Ethiopia’s remarkable socio-economic transformation over the last decade has been marked by: a reorientation of expenditure from recurrent to capital; a significant devolution of resources from Federal Government to Regions; and a clear prioritization of infrastructure spending, while protecting spending on education at four percent of GDP.

The Government of Ethiopia has also leveraged external resources to boost spending in pro-poor sectors, particularly health and social protection. As a result, Ethiopia is home to the largest social safety net program in Africa, and has also achieved remarkable health outcomes using cost effective approaches.

Recent investments have seen a significant build-up of capital stock, with capital spending at sector level pointing towards increased service capacity. The current public investment-led strategy requires to be complemented by increased budgetary provisions in operations and maintenance so that new investments translate into enhanced service coverage and delivery. As Ethiopia lays the foundation to become a middle income country, and the changing global environment implies declining external assistance, it is imperative that domestic taxation activity support this transition. The current tax-to-GDP ratio is low compared to peer countries, and the tax structure would benefit from increased contributions by direct tax sources.

Therefore, there is an immediate need for advancing tax reforms and improve capacity and quality of tax administration. Broadening the tax bases, through review of exemptions, as well as review of tax rates might be venues to consider. Additional revenues will create the much-needed fiscal space to increase funding for operations and maintenance for service delivery, and support fiscal sustainability.

As a follow-up to this Public Expenditure Review, the Government of Ethiopia has asked the World Bank to provide further analytical support, with a view to enhance domestic revenue mobilization through simpler and more efficient taxation, while retaining equity priorities in public finances.

Introduction

Ethiopia’s state-led growth model achieved growth rates well above the average for Sub-Saharan Africa. Economic growth, concentrated in services and agriculture, was driven by productivity gains and capital accumulation arising from a substantial expansion of public infrastructure investment within a conducive external environment. Ethiopia’s Growth and Transformation Plan (GTP) 2010/11-2014/15 defined not only the nature and size of public investment projects but also the level of jurisdiction and responsibilities. For instance, more capital spending on road construction and higher education expansion, and increased pro-poor spending at the lower tiers of administration. The model places crucial emphasis on State-Owned Enterprises (SOEs) to finance and manage public infrastructure development investments.

The primary objective of the Public Expenditure Review (PER) 2015 is to analyze recent fiscal developments in Ethiopia within the context of a broad infrastructure investment program for growth and poverty reduction. The overarching question is to draw insights on how to finance public investment in situations where: revenue capacity is low and the fiscal envelope is finite; external grants play a significant role in government finances; increased capital spending needs to be matched by appropriate levels of recurrent expenditure; domestic and external concessional financing needs to be balanced in a sustainable financing mix of the budget deficit; and non-concessional financing is contained within sustainable debt limits.

The PER 2015 is structured in two complementary parts. The first part reviews the aggregate fiscal framework: its evolution, policies, revenues, spending, fiscal balances and financing. This part also discusses the composition of spending at the three levels of government, federal regional and woreda, by functional and economic classification. The review illuminates potential challenges in the sustainability of the current budget strategy in light of declining provisions for recurrent operating expenses. To strengthen the depth of the review, the PER analysis was complemented by an effort to establish a BOOST database for Ethiopia; BOOST provides detailed expenditure data at line item level for all levels for general government.

The second part of the PER analyzes the equity and efficiency of public spending in four sectors: health, social protection, education, and water and sanitation. Each sector review analyzes the equity and efficiency of spending to inform the design of ongoing reforms in the respective sectors. The health review, for instance, seeks to inform design of the universal health insurance scheme, while review of social protection aims to complement ongoing efforts in the development and implementation of Ethiopia’s Social Protection Strategy and Policy under the National Social Protection Platform. The water and sanitation review aims to illuminate progress in expanding access to water and sanitation and highlight the challenge of reaching rural areas.

Ethiopia’s spending on health expenditure has increased but is still among the lowest in the region at about US$21 per capita. Nevertheless, the health sector analysis shows the country achieved remarkable health outcomes with limited increase in expenditure. The analysis concludes that some of the positive outcomes can be attributed to increased allocative efficiency but there is scope to increase technical efficiency and equity in access to health services.

The social protection review shows that Ethiopia spends an equivalent of three percent of GDP on social protection, in form of safety nets, indirect subsidies (wheat, electricity and kerosene), labor market interventions and social insurance. Social safety net programs are largely financed by donors, while the government mainly finances subsidies and social insurance for public servants. Targeted safety nets are progressive and pro-poor, substantially contributing to reducing poverty by about two percentage points. Going forward, social protection needs and financing requirements remain high and continued expansion is predicted in the medium term. Subsidy reform would provide the much needed fiscal space to expand the safety nets program.

Expenditure on water and sanitation increased from 0.4 to 0.7 percent of GDP, about US$2 per capita. The analysis demonstrates that the sector budget is heavily skewed in favor of capital spending which is about 80 percent of the total spending; and reveals an urban-rural service gap in favor of urban areas. The findings raise concern over underfunded operations and maintenance (O&M), which explains the non-functional rural WSS schemes.

Education expenditure has been stable at about four percent of GDP and about 20 percent of total expenditure. While the government met its national targets, there are disparities in access and outcomes between and within regions. Low-income households are underrepresented at higher levels of education.

Overview of Ethiopia’s Fiscal Position

Revenue mobilization – need to strengthen fiscal capacity and fiscal efforts

The revenue generating capacity of Ethiopia reveals weaknesses in revenue administration. While total revenue (including grants) increased significantly in absolute values, the tax elasticity was below 1.0, resulting in the general government revenue and grants declining from 21 percent of GDP in 2003/04 to 16.1 percent in 2013/14. As regards tax structure, foreign trade taxes reduced (see more detail below) while the proportions of domestic indirect taxes and direct tax increased. In terms of revenue collection within the federation, the federal government retains the bulk of the tax base and collects more than 80 percent of domestic revenue.

Different factors shed light on weak revenue generation, including a dominance of trade taxes in the tax structure; the revenues foregone related to tax exemptions; and tax policy design issues and tax administrative insufficiencies on direct and indirect tax source areas. In a broader context of revenue generation, it is also important to note that the relatively untaxed subsistence agricultural sector activities continue to make up a large part of the economy.

Compared to other countries in East Africa and SSA, some margins for tax-to-GDP improvements in Ethiopia seem to be prevalent. Ethiopia’s tax-to-GDP ratio averages two percentage points behind East African peers, and 5-6 percentage points behind Kenya and Malawi. On tax structure, Ethiopia fares differently in a number of areas. The proportion of direct taxes is well below the peer countries, except for Uganda, while on indirect taxes (except trade taxes), the proportion from these tax sources is by far the lowest in Ethiopia. It is worth noting that the revenue profile in Kenya and Malawi – the countries with the highest tax-to-GDP ratio – is even across direct and indirect taxes, while indirect taxes take a higher share of overall tax revenues in Rwanda, Uganda and Tanzania. Ethiopia is the only country where the proportion of trade taxes is higher than that of direct or indirect taxes.

In the short- to medium-term, the tax-toGDP ratio may potentially be improved by 3-4 percent of GDP (IMF 2014). Estimations of tax revenue gaps across countries usually require a high degree of contextualization to ensure that structural determinants are taken into account in the comparison. In a recent Article IV consultation in Uganda, the IMF estimated the tax gap in East African countries by relating tax-to-GDP to structural variables, such as the proportion of rural population, and the share of manufacturing in the GDP. For Ethiopia, the results of the estimation show a structurally adjusted revenue gap of 3-4 percent of GDP. The potential tax gap on Ethiopia, Rwanda and Uganda is to some extent validated by the actual tax revenue generation, including the tax structure in the three countries. The relative generous tax exemptions to businesses adds to the overall picture, with the impact of the tax holidays and exemptions from import taxes estimated to be between 3-5 percent of GDP.

A closer look at drivers of tax performance by major revenue sources

Foreign trade tax makes for the most important source of government revenue. Foreign trade taxes entirely collected from imported goods make up the largest share of the total domestic revenue, averaging 34 percent in 2008/09-2012/1314. The share, however, was lower after 2007 despite surtax (additional tax) on selected imported goods imposed since that year.

Despite the trade taxes imposed on a broad tax base, the effective import tax rate is volatile and lower now than in 2003/04. The effective trade tax revenue (total trade tax collection per unit of import value) is calculated by dividing total import tax revenue by import value. As indicated in Figure 1.13, the effective rate declined from 24 percent in 2003/04 to 14.7 percent in 2008/09 before it recovered to 18.3 percent in 2012/13. Including the 10 percent surtax on imports in 2005/06, the effective tax rate improved by four percentage points in 2012/13 but still lower than in earlier years. The resulting revenue loss over the past decade may partly be explained by tax exemptions, as outlined below.

The tax exemptions and privileges towards promoting domestic and foreign investment explain a great part of tax revenue foregone on import tax revenue. Government provides tax holidays in the form of profit taxes and exemption from import taxes for new investment and FDI as proclaimed in the investment law. Information on customs data revealed that in the four years preceding 2010, the average tax incentive and privilege provided resulted in a revenue loss of 49 percent of total tax revenue on trade taxation. This represents an average of 4.8 percent of GDP, which is a significant revenue foregone.

Three broad conclusions can be reached from the above analysis: (a) Taxes on imports are large and will likely continue to be important sources of revenue; (b) customs duties tend to be less important for revenue generation with the existence of widespread exemptions; and, (c) the size of tax incentives is substantial, with significant revenue foregone. It may call for a need to review and rationalize investment incentives.

Key findings and recommendations

The government should review the levels of recurrent costs required to sustain public sector services in key sectors, including education, health, roads, water, and other major infrastructure sectors. This requires establishing the costs of sustaining services per unit of capital investment (or r-coefficients) and/or per unit of service delivered. Appropriate unit costs need to take into account efficient scales, locations, technologies, and cost variations that occur by location. In addition, and importantly, minimum standards of public sector services have to be specified when establishing the unit costs of public sector services. Such reviews should advise both whether current service delivery based on existing facilities is underfunded and whether the forward budget required as the government expands its public sector services capacity can be funded (or is financially sustainable). Based on the findings in this report it is expected that upward adjustments in current spending would be justified in many sub sectors and locations to support both current public sector services capacity and new capacity. This type of review should provide the detailed advice needed on sizing and directing the increases.

In addition, there is a need for a comprehensive review and strengthening of the Public Investment Management system. Ultimately, all public investments need to be economically efficient (or producing positive net economic benefits) and not just be financially feasible and sustainable. Whether this is the case cannot be discerned from the types of budget expenditure data analyzed in this report. To some extent the growth rates of an economy and the efficiency of its use of capital are indicators of efficient investment decisions and project and program implementation, by GDP does not capture all the external benefits and costs experienced by individual citizens arising from these projects and programs. This requires high quality ex ante and ex post economic appraisal to ensure that the desired aggregate and distribution net economic benefits of public investments are being achieved.

Finally, a need for strengthening domestic resource mobilization seems evident, and the government is encouraged to review the tax gap and identify improved policy design and tax administrative strengthening. The structural estimate points to a gap of 3-4 percent of GDP, and improvements in the specific policy design on tax bases, exemptions, thresholds and brackets would yield additional revenue. The revenue loss in import taxes through exemptions and incentives alone is estimated at around five percent of GDP. Furthermore, enhanced tax administrative capacity should provide additional revenue, for example, the VAT compliance rate in Ethiopia reveals a huge margin for improvements. While the tax gap assessments are based on desk studies, more analysis is needed to assess tax performance and to inform tax policy design.