Law No. 2004-044 on the Finance Law for 2005

LAW NO. 2004-044 ON THE FINANCE LAW FOR 2005 REPUBLIC OF MADAGASCAR Homeland-Freedom-Progress

---

PRESIDENCY OF THE REPUBLIC LAW NO. 2004-044 ON THE FINANCE LAW FOR 2005

EXPOSITION OF MOTIVES The year 2004 marks the first year of implementation of the poverty reduction strategy outlined in the comprehensive Poverty Reduction Strategy Paper (PRSP). The Government has achieved real progress in executing economic, social, and structural programs. Confidence from funding partners has been secured through their technical and financial support. Given these advances, Madagascar reached the completion point in October under the enhanced Heavily Indebted Poor Countries Initiative (HIPC). Through this completion point, a large portion of our external debt will be forgiven, allowing us to generate additional resources to finance our development programs. This constitutes a step forward rather than an end in itself. The Government is determined to deploy even greater efforts to achieve the poverty reduction objective. These efforts must be accompanied by a strong will to modernize the State in its operations and modes of action, thereby increasing its capacity to deliver better public services and establish an environment conducive to private sector expansion. The 2005 budget fits within the Government's overall economic policies to continue and consolidate results. Since public finance reforms cannot be solely the State's responsibility, this budget was prepared following a process that prioritized a participatory approach where the private sector, civil society, and external technical and financial partners were consulted. This Finance Law for the year 2005 reflects the Government's firm determination to move further forward in implementing economic and financial policies aimed at the rapid and sustainable development of the country.

I - ECONOMIC AND FINANCIAL RESULTS 2004 Production The economic results of 2004 were strongly influenced by exogenous factors: two severe cyclones that struck the country during the first quarter and the persistence of rising international oil prices since the second half of the year. Despite these factors, efforts made over the past two years to stimulate production and promote investment continue to bear fruit. For 2004, the recovery continues; economic growth is estimated at 5.3%, slightly below the initial forecast of 6% and well above the demographic growth rate of 2.8%.

This economic growth was essentially supported by both public and private investment. Indeed, the investment rate increased from 17.9% of GDP in 2003 to 23.7% in 2004. While the public sector ensured infrastructure development, the private sector renewed its means of production. The primary sector experienced certain growth following various actions to stimulate production, including the removal of taxes on fertilizers, agricultural inputs and equipment, the implementation of rural development programs, and the establishment of agricultural competitions. The secondary sector has regained real vigor. Most manufacturing industries as well as free zone enterprises have recovered or even exceeded their pre-2002 crisis production levels. The tertiary sector recorded solid performance. The "buildings and public works" branch experienced remarkable growth due to the accelerated execution of numerous projects involving both construction and rehabilitation. Transport and tourism activity branches demonstrated considerable dynamism following road construction/rehabilitation on one hand, and the opening of new international air routes on the other. Inflation The combination of several factors led to a general price increase during the first six months of 2004. These mainly include: (i) cyclones, (ii) high international prices for oil and rice, and (iii) the depreciation of the Malagasy currency. Consequently, the consumer price index increased by 16.3% between the beginning of the year and August 2004. To curb inflation and contain national currency depreciation through reduced demand and increased supply, the Government took various measures, including blocking 10% of public expenditures outside priority sectors, re-taxing certain consumer products, and facilitating rice distribution by fully leveraging competition. Concurrently, the Central Bank worked to operationalize the continuous interbank foreign exchange market and tightened monetary policy by revising up the benchmark interest rate and raising the mandatory reserve ratio. External Sector The continued economic recovery, infrastructure construction and rehabilitation, post-cyclone reconstructions, and rising international oil prices led to a significant increase in imports of approximately 8.5% in Special Drawing Rights (SDR) terms. Regarding exports, international prices for certain main products, including vanilla and crustaceans, fell sharply. Despite product diversification and the strong performance of free zone enterprises, our exports could decline by 2.4% in SDR terms for the full year of 2004. The competitiveness gain stimulated by Malagasy currency depreciation, along with the influx of external aid, has mitigated the widening of the balance of payments. Thus, the current account deficit may stand at 9.2% of GDP against a forecast of 6.6%. Public Finances The year 2004 is marked by the beginning of public finance reforms.

Regarding revenues, the adopted policy considered the economic role of the fiscal and customs system. Among the main measures taken are tariff simplification and restructuring. The number of taxable income brackets was reduced for the Corporate Income Tax (IRSA) and Personal Income Tax (IRNS). Import duties and taxes were merged into two categories (down from five), with their maximum rate revised downward from 33% to 25%. Furthermore, the tax base was broadened and collection strengthened. Given achievements in the first nine months, the 11.2% tax pressure rate target is maintained for 2004. Regarding expenditures, infrastructure, education and health, rural development, environmental protection, and good governance implementation remained priority areas for budget allocation. In September 2004, public expenditure engagement rates were estimated at 73% for operating expenditures excluding salaries and 67% for investment expenditures. By year-end, public expenditures are estimated at 23.1% of GDP against a forecast of 19.5% of GDP. To contain the public deficit, the Government adopted a prudent salary stabilization policy and suspended 10% of operating expenditures excluding salaries while maintaining allocations to priority sectors. By year-end, the public deficit is estimated at 4.3% of GDP against a forecast of 3.6%. Furthermore, efforts were deployed to concretize sound economic and financial governance. Thus, the legal and regulatory framework for public finances was improved by: (i) adopting a new organic law governing public finances and a new public procurement code, (ii) reorganizing the Budgetary and Financial Discipline Council, (iii) establishing the General Inspection of Finances, (iv) regulating special funds, and (v) merging the functions of authorizing officer and credit manager.

II - ECONOMIC AND FINANCIAL PERSPECTIVES 2005 Objectives for Economic Growth and Inflation For 2005, the goal is to achieve a sustained growth rate of at least 7%. This forecast relies on: (i) renewed economic activity following investments realized or underway across the three economic sectors, and (ii) mobilization of the country's potential. For the primary sector, growth would stem from agricultural activity development driven by measures taken, including continued rehabilitation of agricultural infrastructure (dams, irrigation networks) and dissemination of production techniques. The secondary sector would experience certain improvement thanks to expected strong performance in Industrial Free Zones (IFZ). The extension of the African Growth and Opportunity Act (AGOA) as well as the abolition of quotas on products exported to the North American market, starting January 1, 2005, would contribute significantly. Significant improvements are also expected in other branches such as agro-industry and beverages. Regarding the tertiary sector, the Construction and Public Works (BTP) branch will continue its growth due to public and private investments in infrastructure. Freight and passenger transport, banking, and commerce activities will also benefit. Following the implementation of adequate fiscal and monetary policies, inflation would decrease compared to 2004. Consistent with the PRSP, the target is to achieve a year-on-year consumer price index variation of 5%.

Forecast for the External Sector Measures to promote exports would lead to a recovery of traditional products. Strong dynamism is expected for free zone enterprises. Malagasy export increases are estimated at 23.7% in SDR terms. In 2005, imports should further be amplified by equipment goods for which tax incentives will remain in force until the end of August 2005, allowing the private sector to continue renewing its production means. Total import growth could reach 8% in SDR terms. The current external deficit will be reduced to 7.7% of GDP in 2005, down from 9.2% in 2004. Objectives for Public Finances In 2005, fiscal and budgetary policy focuses on consolidating reforms already underway in recent years: rationalizing the fiscal and customs system, improving expenditure management, and controlling the public deficit. Furthermore, public finance management will be modernized through the use of the Integrated Public Financial Management System (IPFMS). Regarding revenues, the target is to achieve a tax pressure rate of 11.8%. The role of taxation will be further supported. To this end, the following measures will be taken: (i) merging into a single category the two import taxes (customs duties and import tax); (ii) planned cancellation in September 2005 of the suspension of Value Added Tax (VAT) and customs duties on certain products. Furthermore, tax collection will be strengthened through: (i) effective IT tools (SIGTAS for internal taxes and Sydonia ++ for customs), (ii) broadening the tax base, (iii) eliminating customs credit except for clearance credit; (iv) re-examining economic and suspensive regimes in customs; (v) good governance and anti-corruption efforts. In the domain of public expenditures, 2005 will see the establishment of a Medium-Term Expenditure Framework (MTEF) and a program budget, ensuring coherence between the budget and development strategy. It will also see effective application of various legal and regulatory texts adopted in 2004 to improve expenditure management (public procurement, budgetary control, budgetary and financial discipline…). For 2005, total public expenditures are estimated at 22.4% of GDP. The structure of public expenditures is characterized by the predominance of public investments, which increased by 13.8% compared to 2004. Expenditures allocated to priority sectors (infrastructure, health and education, good governance) will be further strengthened. The budget deficit will be maintained at 4.4% of GDP in 2005. Alongside the fiscal efforts initiated by the Government to finance the budget, support from the international community and development partners will be decisive, either through substantial external debt relief or by mobilizing financial and technical resources.

A.- REVENUES Taxes Within the framework of implementing all economic reforms to achieve a 11.8% tax pressure rate for 2005, the Government opted to place taxation at the service of development by considering the partnership between the State on one hand, and economic operators and taxpayers on the other. The main proposed measures continue those taken previously, notably the progressive reduction of rates and support for new investments without neglecting increased fiscal revenues. Measures aimed at simplifying the tax system are proposed. In addition to provisions modifying the General Tax Code (GTC) following the definitive shift to the Ariary and the entry into force of the 2005 General Accounting Plan (PCG 2005), and the necessity of SIGTAS operationalization, new measures are proposed. Provisions modify the GTC in form following:

• translation of scales and tariffs into Ariary to allow calculation of taxes, duties, and levies;
• alignment with PCG 2005 concepts and terminology;
• grouping of infractions and harmonization of sanctions. Provisions, generally substantive, introducing new measures are also taken: Regarding Income Tax, the measures mainly aim to incentivize investment and facilitate business creation: Ø Exemption from Corporate Income Tax (IBS) and minimum perception for the first two years, with a 50% cap on due tax in the third year for newly created companies. Ø Abolition of the lump-sum regime for Personal Income Tax (IRNS) as part of a gradual normalization and professionalization of micro and small entities' activities, which will be supervised by authorized management centers (AGC). Ø Regarding Corporate Income Tax (IRSA), increase in the rate and ceiling for professional expense deductions. Ø Reduction of applicable rates for natural persons regarding Personal Income Tax (IRCM). Regarding registration duties, to facilitate the creation of Single-Person Limited Liability Companies (EURL), measures reducing the rate for contribution duties and lease rights have been taken. Restructuring and downward revision of succession duty rates are envisaged. Regarding product and service taxation, to ensure improved fiscal revenues, some adjustments have been made:

Ø Securing fiscal revenues by extending withholding at source for all indirect taxes and duties on tobacco and alcohol. For turnover taxes, a revision of the VAT imposition regime after investment tax relief has been adopted. Regarding local taxes, a modification of the base for Professional Tax allows easing investment taxation.

Customs

1. On the Customs Code: The context of globalization and trade liberalization, along with updating and adapting customs legislation to the objectives set by the Customs Administration, necessitate modifying certain provisions of the Customs Code. The repeal of Article 94 regarding duty credit reflects the intention to strengthen actions already taken to improve revenue collection by retaining only clearance credit (payment of duties and taxes within 8 days). "Notwithstanding the special safeguard of the law regarding customs agents in the exercise of their functions, prior authorization from the Minister responsible for customs is no longer required for judicial proceedings." (Repeal of Article 34, paragraph 3). Good management of temporary admissions and temporary exports requires introducing and clarifying the concepts of active processing and passive processing. Furthermore, as part of the modernization reform of the Customs Administration, ship entry formalities and declaration submission undergo significant easing to avoid delaying clearance operations. Consequently, measures for simplifying and accelerating procedures have been taken, such as adopting electronic transmission of the manifest before aircraft or ship arrival, and advance submission of customs declarations. Moreover, to favor direct and foreign investments, it is planned to sign a specific Establishment Convention based on the activity domain and investment program, outlining contractual commitments between the Government and the investing company. In view of the shift to the Ariary scheduled for January 1, 2005, all articles of the Customs Code containing provisions expressed in Malagasy Francs have been modified.
2. On the Customs Tariff: Within the framework of strengthening rationalization and simplification measures already applied in recent years, new provisions have been adopted regarding the Customs Tariff. State constraints and private sector expectations were taken into account. These include merging customs duty and import tax into a single duty (Customs Duty), on one hand, and revising the taxation of certain inputs and raw materials, on the other.

The Tariff also provides for the repeal starting September 1, 2005, of Law No. 2003-026 of August 27, 2003, regarding the relief of customs and fiscal tariffs, modified and supplemented by Law No. 2004/010 of July 28, 2004. B.- EXPENDITURES

1. Generalities: They are generally characterized by strengthened poverty reduction efforts, continued sound management of public finances, and reconsideration of civil servants' purchasing power. Organic Law No. 2004-007 of July 26, 2004, on Finance Laws introduces two fundamental innovations regarding budget preparation and execution. Regarding budget preparation, the organic law establishes a program budget, based on defining objectives to be achieved, breaking down activities to reach them, implementing performance/impact measurement tools, and allocating budgetary or human resources, as well as equipment, with cost determination based on a price list that closely approximates market reality. This new presentation aims to ensure better readability and greater credibility of budget documents, which are no longer mythologized with concepts and hard-to-understand number sequences for the public, but also to facilitate execution control at all administrative, judicial, and especially parliamentary levels, where compliance with parliamentary authorization granted upon voting the finance law can be effectively and periodically controlled, monitored, and evaluated regarding achievements. Regarding budget execution, the unification of functions of sub-authorizing officers for expenditures and credit managers within a single entity called "authorizing officer," responsible for commitment, verification, and payment operations of public expenditures, reflects the intention to simplify and accelerate expenditure execution. It also aims to establish a clear distinction between, on one hand, the budgetary function falling under the exclusive authority of the "authorizing officer for expenditures," and on the other hand, the administrative function, which falls under the competence of the activity manager, who will be entrusted with implementing the program according to assigned objectives. This distinction is dictated by the need to grant project heads full operational latitude for program management. Finally, to ensure greater effectiveness and efficiency in budget management, a manual specifying the list of supporting documents has been adopted for commitments, verifications, payments, and disbursements. Mastering these new mechanisms and tools will certainly require several years of learning at central, decentralized, and devolved levels. However, the progressive nature of the approach must be highlighted. Thus, an intensive capacity-building program has been implemented to train political (delegated authorizing officers), administrative, and financial officials at all levels, starting in December 2004 and throughout 2005, or beyond, in accordance with recommendations from the recent General State of Public Finances held in October 2004.
2. Salaries: Compared to 2004 forecasts, salary expenditures record in 2005 an increase of 14.5% excluding HIPC and 16.5% including HIPC expenditures, rising from 368.88 billion Ariary to 422.24 billion Ariary (excluding HIPC) and to 457.58 billion Ariary including HIPC. The main measures supporting this increase are respectively:

• consideration of the inflation effect on civil servants' purchasing power;
• catch-up and definitive resolution of military and gendarme salaries, whose insufficient credits led in recent years to special payment procedures as well as adjustments whose amounts inevitably impacted the following year's credits. A forecast of 11 billion Ariary has been allocated for this purpose;
• settlement of the State's contributory share to Retirement Funds (CPR and