Report No. 14546-BUL Bulgaria Private Sector Assessment June 28i, 1996 (oLINlrV C)O[r.tioii1 (CunlrN IDepIhrtment I Eur]oe)( Id(l (entrjil Asii Rkeriua Document of the World Bank CURRENCY EOUIVALENTS Currency Unit = Bulgarian LEV (plural Leva) AVERAGE VALUE OF US$1.00 IN LEVA 1993 1994 1995 June 1996 28.00 53.73 67.18 149.41 WEIGHTS AND MEASURES Metric System GOVERNMENT'S FISCAL YEAR January I - December 31 ABBREVIATIONS AND ACRONYMS BBRD = Bulgarian Bank for Reconstruction and Development BNB = Bulgarian National Bank BSP Bulgarian Socialist Party CAS = Country Assistance Strategy CMEA = Council for Mutual Economic Assistance DDSR = Debt and Debt Service Reduction Loan EBRD = European Bank for Reconstruction and Development EFTA = European Free Trade Association EIB = European Investment Bank EU = European Union FDI = Foreign Direct Investment FIAS = Foreign Investment Advisory Service FRY = The Federal Republic of Yugoslav (Serbia and Montenegro) G-24 = Group of 24 Countries GDP = Gross Domestic Product GEF = Global Environmental Facility ICOR = Incremental Capital-Output Ratio IDF = Institutional Development Fund IFI Intermediary Financial Institutions LIBOR = London Inter-Bank Offer Rate LRMC = Long Run Marginal Costs NEK = National Electric Company ODS = Ozone Depleting Substances OECD Organization for Economic Cooperation and Development PIR = Portfolio Implementation Review RM = Resident Mission RWC = Regional Water Company SAL = Structural Adjustment Loan SBA = Stand-By Arrangement (IMF) SOE = State-Owned Enterprise STF = Systemic Transformation Facility (IMF) TAL = Technical Assistance Loan VAT = Value-Added Tax BULGARIA PRIVATE SECTOR ASSESSMENT page EXECUTIVE SUMMARY . ..................................... i Constraints to Private Sector Development ........................ i Difficult Environment for Private Firms ......................... ii Limited Access to Credit .................................. iv Taxes and Tax Incentives .................................. vi CHAPTER1 .............................................. 1 SIZE AND SCOPE OF THE PRIVATE SECTOR ...................... 1 Unfavorable Initial Conditions ............................. 1 Rapid Growth in Small, Informal Firms ....................... 2 Small Firms Dominate--Mostly in Trade and Services .............. 2 Few Large Private Firms ................................ 4 Most Firms Owned by Individuals and Partners .................. 5 Underestimated Private Sector Activity ........................ 5 Commercial Relations Between Private Firms and State-- Enterprises Private Gains at Public Expense ................... 6 Limited Entry of Foreign Firms ............................ 8 This report is based on an IBRD mission that visited Bulgaria in October 1994 and a joint IBRD and IFC mission in February 1995. The report was discussed with the authorities in March 1996. The report was prepared under the general direction of Zeljko Bogetic (Task Manager). The main authors are Zeljko Bogetic and Arye Hillman (chapters One and Two), Heywood Fleisig (chapter Three), George Zodrow (chapter Four), Lubomir Mitov (estimates of the informal sector activity), and Laurence Carter (who coordinated IFC's input on private participation in infrastructure, leasing, and parts of chapters One through Three, reflecting inputs from the findings of a field mission in May 1995, as well as drawing on experience from the IFC Europe Department and FIAS). Significant inputs were provided by Kyle Peters and Bob Anderson (section on privatization, chapter Two). Peer reviewers were Neil Roger, Douglas Webb and Christine Wallich. Douglas Webb, Ian Newport and Galina Mikhlin provided comments on Chapter Three. Faith Smith, Jennifer Francis O'Connor and Suzanne Zamora were responsible for the production of the report. The report is prepared in the Country Operations Division (Division Chief Christiaan J. Poortman) of the Southeastern Europe Department (Department Director Kenneth Lay, Lead Economist Frank Lysy). CHAPTER 2 ................................ 11 THE ENABLING ENVIRONMENT FOR PRIVATE BUSINESS .11 The Macroeconomic Climate .12 Privatization .13 The Legal and Institutional Framework .17 Private Property and Freedom to Engage in Economic Activities .17 Foreign Investment .17 Law and Order .18 Supporting Institutions for Private Business .19 Chamber of Commerce and Other Associations .19 Standards and Technical Requirements 19 Government Regulations Affecting Private Business .20 Land and Business Premises .20 Regulation of Anti-competitive Practices .21 Regulation of International Transactions .21 Foreign Market Access .22 Business Licensing .23 State Procurement Policies .23 Infrastructure Constraints and Private Participation .23 CHAPTER 3 .............................................. 25 FINANCIAL MARKETS, SECURED TRANSACTIONS AND ACCESS TO CREDIT .25 Financial Markets .25 Secured Transactions and Access to Credit .27 The sources of the Secured Transactions Problem .29 Leasing .33 CHAPTER 4 .35 REMAINING TAX ISSUES .35 The Current Tax System: Background .35 The Current Income Tax System .37 The Profits Tax .37 The Individual Income Tax .38 Proposed Reforms of the Existing Income Tax Structure .38 Evaluation of the Case for Investment Incentives .39 Rate Reduction ........................... ........... 40 Additional or Accelerated Investment Deductions .42 Tax Holidays . 42 LIST OF BOXES, FIGURES AND TABLES Table 1.1: Private Firms, 1989-95 .............. 2 Table 1.2: Sectoral Distribution of Private Firms in Bulgaria ............... 3 Table 1.3: Bulgaria in Context: Cumulative FDI, 1989-95 ................. 8 Box 1.1: Cost for Foreign Firms in Bulgaria ......................... 9 Box 2.1: Privatizing Main Telecoms .............................. 24 Box 3.1: Developing the Romanian Leasing Industry .................... 33 Table 3.1: Addressing the Legal and Institutional Roots of Limits to Access to Credit . 34 Table 4.1: Tax Structure (1996) in Bulgaria .......................... 36 Box 4.1: The Indonesian Experience with Incentives ..................... 41 Table 4.2: Summary of Recommendations ........ ................... 44 l~ ~ ~~~ ~ ~~~ ~ ~~~ ~~~~ ~~~~ ~~~~ ~~~~ ~~~~ ~~~~ ~~~~ ~~~~ ~~~ ~~~ ~~~ ~~~ ~~~ ~~~ ~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ EXECUTIVE SUINDARY i. The focus of this report is private sector development in Bulgaria. Chapter One reviews the scope and nature of private activity in Bulgaria. Chapter Two analyzes the enabling environment and general constraints to private sector development, including the macroeconomic, legal, institutional, and regulatory environments, slow privatization and the poor state of infrastructure. Chapter Three discusses problems in credit markets and suggests that the development of the framework for secured transactions may alleviate some of these problems. Chapter Four addresses the main distortions in the tax system affecting the corporate sector and evaluates the case for investment incentives. Constraints to Private Sector Development ii. After four years of rapid growth, the private sector is officially estimated to account for 27 percent of total economic activity in Bulgaria. It is estimated that another 18-20 percent of incomes accrue to the private sector under diverse forms of informal activity that escapes official statistics. As in most other transition economies, since 1990, the private sector has been the main source of growth in output and employment. iii. The private sector is concentrated in agriculture and services, particularly retail and wholesale trade and construction. Over 90 percent of private firms are very small, either sole proprietorships or businesses employing fewer than five employees. Much private activity involves informal transactions between private and state enterprises, in which private firms typically purchase inputs on behalf of state enterprises and then market their output. While such functional specialization could bring efficiency gains, in Bulgaria these relationships seem to be based largely on collusion, transfer pricing and tax evasion and are therefore more likely to impair competition, efficiency, and equity. iv. The interaction of three major constraints on private sector development has largely driven the development of Bulgaria's private sector into one characterized by small enterprises heavily concentrated in the informal service sector, with few medium- to large- scale manufacturing firms and little foreign investment: * Macroeconomic instabilty and uncertainty; * Lack of pmgress on structural refonns, especially in privatizing state enterpnses, strengthening theirfinancial discipline and refonning the banking sector; * Inadequate enforcement of contracts and of law and order. These three constraints also underlie the informal, nontransparent relationship between private and state enterprises. These relationships have now become a significant constraint to - ii - reform. They not only impair competition and efficiency. They also deter foreign investors because of their non-transparent and exclusionary nature. v. Many other factors also hinder private sector development. Along with the three main constraints above, this report gives special emphasis to three of those factors: * The poor state of public infrastnrcture, and the potential for increasing private participation in infrastructure provision and finance; * The lack of a proper framework for secured credit transactions; * The remaining distortions in the tax system affecting the corporate sector. Difficult Environment for Private Firms vi. Bulgaria has had a poor record in maintaining a favorable macroeconomic climate for private sector development--one with low inflation and access to credit and foreign exchange. In 1991, an initial strong adjustment effort helped avoid hyperinflation, and made progress in liberalizing the economy by introducing a flexible exchange rate and a liberal trade regime and removing virtually all price controls. And the completion of a debt and debt service reduction agreement with Bulgaria's external commercial creditors was a major step toward reestablishing intemational creditworthiness. vii. But the Government's stabilization efforts have been characterized by stop-go cycles in monetary, fiscal and incomes policies, which have caused periodic exchange rate crises. This has undermined private confidence in domestic currency and caused a shift of household savings into foreign currency deposits. In addition, the authorities have allowed or even required state-owned banks to finance the losses of state-owned manufacturing enterprises and public utilities, leading to large quasi-fiscal deficits. As a result, inflation remains high, limiting private sector confidence and long-term investment and creating much uncertainty. viii. The lack of progress on privatization has been another key constraint on private sector development. The 3,800 remaining state enterprises dominate virtually every industrial subsector and absorb a large share of the economy's available resources. Besides ensuring a stable macroeconomic climate, accelerating the Government's privatization program is the most important step that can be taken to foster private sector development. Successive Governments have established the laws and regulations governing privatization and the institutions responsible for implementing the Government's market and mass privatization programs. But only a small number of large enterprises have been privatized. - iii - ix. Three factors have constrained privatization. First, political commitment to privatization has been weak, and numerous changes in the institutional framework have stalled the process. Second, inappropriate methods (including lengthy prior appraisals of enterprises and top-down, case-by-case approaches) and inappropriate objectives (focussing on maximizing the selling price and identifying strategic investors) have made privatization extremely difficult even for selected enterprises. Finally, factors affecting enterprises, such as ambiguities generated by land restitution, unclear land titles and overlapping authorities of institutions, have severely limited the availability of enterprises for privatization. x. The Government has made a strong political commitment to privatization but the process remains slow and progress limited. One sign of this commitment: it has charged the newly created Ministry of Economic Cooperation and Development with overseeing the entire privatization process, both market and mass privatization. The Government now needs to implement mass privatization; accelerate market privatization by setting clear yearly deadlines and holding line ministries and agencies responsible for shortfalls; permitting all enterprises to be eligible for privatization, unless they are on a short negative list; simplifying evaluation and appraisal procedures; allowing managers and workers to be more involved in the process, particularly through management-and-employee buyouts, which has been successful in other countries; and quickly eliminating legal obstacles, especially those related to land. xi. The Government's mass privatization program is crucial to privatizing large enterprises quickly. The Government has already finished much of the initial planning and made many important decisions. The Czech-style mass privatization program it plans already has an organizational framework and registration system for the vouchers was established. Enterprises have been selected for inclusion in the program, a process that has proved politically contentious in most countries. An auction system must be selected and implemented. Ensuring that this system will work within a reasonable time will require careful monitoring and implementation. Accelerating small privatizations and completing the first wave of mass privatizations will be crucial steps in moving Bulgaria closer to a market economy with a healthy private sector. xii. Bulgaria has overhauled its old legal framework and developed most key components of a legal framework for a market economy (for example, the new Constitution, Commercial Code, and Competition Law). Restitution laws have aided in privatizing farmland and urban property, and the Privatization Law (1992) provides the legal basis for converting state enterprises to private ownership. The 1994 Bankruptcy Law enables bankruptcy procedures to be initiated. The Banking Law and prudential regulations by the Bulgarian National Bank could form the framework for developing a dynamic financial sector. The Value Added Tax Law (1993) moved the old tax system toward a modern one similar to that in many market economies. The Foreign Investment Law, with some required modifications, could ensure a sound legal environment for foreign investment. And while simply rewriting laws does not immediately result in full enforcement and a change in - lv - economic behavior, Bulgaria has established a solid general legal framework for a market economy. xiii. But continuing weaknesses in the legal system are serious constraints to the development of a competitive private sector. Enforcement is lacking in a number of areas. The court system is slow in decisionmaking. Alternative, informal institutions for resolving commercial disputes are poorly developed, costly and uncertain. Furthermore, the private sector's access to land and buildings is complicated by uncertainties about ownership among enterprises, municipalities and the Central Government. Private businesses often complain about the need to seek protection from other individuals and groups. Weak legal enforcement has also led to the establishment of informal commercial interactions between private and state enterprises that are based on a variety of nontransparent and anticompetitive practices and outright collusion between state enterprise managers and insiders and private firms. xiv. Private firms also identify the poor state of the country's public infrastructure-- transport, telecommunications, energy, and urban services--as an important constraint to their development. Heavily limited access and unreliable telephone, water and electricity services raise the cost of doing business; they also deter potential foreign investors. Large investments will be required to upgrade Bulgaria's economic infrastructure, and Bulgaria's public sector is already overextended both financially and in its implementation capacity. In response to similar challenges, many countries are encouraging private participation in infrastructure--through privatization of existing assets and the entry of new firms under concession arrangements--to improve service quality, increase investment and reduce fiscal burdens. Bulgaria has made only limited moves toward private participation in infrastructure, with changes most evident in telecommunications. A more concerted government effort in this area could improve efficiency and service quality and increase domestic and foreign investment. Limited Access to Credit xv. The Bulgarian banking sector, the core of the financial sector, faces many problems. The most important is the practice of continued lending to loss-making state enterprises, which limits its ability to extend credit to the private sector. To date, banking sector reform has focussed mainly on consolidating state banks, enacting prudential regulations and very limited supervision. Reforming banks' governance is crucial to allow the banking sector to play its role in directing credit toward the best investment opportunities and in enforcing financial discipline on the enterprise sector. The key changes needed to improve governance are strengthening bank supervision and regulation, eliminating political interference in the allocation of bank credit, and increasing the share of private banks in the sector (partly by limiting the growth of the state banks and partly by privatizing public banks and divesting some of their activities). v xvi. Improving the framework for the use of collateralized credit transactions (loans secured by fixed or mdvable assets) would complement the reform of the banking system by enhancing the new private sector's access to credit. Legal and regulatory changes are needed to improve this framework, especially by facilitating collection. Experience in many industrial and developing countries shows that more extensive use of secured lending by improving the possibilities of collection, could facilitate overall financial sector reform' in several ways: * For banks with good governance and adequate capital, secured lending will expand lending opportunities in a way consistent with safe and prudent banking practices. * Secured lending will enable nonbank financial lenders, especially leasing and finance companies, to complement and compete with bank project financing. * And it will allow nonbank, nonfinancial creditors, such as wholesalers, dealers, and importers, to expand their lending more safely and securely and consequently at lower interest rates. xvii. A market for collateralized or secured credit has not yet developed in Bulgaria, limiting the development of the overall financial sector. Real estate is the only form of collateral that banks regularly accept. Those who do not own real estate have severe difficulties obtaining credit. The pledge registry necessary for lending against machinery, equipment and vehicles does not exist. Hence, even automobiles cannot be purchased on credit. Private bonded warehouses are non-existent. xviii. Reforms in the following three areas could ease these problems. First, the law concerning secured transactions could permit more general claims against collateral, permitting a wider variety of property to serve as collateral for a larger number of economically important transactions. Second, new pledge registries must be created and existing registries must be streamlined so that lenders can more easily give legal certainty to their claims through perfecting them. Finally, laws and procedures must permit more rapid repossession and sale of collateral to permit shorter-lived and lower-value movable property to serve as a satisfactory guarantee for a loan or a financial lease. xix. Addressing these collateral-related problems will also permit more rapid development of the leasing industry. Experience from other countries shows that leasing companies help to stimulate competition in the financial sector, and stimulate capital market 1. However, this is not likely to affect the behavior of many important state banks in Bulgaria--for example, state banks whose main problem is the political nature of the lending decisions, or banks for which connected lending is the main source of portfolio problems. - vi - development. Of course, the development of a leasing industry is no substitute for the important structural changes needed in the banking sector. Taxes and Tax Incentives xx. Taxes matter for private sector development. Tax reform has reduced and simplified the previous complex rate structure, broadened the base, and introduced modem, less-distorting tax instruments, such as the value added tax (VAT). As a result, the tax structure is- now much simpler than it was at the outset of the transition. The challenge now is to deepen tax reform in specific areas. Two tax issues that require attention are the high burden of payroll taxes and the income tax structure and its effect on investment. xxi. Bulgaria has very high payroll taxes forfinancing social benefits and insurance payments. These taxes discourage formal employment by raising the cost of labor. The large wedge between the gross cost of labor to the employer and the net pay of the employee also encourages tax evasion. To counter the incentives for tax evasion and provide a more hospitable tax environment for expansion of the formal private sector, the best approach is to reduce the burden of payroll taxes. For revenue reasons, the proposed sequencing is first to reduce payroll taxes on the private sector. This would have beneficial incentive effects, and it may not reduce revenues, since the loss in revenue from the formal sector may be compensated for by a reduction in tax evasion. After the revenue effects of this first step are clear, the authorities could then reduce the payroll taxes on the state enterprise sector. Of course, this must be combined with a rationalization of the social protection system and an improvement in its targeting. xxii. Chapter 4 suggests reforms in Bulgaria's corporate income tax structure that would reduce the existing bias in favor of debt over equity finance. Also, in response to the Bulgarian authorities' interest, it discusses the effects of explicit investment incentives and provides examples of such schemes from other countries. The report concludes that explicit tax incentives for investment should not be introduced. Instead, the simplest most efficient and equitable investment incentive in Bulgaria's current circumstances is a reduction of the corporate tax rate in conjunction with the elimination of many deductions, and a complementary reduction of the top individual income tax rate. Consideration of other investment incentives should be deferred to allow time to analyze the level and pattern of investment flows once the proposed reforms have been in place for at least three years. xxiii. The following table provides a preliminary road map for matching identified private sector development policy areas and issues with possible solutions and proposed activities on the part of the government. It aims to provide a preliminary integrated framework for thinking about how best to assist private sector development in Bulgaria and it should be continuously discussed and reassessed. - vii - A ROAD MAP FOR PRIVATE SECTOR DEVELOPMENT IN BULGARIA RB~OPM WA JR0B(~Y (* . .........U .... , . '' ''''.''"'''','""'~~~~~~~~~~~~~~~~~ .... ..... ........ ...... ..... " n'S--" Legal and low at the level of enactment, the basic - revisit and modify foreign institutional legal framework for a private investment law as assessed by framework property, market economy is in the PLAS study place; identify remaining specific - revisit priority claims in the gaps in the laws already in place; bankruptcy law provide legal framework for - prepare a securities law (presently self-regulated) capital markets Political high political will and political stability - forge consensus for further comnmitment and that allows the government to focus reforms ownership of PSD on key policy issues - make public and credible reforms announcement of commitment to further reforms, particularly privatization Macroeconomic high pursue policies that ensure price - establish and maintain environment stability, prudent fiscal and monetary prudent macroeconomic policies, responsible incomes policy policy stance to reduce and access to foreign exchange for inflation and budget deficit private firms and maintain competitive exchange rate Tax system medium Increase stability of taxes over time; - improve the income tax reduce rates and broaden base system (for details, see whenever possible (see Chapter Chapter Four, Table 1) Four); lower tax burden on labor employment; improve tax administration and make widely public non-compliance; create a more level-playing field and better climate for PS investment Labor market high encourage formal labor-market - reduce tax contribution on relations by reducing the tax burden labor employment associated provision for social insurance and benefits in formal employment - viii - Access to land Medium Clear demarcation lines of central - Clarify boundaries of central and premises and local ownership, greater and municipal ownership transparency and less bureaucratic - Simplify leasing procedures discretion in local municipalities' - Establish transparent criteria leases and rezoning decisions for rezoning of land, to minimize discretion of local officials International trade Medium Maintain and deepen liberal trading - Eliminate remaining imnport regime and export quotas - Change foreign investment law subject from the legal person to the foreign investor - Improve the institutional climate for private sector development, as per FIAS _____ ____ ____ _ __ ____ _____ ____ ____ ____ ____report recommendations Infrastructure High Create a business-friendly - Consider options for allowing environment for greater competition private competition and and private sector participation in contracting out for select infrastructure with the goal of services increasing infrastructure investment; - Privatize some infrastructure general need to bring supportive enterprises to attract foreign infrastructure to western levels and domestic private investment Privatization Extremely high Sharply accelerate a privatization, a - Implement on schedule strong government commitment is revised mass privatization needed to mnake privatization the program (See Chapter Twvo) centerpiece of further reforms - Launch a public information campaign to gain popular support for privatization - Relaunch small privatization with new methods, including auctions and mnanagement and employee buyouts (MEBOs) - Accelerate market privatization by decentralizing the process and simplifying procedures lx - .~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~.... ..: ... ..| ....... :~~~~~~~~~~~~~~~~~~~~~~~~~~ .::.::::::.::.;: Supportive Medium Support is available, but increased - Widely publicize services of institutions for publicity is required concerning Chamber of Commerce and private business availability of advisory services other support organizations provided by the Chamber of - Encourage private entry in Commerce and other supportive the business of general business organizations information and service support for private sector development Access to credit Medium Limit bank lending to loss-making (see specific recommendations in and collateral, enterprises and the government to Chapter Three, Table 3.1) and leasing make more credit available to private sector; improve legal and procedural environment to unlock the considerable potential of collateral- based lending to PS; create new registries and widen public access to existing registries CHAPTER 1 SIZE AND SCOPE OF THE PRIVATE SECTOR 1.01. This chapter provides an overview of the private sector in Bulgaria, discussing its size, scope, and the nature of activity. The overall picture is one of fast-growing private activity, organized in units of very small size, mostly in trade and services, and interacting intensively with the remaining state sector enterprises in pursuit of profit. Because of the lack of significant formal privatization to date, much of the private sector is located in the unclear border zone between the formal private and the state enterprise sectors. This zone is often characterized by uncompetitive, nontransparent relations aimed at profit shifting and tax evasion. This is also identified as a major constraint to further formal private sector development and entry of foreign firms and investors (other general constraints are discussed in Chapter Two). A major conclusion of this chapter is that accelerating formal privatization is necessary to increase the competitiveness and transparency of the Bulgarian private sector. Unfavorable Initial Conditions 1.02. Bulgaria under communist regime was an orthodox-planned economy with almost no private property rights over productive resources. Private ownership was limited to owner-occupied housing, country houses, and small plots of land. The communist regime in Bulgaria maintained a rigid attitude toward private activity. Private enterprises were not legalized until late 1988. Therefore, when communism came to an end in Bulgaria, there had been very limited private sector development. The private sector contributed no more than 5 percent to Bulgaria's GDP in 1989. 1.03. The situation in Bulgaria was very different from that in Poland and Hungary. In Poland and Hungary, step-by-step liberalization throughout the 1980s had allowed the development of small private businesses. There was also more informal privatization of state assets, and state enterprises were more loosely controlled by the state. Thus, Hungary and Poland's private sectors were larger and more developed at the outset of the transition. 1.04. Since 1989, Bulgaria's private sector has developed very rapidly. Substantial restitution of land and buildings provided an important impetus to private sector development. This led to flourishing retail and service sectors, particularly in the major cities. Privatization in the state enterprise sector has been very slow, however, for both small and large state enterprises. As a result, the private sector in Bulgaria consists mostly of newly formed firms using owned, restituted or leased land and property, with only a handful of privatized enterprises and a few officially approved joint ventures between state and foreign and domestic private firms. Rapid Growth in Small, Informal Firms 1.05. Since restrictions on private sector activity were removed, there has been a dramatic increase in the number of private firms. Private firms are required to register with the courts as legal entities. The number of registered firms has increased more than tenfold-- from 24,500 at the end of 1989 to 330,000 in 1994 and 360,000 in 1995 (Table 1.1). This growth has meant that Bulgaria has experienced a faster rate of increase in the number of private enterprises per person than either Hungary or Poland. Table 1.1: Private Firms, 1989-95 1989 1990 1991 1992 1993 1994 19950 Shae of private ector in GDP - 9.1 11.8 15.3 20.0 27.2 36 (percent) Numnber of private firms registered 24,500 48,000 180,000 240,000 290,000 330,000 360,000 Increase in number of private firms - 96 275 33 21 14 9 (percent) Memo Ien: Change in GDP (Percent) -3.3 -9.1 -11.7 -6.0 -4.2 2 2.5 Source: National Statistical Institute, Ministry of Industry, and World Bank stff. 01995 Esimate 1.06. Court registrations, however, tend to overstate the number of private firms in actual operation. Apparently, many firms were registered for a single, or a limited number, of business transactions. Roughly half (146,835) of firms registered with the courts complied with the Accountancy Law and reported to the National Statistical Institute (NSI). These firms constitute the principal database for official statistics on the private sector. Small Firms Dominate-Mostly in Trade and Services 1.07. By 1993, 60 percent of the private sector firms reporting to the NSI were in trade and services, and they accounted for 75 percent of private sector net sales revenue; 15.5 percent were in industry, which contributed 9 percent of private sector net sales revenue. Many private firms are also active in construction and transportation. 1.08. Almost all private firms are small, both in employment and in sales. According to NSI data, over 90 percent of firms have fewer than five employees. Only 0.1 percent of firms have more than 50 employees. Firms in trade and marketing, transportation and finance tend to be smallest, employing fewer than five employees. Private firms of significant size are beginning to emerge in construction, where the proportion of firms employing over 5 employees, although small, is the highest of all sectors in the economy. This contrasts with large employment per firm in the state-enterprise sector. Thus, for -3 - Table 1.2: Sectoral Distribution of Private Firms in Bulgaria Net sales Number of Proportion revenue Share of Sectors firms in sector (millions net revenue (percent) of leva) (percent) Total 146,835 100.00 122,233 100.00 Industry 22,801 15.53 11,652 9.12 Construction 7,029 4.79 1,652 7.67 Agriculture 1,654 1.13 9,798 1.01 Forestry 34 0.02 40 0.03 Transport 13,600 9.26 3,288 2.57 Communications 15 0.01 51 0.04 Trade and marketing 88,084 59.99 95,396 74.68 Housing and public utilities 3,981 2.71 662 0.52 Science and scientific services 120 0.08 92 0.07 Education 725 0.49 44 0.06 Culture and arts 959 0.65 127 0.10 Health and social security 1,273 0.87 505 0.40 Finance, credit, insurance 1,397 0.95 1,715 1.34 Management 573 0.39 260 0.20 Other 4,620 3.14 2,787 2.18 Note: The total number of firns in this table refers to the operating Jirms, as opposed to registered finns, referred to in Table 1. 1. Source: National Statistical Institute of Bulgaria. example, 75 percent of the members of the Bulgarian Industrial Association (the employers' federation) which are private firms account for less than 10 percent of total labor employment of Association members. 1.09. Median sales revenue for private firms was approximately $2,000 a month. Seventy percent of firms reported sales revenue of less than 200,000 leva, 4.5 percent of firms in excess of 3 million leva and only 1.3 percent in excess of 10 million leva. - 4 - 1.10. The NSI data on the size distribution of private firms by revenue and number of employees may be subject to a reporting bias. Larger firms paying social insurance and social benefit taxes for their employees have no reason to underreport the size of their labor force. But smaller firms, which can more easily evade such payments, have an incentive to underreport. Similar incentives operate for self-reporting of revenues. Therefore, "small firms" may be somewhat larger than the NSI data indicate. Still, the size distribution of firms would not be much altered from that suggested by the reported data. 1.11. There are a number of reasons for the prominence and the small size of private firms in trade and services. These sectors are relatively labor-intensive and require little physical capital, making entry easy. The centrally planned system underprovided consumer products and services. In the new market economy, private entrepreneurs have responded quickly to demand for restaurants, retail shops, and the small-scale provision of numerous private services. This was facilitated by the land and premises made available for trading activities by restitution of nationalized property. In particular, urban restitution (see chapter two for details) contributed to the availability of retail locations, and was a significant factor in the increase in retail distribution and other small-scale services. 1.12. Another important reason for the large share of private firms in trade and services has been the system of state orders that prevailed under communism. State enterprises typically did not engage in extensive financing, marketing, and sales promotion activities. Demand for such services erupted when market transactions replaced state orders. The response of private firms to the demand for market-based services by state enterprises has resulted in symbiotic relationships between them. Few Large Private Firms 1.13. Although the vast majority of private firms are small, some quite large private firms have emerged (including the so-called G-13 companies and other firms with stock market listings). The emergence of these few large private firms has been at the center of a public debate about why some firms have overcome the constraints on growth that have kept most private firms small. One argument is that superior entrepreneurial abilities underlie the success of large private firms. A counterargument is that successful private firms have preferential access to financial resources. There have also been allegations in the press that the financial resources of the successful large firms originate from informal or illegal activities. 1.14. Without more detailed firm-level surveys,2 it is difficult to know which argument is correct. But whichever one is correct has important implications for private sector development. If entrepreneurial abilities underlie the emergence of the small number of large private firms, the distribution of firms by size distributions of firm size in developed 2. For a detailed guide in the use of surveys in assessing private sector development issues and constraints, see Andrew H.W. Stone (1992). "Listening to firms," World Bank Policy Research Paper 923, June. - 5 - market economies where, equally, the number of firms decreases with size. If large private firms have emerged because of preferential access to resources, this suggests that elements of a competitive market environment are lacking, and that artificial barriers selectively inhibit entry and expansion of new firms. Finally, the near absence of medium-size firms, coupled with the informal nature of the small firms and the lack of significant foreign entry, indicate the presence of strong general constraints on private sector growth and development in the formal, tax-paying economy. These constraints are discussed at length in Chapter Two. Most Firms Owned by Individuals and Partners 1.15. Many firms in trade, marketing and transportation--and in industry--are single-person proprietorships, or partnerships. According to labor survey data (which cover twice the number of private sector employees as the NSI private-sector survey), in June 1994, 38 percent of people working in the private sector were self-employed, another 6 percent were family members of the owner, and the rest were employees. Because of the need for trust associated with informal activity, private firms often employ personal friends or extended family. The 6 percent of private sector employees who report themselves as immediate family of the owner may consequently understate the role of family and personal connections in employment relations. 1.16. New Bulgarian entrepreneurs come from diverse backgrounds and professions. Former state enterprise managers and employees, including lawyers, accountants, commercial and financial specialists, often dominate because of their extensive work experience and professional contacts. But university researchers, physicians and housewives have also prospered in Bulgaria's new market economy. Underestinated Private Sector Activity 1.17. The NSI estimate of the contribution of the private sector to the 1994 GDP is 27 percent (Table 1.1). However, the NSI estimate does not fully reflect the private sector's contribution to GDP. Specifically, several indicators, including private employment and profits, are seemingly inconsistent with the official estimate. A more complete estimate of the size of the private sector should include informal activities. But because the informal activity encompasses some redistributive activities (for example, profit shifting from state to private enterprises), estimates of the informal sector should be viewed with caution. For this purpose, the informal sector is defined as the difference between the inferred estimate, and official statistics which capture only the officially reporting, documented, and tax-paying economy. The informal sector generates income from (i) unreported and underreported legal activities, including tax evasion, (ii) quasi-legal or ill-defined activities ranging from small-scale additional payments for installation and services (e.g., telephone and electrical services), to profit shifting from state to private firms, and (iii) the illegal activities of smuggling, bribes, unlicensed sale of tobacco and liquor on which excise taxes have not been paid, coerced security and protection services. Because of the nature of these activities, direct reported data are unavailable. But recent detailed estimates of the informal sector, based on fairly conservative assumptions about the private sector's use of labor and capital inputs and about its productivity, provide a more complete picture of the scope of private activity.3 1.18. According to these estimates, the total private sector (including both formal and informal activities) has since 1990 grown considerably faster than NSI-recorded private sector activities. Much of this private sector growth is attributable to the informal sector; by 1993-94 some two-thirds of the private sector contribution to GDP was due to the informal sector. The share of the informal sector in GDP has consequently been increasing steadily since 1990. These estimates, which include the informal sector, and were calculated as a residual from the official GDP statistics, indicate that the private sector accrued incomes of over 40 percent of GDP in 1994, but its productive activity is lower, because of the income shifting activities. The difference between this estimate and the official estimate of 27 percent of GDP--roughly 18-20 percent of GDP--indicates how much of the informal private sector escapes official reporting. Moreover, as discussed below, much of this informal sector activity originates in the intricate commercial relationships between private and state firms. Commercial Relations between Private Firms and State Enterprises: Private Gains at Public Expense 1.19. Much private activity in Bulgaria appears to involve an intermediation role--the interface--between the state enterprises and the market--for either inputs or outputs. The interface has formal and informal components. 1.20. Formal commercial relations between private firms and state enterprises take the form of joint ventures officially approved by line ministries. Proposals for formal joint ventures between private and state enterprises are evaluated by sector experts in government ministries (the most important in this respect being the Ministry of Industry) on the basis of a submitted business plan, a feasibility study, and a social and environmental impact assessment. Such joint ventures can be structured to leave liabilities (and redundant workers) with a residual state enterprise, and so offer an advantage over outright privatization attempts, in that accumulated debts of the state enterprise do not deter productive use of the enterprise's assets. 1.21. Officially approved joint ventures are but a small part of the commercial relationships between the private sector and state enterprises. Most commercial relationships between private and state firms are informal and not "officially approved" by the responsible line ministries. As an example, state enterprises can formally lease land and equipment without authorization from the Ministry of Industry, but are required to use a public tender 3. Arye Hillman, Lubomir Mitov and R. Kyle Peters "The private sector, state enterprises and informal activity", chapter in Zeljko Bogetic and Arye Hillffan (eds.) (1995). Financing Government in the Transition: Bulgaria, World Bank Regional and Sectoral Study, World Bank, Washington, D.C., 1995. - 7 - for this purpose. But it appears that the tender is often dispensed with, and that the joint venture is prearranged on the basis of personal association. In many cases, these relationships also involve marketing arrangements between private trading companies and state enterprises. These arrangements typically involve the purchase of inputs and the marketing of outputs by private firms and physical production by state firms. Prices underlying these relationships are often negotiated for mutual benefit (for private firms and state enterprise enterprises, and, sometimes, employees), resulting in systematic shifting of profits from state to private enterprises. 1.22. A simple example of this phenomenon is a private firm's commercial relationship with a state-owned processing company. The private firm arranges the delivery of inputs to the company and takes delivery of a processed product. The refinery does not engage in securing inputs nor in marketing its product. Other examples involve more complex transactions and stages of production but follow the same principle of isolating the state firm from the competitive market. In some cases, managers responsible for marketing and input procurement have left the former state trading organizations to set up their own companies which in turn contract with the state enterprises with which they had professional or personal ties. In other cases, a private firm may use the physical plant and workers of the state enterprise to produce its own product, and pay the state enterprise for this use of equipment and labor. 1.23. The range of goods and services covered by these cooperative arrangements is extensive. In many cases, the quality of such goods and services is higher than the quality of those provided by the state enterprises under the past system.4 In one town, joint ventures between private and state firms provide television repair services, furniture, metalwork products, cartons and paper, coats and dresses, work clothes, shoes, and plumbing services. Such joint ventures are essential to private businessmen, because buildings, raw materials, and physical plant belong to the state enterprise, and access to these inputs is only available though cooperation with the state company. 1.24. Arrangements between private firms and state enterprises offer a basis for mutual benefit. Each side gains: the private firm as provider of marketing and financial services, the state firm as a provider of productive capacity that might otherwise lie idle. Yet efficiency is impaired if, as often appears to be the case, exclusive arrangements are involved. Where the state enterprise is the exclusive (monopolistic) supplier of inputs to a private firm, the relationship preempts access by other private firms, impeding competition. 1.25. Informal joint ventures are also likely to give rise to arbitrary, nonmarket pricing decisions that shift profits to the private sector. Corporate income taxation, which taxes state 4. Leszek Balcerowicz and Alan Gelb, 'Macropolicies in Transition to a Market Economy: A Three-Year Perspective," (1994) the World Bank Annual Conference on Development Economics, Washington, D.C. April 28-29. -8- enterprises more heavily than private enterprises, provides additional incentives for shifting profits from state to private enterprises (see Chapter 4). 1.26. A major problem with such non- transparent, non-competitive state-private enterprise relationships is that they are self- Table 1.3: Bulgaria in Context: reinforcing and tend to persist, developing CumuLative FDI, 1989-95 into a low-quality autarkic and inefficient pattern of private sector development. This FDI type of private sector is less likely to Cumulative FDI dollars respond positively to competitive pressures- million dollars per head -by cutting costs, innovating, and searching Bulgaria 397m 47 for new markets. Instead, it is more likely to engage in a broad range of restrictive Czech Rep. 3,996m 388 practices to deter potential competitors, Hungary 10,634m 1,032 domestic and foreign, from competing on a Poland 6,459m 167 level playing field. These relationships also Romania 1,lOlm 48 create incentives not to engage in formal privatization. To counter this development, Slovakia 483m 91 it is necessary to accelerate the formal Slovenia 438m 219 privatization of the state enterprises, Sources: World Development Report, 1996. From thereby providing private owners with an Plan to Market, World Bank, Washington, incentive to protect the enterprise's capital D.C. and profits from opportunistic appropriation. Limited Entry of Foreign Firms 1.27. The entry of foreign firms in Bulgaria has been disappointing. Foreign direct investment (FDI) in Bulgaria is among the lowest in Eastern Europe (Table 1.3), and portfolio investments are constrained by the underdeveloped, unregulated capital market. The exception is the recently launched "Balkan Fund" (sponsored by EBRD and IFC as well as several Greek banks), which invests in companies in Bulgaria and other countries of Southern Europe. A few large foreign firms have also entered out of strategic considerations (Shell, Pepsi, Monsanto), and a few foreign banks have established a presence in Bulgaria (ING, Raffeisen). But there is still no vibrant competition from foreign firms in the domestic market--despite some natural advantages (entrepot position between Europe and the Middle East, a long tradition of trading, potentially strong tourism and developed agroprocessing industries) and progress in early structural reforms (price and trade liberalization, an open foreign investment law, restitution of urban property and agricultural land). 1.28. There are many reasons for the lack of foreign investor interest in Bulgaria. The unstable macroeconomic environment, political instability, the lack of substantial progress on -9 - structural reform (particularly privatization), and the poor state of the banking sector have left many foreign firms doubtful about both current and medium-term prospects for doing business in Bulgaria. Formal institutions and rules are sometimes superseded by informal practice at the expense of "outsiders" (Box 1. 1). Box 1.1: Costs for Foreign And foreign firms view the informal relations Firms in Bulgaria between domestic private firms and state enterprises as a way for "insiders" to restrict The following examples illustrate the "bidden" competition from foreigners. As a result, the costs for lbreign firms in Bulgaria. has been starved of the potential influx When a large depositor considered transferring its economy has been starved of the potentlal mflux - -deposits from a state-owned bank to a foreign of investment, expertise and competition seen in bank, it was suggested that might not be some other transition economies (e.g., appropriate. Hungary), while domestic consumers often pay higher prices for lower quality and less choice Shell entered Bulgaria's fuel distribution market than would otherwise be the case. intending to invest $10 million quickly. Despite than*would winning tendered bids for sites for petrol stations in several locations, investment has proceeded Summary much more slowly than anticipated as the local municipality delayed transfering title to the land. 1.29. Summarizing, in response to opportunities of a market economy, the private Rover is investing about $20 million in a joint sector in Bulgaria has developed rapidly, venture to assemble vehicles. Delays arose in creatog an economy increasingly guided by purchasing the assembly site, part of a state- creatin an ecnomy icreasigly guded byowned diesel complex, because some of it was market signals. Four years after the beginning under construction. Because the part under of the transition, the Bulgarian economy looks construction could not be sold until it was much different: while the state sector still complete, the site was split into the complete and produces the bulk of industrial goods, a growing unfiuiished areas. private sector now dominates services and agriculture. The private sector accounts for a significant portion of total economic activity, ranging from the official estimates of 22 percent of GDP to 40-50 percent of GDP when the large informal sector is accounted for. 1.30. In essence, three private sectors have emerged in Bulgaria: i) Several hundred thousand very small firms have been set up, some with assets based on restituted land and property. Not all these firms are active; those that are operate mainly in trade and services. Some successful private firms deal largely with SOEs in commercial relationships that are frequently non-competitive and non-transparent. Many small firms operate informally, outside the tax system and formal mechanisms for enforcement of contracts (as elaborated in Chapter Two). ii) A few large private firms have developed, some particularly prominent. Some of these firms have close links to and thus privileged access to SOEs and the heavily - 10 - distorted financial system. There are some indications that part of their activities are based on stripping SOE assets, in informal deals with SOE managers where private firms supply inputs to SOEs at inflated prices and purchase their output for re-sale at reduced rates. iii) A few foreign joint ventures have been set up by such companies as Shell, American Standard, Coca Cola and Pepsi. But foreign firms have remained largely on the sidelines of Bulgaria's new market economy. This is a result of a combination of factors, including macroeconomic uncertainties, lack of substantial progress on such key structural reforms as privatization, and the non-transparent nature of many private-state enterprise commercial relations. 1.31. Overall, therefore, the efficiency of Bulgaria's private sector, and its pattern of development, could be significantly improved. Most important is massive formal privatization fostering competition and transparency, particularly in the relations between SOEs and private firms. If the Government accelerates privatization and establishes a stable, predictable, macroeconomic environment, the domestic and foreign private sector is likely to grow more rapidly, providing a sustained increase in incomes, employment and economic opportunities in Bulgaria. - it - CHAPTER 2 THE ENABLING ENVIRONMENT FOR PRIVATE BUSINESS 2.01. The first chapter described a private sector characterized by small enterprises heavily concentrated in the informal service sector, without a significant presence of medium- to large-scale private manufacturing firms or foreign investment. Moreover, there is evidence of wide-scale informal transactions between state enterprises and the "private sector." Three main factors or constraints to private sector development have largely determined the shape and characteristics of the existing private-sector. Fundamental reforms in these areas are urgently needed to achieve a more healthy climate for the private sector and more robust private enterprises. The first constraint is macroeconomic uncertainty and instability that is largely the result of inconsistent macroeconomic policies. The second is the lack of significant progress in privatization, which has created an environment in which state enterprises dominate virtually every manufacturing subsector and absorb a large proportion of the economy's available resources. A third constraint relates to the legal and institutional framework. While significant strides have been made in establishing the basic laws, regulations and institutions necessary for a market economy, their enforcement is lax and non-transparent. While these three factors are the main constraints to private sector development, other issues are clearly important and need to be addressed: the economy's existing infrastructure is in disrepair and needs rehabilitation; the financial sector and existing collateral instruments to deliver credit to the private sector are weak and ineffective; and, the incentive regime fostered by the tax system inhibits private sector development, especially for nascent private enterprises. 2.02. This chapter describes the overall enabling environment for private activity in Bulgaria, focussing on these general constraints to private sector development. First, it discusses the overall macroeconomic environment in which private businesses operate. Second, it describes the slow pace of privatization. Third, it surveys briefly the general legal environment for private business and stresses the importance of better enforcement of contracts and improved law and order. This section also provides an overview and assessment of some key government regulations affecting private business in Bulgaria. Finally, it identifies the supply constraints in public infrastructure and assesses prospects for private participation in infrastructure, an issue of growing importance in developing countries and Eastern Europe. Issues related to the financial sector and the availability of appropriate instruments for credit provision to the private sector are discussed in Chapter 3 and issues related to taxation are discussed in Chapter 4. - 12 - THE MACROECONOMIC CLIMATE 2.03. A stable macroeconomic climate is essential for private sector development. It creates a hospitable climate for private investment. In a high and unstable inflationary environment and periodic exchange rate crisis, an economy's growth prospects are reduced by the unsettled economic climate. There are distortions in relative prices. There is a need for frequent price adjustments; these adjustments tend to blur the information conveyed by relative prices. Entrepreneurial energies are, therefore, diverted to short-term financial matters rather than long-term investment and production. Similarly, large budget deficits raise interest rates, as they are typically financed by excessive domestic borrowing, which, in turn, leads to higher interest rates that crowd out the private sector. Budget deficits and excessive domestic borrowing also create the expectation of higher taxes in the future, that are detrimental to the climate for the private sector. 2.04. The Government of Bulgaria has taken significant steps to improve the macroeconomic climate that have helped to facilitate and encourage the development of the private sector. The Government's comprehensive adjustment program initiated in early 1991 significantly liberalized prices, the trade regime and the exchange rate. Exchange rate liberalization was also combined with very liberalized rules regarding the repatriation of profits for foreign investors. 2.05. Second, in mid-1994, the Government concluded a comprehensive debt and debt service reduction agreement with its commercial bank creditors. This agreement normalized Bulgaria's relations with international financial markets. It has already had a salutary effect on Bulgaria's access to trade finance. It has also reassured potential foreign investors and created a more favorable climate for foreign investment. Furthermore, the Government has approved a regulation to allow the use of DDSR bonds in debt-equity swaps. This has already had a positive effect on foreign investment, with almost US$ 100 million in DDSR bonds used in privatization transactions since end-April 1994. 2.06. Despite these achievements, the 'stop-go' nature of reform, in particular macroeconomic stabilization, have created an extremely uncertain environment for private entrepreneurs and has undoubtedly contributed to the 'informal' nature of private sector development in Bulgaria. Following a successful period of macroeconomic stabilization immediately following the launching of the comprehensive adjustment program, there was a progressive weakening of the Government's fiscal policy stance beginning in late-1992 that persisted until end-1993. As a consequence, the budget deficit reached about 14 percent in 1993, triggering a rapid depreciation of the exchange rate. Inflation rose from-- percent on average in 1992 to-- percent in 1993. 2.07. In 1994, the Government put in place a new macroeconomic stabilization program. Under this program considerable progress was achieved in fiscal policy. The budget deficit was reduced from about 14 percent of GDP in 1993 to around 7 percent in 1994, with a substantial improvement in the primary balance (about 7 percentage points of - 13 - GDP). Despite the Government's considerable efforts at stabilization, however, inflation accelerated during 1994 reaching 122 percent on a year-end basis. This high inflation was the result of three factors: a carry-over from expansionary policies at the end of 1993 that destroyed confidence in the Lev; a shift away from domestic currency reflecting the public's perception of the Government's inability to tackle the economy's fundamental problems; and inadequate monetary restraint, primarily due to the need to aid several ailing state banks that have severe liquidity problems. And while 1995 was a year of declining inflation and higher reserves, the macroeconomic situation deteriorated again in late 1995 and early 1996. Exchange rate depreciated rapidly and reserves fell in June 1996 to less than two months of inputs. Leva and foreign exchange deposits began to decline. 2.08. The key macroeconomic challenge facing the new Government is to re-establish confidence in the banking system and reduce inflation rapidly. Firm, consistent macroeconomic policies and accelerating structural reforms are critical in establishing a more stable macroeconomic climate that will foster private sector development. Important steps have already been taken. The Government closed two large insolvent banks and decided to close or isolate major SOE loss makers from the banking system. And it substantially tightened the fiscal and monetary policy stance. Re-establishing sustainable macroeconomic stability will be extremely important in improving the climate for the private sector in Bulgaria. PRIVATIZATION 2.09. The lack of progress in privatization has been a key constraint on private sector development. As a result, state enterprises still dominate virtually every industrial subsector in the economy. The advantages enjoyed by these state enterprises make it difficult for private firms to grow and thrive. Moreover, state enterprises crowd out private firms from credit and labor markets. The lack of privatization, combined with the apparent autonomy of enterprise managers, is the primary cause of the pervasive profit shifting discussed in Chapter 1. Aside from a stable macroeconomic climate, privatization is the single most important step that the Government can take to foster the development of the private sector. 2.10. Successive Government's have made considerable strides in establishing the basic legal and institutional framework for privatization. Three Restitution Laws were enacted during 1991-92 and the Law for the Transformation and Privatization of State and Municipal Enterprises (The Privatization Law) in April 1992 was enacted. The Privatization Law permits a wide array of privatization methods and provides for preferential participation of employees in the privatization of their enterprises. The Privatization Law was amended in June 1994, to introduce more flexibility in the privatization process and to accommodate a Mass Privatization Program (MPP). It also improved the incentives for municipal privatization. 2.11. The responsibility for the privatization of state property using conventional or market methods of privatization is divided among: (i) the Privatization Agency (PA), which - 14 - was established in August 1992, is in charge of overall coordination of the privatization program and the privatization of state-owned enterprise (SOEs) with fixed assets higher than 70 million Leva; (ii) sector ministries and agencies are responsible for the privatization of SOEs with fixed assets below 70 million leva; and (iii) the municipalities are responsible for municipally-owned enterprises (MOEs). SOEs are privatized by the PA and by the relevant ministries and committees on the basis of annual programs, prepared by the PA and approved by Parliament. MOEs that are eligible for privatization are selected by municipalities, and these enterprises are not included in the Central Government's privatization program. The new Government, which took office in January 1995, has given the Ministry for Economic Coordination and Development coordination responsibility for both market privatization and mass privatization of SOEs. 2.12. So far, the restitution of confiscated properties to previous owners has been the most successful privatization path in Bulgaria. It has had a remarkable impact on the development of the private sector. Over 55 percent of 5.1 million ha. of eligible agricultural land and more than 31,000 buildings and sites, accounting for about 54 percent of the total claimed value, had been restituted. The restitution of the latter properties has been an important factor behind the rapid growth of private trading activities, particularly in urban areas. 2.13. Formal privatization, however, has proceeded much more slowly in Bulgaria than in other Eastern European countries, such as Poland, Hungary, and the Czech Republic, particularly for small and medium-sized SOEs. Around 3,800 SOEs and 800 MOEs are still available for privatization. At mid-1996, only 110 state enterprises were privatized, accounting for 4 percent of long-term assets and less than 3 percent of employment in the state sector. The remainder were privatizations of parts or assets of enterprises. Sector ministries and agencies, in charge of small privatization, have concluded hundreds of small transactions. However, in contrast to the slow progress in actual sale of SOEs, substantial progress has been made in the preparation of privatization projects. As a result, over 1,000 SOEs are in various stages of privatization. And 1191 SOEs are included in the mass- privatization program Therefore, a considerable acceleration of the market privatization process could be possible, if existing obstacles were removed. 2.14. Progress with privatization in Bulgaria has been contentious and disappointing for three inter-related reasons: a lack of political support, logistical (supply), and demand constraints. First, there has been a lack of consensus on objectives, strategies and methods of privatization as well as varying degrees of commitment to privatization among political groups. There has been no real "champion" of privatization in Bulgaria. As a result, the various institutions involved have followed different, often conflicting strategies. In addition, the PA has been plagued by severe instability in its management, contested authority, and territorial rivalries with some sector ministries. Despite the passage of enabling legislation for a mass privatization program, there has been a long delay in organizing the MPP, mainly the result of previous Governments' lack of commitment to the process. - 15 - 2.15. The second problem has been an excessive focus on market privatization and application of inadequate methods. Market privatization of large enterprises has proven difficult and extremely slow in most Eastern European countries. In Bulgaria, it has been complicated by the pursuit of top-down, case by case approaches, including lengthy prior appraisal of the value of enterprises. The maximization of the selling price and the identification of strategic investors have remained paramount objectives of the various entities involved in privatization. 2.16. Third, pervasive profit shifting from state to private enterprises has generated a lack of incentives to privatize, especially for managers and other "insiders". On the demand side, high losses and indebtedness of many state enterprises has also been a constraint on privatization. Also, inadequate public relations efforts to assure the population's understanding and support has been a serious problem constraining the privatization process. 2.17. The new Government has made a strong political commitment to accelerate privatization. All activities related to privatization have been centralized under the recently established Ministry of Economic Coordination and Development. A mass privatization program in two waves is being developed. The Center for Mass Privatization has been strengthened and funding is available to it. For the first time, a negative list of enterprises that will not be subject to privatization has been established making, in principle, all other enterprises available for privatization. Implementation of the Government's privatization program will be a key indicator of the new Government's commitment to structural reform and private sector development. Speeding implementation will require decisive measures for both market and mass privatization. 2.18. Regarding marker privatization, several new approaches need to be implemented. First, the Government should do away with its annual privatization programs and instead make all enterprises available for privatization, except for those enterprises on the negative list. Second, specific yearly targets and deadlines should be adopted by the relevant ministries, particularly the Ministry of Industry. Third, the process should be decentralized, by adopting a bottom-up approach, including incentives to managements and any outsider to initiate privatization. Fourth. simplification of procedures: prior evaluation of the enterprises should be waived or simplified; pending problems with legal titles should be addressed by the managements before the initial stage of preparation for privatization; and, the whole process should be shortened. Fifth, small enterprise privatization should be significantly accelerated through the sale of shares at auctions and Management and Employee Buyouts (MEBO). 2.19. Regarding mass privatization, significant steps have recently been taken to initiate the process. Mass privatization is the key to achieving a rapid transfer of assets into the private sector in the near term. The key components of the mass privatization program, as defined in the amended Privatization Law, are: 0 every citizen and permanent resident over age 18 may obtain one voucher. - 16 - a voucher is a registered security with a nominal value of 25,000 "investment leva." The term "investment leva" is used to make it clear that the vouchers are not equivalent to currency or cash leva. The plan is to have a central computer registry of voucher holders. * a voucher is not generally tradeable and cannot be used as collateral except it can be inherited and transferred to close relatives. A voucher can also be transferred to an investment fund. * a centralized auction of enterprises will be used similar to that used in the Czech Republic. * a Center for Mass Privatization is organizing the program. 2.20. The MPP will be organized in two waves. The first wave will include enterprise shares with a book value of about 90 billion Leva. Assuming that about 3.6 million citizens will participate, the total nominal value of the vouchers (3.6 million x 25,000 Leva) would match the book value of the enterprise shares. Citizens will pay a nominal fee of between 100 and 500 Leva to obtain and register a voucher. The revenue from this fee will help to cover the expenses of the program. A second voucher would be issued and additional enterprises included in the second wave. 2.21. A law regulating investment funds is also close to enactment. It envisions a strong, active role for such funds in the program and in the future governance of enterprises. A fund would be allowed to own up to 34 percent of the shares of an enterprise. As in the Czech Republic, this would give funds a strong voice in the management of the company. The funds must be organized by their sponsors and licensed by the government before they can participate in the program. The licensing regime should be liberal and transparent. A complicated and lengthy licensing process could either delay the start of the MPP or give funds inadequate time to organize and attract clients who will transfer their vouchers to the funds. 2.22. Considerable progress has been make in organizing the program and the first round of auctions could start in Fall 1996. More than 3,000 post office outlets will register the vouchers and accept bids for the auctions. Some 28 regional centers will input the data provided by the post office outlets into a computerized data base. The list of citizens who can participate is ready, and an initial stock of voucher booklets has been printed. All contractors have been appointed, software for conducting the auctions is being developed, and the necessary hardware (for example, computers) is being delivered. 2.23. Supply Side. The government has prepared a list of enterprises to be included in the first wave of the MPP though this could be modified by Parliament. It includes about 1,200 enterprises. The strength of the MPP is that these enterprises account for about 40 percent of the assets or employees of all state-owned enterprises. The weakness of the - 17 - program, however, was that the MPP by itself would have only completely privatized the smaller enterprises included in the list. Following discussions with the Bank, in June 1996, the authorities raised the target private ownership in many of these enterprises to majority ownership--67 percent. THE LEGAL AND INSTITUTIONAL FRAMEWORK Private Property and Freedom to Engage in Economic Activities 2.24. The main legal constraints on the scope of private economic activity were eliminated by Decree 56 on Economic Activity of January 1989, which permits the private sector to undertake any activity that is not explicitly disallowed and broader basic reforms that permit private sector growth were introduced in early 1991.5 The new Constitution of 1991 provides legal protection for private property. The Commercial Law and Trade Act of 1991 specifies forms of private ownership of firms. In February 1991, most price controls and foreign exchange allocation and surrender schemes for foreign trade were abolished. The government also abolished its monopoly on foreign trade market transactions (Ordinance 15, 1991) and introduced current account convertibility, thereby allowing market-based access to foreign exchange to all companies, including private firms. Ordinances of the Council of Ministers in 1990 (number 35 relating to tourism and 36 to commerce and services) permit the leasing and sale of state assets to small private enterprises. Court registration of firms is compulsory, but this has not impeded their growth (see the previous chapter); court registration is inexpensive and non-obtrusive. A landmark tax law on the Value Added Tax (1994) has made Bulgaria's tax system more similar to those found in industrialized market economies. 2.25. Restitution laws have facilitated privatization of farmland and urban shops and warehouses, and the Privatization Law (1992) provides the legal basis for conversion of state enterprises to private ownership. A division of the Ministry of Culture has been assigned responsibility for enforcement of intellectual property rights. A Fair Competition Law (Protection of Competition Act) modelled on western anti-monopoly and restrictive trade practice laws and an Anti-Monopolies Commission (see below) provide the legal framework for the protection of consumers from monopolistic practices. A Bankruptcy Law (1994) provides the legal framework for creditors to protect themselves against debtors. Foreign Investment 2.26. The Foreign Investment Law (1992) permits foreign investment in any activities other than those designated as non-permissible (military industry, banking, natural resources, and property acquisition in some border areas). The law protects property and investments 5. See Cheryl W. Grey and Peter G. Ianachkov: "Bulgaria" in Cheryl W. Grey and Associates (1993). Evolving Legnl Frameworks for Private Sector Development in Central antd Eastern Europe, World Bank Discussion Paper Series No. 209. 23-46. - 18 - from appropriation, and assures access to foreign currency for repatriation of principal and profits in foreign currency. The sole source of formal discrimination between foreign and domestic investors is that no company with more than 50 percent foreign ownership can own arable land. Foreigners can acquire buildings and lease land for business activities, and own residential property. 2.27. Foreign investment laws usually distinguish by source of investment rather than identity of the investor, whereas the Bulgarian Law designates "foreigners" as subject to its provisions rather than foreign investment.6 Anomalies can therefore arise. Foreigners can own domestic companies, and domestic citizens and companies can establish and own foreign companies. Yet the companies as legal entities are subject to the Law.7 Several other issues have been identified by the FIAS report which analyzed in detail, the climate for foreign investment in Bulgaria. But generally, the Bulgarian legal framework for foreign investment is formally liberal and similar to that in other more developed market economies. Nonetheless, there has been relatively little foreign investment in Bulgaria. This partly reflects the general factors affecting the macroeconomic uncertainty such as inflation, exchange rate instability and business infrastructure. However, in part, it also reflects institutional weaknesses and lack of transparency which make it difficult for Bulgaria to capitalize on the good features of its foreign investment and trade regime. The new government which took office in January 1995 has made one of its priorities to improve the environment for foreign investors in Bulgaria. Law and Order 2.28. By the end of 1994, the legal and institutional framework for private-sector activity was thus basically in place. It is a primary and fundamental role of government to enforce this framework, by maintaining law and order, and in particular protecting private property from illegal appropriation. Yet, as indicated in Chapter One, a substantial portion of private sector activity--perhaps as much as 18-20 percent of GDP--is conducted informally and is not governed by the formal legal and institutional framework. It also appears to be common practice for private businesses to pay to secure protection from damage to property, to avoid theft of property, and to avoid inhibitions being placed on customers and clients to continue business relations. These practices raise the costs of operation of private business, particularly small businesses. While it is difficult to document the extent of this problem in Bulgaria and in comparative perspective, it is important to realize that this problem exists 6. See Bulgaria: 7he Climate for Foreign Direct Investrnent: Diagnosis and Recommendations, (1994). Foreign Investment Advisory Service (FIAS: a joint service of IFC, MIGA and IBRD), February; and Cheryl W. Grey and William Jarosz (1993). "Foreign Investment Law in Central and Eastern Europe," World Bank Policy and Research Paper Series No. 1111, March. 7. Thus, for example, a foreign investor is outside of the framework of the Law if a Bulgarian legal entity (company) undertakes a domestic investment, whereas a domestic-currency investment made by domestic citizens through a foreign registered company does fall within the framework of the Law. - 19 - and that the costs and inconveniences are a serious inhibition to private sector development. The government should act in a concerted fashion to establish a more friendly business environment for private entrepreneurs. SUPPORTING INSTITUTIONS FOR PRIVATE BUSINESS Chamber of Commerce and Other Associations 2.29. In Bulgaria, the private sector is assisted by a number of supporting institutions, both domestic and foreign. The most prominent domestic institution is the regional Chamber of Commerce, with a central office in Sofia. It now includes as members both state and private firms. Registration of firms with the Chamber is a condition for operation of commercial bank accounts for foreign-exchange transactions (court registration which defines a firm as a legal entity is compulsory). The Chamber operates on a user pays basis and assists in locating joint-venture partners, in preparing business plans and contracts, and in arbitrating domestic and international business disputes. Re-export and certificates of origin are provided for preferential foreign market access under foreign trade agreements, and product code bar identification is provided for exports. A National Small and Medium Enterprise (SME) Council serves as "the national body where Government, Parliament, and the private sector meet to discuss SME National Policy." 2.30. Other non-government organizations supporting private business are the Union for Private Economic Enterprise, which is funded by a grant from the European Union and provides business support and consulting services through its "Euroguichet" and "Help Desk" on a payment basis; only a handful of firms have however availed themselves of the services provided. Other organizations of private firms are Vuzrazhdane, Alternative 2000, and the Union of Private Farmers. None of these private-sector organizations encompasses more than about 5 percent of private firms. A number of large, visible private-sector firms are loosely organized as the G-13 group of companies with a policy agenda. There are also more specialized producer organizations, such as automobile dealers and meat producers, which act as producer lobbies with regard to legislation affecting their activities. The private sector is also represented in the Bulgarian Industrial Association, which represents employers in the Tripartite Commission of government, employers and employees. 2.31. Foreign assistance to the private sector is provided by agencies such as the American Enterprise Fund which provides credit to small- and medium-size enterprises under preferential conditions. Also, the European Union's PHARE Small and Medium Enterprises (SMEs) Division which has a credit program, assists in valuation of state enterprises for potential privatization. Standards and Technical Requirements 2.32. The Committee for Standardization and Metrology provides private-sector support in standardization, accreditation, and certification, and manages laboratories for measuring - 20 - instrumentation and certification of instruments, and surveillance of hazardous equipment and consumer products. An information department informs prospective exporters about technical standards in foreign markets and documentation requirements. Importers are obliged to provide the Committee with samples of goods, which are subjected to testing to confirm satisfaction of Bulgarian standards and technical requirements; however, enforcement is a problem, since importers often do not present goods for testing, which allows low-quality or substandard imports. Because of the budget difficulties encountered by the Committee, the Chamber of Commerce provides a service, on a payment basis, to exporters seeking information regarding requisites for compliance with foreign technical standards. GOVERNMENT REGULATIONS AFFECTING PRIVATE BUSINESS 2.33. Government regulation, generally, can inhibit the development of private business, for example by arbitrary procedures that serve as deterrents to entry of new competitors into an industry, by regulations that impede access of new firms to resources, by labor regulations that restrict employers' flexibility in choosing labor employment, and by tax systems that discourage private investment and initiative, and deter formal employment of labor. Where such inhibiting regulations exist, improvements in the design and implementation of government policy can provide for an economic environment more conducive to the growth of the private sector. Land and Business Premises 2.34. Private sector development requires access to land and premises. Such access is often complicated in Bulgaria by policies of local municipalities toward supply of land and premises, and administrative obstacles. The compulsory tendering system is intended to ensure that a market price is received for the lease. The present procedures are however extremely time consuming and disruptive of business and investment plans. Each lease is subject to approval by the local municipal council, with the level of approval required depending on the value of the lease. The number of council members required to approve a leasing decision can be quite large (there are, for example, more than 100 members of the Sofia municipal council, serving on an honorary basis). The broad approval process inhibits opportunistic behavior (corruption) in the assignment of leases, but does not inhibit opportunistic blocking of proposals. In other instances, council approval is no more than a formal step (or rubber stamp) for proposals that have been agreed upon at various levels within the negotiating bureaucracy. 2.35. The conditions of access of the private sector to land and premises can be improved. First, the municipalities should not view themselves as commercial property managers, and should not see their purpose as maintaining a portfolio of municipal real-estate assets. Second, private-sector access to land and premises is often complicated by uncertainties regarding ownership, which may be contested between the central government and the municipalities. Priority should be given to establishing clear property rights so that property can be put to productive use. Third, leases signed with one municipal government - 21 - should be automatically honored by subsequent municipal governments, unless a court of law establishes that the lease is subject to improprieties. Fourth, procedures for rezoning of land from agriculture to industrial and business use should be subject to transparent criteria and not discretion of officials of local municipalities. Regulation of Anti-competitive Practices 2.36. In Bulgaria, the maintenance of a competitive market environment is assigned to the Commission for the Protection of Competition (established via the 1991 Anti-Monopoly Law) subordinated to and elected by parliament. The commission is responsible for (i) investigating violations, (ii) recording decrees of the Council of Ministers and parliamentary acts to check for consistency with the principles of the Law, (iii) compiling data bases, and (iv) international contacts and cooperation. The number of registered complaints grew steadily from 35 in 1991 to 243 in 1993. Monopoly power is defined in Bulgaria as excess of 35 percent market share; however, the small domestic market and continued presence of incumbent firms often results in this market share being exceeded, by state rather than private firms. 2.37. The Commission in principle replies to a complaint within three months of the complaint being lodged. Its recommendation is then placed before the courts, which assess penalties. The court procedure can take 9 months or more. The Commission has argued that the courts do not have the requisite understanding of the substance and consequences of anti- competitive conduct, and that competition would be better served if it were responsible for assessing penalties. The Commission has demonstrated political independence and has been successful in confronting producer interests. Still, there is a lack of awareness among Bulgarian producers and businessmen regarding the basic principles of protection by law against anti-competitive practices; many producers and businessmen do not understand either that their behavior violates the law, or that practices of others that adversely affect them, do so, and that they have recourse. 2.38. The main form of anti-competitive practices, however, escapes regulation. Firm level interviews indicate that it is the nature of the interface between state enterprises and the private sector which results in widespread restrictive practices in the form of collusive and exclusive sales, which can often be illegal. The main policy implication here is that making progress in formal privatization would go a long way towards enhancing competition in Bulgaria due to a simple reason: state-private enterprise interactions must be based on market prices, rather than quasi-market pricing for the purposes of profit shifting and asset stripping from state to private enterprises. Regulation of International Transactions 2.39. Regulation of international transactions could impede private sector development by limiting access to foreign exchange, and by constraining availability of imported inputs. These are not major problems for Bulgaria. The Bulgarian foreign trade and the floating - 22 - exchange regime is liberal, and does not unduly constrain or distort private-sector activities. The international trade sector is increasingly attracting private firms: there are some 56,000 enterprises registered with the Chambers of Commerce eligible to engage in international trade via commercial banking system, and there is a large network of finance houses that engage in cash-based foreign exchange transactions. Due to previously described functional specialization of private firms in trade and SEs in production of goods, increasing share of foreign-trade turnover is conducted by private companies. With limited exceptions, no licenses are required to engage in foreign trade, and there are reasonable recourse and appeal procedures should an application for a license be refused. There are very limited import and export quotas, and import duties are not excessive. There is no anti-dumping law. However, effective protection rates appear high for some activities. 2.40. Bulgaria does have some limited quotas on imports and exports.8 Export quotas are auctioned, and import quotas are assigned on a first-come first-served basis. First-come first-served quota allocation introduces uncertainties into business activities, and may distort the timing of imports. If the quota is binding, the right to import is profitable. Storage costs and perishability can then lead to inter-temporal distortions in consumption, with goods becoming increasingly scarcer as the year goes on. An auction mechanism for quota assignment is preferable in avoiding these distortions, as well as in providing revenue. The goods subject to tariff-quotas are in food processing and agriculture, reflecting food-security concerns. 2.41. In terms of policy directions in this area, two recommendations could be made. First, tariffs should replace the remaining quotas. Tariffs eliminate uncertainties associated with a first-come first served quota-allocation rule, are non-discriminatory, and provide the government with revenue whereas unauctioned quotas do not. This will also reduce the bureaucratic role present in the assignment of quota rights. Tariffs also allow quantity adjustments when domestic demand for imports increases, thereby moderating domestic price rises. Second, customs administration must be improved to ensure that importers pay the same officially due duties, and that thus there is no discrimination that provides some firms with cost advantages. Foreign Market Access 2.42. Private sector development can be constrained by impediments to foreign markets. Bulgaria benefits from preferential market access agreements, and beginning in 1995 has duty-free access to the European Union under Visegrad conditions (industrial goods enter duty-free, but agricultural goods are subject to the EU's variable levies). 8. Import quotas are set on tobacco, oranges, and ice cream. Export quotas set by the government of Bulgaria are on different categories of cattle. Export quotas were established in 1991 for meat and ferrous metals to the E.U., and textiles to the E.U. and Canada. Detailed recommendations for a quota auction system are contained in Trade Policy: Bulgaria, Report on a Trade Policy Technical Assistance Project, 1992. - 23 - Business Licensing 2.43. Businesses and production facilities are subject to health, safety, and environment codes, adherence to which is monitored by licensing to carry out specific lines of business. There are no identifiable impediments from these sources that appear to arbitrarily restrict entry or activities of firms. Although inspectors exercise on-site discretion, the procedures for compliance appear straightforward and transparent. State Procurement Policies 2.44. Bulgaria has no law regulating government procurement. Private sector development would be artificially constrained if government purchases were biased in favor of the state and municipal enterprises, either because of traditional supply relationships or because of employment-related concerns. Procurement policies based on competitive tendering benefit the government as purchaser, and provide the appropriate incentives for private sector development, since private firms are rewarded on the basis of competitiveness. INFRASTRUCTURE CONSTRAINTS AND PRIVATE PARTICIPATION 2.45. Bulgaria's economic infrastructure - transport, telecommunications, energy and urban services - have been identified by some private firms as a constraint to their development. Poor telephone services in particular are frequently cited, and water supply is a severe problem in the Sofia area. Much of the infrastructure is dilapidated or the services are not geared to the requirements of a market economy, and price controls often do not enable the enterprises to maintain assets adequately, let alone invest in new capacity. For example, price controls accompanied by rapid inflation meant that electricity tariffs in December 1994 fell to less than 30 percent of the June 1991 level (in real terms), below even the short run cost of generation. Recent price adjustments in 1995 have reduced the problem, but the tariffs are still insufficient to cover the operating costs. 2.46. Poor infrastructure services constrain private sector development in important ways. The cost of doing business is higher, if firms cannot expect a reliable service; this can dissuade potential investors, or firms may decide to invest in their own back-up services. Just as important as these direct impacts, however, are indirect effects on the budget and access to credit. Loss-making state owned infrastructure enterprises typically absorb large subsidies from the budget and from extra-budgetary sources, such as special accounts, arrears to the social security fund and write-offs of loans to banks. 2.47. Many countries are encouraging private participation in infrastructure (PPI) - through privatization of existing assets and entry of new firms under concession arrangements - in order to improve service quality, increase investment and reduce fiscal burdens. Bulgaria has made limited moves towards PPI, with changes most evident in telecoms. Two cellular licenses have been issued to cellular operators (one is a joint venture with BTC, the - 24 - main telephone operator), another . . . E company has a joint-venture with : 0 B2.1: u Privating MainTelecoms. BTC to operate a data network. CompaC ies YieldWin-Win W'Outcom TV licenses have been issued. With ;about 29 telephones per 100 population, Bularia ha one of Many of these entrants at the thde thighest penetration rates Win Easitern -Europe.Yet theref isit al l-0 margin are doing well, as there is waitig Alist that has ben- stuck: over 600D,000 tor-severall ye:ars,igll huge unmet demand. In contrast, nd :a) dismal 30 percent iof calis get through. 500BTC ha recent0::ly countries which have privatized : been :putX on Xa list 0.of strategic . .not-to rivat ..ed' . enterpises. ..... .. their main telecoms - including :S:vem i other:i00000:000000 :l: EE contie-Hngry Lad: tvia0000 and th Cze:ch;i:0 t l0t :-:0l00 several in Eastern Europe - have Republic--have aidopted iffrn approch o;prta seen "win-win" results (Box 2 .1). privatiZationtlio; a; strategic iinvestor, eomnbined -with build-out and.00 i: . .. . . . . . .. . ........ . . : ,iE E : : . ..iER : . ..:Ei:: i:E :: : Eservice :quality :commitments. :They are: reapmng benefits far: ::;E; 2.48. The changes in the 0beyond better telephone services, ;including :putt:ing::the couinteryont telecoms sector illustrate the ::the map X:for oeign investors, 0fisca benefits,0 improved accessto-;- rthe ad hoc and non-transparent international cEapital markets: fori the telecoms !company, fand;y:: fi ra er . p t~~~~~~stimulation 0of domestic financial markets.: 1-Hungary for example, l approach to PPI in Bulgaria to siiold t:30 percent !of jits telecoms company--(therebiy keepingltg::0000|00002 date - suggesting that commitment majority stt.we rshp but cedingmangemet control) 0)to; ai;y i has been patchy. Licenses have :foredign-edonsorium Cfor :$875: million.;. Th T:stipuilated Sbuild- - mostly been issued after direct out rates meanthat Xthe icountry is expected ito have the fates- t;0 negtiaionrather than open fnetwork expansion of-any EE:country during thbe next :few :year.t:.; neomptiations Ttt rsec he: number of iEnes ;in tHungary- is Sexpected to tincrease by 1S6S.$8 :; competitions stt preenc percent per :annum between 1-992 and 01997, compared ito just-:3.:2:E; remains significant through using p0ercent: per fannum Sin Bulgaria an a 9.1l percent perllannum-t; :00000 a Joint-venture structure, and the javerage: for the -six EE -countries.: #l:i l 0 l : : t:; 00 i ;0 :t : - overall regulatory frame-work -____-__E_ --__-_-E_-_____E______if___ -i:;E_i__i__E_____________t:; t remains unclear (a telecoms bill h,as been stuck in the legislature for over three years). 2.49. Unreformed tariffs are a major barrier to private entry in some sectors. The government should consider raising tariffs nearer cost-covering levels - and preferably depoliticize tariff adjustment mechanisms - before they are likely to be financeable. Several countries (Hungary, Chile and some other Latin American countries) have found that the adoption of simple concession laws defining the scope for private entry, and procedures for awarding and arbitrating concessions, has generated significant investor interest. Bulgaria passed a concession Law in October 1995. 2.50. As a relative latecomer to PPI, Bulgaria has opportunities to learn from the successes and mistakes of experiences in other countries. Negotiations have been ongoing for several years with a potential private concessionaire for Sofia's water system; meanwhile a water supply crisis has developed (which, arguably, would not have happened with better pricing and management). The award of the concession covering six million consumers in Buenos Aires might offer some lessons. - 25 - CHAPTER 3 FINANCIAL MARKETS, SECURED TRANSACTIONS AND ACCESS TO CREDIT 3.01. The financial sector plays a key role in private sector development: it allocates capital to its highest return in the economy, increasing the efficiency of investment and maximizing its contributions to economic growth. The financial sector comprises an array of important financial institutions that operate within limits set by laws and regulatory systems. This chapter begins with a brief examination of some key issues regarding bank lenders, non- bank lenders and securities markets. Then, the chapter looks in greater detail at problems in the legal and institutional framework for secured transactions. Improving the framework for the use of collateralized credit transaction (loans secured by fixed or movable assets) could enhance the access to credit of the new private sector and could facilitate overall financial sector reform. FINANCIAL MARKETS 3.02. The banking sector faces many problems, including severe portfolio problems vis- a-vis state enterprises, that are constraining its ability to extend credit to the private sector. Reform of the banking sector has focussed on bank consolidation and developing supervision and regulation. Seventy state banks have been consolidated into 11 banks; prudential regulations have been enacted; and, external audits have begun on the consolidated state banks. However, banks still have inadequate, and in many cases, negative equity. While new prudential regulations have been enacted in six key areas, the regulations are too ambitious in some areas and are being modified. Banking supervision is still in an embryonic stage. Some limited supervision have been initiated, mostly as a training exercise for central bank supervisors. Little progress has been made in privatizing banks although some minority state shares have recently been sold in some small state banks. Furthermore, continued Central Bank financing of the two ailing banks have jeopardized the monetary policy stance and aggravated the moral hazard problem in the banking system. 3.03. It is beyond the scope of this report to delve more deeply into the significant financial sector problems. Suffice it to say, however, that the authorities will need carefully to weigh alternative reform measures in this critical sector to avoid major mistakes. For example, fiscal cost and moral hazard of continued bank re-capitalization can be huge as evident from Hungary's experience. In Hungary, despite over 10 percent of GDP being expended between 1991 and 1994 in re-capitalizing schemes, several banks still remain with large non-performing portfolios--including many loans made since 1991. More broadly, the costs to Bulgaria of a malfunctioning financial system are huge. Taxpayers, savers, borrowers who repay loans and creditworthy borrowers who are denied loans are all bearing extra costs: in the form of subsidies, low deposit rates, very high real lending rates and lost investment opportunities, respectively. Some of the beneficiaries are simply engaging in - 26 - illegal activities, whether managers of SOEs who are colluding in de-capitalizing their enterprises, bank managers, or borrowers who have no intention of repaying loans. 3.04. Non-Bank Lenders A financial sector that contributes to private sector development also requires expanded lending by non-bank financial and non-financial intermediaries. Because these institutions do not take deposits, and always have at risk the capital of owners, their operation will be less affected by the poor supervision and regulation and less limited by the failure to improve it. These lenders are crucial in reaching key government target groups and sectors like the private sector, farmers, the poor, and small- and medium-scale enterprises. At the margin therefore, reforms of collateral can relatively quickly move a large volume of credit to these groups in a sound and socially efficient way. 3.05. Stock markets. Stock markets are a fundamental institution of a market economy. New capital can be raised, and management is indirectly monitored via the vulnerability of poorly performing firms to acquisition. As of end-1994, Bulgaria had a number of stock markets that facilitate listing and trading of firms' shares. The number of firms listed is a very small proportion of the number of private firms, but the listings do include the large successful private companies in the Bulgarian economy. The two most prominent exchanges in Sofia are the First Bulgarian Stock Exchange, and the Sofia Stock Exchange and other towns also have stock exchanges. The costs of listing do not appear excessive; the cost for the First Bulgarian Exchange is, for example, 0.035 percent of the par or market value. Markets are in general thin, with few shares traded. 3.06. Until recently the stock markets have developed under self-regulated conditions, spontaneously adopting regulatory rules from developed market economies. In June 1995, a sound Securities Law was passed, providing a legal framework in this important part of the financial system. This law offers a basis for better protection of investors from opportunistic practices, such as pyramid Ponzi schemes and insider trading. There was a valid concern that a number of investment companies offered returns which in Bulgaria could only be regarded as non-sustainable. Also, the passage of this law removed an important legal obstacle for the implementation of a broad voucher-based privatization program, because of effects on investor confidence in holding and trading of shares in privatized companies. 3.07. Overall, within Bulgaria's financial system, the situation in the domestic banking system clearly remains a key area of concern for the Government's adjustment program and the primary financial constraint affecting private sector development. Given the dominance of banks in Bulgarian credit, reform of bank supervision and regulation is crucial: only such reforms will direct Bulgarian credit toward the best investment opportunities and yield the greatest overall impact on growth. 3.08. However, along with improvements in the supervisory system, improvements in the performance of collateral and guarantees are necessary to expand and broaden the lending of those banks with adequate capital structure, as well as a variety of potential non-bank lenders. These are typically private banks that do worry about losing their loans and that do - 27 - try to direct their lending toward investments that are profitable. These are the loans that contribute to economic growth. And, when supervision and regulation of banks does improve to the point where more banks care about recovering their loans, a functioning collateral system will permit them to provide more credit while still conforming to safe and prudent banking practices. SECURED TRANSACTIONS AND ACCESS TO CREDIT' 3.09. In Bulgaria, as in most countries, the law permits loans to be secured with two broad classes of property--real property (land and the buildings thereon) and personal property. Loans secured only by personal property are referred to as secured transactions. The items serving as collateral may be tangible--like inventory, livestock, or machines. Or, the items may be intangible--like accounts receivable, chattel paper, or mortgages. Personal property represents an important part of the physical capital--among industrial counties movable capital represents about 1/3 of the capital stock and about 1/2 of gross investment. The rules for lending against this property, the system of secured transactions, play a key role in the development of financial markets. Defects in the system of secured transactions can make banks unwilling to finance equipment, livestock and inventories; can prevent the development of non-bank competitors, like finance and leasing companies; and can block efforts to scrutinize accounts receivable and chattel paper in emerging capital markets. This section examines some of the problems in the Bulgarian framework for secured transactions and sets out some options for addressing the problem. 3.10. In Bulgaria, private banks supply most of the loans to the private sector. For the most part, private Bulgarian banks accept only real estate as collateral for these loans, or the personal guarantee of someone who owns real estate. They usually will not accept movable property as collateral--property like inventory, accounts receivable, livestock or industrial equipment--unless that property remains in the in the physical possession of the bank or the borrower also offers a supplemental security based on the ownership of real estate. Private banks require this guarantee either directly, through a mortgage, or indirectly, by requiring proof that the borrower owns land that the bank could lien and sell in the event of non- payment or by requiring the personal guarantee of another property owner. 3.11. Other potentially important private suppliers of credit which operate in Bulgaria (e.g., non-bank financial intermediaries, such as finance companies and pawnshops, and non- bank non-financial intermediaries, such as equipment, automobile, and primary commodity dealers) essentially follow lending practices of banks. Only material in the possession of the 9. This section of the report draws on a background paper prepared for this purpose. See Heywood Fleisig and Jan-Hendrik R6ver, Bulgaria: Improving the Frameworkfor Secured Transactions (EBRD & IBRD, processed 1995). The analytical framework used in this section draws largely on the experience in the United States. Bulgarian authorities will also need to examine the experience in other European countries which have had long experience of using different models for the structuring of secured, as well as unsecured financial transactions. - 28 - lender served as collateral for loans; otherwise, loans are given only to borrowers meeting the most stringent personal loan qualifications. Consequently, even types of financing which are commonly observed in industrial and developing countries are unknown in Bulgaria, like loans for automobiles and trucks and private financing for heavy machinery, livestock, fertilizer, air conditioning and heating equipment. To a large extent, this gap in the granting of credit arises from Bulgaria's problems in devising a workable system of secured transactions--a system for securing loans with movable property. 3.12. In general, business people and farmers get loans with three types of guarantees: real estate, movable property, and their reputation. Typically real estate is the best collateral, movable property is second best, and reputation is the least attractive. As we move from real estate to reputation, lenders will extend smaller loans and charge higher interest rates for them. This is true in Bulgaria, in Bolivia, and in the United States: it is true at Citicorp and at banks in the developing countries. The problem that arises in Bulgaria, however, emerges from crippling problems associated with using movable property as collateral. Bulgarian business and farm borrowers may get limited credit at the relatively low rates secured by real estate but once they run out of real estate to mortgage, they immediately face the high interest rates on loans secured by reputation alone. Unlike the industrial countries, a Bulgarian borrower's possession of movable property--equipment, inventories, accounts receivables--does not reduce the risk to the lender. Hence lenders who accept movable property as collateral neither lend more nor charge lower interest rates. 3.13. This restriction of credit can be particularly severe when farmers or businessmen work from rented premises or do not own their own land. In these cases, restrictions on the usefulness of movable property as collateral will restrict access and increase the cost of credit. The secured transactions problem also affects the allocation of investment, not just its volume and price. Even for farmers and businessmen who do own real estate, a credit system linked rigidly to real estate will limit development. Different types of businesses and farms will require different combinations of fixed and working capital for their most efficient operation. 3.14. Currently, Bulgarian borrowers pay 24 percent to 36 percent interest on US$- denominated loans ostensibly secured by movable property. Three major features explain those high interest rates: macroeconomic policy, high bank intermediation spreads, and the secured transaction problem. Obviously, the mortgage interest rate on houses in Bulgaria-- typically a four or five year loan--is just as subject to macroeconomic risk as a four or five- year equipment loan. Similarly, such mortgages would have intermediation spreads similar to the spreads on equipment loans. But the mortgage interest rate in Bulgaria is only 16 percent. The difference between the mortgage interest rate and the interest rate for loans for movable property is mostly due to the quality of the collateral -- the secured transactions problem. That difference ranges from 8 to 20 percentage points. This indicates that the - 29 - reduction in interest rates on secured loans from an improvement in the efficiency of the system could potentially be very large."0 THE SOURCES OF THE SECURED TRANSACTIONS PROBLEM 3.15. Macroeconomic instability can threaten lenders through lower spreads, higher incidence of uncreditworthy borrowers, as well as short-term changes in interest rates, in the rate of inflation, and in employment. Macroeconomic problems will thus heighten caution and reduce the availability of credit, especially credit from private banks. However, a macroeconomic disturbance is more likely to disrupt a two year loan than a two day loan, other characteristics of the loan being held constant. Consequently, one should observe a much greater drop in long-term lending than in short-term lending when the macroeconomic situation deteriorates. However, the opposite is observed in Bulgaria. 3.16. Private banks are willing to lend against real estate for longer periods of time--as long as five years--but are unwilling to lend for movable property for much shorter periods of time--as short as five days. Consequently, an independent defect in lending against movable property exists over and above the admittedly adverse effects of macroeconomic policies in lending. In addition to efforts to reform macroeconomic policies, then, improving access to credit will require addressing other issues. The most probable underlying causes are the legal problems that limit lending for movable property. 3.17. Commercial banks are generally concerned about whether they can be repaid by their borrowers. This requires banks to conduct an evaluation of the business prospects of the borrower and the proposed loan. Second, it requires a plan of action that the lender can pursue in the event that the borrower does not pay. In most countries, that plan will rest on the prospects for seizing the collateral that secured the loan, selling the collateral, and applying the proceeds from the sale to the outstanding balance of the loan. The clarity that the law permits in the loan agreement and the amount of time that repossession and sale of collateral takes, therefore, is an important element in determining whether the collateral can satisfactorily secure the loan. Three problems, therefore, underlie the secured transactions problem in Bulgaria: the creation of security interests, their perfection, and their enforcement. 3.18. Creation. A workable and efficient system for securing transactions has several desired traits: the interest should be inexpensive to create, legally unambiguous, and readily extended to most transactions of economic importance. At the other extreme, it should not contain gaps in coverage or arbitrary prohibitions on certain types of assets. 10. For example, in the North American system, rates of interest on loans for a wide array of equipment, cars, and other movable property typically run one-half to one percent above the mortgage interest rate. A similar spread in the Bulgarian context would imply a reduction in the cost of financing movable equipment by 7 to 19 percentage points. - 30 - 3.19. The present Bulgarian legal system makes it impossible for certain economic agents to use certain kinds of property as collateral. However, some of these parties and some of these transactions have great potential economic importance. These gaps in legal definitions or economic unsound prohibitions will not be remedied by speeding up repossession and sale; rather, they can only be addressed by fixing the underlying laws and procedures. For example, the Law of Contracts (1952) makes no provision for the "non- possessory pledge"--the main loan contract for movable property when property remains in the hands of the borrower. Given this absence, there is no practical way to write enforceable contracts for equipment financing, even though in principle this is consistent with the law. More recent laws do contemplate the "non-possessory" pledge but restrict these security interests to foreign investors" and banks .12 The law on agricultural financing"3 would allow farmers to use crops, stock, and farm equipment as collateral for loans when this merchandise remains in the debtor's possession; however, such pledges are limited to those issued by State-owned banks and bearing a rate of interest below the market. These provisions will be of little comfort to non-bank lenders or to non-farm borrowers. The restrictions have no obvious public policy justification but bear a high economic cost. 3.20. Perfection. Perfection, i.e., the establishment of the rank of priority of the claim against the collateral, is crucial in determining the risk of the lender in a secured transaction. The key element in the determination is the registration of the security interest in the collateral. If that determination is not made in a public way, all lenders face heightened risk and will react by lending less. Because of this, differences in perfection systems may seem small from the perspective of their legal structure, but confusion about priorities and the chance of a shift in priority can have disastrous effects on lending."4 A system that conceals information about priorities, therefore, makes it impossible for lenders to judge the risk of the loan and, therefore, to price the loan or set its size. Not surprisingly, lenders respond by demanding other collateral that can be registered or physically possessed. 11. Zakon za spopanskata deyunost na chuzhdestrannite litsa i za zakrila na chuzhdetrannite investitsii, Darzhaven Vestnik, issue No. 8 (1992), hereinafter 'Foreign Investment Law". 12. Zakon za bankite i kreditnoto delo, March 27, 1992, hereinafter "Banking Law. 13. Law on Agricultural Financing, 1993/94. 14. The problem can be seen easily with a simple example. Suppose a lender has a first claim against an asset with an expected resale value of $100,000, whose resale value would range between $80,000 with probability 50 percent and $120,000 with probability 50 percent. A loan of $60,000 in the first position would appear to that lender to be quite secure--it would have zero percent chance of loss because the lowest possible realized value of the collateral would be $80,000. But move the same loan to the second position, with, say, a $30,000 loan in the first position, and now the lender has faces a loss of $10,000 with a 50 percent probability (lender defaults, property realizes $80,000 and first position claimant takes $30,000, leaving $50,000 in equity to cover the $60,000 loan). Evaluated relative to the size of the loan, that is a 50 percent chance of a loss of 16.7 percent ($10,000/$60,000)--so a "safe" loan becomes much riskier solely because of the change in the priority of the claim. - 31 - 3.21. Two serious problems afflict the perfection: properties of the law that create uncertainty, and the lack of unified public registries. The law itself contributes to uncertainty about priority by giving many claimants priority over the possessor of the security interest: the law assigns a higher priority to court costs of liquidation, legal fees, and, possibly, to taxes and worker severance payments."5 As all of these costs are uncertain but potentially high, a lender will have a great deal of difficulty analyzing how much collateral will suffice to cover a loan. 3.22. No functioning registry for security interests in movable property exists in Bulgaria nor is the creation of it contemplated in the law. Rather, the pledge with dispossession--the security agreement used when the collateral is movable property and remains in the possession of the borrower--is filed in the scattered offices of notaries. Any notary in Bulgaria can register a pledge, or, more precisely, assign the "certain date" that determines the priority of the pledge. Even if the lender knew which of Bulgaria's notaries had assigned the certain date, the index within each notaries office might stymie the search for the document. This is a critical defect in the Bulgarian pledge: like other legal systems, the priority of the claim of the Bulgarian lender against the collateral is identified by the time of the filing; unlike other systems, however, it is impossible for a Bulgarian lender to determine a position in the order of priority. Also, the lack of public registries stymies the warehouse lending system that is used all over industrial countries and in many developing countries to routinely finance agricultural and industrial stocks. 3.23. There is sometimes a confusion about the need for a centralized registry for security interests in movable property. It is not necessary to have a centralized registry. It is necessary to have certainty about where to look to determine whether a security interest against a piece of property exists. A decentralized real estate registry can work without interconnection because the geographic area covered by each registry is certain: a potential lender knows exactly where to look to determine whether a mortgage exists. However, personal property is either movable -- inventory, machines, livestock -- or is intangible and has no essential physical location -- like accounts receivable or chattel paper. Where there are hundreds of possible places where security interests could be registered, as in the notarial system of Bulgaria, no potential lender or credit seller can determine whether a security exists and, therefore, whether a loan secured with personal property is well secured. The problem can be addressed by creating a unified registry; but it can also be addressed by linking the existing notarial registries with a computer. 3.24. Enforcement. Slow Bulgarian court procedures make movable property poor collateral in Bulgaria. Businesses indicated consistently that repossessing and selling movable property used as collateral can take six months to two years. Banks reported no collection and sale experience under six months. This is too long for movable property. Farm and industrial equipment will depreciate substantially over such a time; inventory will 15. Zakon za zadalzheniyata i dogovorite, Darzhaven Vestnik, issue No. 12 (1993), hereinafter "LOC'., Art. 136. - 32 - become shopworn; livestock can die; equipment bought used can become valueless; accounts receivable will be gone. For all such collateral, the lender faces a constant threat that the collateral will disappear. Its movability and its physical possession by the debtor threaten the creditor in many ways. Dishonest debtors may sell the collateral or flee with it. Even honest debtors, however, may have the collateral taken from them by others when, as they are unable to service their debt, their business affairs fall into disarray. 3.25. Real estate is less subject to these risks than is movable property like farm and industrial equipment, inventory, or livestock. While its market value can fluctuate, real estate typically would not depreciate substantially during the two-year collection period. Moreover, by definition, real estate is always located in the same place; it cannot be moved. Even with a long court action, lenders know that the real estate will be where it was when the action began. When collection procedures are slow, as they are in Bulgaria, lenders will only take real estate as collateral. They will not take movable property. 3.26. Problems associated with collateral are pervasive and cut across a broad range of economic agents, including farmers, equipment dealers, retail businesses and private banks whose operations are undermined by the lack of appropriate environment for collateral lending. Taking into account the above discussion, the Table 3.1 summarizes a preliminary list of identified problems and solution strategies in addressing the collateral-related problems of credit in Bulgaria. 3.27. Bulgaria can gain a great deal from reforming the system of secured transactions. The experience under both the North American and west European systems indicates that improving the framework for secured transactions could expand lending against such collateral. Similarly, within Bulgaria, the fact that some lenders in the informal sector have been able to create and enforce a security interest in movables offers additional evidence of the need for a legal and formal mechanism for such arrangements. 3.28. Bulgarian decision makers can choose among a variety of options for reform reflecting, broadly, the North American system and the west European system. Like the North American system, the west European system permits lower interest rates on loans secured by movable property. However, these loans appear to be less readily available to borrowers who do not have a broad association with a bank. That is, the west European system depends on a closer partnership between established industries and established banks, wherein, among other things, the industry will give a mortgage on its real assets to the bank and permit some interlocking of directorates. Bulgarian decision makers should consider the appropriateness of this strategy in view of the paucity of established industries and established banks. 3.29. A second feature of the difference between the North American and west European systems lies in the tradeoff between changing laws and changing enforcement institutions. In the North American system, speed of repossession and sale was increased by moving more of the repossession and sale procedures into the hands of the private sector. In - 33 - the west European system speed was increased by improving the quality of the judiciary and police. Again, Bulgarian decision makers will have to consider the appropriateness of the two strategies in view of the likely evolution of the reform of the Bulgarian public sector. LEASING ' ;;..: 3.30. Problems in the - -- - .. - framework for secured 1-OWe fiacwg to t transactions also limit the - Th a s t-n a n P.~~~~~~~~~~t development of leasing. Financial -4 leasing offers an alternative to - a bank financing of equipment - Foreign - d ( h d to provideo th a wi . purchases, particularly for eih t dola .r .OWlMrftcy l1 ti the - a -ta borrowers without collateral, or e (p O-be -currenc i t er without well developed balance ., ffl sheets--essentially small or new .. ..... radt firms. The lessor retains title to Anothr Wse klth ha Piva Ownerhip: the asset--which serves as the Fud. - ThW Bu PO h o of ive tha e cred a: collateral--until the end of the reslt ivatiao pram thiu t lease, when it is transferred to the - - - - t lessee. Leasing industries are u trs d a i Th provit ein oa with A' ed tow o r growing rapidly in several other 1, A it s 1M ct s d Eastern European countries, even - - - t in the face of significant problems in domestic banking industries. In Slovenia, for example, leasing accounts for nearly a third of capital equipment investment. IFC has been active in developing leasing industries in several Eastern European countries, generally following a well-tested formula of matching an international leasing company with local partners who know the market (Box 3.1). 3.31. A nascent private sector leasing industry does exist in Bulgaria. The severe problems with the working of the collateral system mean that it has been mainly focused on vehicles, where title registration is clear. Even so, lessors buy insurance against the lessee defaulting with the asset. Two other obstacles to the development of the industry are: i) lack of a clear legal framework for leasing. Legislation is reportedly under preparation; and ii) difficulties in obtaining domestic financing. Leasing companies generally obtain finance from the banking system. This obstacle is not insuperable, as evidenced by a small leasing company which was writing 18-30 month leases in an environment where there are few bank loans over one year in term. And new leasing companies in countries with distressed banking systems often offer foreign - 34 - exchange denominated leases to exporters first, and then gradually move on to the more profitable locally denominated leases. Nevertheless, the difficulties in raising term local financing reduce the scope for leasing. 3.32. Other problems relate to the tax treatment of leases. It is expected that these will be addressed when leasing legislation is passed. 3.33. Promoting the development of the leasing industry will not solve the significant problems constraining access to finance for many small Bulgarian firms. But it is an example of a reform that can be made ahead of or in parallel with the important structural changes needed in the banking sector. In addition, experience from other countries indicates that leasing companies help to stimulate competition in the financial sector, and stimulate capital market development. Table 3.1: Addressing the Legal and Institutional Roots of Limits to Access to Credit -~~~~~.: .-< ... ........ .. ...... ..E ~~~~~~~~~~~~~~~~~~~~. . . . . . . . . . . . , . . . . . . . . . . . R'f'' '' Creation of Expand the range of movable property that can serve as collateral for a loan; permit Security different types of property rights in that property such as floating security interest in Interests proceeds, after-acquired property clauses; consider the advantages of broad functional approaches to security interests, such as the EBRD model code, Canadian Personal Property Security Act, or the US UCC-9; weigh these advantages against more piecemeal but simpler reforms along the lines of the German or French model. Consider the advantages of extending the abilities to write non-possessory security interests beyond the banks and foreign parties. Perfection Public registration of security interests; consider the type of public registration; consider using public access as a way of providing private registration; consider possibilities of linking and making public the existing notarial registries; consider requiring the registration of security interests in automobiles in the automobile registry. Enforcement Consider options of improving the speed and lowering the cost of public enforcement agents; of expanding public enforcement beyond the judiciary; of changing laws to permit private repossession and sale of the collateral underlying debt contracts. Imrove the incentive environment for leasing and use the IFC experience and expertise Leasing to expand this industry. - 35 - CHAPTER 4 REMAINING TAX ISSUES 4.01. The chapter begins with a brief background of the tax system followed by recommendations for reform of the existing structure. Also, in response to the Bulgarian authorities interest, this chapter discusses the effects of explicit investment incentives and provides examples of such schemes from other countries. The report recommends against the introduction of such schemes. TIHE CURRENT TAX SYSTEM: BACKGROUND 4.02. The tax system affects private sector development, via incentives to engage in the type of risk takdng entailed in entrepreneurial activity. High taxes on capital inhibit investment thus reducing its capacity for growth. The perception of high and unstable taxes in Bulgaria contributes to the existence of the large informal sector (although because of incentives for profit shifting, the informal sector would exist with more moderate tax rates -- see Chapter One). 4.03. The tax system in Bulgaria increasingly resembles that of many developed market economies. The existing tax structure is summarized in Table 4.1. Income taxes dominate direct taxes and the VAT, implemented from April 1994, is becoming the major indirect tax. Yet, the fact that there is massive tax evasion and avoidance indicates that the tax system still suffers from serious problems."6 4.04. With respect to indirect taxes, the introduction of the value-added tax has brought private-sector activity more fully into the tax base. In the first quarter of VAT implementation in 1994, 43 percent of VAT revenue was derived from the private sector; compared with a 10 percent contribution of the private sector in 1993 to the turnover tax which the VAT replaced. Customs and excise taxes are evaded by smuggling and Bulgaria is no exception. Indirect evidence on evasion of excises is indicated by the fact that real volumes of imports are constantly increasing, while revenues from customs do not rise apace. Informal payments (bribes) also facilitate undervaluation of imports for duty purposes, by allowing presentation of fake invoices and/or fake certificates of origin. Fake exports of tobacco products allow collection of excise tax refunds that were never paid. Consideration should be given to reducing duties on imported capital imports. In addition, 16. General tax structure and its problems are discussed at length in the recent World Bank report Bulgaria: Public Finance Reformns in the Transition, 1994. - 36 - every effort should be made to ensure that firms that qualify for VAT credits on imported inputs receive their credits in a timely fashion. Table 4.1: Tax Structure (1996) in Bulgaria .. .. . ... .. .. . . ......... ..... . . . .. ..... . ..... . . . . . . . . . ... ... . .. .. ....:S I tif-r-yp#! -X;|00 -00- W0- 00tlTaT- Rates-00-X.. .. . - .as i ....... e Profits Tax 36% for companies with profits over 2 mnilion leva Profits of all SEs, MEsa, and private enterprises 26% for companies with profits over 2 million leva Same tax holidays for joint ventures and privatized companies Social Security Pension: 35% for normal retirement, 45%, and 50% for early Gross wage contributions retirements. unemployment: 7% Income Tax Marginal rates from 20% to 52% Individual income Turnover Tax/VAT Standard rate: 22% (lower rates: 2%, 10%) Retail turnover of all enterprises; lower rates apply to food and select sectors (construction) VAT (1994) Single rate: 18% Value added of goods and services Excises and customs Ad valorem excise rates vary from 35% (diesel fuel) to 70% Turnover of select goods l_________________________ (alcohol, jewelry), raised as of June 1996 Non-tax revenue Various fees, charges on services Select public services SEs denotes state enterprises, MEs denotes municipal enterprises. Municipal enterprises and state enterprises with more than 50 percent municipal participation in ownership were liable for an additional 10 perceit tax on profits payable to their municipalities. Source: Bogetic and Hillman (1994) 'Tax Base Substitution," in Financing Government in Tran,sidon, edited by Zeljko Bogetic and Arye Hillman, World Bank, Personal and sectoral study, Washington, D.C, 1995 4.05. Formal labor-market relations are discouraged by high taxation for financing social benefits and insurance payments, evasion of which offers substantial, shared gains to employer and employee. For an employer, the total cost of an employee with a take home pay of 3,000 leva per month is in the range of 5,000 leva per month. This represents a serious disincentive to formal sector employment, as well as an incentive for avoidance and evasion. Labor is consequently often employed in the private sector under terms that exclude social benefit and insurance payments, although by law these benefits should be paid to all employees. A policy dilemma is that while evasion of social benefit and insurance payments is illegal, evasion encourages employment in the private sector by reducing the cost of labor - 37 - to employers and increasing the net wage received by employees. The proposed solution is for the authorities to reduce significantly the payroll taxes on the private sector. This would be beneficial from the incentives viewpoint. Moreover, it may not reduce revenues since it would reduce the incentives for evasion, which as mentioned above is very widespread. After a couple of years, once the revenue effects of this change are clear, the authorities could proceed to reduce the payroll taxes on the state enterprise sector, in conjunction with the required reform of the pension system and tax administration. THE CURRENT INCOME TAX SYSTEM The Profits Tax 4.06. In the area of profits taxation, importantly, the treatment of completely private firms is more generous than the treatment of firms that are partially or completely state- or municipally owned enterprises (hereafter, SMOEs). Although both types of firms can take deductions for depreciation which are not indexed for inflation, only completely private firms can also choose between (1) expensing (a full write-off of an asset in one year), and (2) deductions for repayments of principal of loans used to finance asset purchases. (Deductions under these two special provisions are allowed only to the extent of taxable profit, with no loss carryforwards.) In addition, only private firms are allowed to deduct the costs of land purchases under the two options described above; SMOEs receive no deductions for land purchases. Moreover, firms that are completely private are allowed to deduct all nominal interest expense, while firms with any state or municipal participation are allowed to deduct only 75 percent of nominal interest expense. Enterprises that are at least 50 percent private, including foreign entities and private joint ventures with foreign entities are taxed at a 36 percent rate (with a 26 percent preferential rate for enterprises with profits of less than 2,000,000 leva in the previous year). By comparison, SMOEs with 50 percent or more state or municipal ownership face a tax rate of 48 percent (36 percent + 10 percent to the municipality in which the firm is located + 2 percent to the national irrigation fund). SMOEs must also pay a supplementary tax on wages in excess of those established by the state incomes policy. Finally, 50 percent of the distributed earnings of a SMOE are returned to the state (as a return on the state's equity), and deposited into the Dividend Fund, an extrabudgetary fund. 4.07. In addition to the profits tax, four other elements of the tax code are important. First, a 15 percent withholding tax is applied to repatriations to foreigners. This tax may be deferred by re-investing the funds in Bulgarian equity or debt securities. Earnings distributed to Bulgarian residents by firms with foreign participation are subject to a 10 percent withholding tax. Second, firms are generally allowed to carry losses forward for five years; these deductions from the taxable income must be distributed equally over the five-year period. Third, for inventory accounting, firms may use either FIFO, LIFO, or average cost accounting. And fourth, all firms must pay customs duties on imported inputs, and foreign firms must pay customs duties on inputs contributed by parent firms, unless these inputs are used to produce exports. Such customs duties are deductible from the profits tax base. - 38 - The Individual Income Tax 4.08. Sole proprietorships are not taxed under the profits tax, but their earnings are subject to the individual income tax. There are two separate schedular individual income taxes--a monthly tax on wages and salaries that is withheld at source and an annual tax on other individual income, including certain capital income, income from sole proprietorships, and income from service contracts. The same rate schedule (with rates that vary from 20 percent-52 percent) and exemption amount (approximately equal to one minimum wage, with no additional personal exemptions) is applied to each schedule. Bracket amounts are indexed for inflation. Taxation is applied on an individual, worldwide basis. Capital income includes dividends. However, capital gains and pensions are not taxed at the individual level and most interest income is not taxed. 4.09. The provisions for calculating sole proprietorship income are generally the same as those used for calculating income for 100 percent private enterprises under the profits tax. In particular, for purchases of depreciable assets, the sole proprietor may choose between expensing, depreciation deductions or getting deductions for repayments of the principal of the loan used to finance the asset purchase; deductions are limited to the amount of taxable profit with no loss carryforward. In addition, sole proprietorships receive an exemption equal to one minimum wage per month for each month remaining in the fiscal year for each new job created. PROPOSED REFORMS OF THE EXISTING INCOME TAX STRUCTURE 4.10. The basic business tax structure in Bulgaria is quite generous to completely private firms. Actually, some of its features are too generous by international standards and may need revisions. The reforms outlined below would make the Bulgarian tax system more consistent with basic principles of taxation of real economic income, will move it closer to international practice and would provide a more level playing field for unhindered investment and growth. These reforms should be extended to the private sector and to the calculation of the tax burden on sole proprietorships under the individual income tax; the discussion assumes that a policy of differential treatment of the state sector continues to be deemed desirable. 4.11. There are several problems that become important in the context of the current inflationary environment. First, while expensing is very generous, it is allowed only to the extent that it reduces taxable profit in the year of purchase. The excess of cost over profit can be depreciated, but depreciation allowances are not indexed which under current inflation can loose its value. Second, the Bulgarian tax code allows firms full interest deductibility, while very little interest income is subject to taxation at the individual level (under high inflation, most of interest expense reflects compensation paid to the lender for the loss in the value of principal attributable to inflation). As a result, the marginal effective tax rate on debt-financed investment could be negative; that is, the tax system actually subsidizes investment. - 39 - 4.12. The two effects described in the previous paragraph operate in opposite directions. Inflation accounting would take care of these problems but it is quite difficult to implement. However, the Bulgarian tax authorities and the Ministry of Finance should consider introducing some partial adjustment to the tax base and deductions, if high inflation would continue for more than a couple of years. 4.13. Two additional factors related to inflation adjustment must be considered. The first is inventory accounting. Since only the LIFO inventory accounting method approximates accurate measurement of income in an inflationary environment, it is recommended that firms be required to use LIFO accounting. The second issue is the tax treatment of capital gains. Since the proposed tax system would closely approximate full taxation of business income, capital gains taxation would represent a second layer of tax for financial assets of firms subject to the profits tax, and is not necessary. On simplicity grounds, taxation of indexed capital gains is not recommended for owner-occupied housing and foreign assets, primarily because enforcement of such taxation is so difficult. 4.14. Purchases of land can be expensed under the Bulgarian profits tax. Alternatively, debt-financed purchases can be deducted as the principal of the loan is repaid. Most countries do not allow deductions for land purchases. It is recommended that the deductions for purchases of land and for repayment of loans be eliminated. 4.15. The authorities should consider exempting dividends from tax at the individual level. Such treatment would be consistent with an 'integrated" approach to income taxation in Bulgaria--that is, a combined business and individual level tax system that avoids double taxation."7 This approach ensures that the treatment of debt and equity-financed investment would be comparable under the reformed tax system, which in turn would eliminate tax- induced distortions of decisions regarding the use of debt and equity finances. EVALUATION OF THE CASE FOR INVESTMENT INCENTIVES 4.16. In Bulgaria, there has been wide and continued debate in policy circles on the usefulness of explicit income tax incentives for investment. This issue has also been of particular interest to the Ministry of Finance, and received attention in debate over the appropriate means of stimulating foreign investment. In response, this section presents the evaluation of the case for investment incentives, based on theoretical and empirical studies, and the international practice. The prevailing professional opinion is that investment incentives are distortionary and a very expensive way of influencing investment decisions. 17. To see this, recall that full deduction of nominal interest expense, coupled with the application of withholding taxes to interest income, implies that the income earned by debt-financed investment is effectively taxed at the withholding rate, which equals (or approximates) the business tax rate. However, since dividends are not deductible from the business level tax, the income from equity-financed investment is already fully taxed at the business level. Accordingly, no further taxation is required if only a single level of tax is to be imposed on the income from equity-financed investment. - 40 - Also, to the extent that incentives are designed to offset income tax imperfections, direct reform of the tax system is preferable to ad hoc adjustments using investment incentives. Moreover, non-tax factors are likely to play a much more important role in stimulating investment, both foreign and domestic. 4.17. Commonly expressed concerns are that investment incentives are difficult to design, distorted by the political process, costly in terms of foregone revenue, complex to administer, and subject to manipulation by firms. In particular, many observers have stressed the administrative and enforcement problems associated with implementing investment incentives. In the absence of unambiguously positive empirical effects of investment incentives, it is prudent to be skeptical of their practical policy usefulness in stimulating investment. 4.18. The following sections examine two incentive schemes: additional or accelerated investment deductions and tax holidays, and compare them to a reduction in the profit tax rate. The discussion indicates that a reduction in the tax rate is more efficient and simpler to implement. If the Bulgarian authorities decide to reduce the profit tax, they should do so in conjunction with the recommendations mentioned above, which would expand the tax base and therefore would avoid further fiscal deterioration. Rate Reduction 4.19. The recommended investment incentive is straightforward--a significant reduction in the profits tax rate. In 1996, the Government, indeed, reduced the rates to 36 percent (and 26 percent) for firms with profits over (and below) a threshold profitability. Since profits tax revenues are currently quite low and the expansion of the tax base under the proposed reform would be quite large, a reduction to a rate in the neighborhood of 25 percent for all firms might be possible and still achieve the revenue objectives of the Bulgarian government regarding income taxation; this should include the profits tax on the banks which are currently facing higher rates. Simultaneously, consideration should be given to reducing somewhat the top rate under the individual income tax, since a large differential between these two rates is undesirable. 4.20. There are numerous advantages to the reduced rate approach. First, it is the simplest type of investment incentive. It applies uniformly and does not create the avoidance opportunities and complexities associated with rate differentials. A low tax rate provides a clear signal of a friendly investment climate to both foreign and domestic investors. Second, a rate reduction is fairer--and is so perceived--in that it applies uniformly to both new and old investment. Third, a uniformly low rate is relatively easy to apply in terms of administration and compliance. In particular, the transfer pricing problems that plague international tax administration are minimized with a low tax rate; indeed, a low rate provides an incentive for declaring income in Bulgaria while allocating costs to other higher rate countries, thus increasing Bulgaria's revenues. Fourth, a rate reduction applies uniformly across all assets and industries, and thus results in fairly few distortions of the - 41 - BOX 4,6 The4hdonesi encn "Indonesian ux policy in the three. deade por to 94 wsP .. t system was viewd not ony as a mn of ;risi-g u b dinig i osm tion, investt, d eplo t deso td ut b the state. T extios an d .- differentiation of tax raites were the preferrd tecbuiquesfo ecring des oeities.: Fivored activities or pursuits were provided taxinie y f, of , o zero rates. Disfavored activities and products we ineligile fr s ctives", or m som cases ubgjected to special. rates of tax higher than those genrally applicable to axamle u rtaking.- By 1981, thirty years of active pursuit of nonneuttalities in taxtion had yield tax system so inteaced with complex tax incentive arrangements as to e a At inadministrable.: tx pfeces were: similar in structure to incentive schmes commonly used i other countres; fsome were peculiar: to .Indonesia, The former included tax incentives t proimote rgn inve to encourage domestic investment: in specified activities, and: to attrat: both forei-gnand doiestic investment to so-called 'backward" regions. With these "common: incentivssolidly in place by 1970, it:was but a short step to fiurter proliferation of tax incentives over the next decade. These ranged from the unusaiil to the truly bizarre: Wx incentives to encourage development of a national stock market, to purhase life insurance, to encourage construction of bowling alleys, to finance tournament travel of chess players, and to promote use of public accountants.... By 1982, decision makers were in any case already predisposed to discard as unworkable most of the elaborate system of tax preferences that had evolved over the previous two decades. By 1983, this predisposition had cbanged to a: strong preference for-eonomic :neutrality in the tax structre, owing to- results of several studies of tax incentives undertaken fort refor. These studies indicated the waste and complexities of not only the more bizre types of -tax preences but the most hllowed incentive of all: tax holidays for promotion of foreign investment" . . . . - . . . . . .. . - --. - -. --.:--- .- S.3ource: Gillis (1989, 91-2). . . ,:.... . allocation of investment. Although other incentives can in principle be designed to be neutral across different types of assets, this can be difficult, especially in an inflationary environment. Finally, the basic idea suggested by this approach--a broader base coupled with a lower tax rate--is consistent with recent reforms in many developing and developed nations, including the U.S. Such reforms are generally believed to be consistent with both efficiency and equity goals.18 Therefore, a uniform rate reduction is the investment incentive that should be utilized in Bulgaria. The following section outlines the advantages and disadvantages of two alternative general forms of investment incentive. 18. It should be noted that the enactment of an investment incentive in the form of a relatively low tax rate should be accompanied by an explicit commitment on the part of the government to keep the rate at least roughly constant over time. If firms perceive that current low rates are temporary, a serious disincentive to investment would result, since the first-year capital recovery allowance would be taken against the relatively low current rate, while the returns generated by investment would be subject to a future higher tax rate. - 42 - Additional or Accelerated Investment Deductions 4.21. The primary advantage of additional or accelerated investment deductions is that they are targeted only to new investment, and thus have a lower revenue cost per dollar of new investment generated than a generally applicable investment incentive like a rate reduction. They tax high returns on investment at higher rates than ordinary returns. However, as argued above, the relevance of this argument is open in the Bulgarian context, since so much of current tax liability of the private sector is apparently evaded or avoided. 4.22. However, the use of additional and/or accelerated deductions has a number of problems. First, the stimulative impact of the incentive may be reduced significantly if firms expect that countries that typically employ such incentives will have to introduce future rate increases. Second, it is moderately difficult to design such incentives so that they will be neutral across assets and business sectors, especially in a high and highly variable inflationary environment. 4.23. Nonetheless if, despite the above arguments, additional investment incentives are deemed desirable, beyond the relatively low rate recommended above, additional or accelerated deductions would be the best means of achieving this goal. Moreover, these deductions could be designed in such a way as to avoid distorting the allocation of investment across assets and business sectors. Specifically, the allowance could take the form of "partial expensing"--an immediate deduction for some fraction "f" of the cost of an investment, with deductions for economic depreciation for the remaining (1-f) of the cost of investment. If the latter deductions are indexed for inflation, partial expensing is neutral across assets and methods of finance. Alternatively, the deductions for economic depreciation could be taken using the 'first-year capital recovery" approach recommended above; that is, the firm would receive in the year of investment a deduction equal to the sum of partial expensing of the fraction "f" of the investment and the discounted present value of economic depreciation for the remaining fraction (1-f) of the investment. Such an approach is immune to the effects of inflation. If such an approach was adopted, it should be tried on an experimental basis; that is, investment incentives should expire after a fixed number of years unless they are renewed (a "sunset" provision), so that they must be reevaluated to determine if they are achieving their goals at a reasonable revenue cost. For such incentive to be useful to new and emerging firms any losses generated by the use of such incentives should be carried forward with interest. Tax Holidays 4.24. Tax holidays--a tax exemption that is generally applied to specific activities or specific firms--usually target new enterprises and foreign enterprises. Although Bulgaria has in the past experimented with this approach, the current tax system does not utilize tax holidays. In particular, the 1996 Profit-Tax Law envisages a three-year tax holiday for joint ventures with minimum capital of US$5 million, and foreign participation above 50 percent. In the fourth and fifth year of their operation, these companies will be paying one-half the - 43 - standard rate. Also privatized companies with private stakes of at least 66 percent will also enjoy the tax relief. 4.25. The primary advantage of the tax holiday is that it quickly provides firms with a fairly large benefit; that is, firms that qualify for the holiday immediately face a very low effective tax rate. (However, note that this is not true if the existing tax system is already so generous that tax exemption is not beneficial; as discussed above, this would be the case for many firms for debt-financed investment under the current tax system in Bulgaria.) In addition, tax holidays result in roughly equivalent tax rates on debt-financed and equity- financed investment for the firms affected. 4.26. However, the disadvantages of tax holidays are considerable. First, they are difficult to administer, in that firms will try to rearrange their affairs (e.g., forming 'new" firms or using transfer pricing techniques) in order to maximize their reduction in tax burden. Second, tax holidays exempt entirely from tax any extraordinary profits or economic rents; as argued above, such exemption is undesirable on both efficiency and equity grounds. Third, since their provisions apply for only a finite period of time, the effects of tax holidays are not uniform across assets and industries; thus, tax holidays typically distort the allocation of investment. Fourth, tax holidays apply to any old investments made by qualifying firms, so that their revenue cost per dollar of new investment may be relatively high. Fifth, although a relatively low tax rate is likely to be desirable because it will encourage firms to use transfer pricing to allocate income to Bulgaria and costs to other countries--and thus increase tax revenues in Bulgaria--this advantage disappears under the tax holiday; that is, with a zero tax rate, such a transfer pricing reallocation raises no revenue for the government offering the tax holiday. 4.27. On balance, the disadvantages of investment incentives in the form of tax holidays appear to outweigh their advantages. Accordingly, Bulgaria should avoid the use of tax holidays. Instead, for the reasons presented above, it should simply rely on general application of a low business tax rate. Finally, it should be noted that the case for any additional investment incentives is far from compelling. 4.28. Taking into account the above discussion, the following table summarizes the key issues in the Bulgarian income tax system and proposed solutions. The proposed changes could be effected relatively quickly, by appropriate amendments in the income tax laws (profits tax, and individual income tax) or within entirely new income tax laws, if their enactment will not be unduly delayed. - 44 - Table 4.2: Summary of Recommendations .,.-...- .......'''-''0'. 'E,W;' : Excessive payroll taxes causing massive tax evasion Reduce permanently and significantly payroll taxes on the private sector; after revenue effects are clear, proceed with reducing payroll taxes in the state sector, in parallel with the pace of the pension reform and tax administration. Expensing for land purchases is inappropriate since land Disallow deductions for land purchases. does not depreciate. Deductions for loan repayments are inappropriate under an Eliminate deductions for loan repayments. income tax. Dividends are double taxed Exempt dividends from the individual level tax. Cost of goods sold from inventory is not adjusted for Require firms to use LIFO inventory inflation. accounting. Customs duties on imported inputs result in a tax bias Consider reducing customs duties on against input-importing firms. imported inputs. Firms apparently encounter delays in getting VAT credits. Eliminate any significant delays in issuing credits. With reforms outlined above, tax burden on investment Reduce statutory rate significantly. income would increase. The individual income and corporate income taxes should These reforms should also be extended to the treat both tax subjects equally. calculations of the tax burden on sole proprietorships under individual income tax. No additional investment incentives should be enacted until effects of the proposed reforms are evaluated over the next 3-5 years. M:\bul\erol2\green\bul-psar.gm I I I I