metadata: authors: 0: author: O'Mara,Gerald T.
docna: 0: docna: Making Bank irrigation investments more sustainable
docty: Policy Research Working Paper
subtopic: Climate Change and Agriculture,Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Public Sector Economics,Water and Food Supply,Hydrology,Food Security,Public Finance Decentralization and
            Poverty Reduction,Global Environment
teratopic: Finance and Financial Sector Development
abstracts: cdata!: This paper is about sustainability of
            irrigation investments in both the financial and physical
            senses.  Finance provides the claim on resources necessary
            to accomplish physical operations in an economic system,
            while physical operations provide a flow of services for
            which beneficiaries are willing to pay in terms of claims on
            resources.  This paper discusses two polar models of
            irrigation finance, followed by a discussion of quality
            control in irrigation and reviews of World Bank irrigation
            pricing policy, irrigation cost recovery and operations and
            maintenance funding conditionality experience.  It includes
            a discussion of reasons for noncompliance with Bank
            irrigation lending conditionality.  A  framework for the
            design of sustainable irrigation investments is presented
            and a summary of results and recommendations is given.
repnme: repnme: Making Bank irrigation investments more sustainable
display_title: Making Bank irrigation investments
            more sustainable
listing_relative_url: /research/1990/05/700263/making-bank-irrigation-investments-more-sustainable
topicv3: Agriculture and Food Security m1326205 435,Drainage m1326419 990,Water m1326522 137,Environment, Natural Resources and Blue
            Economy m1327391 566,Taxation m1327615 1121
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Policy, Research & Ect Affairs
no_of_pages: 37
author_keys: 0: author_key: 769084
model_extractions: <!-- Start of picture text --> Poby, Nwoh. ob Exsn AW<br>Agricultural Policie<br><!-- End of picture text -->

- This paper a product of the Agricultural Policies Division, Agriculture and Rural Development - Department is part of a larger effort in PRE to provide analytical reviews of major issues in the sustainability of natural resources and prescrvation of environmental quality. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Cicely Spooner, room N8-035, extension 30464 (32 pages).

Until 1976, Bank policy emphasized recovery of all costs on irrigation projects, or at least complete recovery of operating and maintenance (O&M) costs. Subsequently, policy specified three pricing objectives for the design of irrigation service fees: economic efficiency, income distribution, and public savings.

The objective of economic efficiency was framed in irrelevant terms and the detailed objectives for income distribution wcre unwork- able. This left the objective of public savings for which there are no clearcut instructions.

So betwcen 1976 and 1988 no effective formal policy guidelines existed for cost recov- ery on irrigation although the Bank was active in lending for irrigation in those 12 years.

No OED review of loan conditionality on cost recovery for irrigation has been produced for the period, but the 1986 OED review on the period before 1976 concluded tha thie record for the earlier period was not good.

* Acccpt the diversity of wultures and institutional arrangements in borrowing countries and incorporate flexibility and ingenuity into the design of feasible irrigation institutions.

* Focus the Bank dialogue on the physical sustainability of irrigation investments and associated natural resourecs. In short, the Bank should be more flexible about institutional preferences but should insist more strongly on arrangements that preserve sustainability.

* Approach the financing of irrigation as a policy adjustment issue.

* Base cost-recovery policy on an analysis of the total complex of government interventions. Most countries prefer to impose direct and indirect taxes on agricultural commodity output although such taxes are often unjustified in terms of equity or cost recovery.

Decisions on the third and fourth points require thorough economic analysis.

In at Ieast two-thirds of the projects reviewed, the covenant requiring cost recovery to cover at least O&M costs had not been honored. In many cases, the covenants covering cost recovery were so vague that it was difficult to judge if there had been compliance. Auditors found O&M of the irrigation satisfactory in only half of the projects.

Existing guidelines are inadequate, and the need for quality control is great, so O'Mara proposes six points as the basis for a new policy framework for Bank irrigation projects:

* Assign tax policy instruments to appropriate policy objectives.

> * Accept indirect cost recovery where it exists, but insist on an accounting of the equity issues associated with rent transfers for irrigation.

On the fifth and sixth points, analysis must take into account the welfare effects on the major groups involved. The appropriate objective for irrigation serviec fees (if there are no equity issues) is public savings or cost recovery.

The PRE Working Paper Series disseminates the findings of work under way in the Bank's Policy. Research, and External Affairs Complex. An objectivc of the serics is to get these findings out quickly, even if presentations are Icss than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy.

'roducc(i at the PRE Dissemination Ccnter
# Making Bank Irrigation Investments More Sustainable

by Gerald T. O'Mara*

# Table of Contents

|I.|Introduction|1|
|---|---|---|
|II.|Models of Irrigation Finance|4|
|III.|The Growing Concern Over Quality Control in<br>Irrigation Construction, Operations, and Maintenance|6|
|IV.|World Bank Irrigation Pricing Policy|8|
|V.|A Brief Review of Bank Experience<br>with Irrigation<br>Cost Recovery Conditionality|1 2|
|VI.|Some Reasons for Noncompliance with Irrigation<br>Lending Conditionality|1 3|
|VII.|A Framework for Design of Sustainable Irrigation<br>Investments|1 9|
|Vil.|Summary|27|
|lX.|Epilogue|30|
|Refe|rences||
||*Principal Economist, Agricultural Policies Division<br>Agriculture and Rural Development Department<br>The World Bank||
# 1. INTRODUCTION

This paper Is about sustalnabillity of irrigation Investments In both the financial and physical senses. Clearly the two senses are closely related, almost like difference sides of the same coin. Finance provides the clalm on resources necessary to accomplish physical operations In an economic system, while physical operatlons provide a flow of services for which beneficiaries are willing to pay In terms of clalme on resources (i.e., money). Thus stated, the matter seems only to require that private agents organize a market. The difficulty Is that Irrigation Is almost never organized as a market for water. The reasons for this situation will now be sketched.

The use of man-made structures to alter the temporal and spatial distribution of water provided by the natural hydrological cycle goes back thousands of years. Yet the economic, political and legal Issues associated with Irrigation remain sources of conflict to this very day. Some socIetles regard the water from the hydrological cycle as a Godgiven commodity and object to arrangements which require payment fok access to Irrigation (for a revlew of water law systems, see Radosevich (1988)). Moreover, mother nature can be capricious In her distributlon over tlme of rain and snow fall; and the bounty from nature tends to create Its own pattern of distribution In the absence of human Intervention.

The natural patterns of distrlbution are often taken as given by legal systems in assigning property rights to water. Thus, the riparian rights legal doctrine assigns rights of use to property owners whose land touches uprn a stream, river, or lake created by natural drainage flows. When demand for use tends to exceed supply (in years of low flows) along parts of a natu~ral dralnage system, the historical rights legal doctrine often supersedes In an offaDrt to establish woll defined legal rights. However, this precedent-
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based criterIon--"first In time, first In right"--puts latecomers In a disadvantaged position and thus proviles an Incentive for promotlon of investments that will Increase the rate of capture of naturally occurrlng flows as well as facilitating their distribution over time. Slnce water rights are problematic in the absence of clear legal definition and effective enforcement, the supply available to any user depends on the actlons of other users and potential users. This physical linkage between users makes It difficult to finance and organize Irrigation Investments privately, except In the case of tubewells abstracting from groundwater where land owners face no significant legal restralnts and smallscale surface Irrigation where several landowners each Invest together. For a discussion of the economic effects of physical llnkages between irrigating farmers, see O'Mara (1988). In simple consequence, irrigation supply comes overwhelmingly from Investments by some branch of government, even in countries such as the US where custom strongly prefers private sector development.

When the stage of significant pubilc sector Investments Is reached, the natural pattern of drainage Is changed, and the allocation of water supply Inevitably becomes a matter of public policy. Note, however, that distributlon Is constralned by topography and the large Increase In cost that occurs when water must be pumped uphill. Despite this constraint, the Introduction of surface Irrigation to an arid or semi-arid region creates a production potential that Is very Idrge In relation to previous productlon. The value of this potentlal production when realized minus the social opportunity costs of all nonwater Inputs defines the rent that Is available to be distributed vla public pollcy. To the extent that pollcy permits access to Irrigation water at a price less than Its marginal value in agricultural production, the Irrigation rent Is captured by land owners and ultimately capitalized Into land values. Thus, charges for Irrigation services inevitably have
- 3-.

strong distributVonal Implications; and the determination of such charges Is almost Invariably subJect to a political process. For example, a political leadership that assigns large Irrigation rents to a favored group of land owners may create a powerful supportive constituency that will ensure political control over many years. The introductlon of su.-face Irrigation to more humid regions as a supplement to rainfed flows is similar except that the Irrigation rent will be smaller per unit of land.

Given that Irrigatlon supply comes largely from public sector Investments, the related Issues of financlal and physical sustainability of supply tend naturally to be linked to the revenue and expenditure sides of government operations. That Is, ultimately these Issues are determined by the political processes that shape **t,** v Institutional content of government operations. One Institutional possibility Is alr **'st** complete autonomy for Irrigation system operatlons In both the financial and operational senses, permitting an Irrigation organization highly specialized to Its function In terms of administration, personnel, technology, operations and Investment planning. Another possibility Is the almost complete submersion of irrigation finance and operations wlthin general government. The institutlonal options have significant impilcations for the efficlency of Irrigation operations, and a strong case can be made for a more specialized, quasi-autonomous organizatlon. However, in this paper the ultimate right of governments to choose preferred Institutional forms Is accepted; and the focus Is on sustainability in both senses.

In the next section, two polar models of irrigatlon finance are discussed, followed by a discussion of quality control In Irrigation and reviews of World Bank Irrigation pricing policy, irrigation cost recovery and operations and malntenance funding conditionality experience and a discusslon of some reasons for noncompliance witth Bank Irrigatlon
lending conditionality. Then a framework for the design of sustainable irrigatlon Investments Is presented and a summinary of results and recommendatlons Is given.

# IL MODELS OF RRIGATION FINANCE

Analytical characterizations of irrigation finance tend to conform to tne of two polar types: 1) the fiscal autonomy model, and 2) the fiscal dependence model. The former emphasizes efficient deilvery of a well-defined Irrigation service, and the latter looks at irrlgation as only one among many governmental activities directed toward agriculture. The Fiscal Autonomy Model This model consciously seeks the anaiogy of Irrigation finance with the speclalized finance of services such as electricity or telecommunications. It envision; a quasiautonomous oig anizatlon which supplies clearly specifled Irrigation s6rvices to a clientele of Irrigating farmers In a river basin or similar natural irrlgation unit. The Irrigation organization controls Investment, operations and maintenance decisions, assesses and collects Irrigation service fees, and arranges iong-term finance by issulng bonds. Irrlgatlon service fees are set such that they cover costs. Intrinslc to the effective and reliable functloning of this model Is an institutional context that enforces pubilc accountability of the irrlgation system management. This requirement must Include public reporting of operations, maintenance, finance and Investment activities (much In the manner of the reporting required of a private sector corporation In the U.S.) and annual audit by an Independent auditor. It should provide for farmer and finance ministry representation on a revlew board that must approve budgets and Investments. If government wlshes to subsidize irrigating farmers, then the subsidies are pald to the
Irrigation organizatlon In return for setting f*es at a level that Is less than cost. In principle, the Irrigation organization has an Incentive to provide services efficlently (if It Is diligently monitored) and should provide no more or less service than farmers are willing to pay for. In practice, once subsidy Is admitted, the simple efficlency clakns for the fiscal autonomy model no kbnger hold. In addition, once sustained operation comes to depend on subsidy, It Is very likely that tne Irrigatlon organizatin will no longer be as responsive to farmer demands.

The Flscal Dependence Model This model views governments as Irresistibly drawn to Intervene In agriculture by means of taxes or subsidles on the prices of outputs and Inputs, by means of Investment In Infrastructure, research and extension, and by means of services such as Irrigation, pest control, marketing of outputs and Inputs, commodlty Inspection and grading. From this perspective, the provislon and pricing of Irrigatlon services Is shiply one among many Interventions by government, and b<.th efficiency and eoqulty concerns require the consistency of Irrigatlon policy wlth the other governmental Interventlons In agricuittA. e. The fiscal dependence model finds no speclal merit In either fInancia. or operational autonomy. Irrigation ravenues are collected In the same fashion as any other tax, and Irrigation Investments, operations and maintenance are part of the general governinent budget and subjected to the same fiscal scrutiny. Thus, routine maintenance of an Irrigation system must promise marginal returns equal to the marginal cost of government revenue even In times of fiscal stringency If It Is to be fully funded on a sustained basib. It also follows that there Is no necessary connection between payment of Irrigation service fees and the financing of Irrigation Investments, operations and maIntenance. Moreover, the information and high level management requirements for determination of
consistent, officient and equitable pollcles toward agriculture are Increased by at least an order of magnitude. In consequence, many developing country governments are unable to generate polclies toward agriculture that are consistent, efficlent and equltable.

# IIL THE GROWM CONCERN OVER QUALITY CONTROL IN RRIGATION CONSTRUCTION, OPERATINS **AND MAITNANCE**

Quite quletly Rank staff directly concerned wlth Irrigation lending have Increasingly Identified an alarming trend toward loss of control over crucial aspects of quality In Bank financed irrlgatlon projects at both the stage of construction and the subsequent stage of operatlons and maintenance. Thus, staff with technical functions now think of project sustainability largely In physical terms. That Is, an Investment Is not as sustainable as it should be because of shoddy constructlon using Inferlor n,aterlals or because of poor management of operatlons and maintenance (0LOW. As two technical staff members wrote to us: "Massive speclal maintenance budgets or rehabilitatlon only 10 to 15 years after constructlon Is not the best way to reach sustainablilty." Thus, the Issue of project sustainabillty goes way beyond the Issue of providing adequate funds for O&M as well as construction.

Bank irrigatlon staff In Asia region have developed a proposed pollcy response to address the emerging problem of physical sustainability that deserves repetition here. The suggested policy response Is Itemized In descending order of priority as follows:

- (a) Institutional arrangements should be In place to m'et the various objectives of water resource development and exploitation. In general, this means an organizational framework with rules of operation and staffing which allow the varlous specialist functlons (planning, design, constructin, O&M, and regulatory) to be carried out by specialized staff.
-7-

# (b)

For Operations, this rec;uires rules and procedures<sup>for serving all</sup> potential customers (agricultural, municipal,<sup>and Industrlal). Such rules</sup> should define priorities and rights In tknes of<sup>shortage or excess, and</sup> define how temporary surpluses (during<sup>project constructlon) would be</sup> allocated and withdrawn over tkn.m Within Irrigation<sup>projects, rules for</sup> allocating water among farmers, the baslc allocation<sup>(water right) of each</sup> farmer In the "design yearu, the responsibilltles of<sup>the beneficlaries for</sup> specific Items of operation or malntenance and<sup>the penalties for non-</sup> compliance should also be established.

- (c) For Maintenance, this means an organization wlth funding,<sup>equlpment, and</sup> materials adequate to malntain facilities to their<sup>design standard of</sup> performance Indefinitely. Provision of such resources<sup>as are required to</sup> meet this objective should be an explicit requirement<sup>In legal agreements.</sup>

- Cd) Maintenance of accounts reflecting actual<sup>expenditures on OLM, and the</sup> sources of funds for such works (separately identifying<sup>revenues from</sup> water charges).

- (e) Establishing the basis for assessing water chargm:<sup>for each class of</sup> water (baslc allocation, Interim surpluses durlng<sup>construction, annual</sup> surpluses).

While the proposed pollcy clearly envisions<sup>at least a modified fiscal autonomy</sup> Institutional framework, with minor changes<sup>to reflect the absence of a return flow of</sup> water charges that characterizes 'he fiscal<sup>dependence model It can be used as a</sup> standard for construction and O&M within the fiscal<sup>dependence Institutional framework.</sup>
This would, however, require explicit agreements with respect to organization,<sup>staffing and</sup> funding of Ot& that are not always part of the context of fiscal depene.3nce.<sup>Experlence</sup> of Irrigatin staff has been that where these conditions do not obtain, gross deterioratlon In project sustalnability Is ;much more likely; and this means<sup>when It occurs</sup> that irrigation projects are converted from ostensible<sup>Investments to disguised</sup> consumption subsidies through falkure to maintain capital. It Is clear that<sup>such projects</sup> do not constitute development In any meanlngful sense. On<sup>the contrary, with the</sup> proposed framework In place, It can be argued that: those<sup>responsible for operating and</sup> maintaining projects would be provided with the facilities<sup>required; projects would be</sup> maintained; all boneficlarles would have a clear basis for planning<sup>their operations wlth the</sup> maxlmum degree of assuredness; and the real cost of providing water<sup>resources to</sup> various users would be known. It can also be argued that the proposed policy<sup>Is utopian</sup> In that It presupposes a degree of lender leverage that the Bank very<sup>seldom enjoys, to</sup> say nothing of Its neglect of a hardnosed analysis of the real Incentives<sup>for actlon that</sup> confront politicians drafting legislation or authorizing budgets directed<sup>toward Irrigatlon</sup> as well as those Incentives facing bureaucrats managing irrlgation<sup>systems. Yet the</sup> primary Issue remalns. Some of the Bank financed Irrigation systems are<sup>failing apart, and</sup> what Is going to be done about It?

# IV. WORLD BAW FRIGATION PRICING POLICY

From the beginning, Bank policy emphasized recovery of<sup>all costs from project</sup> beneficlaries. This policy was re-affirmed by Operational Policy Memorandum (OPM) No. 2.61 (March 1971), which admitted that agricultural projects were sometimes<sup>an exception, but</sup>
added that *as a minkrnum, operational and maintenance (OW) costs should be recovered completely." This was the policy In place for the sequence of irrigatlon projects assessed In the latest Operations Evaluation Department (OED) review ("World Bank Lending Conditionality: A Revlew of Cost Recovery In Irrigatin Projects", June 1986), which Is discussed bow.

However, cost recovery policy was significantly changed In 1976 with Central Projects Memorandum (CPU) No. 8.4, which Inposed detailed Instructions with respect to the progressive taxation of Incremental project rents. The pollcy of CPM 8.4 was slightly rJvised to provide more flexibility In hplementation by Central Project Note (CPN) No. 2.10 In 1980. This policy statement, which Is now called OPN 2.10, Is operant current polly.

The policy Instructions of OPN 2.10 set forth three pricing objectives for design of Irrigation service fees: economic officlincy, Income distribution and public savings. The Instructlons under each objective will be discussed In turn. Economic Efficiency The Instructlon Is In terms of "efficiency prices" , which are not defined, and It recommends volumetric pricing (where possible) of irrigatlon service fees. Clearly It Is Intended that utillty maxlmizlng farmer irrigators should be given an incentive to apply Irrigation water up to the point at which the value of tha expected utillty from an idditlonal unit of water would be equal to Its marginal cost. If all farmers have the same expected utillty and the private marginal cost (i.e., unit Irrigation servics fee) Is equal to the marginal social coa.t of Irrigation water, then the marginal condition for economic efficiency (Pareto optimality) Is met. However, only a tiny minority of Irrigating farmers In developing countries face volumetric pricing of water and can obtain additional water on demand (even wlthin limits). All other farmers recolve an exogenously determined
- 10 -

allocatlon that Yar'es stochastically from period to period (this neglects the fortunate few that have a tubewell). Such farners form expectations of how much water they will receive (and when) over a cropping cycle and allocate the expected quantity so as to maximize their expected utlIty. That Is, they allocate expected dellverles to given crop acreages according to farm specific shadow prices. The Irrigation service fee (usually area based) Is perceived as a lump sum tax which Is Irrelevant to their water allocation decision. The quantity allocatlon to farmers, Insofar as system design permits choices, Is accompllst. .d by the irrigation system managers under guidelines from their political masters. There Is no reason why such an allocation cannot be efficlent. To achieve efficiency consistently, however, requires appropriate Incentives for system managers, detalled Information on the value of the marginal product of water across farm types and regions, and for many countries enabling legislation. OPN 2.10 does not consider these possibilltles, but rather notes that "other methods of assessing charges may also have to be considered to ensure an equitable Income knpact of the project and an adequate recovery of project costs."

# Income Distribution

This Instruction Is seemingly more precise. It asserts that taxes (Irrigation service fees) to capture a share of project benefits should take Into account the abillty to pay of different farmers. That Is, benefit taxes should be progressive although "taking Into account disincentives, tax evasion and problems of cost collection." The Indicator of benefits Is the Incremental value at the farm level of what we have called the irrigation rent (net of irrigation service fees or thelr equivalent). Farmers below a critical consumption level (CCL) would not be taxed, while those above that level would be taxed progressively as Income Increased above the critical level. Note that this Instruction
> - 11 -

requires the calculatlon of Income on a farm by farm basis, although a proxy such as farm size or marketed output might be used, and then assessing Irrigation service charges under a progressive schedule. The Information requirements for Implementation of this instruction are considerable, as are the opportunities for arbitrary assessment by tax collectors. Moreover, the Income distributlon Instruction Is totally at variance with the thrust of the economic efficlency instruction.

# Public Savings

This Instructlon alms at Increasing the volume of Investable resources In the hands of the government in preference to additional consumption by at least the more affluent citizens. However, It recognizes a potential conflict with the Income distributlon objective If many of the proJect beneficiaries are poor. It Is noteworthy for the absence of any Instructions on project sustalnability or replicabillty.

In summary, existing policy guidelines provide little guidance In applying multiple criteria for pricing of Irrigation service fees. In particular, the Income distribution Instruction seems unworkable and Inconsistent with the spirit of the economic efficlency Instructlon. The project analyst Is left free to develop his own weights for the several objectives; and In that sense, anything goes. One suspects that the unworkable Income distribution guldelines have mostly been Ignored. The spirit of OPN 2.10 Is clearly laissez faire. It recognizes that "efficiency pricing" may be In conflict with the other objectives and suggests that other forms of taxation, such as a land tax or a betterment tax might be substituted. Presumably these taxes may be set at levels which do not confilct wlth other objectives. The Instructlon on benefit taxes also advises that the effects of a project on revenues from other taxes should be taken Into consideratlon, I.e., Increments in other revenues due to the project should be deducted from the Irrigation rent on
12 -

-

which water charges or benefit taxes may be levied. OPN 2.10 goes on to observe that: "There Is no prkna face reason why any particular share of costs, such as OLM costs, should normally be recovered." A further note on financing operations and maintenance (OLM) was Issued by OPS In 1984. This note asked that assurances be required (at the appraisal stage) that sufficient funds would be available for OWM. It also specifled that there should be an analysis of how the fiscal system affects farmer Incentives. Perhaps most Interestingly, the 1984 note did not require that OW8 costs be covered by direct cost recovery from proJect beneficlaries. It should be noted that none of these Instructions asked for an analysis of the consistency of the many government Interventions In agriculture %Ith the proposed scheme for Irrigation service fees. In particular, there was no reference to an analysis of direct and Indirect taxation of agricultural outputs. Nor was any justification ever given for using irrigation water fees as a vehicle for Income redistrlbution when much more esfficlen' means for targeting the poor were avallable.

# V. A **BREF** tEVEW OF **BSA** EXPERENCE **WITH** uRIGATIDN COST RECOVERY CONDITODNALITY

This sectin summarizes documented Bank experience and Is based on the aforementioned OED review of June 1986. As noted above, the review covers the period up to 1976, when relatively unambiguous policy guldelines were In place. The iong gestation period for kIplementatlon of irrlgatlon projects and the lack of consistent guidelines over the 1976-88 period make It likely that the appearance of a snimla **r** eview for that period Is some years away.

Since the overall assessment of Bank experience given In the summary of the 1986
- 13 -

OED review Is clear and concise, It Is repeated here: 'Overall, the cost recovery record hI irrigation projects has not been good. Frequently, the Bank's requirements as expressed In lending covenants, particularly with respect to recovery of Investment costs, have been so vague that compliance or noncompliance Is difficult to determine. In at least two-thirds of the projects reviewed the covenant requirlng that cost recovery satisfy OWM funding has not been complied with. The proportion of OLM costs recovered was frequently between 15 and 45 percent. In addition, there were very few cases where capital costs were recovered." The OED report goes on to note that OLM of Irrigation systems was considered satisfactory at audit In only about half of the projects. Compliance with cost recovery covenants was assessed as satisfactory In only 15 percent of the cases. When the pricing covenants required a soclo-economic survey and It was uIplemented, the recommendations were "generally not applied". The response of Bank operations staff to noncompliance wlth cost recovery covenants has been quite varlable, coverlng the gamut from refusal to consider further financing of Irrigatlon projects to no reaction at all. VL SOME REASONS FOR NONCOWLIANCE **WIlH** RRIGATION **LENDING** CONDTONALITY The 1986 OED review on Irrigation cost recovery singles out three major reasons for the record of noncompliance wlth cost recovery covenants: I) the often heavy burden of direct and Indirect taxes already kIposed on agriculture; 11) unrellable water supply due to poor OWM of irrigatlon systems; and 1ii) the lack of government commitment. The evidence with respect to each reason will be brlefly assessed In turn.
- 14 -

# Direct and Indirect Taxes on Agriculture

The most comprehensive and consistent evidence on direct and Indirect taxation of agriculture comes from the World Bank comparative study of the political economy of agricultural pricing policies directed by Anne 0. Krueger, Maurice Schiff & Alberto Valdes (hereinafter KSV). This study provides estimates from country-level research studied for eighteen deveioping countries. The Initially published results focus on the Inpact of direct and Indirect policles on the prices of major export and Import-competing commoditles. For details of the KSV methodology, the reader Is referred to thelr published papers.

Table 1 (from KSV) presents their estknates of nominal direct, Indirect and total Intervention for representative export crops In sixteen countries over the perlod 197579 and 1980-84. The numbers on direct Intervention give an estknate of the percentage by which domestic producer prices devlated from the border price (adjusted for transport, storage, other costs and quallty differentials) measured at the official exchange rate. The estinates of Indirect effects make allowance for the effect of trade and macroeconomic policies on the real exchange rate and the extent of protection given to nonagricultural commoditles. The total effect Is simply the sum of the direct and Indirect Interventions. For the sixteen countries and representative export crops listed In Table 1 the total of direct and Indirect taxation of agricultural exports averaged about 40 percent over the 1975-84 period. For most countries, there was significant taxation of exports at both the direct and Indirect levels. All of these countries are Bank borrowers, and many have borrowed to finance Irrigation projects--e.g., 'gypt, Malaysia, Pakistan, Philippines, Portugal, Sri Lanka, Thailand, and Turkey. Clearly, the dominant pattern Is one of heavy taxatlon of agricultural exports, with Indirect taxatlon via trade and macroeconomic pollcy accounting for about two-thirds of the total on average.
- **1S** -

Table 1: Dlrect, Indirect, and Total Nominal Protection Rates for Exported Products (percent)

|Country|Product|Direct|1975-79 --<br>Indirect|<br>Total|Direct|8-<br>1CaOe4<br>Indirect|Total|
|---|---|---|---|---|---|---|---|
|Argentina<br>Brazil<br>|Wheat<br>Soybeans<br>|.25<br>-8<br>|-16<br>-32<br>|-41<br>-40<br>|-13<br>-19<br>|-37<br>-14|-50<br>-33|
|Chile<br>|<br>Grapes<br>|1|22<br>|23<br>|0|-7<br>|-7<br>|
|Colombia<br>|<br>Coffee<br> <br>|-7|**-25**|-32|-5|-34|-39|
|Cote D'ivoire<br>|<br>**Cocoa**<br>|-31<br>|**-33**<br>|-64<br>|-21<br>|-26<br>|**-47**<br>|
|Dominican Re<br>|pubCoffee<br>|-15<br>|-18<br>|-33<br>|-32<br>|-19<br>|-51<br>|
|<br>Egypt<br>|<br>Cotton|-36|-18<br>|-54<br>|-22|-14|-36|
|<br>Ghana<br>|**Cocoa**<br>|26<br>|-66<br>|-40<br>|34<br>|**-89**<br>|**-55**<br>|
|Malaysia<br>|Rubber<br>|-25<br>|-4<br>|**-29**<br>|-18<br>|-10<br>|-28<br>|
|<br>Pakistan<br>|Cotton<br>|-12|-48|-60|-7|-35|-42|
|Philippines<br>|Copra<br>|-11<br>|-27<br>|-38<br>|-26<br>|-28<br>|-54<br>|
|<br>Portugal<br>|<br>Tornatoes<br>|17<br>|-5<br>|12<br>|17<br>|-13<br>|4<br>|
|<br>Sri Lanka<br>|Rubber|**-29**|-35|**-84**|-31|-31|-62|
|Thailand<br>|Rice<br>|-28<br>|-15<br>|-43<br>|-15<br>|-19<br>|-34<br>|
|Turkey|Tobacco|2|-40|-38|-28|-35|**-63**|
|<br>Zambia|Tobacco|1|-42|-41|7|-57|-50|
|Average||-11|-25|**-36**|-11|-29|-40|

Source: Krueger, Schiff, and Valdes, 1988, 'Agricultural Incentives in Developing Countries,' World Bank Economic Review 2(3):p.262.

Note: Korea and Morocco are not included because all main agricultural products are are imported.

The direct nominal protection rate is defined as the dfference between the total and the indirect nominal protection rates, or equivalently as the ratio of (1) the difference between the relative producer price and the relative border price, and (2) the relative adjusted border price measured at the equilibrium exchange rate and in the absence of all trade policies.

# Table 2 (from KSV) presents comparable data for representative kmport-competing

food crops in 16 countries. In contrast to the export crops, which were taxed at both the direct and Indirect levels on average, the knport-competing commodities are usually given significant direct protection, but then are Indirectly taxed at higher rates so that the total effect Is taxatlon of import-competing crops on average by about five percent. However, If two countries which have given exceptional protection to rice--Korea and Malaysia--are excluded, the average for total protectlon changes to -15 and -18 percent for the two periods. Some countrles tax kiport-competing commoditles at both levels,
- 16 -

**achieving total protection of** about **-60 percent** In **the** cases of **Pakistan (wheat) and**

**Zambia** (corn).

Tahle 2: Direct, Indirect, and **Total Nominal** Protection **Rates for** Imported **Food** Products (percent)

|Country|Product|Direct|1975-79--<br>Indirect|Total|Direct|Indirect|Total|
|---|---|---|---|---|---|---|---|
|Brazil<br>|Wheat<br>|35|-32|3|-7|-14|-21|
|Chile<br>|Wheat|11|22|33|9|-7|2|
|Colombia|Wheat|5|-25|-20|9|-34|-25|
|Cote d'lvoire<br>|Rice<br>|8<br>|-33<br>|-25<br>|16<br>|**-26**<br>|-10|
|Dominican Re<br>|pub. Rice<br>|20<br>|-18<br>|2<br>|26<br>|-19|7|
|<br>Egypt<br>|<br>Wheat|-19|-18|-37|-21|-14|**-35**|
|<br>Ghana<br>|Rice<br>|79<br>|**-66**<br>|13|118|**-89**|29|
|Korea<br>|Rice<br>|91<br>|-18<br>|73|86|-12|74|
|Malaysia|Rice|38|-4|34|68|-10|58|
|<br>Morocco<br>|Wheat<br>|-7<br>|-12|-19|0|-8|**-8**|
|Pakistan|Wheat|-13|**-48**|**-61**|-21|-35|-56|
|Philippines|Corn|18|-27|-9|26|-28|-2|
|<br>Portugal<br>|Wheat<br>|15<br>|-5|10|26|-13|13|
|<br>Sri Lanka<br>|Rice<br>|18|-35|-17|11|-31|20|
|Turkey|Wheat|28|-40|-12|-3|-35|-38|
|<br>Zambia|Corn|-13|-42|-55|-9|-57|**-66**|
|Average||20|-25|-5|21|-27|-6|

Source Krueger, Schiff, and Valdes, 1988, "Agricultural Incentives in Developing Countries," World Bank Economic Review 2(3):p.263.

Note: Argentina and Thailand are not included because their main food products are exported.

Turkey was a net exporter of wheat in some years, and in the Dominican Republic rice was not traded in some years.

The Direct nomninal protection rate is defined as the difference Detween the total and the indirect nominal protection rates, or equivalently as the ratio of (1) the difference between the relative producer price and the relative border price, and (2) the relative adjusted border price measured at the equilibrium exchange rate and in the absence of all trade policies.

While discrimination against agriculture Is well known, the KSV results provlde quantitative measures of the degree of bias agalnst agriculture. In the face of such massive direct and indirect taxation of agricultural commodities, It Is not surprising that farmers resent additional taxation. Nor is It surprlsing that many governments are reluctant **to** Impose additional taxes on farmers. In **fact,** many **of** their direct agricultural
- 17 -

interventions, e.g., subsidies on irrigatlon water, fort,lizer, pesticidos and credit, are In the nature of second-best measures designed to offset (at least partlally) the disincentives to agricultural output from macroeconomic, trade and agricultural pricing pollcles.

# Unrellable Water Supply

If operations and maintenance are not adequate, or If the Irrigatlon system Is poorly designed, water supply may not be dependable. In such circumstances, farmers are understandably reluctant to pay Irrigation service fees, particularly If they are confident that system managers will not cut off their supply for nonpayment. Since the design of Irrigation systems In most developing countries prevents system operators from discriminating between paying and nonpaying farmers, the threat of loss of supply seems remote to many farmers. Moreover, in most cases, system operators do not depend on Irrigation service fees for finance of O&M. Thus, while good O&M may be a necessary conditlon for adequate direct cost recovery, It Is not sufficient since many countries follow the fiscal dependence model which commingles irrigation fees with general government revcnues and finances irrigation O&M from the general government budget. Bank policy and practice have often Implicitly assumed that governments follow the fiscal autonomy model of irrigation service provision when in fact they do not. In additlon, as Wade (1979, 1982) has demonstrated, In some countries O&M funds are used by the Irrigation system managers for private rent collection. In the light of these hard realities, many Irrigation economists now argue that taxation of agricultural output or a tax on agricultural land value are more efficlent methods of cost recovery since farmers are noc asked to pay for Ineffective or unreliable Irrigation services that fall to produce a net gain In value of production, or equivalently In land values. Of course, taxatlon of
> - 18 -

agricultural commoditles Inevitably means taxatlon of marketed agricultural surplus since farm or village level transactions are virtually Impossible to tax In the sense of ylelding positive net revenue.

To the extent that the conditions of the fiscal autonomy model of Irrlgatlon service provision are met, the linkage of O&M wlth collection of Irrlgation service fees Is real. Farmers will understand that thelr fees finance O&M, and irrigation managers will seek to efficlently collect service fees since they finance their own salarles and perquisites. In such an Institutional context, the participation of farmers In tertlary and quarternary level O&M Is more natural, though not without problems of the free-rider sort. Bank experience with water user assoclations Is still quite limited, and the results are quite mixed. However, given an Institutional context of fiscal autonomy, farmers will quite naturally monitor the activitles of the Irrlgatlon system managers; and In such cases, It seems sensible to formalize the monitoring role by electing farmer representatives to boards of directors who oversee Irrigation system management.

Government Commitment In the final analysis, unless the government of the country Is committed to a policy and stands ready to implement It, the policy Is null and void. Thus, any and all failures In compliance with covenants to loan agreements can be regarded as due to a lack of government commitment. Equivalently, It can be sald that such failure also reflects a lack of commitment on the part of the lending Ir.titutlon when it asks for a covenant that experlence and good Judgement suggest will not be honored In practice. Certainly, the Bank has been guilty of Insisting on cost recovery Dolicies that clearly are Inconsistent with the policies of borrowing government, especially when the implied change Is for a particular proJect. A continuing dialogue with such a government, through special studies
- **19** -

and pollcy-based lending, may be a more officacious<sup>approach to sustainabilty and</sup> replicabillty of infrastructure Investments than<sup>covenants Inserted In ban agreements on</sup> a project by project basis. A case In point Is<sup>the government of India which has stated</sup> In writing more than once that Its pollcy Is dlfferent<sup>and that It does not expect irrigation</sup> projects to generate revenues or recover costs to ensure<sup>sustalnablllty after completion.</sup>

# VL A **FRAMEWORK FOR DESIGN OF** SUSTAALE RIIGATION *VSTENTS

The previous discusslon, by revlewing the Bank's<sup>experlence with conditlonality on</sup> Irrigation project lending and considering the major<sup>reasons for noncompilance with</sup> Irrigation lending covenants, has highlighted the<sup>growing dissatisfactlon with past practice.</sup> In particular, the record of substantlal noncompliance<sup>with covenants requiring adequate</sup> funding of operatlons and maintenance kIpiles<sup>there exists a real hazard of physical</sup> nonsustaInability of Irrigation Investments. It remains<sup>'o synthesize the hard lessons from</sup> experience Into a better framework for Irrlgation lei, 'ing.<sup>We belleve that the lessons</sup> from experience and straightforward application<sup>of economic understanding can be bolled</sup> down to a set of propositlons that do Indeed<sup>comprise the better framework that Is</sup> needed. These propositions are presented and discussed<sup>In sequence.</sup>

1. Accept the diversity of cultures and Institutional<sup>arrangements In borrowing</sup> countries and substitute flexibility and Ingenulty<sup>In place of rigidity In deslgning feasible</sup> irrigation Institutions sufficiently robust to<sup>meet the demanding operatlonal and</sup> malntenance requirements of contemporary<sup>Irrigation. In the past, zeal for the fiscal</sup> autonomy model has led the Bank to Insist<sup>on cost recovery covenants that are not</sup> acceptable to some borrowing countries. This<sup>Is not to deny the evident virtues of the</sup>
- 20 -

fiscal autonomy model of Irrigation finance, but sknply to recognize that some countries have objections to It that are deepseated. In general, countrlos that find the fiecal dependence model of Irrigatlon finance more acceptable, Ie., virtually all former British colonies, will have some problems with the fiscal autonomy model. Moreover, they are correct In their concerns for the rnarrow focus of the fiscal autonomy model. It does not take Into account other government Interventions that Inpact on farmers.

The fIscal autonomy model Is optknal for a first-best world In which other Interventions by government are neutral with respect to resource allocation and distributlonal policy Is handled by lump-sum taxes. However, Its single-minded application to a second-best world offers no assurance that such application would lead to an knr-ovement In either efficlency or equity. Of course, where fiscal autonomy Is acceptable to the borrower, design of project sustainability should recognize and bulid on the opportunity for greater autonomy and professlonalism In Irrigation system management. Second-best Issues can be accommodated within the Institutional context of the fiscal autonomy model.

2. Focus the dialogue concerning Irrigation upon the physlcal sustainabillty of Irrigation Investments and the associated natural resources. We have seen that irrigatlon staff have Identifled a growing trend toward loss of quality control In both the construction and O&M stages of Irrigation systems that threatens the physlcal sustainability of irrigation Investments. Unlike the discussion of finance and cost recovery In irrigatlon which needs to be approached at the sectoral and fiscal levels, physlcal sustalnability Is most naturally discussed at the project level. Here It Is kIportant to distinguish between the finance of and the knplementation of irrigation Investments. Technical irrigation staff assign significant emphasis to decisions during
- 21 -

planning, design and construction<sup>asmajor determhants of project sustalnabilty.</sup> It should be noted that these activities<sup>occur during the porlod of active Bank Involvemont,</sup> Ie., the stages of appraisal and project<sup>supervision. For this reason, some may argue</sup> that existing policy properly Interpreted<sup>Is sufficient to deal with problems of quality</sup> control. On the other hand, the comments<sup>and p,oposed policy changes by Asia technical</sup> staff (in section 111) Imply that existing practice has been Inadequate;<sup>and a need exists</sup> for detalled policy Instructions that prescribe<sup>a sec?uence of steps designed to correct</sup> the problem. It Is probably premature<sup>to take that step, but the evidence from Asia</sup> (where most of Bank Irrigation lending<sup>has been centered) Is highly cautionary. More</sup> active Bank Involvement at the planning,<sup>design and construction stages Is clearly</sup> Indicated. In particular, active testing of construction<sup>quality shold be Initiated.</sup> Supervision of public construction has<sup>always been a problem In both deveioped and</sup> deveioping countries since the responsible<sup>officials and the contractor agents are</sup> exposed to moral hazard In the absence<sup>of active monitoring.</sup> Unlike the earlier phases that end with<sup>constructlon, operations and maintenance</sup> commence after the period of active<sup>Bank Involvement. Yet adequate funding of OW8</sup> though Important Is only one component of<sup>an "OWM</sup> Plan" that technical staff Insist should be In place at the time of appralsal. This<sup>stop forces the borrower to Identify financlal</sup> requirements for O&M early In the project<sup>cycle and opens the door for Influential Inputs</sup> from Bank appraisal teams In talioring<sup>the level of effort to what Is reasonably required.</sup> Once Bank staff close a project, any<sup>further Impact depends on monitoring of borrower</sup> performance wlth respect to loan covenants.<sup>The existence of a detailed O&M plan</sup> greatly facilitates monitoring of compliance<sup>and removes ambiguities that may cioud the</sup> Issue. Disregard of an O&M covenant<sup>should set off an alarm requiring a strong response</sup>
- 22 -

by the Bank. Continued noncompliance would require cossation of all Irrigatlon lending If the Bank Is to retain credibillty w!'h respect to Its Irrigatlon portfolio. While very rarely circumstances might exist which would justify an exception to this rule, the open-ended application of an exceptions clause would render the rule useless. A vlable compromise would requiro that all exceptions be approved by senior management In the operatlons committee.

Quite clearly, sustalnabillty as applied to Irrigation projects must be Interpreted broadly to Include the environment as well as physical irrigation Investments (with the sole exception of nonrenewable groundwater resources). It makes little sense to Insure that Investments In physical structures are sustained and then neglect onvironmental knpacts which affect the economic productivity of the Investments or the productivity of the natural onvironment within which the Investments are embedded. For a discusslon of sustalnability as applied to irrigatlon, see OMara (1988).

The environmental Issue that Is typIcally encountered In surface irrigatlon projects Is that of waterlogging and sallnization due to Inadequate dralnage. Project planning and specification should make provision for adequate drainage In all projects. This does not mean that drainage Investments need to be constructed prior to i realized need, but rather that a foreseeable future drainage requirement should be treated as Integral to the project. That Is, discounted costs and benefits due to future drainage Investments should be Included In the calculation of the overall project rate of return. However, drainage Investment costs would not be Included In the project loan. Rather, they would be treated as a necessary future time silce Investment.

3. Approach tha finance of Irrigation operations, maintenance and replacement as a policy adjustment Issue rather than an Issue of project design. Most of the Irrigation
- 23 -

projects financed In countries with major Irrigation<sup>Infrastructure, I.e., most of the Bank-</sup> fInanced Irrigation projects, are ultimataly<sup>managed by large, existing bureaucracles for</sup> which the additlonal capacity from the project<sup>Is small In relation to the total capacity</sup> managed. They are most uniikely to change<sup>existing practices sknply to accommodate a</sup> small Increment to total capacity. If they do<sup>seem to accept a covenant Inaproject</sup> lending document that would appear to require<sup>such change, the result may simply be that</sup> some other canals of the system will temporarily<sup>recolve less OW8 funding. It Is not clear</sup> that anything has been galned by the transfer of<sup>funds Induced by such a project loan</sup> covenant. On the other hand, conditionality attached<sup>to policy-based lending could and</sup> should apply to the entire system. Such considerations apply with particular force<sup>to</sup> countries that operate according to the fiscal dependence<sup>model since there Is no linkage</sup> between direct cost racovery and financing<sup>of O&M. Even In countrles that operate</sup> according to a modified fiscal autonomy model,<sup>the setting of Irrigation service fees will</sup> ahost always Involve some element of subsidy. The<sup>level of this subsidy should take Into</sup> account other govornment Interventions, and<sup>It Is therefore more easily handled as a</sup> pollcy adjustment Issue.

4. Base policy on an analysis of the totality of government<sup>Interventions. The basic</sup> problem with a second-best world Is that there<sup>Is no assurance that any sincle</sup> Intervention will provide an Improvement in either<sup>efficlency or equity without conducting</sup> an analysis of the impact of all government Interventlons.<sup>This Is a daunting requirement</sup> and causes analysts to seek approximate answers<sup>which require less Information and lead</sup> to a more transparent analysis. However, the choice<sup>of the right approximation and Its</sup> Interpretatlon for policy Durposes Is skill Intensive.<sup>In this sense, the proposed policy</sup> guideline remalns essentially true. In one way or<sup>another, the analyst must take account</sup>
- 24 -

of the totality of government Interventlon In assessing<sup>the Impact on a given sector or</sup> group of people. The previous discussion of the Indirect Inpact on agriculture<sup>of</sup> macroeconomic and trade policy as quantified by Krueger,<sup>Schiff and Valdes has shown</sup> that anything less will be Inadequate. This does<sup>not mean that agricultural, natural</sup> resource and Irrigat!on economists concerned with irrigation<sup>lending must be retrained to</sup> acquire macroeconomic skills. It does mean that the macroeconomists<sup>working on country</sup> pollcy problems must be part of the team reviewing both project<sup>and policy lending related</sup> to irrigation; and that on occasion It will be necessary to bring<sup>In consultants with the</sup> specialized skills needed to assess overall policy Impacts.<sup>Asa first approxhnation, It</sup> would seem desirable that country macroeconomists<sup>use the Krueger-Schiff-Valdes</sup> methodology to determine Indirect commodlty-specific<sup>Impacts of macroeconomic and trade</sup> policy.

5. Assign tax policy Instruments only to appropriate policy<sup>objectives. The need for</sup> this proposition should be evident from the problems<sup>generated by the failure of efforts</sup> to overioad Irrigation service fees wlth multiple<sup>objectives.AsTinbergen demonstrated</sup> decades ago, only one policy target can be assigned<sup>to a pollcy Instrument If unequivocal</sup> results are to be obtained. Glven the multipilcity<sup>of government Interventions In all</sup> countries, the problem Is not a lack of Instruments but<sup>their appropriate assignment and</sup> the determination of Instrument levels that best<sup>achieve overall welfare. Of course, the</sup> decisions that tradeoff galns and iosses for various<sup>pollcy objectives are set, at the</sup> highest political level, and these are typically<sup>resolved through the budgetary process.</sup> Budget requests from various elements of government<sup>are assessed by budgeting offices</sup> or treasuries, and revised allocations are returned<sup>In a multi-stage, Iterative process.</sup> When playing a role In the budgetary game,<sup>no finance minister or budget office director</sup>
- 25 -

with his wits about him Is going to look on Irrigation service fees as an Instrument<sup>of</sup> achieving Income distributional objectives. In the first place, farmers receiving<sup>Irrigatlon</sup> services are not the poorest of the poor. These are landless<sup>laborers and rainfed small</sup> farmers. Secondly, to attempt to collect a tax by discrkninating between<sup>irrigation</sup> recipients on the basis of Income Is unworkable. There are better Instruments<sup>for</sup> achieving Income distributional targets.

At first glance, It Is not clear whether economic efficiency or cost recovery<sup>Is</sup> the proper assignment of Irrigatlon service fees. However, when Irrigatlon<sup>services are</sup> not priced volumetrically and available to Irrigators on demand, then irrigation<sup>fees are</sup> properly perceived as lump-sum taxes. Since these restrictive conditions obtain for<sup>only</sup> a tiny minority of irrlgators In developing countries, for the vast majority of farmers irrigation fees are Irrelevant to their water allocation decisions. They do the<sup>best they</sup> can with the amount of water they expect to get from the Irrigatlon<sup>system by asslgning</sup> a personal scarcity price to water and allocating what they expect<sup>to got on thelr land</sup> Irn such a way as to maximize their private welfare. Thus, we are left with cost<sup>recovery</sup> to achieve resource and project sustainability as the approprlate assignment of Irrigation service fees (except where water Is priced volumetrically and available<sup>on demand). Some</sup> analysts have argued that the transfer of large irrigatlon rents Induces<sup>a political demand</sup> for Irrigation services that results In excessive Investment In Irrigation<sup>(cf. Newbery</sup> (1987)). However, this Is not an argument over the marginal conditions for Pareto efficiency, but rather Is concerned with the political econwmy of large<sup>Irrigation subsidies.</sup> The optknal setting of Irrigation service fees for cost recovery should<sup>certainly be</sup> sufficient to avold excessive polltical demand for Irrigation subsidies.
- 26 -

6. Accept Indirect cost recovery as valid where It exists, but Insist on a rigorous accounting of the equity Issues of irrigatlon rent transfer. Funds are fungible. If government Is recovering costs Indirectly, this Is sufficient In principle to assure sustainability. However, the equlty Issues need to be confronted. These can be discussed In terms of tradeoffs of distrlbutlonal benefits between three pairs of groups: (I) farmers vs. nonfarmers, (11) ralnfed vs. Irrigated farmers and (111) poorer vs. richer Irrigated farmers. The farmers vs. nonfarmers tradeoff occurs via Indirect cost recovery. Where significant Indirect cost recovery exists, farmers are being taxed In preference to taxing nonfarmers; and the case for further taxation of farmers Is very weak. Rather nonfarmers should be asked to assume muire of the tax burden. If rainfed farmers are carrying a significant part of the Incidence of Indirect taxatlon, then a strong case exists for direct taxation of Irrigated farmers via Irrigatlon service frees In order to recover the costs of irrigation, In additlon, a reduction of the Indirect tax burden on rainfed farmers Is recommended since Irrigation costs can be recovered directly from Irrigated farmers and ralnfed farmers should not be taxed when the benefits go to others. Note, however, that rainfed farmers are burdened by the Incidence of Indirect taxes only to the extent that they purchase non-labor Inputs and market Indirectly taxed agricultural outputs. Finally, as we have seen, the attempt to discrkiinate between richer and poorer Irrigated farmers vla differential Irrigation service fees uses the wrong tax Instrument and Is to be avoided. in additlon, to the extent that Irrigation Investments result In lower prices for nontradeable foods. the Irrigation benefit Is transferred to consumers of these goods.

Clearly, the equity Issues of Irrigation rent transfers require analysis of the distributional effects of government interventions on both the demand and supply sides.
- 27 -

This can be done, but It requires skilled analysts and usually some data collection. General principles and some applications to agriculture are discussed In the volume edited by Newbory and Stern (1987), especially Chapter 13 (by Newbery) and Chapter 16 (by Sah and Stigiitz).

To deal with countries, such as india, which reject direct Irrigation service fees and clakm that Irrigation rerit transfers are part of a distrlbutlonal policy, would seem to require a complex analysis of distributional effects. Moreover, the results might Indicate the need for extensive tax adjustments. For less refractory borrowers who accept the prlnciple of Irrigation service fees, a less complex analysis should be adequate In many cases. In general, one would expect that significant Irrigation service fees would be Indicated. If direct cost recovery Is to be meaningful, these fees must be Indexed, elther to an Index of orices received by farmers or to a cost of living Index. The analytical work required to confront the equity Issues of irrigation rent transfer Is best carried out In connection wlth pollcy-based lending. Repetition of this speclalized work for each irrigatlon project would be unnecessary and wasteful.

# VIIL SUIMARY

Up to 1976, Bank policy emphasized recovery of all costs, or at a minkium complete recovery of operations and malntenance costs. Subsequently, policy specified three pricing objectives for design of Irrigation service fees: economic efficiency, Income distribution and public savings. The economic efficiency objective was framed In Irrelevant terms, while the quite detailed Income distribution objective Instructions were unworkabla. This leaves the public savings objective for which there were not any clear-cut,
- 28 -

unambiguous instructions. Thus, for the past 12 years, effective formal policy guidelines for irrigation cost recovery have been nonexistent. Of course, Bank lending for irrigation has been active over the 1976-88 perlod, which leaves the clear Inference that Informal rules of thumb for designing cost recovery covenants have existed. Unfortunately, an OED review of loan conditionality concerning Irrigatlon cost recovery for this period has not yet been produced. However, the 1986 OED review of this topic covering the perlod up to 1976 disciosed that the record was not good In that earlier period. In at least two-thirds of the projects reviewed, the covenant requiring that cost recovery at least cover O&M costs had not been compiled wlth. In many cases, the covenants concerning cost recovery were so vague that It was difficult to determine whether there had been compliance or not. O&M of the Irrlgation systems concerned was considered satisfactory at audit In only about half of the projects.

Given the demonstrated Inadequacy of existing guidelines concerning Irrigation finance aind the growing concern with quality control on Bank-financed Irrigation Investments, a synthesis of the hard lessons from Bank lending experience into a better framework for irrigatlon lending Is needed. This paper suggests that six basic propositions distilled from Bank experience can serve as the basis for such a framework:

- I. Accept the diversity of cultures and institutional arrangements In borrowing countries and substitute flexibility and Ingenulty In designing feasible irrlgation Institutlons.

- li. Focus tNix dlalogue upon the physlcal sustalnability of irrigation Investmer.a and associated natural resources.

- Ill. Approach the finance of Irrigation as a policy adjustment Issue.

- Iv. Base cost recovery pollcy on an analysis of the totality of government Interventions.

- v. Assign tax policy Instruments to appropriate policy objectives.
- 29 -

vI. Accept Indirect cost recovery whore It exists, but insist on an accounting of tho oquity Issues of irrigation rent transfer.

These propositions yleld a number of knplcatlons for irrigatlon lending that should kmprove existing practice. The first two knply that the Bank would be more flexible concerning institutional preferences but would Insist more strongly on arrangements that preserve the sustainability of Irrigation Investments and associated natural rosources. A key feature of the emphasis on sustainabillty requires the development of an "OLM Plan" with the borrower at the tkne of appraisal. This plan would go beyond the provision of adequate O&M funding to specify the level of effort required to sustain the Investment. Covenants requiring compliance with the O&M Plan would be part of ioan agreements and their vilation would Initiate a mandatory Bank response. Repeated violatlon would usually end In cessation of Irrigation lending.

The third and fourth propositions address Issues of Irrigation finance and cost recovery. The clear lesson from the Kruoger-Schlff-Valdes study Is that most countries prefer to kmpose direct and Indirect taxes on agricultural commodity outputs. This taxatlon Is usually massive and further taxes on farmers can only be hkposed on cost recovery or equity grounds. Often additional taxatin will not be justified. This determination requires, however, a thorough-golng economic analysis that goes beyond direct taxation. Repilcation of the KSV methodology (where necessary) would seem to be an obvious first step In such an analysis. An obvlous corollary of the KSV study Is that irrigation finance Is most appropriately addressed as a policy adjustment Issue.

The last two propositions deal specifically with Issues of officlency and equity that arise In connection with the analysis of irrigation service fees. They are compiemontary to the third and fourth propositions In that they are concerned with the Issues of tax
- 30 -

efficiency and equity that emerge in Irrigation cost recovery. In particular, It Is urged that the analysis take Into account the welfare effects on the major groups that are Involved; and the appropriate objective for irrigation service fees Jjn the absence of equlty Issues) Is the pubilc savings or cost recovery objective.

# VIIL EPLOGUE

This paper Is a modest effort to clear away the confusion surrounding irrigatlon policy both Inside and outside of the Bank. That there Is a need for a policy dlalogue within the institutin on this topic Is Increasingly apparent. In Its present form, the paper reflects the comments and criticism of many Bank staff concerned wlth Irrigation; and while some of them may not yet find It entirely to thelr liking, It has significantly benefited from their Inputs. Certainly, this paper represents the first and not the last shot In the latest controversy over irrlgation policy within the Bank. Also, lest we forget, the outside world Is also observing and commenting on our actions. Thus, Stelnberg (1983) observed In an USAID conference volume: "It Is significant that to date the World Bank has no policy paper on Irrigation, as there are Internal disputes on such matters as water-user fees and technological Issues such as the llning of canals."
- 31 -

# **REFENCES**

Krueger, Anne O., Maurice Schiff & Alberto Valdes, 1988, "Agricultural Incentives In Deveioping Countries: Measuring the Effect of Sectoral & Economywido Policies", World Bank Econormic Review, 2(3):255-271.

Newbery, David & Nicholas Stern, editors, 1978, The Theory of Taxation for **Deveobph** Countries, Now York: Oxford University Press (for The World Bank), July.

Newbery, David, 1987, "Agricultural Taxation: The Main Issues", Chapter 13, in Newbery & Stern, eds.

O'Mara, Gerald T., editor, 1988, Efficency hI rrigatbn, Washington DC: rhe World Bank, March.

O'Mara, Gerald T., 1988, "The Efficient Use of Surface Water & Groundwater In irrigatlon: An Overview of the Issues", Chapter 1 In O'Mara, ed.

Radosevich, George, 1988, "Legal Consideratlons for Coping with Externalities In Irrigated Agriculture", Chapter 3 In O'Mara ed.

Sah, RaaJ Kumar & Joseph Stiglitz, 1987, "The Taxation & Pricing of Agricultural & Industrial Goods In Developing Economies", Chapter 16 In Newbery & Stern, eds. Stelnberg, David I., 1983, rriatlon & AID's Experience: A Consideration Based on Evaluatlons, Program Evaluation Report No.8, USAgency for International Development, August.

Wade, Robert, 1979, "The Social Response to irrigation: An Indian Case Study", Journal of Development Studies 16(1):3-26.

Wade, Robert, 1982, "The System of Administrative and Political Corruption: Canal Irrigation In South India", Journal of Development Studles 18(3):287-328.
- 32 -

World Bank, Projects Staff, 1980, 'irrigatlon Water Charges, Benefit Taxes and Cost Recovery Pollcies," Central Projects Note No. 2.10, June 6.

World Bank, Agriculture and Rural Development Department, 1984, "Financing Operations and Malntenance In Irrigation", March.

World Bank, Operations Evaluation Department, 19U6, 'World Bank Lending Conditionality: A RovIew of Coet Recovery i Irrigation Projects", Report No. 6283, June 25.

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|WPS403|Innovative<br>Agricultural<br>Extension<br>for Women: A Case Study of<br>Cameroon|S. Tjip Walker|||
|WPS404|Chile's Labor Markets in an Era of<br>Adjustment|Luis A. R;viiros|April 1990|R. Luz<br>34303|
|WPS405|Investments<br>in Solid Waste<br>Management:<br>Opportunities<br>for<br>Environmental<br>Improvement|Carl Bartone<br>Janis Bemrtein<br>Frederick Wright|April 1990|S. Cumine<br>33735|
|WPS406|Township,<br>Village, and Private<br>Industry in China's Economic<br>Reform|William Byrd<br>Alan Gelb|April 1990|K. Chan<br>38966|
|WPS407|Public Enterprise<br>Reform:<br>A Challenge<br>for the World Bank|Ahmed Galal|April 1990|G. Orraca-Tetteh<br>37646|
|WPS408|Methodological<br>Issues in Evaluating<br>Debt-Reducing<br>Deals|Stijn Claessens<br>Ishac Diwan|||
|WPS409|Financial Policy and Corporate<br>Investment<br>in Imperfect Capital<br>Markets: The Case of Korea|Mansoor<br>Dailami|April 1990|M. Raggambi<br>37657|
|WPS41<br>0|The Cost of Capital and Investmen<br>in Developing<br>Countries|t Alan Auerbach|April 1990|A Bhalla<br>37699|
|WPS411|Institutional<br>Dimensions<br>of Poverty<br>Reduction|Lawrence<br>F. Salmen|May 1990|E. Madrona<br>37496|
|WPS412|Exchange<br>Rate Policy in Developin<br>Countries|g W. Max Corden|May 1990|M. Corden<br>39175|
|WPS413|Supporting Safe Motherhood:<br>A Review of Financial<br>Trends<br>Full Report|L. M. Howard|May 1990|S. Ainsworth<br>31091|
|WPS414|Supporting Safe Motherhood:<br>A Review of Financial Trends<br>Summary|L. M. Howard|May 1990|S. Ainsworth<br>31091|
|WPS415|How Good (or Bad) are Country<br>Projections?|Norman Hicks<br>Michel Vaugeois|April 1990|M. Berg<br>31058|
||ila|PRE Working Panr Seris<br>Athr|2la<br>e|Contact|
|---|---|---|---|---|
|WPS416|World Bank Efforts at Poverty<br>Measurement in the Third World: Th<br>Living Standards Measurement Stud|Paul Glewwe<br>e<br>y|||
|WPS417|Modeling the Macroeconomic<br>Requirements of Policy Reform|William Easterly<br>E. C. Hwa<br>Piyabha Kongsamut<br>Jan Zixik|May 1990|R. Luz<br>34303|
|WPS418|Does Devaluation Hurt Private<br>Investment? The Indonesian Case|Ajay Chhibbor<br>Nemat Shafik|May 1990|M. Colinet<br>33490|
|WPS419|The Design and Sequencing of<br>Trade and Investment Policy Reform<br>An Institutional Analysis|Brian Levy<br>:|||
|WPS420|Making Bank Irrigation Investments<br>More Sustainable|Gerald T. O7Aara|May 1990|C. Spooner<br>30464|
|WPS421|Taxation of Financial Intermediation<br>Measurement Principles and<br>Application to Five African Countries|: Christophe Chamley<br>Patrick Honohan<br>|||
|WPS422|Civil Service Reform and the World<br>Bank|Barbara Nunberg<br>John Nellis|||
|WPS423|Relative Price Changes and the<br>Growth of the Public Sector|M. Shahbaz Khan|||
|WPS424|Mexico's External Debt<br>Restructuring in 1989-1990: An<br>Economic Analysis|Sweder van Wiinbergen|||
|WPS425|The Earmarking of Government<br>Revenues in Colombia|William A. McCleary<br>Evamaria Uribe Tobon|||
|WPS426|Growth-Oriented Adjustment<br>Programs: A Statistical Analysis|Riccardo Faini<br>Jaime de Melo<br>Abdol Senhadji-Semlali<br>Julie Stanton|||