How to improve public sector finances in Honduras

F olicy, Planning, and Research WORKING PAPERS Country Operations Latin America and the Caribbean Country Department 11 The World Bank November 1989 WPS 309 How to Improve Public Sector Finances in Honduras Yalcin M. Baran The Honduran government should develop a plan to modernize administration of the public sector, increase public sector sav- ings, ensure the financial viability of the national electric com- pany, and improve the public investment program. The Policy, Planning, and Research Complex disttibutes PPR Working Papers to disseminate the findings of work in progress and to encourage the exchange of ideas among Bank staff and aU others interested in development issues. These papers carry the names of the authors. reflect only their views, and should be used and cited accordingly. The findings, interpretations, and conclusions are the authors'own. They should not be attributed to the World Bank, iLs Board of Directois, its management, or any of its member counties.  Plc,Planning, and Research | Country Operations I The objectives of a public sector management * Establish financial targets for, and reduce program should be to use resources more govemment transfers to, public enterprises. efficiently, rationalize public sector operations, and reduce financial disequilibrium. * Improve service delivery. Baran recommends that Honduran authori- ties prepare an action plan for improving public * Implement a well-defined privatization pro- sector management. That plan should include gram. measures to: * Prepare and implen- nt a growth-oriented * Increase savings. and financially feasible public investment pro- gram. * Introduce efficiency-saving measures. * Improve dlecisionmaking and increase a~c- * Improve budgeting, debt management, and countability and autonomy in public enterprises. tax collection. * Improve coordination of the sector. - Standardize accounting practices and prop- erly account for debt service obligations. * Target subsidies. * Start external management audits of enter- * Produce better financial information on the prises. public sector. This paper is a product of the Country Operations Division, Latin America and the Caribbean Department II. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Tipawan Watana, room 18-155, extension 31882 (35 pages with tables). The PPR Working Paper Series disseminates the findings of work under way in the Bank's Policy, Planning, and Research Complex. An objective of the series is to get these findings out quickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official policy of the Bank. Produced at the PPR Dissemination Center  TABLE OF CONTENT. I. * INTRODUCTION ...................................................... 1 A. Background ....................................................1 B. Impact of Macro Developments on Public Sector Finances ........2 II. Public Sector Finances ............................................ 2 A. The Tax System ............................................ .. 2 A.1 Income Tax ............................................. 4 A.2 Property Taxes . . ....................................... 4 A.3 Sales Tax .............................................. 4 A.4 Excise Taxes , ....... 5 A.5 Taxes on Imports . . ..................................... 5 A .6 Export Taxes ........................................... 8 A.7 Petroleum Differential Tax . . . 8 A.8 Tax Administration . . ................................... 9 A.9 Customs ............................................. 9 A.10 Overall Conclusions on the Tax System .. 9 B. Central Government Expenditures . . . 10 B.1 Introduction .......................................... 10 B.2 Education Expenditures ................................ 12 B.3 Health Expenditures ................................... 13 C. Central Government Finances ................................ 13 D. Financing of the Central Government Deficit ................ 14 E. Budget for 1988 ............................................ 16 F. Public Investment Program .................................. 18 F.1 Public Investment Expenditures ........................ 18 F.2 Public Investment Program for 1987-90 ................. 19 F.3 The Institutional Framework for the Preparation of Public Investment Programs ............................ 21 G. Public Sector Enterprises ............................ ..... 22 G.1 Introduction .......................................... 22 G.2 Institutional Links among the Central Govtrnment and Public Sector Enterprises ............................. 24 G.3 Privatization ..25 G.4 National Electric Energy Company (ENEE) . 26 G.5 National Agricultural Development Bank (BANADESA) ..... 27 G.6 National Industrial Development Corporation (CONADI)..27 G.7 Honduran Telecommunications Company (HONDUTEL) ........ 28 G.8 National Water and Sewerage Service Company (SANAA) ... 28 G.9 National Port Authority (ENP) ......................... 29 G.10 National Railway of Honduras (FNH) .................... 30 G.ll Honduras Agricultural Marketing Institute (IHMA) .. 30  TABLE OF CONTENTS (CONTINUED) G.12 National Food Marketing Agency (BANASUPRO) ............ 31 G.13 Honduran Forestry Development Corporation (COHDEFOR) and Honduran Banana Corporation (COHBANA) ............. 31 G.14 Honduran Coffee Institute (IHCAFE) .................... 32 G.15 National Agrarian Institute (INA) . . 32 G.16 Central Bank ..33 H. Overall Conclusions .33 H.1 The Main Thrust of a Propsed Action Program ........... 33 H.2 Proposed Package of Measures to Reduce the Fiscal Deficit ..... 34 H.3 Risks of The Suggested Package of Measures .. 34 H.4 Conclusion ............................................ 35 Tables Table 1 Central Government Current Revenues, 1982-87 ............3 Table 2 Rate of Value Added Taxes by Selected Countries, 1987...4 Table 3 Parameters for the New Tariff Regime, 1987 ..............6 Table 4 Rates of Surcharges, 1988 ............................... 6 Table 5 Central Government Expenditures by Function, 1981-87 ... 10 Table 6 Central Government Current Transfers to the Rest of the Public Sector, 1984-86 ............................. 11 Table 7 Central Government Capital Transfers to the Rest of the Public Sector, 1984-86 ............................. 12 Table 8 Central Government Finances, 1981-87 ................... 14 Table 9 Debt Stock of the Public Sector, 1984-86 ............... 15 Table 10 Banking System Financing of the Public Sector, As End of Year, 1983-87 ................................ 16 Table 11 Budgeted Expenditures by Sector, 1988 .................. 1? Table 12 Public Sector Investment Expenditures, 1981-87 ......... 19 Table 13 Planned Investment Program by Sector, Share of Ongoing and New Projects In Investment Program, 1987-90 .20 Table 14 Finances of Public Sector Enterprises, 1981-87 .23  I. INTRODUCTION 1. This Memorandum presents a comprehensive policy program to improve public finances in Honduras.1 In view of the administrative limitations, the implementation of the proposed program would need to be phased over time and a timetable has to be developed for its execution. This report does not propose a timetable for execution of the proposed program, but recommends that such a program be developed in a follow-up report. The report presents both a short-term action plan to reduce the public sector deficit as well as a medium-term program to improve public finances. The report discusses issues and makes suggestions regarding taxes, expenditures, including the public investment program, and major public sector enterprises. A. Backaround 2. Honduras is a poor country. Its per capita income is the second lowest in the Western Hemisphere and very close to subsistence levels. Malnutrition is severe. The literacy rate is less than 60Z. About half the population is without safe water and three quarters of the households are without access to sanitary waste facilities and electricity. 3. The country has also been facing a major external and internal macro disequilibria since 1980. The deficit in the current account of the balance of payments and the Central Government finances reached about 102 of GDP until 1985. With the completion of the El Cajon hydro-electric project, the overall public sector deficit fell in 1987 to 5S of GDP on a cash basis. Public savings amounted to only 0.4Z of GDP. Large USAID transfers and disbursements for the El Cajon project financed a large part of the deficits in the public sector as well as the current account of the balance of payments until the last several years. 4. The macro disequilibria worsened in 1987. With external financing tied to El Cajon no longer available and net external transfers abroad averaging 2Z of GDP, monetary aggregates grew substantially. The monetary expansion put severe pressure on the domestic price level. The expansionary monetary growth, in turn, began to threaten the fixed exchange rate and domestic inflation--kept at very low levels in the past--started to rise, albeit still at a relatively low level of 3-4.51 p.a. 5. In the absence of a substantial further reduction in the public sectur deficit, it is highly unlikely that domestic inflation could be kept to historically low levels. Hence, the maintenance of present policies implies an increased public sector deficit, higher domestic inflation, an enlarged deficit in the current account of the balance of payments and a likely default on external debt obligations. The resulting financial disequilibrium will likely have an adverse effect on domestic economic activity. Furthermore, mounting pressures on the official exchange rate will likely make it virtually impossible to keep the official nominal t/ Public Sector includes the Central Government, public enterprises and municipalities.  -2 exchange rate constant. Since the political costs under this scenario (i.e. owing to high inflation, lower economic activity and high unemployment) will be large, the authorities would likely be tempted to take corrective actions. B. Impact of Macro Developments on Public Sector Finances 6. There is a close association among the macro framework and public sector finances. Macro developments would have an impact on public finances and similarly corrective fiscal measures would have repercussions on macro developments. This report assumes that the authorities introduce a medium-term program to raise economic growth and maintain financial stability. 7. Under one scenario with adjustment measures, favorable macro developments will likely tend to expand public sector savings. High growth in GDP and the recovery of trade volumes would lead to increased public revenues while low domestic inflation would likely reduce the pressure on raising public expenditures. 8. Under the case without adjustment measures, however, macro developments would likely lead to a decrease in public sector savings. Low economic activity and reduced trade volumes would result in a decline of public revenues, while increased domestic inflation would lead to increased pressures on the authorities to expand public programs as a counter- cyclical tool. II. PUBLIC SECTOR FINANCES 9. To confront the issues in public sector finances, the authorities need to define a medium-term program. These actions would be aimed at correcting the present financial disequilibrium as well as addressing public sector management issues. The elements of a proposed program in public finances are described in each section, following a discussion of issues in the sector. The goals of such a program could includes (i) increasing mobilization of fiscal resources; (ii) allocating public resources to high priority uses (i.e. both current and capital expenditures); (iii) eliminating financial disequilibrium, and (iv) improving the efficiency of the provision of services. A. The Tax System 10. The tax system in Honduras is characterized by a dependence on indirect and mainly on trade related taxes (Table 1). Some taxes have specific rates and hence, their base has been eroded through accumulated domestic inflation over the years. Dependence on trade taxes increases the vulnerability of the system to exogenous price swings, leading to fiscal problems as terms of trade deteriorate. The existence of a large number of exemptions also leads to losses of fiscal revenues. As a result, the tax ratio rose only by 0.9 percentage points of GDP in five years to 13.7Z in 1987. This ratio is not high compared to countries at Honduras's level of development.  - 3 - Table lt Central Govornment Curront Revenues. 1982-87 (Millions of t) ^/ 1982 1998 1984 1986 1986 1987 Tax Revenues 716.4 711.0 681.1 986.9 997.1 1,097.1 Direct Tixee 208.2 197.8 241.9 249.4 269.6 297.1 Incom Tax 198.8 190.8 288.9 240.6 250.2 286.7 Property Tax 7.4 7.0 8.0 8.8 8.8 10.4 Indirect Taxes 509.2 618.7 689.4 786.6 788.8 80a.0 Taxes on Domestic Transactions 280.1 226.1 284.7 820.8 828.2 858.6 Tax on production, consumption and sales 211.8 205.7 249.9 278.1 285.5 801.8 Boer 86.9 85.0 48.8 47.7 47.7 60.9 Soft Drinks 10.4 10.1 11.2 12.8 18.1 16.8 Liquors 26.1 28.6 28.8 28.6 28.9 27.2 Petroleum Products 14.6 16.2 17.0 17.0 17.7 19.9 Cigarettes 81.2 26.1 81.8 a8.2 88.7 88.6 Sales Tax 91.6 87.2 116.0 129.2 184.9 148.4 Other Consumption Taxes 1.6 2.8 8.8 6.1 8.5 7.0 Others 18.8 20.4 84.8 47.6 46.7 62.8 Taxes on International Transactions 279.1 287.6 864.7 416.9 410.4 446.4 Imports 178.2 201.5 268.8 816.6 801.1 887.4 Export 98.2 77.8 87.8 92.5 108.4 100.0 Bananas 45.4 84.9 86.8 41.8 88.1 89.6 Coffee 40.8 85.8 42.8 45.8 62.6 62.6 Other* 7.0 7.6 7.7 5.9 4.7 7.8 Others 7.7 8.8 8.6 6.8 6.9 9.0 Non-Tax Revenues 64.7 67.1 68.8 78.2 164.6 171.2 Services 10.2 14.2 18.4 14.6 16.1 16.0 Transfers from rest of the Public Sector 17.0 Ir a 17.8 18.2 18.5 17.1 Qovernmnt Fees, Othor Services 6.7 6.6 7.8 6.8 6.4 6.6 Other Income 11.9 24.2 15.4 21.9 106.8 182.6 Petroleum (-) (12.4) (6.7) (11.1) (90.1) (120.7) Others (11.9) (11.8) (8.7) (10.8) (16.2) (11.9) Other Non-Tax Revenues 8.9 7.2 11.9 17.2 8.8 - CURRENT REVENUES 770.1 778.1 949.6 1,064.1 1,151.7 1,268.t Source: Ministry of Finance, Bank Staff Estimates. 3/ t a lempiras  -4- AlI. Income Tax 11. The income tax gknerates about one-fourth of total tax revenues. This tax has a large number of exemptions. The collection effort for the income tax has been very ws k. The maximum marginal rate is 402 for incomes, exceeding t 10 ml.ion (t - lempiras, US$1 - t 2). 12. Conclusions. In the short-term, the collection effort haa to be intensified, but existing rates should not be increased to avoid a recessionary impact. A.2. Propertv Taxes 13. Collection from this tax has been limited, averaging only 0.81 of total Central Government current revenues in 1987. The tax suffers from outdated valuations, the absence of forceful enforcement and the lack of a cadaster. 14. Conclusions. In view of the lack of a cadaster and of up-to-date valuations, collections can not be expected to increase substantially in the short-term. However, for the longer-term, it is suggested that the Government prepare a cadaster and update valuations with a view to increasing collections. A.3. Sales Tax 15. The sales tax is levied on both domestic and 4.mported goods at a flat 51 rate--except for tobacco, which is taxed at 101. The tax is mostly evaded by store owners, who generally collect the tax from customers but do not pay the Treasury. A 5S tax rate should provide sufficient incentives to intensify collection efforts. However, consideration has to be given to increasing the rate to 71 or perhaps 10? to reduce projected fiscal deficits to sustainable levels in the next several years. Compared to other developing countries, the rate of the tax is low (Table 2). It also has a number of exemptions. Moreover, the Government may set the tax on the basis of the physical characteristics of the establishments that are indicative of their sales volume (e.g. size of store, number of employees). Collection for this tax has averaged less than 22 of GDP or about 121 of Central Government current revenues in the recent past. This compares unfavorably with other developing countries. Table 2: Rate of Volue Added Taxes1/ by Selected Countries2l. 1987 Count-leg 1 Haiti 10.0 Grenada 20.0 Peru 18.0 Bolivia 10.0 Chile ao.o Brazil 1.00 Indonote* 10.0 Madagascar 16.0 Source: IMF. T-ilue added tax or a sales tax. J Only thoso countries with a single rate *re included In the table.  16. Conclusion. It is suggested that the authoritio"s consider increasing the rate of this tax. Depending on the rate of increase--which could vary within a range of 22 to 52--collection for this tax would provide a significant level of revenues. Coupled with an improved tax collection effort, this source could generate a major share of the needed revenues to reduce the fiscal deficit. For the longer-term, it is suggested that the authorities convert this tax into a value added tax, which could provide additional incentives for the private sector to comply. A.4. Excise Taxes 17. These taxes are confined to a small number of commodities, including: beer, soft drinks, liquors, petroleum products and cigarettes. Their rates are mostly specific. With increased domestic inflation, collections from these taxes fell from 2.12 of GDP in 1982 to 1.8S in 1987. 18. Conclusion. It is suggested to convert the outdated excise taxes into selective consumption taxes at ad-valorem rates. Luxury items could be subject ;o higher rates. The product coverage of the tax could also be expanded. The rates under this tax should be the same for goods of both domestic and imported origin. The determination of rates under this tax should also be coordinated closely with suggested changes in import tariffs. Rates could be differentiated within a range. It is suggested not to introduce very high rates, as these might lead to increased evasion. However, cars could be taxed at high rates to reduce import demand and to generate fiscal revenues. A.5. Taxes on Imports 19. A large share of taxes is collected from taxes on imports. Between 1982-87, taxes on imports rose, reflecting the increase in the value of imports and the introduction in 1984 of the 52 customs fee. As a result, the effective import tax rose from 122 in 1983 to about 162 in 1986. 20. Honduras has a complicated system of tariffs and surcharges, with a combination of taxes and surcharges levied on imports. A substantial portion of revenues from imports is derived from surcharges. In 1985, for example, revenues from import tariffs amounted to t80 million, while those from surcharges equaled t221 million. 21. Import tariffs were modified in 1987 in line with the changes introduced to the Central American Common Market (CACM) tariff system. As a result, all specific rates were eliminated, with rates converted into an ad-valorem basis, and the nomenclature was changed from the Central American classification scheme into that of Brussels. The following table presents the parameters for the new tariff regime:  -6- Table 3: Parameters for the Now Tarlff Realme 1937 Ittmo Rates Inputs 1J Inputs for agricultural products 6X Capital goods 6% Final consumer coods 2/ bo - 90X 1 Minimum rate. J Medicino and nome other health products are taxed at IX. Sourco: Ministry of Finance. 22. The tariffs range between 1Z - 90Z. High rates are applied for shoes, garments and few other final consume-: goods--for which there is domestic production. Furthermore, more than one rate applies to some products depending on their end-use. 23. Three decrees define surcharges, which are levied on a CIF basis. They provide high and dispersed nominal and hence effective protection to the industrial sector. With surcharges, the maximum tariff rate equals 125Z. The following table indicates the different rates of surcharges and the decrees which provide the legal framework for those charges: Table 4: Rates of Surcharges. 1988 Decree No. Itemo X Decree No. 64 Inputs 650 Final consumer products 10.0 Docroe No. 85/4 All products 10.0 Decree No. 59 All products 20-0 Source: Ministry of Finance. 24. Collections from imports are reduced, however, owing to the existence of a large number of exemptions. Over 40 laws regulate the granting of exemptions under imports. As a result, only about one-fourth of imports are subject to tariffs, leading to a fiscal revenue loss of about 22 of GDP annually. About one-quarter of imports generate virtually all revenues from imports. The exemptions increase une level of effective protection for industry and raise variability in both nominal and in effective protection. 25. A large number of products and institutions are exempted from the payment of import duties. These include: agriculture inputs, public  sector imports, and inputs for various industries. Exemptions granted to public sector imports account for about one-fifth of all exemptions, and public sector enterprises account for about two-thirds of the exemptions granted to the public sector. Conclusions 26. Rationalization of the tariff regime will likely take time. At present, the main objective of the import regime is to generate government revenues, while dampening import demand and protecting the domestic industry. It is desirable that at the final stage of the reform process, the parameters of the tariff structure resemble the targets whit- he other Central American Common Market (CACM) members aim at achieving he medium-term. In this context, a maximum and unified tariff rat., if 202 should be the long-term goal. 27. As a first step, however, it is suggested to phase out quantitativf tmport restrictions on imports and replace them with tariffs. At a fixed e4charige rate, nominal tariffs would need to be raised to avoid a sharp increase in imparts. Under a flexible exchange rate policy, the exch.ange rate needs to be deprecialed in real terms. However, if the Government does not introduce a compensatory devaluation, then the process of tariff liberalization has to be slowed down. Given that the tariff equivalent of quantitative restrictions is difficult to estimate, there is a danger that the higher tariffs are not subsequently reduced following the substitution of quantitative restrictions by tariffs. To avoid this scenario from happening, the Govarnment needs to define its medium-term goal of reducing tariffs over time. Secondly, it is suggested that a process be started to phase out exemptions on import tariffs. 28. The first stage of the reform process should attempt to rationalize the tariff system by making it more transparent as well as to generate higher levels of government revenues both through a reduction in exemptions as well as a conversion of quantitative import restrictions into tariffs. It would not, however, reduce effective protection. The first stage of the reform would be consistent with the need to establish macro- financial stability and control import demand. 29. The later stages of the tariff reform should aim at initially phasing out import surcharges and then reducing high tariff rates. Given the small and limited size of the private sector in Honduras, and consequently likely slow adjur.r3nt of the private sector to the changing signals in the economy, the adjustment of the tariff regime will need to be a slow process. Furthermore, changes in the tariff regime would need to be coordinated with exchange rate policy. Hence, those changes should be introduced after macro-financial stability is established. Otherwise, attempting to do too mucai in one step would likely raise social and political costs and would not likely be sustainable. Obviously, tariffs can be reduced substantially if the exchange rate is devalu-ed at the same time. This will also provide incentives to non-traditional exports. 30. Fiscal implications of changes in the tariff regime should be assessed and any expected shortfall in government revenues should be compensated for by additional public savings measures. The initial stage of the reform should not necessarily lead to a loss of revenues. However, the precise fiscal impact of subsequent steps of the reform is not yet  - a - certain. To the eutent that further trade liberalization is carried out through increasing low tariffs and phasing out exemptions, declines in high tariff rates sB. uld not necessarily lead to a loss of revenues. However, if subsequent stages of the reform fail to increase low tariff rates or to phase out exemptions, there will likely be a net loss in government revenues. It is suggested, therefore, that any reduction in tariff revenues owing to reduced rates--assuming that the effect of the increased import volume will not change the final outcome--should be compensated for by additional savings measures. Public savings could be enhanced by raising collection from sales tax through strengthening collection effort and raising the rate of the sales tax from 5? to 7Z or perhaps to 102. A.6. Export Taxes 31. About a tenth of tax revenues was derived from export taxation dur'.ng 1982-87. Virtually all of the collection from export taxes is obtained from coffee and bananas. These taxes can be considered quasi- income taxes on coffee and banana farmers since income taxes collected from plantations growing these two crops are low. 32. The authorities modified the tax on coffee in 1988, reducing the minimum international price below which exports of coffee will not be taxable. The minimum taxable price was set at US$1.20 per pound. If the international price drops below US$1.20, the revenues will l:ikely drop by about t50-60 million (i.e., US$25-30 million) a year. 33. Conclusion. In view of the need to maintain revenutes from coffee exports, it is suggested to lower the minimum price limit on coffee exports. For the medium-term, it is important to restructure the coffee export tax along the lines of the Costa Rican coffee export tax, which has a graduated rate structure, with higher international prices taxed at higher rates, enabling the Government to benefit from windfall gains. A.7. Petroleum Differential Tax 34. The Government taxes petroleum products through a petroleum price differential tax. This tax is levied on the difference between the domestic and international price of petroleum in domestic currency. As the international price of oil dropped sharply in 1986, domestic prices were not reduced, thus leading to a significant increase in collection of this tax, which rose from tll.5 million (US$5.8 million) in 1985 to t90.1 million (US$45 million) in 1986. 35. Conclusion. The authorities expect to collect about tlOO-120 million from this source in 1988/89. In the short-term, it is suggested not to reduce domestic petroleum prices to generate government revenues as well as to encourage fuel savings. Furthermore, continuous changes in domestic prices are not politically feasible. Moreover, the large depeneence of Government revenues on this volatile source (i.e. this tax generated about 8.51 of current Central Government revenues in 1987) underscores the need to undertake a tax reform, aimed principally at shifting the burden of taxation from international trade to domestic sources (i.e. see Working Paper on "Harmonizing Taxes in Central America" for a more detailed analysis).  -9- A.8. Tax Administration 36. The authorities believe that there is a high degree of evasion of all taxes owing mostly to weak administration and to the limited number of contributors under the income and domestic transaction taxes. Of the total population of about 4.2 million in Honduras, there are only 160,000 contributors, of which less than half actually pay their income taxes. It is further believed that a large number of stores collect domestic transaction taxes (i.e. sales and excise taxes), but they do not report these collections to the Government. The lack of sufficient logistical support (i.e. computers) also hinders effective monitoring. 37. Conclusion. It is suggested to intensify efforts at tax collection, and mainly on those taxes which could generate large collections such as ineume and sales taxes. USAID is assisting the Government in tightening tax collection procedures. However, efforts need to be intensified on the following areas: *i) improving taxpayer identification (the major thrust of the effort should be on better monitoring of large producers, importers and corporations); (ii) increasing the number of tax-payers; and (iii) providing better logistical support to tax administration in the Ministry of Finance. A.9. Customs 38. The authorities believe that there is a high degree of evasion of custom duties. The main fpctors behind this evasion are believed to include: (i) the lack of sufficient training of the officials at the ports and customs, especially regarding valuation of items; (ii) the lack of adequate logistical support such as equipment, labs etc; and (iii) the existence of bribery. To address these issues, it is suggested that technical assistance be extended to the Government to provide training, logistical support and to strengthen monitoring of customs. A.10. Overall Conclusions on the Tax System 39. Rationalization and modernization of the tax system is urgently needed. Toward this end, the authorities need to focus on increasing the mobilization of fiscal resources, changing the structure of taxes to make them more elastic to economic growth, reducing the vulnerability of the tax system to exogeneous price shocks and shifting the burden from income to domestic transact..on taxes. In carrying out these reforms, there is a need for: (i) coordinating planned changes with the efforts under the trade reform; (ii) minimizing adverse effects on economic activity; (iii) simplifying the tax system; and (iv) reducing exemptions both under the corporate income tax as well as under imports. 40. Changes in the tax system will.nv,bably not be politically popular. First, Congressional approval of changes may prove to be difficult. Second, an increase in rates could encourage evasion. In fact, without ctrengthening the tax administration, it is possible that actual tax collections could decline following a rise in rates.  _ 10 - B. Central Government Expenditures 41. Central Government expenditures grew at about 102 a year during 1982-87. This growth masks the changing composition of expenditures, since capital expenditures (i.e. mostly transfers to ENEE) fell while current expenditures rose. B.1. Introduction 42. The current structure of expenditures presents rigidities. As a result, the scope for decreasing expenditures within a possible adjustment program will likely be minor. For example, interest payments almost tripled in real terms during 1981-1987 and accounted for about 16Z of current expenditures in 1987, while expenditures on defense equalled 7.8Z of the total in 1987 (Table 5). It is generally believed that expenditures related to defense are distributed among various categories such as wages and salaries, debt service, investment, and goods and services. Total military expenditures are believed to have amounted to 232 of current revenues in 1987. Given the sensitive border problems, defense expenditures may prove to be difficult to reduce in the short-term. Furthermore, expenditures on the social sectors remained at one-third of the total during the period. This is mostly due to high education expenditures (i.e. mostly for teacher salaries). As a result, the share allocated to infrastructure, mostly for transport and natural resources which the country badly needs, declined over the years. Table 5: Central Sovornment Expenditures by Function. 1981-87 (X of total) 1981 1982 1988 1984 1985 1986 198 Administrative Expenditures 20.0 17.0 16.8 17.4 19.9 14.7 14.6 Social Sectors 85.6 84.8 82.7 30.7 80.4 82.6 82.2 o/w Education (20.2) (21.2) (19.7) (19.7) (20.1) (20.8) (20.8) o/w H- Ith (11.2) (10.8) (10.4) (11.0) (8.8) (9.8) (9.6) Infrastructure 16.2 18.7 12.8 10.a 9.1 11.8 10.6 o/w Transport and Communications (9.0) (7.3) (6.8) (6 7) (4.8) (5.6) (6.8) @/w Natural Resources (7.2) (6.4) (6.8) (4.6) (4.8) (6.7) (4.8) Defonse 1386 18.1 12.4 14.0 14.0 18.0 7.8 Debt Service 2 16.8 21.4 26.7 27.8 26.6 28.4 84.8 100.0 100.0 160.6 160.6 106.6 100.0 160.0 Source: Ministry of Finance. 1 Budgeted. J Includes amortization psyments. Tho] Ministry of Finance classiflos amortization paymonts as exponditures and it was not possible at this timo to difforentiate Interest from amortization payments In this table.  - 11 - 43. Conclusions. Any fiscal adjustment effort would need to aim at reducing the growth of the non-interest expenditures of the Central Government. This goal can be achieved through a decrease in the wage bill and transfers to public sector enterprises, economizing on expenditures on goods and services, and introducing cost-effective programs. In terms of functional distribution, further growth in military expenditures needs to be restrained. Reductions in the wage bill will likely require retiring personnel and revising wage policy. Both actions are likely to prove to be politically difficult to carry out. But, these actions are indispensable for achieving fiscal austerity. In this respect, the authorities should continue to implement the wage freeze for public employees and extend the freeze also to teachers and medical personnel. Obviously, politically strong unions could counteract these policies. 44. A large part of Central Government spending goes to wages and salaries, averaging about 45% of current expenditures and 7.7Z of GDP during 1982-87. A significsnt share of wages and s. laries are incurred in the education sector, accounting for about one-third of the public wage bill in 1986. The total wage bill grew as public employment jumped from 67,000 in 1982 to about 72,000 in 1986. About one-third of public employees were teachers in 1986. 45. Transfers also constitute a major source of Government outlays (Tables 6 and 7). A large part of these transfers go to public sector enterprises, averaging about 171 of total Central Govern,ment outlays and about 42 of GDP a year during 1984-87. Transfers to National Electricity Company (ENEE), National Water and Sewerage Service Company (SANAM), and National Agrarian Institute (INA) comprised a large share of those transfers over the last couple of years. El Cajon was the major recipient of capital transfers, while current transfers went rostly to the universities and INA. Tabl- 6: Contral Government Current Transfer. to the Rot of the Public Sector. 1984-86 (millions of t) 1984 1985 1996 Public Sector Enterprises 89.8 106.9 128.5 INA (25.4) (80.6) (81.9) NIAN (48.1) (67.9) (7.56) JNBS (9.1) (10.4) (18.2) Municipalities *.6 0.5 0.6 Others 12.9 86.8 81.2 Total Public Sector 102.7 187.2 166.2 Memorandum Item Total current transfers as a of GDP 1.6 2.0 2.1 Source: Central Bonk of Honduras.  - 12 - Table 7: Central Government Capital Transfers to the Rest of the Public Sector. 1984-86 (mililons of t) 1984 1986 1986 Public Sector Enterprises 197.4 118.8 59.4 ENEE (142.8) (80.9) (18.2) INA (18.2) (4.0) (12.6) SANAA (14.0) (16.8) (20.8) HONDUTEL (4.2) (-) (-) INVA (1.7) (2.2) (2.8) INMA (9.8) (6.6) (-) COHDEFOR (-) (2.0) (8.6) INCAFE (8.8) (-) (1.2) Others (8.9) (1.9) (0.8) Municipalities 9.8 12.8 10.0 Others _ 2.0 3.6 Total Public Sector 206.7 128.1 78.0 = == 3 Memorandum Item Total capital transfers * a X of CDP 3.3 2.0 1.0 Source: Central Dank of Honduras. 3.2. Education ExDenditures 46. Education expenditures grew rapidly during 1981-86. About two- thirds of expenditures were spent on wages and salaries. While there has been a freeze on public sector wages over the last couple of years, teachers have consistently received salary increases well above domestic inflation each year. Investment expenditures for the sector, however, fell during this period. 47. Central Government transfers covered over 90Z of the financial needs of the sector in the recent past, while user charges financed the rest. As financial resources devoted to investment contracted, the quality of education also suffered. 48. Regarding the allocation of expenditures by branches, almost half of the total goes to primary education, while 20Z of the total is allocated to secondary education and the rest is spent on universities. Given the difficulties in raising user charges for primary and secondary education--which comprise about 901 of the expenditures spent in the sector--the scope for increasing savings through adjustments in user charges is limited.  - 13 - 49. Conclusions. Given the need to control expenditures and improve quality of education, savings could be generated by reducing the growth of salaries below domestic inflation if politically viable. Obviously, achieving macro stability would help moderate wage increases by reducing the underlying domestic inflation rate. B.3. Health Expenditures 50. Central Government expenditures on health have absorbed about one- tenth of the total during 1982-87. In addition to the Central Government, the Social Security Institute (IHSS) also provides health services. The combined expenditures on health averaged 2.7Z of GDP in 1987. 51. Conclusions. Given the poor social indicators in Honduras (i.e. high mortality rate and low life expectancy), reductions in health expenditures are not desirable. However, efforts should be expedited to make those expenditures more cost-effective, while ensuring improved coordination among the Central Government and IHSS. C. Central Government Finances 52. After a deterioration during 1982-84, overall Central Government finances continued to improve during 1985-87 (Table 8). The fiscal deficit fell from an annual average of about 10.8Z of GDP during 1982-84 to less than 8.2Z during 1985-87. However, the deficit in 1987 on an accrual basis --at 7.32--was still high. The improvement during 1982-87 reflects the effect of an increase in revenues by 2.3 percentage points of GDP to 16.1Z and a reduction in overall expenditures by 0.5 percentage points of GDP to 23.42. However, the decrease in expenditures as a share of GDP masks the changing composition of expenditures, since current expenditures grew by 3 percentage points of GDP to 18.5Z, while capital expenditures fell by 3.5 percentage points of GDP to 4.9Z. The sharp expansion in current expenditures resulted mainly from wage and salary increases as well as a raise in military outlays. As a result, Central Government current dissavings increased from 1.7Z in 1982 of GDP to 2.42 in 1987. The reduced capital expenditures resulted not only from the termination of transfers to El Cajon as the project was completed, it also stemmed from a cutback in investme.nts in transportation and agriculture.  _ 14 - Tabl- S: Central Govornment Flnances. 1981-87 (X of CDP) 1981 1982 1988 1984 1085 1988 1987 Current Revenues 14.0 18.8 18.0 16.6 10.2 16.6 16.1 Tax Revenuos 18.1 12.8 12.0 14.0 14.7 18.2 18.7 Non-Tax Revonues 0.9 1.0 1.6 1.6 1.6 2.4 2.4 Current Expenditures 16.1 16.6 18.8 17.1 18.6 17.9 18.5 Current Account Balance -1.1 -1.7 -8.2 -1.6 -2.8 -2.8 -2.4 Capiteb Exoenditures and Net Lending 8.8 8.4 7.4 10.1 7.2 6.6 4.9 Overall Balanco (accrual basis) -7.9 -10.1 -10.6 -11.7 -9.6 -7.8 -7.3 Overall Balance (cash basis) -7.9 -10.1 -10.6 -11.7 -9.6 -7.8 -6.7 Not Extornal Financing 4.7 4.6 5.1 7.8 4.9 2.7 0.9 Foroign Assistance!/ 0.0 0.6 0.8 1.1 1.7 1.8 1.1 Not Domestic Financing 8.2 5.0 5.2 2.8 2.9 8.8 4.0 Bank credit 8.0 4.4 8.0 1.9 1.9 2.8 1.6 Bonds 0.6 0.8 1.5 1.4 0.6 1.0 1.7 Others -0.4 -0.2 0.7 -0.6 0.6 0.0 0.7 Change In Arrears on amortization obilgations 0.0 0.0 0.0 0.0 0.0 0.0 0.7 Source: Central Bank of Honduras, Ministry of Financo, IMF, Bank Staff Estimates. / Mostly USAID grants. D. Financing of the Central Government Deficit 53. As external assistance contracted, domestic sources of financing gained importance during 1984-87. Net external financing fell from a peak of 7.8Z of GDP in 1984 to 0.9X in 1987, mostly as a result of reduced capital inflows. During this period, the domestic counterpart of USAID assistance provided financing of the fiscal deficit of an amount equal to an annual average of 1.4X of GDP. However, paralleling a reduction in project pipeline, net external financing decreased over the years. An expansion in the domestic sources financed a larger share of the deficit in the last few years.  - 15 - 54. Increased domestic financing of the fiscal deficit is risky, given its inflationary implications. Continued high levels of Central Bank advances to the Central Government will likely fuel domestic inflation and could start an inflation-devaluation spiral in a country which maintained fixed exchange rate for over 60 years. Central Bank advances to the Central Government rose during 1986-1987. Of the total, almost half was provided with no interest and the remainder at subsidized interest rates. Central Bank advances to the Central Government were facilitated by high reserve requirements on commercial banks. Furthermore, treasury bond sales to the public and to commercial banks also accelerated. This increase was made possible by maintaining high interest rates on treasury bills, with rates on these bills ranging between 9Z and 112 in 1987. As a result, the stock of domestic debt continued to expand (Table 9). If the rate of growth of debt is maintained at present levels, interest payments on the domestic debt would likely absorb a large share of Central Government revenues in the next few years. Table 9: Debt Stock of tho Public Soctor. 1984-88 (mlillione of t) 1984 1985 1988 Domestic External Domestic External Domestic Externnl Central Government 1,699.4 2,278.2 1,837.9 2,615.8 2,088.6 2,878.5 Public Sector Institutions 840.9 647.1 929.7 810.2 988.9 902.2 Municipalities 223.8 12.2 230.2 10.4 248.1 9.2 Totel 2,664.1 2,932.6 2,997.8 8,486.4 8,270.6 8,769.9 Memorandum Item Total as X of GDP 42.8 46.5 44.6 51.1 43.6 60.6 Source: Central Bank of Honduras. 55. As a result of liberal and excessive use of almost all possible sources of financing in the past. few years, the Government has virtually exhausted all prudent forms of financing the fiscal deficit for the next several years. Regarding external financing of the deficit, USAID indicated that it will scale down its transfers in the future. Owing to the completion of the El Cajon hydro-project and the weak pipeline of projects by the multilateral agencies coupled with projected increase in amortization obligations on external debt, net external financing for the Central Government will be at reduced levels in the next several years. On the domestic side, further large expansions in Central Bank advances to the public sector will likely fuel domestic inflationary pressures (Table 10 shows the financing of the public sector by the domestic monetary system).  - 16 - If Central Bank credit expansion is financed by increasing reserve requirements of the commercial banks, this could lead to reduced credit availability and higher domestic interest rates, and hence adversely affect economic activity. Excessive reliance on borrowing would unnecessarily raise interest payments in the future, and hence would result in a further increase in the public sector deficit. Hence, the deficit should be reduced to levels which could be prudently financed by net disbursements of external loans, mostly obtained at concessional terms. Based on IBRD projections, this level is projected at about 1.51-2Z of GDP for 1988-90. The reduction in deficit could be achieved through a combination of revenue increases and expenditure restraint. Specifically, raising tax collection effort, increasing public utility prices should provide the bulk of savings effort in the short-term. Obviously, any serious medium-term effort should focus on expenditure reductions through elimination of low-priority programs, divestiture of public enterprises and reduction of public employment. Table 10: Banking System Financing of the Public Sector As End of Year. 1983-87 (millions of t) 1983 1984 1985 1986 1987 Central Bank CreditT To Public Sector 619.9 650.9 698.3 622.8 751.3 To Central Government 530.6 576.9 622.5 628.7 721.3 To Rest of the Public Sector 89.3 74.0 75.8 34.1 30.0 Commercial Bank Credit: To Public Sector 349.8 405.9 387.2 491.8 537.9 To Central Government 371.2 449.2 517.6 676.7 691.1 To Rest of the Public Sector -21.4 -43.3 -130.4 -184.9 -153.2 Source: IMF. E. Budaet for 1988 56. Table 11 indicates the budget for 1988. Essentially, this budget perpetuates the existing problems inherited from previous years. Congress introduced a large number of modifications to the proposed budget prepared by the Executive branch of the Government. These measures reduced the proposed budgetary allocations by about tl53.0 million, or about 1.7? of GDP, with about two-thirds of it expected to be financed by external sources. Congress also changed the composition of proposed expenditures by increasing allocations for some programs, while scaling down others. For example, allocations for defense were increased from the proposed amounts, while some investments with concessional financing were reduced. Also  - 17 - subject to cuts were some developmental investments such as those in natural resources and transport and allocations for the Office of the Presidency. The modifications clearly do not bring out any clear picture; they are likely t.o lead to difficulties in the implementation of the budget. Table 11: Budget*d Expenditures by Sector. 1988 (X of Totol) Percont Administrative Expenditures 15.60 Soclal Sector. 82.0 e/w Education (19.0) */W HoaI th (11.6) Infrastructure 17.6 o/w Transport, Communications (11.8) o/w Natural Resources (5.8) Defense 7.0 Debt Servic-'/ 28.4 Total 100.0 In millons of t 2,168.6 Memorandum Item Total Budgeted Expenditures as X of GDP 2.60 Source: Ministry of Planning. !/ Includes amortization payments. The Budget Process 57. Before 1988, the budget for the Central Government was prepared by the Budget Office at the Ministry of Finance. In 1988, the budget was prepared by the Ministry of Planning in order to ensure consistency between current and capital expenditures of the Central Government.  - 18 - 58. The budget process is burdened with a number of issues. The budget for the Central Government is prepared on the basis of existing programs irrespective of whether there still continues to be a need for some of these programs. As a result, the budget process perpetuates the existing programs. What is worse, almost all programs are expected to grow each year, oftentimes exceeding domestic inflation rate, thus resulting in a real increase in expenditures in most programs. Within this framework, it is not possible to Reriously attempt to reduce expenditures. Furthermore, since the expenditures of the rest of the public sector are not planned through a consolidated public sector budget, the Central Government does not have a powerful handle on controlling expenditures. As a result, the budgeting process has not been used as a macroeconomic tool to reduce expenditures to adjust them to reduced real available resources when terms of trade deteriorate. Additionally, budgets oftentimes failed to incorporate counterpart funds for ongoing projects, resulting in the unnecessary deceleration of ongoing public projects. Lastly, there are structural rigidities in the budget such as earmarking of 6Z of revenues of the Central Government for universities. 59. Conclusions. The implementation of the following actions on the part of the Government would go a long way in rationalizing the budget process and transforming it to be a macro tool for adjusting expenditures as necessary: si) involving the Ministry of Finance in the preparation of the budget to ensure an improved coordination among the Ministries of Planning and Finance; (ii) shifting to a zero-based budgeting system on most programs--to the extent possible--to enable the Government to delete or reduce low-priority programs from the budget; (iii) preparing a consolidated public sector budget to ensure a better planning of expenditures at the public sector level, rather than only at the Central Government level (i.e., this budget could initially cover the Central Government and a few major public enterprises such as ENEE, HONDUTEL (Honduras Telecommunications Company), SANAA, INA, and COHDEFOR (Honduras Forestry Development Corporation), but it could then be expanded to include most of the non-financial public sector); (iv) budgeting adequately for the counterpart funds for public projects to ensure timely implementation of public projects; and (v) ensuring a close monitoring of the efficiency with which earmarked funds are utilized by universities. F. Public Investment ProRram F.1. Public Investment Expenditures 60. Public investment expenditures averaged about 9.4Z of GDP annually during 1981-87 (Table 12). After reaching levels of almost 122 of GDP during 1983-84, public investment expenditures fell to an annual average of 7.32 during 1986-87, following the completion of the El Cajon hydro-power  - 19 - project. Expenditures on El Cajon accounted for about half of the total public investment expenditures during 1981-85. As a result, during 1981-85, over 702 of public investment expenditures were allocated to infrastructure, while 7Z went to productive sectors and 23Z to social sectors. Table 12: Public Sector Invoetm.nt Expenditures. 1981-87 (X of CDP) 1981 1982 1989 1984 1985 1986 1987 Public Sector 90. 9.8 11.5 11.9 9.1 7.1 7.6 o/w Pubi c Sector Enterprises (5.9) (6.2) (7.9) (8. 1) (6.2) (8. ) (8.9) Source: Ministry of Planning. F.2. Public Investment Program for 1987-90 61. The authorities prepared a Droposed investment program for 1987-90. Based on Government projections, the proposed program aims at recovering the share of public investment expenditures to an annual average of 112 of GDP during 1988-90. To achieve this, the authorities plan to start a number of new projects during the proposed program period. 62. Table 13 shows the shares of the new and ongoing projects in the proposed investment program. As indicated in the table, about 702 of the proposed investment program would consist of new projects. The composition of the program would also change, with the productive (i.e. mostly in agriculture) and social sectors increasing their share of the total, while infrastructure's share falling.  - 20 - Table 18: Planned Investment Program by Sector. Share of Oneoine and Now Prolectn In Investment Program. 1987-90 (N of total) Ongoing New Projects Prolectn Total I. Productive Sectors Agriculture 7.7 16.1 28.6 Agrolndustry 0.7 0.6 1.8 Industry 2.7 1.0 8.7 Tourism 0.0 2.6 2.6 Forestry 0.0 0.8 0.8 Fishing 0.0 1.6 1.6 Mining 0.0 0.1 0.1 Sub-total 11.1 22.7 88.6 I. Infrastructure Transport 7.8 18.9 26.2 Energy 2.2 4.0 6.2 Communications 2.7 1.1 8.8 Urban Development 0.8 2.2 2.6 Sub-totol 12.6 28.2 88.7 III. Social Sectors Health 6.4 16.6 21.0 Education 1.4 1.8 8.2 Housing 0.8 8.0 8.8 Sub-total 7.1 20.4 27.5 TOTAL 30.7 69.8 100.0 333= 3= Source: Ministry of Planning. Issues 63. Public investment progr6tns have faced a number of issues during implementation in the past. These issues can be summarized as: (i) the lack of sufficient counterpart funts; (ii) the poor selection and screening of projects; (iii) the absence of utilizing economic efficiency criteria in the selection of public projects; and (iv) the poor supervision and monitoring of projects.  - 21 - 64. Conclusions. The size of the public investment program needs to be reduced to fit financial availabilities. Since some projects will not likely be implemented on schedule, the program would be underexecuted. However, the Government needs to define a doable program, which would allow recovery of public investment. To address issues regarding the preparation, execution and monitoring of public investment program, the implementation of the following actions would be usefult (i) introducing efficiency and other savings measures to generate sufficient counterpart funds for public projects, while obtaining additional external resources (i.e. from Japan, IDB, and USAID); (ii) improving selection and screening of projects; (iii) introducing the use of efficiency criteria to evaluate public investment projects; and (iv) improving the capacity of the Central Government in supervising and monitoring projects. 65. In terms of sectoral allocation of the public investment program for 1988-90, the following suggestions could be mades (i) increase distribution and transmission of electricity; (ii) give priority to projects in the social sectors (i.e. provision of water supply); (iii) maintain transport infrastructure; (iv) expand investments in natural resources; (v) decelerate the pace of growth of telecommunication projects; (vi) limit expenditures on railways to basic minimum maintenance; and (vii) limit expenditures on ports to basic minimum maintenance. F.3. The Institutional Framework for the Preparation of Public Investment Programs 66. The Ministry of Planning (SecPlan) is in charge of planning public investment programs. In carrying out this function, SecPlan does not utilize economic efficiency criteria, nor does it use cost-benefit analysis. As a result, the project screening and selection process has been very weak in the past. SecPlan has prepared another such plan for 1987-90. A review of the program indicated that the financing needed for the plan far exceeds the level of prudently projected public savings and realistically expected capital inflows during the period. Furthermore, the project selection was not based on economic efficiency criteria. 67. Conclusions. It is suggested that planning and screening of public investment projects be strengthened. To achieve this goal, technical assistance needs to be provided to SecPlan to enable it to put together a financially feasible and a growth-oriented p-ablic investment program, incorporating only thoroughly reviewed and screened projects, selected by using efficiency criteria. In this way, a three-year rolling plan could be prepared. The plan should be embedded in a macro-economic framework, which needs to take into account projections of at least five years into the future. In the short-term, however, it is suggested that the size of the program be reduced to the expected financial availabilities, taking into account the Government's priorities.  - 22 - G. Public Sector Enterprises 68. There are a large number of public enterprises in Honduras. These include companies, such as utilities (i.e. electricity, telecommunications, and water), transport (i.e. railways, ports), public banks (i.e. both agriculture and industry), and agricultural marketing agencies. G.l. Introduction 69. In 1987, the combined revenues of public sector enterprises accounted for about 402 total public sector revenues and their combined expenditures, 372 of total public sector expenditures. Investment outlays of these group of enterprises equalled 352 of total public sector investment. 70. The overall finances of this group of entities were in deficit during 1984-87 (Table 14). Their current savings averaged about 2.32 of GDP a year during the same period (Table 14). However, the deficit on their overall finances would have been much larger in the absence of transfers from the Central Government. 71. Public enterprises face a number of issues. These includet (i) the setting of tariff levels on the basis of political considerations rather than on efficiency criteria, and not adequately taking into account the financial needs of entities; (ii) Congressional approval of changes in tariffs and user charges, which make increases in rates very difficult; (iii) overstaffing in some enterprises (i.e. HONDUTEL); (iv) inadequate management practices such as the lack of long-term planning, cumbersome decision-making, the absence of assignments of responsibilities to managers; (v) the lack of adequate supervision and monitoring of financing of public enterprises by the Central Government; (vi) the engaging in activities outside the scope originally envisioned for some of the entities (such as COHDEFOR); (vii) inefficiency in operations; (viii) the lack of standard accounting procedures and the resulting lack of transparency in financial information; (ix) inappropriate decisions on past investments; (x) inadequate efforts to collect revenues (i.e. ENEE, HONDUTEL, SANAA); and (xii) labor problems. 72. The above-noted issues have led to a multitude of undesirable results. These include: (i) weak finances in most institutions; (ii) proliferation of a large number of enterprises without a clear mandate; (iii) price distortions; (iv) high capital-output ratios in investments; (v) inadequate statistical information, produced with a delay which makes it difficult to take policy decisions based on recent information; and (vi) dependence on Central Government transfers and external finance to fund their operations.  - 23 - Table 14: Finances of Public Sector Enterprises, 1981-87 (Z of GDP) 1981 1982 1983 1984 1985 1986 1987 Current Savings 2.1 1.9 2.3 2.3 2.9 2.1 2.0 Overall Balance (-=deficit) -4.8 -5.4 -6.5 -6.5 -2.7 -1.8 -2.3 Net External Financing 2.9 2.0 2.9 5.0 3.1 0.7 0.3 Source: Central Bank of Honduras. 73. The financial assessment of the performance of public sector enterprises is hampered by extensive non-market interventions such as price controls on outputs, as well as conversion of their debt into equity, implicit and explicit transfers received from the Central Government, assumption of external debt obligations of some enterprises by the Central Government and other implicit subsidies they receive from the rest of the public sector (i.e. non-repayment of telephone bills etc.). Interest subsidies and tax privileges also make it difficult to assess the actual financial performance of these enterprises. Suggested Action Program 74. To address issues regarding public sector enterprises, a medium- term action program needs to be prepared and implemented. Such a program should include the following actions: (i) increasing tariffs and user charges; (ii) reducing expenditures; (iii) introducing efficiency measures; (iv) improving services; (v) restructuring ENEE's external debt; and (vi) privatizing and closing some enterprises. 75. Specific examples of an action program are illustrated below: A) Reduction in expenditures: a) Decrease in employment levels (HONDUTEL); b) Introduction of efficiency measures with pre-established targets to increase efficiency (SANAA, ENEE, HONDUTEL); and c) Deferring low priority investments (HONDUTEL).  24 - B) Increase in Revenues: - Adjustments in utility rates and user charges (SANMA, ENEE); C) Improvement in services (LNEE, SANAA); D) Refinancing of existing debt (ENEE); and E) Further privatization and closure of public enterprises (CONADI, BANADESA, IHMA, BANASUPRO's distribution network, FNH, and COHBANA). 76. The introduction of the above-noted measures will likely reduce the reliance of public sector enterprises on the Central Government budget over the years. Hence, transfers to public sector enterprises such as INA and COHDEFOR could then be scaled down considerably, while the Government could begin to receive tax payments from HONDUTEL and the National Port Authority (ENP). G.2. Institutional Links amona the Central Government and Public Sector Enterprises 77. At present, the institutional links among the Central Government and public sector enterprises are quite weak. The legal framework for this link was first established in 1984 with the introduction cf the law for financial adjustment of the public sector. This law led to the establishment of the Superintendency of Decentralized Institutions. The latter entity is responsible for monitoring the implementation of budgets of those institutions. 78. After its establishment, the Superintendency has begun to collect statistical information on the finances of public sector enterprises and to publish reports which indicate actual versus planned expenditures. As a result, the entity has only carried out clerical functions. It did not develop into a mature policy-oriented entity with a good overall view of finances of public sector enterprises; neither did it develop a good and usable statistical data base to judge the performance of public sector enterprises. Furthermore, it failed to obtain information on extra- budgetary outlays of enterprises and did not closely follow actual budget implementation. As a result, the supervision and monitoring of public sector enterprises by the Central Government has remained very weak. 79. Conclusions. There is an urgent need to strengthen the Superintendency both in terms of staff as well as its monitoring powers. Without such a strengthened entity within the Ministry of Finance, it would be an extremely difficult task to implement a tough fiscal package. However, improved monitoring of public sector enterprises should not conflict with the responsible and accountable management practices at the public enterprise level. It should lead to an improved two-way communication among the Central Government and public sector enterprises.  - 25 - G.3. Privatization 80. To reduce the financial burden on the Central Government to own and to operate a multitude of public sector enterprises, there is a need for privatizing some entities and some servJces currently provided by those entities as well as to close down others. This would allow an increase both in allocative as well as in productive efficiency. It would also help the public sector to focus on high priority areas. 81. The Government has taken steps to privatize some public sector enterprises. The authorities have already sold some of the companies in CONADI's (public development bank) and COHDEFOR's portfolios and they intend to continue this process. Given the complexities involved in such operations, the process will likely be lengthy. 82. Issues faced in accelerat.ng the privatization effort includet (i) a cumbersome legal framework, which defines the rules under which privatization is to take place; (Li) the absence of a truly committed political leader who can devote full time to the privatization effort; and (iii) the absence of a well-established capital market in which assets of public sector enterprises are sold and transferred to the private sector. The first issue identified above results in a lengthy process. The third is3ue results in the need to establish sale prices of enterprises--a difficult feat, given the conflicting objectives of trying to determine as high a price as possible to benefit from the sale (i.e. in terms of higher levels of revenues and political saleability) and of attempting to define as low a price as possible to ensure a sale. 83. Conclusions. To expedite the privatization effort, it is suggested that the Government designate a high level official who would be responsible for overseeing the whole operation, providing direction and guidance and top-level Government support. The current arrangement, with one high level official involved in privatization as well as in a multitude of other tasks, is inadequate. Regarding the cumbersome law which defines the privatization process, the suggestion is not to change it in the short- term, given the uncertainties involved in attempting to modify it under the present political atmosphere. Concerning the dutermination of a price at which enterprises will be sold to the private sector, it is important to note that the fiscal impact of the proposed privatization will not be significant in the short-term. However, a decrease in the size of the public sector would allow the Central Government to focus its attention on the issues it has to address and do a better job within the context of a reduced public sector. On the other hand, selling enterprises at a very low price (i.e. compared to their book values or current market values) would go against public sentiment and would likely make further efforts at privatization politically more difficult. Regarding the particular enterprises to be privatized or closed, it is suggested that the Government continue with the privatization effort for enterprises owned and operated by CONADI and COHDEFOR along the lines of its declared strategy. However,  - 26 - it is important to include in the privatization program the following enterprises: BANADESA (National Agricultural Development Bank), IHMA (Agriculture Marketing Agency), and BANASUPRO's (Food Marketing Agency) distribution network. It is also suggested to close those enterprises for which the reason for their existence has disappeared (i.e. COHBANA--Banana Corporation) or a continued operation would imply high levels of Central Government transfers (i.e. CONADI). If priced to market, both domestic and foreign private sector would be interested in buying and operating the above-mentioned publicly owned enterprises. G.4, National Electricity ComDany (ENEE) 84. ENEE faces a major financial problem in its overall finances, which are expected to worsen in the medium-term in the absence of corrcective measures. The root cause of this financial crisis is the high instaUed electric power generation capacity, which is currently not being fully utilized and the mounting external debt service payments, which are expected to increase substantially in the next several years. The lprge increase in ENEE's installed capacity is associated with the lumpy investment project, El Cajon. 85. As described in other parts of the report, expenditures on El Cajon accounted for half of the public investment expenditures during 1981-85. Large external disbursements, including from IBRD and IDB, financed a significant part of the expenditures. The project was found to be the least cost alternative at the time of evaluation of different alternatives--including by the World Bank-- and its economic viability depended on expectations of buoyant domestic and regional markets. However, as both of these markets grew slower than predicted and some CACH members began to experience financial difficulties, ENEE's revenues did not materialize as expected. On the other hand, cost overruns on El Cajon project occurred and debt service obligations started to pressure ENEE's finances. The company's operations resulted in increased deficits of an annual average of t230 million during 1982-86. With hindsight, it is not clear whether or to what extent the company's finances would have been helped by higher levels of domestic and regional demand than those experienced so far. It is possible that even with a higher level of economic activity than experienced so far, ENEE's revenues would still have failed to meet contractual debt service payments in the next several years. 86. Based on ENEE's own financial projections and the present structure of its external debt, the company will not be able to service its contractual debt service obligations at least until mid-1990s. Without refinancing of external debt obligations, ENEE will be insolvent, thus adversely affecting the country's debt repayment capacity. 87. Regarding its tariff levels, ENEE did not modify them for several years, allowing it to decline in real terms. Based on long-run marginal costs and at the official exchange rate, however, the present level of electricity tariffs does not seem to be too much out of line. 88. Conclusions. In view of the magnitude of the financial disequilibrium faced by ENEE, however, electricity tariffs need to be raised to cover part of the financial needs of the company. Additionally, the company must intensify its revenue collection efforts. If the needed  - 27 - adjustments are not introduced by the company and the required refinancing is not provided, then the Central Government has to introduce a stronger adjustment package, including additional revenue increases and expenditure reductions. As explained in the section on Central Government finances, the scope for a strong fiscal adjustment is probably not likely in the next several years, pointing out the need to introduce measures at the company level. Exports of electricity to neighboring countries on a cash payment basis would obviously ease the financial situation only if the regional outlook improves. 89. Concerning expenditures, there is scope for reducing current expenditures through the introduction of efficiency measures on a limited scale. Regarding investment expenditures, however, a well-thought-out program, has to be prepared to enable ENEE to expand the distribution of electricity in the country. The entity is also suffering from the inadequate planning of transmission of the electricity network, which should in fact have been designed and put into implementation along with the El Cajon project. G.5. National ARricultural Development Bank (BANADESA) 90. BANADESA is a Government-owned Bank with a branch network of 33 agencies. At end-1986, the book value of BANADESA's assets was t574 million (US$287 million) and outstanding loans equalled t300 million (US$150 million), of which over 75Z were credits to the rural sector. The entity channeled credit to cooperatives of the reformed sector in agriculture. It also lends to small farmers, mostly producing basic grains. Loans for the livestock sector rose from 34.5Z in 1980 to 45.82 in 1986. 91. Political interventions and directed lending in the past resulted in a large share of BANADESA's portfolio falling into arrears. These financial difficulties of the entity does not peramit increased lending for agriculture in the next few years. In fact, BANADESA is requesting an injection of capital from the Central Government. However, unless the present policies of BANADESA are modified--an unlikely event in the short- term--the entity will likely require continued injection of capital in the future. Given the need to increase public savings, further capital injections will likely postpone the day of reckoning. BANADESA has tried many times, in the past, to introduce corrective measures to recover its portfolio in arrears, with no concrete result to date. 92. Conclusions. If politically viable, BANADESA needs to be closed down. Continued operation of the entity will not be profitable. Closing it will likely prove to be difficult, given the political sensitivities involved. To facilitate the process of closure, assuming that the authorities choose to do so, they should address the issue of channelling credit to the agriculture sector. One option would be to open a window at the Central Bank to provide agricultural credit. G.6. National Industrial Development Corporation (CONADI) 93. CONADI is a public development Bank established to encourage the development of the industrial sector in Honduras. It has investments in  - 28 - about 60 firms. These ventures account for about half of the private investment in Honduras. These firms are in sectors as diverse as in food, cement, sugar, chemicals, and wood. About one-third of these enterprises are not in operation. Four companies did not start operations and 17 closed down after being in operation for some time. Those that still operate have a reported capacity utilization rate of only 302-40Z. Virtually all of these enterprises have faced and are still confronting financial difficulties. As a result, CONADI's liabilities are now well over its assets. The Government has started a serious investment program by which it intends to sell or close down all companies owned by CONADI. It has also assumed the repayment of the entity's large debt service to external creditors since 1980. In the future, the company intends to continue to sell companies in its portfolio. On the negative side, the Government prepared a new draft law, which would maintain CONADI's previous development banking role. The above-mentioned draft law, if enacted, would likely be a repetition of the old mistakes. Given the country's precarious financial situation, there is no more scope for repeating the same mistake. 94. Conclusions. It is suggested that the Government continue with the proposed privatization of CONADI's companies. It is also suggested that it give serious consideration to not proceeding with the above-noted draft law, which would maintain CONADI's development banking role, and close CONADI. G.7. Honduran Telecommunications Comoany (HONDUTEL) 95. HONDUTEL owns, operates, and invests in telecommunications in Honduras. Its operations have produced small surpluses in the recent past. However, the company is burdened by overstaff