Document of The World Bank Report No: 25476 CO PROGRAM DOCUMENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PROGRAMMATIC FISCAL AND INSTITUTIONAL STRUCTURAL ADJUSTMENT LOAN IN THE AMOUNT OF US$300 MILLION FOR THE REPUBLIC OF COLOMBIA February 20, 2003 Colombia-Mexico Country Management Unit Latin America and the Caribbean Region REPUBLIC OF COLOMBIA-FISCAL YEAR January I-December 31 CURRENCY EQUIVALENTS (as of 20 February 2003) Currency Unit Peso 2,903.00 Pesos US$1 0.92 Euros US$1 WEIGHTS AND MEASURES Metric System SELECTED ABBREVIATIONS AND ACRONYMS ATPA Andean Trade Preference Act IDF Institutional Development Facility CAS Country Assistance Strategy IMF International Monetary Fund CIT Corporate Income Tax ISA International Standards on Auditing CONFIS Consejo Superior de Polftica Fiscal: IVA Impuesto al Valor Agregado (Value Added Tax) Superior Council for Fiscal Policy LDP Letter of Development Policy CONPES National Commission for Economic LIL Learning And Innovation Loan and Social Policy MAPF Proyecto Modernizaci6n De La Administracion CPAR Country Procuremnent Assessment Piblica Financiera (Public Financial Report Management Project) DIAN Directorate of National Taxes and MHCP Ministerio de Hacienda y Credito Publico Customs MTEF Medium Term Expenditure Framework DNP National Planning Office PBG Policy Based Guarantee EUR Euro Currency PFMP Public Financial Management Project FIAL Programmatic Fiscal and Institutional PSAL Programmatic Structural Adjustment Loan Adjustment Loan RAS Social Support Network FOREC Fondo para la Reconstrucci6n y el SAL Structural Adjustment Loan Desarrollo Social del Eje Cafetero: SFAL Structural Fiscal Adjustment Loan Fund for the Reconstruction of the SINERGIA Evaluation System for Public Management Coffee Region SNGS Subnational Governments FRL Fiscal Reformn Law SSAL Social Sector Adjustment Loan FSL Fixed Spread Loan TAL Technical Assistance Loan GDP Gross domestic product VAT Value added tax IDB Inter-American Development Bank WBG World Bank Group IBRD Vice President David de Ferranti Chief Economist: Guillermo Perry Director, LCSPR Ernesto May Sector Manager, LCSPS Ronald Myers Country Director: Isabel Guerrero Acting Sector Lead Economist: Steven B. Webb Task Manager Fernando Rojas Team Production Support: Patricia Mendez This operation was prepared by a World Bank team composed of Messrs/Mmes. Rojas, Sangines, Leyton, Frank, del Villar (LCSPS). The team was led by Messrs. Rojas (LCSPS), and Steven Webb (LCC1C) and worked under the general guidance of Mr. Ronald Myers (Sector Manager, LCSPS), Mr. Ernesto May (Director, LCSPR) and Isabel Guerrero (Director, LCC1C). REPUBLIC OF COLOMBIA PROGRAMMATIC FISCAL AND INSTITUTIONAL S;TRUCTURAL ADJUSTMENT LOAN (FIAL) Program Document Table of Contents I. Context of the Operation ........................................................... 2 A. Relevant Socio-economic Background ............................................................2 B. Fiscal Rigidities: The Key Constraint to Effective Public Policy ............... .................. 5 C. Past Government Actions ............................................................7 D. The Challenges Ahead ........................................................... 11 II. The Fiscal and Institutional Reform Program ...................................................... 13 A. Revenue Rigidities and Tax Reform ........................................................... 15 - Fiscal Revenue B. Fiscal Responsibility ........................................................... 19 C. Expenditure Rigidities and Institutional Reform ............................................................ 20 - Horizontal Reforms - Vertical Reforms III. The Proposed Programmatic Operation and Loan . ............................................. 32 A. The Bank's Assistance Strategy ........................................................... 32 B. Objectives and Description of the Program ...... ...................................................... 34 C. The Proposed Loan ........................................................... 35 D. Subsequent Loans ........................................................... 37 E. Fiduciary Policies ............................................................ 38 F. Benefits ............................................................ 39 G. Risks ........................................................... 44 Annex I. Letter of Development Policy ........................................................... 46 Annex II International Monetary Fund Relations Note ........................................................... 64 Annex m. Policy Matrix ........................................................... 67 Annex IV. Colombia at a Glance ........................................................... 79 APPENDIX I: Institutions for Fiscal Responsibility ........................................................... 82 APPENDIX IIX : Tax Policy Reform in Colombia: Challenges and Achievements .................... 85 Figures Figure 1. Fiscal Deficit 1994-2001 ....................................................... 4 Figure 2. NFPS Primary Balance, Real GDP Growth, and Poverty Rates (1990-2001) ..14 Figure 3. Timeline of Changes in Tax Policy ....................................................... 16 Figure 4. Accumulated Fiscal Cost of Contingent Liabilities Against the State ............... 26 Figure 5 & 6. NFPS Expenditure and Revenues Excluding Interest Payments. Alternative Reform Scenarios (2000-2006) ...................................................... 40 Figure 7. NFPS Primary Balance: Alternative Reform Scenarios. 2000-2006 .40 Figure 8. Net Public Debt. Alternative Reform Scenarios. 2000-2006 ............................. 41 Tables Table 1. Colombia - National Taxes and Payroll Contributions .......................................... 17 Table 2. Key Measures of the 2002 Tax Reform (Law 788) ................................................. 17 Table 3. Renovation of Public Administration: Selected Vertical and Horizontal Dimensions ................................................................................................................................. 20 Table 4. Contingent Liabilities -Off Balance Sheet Items ..................................................... 27 Table 5. Reforms Supported by the FIAL First Loan (US$300 million) ................. .............. 36 Table 6. Public Sector Fiscal Balances. Scenario with Reforms 2001-2006 ........................ 42 Box Box 1. SFAL Contribution to Fiscal Stabilization and Expenditure Flexibility .................. 10 PROGRAM DOCUMENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PROGRAMMATIC FiSCAL AND INSTITUTIONAL STRUCTURAL ADJUSTMENT LOAN TO THE REPUBLIC OF COLOMBIA 1. This program document proposes the first of four loans using a Programmatic Structural Adjustment Loan (PSAL) instrument, and will support short- and medium- term reforms with twofold objectives: First, to help attain the substantial fiscal adjustment required to ensure macroeconomic stability and ease the significant fiscal rigidities that make the implementation of public policy extremely difficult; and Second, to improve the provision of public services and establish the institutional basis for higher efficiency and accountability in public expenditure. The program would consist of four single-tranche loans, adding to a notional amount of US$900 million in total. Decisions about whether and when the subsequent loans would go forward will depend on the progress of the reform program. 2. This document attempts to highlight the situation in which the recently elected Government of Colombia finds itself and the issues that this program seeks to address. The incoming administration is faced by mounting social demands to provide essential services - among them, and most importantly, security and peace. It is also faced by a persistent form of budgetary constraint that prevents it from having adequate resources to address these demands: structural rigidities in the tax and public expenditure systems, which make it extremely difficult to allocate scarce resources in an efficient and effective way. The proposed program will support the reforms necessary to attain fiscal adjustment and will constitute an important first step towards liberating Colombian public finance from structural rigidities. The proposed program will also support and help address important issues of administrative efficiency and public sector modernization, which will continue in the subsequent loans of the program. 3. This program supports the policy agenda that the administration of President Uribe has undertaken to resolve Colombia's long and costly internal conflict while at the same time reversing fiscal deterioration so as to safeguard macroeconomic stability. President Uribe, who was elected with a strong mandate in the first ballot, has been gaining even greater internal support through promoting reforms as well as fighting courageously against terrorism. These reforms include the approval of a strong tax iii Annex 1: Letter of Development Policy package, congressional approval of a referendum, important pension reform legislation, labor market reform, and measures to strengthen the financial sector, and new powers granted to the President to streamline public administration. I. CONTEXT OF THE OPERATION A. RELEVANT SOCIOECONoMIc BACKGROUND 4. Macroeconomic Performance. Despite its long tradition of very prudent and successful macroeconomic management, including good debt management, Colombia's economic performance began to deteriorate in the early 1990's and has continued to stagnate, growing by only 1.4 percent in 2001 and about 1.6 percent in 2002. Major domestic obstacles to a more robust recovery include weak domestic demand associated with high unemployment, currently at almost 15 percent in urban areas, and historically low private investment levels. Moreover, exports, which had led the recovery in 2000, have languished over the past year due to a combination of domestic and international factors. This has in turn affected the performance of manufacturing, much of the production of which is directed toward exports as a result of weak demand at home. Sluggish domestic demand and worsening internal security conditions are reflected in the continued weakness of private investment. 5. Private GDP has grown little since the mid-1990s, and private investment has deteriorated from its peak of nearly 12 percent of GDP in 1994 to under 6 percent today. Total investment now stands at about 14 percent of GDP, incompatible with what the resumption of significant growth would require. While government consumption grew by two thirds between 1994 and 2002, household consumption remained basically unchanged. 6. Colombia's traditional exports fell by over one-fourth in 2001 and 2002, because of declining petroleum production (despite the recent rise of world oil prices), historically low international coffee prices, difficulties in the important Venezuelan market, and the real appreciation of the peso in 2001 and early 2002. While the country's non-traditional exports, mainly manufactured goods and cut flowers, performed well in recent years and now amount to over half of total merchandise exports, the appreciation of the peso in early 2002 and the economic slowdown in the United States, Venezuela, and other Andean countries affected them negatively in 2002. Declining imports have, however, maintained a surplus in the trade balance. The total external current account had a deficit of about 1.7 percent of GDP in 2002. 7. Inflation declined in 2002, assisted by sluggish demand, and was about 7 percent over the last 12 months. This allowed the Central Bank to reduce interest rates, which, along with enhanced prudential regulation, helped the financial sector rebound from the significant crisis of 1998-1999. 8. Fiscal Performance. Over the past half-decade, new realities have emerged in Colombia's fiscal domain, including significant deficits and large future fiscal liabilities. The rapid expansion of the public sector over the previous decade, from spending one fourth of GDP in 1990 to over one third of GDP today, combined with growing 4 Annex I: Letter of Development Policy Figure 1: Fiscal Deficit 1994-2001 Source: Departamento Nacional de Planeaci6n 2.0 - as 0- a 2.1-<17_1 00 -03 0 __ ^4 8 -3.0 -- IL.-4.0- 1 -5.0 -6.0 - -7.0 1994 1995 1996 1997 1998 1999 2000 2001 - eNatlonal Government Deficit -U- Decentralized Sector Deficit - Total Deficit NFPS liabilities, particularly on the pensions front, have led to significant and persistent deficits of a structural nature. As public spending rapidly outstripped the sector's revenue- generating capacity, much of the fiscal deficit was financed with debt, both domestic and external. Today, total public sector debt in Colombia stands at about 56 percent of GDP. The estimated deficit of the combined public sector for 2002 is 4 percent of GDP, largely due to election year spending, higher military outlays, and a weakening of the social security institutions. On security spending alone, the administration estimates that it will need an additional 1 percent of GDP per year. 9. Nevertheless, the Uribe Administration has stressed its commitment to continue the fiscal adjustment efforts of the previous administration. On December 20, 2002, Congress approved a strong tax package estimated to yield an increase of tax collections of about 1 percent of GDP in 2003, 1.2 percent in 2004, and 1.7 percent of GDP by 2005. In addition, Congress recently passed two key structural reforms: a pension reform to address the looming deficits of the social security sector, Colombia's largest future fiscal liability; and a labor reform to increase flexibility in Colombia's rigid labor market. 10. The fiscal deficit for the Non-Financial Public Sector is expected to come down to 2.5 percent of GDP in 2003 and 2.1 percent in 2004. Financing has been planned so that the total public debt will start being reduced in 2004. As a precaution, the Government requested a Stand-By agreement from the IMF, which was recently approved by the IMF Board. 11. The External Environment. Colombia's vulnerability to external shocks has risen in the past year as a result of several factors: increased violence domestically and uncertainty about the future path of the internal conflict; the deterioration in sovereign debt spreads (though some recovery has been seen in recent months); the worsening of market sentiment toward Latin America; problems in Venezuela, the largest market for Colombia's nontraditional exports; and an uncertain outlook for the U.S. economy, Colombia's main trading partner. However, given its floating exchange rate, falling 5 Annex I: Letter of Development Policy inflation and adequate international reserve levels, Colombia should be well equipped to deal with moderate external shocks if it undertakes the necessary fiscal adljustment. 12. Poverty. In Colombia, there has been a close positive correlation between fiscal balance, growth and poverty reduction (see Figure 2). During periods of positive growth (and fiscal balance), Colombia enjoyed substantial declines in poverty (even though inequality increased). Specifically, from 1988 to 1995, as GDP grew on average at about 4.2 percent per year, poverty rates declined from about 65 to 60 percent of the population. This reduction, and the government's efforts that helped achieved it, were completely wiped out by the 1998-99 recession. Poverty levels today are not substantially different from what they were in the late 1980s. More immediately, unemployment climbed to, and has since remained at, almost 15.7 percent of the labor force at the national level. Put differently, the evidence suggests that sustainable growth and fiscal balance has been Colombia's best social safety net. A fiscal balance program that increases revenue and makes expenditure more efficient, as well as within prudent limits, is a sine qua non for Colombia's attaining the human development Millennium Development Goals (MDGs). 13. Insecurity and Violence. Colombia has captured headlines around the world for its alarming indices of violence. Since the 1980's, the multidimensional problem of violence has become more widespread and is exacting an increasing economic and social toll. Recently, trends in violence have worsened and are now among the highest in the world. Figure 2. NFPS Primary Balance, Real GDP Growth, and Poverty Rates (1990-2001) _jt- _ -4 Poverty Rate3 65 55O - C 1991-1996 1997-2001 50 I I I I -1 1990 1995 2000 _ Average Real GDP Growth Rate - Average NFPS Primry Balance (Percentage of GDP) Poverty Rate 14. From 1999 onwards, the number of attacks on petroleum infrastructure increased by 160 percent, on electric infrastructure by 680 percent, and kidnappings by 126 percent over the average of the previous 13 years. It is estimated that the conflict reduces the annual economic growth rate by at least 2 percent. There is consensus around the 6 Annex I: Leuer of Development Policy unacceptability of the current levels of violence, which translated into an overwhelming electoral mandate for the Uribe administration and its determined stance to restore security. The current conflicts places the country in a particularly vulnerable and difficult position. The repercussions of the armed conflict on the economy and the overwhelming social demand for its settlement make peace the paramount priority of the government's public policy agenda'. As crucial complements to the direct counter-insurgency measures, the government recognizes the need to sustain fiscal balances and improve the quality and efficiency of public service. B. FISCAL RIGIDITIES: TIE KEY CONSTRAINT TO EFFECTIVE PUBLIC POLICY 15. The fundamental issue that constrains the effective implementation of public policy in Colombia is the inability of the Government to access the necessary budgetary resources to attend policy priorities. Regardless of the political commitment to promote peace and development, there is little that can be done without resources. Budgetary shortfalls are clearly not uncommon; fiscal adjustment is a worldwide reality. However, the nature of the Colombian fiscal imbalance is particularly difficult to unravel, and fiscal rigidities play a critical part in the picture. 16. Fiscal rigidities, in the broad sense, incorporate a number of concepts that cover areas such as tax policy and administration, budget management, civil service, judicial decisions, and administrative processes such as public procurement and contracting and asset management. The common thread that connects these diverse areas is that they all generate an entrenched expenditure that is difficult to reduce, produce excessive costs derived from fundamental inefficiencies, and/or prevent a revenue source from reaching its full potential. 17. Some of the most important types of fiscal rigidities that have hampered the implementation of public policy in Colombia are: * Legal and judicial expenditure entitlements and revenue earmarks that create permanent rigidities in public spending; * Generous tax expenditures-in the form of exemptions, tax credits or zero tax rates- which weaken revenue elasticity, reduce the tax base and damage tax neutrality and tax efficiency; and * Opportunities for the capture of portions of public spending due to administrative weaknesses of the public sector, such as the complex and fragmented budgetary process, deficient asset management and legal protection of State interests, inadequate public procurement rules and institutions, and profuse entitlement- based spending that is not adequately monitored and evaluated. '. It has been estimated, for instance, that war-related additional public expenditures will reach 1.5 percent of GDP by 2006. 7 Annex I: Letter of Development Policy 18. Taken together with the economic contraction and the instability generated by the armed conflict, these factors explain why Colombia has had such difficulty in making the necessary fiscal adjustment and mobilizing resources adequately for the implementation of public policy. It'is clear that an effort to increase revenues is not sufficient; reducing expenditure layouts and strengthening the capacity of the Government to manage the budget according to priorities is a necessary condition. Furthermore, areas where efficiency gains can be achieved or under-utilized assets more wisely used, must be explored and exploited. 19. During the previous decade the country tried to introduce expenditure flexibility and enhance efficiency via state decentralization, incipient evaluation measures or privatization and contracting out with the plivate sector. Those efforts have not fully reached their objectives, due to: i) resistance from powerful nation-wide trade unions to the transfer of personnel to subnational governments, ii) constitutional or legal budget entitlements defended by rent seekers, iii) growing court and arbitration decisions that condemn the. state to make payments beyond present budget capacity; iv) fragmented procurement arrangements that allow for sector capture of state contracts, and/or v) weak government capacity for contracting, execution, evaluation, monitoring or otherwise delivering efficient services and protecting state interests. 20. Pre-committed expenditures (wages and salaries, inter-government transfers, social security transfers, interest, budget carryover of the central administration and in the unpaid bills of selected non-financial public enterprises) amountedl to a substantial portion of Central Government Primary Spending in 2002. Such a restricted fiscal position made Colombia particularly vulnerable and ill-prepared to respond to the economic recession that has unfolded since 1998. Moreover, it has left scarce budgetary room to respond to new government priorities regarding security, rural development and social expenditures. 21. Governance consequences of fiscal imd administrative rigidities. Revenue and expenditure rigidities that cause inefficiency in allocation and production of public services also weaken governance and impose a heavy toll on the state's capacity to reach conflict-ridden areas. 22. This means that the technical design for policy implementation needs to take into account the capacity of corporatist interests to undermine reform. In addition, other forces lie outside the formal political system and often attempt to influence policy through non-transparent ways. Given this broader political environment, the Colombian public administration has faced difficulties in passing or implementing economic and political policy reforms critical for longer term sustainability of the country. The lack of such reforms threatens to seriously disrupt social services and safety nets and exacerbate the undesirable social consequences of the internal conflict, economic recession, and the slow growth of the last few years. 23. The current government recognized the importance of, and obtained a new political mandate for taking decisive policy measures to add flexibility to fiscal management, not only to make the response to social demands possible but also to enable 8 Annex 1: Letter of Development Policy the country to weather future external shocks more resiliently. As discussed later in this report, the key political and governance requirements are in place for a substantial overhaul of the legacy of years of misguided corporatist public policy. C. PAST GOVERNMENT ACTIONS 24. Past government responses. All recent governments have attempted to reverse these negative trends. However, the responses primarily addressed revenue and were partially ineffective with respect to the expenditure side, that is, reform of the public sector. In order to deal with the immediate effects of the recession, the then-incoming Pastrana Administration formulated a three-year stabilization program for the period 1999 through 2002 based on increased exchange rate flexibility, fiscal stabilization, and the implementation of structural reforms, including financial sector restructuring, tax reform and privatization. 25. The international financial community mobilized to support that program, and in December 1999 the IMF Board of Directors approved a three-year, SDRI.96 billion Extended Arrangement Facility-the first of its kind for Colombia. This arrangement was entered into with a clear understanding on the part of the Colombian authorities that: (a) it was precautionary in nature, (b) it was meant to send a confidence-building signal to international markets, and (c) it would not be drawn upon unless there was a pressing balance-of-payments need. The authorities proceeded along the precautionary path by not drawing upon the arrangement -despite the deteriorating external environment-with a view to avoiding possible wrong signals to the markets. 26. To deal with excessive spending, previous administrations had launched several public sector reform programs. Yet these initiatives-during 1992 and 1994; during 1998 and 1999; and in 2000-did not fully reach their desired outcomes. The limited success of these past reforms was primarily due to: (a) some reforms, especially those between 1998 and 1999 -though explicitly focused on expenditure reduction-- faced legal or political obstacles; and (b) other reforms were not primarily targeted to expenditure reduction or to effectively tackle the inner roots of rigid growth in fiscal transfers or legal claims against the state. After these attempts at reform, the Colombian public sector still requires a significant effort to reduce inefficiencies, align responsibilities, foster transparency and improve management and accountability. 27. From the point of view of reform management, the limited success of administrative reform efforts in Colombia can be largely explained by the lack of consensus, limited involvement of-leading to lack of ownership by-potential beneficiaries, inadequate monitoring or evaluation disclosure, and policy discontinuity between one government and the next. Successful public sector reforms calls for a realistic strategy for implementation and sustainability-an approach that is built on stable political consensus, ownership at various levels of the administration, and the mobilization of civil society in support of the reforms. 9 Annex 1 Letter of Development Policy 28. World Bank support. The World Bank has joined the stabilization efforts and the country's quest for minimizing tax expenditure and public spending rigidities. Beginning in 1999, four Bank projects have sought to tackle the structural factors that are at the bottom of Colombia's weakening fiscal balances and limited efficiency in allocation and service delivery: Financial Sector Adjustment Loan, MAFP II, SFAL and SECAL I. 29. In November 1999, the Bank Board approved an EUR482 million Financial Sector Adjustment Loan, the second tranche of which was converted, in February 2001, to a Policy Based Guarantee (PBG) operation of about EUR238 million, further reinforcing credibility in international markets. 30. In 2001, the Bank approved MAFP II, a Technical Assistance Project for modernization of revenue and financial administration and public sector evaluation.2 MAFP II set ambitious goals in Colombia's road map toward overall public sector modernization. The core of this project is the establishment of a framework for improved public expenditure management and increased transparency and accountability for outcomes, as well as substantial modernization of the tax and customs administrations. 31. One of its elements, intended to integrate financial management (Sistema Integrado de Informacion Financiera, SUF), is still being implemented. The results to date, indicate that it will contribute to enforcing hard budget constraints, upgrading budget and treasury planning, producing reliable accounting data in real time, and ultimately enhancing Government resource allocation. A second element-the evaluation component (Sistema Nacional de Evaluaci6n de Resultados, SINERGIA)- should deliver state-of-the art, objective performance and result assessments when it is fully developed. It is also expected to provide the inputs needed for transforming planning, budgeting and public administration generally into greater result-oriented, performance-based operations. SINERGIA could ultimately bring Colombia to the level of Chile and Brazil-the two most advanced Latin American countries in public sector evaluation. 32. Both SIIF and SINERGIA have faced circumstances which have slowed down their implementation. As far as SINERGIA is concerned, despite its conceptual and technical advances, structural features of the Colombian budget have become significant obstacles for its complete implementation. The incentive framework around public sector policymaking is not conducive to the efficient and effective use of resources. Public sector managers do not have the flexibility in the allocation of resources to implement 2 Public Financial Management Project H (2001) is a follow-up to the Bank-financed MAFP I, and has two components. First, it proposes to strengthen Colombian revenue administration to foster voluntary compliance and revenue collection and combat tax evasion and smuggling. It will do this through organizational, managerial, and procedural changes and improving the policy and the legal framework for revenue administration. Second, it aims to strengthen public expenditure management at the central government level, to facilitate achievement of fiscal and national development objectives, improve cost effectiveness of public services, and increase transparency and accountability. It will do this through improving macro-programming and formulation and monitoring of the budget; strengthening budget execution, treasury, and public credit and accounting; improving the evaluation of results of public expenditure; and strengthening public procurement and contracting. 10 Annex 1: Letter of Development Policy public policy and therefore the integrated financial information or evaluation assessments are not yet feeding a results oriented framework 33. Furthermore, the budgetary rigidities discussed earlier impose a severe limitation on the capacity of these instruments to develop fully and have a real impact on the quantity and quality of public expenditure and on fiscal stabilization efforts in general. The present institutional framework also calls for separate preparation and execution of the current and investment columns of the expenditure budget. Therefore, as elaborated below, coordinating these two key part of the budget process will be essential to implement sector or service efficiency measures-or to adequately introduce result- driven budgets and adequate evaluation. 34. The Structural Fiscal Adjustment Loan (SFAL) of 2001-02 further contributed to the country's stabilization efforts through the measures described in Box 1. It supported the Government's program for reaching an inflection point in the path of fiscal accounts-an essential first step toward achieving full fiscal sustainability, economic growth, and poverty reduction. It strengthened fiscal accounts by: (a) rationalizing the system of transfers to sub-national governments (especially education-related transfers) and imposing more market-driven and binding budget constraints on their finances; (b) establishing mechanisms to arrest the exploding cost and inefficiency of public health services (particularly the cost of public hospitals and the health arm of the Social Security Institute); (c) advancing the reorganization of public agencies and their current expenditures; (d) halting the accumulation of pension-related contingent liabilities; and (e) setting up a better system for managing public debt. The combination of measures to improve intergovernmental fiscal relations, rationalize and reallocate public sector expenditures, and improve financial management of assets and liabilities of the public sector helped to bring about both a more sustainable fiscal path in the long run-a necessary condition for sustaining economic growth and poverty reduction-and greater efficiency in allocation of public resources in the social sectors-a necessary condition for improving the provision of key public services, particularly education, health and pensions. 35. SFAL supported ceilings on transfers to subnational governments that were aimed at restraining growth in spending and reducing the moral hazard from the deficits of subnational governments and decentralized social security institutions. By so doing, SFAL supported the first step towards reducing expenditure rigidities. Supplementary measures are still needed to reduce budget entitlements promptly and effectively.3 The next step is to reduce and eliminate powerful rent-seekers' influence in the actual allocation of expenditures and tax exemptions. Since most budget rigidities are enshrined in the Constitution or in the laws, that next step requires legal or constitutional measures that can only be enacted when governments are backed by multi-party coalitions and country-wide political support -such as the support expressed in the elections and 3. Some of the reforms-although urgently needed-can only be expected to produce fiscal relief in the medium or long term. This is the case of the pension reform, just approved by Congress, whose positive impact on the fiscal accounts will only be felt 5 or 6 years from now. Transformation of the current pay-as-you-go system in a provision-based system usually creates additional fiscal demands in the early years of the reform while fiscal benefits come later-in the form of saving the country from the potentially devastating effect of a pension crisis or government bail out of the pension system. Annex I: Letter of.Development Policy maintained since for President Uribe. Besides, the reformns themselves can only be sustained if stakeholders (other than traditional rent-seekers) and civil society at large are involved in the public sector reforrn agenda through disclosure, greater evidence of protection of state interests and tangible improvements in the day-to-day priority concerns of the population. Box 1. SFAL Contribution to Fiscal Stabilization and Expenditure Flexibility Supported the constitutional amendment of 2001 which simplified the system of inter-government fiscal transfers into one single Sistema General de Participaciones and limited the rate of growth of: (a) total transfers to subnational governments to last year's inflation plus 2 percentage points; and (b) the central admninistration's operational expenditures to last year's inflation plus 1.5 (percentage points). * Supported the new regime for debt and boirrowing by government agencies (Decree 2540 of 2001), which requires credit ratings by authorized institutions and includes provisions for capital-risk weighting. In addition, SFAL supported application of Law 617 that requires that no territorial entities receive further bailouts or guarantees of their debt after July 1, 2002. * Supported acceleration of transfer of education responsibilities and resources to municipalities. Law 715 of 2001 that amended Law 60 of 1993 introduced capitation formulas for education transfers and automatically certified large municipalities, which are now recipients of education transfers and are held accountable for education results. Similarly, SFAL supported design of performance matrices for each certified rnunicipality that signed an inter-government performance agreement with the National Goverrnent for enhancing quality and coverage of education. 36. In the case of transfers to the education sector, for instance, SFAL supported the issuance of a new law that changes the calculation of the transfer from the current payroll (supply)-base to a per-student (demand) base. SFAL also advanced the preparation of inter-government result agreements that would make municipal authorities fully accountable for increasing coverage and enhancing efficiency in education. But the initial implementation, expansion and further institutionalization of the proposed result- based inter-government agreements will take several more years to bear much fruit. Likewise, it is still premature to evaluate the impact of the new performance management contract between the Instituto de los Seguros Sociales and the Ministiy of Finance that was also supported by SFAL. Moreover, SFAL's ultimate fiscal benefits are apt to be offset by the unexpected surge of fiscal requirements to pay for legal decisions against the state. 37. The social sector adjustment loan (SECAL) approved in 2002 has successfully introduced greater flexibility in health and education expenditures. It sought to enhance the efficiency of inter-government transfers for education by changing their governing criteria from supply-side bases to demand-driven allocations. SECAL also has aimed at overcoming legal and constitutional rigidities by effectively transferring human and financial resource management to the local level. These are steps in the right direction since monitoring and evaluation of as well as incentives for teachers need to be managed at that level. For now, the central government is being equipped to monitor results municipality by municipality while local governments evaluate school by school. 38. The expected SECAL II, in addition to other elements of the Government's reform program, will face the subsequent challenges in the path towards raising efficiency and accountability for the country's substantial transfer for education. 12 Annex 1: Letter of Development Policy Subsequent challenges are threefold: i) to ensure effective implementation of Law 715 that transforms fiscal transfer from a supply-side basis to a demand-based transfer; ii) to enhance accountability of subnational governments through better defining education responsibilities of each layer of government, and iii) to apply result-based incentives and monitoring to ensure higher efficiency of current fiscal transfers in terms of coverage and quality. 39. Four main lessons come from recent Bank operations that have supported the country's quest for raising the efficiency of public expenditures, moving towards result- oriented budget and minimizing tax expenditure and public spending rigidities: i) reducing budget entitlements is a pre-requisite for higher flexibility in expenditure allocation and service production functions; ii) further involvement of civil society at large is needed to increase political support for reforms that impinge on interests that have been long entrenched in the country's budget; iii) simpler, targeted and specialized budget reporting is needed to involve congress, political parties and communities in the discussion and approval of a more flexible budget; iv) social efficiency gains from the decentralization of health and education can only be achieved when subnational governments are empowered to manage productions and are fully accountable for service delivery; and when central government fiscal transfers come with clear conditions and incentives for achieving results. D. THE CHALLENGES AHEAD 40. Results of the economic reform program and remaining challenges. The implementation of the stabilization program in the last few years has produced some positive results-key indicators such as growth and inflation have improved; the extemal position and financial system have been strengthened; key legal and constitutional reforms geared to reducing the inflexible growth of inter-govemment and social security transfers have been passed by Congress, and compliance under the past IMF and World Bank operations has been satisfactory. Yet, a number of unresolved issues and challenges remain and require attention, especially regarding the fiscal situation and the working of the public sector. 41. Fiscal reform challenges. The immediate objective for the government of Colombia is to strengthen the fiscal accounts. This will contribute to: i) promoting a more positive atmosphere for new investment and consolidating of the observed, albeit timid, recovery of growth, ii) creating enough fiscal room for financing this government's top priorities in a fiscally responsible way; and iii) reducing the crowding out effect of government over-borrowing in domestic markets. This will also have a positive impact on poverty reduction, since, as mentioned previously, the link between growth and poverty in effect dictates Colombia's economic policy agenda over the next few years. 42. In spite of important progress, the initial round of stabilization-related reforms did not attend to some important structural, sector-specific imbalances continue to weaken, the country's fiscal position. If not properly addressed, these weaknesses will further push down economic growth; indeed, growth has recovered more slowly and tax revenues have therefore not met expectations. Failure to restore peace and the rule of law 13 Annex !: Letter of Development Policy could further undermine investor confidence in Colombia; and external shocks could restrict Colombia's access to international capital markets even more. The financing scenarios for 2003 call for significant foreign funding, of which an important proportion will be lending by multilateral institutions. In brief, in the absence of further structural fiscal strengthening, macroeconomic vulnerability will remain and external or domestic shocks could easily lead to a sharp rise in poverty. 43. Public sector and institutional reform challenges. The institutional factors that underlie today's fiscal problems are not new in Colombia. Enhancing efficiency and accountability of public administration appears to be difficult when public resources are pre-committed to specific interest groups, without regarding the country's changing priorities or fiscal situation. 44. Fiscal problems that long plagued the country have intensified and become more apparent since the end of the Frente Nacional (National Front) in 1974. The National Front (1958-1974), a bi-partisan concert of the two major political parties primarily geared to suppress inter-party fighting and rural violence, expanded the size of government and created a number of expenditure rigidities that were later confirmed or increased by the Constitution of .1991. Although the Front ensured some policy cohesiveness and party and fiscal discipline, this success, has long been dissipated. Fragmented political factions have multiplied special interest pressures on limited budgets. Trade unions and other political clienteles gained independent leverage which they abused for their parochial "captive sectors." Weak national administrations and populist courts gave in too readily to demands on budgets, contracts and fiscal transfers. 45. State capture has remained-and has often been exacerbated by-the introduction of contemporary tools of state modernization. Prominently, the extensive movement towards decentralization has not fully achieved its intent to improve public service delivery. At the same time, inter-government fiscal transfers have become politically difficult to reverse. The intermediate level of government-which receives a substantial part of the. total public budget-is still largely not accountable, neither to the central government nor to the local citizens. As a result of these and other forces, including the country's internal war and drug-trafficking, the weakening of Colombia's governance became perhaps the single most important cause of the country's fiscal and administrative deterioration. 46. Facing this situation, the relatively independent Mr. Alvaro Uribe received a clear mandate, with multi-party votes from the electorate. It is to re-establish security, eradicate political corruption, improve public services, bolster fiscal discipline and bring the internal conflict to an end. Significantly, in December 2002, the government was still as strong in the polls as when it was elected in May 2002. The congressional sessions that ended in December 2002-and ensured the passage of an unprecedented number of legal reforms (including tax, labor and pension reforms) and advancement of constitutional reforms (both via popular referendum and via ordinary Congress approval)-did not appear to diminish people's high regard for the President. On the contrary, those sessions further demonstrated the capacity of Mr. Uribe's government to enact and implement reforms and meet people's high expectations for this government. For the first time in many years, a significant window of opportunity has opened to implement bold reforms that has led significant sectors of the country and the 14 Annex I: Letter of Development Policy international community to be increasingly optimistic about the reversal of years of corporatist public policy. 47. Today, the challenge consists of making sure that the public sector operates under two principles while delivering more and better quality public services: (a) a budget constraint principle, and (b) an efficiency principle. The budget constraint calls for the elimination of rigidities and entitlements that impede flexible fiscal policies; this also creates the need to enhance the transparency and to commit agencies to deliver specified results that can be evaluated. The efficiency principle requires that the government introduce performance and result indicators for agency evaluation and management of human resources, strengthen and modernize external audits, improve asset management, pursue effective procurement, protect the state from spurious legal claims, and introduce electronic government tools for promptly disclosing public information and reducing transaction costs.4 II. THE FISCAL AND INSTITUTIONAL REFORM PROGRAM 48. General Framework: The Estado Comunitario and the Future of the Colombian Public Sector. The idea of "Estado Comunitario" lies at the heart of this government's public sector reform program. The "Estado Comunitario" is a set of basic reform guidelines put together and demonstrated in practice by President Uribe at the time he was governor of the department of Antioquia, perhaps the most developed intermediate level administration in Colombia. Already elaborated and announced during President Uribe's campaign, the concept of Estado Comunitario should inspire criteria for selection of entry points and impact evaluation of public sector reform under the present administration. Although still evolving as a guiding concept of public sector reform, the Estado Comunitario incorporates and adapts to Colombia a number of widely accepted, contemporary principles of public sector reform that will guide the renovation of the Colombian public sector under the current administration. 49. The concept of the Estado Comunitario is the foundation of the National Development Plan 2002-2006. The fundamental principle underlying the concept is that the State should exist for the service of its citizens and not for the benefit of special interests. The Estado Comunitario involves civil society in the attainment of social objectives; it is a modern State where scarce resources are invested wisely and efficiently; and it is a decentralized State that stands for regional autonomy with transparency, political responsibility and community participation. 50. The National Development P!an proposes the development of the Estado Comunitario through four basic pillars: 4. Additional focus on corruption, crime and violence will be supported by a judicial reform project and an anti-corruption project that are anticipated as parallel operations. 15 Annex I: Letter of Development Policy * Democratic Security. The State must provide security and protection to all Colombians, without political, ideological, religious or socio-econoniic distinctions. * Sustainable Development and Employment. Economic growth stagnated during the last few years and unemployment has grown by around 10 percent since 1999. The State must provide the conditions to recover the path to econornic growth. * Social Equity. The State must ensure that the fruits of economic growth are enjoyed by all Colombians. * Renovation of the State. The State must modernize its administration and reform intergovernmental relations. The ultimate goal is to build a managerial, participatory and decentralized public sector. 51. The Estado Comunitario and the Fiscal and Institutional Reform Program The fundamental purpose of the Fiscal and Institutional Reform Program is to liberate resources for the effective implementation of public policy and to generate efficiency and transparency gains that will contribute to fiscal sustainability and the improvement of service delivery. In this sense, the Program is a necessary condition for the attainment of the goals of the National Development Plan as described above. Democratic Security hinges upon the availability of untied fiscal resources, within a framework of macroeconomic stability, to invest in restoring peace to the country; Sustainable Development requires a sound macroeconomic framework and effective fiscal policy; Social Equity requires ability to deliver improved services to the poor and increase their ability to benefit from economic growth; and the Renovation of the State clearly entails efficiency and transparency gains as well as the necessary institutional strengthening actions to deliver more and better public services in a fiscally sustainable way. 52. The new government and the private sector are frank and open to acknowledge the long-entrenched state capture and the gradual deterioration of investment climate. Since the presidential campaign, the government has announced and put together an ambitious yet realistic program for fiscal and institutional reform that covers both the revenue and expenditure sides of the fiscal accounts. This reform program involves a wide array of constitutional, legal and administrative measures that, together, represent the most significant reform effort since the Constitution of 19915. 53. New legal and constitutional framework. Upon taking office, the government launched an array of legislative proposals and actions. Indeed, the unusual number of substantial constitutional and legislative proposals congested the legislature to the point that only selected priority issues were approved in the session that ended in mid- December 2002. Other important proposals, such as the Fiscal Responsibility Law, received only initial consideration and must wait for the next ordinary Congress session that will start in March and end in June 2003. 54. The administration is using a three pronged approach to strengthen its governance and fiscal discipline. First, it targeted two constitutional reform iniliatives, one via 5 World Bank projects are supporting these reform efforts; through a combined package of structural reform projects that include overall rationalization of public expenditures (including pension and social security expenditures), labor reform, tax reform and tax administration, financial reform, and improvement of health, education and family services. 16 Annex !: Letter of Development Policy pending referendum and the other via Congress, to strengthen its capabilities at all levels. One provision of these measures would eliminate the Congress' power to allocate portions of oil and mining royalties. If approved, these funds would become available for use as incentives for improving education performance. Second, several legislative initiatives should remedy a variety of structural impediments contributing to budget expenditure rigidity and the fiscal deficit. These call for merging some ministries and advancing ongoing pension and labor reforms. Third, there are reform proposals for a number of executive branch actions aimed at mitigating important causes of expenditure rigidity. They are directed at improving the management of state assets, installing inter- government incentives for higher efficiency and flexibility in education spending, bolstering the state's protection against excessive-and often unjustified-legal claims, tightening government procurement, advancing the performance and results-based management agreement with and monitoring of the Instituto de Seguros Sociales, and establishing the bases for overall budget reform. 55. The government is already planning substitute measures in case the Referendum is not approved by the voters. Those alternative measures would include: i) gradual elimination of some special pension regimes through legal reform and collective bargaining; ii) legal reform proposals and administrative measures to ensure expenditure cuts and additional tax revenues with a fiscal effect at least equivalent to the expected impact of the current expenditure freeze, and iii) reforms to encourage subnational governments that currently receive royalty transfers to concentrate their project proposals in the education sector. 56. Concept and Structure of the Public Sector Reform Program. The core of the reforms is contained in two reform packages known as the Tax Reforn and the Renovation of Public Administration. These two packages are framed within and supplemented by other government reforms in such a way that the magnitude and expected impact of the former cannot be adequately grasped without reference to the latter. The program is both coherent with and strengthened by the constitutional and legal reforms courageously undertaken by the present administration, involving a popular referendum scheduled for early 2003, a constitutional reform that has completed one of two rounds of congressional review, a pensions reform, and the reform of the central government structure. All these reforms have significant fiscal implications and should establish the necessary basis for the proposed Fiscal Responsibility Law and for Colombia's political reconstruction and economic recovery. A. REVENUE RIGIDITIES AND TAx REFORM Fiscal Revenue 57. Given the pressure to spend for both domestic security and social programs, and the tight borrowing constraints, the government knows that it has to raise more revenue. The additional tax revenue will come from important measures, some already taken and some still pending, along two main fronts: Tax Policy and Tax Administration. 17 Annex 1: Letter of Development Policy 58. Tax Policy. Colombia gets its fiscal revenue from three main sources-oil royalties, customs duties, and domestic taxes. The value of oil revenues depends largely on world market factors beyond the govermnent's control, although there is scope for reform of how these revenues are allocated and shared between different levels of government.6 Customs revenues have generally declined over recent years, with trade liberalization, and should continue this trend for the sake of economic development. The main opportunity for increasing revenues comes from domestic taxation, which is also an important area for reducing economic distortions and administrative complexities. Figure 3: Timeline of Changes in Tax Policy Total Income 1990-2002 (% GDP) 1t8- FL.-2---991Lw383df1997 14.9 Law223of 1993 VA ZI Conb evaon 14 - lTdbutary staNde l _ 14~~~~~~~~~~~~~~~~~~~~~~~~1. 12- < -;~~~~~~~~I 12.-77- 13.37 12 - eX 10 < 0.78 1128 11A 633ctI 1oovA11.%7 1 10a41 ] 8.53 mvret LawBOf 1992 Law488o11998 L; 49 o 19921 VAT14% E02% Fianailmovenents| VAT 12% tnponnt 37.5% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Year 59. Previous rounds of tax reform, particularly in 1974 and 1986, left the country with a fundamentally sound array of taxes at the national level-on value added, corporate, and personal income. The two aspects of the income tax are largely integrated by exempting dividends from taxation as personal income and giving all corporate forms equal tax treatment. Prior to 2003 capital gains were not taxed at the individual level, which had the advantage of avoiding double taxation of retained earnings (matching the non-taxation of distributed earnings and further integrating the business and individual tax systems) but had the disadvantage of reducing revenue and offering opportunities for tax avoidance through schemes to convert current income into capital gains. 60. Aside from the major reforms, however, the tax laws have suffered frequent changes that reduced revenue collection and introduced distortions by granting preferential treatment to special interests or, alternatively, increased revenue and intensified distortions by raising the rates on activities already being taxed. Figure 4 6For the last 15 years the value of oil revenues has also suffered from guerrilla attacks on the pipelines. 18 Annex 1: Letter of Development Policy shows the recent time line of changes in tax policy and revenue. Now, the new government of Colombia has an electoral mandate to raise more tax revenue, and the challenge is to do so in a way that reduces privileges and distortions. 61. Key Policy Actions. The enactment of Tax Reform Law 788 in December 2002 brought together some of the key policy actions geared to the modernization of Colombian tax policy. This law: (i) eliminates exemptions and expands the tax base for the Value Added Tax; (ii) establishes a new ceiling on the wage exemption for the personal income tax, and reduces incentives for non-taxed compensation to employees; and (iii) phases out the corporate income tax exemption for capital gains from sales of stock, mutual funds and real estate and for profits from previously privileged corporate forms, contracts, funds or bonds. On a tax-by-tax basis, the 2002 tax reform included the measures shown in Table 2 (a diagnosis of the previous structure and a description of the latest reforms and the remaining agenda is presented in Appendix 1[). TABLE 1. NATIONAL TAXES AND PAYROLL CONTRIBUTIONS 1995 1996 1997 1998 1999 2000 2001 Percent of GDP Income Taxes 4.0 3.8 4.4 4.3 4.2 4.3 5.2 olw Corporate 2.2 2.2 2.7 2.5 2.4 2.5 3.0 Personal 1.8 1.6 1.7 1.9 1.8 1.8 2.2 Tax on Banking 0.6 0.7 Transactions Value Added Tax 4.1 4.7 4.8 4.6 4.4 4.9 5.2 Excise Taxes 0.6 0.7 0.6 0.5 0.5 0.5 0.6 Taxes on 1.0 0.9 1.0 1.2 0.9 1.0 1.1 International Trade Other 0.6 0.7 0.7 0.7 0.7 0.7 0.7 Social Security 3.5 3.5 3.3 3.5 3.3 2.7 2.6 Contributions a Total 13.8 14.3 13.1 14.8 14.0 15.3 16.1 a. Social security contributions and other payroll contributions are collected by institutions outside the national central government. They include pension contributions and health insurance. Sources: Estimates based on data provided by CONFIS, IMF, and High Commission on Taxes. TABLE 2. KEY MEASURES OF THE 2002 TAX REFORM (LAW 788) Tax Key Effects Value-Added * A large number of previously exempted or excluded goods and services will be Tax subject to the VAT at 7 percent from 2003, rising to 10 percent in 2005 * Nearly all other exempted and excluded goods and services will be taxed at 2 percent from 2005 onwards * Mobile phone rate established at 20 percent * Rate on automobile sales will be unified at 25 percent from the current range of 20 percent to 35 percent a Collection of VAT on all capital goods with a 3-year rebate or credit for registered firms making further sales Personal * Reduction of the wage tax exemption from 30% to 25% with a ceiling in the Income Tax amount of Col$16 million in monthly wages and reduction of tax exemptions, tax credit and non-taxed income for the personal income tax 19 Annex I. Letter of Development Policy TABLE 2. KEY MEASURES OIP TH 2002 TAx REFORM (LAW 788) Corporate * Phase-out of exemptions for capital gains from sales of stock, mutual funds and real Income Tax estate and for profiis from a variety of previously privileged corporate forms that often served as tax shelters * Reduced access to the special tax regime (20 percent rather than the standard 35 percent) * 10 percent special surcharge for 2003, to be lowered to 5 percent in 2004 Other National * Does not eliminate the distortionary financial transactions tax implemented in Taxes and 1999; however, it closes some loopholes for transactions in the real economy and Contributions allows exemptions for some inter-bank transactions not meant to be taxed Sub-National * Rationalizes departmental and clistrict taxes on alcoholic drinks Taxes * Increases the gasoline tax surcharge transferred to subnational governments by 5 percent 62. Prior to the Congressional approval of Law 788, the Government established a special, one-time net wealth tax of 1.2 percent (Decree 1838, August 11, 2002) to finance the restoration of public order. The Government has estimated that the total revenue from this one-time tax will be in excess of 1 percent of GDP7. 63. Expected outcomes. These measures will expand the VAT tax base from about 41 percent of consumption in 2002 to about 59 percent by 2005, a major achievement. Regarding the corporate income tax, the phase out of exemptions will reduce them from 70 percent of potential revenue in 2003, to 50 percent in 2004, to 20 percent in 2005, and to 0 percent in 2006. An increase in subnational revenues by one-fifth is expected. Preliminary estimates by the authorities indicate that tax collections would increase by about I percent of GDP in 2003 as a result of the tax package, rising to 1.2 percent of GDP in 2004 and to 1.7 percent of GDP in 2005. These expected outcomes are additional to the one-time wealth tax described in the previous paragraph, which is not a permanent tax policy measure. 64. Tax Administration. Even the best policy reforms would realize their goals of greater revenue yields with fewer distortions only if there are improvements in tax administration. This remains a major weakness in Colombia, where tax revenues are substantially below what the rates and the tax base would normally suggest. 65. The VAT and income taxes each collect only a little over 5 percent of GDP. The Direcci6n de Impuestos y Aduanas Nacionales (DIAN) is the entity responsible for tax and customs administration. Some of the most important areas where the tax administration needs improvement are: * Revision of the relationship with the banking system in order to standardize information flows and reduce-the period during which funds are held by banks (now 14 days); * Improved coverage of withholdings of interest income on individuals, now only at 7 percent and from large accounts only; * Increased integration between the areas of internal revenue and customs, especially in processes such as auditing and information management; * Reduced costs of enforcing compliance. 7 The collection of this tax is done in four installments. The first two installments have yielded approximately US$500 million, close to 0.6 percent of GDP. 20 Annex I: Letter of Development Policy 66. Key Policy Actions. The reform of tax administration will include a number of measures aimed at the aforementioned problems8. In order to improve collection of taxes on interest paid to individuals, DIAN will require all entities (banks, governments, etc.) paying interest to expand their reporting on the recipients. 67. In addition, DIAN will establish unified accounts between customs and domestic taxes, starting with all large taxpayers in 2003. It will clean up data so that it is in standard formats and becomes part of centrally managed taxpayer databases, to which all IASD units contribute and that they can access. To improve enforcement, DLAN will issue a plan for coordinating audits and sharing information across its departments. It will establish a list of collectable tax debts and publish a plan and timetable for their collection, starting with the largest. 68. To improve the system from the point of view of the taxpayer, DLAN will establish indicators and will publish data on the cost and time required for compliance. A series of actions are needed to complement these measures. These should include the improvement of opportunities for electronic filing (especially for large taxpayers); and steps to enhance user friendliness and motivate taxpayers to declare and pay electronically. In addition, DIAN will establish indicators of customs clearance time, and design procedures permitting expedited shipment inspections based on risk-management techniques. B. FISCAL RESPONSIBILITY 69. The fiscal situation in Colombia reflects the extent of excess demand on the State, its inability to meet those demands, and the urgency of achieving sustainable balances. A sound fiscal framework is essential for the national security effort, for the social programs that sustain the State's legitimacy, and for the protection of common citizens against the ravages of inflation. Achieving that will require, among other things, institutional reform of the formulation of macroeconomic policy, and close monitoring and control to meet short- and long-term fiscal targets. 70. Behind the unavoidable fiscal arithmetic by which spending in excess of revenue has led to deficits and the accumulation of debt in Colombia, there lie budgeting and fiscal management procedures that gave rise to the unsustainable fiscal tendencies. Colombia has given increasing attention, therefore, to changing its rules of the game for fiscal policy at all levels of government. Until recently, the Constitution and legal rules for budgeting and treasury have done little to restrain central government deficits and debt, and in some ways they encouraged them. For example, vigencias futuras make commitment for future expenditure and the allowance for arrears based on ad hoc promises for future payment of present expenditures. 71. In the 1990s, the new Constitution broadened political participation, increased spending impulses, and weakened the tax base of the national government (automatically sharing it with subnational governments), all of which compromised overall fiscal prudence. The Acto Legislativo (constitutional amendment) of 2001 sought to put ex ante 8The MAFPII project, mentioned in the introductory section, has tax administration modernization as one of its key objectives and will contribute to the implementation of the key policy actions for DIAN. 21 Annex I: Letter of Development Policy limits on some of the spending impulse coming from transfers to subnational governments. 72. Despite these reforns, the national government believes that at all levels of government there remains too much discretion affecting fiscal deficits and not enough assurance of fiscal sustainability. Evidence to this effect is the fact that Central Government expenditures have increased steadily from 9.4 percent of GDP in 1990 to 20.8 percent of GDP in 20029. 73. Key Policy Actions. The key policy action in relation to fiscal responsibility is the final enactment of the Fiscal Responsibility Law (FRL) and its full application by year 2004. The bill had been prepared and submitted to congress by the previous Pastrana administration. It has already gone through two approvals in Congress and is expected to become law in the forthcoming legislative sessions of March-June 2003. The current draft of the FRL contains rules for fiscal stability, transparency and macroeconomic consistency, fiscal discipline, and sub-national debt limits. The Law to be enacted is expected to contain, at a minimum, rules for: a) setting fiscal targets linked to debt sustainability and primary balance for the NIPS; b) annual reports of fiscal results to Congress, including floating debt; c) publication of the financial plan that will include, among others, information on floating and contingency debt; and d) the obligation to include the fiscal impact and source of financing within any law that creates new tax expenditures. 74. The design of the Colombian FRL has benefited from the regional experience of several countries that have implemented similar fiscal rules, either through fiscal responsibility laws of their own or through other mechanisms that fall short of an integrated FRL. Appendix II offers a more detailed analysis. C. EXPENDITURE RIGIDITIES AND INSTITUTIONAL REFORM 75. The Renovation of Public Administration. The structural rigidities that prevent public expenditure from being flexible enough to address public policy demands constitute a common thread among the areas contained in the public administration reform program. The government has identified the need for shorter- and longer-term actions in a number of horizontal (i.e. systemic, cross-agency) areas and vertical areas (i.e. agency-by-agency reforms to redefine mission, increase efficiency, and improve coordination) of public administration. 76. The initial momentum to this process was Presidential Directive number 10 (August 20, 2002), which establishes the guiding principles for the renovation of the public administration. Based upon this document, the government started a process of consultation with international financing organizations to receive financial and technical support for its implementation. The IBRD focused primarily on the horizontal aspects of the reform process, as well as some vertical elements that can lead to enhanced service delivery by the education sector or government agencies. The Inter-American 9 Source: Departamnento Nacional de Planeaci6n 22 Annex I: Letter of Development Policy Development Bank focused primarily on the vertical reforms and some cross-cutting issues such as information management, e-govemment and civil service reform. TABLE 3. RENOVATION OF PUBLIC ADMINISTRATION: SELECTED VERTICAL AND HORIZONTAL DIMENSIONS Vertical Horizontal Simplification and Rationalization of the Higher efficiency in largely captured sectors and Government's Structure agencies and initial steps towards results-oriented management Agency-by-agency selective retrenchment Budget reform, including regulatory adjustments similar to a Medium-Term Expenditure Framework (MTEF) Agency-by-agency procedural and organizational Administrative reform: Asset management, public simplification and enhanced service delivery procurement, legal protection of the State 77. The timing of reform differs for vertical and horizontal reforms. Some of the vertical reforms can be quickly introduced. Therefore, as soon as the government took office it issued regulations and instructions for implementation of reform in the vertical areas and subrnitted a bill requesting congressional authority to reform the structure of the administration. That bill was recently approved by Congress and was enacted as Law 790 of December 27, 2002. Reform of horizontal areas will take anywhere from a few months to the entire four years of the Uribe administration. Horizontal Reforms 78. Budget Management Colombia's planning and budgetary process is a complex interplay of various entities operating under diverse rules and procedures. It produces the National Development Plan, the Financial Plan, the National Investment Plan, the Annual Investment Operative Plan, and the Budget. Theoretically, they are fully consistent with one another, but in practice they differ among themselves. Budget law figures are actual appropriations instead of expenditure caps which consequently limit the scope for expenditure control during the budget year. Furthermore, the budget process does not produce reliable revenue estimates. 79. Over the years, many Colombian interests have successfully won permanent budget entitlements or revenue earmarks . This has served to circumvent resource constraints and to reduce the scope for government decision-making and good fiscal policy. It has also crimped the mobilization of funds for new prograrns. This problem has been recognized and acknowledged by the Colombian authorities since it was first pointed out by the 1980-81 Presidential Commission for Inter-Government Fiscal Relations. However measures to attenuate it have been too weak or short lived.10 80. Other deficiencies in the system include the absence of suitable controls over budget outcomes. Instead of having effective "checks," Colombian budgeting is too process-oriented. This has hampered the tracking of such important elements as stability, 0. Cf. Bird, R. M. (1981) Colombia. Inter-government Fiscal Relations. Harvard University, International Tax Program. The Presidential Comision de Gasto Publico of the early nineties produced a report of similar category. 23 Annex 1: Letter of D,evelopment Policy effectiveness, and efficiency. In addition, Congress lacks the capacity to properly analyze budget information. 81. Thus, the challenge is to initiate a transformation of the budget system in order to be more policy focused and accountable for results. This will not be an easy task. Besides the inertial tendencies to maintain existing practices, the vested interests who have gained power on budget decisions will resist giving it up. Refoim will require sustained changes in rules and procedures to make budget decisions according to policy priorities (allocative efficiency), performance and results (productive efficiency), and available resources. This would affect how central government and sectoral authorities decide on what should be done, how it is going to be achieved, and who is responsible for it. It would also affect subnational governments to the extent that national rules and practices are also applicable to regional and local governments. The new rules also call for mechanisms to hold policy makers and managers accountable for planned outputs and outcomes to be delivered in a timely fashion. 82. Key Policy Actions. The government has determined that substantial reforms in the budgetary process are essential to restore its capacity to implement fiscal policy within a framework of macroeconomic stability. A number of key policy actions have been identified that when taken together, constitute an important package of reforms that will restore flexibility to budgetary managernent and strengthen the policymaking capacity of the Executive Branch. 83. The key initial steps to be taken by the present government include: Pursuing a Medium-Termn Expenditure. Framework (MTEF) adjusted to the Colombian legal and political constraints. This document must propose aggregate fiscal targets for a multi-annual period (in conjunction with the FRL), identify key strategic and policy issues and propose sectoral allocations. Once these sectoral priorities and 'activities are identified by line-ministries and decentralized agencies, it would be possible to carry out a cost assessment of total requirements within each sector. This medium term perspective would also serve other purposes: provide reliable figures to evaluate possibilities of budget cuts from the standpoint of output impact rather than the more traditional input perspective, and clarify the need to evaluate legal entitlements in the light of sectoral objectives and priorities, and how to shift resources when priorities change. * Restore Budget Powers to the Ministry of Finance. The yearly budget law, once approved by Congress, creates mandatory entitlements for the- public sector institutions that the Executive Branch must honor, regardless of their consistency with fiscal or macroeconomic developments during the fiscal year. To introduce a greater degree of oversight by the Executive Branch during budget implementation, the Government is seeking a Constitutional amendment that would introduce "filters" between budget approval and implementation to ensure overall fiscal coherence. * In addition to the Constitutional amendment, important changes in.the Organic Budaet Law (LOP) are needed. Once the Constitutional amendment is passed, the LOP must be modified to regulate the operation of the "filters" that would be 24 Annex 1: Letter of Development Policy enshrined in the Constitution. Even if the amendment is not passed, a reform to the LOP will still be necessary to enhance the Executive Branch's capacity for budget management within the existing Constitutional constraints. To support this process, a high-level Special Commission comprising s.veral stakeholders will comprehensively review, entitlements and revenue earmarking to identify and recommend necessary reforms and help build broad support for them. * Ensuring Consistency between Current and Capital Expenditures. Over decades, the processes of assigning current and capital experditures by the MOF and by the DNP respectively have resulted in two almost autonomous budgets. This resulted, among other things, in an inability to effectively analyze the current expenditure consequences of public investment. The authorities will act to ensure coherence between current and capital spending. o Greater Transparency and Accountability for Outcomes. This element of the strategy calls for simplifying budgetary information in order to make it easier to understand and available for public use. This proposal goes hand in hand with the government's initiatives to launch a website with comprehensive fiscal information based on SIIF outcomes, and will require the immediate implementation of a Communication Program to convey to the public the present budget figures. * Review of Entitlements and Earmarked Revenues. To promote flexibility in public expenditure, the GOC will establish a high level Special Commission to undertake a process of review of expenditure entitlements and earmarked revenues, and recommend the necessary legal and administrative measures to introduce greater flexibility in budget management. o Budgeting and Accounting Classifications using International Standards. Different government levels have been reluctant to unify accounting and budgeting classifications, instead using non-standard accounting practices. The strategy aims at unifying budgeting and accounting bookkeeping according to international standards in time for the FY2006 budget. * Budget Control. The weakness of political, technical, tiscal, and social controls of budget outcomes has left the budget system without effective "checks." In Colombia, the fundamental problem with control is that it is process oriented, making it virtually impossible to keep track of fiscal outcomes (stability, effectiveness, and efficiency). The Government will implement a performance management exercise that will promote a different approach to analyzing budgetary outcomes. 84. Asset Management. By "asset management" we refer to the rules, regulations, systems and practices with which the Government manages its existing assets, both fixed assets of high value (especially real estate) as well as other lesser assets that are part of the public sector's capital stock. Improper asset management can impose significant rigidities and inefficiencies in public financial management. From the expenditure side, 25 Annex!1: Letter of Development Policy the public sector often needs to makce additional investments because of the inability to use its existing assets due to improper titling, incomplete inventory, or other reasons. From the revenue side, unproductive or unnecessary public sector assets constitute a potential source of capital income should they be sold. 85. The Planning Department (DNP) is taking the leadership to develop a strategic vision on how to approach the subject of asset management. There is no complete information on the total of assets owned, their current value, and their legal status. Although the Contaduria General de la Naci6n has started a sort of inventory process, the public accounts give a partial and out of date view of the real situation. 86. Some agencies have accumulated a varied array of properties and other assets, which with unclear legal status and economic value, incomplete registration, and irregular control, constitute no solid basis to begin applying professional management criteria. The complex legal framework is an additional burden as it doe.s not recognize market principles, nor does it provide adequately for discretionary managerial actions. As a result of all these factors, there is a substantial accumulation of idle assets. 87. Since almost everything is to be done, challenges for asset management are numerous. Nevertheless, there are three major challenges that can be addressed during the life of this program. First, to know precisely what is owned, its value, legal title and effective possession; second, to effectively execute new policies based on criteria encouraging the keeping of useful and productive assets and mandating the release from state ownership of unproductive assets which have no direct connection with governments' mission; and third, to manage all state owned assets within strict parameters of efficiency and transparency. 88. Key Policy Actions. The key policy actions for asset management are divided into the short- and medium-term: * Short-term policy actions. DNP wili, as an initial step, develop a framework for asset management which defines the scope of government action and policy. This is crucial since at present no entity in the central government is in charge of asset management, and strategy, policies, and procedures, have to be develop from scratch. The scope of this initial work also includes the operational planning for the elaboration of consolidated inventories (with verification of title, possession, value and accounting registration), as well as the implementation of a Pilot Program conducive to quick results with positive fiscal impact. A small Committee is being formed with representatives from key agencies and the technical assistance of a limited group of external consultants, for the dual purpose of executing certain actions of this first stage, and coordinating the execution of other actions by government agencies. * The government intends to put in place a quick-action pilot plan, basically an assets sale and optimization program for 2003 and 2004 under the current regulatory framework. Although the government will not have yet developed an adequate asset management capacity, it is important to rapidly produce some needed income in order to send a definite signal of the new public asset policy and reach the more profitable later stages with continuing public support. This 26 Annex I: Lener of Development Policy program will yield by 2005 at least $175,000 million (Colombian pesos of 2002), equivalent to roughly US$60 million. * Medium-term policy actions. Subsequent actions include: (i) the formation of a centralized unit charged with the coordination of the more substantial reforms, develop Manuals of Policies and Procedures, provide technical assistance and overall guidance to other participating agencies, and be responsible for the centralized management of a Data Base system; and (ii) develop a more flexible and open-minded approach to concessions, leasing, privatization, outsourcing, etc., and the publication of the inventory of assets owned by each agency, increasing transparency and accountability. Through these reforms it is expected that assets worth approximately US$1 billion can be registered and prevented from further deterioration, which highlights the considerable fiscal impact of this reform. 89. Development of Incentives for Efficiency Gains. Service delivery in Colombia, as in many other countries, has long emphasized inputs over outcomes. The traditionally centralized public sector management tended to distance public managers even further from the outcomes achieved by the interventions of their programs, yielding mediocre public services at unreasonably high costs. It was hoped that decentralization would be a strategy to reverse this tendency, and since the mid-1980s a shift of resources and decision making authority to local government has occurred. But decentralization has not fully reached its objectives, and its level of implementation varies among the regions. The transfer of powers has resulted in blurred responsibilities in a number of sectors, which further undermines accountability. 90. This calls for a reform in which agencies commit themselves to managing for results. International experience suggests that results-based management has the potential to redirect efforts of public servants toward the user by a focus on costs, quality, and outcomes; however, the necessary conditions for results-based management include true managerial discretion for public sector managers to accompany accountability for results, as well as deep reforms in the budgetary process. Although Colombia is not in a position, at this time, to undertake the challenge of implementing results-based management, important steps forward can be taken towards this long-term objective. 91. The present challenge for Colombia lies in the ability to use results-based management to improve the efficiency and effectiveness of fiscal transfers. In the case of mandatory transfers, the government must adopt a role of tutelage: first, technical assistance can improve management in local governments and thereby match their existing autonomy with tools to manage; second, the government can encourage municipalities' voluntary application of the new instruments through non-binding results agreements that enshrine these objectives. The government has the opportunity to turn non-mandatory transfers (particularly royalty transfers or transfers from oil and mining revenues) into incentives to apply the new instruments and to require co-funding from local governments. 92. Key Policy Actions. The government is committed to raising the efficiency of education transfers as a first step towards freeing resources for new sector or inter-sector priorities. 27 Annex I: Letter of Development Policy 93. The government policy for enhancing efficiency in education consists of defining capacity standards for subnational governments to manage the new transfer based on calculations of resources per capita, then providing incentives to those municipalities or departments that meet government standards. The new financial incentive will be drawn from the reallocation of the Royalty Fund. Reallocation of the royalty transfers already has been initiated in the budget for 2003 and will be expanded and consolidated by the national referendum approved by congress and up for popular vote in 2003. 94. Protecting the State against the Extraordinary Growth of Legal Claims. Litigation against the state has a substantial fiscal impact in Colombia, much above known impacts for other countries. Typically, lawsuits against the state arise from poorly drafted contracts, which leave space for litigation regarding the interpretation of rights and obligations. Since 1994, the number of cases filed has increased enormously, and their outcome has contributed negatively to the current fiscal crisis. In 2001, legal liabilities due to formal first instance judicial or arbitration decisions against the state amounted approximately US$500 million"1. This amount alone is cause for serious concern. But the growing trend being shown by statistical data is alarmning. If trends continues, it is estimated that by the year 2006, judgments against the State will represent approximately 2 percent of GDP. Figure 4. Accumulated Fiscal Cost of Contingent Liabilities Against the State 7,000 00 V 7,000 O4M 6,000 T , --000 ' 4,000 300 21000 Li 1995 1996 1997 1998 1999 2000 Sep-01 2002* Sources: Contralorfa General de la Republica, Contadurfa General de la Nacion and The World Bank 95. This scenario is aggravated by the fact that the state cannot afford to honor on time all compensatory payments. An extremely high rate of Penalty Interest (up to 30 percent p.a.) is applied, creating a "snowball effect" in the State's liabililies. This allows ample margin for unethical practices, as creditors "prefer" to be paid late and benefit from a very attractive return on their accounts receivable. iWorld Bank estimates based on data from the Contralorfa General de la Republica and the Contadurfa General de la Naci6n. Before the decision of the appeal level. Note that a single case still pending decision, Telecom, could generate compensation payments of up to US$282 million, adding great fiscal pressure that is not sustainable in the short term. 28 Annex 1: Letter of Development Policy TABLE 4. CONTINGENT LIABILrrIES-O0F BALANCE SHEET ITEMS (IN THOUSANDS OF MILLIONS OF COLOMBL4N PESOS) Dec Dec Var Dec Var Dec Var June Concept 1998 1999 Percent 2000 Percent 2001 Percent 2002 Litigation & claims filed 7.582,1 9.292,2 22,6% 11.892,2 28,0% 17.727,8 49,1% 20.213,7 Civil claims 997,7 1.712,4 71,6% 2.173,0 26,9% 6.512,0 199,7% 6.441,0 Labor claims 91,9 316,6 224,5% 508,9 60,7% 561,5 10,3% 605,0 Crimninal claims 2,3 76,0 ... 69,2 -8,9% 89,7 29,6% 88,5 Administrative 834,8 2.447,7 193,2% 8.227,8 238,2% 9.555,7 15,4% 11.818,3 Fiscal obligations 34,6 46,8 35,2% 43,4 -7,4% 35,2 -18,8% 34,5 Other obligations 5.620,8 4.692,7 -16,5% 819,9 -82,5% 973,7 18,8% 1.226,4 96. Regardless of the complexity of the situation, three distinctive elements can be identified as the main reasons for this problem. Firstly, there seems to be a web of civil servants, contractors, judges, attorneys, etc. engaged in coordinated corruptive practices that materialize in reciprocal favors of poorly drafted contractual agreements, fake accusations and claims, high compensation payments, intentional "erroneous" decisions, etc. 12 Secondly, the Colombian state has a weak capacity to defend itself in Court. The private sector is better equipped to retain expert legal advice and therefore their claims are exerted with much more rigor. Thirdly, the legal framework encourages the State to take the backseat in demands and claims from individuals. In labor and contracting legal issues, the State recognizes certain rights to counterparts, but in doing so, compromises its own position. 97. The Ministry of Finance, the Planning Department and the Ministry of Justice are especially concerned with the fiscal threat that originates from a weak legal and judicial performance of the State. These government units, with the support of sector ministries, the Procuraduria, the Contraloria and the Consejo de Estado, are committed to elevating the institutional capacity of the state to protect itself from legal claims as a precondition for an effective reform. 98. Key Policy Actions. The major challenge for the Colombian government is to introduce enforceable legal provisions that: a) minimize, if not eliminate, errors and/or weaknesses in the execution of government decisions and government contracts; and b) facilitate the strengthening of the government capacity to defend itself mandating a proactive approach in protecting State interests. 99. The key actions in this area seek to ensure effective budget compensation whenever the state is held responsible for contractual or extra-contractual damage, according to Colombian laws and international conventions --including those of the Inter- American Legal System-- signed by the country. The objectives of strengthening legal protection of the state are: i) to reduce negligence and corruption in the management of 12 This appears to have happened, for example, in the recent decisions against the state for the cases of Foncolpuertos and Tennorrio. 29 Annex I: Letter of Development Policy state affairs, including labor and commercial contracts; ii) to reduce fiscal impact of judicial and arbitration decisions against the state by seeking compensation from responsible officers or third parties; iii) to strengthen the state capacity to prepare, monitor and control large investment contracts and labor relations with a view to prevent contractual disputes; iv) to anticipate and prevent state responsibility for infringement of basic rights; and v) to foster a better investment climate through enhancement of transparency, predictability and responsibility in the state contractual and extra- contractual relations. 100. To achieve these goals a comprehensive policy will have to be designed from scratch. A task force of lawyers and procurement specialists will be charged with identifying and directly handling all judicial issues-or issues subject to alternative means of dispute resolution-that could have the most negative fiscal impact. A new binding rule will make it mandatory that sensitive sectors, particularly those representing high value transactions-such as telecommunications, electricity, and road concessions- require technical assistance from specialized professionals. This institutional strengthening program will also include generating information that is currently missing-such as better analytical data, specialized know-how of certain situations, and techniques for developing preventive and/or curative strategies. Together, the above measures should enable the government to systematically prevent and correct ongoing abusive legal claims against the State. 101. Strengthening Public Sector Procurement. Contracting and procurement with clear and transparent rules are critical for making efficient choices in buying goods and services, and averting corruption in the process. In Colombia, inefficiencies in public contracts are due to a large extent to the legacy of traditional patronage systems in the state and the lack of a clear division between the private and public sectors. A dispersed and highly diversified legal framework also contributes to procurement problems. 102. Presently some 80 laws regulate government purchases, with frequent overlaps and omissions. This debilitates monitoring and protects both buyers and vendors of services from being accountable to each other, providing much opportunity for corruption. Moreover, no central agency is in charge of promoting reform and determining rules that could introduce more transparency. Overly complex procedures thus still prevail, partly because the use of modem information technology is relatively weak. Finally, civil society does not yet play a significant supervisory role, which further undermines accountability and transparency. 103. Key Actions. The government has already taken a significant step towards enhanced transparency in procurement contracts. Decree 2170 of 2002, which regulates Law 80, adopted some Bank recommendations and international best practice to this effect. In addition, Congress is considering a draft law which seeks to reform Law 80 in a substantial manner, including simplifying the numerous special procurement regimes, among other measures. In addition, the government will: a) develop a concept for monitoring and evaluating government purchases since strong follow-up and control are critical to holding contractors accountable for results; and b) make extensive use of modern technology towards e-procurement for purposes of transparency and efficiency as well as for helping to lower compliance costs for the user. 30 Annex I: Letter of Development Policy 104. Furthermore, the government will implement a framework to facilitate public access to information on contracts. It intends to create a single data bank for all government purchases showing which contracts are being administered at any particular time. Moreover, civil society will be enabled to take a more prominent role in reviewing in decision-making processes by assuming a supervisory role in the selection process, while the State ensures that decisions are made more publicly. Finally, the central government will try to extend this reform program to municipalities and provide them with incentives for adopting in similar practices. Vertical Reforms 105. The process of public sector modernization emphasizes the need to rethink the role of the State; more systematically determining what activities should be conducted by government. This exercise has produced a "vertical reform" program whose objectives are to: (i) redefine the role of the State in each sector; (ii) design the organizational structure of each sector-leading entity; (iii) establish sensible structures of subsidiary entities; and (iv) rationalize personnel, reduce current expenditures and otherwise liberate public resources that can be reallocated to improvements in the provision of goods and services. 13 106. Cost containment . A large share of the above measures aim at the overall containment of costs, and many actions have already been taken. A decree has been issued for the rationalization of central government current expenditures, notably personnel expenses. There has been a reduction in the National Government's organizational structure. While many of these measures are not expected to produce substantial savings, they will send clear signals to bureaucrats and the public at large that this government is committed to keep public expenditures within available resources- even at the cost of some downsizing or political favoritism. 107. Some of the key downsizing measures include the elimination of three ministries by mergers with other ministries: Health with Labor; Interior with Justice, Development with Foreign Trade or Environment, and a selective retrenchment and training for staff made redundant (an instruction has been issued requesting downsizing of the central 14 administration through an indicative 20 percent cut in personnel) 108. The cost-containment effect of these reforms is supplemented by a number of important policy reforms that are expected to have a significant impact on public expenditures. First, the budget approved for 2003 includes significant reductions in real terms of public expenditures other than debt service. Second, the reform of the constitution via popular referendum includes provisions for freezing current expenditures15 for years 2003 and 2004 to their level (in current terms) in 2002. This initiative should produce savings of 0.7 of GDP in 2003 and 0.5 of GDP in 2004. Third, the government is committed to not-filling and eliminating 30,000 job posts presently empty or occupied by employees that will retire during the current administration. 13 The IDB is also providing technical and financial support to this component of the reform program. 14 If completely implemented, this measure, together with freezing and elimination of vacancy posts, should reduce the number of public employees by 40,000 -or a savings of 0.6 percent of GDP by 2006. '5 With the exception of lowest wages and pensions and military expenditures. 31 Annex 1: Letter of Development Policy 109. Key Policy Actions. Most of the vertical measures aimed towards an immediate reduction in public expenditure have already been taken. The key upcoming policy actions must therefore be geared toward achieving long-term, sustainable gains in efficiency and quality in the delivery of services by key public sector entities. This process of business process reengineering and institutional strengthening will take time and will require close supervision, input from clients, and other elements to guide the reforms in the medium term. 110. Management Contracts for Government Agencies. Colombia has good reasons to be disappointed with the so-called functional decentralization. Promoted by the administrative reform of 1968-70, functional decentralization was expected to create a number of specialized, technically managed, government agencies. With the passage of time,, more than one hundred government agencies were created -often with the expectation of becoming self-financing entities. 111. With only a few exceptions (most notably some local public utility companies such as Empresas Publicas de Medellin), these agencies were either captured by trade unions and other closed circles of stakeholders or have extended their life long beyond their initial raison d'etre. Many agencies create additional fiscal pressure for transfers from the central government or otherwise maintain a confusing system of back and forth transfers and credits with the central government. 112. Key Policy Actions. The government is pursuing some restructuring of at least 30 government agencies during the four years of the Uribe administration. Re-engineering should provide the basis for adjusting and self-financing. A complementary step will be the design and implementation of management contracts with specific revenue and balance targets for two pilot agencies selected among the largest government agencies.'6 If successfully applied, those pilots should lead to further extension of management contracts under subsequent administrations. Manauement of the Public Sector Reform Process 113. Reforming the State is a complex undertaking that challenges any government's capability. This is also true for Colombia as it prepares for its ambitious reform program. For this to be successful it must be able to respond to two fundamental questions: 114. Will the process have enough stakeholder involvement? As the reform process unfolds-but especially in the short run- resistance by political and social groups often tends to increase rather than decrease. Policymakers cannot take for granted that all stakeholders participate in and approve of the changes. Maneuvering through these obstacles requires careful choices and smart communication strategies. This is especially true for Colombia since, during the initial phase of reform design, the public sector reform program very much followed a top-down approach with little room for consultation. and open, participatory politics. To be sure, the DNP enjoys much respect within the government and has the backing of the highest political leadership in the 16The country has already experimented with and drawn lessons from the SFAL-supported management contract for the Social Security Institute, ISS 32 Annex I: Letter of Development Policy country. Moreover, this government was elected by an overwhelming majority that has been fully supportive of the president's reform program -and his government's exceptional capacity to pass and implement long-expected reforms-- since the days of the Presidential campaign. What is needed now -and the government is aware of it-is to instill understanding ownership of the proposed reforms within the legislature, the private sector, academia, think-tanks, NGOs and civil society at large. Management of the reform process has to be primarily geared to extending ownership of the reform beyond the small circle of technocrats that put together the technical details of the reform program. In addition, managing a growing number of participating agencies requires oversight and knowing precisely who is responsible for what at each stage of the process, while simultaneously adjusting to changing circumstances and opportunities. 115. Can the impact of the reform be properly evaluated so that politicians can be held accountable? Contracting for results is not only a modern management tool for service delivery; its principles also apply for reform processes of governments. In an ideal setting, politicians would set clear goals and commit themselves to reach certain results and targets; progress-and more important -outcomes and impact of the reform-would be evaluated and politicians would be held accountable for their actions. Each of these tasks poses a considerable challenge to the government which must respond by creating a conducive institutional framework for reaching the envisaged goals. This is particularly challenging since the reform is already well under way and moving with quickening pace. At the same time, there is a growing demand for results from civil servants, the media and the electorate. 116. Key Policy Actions. To meet the above challenges, common to any administrative reform process, the government has chosen to establish a systematic management of the reform process, consisting of four components: political coordination, technical coordination, communication and public marketing, and monitoring and evaluation. 117. Political coordination. Gaining the acceptance of political actors is key for successful reform. Initially, this role will be played by the National Commission for Economic and Social Policy (CONPES) as the principle planning commission. Over the course of the reform, however, there will be the need to guide the process on a more continuous basis to avoid the danger of loss of political momentum. Not all participating ministries are equally affected or interested in the State reform process, so much specificity will be gained from working only with the most relevant onesby creating a specialized commission in addition to CONPES. This core Commission for State Reform (CSR) has already been established, composed of the Ministry of Finance, the Planning Department and the Departamento Administrativo de la Funcio'n Piiblica. 118. Technical coordination. Transforming political priorities and goals into effective application is the challenge that underlies technical coordination of the process. The DNP will tackle this by regularly incorporating into its work the advice of top experts in State reform, initially for the crafting of general government policy. In the medium term, this should be complemented by a group of seasoned experts to consult independently. Equally important is the establishment or continuing support of technical task teams in both DNP and each of the ministries and agencies subject to reform. The entire process will be supported by CSR. 33 Annex I: Letter of Development Policy 119. Communication and public marketing. The benefits and costs of reform will not be equally distributed and some citizens will not be directly or immediately affected by certain actions. Therefore, an effective public marketing strategy is needed to reaching out to involve and obtain the support of a wide array of Colombians for the requisite institutional changes. This must be tailored to different audiences and their particular information needs. 120. Monitoring and evaluation. Conducting systematic monitoring can critically contribute to informed decision-making at the political and technical level. As a first step, the tasks include development of a baseline and the establishment of indicators. When done properly, monitoring and evaluation add much to the quality and sustainability of reform, providing the necessary information to generate needed public support. In. THE PROPOSED PROGRAM AND OPERATIONS A. LINKS WITH THE BANK'S ASSISTANCE STRATEGY 121. As described in the 2003 CAS discussed at the Board on January 19, the WBG's strategy will seek to support Colombia's quest for peace in three essential areas: a) achieving fast and sustainable growth; b) sharing the fruits of growth; and c) building a government of quality. To support this strategy, the Bank lending program envisioned in the CAS focuses on operations that would: a) have the most tangible impact on poverty alleviation; b) achieve fast and sustainable growth while protecting the poor; c) incorporate the lessons learned from Bank's operations, particularly from on-going Learning and Innovative Loans; and d) pilot innovative interventions with important demonstration effects. 122. The FIAL will directly contribute to achieving the Country Assistance Strategy (CAS) objectives from a variety of perspectives: * CAS Goal "Achieving Fast and Sustainable Growth": The fiscal consolidation supported by the proposed loan would protect the country's rnacroeconomic framework by reducing the likelihood of fiscal crises and inflation that would most impact the poor. Fiscal stabilization will promote a better investment climate and facilitate access to markets in better terms. * CAS Goal "Sharing Growth with all Colombians": While this programn will not directly address inequality, the public sector reform component contributes to better and more uniform spending for all groups of society. More importantly, by broadening tax bases and improving tax administration, the costs of revenue raising will be shared more equally across citizens. By preventing major fiscal crises and focusing on quality and quantity of public service delivery, the FHAL-supported program also ensures that essential public services would continue to be available to those who could not otherwise procure them-namely, the poor and most vulnerable. 34 Annex I: Letter of Development Policy CAS Goal "Building a Government of Quality": Creating a more efficient and more transparent government lies at the core of the institutional reform program. Reforming budgetary institutions, introducing results-oriented management-both intra-government and among levels of government-streamlining the operation of ministries and agencies, making a more transparent procurement system, and evaluating the results of government services would contribute to the achievement of this goal. 123. Linkage between the Programmatic Fiscal and Institutional Adjustment Program and other Bank operations. The proposed Programmatic series of Fiscal and Institutional Adjustment Loans to support public sector reform and fiscal adjustment is the core of the Bank's support to the reform efforts of the government and it will provide the basis upon which complementary policy-based operations will be developed. These include support to the financial sector in the form of Programmatic Financial Sector Adjustment Loan (FY03 and FY04) that aims to promote the development of a well- functioning financial system that can provide adequate services to all segments of the productive sector and the population at large. In addition, building on the achievements of the Financial Sector Adjustment Loan (FY00), it will address the remaining agenda to ensure the health and financial sustainability of the banking system and to foster capital markets development. 124. The anticipated Sustainable Development Sector Adjustment Loan (FY05) will support the mainstreaming of environment in practically all infrastructure sectors, including water and sanitation, energy, transport and disaster management. The tools for mainstreaming environment include: policy setting, strategic environmental assessments, land use planning (planes de ordenamiento territorial), permits and licensing, environmental regulation, economic and fiscal instruments, social impact analysis and valuation, assessment and linkage with global environmental goals, participation and conflict resolution mechanisms, and development of sector-environment indicators linked to health impacts. These tools are currently being used in most sectors, however this operation aims to enhance effectiveness and impact by providing a more rational application based on priority-setting and institutional analysis (how the environmental management institutions set priorities, receive budgets, and function). 125. The anticipated program of Labor and Social Sector Adjustment Loans (FY04 and FY05) will support the policy and institutional framework to enhance decentralization in education. In addition, it will support reforms in the health sector to create a financially sustainable system that provides incentives for greater efficiency and that will deepen the reform initiatives of the early 1990s to improve coverage, access, quality and equity. It will also implement reforms in the treatment of labor, such as improving the efficiency of the training system now in place by means of redefining the role of SENA. Two important issues related to Colombian labor markets are: (i) payroll taxes; and (ii) wage inflexibility. Studies will be carried out to shed light on initial steps that might be taken to tackle these issues. These steps may include the explicit regulation of apprentice contracts (that permit firms to hire apprentices without paying some taxes and at lower wages) and the introduction of portability for many social security benefits financed by means of payroll taxes. 35 Annex 1: Letter of Development Policy 126. In addition, the FIAL program is highly interrelated with the current MAFPII Project, aimed at strengthening budgeting, tax administration, public investment management, procurement, and results management, and will provide significant inputs and support for the proposed FIAL. 127. Complementarities with Other Institutions' Operations. The IMF has signed a stand-by agreement with the Colombian government in January 2003. The IDB is considering to provide support to the government of Colombia in some of the reforms classified as "vertical," that is, sector reforms such as downsizing (including personnel cuts) and adjustments of the government structure. The IDB is also considering to support the expansion of e-government in Colombia. B. OBJECTIVES AND DESCRPTiON OF THE PROGRAM 128. Overall Objective. The objective of the program is twofold: first, to promote reforms addressing fiscal rigidities necessary to attain the substantial fiscal adjustment underlying sustainable macroeconomic stability; and second, to improve the provision of public services and establish the institutional basis for higher efficiency and accountability in public expenditure. The emphasis of the reform programt will gradually shift, from tax andfiscal responsibility at the beginning, to expenditure and public sector reform towards the second and third years of the program. 129. These objectives are the backbone of the government's broad program of reforms, which includes significant policy actions to increase the mobilization of resources to the public sector, improve critical public administration processes, and enhance the efficiency and effectiveness of key government institutions. The Bank's support for this ambitious program is well complemented by the efforts of other development partners and will be structured under a proposed Programmatic Fiscal and Institutional Adjustment Loan (FLAL). The Bank has received a Letter of Development Policy that outlines the Government's vision (Annex 1) and requests the Bank's financial support. 130. Specific Objectives. This program supports the following key elements of the Government's reform program over the next four years17: * Increase tax revenue and reduce distortions in the tax system; * Modernize tax administration; * Improve budget management with modern tools and legal reformns; * Develop incentives for efficiency gains in subnational entities; * Prevent massive losses to the State from judicial claims; * Strengthen the public sector procurement system; * Reduce losses and generate revenues through improved asset management; * Improve performance through management contracts for government agencies; * Promote the development of a sound fiscal responsibility legal framework; and * Support a coherent and comprehensive reform implementation process. 17 The detailed set of benchmarks for the first loan and an indicative detailed list of benchmarks for the second and third loans are specified in the policy matrix in Annex III. 36 Annex I: Letter of Development Policy 131. This program is being supported by a series of up to four loans, with a notional envelope of up to US$900 million in total. Depending on successful implementation of the program, the proposed first loan in the amount of US$300 million would be followed by subsequent loans with the notional amounts of up to US$150 million; US$150 million; and US$300 million. These envisaged loans are fully consistent with the Country Assistance Strategy (CAS) of 2003. 132. The current loan capitalizes on lessons learned by: i) supporting government commitment to undertake constitutional, legal and administrative measures to reduce budget entitlements and enhance expenditure flexibility; ii) enhancing transparency, dissemination and reporting standards that call for participation of civil society in monitoring budget allocations and expenditure efficiency; iii) strengthening subnational capacity to effectively manage social services; and iv) introducing and/or ensuring application of efficiency signaling and conditioning in fiscal transfers for social sectors. 133. Technical Assistance. Many of the technical assistance requirements of several key components - particularly tax administration, budgeting and procurement- as well as the financial management or evaluation features of other components, will be partially or fully provided by the MAFPII project, currently in execution. In addition, the Government and the IDB are considering to include technical assistance support for other FIAL components -particularly asset management and legal protection of the state-- under an IDB-TAL project currently under preparation. Moreover, the GOC and the Bank have initially agreed that, should it become necessary, a technical assistance loan (TAL) can be prepared to support the implementation of other areas of the FIAL reforms, particularly management contracts for government agencies. 134. Fiscal Commitments. Within its macroeconomic framework, the government signed a new Stand-By loan with the IMF in the amount of SDRI.5 billion for the next two years (See Annex if). Achieving the structural benchmarks of the agreement will constitute an overarching policy condition for the FIAL. Some of the targets of the IMF- backed program for 2003 are a consolidated non-financial public sector deficit of 2.5 percent of GDP, a current account deficit of 0.8 percent of GDP and an inflation rate between 5 and 6 percent. 135. By the end of the program, it is expected that the Colombian Government will be able to address social demands and implement its program under a framework of increased fiscal flexibility, while maintaining macroeconomic stability. C. THE PROPOSED OPERATION 136. The first operation of the program is primarily designed to support the first phase (Congressional approval) of the constitutional referendum, the tax reform, and the initial measures that comprise the building blocks for other/subsequent public sector reform initiatives supported by the overall program. It is proposed as a single tranche loan to be fully disbursed in March 2003. The timing of the first loan is calibrated to support the government in its efforts to deliver an immediate confidence-building signal to the markets through major reforms that have recently been approved or are being implemented in the first weeks of 2003. 37 Annex I: Letter of Development Policy 137. The first loan is linked to, inter alia, the tax reform law, the law that grants special authority to the government to adopt administrative reform measures, and the law that authorizes the constitutional referendum. It also supports government initiatives and preliminary congressional approval for the constitutional reform that gives power to the borrower's Executive Branch to control and manage the budget within fiscal targets and the fiscal responsibility law. Triggers for second loan include, among others, the final approval of the fiscal responsibility law. The second, third and fourth loans, all envisioned as single tranche operations, will be addressed primarily to institutional reforms and improvements in tax administration. The detailed legal and regulatory reforms required as riart of the first loan are shown in the following table: TABLE5: REFORMS SUPPORTED BY THE FIAL FIRST LOAN (US$300 MILLION) I . The Borrower has attained, for the period covered by any three (3) continuous months among the twelve (12) months preceding withdrawals from the Loan Account, an overall deficit of the Combined Public Sector of no more than US$1,352,000,000 equivalent to P$3,874,000,000,000. 2. Borrower has enacted tax reform law (Law 788 of 2002), including: a) reduction of exemptions and expansion of the tax base for the VAT b) reduction of the wage tax exemption from 309% to 25% with a ceiling in the amount of Col$16 million in monthly wages (rentas laborales) and reduction of tax exemptions, tax credit and non-taxed income for the personal income tax, and c) the phasing out of the corporate income tax exemption for capital gains from sales of stock, mutual funds and real estate, and as well as for profits from corporations previously exempted. 3. The Ministry of Fmance, through DIAN, has enacted new rules for tax administration including: a) daily interest payments higher than Col$900 are subject to withholding at the source; b) obligation of financial institutions to report information on taxpayers' accounts that are credited with annual interest of at least Col$5 million'8, and/or have total annual deposits equal or higher than Col$50 million; c) establish a list of collectable tax debts on December 31 of 2002 and elaborate a plan and set up a schedule to collect at least 20 percent of these collectable debts; and d) establish indicators of customs clearance time and procedures to select shipments for inspection based on a risk-management system for the customs offices of BogotA and Medellfn. 4. Borrower has submitted to congress and congress has approved, in first round, constitutional reform that gives power to the borrower's Executive Branch to control and manage the budget within fiscal targets. 5. Royalty transfer: borrower has enacted law to enable constitutional referendum for transfer of royalties for educational services. 6. Borrower has promulgated Law 790 of 2002, that grants authority to central govemment for strengthening the Direcci6n de Defensa Judicial del Ministerio del Interior y de Justicia with the purposes of: a) policy formulation and coordination for the limiting the state's civil liability; b) to demand indemnization by borrower's civil servants who acted with gross negligence and bad faith; and professionalization of judicial defense of the state. 7. Government has issued Decree 2170 dated September 30, 2002 that strengthens transparency and objectivity in public sector procurement. 8. Bill of Law 018/2002 modifying current public sector procurement legal framework in consideration by borrower's Congress. 9. Government has created a Commission for Asset Management charged with preparation of draft government policy, define the scope of work and an operational plan to define accounting systems and inventories in public agencies. 10. Government has selected at least two government agencies, agency intervened 6y central government for pilot management contracts 2003-2006. 11. Borrower has: a) published its strategy of state reform; b) established a high level commission for state reform and a task team for technical coordination; c) formed task teams in each participating agency with coordination mechanism with DNP; and d) developed a concept for public marketing of public sector reform. The borrower has submitted to Congress the proposal for a bill of law for fiscal responsibility. 18DLAN Resolucion 10537, October 29, 2002 38 Annex I: Letter of Development Policy 138. Loan Amount. The proposed (US$300 million) loan in the form of a fixed spread, U.S.-dollar-denominated loan would be made to the Republic of Colombia. Disbursements under the proposed program would be made to an account (Deposit Account) of the Republic of Colombia, established at the Banco de la Republica for this purpose. The first loan would have one tranche of US$300 million - expected to be disbursed in March 2003. D. SUBSEQUENT OPERATIONS 139. The second, third and fourth loans are expected to primarily support the implementation of the institutional reform process, whose basic foundations will have been developed with support of the first loan. 140. Annex m lists the triggers for these future operations. Those triggers will serve as guideposts to signal progress of decisions/actions towards achieving the objectives of the reform program. Triggers were chosen on the basis of their importance in the government's fiscal strengthening program and their contribution to implementation of subsequent reforms. 141. The nine key policy measures that make up the individual triggers for the second loan are listed below. These triggers are critical for the success of the program and their implementation will form the basis for the preparation and presentation of second loan. The triggers for the third and fourth operations will be drawn from the government's program (see Section II of this report) and, in particular, the set of expected key reform measures set out in the Policy Matrix in Annex m. Revenue Rigidities and Tax Reform (1) Government has issued the necessary legislation to regulate the application of Law 788 of 2002 (2) DIAN has: a) developed and implemented software to cross reference information with financial institutions to ensure that interest reported by them match interest reported by taxpayers; b) audited at least 50% of large taxpayers affected by the new taxes; c)established and published indicators of the cost and time required for compliance by the taxpayer, and d) established unified accounts between customs and domestic taxes for large taxpayers beginning in 2003. Expenditure Rigidities and Institutional Reform (3) Borrower has approved a Constitutional reform that restores budget powers to the Borrower's Executive Branch, or Government has submitted to Congress amendments to the organic budget law permitting greater flexibility in annual spending within present constitutional framework. (4) Borrower has submitted to popular vote the provision of the Referendum that reallocates royalty transfers for educational services. 39 Annex 1: Letter oJ Development Policy (5) Borrower has issued a CONPES docurnent establishing the new policy for legal defense of the state, including legal reform if necessary. (6) Borrower has proposed to Congress the. modifications to the legal bill amending Law 80 that incorporate the recommendations of CONPES, emphasizing: a) Common principles for public sector procurement; b) introduction of economic considerations into the procurement process; and c) institutional framework for public sector procurement. (7) Central government has signed management pilot contracts with at least two government agencies. (8) Short terrn Asset Management program has produced revenues or savings equivalent to at least 27,000 million Colombian pesos of 2002. Fiscal Responsibility (9) Borrower has approved a Fiscal Responsibility Law acceptable to the Bank, that contains, at a minimum, rules for: a) setting fiscal targets linked to debt sustainability and primary balance for the NFPS; b) annual reports of fiscal results to Congress, including floating debt; c) publication of the financial plan that will include, among others, information on floating and contingency debt; and d) the obligation to include the fiscal impact and source of financing within any law that creates new tax expenditures. E. FIDUCIARY POLICIES 142. Environmental Aspects. Being a structural adjustment program, the proposed operation does not trigger OP 4.01, and, as a consequence, does not require an environmental rating. The Quality Assurance Team (QAT) has reviewed the Program Document for the project and determined that it has no direct effect on safeguard issues. 143. Procurement and Financial Administration. The Bank plans to advance work in two distinct stages. First, a short financial management risk assessment (FMRA) should be ready by the end of March 2003, then a CFAA should be completed in about eight months. This new CFAA will raise the questions of: a) how does the current state of public financial management in Colombia affect the country's efforts to stimulate economic growth, and b) what remedial measures should be taken to improve the current state of financial management in the country. Both assessments will contribute to the design of subsequent loans of the FIAL. In particular, the CFAA team will be able to contribute relevant Policy- actions which could be embedded in the policy matrix for upcoming FIALs. Moreover, the FMRA team will advise with regard to audit of the depository account at the Central Bank. In addition, a Country Procurement Assessment Report (CPAR) was prepared in March 2001. 144. The program currently takes into consideration the recommendations of the CPAR and the basic guidance of the previous Country Financial Management Assessment (CFMA), dated September 2001. As the new CFAA becomes available, the subsequent loans of the program will incorporate the additional insight into all relevant areas of the operation, in particular the budgetary reform process. 40 Annex I: Letter of Development Policy 145. As mentioned earlier in this document, the Bank is currently financing the implementation of the MAFPII project, which is a joint effort of MHCP, DNP, and DIAN. Among its key objectives are the modernization of the public procurement process (including legal reform), review and reform of the budget process, implementation of financial management information systems, and support to government accounting. All of these efforts are compatible with the FLAL and are the primary source of technical assistance requirements for the implementation of the budget and procurement related components of the program. F. BENEFITS 146. Fiscal Adjustment The reform program supported by the FIAL would put the NFPS accounts on a more sustainable path. Each of its proposed measures carries fiscal implications, which are singled out in the projections, through 2006, shown in the following charts and figures. As shown in Table 6, the reforms are projected to improve the overall balance of the non-financial public sector by 0.8 percent of GDP in 2003, relative to the alternative without reforms. Continued pursuit of the reforms, which the proposed programmatic program will support, is projected to have a fiscal benefit of over two percent of GDP by 2006. Clearly this will contribute to meeting the CAS high-case criteria of making the public sector debt sustainable. As reflected in Table 6, reform of tax policy and tax administration make the largest projected contribution, with the legal defense of the state and public asset management (horizontal reforms) contributing most of the rest of the savings. When combined with the constitutional referendum, the vertical reforms, and the pension and labor reforms just approved by congress, the impact of the whole reform package is projected to reach 4 percent of GDP primary surplus -as envisioned in the CAS. 41 Annex I: Letter of Development Policy Figure 5 and 6. NFPS Expenditure and Revenues Excluding Interest Payments. Alternative Reform Scenarios (2000-2006) Expenditure Revenue 31 ~30 ~29 j2.7 1 _ _ _ _ _ _ _ _ _ _ ___ __ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 27 26 28 .................fi i 27 25 - W*h Refimns ....... Wm Ref Wh Rd*m= -.... -..-- Wkibut Refm 147. The measures supported by the FAL would prevent-and reverse-an otherwise unsustainable debt and debt-service accumulation, while also protecting social sector expenditures and vulnerable groups. To achieve these targets, the combination of policies will enhance revenues and rationalize spending. Those policies include, among others, budget reforms that will produce efficiency gains that will allow the government to finance additional programs and reduce the fiscal pressure. The non-financial public sector deficit of 4 percent of GDP would be virtually eliminated by the year 2006. Figure 7: NFPS Primaiy Balance Alternative Reforms Scenarios (2000-2006) 4.5 4.0 - ..3.5- 3.0- CD 2.5- .. 1.0 0.5 0.0 II No Reformis U With Reforms 42 Annex I. Letter of Development Policy [Figure 8 Net Public Debt. Alternative Reform Scenarios 2000-2006 65L 60 55 50 45 40 200 200 200 200 200 200 200 35 - I 2 , , I , I 6 - No Rdbn -nWith Refonns 148. If no reforms were implemented or if these reforms were delayed, the NFPS would remain on an unsustainable path, and probably spiral into protracted-increasing deficits. Instead, as a result of the reform package, the public sector's debt path will change significantly. Colombia's ratio of net public sector debt to GDP would remain on a more manageable path and stabilize at levels slightly above 50 percent of GDP by 2006 (Figure 8). 43 Annex I. Letter of Development Policy TABLE 6. PUBLIC SEcTOR EISCAL BALANCES, SCENARIO WIrH REFORMS (2001-2006) Percent of GDP' 2001 2002p 2003p 2004p 2005p 206p Total Revenues 29.3 29.5 29.9 29.6 29.6 29.5 Current Revenues 29.3 29.5 29.9 29.6 29.6 29.4 Tax Revenues 19.1 19.3 20.1 2.0.4 20.6 20.7 of which: Tax Administration 0.1 0.2 0.5 0.5 of which: Tax Policy 2 0.6 0.9 1.0 1.1 Non-Tax Revenues 10.2 10.2 9.8 9.2 8.9 8.8 Property Income 1.3 0.9 0.9 0.8 0.8 0.7 Operational Surplus of Public Enterprises 4.2 4.6 4.4 3.9 3.7 3.6 Other 4.7 4.7 4.5 4.4 4.4 4.4 of which: Public Asset Management 0.0 0.1 0.1 0.1 Total Expenditure and Net Lending 33.0 33.9 32.5 31.1 30.7 29.9 Current Expenditures 24.7 25.6 25.3 24.6 23.4 22.3 Wages and Salaries 7.4 7.6 7.2 6.5 6.4 6.3 of which: Effect of Acto Legislativo4 -0.2 -0.3 -0.4 -0.5 Goods and Services andOther 3.5 3.7 3.2 3.1 3.0 2.9 Interest 5.0 4.6 5.1 5.1 4.7 4.4 External 2.2 2.2 2.4 2.4 2.3 2.2 Internad 2.7 2.4 2.6 2.7 2.5 2.3 Transfers to Private Sector 9.7 9.9 10.0 10.0 9.4 8.8 of which: Savings Due to Legal Defense of the State 5 -0.3 -0.3 -0.6 -0.7 Other -0.9 0.0 -0.1 -0.1 0.0 0.0 Capital Expenditure 8.2 8.2 7.1 7.1 7.4 7.6 Fixed Capital Formation, cash basis 8.1 8.1 7.1 7.1 7.3 7.5 Transfers 0.1 0.1 0.1 0.1 0.1 0.1 Net Lending 0.1 0.1 0.0 0.1 0.0 0.0 Statistical Discrepancy 0.3 0.0 0.0 0.0 0.0 0.0 No financial public sector balance -3.4 -4A -2.5 -2.5 -1.1 -Q4 Quasi-fiscal balance 0.7 0.6 0.4 0.4 0.5 0.5 FOGAFIN balance 0.2 0.2 0.1 0.1 0.1 0.1 Net cost of financial restnicturing -0.7 -0.5 -0.5 -0.5 -0.2 -0.2 Overall balance -3.1 -4.0 -2.5 -2.1 .0.7 0.0 Overall Financing 3.1 4.0 2.5 2.1 0.7 0.0 Memorandum itern NFPS Primary Balance, with reforms 1.6 0.2 2.6 2.9 3.6 4.0 NFPS Priniar Balance, no reforms 1.6 0.2 1.2 1.2 1.2 1.2 Source: Ministry of Ftnance, IMF and World Bank Esimates 1. Annual tax collection increases, on average, by about US$250 million in the 2003-2006 period as a result of increased tax compliance and enforcement. Tbese are conservative estimates relative to the government's projections. 2. Annual tax collection increases, on average, by about US$700 million in the 2003-2006 period as a result of changes in income tax, VAT and territorial taxes. These are conservative estimates relative to the government's projections. 3. Annual income form improved management of public assets averages US$60 million in the 2003-2006 period. 4. The annual operating expenses of the public sector fall by about US$280 million, on average, in the 2003-2006 period. The Acto Legislativo sets a 2 percent ceiling on the real growth rate of transfers from the national to sub-national government. The Acto Legislativo also sets a 1.5 percent ceilng on the real rate of growth of government operating expenses. 5. Annual savings averaging US$400 milion in the 2002-2005 period result from improved legal defense of the State. 149. Social Impact Colombia's social conflict constitutes one of the most determining elements of its fiscal and public sector reform requiremenits and prospects. The government has successfully established a climate of dialogue and understanding backed by determined application of its laws to contain social movements within the constitutional order. It has worked in close collaboration with Congress and political parties to enact substantial reforms that hacl been impossible to achieve in previous administrations. Moreover, the government is inviting the population at large to vote on a referendum that will substantially amend the constitution. The government also offers a package of vertical and horizontal reforms of the public sector airmed at enhancing 44 Annex 1: Letter of Development Policy transparency and accountability, citizen participation in public affairs, public administrative efficiency, and higher coverage and quality of service delivery. 150. This project intends to ensure the feasibility and sustainability of this package of reforms by strengthening the fiscal capacity and the adequacy of government actions, while simultaneously minimizing risks in the government's comprehensive, multi-sector reforms. If this package is successfully implemented and maintained after the change of administration, Colombia should have a public sector that is more responsive to citizen demands, accountable, and participatory. For the broader citizenry it can be expected that the reforms will contribute to better service delivery and a more transparent form of government. 151. The public sector reform process includes the elimination of at least 40,000 jobs in the central administration, of which 30,000 will come from the elimination of the posts of employees who reach retirement during the next few years, and the rest from the elimination of staffed positions. All staff deemed redundant will receive the legally established severance package, and those who are not legally entitled to removal benefits (such as temporary or directly appointed staff) will receive at least one year's salary as severance. In addition, all those who lose their employment will be entitled to participate in a retraining and career counseling program. Finally, the government has indicated its commitment to the protection of vulnerable groups and will ensure that single mothers without job alternatives, the handicapped, and those about to reach retirement age will not be removed. 152. The social impact of the program will be closely monitored jointly by the borrower and the Bank. Assessments will measure the family income effect and the overall poverty and inequality effect on the basis of the country's household surveys. 153. Poverty Impact The proposed FIAL will contribute to poverty reduction at all levels. First, it will help protect the macroeconomic framework of the country by reducing the likelihood of widespread government fiscal crises. This is important since, as noted, the Bank's analysis shows that negative macro shocks are the most important cause of poverty increases in Colombia. Second, the various proposed sectoral reforms which FIAL would support should sustain economic recovery, consolidate economic growth in the medium and long term, and reduce poverty. It also bears repeating that economic growth continues to be the major source of poverty reduction and social stability in Colombia. 154. Third, the FLAL will also ensure that through the fiscal strengthening program, in particular the tax reforms, more resources will become available to help ensure the allocation of adequate public resources to social programs and reduce the insecurity that affects particularly those that lack the resources to protect themselves. This is especially pertinent for education and health, facilitating the provision of public services for the poor. Fourth, the FIAL supports measures to improve the efficiency and coverage of these services, benefiting the poor directly. This is to be achieved through better budgeting, the results agreements and their evaluation, and more transparent procurement. These together should ensure that essential public services are more efficiently available to those who could not otherwise obtain them on their own. 45 Annex I: Letter of L)evelopment Policy G. RisKis 155. The proposed program carries considerable risks. With regard to internal risks, the first is that the overall political context, including the conflict and violence associated with illegal drug activity, could escalate, which would negatively impact the implementation of the program. Although Colombia is deeply committed to ending the violence that has plagued the country for decades, and has obtained the pledge of the international community to support this endeavor, the conflict could still intensify during the next few years. The FIAL supports reforms that will help liberate resources to address the country's priorities during transition from the conflict to the post-conflict era. The FIAL will also support introduction of institutional reforms that would help consolidate peace and stability during the post-conflict era. 156. Second, due to the internal conflict the government may be unable to endure prolonged social disruptions and resistance from major interest groups (such as teachers and health sector unions) that could derail the reform agenda and lead to more social and political instability. The government is reducing this risk by working together with political parties, congress, the judiciary and independent auditing and control agencies in the formation of a broad-based state coalition that ensures continuity of reforms within the public sector. The program supported by the proposed loan promotes the joint effort of all branches of the Colombian state, private capital and civil society through built in participatory, consultation and other consensus building mechanisms. Consensus building instruments have been incorporated in each one of the proposed components and in the overall management of the reform process. If successfully applied, consultation and evaluation should be sufficient to mobilize government and non-government institutions in support of the reforms and overcome resistance from particular interests that have previously captured the state. 157. Although President Uribe won the elections with a substantial majority, it is not certain that he will be able to maintain the needed level of support to implement important reforms. Congress could block or alter policy initiatives and/or the Constitutional Court could reverse key reforms. This risk is lessened because the reform program proposed by the Uribe Administration has the support of both major political parties and the government reform program, including initial reform measures, has been fully endorsed by the vast majority of the population. Furthermore, the composition of the Constitutional Court has changed and its recent rulings have been more pragmatic and market-oriented. 158. The Referendum approved by Congress on December 2002 that contains most of these reforms will be placed before the people in 2003. In this connection, and in order to avoid delays in advancing the government's program, most of those reforms that require Congressional approval were included up front -and have been largely approved by Congress-- during the first year in the program. Congressional approval of long- pending reforms such as pensions, tax or labor is by itself an indication of the government capacity to mobilize legislative and country-wide support in favor of reforms that had been impossible to achieve during the previous decade. Besides, the government has put together a dissemination and participation strategy geared to ensure discussion, mobilization and ownership from civil society. 46 Annex 1: Letter of Development Policy 159. There is of course the risk that the Referendum approved by Congress will not be supported by the population. The government is already planning on substitute measures in case the Referendum is not approved by the people. Those substitute measures would include: i) gradual elimination of some special pension regimes through legal reform and collective bargaining; ii) law reform proposals and administrative measures to ensure expenditure cuts and additional tax revenues with a fiscal effect that is at least equivalent to the expected impact of current expenditure freeze, and iii) national government put pressure on subnational governments that currently receive royalty transfers to concentrate their project proposals in the education sector. 160. Third, through external or internal shocks, the fiscal situation may deteriorate, which would jeopardize the macroeconomic situation. The World Bank program, and that of the IMF and IDB, are intended to lessen this risk by demonstrating active, visible support of the government's proposed fiscal and public sector adjustments. The macroeconomic situation may also be weakened by external factors such as regional political or economic instability or further deterioration of the terms of trade. On balance consequently, the FHAL is judged to be a "high-risk, high-return" program. Therefore, it will be essential to maintain a close working relationship with the client, and to provide ample, ongoing dialogue and assistance during the implementation period. To this end, the parallel TAL (MAFPH) will provide an important opportunity for the Bank to closely accompany the program. The supervision activities of MAFPII will be a fundamental vehicle to maintain frequent coordination with the Government counterparts. All these reflect the belief that, as this program would form the core of the Bank's interventions in Colombia, its successful implementation will be critical. 47 Annex!: Letter of Development Policy Annex I (Translated from Original in Spanish) REPUBLIC OF COLOMBIA MINISTRY OF FINANCE AND NATIONAL PLANNING DEPARTMENT LETTER OF DEVELOPMENT POLICY TO THE WORLD BANK BogotA, January 20, 2003 48 Annex 1: Letter of Development Policy Bogot§, January 20, 2003 Mr. James D. Wolfensohn President World Bank Washington, DC Dear Mr. Wolfensohn: Since the inception of the Uribe-Velez Administration in August of 2002, the intention to significantly expand the World Bank's assistance strategy for Colombia (CAS) has been one of the most important signs of support to our country. The credit program announcements on part of the multilateral development agencies, specially of the World Bank and the Inter-American Development Bank, encouraged the recovery of the confidence in the stability of the Colombian economy and helped restore access to the markets. This expression of confidence has been fundamental for the accomplishment of an ambitious program of reforms, many of which have been passed by the Colombian Congress. Since the 1998-1999 crisis, Colombia has reduced the imbalances that threatened economic growth and social progress. Inflation has been reduced, financial stability has been restored and private activity has recovered, albeit not yet fully.. However, poverty has increased in tandem with the deterioration of the labor indicators. Considering that internal security, building social equity and economic recovery are the highest priorities of the Government, the new administration is fully committed with fiscal stability and sustainability and the implementation of the structural reforms required to carry out the necessary changes that would allow all Colombians to benefit from the opportunities offered by a healthy economy. Attached to this letter, we provide a document on the recent evolution of the country's economic situation and, within that context, a synthesis of the objectives and the content of the policies and reforms that we have undertaken. The program of the new administration increases fiscal revenue, reduces unproductive public expenditures, attacks corruption, supports economic recovery and seeks to promote a better income distribution and a more extensive and efficient provision of social services that offer genuine opportunities for all Colombians. The National Government is committed to building a Communitarian State (Estado Comunitario): a State with one legitimate authority where the violent population hold no power, at the service of the citizens and free of the ravaging effects of corruption and clientelismo. A State that focuses its efforts on the eradication of poverty, in the search for social justice and security conditions. A State that makes an effort so that the resources reach the citizens. A State for the people, which assumes the political 49 Annex I: Letter of Development Policy responsibility of bringing in citizen participation in the definition of public actions, as well as in their implementation and monitoring. The Government recognizes some risks that may threaten the appropriate implementation of its program, including an unforeseen increase in security expenditures, insufficient support to the economic initiatives included in the referendum and higher volatility in external markets. Aware of these risks, the Government has identified contingency measures designed to safeguard the program. These include additional taxes and early implementation of some measures discussed in this document. Finally, the Government is committed with the program hereby presented in this document and is pleased to count with the World Bank's partnership and financial support. In support of the measures already taken and implemented, the Government would appreciate the prompt consideration by the Bank's Board of Executive Directors of the first programmatic fiscal and institutional structural adjustment loan, foreseen in the CAS for Colombia for period 2003-2006. The Government is available to assist the Bank's technical team to jointly define future loans of the program as the Tax ,State, Territorial Fiscal, Financial and Social Reforms are consolidated. Sincerely, (original signed) (original signed) ROBERTO JUNGUITO BONNET SANTIAGO MONTENEGRO TRUJILLO Minister of Finance National Planning Department 50 Annex 1: Letter of Development Policy I. THE CONTEXT. MACROECONOMIC SITUATION AND SECURITY A. The Context 1. The present panorama facing Colombia is worrisome: the insecurity problem is well known and there are other problems of equal or greater importance. The country- .wide rate of unemployment reached 16% in 2002,-one point higher than the previous year. Despite the increase of Government expenditures and the significant increase in the number of agencies of the central Government, the deterioration of social indicators has been evident. Moreover, the growing public expenditure has contributed to the deterioration of the country's public finances. 2. The legitimacy of the State has been damaged by the perverse effects of corruption, clientelismo and politicking. Recent surveys indicate that the percentage of citizens who are not satisfied with the country's democratic regime and distrust Congress is among the highest in Latin America. The absence of tangible social improvements makes that perception even worse. B. Recent Evolution 3. Colombia has achieved considerable macroeconomic stability since the crisis of 1998-1999, in spite of the growing seriousness of violence and the existence of an adverse international environment. Fiscal consolidation has advanced, inflation has been reduced and the financial system has been restructured. By the beginning of the year 2002, these achievements permitted-access to international credit markets and guaranteed the stability of the exchange rate. 4. Nevertheless, during 2002, the country suffered the consequences of the regional instability: the spreads of sovereign bonds increased considerably and the peso was consequently devalued. This situation was aggravated by the increase in the fiscal deficit and by the recent, unprecedented escalation in the armed conflict, brought about by uneven progress in the peace process of the time. 5. On the other hand, it should be remembered that in recent years the armed conflict has intensified dramatically. Between 1986-1999 and 1999-2001 the number of attacks on the petroleum infrastructure was up-by 160%, the blowing up of electricity towers was up 680% and kidnappings were up 126%. The worsening of the conflict only has not only increased capital flight and brain drain but has also diminished the productivity of the economy and private investment. Various estimates show that the armed conflict reduces the annual rate of growth of the econorny in at least two percentage points each year. 6. In order to finance the strategy torestore security, which is one of the priority objectives of the Government, a transitory and highly progressive tax of 1.2% on net assets was introduced on individuals and corporations. The additional income is 51 Annex I: Letter of Development Policy estimated at 1% of the GDP (collected from September of 2002 through June of 2003). The totality of these revenues will be dedicated to strengthening Democratic Security. 7. Faced with an adverse regional environment and huge fiscal problems, the new Government acted quickly. First, it proposed (and managed to approve) important budgetary cuts for the year 2003, resulting in the growth of non-interest Government expenditures at a rate lower than inflation. Second, it established a one time tax on assets and presented to Congress an unprecedented package of tax measures and control of expenditures. And third, it enacted decrees that trimmed expenditures, entitlements and subsidies: the rate for the Certificate of Tax Refund (CERT) was reduced to zero, fringe benefits were reduced and the vacancies that had not been filled as of July 2002 were eliminated. In parallel, the Government initiated the design and establishment of an ambitious program to reduce and restructure the public administration. 8. In December, Congress approved the Financial Reform that raises the sectoral regulatory framework to the level of international standards for regulation and banking supervision. The financial reform emphasizes the development of mechanisms that permit an early detection of companies in difficulties and attention to companies in crisis. Along these lines, of special importance is the treatment of assets and liabilities; the administration of the Central de Inversiones, CISA; the consecration of new operations, especially with reference to housing leases and micro-credit; and measures related to divulging information and the administrative enforcement applicable to financial entities. 9. The Government is conscious that debt sustainability should have its foundation in solid structural reforms and not on optimistic scenarios of economic growth or assumptions about the behavior of the exchange rate or the interest rate. The Government program is based on three pillars: recuperate security, achieve macroeconomic stability and transform a corrupt and clientelist state into one that is transparent and produces clear and profound changes in the social fabric of the country. Undoubtedly, the support of the World Bank is fundamental for the advancement of these reforms. The support of the Bank is particularly essential at this time, while interest rates paid by the country remain high: nearly 25% of the expenditure of the National Government is destined to interest payments. 10. During 2002 the real increase of the GNP was around 1.7%, inflation was 6.99%, the current account deficit remained at levels around 1.8% of GDP and net international reserves increased by approximately US$ 220 million. In 2003 we expect renewed economic growth with stability: a growth rate between 2% and 2.5%, inflation between 5% and 6% and the current account deficit reduced to 0.8% of the GNP. 11. On the fiscal side, upon finalizing the year 2002, the consolidated deficit was 4% of the GDP, 1,4 points above the target initially agreed with the International Monetary Fund. This deviation is explained, in good measure, by the greater expenditures (associated in part with the electoral process) and by the declining economic growth in 2001 and in the first semester of 2002, which adversely affected revenue collections. 52 Annex I: Letter of Development Policy 12. In 2003, it is projected that the fiscal deficit of the consolidated public sector will be cut to 2.5% of the GDP. In order to reach this fiscal objective, the Government has put in place a strategy that has two main elements. First, the law of Referendum which, once approved, will freeze the operational expenses of the State in nominal terms during 2003 and 2004. The direct savings expected by this initiative will be 0.7% of GDP (Col. $1.5 trillion) in 2003 and 0.5% of GDP (Col. $1.2 trillion) in 2004. Second, the tax reform will increase revenue by 1% of GDP during 2003 and 2004 and byl.8% from 2005 onward. These resources will be obtained, mainly, by means of a drastic broadening of the tax base of the VAT, a gradual reduction of income tax exemptions, a surtax on the income tax and a series of improvements in tax administration. 13. The program of the Government is oriented to guarantee fiscal sustainability and, ultimately, to recover security and economic growth and to increase social equity. The fiscal adjustment and the structural reforms will ensure that these objectives are reached within a framework of macroeconomic stability, supported by prudent monetary policy and the strengthening of the financial system, while at the same time strengthening social assistance programs, expanding education and health coverage and mitigating the impact of the increases in the tariffs of public utilities on the poorest. C. The Perspectives 2002 - 2006 14. The macroeconomic outlook for the next four years forecasts the current account deficit between 0.8% and 1.9% of GDP, and a rate of investment that increases from 13,7% to 14,6% of GDP. As a result, the domestic savings rate increases from 11,9% to 12,6% of GDP. In this way, the financing of the capital account will be covered by direct foreign investment and the net indebtedness of the public and private sectors. 15. On the other hand, the private sector will anticipate an adjustment in the balance of savings and investment between 0,2% and 1,6% of the GDP as result of the recovery of private investment. This private adjustment is necessary to make the public adjustment viable. Both the direct foreign investment and net external financing of the private sector will finance the external deficit of the current account, which in effect means that the private sector will have an important role in financing the investment that will take place during the following four years. 16. The overall public sector balance shows a deficit that is financed with internal credit (between 2,1% and 1,7% of GDP) and external credit (between 0,3% and 0,4% of GDP). The gradual adjustment of the excess expenditure in the public sector will be financed with the savings generated by the adjustment of the private sector. The credibility of the adjustment in the public sector is underpinned by th-e scope of the comprehensive structural reforms that are advancing. 17. The fiscal consolidation will continue in the medium term. It is expected that the economic conditions will improve in 2004 and that the real growth of GDP will exceed 3 53 Annex 1: Letter of Development Policy percent from that year onward. The higher deficit would be financed by direct investment, the continuous support of the multilateral banks, and access to the international financial markets. Monetary policy will be managed to support a moderate reduction in inflation within a framework plan of target inflation rates and a floating exchange rate. 18. The public sector deficit will be reduced to 2.1 percent of GDP in 2004, with the support of the measures presented above. The adjustment will reduce the debt of the non financial public sector to less than 50 percent of GDP. The Government expects that the sustained reduction of the debt, the continuous improvement in the indicators of economic vulnerability and the sound economic management will increase confidence, improve the Colombian credit rating and reduce the cost of acquiring debt. 19. Strengthening public finances is one of the central strategies for recovering confidence and economic growth. An explicit objective is to reduce the deficit of the consolidated public sector from 4.0% of GDP in 2002 to 2.5% in 2003, and to continue the consolidation of the process in the following years. The fiscal adjustment will increase the primary surplus of the non financial public sector from 0.7% of GDP to 3.0%. D. The Stand-By Program with the International Monetary Fund 20. Within its macroeconomic policy framework, the Colombian Government signed a Stand By Agreement (SBA) with the IMF for SDR 1.548 million for the upcoming two years. One of the main objectives of the program is the reduction of the fiscal deficit by two points of GDP. This reduction will be achieved through the higher tax revenues expected from the newly enacted tax reform and with the proposed freeze in current expenditures for a period of two years. In the medium term, structural reforms such as the Pension Reform - recently approved by Congress- and the public sector modernization program, will contribute to ensure debt sustainability and consolidate the process of adjustment initiated by the Government. The SBA includes a non financial public sector deficit target of 2.5% of GDP, a current account deficit of 0.8% of GDP and an inflation rate between 5 and 6% for 2003. II. OBJECTIVES OF THE GOVERNMENT'S PLAN A. Democratic security 21. The Government has initiated a strategy that will allow it to offer security to all sectors of society, consolidate the State's control of the national territory and to recover control over the zones with influence of illegal armed groups. The concept of Democratic Security launched by the Government goes beyond that of national security, understood as the capacity of the State to penalize and to dissuade those who oppose the rule of law. As put forward by the Government, the adjective "democratic" means security for all in a context of profound respect for human rights. 54 Annex 1: Letter of Development Policy 22. "Democratic Security" is a vital element for the recovery of confidence and, therefore, for economic growth. The strategy of Democratic Security has as first objective the punishment and the dissuasion of violence and the control of drug- trafficking, with the viability of democracy and the legitimacy of the State as ultimate objectives. 23. Specifically, the Government is advancing initiatives to achieve greater development and institutional strengthening of the Ministry of Defense. The armed forces and the national police are adapting their institutional structures for the implementation of the national security policy. For the Government, achieving security is a collective process. The foundations of this process are based upon conflict resolution through non-violent means. Institutions such as the Defensorfa (human rights defendant), the Procuraduria (vigilance of public administration) and the Fiscalia (General Attorney's Office) are key entities for the success of this policy and each of them will be strengthened in the process. Following the principles of transparency and accountability, the Government will seek to communicate and systematically explain, to both national and international audiences, the policies and actions that the Government will apply within this framework. B. Sustainable Economic Growth and Employment 24. Part of the strategy for economic recovery of the Government will be focused on housing sector and construction. To this effect, the Government has designed a strategy that includes an impulse to low-income housing and a package of stimuli for the reactivation of mortgage credit markets and, through reactivation mortgage markets, new housing construction for middle and high income groups. These measures, combined with a competitive exchange rate, a low interest rate and the application of trade preferences given to the Andean countries, will contribute to lead economic growth in the short term. 25. The ensure growth sustainability in the long term, the Government will introduce legislative, regulatory and institutional changes geared to stimulate private sector participation in infrastructure, mining and public utilities. These changes will not only attract additional investment (foreign and domestic), but will also help compensate the deficit in strategic infrastructure that, nowadays, hinders economic growth. By the same token, the Government will continue setting the bases for an orderly insertion of the national economy in the world economy and will give an unprecedented impulse to the formation of human capital at all the levels. Given current fiscal restrictions, the emphasis of growth policies lies in stimulating private sector participation in strategic economic sectors, expanding the impact of public investments and eliminating the bureaucratic obstacles and other impediments that constrain private initiative. The Government policy of democratic security referred to previously, complements these growth policies by offering peace and greater confidence to all those that have a potential interest in investing in the country. 55 Annex I: Letter of Development Policy C. Equity and Social Protection 26. In order to reach the objective of a more equitable society, where all citizens share the fruits of economic growth and improved public services, the Government's social policies must face three main challenges: a) to increase the efficiency of social expenditures so that higher expenditures translate into better results; b) to improve expenditure targeting so that resources reach those who need them the most, and c) to consolidate a system of social protection so that economic crises do not compromise the future possibilities of the most vulnerable groups. By taking care of those challenges social investment will produce expected results and, ultimately, a more equitable society. 27. The Government gives priority to the consolidation of strategy that protects the poorest and most vulnerable population by means of preventive instruments and social assistance. To this effect, the Government will implement the following measures: 1. The System for Identification of Beneficiaries (SISBEN), will be brought up to date to correct its current design and implementation problems. 2. Special attention will be given to the needs of the internally displaced population. Actions will be focused on the regions that receive the largest inflows of displaced persons. It will be ensured that barriers of access do not exist that restrict the access of displaced persons to health and education programs. 3. The management of the main social programs will be gradually decentralized (including the Colombian Institute of Family Welfare -ICBF- and the National Service for Technical Training -SENA-). Outsourcing alternatives that involve the private sector and non-Governmental organizations, NGOs, will be explored. 4. The impact of the programs of the Network of Social Support (Red de Apoyo Social, RAS) will be evaluated and some of these will be transferred to the new Ministry of Labor and Social Security. These programs will be financed on a more permanent basis. 5. A counter-cyclical element will be established within the social safety net, consisting of the creation of a fund that accumulates resources during periods of economic expansion in order to spend them during times of macroeconomic crisis. D. Renewal of the Public Administration 28. The National Government is committed to reforming both the public administration and interregional relations in the country. The present size and structure of the public sector favor inefficiency, corruption and waste. Likewise, the lack of clarity about the responsibilities among different levels of Government allows for inefficiencies and has hindered the process of decentralization. 56 Annex I: Letter of Development Policy 29. In view of all the above, the Government will promote an integral reform of the public administration and will lead a transformation of the relations between municipalities, departments and the Nation. III. THE FISCAL AND INSTITUTIONAL ADJUSTMENT PROGRAM A. Objective and Components of the Program 30. The Fiscal and Institutional Adjustment Program to be financed with resources from the World Bank has the objective of accompanying the Government of Colombia in the process of fiscal adjustment and in the introduction of public management tools that will permit a transparent and efficient administration and allocation of scarce public resources. 31. For achieving this objective, the Government has identified a package of structural measures that will lead to an increase in fiscal revenues by means of an effective expansion of the tax base and the elimination of tax exemptions, the progressive addition of flexibility to budgetary expenditures, the introduction of fiscal responsibility principles and the integration of the budgetary system, enhanced transparency in the mechanisms of procurement and contracting, and the restructuring of the public employment introducing "meritocracia" and the evaluation of performance. We will refer to each one of them subsequently: 1. The Reform to Tax Policy and Tax Administration 32. On December 20,2002 the Congress approved the Tax Reform that, among other things, will increase the VAT rate of 10 percent applicable to some products to the general rate of 16 percent and will expand the base of said tax. The articles that were added to the base, including some industrialized food products, will be taxed at 7 percent. The tax reform includes a one-year surcharge to all income taxes, the decrease of the deductions of some of the territorial taxes from the income tax base, and a ceiling to the overall exemptions for higher income individuals. Finally, the tax reform will allow an improvement in controlling evasion through the application of new measures and stricter penalties and by closing the channels of evasion in the financial transactions tax. At the territorial level, the reform proposes to simplify the excise tax on alcoholic beverages and to increase the gasoline tax surcharge. The increase in tax collection will be of 1% of GDP in 2003 and 2004. From 2005 onward, all the goods excluded or exempt will be subject to a 2 percent VAT rate. The expansion of the base is a fundamental pillar in the fight against tax evasion and the introduction of a culture of fiscal responsibility. 2. Freeze of current expenditures 33. The Government has proposed to freeze, in nominal terms, a good part of the public sector's current expenditures during the next two years. The lowest salaries and pensions are excluded, as are military expenditures, which will increase by 0.3% of GDP in 2002 and 0.6% in 2003. This measure will be voted in a national referendum at the 57 Annex I: Letter of Development Policy beginning of 2003 and, if approved, will generate savings of 0.7% of GDP in 2003 and 1.2 percent in 2004. The savings achieved by local entities, due to the freeze of salaries and pensions, will be assigned to the territorial fund of pensions of the Government (FONPET) and to other funds of public pensions. 3. Pension Reform 34. On December 20, 2002 Congress approved the reforms to the general system of pensions and granted special authority to the Government to strengthen the finances of the Armed Forces pensions regime. The new law increases the rates of contribution by two percentage points. The period of contribution expands from 1000 to 1050 weeks beginning in 2005 and by25 weeks per year thereafter, reaching a maximum of 1,300 weeks in 2013. The rate of replacement and the ceiling of the pension are diminished substantially for those that have a liquidation base salary above6 minimum salaries. Besides, the Government has proposed in the referendum law to limit all the new pensions under public sector responsibility to 25 minimum salaries, and to require the same age and period of contribution for all those affiliated. All this is complemented with a disposition that would eliminate all the special regimes starting in 2008. Notwithstanding the effects of the elimination of the special regimes, the reform will reduce the net present value of the pension liabilities of the public sector from 210 to 168 percent of GDP and will generate fiscal savings that will increase from 0.1 percent of GDP in 2003 to 1 percent in 2010, when the transition to the new scheme takes place. 4. Fiscal Responsibility Law 35. The Government expects that the fiscal responsibility law will be approved by Congress in early 2003. The Government bill has already passed through the Chamber of Deputies and must now be passed by the Senate. The law would force the Government to establish and publish primary surplus targets for the not financial public sector for ten years, in order to ensure fiscal consistency with the sustainability of public debt. 5. Modernization and Rationalization of the Public Administration 36. The Government has taken several actions towards modernization and rationalization of the public administration through the merging of ministries, the elimination of unnecessary agencies and offices, the closure of some diplomatic representations, the abolition of preferential lending and the suppression of vacancies. These actions form part of an integral reform to restructure and reduce the state bureaucracy. The objectives of the reform of the State aim not only to consolidate the fiscal adjustment, but also to increase the efficiency of public expenditure. 37. The reform of the public administration includes the elimination of at least 40,000 posts in the central administration: thirty thousand correspond to the suppression of the vacancies generated by those that will retire in the next few years, and the remainder to the elimination of staffed posts. The severed personnel will be compensated with all benefits established by law and, for those whom norms do not recognize benefits (staff of 58 Annex 1: Letter of Development Policy free appointment and removal or temporary), a benefit of at least one year of salary will be granted. All the persons affected by the institutional renovation program, will have access to a labor protection plan (PPL) whose main objectives are professional training and labor reallocation. Finally, the Government is committed to protect those most vulnerable during this process and will ensure labor stability for the mothers who are the head of family who don't have other economic alternative, the disabled and those that are close to retirement. 38. The Government has estimated that the savings generated by the implementation of these measures will increase from 0.1% of GDP in 2003 to 0.6 percent in 2005. It is important to emphasize that in December Congress approved a Law that grants an extraordinary authority to the President to carry out the reforms described. 39. In order for the size of the administration's labor force to be the adequate, goals have been set for a reduction in the operational costs and for an increase in the proportion of officials assigned to of core tasks. Within these objectives, all entities of the national level are found in a process of institutional reengineering. 40. The process of renovating the administration emphasizes the need of re-thinking the sectors, analyzing -independently of the present situation- which should be the role of the State in each one of them. This exercise, (e.g. the need to adjust the organizational structures of the sector head entities, their institutional networks and their human resources), represents what have been called the "Vertical Reforms", which are those that are done in the sectoral context, covering from the entity head of the sector down to all linked agencies. 41. The guidelines for the implementation of this program were established in the document "Directiva Presidencial" N° 10 of 2002 and the guiding principles and methodological procedures were prepared by the DNP and distributed through the several "Circulares Instructivas". According to these Circulares, the main objectives of the vertical reforms in each sector should be the following: (i) re-think the role that the State should play in the sector; (ii) design an organizational structure for the sector head entity coherent with its obligations, redefined in function of the new sectorial concept; (iii) design an institutional network coherent with the effective and efficient exercise of the core functions that the State should fulfill within the sector; and (iv) rationalize the payroll of the public administration and, consequently, reduce the operational expenditures of the state apparatus, freeing resources that will be reallocated to the provision of goods and services to the citizens. 42. The vertical reforms also include also the restructuring of at least 30 decentralized entities under the premise that its permanence depends upon their financial viability. Among the entities subject to restructuring are the Colombian Institute of Social Security (ISS), TELECOM, ECOPETROL, several regional electric companies and a large number of public hospitals. 59 Annex I: Letter of Development Policy 43. One of the most important characteristics of the Program of Renovation of the Public Administration is the comprehensiveness of the process. In this sense, it includes a series of specific measures that have been identified as crucial to an improved public sector and for the financial sustainability of the State. These reforms have been defined as transversal, since they influence all the sectors of the State. 44. The following are some of these transversal policies: (i) a reform of the system of public procurement and contracting (ii) the establishment of a Government strategy (with the corresponding institution building) for the legal defense of the State, (iii) the design of a comprehensive policy for the productive management of the assets of the State, (iv) the establishment of a results evaluation system and monitoring of policy implementation for the totality of the departments, (v) a reform of the system of public sector employment, (vi) a reform of the agencies of regulation and control, (vii) a reform of the budgetary system, (viii) the unification of the information systems within the State and from the State with the citizens, (ix) the strengthening of electronic Government, (x) a strategy to simplify procedures and (xi) a policy of regulatory rationalization. 45. Subsequent paragraphs describe in detail the objectives of each one of these "transversal reforms". 46. Public employment. The objective of this initiative is to define an integral policy for public employment and to design and implement a new institutional management for the personnel at the service of the state. A new institutional plan for regulation and administration will centralize the formulation of human resource policies, including issuance of new rules, and will decentralize management, leaving policy implementation in the hands of the head of each entity. 47. Systems of purchases and contracting. The reform of public procurement is the core stone of the anti-corruption strategy of the Government. With this reform the state entities will disclose its programs and budgets for contracting and investment and the particular features of the investment projects that will be undertaken; procurement of goods and services will follow public bidding procedures and winners will be selected by auction. Each state agency will adopt audits of quality and service delivery to citizens; citizen control will be stimulated and the Government will propose a reform of Law 80 of 1993. 48. Legal defense of the State. The objective of this reform is to design an integral strategy to strengthen the legal and judicial capacity of the state to protect itself from legal claims. This reform seeks to reduce the number and the fiscal impact of legal claims and judicial decisions against the state. The Government is committed to preparing a diagnosis that lays the ground for the development of a preventive strategy, including the design of a "system of safeguards and quality protection", with special provisions for the high risk sectors (communications, energy, road -infrastructure, concessions, etc.). The Government strategy will propose alternative mechanisms for legal protection of the state, will identify the legal assumptions and judicial interpretations that work against the 60 Annex I: Letter of Development Policy interests of the State, will preventive and remedial actions and will explore the convenience of a Government proposal for the reform of the judiciary. 49. Asset Management. The objective of this initiative is to establish a policy for the administration of state assets, including the processes for acquisition, assignment, use and disposition. This reform initiative seeks that the administration of state assets responds to the general interest of the Nation regarding security, productivity, efficacy and efficiency. Once the Government has prepared the inventory of assets and has established mechanisms for their appraisal and legal titling, it will define a timetable for institutionalization of asset management. Likewise, the Government expects to formulate a legal framework for the acquisition, registration and use of new assets by public agencies. 50. Budgetary system. The national Government is committed to redesigning public expenditure policies and reviewing the institutional framework for the state budget. The Government is conscious of the need to define priorities for the allocation of scarce resources and understands that the budget is one of the fundamental tools to accomplish this purpose. The present distribution of the public expenditure budget follows, in good measure, numbers of laws that demand resource allocation in such a way that create severe inflexibilities and limit the capacity of the budget to effectively operate as an economic policy instrument. 51. It is necessary to redesign budgetary institutions in order to transform the budget into a key instrument for fiscal policy and to strengthen revenue and expenditure management. Fiscal discipline, flexible budget and technical efficiency shall be the main objectives of the budget system reform. Accountability and transparency mechanisms in budget management will be enhanced at the same time. 52. The objective of budget reform is to establish a comprehensive strategy that aims at the rationalization of planning, allocation, execution and control of public revenues and expenditures. The reform should achieve a more transparent resource allocation in line with national priorities, deeper fiscal stability, better functioning of the state machinery (including the procurement system), and the use of the budget as an effective tool to evaluate public sector performance on the basis of results. 53. With that purpose in mind, the budget system reform will encompass the revision of those parts of the legal framework that introduce rigidities in resource allocation and budget execution. The reform will also pursue a better integration between current and capital expenditures in order to ensure a more efficient and sustainable articulation of public expenditure. 54. Management by results. The objective of this reform is to formulate a comprehensive public management policy that aligns the rationality of public managers with state interests under a new incentive framework geared to more substantive results and expenditure efficiency. The long term vision is to link budget preparation and, 61 Annex 1: Letter of Development Policy whenever possible, resource allocation, with the results expected from each government sector. 55. Regulatory, supervision and control agencies. The purpose of this reform is to establish a policy framework for regulatory, supervision and control actions. The policy will seek to establish the most appropriate institutional framework, including new instruments and distribution of responsibilities. The new policy will establish the principles that should guide regulation, supervision and control by state agencies, including the principle of reduction of transaction costs for the state as well as for those that whose activities are regulated, supervised orcontrolled. 56. Information systems. The Government intends to evaluate the current situation regarding basic information needed for public management and to propose a comprehensive strategy to enhance that situation. The new strategy will include proposals for new institutional arrangements and optimal coopeiration between public and private sectors. It will seek to strengthen the transparency and reliability of corresponding information. 57. E-Government. The objective of this strategy is to define a policy for introducing and ensuring the sustainability of information technology uses in state activities, both in activities that are internal to each public agency and in activities that bring public agencies in contact with other public entities, private sector or citizens at large. 58. Strategy to simplify procedures (Anti-trdmites). This reform seeks to establish a policy framework that permits simplification and ovetall rationalization of public administration procedures, either internal to the administration or in relation with citizens. The rationalization of procedures will be guided by the cost-benefit analysis of procedural reform. 59. Rationalization of the legal framework. This reform will seek to enact a general rule that lists precisely all the requirements that must be met by laws and administrative rules (decrees, resoluciones, circulares, ordenanzas, acuerdos) --especially in their relation with previous rules-- with the purpose of improving quality control in the process of preparation and in the contents of those norms that are in force and have to be applied. The Government will propose to reduce the current number of rules to a smaller set of rules of better quality and will propose the principles for their issuance as well as the institutional mechanisms by which citizens can exercise control over its application. Finally, the Government will define a strategy and methodology to replicate the rationalization of the legal framework at the local and regional levels of public administration. B. Coordination of Actions with multilateral agencies 60. Keeping in mind the important scope of the Government program for the Renovation of Public Administration and the huge national effort required to implement it, the Government has requested the support and the financial and technical aid of 62 Annex I: Letter of Development Policy several multilateral agencies. In this regard, the World Bank will support the following areas: asset management; judicial and legal defense of the State; budgetary system, management by results and procurement and contracting. 61. On the other hand, the Inter-American Development Bank, will support the Government in the implementation of the activities that are part of the vertical reforms insofar as: public employment, regulatory agencies, supervision and control; information systems; electronic Government, strategy to simplify procedures and rationalization of the legal framework. IV. Conclusions and results expected 62. The application of the package of policies and actions put together by the Government, part of which are included in the Fiscal and Institutional Adjustment Program to be financed with resources of the World Bank, will permit the country to faithfully follow the mandates of the National Plan of Development that seek to fulfill citizen demands in the areas of democratic security, growth, social equity, transparency and efficiency of the State. 63. Finally, the Government is committed to the program presented above and sees with great pleasure the financial support of the World Bank to this reform program. In support to the measures taken and implemented, The Government will appreciate the prompt consideration of the Board of Directors of the Bank to the first programmatic fiscal and institutional adjustment credit, contemplated in the CAS for Colombia for the period 2003-2006, in support of those policy measures recently adopted and implemented. The Government will be available to the technical teams of the Bank for jointly defining future loan programs while ongoing Tax, Subnational Fiscal, Financial and Social reforms are consolidated. 63 Annex 11 Annex II Fund Relations Note International Monetary Fund Public Information Notice (PIN) No. 03/09 700 19th Street, NW January 23, 2003 Washington, D. C. 20431 USA Colombia: Public Information Notice On January 15,2003 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Colombia.' Background The Colombian economy has staged a steady, albeit slow recovery'since the 1998- 99 crisis. Macroeconomic stabilization has been achieved, and robust fiscal and structural policies during most of the period since then have allowed the country to avoid some of the difficulties faced by other economies in the region. This is all the more remarkable since Colombia also has had to contend with a costly internal conflict that disrupts economic processes and distorts resource allocation. However, the economic situation worsened in the first half of 2002. Peace negotiations with the guerillas broke down in February, after which violence escalated. Economic activity has remained sluggish, and the fiscal consolidation has gone off track. Exacerbated by increased contagion from other countries in the region, concerns about fiscal solvency led to increased pressure on the peso from mid-year and a loss of external market access. After taking office in August 2002, a new administration took determined action to quicken a resolution of the internal conflict, reverse the fiscal deterioration, and safeguard macroeconomic stability, which had come under threat. At the same time, a two-year economic program has been designed, under which the govemment aims to achieve fiscal consolidation and effect critical structural reforms, so as to lay the basis for strong and sustained growth and a better distribution of income and social services. I Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On retumn to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. This PIN summarizes the views of the Executive Board as expressed during the January 15, 2003 Executive Board discussion based on the staff report. 64 Annex If Executive Board Assessment Directors commended the new government's swift and comprehensive action to face a difficult domestic and external situation. A deterioration in the domestic security situation last year, together with the turbulence in international financial markets and a weakening of the public finances, had exerted pressure on the peso and had resulted in a temporary loss of market access. Directors strongly welcomed the new government's rapid and determined actions to reverse the fiscal slippages and safeguard macroeconomic stability, advance institutional and economic reforms, and accelerate resolution of the internal conflict. In particular, Directors were encouraged by the measures already taken, and the strong domestic ownership in support of further reforms, that will allow Colombia to lastingly improve its debt dynamics and prospects for growth and employment. They saw Colombia's recent return to the capital markets as a recognition of the improved economic policies and the reform momentum created by the government. Directors supported the authorities' plan to reduce the fiscal deficit sharply in 2003- 04 and welcomed their commitment to take the measures needed to ensure public debt sustainability. In particular, they welcomed the recent passage of tax reform that will help underpin the lower deficit, as well as the effort to mobilize broad public support for spending measures. While the program provides for fiscal consolidation to continue over the medium term, it will, nevertheless, remain important that the authorities stand ready to take additional measures, as needed, to address risks that could affect the public finances, including those from security-related spending. Directors welcomed the govemment's commitment and preparedness to take action in this regard. Looking ahead, they saw a need for further efforts to strengthen the tax base. This would include a reduction in the dispersion of VAT-rates, while, over the medium-term, efforts should aim at alleviating the need to resort to ad-hoc measures, such as the financial transaction tax. Directors supported the authorities' decision to finance the fiscal program for 2003 entirely from the domestic market and from increased borrowing from multilateral lenders. They underscored the importance of advancing the structural reforms that will help secure this multilateral financing. Directors also noted the efforts underway to reduce the vulnerability of Colombia's debt structure. Going forward, it will remain important to continue to implement policies aimed at reducing the vulnerability of the public debt to shocks, which will require, in addition to fiscal consolidation, the pursuit of sound policies that help avoid volatility of exchange and interest rates. A few Directors encouraged the authorities to introduce collective ction clauses in sovereign bond contracts. Directors were encouraged by the authorities' commitment to wide-ranging structural reforms, which will be key to underpin the fiscal consolidation effort over the medium term. They welcomed the recent approval in congress of the reform of the general pension system, and looked forward to the next step, which will include reform of the special pension regimes. They also highlighted the importance of reforms to put the health system on a sound financial footing. Directors supported the. high priority assigned by the new administration to modemizing and streamlining the state and 65 Annex II introducing greater flexibility in public spending. They looked forward to sustained implementation of reform plans in these areas, building on the ongoing initiatives to close existing vacancies and reduce staffing through attrition, and the impending adoption of a Fiscal Responsibility and Transparency Law. Tuming to monetary policy, Directors commended the central bank for the high credibility that it has established after having presided over a period of significant disinflation. They noted that the continued skilful management of the inflation targeting framework in the period ahead will need to balance carefully the risk that the recent peso depreciation may fuel higher inflation against the still large unused capacity in the economy. In this regard, Directors recommended that the authorities should be ready to act promptly to signs that inflationary expectations could become embedded. Some Directors expressed concern that the central bank's policy rate is negative in real terms. Directors welcomed the significant progress achieved in strengthening the banking system, including the recent legislation to further strengthen the safeguards, and the authorities' commitment to refrain from introducing new subsidy programs for distressed borrowers. They recommended continued vigilance in the period ahead, especially with respect to the mortgage institutions, and encouraged the authorities to strengthen the regulation of securities firms and brokerages. Directors commended the authorities for their exemplary and comprehensive elforts to combat money laundering and the financing of terrorism, and encouraged continued efforts against terrorist assets. Directors emphasized that increased labor market flexibility will be key to address Colombia's high unemployment and support the government's social equity objectives. While welcoming the recent reform of the labor code, they encouraged the authorities to continue to work toward addressing remaining problems, in particular the backward indexation of the minimum wage and the high payroll charges, which tend to exclude workers from the formal sector. Directors considered that Colombia's floating exchange rate regime was appropriate and had helped strengthen the country's ability to respond to shocks, and that Colombia's increasingly diversified exports are competitive at the current exchange rate. They commended the authorities for progress in liberalizing the trade regime and encouraged them to phase out remaining import restrictions. A number of Directors underscored the improved export prospects that Colombia would gain from faster trade liberalization by its trading partners. Directors encouraged the authorities to accept the obligations of Article VIII of the Fund's Articles of Agreement as soon as possible, and eliminate the few remaining exchange restrictions. For questions please contact Mr. R. Rennhack, Division Chief, South/Central American 1, Westem Hemisphere Department, IMF, ext. 37350. 66 Annex IIX Annex I: Policy Matrix -_-_-;_____._:_:-_^._d_._.- First L'a,.n VSeod; Lov Tr L Fourth LA Loan e E' '(Pror Actions) (Fy-4) (FYOS) 1. (FY06) Result at fte end (FY03) ~~~~~~~~~~~~~~~~~~~~~of FIAL' OVERALL FISCAL COMMITMENT The macroeconomic framework of the republic of Colombia is consistent with the objectives of the program. Responsible GovernmentAgency: MHCP 1. The Borrower has attained, for 1. The execution of the 2003 1. The execution of the 2003 1. The execution of the 2004 MACRO-FISCAL the period covered by any three Budget through the end of the Budget through the end of the Budget through the end of the RESULTS (3) continuous months among the most recent quarter will be in most recent quarter will be in most recent quarter will be in twelve (12) months preceding line with overall deficit limnits line with overall deficit limits in line with overall deficit limits Gradual reducion of withdrawals from the Loan in the approved budget. the approved budget and the in the approved budget and overall deficit of the Account, an overall deficit of the overall deficit of the non- the overall deficit of the non- an in Combined Public Sector of no financial public sector in the financial public sector in the 2005. more than US$1,352,000,000 approved budget for 2004 will approved budget for 2005 will equivalent to not exceed [2.2] percent of GDP. not exceed [1.1] percent of P$3,874,000,000,000' _GDP I. REVENUE RIGIDITIES AND TAX REFORM Tax Reform Policy Obiectives: Increase tax reveniues, improve tax neutrality and equity, reduce tax expenditures. Responsible GovernmentAgency: MHCP 2. Borrower has enacted tax 2. Government has issued 2. The reforms to taxes specified 2. Income tax surcharge has FISCAL RESULTS reform law (Law 788 of 2002), the necessary legislation to for 2004 in Law 788-2002 are been reduced to 5%8T including: a) reduction of regulate the application of being implemented, including: i) the VAT tax base exemptions and expansion of the Law 788 of 2002.* a) the VAT coverage has 3. The reforms to taxes has expanded to tax base for the VAT2; b) increased to 51% of GDP6, and specified for 2005 in Law cover additional 'As reflected in the Stand-By Agreement with the IMF dated January 15, 2003 (exchange rate of P$2,864.79 - US$1) 2Chapter 3 of Law 788 of 2002 67 Annex III ._______*_ :- v.;........A mleXllJ:RbllcyMvA -;-A _;_.___._I.__ First Loan-Second Loan 'hrd L;o' ' ' -NFo L K . . . d (-.-orActious)- ( 4 :-Y05)- (FY0,) . - . -d0 -of FIAL .(F. - . -: . 3 ) ._- -_ _._ _..:_ _.AA ,_,,;_ _. _ _ __ ,,__ _ ___ _8 , A ___A___.__ _' reduction of the wage tax b) exemptions to income tax 788-2002 are being goods and services, exemption from 30% to 25% with have been reduced according to implemented, including: a) and ii) the phased a ceiling in the amount of Col$16 the phasing out schedule defined goods and services that were elimination of million in monthly wages (rentas in Articles 12 and 14 of Law 788 taxed at 7% in the Law 788- income tax laboraleW) and reduction of tax of 20027 2002 are being taxed at 10% exemptions during exemptions, tax credit and non- starting in 2005, b) goods 2003-2005 is taxed income for the personal and services newly included in effectively applied income tax4, and c) the phasing the base of the VAT will be according to out of the corporate income tax taxed at a rate of at least 2%, schedule, i.e., exemption for capital gains from c) non-taxed and exempted reduced to 70% in sales of stock, mutual funds and goods and services specified 2003, 50% in 2004, real estate, and as well as for in Law will also be taxed at a 20% in 2005 and 0% profits from corporations rate of at least 2%, and d) in 2006. previously exempted5 exemptions to income tax reduced as scheduled in Law 788-2002. * Essential to the next phase of the program 3Rentas laborales include, for this project, all forms of compensation originated in a labor relation. AArts. 12, i4 and 17 of Law 788 of 2002. 5 Including "empresas comunitarias, empresas asociativas de trabajo y fondos ganaderos, y los beneficios derivados de la emisi6n masiva de tftulos" (Arts. 12 and 14 of Law 788 of 2002) 6With a margin of error of +/-2.5%. Certification issued by the Oficina de Estudios Economicos of DIAN, based upon a consistency analysis referred to DANE- certified information. 7 Taxpayers' guide and format of income tax returns. 8DIAN Forms. 68 Annex III Annex m;I: Policy Matrix: -_^_- .^~.4q<.-First Loan ; Second Loan . Third Loan Fourth loan KeylEeete (Prior Actions) (FY04) (FY05) I (FY06) Results at the end .-(FY03) ___________________________________________of FIL Tax Administration Poicy Obiective. Increase Tax Revenues, Strengthen Tax Equity; Reduce Tax Expenditure And Opportunities For Corruption. RESPONSIBLE GOVERVNMENTAGENCY: MHCP (ITROUGH DIAN) 3. The Ministry of Finance, 3. The Ministry of Finance, 3. All taxpayers that receive 4. Collections per customs FISCAL RESULTS through DIAN, has enacted new through DLAN, is publishing VAT refunds have unified the inspection increased by at i) substantial rules for tax adrninistration regularly: i) semi-annual taxpayer current account for least 30 percent in real terms increase in reporting including: a) daily interest indicators, including the ratio VAT, income tax and customs in in 2004 compared to 2002. of interest income; ii) payments higher than Col$900 are of actual and estimated 2004. 5. Administration cost per collections from subject to withholding at the revenues, ii) annual results of 4. The Import & Export module peso collected reduced by at firms previously source ; b) obligation of financial surveys of taxpayer's for integrated domestic tax and least 10% in real terms in exempted from the institutions to report information satisfaction, and iii) indicators customs systems is in operation 2004 compared to the corporate income tax on taxpayers' accounts that are of the ratio of admninistration collections of 2002. has increased to 75% credited with annual interest of at cost per peso collected, 5. Collections from finms least Col$5 million'0, and/or have disaggregated by type of tax previously exempted from the 6. At least 20 monthly tax of their potential totalannul depsitsequalor ad of axpaer'5 corporate income tax has audits have been performed revenue, iii) hoge tann dosits eulon c) 4 Th taNpay :a increased to at least 75 percent jointly by the customs and the administration cost hgestabihan Clst of clliontabce 4.Tdevelope hand imleene of their estimated corporate internal taxes units of DIAN per peso collected destbtish on Decmbe 31of 2002.betx eeopdad pemne income tax potential revenue, has been reduced by debt onDecmber31 f 202. software to cross reference at least 10%, and iv) Elaborate a plan and set up a itod tion with fmancial 6. 100% of lage contibutors dministration shdltof thlese ales20 institutions to ensure that have unified accounts and are efficiency has percent ofteecollectable intestreported by them submtitting electronic income tax improved according debts3 ; d) establish indicators of match interest reported by returns by the end of 2003 to standard indicators customs clearance time and t4 M __ _-P . 01 9 Decree 3257 of December, 2002 '0 DLAN Resolucion 10537, October 29, 2002 ' DIAN Resolucion 10539, October 29, 2002 12 "Collectable" tax debt is defined as the "debido cobrar" established in the Plan "3 "Plan de Produccion" approved by the Comit4 de Direccion of DIAN 69 Annex III , - ; . A ex X : P . St;aA_,JSecon,-Aat, - Third Loafi Fourth LoAnn ^.qAX . : , . - . . - . ... - ..--- . 'eut at tE1A en- - rior~Avt ' .s (FY04) 0 (FY0) of ,,AL (FY03) procedures to select shipments for taxpayers; b) audited at 7. The Ministry of Finance like 1% annual inspection based on a risk- least 50% of large taxpayers (DIAN has renegotiated decrease in the ratio management system for the affected by the new taxes; c) agreements with banks with of recurrent customs offices of BogotA and estabUlshed and published regard to submission of expenditures of Medellfn.14 indicators of the cost and infordation in stan d form DIAN to total time required for and incentives for prompt revenue collected by compliance by the taxpayer, processing of data and turning it. and d) established unified over funds. accounts between customs and domestic taxes for large taxpayers beginning in (2003.* . II. EXPENDITURE RIGIDITIES AND INSTITUTIONAL REFORM A. Budget Management . - Polkcv obiective: Convert the budget into a more effective tool for sound fiscal policy and service delivery improvement. ResDonsible Government A0enci: -MHCP and DNP 4. Borrower has submitted to 5. Borrower has issued a 8. An information campaign on 7. The 2006 budget is FISCAL AND congress and congress has CONPES document approving the budget has been launched prepared within a medium INSTITUTIONAL approved, in first round, the Budget reform strategy17. and provides information for term perspective including the RESULTS constitutional reform that gives different target audiences such new accounting and budget Budget includes power to the borrower's 6. Borrower has developed as ministries, auditing agencies, classification model and targets and Executive Branch to control and and published a medium term and civil society. integration of current and tets an --on#, th. h ... t -4nth,n fical ficral frnmpwnrlr (MrTFP\ .p.rformance_ __ _ 14 Official Memorandum (Oficio) from Direccion de Comercio Exterior of DIAN 15 DIAN Resolution 70 Annex III .___.__-__-__A__._ Annex : Policy:Matrix - .. -;- First Loan Second Loan Third Loan Fourth Loan . Key Expectied (Prior Actions) (EY04) (FY05) (FY06) ,Resuhs at the/end of FIAL. (FY 03) _ _ _ _ __ _ _ _ manage the budget within fiscal fiscal framework (MTFF) 9. Government ha i capital expenditures. indicators for at least targets.16 consistent with the Plan regulations that require: a) a 8. Government has extended six sector ministries Financiero and the model of budget classification performance management in accordance with a requirements of the Fiscal that meets international pilots to at least six rministries medium term budget Responsibility Law. standards, b) new budget clarifying objectives, setting plan like a medium Superior Council of reporting standards, and c) targets and devising simple term expenditure 7. The Supenor Council of coordination to ensure performance indicators. framework. Fiscal Policy (CONFIS) has consistency of current and issued a resolution that capital expenditures regulates the criteria for the approval of budget forwards 10. Government has initiated commitments (vigencias performance management pilots futuras) according to the in two mninistries by clarifying Annual Financial Plan. objectives, setting targets and devising simple performance 8. Borrower has established a indicators. high level Special Commission to comprehensively review expenditure entitlements and earmarked revenues and recommend changes. 9. Borrower has approved a Constitutional reform that restores budget powers to the borrower's Executive Branch, or Government has 16 Diario Oficial, Decree 099, January 20, 2003, Article 42 7 CONPES document 71 Annex III M -- : -: ... - AnnexY I: PolicY-Matrix -',_ _ _ First Loan Second Loan ~~~~~~~~~Third loan F ourth Loan -~ ey E%pce (Prior Actions) (FY04) (FY05) (FY0.) Res.,ta t th end - v- (FY0) .( oYF4AL submitted to Congress amendments to the organic budget law permitting greater flexibility in annual spending within present constitutional frameworL* Development of Incentives for Efficiency.Gains PoUic Objective: Ensure that spending for service delivery is realized with greater efficiency, effectiveness and within budget constraints. A step toward elimination of transfer rigidity and management forresults. Responsible Government Agencies: Presidency, MHCP, Ministry of Education 5. Royalty transfer: borrower has 10. Borrower has submitted I11. Government is fully INSTTTIMONAL enacted law to enable to popular vote the provision applying Law 715 of 2002 on RESULTS constitutional referendum for of the Referendum that I capitation transfer and is . transfer of royalties for reallocates royalty transfers auditing and applying sanctions I) Government has educational services.'8 for educational services.* to sub national governments that effectively - commit fraud with respect to transformed supply- 11. Government has number of students enrolled based transfer for established eligibility education into a requirements for sub-national demand-based governments to access capitalization transfer additional resources for and, education at sub-national ii)subnational levels. Eligibility governments have repnUfferntsernrheludpe nmng fu! ! y assu a others, restructuring of sub- responsibility for national Secretary of delivering education Education, enhanced capacity services as reflected is Ley 796 of January 21, 2003, Diario Oficial 72 Annex 111 'Annex m: Policy Matirix First Loan ; . Second Loan Third Loan Fourth Loain Key Expectd; _;-,(PriorActions) -(FY04) (FYOS) (FY06) Results.atthee (FY03) ~~~~~~(Y0)Of F for human resources in indicators such as: management at and co- a) capacity to financing of education reallocate teachers, b) expenditures at competent capacity to enforce sub-national level. teachers' attendance and other teacher performance indicators, c) co- financing commitments, and d) publication of local or regional improvement goals in standardized national tests. Defending the State against the Extraordinary Growth of Legal Claims Policy Obiective: Improve the capacity of the state to reduce and respond to legal claims and diminish their fiscal cost. Responsible Government Agency: Ministry of Justice through Direccion General de Defensa Judicial 6. Borrower has promulgated Law 12. Borrower has issued a 12. Government has established 9. Government is INSTITUTIONAL 790 of 2002'9 that grants authority CONPES document a public monitoring, information implementing the new policy RESULTS to central government for establishing the new policy and reporting system that for legal defense of the state Present value of strengthening the Direccion de for legal defense of the state, includes performance and result and is publishing semi-annual judicial contingency Defensa Judicial del Ministerio including legal reform if indicators and expected fiscal reports on performance and debt has been del Interior y de Jusdcia with the necessary. * impact for the legal defense of results indicators, including reduced with respect purpose of: i) limniting the state's the state. expected fiscal impact, of the to the value of 2003. civil liability through improved legal protection policy 19 Article 15 of Law 790 of 2002. 73 Annex III '- ,-';,- Annex -ml. PolicyMatrix ____-_________ First ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ U Lon- eodLanTidLa , orhLa 'Key 'E,pected -'(Prior A&,ons) . (FY4> (FY05) ' l t th e . . ,,( , ,,03) - 1< ,,.. of FIAL. policy formulation and coordination, ii) seeking indemnification from borrower's civil servants who act with gross negligence and bad faith, iii) professionalizing judicial defense of the state. Strengthening Public Sector Procurement Polkv Obiective: Ensure that government purchases are'transparent and efficient. Responsible Government Agencyi -DNP 7. Government has issued Decree 13. Borrower issued CONPES 13. Borrower has began the 10. Borrower has issued the INSTITUTONAL 2170 dated September 30, 2002 document that: a) dictates the iopratior. of the govern.ent I -egulaatory decrees f.or thc RESULTS that strengthens transparency and principles that apply to agency responsible for implementaion of the new i) The country's legal objectivity in pubfic sector goverment procurement, b) monitoring, evaluating, and procurement legal framework. framework for procurement. recommends the creation of a establishing common guidelines procurement has new agency or the assignment in public sector procurement been reformed 8. Bill of Law 018/2002 to an existing agency of public matters. been guided modifying current public sector sector procurement following guidelines procurement legal framework in responsibilities, and c) defines agreed between the consideration by borrower's a strategy for developing and Government and the Congress. implementing e-procurement. Bank, including guidelines such as: a) I'. . LA ro measures to enhance A' Orower bas proposedtanprncun to Congress modifications to transparency and the legal bill amending Law objectivity, and b) 80 that incorporate the assignment of recommendations of monitoring and CONPES, emphasizing: a) evaluation common principles for responsibility in 74 Annex lll Annex m: PolicyMatr-ix First Loan Second Loan Third Loan Fourth Loan ;Key Expected (Prior Actions)(FY04) (FY05) (FY06) Results at the end (FY03) ~~~~~~~~~~~~~~~~~~~~~of FLAL -¢:(FY03) .. -. public sector procurement; procurement policy b) introduction of economic to a competent considerations into the agency; ii) advances procurement process; and c) in coverage of e- institutional framework for procurement. public sector procurement.* Asset Management Policy Obiective: Increase the value of assets owned by the state, generate additional revenue by liquidating those that are not directly linked to service delivery, reduce replacement and restoration costs, and eliminate opportunities for corruption Responsible Government Agency: DNP 9. Government has created a 15. Borrower has issued 14. Government has submitted 11. Asset registration, INSTlTUTIONAL Conmmission for Asset CONPES document that to congress law reform proposal including updated valuation, RESULTS Management charged with defines basic principles and to authorize and facilitate new has been completed for 100% i) The state has preparation of draft government establishes strategic plan for asset management. of the assets listed by the institutionalised policy, defined the scope of work Asset Management. 15. Titling has been regularized Contadurfa Nacional mohanisms to and an operational plan to define for at least 100 real estate assets 12. Asset management monitor, evaluate, accounting systems and 16. Short term Asset 16. Short term Asset program has produced of public assets, and invntoi cagencies. Management program has Management program has cumulative revenues for at ii) the state has produced revenues or produced cumulative revenues least 175,000 million received accumulated savings equivalent to at least or savings for at least 51,000 Colombian pesos of 2002. revenues for asset 27,000 million Colombian million Colombian pesos of 13. Inventory of government management pesos of 2002.** 2002. assets is completed and equivalent to at least published for all ministries US$70 million. 20 DNP memorandum conforming Commission 75 Annex III First Ia I. S Third Loan -Y.Fort Loan . E ecd (Prior Actions) (FY04)V ( R t a th end --Y06) (FY03) - o --AL Management Contracts for Government Agencies Poliy Object ive: Enhance the efficiency and financial self-sufficiency of government agencies. Responsible GovernmentAgencies: DNP, Ministry of Labor and Social Security - 10. Government has selected two 17. Central government has 17. Government has published, 14. Government has adjusted Participating government agencies21 for pilot signed management pilot monitored and adjusted and extended management agencies are management contracts 2003-2006 contracts with two performance and results contracts to at least 6 performing better and government agencies. * indicators for two government government agencies. reaching results agencies, according to indicators such as reduced dependency on fiscal transfers, higher coverage, and increased customer satisfaction. Management of the Public Sector Reform Process Policv Obiective: Promote policy and technical coordination for the successful application of reforms within a framework of strengthened governance, accountability and policy;sustainability. - Responsible Government Agency: DNP. - 11. Borrower has: i) published its 18. Borrower has issued 18. Base line and progress 15. Base line and progress INSTITUTIONAL strategy of state reformb , ii) CONPES document for indicators for monitoring indicators for monitoring RESULTS 21 Organismos administrativos. The two selected agencies are ICBF and SENA. ** Judgment will be exercised to verify satisfaction of this requirement. 22 Direcnva Presidencial Nos. 10, 12, and 13 of 2002. 76 Annex III Annex I: Policy Matrix . First Loan -'Second Loan -Third.Loan Fourth Loan Key Expected (Prior Actions) (FY04) (FYOS) (FY06) Results at the end - . (FY03)~ - ~ 4 - . . .......... .. . A - . . .-of F.AL established a high level government policy on state progress and final goals of the progress and final goals of the i) Reform has been commission for state reform23 and reform reform are applied to the reforms reform are applied to the widely consulted a task team for technical 19. Borrower bas developed a achieved during 2003 and are reforms achieved during 2004 within public and coordination; iii) formed task system for monitoring and disseminated countrywide. and are disseminated private sectors, and teams in each participating evaluation of state reform and countrywide. ii) reform process is agency with coordination has atnounced monitoring proceeding on mechanism with DNP24, and iv) indicators for public sector schedule. developed a concept for public reform progress in the web marketing of public sector page of the DNP and other reform.' means. III. FISCAL RESPONSIBILITY Fiscal Responsibility. PoiUcy Obiectives: Reduce fiscal imbalances. Responsible Government Agency: MHCP 12. The borrower has subnmtted to 20. Borrower has approved 19. Borrower has: a) disclosed 16. Borrower has: a) disclosed FISCAL RESULTS congress draft law for fiscal a rfl responsibility law, fiscal targets for 2004 in fiscal targets for 2005 in i) Government has responsibility. 26 that contains, at a minimum, accordance with the new law of accordance with the new law enacted measures for rules for: a) setting fiscal fiscal responsibility, and b) of fiscal responsibility, and b) signaling and targets linked to debt submitted reports to congress of submitted reports to congress disclosing fiscal sustsinability and primary fiscal results of 2003. of fiscal results of 2004. targets, and ii) balance for the NFPS, b) Central Government annual reports of fiscal I_ rniiPr in oni 23 Minutes of some of the meetings of the high level commission for renovation of the state. 24 PNUD Document; DNP Circular 530 and 582, 2002; letters from the ministries appointing responsible persons for coordination with DNP 25 DNP Document 26 Gaceta of Congress with approval in second debate. 77 Annex III ____-____ .<_x_ - Annes ml:. P.olcy.Mati - . . . x. e - C Fir."._'''st Loan ~ ASecond Loan Fourth "oa 'e;Ep. . (Por Aoction) .FY Y - os Rs at of FIAL_ v ;(FY03) a v ; a|- - results to congress, including is collecting and floating debt, c) publication publishing reliable of the riancial plan that will fiscal sustainability include, among others, data for the 50 largest information on floating and subnational contingency debt, and d) tde governments obligation to include the according to fiscal impact and source of indicators defined in funancing within any law the proposed bill for that creates new tax a fiscal responsibility expenditures.** law and Law 617 of 2000. Conditions in bold are triggers for moving to the second operation. The triggers for the third and fourth operations will be drawn from the government's program (see Section II of this report) and, in particular, the set of expected key reform measures set out in this Policy Matrix. 78 0 0 V C* D _~ _ M _n Co 0 r4 CD o d4 0 n - aD .0 ° A a N ; < fl f . g 8 0 N R R ° 8 8 6 ^ S n 0 n n n s R S4 N a n ~ o CO 8b+Xn - O s t ffi X X ;E ° ~~~~~~~~~~~~~2 K: S _1 sro l o 0f m P; o !aqn0anm9 2 A. co r ,S,l il 1t;nS§1tBil tg i i j Z E E 3g | * D l} ; ffi g g ffi i 3 i 3 | ~~~Z Z i- |, |n X z1 s s 8~~~~~~L tr 9: CD iooco_ 1 - O :81fio5 S 18s su11k 896 oim g f~~~~~~5 P s~~~~~~~~C n & ti co 0 c X o R) t .a>f 00~~~~~~~~~~~~~~~0 _3tDL O~~~~~~~~~ 0 < Appendix I APPENDIX I Institutions for Fiscal Responsibility 1. Experience in a variety of countries, including those with explicit fiscal responsibility laws, shows that good maintenance of fiscal sustainability with democratic governments at more than one level requires a net work of institutional checks and balances; no one law or agency can bring about the necessary discipline. Whatever the benefits a Fiscal Responsibility Law, they come from its complementary relationship with other laws and institutions; it cannot be evaluated in isolation. 2. In Colombia, the Constitution, budgeting and treasury rules, and the Central Bank have been the main formal instruments of national-level control. Until recently, the Constitution and legal rules for budgeting and treasury have done little to restrain central government deficits and debt, and in some ways they encouraged it, such as by the vigencias futuras that make commitment for future expenditure and by the allowance for arrears that made ad hoc promises for future payment of present expenditures. The two pillars of fiscal prudence, for which Colombia earned a good reputation until the mid- 1990s were, first, the power sharing (really alternation in power) between the two traditional parties that concurred on the virtue of fiscal stability and, second, the prestige and relative autonomy of the Central Bank. The former acted as an ex ante limit, while the autonomy of the Central Bank mainly imposed an ex post sanction through tighter money if deficits became excessive. Both of these pillars relied to a large extent on discretion of the policymakers, although some legal limits on Central Bank credit to the government were non-discretionary. In the 1990s, the new Constitution broadened political participation, increased spending impulses, and weakened the tax base of the national government (automatically sharing it with subnational governments), all of which weakened the fiscal prudence of the government. The Acto Legislativo (constitutional amendment) of 2001 sought to put ex ante limits on some of the spending impulse coming from transfer to subnational governments. There has not been time to assess the effects of this change.' 3. Now the Colombian government has proposed a Fiscal Responsibility Law to reinforce the other institutions for fiscal restraint and to provide a framework for the reforms to the budget-management process that are planned for the next two years. Experience elsewhere, most dramatically in Argentina, shows that the rules for subnational fiscal discipline become irrelevant and even absurd if fiscal discipline breaks down at the national level. To this end, the FRL will specify process for setting budget targets and linking them to target ranges for debts and deficits. Regulations for the law will build on the current practice of publishing quarterly fiscal results, defining deficits on the basis of cash revenue and accrual of spending obligations, and defining debt to include floating debt. The FRL will set a target to eliminate reservas presupuestales in I This point is closely linked with the contractualization of education results. As the main source of ever increasing transfers to subnational governments, the growth of the education payroll needs to be restricted through a combination of constitutional ceilings on transfers and effectively submitting salary to teacher performance and school results. 81 Appendix I two years. The other part of floating debt, cuentas por pagar, will be counted as regular debt and will thus be controlled by the fiscal/financial plan. To help with fiscal discipline at all levels, the FRL will complement the Acto Legislativo 2001 and will prohibit the national government from lending to an SNG or guaranteeing its debt if it is in violation of Ley 617 of 2000 or Ley 357of 1997 (the traffic-light law) or is in arrears on any debt service to the national government, Indeed, a subnational government with those fiscal violations may not legally borrow from anyone. To discourage electoral cycles in fiscal policy, the FRL will also prohibit any government from approving future spending (vigencias futuras) or increasing personnel spending, by hiring or wage increases, after January 1 of an election year. For the subnational governments there are additional restraints on deficits: eliminating the intermediate category in Ley 357 (thus putting tight fiscal restraints immediately on SNGs that show signs of problems), and requiring that departments and large municipalities get satisfactory credit ratings from international rating agencies before they borrow. While some of these legal measures need further refinement, such as through their regulations, they will represent important advances as long as they are enforced well. 4. The strategy for fiscal control in the FRL differs between the national and subnational levels, because of the different constitutional constraints they face on fiscal policy. The Constitution (and debt obligations) specifies almost all outlays for the national government, to which taxes and deficits adjust. Therefore, for the national govemment, the FRL focuses on limiting the deficits so that the adjustment will have to concentrate on the tax side and thus eventually motivate political restraint on spending. For the subnational govemments, on the other hand, the Constitution specifies most of their revenue, via transfers, and gives them little leeway to raise more own revenue, so the FRL strengthens the restraints on subnational deficits to complement the direct restraints on subnational spending, mostly in Ley 617. 5. Experiences with fiscal control efforts elsewhere in Latin America show the importance and promise of Colombia's efforts. Brazil also passed a FRI, in 2000 which, as in Colombia, adds to the mix of laws and policies that aim to increase fiscal control at national and subnational level. It seems to be having a favorable effect, although many more years of experience will be need to reach a firm conclusion. The Brazilian FRL sets minimum standards for federal, state, and municipal budgeting, personnel management, and debt management. The annual budgets of the federal and state governments have to be consistent with their multiyear budget plans and with the federal fiscal and monetary program. The FRL systematizes and reinforces the restrictions on personnel spending, deficits and debt that were in the debt-rescheduling agreements with states and in other earlier measures. The law sets limits to spending and borrowing decisions and reiterates the requirement in other legislation that the federal government deduct from tax-sharing participation transfers any money owed by an SNG to the federal government and agencies. Debt and labor contracts in violation of the FRL are not legally valid, which would impose a penalty on any lender to an ineligible government, especially at the subnational level. The Brazilian FRL came after a lot of public discussion and consensus building in its favor, which suggests that Colombia should have a similar public- information campaign to convince people of the benefits of the new law. Although Mexico does not have a fiscal responsibility law per se, it does have a regime for 82 Appendix I promoting fiscal restraint that has proven effective, especially since the reforms for SNGs in 1999-2000. One feature of the Mexican system, using market-based credit ratings to determine the eligibility of SNGs to borrow, was specifically adopted in Colombia. Mexico also issued regulations in June 2002 that institutionalized improved federal budgeting and deficit control procedures, some that had been in practice since 2001 and some that are being implemented with the 2003 budget cycle. In Both Brazil and Mexico, the latest measures to institutionalize fiscal responsibility were preceded by several years of actual fiscal policy changes to bring down deficits. That Colombia does not have such a running start on fiscal reform means that the government will need to make extra efforts to improve actual balances, and not to rely solely on the FRL as an auto-pilot that would now guide them to a safe landing. 83 Appendix 11 APPENDIX II Tax Policy Reform in Colombia: Challenges and Achievements 1. Tax policy in Colombia has changed a number of times in recent years, occasionally for the better, such as in the reforms of 2002. To tnderstand those reforms in their context, this appendix looks at the tax policy prior to December 2002 and evaluates the new law relative to the prior situation. 2. Colombia has a set of taxes at the national level that are typical in middle and upper income countries-value added, corporate and personal income, import duties (not discussed here nor touched in the 2002 reform), and excises. Municipal taxation is mostly from the property tax and fees. Department taxation is the weakest, focusing on alcohol and lotteries. 3. Three general principles should guide the choice of reforms, in addition to the objective of raising revenue. First, social concerns about the equity of the income distribution in Colombia should be addressed primarily through expenditure policy, and secondarily through appropriate adjustments in the progressivity of the individual income tax, with all other aspects of tax policy focused on raising revenue, improving' economic efficiency and neutrality, and reducing administrative complexity. Second, the tax system should be as neutral as possible with respect to both production and consumption decisions, in order to leave the best incentives for efficient growth and consumption. This means broadening the base rather than raising rates, which is especially important now due to the weakness of growth and investment in Colombia. Third, reforms should simplify tax compliance, administration, and enforcement of the tax system, in order to free up scarce administrative and managerial skills for productive uses, rather than coping with an unduly complex tax system. Value Added Tax 4. Diagnosis and Challenges. Colombia was one of the first Latin American countries to adopt a consumption-based value added tax (VAT) (in 1965), a tax now used in 120 countries. Under an ideal consumption-based, destination-based VAT, all domestically consumed consumer goods and services (including imports) should be subject to a uniform tax rate, with at most a very few exemptions or zero-rated goods. VAT paid on all capital goods should be fully credited under the invoice-credit system, so that tax pyramiding (multiple layers of tax attributable to taxation of inputs and final outputs) is avoided; taxation of business inputs, including capital goods, is highly undesirable because it creates inefficient incentives for under-using capital goods and for verticad integration (to avoid the tax by providing otherwise taxable goods and services in-house) and, to the extent shifted forward as higher commodity prices, distorts consumer The goal for Colombia's income tax is neutrality within that context, for income taxes are inherently not neutral between consumption and investment. 84 Appendix 11 purchasing decisions. Finally, all exports should be zero-rated to ensure that the tax is assessed on a destination basis. 5. The VAT in Colombia falls far short of this ideal; it has a large number of exemptions to its base; there is an "implicit" VAT charged on certain imports; many nonexport goods are zero-rated, some goods are taxed at preferential rates while others are taxed at luxury rates, and capital goods are not fully credited against subsequent VAT liability. As a result, the yield on the VAT is low relative to all personal consumption.2 6. Government Program. The government passed a new tax law in December 2002, effective in 2003, which includes important reforms to the income tax and the VAT. Reforms to the VAT will expand the base to cover a number of products and services that were previously not taxed, but will now be taxed at a lower rate. Most new items will be taxed at 7 percent starting in 2003 and then a 10 percent in 2005 and thereafter. Although moving all products to a uniform rate would be the ideal (perhaps reducing the standard rate somewhat from its current 16%), it is an important achievement to establish the principle of expanding the base. The new goods taxed at 7% include work horses and mules, coffee, most grains, sugar, cocoa, pasta, baked goods other than bread, tobacco, coal, cotton fiber, air pumps, refrigeration equipment, dairy processing equipment, original art work and matches. The newly taxed services include security services, insurance and pre- paid plans for health care, social and health clubs, tourist hotel services, and financial brokerage commissions. On mobile phone services the tax will be 20%. On automobiles, the rates that ranged from 20% to 35% will be gradually unified to 25% by 2005. There are also some goods and services that will be taxed at 2%, starting with only live meat animals in 2002 and broadening in 2005. The reforms will also eliminate implicit VAT on imports, which is a source of complexity and favoritism, and rationalize the treatment of capital goods. The reform will collect the VAT on all capital goods, with a three-year rebate or credit for registered firms making further sales (the rebate will be phased in with 50 percent rebated in the year of purchase and 25 percent in each of the next two years). Although this has some fiscal cost, it will largely eliminate a bias against investments in capital equipment. Personal Income Tax 7. Diagnosis and Challenge. The personal income tax in Colombia is a highly progressive tax that applies solely to higher-income individuals and from a social equity viewpoint should be viewed as a supplement to the two broad-based taxes on wages and consumption, the payroll taxes (discussed below) and the VAT. The tax adds some progressivity to the tax system, because it applies only to the higher-income individuals (above three times average per capita income) who 2 The ratio of VAT collections to national consumption is less than half of the standard rate of 16 percent, even though some problematic features of Colombia's VAT, like the implicit VAT, do raise some extra revenue 85 Appendix H have the capacity to pay the tax and to cope with the complexity of filing a personal tax return. Limiting the personal income tax to higher-income individuals also facilitates administration by allowing the tax authorities to focus all of their administrative and enforcement efforts where the revenue yield is greatest. Administration and enforcement are also facilitated by raising as much revenue as possible through withholding nearly 90 percent of revenues at source, and by choosing a tax structure (for example, taxing on an individual basis with few exemptions or deductions) that is conducive to accurate withholding so that filing can be optional. The personal income tax exempts dividends and capital gains from corporate holding, to avoid double taxation of profits. 8. Still the tax has some problems, the most important being that 30 percent of all wages and salaries are exempt. This undercuts the progressivity of the tax, and of course reduces revenue. Other less urgent issues are that there are differing definitions of taxable (and deductible) salaries in the personal and corporate income tax and the payroll taxes (including social security) have and that the minimum tax rate and minimum income subject to tax is relatively high (steps are 20, 29, and 35 percent, starting at about three times per capita income). 9. Government Program. The 2002 reforms to the personal income tax the government addressed the 30 percent exemption of wages, by reducing the exemption to 25% and limiting it to a ceiling of 4 million pesos per month of income, equivalent to US$1,200 monthly. A further improvement, for future years, would substitute a smaller, uniform exemption, which would be more consistent with international practice and make it easier to achieve equity goals, especially given the proposed expansion of the VAT base. It would also facilitate administration, as a larger 'number of taxpayers could simply be exempt from tax and not required to file a return. The 2002 reform also addressed the problem of tax exempt compensation to workers, via a change in the corporate tax rules, saying that firms may no longer claim any deduction for any labor cost that is not reported in the tax base for withholding taxes from the employees. This effectively puts a tight limit (and should virtually eliminate) tax exempt compensation to workers. Corporate Income Tax 10. Diagnosis and Challenges. The business income tax in Colombia applies to all forms of businesses, including corporations, limited liability companies, and partnerships, and does not double tax the passage of profits in dividends to individuals. It thus avoids the distortions of business organizational form that plague tax systems in other countries. Nevertheless, there are numerous distortions in the business tax, particularly sectoral preferences and some excessive depreciation rates. 11. The Colombian business tax is characterized by numerous sectoral preferences. These distort the allocation of resources, increase the complexity of the tax system, and create opportunities for tax avoidance. Accordingly, they should be 86 Appendix II eliminated from the tax system. Examples of preferences that should be eliminated include the tax exemption for publishing firms, liquor producers, livestock producers, firms investing in "privileged" locations such as the Paez River region or regions of other natural disasters or tax-free zones, certain types of cooperatives, public service enterprises (water, sewerage, electricity, telephones, and gas), and investment funds organized by financial institutions.3 To preserve the credibility of tax policy in the eye of investors, there probably should be a transition regime. 12. The corporate tax also includes a complex subsidy for employment generation, designed to encourage employment and raise the net wages of low-income workers. The program increases administrative difficulties and has a high revenue cost per job, as is typical, because such programs create incentives for employee turnover as firms attempt to qualify for the credit. Finally, given the large supply elasticity of unskilled labor from the informal sector, any effect of a jobs credit may be simply to shift employment between sectors-from the uncovered to the privileged covered sector-without raising net wages in the long run. 13. The rate of the corporate tax is high by international standards, especially considering the need to attract foreign investment. Also, the government is putting a temporary surcharge of 10 percent on the CIT, for one year. 14. Government Program. Reforms to the corporate income tax, passed in December 2002, will phase out exemptions for capital gains from sales of stock, mutual funds and real estate and for profits from a variety of previously privileged corporate forms that often served as tax shelters, including community enterprises, small and hydro-electric power generating enterprises, contracts and mortgages enforce in Oct 1974, cattle investment funds, empresas asociativas de trabajo, and bonds from the agrarian and urban reforms of 1988 and 1989. The phase-out would reduce the exemptions to 70% in 2003, 50% in 2004, 20% in 2005, and 0% in 2006. Access to the special tax regime (at a 20% rate rather than the standard 35%) was tightened, now to include cooperatives providing education and health services only if they are formally approved by the Ministry of Education or Health, respectively. These personal and corporate income tax reforms will help raise more revenue in the most economically efficient way possible, by broadening the base and removing policies that distorted incentives for choices in production and investment. The government also refrained from imposing a surcharge of ten percent on corporate taxes, which was widely discussed but which would have hurt the attractiveness of Colombia as a destination for international investment and would have increased the distortion of incentives in the tax regime, especially if the surcharge had been used as a substitute for eliminating exemptions. 3 In addition, nonprofit organizations should be subject to the business income tax on any activities not directly related to the purpose for which they are granted nonprofit status. 87 Appendix II Other National Taxes and Contributions 15. Payroll. The wage and payroll deductions for parafiscales, when combined with other payroll taxes related to health and pension plans and separation payments, impose a tax wedge of roughly 50 percent between labor earnings and the cost to employers, which is high in an absolute sense and in comparison to other countries. The three main programs to which they go have several problems, including their (in)effectiveness and the fact that they start taxing the first peso earned. All three of the programs funded by the parafiscales are intended to be redistributive in nature, so it is anomalous to finance them with payroll taxes that most heavily impact the poor, which in effect mostly just redistributes income within the lower-income classes. The programs should be evaluated carefully to see whether they are successfully meeting their goals and, if not, should be eliminated or significantly reduced in size. 16. Financial Transactions. In 1999, under pressure to raise more revenue, the government introduced a tax of 0.3 percent on each bank-account debit. Although it has served as a temporary source of revenue- and does tax some parts of the illicit economy that would otherwise escape taxation, the tax has some serious disadvantages: It discourages financial intermediation and financial transactions and this limits the growth of the financial sector and indirectly the growth of the economy. It gives rise to tax pyramiding for goods that require multiple transactions subject to tax during the process of production, distribution and final sales, and thus distorts production and consumption decisions. It encourages inefficient vertical integration designed solely to avoid the tax. It can easily be avoided by shifting transactions offshore or engaging in financial transactions outside the banking system (e.g., cash, non-bank financial instruments, and multiple endorsements on checks) and is thus a difficult tax to enforce properly. Although the government could not afford the fiscal cost of eliminating the tax, the tax law of December 2002 does close some loopholes previously available for transactions in the real economy and allows exemptions for some inter-bank financial transactions that do not represent real transactions in good and services, which is the intended base of the tax. Subnational Taxes 17. Diagnosis and Challenge. While the municipalities have the property tax (predial) and a turnover tax on industry and commerce, the departments have little tax power at their disposal, mainly excises and vehicle fees. There are a number of problems with the taxes at both levels. In most localities, the taxes are badly distorted by both national law and local administration. For example, national law specifies many exemptions to the turnover tax and the predial, favoring special interests. Also, municipalities with the turnover tax are in conflict over where firms should pay it when production and sales are in different 88 Appendix 11 places. Liquor and cigarette taxes for the departments are specified in a complex way, making them hard to enforce and easy to evade. 18. Government Program. The tax reform will include a rationalization of departmental and district taxes on alcoholic drinks. As prepared by the previous administration and supported by the 2001 SFAL project, this rationalization will ensure convergence of tax rates to avoid distortions and smuggling. The tax reform will also include elimination of the income tax credit for municipal taxes other than the turnover tax. Besides, the tax reform will increase by 5 percentage points the gasoline tax surcharge which is transferred to subnational governments. 19. Although it will not act on this immediately, the government intends to strengthen the subnational tax system, particularly to rationalize the tax system of territorial entities (Estatuto de Ingresos Territoriales) and help them strengthen enforcement. The contemplated revisions include measures to regulate (a) the basic principles and rules for all departmental, district, and municipal revenues, including taxes, fees, and special contributions; (b) the distribution of tax revenues by level of government; (c) the tax base and tax rates (or delegation to subnational entities) for liquor, beer, and tobacco excises, vehicle taxation, property tax, and industry and commerce tax, valorization contribution, and participation in surplus value of real estate; (d) penalties for noncompliance by taxpayers or beneficiaries; and (e) tax procedures. In addition to benefiting subnational governments, the proposed reforms would help the central government because increases in subnational revenues would decrease pressure for more transfers and bailouts. 89 MAP SECTION IBRD 31251 780 -7. e a rib b ea*n ~~~ ~~~ ~COLOMBIA sea X j .. ' , ' :ATW* -80 ~ ~ ~ ~~~~~ )" /J/ O D B A A T NgR eon tcbsceololnenmuni6-Sn R~~~~~~~atg~ Vu erpo / iXv w\ +cctj op;ldmt;lr,rn ~' cEs iiror.cob 'R PANXAMA Ei R U PA ClFIC CHOCOA, = - O C EAN ? J ) DlAC YCUNDINAR lue1o * CA S AN A RE/ COLOMBIA~~~~~~~~~~~~~~~~~~~~~~~BOII S Deote Co a AMAZ( ONAS CH DA PERU 780; 74 * 70a