## 1. The Compact of Free Association

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### Fiscal challenges
- Heavy reliance on external grants, particularly Compact grants:
  - On-budget grants averaged 21 percent of GDP and represented 52¾ percent of total fiscal revenues during fiscal years FY2000–12.
  - Compact grants were renewed in FY2010, but are scheduled to end in FY2024.
  - Total assistance under the renewed agreement, including advances, will amount to US$229 million (98½ percent of FY2012 GDP) by FY2024.
- Post-FY2024 financing needs:
  - Fiscal expenditure will need to be financed mainly by government domestic revenue and deposits, and withdrawals from the Compact Trust Fund (CTF).
- CTF and withdrawal rules:
  - Under the original Compact: US$70 million were provided to establish the CTF (US$66 million in FY1995 and US$4 million in FY1997).
  - Once the renewed agreement enters into force, the United States will contribute additional US$30.25 million to the CTF over 9–10 years.
  - Palau will be allowed to gradually increase annual withdrawals from US$5 million to US$13 million in FY2023, and to withdraw US$15 million from FY2024 through FY2044.
- Revenue-side challenges:
  - Volatility from tourism-related taxes (including departure-tax collections).
  - Low collection: income tax and goods and services tax as percent of GDP are among the lowest in the region.
  - Identified weaknesses: double taxation of exports; effective tax rates that differ significantly between firms with similar profits; gaps in the tax base.
  - Table 1 (Tax Revenue in Pacific Islands Countries) shows Palau total tax revenue at 17.4 percent of GDP with Income Taxes 3.2, Domestic Goods and Services Taxes 6.9, International Trade Taxes 4.2, Other 3.0 (all in percent of GDP).
- Expenditure-side challenges:
  - High wage bill: about half of fiscal expense goes to the wage bill.
  - Wage bill ratios: wage bill-to-revenue was 43¾ percent of total revenue and 92½ percent of total revenue excluding grants (domestic revenue) during FY2000–12.
- Fiscal buffers, budget execution, and payables:
  - Budget execution based on appropriations rather than cash availability has led to drawdowns of government domestic deposits and/or accumulation of accounts payable.
  - Domestic accounts payables doubled from about 7 percent of GDP on average during FY2000–08 to 15 percent in FY2010; remained high at 11 percent of GDP in FY2013.
  - Government initial net worth at end FY2013 estimated at 60½ percent of GDP: CTF 77 percent of GDP, government domestic deposits 5 percent of GDP, domestic accounts payable 11 percent of GDP, government external debt 10½ percent of GDP.
- Public external borrowing:
  - AsDB loans: US$16 million in FY2012 (7 percent of FY2012 GDP); additional US$28.8 million approved in FY2014 (12½ percent of FY2012 GDP).
  - AsDB expected disbursements: US$35 million throughout FY2014–22 under infrastructure loans; potential negotiations with AsDB and World Bank for fiber optic project.

### Achieving long-term fiscal sustainability — framework and assumptions
- Analytical framework: government’s intertemporal budget constraint W + G + R = C + K, where:
  - W = government’s net worth,
  - G = NPVs of grants,
  - R = NPVs of domestic revenue,
  - C = NPVs of fiscal expense (current spending),
  - K = NPVs of net acquisition of non-financial assets.
- Policy variable: current balance excluding grants (R-C).
- Exogenous/inherited variables: W, G, K.
- Government initial net worth components (end FY2013): CTF 77 percent of GDP; government domestic deposits 5 percent of GDP; domestic accounts payable 11 percent of GDP; government external debt 10½ percent of GDP; net worth 60½ percent of GDP.
- Key model assumptions:
  - Nominal GDP growth: 4 percent (real GDP growth: 2 percent).
  - CTF nominal rate of return: 6 percent (real rate of return: 4 percent). Average annual return was 5¾ percent during FY2000–12 and 8 percent since the trust fund’s inception in 1995.
  - U.S. Compact grants: US$146.2 million over FY2014–24 (total direct assistance of US$229 million minus advances of US$52.5 million received during FY2010–13 and US$30.25 million in contributions to the CTF).
  - Annual drawdown from the CTF: gradual increase from US$5 million to US$13 million during FY2014–23, US$15 million during FY2024–44, and 1¾ percent of GDP thereafter.
  - Other U.S. grants: US$170 million over FY2014–24, and 4½ percent of GDP thereafter.
  - Other country grants: 4½ percent of GDP.
  - Acquisition of non-financial assets: ranges between 6¾–9¾ percent of GDP in FY2014–25, and 9 percent of GDP thereafter.

### Findings and recommended adjustment
- Required adjustment:
  - Reducing the current deficit excluding grants (R-C) by 7¾–8½ ppt of GDP would ensure Palau’s fiscal sustainability if implemented between FY2014 and FY2023.
  - Trade-off: longer adjustment period reduces achievable net worth and thus lowers the sustainable deficit that can be financed.
- Recommended path:
  - Gradual reduction of the current deficit excluding grants by 8.1 ppt of GDP during FY2014–19 (average annual reduction 1.35 ppt) is recommended as most appropriate given vulnerability to external shocks.
  - Fiscal adjustment in FY2014 is projected to be 1½ ppt of GDP; FY2015–19 adjustment should average about 1¼ ppt a year.
- Scenarios of adjustment (selected figures):
  - Immediate (Years of adjustment: 1; Total reduction in R-C (ppt of GDP): 7.7; Annual reduction in R-C (ppt of GDP): 7.70; Sustainable R-C (percent of GDP): 4.6; Sustainable overall deficit by FY2043 (percent of GDP): 2.6; Sustainable net worth (W) by FY2043 (percent of GDP): 139.3).
  - Gradual (Years of adjustment: 6; Total reduction in R-C (ppt of GDP): 8.1; Annual reduction in R-C (ppt of GDP): 1.35; Sustainable R-C (percent of GDP): 4.2; Sustainable overall deficit by FY2043 (percent of GDP): 2.3; Sustainable net worth (W) by FY2043 (percent of GDP): 120.1).
  - Minimum (Years of adjustment: 10; Total reduction in R-C (ppt of GDP): 8.4; Annual reduction in R-C (ppt of GDP): 0.84; Sustainable R-C (percent of GDP): 3.9; Sustainable overall deficit by FY2043 (percent of GDP): 2.0; Sustainable net worth (W) by FY2043 (percent of GDP): 104.2).
- Outcomes of the recommended gradual adjustment (FY2014–19, total 8.1 ppt):
  - Current fiscal deficit excluding grants reduced to 4¼ percent of GDP by FY2019.
  - Government builds up deposits during FY2019–25 as overall balance remains in surplus until FY2025.
  - After FY2025, overall balance switches into deficit due to expiration of Compact grants and gradually increases until reaching a sustainable level of 2¼ percent of GDP in FY2043.
  - Government’s net worth projected to reach about 105½ percent of GDP in FY2024 and increase to about 120 percent of GDP in the long run.

### Policy implications and priorities
- Fiscal consolidation is critical to:
  - Build fiscal buffers and ensure long-term fiscal sustainability by FY2024 when Compact grants expire.
  - Maintain adequate capital expenditure to support long-term growth.
  - Provide fiscal space to respond to downside risks given absence of monetary and exchange rate policy tools.
- Areas for policy action:
  - Comprehensive revenue reforms to raise domestic revenue and reduce reliance on volatile tourism-related taxes (e.g., strengthen income tax and goods and services tax bases).
  - Expenditure reforms to contain the wage bill and improve efficiency of public spending.
  - Improvements in public finance management to strengthen budget execution, avoid drawdowns of deposits, and reduce domestic accounts payable.
  - Strong governance of externally financed infrastructure projects and debt management given large loans from development partners.

*International Monetary Fund (April 7, 2014) — “1. The Compact of Free Association”*

### Robustness and sensitivity

### Sensitivity of adjustment estimate
- The estimated required annual fiscal adjustment is "1.35."
- Lower rates of return and lower valuations of the government’s initial net worth (for example, to reflect new external debt and/or to include public enterprise debt) increase the required annual fiscal adjustment.
- Higher real GDP growth rates and inflation also increase the needed adjustment.
- Overall, reasonable variations in these parameters have fairly small impacts on the estimated annual fiscal adjustment of 1.35.

### Policy implications: broad overview
- Long-term fiscal sustainability can be secured by pursuing fiscal consolidation over the medium term.
- Adjustment can be achieved through lower fiscal expense (C), higher taxes (R), or a combination.
- Raising domestic revenue (R) during the adjustment period reduces the necessary fiscal expense (C) cuts.
- Anchoring fiscal policies on the adjustment path would isolate the budget from tourism revenue volatility and build adequate fiscal buffers.

### Revenue reforms: recommended priorities
- FAD and PFTAC recommended priorities:
  - Replacing the gross revenue tax (GRT) and existing import taxes with a single-rate VAT with no exceptions except for exports.
  - Moving to c.i.f. valuation for imports.
  - Raising the net income tax (NIT) for financial institutions.
  - Expanding NIT to all taxpayers registered for VAT.
  - Reducing the wage and salary tax rate for low income households to offset potential adverse impacts of price increases from VAT adoption.
  - Improving revenue administration capacity.
- Intermediate actions if full reform not feasible immediately:
  - Remove import tax exemptions.
  - Move to c.i.f. valuation.
  - Apply an excise equivalent to import taxes on local production of excisable goods.
  - Increase the NIT rate for financial institutions.

### Revenue reform quantitative impacts (FY2014–19)
- Tax reforms, including Value Added Tax and Net Income Tax: 3.5 (ppt. of GDP)
- Improvement in nontax administration: 0.5 (ppt. of GDP)
- Combined revenue and nontax measures: implied 4.0 (ppt. of GDP)

### Expense reforms: priorities and quantitative impacts
- Containing fiscal expense is critical; the wage bill-to-revenue ratio is high relative to other Pacific Island Countries.
- Top priority: contain wage bill growth below the inflation rate to reduce fiscal expense and protect capital spending.
- Recommended actions:
  - Undertake a well-planned civil service reform.
  - Enforce mandatory retirement.
  - Retrain civil servants to improve public service delivery effectiveness and efficiency.
- Quantitative impact FY2014–19:
  - Civil service reforms (expense reduction): 4.0 (ppt. of GDP)

### Combined impact of reforms (FY2014–19)
- Revenue measures (tax reform + nontax admin): 3.5 + 0.5 = total 4.0 (ppt. of GDP)
- Expense measures (civil service reforms): 4.0 (ppt. of GDP)
- Total impact reported: 8.0 (ppt. of GDP)

### Public financial management, debt, and buffers
- Need for sustained improvements in public finance management to support medium-term consolidation.
- Budget reserve fund established to manage increasing government deposits over the medium term; requires accountable, transparent, and prudent management.
- Given disbursements of new infrastructure loans:
  - Sound public debt management and strong governance of infrastructure projects needed to ensure debt sustainability and minimize fiscal risks.
- Grant disbursements under the Compact’s fiscal consolidation fund should help reduce domestic account payables.
- Authorities should strengthen budget execution and planning to prevent buildup of payables.
- Adoption of a medium-term budget framework is needed to formulate multiyear fiscal policies and strengthen fiscal discipline and transparency.

### Box 2: Technical assistance recommendations for comprehensive tax reform (summary of measures)
- Move to c.i.f. valuation for imports.
- Replace GRT and import taxes with a VAT having these features:
  - A single rate of VAT in the range of 10 to 15 percent.
  - Exemptions kept to a minimum; exports zero-rated.
  - All government institutions and public enterprises subject to VAT.
  - Businesses with turnover of more than US$300,000 required to register for VAT.
  - Other businesses with turnover exceeding US$100,000 can register if they meet record keeping requirements.
- Reduce wage and salary tax rates for low income households to improve fairness and offset VAT effects.
- Increase NIT rate for financial institutions to around 20 percent.
- Expand NIT to all taxpayers registered for VAT; a rate of around 20 percent is suggested.
- Retain current GRT arrangements for international airlines until VAT and NIT impacts are understood.
- Introduce a simple, low rate turnover tax for smaller businesses.
- Exempt micro businesses with turnover less than US$40,000 from turnover tax, subject to payment of a business license.

*Source: Fund staff estimates.*

### Tourism sector: contributions, vulnerabilities, and policy priorities

### Factors affecting tourism performance
- Flight routes: direct flight availability strongly affects tourist arrivals.
- Hotel capacity and infrastructure:
  - Hotels operate at nearly full capacity (around 1,400 rooms), constraining tourism growth and raising hotel rates.
  - Two new hotels are expected to start operation in FY2014.
  - Infrastructure bottlenecks have hampered new hotel development; upcoming improvements include water and sanitation projects, faster internet connection, and ongoing airport renovation.
- Business climate: restrictions on foreign investment and complex licensing arrangements hinder hotel development.
- Exchange rate: depreciation of Asian currencies against the U.S. dollar (Palau’s legal tender) made Palau more expensive for Asian tourists; historical inverse correlation between number of tourists and Palau’s REER.
- Tourist spending: spending per tourist has remained flat over the past decade.
- External influences: Asia’s economic conditions and international food and fuel prices affect tourism demand and domestic inflation.

### Economic role of tourism: contributions and vulnerabilities
- Contribution to growth and GDP:
  - Tourism activities contributed to about three quarters of Palau’s economic growth; non-tourism activities contributed the remaining ¼.
  - Tourism-related industries contributed around 4½ percentage points of the 5½ percent growth in real GDP in FY2012, or 3.6 percentage points of the 5.2 percent growth in FY2011.
  - In FY2013, without tourism-related activities, growth would have been lower than -0.2 percent.
- Trade and external sector:
  - Exports of travel services account for more than 80 percent of exports of goods and services.
  - Tourism-linked imports (mainly food and fuel) amount to 30 percent of GDP.
- Fiscal impact:
  - Two main direct taxes related to tourism: traveler’s head (departure) tax and hotel occupancy tax.
  - Share of these two taxes to total tax revenue increased from nearly 9 percent in FY2003 to around 15 percent in FY2013.
- Employment:
  - More than 40 percent of total employment is in tourism-related activities.
  - Foreign workers make up around 50 percent of total employment.
- Reliance and risks:
  - Tourism receipts stand above 50 percent of GDP, higher than other countries except Maldives.
  - Palau is second behind Maldives in tourism receipts per visitor.
  - Heavy dependence on tourism creates volatility, high import dependence, vulnerability to currency appreciation, economic slowdowns in Asia, and natural disasters or environmental accidents.
  - Recommendation: promote diversification within and outside tourism to reduce volatility, support growth, and build buffers.

### Empirical estimation: impact of tourism on income (Box 1)
- Panel fixed effect model (countries: Palau, Maldives, Fiji, Samoa, Tonga, Vanuatu, Federated States of Micronesia; period 2000-13) with variables in logs:
  - Dependent variable: YPCP = per capita income.
  - Regressors: GOV, OPEN, T_PCP, T_EXP, INFL, INR.
- Key parameter estimates and statistics:
  - Constant 2.21
  - GOV 0.04
  - OPEN 0.12
  - T_PCP 0.45 ***
  - T_EXP 0.28 ***
  - INFL 0.64 *
  - INR 0.44 **
  - R-squared 0.998
  - Adjusted R-squared 0.997
  - Number of observations 98
  - Asterisks indicate the p-values: * p-value<0.1, ** p-value<0.05, *** p-value<0.01
- Interpretations:
  - A one percent increase in tourist arrivals, holding other factors constant, would lead to ½ percent increase in per capita income.
  - A one percent increase in spending per tourist contributes to ¼ percent increase in income.
  - Both quantity and quality (spending) of tourists matter for growth.

### Cross-country comparisons and constraints
- Palau ranks:
  - Receipts from tourism above 50 percent of GDP, higher than peers except Maldives.
  - Second behind Maldives in tourism receipts per visitor.
  - Slightly behind Maldives and Vanuatu in tourism contribution to GDP.
  - Highest in travel exports as a share of total exports of goods and services.
  - Tourism contribution to employment comparable to Vanuatu and Maldives.
  - Limited number of hotel rooms compared to peers, constraining tourism growth.

### Policy recommendations to promote tourism and private sector development
- Diversify within tourism:
  - Expand attractions beyond diving (eco-tourism, aquatic sports, golf) to increase length of stay and spending.
  - Promote ecotourism and terrestrial attractions, particularly in the underdeveloped Big Island.
  - Diversify tourist origins: promote arrivals from China, Southeast Asia, Russia, and Europe; adapt hospitality and services.
  - Attract higher-income tourists to reduce environmental strain while maintaining or increasing tourism revenue; creation of the Bureau of Tourism noted as positive.
- Diversify outside tourism while keeping tourism central:
  - Develop agriculture, aquaculture, and fishery to supply hotels and restaurants and reduce food imports (constraints include small share of agriculture and forestry <2 percent of GDP, complex land ownership, limited labor).
  - Move up the value chain: increase domestic production and distribution of tourism-related goods and services.
  - Expand the service industry using improved internet connectivity (call services, conferences/conventions).
  - Improve education system to match graduates' skills with service sector employment.
- Address binding constraints:
  - Preserve macroeconomic and financial stability.
  - Address infrastructure bottlenecks (water, sanitation, internet, airport).
  - Improve business and investment climate to attract private investment.

*Source: IMF staff report excerpt on Palau tourism sector and economic role.*

### Macroeconomic and financial stability, and structural reforms

### Role and needs
- Preserving macroeconomic and financial stability and fiscal sustainability is essential to support diversification and private sector development.
- Successful tax and expenditure reforms over the medium term would help achieve fiscal consolidation and debt sustainability.
- Given absence of monetary policy, prudent fiscal policy would contribute to low inflation and stable external balances.
- Financial sector constraints:
  - Banks provide limited domestic credit and place most assets abroad due to credit risks, limited domestic investment opportunities, and inadequate capacity by small businesses to prepare financial plans and statements.
- Institutional steps:
  - Establishment of the Economic Advisory Group and the Small Business Development Center to address coordination and small-business capacity challenges.

### Structural reforms to complement stability and promote diversification
- Infrastructure bottlenecks:
  - Development of new hotels requires water and sanitation systems, road network improvements, aviation connectivity, telecommunications upgrades, and enhanced medical services.
- Business and investment climate:
  - Doing Business rank improved from 114 to 100 in 2014.
  - Palau’s performance is slightly behind Maldives and significantly behind Vanuatu and Fiji, indicating scope for improvement in investor protection, contract enforcement, and starting a business.
- Small business support:
  - The Small Business Development Center assists small businesses and new entrepreneurs with financial statements and loan application preparation.

### Doing Business indicators and 2014 rankings (out of 189 countries)
- Overall "Ease of Doing Business": Palau 100, Maldives 95, Vanuatu 74, Fiji 62
- Starting a Business: Palau 129, Maldives 71, Vanuatu 112, Fiji 61
- Dealing with Construction Permits: Palau 45, Maldives 18, Vanuatu 50, Fiji 74
- Getting Electricity: Palau 78, Maldives 13, Vanuatu 112, Fiji 98
- Registering Property: Palau 20, Maldives 16, Vanuatu 111, Fiji 63
- Getting Credit: Palau 86, Maldives 10, Vanuatu 95, Fiji 55
- Protecting Investors: Palau 178, Maldives 80, Vanuatu 80, Fiji 52
- Paying Taxes: Palau 84, Maldives 11, Vanuatu 53, Fiji 88
- Trading Across Borders: Palau 96, Maldives 13, Vanuatu 81, Fiji 111
- Enforcing Contracts: Palau 141, Maldives 90, Vanuatu 72, Fiji 63
- Resolving Insolvency: Palau 96, Maldives 40, Vanuatu 57, Fiji 50

### Tourism-related challenges and policy priorities (high-level)
- Limited hotel capacity:
  - Policy: Promote development of new hotels, particularly the high end, by addressing infrastructure bottlenecks and improving investment and business climate.
- Flat spending per tourist:
  - Policy: Diversify tourist attractions and attract tourists from wealthier countries to increase stay and spending.
- Reliance on few markets and direct flights:
  - Policy: Promote tourism from, and increase flight connectivity with, new countries.
- Heavy reliance on imports of food and fuel:
  - Policy: Develop domestic supply chains for the tourism industry (environmentally friendly agriculture, aquaculture, fishing).
- Heavy reliance on tourism for growth:
  - Policy: Diversify sources of growth outside tourism and increase domestic share of tourism-related operations.

*Source: INTERNATIONAL MONETARY FUND — excerpted content.*

### 1.  The Compact of Free Association _______________________________________________________ 3

### 1.  The Compact of Free Association

### Fiscal challenges

- Palau relies heavily on external grants, particularly Compact grants, to finance fiscal expenditure.
  - On-budget grants averaged 21 percent of GDP and represented 52¾ percent of total fiscal revenues during fiscal years FY2000–12.
  - Compact grants were renewed in FY2010, but are scheduled to end in FY2024.
  - Total assistance under the renewed agreement, including advances, will amount to US$229 million (98½ percent of FY2012 GDP) by FY2024.
- As Compact grants expire in FY2024, fiscal expenditure will need to be financed mainly by:
  - government domestic revenue and deposits, and
  - withdrawals from the Compact Trust Fund (CTF).
- CTF and withdrawal rules:
  - Under the original Compact: US$70 million were provided to establish the CTF (US$66 million in FY1995 and US$4 million in FY1997).
  - Once the renewed agreement enters into force, the United States will contribute additional US$30.25 million to the CTF over 9–10 years.
  - Palau will be allowed to gradually increase annual withdrawals from US$5 million to US$13 million in FY2023, and to withdraw US$15 million from FY2024 through FY2044.
- Revenue-side challenges:
  - Volatility: Continued and increased reliance on tourism-related taxes (including departure-tax collections) contributes to revenue volatility and vulnerability to external shocks.
  - Low collection: Income tax and goods and services tax as percent of GDP are among the lowest in the region, indicating potential areas to raise revenue.
  - Recent IMF and PFTAC TA identified weaknesses: double taxation of exports, effective tax rates that differ significantly between firms with similar profits, and gaps in the tax base that distort activity and lead to unfair outcomes.
  - Table 1 (Tax Revenue in Pacific Islands Countries) shows Palau total tax revenue at 17.4 percent of GDP with Income Taxes 3.2, Domestic Goods and Services Taxes 6.9, International Trade Taxes 4.2, Other 3.0 (all in percent of GDP).
- Expenditure-side challenges:
  - High wage bill: About half of fiscal expense goes to the wage bill.
  - Wage bill ratios: wage bill-to-revenue was 43¾ percent of total revenue and 92½ percent of total revenue excluding grants (domestic revenue) during FY2000–12.
  - High wage bill-to-expenditure relative to PIC average (figures shown in source).
- Fiscal buffers, budget execution, and payables:
  - Budget execution based on appropriations rather than cash availability has led to drawdowns of government domestic deposits and/or accumulation of accounts payable.
  - Domestic accounts payables doubled from about 7 percent of GDP on average during FY2000–08 to 15 percent in FY2010; remained high at 11 percent of GDP in FY2013.
  - Government initial net worth at end FY2013 estimated at 60½ percent of GDP: CTF 77 percent of GDP, government domestic deposits 5 percent of GDP, domestic accounts payable 11 percent of GDP, government external debt 10½ percent of GDP.
- Public external borrowing:
  - AsDB loans: US$16 million in FY2012 (7 percent of FY2012 GDP); additional US$28.8 million approved in FY2014 (12½ percent of FY2012 GDP).
  - AsDB expected disbursements: US$35 million throughout FY2014–22 under infrastructure loans; potential negotiations with AsDB and World Bank for fiber optic project.

### Achieving long-term fiscal sustainability — framework and assumptions

- Analytical framework: government’s intertemporal budget constraint W + G + R = C + K, where:
  - W = government’s net worth,
  - G = NPVs of grants,
  - R = NPVs of domestic revenue,
  - C = NPVs of fiscal expense (current spending),
  - K = NPVs of net acquisition of non-financial assets.
- Policy variable: current balance excluding grants (R-C).
- Exogenous/inherited variables: W, G, K.
- Government initial net worth components (end FY2013): CTF 77 percent of GDP; government domestic deposits 5 percent of GDP; domestic accounts payable 11 percent of GDP; government external debt 10½ percent of GDP; net worth 60½ percent of GDP.
- Key model assumptions:
  - Nominal GDP growth: 4 percent (real GDP growth: 2 percent).
  - CTF nominal rate of return: 6 percent (real rate of return: 4 percent). Average annual return was 5¾ percent during FY2000–12 and 8 percent since the trust fund’s inception in 1995.
  - U.S. Compact grants: US$146.2 million over FY2014–24 (total direct assistance of US$229 million minus advances of US$52.5 million received during FY2010–13 and US$30.25 million in contributions to the CTF).
  - Annual drawdown from the CTF: gradual increase from US$5 million to US$13 million during FY2014–23, US$15 million during FY2024–44, and 1¾ percent of GDP thereafter.
  - Other U.S. grants: US$170 million over FY2014–24, and 4½ percent of GDP thereafter.
  - Other country grants: 4½ percent of GDP.
  - Acquisition of non-financial assets: ranges between 6¾–9¾ percent of GDP in FY2014–25, and 9 percent of GDP thereafter.

### Findings and recommended adjustment

- Required adjustment:
  - Reducing the current deficit excluding grants (R-C) by 7¾–8½ ppt of GDP would ensure Palau’s fiscal sustainability if implemented between FY2014 and FY2023.
  - Trade-off: longer adjustment period reduces achievable net worth and thus lowers the sustainable deficit that can be financed.
- Recommended path:
  - Gradual reduction of the current deficit excluding grants by 8.1 ppt of GDP during FY2014–19 (average annual reduction 1.35 ppt) is recommended as most appropriate given vulnerability to external shocks.
  - Fiscal adjustment in FY2014 is projected to be 1½ ppt of GDP; FY2015–19 adjustment should average about 1¼ ppt a year.
- Scenario table (Scenarios of Adjustment in Current Fiscal Balance Excluding Grants (R-C)):
  - Immediate (Years of adjustment: 1; Total reduction in R-C (ppt of GDP): 7.7; Annual reduction in R-C (ppt of GDP): 7.70; Sustainable R-C (percent of GDP): 4.6; Sustainable overall deficit by FY2043 (percent of GDP): 2.6; Sustainable net worth (W) by FY2043 (percent of GDP): 139.3).
  - Gradual (Years of adjustment: 6; Total reduction in R-C (ppt of GDP): 8.1; Annual reduction in R-C (ppt of GDP): 1.35; Sustainable R-C (percent of GDP): 4.2; Sustainable overall deficit by FY2043 (percent of GDP): 2.3; Sustainable net worth (W) by FY2043 (percent of GDP): 120.1).
  - Minimum (Years of adjustment: 10; Total reduction in R-C (ppt of GDP): 8.4; Annual reduction in R-C (ppt of GDP): 0.84; Sustainable R-C (percent of GDP): 3.9; Sustainable overall deficit by FY2043 (percent of GDP): 2.0; Sustainable net worth (W) by FY2043 (percent of GDP): 104.2).
- Outcomes of the recommended gradual adjustment (FY2014–19, total 8.1 ppt):
  - Current fiscal deficit excluding grants reduced to 4¼ percent of GDP by FY2019.
  - Government builds up deposits during FY2019–25 as overall balance remains in surplus until FY2025.
  - After FY2025, overall balance switches into deficit due to expiration of Compact grants and gradually increases until reaching a sustainable level of 2¼ percent of GDP in FY2043.
  - Government’s net worth projected to reach about 105½ percent of GDP in FY2024 and increase to about 120 percent of GDP in the long run, providing an adequate fiscal buffer.

### Policy implications and priorities

- Fiscal consolidation is critical to:
  - Build fiscal buffers and ensure long-term fiscal sustainability by FY2024 when Compact grants expire.
  - Maintain adequate capital expenditure to support long-term growth.
  - Provide fiscal space to respond to downside risks given absence of monetary and exchange rate policy tools.
- Areas for policy action:
  - Comprehensive revenue reforms to raise domestic revenue and reduce reliance on volatile tourism-related taxes (e.g., strengthen income tax and goods and services tax bases).
  - Expenditure reforms to contain the wage bill and improve efficiency of public spending.
  - Improvements in public finance management to strengthen budget execution, avoid drawdowns of deposits, and reduce domestic accounts payable.
  - Strong governance of externally financed infrastructure projects and debt management given large loans from development partners.

*International Monetary Fund (April 7, 2014) — “1. The Compact of Free Association”*

### 17.      The above result is fairly robust to different parameter assumptions. Lower rates of return

### 17.      The above result is fairly robust to different parameter assumptions. Lower rates of return

### Robustness and sensitivity
- The estimated required annual fiscal adjustment is "1.35."
- Lower rates of return and lower valuations of the government’s initial net worth (for example, to reflect new external debt and/or to include public enterprise debt) increase the required annual fiscal adjustment.
- Higher real GDP growth rates and inflation also increase the needed adjustment.
- Overall, reasonable variations in these parameters have fairly small impacts on the estimated annual fiscal adjustment of 1.35.

### Policy implications: broad overview
- Palau could secure long-term fiscal sustainability by pursuing fiscal consolidation over the medium term.
- The adjustment can be achieved through:
  - Lower fiscal expense (C), or
  - Higher taxes (R), or
  - A combination of both.
- Raising domestic revenue (R) during the adjustment period reduces the necessary fiscal expense (C) cuts.
- Anchoring fiscal policies on the adjustment path would:
  - Isolate the budget from tourism revenue volatility.
  - Build adequate fiscal buffers for future shocks.

### Revenue reforms: recommended priorities
- A comprehensive revenue reform tailored to Palau can address tax-system weaknesses and increase fiscal revenue.
- Priorities recommended by Fiscal Affairs Department (FAD) and PFTAC include:
  - Replacing the gross revenue tax (GRT) and existing import taxes with a single-rate VAT with no exceptions except for exports.
  - Moving to c.i.f. (cost, insurance, and freight) valuation for imports.
  - Raising the net income tax (NIT) for financial institutions.
  - Expanding NIT to all taxpayers registered for VAT.
  - Reducing the wage and salary tax rate for low income households to offset potential adverse impacts of price increases from VAT adoption.
  - Improving revenue administration capacity to support major reform.
- Intermediate actions if full reform is not feasible in the short run:
  - Remove import tax exemptions.
  - Move to c.i.f. valuation.
  - Apply an excise equivalent to import taxes on local production of excisable goods.
  - Increase the NIT rate for financial institutions.

### Revenue reform quantitative impacts (FY2014–19)
- Tax reforms, including Value Added Tax and Net Income Tax: 3.5 (ppt. of GDP)
- Improvement in nontax administration: 0.5 (ppt. of GDP)
- Combined revenue and nontax measures: implied 4.0 (ppt. of GDP) from revenue side as reported elsewhere (see combined totals below).

### Expense reforms: priorities and quantitative impacts
- Containing fiscal expense is critical; the wage bill-to-revenue ratio is high relative to other Pacific Island Countries.
- Top priority: contain wage bill growth below the inflation rate to reduce fiscal expense and protect capital spending.
- Recommended actions:
  - Undertake a well-planned civil service reform.
  - Enforce mandatory retirement.
  - Retrain civil servants to improve public service delivery effectiveness and efficiency.
- Quantitative impact FY2014–19:
  - Civil service reforms (expense reduction): 4.0 (ppt. of GDP)

### Combined impact of reforms (FY2014–19)
- Revenue measures (tax reform + nontax admin): 3.5 + 0.5 = total 4.0 (ppt. of GDP)
- Expense measures (civil service reforms): 4.0 (ppt. of GDP)
- Total impact reported: 8.0 (ppt. of GDP)

### Public financial management, debt, and buffers
- Sustained improvements in public finance management are needed to support medium-term consolidation.
- The recently established budget reserve fund will serve to manage increasing government deposits over the medium term; accountable, transparent, and prudent management is essential.
- Given disbursements of new infrastructure loans:
  - Sound public debt management and strong governance of infrastructure projects are needed to ensure debt sustainability and minimize fiscal risks.
- Grant disbursements under the Compact’s fiscal consolidation fund should help reduce domestic account payables.
- Authorities should strengthen budget execution and planning to prevent buildup of payables in the future.
- Adoption of a medium-term budget framework is needed to formulate multiyear fiscal policies and strengthen fiscal discipline and transparency.

### Box 2: Technical assistance recommendations for comprehensive tax reform (summary of measures)
- Move to c.i.f. valuation for imports.
- Replace GRT and import taxes with a VAT having these features:
  - A single rate of VAT in the range of 10 to 15 percent.
  - Exemptions kept to a minimum; exports zero-rated.
  - All government institutions and public enterprises subject to VAT.
  - Businesses with turnover of more than US$300,000 required to register for VAT.
  - Other businesses with turnover exceeding US$100,000 can register if they meet record keeping requirements.
- Reduce wage and salary tax rates for low income households to improve fairness and offset VAT effects.
- Increase NIT rate for financial institutions to around 20 percent.
- Expand NIT to all taxpayers registered for VAT; a rate of around 20 percent is suggested.
- Retain current GRT arrangements for international airlines until VAT and NIT impacts are understood.
- Introduce a simple, low rate turnover tax for smaller businesses.
- Exempt micro businesses with turnover less than US$40,000 from turnover tax, subject to payment of a business license.

### Fiscal framework and analytical basis
- The analysis uses the government’s intertemporal budget constraint: all present and future government expenditures must be covered by the government’s net wealth or by present and future fiscal revenues, discounted to a base year.
- Notation in the analytical framework includes:
  - Government’s net worth (ܹ)
  - Nominal interest rate (ݎ)
  - Grant revenue (ܩ)
  - Domestic revenue (ܴ)
  - Fiscal expense (ܥ)
  - Net acquisition of non-financial assets (ܭ)
- Intertemporal budget constraint implications:
  - Fiscal policies changing one component induce changes in other components.
  - Government net debt equals the sum of discounted net taxes paid by current and future generations.
  - Long-term government spending must be balanced by taxes paid by current or future generations.

*Source: Fund staff estimates.*

### 6.      These patterns suggest that the performance of Palau’s tourism sector depends on the

### 6.      These patterns suggest that the performance of Palau’s tourism sector depends on the

### Factors affecting tourism performance
- Flight routes: Tourist arrivals depend heavily on the availability of direct flight routes. Changes in direct flights (initiation or cessation) lead to substantial changes in tourism performance.  
- Hotel capacity and infrastructure:
  - Hotels operate at nearly full capacity (around 1,400 rooms), constraining tourism growth and raising hotel rates.
  - Development of new hotels has been hampered by infrastructure bottlenecks, although Palau’s tourism infrastructure compares favorably with other small island tourist destinations.
  - Upcoming improvements: water and sanitation projects, faster internet connection, ongoing airport renovation, and the construction of new hotels (Two new hotels are expected to start operation in FY2014).
- Business climate: Development of new hotels appears hindered by restrictions on foreign investment and complex licensing arrangements to start a business.
- Exchange rate: Depreciation of Asian currencies against the U.S. dollar (Palau’s legal tender) made Palau’s tourist attractions more expensive for Asian tourists; past data show the number of tourists and Palau’s real effective exchange rate (REER) are inversely correlated.
- Tourist spending: Spending by tourists contributes to domestic economic activities and fiscal revenue, but spending per tourist has remained flat over the past decade.
- Asia’s economic growth: Economic conditions in major tourist origins (Taiwan Province of China, Japan, and Korea) influence Palau’s tourism; tourist arrivals declined substantially during the Asian crisis in the late 1990s.
- International food and fuel prices: Heavy reliance on imports of food and fuel makes inflation sensitive to their price fluctuation; higher prices raise domestic prices (Palau uses the U.S. dollar), making tourism services more expensive and less competitive.

### The economic role of tourism: contributions and vulnerabilities
- Contribution to growth and GDP:
  - Tourism activities contributed to about three quarters of Palau’s economic growth; remaining ¼ contributed by non-tourism activities such as construction and public sector spending.
  - Tourism-related industries (hotel, food services, transport) contributed around 4½ percentage points of the 5½ percent growth in real GDP in FY2012, or 3.6 percentage points of the 5.2 percent growth in FY2011.
  - In FY2013, had it not been for the positive contribution of tourism-related activities, growth would have been even lower than -0.2 percent.
- Trade and external sector:
  - Exports of travel services (travel receipts) account for more than 80 percent of exports of goods and services.
  - Imports of goods (mainly food and fuel), which account for nearly half of Palau’s total imports of goods and services, are partly driven by tourism.
  - Tourism-linked imports can serve as an automatic stabilizer to the current account because a tourism slowdown would be partly mitigated by a decline in food and fuel imports (provided international fuel and food prices do not increase).
  - Tourism-related goods and fuel imports amount to 30 percent of GDP, exposing Palau to global commodity price fluctuations.
- Fiscal impact:
  - Two main direct taxes related to tourism: traveler’s head (departure) tax and hotel occupancy tax.
  - Share of these two taxes to total tax revenue increased from nearly 9 percent in FY2003 to around 15 percent in FY2013.
- Employment:
  - More than 40 percent of total employment is in tourism-related activities.
  - Foreign workers make up around 50 percent of total employment.
- Reliance and risks:
  - Palau’s reliance on tourism is greater than peers; tourism receipts as percent of GDP and tourism receipts per inbound tourist are higher than peers except Maldives.
  - Heavy dependence on tourism creates volatility, high import dependence, vulnerability to currency appreciation (U.S. dollar), economic slowdowns in Asia, and natural disasters or environmental accidents.
  - Recommendation: promoting diversification within and outside tourism to reduce volatility, support growth, and build buffers.

### Empirical estimation: impact of tourism on income (Box 1)
- Model specification (panel fixed effect, countries: Palau, Maldives, Fiji, Samoa, Tonga, Vanuatu, Federated States of Micronesia; period 2000-13) with variables in logs:
  - Dependent variable: YPCP = per capita income, nominal GDP in US$ divided by population
  - Regressors: GOV (government expenditure % of GDP), OPEN (exports+imports % of GDP), T_PCP (tourists per capita), T_EXP (tourist expenditure per tourist in US$), INFL (inflation), INR (infrastructure proxied by share of urban population)
- Key parameter estimates and statistics:
  - Constant 2.21
  - GOV 0.04
  - OPEN 0.12
  - T_PCP 0.45 ***
  - T_EXP 0.28 ***
  - INFL 0.64 *
  - INR 0.44 **
  - R-squared 0.998
  - Adjusted R-squared 0.997
  - Number of observations 98
  - Asterisks indicate the p-values: * p-value<0.1, ** p-value<0.05, *** p-value<0.01
- Interpretations:
  - A one percent increase in tourist arrivals, holding other factors constant, would lead to ½ percent increase in per capita income.
  - A one percent increase in spending per tourist contributes to ¼ percent increase in income.
  - Conclusion: both quantity and quality (spending) of tourists matter for growth; attracting higher-income visitors raises value added.

### Cross-country comparisons and constraints
- Palau ranks:
  - Receipts from tourism stand above 50 percent of GDP, higher than other countries except Maldives.
  - Second behind Maldives in tourism receipts per visitor.
  - Slightly behind Maldives and Vanuatu in tourism contribution to GDP.
  - Highest in travel exports as a share of total exports of goods and services.
  - Tourism contribution to employment comparable to Vanuatu and Maldives.
  - Limited number of hotel rooms compared to peers, constraining tourism growth.

### Policy recommendations to promote tourism and private sector development
- Diversify within the tourism industry:
  - Diversify tourist attractions beyond diving (eco-tourism, aquatic sports, golf) to increase length of stay and spending.
  - Promote ecotourism and terrestrial attractions, particularly in the underdeveloped Big Island, to distribute activities between land and sea.
  - Diversify tourist origins: promote arrivals from China, Southeast Asia, Russia, and Europe; adapt hospitality and services (e.g., web presence and service offerings) to new visitor preferences.
  - Attract higher-income tourists to reduce environmental strain while maintaining or increasing tourism revenue; creation of the Bureau of Tourism to ensure compliance and standards is a positive step.
- Diversify outside the tourism industry while keeping tourism central:
  - Develop agriculture, aquaculture, and fishery to supply hotels and restaurants, reduce food imports, and mitigate volatile commodity prices; note constraints: small share of agriculture and forestry (<2 percent of GDP), small-scale operations, complex land ownership, limited labor supply.
  - Move up the value chain: increase domestic production and distribution of tourism-related goods and services (foods, crafts, spa products, transport) to raise domestic value added; requires improvements in investment and business climate.
  - Expand the service industry: with improved internet connectivity, explore call service business and opportunities to host conferences and conventions by expanding high-end hotels and resorts.
  - Improve the education system to better match skills of graduates with service sector employment, providing domestic employment opportunities for Palau youth.
- Address binding constraints:
  - Preserve macroeconomic and financial stability.
  - Address infrastructure bottlenecks (water, sanitation, internet, airport).
  - Improve business and investment climate to attract private investment.

*Source: IMF staff report excerpt on Palau tourism sector and economic role.*

### 18.      Preserving macroeconomic and financial stability and fiscal sustainability is essential to

### 18.      Preserving macroeconomic and financial stability and fiscal sustainability is essential to

### Macroeconomic and financial stability: role and needs
- Preserving macroeconomic and financial stability and fiscal sustainability is essential to support Palau’s efforts to diversify the economy and promote private sector development.
- Successful tax and expenditure reforms over the medium term would help achieve fiscal consolidation needed to ensure long-term fiscal self-sufficiency and debt sustainability.
- Given the absence of monetary policy, a prudent fiscal policy would contribute to low inflation and stable external balances.
- A sound financial sector would reduce financial risks and facilitate business activities.
- Banks provide limited domestic credits and place most of their assets abroad due to credit risks, limited domestic investment opportunities, and inadequate capacity by small businesses to prepare financial plans and statements.
- The recent establishment of the Economic Advisory Group (representatives from the government, congress, and the private sector) and the establishment of the Small Business Development Center are identified as steps to address coordination and small-business capacity challenges.

### Structural reforms to complement stability and promote diversification
- Addressing infrastructure bottlenecks:
  - Promoting development of new hotels would improve tourism growth, but requires development of basic infrastructure such as water and sanitation systems.
  - Further improvement in the road network and aviation connectivity can benefit other sectors.
  - Improving telecommunications infrastructure is needed to expand the services sector.
  - Enhancing medical services would attract more high-income tourists of a wider age range.
- Improving the business and investment climates:
  - The Doing Business Indicators show Palau’s rank improved from 114 to 100 in 2014.
  - Palau’s performance is slightly behind Maldives and significantly behind Vanuatu and Fiji, suggesting large scope for improvement.
  - Some regulations in Palau pose hurdles that limit private sector development; there is ample room to strengthen investor protection, contract enforcement, and starting a business.
- Small business support:
  - The Small Business Development Center was established to assist small businesses and new entrepreneurs with setting up financial statements and prepare them for the loan application process required by the banks’ regulations.

### Doing Business indicators and rankings (Indices in "Doing Business" and Rankings out of 189 Countries, 2014)
- Overall "Ease of Doing Business": Palau 100, Maldives 95, Vanuatu 74, Fiji 62
- Starting a Business: Palau 129, Maldives 71, Vanuatu 112, Fiji 61
- Dealing with Construction Permits: Palau 45, Maldives 18, Vanuatu 50, Fiji 74
- Getting Electricity: Palau 78, Maldives 13, Vanuatu 112, Fiji 98
- Registering Property: Palau 20, Maldives 16, Vanuatu 111, Fiji 63
- Getting Credit: Palau 86, Maldives 10, Vanuatu 95, Fiji 55
- Protecting Investors: Palau 178, Maldives 80, Vanuatu 80, Fiji 52
- Paying Taxes: Palau 84, Maldives 11, Vanuatu 53, Fiji 88
- Trading Across Borders: Palau 96, Maldives 13, Vanuatu 81, Fiji 111
- Enforcing Contracts: Palau 141, Maldives 90, Vanuatu 72, Fiji 63
- Resolving Insolvency: Palau 96, Maldives 40, Vanuatu 57, Fiji 50

### Tourism-related challenges and policy priorities (Table 1)
- Challenge: Limited hotel capacity has constrained tourism growth and raised hotel rates, making tourist attractions expensive and undermining competitiveness.
  - Policy: Promote development of new hotels, particularly the high end, by addressing infrastructure bottlenecks and improving investment and business climate to attract new investments in the sector.
- Challenge: Spending per tourist has remained flat in current dollar value.
  - Policy: Diversify tourist attractions to make tourists stay longer and spend more. Attract tourists from wealthier countries.
- Challenge: Heavy reliance on tourists and direct flights from three markets only contributes to tourism volatility.
  - Policy: Promote tourism from, and increase flight connectivity with, new countries to diversify tourist origins.
- Challenge: Heavy reliance on imports of food and fuel contributes to external sector vulnerability.
  - Policy: Develop domestic supply chains to the tourism industry by developing environmentally friendly agricultural produce, aquaculture, and fishing catered to the tourism industry.
- Challenge: Heavy reliance on tourism contributes to growth and fiscal volatility and balance of payment vulnerability.
  - Policy: Diversify the sources of growth outside tourism sector (for example services), and enhance the growth potential by increasing the domestic share of tourism-related operations (production, distribution, and marketing).

### Summary
- By identifying and addressing the tourism-related challenges above, Palau could improve growth potential and reduce economic vulnerabilities.
- Priority actions include promoting development of new hotels (particularly for high-end tourists), promoting tourism from and establishing flights with new countries, establishing domestic supply chains oriented towards the tourism industry, and diversifying tourist attractions to increase tourist spending and reduce reliance on a narrow set of markets.

*Source: INTERNATIONAL MONETARY FUND — excerpted content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14111.pdf_