Honduras - Prospects for public sector reform (Vol. 1 of 2) : Summary of main findings and recommendations

Report No. 10318-HO Honduras Prospects for Public Sector Reform (In Two Volumes) Volume 1: Summary of Main Findings and Recommendations September 30, 1992 Public Sector Management Division Technical Department MICROFICHE COPY Latin America and the Caribbean Region Report No.:10318-HO Type: (SEC) FOR OFFICIAL USE ONLY Title: PROSPECTS FOR PUBLIC SECTOR RE] Author: DEL GAMPO,A. Ext.:37775 Room:I-4159 Dept.:LATPS 2 VOLS Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. GLOSSARY OF ACRONYMS BANASUPRO Suplidora Nacional de Productos Básicos BANMA Banco Municipal Autónomo BANTRAL Banco Central de Honduras BCIE Banco Centroamericano de Integración Económica CG Contaduría General CGR Contraloría General de la República CM Consejo de Ministros CNA Consejo Nacional Agrario COHDEFOR Corporación Hondureña de Desarrollo Forestal CONAPLAN Consejo Nacional de Planificación CONSUPLANE Consejo Superior de Planificación Económica COPEN Comité Permanente de Emergencia Nacional CSC Consejo de Servicio Civil DGA Dirección General de Aduanas DGCP Dirección General de Crédito Público DGP Dirección General de Presupuesto DGT Dirección General de Tributación ENEE Empresa Nacional de Energía Eléctrica ENP Empresa Nacional Portuaria FNH Ferrocarril Nacional de Honduras GDS Gabinete de Desarrollo Social HONDUTEL Empresa Hondureña de Telecomunicaciones IAs Instituciones Autónomas IHCAFE Instituto Hondureño del Café IHMA Instituto Hondureño de Mercadeo Agrícola IHSS Instituto Hondureño de Seguridad Social INPREMA Instituto Nacional de Previsión del Magisterio INA Instituto Nacional Agrario INFOP Instituto Nacional de Formación Profesional INJUPEMP Instituto Nacional de Jubilaciones y Pensiones de Empleados del Poder Ejecutivo JNBS Junta Nacional de Bienestar Social PANI Patronato Nacional de la Infancia SANAA Servicio Autónomo Nacional de Acueductos y Alcantarillados SCT Secretaría de Cultura y Turismo SDNSP Secretaría de Defensa Nacional y Seguridad Pública SEC Secretaría de Economía y Comercio SECOPT Secretaría de Comunicaciones, Obras Públicas, y Transportes SECPLAN Secretaría de Planificación, Coordinación y Presupuesto SEP Secretaría de Educación Pública SGJ Secretaría de Gobernación y Justicia SHCP Secretaría de Hacienda y Crédito Público SP Secretaría de la Presidencia SRE Secretaría de Relaciones Exteriores SRN Secretaría de Recursos Naturales SSP Secretaría de Salud Pública STPS Secretaría de Trabajo y Previsión Social TGR Tesorería General de la República UNAH Universidad Nacional Autónoma de Honduras FOR OFFICIAL USE ONLY HONDURAS: PROSPECTS FOR PUBLIC SECTOR REFORM ' TABLE OF CONTENTS L THE MACROECONOMIC CONTEXT AND THE NEED FOR PUBLICSECTORREFORM ............... ........ 2 I. AN ASS S OF TIEPUBLIC SECTOR.e... e.e.......... 4 A. Major Institutional and legal Problems . . . . . . . . . . . . . . . . . . . . 4 B. Budgetary Trends in the Publc Sector . . . . . . . . . . . . . . . . . . ... 5 C. Public Sector Employmient andWages ..................... 7 IIL RERM OF TEE HONDURAN PUBC SECTOR ................. 8 A. Administrativeeform ofthePublc Sector.................. 8 B. Reform of the M of Key Public Sector Functions within the Central Goverament . . . . . . . . . . . . . . . . ... 11 ManagementofTaxRevenues ..........................12 MangeenofExpenditures ..........................13 Invetment Programming ... .. . ... .. . .. .. .. .. . .. ..13 Financial Management ........................... 14 This report is based on the findings of a Public Sector A.waeut mission that visited Honduras in October 199L Main coutrilBtans to the report include Antonio Martia del Canpe (misndon leader), 1ATPS; Angel GonfilerrMalazechevarrk, IATPS; Jaime Vdwffue-Caro, LATPS; Pablo Gerchunoff (Consultant); Ann Mitchell (Consultant); Richard Moore toultant); and Inder Ruprah (onne.tann). Edgar Martne (Co ltant) as parmicIpateA in the mission. Baran Tmncer, lead Economist, LA2C2, advised the mission. The responsible managers were: Shahid A. Chamdbry, ChiefATPS; Marke VoUc, Chief, LA2C; andlalner B. Steckhan, Director, LA2. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authoriation. Managnentof Internal and External Control . . . . . . . . . . . . . . . . 15 ~~ *9,-soo 9 *****. **19 C. Reform of the Dentdra~e diitain.... 1 Pabäc Enterprise ... .. .. .. . . .. .. .. .. .. .. .. .. .. ..... .17 Agrdcltra and Food Distäu'on PubUe Ut1te and Trnsor Servce Enterrss.........1 - ivaätizt of Pub^e Enerre .... . ........... . 19 Dg a Reform Stry ......................... .23 INTRODUCTION 1. This study contains an assessment of the public sector issues in Honduras, and a set of recommendations to increase the internal efficiency of the public sector and its contribution to the Honduran economic development. The study lays down the foundation for a policy dialogue and subsequently for a possible IDA credit in support of a public sector reform. 2. The report is structured as f,Iows. The first section reviews the macroeconomic context and ientifies the need for pblic sector reform in order to ensure the sustainability of progress made under the current economic program. An assessment of the Honduran public sector is presented in the second section. The last section discusses three areas for public sector reform proposed by this study: Administrative Reform, Reform of Public Sector Management, and Reform of the Decentralized Administration. 3. The three areas for public sector reform proposed by this study should be seen as complementary parts of a broad strategy, and ideally progress should be made in all fronts simultaneously. However, experience in other countries, as well as the analysis of the Honduran public sector, indicate that public sector reform should involve a sequence of reforms that combines a sense of priority with feasibility. Administrative reform of the Honduran public sector can be implemented in the short term; at the same time, progress can be made in the design and implementation of specific programs to reform and improve public sector management. Finally, administrative reform should also provide the vehicle to prepare, at the institutional level, restructuring/privatization programs for the Autonomous Institutions, and to support actual implementation of the new role foreseen for the Municipalities. 1 I. THE MACROECONOMIC CONTEXT AND THE NEED FOR PUBLIC SECTOR REFORM 4. Throughout the eighlies Honduras experienced moderate economic growth, worsening medium term imbalances, and growing macroeconomic instability. The primary cause of the medium term imbalances was a persistent fiscal deficit and growing intervention of the public sector in the economy. The fiscal deficit of the non-financial public sector (NFPS) ranged from 6 to 12 percent of GDP during 1980-90 and was 8.5 percent in 1990. Fiscal adjustments during this period were achieved only at the expense of public investment, which fell by almost half as a proportion of GDP during 1980-89. 5. The government also increased its presence in the economy through the adoption of ant array of rules and regulations. As these new regulations were designed to "contain" the economic disequilibria, they targeted certain specific problems without consideration of long- term consequences. These regulatory changes produced uncertainty and discouraged development of private sector economic activity in the formal economy. 6. The manifestations of the economic disequilibria and negative impacts of the persistent deficit were temporarily contained by the use of a series of ad hoc measures. These temporary actions implied increased arrears on foreign debt and additional command control mechanisms. By the end of the eighties the country's economic performance sharply deteriorated, reflecting the fundamental structural weaknesses in the economy and the lack of consistency in economic policy. In 1990, the rate of GDP growth was 0.1 percent, inflation had risen to 23 percent (average for the year) and the current account deficit of the balance of payments was nearly 8 percent of GDP. 7. In 1990, a new government initiated a broad-based economic reform program consisting of a four-pronged strategy. First, the Government adopted a stabilization program including a commitment to reduce the fiscal deficit and shift to non-inflationary finance, along with efforts to obtain a competitive exchange rate. Second, the Government took steps to rebuild ties with the international financial community by resuming debt service payments to multinational institutions. Third, structural reforms were designed and partially implemented in the areas of foreign trade liberalization, financial sector reform, reform of tax policy and administration, and a reduction in the negative incentive structure in agriculture. Finally, the Governmeat initiated a targeted poverty program to alleviate the hardsiaps faced by the extreme poor exacerbated by the reform measures. 8. The new strategy and reforms, if continued and deepened, should reverse the decline in the economy. Progress to date in the economic reform program of the Government has been noteworthy and is beginning to translate into positive economic growth. Macroeconomic stability, however, remains fragile. A critical factor that endangers success 2 remains the continued high fiscal deficitf and excessive government involvement in the economy. The public sector is not only oversized; but also inefficient, and unable to adequately perform its core functions. 9. The fiscal adjustment achieved thus far also remains unconsolidated. The recent reduction in the fiscal deficit partially reflects temporary measures to raise revenues that cannot be sustained in the long term. A temporary export tax was implemented to capture the gains from the exchange rate devaluation of March 1990.2 In addition, Public Enterprise price increases adopted in late 1990 and mid-1991 allowed for adequate recovery of production costs. However, while tariffs for international services are to be kept constant in dollar terms in the cases of HONDUTEL (telecommunications) and ENP (ports) and there is Government commitment to maintaining ENEE (electric power) tariffs in real terms, for the rest of the public services there is no adequate pricing policy criteria, and in the case of SANAA (water and sewage) there is even lack of an effective revenue collection mechanism. Several other factors will put increased pressure on government resources in the near future and could make the fiscal adjustment unsustainable, if additional measures are not implemented. These include: (a) rising debt service payments; (b) the need to raise real wages of civil servants to avoid losing the most qualified personnel; (c) the pressures derived from the political expenditures cycle; and (d) the need to expand investment in basic economic and social infrastructure. 10. The degree of the fiscal adjustment required suggests that it will only be possible and sustainable if accompanied by a comprehensive public sector reform. Reform is not only necessary to achieve fiscal adjustment, but also to enable the public sector to perform its essential functions more efficiently and reliably. Public sector reform should aim to: (a) reduce the fiscal deficit to a level compatible with price stability and a stable or falling debt to output ratio, (b) improve the overall organization and management of government functions, (c) stimulate private sector development through the elimination of inefficient and unnecessary regulatiGn, and (d) withdraw state participation from economic activities that can be performed more efficiently by the private sector. I Although the fiscal deficit declined to less than 4 percent of GDP in 1991, the burden of its financing is on external sources on concessional terms which are unstable and likely to decline over time. 2 This temporary export tax implied an increase in revenues of 1.4 percent of GDP in 1990 and 0.65 percent in 1991, but was phased out by January, 1992. 3 H. AN ASSESSMENT OF THE PUBLIC SECTOR 11. While adjustment is It :rtive for Honduras, equally imperative is the establishment of a public sector wi' capacity to carry out economic reforms. The implementation of successful policy rew - requires the creation of a responsive institutional reform environment. From the perspective of public sector reform, the question is what proactive role should the public sector take to make markets work, and what is required of the public sector to carry out this role? A. Major Institutional and Legal Problems 12. Since the 1950s, the public sector increasingly became entrepreneurial, interventionist, and paternalistic, assuming responsibilities for basic infrastructure, basic social services, and committed to pdertake activities in the productive sectors traditionally considered the domain of the private sector. This incremental expansionist role in response to the exigencies of economic crisis is evident in the growth of the Central Government in the intergovernmental system and, most spectacularly, in the growth of the Decentralized or Autonomous Institutions. However, this expanded role has not been based on a clear vision of the State's appropriate role in stimulating economic development and internal efficiency. As a result, the institutional apparatus of the State now is unmanageable, and the organizational and functional distribution of government responsibilities has grown in an often inchoate fashion, responding to legal prescriptions and incremental tendencies that severely restrict its effectiveness. 13. One of the major difficulties resulting from the expansion of State responsibilities has been the inadequate capacity of the legal system to respond. The incrementalist form in which the legal instruments have been added has not provided a conceptual logic for the functional organization of the public sector. In particular, the Law of Public Administration establishes the principal norms for institutional behavior in the executive branch of government but lacks a precise definition of responsibilities among the fundamental public sector entities. There is a need to clarify and to define with greater specificity the functional and organizational structure of the public sector. In addition, within the law, there are a number of institutional relationships that either remain unclear or contradict other legal statutes. For example, the Law establishes that entities of the State can be created or terminated in response to administrative and economic criteria or need (art. 3). Yet, it is not clear who assumes this responsibility. The Constitution specifies legislative preeminence, and the LPA should delimit (eliminate) discretionary powers of the Executive to create secretariats. While DIs (Als) are subject to Congressional jurisdiction in terms of both their creation and dissolution (art. 261), their activities are subject to executive control. Also, Article 260 (section 7) empowers the Public Administration Law to exercise juridical control over DIs. In addition, direction, coordination, and control over DIs is the purview of the corresponding Secretariat (art. 36, section 11); yet, 4 the implication of budgetary "control" terms remain unclear. The LPA should clarify the relationship of Als to the Central Administration according to modern management principles that delineate lines of authority, autonomy, and accountability. 14. The expansion of the public sector over the past decades has resulted in a number of fundamental institutional problems in the public sector. These include: (a) overextension of government; (b) overlapping and unclear demarcation of responsibilities within the Central Government, resulting in poor coordination among lines of authority; (c) multiple and sometimes contradictory lines of authority and responsibility over the Decentralized Administration, both with regard to the Autonomous Institutions and the Municipalities; (d) weak public sector management; (e) expansion of executive control over all levels of gov,w mment; and (f) weak administrative capacity of the legislature to perform its oversight functions. In addition, and as it is discussed in the next two sections, the public sector is characterized by: (g) perverse trends in the categorical and functional composition of its expenditures; and (h) excessive level and improper composition of public employment, inadequate level of remunerations, very high compression of the salary scale, and absence of personnel policy. A consequence of these institutional weaknesses has been the omnipresence of a public sector characterized by poor performance, rigidity, and lack of transparancy in governmental functions and, therefore, inappropriate for the promotion of economic growth. 15. The needed transformation of the public sector will requite the alteration of the nature of public sector responsibility to adjust and to respond to changes in the environment within which the State must act. This transformation of the Honduran public sector requires that a new vision of the State in society be created. In turn, this suggests the need to restructure the governmental organization, to refine the functional distribution of responsibilities, to redefine the procedures by which governmental action is taken, and to provide a more efficient, professional, and committed human element for the conduct of governmental affairs. The problem of the public sector has two sides: inefficiencies in the administrative apparatus which requires careful review of the relationship between functions and organs of government, and inefficiencies in the use of human resources in government, which requires review and strengthening of public personnel in relation to proper functions. B. Budgetary Trends In the Public Sector 16. The Honduran Government has maintained weak control over expenditures at all levels of the public sector. Central Government expenditures rose from 22.7 to 25 percent of GDP between 1980 and 1990, twith the largest increases being in interest payments, the wage bill, and transfers to the Decentralized Administration. Interest payments increased from about 5 percent of total expenditures in 1980 to about 13 percent in 1989. Wage expenditure was about 35 percent in 1980 and had risen to about 38 percent by 1989. As a share of GDP, wage expenditure rose from 8 percent of GDP in 1980 to a peak of 9.4 percent in 1987 and have fallen only slightly since then. Growth in expenditures (in lempiras) during 1989/90 was 31 percent, composed of a weighted growth of 27 percent in transfers and net lending, 6 percent in the wage bill, and 3 percent in interest payments. 5 17. There is also a disturbing trend in the composition of Central Government expenditures by function; the importance of secretariats involved in core activities has declined. The combined share of expenditures of the education (SEP), health (SSP), and communications, public works and transport (SECOPT) secretariats declined from 45 percent of total expenditures in 1984 to 35 percent in 1989. Expenditures of secretariats involved in control and regulations, as well as military expenditure (particularly those of the National Defense and Public Security secretariat (SDNSP), however, increased. This changing expenditure pattern within the Central Government suggests that the public sector is increasingly departing from its central role of providing basic services. 18. Government debt grew in importance steadily throughout the 1980s, increasing from 16 percent of GDP in 1980 to about 30 percent in 1989. Given the government's commitment to providing prompt debt service, the rising debt service represents a significant portion of government expenditures that cannot be cut. 19. Total Central Government revenues rose by 2.4 percent of GDP between 1980 and 1990. Recent growth in revenues (in lempira) during 1989/90 came from a 17 percent increase in foreign trade taxes and a 15 percent rise in domestic indirect taxes. 20. The overall deficit of the Central Government reached a peak of 11 percent of GDP in 1984 and has remained consistently high at about 8 percent of GDP since then. If net transfers to the Decentralized Administration, however, are excluded from the Central Administration's budget, its fiscal deficit has been consistently lower. This disturbing trend is a clear argument for reform of the parastatal sector. 21. The Decentralized Administration which includes the Public Enterprises, the Public Institutes, and the Municipalities has, in general, represented a burden on the non- financial public sector budget. Public Enterprise fiscal performance deteriorated during the 1980s. The Public Enterprise overall fiscal budget has in general been in deficit, except for the years 1987/88 and 1990. Net of transfers from the CG the PB deficit has been even worse. Within the PE sector, however, there are considerable differences in the relative importance of individual enterprises, as well as in their financial and budgetary performance. In 1990, ENEE (electricity generation and distribution) and SANAA (water and sewage) received a huge majority (about 95 percent) of net transfers from the Central Government, while HONDUTEL (telecommunications) was in surplus. 22. While the Public Institute's current revenues have been sufficient to cover current expenditures, they have consistently required transfers from the Central Government of about 1 percent of GDP to finance capital expenditures. Furthermore, increases in Public Institute current expenditures are mainly due to an unwarranted rise in wage expenditures. 23. The central feature concerning local governments or Municipalities is that they have had a fiscal deficit throughout the 1980s (except for 1982-1983). The current account has been consistently in deficit since 1986. Within current revenues about half are tax revenues with 6 the rest composed mainly of operational revenues but including transfers from Central Government. Lack of clear rules of the game for government tran3fers has resulted in discretionary expenditures. One aggravating effect of Central Government transfers Is that they have tended to discourage tax revenue collection by the municipalities. C. Public Sector Employment and Wages 24. MAor sources of weakness in the Honduran civil service t A.stration are its partial coverage of public employees and lack of management information systems. The civil service administration is only responsible for Central Administration "permanent staff"- its coverage neither includes the military, teachers, doctors and nurses-and has little or no facility for analyzing wage/employment data. The civil service system has further deteriorated as a result of the tradition of granting employment and promotion to favorable political activists, further aggravating the problem of excessive public employment. 25. Public sector employment grew consistently throughout the 1980s, with the largest increases occurring in the Decentralized Administration. Recent efforts at employment rationalization have not achieved meaningful reductions. Significant reductions in the wage bill were achieved, but only through a strong deterioration in real wages, which were already low. 26. Another mAjor problem with public employment is the excessive number of staff with administrative and support responsibilities. As of 1990,administrative and service employees represented over 64 percent of total employment and 48 percent of wages in the Central Government, while professional and technical staff only represented 20 percent of employment and 38 percent of wages. In addition, there is significant variation among different secretariats. 27. The structural and institutional inadequacies of the public sector, described above, combined with the destabilizing and unsustainable trends in the fiscal deficit and public employment, suggest that administrative reform of the public sector is long overdue and urgently needed. 7 IL. REFORM OF THE HONDURAN PUBLIC SECTOR 28. Reform of the Honduran Public Sector requires measures to be undertaken at three levels. First, a broad administrat refXrm pMgram is needed to redefine the public sector's primary functions, establish an efficient organizational structure with a clear demarcation of responsibilities, and reform the civil service system. Second, reform of management of key public sector functions in the Central Government is needed to raise Internal efficiency and improve the allocation of resources and provision of services by the government. Third, reiorm of the D ntralized Administraidn (DA) would aim to eliminate nonessential public enterprises and public institutes and improve their managerial functions, as well as improve financial and managerial coordination between the Municipalities and the Central Administration. As these three levels of reform are highly interdependent, each can be fully successful only if necessary changes are accomplished in each of the other areas. A. Administrative Reformi of the PubBe Sector 29. The implementation of administrative reform of the public sector in Honduras is facilitated by the facts that: (a) there is commitment of the Government to the modernization of the State, as evidenced by the recent approval by Congress of the Law of the Modernization of the State and the establishment of a Presidential Commission created by the Law; (b) legislation on the public administration and the civil service enables the executive branch to implement the rationalization measures required by the reform; and (c) the financial viability of a rationalization process even in the short term. 30. Significant fiscal savings would result from an administrative reform. Each 10 percent reduction in public employment would result In a reduction of the wage bill equivalent to one percent of GDP. In addition, decompression of the salary scale, incorporating wage increases, particularly for senior level management and "key positions" may substantially be financed with other related savings resulting from administtative reform (e.g., reductions in maintenance and facilities expenses). 31. Following from the redefinition of the role of the state in the economy, administrative reform on the basis of a functional review would redefine public sector functions and responsibilities, and establish a more efficient organizational structure. A primary goal of administrative reform would be the rationalization of resource utilization, with particular emphasis on civil service reform. The role of SECPLAN in particular needs to be reevaluated. SECPLAN should concentrate on investment programming and monitoring, external aid coordination, and possibly also on longer term development policy analysis; SECPLAN's areas of overlap with the Secretariat of Finance should be eliminated. 8 32. The lessons from public sector reform programs in other Latin American countries provide the following general principles for aiding in the design of an administrative reform program in Honduras. First, uniform criteria and design of organizational structure should be applied to all Secretariats, in terms of responsibilities and administrative correspondence across different levels, and the maximum number of agencies that should depend on each organizational level. Second, a unique primary responsibility should be assigned to each entity at each level of the organizational structure. Third, a minimum organizational level should be established at which an entity can be identified as an executing administrative unit (generally the Direcei6n General). Fourth, there should be functional specialization at the level of executing unit. The application of these principles would aim to eliminate duplication, give clarity to the definition of responsibilities, facilitate delegation, and generate,effective coordination within the Central Administration. 33. Rationalization of public employment in Honduras is both essential and financially viable in the short term. The Civil Service Law (applicable for all of the Central Administration and a few of the Public Institutes) establishes that public employees can be asked to leave service if there is a need for budget rationalization or if it is required in order to increase the efficiency of the administrative organization. The law also specifies that employees should receive severance payments equal to two months of salary after receiving notice of resignation plus one month of salary for each year of service up to a maximum of eight months of salary. In other Latin American countries the availability of funds to fipance severance payments has been a key constraint on the reduction of public employment. In the Honduran Central Administration the financing of redeployment should not constitute a major constraint sin-c each redeployed person, even assuming the maximum indemnification, will generate fiscal savings within one year.' 34. Civil service reform should include measures to rationalize public employment, decompress the salary scale, and establish adequate personnel policies. To achieve these goals, reforms should distinguish between short term measures and longer term sustainable solutions. In the short term, the number of government employees should be reduced based on an evaluation system of organizational need and individual performance. A primary source for these reductions would be from the cancellation of positions following the elimination of some public entities. Targets for employment reduction in the Autonomous Institutions will have to be the result of a concerted agreement with the corresponding unions in which the common objectives of improving the quality of personnel and their remuneration should act as a leading force. Wage levels, particularly for senior level management, should also be raised in order to avoid loss, of qualified personnel. . At the same. time, the compression ratio (max./min.), currently estimated at about 5:1, should be increased to at least 10:1 during the first stages of implementation of the program. 35. Over the long term the civil service reform should include the following actions. First, the ratio of technical/operational to support personnel should be radically increased from 3 In Argentina the average cost of redeployment from the public sector is twenty months of salary. 9 less than 1:1 currently to 2.5-3.0:1. Second, a comprehensive personnel management system, including procedures for recruiting and retaining qualified personnel through testing, performance evaluation, and remuneration policies should be established. Third, both an incentive system and improved training programs should be created to improve individual efficiency. 36. Specific mechanisms for reducing public employment should include: (a) freezing or cancellation of vacancies, (b) voluntary resignation with full payment of indemnification, (c) selective transfer of personnel to the municipalities, (d) efforts to transfer personnel to the private sector, and (e) cancellation and imposition of severe constraints on the contracting of temporary personnel. A meaningful rationalization of public sector employment also requires making use of direct redeployment measures. 37. In addition to the strong commitment of the Government, a program like the one just delineated will require a solid institutional basis for design and implementation of the reforms. The Law for the Modernization of the State provides the legal basis for a global effort of State reform. The Presidential Commission, as a representative body, is expected to develop the social and political consensus on the need for reform, and should constitute the fundamental mechanism for successful concerted action. The Presidential Commission would be supported by a Technical Secretariat that would help formulate, implement and follow up on the actions undertaken in executing the Global Program for the Modenization of the State. 38. The modernization of the State is conceived in the Law as a broad process of transformation at several levels that will involve the administrative, legislative and judicial activities of Government (National and Municipalities), as well as the electoral process. Accordingly, the Presidential Commission and its Technical Secretariat would have to concentrate on complex political processes and decisions that may make difficult for them to deal with the specific technical analysis and proposals for implementation of the administrative reform. Since the administrative reform program is only one of the components of the broader strategy for the reform of the State, it seems appropriate to recommend that the Executive consider the establishment of a focal point for coordination and technical support to the design and implementation of the administrative reform. This focal point, or Special (ad-hoc) Technical Group, could produce the basic policy orientation and guidelines, and later could advise on their application in each entity of the Central and Decentralized Administration. 39. In the context of the overall strategy for modernization of the State, an administrative reform program of the executive branch could begin implementation with a Presidential Instruction to all the Secretaries and Heads of the Autonomous Institutions defining the basic policy orientations, targets, and timetable for the reform process, as well as prescribing the mechanisms that will ensure a concerted effort across all levels of the public sector, particularly the institutional arrangements made for coordination and control of the reform. 10 B. Reform of the Management of Key Public Sector Functions within the Central Government 40. One of the primary needs of public sector reform in Honduras is reform of management of key functions in the Central Administration. Weaknesses in public sector management generate not only low internal efficiency, but also inefficient allocation of resources, poor quality of public services, and macroeconomic instability. There is a need to reform and strengthen the following key management functions: (a) macroeconomic policy formulation and implementation; (b) management of public sector revenue generation, collection, and monitoring; (c) management of expenditures and budgetary and investment programming and control systems; (d) procedural and operational efficiency and consistency of the internal administration of the Central Government; and (e) institutional structure for internal and external control. Macroeconomic Management 41. Several factors contribute to weak macroeconomic policy management in Honduras. First, there is lack of coordination between the preparation and execution of the budget and the macroeconomic program. Second, the capacity to plan, monitor, and control public expenditures is weak. These weaknesses are further exacerbated by insufficient, untimely, and inaccurate information flows, especially on public finance and monetary statistics. The public sector must have the capacity to adapt policies to changing economic conditions; hence, failure to correct these problems will put the sustainability of the macroeconomic program at risk. 42. The key to successful macroeconomic policy management is the availability of a reliable, highly qualified management team. This team must be capable of analyzing economic policy options, making decisions in a coordinated way among agencies, and maintaining effective communications with individuals at all political levels to ensure consistency between political decisions and macroeconomic policy. 43. In Honduras the strengthening of policy analysis capabilities is particularly important in key institutions such as the Central Bank of Honduras (BANTRAL), and the Secretariat of Finance and Public Credit (SHCP), and perhaps the Secretariat of Economy and Commerce (SEC). This could be achieved by establishing a team of possibly as few as 30 qualified professionals distributed among the three institutions. The two existing groups of economic policy analysts-the Technical Advisory body within the SHCP and the Economic Studies Department at BANTRAL-constitute a basis on which a strong management team could be developed. This is a case where improvements in civil service pay, benefits, and employment policies for high-level personnel would be essential to attract and retain qualified personnel. Furthermore, efforts to strengthen the capacity for policy formulation and implementation outside the aforementioned institutions, and even outside the government, would produce additional positive externalities. It may be advisable, for example, for the Honduran Government to 11 support the UNAH and other politically independent institutions. In the immediate future, the limited use of international consultants to assist current policy analysis capabilities is advisable. 44. The core of the institutional setting for macroeconomic management (i.e., the Economic Cabinet) also has to be strengthened, and the responsibilities of its members clearly delineated. Coherence in macroeconomic policy also requires that the fiscal objectives of the macroeconomic policy actually be implemented through the budget process. An effective link between the management of the macroeconomic program and the fiscal budget, and efficient and timely flows of accurate fiscal and monetary information should therefore be established. Management of Tax Revenues 45. Tax revenue remained constant at about 13 percent of GDP until 1989 and increased to about 16 percent in 1990, a tendency that basically continued in 1991. This improved tax revenue performance results from the ongoing tax reform and management measures aimed at upgrading and simplifying the tax system that the current administration began after taking office. 46. Key problems, however, still remain. First, intensive use of tax incentives has caused the deterioration of the effectiveness of the system. Second, income tax rates remain high by international standards and unnecessarily progressive for business incomes. Third, some relatively minor taxes still demand disproportionate administrative attention by DGT relative to their revenue yield. Fourth, the distribution of operational responsibilities between the Tax Directorate (Direcci6n General de Tributaci6n - DGT) and the Customs Directorate (Direcci6n General de Aduanas - DGA) still does not follow the logical distinction between taxes on bases generated domestically and taxes on bases generated from foreign trade activities. DGA is in charge of import and export taxes but also for various other taxes under the responsibility of the equivalent of DGT in other countries. Fifth, both DGA and DGT lack fully integrated computer systems to efficiently compile and process tax information. Sixth, erroneous classification and under-valuation of merchandise are characteristic of customs operations. Approximately one- third of all imports are not taxed in part due to the application of special regimes, but also because of fraudulent operations. 47. The authorities have to define and put to work a sustainable tax system able to cope with the level of debt service and the required amounts of public expenditure under the reformed state. Improvements in revenue administration require the following actions. First, the base definition of main taxes should be further simplified by eliminating exemptions and the preferential treatment associated with promotion regimes. Second, surcharges and the two-rate system should be eliminated and replaced with a uniform income tax rate at levels comparable with international standards. Third, there is further need for simplification in the tax code, especially with regard to minor taxes that are administratively cost-inefficient and encourage non-compliance. Fourth, the division of responsibilities between revenue collection agencies need to be redefined and the institutional structure strengthened. Fifth, although efforts to computerize the revenue collection system are currently underway, a more comprehensive 12 approach is needed to provide computerization of revenue administration to all components of the revenue collection system. Sixth, significant additional efforts are needed to reduce erroneous classification and undervaluation of merchandise in border operations. Finally, strengthening of staff quality, improvements in employee incentives, and streamlining the number of employees will be necessary to attain increased institutional capacity of the revenue collection agencies. Management of Expenditures 48. There is an urgent need to reduce overall government spending in Honduras and to improve the management and programming of both public investment and current expenditures. It will not suffice to institute short-term expenditure reduction targets in the current account in the absence of long-term managerial reforms. A primary goal of management reform in the Central Administration should be the establishment of effective and integrated systems for both investment programming and financial management. Investment Programming 49. Investment decisions in Honduras generally occur at the level of the executing agency without effective standards and norms, evaluation, prioritization, and centralized controls. There is neither sufficient linkage of annual investment planning to the medium term nor capacity for regional or local investment planning and coordination. Although the 1986 Planning Law gave technical responsibility to SECPLAN for short term operational activities and medium-term investment planning, this agency has neither the administrative nor technical capabilities to carry out this role. Ambiguity and lack of coordination also exists between programming responsibilities of SECPLAN and the project executing units and the financial or budgetary responsibilities of SHCP -- DGP (Budget Office) and DGCP (Public Debt Management Office) -- and BANTRAL. 50. To improve the investment programming process, first, there is a need to strengthen the coordination of the public investment process. A more efficient and effective public investment programming process calls for the restructuring of SECPLAN to focus on this major responsibility. Second, the institutional capacity of SECPLAN should be strengthened so as to enable it to effectively integrate, analyze, and monitor public investments. Third, standardized criteria should be developed for project selection, including the evaluation of a project's relationship with national development priorities. Fourth, the application of such criteria requires that individual planning units within key entities such as SECOPT, SRN, SEP, SSP, ENEE, HONDUTEL, and SANAA. be strengthened. Fifth, effective procedures for gathering, recording, and transmitting basic information on project goals, projected benefits, and the impact on basic indicators (e.g., employment) should be developed. Finally, the attainment of these reforms will likely imply the need for modification in the Law of Public Administration and abrogation of the Planning Law. 13 Financial Management 51. A primary source of inefficiency in the financial management system in Honduras is the unclear definition of responsibilities among agencies as well as the considerable duplication of activities at various stages of the budgetary process. Both SHCP and SECPLAN, for example, have direct responsibility for budget formulation and various aspects of budget execution and control. There is also an inadequate distribution of responsibilides among key financial management agencies within SHCP. While the DGP (Budget Office), CG (General Accounting Office, GAO), TGR (Treasury), and DGCP (Debt Management Office), each play a key role in the financial management system, the operational reality of the system concentrates treasury and accounting functions within DGP. Yet despite DGP's responsibility for day-to-day operations, there is no overall expenditure planning system. The absence of an efficient system of budget programming means there are few links between the operational aspects of financial management and policy formulation. 52. In addition to poor budgetary programming, a weak system of budgetary execution and control results from ineffective accounting norms, unreliable and untimely financial information, and tremendous duplication of effort. These problems stem largely from flaws in management of the financial information system, particularly in the flow of information between agencies. Contradictory information is provided by different agencies, and information is often interpreted in different ways by distinct users. 53. The following recommendations are given for strengthening the financial management system. First, the legal responsibilities among institutions at all levels of budgetary programming, execution, and control should be clearly defined. This calls for the removal of SECPLAN from the financial management system. Second, institutional control within DGP should be strengthened. This requires that DGP's institutional authority over current expenditures be firmly established and that extra-budgetary expenditures outside of DGP purview be eliminated or controlled. Third, a consistent and efficient system should be developed for recording financial data and transmitting it to the appropriate institutions. Finally, effective integrated financial management requires that, in the context of a clear arrangement for sectoral coordination and discipline, counterpart institutional structures within the secretariats and the Decentralized or Autonomous Institutions be created and/or strengthened to ensure compatibility and co-responsibility in the budget execution and control functions. In effect, this strengthening at the decentralized level will assure that SHCP does not assume authority and responsibility in a very centralized controlling fashion. Management of Internal Administration 54. Improvements must be made in the management of the internal administration. Current practice is characterized by a lack of clarity and overlap in responsibilities and authority across secretariats and agencies and by weak lines of authority within agencies. The absence of consistent organizational structures for administrative support functions has resulted in a high degree of centralization of responsibilities with little appropriate delegation of authority and 14 responsibility to the sub-Secretariat and other executing unit levels. Further, the absence of uniform and transparent personnel policies, along with weaknesses in the overall civil service system, have created uncertainty in the organizational environment and lowered staff motivation and morale. Finally, the absence of clear and consistent procurement procedures and facilities management creates the potential for fraud and abuse. 55. The establishment of a modern, integrated system for public sector internal resource administration requires reform in the following areas. First, a consistent design in organizational structure should be developed for all secretariats so that there is direct correspondence in administrative functions across the Central Administration. Second, within individual secretariats, clear and more decentralized lines of authority and accountability should be developed for administrative decisions. Third, transparent and consistent personnel, financial, and facilities management policies and procedures should be developed across all agencies in the Central Administration. Procurement policy in particular needs to be modernized, as current practices contribute to paralysis of government operations and increase the cost of doing business with the government. Management of Internal and External Control 56. It theory, the General Accounting Office (GAO-Contadurfa General) in Honduras has the responsibility for recording and consolidating all financial transactions of the Government, as well as for establishing accounting norms and practices. The GAO, however, is not prepared institutionally or in terms of personnel to carry out these functions. The annual report prepared by GAO offers little guidance for the annual budget process and provides virtually no control over finances. Delays in the preparation of the annual report are often more than one year. Excessive quantities of unanalyzed data are presented without any critical comments on the figures. Furthermore, this raw data represent substantial duplication of information produced by SHCP. 57. The following recommendations would aid in improving the general accounting function. First, the Government should increase the number and quality of personnel in the GAO, including the transfer of personnel located within the individual secretariats involved in the accounting function to the GAO. Second, uniform and transparent standards and procedures for basic financial accounting and management should be developed. Third, there is a need for standardization and centralized control of the financial information system, including the improvement of computer facilities and training of personnel in the use of these facilities. Finally, GAO should develop a consolidated financial statement for the entire public sector. 58. Like GAO, the Comptroller General (Controlaria General de la Repdblica-CGR) has insufficient capacity to perform its duty of external audit control. Although CGR is required to submit an audit report to Congress within 40 days of the end of the fiscal year, as well as an integrated Balance Sheet to the SHCP by April 30 of each year, actual submission of each is generally several years behind schedule. The institutional capacity and in particular the quality 15 of staff of COR is very weak largely because little funding is available for the agency. In addition, there is an absence of an institutional structure for internal control in the Central Government part of the-Executive branch. 59. To improve the functioning of COR, the Government should first assess pay and employment policies and hire more qualified personnel at significantly higher wages. The total number of staff, currently at 125, should be increased to a level that can handle a workload of an agency responsible for supervising some 1,300 entities., Second, there is a need for improvement in the information capabilities through expansion of computer facilities and staff training programs. Finally, as a first stage in the development of a more adequate institutional structure for internal control of the Executive branch, in the short term, an Internal Audit Agency (IAA) should be established within the national government, reporting directly to the Office of the Presidency.' In the longer term, this assumes the existence of an efficient unit of internal audit dully staffed in each secretariat and public sector entity. These units, while administratively depending from the secretary or head of the entity, would be technically coordinated and monitored by the IAA. C. Reform of the Decentralized Administration 60. In recent years, the Autonomous Institutions have been a primary source of increases in government expenditure in Honduras. This was partly due to the fact that the services provided by the State were extended to more affluent sectors of society. Several other factors have distorted the allocation of resources and reduced internal efficiency in the Autonomous Institutions, thus also contributing to rising expenditures and falling revenues. First, the role of institutions in the economy has not always been clearly defined. Second, public enterprises, particularly the public utilities and those in charge of transport services, have not had sufficient managerial autonomy from the Central Government. The incentive regime, the institutional and legal framework, as well as public policies have forced enterprises to deviate from their commercial goals and have thus discouraged efficiency. Third, some public agencies providing social services have strayed from their original mandates, making them unable to satisfy the needs of targeted groups. ' Similar Auditorfas del Ejecutivo Nacional operate efficiently in Mxico (SECOGEF) and are being developed in Argentina (SIGENAC). 16 Public Enterprises 61. Public Sector reform will have to include divestiture of a part or all of some public enterprises, and stricter control of their budgets during the stabilization process. Once the urgency of fiscal adjustment has been reduced, there is need for a broad-based reform of the relation between public enterprises and the Central Government to obtain greater managerial and financial autonomy of the public enterprises, combined with greater accountability through performance evaluation. Finally there is need for improvement In their competitive environment through a reduction in barriers to entry, forcing enterprises to respond to market pressures. Additional specific reform strategies will need to be designed according to the principal economic role of the enterprises. AgricUual and Food Distbtion Services Enteprse 62. The primary problem within public enterprises associated with agricultural and food distribution services is overregulation and excessive intervention in activities that could be more efficiently performed by the private sector. This applies to the enterprises involved in grain marketing (IHMA), food distribution (BANASUPRO), forestry (COHDEFOR), and coffee (IICAFE), as well as to the National Agrarian Institute (INA). 63. COHDEFOR, for example, has extended its role into all aspects of forestry development and exploitation, including production, pricing, control of private agents, marketing of processed wood products, as well as maintaining a legal monopoly on timber exports. It has supported inefficient regulatory mechanisms, including (i) a stumpage fee system that discourages thorough harvesting and results in "overgrading"; (ii) short term extraction permits (less than one year) that inhibit investment; and (iii) limits on foreign participation in enterprises related to forest exploitation. These distortions have contributed to an alarming rate of deforestation: Honduras' forested area declined from 6.8 million hectares in 1960 to an estimated 5 million in 1990. Deforestation has also resulted from the movement of landless families into the practice of slash and burn agriculture and extensive livestock ranching, flowing from perverse incentives associated with the agrarian reform. 64. In the coffee sector, IHCAFE has expanded its duties to include: support of small coffee producers by building roads and providing other infrastructural services; establishment of coffee production quotas for domestic and foreign markets; setting of domestic prices to neutralize the market power of the coffee toasters; quality control and the granting of export certificates; and, in the past, the administration of a fund to support producers. These services have been financed with revenues from a charge for export certificates of 7 lempiras per sack. This charge, combined with the 7 percent export tax on coffee, has created strong export disincentives. 65. INA (a "public institute") created in 1961 to carry out the agrarian reform has also not met its initial goals. The agrarian reform affected only 15 percent of total farm area, and the land titles granted by INA are only provisional, with about 70,000 of the beneficiaries 17 receiving land almost exclusively as "collective property" managed by cooperatives or producers associations. 66. The Government's program of price and commercial deregulation in the agricultural and food distribution sector should be continued and strengthened. IHMA should aggressively implement its agreed restructuring plan; in particular it should sell its silos, give up access to preferential exchange rates and credit, and reduce its role to maintaining a strategic grain reserve. BANASUPRO should clearly be privatized; at the minimum it should limit itself to market-cost sales of basic goods in low-income areas. 67. Reform of COHDBFOR and IHCAPE should focus on changes in the regulatory and incentive regimes, as well as measures to raise internal efficiency. It is recommended that both enterprises focus exclusively on regulatory functions and agricultural extension, avoiding direct production and commercial activities. The Government has already stated its intent to correct incentives in forestry through a gradual reduction in export duties on sawed timber, with their total elimination by 1993, and adjustments in stumpage fees to appropriate levels. In the coffee sector, the Government should institute a gradual deregulation of production, processing, and marketing of coffee. Reform of IHCAFE should include internal restructuring, measures to reduce expenditures, along with gradual deregulation and elimination of inefficient subsidies to producers. As a smaller enterprise, IHCAFE would have greater management capacity to carry out its primary tasks of agricultural extension, quality control, and eventually price regulation in an oligopolistic domestic market. 68. The agricultural sector reforms should be accompanied by a clearer definition of land titles, so as to discourage inefficient exploitation and predatory practices. INA could demand return of all unlawfully occupied public lands, however, it should adjudicate definitive titles to those able to prove they have been rationally exploiting the land for no less than 10 years, in accordance with the Government's initiative. Publi Iflities and Transpor Servce Enterprses 69. A primary problem associated with the public utilities (SANAA, ENEE, and HONDUTEL) and transport services enterprises (ENP-ports and FNH-railways) is lack of autonomy from the Central Government. The Government, for example, has maintained excessive intervention and has frequently given contradictory signals regarding PB employment. On the one hand, the Government has used PEs as a means to reduce unemployment so as to moderate social conflict. On the other hand, during fiscal adjustment periods the Government has established general and indiscriminate restrictions on the hiring of workers and prevented wage increases, which in some cases led to the departure of qualified personnel. The Central Government has also interfered in PE investment decisions, causing the allocation of resources to be determined based on political rather than profitability criteria. Finally, the Central Government's power to monitor the purchases and contracts of PEs has had the effect of curtailing the flexibility of purchasing and contracting policies and has often inhibited the fulfillment of commercial objectives. 18 70. Another area in need of reform is pricing policy. The price and incentive regimes for these PBs have tended to discourage productivity, thereby worsening the financial positions of enterprises. Tariffs were frozen for a number of years as an anti-inflationary measure. In September 1990 and again in May 1991, tariffs of some major companies were adjusted, leading to significant improvements in the financial positions of the public utilities and ENP. In an effort to address this problem, the Government recently established the "Comisi6n Nacional Supervisora de los Servicios Pdblicos" which will have the task of approving tariffs on the basis of the economic costs for providing services to each category of consumers. This commissio contains members representing the Congress, different secretariats of the Executive branch, and representatives of workers unions, and the private sector, and will face the challen.e of balancing political interests and technical criteria. 71. A broad-based reform of the PE institutional framework has to be implemented to obtain greater managerial and financial autonomy, combined with greater accountability through effective performance evaluation. Political authorities should reduce intervention on all levels of enterprise management. In addition to increased managerial autonomy, effective improvement of PE employment and wages administration requires elimination of excessive political and union interference. Economic criteria should predominate in making PE investment decisions, and mechanisms need to be developed for coordinating sectoral investment decisions and its financing among the agencies of the public sector involved in this process. Procurement procedures and the role of the Internal Auditors and the Office of Administrative Compliance (Direci6n General de Probidad Administrativa) have to be simplified and improved following modern practices. 72. The appropriate functioning of the price setting mechanism (the "Comisi6n Supervisora de los Servicios Pdblicos") has to be ensured, as well as the application of sound policy criteria for all services produced by these PEs. Gradual adjustments in real rates should be made in cases where prices are still below long-run marginal costs, particularly in SANAA and ENEE. Further rationalization of the tariff structures and improvement in revenue collection mechanisms is required. In SANAA subcontracting of meter reading and revenue collection is highly recommended. 73. The Government should investigate areas where deregulation would be feasible and efficient. The high value added services, such as telecommunications, could be gradually deregulated so as to allow for private sector participation. Privatization of Public Enterpses 74. The Honduran Government should also evaluate the desirability of a privatization program for these PEs, including the assessment of options to decentralize some activities, as stated under the new Law of Municipalities. Privatization offers the following advantages. First, if concessions are granted through a competitive auction, the state will receive the corresponding fees, in addition to the elimination of the budgetary burden of transfers from the Central Government. Second, if enterprise assets are sold, the Government will receive short- 19 term financing that can be used for debt-service payments. Third, privatization may foster increases in productive efficiency as a result of a clarification in property titles and elimination of distortionary intervention by the Government. 75. Given the experience with the privatizations that have already occurred in Honduras (primarily industrial, agro-industrial, and cattle enterprises), it is apparent that the agency responsible for privatization should be given greater political power, and improvements should be made in its institutional capacity. The reform of the legal framework of Public Enterprises is also required to support divestiture. The debt status of enterprises offered for sale also needs to be clarified, and eventually their debts should be assumed by the government. Finally, use of competitive auctions should be encouraged in all privatization cases, allowing international firms to participate, so as to maximize the return. Public Institutes 76. The Public Institutes are intended to provide administrative functions and services. The majority are concentrated in the areas of health services, social security, and education. A problem common to many of the PIs is lack of autonomy to carry out the specific goals of the institute. Many PIs havq representatives on their boards of directors, both from the Government and from private corporations that supply them with services.. The board of directors of the IHSS, for example, contains a representative from the Honduras Medical Association. This tends to reduce the Public Institute's autonomy and in some cases has caused employment and expenditures decisions to be based on political or other criteria without due attention to efficiency objectives. 77. Within the Public Institutes, the Honduran Social Security Institute (Instituto Hondureflo de Seguridad Social - IHSS) is in particular need of reform. Current revenues of IISS, which come primarily from wage-earner contributions, have been insufficient to cover current expenditures. Two practices have limited these contributions. First, the ceiling on mandatory contributions; second, many private firms (and even the public sector) evade totally or partially the payment of contributions. Low revenues have resulted in a dramatic and recurrent shortfall in the Medical Fund account which is covered by direct transfers from the Pension Fund. While this transfer resolves the short term deficit problem, in the longer term these reserves are intended for future beneficiaries. If this trend of gradual decapitalization is not corrected, the IHSS will eventually require direct transfers from the Central Government. While the recent measure that .increased the ceiling on mandatory contributions from 600 lempiras to 1500 will substantially strengthen IHSS finances (though constrained by the fact that collections are still very, weak), medical services will continue to be partially financed with transfers from the Pension Fund. Furthermore, budgetary constraints of the Medical Fund have also caused the quality of medical services to deteriorate. Medical personnel per 100 persons insured fell from 2.1 to 0.8 and the number of paramedics from 5.6 to 2.8 between 1986 and 1990. 20 78. A similar situation exists for the pension fund for public employees of the executive branch (INJUPBMP) and for the teachers' pension fund (INPREMA). In recent years their authorities have made low profit investments, thus jeopardizing their future financial situation and ability to satisfy future obligations. 79. As part of the public sector reform program, the Government should carry out a thorough evaluation of the Public Institutes to determine whether their original goals and mandates still hold and to find mechanisms for improving managerial efficiency. To improve budgetary performance and reduce dependence on the Central Government, the Public Institutes require a simultaneous increase in service charges, a reduction in personnel, combined with a gradual process of divestiture from some activities. Areas of divestiture might range from the subcontracting of in-house cleaning and maintenance to the replacement of some existing institutions with private ones. 80. Public Institutes that provide health services and manage pension funds (IWSS, INJUPEMP, and INPREMA) must be required to separate financially these two functions. The basic parameters of the social security system should be redefined to reestablish the long-term sustainability of the system. The following specific recommendations are made for reform of the IHSS. First, improvements should be made in IHSS's collection system to reduce delays in payment. Second, to eliminate the budgetary shortfall in the Medical Fund, IHSS should raise user charges for medical services. Third, rates and ceilings on pension fund contributions should be further reviewed on the basis of sound actuarial analysis. Foith, cross-subsidization of the Medical Fund through revenues from the Pension Fund should be curtailed and more effective investment of technical reserves in the Pension Fund should be established. Finally, the Government should explore mechanisms for encouraging private sector involvement in the pension fund market. 81. Public Institutes that provide educational services (UNAH and INFOP) should increase their own sources of revenue - mainly through the adoption of realistic pricing policies - and should also eliminate non-core functions. Municipalities 82. There are 289 municipalities in Honduras of various sizes and population densities. This high degree of municipal atomization, however, does not imply a high degree of political decentralization. The electoral system that restricts voters to cast votes for the same party in local and national elections implies that municipal leaders are highly dependent on the central power. From an economic viewpoint, this centralized system has led to a rather discretionary financial relationship between the Central Government and the municipalities. As a result, the municipalities have accumulated a debt of over 428 million lempiras (4.3 percent of GDP) through transfers from the Central Government and loans from BANMA (Banco 21 Municipal Aut6nomo).3 Such high debts have resulted in high debt service payments and growing arrears for the Municipalities which have contributed to BANMA's bankruptcy. 83. The Honduran Government has taken action to reduce the discretionary relationship between the municipalities and the Central Government through the adoption of the new Law of Municipalities. This law gives the municipalities full responsibility for the development, approval, and administration of budgets. The municipalities are also no longer required to contract with the national public enterprises for public utilities. Municipalities can therefore now contract independently for services that can be provided more efficiently locally, such as water distribution, sewage service, and the expansion and maintenance of public roads. Finally, an automatic mechanism for revenue sharing should replace the previously discretionary (and often politicized) system. The new law establishes that the Government will earmark 5 percent of tax revenues for municipalities, of which 20 percent will be allocated equally Rcross municipalities and 80 percent proportional to the number of inhabitants. 84. Even though the new law represents significant progress, problems still remain. In the new tax revenue-sharing system, there are no weights attached to fiscal efforts or to regional inequities in income distribution. Furthermore, coexisting with the 5 percent allotment of tax revenues, there are two preexisting mechanisms for municipalities to obtain national public revenues. First, there is the mandatory distribution of 4 percent of revenues collected by the National Port Enterprise (Empresa Nacional Portuaria - ENP) to municipalities where ENP ports are located. Second, the municipalities in which coffee is produced receive a share of coffee revenues. The greatest problem with the new law is that while it provides for mandatory decentralization of tax revenues, there is no provision for decentralization of expenditures. Municipalities are therefore able to increase their revenues without taking on the responsibility for providing additional services actually paid for by the Central Government-thereby increasing the total expenditure level and the overall deficit of the consolidated public sector. 85. The main recommendation for improving the relationship between the municipalities and the Central Government is to eliminate the existing asymmetry in the decentralization of public expenditures and public revenues. The municipalities should assume part of the expenditure responsibilities of both the Central Government and the Public Enterprises to prevent further deterioration in the fiscal deficit. Actual transfer of responsibilities can only take place once the required minimum institutional capacity has been developed in the municipal corporations; accordingly, a focused technical assistance program is warranted. iThe Central District and the San Pedro Sula Municipality account for 85 percent of the total debt. 22 D. Implementing a Reform Strategy 86. This study proposes three major areas for implementation of Honduran public sector reform: Administrative Reform; Public Sector Management Reform; and Reform of the Decentralized Administration including Public Enterprises, Public Institutes and Municipalities. While these three areas are seen as complementary parts of a broad strategy for public sector reform, actual implementation of reform measures will necessitate a clear definition of priorities and also will depend on the existence of feasibility conditions to ensure success of the reform process. An adequate sequence of reforms should result in greater capacity to implement a reform strategy. 87. The administrative reform of the public sector is the keystone for starting an ambitious process of state modernization. There are two reasons for this: (a) in Honduras administrative reform of the public sector is not only urgently required, but also feasible in the short term; and (b) since administrative reform would comprise the entire public sector, it thus provides an adequate context to prepare, at the institutional level, more specific restructuring and privatization programs, particularly for Decentralized or Autonomous Institutions. 88. Specifically, it is suggested that the first phase (12 to 18 months) of the proposed public sector reform program be comprised of the following: (a) the core of the administrative reform; this should include functional review, organizational change and resources rationalization with emphasis in public employment. The reform of civil service during this phase will target the number and composition of employees and the decompression of the salary scale; (b) continued efforts to strengthen public sector management systems in areas where there are ongoing efforts (tax administration, macroeconomic management, and public finance information systems) and new reforms and improvements in other systems which are crucial for the sustainability of the economic reform program (customs administration, investment programming, integrated financial management, internal administration and internal and external control); (c) reform of the institutional framework of the Decentralized Administration (to increase autonomy and improve accountability through performance evaluation) and of the policy environment (including generalization of cost based pricing, increased labor flexibility, elimination of litigious procurement practices and the establishment of sound rules for investment programming and financing), especially where Public Enterprises are involved; at the same time and with a view towards a deep reform of Decentralized Institutions (PEs and PIs), specific programs for restructuring/privatization will have to be prepared on a case-by- case basis for implementation during subsequent phases; 23 (d) on the basis of an action plan assistance should be provided to facilitate the implementation of the new, expanded role foreseen for the Municipalities. 89. In the second phase (involving two to three years or more) the programs for in depth restructuring/privatization of Public Enterprises and Public Institutes will be actually implemented. Also during this phase the new comprehensive civil service system will be consolidated including the establishment of adequate personnel policies (e.g. career development, incentives, training), salary scale and administrative procedures. Public sector management reforms and institutional strengthening programs in this phase will continue to be implemented and give emphasis to those functions for which, previously to the implementation of strengthening programs, major legal changes and/or other institutional and policy reforms will have to be undertaken. 24