early on and implement timely responses. Budget preparation is a time for stock taking, when the findings from monitoring together with updated forecasts of expenditures can be used to inform resource allocation decisions. The reporting should indicate differences between the planned and actual expenditures, explain any deviations, and assess the implications for the financial implementation profile and total estimated cost of a project.

4.3. Strengthening the Broader Capital Budgeting System

Strengthening the broader capital budgeting system can serve as a key instrument for Georgia to manage its growing pipeline of infrastructure needs by ensuring that all projects financed are screened through a rigorous system. The reforms in the previous section dealing with the content and presentation of the capital budget intended to improve the programming of public investment over a medium term horizon and to enhance transparency and accountability, thus embedding incentives greater efficiency and effectiveness. The broader capital budgeting system dealt with in this section aims to ensure that only high quality projects, consistent with government policy priorities and representing good value for money, are selected for funding, implemented on time and within budget, and then go on to deliver sustainable benefits to intended users.

4.3.1 Main features of an effective capital budgeting system An effective capital budgeting system is composed of five main components linked intimately to the project cycle. These five components are: strategic planning; project planning and screening; capital budget formulation and project selection; capital budget implementation and monitoring; and evaluation and audit of completed projects.37 The capital budgeting system is thus intimately linked to the project cycle illustrated in figure 4.1, covering six steps from identification of new projects to

Figure 4.1. The Project Cycle Strategic Planning

Evaluation & Audit

Budgeting

Implementation & Monitoring

Strategic Planning

Identi cation

Preparation

Funding Approval

Budgeting

Appraisal

Budgeting

37 Different countries/organisations have slightly different representations of the project cycle—Ireland, for example, has a four step cycle that condenses some of the steps in Figure 1—but the same processes are always covered.

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evaluation and audit of completed projects. The capital budgeting system encompasses the familiar project cycle, but also the processes linking it to the budget and strategic planning cycles. In a well functioning capital budget system, a clear and formal calendar sets out the key dates for projects submissions and approvals. For example, while it is possible for project preparation activities to be performed outside the budget preparation cycle, prepared projects must be submitted for appraisal and approval by a date that is coordinated with the budget cycle (otherwise they must await the next annual budget cycle). The Policy Note on Strengthening Capital Budgeting in Georgia prepared for the authorities explored in detail what each of the five components of the capital budgeting system entailed, and provided specific international good practice examples. A recent World Bank paper38 identifies the minimum system requirements under each of the five components of an effective capital budgeting system. These include:

Strategic planning ●● Authoritative and actionable strategic guidance to guide sector-level decision-makers in project identification. Planning and screening of capital projects ●● Preliminary screening of projects to ensure project concepts meet minimum criteria of consistency with government’s strategic objectives as set out in strategic guidance.

●● A formal project appraisal process: a regulated set of project preparation steps, such as pre-feasibility study and feasibility study, including preliminary design, and environmental and social impact assessments, that must be completed before a project can be approved as eligible for funding. ●● Independent review of appraisal: an objective review by the finance ministry, a planning ministry or an independent agency is an important way of countering optimism bias39 amongst those developing project proposals.

Capital budget formulation and project selection ●● Project selection through a well managed budget process: linking the process of appraising and selecting public investment projects to the budget cycle in an appropriate way even though the project evaluation cycle may follow a different timetable. Involves verification of project eligibility and priority, and close scrutiny of forward costs and their funding during budgeting. Capital budget implementation and monitoring ●● Efficient project implementation: scrutiny for implementation realism, including organisational arrangements, procurement planning and timetable; adequate monitoring systems; and systems for managing total project costs. ●● Ability to make project adjustments: flexibility to allow changes in the disbursement profile to take account of changes in project circumstances identified through responsive monitoring.

38 “A Diagnostic Framework for Assessing Public Investment Management”, A. Rajaram, Tuan Minh Le, N. Biletska & J. Brumby, World Bank Policy Research Working Paper 5397, August 2010.

39 The systematic under-estimation of costs and over-estimation of benefits – ‘optimism bias’ - is well documented across countries. See for example: ‘Policy and planning for large-infrastructure projects: problems, causes and cures’, Bent Flyvbjerg, 2007.

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●● Provision for sustainable operation of facilities: processes to ensure that a new facility is ready for operation and that the intended services can be delivered on a sustainable basis. Requires effective handover of management responsibility for operation and maintenance, and upkeep of robust and up-to-date capital asset registers40.

Evaluation and audit of completed projects ●● Basic completion review and ex post evaluation: a systematic review of all projects upon completion to assess whether a project was delivered as specified, on time and to budget. Introduction of a more sophisticated ex post evaluation to assess the project’s outputs and outcomes against objectives established in the design should follow.

4.3.2 Strengths and Weaknesses of Georgia’s Capital Budgeting System Georgia’s capital budgeting system is characterized by several strengths and weaknesses. Georgia has been successfully addressing critical infrastructure development needs in recent years and the investment program has been delivered in an expeditious and efficient manner. Strategic guidance on overall infrastructure development priorities is provided from the highest levels of government. Implementation of projects usually proceeds in a smooth, efficient, and timely manner, and procurement systems are being progressively improved. A disciplined budgeting process is set out in the Budget Code and the content of the capital budget is being improved as discussed in the previous section. On the other hand, the systems of project identification and selection are largely informal, lacking in methodological and procedural foundations, and heavily reliant on donors for analytical work for major projects. It is also not clear that the system will be able to continue to deliver in the context of an inevitable tightening of resource availability for infrastructure investment, diminishing donor support, and mounting pressure to enhance selectivity and efficiency of a growing pipeline of infrastructure development needs.

Strong strategic guidance on infrastructure priorities comes from high levels of government, although not always firmly grounded in technical analytical work. High level strategic guidance provides an important foundation for project identification. At the same time, the strategic thinking may not always be firmly grounded in technical analytical work and important trade-offs between sectors and within sectors may not be adequately addressed. The strategic direction is not formalized in publicly available strategies or plans and, therefore, potentially subject to arbitrary shifts in direction. While the BDD is an important tool for summarizing strategic priorities and setting out their medium-term financial implications, it should not be seen as a substitute for developing the national and sector strategies that would normally be expected to underpin a medium-term capital investment program. These issues will become more important as the more obvious investments of strategic national importance come to completion and more nuanced strategic thinking becomes necessary. Georgia benefits from a disciplined budget process as set out in the Budget Code and the content of the capital budget is improving. Budgeting is carried out within a medium-term perspective through the BDD that is growing in credibility and becoming more firmly embedded in the formulation process. Decision-making on current and capital expenditure is, in principle, integrated and externally-funded projects are being captured in 40 A good inventory of existing capital assets should identify each asset, the ministry owning it, the program it supports, the date it entered service and original construction cost, annual maintenance and repair expense history, current condition, current replacement cost, and similar data.

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the budget. On the other hand, there are, as yet, no systematic documented checks by the Ministry of Finance on whether the viability of projects proposed for the budget has been assessed using a robust methodology.41 Furthermore, the content and presentation of the capital budget is being improved, as discussed in the previous section. Project implementation systems are reasonably robust and where weaknesses exist, improvements are being introduced. The procurement system has been improving, and open, competitive bidding has become the norm. From a technical and engineering perspective infrastructure projects seem to be well planned and capital budget execution is relatively smooth42, both from the perspective of the supply of financial resources and their use. Adequate internal financial control procedures are in place and are being followed. Reporting and monitoring of implementation progress is decentralized to implementing organizations, but there are no obvious signs that systems are not working (although they are not necessarily feeding into the budget process as previously discussed). Good procedures are in place to check the quality of construction works, both during construction and at handover.

On the negative side, unified national procedures for project identification, preparation and appraisal are missing, and there is no explicit calendar linking activities in the project cycle to the budgeting and strategic planning cycles. There are no formal decision points at key steps in the project cycle—including a preliminary screening decision—where designated decision-makers sign-off and authorize continuation to the next step. Project identification often takes place in an ad hoc manner, with major investment decisions are often presented as a fait accompli at budget time. Georgia does not yet have its own national technical guidance on project appraisal methods for assessing value for money from capital expenditures. In this respect, there seems to be a dichotomy between processes for externally-funded projects and for domestically-funded projects: domestically-funded capital projects are not subject to the more rigorous assessment of value for money (including cost-benefit analysis) that is more often the case with donor-funded projects. Appraisal methods also vary considerably across organization, so that while individual ministries may be applying good practices, these practices are not consistent.43 Finally, because investment decisions are often made outside the budget process, they are made in the absence of a full consideration of the recurrent cost implications.

Once execution has started, there exists no formal process for reassessment of the justification of problem projects during implementation—and adjustment if necessary—in the case of significant cost overruns or negative factors changing the likely scale of benefits. Upon completion, post-completion evaluation of project results and lesson-learning also seem to be missing. Finally there is no ex post performance audit of capital projects, except that performed by donors according to their own procedures. The preceding analysis suggests that the focus of any reinforcement of Georgia’s capital budgeting system should be on ‘upstream’ elements such as project identification and appraisal. The emphasis should be on moving away from ad hoc decision-making and informality to a system with procedurally determined decision-points, an official calendar, sound guidance on analytical methods and an auditable paper trail. The

41 This is not meant to imply a requirement for the MOF to carry out such assessments, although it might decide to contract independent assessments for projects of macroeconomic significance.

42 Reported budget execution rates for total expenditures on increase in non-financial assets were 98%, 94% and 99% in 2008, 2009 and 2010, respectively, with some variations between sectors.

43 For example, there are different approaches to valuation in cost-benefit analysis and there needs to be a uniform discount rate for making present value calculations across the public sector.

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aim of implementing such improvements would be to move towards a system that passes project proposals through finer and finer filters in order to arrive at those that are most suitable to receive budget funding, i.e., those aligned with government objectives, representing good value for money, and consistent with available resources. In a well designed system, many projects can be filtered out before detailed planning and analysis begins, thus avoiding the need for elaborate studies too early in the process.

The need to strengthen capital budgeting systems in Georgia will become increasingly pressing as dependency on donor assistance declines and selections between competing infrastructure priorities become more nuanced. In recent years, Georgia has been addressing an array of obvious infrastructure deficits in the transport, energy, and utility sectors, thus mitigating the urgency of developing rigorous systems of project identification and screening. Furthermore, the public investment program has been financed in large part through donor assistance, accompanied by a ready assortment of appraisal techniques. As the fiscal landscape shifts considerably in the years ahead, the current capital budgeting system will become unsustainable. Donor assistance will almost inevitably fall as Georgia moves out of the post-conflict phase. Furthermore, infrastructure investment priorities will need to be identified through increasingly systematic demand forecasting44, rather than through the more obvious signs of excess demand, e.g., electricity blackouts or brown-outs, or water rationing.

4.3.3 Reform Options to Strengthen Georgia’s Capital Budgeting System Based on the preceding assessment, this section describes a sequenced set of medium-term reform options to strengthen Georgia’s broader capital budgeting system. The first set of options in the sequence relate to (i) developing a systematic project identification and preliminary screening process; and (ii) developing uniform methodological guidance on cost-benefit analysis. The second set of options in the sequence relate to strengthening strategic guidance and systematization of the overall capital budgeting system.

Introduction of a Systematic Project Identification and Preliminary Screening Process A systematic project identification process involving a “simple and light” preliminary assessment step can have significant impact in effectively screening a growing pool of infrastructure project needs within the fiscal envelope. When applied seriously, such a systematic project identification process can help in ensuring that only affordable projects with the potential to offer good value for money and in line with strategic policy objectives enter the project pipeline and proceed to more detailed preparation (and thus to budgeting). A suggested format for a preliminary assessment for major45 projects is presented in Box 3. This form is intended to assist budget organizations decide whether to proceed to detailed project preparation (feasibility study) and appraisal. This preliminary assessment tool is best used as a basis for dialogue between spending ministries and the Ministry of Finance, rather than a control tool, although failing to complete a project identification form would still be a reason for denying budget funds for project preparation. Project identification is recommended as a short-term priority because the sooner it is introduced, the sooner it can impact the quality of the forward 44 At least in the energy sector, long-term demand forecasting and power planning is not currently being undertaken. The situation appears to be similar in the water and sanitation sector.

45 To avoid unnecessary bureaucracy and economize on limited analytical skills, the formal project identification process should probably be confined to major capital projects (as defined by the government).

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pipeline of projects. Savings on the preparation of weaker or unaffordable projects (which can often represent upwards of 5% of project costs, depending on complexity) can also begin to be realized.

The project identification process should be coordinated with the budgetary calendar, so as to be well integrated into the medium term fiscal framework. Only projects completing preparation by cut-off date early in the BDD/MTEF calendar should be eligible for consideration. Project identification can take place at any time during the year, but submission of new project concepts for confirmation to proceed to preparation and appraisal should be linked to the BDD/budget calendar through a specific calendar for the capital budgeting system. This is useful both in helping to establish medium-term capital spending ceilings and in ensuring that the project pipeline remains consistent with resource availability over the medium-term46. In the Georgian context, project identification would be best coordinated with the early stages of the BDD process (before budgetary ceilings are set) when decisions are being made on overall resource availability, on the fiscal space available for new spending initiatives, including new capital spending, and on the allocation of this fiscal space between competing capital expenditure proposals. International good practice examples of capital budgeting systems involve a sound preliminary assessment step before proceeding to project preparation. Table 4.2 presents a comparison of project identification, screening, and appraisal procedures in Chile, South Korea, Ireland and the United Kingdom, Table 4.2. International Experience in Identification, Screening, and Appraisal Dimension

South Korea

Ireland

United Kingdom

Coverage of PIM System Public investment projects at all levels of government and to investment proposals from state enterprises

Central government projects and to local government projects receiving central government subsidies

Capital expenditure proposals in the public sector

Central government only

Proportionality in application of tools.

Yes

Only for very large projects, e.g., road schemes >£500 million

Prominent assessment tools

Chile

CBA/CEA No

Requirement for Yes preliminary assessment before commencing preparation Project screening by central agency

Project selection delegated to sector spending agencies, within budget ceilings

CBA and MCA

Yes, for projects >$50 m Yes

Yes, but de-concentrated Yes, structure of autonomous provincial offices Yes

Yes

Involvement of central Yes, Ministry of Planning Yes, PIMAC organises agencies other than the responsible for prepreliminary feasibility finance ministry investment phase studies for Ministry of Planning and Budget. Central agencies issue guidelines on project planning

Yes –sector specific guidelines

Single Criterion Analysis, CBA/CEA and MCA MCA and CBA/CEA

Yes, sector specific guidelines

Yes

Yes, general guidelines

Source: PER Background Policy Note on Strengthening Capital Budgeting in Georgia.

46 Iteration is usually required between ceiling setting and the choice of which projects to proceed with. This process is managed by the finance ministry.

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Box 4.3. Proposal for Preliminary Assessment Form for Major Projects 1. Administrative Information and Description

Project name: [Short name of project] Responsible budgetary institution: [First-level budget institution with responsibility for the project.] Organization code: Project proposer: [Name & title of the senior official with overall responsibility for proposing the project and ensuring that it meets its objectives and delivers the forecast benefits.] Location(s): [Geographic location of the project, or locations if it is a programmatic project consisting of a number of similar smaller projects in different locations.] Project description: [Brief description of the preferred project and its main components, including approximate scale and service delivery capacity (rough estimates only) of the assets to be created.] 2. Relationship with Program Budget Program: [Budgetary program to which the project belongs.] Sub-program(s): [Budgetary Sub-program or sub-programs to which the project will contribute.] 3. Strategic Case for the Project Strategic objectives: [To which strategic objectives of the Government or sector ministry will the project contribute and how? Identify the relevant goals and objectives of the budgetary program and sub-programs and the quantified indicators of their achievement. How will the project help in achieving these?] Supporting documentation: [Where are the strategic objectives set down? Identify relevant decrees, strategic plans, BDD, program budget or other documentation.] Risks and assumptions: [Main external risks that could affect the success of the project. Main assumptions, including dependencies on actions by other public institutions. What will be the requirements for risk mitigation and coordination measures?] Lessons from similar projects: [Are there any relevant lessons from similar completed and ongoing projects that have influenced the strategic approach?] 4. Preliminary Economic Case for the Project Specific problem or constraint: [What problem or constraint in the community or economy, or capability weakness in the public sector is the project designed to address? This could relate to the condition of existing infrastructure, current capacity constraints, because of excess demand for infrastructure services, or anticipated future growth in demand beyond current capacities. How is the project expected to address the identified problem or capability weakness?] Demand for the project services: [Who are the intended beneficiaries of the project and what is their expected demand for its services (quantified if possible)?] Project costs and benefits: [What will be the approximate capital costs of the project (based on the cost of recently completed works of a similar nature or international experience)? What future operating and maintenance costs will be involved (qualitative assessment only required, but quantitative if available)? What are the main sources of project benefits - financial and economic? Are there likely to be any significant environmental and social costs and benefits? Are the full-life economic benefits of the preferred option expected to exceed the life-cycle economic costs (including operations and maintenance)? What is the basis for this assessment?] Project alternatives and preferred option: [What alternative project (or policy) solutions been considered, including doing nothing, and why is the proposed project to be preferred? Which options should be taken forward for analysis, alongside the preferred option, during project preparation?]

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Lessons from similar projects: [Lessons from similar completed and ongoing project relevant for the choice of preferred project and its design?] 5. Project Financing, Implementation and Management Project financing: [Set out the proposed sources of finance for the project. Are potential requirements for State Budget funding consistent with medium to long term projections of resource availability? If external financing is involved, what is the status of discussions with potential funding agencies?] Procurement: [Briefly outline the intended approach to procurement and contracting. Will the project be implemented through traditional procurement or are there possibilities for PPP arrangements? If PPP is a possibility summarise the potential options, the criteria for going down this route and the assessments that will be required for ensuring value for money.] Project management: [Briefly outline the expected arrangements for managing project implementation so that project will be delivered on time, to budget and consistent with the specification. Does the implementing institution have adequate managerial and technical capacity for implementing projects of this nature? If not, what additional measures might be required to ensure this is the case.] 6. Operational Sustainability Asset ownership: [Which entity will own the asset? Does it maintain an up-to-date asset register?] Operational responsibilities: [Which entity will have responsibility for operating and maintaining the capital asset once completed? Does the institution have experience of managing the operation of similar assets? If not, what measures will be necessary to create the necessary capacities?] Operations and maintenance expenditures: [Are operations of existing assets in the sector/sub-sector currently being funded on a sustainable basis. Explain how the necessary operating and maintenance expenditures for the new asset(s) will be financed. If additional State Budget funding will be required, is this consistent with medium to long projections of resource availability for the operating entity? If other financing mechanisms are expected to be involved, briefly explain how these will work.]

which are recognized as international good practice examples of capital budgeting systems. Chile and Korea have some similarities, particularly the degree of direct central involvement, as do Ireland and the UK, where the centre is less involved, preferring to assess results rather than means. However, in spite of some institutional differences, the following good practice features are common to all four countries: the systematic application of CBA (cost-benefit analysis) and CEA (cost-effectiveness analysis); a conceptual distinction between ‘screening’ and ‘selection’ processes; use of preliminary assessments before more detailed project preparation; project selection by sector spending agencies as part of the budget process—within defined ceilings; and issuing of methodological guidelines by a central agency (usually the finance ministry).

Methodological Guidelines on Project Appraisal Techniques Methodological guidelines on project appraisal techniques, including cost-benefit analysis (but also less sophisticated techniques) are a central requirement of a sound capital budgeting system. Major projects that have passed the identification stage should be subject to rigorous and systematic preparation and appraisal. This step should include economic cost-benefit analysis (or cost-effectiveness analysis where this is more appropriate) to verify that the project represents a good use of public money. Methodological guidance is a priority because it is usually at the centre of a national public investment assessment system and it takes time to develop and embed. The short term benefits may come in the shape of the increased internal consistency of the

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externally financed part of the investment program. Full implementation across all significant capital projects may take considerable time though, particularly as it will probably require significant capacity building, so that the sooner this starts the better.

Without uniform methodological guidelines on appraisal techniques, Georgia is at risk of uneven standards of scrutiny across projects and weaker standards as heavy reliance on donor funding for public investment phases out. The lack of an approved methodology for economic analysis of projects is not currently viewed as a major drawback by the authorities since most major investment projects have been externally financed by donors applying their own methodologies. It should be noted, however, that donors are not always rigorous in deploying cost-benefit analyses and their analysis can sometimes lack objectivity or be performed after an investment decision has already been taken. Donors also use different methods and values for key parameters, like the discount rate, presenting difficulties in comparing with other projects in the same sector/sub-sector. One of the main reasons for developing and adopting a national project appraisal methodology is that projects should be subject to the same analysis and scrutiny irrespective of their source of funding. This will be particularly important in Georgia as heavy reliance on donor funding for capital investment phases out over time. International good practice in methodological guidance for appraisal techniques addresses a set of key issues to ensure economic viability of publicly funded projects. In transition countries, project preparation is often interpreted as an engineering analysis, with capacity to undertake such analysis usually well developed, whereas capacities in microeconomic analyses of economic viability are often lacking. In more developed capital budgeting systems, project preparation involves feasibility studies including economic, financial, and technical/ engineering analyses, as well as environmental and social impact assessments. For full economic feasibility studies, demand for project services is estimated and benefits, as well as costs, are assessed and quantified in a cost-benefit analysis (CBA). Box 4.4 presents a number of different of international good practice examples of methodological guidance on project appraisal. As New Zealand’s methodological guidelines state, the aim of the analysis undertaken for project appraisal should be to provide answers to the following questions: ●● What are the specific outcomes sought through the investment? ●● Are there better ways to achieve these outcomes? ●● Are there better uses for these resources? ●● Is this an appropriate role for government?

Good practice in methodological guidance on appraisal includes utilizing different techniques for projects falling under different value thresholds. CBA is an important and useful tool for assessing the value for money of a project proposal, but it has its limitations, including its need for skilled practitioners and the difficulty of applying it where it is less easy or too costly to value benefits. The methodological guidance thus needs to be supple enough to allow the use of simpler alternative methods (e.g., cost-effectiveness analysis or multi-criteria analysis) where appropriate. Table 4.3 shows the value thresholds for different assessment techniques in the case of Ireland’s capital budgeting system. One of the challenges facing methodological guidelines on appraisal is to decide on an appropriate discount rate for use in cost-benefit analyses. Broadly speaking, there are two approaches to setting the discount rate, as well as a couple of variants. One is the “social rate of time preference”, a normative notion reflecting society’s evaluation of current versus future consumption. The other is the “social opportunity cost of capital” which is in effect the pre-tax rate of return that can be expected from private sector investments

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Box 4.4. Examples of methodological guidelines from other countries

●● ‘Appraisal and evaluation in central government’ - ‘The Green Book’, UK Treasury;

●● ‘Guide to cost-benefit analysis of investment projects’, EC Directorate General for Regional Policy;

●● ‘Introduction to cost-benefit analysis and alternative evaluation methodologies’, Department of Finance & Administration, Commonwealth of Australia. ●● ‘Cost Benefit Analysis Primer’, New Zealand Treasury

●● ‘Guidelines and discount rates for benefit-cost analysis of federal programs’ (Circular No. A-94 Revised), Office of Management and Budget, USA Table 4.3. Assessment techniques by project value in Ireland Project Value

(Minimum) Type of Assessment

< € 0.5 million

Simple assessment for minor projects, such as those involving minor refurbishment works, fit-outs, etc.

> € 5.0 million < € 30.0 million

Multi-criteria analysis

> € 0.5 million < € 5.0 million > € 30.0 million

Single appraisal (combining elements of Preliminary Appraisal and Detailed Appraisal) Cost-benefit analysis

Source: PER Background policy note on strengthening capital budgeting in Georgia.

with similar risk characteristics. The different approaches to setting the discount rate illustrate the potential difficulties in comparing CBAs using different techniques and call for uniform national methodological guidelines on appraisal.

Strengthening Strategic Guidance Georgia can begin a process of developing more systematic strategic guidance for capital budgeting based on rigorous analytical work. At present, strategic guidance on priority areas for investment is provided by the BDD and high levels of government, although this is not backed by systematic and rigorous analytical work. While this may have been adequate with obvious infrastructure deficits, a more systematic approach based on solid technical work is becoming important as more nuanced choices on investment areas need to be made. Sound public investment requires credible, operational and authoritative strategic guidance that is based on sound theoretical foundations of the role for the state in a market economy,47 as well a rigorous analysis of the most important needs at the sector level. In the absence of such firm strategic guidance, it is difficult to identify project concepts that are suitable for further development and to prioritize prepared projects for inclusion in the budget. Project concepts should ideally originate in investment strategies that are derived through a systematic strategic planning process for a sector. Options for Georgia include developing a national infrastructure strategy or reinforcing strategic orientation for investment at the sector level, or some combination of the two. To be relevant, investment strategies need to achieve the right blend of technical input and political ownership and strategy-making needs 47 Justification for state intervention derives from: i) addressing inefficiencies in the operation of markets or institutions; or ii) achieving equity objectives.

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to be closely linked to the means for delivering policies, i.e., the budgetary process. While the overarching national development plan has been a useful tool in a number of countries, a more ‘light touch’ approach for Georgia could involve reinforcing sectoral investment strategies. National development plans are by no means obligatory48, but where these do exist, sector planning needs to be integrated into the wider process for preparing and updating the national development plan.

Sector investment strategies should be developed within a realistic macro-fiscal framework based on a convincing assessment of potential funding sources for investment plans49. The strategic planning process begins with analysis of the most important problems facing a sector and establishment of the main aims (improved future situations) for the sector. Alternative strategies for achieving these aims are then analyzed and concepts for major investment projects and/or priority areas for investment emerge as one set of concrete components of the preferred strategy. These concepts are then analyzed further and prioritized to form a sector investment strategy. It is important to avoid strategic plans becoming long wish-lists of projects with no realistic possibility of being financed50. This requires close coordination between the sector ministry and the finance ministry during the development of strategic plans and, ideally, the preparation and roll-over of these plans within a medium-term fiscal and expenditure framework. International experience does not point to any one blueprint for developing strategic guidance for capital budgeting. Some countries have successfully implemented national development planning processes (Ireland and Botswana), with public investment strategies being derived as part of these plans. Many other countries have chosen looser planning arrangements without the need for overarching national plans (UK). Amongst the latter, there does appear to be a trend towards developing national infrastructure strategies. This is partly a response to the need to prioritize public investment more carefully in the current economic and fiscal climate and partly in recognition that infrastructure investment may have been given too little weight in budgetary systems where expenditure decision making has largely been decentralized and where there is a limited role for the centre in deciding the balance between capital and recurrent spending. Examples are: ●● Canada’s national infrastructure plan – ‘Building Canada’

●● Australia’s ‘Building Federal Infrastructure Plan’ (2007–2014) ●● UK ‘Strategy for National Infrastructure’

lbania has recently introduced a comprehensive strategic planning process (the Integrated Planning System A or IPS) that is integrated with medium term budget planning and annual budget preparation; other countries in the same region have been less successful and some attempts at national development planning have stalled.

48 Except for candidates for EU membership, which must produce national development plans to access pre-accession funding.

49 Similarly, national development plans are only a useful component of public investment planning when they are sensibly costed and framed by realistic estimates of resource availability. Some countries prefer instead to focus planning at the sector level and link strategic plans to medium term budget estimates.

50 In Canada nothing can be called a ‘plan’ unless the resources for its implementation have been approved.

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Systematization of Capital Budgeting Procedures A key weakness of Georgia’s capital budgeting system is its informal nature, without clearly defined organizational roles, procedures, and decision-points integrated into a calendar coordinated with the budget cycle. As previously discussed, national procedures for project identification, preparation and appraisal are missing, and there is no explicit calendar linking activities in the project cycle to the budgeting and strategic planning cycles. There are no formal decision points at key steps in the project cycle—including a preliminary screening decision—where designated decision-makers sign-off and authorize continuation to the next step. Project identification often takes place in an ad hoc manner, with major investment decisions are often presented as a fait accompli at budget time.

Box 4.5. Main Contents of US Capital Programming Guide ●● Introduction: The Guide’s Purpose ●● Planning and Budgeting Phase

●● Strategic and program performance linkage ●● Agency enterprise architecture ●● Functional requirements ●● Alternatives to capital assets ●● Choosing the best capital asset ●● The agency capital plan ●● Agency submission for funding in the budget year

●● Acquisition Phase

●● Validate planning decision ●● Manage the acquisition risk ●● Consider tools

●● Select contract type and pricing mechanism ●● Issue the solicitation ●● Proposal evaluation and negotiation ●● Contract award ●● Contract management ●● Acquisition analysis ●● Acceptance

●● Management In-Use

●● Objectives during management in-use ●● Operational analysis is a key tool in management-in-use ●● Operational analysis process and outcome ●● Asset disposition

●● Technical Appendices

Georgia’s capital budgeting system needs to be put on a sustainable, long-term footing through the development of systematic ‘capital budgeting guidelines’ - to be developed by the Ministry of Finance and made available to spending agencies. These should systematize the whole capital budgeting system, while giving particular emphasis to the project identification and appraisal stages, which are the critical steps towards ensuring the efficiency and effectiveness of public investment. These procedural guidelines would explain how the capital budgeting system operates in Georgia, including recommendations on methodological approaches to project appraisal. Examples from other countries are:

●● Ireland: Department of Finance, ‘Guidelines for the appraisal and management of capital expenditure proposals in the public sector’; ●● Albania: Ministry of Finance, Public Investment Management Guidelines (as part of manual on programbased MTEF); and ●● South Africa: Ministry of Finance 2010 MTEF - Budgeting for infrastructure and capital expenditure guidelines. ●● USA: Office of Budget and Management, Capital Programming Guide, Circular No. A-11 (2011),

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ox 4.5 gives the main contents of the US Capital Programming Guide as one example of what procedures can B cover.

A detailed suggested outline of procedural guidelines for capital budgeting in Georgia has been shared with the Georgian authorities. The guidelines could be prepared as a subset of the guidelines on program budgeting and might cover the following:

●● Motivation for and scope of guidelines ●● Definitions of terms and concepts ●● Basic principles ●● Roles and responsibilities of main participants - Decide on organizational arrangements for public investment assessment system: ●● Decision-making arrangements – possible creation of a Cabinet committee for decisions relating to major projects; ●● Technical arrangements – possible creation of a public investment analysis unit in the Ministry of Finance, another ministry, or an independent agency reporting to the Minister of Finance ●● Allocate decision-making responsibilities for commencing project preparation and for the appraisal decision, including any delegation of responsibilities according to project size. ●● Elements of the capital budgeting system in Georgia ●● Outline of the project cycle. ●● Project identification: identifying good ideas for further development, usually through strategic planning. ●● Project preparation: undertaking feasibility studies to aid decision-making. ●● Appraisal decision: making a decision on whether a project has the potential to represent a good use of public money. ●● Capital Budgeting : financing ongoing projects and selecting new projects for implementation; programming projects within a medium-term framework. ●● Implementation & monitoring: procurement and project management arrangements; monitoring progress and making adjustments. ●● Evaluation: verifying project delivery, efficiency and effectiveness; learning lessons. ●● Key decision points in the capital budgeting and project cycles and allocation of roles and responsibilities between the main actors

his guidance is informed by the examples of guidelines from Ireland, South Africa, Moldova (draft only), and T Albania. Guidelines from these countries show considerable variation in the level of detail and length, but the content is broadly similar.

One issue of importance that will need to be addressed by the Georgian authorities is the legal status of the capital budgeting guidelines. In this respect, there exist a number of international good practices. Chile’s capital budgeting system is given a strong legal basis, as is that in Paraguay, while and Vietnam is in the process of developing a Public Investment Law. At the other end of the range, the USA has a more flexible approach. The introduction to the US Capital Programming Guide states that the purpose of the guide is to professionals in the Federal Government guidance for a disciplined capital programming process, as well as techniques for planning and budgeting, acquisition, and management and disposition of capital assets. At the same time, agencies are provided flexibility in how they implement the key principles and concepts discussed.

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4.4. Conclusion: the way forward

The analysis in this chapter indicates that Georgia can move forward along one of several paths in managing the growing body of infrastructure investment needs with which it is faced. On the one hand is the path of continued informal and ad hoc project screening and selection and inadequate coverage and consistency of the medium term capital budget. Along this path, decisions on new investments projects are taken in a manner that is not fully consistent with the medium term fiscal framework. A growing pool of projects screened and selected without a uniform set of criteria find their way into the budget. Consolidation of capital expenditures is progressively delayed, thus delaying fiscal consolidation and crowding out important social expenditures. On the other hand is the path of improving the content of the capital budget and strengthening procedures for preliminary screening and subsequent appraisal of project proposals. Along this path, the transparency of the capital budget is enhanced and medium term public investment programming is improved. Moreover, project ideas are screened and appraised using a uniform set of well-defined criteria, closely coordinated with the annual budget cycle. Projects are selected for budgetary funding in a manner that is fully consistent with a defined medium term expenditure framework. Along this path, consolidation of public capital expenditures proceeds on schedule and the selected projects effectively contribute to Georgiaâ&#x20AC;&#x2122;s infrastructure needs for growth, while important social expenditures are also met as needed. The options discussed in this chapter are intended to move Georgia down the second path described above.

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Chapter 5. Road Sector Expenditures 5.1. Introduction

Against the backdrop of fiscal consolidation, the roads sector in Georgia will continue to pose substantial demands on public funding in the years ahead. Georgia has made considerable progress in upgrading its transport sector in recent years: ports, airports, and railways have been improved and much of the international road network has been restored to good or fair condition. On the other hand, the majority of secondary and local roads remain in poor condition and in need of considerable public funds for improvement. Only 30 percent of secondary roads and 15 percent of local roads were in good to fair condition in 2010.51 Secondary and local roads comprising the bulk of the road network have received little or no attention for decades and will need complete reconstruction in many cases. The high priority East-West Highway will need further investment to reach completion. Although rehabilitation budgets have increased to make some progress in clearing the large backlog of the secondary network in poor condition, considerable work lies ahead. Periodic and routine maintenance has been chronically underfunded and further resources will be needed to achieve long run sustainability of the road investment program. Improving road networks will be important in achieving Georgia’s development objectives. At the same time, the substantial demands for public funding for roads will need to be balanced against competing public investment needs in the other areas, including energy, water, regional development, and agriculture. All this needs to take place within a fiscal framework that calls for capital expenditure consolidation going forward. Addressing road sector priorities within the fiscal framework will require improving long run sustainability of the road investment program, as well putting in place institutional arrangements for more efficient utilization of resources. Specifically, the analysis in this chapter discusses the following options for consideration:

●● Address the chronic underfunding of routine and periodic maintenance expenditures by providing funding in line with the HDM model, as allowed by available resources

●● As lumpy investment in the EW Highway winds down, phase in a rebalancing of outlays for new construction and rehabilitation over a period of time to reduce the backlog of the secondary network in poor condition ●● Develop a viable system for attending to the needs to the local road network by initiating rehabilitation of a target subset of the network ●● Put in place institutional arrangements to enhance road expenditure efficiency, including the road asset management system (RAMS), use of more efficient contracting technologies, and improving capacity of the roads department. 51 The Roads Department, under the Ministry of Regional Development and Infrastructure (MRDI), is responsible for international and secondary roads, while local roads have been under the responsibility of municipalities since 2007.

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The structure of this chapter is as follows. The next section elaborates on the key issues associated with sustainability and efficiency of the road investment program in Georgia. The third section provides a summary of the state of the overall road network in Georgia. The fourth section provides an account of the road investment and improvements to date. The fifth section considers the government’s medium term road investment program and provides an alternative illustrative option to demonstrate reforms to improve sustainability and efficiency. The sixth section provides an account of institutional improvements that can lead to improved efficiency.

5.2. Key Issues in Sustainability and Efficiency

The Government of Georgia’s transport sector strategy aims to upgrade its transport infrastructure to reach international standards of serviceability. The strategy seeks to harness the strong correlation between infrastructure development and economic growth by increasing competitiveness of Georgian goods, better regional integration, and enhanced access of the rural communities to markets and health and education services. Underlying the strategy is the government’s keen interest in exploiting Georgia’s key geographic location and potential to serve as a transit and logistics hub for trade routes between the Central Asian Republics and the Far East on one hand and Europe and the Western World on the other. The significance of this potential is increasing with the rise in Caspian oil production and high rates of economic growth of countries in the neighborhood. The Georgian authorities have thus placed a good deal of emphasis on upgrading main international trade corridors.

In recent years, substantial progress has been made in implementation of the transport sector strategy, although considerable needs in road improvement remain. The country’s main ports and airports were concessioned to the private sector and are now essentially privately financed. Georgian Railway is gradually moving towards the adoption of modern marketing techniques. Customs has been reformed considerably by streamlining procedures, eliminating corruption, and upgrading infrastructure. The main arterial roads are being improved and mostly brought up to maintainable conditions. A major focus of the roads program has been the E60 East-West highway, a 380-km corridor connecting the Port of Poti in the west to Azerbaijan in the east. The economic rates of return (ERR) on World Bank financed projects in the E-W Highway have been strong, in the range of 15–25%, thanks in large part to the high levels of traffic on this main international trade corridor through Georgia. As a result of these and other investments, the condition of the international road network (constituting 7 percent of the overall network) has improved markedly: from 34 percent in good or fair condition in 2004 to 76 percent by 2010. At the same time, as discussed, the roads sector will pose substantial demands on public funding in the years ahead, with maintenance expenditures chronically underfunded, most of the secondary and local network in serious need of rehabilitation, and the further work ahead in completing the EW Highway. Addressing the chronic underfunding of routine and periodic maintenance will be critical to improving sustainability of the road investment program. The government’s medium term road expenditure program (MTER) provided GEL 32 million in 2010 to routine and periodic maintenance of the international and secondary networks (GEL 28.56 million for routine maintenance and GEL 3.1 million for periodic maintenance). In contrast, the estimated need for routine maintenance alone amounted to GEL 42.7 million in 2010, based on unit costs per km of four-lane and two-lane roads of GEL 11,000 and GEL 5,500, respectively. The need for periodic maintenance applied to one tenth of the network every year amounted to GEL 123.12 million in 2010

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(assuming a resurfacing cost of GEL 324,000 per km for a four-lane road and GEL 162,000 per km for a two lane paved road).

The financial burden and economic consequences to the country of underfunding maintenance are considerable. Neglecting maintenance results in substantially higher eventual costs of rehabilitation or restoration, which would be in the order of GEL 1.5 million per km of a paved four lane road and GEL 600,000 per km of a paved two lane road. This is 2.5 to 8 times higher than the costs of maintenance. Furthermore, neglecting maintenance to place priority on new construction can result in an average of 3 to 4 km of existing potentially good roads being lost for every km of new road constructed. The economic consequences of neglecting maintenance are primarily borne by private road users in the form of reduced productivity and increased vehicle operating costs. A dollar of neglected maintenance expenditures can result in an increase of $2 to 3 in vehicle operating costs caused by deformed and rough road surfaces.

As lumpy investment in the important EW Highway winds down, a phased-in rebalancing of outlays for new construction and rehabilitation can help reduce the backlog of the network in poor condition. The arguments in the preceding paragraph to support the preservation rather than the expansion of the network, can be further strengthened by a comparison of the economic rates of return (ERR) of a typical widening to four lanes of a 100 km road with 5000 vehicles per day at a cost of $ 700 000 per km52, and the rehabilitation of 100 km of a two-lane road with 2000 vehicles per day at a cost of $ 200,000 per km53. Depending on the difficulty of the terrain, the widening will have an EER in the range of 10-14 percent while the rehabilitation EER will be in the range of 20-35%. (Periodic maintenance—resurfacing of the two lane road—would have an EER in the order of 30-50% at the cost of $80,000 per km). The two major donor funded programs for rehabilitation (funded by the Millennium Challenge and by IBRD/IDA through the First Secondary and Local Roads Program SLRP) were completed in 2011. IBRD/IDA is following on with further support for rehabilitation through the Second SLRP and planned additional financing for the Third East-West Highway Improvement Project. However, budget allocations beyond 2011 are not sufficient to compensate for the overall reduction in external funding. Developing and implementing a viable system for attending to the needs of the local roads network can be important in enhancing access to markets and social services for the rural population. Although reliable information is scarce, the local road network is extensive but in very poor condition, thus impeding access to markets and social services for the rural population. At the same time, improving the entire local road network will prove both unaffordable and inefficient. Addressing the challenge of improving local roads will require identifying a core local roads network which provides access to economic centers and social services to a large population. A rehabilitation and maintenance program for this core network should then be formulated. Given the uneven availability of resources at the local level for roads, it would be useful to manage and coordinate the improvement of non-urban local roads under the Ministry of Regional Development and Infrastructure (MRDI). Finally, putting in place improved institutional arrangements to enhance efficiency of road expenditures will be important in the face of limited resources. A number of reforms are particularly important in this regard. The first is to move toward implementation of a comprehensive Road Asset Management System (RAMS) based on a comprehensive database of the entire road network, including local roads, as well as analysis based on economic and social criteria. The second is to introduce and increase the use of more efficient contracting 52 This estimate is based on the average cost per km of works on the East-West Highway.

53 This estimate is based on the average cost per km of the works under the SLRP.

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technologies such as Design Build and performance-based contracting based on the Design-Build-OperateMaintain-Transfer (DBOMT) technology. The third is to improve capabilities of the Roads Department on a number of fronts, including training in the use of modern asset management principles; capability to assess benefits in terms of several criteria, including benefit-cost ratios, community access to essential services, emergency access, environmental sustainability, and agency risk; and capability in procurement and contract monitoring. The following sections (i) present an overview of the general characteristics and situation of the road sector in Georgia; (ii) assess the government’s proposed Road Investment and Maintenance plan for the 2010–2014 period; (iii) consider an alternative illustrative scenario that holds expenditures steady as a percentage of GDP at the 2011 level but considers an alternative construction/rehabilitation/maintenance structure and an increased emphasis on local roads; and (iv) discuss specific measures to increase the cost effectiveness of priority projects.

5.3. The Road Network

The total length of Georgia’s road network is about 20,400 km. The network is sub divided by functional classification into three classes: (a) 1563.5 km of international roads; (ii) 5,466 km of secondary roads, and (iii) 13,386 km of local roads54. There are five main roads and highways, totaling 859 km: (i) Poti–Tbilisi–Red Bridge; (ii) Mtskheta–Kazbegi–Larsi; (iii) Sarpi–Batumi–Samtredia; (iv) Khashuri–Akhaltsikhe–Turkish border; and (v) Tbilisi–Marneuli–Guguti. There are two main transit corridors: the E60 East-West Highway (Senaki-Tbilisi-Red Bridge) and the E70 (Senaki-Poti-Batumi-Sarpi/Turkish Border). Although the international road network has improved considerably in recent years, the often Table 5.1. Road Network in Georgia challenging topography, inadequate maintenance in kilometers regime, poor technical standards of vehicles, and Road Class 2 Lane 4 Lane Total other adverse conditions mean the traffic flow is International roads 1,484 80 1,564 slow and the risk of accidents high on much of Secondary roads 5,466 0 5,466 the overall network. The absence of rehabilitation Local roads 13,386 0 13,386 and maintenance of a bulk of the secondary and local roads has led to failure of many of these Total 20,336 80 20,416 Source: Roads Department of Georgia. roads. About 34 percent of the network is paved, while 59 percent is gravel and 7 percent earth roads. International and secondary roads are managed by the Roads Department under the MRDI, while local roads are managed by local municipalities. In 2007, the Roads Department transferred local roads to 69 local governments as part of a broader public sector reform aimed at decentralizing government functions.

Although Georgia compares favorably with regional comparators in terms of road density, the condition of the majority of the road network remains poor. Road density in Georgia is 291 km per 1000 sq km or 4.57 km per thousand people. These levels fall short of OECD levels, but it compares favorably with respect to regional peers in the Caucasus, Central Asia, and the Balkans. On the other hand, the condition of the

54 These figures include about 323 km of international roads and 1129 km of secondary roads in the occupied territories of Abkhazia and South Ossetia.

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majority of the road network remains poor, with the exception of international roads. Transport costs are high and connectivity to markets poor due to degraded rural infrastructure. Only 41 percent of international and secondary roads were in good or fair condition in 2009. This is well below the international benchmark of about 70 percent of main roads (primary and secondary Table 5.2. Road Coverage in Selected Countries roads) in developing countries in good or fair in km per sq km and km per 1000 people condition. While international roads are in Road Density relatively good condition, with 77 percent in good Road Km/ Road Km/ or fair condition, the same cannot be said for 1000 sq km 1000 people secondary roads, with only 30 percent in good or Azerbaijan 288 2.9 fair condition. This has been a result of neglect of Kyrgyzstan 170 6.3 maintenance of secondary roads in recent years Kazakhstan 40 7.1 as priority has been placed on improving the Georgia 291 4.57 condition of international roads. Estonia

1320

41.2

Hungary 1733 15.7 Traffic load patterns vary considerably by road FYR of Macedonia 342 4.3 type. The average annual daily traffic (AADT) Serbia & Montenegro 494 4.8 is 3,999 vehicles per day (vpd) on international roads, 825 vpd on secondary roads and up to Slovenia 1007 10.2 89 vpd on core local roads. Total annual vehicle Albania 657 3.5 utilization is estimated to be 4,527 million vehicleEurope and Central Asia 580 8.6 km and although international and secondary Upper Middle Income 1076 9.2 roads account for only 32 percent of the network Lower Income 328 4.9 length, they carry 89 percent of total traffic Source: WDI and IEF data bases. measured in terms of vehicle-km. The number of vehicles registered has substantially increased in recent years, reflecting high economic growth, although this was interrupted temporarily during the global economic downturn of 2008–09. From 2003 to 2007, the vehicle fleet grew at around 12 percent per year to reach 511,000 vehicles in 2007, of which 81 percent are passenger cars.

Road design standards are inadequate and outdated for the international and secondary network, but excessive for local roads. Although many international and secondary roads now carry traffic comprising heavy trucks with European dimensions and axle loads of 11–16 tons on double axles, the design standards are still based on maximum axle loads of 6 tons. In addition, pavement standards in Georgia are based on the old Soviet designs that do not require factoring in forecast traffic demand over the design life to determine pavement strength. On the other hand, standards used to rehabilitate local roads are higher than justified by the level of traffic, thus resulting in fewer segments of local roads being rehabilitated than would otherwise have been the case. In addition, funding of routine and periodic maintenance is very limited, resulting in faster than planned deterioration of road assets. This approach ends up being expensive and unsustainable as improved sections rapidly deteriorate before the rest of the network is improved.

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5.4. Road Expenditures and Outputs to date

A review of road expenditures to date shows that while funding has increased considerably in recent years, there is room to improve sustainability and efficiency on several fronts.55 Specifically, the review shows that:

(a) There has been a marked increase in funding for the improvement and rehabilitation of arterial roads, which has resulted in a substantial improvement of the international and secondary networks. (b) Maintenance allocations have increased although the current levels are still insufficient to ensure the sustainability of the country’s road assets. (c) Local roads which connect villages in rural areas and were transferred to local governments in 2007, have received minimal attention and are largely in poor condition. (d) Urban roads (which are predominantly in the city of Tbilisi) are being improved at a healthy rate but mostly in Tbilisi. (e) There is substantial potential for increasing the efficiency of investment through improved design standards, better planning, use of more efficient contracting methodologies, and enhanced supervision of works.

Road investment has risen markedly in recent years, financed in large part by international financial institutions. Table 5.3 below shows expenditures for the international and secondary networks under the responsibility of the Road Department (RD) for the period 2004–2010. Expenditures on the national road network jumped from 0.95 percent of GDP (or GEL 110 million) in 2005 to 2.78 percent (or GEL 509 million) in 2009, with the bulk of the funds going to international roads. Most of the allocations for construction are concentrated in upgrading and increasing the capacity of the East-West Highway, the life line of the country, linking the city of Tbilisi with the Port of Poti and the Turkish border to the West and with Azerbaijan to the East. About 75 km of the 380 km corridor has been or is in the process of being upgraded with the support of the World Bank and other international donors, while additional works are programmed to start in the years ahead. Total expenditures on new construction increased from GEL 18.26 million in 2005 to GEL 150.0 million in 2009. About 57 percent of the total expenditures on new construction during that period were financed by bilateral or multilateral donors.

Funding for reducing the backlog of international and secondary road rehabilitation has also increased substantially in recent years. Total funding for rehabilitation and periodic maintenance increased from GEL 71.4 million in 2005 to GEL 326.91 million in 200956. The structure of the budget also changed in 2009, in particular through a jump in foreign funding both for new construction and for the rehabilitation of the network. In fact, as shown by figure 5.1, the 2009 budget for main roads exceeded the total combined budgets for the 1998–2004 period. The figure, prepared and made public by RD, also shows the relationship between financial outlays and physical outputs. About 57 percent of rehabilitation and periodic maintenance expenditures were financed by donor and Millennium Challenge Georgia Fund (MCG) in 2009 and 75 percent committed for 2010. This raises the issue of the sustainability of the rehabilitation budget if MCG and other donor funds are not available after 2010. 55 Unless stated otherwise, expenditures refer only to the international and secondary networks. Local roads under the jurisdiction of local governments and for which scant data exist are treated separately.

56 37 percent of these expenditures were funded by the MCC grant, which will not be available beyond 2010.

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Table 5.3. Expenditures on International and Secondary Road Networks (2004–2010) in millions of lari and percent of GDP

2004

2005

Road Expenditures 2006 2007

2008

2009

2010

13.12

30.00

New construction Government Budget

0.00%

0.12%

0.38%

0.16%

0.25%

0.03%

0.00%

0.17%

0.38%

74.03

0.44%

67.37

0.35%

150.00

183.40

0.16%

52.43

120

0.03%

18.26

54.25

0.66%

3.16

29.38

0.28%

Sub-total

44.65

0.07%

3.76

52.43

0.26%

3.16

14.5

0.82%

231.60

Government Budget

17.58

59.83

75.85

132.36

125.00

142.00

111.04

13.21

GDP share %

Donors

GDP share %

MCG

GDP share %

Donors

GDP share %

Routine Maintenance GDP share %

Sub-Total

GDP share %

Total

GDP share %

Rehabilitation/Periodic Maintenance 0.00

0.00

33.03

34.5

121.10

0.19%

0.07%

0.35%

0.21%

0.19%

122.35

197.39

32.32

48.20

0.96%

1.22%

0.18%

0.00

0.51%

0.55%

25.09

0.00

0.26%

0.10%

0.13%

21.51

11.57

0.22%

0.18%

64.18

20.52

18.05

0.65%

0.79%

67.34

91.92

28.45

110.18

174.78

271.42

272.08

509.23

708.30

0.69%

0.95%

1.27%

1.60%

1.43%

2.78%

3.72%

0.78%

0.89%

0.66%

1.16%

0.78%

212.10 0.58%

63.81

125.00

0.17%

0.18%

0.15%

204.71

359.23

476.70

1.07%

1.96%

0.66%

28.56

2.50%

Source: Roads Department of Georgia and WB staff estimates.

Economic analysis of road projects financed by the World Bank in Georgia shows that the economic rates of return have been strong. The estimated ERR for the First, Second, and Third East-West Highway projects have been 24.6%, 15.3%, and 16.3%, respectively, which are at the high end of the range expected for projects of this nature (with an ERR of 10–14% being typical for new construction projects). This is in large part a result of the high traffic volumes, including significant traffic in cargo carrying trucks, on this main international trade corridor through Georgia. As noted, the E-W Figure 5.1. Evolution of Road Expenditures and Outputs Highway is a central piece in the government’s in millions of lari and in kilometers strategy of transforming Georgia into a transport and logistics hub for trade between Central Asia 108 and the Far East on the one hand and Turkey and bridges 10 bridges Europe on the other hand. The estimated ERR for the Second Secondary and Local Roads project is 553 19.8% and that for the Kakheti Regional Roads 504 mln 46 bridges mln 630 project is 51.8%, both of which are in line with 48 km km what would be expected for projects of this nature. 279 335 km

mln

The substantial increases in new investment and rehabilitation has resulted in a major improvement of the international road network. The share of the international network in

11 km

1996 2004

2008 2009

2008

Budget

2009

Construction

2008

2009

Rehabilitation

Source: Roads Department of Georgia.

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Georgia Public Expenditure Review 2012

Figure 5.2. Condition of the International and Secondary Road Networks in percent of network

in percent of network

International Road Network Condition

Secondary Road Network Condition

34 26

23 18 13

12 4 2009

Good

Fair

2004 Poor

Bad

Source: Roads Department of Georgia, WDI, and IEF data bases.

2009 Good

Fair

11 8

2004 Poor

Bad

good condition improved from 34 percent in 2004 to about 80 percent at present. The condition of the secondary network has also improved, with the share in good condition rising from 6 percent in 2004 to 26 percent in 2009. However, the majority of secondary roads remains in poor condition and are the major contributor to the remaining rehabilitation backlog for the network under the Roads Department’s responsibility. Maintenance and rehabilitation of existing roads are essential in order to avoid costly rehabilitation and reconstruction costs in the future. Routine maintenance, which is fully financed by the government budget, is considerably underfunded compared to estimated need. In spite of the increased allocation of funds for maintenance, Georgia spends about 33 percent less on routine maintenance of the international and secondary networks than it is required to ensure that these networks can be maintained in a “steady state” or sustainable condition. The required annual amount has been estimated to be at least GEL 43 million for routine maintenance, assuming unit costs of routine maintenance per km of four-lane and two-lane roads of GEL 11,000 and GEL 5,500, respectively. In contrast, actual routine maintenance expenditures for 2010 were about GEL 28.5 million. One of the shortcomings of the road budget is the aggregation of periodic maintenance and rehabilitation under the same category, which has resulted in chronic underfunding for periodic maintenance. These items are conceptually very different (under ideal circumstances rehabilitation would not be necessary) and their aggregation masks a marked decrease in the funding of periodic maintenance. Periodic maintenance applied to one tenth of the network every year would amount to GEL 123.12 million (assuming a resurfacing cost of GEL 324,000 per km for a four-lane road and GEL 162,000 per km for a two lane paved road). In contrast, according to information provided by the

90 | Chapter 5. Road Sector Expenditures

Figure 5.3. Sharp Decline in Periodic Maintenance Funding in Recent Years in millions of lari

25 25 22.5 20 16.3 15

3.1

0 2007

2008

Source: Roads Department and WB staff estimates.

2009

2010

Managing Expenditure Pressures for Sustainability and Growth

roads department, expenditures on periodic maintenance dropped from GEL 22.5 million in 2008 to GEL16.3 million in 2009 and to a projected GEL 3.1 million in 2010. This amount represents less than ten percent of the funds necessary to provide periodic maintenance interventions to the roads every ten years. The local road network is in very poor condition and reliable data on expenditures or conditions is not available. The organic Law on Local Self-Government (LSG) established a two level administrative framework in Georgia effective November 2006, comprising the central government and local governments. The change resulted in the consolidation of 1,100 small and resource-poor LSG units into 69 units.57 While the international and secondary road networks benefited from the increased funding of the last four years, the tertiary or local roads network continues being mostly in very poor condition. Reliable data on the condition and expenditures in local roads is not available. The government, with World Bank financing, has started the condition inventory of the 13,000 km network of local roads and the preparation of the basic data bank necessary for planning future interventions. Despite the lack of hard data, government officials and stakeholders agree that local roads are in urgent need of rehabilitation in order to become maintainable. In 2010, about 15 percent of the budget for local governments are planned to be allocated for roads. The lion share of the GEL 226.6 million allocated through local budgets for roads goes to city streets (mostly Tbilisi) leaving about GEL 49.1 million for the 13,000 km of the local network that connects villages in rural areas (see Table 5.4). This amount, once the cost of basic maintenance (including winter maintenance) to keep the roads passable is subtracted, would allow for the rehabilitation of less than 50 km of roads per year. Table 5.4. State Government Transfers and Expenditures on Local and Urban Roads in thousands of lari

Total Central Government Transfers...

....of which expenditures on roads

Cities

995,952.0 741,940.0

177,492.0

Municipalities

469,712.5

49,117.0

of which Tbilisi

Total

Source: Ministry of Finance of Georgia.

1,465,664.5

137,000.0

226,609.0

Urban roads are being improved at a healthy rate, although mostly in Tbilisi. The city of Tbilisi budget for roads in 2010 amounted to GEL 137 million of which GEL 95 million was for the central Tbilisi government for the improvement and maintenance of the main arterial urban roads and the rest to the five Tbilisi districts which are responsible for less trafficked roads. About 55 percent of the central roads are in good condition, and Tbilisi officials plan to complete the total rehabilitation of the central network in about four years. Once the rehabilitation process is completed, it is estimated that the maintenance of the main city links will require annual budgets of about GEL 10-15 million. The city of Tbilisi accounts for 85 percent of the urban road network of the largest five Georgian cities. There is room for improving the efficiency of road sector expenditures. Several factors adversely impact the quality of road sector expenditures, of which the most salient are: (i) the lack of a systematic process of project

57 The 69 new units consist of 59 former Rayons, 4 former Districts, and 5 special status cities - Tbilisi, Kutaisi, Batumi, Rustavi, and Poti. Local councils are elected in these local self-governments which encompass 3,736 settlements (cities, towns and villages).

Chapter 5. Road Sector Expendituresâ&#x20AC;&#x192; â&#x20AC;&#x192;

Georgia Public Expenditure Review 2012

identification, selection, preparation, and appraisal, thus leading in some cases to investment choices with marginal economic merit (or with reduced returns because of the choice of suboptimal technical specifications); (ii) for the high profile investments, pressure to carry out works under a too tight timeframe can affects the quality of the design, have a negative effect on the procurement process, and impinge on contract costs and quality of execution; (iii) institutional weaknesses affect the supervision of works and the enforcement of contract conditions; (iv) obsolete design standards inherited from the Soviet times result in overdesign especially on the local and secondary network; and (v) lack of sufficient routine, preventive, and periodic maintenance can result in the squandering of investments and higher long run road sector costs. Works on city streets have also been found lacking good urban road design and construction supervision. Typical problems include: (i) lack of a holistic approach to improving overall street conditions within the street right of way; (ii) deficient sidewalk designs, especially a lack of ramps at street crossing and driveways; (iii) poor drainage solutions; (iv) costly and deficient curb and gutter solutions; (v) street widths not appropriate for traffic conditions (either too wide or too narrow); (vi) asphalt concrete with two-layer, thickness of total 7–10 cm was adopted in most cases, and no road hierarchy (arterial, secondary arterial or alleyway), traffic (AADT), distress condition of existing pavement, and condition/strength of base course were taken into account. A pavement decision matrix with a list of pavement treatment would contribute to address this issue. Similar problems have been encountered in villages under the Bank’s funded Secondary and Local Roads Program, with inconsistent design, frequent over-design for the asphalt but lack of side amenities and drainage.

5.5. The Medium Term Road Investment Program

The Government’s Medium Term Road Program 2011–2014 A review of the government’s medium term road investment program shows a large increase in new construction through 2013, as well inadequate funding for rehabilitation and maintenance. Specifically, the most relevant features of the program are the following: (a) A hump of front loaded expenditures on new construction; (b) A sharp increase in expenditures on new construction with continued concentration on the international network; (c) A significant decline in expenditures on rehabilitation and maintenance since 2011; (d) A strong reliance of capital expenditures on commitments from donors which imposes a degree of rigidity on the medium term budget.

The medium term program features a hump of front loaded expenditures on new construction. Overall expenditures on roads increased significantly from 2.8 percent of GDP in 2009 to 3.7 percent in 2010. The medium term program envisages overall expenditures remaining high at around 3.5 percent of GDP during 2011–13 before dropping quite dramatically to 1.8 percent in 2014. The substantial increase in resources during the 2011–13 period is based on the desire of rapidly completing the improvement and widening of international roads. Most of the works are ongoing under existing loans. The only major project with already available funding that has not yet started is the construction of the Adjara by-pass. Sections of the East-West Highway with traffic levels below 5000 vehicles per day and for which the government is seeking financing, are also at the planning stage but intended to be carried out in the next two or three years.

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Table 5.5. Actual and Planned Road Expenditures, 2007–2014 in million of lari and percent of GDP

2007

2008

2009

2010

2011

44.65

0.26%

0.07%

0.16%

0.46%

0.17%

0.28%

0.66%

74.03

54.25

30.00

0.25%

29.38

13.12

380.00

0.35%

150.00

183.40

0.44%

67.37

120

132.36

125.00

33.03

34.5

121.10

0.19%

0.07%

0.35%

0.19% 197.39

32.32

2012

2013

2014

104.00

113.00

40.00

New construction Government Budget GDP share %

Donors

GDP share %

Sub-total

GDP share %

Government Budget

MCG

GDP share %

Donors

GDP share %

Routine Maintenance GDP share %

Sub-Total

GDP share %

Total

GDP share %

0.00

0.78%

1.16%

48.20

0.96%

95.00

1.83%

0.45%

416.00 1.80%

0.43%

0.14%

452.00

160.00

1.72%

0.57%

231.60

475.00

520.00

565.00 2.15%

200.00

111.04

208.20

216.30

243.45

264.00

63.81

125.00 0.66%

0.19%

0.00%

0.17%

0.18%

0.15%

0.18%

0.17%

0.16%

359.23

476.70

285.20

255.80

42.50

0.16%

204.71

39.50

0.00

0.00%

37.00

0.00

0.00%

28.56

40.00

285.95

44.50

308.50

0.66% 13.21

1.07%

0.82%

1.22%

2.28%

2.25%

Rehabilitation/Periodic Maintenance 142.00 0.78%

1.96%

212.10 0.58%

2.50%

0.00

1.00%

1.37%

0.00

0.93%

1.11%

0.00

0.93%

1.09%

0.71%

0.00

0.94%

0.00

1.10%

271.42

272.08

509.23

708.30

760.20

775.80

850.95

508.50

1.60%

1.43%

2.78%

3.72%

3.65%

3.35%

3.24%

1.81%

Source: Roads Department of Georgia and WB staff estimates.

The program also features a sharp increase in resources for capacity expansion. The medium term program trebles resources for new construction from GEL 150 million (0.8 percent of GDP) in 2009 to GEL 565 million (2.2 percent of GDP) in 2013, which includes GEL 115 million in government own financing in 2013. Some part of the external funding required for the planned program has not yet been obtained.

Rehabilitation and maintenance are underfunded in the medium term program. Resources for rehabilitation and maintenance decline in the medium term program from 2.50 percent of GDP in 2010 to 1.1 percent during 2012–14. External funding for road rehabilitation and maintenance has declined since 2010, primarily due to the winding down of the MCG program. The Bank-financed First SLRP project is being followed by the Second SLRP and support from all IFIs is not yet all known, although external funding for rehabilitation is still projected to decline. Georgia’s current maintenance backlog is an indicator of the gap between required and current standards. The required standard is the network condition under which it is maintainable. Filling the gap requires funds and a strategy that usually aims at (a) reducing the length of roads in Bad and Poor condition (reduction of backlog); (b) applying low cost interventions to bring back roads in Poor and Fair to Good condition; and (c) preserving roads in Good and Fair condition through preventive roadwork activities. Very substantial resources would be needed to eliminate the backlog of the road network in poor condition. Based on the 2009 road condition survey for International and Secondary Roads and with the help of the HDM-4 model under an unconstrained budget RD calculated that the elimination of the backlog for the international and secondary roads would require about 900 mln GEL. In the case of local roads, due to lack of data, the backlog was estimated on the basis of estimated unit costs. It was conservatively assumed that about

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70 percent (9,100 km) of local roads, of which about 65 percent are unpaved, are in poor to bad conditions. The estimated cost of rehabilitation of paved and unpaved local roads to bring them to a maintainable condition exceeds GEL 1 billion. As already discussed, funding for the more modest but key routine maintenance, is also underfunded. The reliance on international donor commitments induces some rigidity into the road sector capital budget. The ample supply of multilateral and bilateral funding for the sector and the consequent possibility of starting several big projects at the same time, leaves limited flexibility for reducing government expenditures if macroeconomic conditions so require. Commitments with lenders are difficult to change and the cost of slowing down ongoing contracted works might be high. Thus, budget reductions triggered by macroeconomic considerations tend to affect primarily the higher priority expenditures in road maintenance. Table 5.6. Asset Value of Road Network in Georgia in kilometers and in lari

Length (km)

Estimated 1km Value

Total Value

International Roads

1,495

2,000,000

2,990,000,000

Local Roads (Paved)

5,000

200,000

1,000,000,000

Secondary Roads

Local Roads (Unpaved)

Total Asset Value GDP 2010

5,446

10,000

600,000 40,000

Road Asset Share

3,267,600,000 400,000,000

7,657,600,000 19,046,000,000

40.21%

Source: Roads Department and WB staff estimates.

The asset value of the overall road network is half of what it would have been without the backlog in poor condition, but quite high relative to what can be sustained by the size of the economy. Estimates for Georgia indicate that the network has a replacement value slightly in excess of 40 percent of GDP (Table 5.6). This is about half of what the asset value would have been if there was no backlog of the network in poor condition. On the other hand, the asset value is quite high relative to what can be sustained by the size of the economy. An Asian Development Bank study (2006) based on network size, maintenance spending, and the network quality in sample of countries assessed the size of the road network that could be sustainably maintained from public sources. The study found a negative relationship between network quality and network replacement value as a share of GDP and concluded that the road network of a country was greater than its economy could sustain when the replacement value reached 40% of GDP. One option for Georgia would be to focus on rehabilitating a select subset of local roads that are the most important in linking populations to markets and social services.

An illustrative alternative scenario for the medium term road program An alternative scenario for the medium term road program with adequate resources for rehabilitation and maintenance would require slowing down the pace of new construction (table 5.7). While such an alternative may not be feasible while the high priority EW Highway is still being developed, it nevertheless provides a useful illustration of the implications of such a program that could be phased in after the most important lumpy investments are completed. Specifically, such an alternative could feature the following:

94窶ポ窶イhapter 5. Road Sector Expenditures

Managing Expenditure Pressures for Sustainability and Growth

(i) Increasing road rehabilitation to the level recommended by HDM. (ii) Introducing periodic maintenance in line with HDM recommendations. (iii) Introducing a program for intensive rehabilitation of the local network. (iv) Slow down the pace of new construction by fixing the Government’s budget allocation for new construction at 0.25% of GDP during the 2012–15 (the government’s program envisages an allocation of 0.43 % of GDP for 2013).

Table 5.7. Alternative Illustrative Scenario for the Medium Term Road Program in million of lari and percent of GDP

Proposed Medium Term Investment And Maintenance Program 2010 2011 2012 2013 2014 2015 New Construction

Government Budget GDP share %

Donors

GDP share %

Sub-total

GDP share %

Government Budget GDP share %

Donors

GDP share %

Periodic Maintenance Routine Maintenance GDP share %

Local Roads Rehab

Local Roads Maint.

Sub-Total

GDP share %

International and Secondary Roads Rehabilitation

International and Secondary Roads Periodic Maintenance

Local Roads Rehabilitation

Local Roads Routine+Periodic

Total

GDP share %

0.25%

48.2

0.25%

0.96%

1.00%

1.25%

289.4

1.25%

328.2

1.25%

351.2

297.8

1.22%

260.0

280.9

1.00%

231.6

262.6

70.2

0.25%

231.5

65.6

0.25%

208.0

57.9

0.25%

183.4

52.0

1.25%

Rehabilitation/Periodic Maintenance

74.4

372.2

0.58%

111.0

1.16%

1.01%

1.77%

0.29%

0.00%

0.59%

123.1

0.53%

123.1

0.47%

123.1

0.0

0.02%

123.1

0.0

0.00%

3.1

0.0

343.0

1.28%

0.0

302.7

1.22%

60.0

233.9

1.15%

337.1

242.2

0.44%

123.1

0.41%

0.0

106.9

632.1

28.6

0.15% 0.0

42.7

0.21% 0.0

42.7

0.18% 14.2

42.7

0.16% 15.3

42.7

0.15% 16.3

379.9

42.7

0.14% 17.4

2.52%

479.8

2.25%

810.2

590.8

2.25%

728.0

520.9

2.25%

711.4

468.0

670.0

919.0

983.3

1042.3

3.74%

3.50%

Source: Roads Department and WB staff estimates.

The alternative scenario would increase rehabilitation to adequate levels while slowing down the rate of capacity increase. The government’s five year road investment and maintenance program developed using the HDM model shows that the NPV of the investments is maximized by carrying out an intensive and overdue rehabilitation program in the next two years. To reduce impact of rehabilitation in the already front loaded government program, the alternative program proposes to carry complete the urgent rehabilitation in five years. Fiscal space for the higher rehabilitation needs would have to come from slowing down the rate of capacity increase. At the current time, this would require postponing the commencement of the works not yet started and leaving for later years work on international links with 5000 vehicles per day or less.

Chapter 5. Road Sector Expenditures

Georgia Public Expenditure Review 2012

The alternative scenario would considerably increase resources for routine and periodic maintenance to levels recommended by HDM. Adequate routine and preventive maintenance is the first priority in any sound road management strategy and should take precedence over any other possible use of scarce resources. The alternative program would bring routine and Figure 5.4. Periodic Maintenance—Actual 2007–10 preventive maintenance, such as crack sealing and versus Need 2010–19 preparation of the network for winter, to its proper level. The importance of periodic maintenance is underestimated in Georgia based on the fallacy that the cost of periodic maintenance is not much less than that of rehabilitation over a 20 year period. This fallacy neglects the substantial costs to road users over the 20 year period when roads are left to deteriorate and later rehabilitated rather than being subject to periodic maintenance. Figure 5.4 shows actual periodic maintenance through 2010 versus needs from 2010. For a country with a road network and traffic levels of Georgia, the estimated cost to the users of lack of periodic maintenance may be in the order of GEL 140 million per year.

in millions of lari

160 140 120 100 80 60 40 20

0 2007 HDM-4

2008

2009

2010

2011 2012

2013

2015

2016

2017

2018

2019

Actual

Source: Roads Department and WB staff estimates.

The alternative scenario would introduce a comprehensive program of rehabilitation and maintenance of local roads. The alternative option would introduce local roads rehabilitation on the steady rate of 1000 km per year during 10 years starting from 2012. Local roads connect the poorest population segments and agricultural rural populations to centres, services, and markets. Substantial lead-time may be necessary for initiating a sustainable local roads strategy because of difficulties associated with: defining a sound decentralization program; bringing together different levels of government; tailoring programs for local governments with marked differences in resources and technical capabilities; engaging community participation in the long term sustainability of the network; maximizing the potential of a well planned rural road development program to generate employment and/or to unleash entrepreneurial capabilities through the creation of mini-enterprises for road maintenance.

Socio-economic surveys suggest that upgrading and expanding local roads would be a good instrument to stimulate growth and improve the social well-being of the poor.58 The surveys cover a random sample of 400 persons in five districts (Lanchkhuti, Gori, Kaspi, Gurjaani and Borjomi). In rating the problems they faced, the condition of roads ranked second only to health services, with 93 percent of respondents rating it an important problem. They felt that reduced transport costs and better connectivity would increase the competitiveness of local produce, improve access to social services (i.e. schools and medical facilities), and offer employment opportunities. In some cases it would spur tourism which in the past was an important economic sector. Isolation perpetuated by poor transport restrains economic progress and traps rural people in poverty. Poor transport restricts opportunity for trade-even within local markets. It raises the cost s of production and distribution, reduces the profit margin on produce sales, and limits production yields to levels below their potential, impeding the transition from subsistence to income-producing agriculture. The economic effects of better access to, from, and within rural areas can be cumulative and far reaching. Access to markets makes 58 Secondary and Local Roads Economic Evaluation and Poverty Impact Study, INOCSA, Madrid, 2004.

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it worthwhile to modernize agriculture through mechanization, fertilizers, and high-yield varieties. Those improvements increase demand for agricultural inputs and for credit. When new roads reach remote rural areas, the economic effect can be dramatic. Figure 5.5 shows the comparison between the government’s program and the alternative illustrative scenario, although other alternative scenarios can also be explored by the authorities. The government now has both the data and the in house capacity to program alternative scenarios to optimize benefits of its road investment policy. This is recommended. This report provides one illustrative scenario for the period 2012–15. The example brings out the main issue to be tackled by the government: the funding of the high priority rehabilitation and maintenance program will require a substantial increase in budget resources even if the new construction program is slowed down. The government should consider alternatives to gradually shift donor funding away from construction and into rehabilitation and maintenance.

Figure 5.5. Government Roads Program and Alternative Illustrative Scenario in millions of lari

600

500

400

300

200

100

0 2008

2009

2010 2008

Construction alternative

Rehabilitation alternative

Construction GB

Rehabilitation GB

67.4

153.3

67.37

204.71

2011 2009 190.3

206.6

150.00

359.23

Source: Roads Department and WB staff estimates.

2012 2010 231.6

249.2

231.60

476.70

2011 189.3

351.5

475.00

285.20

2013 2012 210.7

391.2

520.00

255.80

2014

2013

2014

238.9

443.7

565.00

285.95

255.7

474.8

200.00

308.50

5.6. Institutional Arrangements for Improved Efficiency

The accomplishments of the Roads Department in improving the management of the road sector during the last few years have been impressive. Basic data collection is taking place periodically for the international and secondary networks and the agency is in the process of gathering basic data on the local roads. The HDM model is being used to identify priorities for rehabilitation and periodic maintenance and for estimating the economic merits of capacity expansion projects. Maintenance has been contracted to the private sector and important elements of performance management and accountability can be seen in attractive publications linking expenditures with physical outcomes. The successful first steps place the Roads Department in an excellent position to tackle a number of key challenges ahead in further improving expenditure efficiency. Key priorities going forward include: ●● Move towards the implementation of a comprehensive Asset Management System, including both information processing and human resources for the integrated management of the network, including the determination and optimisation of economically warranted projects, programmes, strategies and budgets for both network development and maintenance.

The next step for RD development is to set targets and time framework (including training) for the establishment of a process that is capable of generating policy packages (options) which would lead to

Chapter 5. Road Sector Expenditures

Georgia Public Expenditure Review 2012

investments that provide the greatest overall economic and social benefits (i.e. the highest economic/social returns per unit of expenditures). For that the HDM model, which concentrates in pavement management, should be a subprogram within an asset management program that integrates other information systems. The latter should have the capability to assess options that balance monetary returns with other societal values such as environmental protection, social inclusion or poverty reduction, particularly in the treatment of low volume roads for which the HDM is not an adequate tool This includes: (i) information and analysis of the use and performance of the current network, and forecasts of future demand and performance under different social, environmental, and economic scenarios; (ii) models which allow assessment of the costs and benefits of different standard options and the full range of policy options on the strategic priority links, (iii) methodologies for estimating, and where possible placing a monetary value on, the impacts of policy options on social, environmental and economic objectives, and (iv) evidence on what policies deliver in practice.

●● Improve the efficiency of current performance based maintenance contracts.

All the maintenance works were contracted out in 1999, when force account work units were privatized. Since April 2007 there are 35 contracts with duration of 27 months (2 years 3 months). Usually there are 5–10 bidders per contract for periodic maintenance, but only 1–3 for routine maintenance. All the routine maintenance contracts were recently rebid and awarded at the same time. Each routine maintenance contract covers about 200 km, which is on the short side to capture economies of scale. The contract network is also too short to allow for sufficient predictability and encourage investments in necessary equipments. An easy way to expand the contracted road network would be to include the local roads in the contracts, thus encouraging the benefits of horizontal integration.

The size and length of the contracts discourages competition, and only one bidder for each contract is fairly common. Contractors on the other hand were often part of the road agency prior to privatization. Thus, they were not exposed to different techniques and ways of approaching different road problems. Lack of technical know-how, inadequate standards inherited from the Soviet times and lack of financing facilities to modernize the aging equipment fleet contributes to suboptimal road maintenance. These issues have been reviewed a number of times by international consultants, which proposed alternative maintenance standards which are adequate and affordable for Georgia. However the standards have not yet been approved. Currently the maintenance works are supervised by consultants. Competence exists for the supervision of periodic maintenance contracts. This is in part because pavement standards, which were prepared under the Bank-financed Highway Project, are being used but not formally approved. Supervision of maintenance works is poor for several reasons which include giving higher priority to larger works, lack of maintenance standards; and insufficient technical capacity, including contractor capacity. If adequately funded, the existent periodic maintenance supervising companies have the competence to move on to supervising routine maintenance. Based on the above the GOG should: (a) Adopt the recommended maintenance standards (b) Extend the routine maintenance contracts to 5-7 years, and do not bid all the contracts in the same year. (c) Expand the professional capacity in the regional offices to be capable of supervising the maintenance

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contracts, or outsource supervision of the maintenance contracts. (d) Train the regional offices to assume the Employer functions in the maintenance contracts. (e) Include the local roads in the routine maintenance contracts. This could be done in two ways: (i) move the local roads back to RD’s administrative and management responsibility; or (ii) enter into management contracts between the local governments and RD for maintenance of the local roads. The former would have the advantage of joint prioritization of maintenance works, greater efficiency, and greater equity in funding. (f) Review the current road classification, and the pavement and structural standards to meet Georgia’s needs and financial capacity.

●● Introduce further efficiencies with improved contracting methodologies.

The Roads Department has the opportunity to already increase its efficiency by introducing and applying more efficient contracting methodologies in the road sector. International experience shows that roads contracts based on outcomes (performance-based contracting) and not outputs result in significant cost and implementation savings. The Table below is one example of research done in Florida, USA and compares the result of several outcome-type (non-traditional) contracts to traditional (the standard civil works contract) contracts (table 5.8). Table 5.8. Value for Money: Cost and Time Savings: State of Florida 1997–1998 in dollars, percent and days, as noted

Non-Traditional Contracting Technique A+B (cost-plus-time)

Non Excuse Bonus

Incentive/Disincentive Lane Rental

Liquidated Savings

Bid Averaging

Lump Sum

All Non-Traditional Contracts Traditional Low-Bid Contracts

Number of Contracts

Construction Award ($)

Percent Cost Overrun

Contract Days

Percent Time Overrun

48,527,280

3.5%

2,283

8.1%

12 8

30,991,918

7.2%

2,110

1.5%

16,847,048

-4.1%

1,535

5.7%

28,577,800

8.4%

2,835

5.8%

18,174,776

-1.8%

1,171

13.2%

7,703,934

-0.7%

915

16.0%

17,205,296

168,028,054

375 1,162,868,676

4.5%

790

3.6%

11,639

12.4%

87,861

7.2%

7.1%

30.7%

Source: Batelle, Performance-based contracting for the Highway Construction Industry, Feb 2003.

●● The Bank is supporting the first of these contracts (design-build using Output and Performance-based Contracting methodology) and DBOMT on an area-wide basis in Kakheti region) on a pilot basis. Following successful implementation, these methodologies could be rolled out into the government programs in future years, resulting in significant cost savings.

5.7. Conclusion: the way forward

The analysis in this chapter indicates that Georgia can move forward along one of several paths in managing its road investment program. On the one hand is the path of continued inadequate allocations for

Chapter 5. Road Sector Expenditures

Georgia Public Expenditure Review 2012

routine and periodic maintenance, with the budget for the latter mixed in with and thus crowded out by the budget for rehabilitation. This path is also associated with continued focus on international roads, with neglect of the secondary and local network. Along this path, inadequate maintenance leads to progressive deterioration of the road network, thus resulting in lower productivity of users and higher costs from having to subsequently reconstruct or rehabilitate roads. Along this path, much of the secondary and local network remains in poor condition, thus impeding growth and employment generation in rural areas. On the other hand is the path where routine and periodic maintenance expenditures are raised to levels recommended by HDM and outlays for new construction and rehabilitation are rebalanced to reduce the backlog of the secondary network in poor condition. A priority subset of local roads is identified for rehabilitation and the necessary financing is provided. Along this path, the medium to long term costs of maintaining and upgrading the road investment program is lower and productivity of road users rises to contribute to Georgiaâ&#x20AC;&#x2122;s growth and development objectives. Access to education, social benefits, and employment opportunities is enhanced in rural areas and the geography of growth drivers is broadened within Georgia. The options considered in this chapter are intended to move Georgia down the latter path as it manages its important road development needs.

100â&#x20AC;&#x192;|â&#x20AC;&#x192;Chapter 5. Road Sector Expenditures