Document ofThe World Bank

Report No: 18485 - LV

PROJECT APPRAISAL DOCUMENT

ONA

PROPOSED LOAN

IN THE AMOUNT OF DEM 8.585 MILLION

TO THE

REPUBLIC OF LATVIA

FORA

STATE REVENUE SERVICE MODERNIZATION PROJECT

October 30, 1998

Baltics and PolandEurope and Central Asia Region

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CURRENCY EQUIVALENTS

(Exchange Rate Effective October 28, 1998)

Currency Unit = LatLC = US$1.73US$O.577 = LC

LATVIA - FISCAL YEARJanuary 1 - December 31

ABBREVIATIONS AND ACRONYMS

ASYCUDA - Automated System for Customs DataCIS - Customs Information SystemsCIT - Corporate Income TaxCY - Calendar YearEU - European UnionFY - Fiscal YearGDP - Gross Domestic ProductIMF - International Monetary FundIRR - Internal Rate of ReturnIT - Information TechnologyLAN - Local Area NetworkMOF - Ministry of FinanceNPV - Net Present ValuePIT - Personal Income TaxPIU - Project Implementation UnitSOE - Statement of ExpendituresSRS - State Revenue ServiceVIES - VAT Information Exchange SystemsVAT - Value Added TaxWAN - Wide Area Network

Vice President: Johannes Linn, ECAVPCountry Director: Basil Kavalsky, ECCPL

Sector Director: Pradeep Mitra, ECSPETeam Leader: Mansour Farsad, ECSPE

Republic of LatviaState Revenue Service Modernization Project

CONTENTS

A. Project Development Objective ............................ 2

1. Project development objective and key performance indicators

B. Strategic Context .. 2

1. Sector-related CAS goal supported by the project2. Main sector issues and Government strategy3. Sector issues to be addressed by the project and strategic choices

C. Project Description Summary .9

1. Project components2. Key policy and institutional reforms supported by the project3. Benefits and target population4. Institutional and implementation arrangements

D. Project Rationale .13

1. Project alternatives considered and reasons for rejection2. Major related projects financed by the Bank and/or other development agencies3. Lessons learned and reflected in proposed project design4. Indications of borrower commitment and ownership5. Value added of Bank support in this project

E. Summary Project Analyses .16

1. Economic2. Financial3. Technical4. Institutional5. Social6. Environmental assessment7. Participatory approach

F. Sustainability and Risks .18

1. Sustainability2. Critical risks3. Possible controversial aspects

G. Main Loan Conditions ........................ 20

1. Effectiveness conditions2. Other

H. Readiness for Implementation ........................ 20

I. Compliance with Bank Policies ........................ 20

Annexes

Annex 1. Project Design Summary .21Annex 2. Project Description .24Annex 3. Estimated Project Costs .33Annex 4. Cost-Recovery Analysis Summary .34Annex 5. Financial Summary .36Annex 6. Procurement and Disbursement Arrangements .37

Table A. Project Costs by Procurement ArrangementsTable B. Summary of Procurement Activities

Section 1: Procurement Review.Section 2: Capacity of the Implementing Agency in Procurement and

Technical Assistance requirements.Section 3: Training, Information and Development on Procurement.Section 4: Procurement Staffing.Section 5: Procurement Plan.

Table C. Allocation of Loan ProceedsTable D. Disbursement Categories

Annex 7. Project Processing Budget and Schedule .45Annex 8. Documents in Project File .46Annex 9. Statement of Loans and Credits .47Annex 10. Country at a Glance .48Annex 11. Latvia Taxes, Summary of the Main Features .50

MAP

LATVIASTATE REVENUE SERVICE MODERNIZATION PROJECT

Project Appraisal Document

Europe and Central Asia Regional OfficeBaltics and Poland

Date: October 30, 1998 Task Team Leader: Mansour FarsadCountry Director: Basil Kavalsky Sector Director: Pradeep Mitra

Project ID: LV-PE55585 Sector: Public Sector Program Objective Category: Economic ManagementManagement

Lending Instrument: Specific Investment Loan Program of Targeted Intervention: [] Yes [ x ] No

Project Financing Data [x] Loan [ ] Credit [] Guarantee [] Other [Specify]

For Loans/Credits/Others:

Amount: DEM 8.585 millionProposed terms: [] Multicurrency [x ] Single currency DEM

Grace period (years): 3 [] Standard Variable [x ] Fixed [] LIBOR-basedYears to maturity: 15Commitment fee: 0.75%

Service charge: 0%

Financing plan (US$M):Source: Local Exp. Foreign Exp. Total Exp.

Government 17.91 22.73 40.64CofinanciersIBRD 0.56 4.49 5.05IDA

Total 18.47 27.22 45.69

Borrower: Government of LatviaGuarantor:Responsible agency: State Revenue Service

Estimated disbursements (Bank FY/US$M): 1999 2000 2001 2002 2003Annual 0.81 1.67 1.57 0.86 0.14

Cumulative 0.81 2.48 4.05 4.91 5.05

Amortization Every 6 monthsprofile

Project implementation period: January 1, 1998 to December 31, 2002Expected effectiveness date: January 5, 1999 Expected closing date: June 30, 2003

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A. Project Development Objective

1. Project development objective and keyperformance indicators (see Annex 1):

The project objective is to support the development of:

* A revenue system that promotes sustainable revenue performance on the basis of voluntarycompliance, reducing corruption and evasion, and facilitates private sector development bylowering compliance costs and tax rates.

* A State Revenue Service (SRS) that efficiently, equitably and honestly administers tax andcustoms laws and is equipped with modem business processes, management systems, andoperational tools.

Key performance indicators:

* Sustained revenue performance.

* Reduced compliance costs.

* Decline in arrears, evasion and contraband traffic.

* Improved transparency and integrity of the revenue administration system.

* A more equitable distribution of effective tax burden, through increased compliance.

* Reduction in tax rates, in particular the social insurance contribution rate, starting the year2002.

B. Strategic Context

1. Sector-related Country Assistance Strategy (CAS) goal supported by the project (see Annex 1):

The project will further the identified objectives in the CAS for Bank support to Latvia, includingreshaping the role of the state, improving public sector management, promoting private sectordevelopment, and reducing corruption. In particular, by contributing to revenue sustainability andincreasing compliance on a broader base, the project will allow the Government to maintainmacroeconomic stability, to preserve social expenditures, and to achieve the objective of reducing the taxburden.

CAS document number: 17706-LV Date of CAS discussion: May 19, 1998

2. Main sector issues and Government strategy:

To date, Latvia's fiscal system has shown considerable success in maintaining its revenueperformance during the country's continuing economic transformation. This success has rested on bothtax and non-tax sources -- most notably VAT on traded goods and privatization receipts. Two challengesremain. First, as the privatization process ends and as the private sector expands, the actual tax base mustbe widened to avoid a deterioration in revenue collection. As witnessed in other transitional economies,substantial revenues can readily slip beyond the reach of tax administrators, as the number and diversityof private enterprises increases and as their sophistication in tax avoidance grows. Second, sincecomplying with tax and customs regulations represents costs to productive agents and since unevenadministration of these regulations distorts costs and relative prices, the administrator must minimize thecost of compliance and increase the uniformity of revenue administration to prevent these factors fromretarding long-term growth. In short, revenue administration goes beyond mere revenue performance asmeasured by the revenue to GDP ratios. It must encompass non-revenue aspects, such as the equity ofthe tax burden, the credibility of the administrator to monitor and enforce compliance, the transparency

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and honesty of administration, as well as the quality of services provided to taxpayers and to thoseengaged in international trade and transport.

Revenue administration in Latvia needs organizational and administrative arrangements thatmatch Latvia's success in its transition to a market economy. Organization structures of the SRS are stillsomewhat disjointed and administrative arrangements (including its operational and managementsystems) embody a large measure of temporary and interim solutions. To improve these systems, theSRS has embarked on a broad-based modernization program. This program entails an integrated set ofinvestments to strengthen its organizational, management and operational capabilities, to address thefollowing challenges:

(i) Ensuring stable and predictable revenue flows, during a period of far-reaching structuralchanges in the economy, to meet various demands on the budget and maintain the overallfiscal balance.

(ii) Improving tax and customs compliance and revenue collection, to enable a reduction intax rates (particularly those on social insurance contribution and foster private sectordevelopment, employment growth and the expansion of the formal economy.

(iii) Improving the overall quality of taxpayer and customs services, to reduce the time andfinancial costs associated with compliance and with tax, customs and social insuranceregulations.

(iv) Improving transparency of the revenue administration system and reducing opportunitiesand incentives for corruption.

(v) Facilitating trade and meeting EU standards in tax and customs administration, to preparefor EU accession.

(vi) Improving the overall organizational effectiveness and efficiency of the SRS, to make thebest use of the human, material and information resources available to it.

(vii) Strengthening SRS human resources and redesigning the pay system, to ensure highquality staff with defined career paths and commitment to the organization.

(i) Ensuring stable and predictable revenue flows

Since 1995, when the twin banking and fiscal crises led to a loss of confidence in the economyand a disruption in economic growth, the Latvian Government has embarked on a number of fiscalmeasures to control expenditures and to bring the general government budget into balance (Table 1).

Table 1- Selected Financial Indicators, 1993-97(in percent of GDP)

1993 1994 1995 1996 [ 1997

Revenue 36.4 36.5 35.5 36.8 39.9

Expenditure 35.3 J 38.2 I 38.2 38.0 38.2Financial balance 1.0 -1.7 l -2.7 -1.2 1.6Net lending i -0.4 -2.3 l -0.6 -0.2 -0.3Fiscal balance 0.6 4.0 -3.3 -131.3L _ _ _ _ _ _ _ _ _ . 6 4 0I-1 3 [1 3

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Although the ratio of total revenue to GDP has risen considerably from 35.5% in 1995 to 39.9%in 1997, the ratio of tax revenue to GDP has remained relatively stable at around 32%-33% of GDP(Table 2). The continued revenue flows from non-tax sources, including privatization receipts, havecontributed to the overall rise in total revenues. With the continuing demand on fiscal resourcesassociated with EU accession and other reform objectives, the Government has declared adequate andsustainable revenue performance as a primary macroeconomic goal.

In recent years, the revenue performance of the various taxes has been mixed. Taxes on goodsand services have grown considerably with the increase in imports. Tax revenues from personal incomehave also increased. However, tax revenues on profits of enterprises have fallen significantly. Revenuesfrom the social tax have also declined somewhat, despite a substantial increase in private enterpriseemployment and higher private sector wage payments. These trends suggest that tax compliance has beenlow and that the business community has adopted a less compliant attitude towards paying taxes.

Table 2 -Tax Revenue to Central Government and Social insurance, 1994-97(as a percentage of GDP)

19941 19951 19961 1997Taxeson profits 372.72 2.0 2.41Taxesonpersonal incon el . 4.6oe 5.1 5 5.5Social insurance taxes .l.6; 11.7. 11.2i 1 .41Tx_eson goods and serices 12 11.8 13.4' 13. |Otheratxes - j 1.0 0.50:21

32.2 31.6 32.4i 33.0~~~~~~~~~~~~~~~~~~~~~~.. ..._._. _.................... ... . ... .... .., ,..... ....,, .. ... ...... ., ..,,. .. , ......... ... ... ... .... ....... L..,.... .. .......... ......

(ii) Improving compliance and revenue collections and widening the tax base

Improving compliance critically hinges on the institutional capacity of the revenue administrationsystem to monitor and control taxpayer and customs declarations. International experience suggests that,during the period of transition to a market economy, revenue administration is severely tested by corrupttaxpayers and officials, by increased incidences of bankruptcies, high volumes of cash and cross-bordertransactions, high levels of evasion and arrears, and the growth of the informal economy. Latvia has beenno exception. Since 1995, privatization has led to a significant decline in the number of state-ownedenterprises and a sharp increase in the number of hard-to-tax private entrepreneurs. Cash transactions, asmeasured by the ratio of the base money to money and quasi-money, have increased from 30% in 1994 to37% in 1997, while the share of the informal sector in the economy is estimated to have grown to around25% of GDP.

Tax evasion and tax arrears have remained large as a share of GDP. The SRS estimates that taxevasion amounted to about 15% of GDP in 1997. Total tax arrears (including social tax arrears) increasedfrom about 7% of GDP in 1995 to about 10% of GDP in 1997. This reflected the deterioration in thefinancial position of many undercapitalized, poorly managed new enterprises. It also reflected inadequateeffort to collect tax debts. With the increased efforts to collect the tax debt, however, the level of arrearshas stabilized since the beginning of 1997. Tax exemptions (on profits and VAT) granted to businessactivities in the four newly established free economic zones have resulted in loss of revenues estimated atabout 3.2% of the consolidated budget tax revenues in the first half of 1998.

Although the tax rates for VAT (18%) and corporate income tax (25%) are not excessivecompared to many European countries, the effective tax rate on personal income is very high, given thesocial insurance contribution tax rate of 37% and the personal income tax rate of 25%. The high socialinsurance contribution rate was necessary to start up the new pension scheme. The Government intended

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to gradually reduce the rate over a five year period. However, the worsening arrears in the social taxcollections, coupled with the 1997 decision to raise pensions, led the Government to postpone a furtherdecrease in the rate until 2002. Improving social tax collections and reducing social tax rates remain astrategic objective of the Government, since the high rate discourages employment, erodes the tax base,and leads to further growth of tax arrears and tax evasion. Reversing this dynamic, while maintainingfiscal prudence, requires increasing compliance rates and broadening the base through more effectiverevenue administration.

(iii) Improving the overall quality of taxpayer services

Modern revenue administrations are largely based on voluntary compliance. In addition to thecredible threat of detection and enforcement, a cornerstone of compliance-based revenue administrationis improvement in the quality of the services provided to taxpayers and those engaged in internationaltrade and transport (i.e., importers, exporters, transporters, brokers, warehouse operators, etc.).

Anecdotal evidence suggests that the SRS is considered by the public to be among the verydifficult and less transparent institutions to deal with. The current administrative arrangements exhibit afairly high rate of face-to-face interaction by taxpayers and customs clients with SRS staff. Theseinteractions are typically motivated by the need to: submit and/or clarify documents; certify and/orfollow-up on procedures; clarify the applicability of rules and regulations; determine account status; etc.In addition to creating unnecessary opportunities for corrupt practices, the over-reliance on face-to-faceinteractions with SRS staff represent real burdens for taxpayers and customs clients, raising the cost ofcompliance. The over-reliance on face-to-face interactions is also a source of uneven administration andfurther increases compliance costs.

There are a number of areas through which tax and customs administration could improve thequality of service. Simplification of transactions, procedures, and forms are important areas, as is thesimplification of tax and trade-related record-keeping requirements. Establishing consistency inadministration and strengthening the competency of administrators are also important elements inimproving taxpayer services. Training and better organizational arrangements are ways to increasequality of service, particularly to large, complex enterprises. In addition, mechanisms to increase theavailability, timeliness and accuracy of information to taxpayers and those engaged in international tradeand transport can reduce compliance costs and facilitate tax and customs transactions. These mechanismscan be telecommunications-based, such as hot-lines and web-sites, or more traditional methods can beused, such as seminars and out-reach programs. Electronic filing of declarations is yet another way toreduce the burden on the taxpayer and those engaged in international trade and transport, as well as onrevenue administrators. For each of these areas, improvements in quality of services need to be built intothe design of the revenue administration, including its regulations, procedures and organizational culture.

(iv) Improving transparency and reducing corruption in the revenue administration system

The Government has demonstrated its commitment to fighting corruption at all levels byimplementing a wide-ranging Corruption Prevention Program. Under this program the SRS requested ananalysis of the agency's vulnerability to corruption, and a review of the laws on income and assetdeclarations of public officials. This law, for which the SRS is implementing agency, is designed toprevent conflict of interest and provide prima facie evidence of income and assets corruptly obtained. TheSRS is also making progress towards increasing the transparency of its operations and reducingopportunities and incentives for corruption. It is benefiting from external advisers on management andefficiency reforms in customs, and recently commissioned its own study of information flows within theSRS. This study showed a plethora of non-standard documents being used and the fact that the centraloffice had insufficient information on activities at the regional and local level.

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The vulnerability analysis, which was carried out with the help of the Bank in April 1998, founda number of features that provided opportunities and incentives for corruption and lack of transparency inoperations. These included: (a) frequent close contact between officials and taxpayers; (b) inadequateinformation for management and supervisors; (c) lack of clear criteria for audit case selection;(d) unrealistically high penalties; (e) uneven implementation of procedures for tax deferrals, penalties andappeals; (f) lack of clear mandated supervision routines; (g) insufficient intemal controls; (h) unevensupervision of local offices; (i) undue closeness between some local offices and their communities,related to an infrequent rotation of officers; (1) low levels of remuneration and few opportunities forprofessional development; (k) lack of legislative clarity and inadequate regulations; (I) absence of realtime information on merchandise in transit and on vehicles crossing the country; (m) difficulty in cross-checking information on imports for purposes of VAT and income tax controls because tax identificationnumbers are not used for customs declarations; and (n) lack of equipment needed by customs to monitorand inspect vehicles and containers.

Since the vulnerability analysis was completed, the SRS has developed a number of plans toincorporate the main recommendations into project design and implementation. The department ofintemal audit has been re-established, and stronger and more transparent procedures are being introducedin the human resource strategy covering recruitment and promotion. A positive step towardsstandardizing procedures in tax audit units has been taken with the introduction of a manual, which willneed to be reinforced by good implementation and supervision.

(v) Facilitating trade and EU accession

The flow of goods into and out of Latvia is of major importance to the economy, as the tradesector accounts for nearly half of GDP. However, illegal trade (weapons, radioactive materials, drugsand other contraband) is a significant threat that strains the authorities' capacity to tackle it and providesopportunities and incentives for corruption. It can also be a source of danger to staff who attempt toreduce the flows. These are serious concems for Latvia and its neighbors, especially in the light of EUaccession requirements which require more effective border controls than Latvia now has. Nevertheless,in designing and implementing such controls, the SRS must strike a balance between the degree ofcontrol and the speed with which goods may cross Latvian borders.

As part of the second cohort of countries preparing for EU accession, Latvia must establishmodem tax and customs services which can operate on an EU-compatible basis and achieve EU-standards of compliance. This objective requires developing a modernization strategy to administer taxesand an operational capacity to apply the acquis communautaires of the EU. Upon accession, part of thecustoms decision-making, tariff rate setting and collections will transfer to Brussels. While taxcompliance must remain within EU acceptable levels, the administration of intemal taxes remains inLatvian control.

The Govemment is already receiving assistance from the EU to improve controls on Latvia'seastem border (as a prospective EU border) and to put in place the ASYCUDA++ customs informationsystem. However, much work remains to be done during the period of pre-accession, including:

* Harmonizing the tax base and rates to ensure that tax revenue is as neutral as possible tointemational trade.

* Implementing EU registration for VAT and the EU VAT Information Exchange System(VIES), for cross-checking of intemational transactions.

* Achieving acceptable compliance standards to prevent Latvia from becoming a tax haven inthe EU.

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Educating and training SRS staff to become familiar with and perform procedures accordingto EU standards.

(vi) Improving SRS organizational effectiveness and efficiency

Immediately after Latvian independence, two organizations were established to collect revenue:the State Finance Inspection Board (for taxes) and the Custom Department (for customs duties and taxeson international trade). To improve revenue collection and economize on administrative costs, the twomerged to form the SRS in 1994. Starting January 1, 1998, the SRS has also been responsible forcollecting social insurance contributions. The SRS has seven local offices in Riga and 27 offices outsideRiga. There are also 60 customs border posts that need to be staffed on a 24 hour basis.

Although a number of organizational changes have been made to integrate various SRSfunctions, the optimal structure is still not in place. In particular, there is no uniform organizationalstructure for SRS offices and the number of staff in each office ranges widely from 28 to 334.Management and administration overheads are generally high by European standards and range from12% to 44%. Despite the relatively high overheads, coordination between headquarters and the localoffices is insufficient to ensure effective implementation of operational policies and the best use ofSRS's physical, human and information resources. Many managerial and business planning changeshave been introduced by the SRS in recent years to address some of these shortcomings. However, manyhave not yet been fully institutionalized. Among the key areas requiring further development are workstandards, job descriptions, performance targets and monitoring systems, as well as financial and assetmanagement systems.

(vii) Strengthening human resources

From 1997, SRS staff have been taken out of the Civil Service and made subject to the privatesector Labor Code. This has given the SRS greater flexibility in hiring, promoting and firing employeesand setting remuneration levels. However, the SRS does not have an explicit policy regarding long-termcareer paths or promotion. There are some rules governing job rotation, but no incentives to encouragerotation. There are no standards concerning evaluation of staff performance. The training activities areconsiderable, but there are no standard job descriptions to identify the training needs or improverecruitment.

The general pay level is not competitive with the private sector, and the remuneration systemdoes not provide adequate incentives to attract and retain skilled staff. In addition, the basic features ofthe pay system are rigid. This makes it difficult to adjust the pay structure to changing conditions andneeds. In particular, the rigidity has led to an over-use of the bonus payment mechanism. This has madethe pay system relatively unpredictable and non-transparent. In July 1998, the Cabinet approved a newconcept paper for public sector pay, which will cover the SRS. The working group tasked withelaborating the new concepts, however, is in the earliest stages. Thus, the details of the new policies andtheir impact on SRS are not yet known. Nevertheless, the new approach should give the SRS theopportunity to harmonize its pay policies with the new public sector pay scale, as it develops its humanresources strategy.

3. Sector issues to be addressed by the project and strategic choices:

The project will address the sector issues identified above through an integrated package ofinvestments in organizational and management strengthening and in operational capacity building.

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(i) The project will provide a wide range of support aimed at increasing the SRS's long termorganizational effectiveness and efficiency. This includes: (a) increased integration ofthe basic business lines of the SRS; (b) a pilot and roll-out of a regional consolidationstrategy; (c) strengthened management capacity in a wide range of areas (e.g., personnel,financial management, operational policy formulation); and (c) an improved humanresources strategy and incentive structure.

(ii) By modernizing SRS's operational capacity (including business process re-engineering,skills development, and a. major overhaul of the SRS's tax and customs informationsystems), the project will help combat smuggling and tax evasion, including non-filersand non-payers. This will raise compliance rates, broaden the base for taxes andcustoms, increase revenue collections, and, in turn, help ensure fiscal balance.

(iii) The project's support to customs administration (both revenue and non-revenuefunctions) will be especially targeted at preparing Latvia for EU accession. In particular,the project will complement and extend the customs policy advice and legal assistancebeing supported by the EU, and will help implement procedural improvements which arenecessary to achieve the standards of operations required for EU accession.

(iv) The project will provide a variety of technical means, including taxpayer surveys, to raisethe quality of client services, as well as support for strengthening taxpayer rights throughupgraded appeals and grievance resolution mechanisms.

(v) The project will improve the transparency of revenue administration and reduces itsvulnerability to corruption through a number of channels: (a) an internal Vigilance Unitwill be established, to provide a credible and independent mechanism to ensure that SRSpersonnel carry out business in accordance with a proper code of conduct; (b) the SRS'snew operational systems will greatly reduce the scope for tampering with the paper filesor the records in the currently isolated computer systems, through greatly improvedcross-checking and reporting capacities; (c) a new human resource strategy will improvesupervision, training, pay, motivation, and efficiency, while also rotating staff regularlyin order to maintain arm's length relationships; (d) objective, depersonalized criteria willbe introduced for audits, appeals, and Customs inspections; and (e) SRS capacity will bestrengthened to perform its responsibilities to accurately monitor the income and assetsof public officials, through the legally mandated requirement that such officials filedeclarations with the SRS.

Strategic Choices. The overarching goal of EU accession, to a large degree, defines Latvia'sstrategic choices in the area of tax and customs administration. The policy framework is mainlydetermined at the supra-national level, as are many administrative arrangements and performancestandards. To the extent that this leaves the pace of modernization as a strategic choice for Latvia, thistoo is constrained by the lead-time required to build up the institutional capacity to carry out revenueadministration to the necessary standards. Thus, the remaining strategic choices mainly revolve aroundthe extent to which the functions of tax administration, customs and social insurance collections are to beintegrated in a single institution. The authorities have already committed to a strategy of unifying theseadministrations, to ensure that revenue functions are all administered in a unified fashion. Among otherthings, this greatly facilitates cross-checking declarations and other transactions for consistency. In short,the strategic decision to integrate the tax and customs functions has already been taken and is unlikely tobe reversed. Indeed, further integration is envisaged, although some specific functions, such as bordercontrols, may remain separate for technical reasons.

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C. Project Description Summary

To improve revenue administration operations and at the same time bring significant change intaxpayer understanding, attitudes and compliance levels, the SRS has prepared a Strategic Plan for theperiod 1998 to 2002, with the following strategic goals:

* Improve operational efficiency.* Simplify tax laws, internal regulations, business and appeal processes.* Modernize the SRS, customs, tax, and information system.* Improve services to taxpayers.* Strengthen anti-smuggling operations and control of Eastern borders.

The SRS modernization project would build on the Strategic Plan of the SRS and providetechnical assistance, training, information technologies, other equipment and minor civil works, over the1998-2002 implementation period. The project would support two closely inter-related components.

* Organization and Management Component -- to improve the overall organizationaleffectiveness of the SRS.

* -Operational Component -- to improve the performance of the SRS in critical technical areasof tax, customs and social insurance collection administration.

1. Project components (see Annex 2 and Annex 3for a detailed description and cost breakdown):

Indicative % of Bank- % ofComponent Category Costs Total financing Bank-

(US$M) (US$M) financing

1. Organization & Management Comp. Institution-building 6.4 14.0% 1.6 32%

A. Information technologies (IT) 2.1 4.6%B. Non-IT 3.3 7.2%C. Incremental recurrent costs 1.0 2.2%

2. Operational Comp. Institution-building 39.2 86.0% 3.4 68%

A. IT 24.6 53.9%B. Non-IT 4.3 9.5%C. Incremental recurrent costs 10.3 22.6%

Total I_45.6 100% 5.0 100%

Organization and Management Component:

The Organization and Management component of the project would provide consultant services,training, goods and minor civil works to strengthen the institutional effectiveness of the SRS. It wouldinclude support for:

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* Rationalization of Organizational Structures: including, development of a three level organizationstructure for the SRS, creation of two pilot regional offices (Zemgale, Latgale) to implement neworganization structure; and restructuring of local offices to insulate internal processing activitiesfrom the public and to enhance client services provided through them.

* Strategic planning, budgeting, and financial and asset management: including, revision andstrengthening of the SRS's vision statement, strategic plan and planning methods; development andimplementation of methodologies for preparing budgets and substantiating the cost effectiveness ofbudget proposals; development and implementation of methodologies for planning SRS expenditures;and enhancements to SRS's financial, physical and information asset management systems.

* Operational management: including, improvements in operational policy formulation; improvementsin administrative aspects of tax, customs and social security laws to increase the effectiveness of theSRS in implementing them and to make them compatible with EU requirements; and development ofmonitoring, performance contracting and evaluation mechanisms.

* Personnel management: including, development and implementation of a differentiated pay andincentives system for SRS staff; development of career paths for SRS staff at all levels; developmentof policies and procedures for staff rotation; enhancement of the capacity of the SRS Training Unit todeliver high quality training; enhancements of the SRS's human resource management informationsystems.

* Internal controls and prevention of corruption: including, development and implementation of theSRS's intemal reporting and internal audit strategy; development of guidelines for managers fordealing with corruption cases; training of staff about the Code of Ethics; establishment of a VigilanceUnit; and establishing a channel for taxpayer complaints.

* External and internal relations: including, design and implementation of: (i) periodic client surveys;(ii) public relations campaigns aimed at staff, taxpayers, importers, transporters, brokers, warehouseoperators, etc., and (iii) strategies and mechanisms to support and liaise with professional groupsinvolved in tax-related matters, such as preparers, lawyers, industry associations, and accountants.

* Management information system: including, design and implementation of planning and decision-support tools, with linkages to the SRS's resource management systems and operational systems.

Operational Component:

The Operational Component of the project would extend the capacity building efforts initiated bythe SRS in the functional areas of tax, customs and social insurance collections. The objective would beto increase the productivity of routine operations, while improving the SRS's ability to fight tax evasion,smuggling and defaults in revenue payments. Important operational areas to be covered are the following:

* Taxpayer registration: including integration with the external registries for persons, businesses andproperty.

* Declaration, collection, and recovery of arrears: including unification of income tax and socialinsurance tax declarations, detection and follow up of non-filers and stop-filers through closercollaboration with the Enterprise Registry.

* Audit and investigation: including an analysis of compliance pattems; assessment of revenue risks;development of audit strategies; information systems to select cases for audit, perform informationcross checks, conduct audits and evaluate audit effectiveness; development of links betweencompliance rate monitoring and SRS performance assessments; and development of referencedatabases of external information on taxpayer transactions.

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* Customs operations: including trade facilitation; physical inspection of goods; warehousing;detection, confiscation and disposal of contraband.

* Adjudication and appeal: including appeals filed before SRS authorities, as well as the processingof appeals and prosecutions filed before the judiciary.

* Taxpayer and customs client services: including facilities for information exchange between theSRS and taxpayers and those engaged in international trade and transport; education; help desk; andprocedures to redress grievances. Periodic client surveys will be undertaken to test and respond totaxpayer views over time and to provide a feedback into the internal performance monitoring.

* Common information technology (IT) infrastructure: including information security; networkmanagement; distributed server configuration; power supplies; local and wide area networks; andinter-agency data exchange.

The bulk of resources of this component would be devoted to the continued development of up-to-date tax and customs information systems. The infommation systems would help the SRS to:(a) efficiently manage the volume of day to day transactions; (b) monitor compliance; (c) promptly detectdefaulters and initiate remedial measures; (d) target resources to cases of suspected evasion; (e) increasethe incisiveness of audits and investigations; and (f) feed decision-support systems.

2. Key policy and institutional reforms supported by the project:

By providing a sustainable revenue flow, the project would help the Government with the goal ofmaintaining a balanced budget and a reduction in social insurance rates. The project is part of the generalpublic sector modemization effort which is taking place simultaneously with anti-corruption efforts. Theproject builds on and extends the institutional reforms underway in the public sector.

A key policy decision is to maintain the integration of common functions of customs and taxadministration. The project would support this and seek to promote stability and continuity among SRSmanagement and staff, by enhancing long term career development. From 1997, SRS operations havebeen govemed by performance contracts between headquarters and the local offices. The project wouldseek to extend these reforms, by strengthening the tools to measure and monitor performance and, in turn,further refine the performance-based contracting arrangements. The reforms supported by the projectcould be complemented by additional reforms to modify the legal framework to improve administrativeprocedures and the enforcement powers of the SRS.

3. Benefits and target population:

The project would broadly benefit the citizens and residents of Latvia, through more stable andpredictable revenue flows. This will help maintain macro-economic stability and enhance theGovernment's ability to implement its public policy, including the payment of pensions. The increase intax and customs compliance and improved revenue collection will also enable the imposition of lower,less distortionary tax rates. Improved revenue administration will encourage a shift of activities into theformal sector, as a result, both entrepreneurs and enterprises that currently operate in the "unofficial"markets would be able to benefit from formal financial intermediation and proper enterprise governance.

Taxpayers and those engaged in intemational trade and transport who comply with their tax andcustoms obligations would benefit through reduced cost of compliance, including more clear andstandardized regulations, as well as improved tax and customs transactions processing. Law-abidingtaxpayers, importers, exporters, transporters, brokers, and warehouse operators would also benefitthrough improvements in the equity of the tax and customs burdens.

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SRS managers and staff would benefit from the improvements brought by the project in theirworking environment, incentives, productivity and effectiveness.

4. Institutional and implementation arrangements:

Estimated period of implementation: January 1998 to December 2002.

(Note: January 1998 marks the beginning of the ramp-up period for SRS's modernizationprogram, of which the Bank-financed investments form an integral part. Consequently, activitiesthroughout 1998 are subsumed into the project description and cost estimates.)

The authorities have established the following oversight and management structures to implementthe project.

Steering Committee, which was established on July 28, 1998, will oversee the implementation ofthe project. In addition to the oversight function, the Steering Committee will be responsible for leadingthe organization and management reforms. It will also coordinate among the various affected agencies inthe Latvian public sector and resolve problems which require inter-agency agreement. This committeecomprises:

* Minister of Finance (Chairman).

* Deputy State Secretary, Ministry of Finance (Deputy Chairman).

* State Minister for State Revenue.

* Director General, SRS.

* Deputy Director General, SRS.

* Deputy Director General, SRS.

* Deputy Director General, SRS.

Project Implementation Unit (PIU) will coordinate and monitor the day-to-day project activitiesand manage the financial, procurement, record-keeping and reporting activities associated with theproject. The Unit, which was established in July 1998, includes:

* Project Manager (the Director General of SRS).

* Deputy Project Manager (nominated).

* Procurement specialist (nominated).

* Financial specialist (nominated).

SRS will ensure that the PIU has the necessary resources and facilities to carry out itsresponsibilities. These responsibilities include, but are not restricted to, the collection and monitoring ofthe project performance indicators (as elaborated in Annex 1), the preparation of a report for the Mid-term Review (by December 31, 2000) to be reviewed with the Bank (by January 31, 2001). In addition,the PIU will have prepared a plan to ensure the continued achievement of the Project objectives, based onguidelines acceptable to the Bank. The PIU will ensure that no later than six months after the closing dateof the Loan, or such later date as may be agreed for this purpose between the SRS and the Bank, the planis furnished to the Bank and that the Bank has a reasonable opportunity to exchange views with the SRS.

Project Teams are responsible for the specific technical details in the three areas mentionedbelow. They are also responsible to manage the change processes associated with the introduction of new

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procedures and systems, among other things, to minimize the adverse impact on on-going operations.

* Tax Modernization Project Team.

* Customs Modernization Project Team.

* Information Technology Project Team.

D. Project Rationale

1. Project alternatives considered and reasons for rejection:

The original request of the government focused primarily on the implementation of a five-year ITplan. This alternative was rejected because it did not include the institutional reforms necessary to fullyexploit major investments in information technologies and to ensure that the system investments would beconsistent with the actual capacity and needs of the revenue agency. It also did not include theenhancement of management and operations needed for accession to the EU.

A less comprehensive and shorter project was also considered. This altemative was rejected inthat it compromised the ability to implement a tightly integrated package of information system tools andcomplementary organizational, business process and management improvements. This alternative wouldalso have greatly diminished the potential role of the World Bank in coordinating the assistance efforts byother donors, as requested by the Latvian authorities.

A slower paced project was considered and rejected, since it would introduce significant risks that tax andcustoms administration would become an unnecessary hindrance to achieving the national goals of early EUaccession and an ambitiously paced economic transformation.

2. Major relatedprojectsfinanced by the Bank and/or other development agencies (completed, ongoingandplanned):

As a prospective EU member country, the EU-PHARE has provided Latvia significant support in the areasof tax and customs administration. The project builds on and extends this work. In particular, EU-PHARE supportin the area of tax administration has focused on the tax laws and regulations. The project largely takes this work asa point of departure (with some further work to refine the aspects of the tax laws and regulations which address theSRS's administrative arrangements) and focuses on strengthening the SRS's institutional capacity to implement thelaws and regulations. In the area of customs, EU-PHARE has focused on border controls, anti-smuggling and theregional piloting of the ASYCUDA++ customs information system. The project, among many things, will extendthe work on anti-smuggling with support for strategy development, risk-analysis, training and equipment. Based onthe experience with the ASYCUDA pilot, the project will support the integration and incorporation of theASYCUDA technologies into the comprehensive customs information systems (CIS) that the SRS is developing.This will include the roll-out of the selected elements of the ASYCUDA system to the SRS's customs units nation-wide.

In addition to the EU-PHARE programs, bilateral assistance on specific topics and initiatives hasbeen provided by the Swedish Customs Board (strategic planning and operational training in customs),the Danish Customs and Tax Board (tax accounting methods), and USAID (internal audit and taxrecovery).

Coordination with the EU-PHARE and the bilateral donors will be a key element in Bank projectsupervision.

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Major Related Projects Financed by the Bank and Other Development Agencies

Sector Project Latest Supervision (Form 590)Ratings

(Bank-financed projects only)Implementation Development

Progress (IP) Objective (DO)

Bank-financedSAL SPublic sector reform IDF n.a. n.a.

Other development agencies

EU-PHARE Tax Administration

Projects (approx. US$ 2.5million)

Tax legislation S STax administration S STraining courses in tax HS HSadministration area

EU-PHARE Customs administration(approx. US$ 2.5 million)

Program management Unit HS HS(I project)Customs Management Plan HS HS(I project)Supply of equipment; S HSdevelopment ofinfrastructure (3 projects)Senior management training HS HS(I project)Customs procedures,processing of declarations S S(8 projects)Legislation (2 projects) S SOrganizational reforns (4 S Sprojects)EU guidelines (I project) HS HS

IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory)

3. Lessons learned and reflected in the project design:

This project reflects the experience of Bank-financed tax administration projects in Hungary,Thailand, and several Latin American countries. It also draws on the recent tax and customs integrationexperiences of Canada, Denmark and the Netherlands, among others. Lessons learned include theimportance of: (a) meaningfuilly connecting IT and business plans, by complementing the IT-dominatedoperational components with components aimed at the organizational and management aspects ofrevenue administration; (b) maintaining a long-term perspective, while satisfying short-term policy andoperational needs; and (c) introducing performance indicators as benchmarks for revenue agency staffand managers. The experience also demonstrates that institutional modernization is an iterative processwhich requires a number of years to carry out.

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4. Indications of borrower commitment and ownership:

The proposed project resulted from the administrative requirements of the Latvian Governmentrevenue, organizational and automation strategies. Notwithstanding the substantial outside technicalassistance, all policies essentially emerged from within the Govemment, including the path-breakingdecision to integrate tax, social security contributions, and customs. (Latvia is the only Baltic state whichhas chosen to integrate its tax and customs functions.)

Project preparation has been strong. The SRS has developed strategic plans for tax and customsadministration. SRS management is now integrating these plans, thus forming a coherent andcomprehensive vision for a multi-year institutional investment program. Business planning has beeninstituted to organize the operational work of different offices. Also, the practice of executingperformance contracts has been introduced. In addition, the IT Strategic Plan is a solid document, whichguides the integration and automation pro-cesses. The Govemment requested the Bank to help furtherintegrate all aspects of the project and has assigned a high priority to this project among its financingrequests to the World Bank.

The State Minister of State Revenue Service is a key member of the Govemment's CorruptionPrevention Council. She has provided leadership for anti-corruption efforts in the SRS including theanalysis of vulnerability to corruption that was completed in time to feed results into the projectpreparation process. During the preparation of the project, a detailed organizational diagnosis was alsocarried out, and deficiencies in the organizational structure, management practices and operational tasksof tax and customs administrations were identified. Based on this exercise, the SRS developed a set ofproject activities and submitted them to the Bank. The Bank team and the Latvian counterpartsreconciled these activities with those indicated by the diagnosis. The design of each of the projectcomponents, their sub-components, activities under each sub-component, activity schedules and activitycosts were discussed at length and agreed with the Govemment. This process led to full participation ofthe counterparts in the preparation of the project and has created a sense of ownership on their part.

5. Value added of Bank support in this project:

By bringing comparative experience, the Bank's involvement will help Latvia define a moresecure reform path and preclude mistakes that other countries have made in similar reform efforts. TheBank would also help maintain forward momentum on this major institutional investment, by providingboth financial and systematic technical assistance during project implementation. Recent experience inLatin America indicates that World Bank projects (e.g., Mexico and Argentina I and II) do act as catalyststo accelerate and sustain the change processes.

The Latvian authorities have asked the Bank to take on a coordinating function to ensure thatthemultiple foreign assistance initiatives in tax and customs administration are coherent and complementary.By concentrating on outcomes and the connections to an agreed development strategy, the Bank'sapproach to projects transcends the open-ended and segmented approach of most bilateral assistance.

Banik work in the revenue area also complements IMF efforts in Latvia. The IMF providesimportant policy guidance and has in the past provided some long-term technical assistance. Capacity toimplement IMF advice is strengthened when it rests upon a coherent Bank-supported project which buildsthe capacity to implement the policy reforms.

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E. Summary Project Analysis (Detailed assessments are in the projectfile, see Annex 8)

1. Economic (supported by Annex 4):

[C]ost-Benefit Analysis: [] Cost Effectiveness Analysis: [x] Other: Cost-Recovery Analysis

The economic benefits from the modernization of tax, customs and social insurance contributionadministration come through a number of channels. Among the most important are increases in theeffectiveness of revenue administration, as manifested in improved cost effectiveness of revenuecollection, as well as increases in the efficiency of revenue collection, as manifested in loweradministrative costs per Lat collected and lower compliance costs for taxpayers. Other less quantifiablebenefits associated with the project include: (a) more equitable distribution of the tax and customsburdens; (b) reductions in corruption in revenue administration; (c) reduction in rent-seeking anddistortions associated with illegal and evasive behavior; (d) benefits associated with regional integration,and EU accession in particular; and (e) increased economic growth through lower, less distortionary taxrates, in particular a lower rate for social insurance contributions by 2002.

Because of inadequacy of reliable data on compliance costs, a precise cost - benefit analysiscannot be undertaken at this stage. Instead, the quantitative analysis presented here is a simple a cost -recovery analysis. This analysis focuses simply on ensuring that an exceedingly pessimistic projectedincrease in the effectiveness of revenue administration will be sufficient to raise revenues in excess of thecost of the modernization program. In this case, the present value of a permanent, one-time increase inrevenue performance of merely 0.7 percent is sufficient to cover the present value of investment costs,incremental recurrent costs and depreciation. The analysis also shows that increases in administrativeeffectiveness sufficient to increase revenue performance by 3 percent are sufficient to cover total costsapproximately four times over. (A one percent increase represents a fiscal gain of about US$48 millionin NPV at a 10 percent discount rate, and yields an IRR of 29%.)

International experience suggests that, although the actual increase in revenue performanceassociated with such modernization investments are hard to predict, they invariably exceed the associatedcosts by a large margin. With an informal economy estimated to be equivalent to a quarter of GDP, thereis little reason to suggest that Latvia would prove to be the exception.

Turned around, the analysis indicates that the cost of obtaining increased administrativeeffectiveness -- through which the project derives benefits such as more equitable and less distortionarytax and customs burdens -- is quite low.

It should be strongly emphasized that the above cost - recovery analysis is only a proxy for theother benefits of the project. The Government does not intend to transfer the improved revenue intohigher expenditure. Indeed, the project will: (a) allow fiscal flows to be maintained as privatizationrevenues begin to decrease; and (b) permit tax rates to be lowered over time.

Another point worth emphasizing here is that most of the data which is required to undertake aproper cost - benefit analysis will be generated in the course of operations of the SRS's modernizedinformation systems. These systems will provide the necessary data and analytic capacities to constructand monitor trends in compliance, equity of tax burden, administrative costs associated with revenuecollection, etc. In addition, technical assistance under the project will, among other things, help developsuch performance monitoring methodologies and incorporate them into the SRS's internal contractingand evaluation arrangements.

Three assumptions of the cost - recovery analysis are notable. First the model assumes awaychanges in many extra-project factors that determine actual revenue performance, such as changingeconomic conditions and other drivers of economic growth. Second, it assumes no deterioration inrevenue performance in the no-investment scenario. Third, it also assumes that the increase in the revenueperformance would begin only in the year 2000. These last two understate the revenue benefits from the

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investments. As the economic transformation progresses and the private sector expands and becomesmore sophisticated, revenue authorities must actually work harder to maintain the same level of revenuecollections. Also, many of the key operational systems become active in 1998 and 1999, and thusimprovements in administrative effectiveness and revenue performance should appear earlier thanestimated in the model.

Details of cost-recovery analysis is presented in Annex 4.

2. Financial: (Fiscal Impact)

Based on current projected costs and schedules, the necessary counterpart funding for the projectinvestments (excluding the recurrent costs) are: CY99-US$11.3 equivalent, CYOO -- US$6.5 millionequivalent; CY01 - US$3.5 million equivalent; and CY02 - US$1. 4 million equivalent. The SRS and theBank will review the planned and actual expenditures for the project and the correspondingdisbursements each year. The counterpart funding requirements for the following year will be updatedaccordingly. These agreements shall be the basis to determine the adequacy of the subsequent year'sallocation from the PIP for the SRS. Total recurrent cost during the same period would be US9.9 million.Of these investment and recurrent costs approximately US$7 million would be returned to the budget inthe form of taxes.

On the revenue side, improving compliance will allow the overall fiscal balance to be maintained,and, over time, allow tax rates to be lowered.

3. Technical:

Maintaining the operations of the existing systems, while undertaking a major institution buildingeffort, commonly strains the technical capacity of an organization. In addition, phasing in newcapabilities and new systems over a multi-year period raises a whole host of systems integration issues.Developing and retaining sufficient qualified IT specialists is a key issue.

Any serious attempt to curb tax evasion and smuggling requires strengthening enforcement andinvestigation capabilities. Even to maintain voluntary compliance at a reasonable level the deterrenteffect of enforcement actions is critical. However, an emphasis on enforcement could raise genuine fearsof administrative excess. Therefore, it has to be accompanied by strong safeguards against harassment oftaxpayers. Thus, a delicate balance would need to be struck in providing the SRS with the capacity toenforce the tax laws, while at the same time protecting the rights of the taxpayers.

4. Institutional:

a. Executing agencies: State Revenue Serviceb. Project management: PIU within SRS, headed by the Director General of SRS.

Important institutional issues incorporated into the project design during appraisal include:

* EU accession issues.* Managerial capacity.* Wage and incentive structures.* Organizational structures.* Informal organization.* SRS, Customs and Social Insurance organizational cultures.* Legal framework consistency and completeness.* Human resources deployment and management.* Vulnerability to corruption in organization and processes.* Donor coordination.

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5. Social:

The modernization of SRS entails changes in the management and operational functions,including Social Insurance Contribution collections. Disruptions in these functions create some risk ofcompromising the Government's ability to pay social benefits.

6. Environmental assessment: Environmental Category I I A I I B [xi C

With only minor office refurbishment envisioned, the project should have no directenvironmental impact. Indirect impacts are also likely to be negligible, in that improvement of tax andcustoms administration is unlikely to influence relative prices of environmentally significant resources.Better control of borders will, however, yield some benefits through interdiction of dangerous contrabandmaterials, in particular radioactive substances. The magnitude of this impact is exceedingly hard toassess.

7. Participatory approach:

Primary beneficiaries and other affected groups:

Consultations have been carried out with major accounting firms in Riga. Selected majortaxpayers were contacted at pre-appraisal about their experience at SRS services. Surveys of businesses,households, and public officials were also mounted in June 1998 to feed the perceptions of the SRS heldby taxpayers and the population into the process of project development. In addition, as stated earlier, theproject design itself predominantly reflects the work of SRS staff and management.

F. Sustainability and Risks

1. Sustainability:

As discussed above, the financial / economic sustainability of the project is ensured by a ratherwide margin. By virtue of the project's comprehensive approach to institutional capacity building, thepackage of technical assistance, equipment and information systems investments are each mutuallycomplementary. Over the long term, this will help ensure that the SRS can make optimal use of theinformation systems tools financed under the project and, reciprocally, that the investments inorganizational realignment and staff / management strengthening are supported by effective operationaland management systems tools. In particular, the project will support the strengthening of theperformance-based contracting scheme adopted by the SRS and, more generally, pay close attention tothe role of incentives in the proper and sustainable conduct of the SRS business by its staff and officers.

Sustainability will depend, however, on the political environment and commitment to the reform.It also will depend on the ability of the SRS to attract and retain staff with skills commensurate with themodem systems and practices to be introduced by the project.

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2. Critical Risks (reflecdng assumptions in the fourth column of Annex 1):.

Risk Risk Risk minimization measureRating

Objective to Goal

Change of Government or other political H Special attention will be paid to briefmg any incomingfactors may delay or derail the management and ministerial decision-makers on natureimplementation of organizational reforms of and rationale of the project.the SRS.Outputs to Objective

Low commitment to implement M Widespread management support and involvement atmanagement changes project design stage.

High turnover of senior managers and M Development of a new pay and incentives system,skilled staff which is designed to attract and retain high quality staff,

is supported by the project (see Personnel Managementsub-component).

Most of the IT development and technical support workis out-sourced, thereby avoiding the need to find andretain a large cadre of IT specialists.

"Losers" (potential, internal or external) S Threatened internal groups are somewhat lesswill obstruct changes, by non-cooperation thoroughly entrenched than in older, more establishedor political means. organizations. Spending on internal relations and

change management should help overcome internalresistance. The national political mood has becomeincreasingly intolerant of corrupt officials andtax/customs evaders. Well publicized measures aimedat reducing corruption (in the context of the CorruptionPrevention Program) should provide a reasonabledefense against attacks motivated by lost opportunitiesfor ill-obtained gains.

Taxpayers will be confused about changes M Improved public relations and taxpayer services areand tax collections will be disrupted. supported by the project (see Taxpayer and Customs

Client Services).

The current scheme, where most tax payments are madeby bank transfer to the State Treasury from thetaxpayer's account, will be unchanged under thisproject.

Components to Output

Restructuring of local offices will be M Government policy is supportive of consolidation andimpeded by political pressures from regionalization in many agencies and in SRS inexternal or internal sources. particular.

Establishment of two regional pilot units in Zemgaleand Latgale to ensure a smooth transition to the neworganization structure (see Rationalizing OrganizationalStructure).

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Consultation with key stakeholders at theimplementation stage.

Staff will resist changes to existing M Training in change management is supported by theprocedures project (see External and Intemnal Relations).

The systems implementation will miss the M The design and implementation processes follow.requirements turget and user acceptance will industry best practices with formal user involvement,be low formal analysis and documentation regines, together

with a phased and iterative approach to system design,implementation, subsequent extension and refinementNew system will run in parallel with existng systemsuntil full acceptance of each module.

The ftmding allocations to cover counterpart S The Government wil mclude the imvestment ffnancinginvestment expenditures will not be timely. needs of the Project in the Public Investment Program.__________________________ ______ and the annual budgets.

Risk Rating - H (High Risk), S (Substantial Risk), M (Mod est Risk), N (Negligible or Low Risk)

3. Possible controversial aspects:

None envisioned.

G. Main Loan Conditions

Effectiveness Conditions:

Selection of Project auditor.

H. Readiness for Implementation[x] The engineering design documents for the first year's activities are complete and ready for the startof project implementation.

[x] The Project Implementation Plan has been appraised and found to be realistic and of satisfactoryquality.

L Compliance with Bank Policies[x] This project complies with all applicable Bank policies.

Team Leader- Mansour Farsad

Sector Director: Pradeep Mitra

Counuy Director. Basil

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Annex 1

REPUBLIC OF LATVIAState Revenue Service Modernization Project

Project Design Summary

Narrative Summary Key Performance Monitoring and Critical AssumptionsIndicators Evaluation

Project Development (Objective to Goal)Objective:To develop:

A revenue system that 1. Sustained revenue 1. SRS and national Change of Government, orpromotes sustainable revenue performance. statistics. political pressure fromperformance on the basis of interest groups, -or poorvoluntary compliance, 2. Reduced compliance 2. SRS statistics and coordination amongreducing corruption and costs. taxpayer surveys. ministries involved willevasion, and facilitates not delay or derail theprivate sector development 3. Decline in arrears, tax 3. SRS statistics implementation ofby lowering compliance costs evasion and contraband organizational reformsand tax rates. traffic. initiated by the SRS.

A SaeRvneSi4. Improved transparency 4. SRS statistics, The Govemment will

(SRS) that efficiently, and integrity of the revenue supervision reports. ensure adequate resourcesequithab andihonetly, administration system. are allocated in Publicequitably and honestly Investment Program.

administers tax and customs 5. A more equitable 5. Supervisionlaws and IS equipped withmodernnd is pes distribution of the effective mission reports andmanageme b esystoemssand tax burden, through project evaluationmanagement systems, increased compliance. report.operational tools.

6. Reduction in social 6. Project evaluationinsurance contribution rate report.starting year 2002.

Project Outputs (1): (Outputs to Objective)

Improved organizational and Mid-term evaluation Strong commitment tomanagerial efficiency. by the year 2000 implement managerialRationalized local office changes will continue.structures. Improved 1.1 New 5 year strategic 1.1 Supervisionintegrity of operations. plan produced. mission reports. Low turnover of SRSReduced opportunities for senior management.corruption. 1.2 New regional and local 1.2 Supervision

office structures introduced mission reports. "Losers" will not obstructin two regions. changes, by non-

cooperation or politicalmeans.

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1.3 Improved action plans 1.3 SRSand performance indicators performance reports.introduced.

1.4 Differentiated pay and 1.4 Supervisionincentives scheme mission reports.implemented for SRS staff.

1.5 Intemal audit program 1.5 Annual intemalimplemented. audit reports and

supervision missionreports.

1.6 Incompatible functions 1.6 Supervisionare separated mission reports

1.7 Management and 1.7 Projectsecurity of taxpayer case evaluation report.files are improved

Project Outputs (2): (Outputs to Objective)

Increased operational Mid-term evaluation Taxpayers will beefficiency. Strengthened by the year 2000. informed about changes inenforcement and audit laws and regulations, andcapabilities. Improved 2.1 IT system developed 2.1 Supervision tax collections will not betaxpayer services. Reduced on schedule and within mission reports. disrupted.compliance costs. budget.

2.2 Revenue collections 2.2 SRS reports.maintained and revenuetargets met.

2.3 Tax arrears reduced. 2.3 SRS reports

2.4 Increased audit 2.4 SRS reports.revenue and auditcoverage.

2.5 Increase in positive 2.5 SRS reports.identification of violationsby Customs.

2.6 Reduced cost of 2.6 SRS reports.collections.

2.7 Reduced taxpayer 2.7 Taxpayer surveycompliance costs. (at start, mid-term

and end).

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Project Components/Sub- Inputs: (budget for each (Components to Outputs)components: component)(See Annex 2for detailedProject Description)

1. Organization and US$ 6.4 million. Supervision reports, Restructuring of localManagement periodic project offices will not be impededComponent status reports, and by political pressures from

disbursement reports. affected parties, such asA. Rationalization of local govemment, current

organizational structure. tax evaders or smugglers,B. Strategic planning, or SRS line management.

budgeting, financial andasset management.

C. Operational management.D. Personnel management.E. Intemal control and

prevention of corruption.F. Extemal and intemal

relations.G. Management information

systems.

2. Operational Component US$ 39.2 million. Supervision reports, Staff will cooperate toperiodic project change existing

A. Taxpayer registration. status reports, and procedures.B. Tax declaration, disbursement reports.

collection and recovery Users acceptance will beof arrears. high.

C. Audit and investigation.D. Customs operationsE. Adjudication and appeals.F. Taxpayer and customs

client services.G. Common IT infrastructure

development.

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Annex 2

REPUBLIC OF LATVIAState Revenue Service Modernization Project

Project Description

The State Revenue Service

The SRS is responsible for collecting Customs Duty, VAT, Enterprise Income Tax, Excise Tax,Personal Income Tax, Land Tax, Real Property Tax, Natural Resources Tax, Social InsuranceContributions and local fees. In addition, SRS performs various non-revenue functions, including theadministration of the Anti-corruption Law, insofar as it relates to the processing of the declarations ofincome and assets filed by public officials, and the performance of financial audits requested by lawenforcement agencies. In 1997, SRS's 4,300 employees managed 83,000 business taxpayers andcollected $1,039 million in revenues.

The SRS operates in a challenging environment characterized by: (a) a frequently changing legalframework; (b) rapidly increasing number of taxpayers, many of whom do not have much experience withtaxes and depend on the SRS for assistance in the absence of a well-developed Tax and AccountingProfession; (c) growing complexity of business transactions; and (d) the pressure of conforming revenueadministration systems to EU requirements to facilitate early accession.

Since regaining independence in 1991, the Govemment has taken significant initiatives to increaseeffectiveness of the revenue administration. The present project is a continuation of these efforts. It willassist in deepening many of the recent reforms, while addressing other critical areas where institutionalcapacity needs to be strengthened. The project would consist of two components: one aimed at improvingOrganization and Management and the other at strengthening Operations.

A. CURRENT SITUATION

1. Organization and Management

a. Organizational StructureImmediately after independence, two organizations were set up to collect revenue: the State

Finance Inspection Board (for inland taxes) and the Customs Department (for customs duties and taxeson intemational trade). In April 1994, these two entities were merged to form the SRS. Latvia is the onlyBaltic State to have chosen to integrate its tax and customs agencies. The process of integration was takena step further by bringing the collection of Social Insurance contributions also within the purview of theSRS, effective January 1, 1998. In line with intemational trends in tax administration modemization, localoffices of the SRS have been reorganized along functional lines, instead of being organized on the basis oftaxes administered. A Large Taxpayers Division was created in Riga, in 1995, to deal with cases of suchtaxpayers. This Division currently manages about 220 large taxpayers and taxpayers related to them, whotogether account for 44% of tax collections.

In August 1996, wide-ranging amendments to the Law on the State Revenue Service were madewhich allowed greater flexibility in the SRS's organizational structure. As a result, functions that arecommon to both tax and customs administration, such as strategic and development planning,informatics,legal services, collection of revenue arrears and intemational affairs were combined. At present, besides

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its headquarters in Riga, the SRS has 34 local offices and about 60 customs control posts. These includeseven offices in Riga dealing with tax matters only and the Riga Customs office. The remaining 26 localoffices outside Riga handle both taxes and customs. Each of these offices has one local director and onedeputy director each for taxes and customs.

Although, significant progress has been made in developing the organizational structure, theoptimal structure is still not in place. At the operational level, 34 full-fledged local offices are too manyfor a country of Latvia's size and create a needlessly wide span of control for the head quarters. Whilelocal offices outside Riga are expected to perform the full range of tax and customs functions, many lackthe critical mass of staff required to do so: 15 of the 34 offices have less than 50 staff members and 12offices have less than 20 customs staff. The workload distribution between local offices is uneven.Reporting, coordination and control linkages with Headquarters are inadequate. Coordination betweenlocal offices is also weak. At the headquarters, integration between taxes and customs is incomplete.There are separate Tax and Customs Departments each headed by a Deputy Director General.

b. ManagementSince 1997 the SRS has adopted strategic planning to provide a focus to its modernization efforts.

In addition to annual strategic programs for 1997 to 1999, a Strategic Plan for the SRS for 1998-2002; aStrategic Information Systems Plan and a Training Strategy have been developed. Business planning hasbeen instituted to organize the operational work of different offices. All local offices prepare, defend andimplement detailed Business Plans that include strategic targets, performance indicators, revenueprojections and resource requirements. The amendment of the Law on the SRS mentioned above, hasintroduced fundamental changes in personnel management. SRS staff have been taken out of the CivilService and made subject to the private sector Labor Code. This has freed the SRS management fromconstraints imposed by the Law on the Civil Service and has given it greater flexibility in hiring,promoting and firing employees and setting remuneration levels. The practice of executing performancecontracts has been introduced, with contracts being signed between the Minister of Finance and theDirector General, between the Director General and local Directors and between the Directors and theirstaff.

Notwithstanding these important initiatives, the managerial capacity of the SRS requiresconsiderable improvement. This would involve both the refinement and institutionalization of recentinnovations as well as the strengthening of management in other areas. Important deficiencies that need tobe addressed are discussed below.

Methodologies for preparation of strategic and annual plans, formulation and substantiation ofbudget requests, and planning and execution of budgeted expenditures are still at an incipient stage andthe link between organizational objectives, activities, expenditures and performance is not strong. Rulesand procedures for financial and asset management need to be improved.

The administrative aspects of laws, regulations and norms relating to tax, customs and socialsecurity collections need to be improved to grant the SRS adequate enforcement powers, reduceadministrative discretion and make its procedures compatible with the EU. The supervision of fieldoffices is limited to monitoring of performance statistics, with inadequate emphasis on quality of work andclient service. Forms, document flows and business processes are not standardized across all field officescausing management difficulties and increasing administrative and compliance costs. Coordinationbetween tax and customs functions of the SRS in policy formulation, sharing of information and conductof joint operations in overlapping areas, such as audits and investigations, is not strong. Also, there isvery little coordination in the development and execution of modernization programs. Managers and staffof the two areas still perceive themselves as belonging to two different organizations.

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In the area of human resource management, performance contracting is, as yet, at a preliminarystage. There is a need to improve the specificity of performance indicators, develop mechanisms forobjective evaluation of performance and link actual performance to rewards and sanctions. At present, noclear career paths exists for SRS. This affects staff commitment to organizational goals as well as itsmorale. Policies for recruitment, promotion, transfer and discipline of SRS staff need to be improved toincrease transparency and objectivity. The remuneration of SRS staff, especially customs staff in localoffices and all staff in Riga, are below market comparators. Although, some flexibility is available tomanagement to increase salaries of individual staff based on seniority, level of responsibility, risk andperformance, the overall remuneration level is insufficient to attract and retain the skills needed by theSRS. There are deficiencies in training of managers in modem management practices, especially at themiddle level. The capacity of the SRS Training School to provide or procure high quality training forstaff needs to be strengthened.

The SRS, like most revenue administration entities, is vulnerable to corruption. The level ofdiscretion available to SRS officials engaged in customs operation and tax enforcement is high. There isconsiderable personal contact between field officials, taxpayers, importers and their agents. Lack ofdetailed regulations under the Customs Code increases the scope for corruption. The SRS does not havean intemal audit unit, although efforts are being made to establish such a unit with the assistance of EUPHARE. Intemal controls are not well developed and those that exist are not uniformly applied. Rulesfor delegation of financial authority have not been developed. There is inadequate transparency indecision-making. No line management inspection/supervision regimes are in place. There are no intemalgrievance procedures and systems. The SRS has adopted a Code of Ethics. However, its intemalizationamongst staff needs to be enhanced. Anti-corruption work is the responsibility of the Financial Police.Since the Financial Police itself investigates cases of serious tax evasion, its anti-corruption efforts aresubject to a serious conflict of interest. The SRS is responsible for monitoring declarations of assets andincomes by public officials. At the moment the unit in charge of this activity is merely receiving suchdeclarations. There is a need to strengthen the relevant law, create methodologies for processing thesedeclarations and train staff of the unit.

Finally, there is a need to improve communications within the organization in order to ensure thefull operational integration of tax, customs and social security collection activities, introduce a results-oriented culture, strengthen integrity and facilitate the modemization process. At the same time, theSRS's communications with external stakeholders including the Judiciary, taxpayers, importers, brokers,transporters, warehouse operators, chambers of commerce etc., need to be strengthened.

c. OperationsThe SRS has taken various steps to increase its ability to effectively implement tax and customs

laws. Some of the initiatives have been self-financed, while others have been assisted by different donors.In tax administration, EU PHARE has helped in developing laws, rules and regulations for VAT, Exciseand Income Tax, in line with EU standards; providing short-term consulting services in the areas oftaxpayer registration, tax collection, audit, case-filing, intemal audit and library facilities; and trainingstaff in taxpayer services, tax audit, intemal audit and planning. The US Treasury has provided technicalassistance in collection enforcement. In Customs administration, a multi-pronged modernization programsupported by EU PHARE, Denmark and Sweden has been developed. A new Customs law has beenpassed; four Free Zones have been created; border posts on the eastem border are being strengthened;with the assistance of Crown Agents, FAST TEAMS for anti-smuggling operations have been created anda risk analysis system has been installed; the ASYCUDA system for computerizing customs operations isbeing developed; mutual assistance agreements have been concluded with many countries; and Customsofficers have been trained.

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At the operational level, the biggest deficiency is the inadequacy of computerization. Thecoverage of the current information systems of the SRS is very limited. These systems, built on obsoletePC software (FoxPro), are scattered in SRS offices and among functional units. They offer little to nointegration across these functions and offices, preventing routine cross-checking a taxpayer's transactionsamong taxes and across jurisdictions. Equally problematic, the existing systems are poorly documented,highly inflexible and generally not scaleable. As a result, they exhibit very high software maintenancecosts associated with keeping pace with changing regulations, business processes, organizationalarrangements and technological characteristics of the underlying hardware platform. In addition, thesesystems expose SRS operations to substantial risks, as a result of the low level of data and systemsecurity/integrity and weak capacity to provide continuity of operations in the event of a disruption ordisaster.

Besides weak information systems, SRS operations suffer from various other deficiencies. TheSRS is unable to detect non-filers, stop-filers and tax defaulters in time. Good quality information on real-time transactions of taxpayers is not available. There is no system for risk analysis and selection of casesfor tax audit. The investigation function, outside the Financial Police, is non-existent and tax audits tendbe perfunctory. Staff skills in tax audit and investigation of tax fraud are inadequate. Tax arrears are highand recovery procedures not very effective. There are significant deficiencies in the control of transittrade and bonded warehouses. The infrastructure at Customs posts for inspection of cargo, surveillanceand communication is inadequate. Objectivity and equity in hearing of objections to SRS actions need tobe improved. Cases before the Judiciary suffer long delays, judges lack adequate knowledge of taxmatters and tend to assign a low priority to these cases. There is considerable scope for enhancing thequality of representation of the SRS before the judiciary.

B. ASSISTANCE TO BE PROVIDED BY THE PROJECT

The project would provide consultant services, training, goods and minor civil works tostrengthen the organization, management and operational capabilities of the SRS on a sustainable basis.For this purpose, the project would support the following activities:

1. Organization and Management Component - US$ 5.4 million ($6.4 million including recurrentcosts)

a. Rationalization of Organizational Structures -- US$ 2.3 million (investment costs)(a) Develop a three-level organization structure for the SRS consisting of the Central

headquarters, 6-9 Regional Offices, performing most of the substantive tax and customs administrationfunctions, and attached Local Offices, essentially providing taxpayer services and/or serving as customsposts controlling important entry points. This would help realize economies of scale, shorten span ofcontrol, ensure adequate staffing of important functions and improve coordination. (b) Develop SRSunified functions, tasks and classificatory of actions. (c) Develop job descriptions on the basis ofclassificatory for structural unit of pilot offices. (d) Implement the new organizational structure inZemgale Region and Latgale Region, on a pilot basis. (e) Implement the new Regional and Local structurethroughout the country. (f) Develop and implement structural improvements at the central level; (g) Trainmanagers and staff to facilitate implementation of the new structure.

b. Strategic planning, budgeting, financial and asset management -- US$ 1.0 million(investment costs)

(a) Improve methodology for preparation of Strategic and Activity Plans. (b) Develop andimplement methodology for preparation of budgets and substantiation of cost effectiveness of budgetproposals. (c) Develop and implement planning methodology for SRS expenditures. (d) Train managersin strategy, planning, budgeting, use of information for management decisions, project management,

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financial management and asset management. (e) Develop and refine Informatics Strategy. (f) Developrules and procedures for acquisition, control, accounting, maintenance, security, retention, verification anddisposal of assets of the SRS, including information and official records. (g) Renew SRS bookkeeping andbudgeting information systems (h) Develop information systems to manage life-cycle ofSRS's physicalassets, with linkage to other management modules. (i) Develop information systems to support life-cyclemanagement of SRS's information assets, including paper documents. (j) Implement basic work-flowsystem, including electronic capture, routing, storage and management of selected documents, based onimage scanning (although production use of character recognition will wait for the maturation of thesetechnologies).

c. Operational management -- US$ 0.4 million (investment costs)(a) Improve administrative aspects of tax, customs and social security laws to increase the

effectiveness of the SRS in implementing them and to make them compatible with EU requirements.(b) Improve rules, regulations and norms relating to different areas of SRS operations including penalties.(c) Develop unified forms for SRS outgoing documents. (d) Develop improved SRS document flows.(e) Increase operational autonomy of regional managers, subject to strict accountability for results.(f) Develop and implement evaluation system for central, regional and local offices. (g) Review and re-engineer business processes of the central, regional and local offices to improve efficiency, effectivenessand integrity of the SRS and reduce compliance costs for taxpayers. (h) Strengthen supervision of fieldoffices. (i) Strengthen coordination and communication linkages between different organizational units.

d. Personnel management -- US$ 0.6 million (investment costs)(a) Develop and implement a differentiated pay and incentives system for SRS staff. (b) Develop

career paths for SRS staff at all levels. (c) Develop and implement transparent rules and procedures forstaff recruitment, promotion, rotation and discipline. (d) Enhance the contracting process by improvingperformance indicators, performance measurement and evaluation systems and linking performance toinstitutional incentives. (e) Develop and implement methodological instructions for the employees of SRSPersonnel Divisions. (f) Enhance physical security and access controls, using ID making equipment.(g) Evaluate skills of SRS staff in view of revised functions and job descriptions. (h) Strengthen thecapacity of the SRS Training Unit to deliver or procure high quality training. (i) Develop a graduatedstructure of pay and incentives at a high enough level to attract and retrain high quality and committedstaff. (j) Renew SRS's personnel and payroll information systems, to put them on a more technicallysound and secure footing, and increase their flexibility and capabilities -- including support for the internalperformance contracting system and linkages to other modules, such as bookkeeping, budgeting and themanagement information system.

e. Internal controls and prevention of corruption -- US$ 0.4 million (investment costs)(a) Develop and implement SRS internal audit strategy. (b) Develop training course on internal

audit. (c) Train internal audit personnel. (d) Design audit information systems. (e) Create and equip aVigilance Unit to monitor and investigate conduct of SRS staff. (f) Develop guidelines for managers fordealing with corruption cases. (g) Train staff about Code of Ethics. (h) Train' staff of the Vigilance Unit.(i) Improve legislation relating to declaration of assets and income by public officials. (j) Developmethodology for processing the declarations. (k) Train staff of the declaration Monitoring Unit.(1) Provide resources to the Monitoring Unit for handling of declarations of income and assets by publicofficials, including parliamentarians and ministers. (m) Provide standardized documentation feeding intowide area communication networks. (n) Minimize contact with the public by separating advice totaxpayers from the collection and processing of returns. (o) Enhance capacity to cross check and monitoroperational activities across functions and geographical spans of SRS activities, by the implementation ofunified and integrated tax and customs information systems. (p) Introduce computerized risk analysiscriteria into selection of cases for tax audit and customs inspection. (q) Generalize the use of taxidentification numbers. (r) Improve controls on warehouses and temporary imports. (s) Standardize and

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strengthen supervision routines. (t) Strengthen the appeal system. (u) Reduce the degree of discretionavailable to many officers, particularly at the local level and at the borders. (v) Establish a channel fortaxpayer complaints.

f. External and internal relations -- US$ 0.1 million (investment costs)(a) Design and organize periodic client surveys, with links to SRS performance assessment,

operational design and public awareness initiatives. (b) Design public relations campaigns aimed at staff,taxpayers, importers, transporters, brokers, warehouse operators etc. (c) Develop strategies andmechanisms to support and liaise with professional groups involved in tax-related activities, such aspreparers, lawyers, industry associations, accountants, etc. (d) Develop mechanisms for exchange ofinformation with other govemment agencies and foreign countries. (e) Train staff in change management.

g. Management information system -- US$ 0.6 million (investment costs)(a) Design and implement a management information system (MIS) to bring together the

necessary information on management functions and operational activities to support decision-making ateach level of SRS management. (b) Integrate data from resource management systems as well as tax andcustoms operational information systems.

2. Operational component - US$ 29.9 million ($39.2 million including recurrent costs)

The Operational Component of the project would extend the capacity building efforts initiated bythe SRS in the areas of tax, customs and collection of social insurance collections. The objective wouldbe to increase the productivity of routine operations, while improving the SRS's ability to fight taxevasion, smuggling and defaults in revenue payments.

This component would help modernize the SRS's operational information systems to overcomethe deficiencies in the existing systems. The new systems would increase coverage of SRS's operationalfunctions and provide a full range of application, data and systems management tools. In addition, thecomponent would assist in re-engineering business processes, developing methodologies and trainingstaff.

a. Taxpayer registration -- US$ 3 million (investment costs)The project will implement SRS's new taxpayer registration system. "Phase 1" and "Phase 2" of

the registry, which will be completed by the end of 1998, implement a central database of taxpayers (legaland physical), replication of registry sub-sets to regional/local offices, and cross-jurisdictional queries.Phase 3, in 1999, will implement additional data recording to support functions introduced in othermodules such as collection, audit, social insurance collections, etc. Phase 3, among other things, will alsoimplement the links between SRS's unified taxpayer registration and the renewed citizen, enterprise andcadastre registers. During 1997-98, SRS has funded and overseen the development of these registers forthe benefit of the Ministry of Justice and Ministry of Interior. The project will support the completion ofthese external registers in 1999, as well as the implementation of a common, "meta-register" (a register ofthe data and other characteristics of the various public registers). The meta-register will help maintainconsistency among these key public registers. In addition, the process of registration of taxpayers will besimplified and a methodology for registration and monitoring of businesses operating in free economiczones will be developed and implemented.

b. Declaration, collection and recovery of arrears -- US$ 3.3 million (investment costs)The project will implement SRS's new declaration processing system including unification of

income tax and social insurance contribution declarations. Together with the consolidated taxpayeraccounting sub-system and payments recording sub-system, the declaration processing sub-systemconstitutes the "kernel" of the integrated Tax Information System (TIS). Phase 1 and Phase 2, which will

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be completed by end of 1998, encompasses the bulk of the system development work for the kemel(including processing of VAT, PIT, CIT, Excise Tax, Gambling Tax, Natural Resource Tax, Real EstateTax, and Social Insurance Contributions declarations). Phase 3, in 1999, will primarily cover the roll-outof these functions to SRS offices nationwide. In addition to the aforementioned declarations, the systemwill also address State Officials income declarations, Enterprise Annual Report declarations, large-valuecash transactions reports, and tax payment registration (data from the Treasury on taxpayer paymentswhich flows through the banking system to the Treasury).

The project will support the development of standard procedures and automated tools for thecollections, enforcement and arrears management functions. These include monitoring systems withautomated triggers and wamings for the collections staff. They also include case action recording andcase file management tools. In addition, closer collaboration will be made with the State Committee forStatistics and the Enterprise Registry to better identify non-filers. Also, a database of precedent-settingcases on important issues in tax and customs administration for reference by SRS staff will be developed.

c. Audit and investigation -- US$ 3.3 million (investment costs)The project will support a major strengthening of the audit function. This includes buildingSRS's

capacity to analyze compliance patterns and develop criteria for an audit case selection, as well as todevelop an integrated approach for auditing social tax and income tax. Under the project, SRS willacquire a "full-cycle" audit system, including tools to plan, specify, conduct and evaluate audits. Thissystem will build on the information base created through the routine transactions and taxpayer accounts.Among other things, these tools will record results, prepare appropriate communications and assess auditquality. To facilitate SRS's transition from the traditional practice of numerous, "shallow" audits to thecontemporary approach of relatively few, but well-selected and careful audits, the project will support thedevelopment of data management and data analysis tools which will allow the selection of audits based onthe pattems and profiles of taxpayers and taxpayer activities. In this context, SRS will move operationaldata to special "data warehouse" systems (and combine it with other data). There statistical and other dataanalysis tools can be used without compromising the performance or integrity of the operational data andtransactions processing. Such data and analysis, particularly of compliance, would also feed the SRS'sperformance monitoring mechanisms to provide a quantitative base to measure progress on compliancerates and equity. Extensive training would be provided to staff in tax audit and investigation of tax fraud.The capacity of the Financial Police to investigate serious cases of tax evasion and smuggling will bestrengthened.

d. Customs operations -- US$ 3.5 million (investment costs)The project will support a wide range of capacity strengthening in the areas of trade facilitation,

classification and valuation of imports, physical inspection of goods, warehousing, detection of smugglingactivities and the confiscation and disposal of contraband. SRS is in the process of devising an integratedCustoms Information System (CIS). The structure and approach to the CIS is unfolding, in large measure,through the process of the EU-PHARE financed pilot of UNCTAD's ASYCUDA++ system. This system,which centers around the processing of customs declaration, is being piloted in two sites, in conjunctionwith similar pilots in Estonia and Lithuania. In the course of the pilot, which runs through mid-1999, SRSwill determine which modules and functions in ASYCUDA++ it will generalize to the whole of thecustoms administration, and which modules and functions need further development (e.g., transit trade).Under the Project, these will be integrated to extend the CIS. Also, further development of the CIS will besupported by the project.

One obvious benefit of the CIS will be a common customs information system for all border postsand inland customs offices throughout Latvia. Through SRS's wide area network (WAN) other benefitsinclude the capacity to: (a) track freight across internal jurisdictions as well as across internationalborders; (b) respond to suspicious traffic before the traffickers can exit the country or disappear within it;

Page 31

(c) operate the newly-legislated, credit-based tariff collection scheme using up-to-date data on the creditbalances and credit limits of eligible traders; (d) transmit to the relevant tax office(s) tax payments andcredits information regarding transactions that are conducted at customs posts in connection with cross-border trade (e.g., excise and natural resource taxes and VAT); and, (e) better sharing of intelligenceinformation between customs and tax functions.

The Project also provides various non-IT equipment, such as vehicles, for customs operations, inparticular to strengthen anti-smuggling operations.

e. Adjudication and appeals -- US$ 0.1 million (investment costs)The Project will support activities aimed at strengthening and streamlining the system for

adjudication of objections and appeals resulting from the SRS's actions, so as to enhance transparency,objectivity and equity. It will help improve the quality of representation of the SRS before the courts toensure that the interests of revenue are adequately safeguarded. Although there is no appeals-specific sub-system, the appeals process will be facilitated by the automated document management tools implementedunder the project. In addition, the case-action and case-file tools developed to support collections andenforcement will also facilitate the appeals function.

f. Taxpayer & customs client services -- US$ 0.3 million (investment costs)The project will support a wide range of capacity building activities in the area of taxpayer and

customs client services, including: (a) developing methods to assess and monitor service standards fromthe client perspective, through, among other things periodic surveys; (b) developing strategies forimproving taxpayer education; (c) developing and implementing ground floor taxpayer inquiry countersand facilities for depositing tax declarations and forms; (d) training staff in customer assistancetechniques; (e) designing new procedures for receiving and processing declarations and forms. To helpreduce the cost of tax and customs compliance to taxpayers and importers, exporters, transporters,brokers, warehouse operators, etc., the project will support a number of outreach functions to assist themwith information about regulations, procedures and other such matters. These include the strengthening ofSRS's Web site, the implementation of information servers for automated voice-based and fax-basedinformation dissemination. In addition, SRS will facilitate the development of electronic filing ofdeclarations, by supporting the development of taxpayer software and enhancing SRS's technical capacityto accept and process electronic filings. Periodic surveys of taxpayers are also planned to improvetaxpayer services and to get a feedback into the internal performance monitoring and contracting process.

g. Common IT infrastructure development -- US$ 16.4 million (investment costs)Whereas the other sub-components of the Operations Component focus on implementing and/or

strengthening of SRS business functions, the Common IT Infrastructure sub-component separatelyaddresses the underlying technology platform for these business functions. The reason is two-fold. First,the common IT infrastructure is shared by most, if not all, of SRS's operational and management systems.Accordingly, these underlying technologies are hard to apportion meaningfully to each business function.Second, the common infrastructure itself needs management, particularly in the form of security,integrated operations management, and business continuity and disaster recovery. Thus, the project placesspecial emphasis on implementing the required systems management tools for the IT infrastructure. Thecommon infrastructure comprises: database technologies, system software, processing equipment(servers, PCs), input and output devices (e.g., printers and scanners), local and wide area data networkingequipment, and communications service subscriptions.

Overall, the sub-component supports: (a) IT planning and coordination; (b) informatics staffdevelopment; (c) informatics-related, physical facilities development; (d) WAN and LANimplementations; (e) a distributed processing and database architecture, comprising central and localservers (both database and application) and intelligent workstations (PCs); (f) power conditioning, un-

Page 32

interruptable power supplies, and (for remote customs posts) generators; (g) comprehensive systemsecurity and integrated system management tools; and (h) back-up and other business-continuity / disasterrecovery resources.

The WAN warrants some additional description. It is primarily based on leased equipment andleased data channels, which SRS will obtain from a set of digital communications service providers (andtheir corresponding mix of channel medium). A large measure of the financial cost of the WAN,particularly the links to the customs posts, is offset by savings associated with the consolidation (into adedicated digital line) of the conventional analog voice communications capacity required by Customs,Ministry of Interior, Ministry of Agriculture and other public offices co-located with the customs staff.This arrangement permits data communications to be automatically squeezed into the unused bandwidth,which expands and contracts in response to voice traffic.

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Annex 3

REPUBLIC OF LATVIAState Revenue Services Modernization Project

Components Project Cost Summary(US$'000)

Local Foreign Total

Organization & Management Component 2,639 3,385 6,024Operations Component 14,581 22,405 36,986

Total Baseline Costs 17,220 25,790 43,010Physical Contingencies 261 1,155 1,416Price Contingencies 990 271 1,261

Total Project Costs 18,471 27,216 45,687

Page 34

Annex 4

REPUBLIC OF LATVIAState Revenue Service Modernization Project

Cost - Recovery Analysis Summary

Present Value of Flows Fiscal ImpactEconomic FinancialAnalysis Analysis Taxes Subsidies

BenefitsIncremental revenue US$ 250 US$ 250 Nonefrom a permanent, one- million (1998 milliontime I percentage point constant) over increase inincrease (relative to 1997 29 years @ revenueslevels) in the compliance 10% discount collectedrates for taxes, customs& social insurance rate. (present valuecontributions, starting in in 19982000 constant

dollars over 29years).

CostsInvestment costs, plus US$ 143 US$ 26 million Noneincremental recurrent million (1998 (present valuecosts plus 5-year constant in 1998straight-line depreciation dollars) over constanton physical and 29 years @ dollars over 29technological assets 10% discount years

rate.

Net Benefits: Net BenefitsIRR US$ 107

million.IRR =28.7%

Summary of Benefits and Costs

The economic benefits from the modemization of tax, customs and social insurance contributionadministration come through a number of channels. Among the most important are increases in theeffectiveness of revenue administration, as manifest in increased compliance rates, and increases in theefficiency of revenue collection, as manifest in lower administrative costs per Lat collected and lowercompliance costs for taxpayers and for those engaged in intemational trade and transport. Other lessquantifiable benefits associated with the project include: (a) more equitable distribution of the tax andcustoms burdens; (b) reductions in corruption in revenue administration; (c) reduction in rent-seeking anddistortions associated with illegal and evasive behavior; (d) benefits associated with regional integration,and EU accession in particular; and (e) increased economic growth through lower, less distortionary taxrates, in particular a lower rate for social insurance contributions by 2002.

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Because of inadequacy of reliable data on compliance costs, a precise cost - benefit analysiscannot be undertaken at this stage. Instead, the quantitative analysis presented here is a simple a cost -recovery analysis. This analysis focuses simply on ensuring that an exceedingly pessimistic projectedincrease in the effectiveness of revenue administration will be sufficient to raise revenues in excess of thecost of the modernization program. In this case, the present value of a permanent, one-time increase inrevenue performance of merely 0.7 percent is sufficient to cover the present value of investment costs.incremental recurrent costs and depreciation. The analysis also shows that increases in administrativeeffectiveness sufficient to increase revenue performance by 3 percent are sufficient to cover total costsmore than four times over. (A one percent increase represents a fiscal gain of US$ 48 million in NPV at a10 percent discount rate, and yields an IRR of 29%.)

International experiences suggest that, although the actual increase in revenue performanceassociated with such modernization investments are hard to predict, they invariably exceed the associatedcosts by a large margin. With an informal economy estimated to be equivalent to a quarter of GDP, thereis little reason to suggest that Latvia would prove to be the exception.

Turned around, the analysis indicates that the cost of obtaining increased administrativeeffectiveness -- through which project derives benefits such as more equitable and less distortionary taxand customs burdens -- is quite low.

It should be strongly emphasized the above cost - recovery analysis is only a proxy for the otherbenefits of the project. The Government does not intend to transfer the improved revenue into higherexpenditure. Indeed, the project will: (a) allow fiscal flows to be maintained as privatization revenues tailoff; and (b) permit tax rates to be lowered over time.

Main Assumptions

Three assumptions of the cost - recovery analysis are notable. First the model assumes awaychanges in many extra-project factors that determine actual revenue performance, such as changingeconomic conditions and other drivers of economic growth. Second, it assumes no deterioration inrevenue performance in the no-investment scenario. Third, it also assumes that the increase in the revenueperformance would begin only in the year 2000, the 3rd year of the investment program. These last twounderstate the revenue benefits from the investments. As the economic transformation progresses and theprivate sector expands and becomes more sophisticated, revenue authorities must actually work harder tomaintain the same level of revenue collections. Also, many of the key operational systems become activein 1998 and 1999 and thus, improvements in administrative effectiveness and revenue performanceshould appear earlier than estimated in the model.

Sensitivity analysis / Switching values of critical items

With a ten percent discount rate, the present value of the total cost of the project is covered byonly a 0.7 point permanent increase in revenue compliance, relative to the 1997 levels. Given estimatesof the informal economy of at least 25 percent of GDP, this is far below what can be reasonably assumedfor modernizing the Latvian revenue administration system. The return of the present value of total. costsfor 3 and 5 point increases are 353 and 656 percent, respectively (and IRRs of 124 and 196 percent).

Return on Present Value of Total Costs-- sensitivity analysis -

discount rate incremental revenue (percentage over 1997)i .0.o.5 -. 0.7- 1.0 2.0 3.0 . . 5°0

-20% 5% 60% 220% 379% 699% 1498%-22% 3% 55% 211% 366% 677% 1453%-24% 0% 51% 202% 353% 656% 1411%

M S -28% -5% 43% 187% 330% 617% 1333%

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Annex 5

REPUBLIC OF LATVIAState Revenue Service Modernization Project

Financial Summary(US$ '000)

1998 1999 2000 2001 2002 Total

PROJECTI COSTSTotal Investment Costs 7,754 13,063 8,117 4,746 1,694 35,374Total Recurrent Costs 453 1,556 2,335 2,889 3,080 10,313

total 8,206 14,619 10,453 7,635 4,774 45,687

FINANCING SOURCESIB3RD 0 1,620 1,721 1,420 293 5,054Govemment

o/w investment funds 7,754 11,444 6,396 3,326 1,401 30,320o/w administrative funds 453 1,556 2,335 2,889 3,080 10,313

sub-total (Govt.) 8,206 12,999 8,732 6,215 4,480 40,633total 8,206 14,619 10,453 7,635 4,774 45,687

% of total costsIBRD 0% 11% 16% 19% 6% 11%Government 100% 89%io 84% 81% 94% 89%

sub-total 100% 100%b 1000/% 1000/0 100% 100%

miemorandum The 1999 Government investment funds are US$ 8.0 million from the PublicInvestrnent Program plus US$ 3.0 million of SRS's US$ 5.9 million allocation from thesupplemental budget.

Main assumptions

The availability of the necessary funds from the Public Investment Program to cover theinvestment costs and adequate administrative budget for the SRS to cover the incremental recurrent costs.

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Annex 6

REPUBLIC OF LATVIAState Revenue Service Modernization Project

Procurement and Disbursement Arrangements

Procurement

Procurement Arrangements (Table A)

Summary of Procurement Activities (Table B)Section 1: Procurement Review.Section 2: Capacity of the Implementing Agency in Procurement and Technical

Assistance requirements.Section 3: Training, Information and Development on Procurement.Section 4: Procurement Staffing.Section 5: Procurement Plan.

Disbursement

Allocation of Loan Proceeds (Table C)Disbursement Categories (Table D)

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Annex 6, Table A

REPUBLIC OF LATVIAState Revenue Services Modernizaton Project

Procurement Arrangements(US$ '000)

Procurement Method

International NationalCompetitive Competitive

Bidding Bidding Other N.B.F. Total

A. WorksBuildingsInfrastructure -Rehabilitation & Maintenance - - - 1,147.0 1,147.0

B. Goods and S&I1. Equipment and Machinery

Info. & comm. tech. 2,478.0 - 299.3 23,872.6 26,649.8(2,100.0) (251.0) (2,351.0)

Office equipment & fumishings - - - 1,305.9 1,305.9

Vehicles 538.8 - - 264.8 803.6(456.6) (456.6)

2. Construction materials - - - -

3. Commodities

C. Technical Service Contracts - - - -

D. Consultancies1. Studies, Engineering and Supervision - - - -

2. Technical Assistance - - 1,687.7 1,391.7 3,079.4(1,430.3) (1,430.3)

3. Training - - 963.4 1,425.2 2,388.6

(816.5) (816.5)E. Miscellaneous

1. PPF Repayment - - - -

2. Recurrent CostEquipment 0 & M - - - 10,312.6 10,312.6Incremental Staff - - - -

Facilities

Total 3,016.8 - 2,950.4 39,719.8 45,687.0(2,556.6) (2,497.7) - (5,054.3)

Note: Figures in parenthesis are the respective amounts financed by IBRD. NBF = Not Bank Financed. Other methodsinclude approximately US$ 300,000 in Intemational Shopping (o/w US$ 251,000 is Bank-financed) andapproximately USS 2.65 million in consulting services (o/w 2.25 million is Bank-financed).

Annex 6, Table B

Summary of Procurement Activities

% of loanMinor Other subject to prior

ICB NCB IS NS Works Methods reviewWorks

Procurement thresholds:individuals and aggregate

(Bank-finance)Prior review 0%

.........................._L. ... ..... ......... . ..... .. ...... .. .. .. .......... .. . . ... .. ......... .......... . ..... ...... .. ....... .. . ...... . ....... ......... ..........Goods

Procurement thresholds: Above $300,000 Below $300,000 Below $75,000individual and aggregate

(Bank-finance) Aggregate:. Aggregate ..US$ 3.02 million USS 0.30 million

(2.56 million) (0.25 million)

Prior Review l First FirstPackages Contract Contract 55%

SingleQBCS Fixed Budget Source/(firms) QBS (firms) LCS Qualifications Co-Fin Individual

Consultants P . _._ .. .......... _ ............ ..... _....... . ....... ... ... ....... ... ... ..... . .- - ... -----.......................Procurement method Aggregate:

thresholds: US$ 2.65 million(Bank-finance) (2.25 million)

_ __ _ __ ! ___ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~..___. _. .. ........... . ..... . .. _.. . _ ._._. . .............. .. .. ..... . .___. . ....... . .............. ... .

I All TOR and !!Prior Review Short Lists for

all assignments i 45%RFP/SL and

Contract ' '- _ _ __._!

Ex-post Review Ex-post Review carried out in accordance with Para. 4 of Appendix I of the Bank's Guidelines and reviews during supervision missions.

Brief statement:

Overall responsibility for Project management and coordination will rest with the Project Implementation Unit (PIU) established in the State Revenue Service in July 1998.

A CPAR for the Republic of Latvia has not yet been completed. For this project, the Are the bidding documents for the procurement actions for the first year ready byGovernment will follow the agreed Bank procurement procedures, as described in this negotiationsdocument, in the Loan Agreement, and the Guidelines Procurement under IBRD Loans and Yes 0 No 0 Under preparation XIDA Credits January 1995, revised January and August 1996 and September 1997, and theGuidelines Selection and Employment of Consultants by World Bank Borrowers January1997.

Estimated date of Project !lEstimated date of publication of Indicate if there is procurement Domestic Preference for Domestic Preference forLaunch Workshop General Procurement Notice subject to mandatory SPN in Goods Works, if applicable

Development BusinessJanuary 28-29, 1999 December, 1 1998 Yes 0 No X Yes 0 No X Yes 0 No X

Rtoctive financing CD

Yes 0 No X Explain:

Explain briefly the Procurement Monitoring System:

The procurement plan (see section 1) will be up-dated monthly, with any changes in the expected dates noted and explained. This plan will be sent to the Bank on a quarterlybasis during the first two years of the project and semi-annually after that.

.... ...... ............ I............... ........ ............................................................................................................... .......................................

Co-financing:No co-financing used in this project. SRS will use standard public procurement procedures for all non-Bank financed items.

Procurement Staff or Bank's staff part of Task Team responsible for the procurement in the Latvia State Revenue Service Modernization ProjectName: Rama Chandran for general procurement. Craig Neal for information systems procurement.

Explain briefly the expected role of the Field Office in Procurement: None.

1 2 3 4 5 ~~~~~~~~~~~~~~~~~~6 Estimated Dates

Descriiip tio-n- .Type N__o'. 'of Estimat-ied Procureme Pre- Bid doc. IBid -Contract Contractitems I cost nt method qualific- RPsigning completionslices! ation!pkgs. Short-

listing

I Invitation, 1. Prepare I. Invitation,GPN SPN ~ GPN/SPN/

local advert. .local advert.2. Opening. 2. Opening.3. Eval. & 3. Eva]. &

recommend. recommend.of Award

1. Consulting srices for CS 1 US..........2.65... .... ..Q...B....1. Nov. 98 Dec. 98 I. Feb. 99 May 99 Dec. 02TA and training mu .Dc 82. Mar. 99

I ~~~~~~~~~~~~~~~2. Dec. 98 3.Ari9

2. Full-cycl audit info. S&I of I US$ 2.48 1CB n.a. Nov.-Dec. .1. Jan. 99 Aug. 99 Dec. 02

system & training. iinfo. mil. (2-stage) .98 2. May 99

Sys. (2nd stage)

- ~ ~ ~ ~ ~ ~ ~ .. ~~~~~~~.. - -~~~~~~~~~~~~3 . Ju l. 9 9

3. Optical storage fo,r plo'_t"_[_ Gods 1 - U'S '3 0-0 . .... ...IS_' n.----a-. "N o'v .98, L. D'ec'. 9'9 Jain.- 99" .M' Mar. '9'9

regional offices to.2. Jan. 99

archives __ -.. 3. Jan. 99 -

4. Vehicles for customs I Goods 2 US$ 538 1G~ ~ ~~~B n.a. Mar. 99 1. May 99 Aug. 99 Mar. 00

anti-smnuggling Ithiou. 2. Jun. 99

__ .. ~~~~~~~~~~~ ... 1~~~~~~~~~~~.. Jul. 99

Page 42

Annex 6, Table C

REPUBLIC OF LATVIAState Revenue Services Modernization Project

Allocation of Loan ProceedsIBRD

(US$ '000)

Loan Amount Disbursement %

A. WorksRehabilitation and Maintenance -_-

Subtotal Works -B. Goods and S&I

1. Equipment & MachineryInfo. & comm. tech. 2,239.1 8.8Office equipment & fumishingsVehicles 434.8 56.8

Subtotal Goods and S&I 2,673.9C. Technical Service ContractsD. Consultancies

2. Technical assistance 1,430.3 46.43. Training 816.5 34.2

Subtotal Consultancies 2,246.7E. Miscellaneous

2. Recurrent costEquipment operations & maintenance

Subtotal MiscellaneousUnallocated 133.7Total 5,054.3 11.1

PRage 43

Annex 6, Table D

REPUBLIC OF LATVIAState Revenue Services Modernization Project

Disbursement Categories(US$ million)

Category Amount Percentage of Expendituresto be Financed

WorksRehabilitation and Maintenance 0.00 none

Goods and S&IEquipment & Machinery 2.67 100 offoreign expenditures

Info. & comm. tech. 2.24 100% of local manufacturesOffice equipment & furnishings - (ex-factory cost), or 80% ofVehicles 0.43 other items procured locally.

Technical Service Contracts 0.00 none

Consultancies 2.25 100%Technical assistance 1.43Training 0.82

Miscellaneous 0.00 noneRecurrent cost

Unallocated 0.13

Total 5.05

Special Account. To facilitate project implementation SRS would establish a Special Account inone of the commercial banks, on terms and conditions satisfactory to the Bank, to cover the Bank's shareof expenditures. The Authorized Allocation would be DEM 650,000, representing about four months ofaverage expenditures made through the Special Account. During the early stage of the project, the initialallocation to the Special Account would be limited to DEM 300,000. However, when the aggregatedisbursements under the Loan have reached DEM 1,700,000, the initial allocation may be increased up tothe Authorized Allocation of DEM 650,000, by submitting the relevant Application for Withdrawal.Applications for replenishment of the Special Account would be submitted monthly or when one-third ofthe amount has been withdrawn, which ever occurs earlier. Documentation requirements forreplenishment would follow standard Bank procedure as described in the Disbursement Handbook,Chapter 6. Monthly statements of the Special Account which have been reconciled by the Borrowerwould accompany all replenishment requests.

The minimum size of the application for direct payment and the issuance of special commitmentwould be twenty percent of the prevailing Special Account allocation.

Statement of Expenditures. All disbursements against contracts for goods exceedingDEM 500,000 will be fully documented. For expenditures for goods below that level, disbursementswould be made against Statement of Expenditures (SOEs). Similarly, SOEs would be used for

Page 44

disbursements against contracts for consulting services from firms up to DEM 170,000. For theseexpenditures, detailed documents evidencing expenditures will be reviewed and kept by the SRS andmade available for the required audit as well as to Bank supervision missions.

Project Financial Management

Project accounting.

The PIU will establish a financial management system following the guidelines provided by theBank under the Loan Administration Change Initiative (LACI), including accounting and financialreporting systems and auditing arrangements adequate to ensure accurate and timely informationregarding project resources and expenditure. In particular, it is expected that the PIU will have:

* Adequate financial management capacity to properly handle the tasks of disbursement andaccounting required for implementation of the project objectives;

* Proper monitoring mechanism to report accurately on the status of the expenditure for theproject as a whole, its various components and each expenditure category as represented in theLoan Agreement, by each funding source; and

* Adequate capacity to generate auditable financial statements.

Project records and accounting policies will be established and maintained in accordance withIntemational Accounting Standards (IAS) as issued by the International Accounting Standard Committee(IASC).

Project Reporting

The PIU will ensure that proper project reports are prepared and submitted to the Bank in atimely fashion. These include comprehensive quarterly reports covering project financing, implementationprogress (including variance reporting), procurement progress and contract expenditure. The reportingsystem will be in compliance with the formats provided by the Bank in theLACI Implementation Manual(September 1998). These include: project status reports, reflecting: (i) the status of implementationprogress, problems encountered, corrective actions needed, rationale for actions; (ii) the current state ofproject indicators (see Appendices G); and (iii) the current costs of each project component and estimatedcosts of completion Procuremnent reports, including: (i) semi-annual procurement progress reports, whichdescribe the progress of procurement activities against the plans set forth in the PIP, variations inprogress, reasons for variations, and remedial actions; (ii) bid evaluation reports, as they arise in theprocurement processes.

Project Audits.

Project accounts, financial statements, the Special Account and Statements of Expenditures will beaudited in accordance with the Guidelines for Financial Reporting and Auditing for Projects Financed bythe World Bank (March 1982) as well as the Financial Accounting Reporting and Auditing Handbook(January 1995). In particular, International Auditing Standards (ISA) as published by the InternationalFederation of Accountants (IFAC) will be consistently applied. The Government will provide the Bank(within six months of the end of each fiscal year), an audit report of such scope and detail as the Bankmay reasonably request, including an opinion by an independent auditor acceptable to the Bank, ondisbursements against certified SOEs. The opinion should mention whether the SOEs submitted duringthe fiscal year, together with the procedures and internal controls involved in their preparation, can berelied upon to support the related withdrawal applications.

Page 45

Annex 7

REPUBLIC OF LATVIAState Revenue Service Modernization Project

Project Processing Budget and Schedule

A. Project Budget (US$000) Planned Actual(At final PCD stage)

265 213....... .. ....... . . .. ...... ....... ........ .. .. ....... .. ... ...... .....: ..

B. Project Schedule

First Bank mission (identification) 9/30/1997Appraisal mission departure 9/03/1998Negotiations 10/19/1998Planned Date of Effectiveness 1/15/1999

Prepared by: State Revenue Service, Republic of Latvia

Preparation assistance: PHRD (US$ 412,000)

Bank staff who worked on the project included:Name Specialty

Mansour Farsad Program Team LeaderJaime Vazquez-Caro Tax Administration Specialist

Jit Gill Public Sector Management SpecialistCraig Neal Information Systems SpecialistHelen Sutch Economist (Public Economics)Gyorgy Lazi Operations Specialist

Andrejs Jakobsons Economist

Page 46

Annex 8

REPUBLIC OF LATVIAState Revenue Service Modernization Project

Documents in the Project File

A. Project Implementation Plan

B. Bank Staff Assessments:

1. Return on Investment analysis worksheet.

Page 47

Annex 9

REPUBLIC OF LATVIAState Revenue Service Modernization Project

Statement of Loans and Credits

Amount in millions (USD)CCY

Loan/ Project of Approval ClosingCredit Financier ID Description Conmmit Principal Undisb. Disbur. Date Date35250 IBRD 8525 REHABILITATION USD 45 0 41.9 22-Oct-92 31-Dec-9426950 IBRD 8527 AGRI. DEV. USD 25 0 25 11-Jan-94 31-Dec-9737950 IBRD 8529 ENTERP. FIN. SECT. USD 20 6.1 13.9 20-Sep-94 31-Dec-9837960 IBRD 8529 ENTERP. FIN. SECT USD 10 5.3 4.7 20-Sep-94 31-Dec-9837961 IBRD 8529 ENTERP. FIN. SECT DEM 5 0.6 4.2 20-Sep-94 31-Dec-9838140 IBRD 8533 LIEPAJA ENVIRON. USD 4 0.2 3.8 6-Dec-94 31-Mar-0038900 IBRD 8526 JELGAVA DIST. HEAT USD 14 3.7 10.3 23-May-95 30-Jun-0039640 IBRD 34584 MUN. SERVICES DEV. USD 27.3 13.2 14.1 14-Dec-95 30-Jun-0141260 IBRD 44123 SAL DEM 60 0 51.2 19-Dec-96 30-Jun-9841450 IBRD 8532 HIGHWAY USD 20 15.8 4.2 27-Mar-97 31-Dec-0041540 IBRD 35807 WELFARE REFORM DEM 18.1 16.3 0.5 6-May-97 31-Dec-0242860 IBRD 40553 SOLID WASTE MGMT. USD 8 8 0 26-Feb-98 30-Jun-0343800 IBRD 44804 RURAL DEV. DEM 10.5 10.3 0 30-Jul-98 30-Jun-01

Page 48

Annex 10REPUBLIC OF LATVIA

Country at a Glance

Europe & Lower-POVERTY and SOCIAL Central middle-

Latvia Asia Income Development diamond1997Population. mid-year (millions) 2.5 476 2,285 Life expectancyGNP per capita (Atlas method, US$) 2,430 2,320 1,230GNP (Atlas method US$billions) 6.0 1.106 2,818

Average annual growth, 1991-97

Population (Y.) -1.3 0.2 1.2Labor force (%) -1.1 0.5 1.3 GNP / Gross

per ~ primaryMost recent estimate (latest year available, 199197) capita enrollment

Poverty (% of population below national poverty line)Urban population (% of total population) 73 67 42Life expectancy at birth (years) 70 69 69Infant mortality (per 1,000 live births) 15 25 36Child malnutrition (% of children under 5) . Access to safe waterAccess to safe water (% of population) .. .. 84Illiteracy (% of populafion age 15+) 19Gross primary enrollment (% of school-age population) 89 92 111 -Lahia

Male 91 116 - Lower-middle-income groupFemale 86 113 j-

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1976 1986 1998 1997Economic ratios

GDP (US$ billions) .. .. 5.1 5.4 1Gross domestic investmentVGDP 36.5 18.8 19.7Exports of goods and services/GDP 50.9 50.5 TradeGross domestic savingslGDP 35.9 10.7 9.6Gross national savings/GDP . ..

Current account balance/GDP -4.2 -5.4 DomesticInterest paymentslGOP 0.3 0.4 InvestmentTotal debtUGDP 9.3 9.4 SavingsTotal debt service/exports 2.4 4.3Present value of debVGDP 8 6Present value of debt/exports 16.0

Indebtedness1976-46 1987-97 1996 1997 998-02

(average annual growth)GDP 3.6 -.80 2.8 7.1 L atviaGNP per capita 3.0 -7.3 3.5 5.0 --- Lower-middle-income groupExports of goods and services -2.6 27.0 10.8

STRUCTURE of the ECONOMY1976 1986 1996 1997 Growth rates of output and Investment I%)

(% of GDP)Agriculture 20.3 8.9 7.4 !Industry 44.4 31.9 30.7 50

Manufacturing 38.9 21.5 21.2 °Services 35.4 59.3 61. 9 97

Private consumption 54.9 67.6 67.2 o100 lGeneral govemment consumption 9.3 21.6 23.3 GDI * GDPImports of goods and services 59.0 60.6

197648 1987i-97 7m 9 Growth rates of exports and Imports (%)(average annual growth)Agriculture 4.9 -9.0 -9.5 3.3 40

Industry 3.2 -14.2 3.0 6.1 20Manufacturing 3.2 -13.0 3.0 9.4 0

Services 3.2 -1.4 5.1 8.2 - - 2 \ 97

Private consumption 2.1 -10.7 0.3 1.8 General govemment consumption 5.2 2.8 3.0 14.4Gross domestic investment 6.9 -23.9 10.0 41.2 -Imports of goods and services . -7.3 31.0 14.8 -Exports 0-ImportsGross national product 3.6 -8.1 2.4 4.0

Note: 1997 data are preliminary estimates.

The diamonds show four key indicators in the country (in bold) compared with its income-group average. U data are missing, the diamond willbe incomplete.

Page 49

PRICES and GOVERNMENT FINANCE1976 196 1996 1997 Inflation (%)

Domrestic prices(% change) 1200 -

Consumer pfices .. .. 17.6 7.0 sooImplicit GOP deflator 0.1 -1.4 17.1 6.0 600/

400Government finance 200

(% of GDP, includes current grants) 0 OCurrent revenue .. .. 36.6 39.9 92 93 94 95 98 97

Current budget balance . .. 0.6 1.6 - GDP deflator O CPIOverall surplus/deficit .. .. -1.3 1.3

TRADE

(US$ millions) 1978 1980 1996 1997 Export and import levels (USS millions)

Total exports (fob) .. .. 1,488 1,838 3.o00-

Commodity 1 2,500 -

Commodity 2 ZODO .Manufactures . .. .-

Total imports (cif) 2,286 2,686 1.5000Food 171 220 1000,Fuel and energy 500 11 M.Capital goods 171 277 o.

91 92 03 94 ss srJ 97Export price index (1995=100) .. .. 106 108Import price index (1995=100) Exports r I ImportsTerms of trade (1995=100) .. .. . ..

BALANCE of PAYMENTS1976 1986 1996 1997 Current account balance to GDP ratio)

(US$ millions) Exports of goods and services . . 2,613 2,890 10,Imports of goods and services .. .. 3,028 3,350 9 t . -Resource balance .. .. -414 -460 9

4,Net income .. .. 42 54 2 . - r

Net current transfers . I iL T

Current account balance .. .. -217 -287 -2,91 92 93 94 95!96 1 .4 .

Financing items (net) .. .. 455 525 .- IiChanges in net reserves .. .. -238 -238 -8

Memo:Reserves including gold (US$ millions) ..Conversion rate (DEC, locaWUSS) .. .. 0.6 0.6

EXTERNAL DEBT and RESOURCE FLOWS1976 1988 1996 1997

(US$ millions) Composition of total debt, 1997 (USS millions)Total debt outstanding and disbursed 0 0 475 503

IBRO 0 0 75 120IDA 0 0 0 0 G65

A: 120Total debt service 0 0 65 133

IBRD 0 0 4 5IDA 0 0 0 0 F: 79 /

Composition of net resource flows /

Official grants 0 0 41 .. /Official creditors 0 0 40 63 , .C:86Private creditors 0 0 3 12 , /

Foreign direct investment .. .. .. E: 74Portfolio equity 0 0 0 0

D:79World Bank program

Commitments 0 0 87 98 A- IBRD E - BilateralDisbursements 0 0 24 53 B -IDA D -Other multilaterat F - PrivatePrncipal repayments 0 0 0 0 C -IMF G - Short-termNet fiows 0 0 24 53Interest payments 0 0 4 5Net transfers 0 0 20 48

Development Economics 10/28/98

Page 50

Annex 11

REPUBLIC OF LATVIAState Revenue Service Modernization Project

Latvian TaxesA summary of the main features

(as of end October 1998)

Tax Definition of Taxpayer Tax base Tax rates

VAT A person whose taxable Supply and importation 18% on taxabletransactions exceed Ls. of goods and services transactions;10,000 p.a. __0°/O on exports

Exemptions: Services of nursing homes; education fees library services; cinemas, museums, etc.;sporting and cultural events; medical supplies and services; lotteries and gambling; funeral andreligious services; payments by residents for rent, heating, water, sewerage and garbage services;scientific investigations; financial and insurance services; mass media; certain Latvian art andliterature; mutual services to members of cooperatives; sale of real estate; fire safety devices; postalservices.

Enterprise Enterprises engaged in Taxable income, as 25% of taxable incomeincome tax business, including non- determined from the Also withholding taxes on

resident enterprises and annual profit and loss payments made to non-their permanent account. Residents are residents:-establishments taxed on global income 5% on rent for use of

property located in Latvia;10% on dividends paid,interest paid to relatedpersons, fees formanagement andconsulting services, profiton sale of securities;15% on royalty payments;25% on sale of real estate

Exemptions: State owned enterprises, state budget institutions and local government institutionswhose income goes into special state and local govt. budgets; non-profit organizations; enterprisesusing prisoner labor, approved charities. There is tax relief of 20% of the calculated tax for smallenterprises, and tax relief of Ls. 10 per hectare for agricultural enterprises.

Personal Resident physical persons Annual taxable income, 25% of taxable incomeincome tax aged 15 years and older after deductions for

who gain income in annual non-taxableLatvia or abroad; non- minimum allowance,residents who gain dependents allowances,income in Latvia. and allowable expenses

(social tax paid, pensionfund payments, educationexpenses, medicalexpenses, donations tocharities)

Page 51

Exemptions: Income from agricultural production if less than Ls. 3000 per year; dividends andinterest; insurance payments; prizes; most welfare benefits; education scholarships; inheritances; childsupport; divorce settlements; workers compensation; blood donations; subsidies paid to agriculturalproducers.

Social Resident physical persons Annual taxable income Insurance for:insurance aged 15 years and older Pension - 27.37%contributions who gain income in Unemployment - 3.1%

Latvia or abroad; non- Workers compensation -residents who gain 0.09%income in Latvia. Disability - 5.94%

Matemity & sickness -0.59%Total rate 37.09%, ofwhich employee pays 9%,employer pays 28.09%Special rules for selfemployed, pensioners andforeigners.

Exemptions: as for Personal Income Tax

Excise tax Persons who sell, produce Alcohol and alcoholic Ls. 4.10 per liter ofor import goods subject to drinks absolute alcoholexcise Champagne and wines Ls. 0.25 per liter

BeerCigarettes Ls. 4.00 per hectoliterCigarettes without filters Ls. 4.00 per 1000Cigars Ls. 5.00 per 1000Other tobacco productsGold and other precious Ls. 10.00 per 1000metals 100% of valueAutomobilesLead-free petrol 30% of valueLeaded petrolDiesel 10% of valueFuel oil Ls. 140 per 1000 litersGas, except natural gas Ls. 160 per 1000 liters

Ls. 100 per 1000 litersLs. 2 per 1000 litersLs. 10 per 1000 liters

Exemptions: alcohol for medical, veterinary, scientific needs and for pharmaceutical production; lowalcohol beer (below 5.5%); tobacco dust used for insecticides; precious metals used in dentistry;precious metals and precious stones imported by the precious metal fund of the Republic of Latvia;cars with petrol engines below 1600 cc and diesel engines below 1900 cc; cars more than 7 years old;cars with electric motors, pick-up and flat-bed trucks; for farmers - 120 liters of diesel per year foreach hectare of land used for farming.

MAP SECTION

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