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6. Analyzing Project Effects on Government Receipts and Expenditures
Implementing an agricultural project has obvious implications for government receipts and expenditures. The amount and timing of additional government receipts generated by a project and the effect of the project on government expenditures should be traced by the analyst. This will permit the government to plan for the capital investment in the project and to ensure that sufficient government funds will be available to meet the recurrent cost of the project. By tracing the foreign exchange flow generated by the project, the analyst can estimate the effect of the project on the balance of payments. The proportion of the cost and the proportion of the new benefit to be recovered by the government from the project beneficiaries should be estimated. It may be desirable, too, to determine how the cost of the project could equitably be allocated among the various groups that will benefit from it.
The primary issue analysis of government receipts and expenditures addresses is whether the project will generate sufficient funds to reimburse the government for the resources expended on the project. The analysis should treat the government as a distinct financial entity and should focus on inflows and outflows to and from governmental budgetary and extrabudgetary accounts to anticipate the amount and timing of project needs from government sources. Such an analysis permits careful consideration of the implications a project has for government finance to meet not only the initial investment needs of the project but also its recurrent cost. Too often inadequate attention is paid to recurrent cost, and then budgetary stringencies starve a project for funds-greatly reducing its efficiency, leading to a waste of resources, and dashing the expectations of farmers and others who participate.
It is common in agricultural projects that user charges or benefit taxes assessed on the project beneficiaries are insufficient both to recover the capital investment in the project and to pay all the operation and maintenance costs of the project. This might be the case in an irrigation project, for example, in which water charges are less than the amount the government incurs for capital repayment and operating the system or in which a program to increase production makes no charge for the services of agricultural extension agents. Sometimes other revenues arising from the project will be sufficient to reimburse the government for its costs. Such might be the case if the project increased agricultural production that is destined for export and is subject to an export tax. In many instances, however, not enough of the benefit from the project will be captured through charges or by the workings of the fiscal system to reimburse the government fully. In these instances, the difference will have to come from taxes levied elsewhere in the economy or through inflation. Whether this is to be the practice or not is a policy decision; one consideration may be that poor farmers are entitled to some income transfer through an agricultural project. The point of the analysis is not to say that the project beneficiaries must pay enough to cover all the costs of the project, both capital and recurrent. It is to say that the fiscal effects of the project need to be traced so that a conscious decision can be made about reimbursement of cost incurred by the government.
Because of problems associated with budgetary stringencies, in many projects in which not all the costs are to be recovered from charges levied on project beneficiaries, the beneficiaries may still be charged enough to pay the recurrent cost of the project. This frees the project from dependence on year-to-year budget appropriations that may be subject to sudden cuts and decrease the efficiency of project implementation.
The importance of anticipating future recurrent expenditure goes much beyond the individual project analysis, of course. Any one project-unless it is very large relative to the government budget-would not impose a serious burden for recurrent expenditure. All development investments together, however, may well lead to significant recurrent government expenditure. As a general rule of thumb, in developing countries capital expenditures tend to give rise to between 10 and 15 percent of their value in recurrent costs. Moreover, as the nature of development programs in many developing countries has tended to shift more and more toward projects that do not generate revenues sufficient to reimburse the government for recurrent cost, these expenditures have tended to grow rapidly. One result has been a persistent tendency to underestimate the burden of recurrent cost.
The elements of the flows that affect government receipts and expenditures vary from project to project, and some may not always be obvious. They can, however, conveniently be cast in the form of a government cash flow account valued at market prices. Inflows will include user charges levied on project beneficiaries, new tax revenues generated as a result of the project investment, debt service for loans made to project participants, the surplus or profit made on sales of the project or on services provided, and receipts from foreign loans made to help finance the project. Expenditures will include the initial capital expenditure on the project, including direct expenditure on such items as dams and canals; loans to project participants; equity positions taken in a processing industry; recurrent costs of the project in whatever guise they occur, whether operation and maintenance, general administration, or some other form; and debt service, including commitment fees on any foreign loans received to support the project. The analysis includes among the government expenditures related costs needed to make the project effective (such as the costs of new roads or other infrastructure facilities) because, although these may not be the responsibility of the project management, they are costs incurred for the project and would appear in the project accounts when they are aggregated as discussed in chapter 8.
Many agricultural projects will have an effect on the balance of payments, so it may be desirable to do a separate analysis of the project's foreign exchange effects in a foreign exchange flow account. Analysis of project effects on government receipts and expenditures can be illustrated by an example drawn from the South Nyanza Sugar Project, the same project used in the last chapter to illustrate the financial analysis of processing industries. As before, the general headings that might be expected to appear in most analyses of this kind will appear in italic type in the text.
Government Cash Flow
The government cash flow account for the South Nyanza Sugar Project is excerpted in table 6-1.
There is a problem about whether to make government cash flow projections in constant or current terms. For financial planning by the treasury and other government agencies, a current projection is much preferred, even though this involves projecting the inflation rate both domestically and worldwide. [A projection of worldwide inflation for capital goods is available in Price Prospects for Major Primary Commodities (World Bank 1982a).] But projecting inflation is difficult at best, and when done for more than just a few years it is of very little usefulness. In the South Nyanza project, therefore, the analyst chose a useful compromise: he projected the government cash flow in current terms for the five years of the investment phase during which the sugar factory was to be built. Then, from year 6 onward, he projected the cash flow in constant
KSh Kenyan shillings.Note: In current prices for years 1 through 5 (1977-81); thereafter, in year-5 (1981) constant prices. Parentheses indicate negative numbers.Source: Adapted from World Bank, "Kenya: Appraisal of the South Nyanza Sugar Project," 1418-KE (Washington, D.C., 1977; restricted circulation), annex 20, table 17.a. The disbursement of the German and Indian suppliers' credit and loans from the European Investment Bank, East African Development Bank, and the U.S. Export-Import (Exim) Bank have been assumed to be directly to the South Nyanza Sugar Company (SNSC) and not through the government.b. The excise tax per ton is in constant 1976 prices and is assumed at KSh 1,000 for sugar and KSh6 for molasses for years 1 through 5, adjusted to current terms by using a factor of 32.2 percent in year 4 (1980) and 41.4 percent in year 5 (1981) and thereafter.c. Values are in constant 1976 prices adjusted by 41.4 percent to year-5 (1981) constant prices.d. Includes import duties on materials, machinery, vehicles, and equipment; excise taxes on capital and current input; and income tax on staff salaries. The values are in constant 1976 prices adjusted by 41.4 percent to year-5 (1981) constant prices.e. It is assumed that sxsc dividends to the government will be 95 percent of sxsc net profits after tax, expressed in year-5 (1981) constant prices.f. The on-lending margin to sxsc has been assumed to be 1.5 percent.g. Includes the incremental cost to the Kenya Sugar Authority arising from the project and the cost of training and conference participation not included in the SNSC accounts. h. Incremental cost to the National Sugar Research Institute arising from the project. i. Includes the cost of roads needed for the project not included in sxsc nucleus estate.terms at year-5 prices. This avoided making a long-term projection of inflation. (Note that this would not be a suitable format if the cash flow were to be discounted as discussed in chapter 9.) The analyst also chose to include in his cash flow table a total column after year 5 for the first five years (not reproduced in the excerpt in table 6-1). The government cash flow is projected for sixteen years, long enough to trace the effect of all the financial transactions except the repayment of the World Bank loan.
The government cash flow account is divided into cash inflow and cash outflow. The first inflow is the loan receipt obtained from abroad to support the project. In the case of the South Nyanza project, the government of Kenya received loans from the World Bank and the African Development Bank for the project. Other loans were made by suppliers and by other international lending agencies that dealt directly with the South Nyanza Sugar Company. The flows from these loan transactions, since they did not go through the government, do not show in the government cash flow. Next in the table are the taxes. The South Nyanza project is expected to generate new tax revenues from the sugar excise tax collected at the factory gate and a similar excise tax on molasses; company income tax; and other taxes that include import duties on materials, machinery, vehicles and equipment, excise duty on capital and current inputs, and income taxes on staff salaries. Next comes the debt service receipt from the South Nyanza Sugar Company for the loan it has received from the government. The debt service is broken down into the interest payment, loan commitment fee, and repayment of principal. Finally, there is the transfer of company profit that is made to the government in lieu of dividends. Some proportion of this profit would by agreement customarily be reinvested in company expansion. Had there been any user charges, these, too, would have been included in the cash inflow.
The first entry in the cash outflow is the equity participation the government contributed to the South Nyanza Sugar Company, followed by loans to the company. These, in effect, constitute the capital cost contributed from the government budget to the company operation. Two other outflows are the financing for the Kenya Sugar Authority for training not directly administered by the company, including overseas university education in business management and sugar technology and participation in international symposia and conventions, and a grant to the National Sugar Research Institute to reimburse it for incremental expenses arising from the project. This is followed by road construction that is a part of the project cost to be paid directly by the government and not channeled through the company.
Then comes the debt service payment the government must make as a result of the project. This includes interest, loan commitment fee, and repayment of principal to the World Bank and the African Development Bank.
The difference between the cash inflow and the cash outflow gives the cash current surplus (deficit), which in the South Nyanza case is negative through project year 3 and positive thereafter. The cumulative surplus (deficit) indicates how long it will be before the government recovers its net expenditure on the project in undiscounted terms-six years in the South Nyanza example. In other projects, of course, both the current and the cumulative surplus (deficit) might remain negative throughout the life of the project.
Foreign Exchange Flow
The foreign exchange flow generated by the South Nyanza project is calculated in table 6-2.
Note: In current prices for years 1 through 5 (1977-81); thereafter in year-5 (1981) constant prices.Source: Same as table 6-1.a. Based on the foreign exchange element of the import substitution price of KSh3,897 per ton in constant March 1977 prices adjusted for inflation to KSh5,152 per ton in year 4 and KSh5,510 per ton from year 5 onward.b. Based on molasses price f.o.b. Mombasa of KSh463 per ton in year 4 and KSh495 per ton from year 5 onward.
As in the case of the government cash flow, the question arises of whether to calculate the foreign exchange flow in constant or current terms. Matching his choice for the government cash flow, the analyst chose to project the foreign exchange flow in current terms for the five years of the implementation phase of the project while the sugar factory was to be built and then, from year 6 onward, in constant terms at year-5 prices. As before, this provided the treasury and other planning agencies with a current projection of the foreign exchange effects of the project for the first few years of its implementation but avoided a long-term projection of inflation. Again, the analyst chose to carry out his calculations for sixteen years, long enough to trace all the financial transactions except repayment of the World Bank loan.
The foreign exchange flow is derived by tabulating the inflow, deducting the outflow, and obtaining the net foreign exchange flow. The first inflow is the loan receipt in support of the project. Note that the suppliers' credit and loans from several international agencies were received directly by the South Nyanza Sugar Company, so they do not show in the government cash flow examined in the previous section but do appear here. Then comes the foreign exchange value of the sugar production. This is the foreign exchange saved as a result of substituting domestically produced sugar for imported sugar. The last inflow listed is the foreign exchange earned from the export of molasses.
Foreign exchange outflows include the foreign exchange component of the various aspects of project implementation, including equipment and materials purchased from abroad and management fees. The other major component of the foreign exchange outflow is the debt service payment for loans received from abroad. This includes interest, any loan commitment fee, and repayment of principal to the suppliers of equipment and the international agencies that lent to support the project.
Subtracting the total outflow from the total inflow gives the net foreign exchange flow, which is reported in two variations: the current surplus (deficit) and the cumulative surplus (deficit). In part because of the financing available, the foreign exchange effect of the South Nyanza project is positive every year except the first.
Cost Recovery
When governments invest in projects that increase the incomes of individual farmers, the question arises about how much of the government expenditure should be recovered from the project beneficiaries. Only through appropriate cost recovery policies can governments recoup the money expended on a project for investment in other projects that will benefit other members of the society. To the extent that the cost of a project is not recovered, some part of the project benefit individuals receive represents a subsidy paid by others in the society who did not benefit from the project.
There are two important issues to be addressed in formulating cost recovery policy. One is the proportion of the cost expended on a project to be repaid. The other is the proportion of the benefit received by individuals (which may be far higher than the cost) to be recovered through direct charges and such indirect means as increased tax revenue. Project analysis, however, clearly cannot make the policy decision. Moreover, attempts to determine the proportion of government expenditure and individual benefit to be recovered under various alternative policies very quickly run into great practical difficulties. These involve estimating values, often imputed values, and more theoretical economic issues, so
that in the end cost recovery computations are of necessity more indicative than precise. Even so, cost recovery estimates based on sound economic principles can greatly improve understanding of the issues and improve the efficiency and equity of cost recovery policies.
Some aspects of cost recovery have little to do with the specifics of computation. Many countries have well-established policies about such things as water charges or taxes, policies that may not be politically possible to change all at once. Other considerations have to do with the project itself. Those projects which provide reliable service to farmers are more likely to have a better record on cost recovery than projects in which farmers feel services are poor and unreliable and, to that extent, not worth paying for.
In the final analysis, any cost recovery policy must be a political decision; it cannot be divorced from the broader sectoral and social setting. Any approach to cost recovery must be flexible and based on a recognition that what might be a good policy decision at one place or at one time is not necessarily the best decision at another place or time.
Problems of cost recovery in agricultural projects tend to be prominent in irrigation projects because these projects often are very expensive and bring proportionally large increases in income to the farmers who benefit. Much of the discussion of cost recovery, therefore, has centered around water resource projects, and the examples used in this section to illustrate methods of computation will be drawn from an irrigation project in India. The discussion here must necessarily be very general; more detailed information can be found in "Irrigation Water Charges, Benefit Taxes, and Cost Recovery Policies" (World Bank 1982b).
Objectives of cost recovery
Three basic objectives are involved in considerations of cost recovery issues: (1) economic efficiency, (2) income distribution, and (3) public saving.
Economic efficiency
The first objective concerns the level and structure of the prices to be charged-in irrigation projects, the price for water. The objective is to minimize waste and to allocate water optimally to maximize the net benefit from the project to the economy. The best way to do this would be through a price that would be equal to the contribution the water would make to increased output-an "efficiency price." This theoretical ideal is very rarely, if ever, met. It would require sale of water on a volumetric basis, which would lead to difficult problems in practice and would require estimating the contribution of water. But even a nominal price for water, perhaps one based on an acceptable if less than perfect measurement technique, would offer users an incentive to eliminate at least some of the conspicuous waste and overwatering that occur when farmers treat water as a free good. This, in turn, could reduce drainage and salinization problems.
Even if it were possible to charge farmers an optimal economic price, this might not be compatible with objectives of income distribution and public saving and investment. Hence, other criteria of assessing charges will have to be considered to ensure an equitable income effect from the project and an adequate recovery of project costs by charges that prospective beneficiaries can afford to pay and that still leave them adequate incentive to participate. Some recovery of benefits and costs will usually come from existing general taxes, such as an export tax or an income tax. But this recovery method is not geared to the circumstances of the particular project and is often unsatisfactory from the point of view of either income distribution or public savings. Moreover, capturing a larger part of the benefits and recovering more of the costs of a project through an increase in general taxation also affects those who do not directly benefit from the project. Hence, any measure to recover costs and benefits in addition to water pricing and existing general taxes should be selective and affect, to the greatest extent possible, only the project beneficiaries. These measures are usually called "benefit taxes." The most common form is a betterment levy assessed against the land benefited and perhaps varied according to the different crops grown.
Income Distribution.
The second objective of a cost recovery policy is to collect charges equitably and in line with national policy for income distribution. It may be desired to charge small farmers proportionately less than large farmers in the same project. Thus, specific taxes designed to capture part of the benefit of a project should take into account differences in income level and in the ability of beneficiaries to pay. Benefit taxes should allow for the quite different amounts of net benefit a project generates on farms quite similar in size and other characteristics. The taxes will have to be set taking into account disincentives, tax evasion, and the cost of collection. In irrigation projects, in practice only the broadest income distribution measures are implemented. A ceiling may be set on the total area an individual family may irrigate, for example, and an effort is usually made to ensure that small farmers at least do not pay a higher proportion of their benefit from the project than do larger farmers.
Public Saving
Most governments in developing countries are short of financial resources for development. Consequently, it may be desirable for the government to collect more resources than would be generated solely from efficiency pricing (which, in any case, is generally impractical) or from recovering only the cost of the project and no part of the net benefit. Not only would this make the projects financially self-supporting, but it would also enable governments to undertake additional rural development projects that would reach other members of the society. But farmers participating in a project may be poor. To recover more than the cost of the project may therefore be unacceptable, and it may be desirable to recover less.
Setting the level of water charges and benefit taxes
As the discussion to this point has indicated, the level at which to set water charges and benefit taxes will depend on a broad range of considerations. First, some estimate must be made of the net benefit received from the project by various participants. Then a system of charges and taxes must be established that captures an acceptable proportion of the benefit generated by the project while still meeting criteria of efficiency, income distribution, and equity. The level of charges and taxes must take into account similar levies in other areas and the political feasibility of charging a different amount in the project area, the disincentive effects of a benefit tax, and the administrative problems of tax collection. Benefit taxes should be designed to minimize the adverse effects these taxes may have on the production and consumption decisions of the farmers and others in the economy. It might be possible in some cases, for example, to recover costs by selling farm inputs to project beneficiaries at prices higher than those paid by others, or to purchase the output from beneficiaries at prices lower than otherwise would be paid-that is, to establish a monopolistic marketing margin. Such discriminatory taxes may induce choice of the wrong crops by farmers, although these taxes may be impossible to avoid completely. Volumetric sale in some form acceptable to farmers and project-specific betterment levies are generally better options.
The extent and manner of cost recovery directly affects the financial cash flows of the farmer, the project organization, and usually more than one government agency. Cost recovery can also affect the contribution an irrigation project will make to increasing national income. If cost recovery plans impose too heavy a burden on the farmers, the farmers may have insufficient incentive to participate fully in the project, and the anticipated output of the project will not be realized. In contrast, if cost recovery levels are set too low, the project organization may have too small an operation and maintenance budget-whether it is financed by water charges paid by farmers or by a government subsidy-so that water deliveries to farmers may be insufficient and unreliable, and production again could suffer.
The total benefit arising from the project sets a theoretical upper limit to the amount of revenue that can be collected from water charges and benefit taxes, but the actual amount collected will always be less-and usually much less-than the total benefit arising from the project. This is true simply because it is necessary to allow for errors of measurement and for the desire to increase the income of the poorest farmers. The lower limit of charges to be collected cannot be stated arbitrarily. A rule of thumb followed by many governments, however, is to attempt to establish water charges and benefit taxes that will at least recover the operation and maintenance cost. This will avoid an outright drain on current government revenues by the project. It will also reduce the
likelihood of problems arising from delays in receiving operation and maintenance funds caused by budget stringencies. There is another advantage. Where systems receive their operation and maintenance funds from the project beneficiaries, and the beneficiaries have a significant influence on the operation of the system (often through an appropriate local farmers' organization), the systems generally are fairly well managed and maintained. Past experience in World Bank projects suggests that cost recovery as a percentage of incremental net cash income rarely exceeds 30 to 35 percent.
Once established, cost recovery charges-whether water charges or benefit taxes-should be indexed so they can change in response to changing costs and to inflation. Because in new projects it is likely that farmers will need several seasons to learn to use new water efficiently, a grace period is probably appropriate during which the full water charges and benefit taxes can be phased in.
Measuring cost and rent recovery
Two measures are usually calculated to help form judgments about cost recovery. They are the cost recovery index, which gives an idea of what proportion of public expenditure on a project will be recovered directly from the beneficiaries and through taxes collected off the farm, and the rent recovery index, which gives an idea of what proportion of the total benefit will be recovered from the project beneficiaries and from other sources. These ratios are descriptive only-they should only supplement, not substitute for, an analysis of proposed water charges as they bear on efficiency, income distribution, public sector savings, and such factors as tax disincentives, costs of tax collection, broader sectoral considerations, and the political implications of any charge or tax. Furthermore, both measures depend on several values that are impossible to establish with precision, so that decisions based upon them must be treated with great caution.
Cost Recovery Index
. The first measure of cost recovery is the cost recovery index. It is:
The cost recovery index is calculated using constant market prices. The appropriate discount rate is the economic opportunity cost of capital. An example of how to calculate the cost recovery index is given in table 6-3, which is drawn from the Maharashtra II Irrigation Project in India. The first element is an estimate of the present worth of capital cost (per hectare of net cultivable "command area"-the area that can be irrigated by a particular group of irrigation works). This is based on the same cost estimates for the project as are used for other parts of the
(Rs per hectare, constant 1979 prices)Rs Indian rupees.
Source: Adapted from World Bank, "India, Staff Appraisal Report, Maharashtra Irrigation II Project," vol. i, "Main Report," 2529'-IN (Washington, D.C., 1979; restricted circulation), pp. 83-84.a. For the method of calculating present worth, see chapter 9.b. Annuity for recovery over fifty years at 10 percent interest rate. Calculated by multiplying the present worth of the capital cost of the irrigation infrastructure by the capital recovery factor for fifty years at 10 percent, which is 0.100 859, to give Rs1,871 (18,550 x 0.100 859 = 1,871).c. Annuity for recovery over ten years at 10 percent interest rate. Calculated by multiplying the present worth of the capital cost of the supporting works by the capital recovery factor for ten years at 10 percent, which is 0.162 745, to give Rs301 (1,850 x 0.162 745 - 301).d. Incremental benefit taxes include a tax to recover the capital cost of the supporting works, amounting to Rs301 per hectare (see note c above), and an incremental land revenue assessment of Rs5 per hectare, or a total of Rs306 (301 + 5 = 306).e. Indirect cost recovery receipts average Rs40 per hectare for the purchase tax on sugarcane and Rs55 per hectare for the sales tax on cotton and oilseeds, or Rs95 per hectare (40 + 55 = 95).f. Total cost recovery under existing charges divided by annual financial equivalent per hectare of net cultivable command area multiplied by 100 (659 - 2,272 x 100 = 29).
project analysis. Next, the annual financial equivalent (per hectare of net cultivable command area) is determined. For capital items-in this instance, the irrigation infrastructure and the supporting irrigation works-this value is calculated by multiplying the present worth of the capital cost by the capital recovery factor for the appropriate period and discount rate. [For capital recovery factors, see Gittinger (1973) or a similar set of compounding and discounting tables.] In this Maharashtra example, the irrigation infrastructure was assumed to have a life of fifty years, and the opportunity cost of capital was taken to be 10 percent, so the capital recovery factor for fifty years at 10 percent, or 0.100 859, was applied to the present worth of the irrigation infrastructure. The supporting works were taken to have a life of only ten years, so the capital recovery factor for ten years at 10 percent, or 0.162 745, was applied to them. The operation and maintenance charge, of course, is an annual charge, so it may be taken directly. Next the cost recovery is determined, in this case calculated assuming that existing charges will continue. The Maharashtra project is typical of many irrigation projects in that part of the cost recovery will come directly through water charges and a benefit tax, and part of the cost recovery will come from an indirect charge in the form of an excise tax on incremental sugarcane production and incremental sales tax revenues from marketing cotton and oilseeds. The total cost recovery index, then, is simply the total cost recovery divided by the total annual financial equivalent and multiplied by 100, which in this instance gives 29 percent (659 - 2,272 x 100 = 29).
There are variations that may be calculated, depending on the need for information on which to base cost recovery charges and benefit taxes. In the case of the Maharashtra project, for example, table 6-3 illustrates computation of the total cost recovery index, which includes as part of the cost recovery both the direct recovery through water charges and benefit taxes and the indirect recovery through excise and sales taxes. An alternative would be to calculate the direct cost recovery; that is, the amount recovered directly from the farmers themselves. In this instance the direct water charges and benefit taxes come to Rs564 per hectare (258 + 306 = 564), which would be divided by the total annual financial equivalent of Rs2,272 per hectare and multiplied by 100, so that the direct cost recovery index would be 25 percent (564 - 2,272 x 100 = 25). (The symbol for Indian rupees is Rs.)
The cost recovery index in various forms may then be used as a basis for conclusions about cost recovery policy. The effect of various levels of water charges and benefit taxes can be tested until a decision is reached about a suitable level and combination of these given such other public policy considerations as equity and the amounts charged elsewhere in the country.
Rent Recovery Indext
. The other cost recovery measure commonly calculated is the rent recovery index. It is based on projected farm budgets that are similar to those developed in chapter 4 but that have significant differences in that they include imputed values for labor, management, return to capital, and risk. In the illustrative calculation that follows, the rent recovery index for beneficiaries will be used to estimate the proportion of the benefit received by project beneficiaries that is recovered by the public authorities. The rent recovery index is:
Since the rent recovery index is generally computed to be used in forming a judgment about the amount of water charges and benefit taxes, it is not a discounted measure; rather, it is done for one year at the full development period. It is based on market prices.
In a general sense, the rent recovery index may be thought of as being based on the farmer's "ability to pay," his "capacity to pay," or his "repayment capacity." To calculate the rent recovery index, however, the more formal concept of "economic rent" is used. Economic rent is the surplus remaining after beneficiaries receive the rewards necessary to attract physical inputs, labor, entrepreneurship, and the willingness to bear risk. Economic rent is allied to the more familiar concept of rent as a payment for use of a capital item, but it is quite distinct from this more common use of the term "rent" and should not be confused with it.
In the case of an irrigation project, to calculate the economic rent accruing to a beneficiary, one starts with the incremental gross value of farm production, from which is deducted all incremental cash payments, incremental depreciation of farm assets, the imputed value of family labor and of management, a return on the family's own incremental capital, incremental general taxes, and an allowance for additional risk and uncertainty. Incremental water charges and incremental benefit taxes related to the project are not deducted. It will immediately be seen that estimating economic rent is not easy and is subject to a large margin of error. The various noncash and imputed values of costs cannot be determined with precision; they inevitably involve substantial judgment. It is necessary to make some estimate of this sort, however, to judge whether a sufficient proportion of the benefits received by farmers in the project is being recovered because these same elements must be considered however benefits may be measured.
An example of the computation of the rent recovery index is found in table 6-4, which is drawn from the same Maharashtra irrigation project used as an example in the previous subsection. The computation starts with the gross value of farm production at farm-gate prices without sales taxes. Of this, sales without the project amount to half, but as the family's income rises the proportion of sales rises sharply. From the gross value of farm production is deducted the cash production cost, and this gives the net benefit. This is consistent with the net benefit as defined in chapter 4 and as illustrated by the farm budget in tables 4-18 and 4-19, except for any off-farm income the family may receive. The net cash income is determined by subtracting the cash production cost from the sales. The net cash income can be compared later with any incremental water charge or benefit tax levied.
Next a group of imputed values are deducted. The first of these is depreciation. Since the rent recovery index is computed on the basis of one year at full development, depreciation must be deducted as a cost. Then an estimate of the imputed value o f family labor is deducted. This is an estimate of the wage necessary to induce the family to operate its farm. In practice, it is suggested that the analyst take the weighted average of the seasonal market wage as a proxy. Next comes an estimate
Source: Same as table 6-3.
a. May include some payment in kind for labor.b. Since the farmer has few physical assets other than land, no depreciation was assumed.c. An imputed value of management services equivalent to 10 percent of the net benefit less the imputed value of family labor and the allowance for risk and uncertainty rounded to the nearest Rs10. For the with-project situation, this amounts to Rs1,030 rounded to the nearest Rs10 {0.1[21,690 - (1,350 + 10,010)] = 1,033).d. Since the family has few physical assets, no imputed return to the family's own capital was assumed.e. Some studies of farmers' behavior show that a simple approach can be adopted to take account of the farmer's risk aversion. An allowance for risk and uncertainty is estimated based on the coefficient of variation of the gross value of farm production-the standard deviation divided by the mean-and a measure of farmers' risk aversion. The formula used isRA =EVxnxv,where RA is the risk allowance, EV is the expected value, v is the coefficient of variation, and n is a factor that expresses farmers' risk aversion. The studies indicate that the farmers' choice of cropping patterns and production can be predicted for values of n in the interval between 1 and 2 and that n decreases when the farm size increases. For this analysis, it is assumed that n = 1.5 for 5-hectare farms. For the project area, the coefficient of variation of gross returns under rainfed conditions is roughly 30 percent of the average value. It has been assumed that under the with-project conditions, the gross returns would vary within 20 percent of the net returns. The results were rounded to the nearest RS10. Following this approach, the allowance for risk and uncertainty in the with-project situation was estimated to be RSI0,010 rounded to the nearest Rs10 (33,380 x 1.5 x 0.2 = 10,014).f. No general taxes are expected to be levied.g. Economic rent divided by net benefit multiplied by 100. For the incremental net benefit this amounts to 51 percent (8,660 - 16,880 x 100 = 51).h. Incremental direct water charges are Rs258 per hectare of net cultivable area, or Rs1,290 for the 5-hectare farm (258 x 5 = 1,290).i. Incremental benefit taxes include a tax of Rs301 per hectare to recover the capital cost of the supporting works and an incremental land revenue assessment of Rs5 per hectare, or Rs1,530 for the 5-hectare farm [(301 + 5) x 5 = 1,5301.j. Incremental water charges plus incremental benefit taxes.k. Total incremental direct charges and benefit taxes divided by economic rent multi-plied by 100 (2,820 - 8,660 x 100 = 33).of the imputed value of management services. This is a very difficult estimate to reach. In practice, project analysts take an arbitrary amount. A common estimate is 5 to 10 percent of the net benefit. In the Maharashtra project, however, the analyst took 10 percent of the net benefit less the imputed value of family labor and the allowance for risk and uncertainty. The imputed return on own capital is an estimate based on the incremental net value of assets financed by farmers out of their own savings and should reflect the rate of return that their funds could earn elsewhere. In the Maharashtra project, no imputed return on own capital was assumed because the family had relatively few physical assets. Other analysts, however, might at least have imputed a return to the family's own capital invested in land.
The next imputed value deducted is the allowance for risk and uncertainty. This is extremely difficult to formulate conceptually and notoriously difficult to estimate with confidence. Again, most project economists use a rule of thumb-a common one is 10 percent of the gross value of farm production in the first line of the table. The project analyst in the Maharashtra project used a more sophisticated approach. He based his estimate on the standard deviation of farm production in the project area and on an estimated factor that expresses the farmers' risk aversion. (The details of this computation are given in note e of table 6-4.) Most project analysts probably will have some sense of the variability of farm production in the project area for which they are preparing the analysis, and they may even have some more formal estimate such as the standard deviation. This will provide a basis for estimating the allowance for risk and uncertainty, but it will have to be substantially modified in light of the analyst's judgment about the accuracy of the estimate of variability and the willingness of farmers in the project area to accept risk. The last imputed value deducted is an estimate of the general taxes the farmer pays. These are taxes that are not specific to the project as a benefit tax would be. General taxes might include, for example, income taxes or a land tax to raise general revenue that is not linked to the project nor to improvements arising from the project investment.
When all these values have been deducted, the remainder is an estimate of the economic rent (surplus) accruing to the farmer. It is thus an estimate of the surplus remaining for the farmer after paying the rewards necessary to attract the physical inputs, labor, entrepreneurship, and willingness to bear risk necessary to operate the farm-the definition of economic rent above. The economic rent as a percentage of net benefit, the next entry in the table, relates economic rent to the net benefit received by the farmer, which for the incremental net benefit amounts to 51 percent (8,660 - 16,880 x 100 = 51).
Next are entered the proposed incremental water charges and incremental benefit taxes that the farmer is expected to pay. Dividing the total of these by the economic rent gives the rent recovery index. This is an estimate of the proportion of the surplus the farmer receives over and above the minimum necessary to induce him to participate in the project that will be recaptured by the public authorities. In the case of the Maharashtra project, this recovery amounts to 33 percent of the economic rent [(1,290 + 1,530) - 8,660 x 100 = 33].
This discussion of the rent recovery index has highlighted the many elements of the estimate that can be approximate at best. Hence, the rent recovery index, although very useful as an aid for setting cost recovery policy, must be used with caution.
As with the cost recovery index, there are variations of the rent recovery index that give insight into other questions about a project. A common variation is to estimate the rent recovery index for the project (as opposed to that for the beneficiaries, as illustrated in table 6-4). For this the project rent must be estimated. Essentially the same elements are used as discussed above, except that the concept of the incremental benefit tax is expanded to include not only benefit taxes collected directly from the beneficiary but also taxes arising from the incremental output due to the project but collected off the farm. These include, in the case of the Maharashtra project, the excise tax on sugarcane and the sales tax on cotton and oilseeds. In other cases they might include an export tax or the net increase in a marketing board margin (technically, in the monopolistic marketing margin) arising from handling incremental production from the project area. In general, estimates of project rent are made for each major farm pattern, and the results are aggregated to the project level. Since the incremental benefit taxes include taxes and marketing margins arising off the farm, the project rent recovery index will be higher than the weighted average of the beneficiary economic rent received by the individual farmers. In the case of the Maharashtra project, for instance, the rent recovery index for the individual farm pattern analyzed in table 6-4-33 percent-rises to 40 percent for the Bhima scheme as a whole (including pattern farms other than the one represented in table 6-4) because the additional taxes are included.
Another variation of the rent recovery index is to calculate it, for either beneficiaries or the project, on a discounted basis. This provides a means to estimate on the basis of present worth the proportion of the benefit of a project captured by the public authorities. This is useful from a public policy standpoint, but is not a suitable basis on which to determine the level of water charges and benefit taxes at full development. From a public policy standpoint, one can then test varying assumptions about water charges and benefit taxes until a rent recovery index is reached that is considered to be equitable given the income of the farmers in the project and the charges levied elsewhere in the country.
Joint Cost Allocation
When a government undertakes to implement a multipurpose project, a problem arises about how to allocate the cost of the project among the various beneficiaries. The complication arises, of course, because there are joint costs in a multipurpose project, costs that cannot clearly be attributed to one purpose or another. A technique often used to allocate joint cost-especially in multipurpose water development projects, but by no means limited only to them-is that known as the "separable costs-remaining benefits" method.
We will discuss joint cost allocation using market prices and as a financial problem, since this is by far the most common practice. The same techniques we will outline, however, can be applied to economic values, and in some cases this may be more appropriate. In the Senegal River Development Program we will use as an example for joint cost allocation, the prices for agricultural commodities were indeed taken not as the internal administered prices actually paid farmers but as the border prices at world market values-already a step away from strict financial analysis and toward economic values and the use of shadow prices. This was done because the major objective of the analysis was to determine a fair cost allocation among the participating nations, not to determine equitable financial charges to levy on benefiting farmers.
General principles of cost allocation
There are several general principles or guidelines of joint cost allocation that underlie the rationale of the separable costs-remaining benefits method.
In general, no project purpose should be assigned a cost that is in excess of the value of its benefit nor be supported by the benefit of another purpose. Thus, the charge for irrigation water should not be greater than the contribution of that water to the benefit of the project. Similarly, in general we feel that no purpose should be subsidized by another purpose. Power users in most cases should not be charged high rates to make irrigation water available at low cost to farmers.
All the cost incurred for one purpose only should be allocated wholly to that purpose. The cost of canals is wholly allocated to the irrigation purpose, and the cost of the transmission lines wholly to the power purpose. Each "separable cost" is the minimum that can be charged for the respective purpose. If the cost of the canals alone exceeds the benefit from the irrigation water, then clearly the project should not include an irrigation component.
No purpose, however, should be assigned a cost that is any greater than would be incurred if that function were to be supplied by the most economic alternative single-purpose project. The alternative single-purpose project establishes the maximum that can be charged for any one purpose. It is not equitable to allocate to the power component of a
multipurpose water development project a cost more than that of the alternative thermal plant that could provide the same electrical service, nor is it equitable to charge the irrigation component more than the cost of an alternative single-purpose pumping scheme.
Separable costs-remaining benefits method
The application of the separable costs-remaining benefits method is illustrated by the Senegal River Development Program cost allocation in table 6-5. The three West African states of Mali, Mauritania, and Senegal have formed the Senegal River Development Organization (known by the initials of its French name, omvs) to plan and develop a multipurpose project on the Senegal River. In the configuration for which the joint cost allocation is outlined as an example, the project would consist of the multipurpose Manantali Dam on the Bafing River, a major tributary of the Senegal River, to provide a regulated flow; the Diama Dam close to the mouth of the river to prevent upstream intrusion of salty ocean water; a power generation station with associated distribution network at the Manantali Dam; and navigation improvements to permit year-round service to Mali. The benefits of the project are (1) increased production of agricultural crops because of double cropping in the dry season and better water regulation in the wet season, (2) power, and (3) reduced transport costs because of the navigation improvements. [This example is adapted from Riley and others (1978).]
We will follow the analysis line by line. The first part of table 6-5 summarizes the basic information about the project that will be needed to allocate cost. The technical information would be supplied by the engineers and the other technicians; the cost and benefit would be estimated by the technical staff working with the economists.
We begin with the project cost to be allocated (line 1.1). This is the total cost for the project as a whole that is to be allocated among the three purposes. Included are both the construction cost (line 1.1.1), stated at its present worth as of the beginning of the project, and the annual operation and maintenance cost (often abbreviated in project accounts as o&m; line 1.1.2) necessary to operate the project.
The annual project benefit for each purpose is listed and the total of these is entered (line 1.2). In the Senegal River case, the power benefit was assumed to be the amount for which the power could be sold. In most instances, however, the power benefit would be assumed to be the annual cost of providing the same amount of electricity by means of the most economic single-purpose alternative project-always assuming that consumers would purchase electricity at that price. This simplification avoids the problems associated with valuing electricity. It implies that the real benefit of power-whatever that might beis greater than the cost of the single-purpose alternative. The effect of this assumption is to set the maximum that can be charged for power to equal the benefit of the most economic alternative single-purpose project, which is what the analytical technique would do in any case.
Next is listed the alternative cost for each purpose (line 1.3), both for construction, stated at its present worth (line 1.3.1), and for the annual operation and maintenance charge (line 1.3.2). As noted, an alternative cost is the cost of the most economic single-purpose project that could provide one of the same benefits provided by the multipurpose project. An alternative does not have to be located at the multipurpose site, but it should be capable of producing its benefit in essentially the same geographic area as the one in which the benefit from the multipurpose project is to be utilized. The alternative project may be of an entirely different physical nature, as would be the case if the alternatives to a multipurpose river development were pump irrigation and a thermal generating plant. Of course, the most economic single-purpose alternative might cost more than the benefit it would generate; even the most economic alternative might not be justified as a separate project.
Next is the separable cost (line 1.4) given by purpose, both for construction at present worth (line 1.4.1) and for the annual operation and maintenance charge (line 1.4.2). Separable cost is expenditure that could be avoided if one purpose were excluded from the project. It is possible to find that no portion of the joint cost is solely and clearly traceable to a particular purpose. In measuring the separable cost, each purpose should be treated as if it were the last increment added to a project that serves all the other multiple purposes; in this way favoring one purpose over another may be avoided.
In many projects, the annual figures such as those for the operation and maintenance cost and annual benefit in the Senegal River example would not be constant during the life of the project. In these instances, the present worth of the cost or benefit stream would be substituted because that is what is called for in the joint cost allocation in the second part of table 6-5. Indeed, Riley and his colleagues (1978) do treat both operation and maintenance cost and annual benefit in this manner in the report from which this example is drawn.
The discount rate (line 1.5) is either the financing cost of the project if the project is to be constructed using loan funds or the government borrowing rate if the project is to be financed from allocations in the current government budget.
The project life (line 1.6) and the length of the construction period (line 1.7) are part of the technical data supplied by those responsible for designing the project. Carrying out the analysis for a very long period, however, has little meaning because of the very small present worth of values assumed in the distant future. In the Senegal River project, for example, the physical facilities would probably last much longer than the thirty-year period chosen for analysis, but extending the period of analysis would hardly affect the joint cost allocation.
The last part of tabulating the basic information for the joint cost allocation is to derive the factors for converting between annual values and present worth. The factor to convert annual cost or benefit to present worth (the present worth of an annuity factor; line 1.8) is computed for the discount rate as indicated. (The method of deriving the present worth
of an annuity factor for a period beginning in the future is discussed in chapter 9, under "The Time Value of Money. Present worth of a stream of future income.") The factor to convert present worth of cost or benefit to annual cost (capital recovery factor) for a period beginning some time in the future (line 1.9) cannot be computed directly from the capital recovery factors given in standard tables in a manner similar to the computation of the present worth of an annuity factor. This problem may be avoided, however, by taking advantage of the fact that the capital recovery factor for any period is the reciprocal of the present worth of an annuity factor for that period. Thus, we find that the capital recovery factor for the tenth through the thirtieth year at 10 percent is 0.272 636 (1 - 3.667 890 = 0.272 636).
CFAF African Financial Community francs.Source: Adapted from Riley and others (1978).a. o&m Operation and maintenance cost.b. The annual cost does not exactly equal the allocated cost times the capital recovery factor because of rounding.
The second part of table 6-5 lays out the computation of the joint cost allocation. Note that all values (except the distribution percentages) are stated in their present worth equivalents.
The cost to be allocated (line 2.1) is the total cost of the project, obtained by adding the construction cost at present worth (line 2.1.1), taken from line 1.1.1, and the present worth of the operation and maintenance cost for the project (line 2.1.2), computed by taking the value of CFAF449 million supplied in line 1.1.2 and multiplying it by the present worth of an annuity factor for the tenth through the thirtieth years, which gives CFAF1,647 million (449 x 3.667 890 = 1,647). (The symbol for African
Financial Community francs is CFAF.) It is this cost that is to be allocated among the various purposes.
The benefit (line 2.2) is the annual project benefit given in line 1.2 multiplied by the present worth of an annuity factor for the tenth through the thirtieth years. Thus, the present worth of the irrigation benefit stream over the life of the project is CFAF94,290 million (25,707 x 3.667 890 = 94,290).
The alternative cost (line 2.3) lists the total costs for the most economic alternative single-purpose projects with the same benefit as the appropriate components of the multipurpose project. The subentries that are added for the total are taken from the first part of the table: the alternative construction cost (line 2.3.1) is given in line 1.3.1; the operation and maintenance cost for the alternative single-purpose projects (line 2.3.2) is taken from the annual operation and maintenance cost in line 1.3.2 and is converted to present worth using the present worth of an annuity factor.
The justifiable expenditure for each purpose (line 2.4) is either the benefit on line 2.2 or the total alternative cost on line 2.3, whichever is less. The sum of the justifiable expenditure for the various purposes is the total justifiable expenditure for the multipurpose project; this amount is entered in the total column of line 2.4. We noted this earlier: the amount to be allocated to a particular purpose is limited on the one hand by the benefit it will produce and on the other hand by the cost of the most economic single-purpose alternative.
The separable cost (line 2.5) is taken from the first part of the table. The separable construction cost for each purpose (line 2.5.1) comes from line 1.4.1. The present worth of the separable annual operation and maintenance cost (line 2.5.2) is derived by multiplying the value in line 1.4.2 by the present worth of an annuity factor. The separable cost is then totaled. In general, the total separable cost for each purpose will be the minimum allocation that will be charged to that purpose.
To determine the remaining justifiable expenditure (line 2.6) for each purpose and for the project as a whole, the separable cost of each purpose given in line 2.5 is deducted from the justifiable expenditure given in line 2.4. In the case of the irrigation purpose, for example, the separable cost of CFAF5,696 million is subtracted from the justifiable expenditure of CFAF16,678 million, and this leaves a remaining justifiable expenditure of CFAF10,982 million (16,678 - 5,696 = 10,982). Of course, if the value for any purpose is negative, it means that the present worth of the benefit at the discount rate being used is less than the present worth of the cost. If one purpose is not to subsidize another, then any purpose with a negative justifiable expenditure should be omitted from the project.
The percentage distribution of the remaining justifiable expenditure in line 2.6 is calculated and entered in line 2.7.
Now we must calculate the remaining joint cost for each purpose (line 2.8). This is done by allocating the joint cost of the project to each purpose in proportion to the excess over the separable cost that we would be justified in spending to realize the benefit from each purpose. We begin by determining the total remaining (joint) construction cost in the last column of line 2.8.1. To do this, the total separable construction cost for the entire project in the last column of line 2.5.1 is subtracted from the total construction cost for the entire project in line 2.1.1 to give the total remaining joint construction cost of CFAF22,679 million, which then is entered in the last column of line 2.8.1 (41,464 - 18,785 = 22,679).
Similarly, the total remaining (joint) operation and maintenance cost in the last column of line 2.8.2 is determined by subtracting the separable operation and maintenance cost in line 2.5.2 from the total operation and maintenance cost in line 2.1.2. This gives a value of CFAF770 (1,647 - 877 = 770). These totals are then allocated to the various purposes according to the percentage distribution of the remaining justifiable expenditure in line 2.7. Thus, the remaining construction cost for irrigation is 28.70 percent of CFAF22,679, or CFAF6,509 (22,679 x 0.2870 = 6,509), and the remaining operation and maintenance cost for power is 27.78 percent of CFAF770, or CFAF214 (770 x 0.2778 = 214). The total of the remaining joint cost for each purpose is the sum of the remaining joint cost for construction (line 2.8.1) and operation and maintenance cost (line 2.8.2).
The total allocated cost (line 2.9) may now be determined. The total allocated construction cost (line 2.9.1) for each purpose is determined by adding the separable construction cost for that purpose in line 2.5.1 to the remaining joint construction cost in line 2.8.1. Thus, the total allocated construction cost for the irrigation component is CFAF12,003 million-(5,494 + 6,509 = 12,003). Similarly, the total allocated operation and maintenance cost for each purpose (line 2.9.2) is the sum of the separable operation and maintenance cost for that purpose in line 2.5.2 and the remaining joint operation and maintenance cost in line 2.8.2. Hence, the total allocated operation and maintenance cost for the irrigation purpose is CFAF423 million (202 + 221 = 423). The sum of the total allocated construction cost for each purpose and the total allocated operation and maintenance cost for each purpose is the total allocated cost for each purpose. Of course, the total allocated cost in the last column of line 2.9 must equal the total cost to be allocated in the last column of line 2.1, and this provides an internal check on the calculations.
The third part of table 6-5 gives the annual costs. The annual cost (line 3.1) for each purpose is determined by multiplying the total allocated cost in line 2.9 by the capital recovery factor for the tenth through the thirtieth year at 10 percent as computed in the first part of the table. Thus, the annual cost for navigation is determined by multiplying the total allocated cost by the capital recovery factor to obtain the annual cost of CFAF5,002 million (18,347 x 0.272 636 = 5,002). Because of rounding, the annual costs for irrigation and power do not quite check when calculated in this manner. In table 6-5 the total annual cost (line 3.1) is shown as the total of the annual construction and annual operation and maintenance costs. The annual construction cost (line 3.1.1) and the annual operation and maintenance cost (line 3.1.2) may be determined separately as explained above. Thus, the annual construction cost for irrigation is CFAF3,272 million (12,003 x 0.272 636 =
3,272), and the annual operation and maintenance cost chargeable to irrigation is CFAF115 million (423 x 0.272 636 = 115). An equitable annual charge for the use of irrigation water in the project would thus be CFAF3,387 million, of which CFAF3,272 million would go toward the construction cost and CFAF115 million would be for operation and maintenance cost (3,272 + 115 = 3,387). If it were determined that the governments were to bear the capital cost of irrigation and the farmers to pay only the operation and maintenance cost, the farmers would have to pay only the CFAF115 million annual operation and maintenance charge. (In the Senegal River project, there would be additional cost to bring the water from the river to the fields, but this falls outside the project cost as such.)
Note that the separable costs-remaining benefits method when calculated using market prices only specifies what would be an equitable financial charge using as a sole criterion the cost incurred for each purpose and the benefit generated by each purpose. What the beneficiaries actually will be charged depends on many other considerations, as noted in the previous section on cost recovery. Sometimes, for example, the capital cost for irrigation will be assumed by the treasury and be paid from general tax revenues, but farmers will be assessed enough to pay for the operation and maintenance cost. Other services may also not be charged precisely the amounts the separable costs-remaining benefits method indicates as equitable. Often, for example, no charge is levied for flood control benefits that are paid for from the general revenue, and it is likely that power users will be charged the prevailing rate for the area served by the multipurpose project and not the rate determined by the annual cost of the project power component.
We have covered the primary elements of joint cost allocation in this discussion. Readers who wish to go further might consult the report prepared by Riley and his group (1978) from which the Senegal River example is drawn; the report includes variations on the allocation method outlined here as well as interesting discussions of valuing benefit and allocating cost equitably between countries. A more extensive discussion of joint cost allocation will be found in James and Lee (1970), and Loughlin (1977) proposes a modification of the separable costs-remaining benefits methodology to increase the equity by applying weights for the relative amounts of the separable cost assigned to each purpose.
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