INTRODUCING A REVENUE SHARING SYSTEM IN LAO PDR

1. Legal Framework

Article 36 of the Budget Law mentions as “division of Central and Local Budget Revenue Source”,

“revenue apportioned between the central and the local budget”. Further, Article 34 of the Law

states that “The Government determines the detailed budget revenues and expenditures of the local

Administrations in accordance with the laws and regulation”, and Article 39 detailed “the sources of

revenues apportioned between the central and local level” and stipulates that “the apportionment

ratios by type of revenue are decided by the Government”.

The Revised Budget Law Implementing Decree of 14-02-2008 has clarified some of those points.

Article 16 details the shared pool of revenues. Article 20 specifies that provinces can receive “general

grant and earmarked grant” those funding “includes revenues apportioned between the central and

local levels.

2. Methodology

At an early stage the Ministry of Finance has opted for a revenue sharing approach to the problem of

apportionment of shared revenue between the central Government and the provinces. From the

onset it was decided that the revenue sharing formula will be based on several indicators

representative of provincial budgetary needs.

After reviewing all issues and options, it was decided that the methodology used will be based on (a)

a policy framework, and (b) a macroeconomic model to test the revenue formula.

2.1. Policy Framework

The policy framework has been defined along a number of principals.

The objectives to be achieved by the revenue sharing system have been defined as followed:

The revenue sharing system should be a fair and transparent system for apportioning shared

revenue between provinces on an equitable basis.

The System should aim at correcting horizontal imbalance between provinces, i-e existing

disparities in fund allocation and spending per capita

The System should be pro-poor with the aim of providing additional resources to the poorest

provinces to accelerate their social and economic development.

The System should provide incentives for improving the delivery of Government’s services,

the provincial economic environment and good public finance management.

Based on those principles, it was decided that the revenue sharing formula should have the following

characteristics:

• The formula should use several indicators representative of the social and economic

development in key sectors

• The Formula should tend to correct gradually disparities between provinces over a several

year period of time by providing a balance between revenue allocation based on population

and transfers based on poverty alleviation strategy.

• The Formula should not increase significantly the budget deficit.

• The Formula should not reduce transfers made to any province under the previous budget

law.

Additionally, the revenue sharing system should be completed by a system of equalization grants

based on the same principles and tied to a number of objectives such as revenue targets and

improvement of the Human Poverty Index.

2.2. The Macroeconomic Model

In the absence of an updated Medium Term Financial Framework, a simple macroeconomic model

has been developed to test various formulas. The model integrates all budget data since fiscal year

2004-2005 and a number of assumptions to make projections for the next two years.

It should be underline that the macroeconomic model has not been developed with the objective of

predicting next years provincial revenues and expenditures but rather with the objective of ensuring

that the revenue sharing formula can apply under various budgetary circumstances such as high /

low GDP growth, high / low inflation, etc.

The Ministry of Finance is not in position at the moment to analyse in details provincial revenues and

expenditures, even less to understand provincial economy. With the introduction of revenue sharing

and budget norms, the Ministry will feel the need to devote more resource to the analysis of

provincial fiscal data in order to ensure that each provincial budget is in line with the national policy.

3. Lessons learned from the macroeconomic model

Using the macroeconomic model, a number of important lessons have been learned regarding

changes in revenue assignment, size of the shared pool, revenue disparities between provinces,

expenditure disparities, impact of foreign investments, etc.

3.1. Changes in revenue assignment

The Macroeconomic Model developed for testing the revenue sharing formula includes data from all

fiscal year since 2004-2005. This model shows that there have been considerable changes in revenue

assignment over the years.

This table shows that shared revenues after knowing a sharp increase of 106% in FY 2005-2006 have

decrease to 23% of the previous year due to a change in the fiscal regime. Growth in 2007-2008 is

slightly under GDP and we can assume that for FY 2008-2009 and FY 2009-2010 the shared revenue

will stabilize between 1.40 and 1.50% of GDP.1

Changes in provincial revenues have been more erratic and cannot be fully explained by changes in

revenue assignment. There has been a sharp decline from 2.09% of GDP in FY 2004-2005 to 1.15% in

FY 2007-2008. It will be essential to reverse this trend to make the new revenue sharing system

sustainable.

1 The 2007-2008 figure for Shared Revenue does not include SOE revenues for Atapeu province as the figures

were not available. However, we believe that it can only have a minor incidence on the total number.

3.2. Size of the shared pool and province revenue (100%)

The change in revenue assignment has caused a reduction of the pool of shared revenues. Whereas

in FY 2004-2005 and FY 2005-2006 provincial domestic expenditure were representing 40% of the

shared revenue, in FY 2007-2007, the total shared revenue represents only 24.17% of provincial

domestic expenditures and the total provincial revenue 19.83%. That lives a structural deficit of 56%

to be covered by equalization grant.

Even Savannakhet province, that used to run an important budget surplus, under the revised budget

law, covers only 29.5% of its domestic expenditures against 48.9% for Vientiane Capital and 41.3%

for Kammouane. Under the new revenue sharing system, the amount of shared revenue transfer

would represent only 11.12%. Savannakhet would need receiving an equalization grant equal to 40%

of its domestic expenditures.

In that context, the new revenue sharing system will not affect significantly the provinces’ level of

funding. Provinces will see the grant policy as more critical than the revenue sharing policy.

The fact that domestic provincial revenues represent less than 20% of total domestic expenditures

and shared revenues less than 25% reveals that the vertical imbalance that existed previously in

favour of the provinces has been reversed in favour of the Government. In the short term, the new

revenue assignment system will facilitate treasury centralization and fiscal disciple, in the medium

term (three to five years) the system will need to be revised.

3.2. Disparities in revenues

The table below shows that important disparities in revenue exist between provinces. When

provinces have revenues covering less than 10% of their domestic expenditures they become depend

on the central government for grant transfer and the revenue sharing system is politically and fiscally

undermined.

Revenue assignments and poverty are not enough to explain such disparities. Room exists to improve

tax collection in some of the provinces. Each province must develop a revenue policy. Equalization

grants must be linked to revenue targets.

3.3. Disparities in expenditures

As shown in the table below, although the Government has already made considerable efforts to

correct them, disparities also exist in expenditures. However, the size of pool of shared revenue will

not allow the shared revenue system to play a significant role in reducing those disparities.

4. Revenue Sharing Formula

4.1. Total Shared Revenue and Total Provincial Appropriation

Because the pool of shared revenue is small, the Total Provincial Appropriation (TPA) is equal to the

Total Shared Revenue (TSR).

TPA = TSR

4.2. Component of the Formula

It has been decided that the formula will be based on three components:

Population

Land Area

Poverty Index

(a) Population is always a major factor for revenue transfer. Population growth needs also to be

taken into consideration. According to the Statistic Office’s report on population, the average

population growth in Lao PDR is 2.24% per year. Although differences in population growth

and in migrations might exist from province to province, it is recommended to apply the

same population growth ratio to all provinces for the next three years, until more reliable

data are published.

(b) Taking into consideration land area is a way for differentiating between densely populated

provinces that will receive important transfer for population and provinces with low density

population that might beneficiate from land area based transfers.

(c) Revenue Sharing Formula must include a component that transfers funds to poor provinces

with large fiscal deficits. Fiscal deficits can have several causes such low population density,

low urbanisation, absence of large tax payers, of etc. In the case of Lao DPR the main cause is

low social economic development resulting in the lack of taxable activities. Because of this

lack of social economic development, we need selecting an indicator that not only will

measure the degree of poverty, but by linking it to the budget will have a direct influence on

the type of expenditure that can boost social and economic development. This indicator is

the Human Poverty Index (HPI-1) which is available from the Statistic Office for all provinces.

We will say more on the poverty index in the section on poverty based transfers.

Based on this approach, the revenue transferred from the pool to the provinces will have three

streams: one stream based on population, one stream based on land area and one stream based on

the poverty index.

Provincial Allocation = (Population Based Transfer) + (Land Area Based Transfer) + (Poverty Based

Transfer)

4.3 Weight of the three revenue sharing components

Various transfer ratios have been tested using the Macroeconomic model. One of the criteria used

for selecting the ratios is that the formula should not increase budget deficit or increase provincial

budget by more than 10% in one year. The introduction of a revenue sharing system has usually a

negative effect on budget deficit because poor provinces received more funding while it is impossible

to reduce rich provinces funding. That negative effect can easily reach 10 to 15%. In the case of Lao

PDR, there will be no deficit increase because the pool of shared revenue is smaller than the total of

domestic provincial expenditures. However, we have tested the formula on the fiscal years 2004 to

2006 when the pool was much larger and we have selected ratios that do not increase the total of

provincial appropriation by more than 4%.

Land Area based transfers are high in country which have a high level of investments in

infrastructures which are relatively independent from population density such as roads, canals,

electricity transmission lines, telephone cables, airports, etc. In the US or Australia, even deserts

must have roads while there is no population to pay for it. Such is not the case of Lao PDR, which has

a low level of infrastructures and does not need to maintain a large road network. For that reason it

was decided to give to the land area based transfer a low weighting of 10% of the total shared

revenue.

Following that first decision, it has been decided to divide the remaining 90% equally between

population based transfers and poverty based transfers, giving 45% for population based transfers

and 45% for poverty based transfers.

4.3. Calculation of Population Based Transfer

The Population based transfer is given by taking the percentage of the province population

compared to the country population and applying it to the fund available for population based

transfers.

If we take the example of FY 2007-2008:

Total Shared Revenue = 605 301.71

Fund for population based transfer = (605 301.71 x 0.45) = 272 385.77

Luangphrabang province population is 437 055 inhabitants representing 7.24% of the total

population

Luangphrabang will receive 7.24% of the population based transfer fund:

272 385.77 x 7.24% = 19,722.36

(new table)

4.4. Calculation of the Land Area Based Transfers

The same principle applies to land area based transfers. The land area based transfer is given by the

percentage that represents the province land area compare to the national territory and applied to

the fund available for land area based transfers.

If we take the example of FY 2007-2008:

Total Shared Revenue = 605 301.71

Fund for population based transfer = (605 301.71 x 0.1) = 60 530.17

Luangphrabang province land area is 16,875 square miles representing 7.02% of the national

territory.

Luangphrabang province will receive 7% of the land area based transfer fund:

60 530.17 x 7.02% = 4 247.59

4.5 Calculation of the Poverty Based Transfers Poverty Based Transfers are slightly more complicated to explain because it uses the poverty index that needs to be explained.

The Human Poverty Index (HPD-1)2 is an indication of the standard of living in a country, developed

by the United Nations. It is a measure of the extent to which people in a country are not benefiting

from development. The three components of HPI-1 are:

2 HPI-1 is the poverty index for developing countries and HPI-2 is the poverty index for developed countries.

1) Longevity - measured by the proportion of the population not expected to survive to the age

of 40 years.

2) Knowledge - measured by the adult illiteracy rate.

3) Standard of living - a composite value measured by the proportion of the population

without access to clean water, health services, and the proportion of children under the age of

5 years who are underweight.

Investments in health, education and sanitation can easily improve the poverty index, making it a

good instrument for budget allocation.

In Lao PDR, the Statistics Office of the Ministry of Planning is responsible for publishing the HPI-1 by

province. The last survey was conducted in 2005 and it has not been possible yet to check the

methodology used.

The two main constrains on the use of HPI-1 are periodicity and reliability.

Periodicity: Using the HPI-1 in a revenue sharing formula supposes that the HPI-1 will be calculated

on a regular basis. A periodicity of three years is usually considered as good practice. Introducing the

HPI-1 in the revenue sharing formula supposes that MoF will have an agreement with the Ministry of

Planning for recalculating the index in 2009.

Reliability: When read in a table, the poverty index appears as a very precise number; for example,

1.17 for Vientiane Capital and 1.19 for Champasak Province, or 1.42 for Xiengkhuang and 1.43 for

Savannakhet. Based on these indexes Champasak should get slightly more funds for poverty transfer

than Vientiane Capital and Savannakhet slightly more than Xiengkhuang. However because at the

provincial level precise data are often not available and must be estimated, no one can be sure that

the variations that we see are not affected by data quality. The Human Poverty Index is not a good

instrument for budget fine tuning unless we can ensure that the same methodology is applied across

all provinces and no data results from an estimate.

After testing various formulas on the macroeconomic model, it was decided that the poverty based

transfer will not be a mathematical function of the poverty index and a more empiric approach was

adopted.

Based on the second digit of the poverty index, provinces have been classified in 5 categories as

followed:

This approach does not require frequent recalculation of the poverty index.

Based on the simplification of mathematic formula, percentages of the poverty based transfer fund

have been assigned to each poverty level as follows:

(new table)

5. Summary

The Revenue Sharing Formula can be summarized as follows:

If TSR is the Total Shared Revenue

If PA is the Provincial Appropriation

If the population index (pop. Ind.) is Total population/ Province Population

If the Land Area index (LA.ind.) is Total Land Area/Province Land Area

If the Poverty Transfer Ratio (p.t.r) is a function of the Human Poverty Index (HPT-1)

Then we have the formula:

PA= (LA. Ind.)(TSR x 0.1) + (pop. ind.)(TSR x 0.45) +(p.t.r)(TSR x 0.45)

6. Consequences for the MoF and way forward

(a) Revenue Sharing will give great importance to the analysis of economic and budgetary data

from provinces. At the moment we cannot measure the GDP by province and we cannot

explain variations in revenues and expenditures. As a result, we do not have any forecasting

system for provinces. In future, MoF will need to devote more resources to the monitoring

and forecasting of provinces revenues and expenditures.

(b) The Ministry of Planning needs to be consulted as the revenue sharing might affect

marginally investment policy.

(c) The Revenue Sharing System must be implemented in parallel with a grant policy. Large size

equalization grant might be given for covering operating expenditures and block grants for

covering investments. However the grant policy must be linked to revenue targets and the

development of specific revenue policy for each province.

(d) An up-dated MTFF would considerably help the formulation of provincial budgetary policy

including the grant policy.

(e) The introduction of budget norms will be essential for the good functioning of the revenue

sharing system.

(f) The Budget formulation process at the provincial level must be reformed to bring it in line

with national policies.